Lecture 19

BEHAVIOURAL FINANCE
The Irrational Influence

Outline
Key Differences between Traditional Finance and Behavioural
Finance
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

Illusion of Control

Overconfidence

Affect heuristic

Anchoring

Regret aversion

Familiarity

Aversion to ambiguity

Confirmation bias

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

emotional factors.

a mix of cognitive and

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

Pt = Price

ut = ut-1 + vt

Pt*

= 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

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

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.

In Practice
Investors are not sure about their
goals.
Investors often act impulsively.

Investors carefully weigh the odds of

success and failure.

Investors know how much risk they are

comfortable with.

The risk tolerance of investors varies

with the market conditions.

The smarter an investor is, the more

money hell make.

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 monitor their investments

closely tend to make more money.

People who pay almost no attention to

their investments tend to do better.

Greater effort
performance.

On average, professional investors do

not outperform amateur investors.

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

power of your inner grasshopper.

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.

This explains why money does not buy

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.

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.