Chapter 10 BEHAVIOURAL FINANCE The Irrational Influence

Outline

Key Differences between Traditional Finance and Finance Behavioural

Heuristic Driven Biases Frame Dependence Emotional and Social Influences Market Inefficiency Strategies for Overcoming Psychological Biases

Traditional Finance
People process data appropriately and correctly
People view all decisions through the transparent and

objective lens of risk and return People are guided by reason and logic and independent judgment Market price of a security is an unbiased estimate of its intrinsic value.

Behavioural Finance
People employ imperfect rules of thumb that predispose
them to errors Perceptions of risk and return are influenced by how decision problems are framed Emotions and herd instincts play on important role in decisions Often, there is a discrepancy between market price and fundamental value

Heuristic-Driven Biases
The important heuristic-driven biases and cognitive errors that impair judgement are
Representativeness Overconfidence Anchoring Familiarity Confirmation bias Illusion of Control Affect heuristic Regret aversion Aversion to ambiguity Innumeracy

Representativeness
Representativeness refers to the tendency to form judgments based on stereotypes. While representativeness may be a good rule of thumb, it can lead people astray. For example:

Investors may be too quick to detect patterns in data that are in fact random Investors may become overly optimistic about past winners and overly pessimistic about past losers Investors generally assume that good companies are good stocks

Over Confidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge and partly from the illusion of control People remain overconfident despite failures because they tend to ascribe their success to their skill and their failure to bad luck. Overconfidence manifests itself in excessive trading and the dominance of active portfolio management.

Anchoring

After forming an opinion people are unwilling to change it, even though they receive new information that is relevant.

Anchoring manifests itself in a phenomenon called the postearnings announcement drift. Stock market reacts gradually, not instantaneously, to unexpectedly bad (good) earnings.

Aversion To Ambiguity

People are fearful of ambiguous situations where they feel they have little information about the possible outcomes.

Aversion to ambiguity means that investors are wary of stocks that they feel they dont understand. On the flip side it means that investors have a preference for the familiar.

Innumeracy
People have difficulty with numbers. Trouble with numbers is reflected in the following: People confuse between nominal changes and real changes. People have difficulty in figuring out the true probabilities. People ignore the base rate and go more by the case rate.

Familiarity
People are comfortable with things that are familiar to them. The human brain often uses the familiarity shortcut in choosing investments. Indeed, familiarity breeds investment. That is why people tend to invest more in the stocks of their employer company local companies, and domestic companies.

Confirmation Bias

People tend to overlook information that is contrary to their views in favour of information that confirms their views. Investors often only hear what they want to hear. They spend more time searching for reasons supporting their views and less time searching for reasons opposing their views.

Illusion of Control
The outcome of an investment decision typically depends on a combination of luck and skill. In general, investors have an inflated view of how much control they have over outcomes. This bias is called the illusion of control and leads to over-optimism.

Affect Heuristic
People decide mostly on what feels right to them emotionally. They rely heavily on intuition and gut feeling. Psychologists refer to this as the affect heuristic. Like other heuristics, the affect heuristic involves mental shortcuts that can cause bias.

Regret Aversion
Regret is the emotional pain a person experiences when his decision turns sour. Regret of commission is the disappointment from taking an action, whereas the regret of omission is the disappointment from not taking an action. Regret of commission is typically more painful than the regret of omission. People avoid actions that cause regret.

Frame Dependence

Frame independent investors pay attention to changes in their total wealth. In reality, behaviour is frame-dependent. This means that the form used to describe a problem has a bearing on decisionmaking. Frame dependence stems from a mix of cognitive and

emotional factors.

Prospect Theory
According to the prospect theory people value gains/losses according to a S-shaped utility function shown below

Utility

Losses

Gains

Loss Aversion

The utility function is steeper for losses than for gains. This means that people feel more strongly about the pain from a loss than the pleasure from an equal gain about 2 times as strongly, according to Kahneman and Tversky. This phenomenon is referred to as loss aversion

Because of loss aversion, the manner in which an outcome is described either in the vocabulary of gains or in the

vocabulary of losses has an important bearing on decision making.

Mental Accounting

People separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance for them Mental accounting manifests itself in various ways: Investors tend to ride the losers People are more venturesome with money received as bonus People often have an irrational preference for stock paying high dividends.

