BEHAVIOURAL FINANCE

MODERN PORTFOLIO THEORY

Introduction

• originally proposed by Harry Markowitz in the 1950s

• First attempt to quantify the risk of a portfolio and develop a methodology for
determining the optimal portfolio.
• He was the first person to show quantitatively why and how diversification reduces risk
• modern portfolio theory has led to a mathematical explanation of the expression
• Investors will consider the co-variation between the different assets
when they investing.
• As the number of assets in a portfolio increases, the covariance
increasingly makes up a greater part of an individual assets
contribution to the total risk of a portfolio
• MPT concept is to chose the right combination (or proportions) of
these assets to the optimal portfolios.
ASSUMPTIONS OF MODERN PORTFOLIO THEORY

• Investors ask for maximizing the expected return of their total wealth
• All investors have the similar expected single period investment
horizon
• All investors are risk-averse
• Investors base their entire investment decision on the expected
return and risk.
• Investors prefer higher returns to lower returns for a given level of
risk.
Another assumptions
• For buying and selling securities there are no transaction costs
• An investor has a chance to take any position of any size and in any
security
• Investors are generally rational and risk adverse
• The risk-return relationships are viewed over the same time horizon
• Investors share identical views on risk measurement.
• Investors seek to control risk only by the diversification of their
holdings.
• In the market all assets can be bought and sold including human
capital
• Politics and investor psychology have no influence on market
• The risk of portfolio depends directly on the instability of returns from
the given portfolio.
• An investor gives preference to the increase of utilization
• An investor either maximizes his return for the minimum risk or
maximizes his portfolio return for a given level of risk.
• Investors prefer more over less
• Utility is a function of expected return and variance and nothing else
• There is no distortion from inflation
CENTRAL CONCEPTS OF MARKOWITZ’S MODERN PORTFOLIO
THEORY

• Maximize Return - Minimize Risk

Any investor’s goal is to maximize return for any level of risk

• Diversified Portfolio & the Efficient Frontier

Risk can be reduced by creating a diversified portfolio of unrelated assets
CRITICISM OF MODERN PORTFOLIO
THEORY
• The behavioural economists have proven that the assumption on
“investors’ acting rationally” is wrong.
• the expectations of investors are biased.
• The opinion that investors do not need to pay any taxes or transaction
costs does not hold true.
• some securities have the minimum order sizes, and securities cannot
be bought or sold in fractions.
• Besides, investors have a credit limit which does not allow them to
lend or borrow unlimited amounts of shares
• great amount of sale and purchase of separate securities has an
impact on the price value of the security or related securities
• The critics also challenge the idea that the actions of investors do not
have an influence on the market
• the correlations between assets are never stable and fixed; they tend
to change together with the changes in the universal relations
• experienced investors consider past performance not to be a
guarantee of future performance.
IMPORTANCE OF MPT FOR RISK
MANAGEMENT
• The theory is of vital importance when it comes to financial risk management
• the results of its implication lead to portfolio optimization with either the same
expected return with less risk than before or a higher expected return with the same
level of risk
• traders cannot simply rely on a single investment for financial stability
• representing quite a new approach and range of opportunities in the financial
markets
• NetTradeX platform, allows any trader, investor to realize diverse trading strategies, by
allowing to combine assets of their choice and create unique personal instruments
• All these features are oriented towards the investors’ benefits and make it possible to
make a profit through minimizing the risk of loss
CAPITAL ASSET PRICING MODEL
(CAPM)
CAPM is concerned with two key questions

