SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

Chapter 1 Introduction to Behavioural Finance

TERMS & DEFINITIONS
1. BEHAVIOURAL
FINANCE

2. LOSS AVERSION

3. RISK AVERSE
INVESTOR

4. GAMBLING

Behavioural finance is a relatively new field of study that seeks to

combine behavioural and cognitive psychological theory with
conventional economics and finance to provide explanations for
why people make irrational financial decisions. It also helps in
explaining why and how markets might be inefficient.
Loss aversion refers to the tendency for people to strongly prefer
avoiding losses than acquiring gains. Some studies suggest that
losses are as much as twice as psychologically powerful as gains.
A description of an investor who, when faced with two
investments with a similar expected return (but different risks),
will prefer the one with the lower risk.
A risk-averse investor dislikes risk, and therefore will stay away
from adding high-risk stocks or investments to their portfolio
and in turn will often lose out on higher rates of return.
Investors looking for "safer" investments will generally stick to
index funds and government bonds, which generally have lower
returns.
Gambling is defined as staking something on a possibility.
However, when stock trading is considered, gambling takes on a
much more complex dynamic than the definition presents. E.g.
wagering 500 with your friend that India will win the semifinals of the world cup.
Many traders are gambling without even knowing it - trading in
a way or for a reason that is completely dichotomous with
success in the markets.

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SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

5. SPECULATION

6. ARBITAGUER

Speculation is the act of trading in an asset, or conducting a

financial transaction, that has a significant risk of losing most or
all of the initial outlay, in expectation of a substantial gain.
With speculation, the risk of loss is more than offset by the
possibility of a huge gain; otherwise, there would be very little
motivation to speculate.
While it is often confused with gambling, the key difference is
that speculation is generally tantamount to taking a calculated
risk and is not dependent on pure chance, whereas gambling
depends on totally random outcomes or chance.
It may sometimes be difficult to distinguish between
speculation and investment, and whether an activity qualifies as
speculative or investing depends on a number of factors,
including the nature of the asset, the expected duration of the
holding period, and the amount of leverage.
Speculation has its benefits in a free economy. By their
willingness to assume the other side of the trade (for a price, of
course), speculators provide market liquidity and narrow the
bid-ask spread, enabling producers to hedge price risk.
Speculative short-selling may also keep rampant bullishness in
check and prevent the formation of asset price bubbles.
A type of investor who attempts to profit from price changes in
the market by making simultaneous trades that offset each
other and capturing risk-free profits.
An arbitrageur would, for example, seek out price changes
between stocks listed on more than one exchange, and buy the
undervalued shares on one exchange while short selling the
same number of overvalued shares on another exchange, thus
capturing risk-free profits as the prices on the two exchanges
converge.
Arbitrageurs are typically very experienced investors since
arbitrage opportunities are difficult to find and require
relatively fast trading.
Arbitrageurs also play an important role in the operation of
capital markets, as their efforts in exploiting price inefficiencies
keep prices more accurate than they otherwise would be.

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SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

7. ARBITRATION

8. IRRATIONALITY

The simultaneous purchase and sale of an asset in order to

profit from a difference in the price. It is a trade that profits by
exploiting price differences of identical or similar financial
instruments, on different markets or in different forms.
Arbitrage exists as a result of market inefficiencies; it provides a
mechanism to ensure prices do not deviate substantially from
fair value for long periods of time.
Given the advancement in technology it has become extremely
difficult to profit from mispricing in the market. Many traders
have computerized trading systems set to monitor fluctuations
in similar financial instruments.
Any inefficient pricing setups are usually acted upon quickly and
the opportunity is often eliminated in a matter of seconds.
Irrationality is thinking, talking or acting without inclusion of
rationality. It is more specifically described as an action or
opinion given through inadequate use of reason, emotional
distress, or cognitive deficiency.
The term is used, in behavioural finance, to describe thinking
and actions of the participants in a financial environment that
cannot be explained by theories based on rationality
assumption.

Chapter 2 Sense and Non-Sense in Corporate Finance

1. CAPM

Capital Asset Pricing Model A model that describes the

relationship between risk and expected return and that is used
in the pricing of risky securities.
Return = Rf + Beta*(Rm Rf))
The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk. The
time value of money is represented by the risk-free (Rf) rate in
the formula and compensates the investors for placing money
in any investment over a period of time.
The other half of the formula represents risk and calculates the
amount of compensation the investor needs for taking on
additional risk. This is calculated by taking a risk measure (beta)
that compares the returns of the asset to the market over a
period of time and to the market premium (Rm-Rf).

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SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

2. EMH

3. BELL-CURVE

Efficient Market Hypothesis An investment theory that states

it is impossible to "beat the market" because stock market
efficiency causes existing share prices to always incorporate and
reflect all relevant information.
According to the EMH, stocks always trade at their fair value on
stock exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices.
Although it is a cornerstone of modern financial theory, the
EMH is highly controversial and often disputed by behavioural
finance.
Meanwhile, while academics point to a large body of evidence
in support of EMH, an equal amount of dissension also exists.
For example, investors, such as Warren Buffett have
consistently beaten the market over long periods of time, which
by definition is impossible according to the EMH.
Also called the normal curve, it is a tool that a statistician can use
to tell how far the sample is likely to be off from the overall
population. The theory supported by this curve prescribes that
generally, majority of the investors earn only average returns.