Narrow Framing

Investors engage in narrow framing they focus on

changes in wealth that are narrowly defined, both in a crosssectional as well as in a temporal sense.

Narrow framing in a cross-sectional sense means that

investors tend to look at each investment separately rather than the portfolio in its totality

Narrow Framing
Narrow framing in a temporal sense means that investors pay
undue attention to short-term gains and losses, even when their investment horizon is long.

Since people are loss-averse, narrow framing leads to myopic risk aversion. So investors tend to allocate too little of their money to stocks

Behavioural Portfolio
The psychological tendencies of investors prods them to build their portfolios as a pyramid of assets as shown below

Options Commercial property

Stocks Bonds Residential house Cash

Shadow Of The Past

People seem to consider a past outcome as a factor in evaluating a current risky decision. In general, people are willing to take more risk after earning gains and less risk after incurring losses. Experimental studies suggest the following: House-money effect Snake-bite effect Other influences of the past are: Trying-to-break-even effect Endowment effect Status quo bias Cognitive dissonance

Emotional Time Line

Hope Decisions Fear Anticipation Anxiety Pride Goals Regret

Investors experience a variety of emotions, positive and negative. Positive emotions are shown above the emotional time line and negative emotions below the emotional time line.

Hope and fear have a bearing on how investors evaluate alternatives. The relative importance of these conflicting emotions determines the tolerance for risk

Herd Instincts And Overreaction

People tend to herd together. Moving with the herd, however,
magnifies the psychological biases. The heightened sensitivity to what others are doing squares well with a recent theory about fads, trends and crowd behaviour. Called the information cascade, this theory says that large trends or fads begin when individuals ignore their private information but take cues from the action of others. Information cascades lead investors to overreact to both good and bad news, causing stock market bubbles and crashes.

Market Inefficiency
Behavioural finance argues that, thanks to various behavioural influences, often there is a discrepancy between market price and intrinsic value. This argument rests on two key assumptions:

Noise trading Limits to arbitrage

Noise Trading
Noise traders may suffer from similar judgmental biases while processing information. For example : They tend to be overconfident and hence take more risk They chase trends They tend to put lesser weight on base rates and more weight on new information and hence overreact to news They follow market gurus and forecasts and act in a similar fashion

Correlated behaviour aggregate shifts in demand

Limits To Arbitrage
Arbitrage . . real world is limited of two types of risk Fundamental risk : buying undervalued securities tends risky .. because .. market may fall further & inflict losses Resale price risk : . . arises mainly . . fact . . Arbitrageurs have finite horizons : Arbitrageurs usually borrow money / securities . . pay fees periodically Portfolio managers . . evaluated every few months. This limits . . horizon of arbitrage.

Price Behaviour
Presence . . noise traders . . & limits to arbitrage . . Investor sentiment does influence prices Prices vary more warranted by changes . . fundamentals Indeed, arbitrageurs may also contribute to price volatility as they try to take adv mood swings of noise traders Returns over horizons of few weeks or months positively correlated . . arbitrageurs positive feedback trading Returns horizons . . few years . . negatively correlated arbitrageurs . . eventually help prices return to fundamentals.

Returns . . mean reverting .. emp . . evidence

L. Summers, does the stock market rationally reflect fundamental values, J. Finance (1986), 591-601 He proposes . . a plausible alternative . . emh Pt = Pt* + ut ut = ut-1 + vt Pt* Pt = Price = Fund Value ut and vt Random stocks IF 0 < < 1 Errors security prices persist but fade away. This is clearly consistent . . Shillers & de Bondt & Thalers evidence, & more generally with overreactions, fads . . mkt, & speculative bubbles

Critique of Behavioral Finance

Apart from presenting evidence of investor under-reaction (or overreaction), they must demonstrate that such investor behaviour is firmly grounded in human psychology. True, behaviouralists talk about things like representativeness heuristic and conservatism. But, a substantial proportion of academic finance community regards such links with skepticism. As Nicholas Barberies put it: They accuse behavioral finance theorists of going on a fishing expedition, sifting through texts of human psychology until they found something that could be related to the effects they are trying to explain. The debate over the findings of behaviouralists continues. As Nicholas Barberis put it: Researchers in behavioural finance are trying to build more robust and convincing models of the interplay of psychology and finance. On another front, firm believers in efficient markets are trying to understand the relationship between risk and return better in the hope this might shed light on the evidence.

