As an Investment Advisor, you will have to play an important role in enabling your clients to reach their financial goals without the emotions of fear or greed playing havoc. It is essential to understand Behavioural Finance, especially Heuristics and Biases that creep into financial decision making.

1. BEHAVIOURAL FINANCE
FIRDAUS KHAN
Associate Professor, Dept. of Finance.
ICBM-SBE, Hyd. India
firdaus@icbm.ac.in

2. firdaus@icbm.ac.in

3. What is Behavioral Finance?
• The study of psychological
factors on financial decision
making.
firdaus@icbm.ac.in

4. Behavioral Finance
It attempts to answer the question:
why stock market anomalies (abnormal trends)
arise & persist for some period of time?
It uses Psychology + Fin. theory to understand
- how information structure and nature of
market participants
- can systematically influence
- individuals' investment decisions as well as
final market outcomes.firdaus@icbm.ac.in

5. BEHAVIOURAL FINANCE
Structure of
Mkt. info
Nature of
mkt.
participants
INDIVIDUAL
DECISIONS
+MKT.
OUTCOMES
firdaus@icbm.ac.in

6. DEFINITION
• Behavioral Finance is a sub-field
of behavioral economics that proposes
psychology-based theories to explain
stock market anomalies, such as severe
rise or fall in stock prices.
• The purpose is to identify and understand
why people make certain financial
choices.
firdaus@icbm.ac.in

7. W..H..A..T!!
• EMOTIONS???
• MENTAL ERRORS???
• In financial decision making?
firdaus@icbm.ac.in

8. WHAT IS THIS?
firdaus@icbm.ac.in
Keep distance of 10 feet between your car and
the car in front of you

9. WHAT ARE THESE?
• Judge the distance of an object by its clarity
• Judge the distance of a person by her size
• Save 10% of your income for retirement
• 100 – age = % to invest in shares (If 25 years
old invest 75% in shares. If 70, invest 30%)
• Never borrow on credit cards
THESE ARE HEURISTICS
firdaus@icbm.ac.in

10. HEURISTICS
firdaus@icbm.ac.in

11. HEURISTICS
• Heuristics are rules or strategies for
information processing, which help to make a
quick but not necessarily optimal decision.
• When people are overwhelmed by
information processing they use heuristics to
control extreme complexity
• Heuristics help to find a QUICK (but NOT
NECESSARILY OPTIMAL) SOLUTION.
firdaus@icbm.ac.in

12. The problem with Heuristics
• Sometimes heuristics are good for making
decisions, while sometimes they are bad.
• It is a mixed verdict…
• …because heuristics act faster than rational
deliberation, but precisely because of their
speed, heuristics can mislead us into
systematic errors in making decisions.
firdaus@icbm.ac.in

13. What Heuristics do ….
• Speed up cognition
• Give a quick, approximate solution
• Occasionally give incorrect answers
or errors
• Systematic errors are called
“biases”

14. When does a Bias occur?
• When people’s actions are based on feelings
or perceptions, not on facts.
• Biases are of two types:
1. Cognitive – relating to perception, memory,
judgment, and reasoning
2. Emotional – relating to sentiments
firdaus@icbm.ac.in

15. firdaus@icbm.ac.in
Heuristics & Biases in Investing
decision making

16. ?????
firdaus@icbm.ac.in

17. 1. Representativeness Bias
• A faulty heuristic based on the presumption
that once people or events are categorized,
they share all the features of others members
in that category.
• It is similar to stereo-typing.
• small cap companies ill managed,
fraudulent. Avoid!! Is this the correct decision?
firdaus@icbm.ac.in

18. Have you seen this?
• Father to son: “You only did something wrong,
I am sure. Your coach will not remove you
from team just like that.”
• Participant in talent show: “I performed so
well, but they didn’t choose me. They don’t
know anything about singing. Who made
them judges!!”
firdaus@icbm.ac.in

19. 2. (Self) Attribution Bias
• When people evaluate or try to find reasons
for their own behavior or other people’s
behavior.
• Attribution can be internal or external.
• SELF – ENHANCING BIAS
The good outcome occurred because of me!
• SELF – PROTECTING BIAS
The bad outcome occurred because of them!
firdaus@icbm.ac.in

20. Reflect…
• Why parents in India get uneasy when girls are
travelling by Ola or Uber?
• Why do people still feel uneasy to invest in
stock markets?
firdaus@icbm.ac.in