THE NONSENSE in Corporate Finance:

1) The notion of RISK

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Very Very Important

for the Test

Risk as measured by BETA is a measure of volatility, but that is not all to the
definition of risk in behavioural finance.
Warren Buffet points out the following primary factors while judging RISK:
i. The certainty with which the long-term economic characteristics of the
business can be evaluated
ii. The certainty with which the management of the company can be
evaluated, both as to its ability to realize the full potential of the business
and to wisely employ its cash flows
iii. The certainty with which the management can be counted on to
channelling rewards from the business to the shareholders rather than to
itself.
iv. The purchase price of the business

SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

v. The levels of taxation and inflation that will determine the degree by
which the investors purchasing power return is reduced from his gross
return.

2) The relationship of RISK and RETURN

Lets suppose beta as being the correct measure of risk and we were to examine Page | 5
this relationship, lets look at following statements:
i. Stocks with higher beta dont outperform stocks with lower beta
ii. No two stocks with identical beta give the same return
These two statements have been empirically concluded, which means that either
beta is not the correct measure of risk or the relationship between beta and
return is not what we were taught.

3) CAPM

The first critique given against CAPM is that the risk cannot be measured as a
single statistic like BETA as it is impossible to represent all kinds of risk involved
with a business
The second critique is that the model smells of a feeling of ENVY. Envy in this
context can be defined as the rejection of opportunities that would make you
rich because others have better ones.
While CAPM advocates that one should reject a portfolio or investment if its IRR
(Internal Rate of Return) is less than WACC (Weighted Average Cost of Capital),
behavioural finance terms it as being envious. As Charlie Munger says, What the
hell do I care if somebody else makes money faster. Theres always going to be
somebody who is making money faster, running the mile faster or what have
you. Once you get something that works fine in your life, the idea of caring
terribly that somebody else is making money faster strikes me as insane. If
youve got a way of investing your money that is overwhelmingly likely to keep
you comfortably rich and someone else finds something that would make him
richer faster, that is not a big tragedy.

4) Markets are EFFICIENT

EMT says that no investor can beat the market and if someone does earn year
after year, then he or she just got lucky. But we have examples like Warren
Buffet, who are super-investors and they have beaten the market year after year
that means, they are not just lucky and hence the EMT is a non-sense theory.
As humans, stock markets are semi-psychotic creatures as they are made of
humans only. Thus, the notion of an efficient market cannot be true in reality as
the market tends to over-react or under-react to any kind of news.

SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

5) The assumption of HUMAN RATIONALITY

Is 1,000 saved on a 10 lac car is worth MORE than the 1,000 saved on a
10,000 lamp? After all the 1,000 saving when compared to 10 lacs looks SO
MUCH SMALLER than the 1,000 saving on a 10,000 lamp. In traditional
economics, the "rational" investor would have been indifferent about the 1000 Page | 6
gain but we all know a usual investor doesn't rank the gains as same. This is how
a human mind works and any financial models based on this assumption cannot
reflect reality.

6) The BELL CURVE

In a world described by the bell curve, most values are clustered around the
middle. The average value is also the most common value. Outliers contribute
very little statistically. If 100 random people gather in a room and the world's
tallest man walks in, the average height doesn't change much. But if Bill Gates
walks in, the average net worth rises dramatically.
Wealth does not follow normal bell curve instead in follows the L-shaped curve
If one observes Low Probability and High Impact events then, the bell curve is
the wrong distribution to use. This is the way the world works now-a-days, the
winner takes it all and rest get nothing.

WARREN BUFFET SAYS:

To invest successfully, you need not understand beta, efficient markets, modern portfolio
theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing
of these. That, of course, is not the prevailing view at most business schools, whose finance
curriculum tends to be dominated by such subjects. In our view, though, investment students
need only two well-taught courses - How to Value a Business, and How to Think About
Market Prices.
Source: 1996 Annual Report of Berkshire Hathaway

SESSIONAL TEST NOTES BEHAVIOURAL FINANCE

Chapter 3 The Psychology of Human Misjudgement

1. AVAILABILITY TRAP

2. VIVIDNESS

It refers to the mental shortcoming of the human mind, where a

person perceives that an event is more likely to occur if they are
easier to bring to mind.
Due to this trap, investors have a tendency to say, think or write
only what they know, no matter how unrepresentative it is. E.g.
Due to hike in interest rates by RBI on a particular day, many
stocks decline in price but it is not possible that every
companys financial position would get affected by the change
in interest rates.
Research has pointed out that under the availability trap,
humans are not reliable because they assess probabilities by
giving more weight to current or easily recalled information
instead of processing all relevant information.
An investor's lingering perceptions of a dire market
environment may be causing him/her to view investment
opportunities through an overly negative lens, making it less
appealing to consider taking on investment risk, no matter how
small the returns on perceived "safe" investments.
Perceived as bright and distinct; It is a factor which is
responsible for the "availability trap". E.g. more vivid the picture
more is our attraction towards the picture.
After the 9/11 terrorist attacks in New York and Washington
where around 3000 people died, many people in USA avoided
air travel and switched to cars for commuting. As a result of
increased traffic on roads, around 1500 people died in road
accidents during a time period of 2 months after the attack. The
vividness in the media coverage of the attack led to people
believing that road travel was safer than air travel.
Extra vivid annual reports of Temptation Foods (a fraudulent
company) resulted in seducing many investors as the Annual
Report contained pictures of nude women to attract eyeballs.

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3. RECENCY

This is the principle that the most recently presented items or

experiences will most likely be remembered best.
If you hear a long list of words, it is more likely that you will
remember the words you heard last (at the end of the list) than
words that occurred in the middle.
When the market is down, generally investors become
convinced that it will never climb out so they cash out their
portfolios and stick the money in a TV. They know the market
isnt going back up because the recency bias tells them so. But
then one day it does, and theyre left watching a really
expensive TV thats earning nothing.

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