Views Of Experts
J.M. Keynes : in point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield Irwin Friend : a broad overview of the past half century suggests that there have been numerous occasions when large bodies of investors have been emotionally affected by fads & fashions in wall street William Baumol : we have all seen cases where the behaviour of prices on the stock market has apparently been capricious or even worse, cases where hysteria has magnified largely irrelevant events into controlling influences

Strategies For Overcoming Psychological Biases

Understand the biases
Focus on the big picture Follow a set of quantitative investment criteria Diversify Control your investment environment Strive to earn market returns Review your biases periodically

Summing Up

The central assumption of the traditional finance model is that people are rational. However, psychologists argue that people suffer from cognitive and emotional biases. The important heuristic-driven biases and cognitive errors that impair judgment are: representativeness,

overconfidence, anchoring, aversion to ambiguity, and innumeracy. The form used to describe a problem has a bearing on

decision making. Frame dependence stems from a mix of cognitive and emotional factors.

People feel more strongly about the pain from a loss than the pleasure from an equal gain about 2 times as strongly, according to Kahneman and Tversky. This phenomenon is referred to as loss aversion.

People separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another.

Investors engage in narrow-framing they focus on sectional as well as a temporal sense.

changes in wealth that are narrowly defined, both in a cross The psychological tendencies of investors prod them to build their portfolios as a pyramid of assets.

People seem to consider a past outcome as factor in

evaluating a current risky decision. The emotions experienced by a person with respect to

investment may be expressed along an emotional time line. Thanks to information cascade, large trends or fads begin when individuals ignore their private information but take cues from the action of others. Due to various behavioural influences, often there is a

discrepancy between market price and intrinsic value. To overcome psychological biases, a disciplined approach is required.

Appendix 10 A NEUROECONOMICS

Divide between Theory and Practice

There seems to be a deep divide between the theory and practice of investing as the following table suggests:
In Theory Investors have well-defined goals. Investors carefully weigh the odds of success and failure. Investors know how much risk they are comfortable with. The smarter an investor is, the more money hell make.

In Practice Investors are not sure about their goals. Investors often act impulsively. The risk tolerance of investors varies with the market conditions. Many smart people commit dumb investment mistakes. For example, Sir Isaac Newton was financially wiped out in a stock market crash in 1720. People who pay almost no attention to their investments tend to do better. On average, professional investors do not outperform amateur investors.

People who monitor their investments closely tend to make more money. Greater effort performance. leads to superior

What Causes the Divide

What causes this divide? Neuroeconomics, a new-born discipline, helps in explaining this divide. A hybrid of neuroscience, economics, and psychology, neuroeconomics seeks to understand what drives investment behaviour, not only at a theoretical and practical level, but also at a biological level. This appendix presents some of the important insights and findings of neuroeconomics in a very condensed fashion and suggests some guidelines for improving the odds of investment performance. It draws mainly from a fascinating book titled Your Money & Your Brain written by Jason Zweig and published by Simon & Schuster.

Reflexive and Reflective Brain

There are two aspects of human brain, the reflexive (or intuitive) system and the reflective (or analytical) system. The reflexive system has served us for millions of years in an environment characterised by immediate threats. But in the modern world, characterised by considerable complexity, it is not enough. The reflective (or analytical) system resides largely in the prefrontal lobe of the brain. Neuroscientist Jordan Grafman calls it as the CEO of the brain. Jason Zweig describes its functioning as follows: Here, neurons that are intricately connected with the rest of the brain draw general conclusions from scraps of information, organise your past experiences into recognisable categories, from theories about the causes of change around you, and plan for the future.

Amygdala
Deep inside the brain is an almond-shaped tissue called the amygdala. When you face a potential risk, the amygdala (which is a part of your reflexive brain) acts as an alarm system. As Jason Zweig explains: The amygdala helps focus your attention, in a flash, on anything thats new, out of place, changing fast, or just plain scary. That helps why we overreact to rare but vivid risks. After all, in the presence of danger, he who hesitates is lost; a fraction of a second can make the difference between life and death.

