3. Introduction
2
Behavioral Finance
What is it?
Study that seeks to combine psychology,
sociology, and traditional finance.
Helps explain why people make irrational
financial decision
Source: Yale University
Why is it important?
It is necessary because “technical analysis” assumes that people
act rationally
4. Introduction
2
History of Behavioral Finance
Over last 40 years, standard finance has
been the dominant theory
Academic Finance emphasized theories
such as modern portfolio theory and the
efficient market hypothesis
These theories failed to explain 2008
crash, dot com bubble etc.
Source: Yale University
Only recently, evolving and of increasing importance field of neuroscience
has also won appreciation from the finance industry.
Works of Kahneman (Nobel Prize Winner) is considered most creditworthy
5. Anomalies
3
Anomalies
Regular occurring anomalies is a big factor that contributed to the formation of
behavioral finance.
January Effect: Financial security
prices rise in the month of January.
Winner’s Curse: a tendency for the
winning bid in an auction that
exceed the intrinsic value of item
purchased.
Equity Premium Puzzle: Equity
returns less bond returns have
Source: The Economist
been roughly 6% for the past
century.
6. Key Concepts
6
Prospect Theory and Loss-Aversion
Investor decision weights tend to overweigh small probabilities and underweigh moderate and high probabilities.
Basing decisions on perceived gains rather than perceived losses.
Example
Option 1
Guaranteed Profit of $5,000
Option 2
80% chance of gaining $7,000
20% chance of gaining $0
Question: Which option would give the best chance to maximize your profits?
Correct Answer – Option 2
If investors are faced with possibility of losing money, they often take riskier
decisions aimed at loss aversion.
7. Key Concepts
4
Anchoring
Using irrelevant info as a reference for evaluation.
For example, assuming decline in a stock price is only temporary.
Example
Source: Thinking Fast & Slow
Thus, investors tends to focus on message’s content rather than its relevance
when making financial decisions.
8. Key Concepts
4
Mental Accounting
Dividing current and future assets in separate portions.
Results in different level of utility of each portion
provokes bias and other behaviors.
Examples
Option 1
Would you drive 20 min to save $5 on a
$15 calculator?
Option 2
Would you drive 20 min to save $5 on a
$125 jacket?
Question: What option will you choose?
This theory helps explain irrational financial behavior. For example, why you
bought so many calculators on sale when you only needed one.
9. Key Concepts
4
Confirmation & Hindsight Bias
Confirmation Bias – having preconceived opinion which serves as self-fulfilling
prophecies.
Hindsight Bias – believing that past event was predictable and obvious
Examples
Investors will be overly
optimistic and overvalue their
talents when sharing stories.
Investors will put greater
weight on their knowledge
than it should have.
10. Key Concepts
5
Gamblers Fallacy
Lack of understanding resulting in incorrect assumptions and predictions about
the onset of events.
E.g investors viewing further declines and improbable.
Examples
Investors – “After all those losses, I am due to WIN!”
Parents – already have three daughters but are overly optimistic that their next
child will be a male.
Entrepreneurs – “I have failed so many times, success is around the corner.”
11. Key Concepts
5
Herd Behaviour
We are programmed to feel that the consensus view must be the correct one
Imitating behavior and actions of others.
Examples
Health Choices – Eating habits of the western
world, smoking of groups etc.
From US Housing Bubble, Dot Com Crash in
2001and the Credit Crisis of 2008.
Source: The Economist
12. Key Concepts
5
Overconfidence
Being overconfident in your stock-picking ability
Results in increased number of trades
Examples
Investors - “I know exactly how to evaluate stocks”.
Thus, I don’t need a second opinion.
Entrepreneurs – despite knowing the statistics, they
strongly believe “their chance of failing is zero”
13. Key Concepts
6
Overreaction and Availability Bias
Overreaction - Investors overreact to news and create larger than appropriate
effect on a security price
Availability – our thinking is strongly influenced by what is personally most
relevant, recent or dramatic.
Examples
Investors – weighing their financial decision on most
recent news.
Lottery Winners – buy it because they recall memory
of people who won.
14. Conclusion
6
Closing Comments
Being consciously aware of these biases or irrational behaviour will allow us to
better make investment decisions
Practise critical thinking and study your thought process during investment
decision making
Allows you to provide better investment recommendations to your clients
Suggested Reading
Book: Thinking Fast and Slow
By: Daniel Kahneman
(Noble Prize Winner in Economics)