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Behavioral Finance

Behavioral finance is the study of how psychology influences the behavior of investors and financial analysts. It challenges the assumptions of rationality, self-interest, and perfect information that are used in traditional economic theory. Traditional finance looks at how investors should behave, while behavioral finance studies actual investor behavior and the cognitive biases that influence financial decisions. Some of the key cognitive biases discussed in the text include loss aversion bias, framing bias, anchoring bias, herd mentality bias, mental accounting bias, overconfidence bias, self-attribution bias, and confirmation bias. The document provides examples and explanations of each bias.

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108 views20 pages

Behavioral Finance

Behavioral finance is the study of how psychology influences the behavior of investors and financial analysts. It challenges the assumptions of rationality, self-interest, and perfect information that are used in traditional economic theory. Traditional finance looks at how investors should behave, while behavioral finance studies actual investor behavior and the cognitive biases that influence financial decisions. Some of the key cognitive biases discussed in the text include loss aversion bias, framing bias, anchoring bias, herd mentality bias, mental accounting bias, overconfidence bias, self-attribution bias, and confirmation bias. The document provides examples and explanations of each bias.

Uploaded by

LAZY TWEETY
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Behavioral Finance

Behavioral finance, commonly defined as the


application of psychology to finance
•Behavioral finance is the study of influence of psychology
on the behavior of investors or financial analysts.
•It is a field of study that utilizes psychology to understand
how investors make financial decisions, both individually
and as a whole, while challenging (1) the “rationality,” (2)
“self-interest,” and (3) “perfect information” of traditional
economic theory.
Difference between Traditional Finance and Behavioral Finance

Traditional Finance is based on assumption of how


investors and market should behave whereas Behavioral
Finance attempts to understand and explain actual
investor behavior.
Biases in Behavioral Finance
Self-attribution bias

Heads I win, tails it’s chance.

-Ellen Langer and Jane Roth


Self-attribution is a cognitive phenomenon by
which people attribute failures to situational factors
and successes to dispositional factors.
Self-serving bias can actually be broken down into
two constituent tendencies or subsidiary biases.

1. Self-enhancing bias

2. Self-protecting bias

How to limit the self serving bias?


Loss Aversion Bias

•A tendency to avoid losses.


•People are risk takers but loss averse.
•Selling Winners and Holding Losers.
•How to overcome Loss Aversion?
Framing Bias
● A tendency to decide on the basis of way the information is presented
rather than on the facts.
● Example - when questions are worded in the “gain” frame, a risk-averse
response is more likely. When questions are worded in the “loss” frame,
risk -seeking behavior is the likely response.
● How to guard against Framing Bias?
Which line is longer?
A company has not been able to achieve its target of 20% profits. It missed its
profit margin by 10 percent.

A company’s profits are 10 percent higher than the previous year’s profits.
Option 1: “In Q3, our Earnings per Share (EPS) were $1.25, compared to expectations of $1.27.”

vs.

Option 2: “In Q3, our Earnings per Share (EPS) were $1.25, compared to Q2, where they were $1.21.”
Anchoring Bias
•Anchoring bias occurs when people rely too much on pre-existing
information or the first information they find when making decisions.
•What is the stock price of IRCTC? Or 52 week high-low?
•How to avoid anchoring bias?
“Am I analyzing the situation rationally, or am I holding out to attain an
anchored price?” When making forecasts about the direction or
magnitude of markets or individual securities, ask yourself: “Is my
estimate rational, or am I anchored to last year’s performance
figures?”
Overconfidence
overconfidence can be summarized as unwarranted faith in one’s intuitive
reasoning, judgments, and cognitive abilities.
● A tendency to overestimate our skills.
● Underestimating downside risk, trading too frequently and/or pursuit of the
next best performance stock and holding an undiversified portfolio.
● Types of Overconfidence - Prediction overconfidence and Certainty
Overconfidence
● Behaviors that can cause investment mistakes
● How to overcome overconfidence?
Herd Mentality Bias
● Herd mentality bias refers to investors’ tendency to follow and copy what other
investors are doing. They are largely influenced by emotion and instinct, rather
than by their own independent analysis.
● Herding is the idea that people feel most comfortable following the crowd and
tend to assume the consensus view to be the correct one.
● How to avoid herd bias
● Switch off autopilot (Review)
● Make a conscious effort to form your own opinion
● Take time when making decisions
● Remember that stress affects decision-making
Mental Accounting Bias
Refers to the coding, categorization and evaluation of financial decisions.

Current income and future income - the propensity to consume is greatest from
the current income account while sums designated as future income are treated
more conservatively.
Mental Accounting Bias Test
Question 1—Part A: Suppose that you are at a warehouse store, where you intend
to purchase a flat screen television. The model you’ve selected is priced at $750,
and you are about to pay. However, at the last minute, you notice a discarded
advertising flier featuring the same television—at a price of $720. You retrieve the
ad, examine it more closely, and discover that the offer is still valid. To receive the
discount, you’ll need to drive to a competing electronics outlet about 10 minutes
away. Will you get into your car and travel to the other store to take advantage of
the lower price?

a. Yes. b. No
Question 1—Part B: Now suppose that you are in the same warehouse store, this
time to buy a mahogany table. The table that you want costs $4,000, and you are
willing to pay. While you are waiting, you strike up a conversation with another
store patron, who reveals that she’s seen the same table available for $3,970 at a
competing local furniture store about 10 minutes away. Will you get into your car
and drive to the other store to obtain the lower price?

a. Yes. b. No.
Confirmation Bias
Confirmation bias refers to a type of selective perception that emphasizes ideas
that confirm our beliefs, while devaluing whatever contradicts our beliefs.

It refers to the tendency of people to pay close attention to information that


confirms their belief and ignore information that contradicts it.

confirmation bias refers to our all-too-natural ability to convince ourselves of


whatever it is that we want to believe. We attach undue emphasis to events that
corroborate the outcomes we desire and downplay whatever contrary evidence
arises.
Investors often fail to acknowledge anything negative about
investments they’ve just made, even when substantial evidence
begins to argue against these investments.

How to overcome the confirmation bias?

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