Two Minds
Humans literally have two minds when it comes to time. On the one hand, we are impatient, fixated on the short run, eager to spend now, and keen on becoming rich quickly. On the other hand, we save money for distant goals (like childrens college education and our retirement) and build wealth gradually. Invoking the Aesops fable, neuroscientist Jonathan Cohen argues that a grasshopper and an ant battle within our brains to dominate over our decisions about time. The emotional grasshopper represents the reflexive brain and the analytical ant symbolises the reflective brain. To be a successful investor or a happy person you should learn to check the impulsive

Emotion and Reason

Pure rationality without emotions can be as bad as sheer emotions without reason. According to neuroeconomics, you get best investment results when you strike the right balance between emotion and reason. Our investing brains often drive us to do things that make emotional sense, not logical sense. This is because emotional circuits developed tens of millions of years ago make us crave for whatever feels like rewarding and shun whatever feels risky.

Intuition
Most judgments are driven by intuition. People who buy stocks rarely analyse the underlying business. Instead, they rely on a feeling, a sensation : amateur investors as well as professional investors. Portfolio managers constantly talk about their gut feeling. Intuition can yield fast and accurate judgments only when the rules for reaching a good decision are simple and stable. Unfortunately, investment choices are not simple and the key to success, at least in the short run, is seldom stable. As Jason Zweig put it: In the madhouse of the financial markets, the only rule that appears to apply is Murphys Law. And even that guideline comes with a devilish twist: Whatever can go wrong will go wrong, but only when you least expect it to.

Monetary Gains and Losses

A monetary gain or loss is not merely a financial or psychological outcome. It is also a biological change that has profound physical effects on the brain and the body. The neural activity of someone whose investments are making money is no different from that of someone who is on cocaine or morphine. The brain responds to financial losses the way it responds to mortal danger.

Expectation and Experience

Anticipation of a gain and its actual receipt are expressed in very different ways in the brain. happiness. Expectation, both good and bad, is more intense than actual experience. It often feels better to anticipate making money than actually making it. There is an old saying, tis better to hope than to receive. Why do we imagine that money will matter more than it really does? Jason Zweig explains: Its how the brain is built. The nucleus accumbens in your reflexive brain becomes intensively aroused when you anticipate a financial gain. But that hot state of anticipation cools down as soon as you actually earn the money, yielding a lukewarm satisfaction in the reflective brain that pales by comparison. This explains why money does not buy

Expectation and Experience

The brains anticipation circuitry does not evaluate potential gains in isolation. Evolution has designed the human brain to pay closer attention to rewards when they are characterised by risks we know that we have to be more careful in plucking a rose than picking a daisy. Psychologist Mellers has demonstrated that a gamble that can result in either a gain or a loss provides more relative pleasure than a gamble that offers only gain.

Pattern Seeking
The human brain incorrigibly searches for patterns even when none exist. There appears to be module in the left hemisphere of the brain that drives humans to search for patterns and to see causal relationships, even when none exist: Gazzamicga has named it the interpreter.

Dopamine and Reward

Wolfram Schultz, a neuropsychologist, and others have made important discoveries about dopamine and reward: 1. Getting what you expected does not provide a dopamine kick. Put differently, it is neutrally unexciting. That explains why drug addicts yearn for an even larger fix to get the same kick or investors hanker for fast rising stocks with a positive momentum. 2. An unexpected gain provides a dopamine kick or neural excitement. This makes people willing to take risks. 3. Dopamine dries up if the expected reward does not materialise. 4. Predictions and rewards of an earlier period evoke a fainter response of dopamine neurons.

Dopamine-drunk Wanting
Over millions of years our brains have developed a dopamine drunk wanting system that prods us to compete for more money, power, and material things. We are drawn to these things not because they bring happiness but because those who managed to get the stone-age equivalent of these things are our ancestors, and those did not , turned out be biological dead ends. As psychologist Daniel Nettle put it: I will argue that we are programmed for by evolution in not happiness itself, but a set of beliefs about the kinds of things that will bring happiness, and a disposition to pursue them.

