Behavioural finance

Traditional Finance vs Behavioural Finance

People process data appropriately & correctly All decisions through lens of risk & return People are guided by logic, reason & ind judgement Markets are efficient price = intrinsic value People employ imperfect rules of thumb Perceptions influenced by frame dependence Emotions & herd instinct influence decisions Discrepancy between market price and fundamental value

Danel Kahneman & Amos Tversky

US is preparing for an unusual disease expected to kill 600 people. If Program A is adopted 200 people will be saved (72%) If program B is adopted, 1/3rd probability that 600 people will be saved and 2/3rd probability that no one will be saved (28%)

 If program C is adopted, 400 people will die (22%) If program D is adopted, there is a 1/3rd probability that 600 people will be saved, and 2/3rd probability that no one will be saved (78%)

Behavioural finance
Study the effect of social, cognitive and emotional factors on economic decisions and consequences for market prices, returns and resource allocation

Themes in behavioural finance

Heuristics decisions on approximate rule of thumb and not strict logic Framing collection of anecdotes and stereotypes Market inefficiencies mis-pricing and non rational decision making

Inefficiencies
Under/Over reaction to events cause for market trends limited investor attention, overconfidence, over-optimism, herd instinct, noise trading. Loss aversion The economic premium theory

 Mutual Fund investors are predictably irrational Various behavioural biases influence their investment decision A) chase past performance B) reluctant to sell their losses C) react differently to different forms of fund expenses D) attribute successful outcomes to own skill and unsuccessful to bad luck.

 Prospect theory (Tversky and Kanheman) how people manage risk and uncertainty not consistently risk averse depends on outcomes certainty effect. Regret theory- the emotional reaction experienced after realising you have made a mistake Anchoring

Biases
Representativeness jump to conclusions based on limited information, stereotypes Anchoring and adjustment anchor your understanding of a situation on a familiar one. Availability bases probability assessments on recent or visible events. Overconfidence Path of least resistance

 Behavioural finance provides little insight into A) Causes of behavioural biases B) Impact of these biases on investors decision making process