21. 3. Anchoring
• Anchoring is a cognitive bias that describes
the common human tendency to rely too
heavily on the first piece of information
offered (the "anchor") when making decisions.
• During decision making, anchoring occurs
when individuals use an initial piece of
information to make subsequent judgments.
firdaus@icbm.ac.in

22. Reflect…
• What was the response of Indians to ULIP?
• Why FD is preferred?
• Pension vs. Insurance vs. Provident fund
firdaus@icbm.ac.in

23. 4. Aversion To Ambiguity
• People prefer known risks over unknown risks.
• An ambiguity/uncertainty averse individual
would rather choose an alternative where the
probability distribution of the outcomes is
known over one where the probabilities are
unknown.
firdaus@icbm.ac.in

24. Virtually Impossible – is it?
• In a lottery in which six numbers are selected
out of fifty, what are the chances that the six
numbers will be 1, 2, 3, 4, 5, and 6?
• Equally probable to any other combination
• 50C6 = 1 in 5,464, 817, 280
firdaus@icbm.ac.in

25. 5. Innumeracy Bias
•People have difficulty in figuring
out "true" probabilities.
•Also, calculation of discounts
and premiums are difficult for
people.
firdaus@icbm.ac.in

26. Use of ….
• Full time salary
• Part time earning
• Interest income
• Gift money
firdaus@icbm.ac.in

27. 6. Mental Accounting
• Individuals divide their current and future
assets into separate, non-transferable
portions.
• Individuals assign different levels of utility to
each asset group, which affects their
consumption decisions and other behaviors.
firdaus@icbm.ac.in

28. Discuss
• Heat or cold waves
• Tiger attack, train/plane crash
• Rich, educated dalits
firdaus@icbm.ac.in

29. 7. Availability Bias
• Human tendency to judge an event by the ease
with which examples of the event can be
retrieved from memory, memorable = common
• People misjudge the frequency and magnitude
of recent events
• Importance of event depends on how easily
and clearly you can remember it…
• Media can influence issues at societal level
firdaus@icbm.ac.in

30. ???
firdaus@icbm.ac.in

31. 8. Confirmation Bias
• Have you noticed that you put more weight
into the opinions of those who agree with
you?
• Confirmation bias occurs when people seek
out information that confirms their existing
opinions and overlook or ignore information
that refutes or challenges their current beliefs.
firdaus@icbm.ac.in

32. ???
firdaus@icbm.ac.in

33. 9. Hindsight Bias
• People overestimate their ability to have
predicted an outcome that actually could not
possibly have been predicted.
• After an event, people often believe that they
knew the outcome of the event before it
actually happened. The phenomenon has
been demonstrated in a number of different
situations, including politics, war and sporting
events
firdaus@icbm.ac.in

34. firdaus@icbm.ac.in

35. 10. Gambler’s Fallacy
If something happens more frequently
than normal during a given period, it will
happen less frequently in the future (or
vice versa).
When an individual falsely believes that
the occurrence of a certain random event
is less likely to happen following a series
of occurrence of that event.
firdaus@icbm.ac.in

36. firdaus@icbm.ac.in

37. 11. Herd Behavior
• Herd behavior describes how individuals in a
group can act collectively without centralized
direction.
• The term can refer to the behavior of animals in
herds or packs, and is emulated by humans in
demonstrations, riots and general strikes,
sporting events, religious gatherings, episodes of
mob violence and everyday decision-making,
judgement and opinion-forming.
• It is also called Bandwagon Effect. Panic selling
and greed based purchase are seen on stock
markets.
firdaus@icbm.ac.in

38. Think of your mind set in each
• Paying Rs. 200 for something you
thought was free.
firdaus@icbm.ac.in
• Paying Rs.1400 for something
that you thought would cost Rs.
1200

39. 12. Framing
• The framing effect is an example of
cognitive bias, in which people react
to a particular choice in different
ways depending on whether it is
presented as a loss or as a gain.
firdaus@icbm.ac.in

40. firdaus@icbm.ac.in

41. 13. Loss Aversion
• People’s tendency to prefer
avoiding losses than to acquiring equivalent
gains: it is better to not lose Rs.500 than to
find Rs.500.
• Sometimes people have a stock (or more
than one stock) in their portfolio that is
down so much that they cannot accept the
thought of selling the stock/s. In reality, if
the stock is sold the money that is left could
be reinvested into a higher quality stock.
firdaus@icbm.ac.in

42. Thank you!
firdaus@icbm.ac.in