Aversion to Randomness and Ignorance

Human beings hate randomness. So they compulsively predict the unpredictable. Just as nature abhors a vacuum, the human mind abhors the words, I dont know Inside each of us, there lurks a con artist who is forever cajoling us into an inflated sense of our powers. The Principal reason why we claim that we know more than we do is that admitting our ignorance erodes our self-esteem.

Exposure Effect
Human beings tend to like what they experience most often. Psychologist Zajonc call this the mere-exposure effect. Says Zajonc: The repetition of an experience is intrinsically pleasurable. It augments our mood, and that pleasure spills over anything which is in the vicinity. Aesop got it wrong when he said familiarity breeds contempt. On the contrary familiarity breeds contentment. Illustrating this, Jason Zweig says: You might think you like Coke better for the taste, when in fact you like it better mainly because its more familiar. Likewise, investors plunk money into brand-name stocks, precisely because the brand name makes them feel good.

Illusion of Control
Humans suffer from illusion of control, an uncanny feeling that they can exert influence over random choice with their actions. For example, when a person wants to roll a high number, he shakes the dice and throws them hard. The illusion of control tends to be stronger when an activity appears at least partly random, offers multiple choices, requires effort, and appears familiar. Since investing satisfies these tests, many investors suffer from the illusion of control. According to neuroeconomists, the caudate area which lies deep in the centre of the brain serves as the coincidence detector. In this part of the reflexive, emotional brain, actions are matched against the outcomes in the world around us, irrespective of whether they are actually connected or not.

Hindsight Bias
Once we learn what actually happened, we look back and believe that we knew what was going to happen. Psychologists call this hindsight bias. Says Nobel Laureate Daniel Kahneman Hindsight bias makes surprises vanish. People distort and misremember what they formerly believed. Our sense of how uncertain the world really is never fully developed, because after something happens, we greatly increase out judgments of how likely it was to happen.

Risk Tolerance
The conventional assumption that every person has a certain level of risk tolerance is not correct because our perception about risk changes all the time. As Jason Zweig puts it: In reality, your perception of investment risk is in constant flux, depending on your memories of past experiences, whether you are alone or part of a group, how familiar and controllable the risk feels to you, how it is described, and what mood you happen to be in the moment. Even a slight change in these elements can turn you from an adventurous bull to a cautious bear. If you mindlessly rely on your intuitive perception of risk, you are likely to assume risks that you should avoid and shun risks that you should embrace.

Surprise
Humans and great apes chimpanzees, gorillas, and organgutans have specialised neurons called spindle cells located in a central forward region of the brain called the anterior cingulated cortex (ACC). The ACC helps in generating the feeling of surprise when normal expectations are belied that is why some neuroscientists call it the Oops! centre.

Some Guidelines
You can improve the odds of your investment performance by engaging more on the reflective side of the brain. Here are some guidelines to help you in doing so. Rely on words and numbers, not sights and sounds Invest with rules Count to ten Take a global view Control the controllable Dont obsess Maintain an investment diary Track your feelings Rebalance Be happy

Control the Controllable

While you have no control over whether the stocks or funds you pick will produce superior returns, you can control Your expectations (by setting realistic expectations) Your risk (by asking how much can lose if you are wrong) Your readiness (by making sure you adhere to an investing checklist) Your expenses (by avoiding mutual funds with high management fees) Your commissions (by trading infrequently) Your taxes (by extending your investment period to at least one year) Your own behaviour (by not succumbing to the prediction addiction)

Be Happy
A very powerful lesson from the new research into happiness suggests that managing your emotions and expectations is as important as managing your money to your sense of well-being. According to Martin Seligman, an eminent psychologist, having, doing, and being are three basic paths to happiness. Having is concerned about material purchases and possessions what Martin Seligman calls the pleasant life. Doing centres around activities and experiences what Seligman calls the good life. Being is about committing yourself to a larger cause what Seligman calls the meaningful life. Money spent on having creates diminishing returns; the more accustomed you become to material possessions, the less happiness you derive from them. However, money spent on doing and being provides a much longer afterglow. As Jason Zweig puts it: In the end, living a rich life depends less on how much you own than on how much you do, what you stand for, and how fully you reach your own potential. There are many ways in which you can get happiness with minimal effort, such as learning new things, pursuing interesting hobbies, participating in social service, counting your blessings, breaking your routine and embracing new experiences, accentuating the positive, meditating, and so on.