• What is the relationship between risk and return for an efficient

portfolio?
• What is the relationship between risk and return for an individual
security?
CAPITAL ASSET PRICING MODEL
(CAPM)
• The capital asset pricing model was developed in mid-1960s by three
researchers William Sharpe, John Lintner and Jan Mossin
independently.
• the model is often referred to as Sharpe-Lintner-Mossin capital asset
pricing model
• Capital Asset Pricing Model is a theoretical model for pricing
individual security
• It helps in determining the appropriate rate of return for an asset that
is to be added to a diversified portfolio, given the risk of that
particular asset.
Content….
• The core idea of this model is that investors need to be compensated for the
time value of money and market specific risk.
• As per the model, the difference in the expected returns of any two assets can
be related to the difference in their betas
• each security is expected to provide a return that is commensurate with its level
of risk, measured in betas
• This is applicable not just for individual securities, but to all portfolios— efficient
or inefficient
• The model states that the only important ingredient that determines expected
returns is the systematic risk
• All unsystematic risks can be eliminated through diversification
ASSUMPTIONS OF CAPM
• Investors are risk averse
• Security returns are normally distributed.
• The utility function of investors is quadratic.
• Investors have homogeneous expectations - they have identical subjective
estimates of the means, variances, and covariances among returns.
• Investors can borrow and lend freely at a riskless rate of interest.
• The market is perfect: there are no taxes; there are no transactions costs;
securities are completely divisible and the market is competitive.
• The quantity of risky securities in the market is given
ELEMENTS or COMPONENTS OF CAPM
• Capital Market Line
• Security Market Line

Capital Market Line :-

Capital market line is the graph of the required return and risk (as measured by standard
deviation) of a portfolio of a risk-free asset and a basket of risky assets that offers the best risk-
return trade-off.
The rational investors would choose a combination of Rf and S (S represents the point on the
efficient frontier of risky portfolios)
If all investors attempt to purchase the securities in S and ignore securities not included in S, prices
of securities would be revised
prices of securities included in S would rise and hence, their expected returns will fall
prices of securities not included in S will fall, leading to an increase in their expected return
Adjustment of the Efficient Frontier
• Portfolios which have returns that are perfectly positively correlated
with the market portfolio are referred to as efficient portfolios.
Obviously, these are portfolios that lie on the linear segment.
• For efficient portfolios (which includes the market portfolio), the
relationship between risk and return is depicted by the straight line Rf
MZ. The equation for this line, called the capital market line (CML), is:
• E(Rj ) = Rf + λσj
• where E(Rj ) is the expected return on portfolio j, Rf is the risk-free
rate, λ is the slope of the capital market line, and σj is the standard
deviation of portfolio j.
• Given that the market portfolio has an expected return of E(RM) and
standard deviation of σM, the slope of the CML can be obtained as
follows:
•
• where λ, the slope of the CML, may be regarded as the “price of risk”
in the market.
• there is a simple linear relationship between expected return and
standard deviation
Security Market Line
• What about individual securities and inefficient portfolios (not coming under
linear line)
• The expected return and standard deviation for individual securities will be
below the CML, reflecting the inefficiency of undiversified holdings
• such points would be found throughout the feasible region with no well-
defined relationship between their expected return and standard deviation
• However, there is a linear relationship between their expected return and
their covariance with the market portfolio
• The securities market line is used by investors to determine whether to
include security in their portfolio or not.
• where E(Ri ) is the expected return on security I
Rf is the risk-free return
E(RM) is the expected return on market portfolio
δ2 M is the variance of return on market portfolio
σiM is the covariance of return between security i and market portfolio
Example
• imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared
to the market of 1.3, which means it is riskier than a market portfolio.
Also, assume that the risk-free rate is 3% and this investor expects the
market to rise in value by 8% per year.
• The expected return of the stock based on the CAPM formula is 9.5%:
• 9.5% = 3% + 1.3 times ( 8% - 3% ) ​
Importance of CAPM
• Some objective estimate of risk premium is better than a completely
subjective estimate or no estimate
• CAPM is a simple and intuitively appealing risk-return model. Its basic
message that “diversifiable risk does not matter is accepted” by nearly
every one
• While there are plausible alternative risk measures, no consensus has
emerged on what course to plot if beta is abandoned. As Richard
Brealey and Stewart Myers say: “So the capital asset pricing model
survives not from a lack of competition but from a surfeit”
IMPLICATIONS OF CAPM
• The CAPM has asset pricing implications because it tells what
required rate of return should be used to find the present value of an
asset with any particular level of systematic risk (beta)
• If the asset’s expected rate of return is different from its required rate
of return, that asset is either under priced or overpriced
• The job of security analyst is, thus, to find the assets with
disequilibrium prices, because it will be profitable to buy under priced
assets and sell the overpriced assets
content
• With the help of CAPM, every investor can analyse the securities and determine the
composition of his portfolio
• there is a complete agreement among investors on the estimates of expected return,
variances and covariances and risk free rate, efficient set of portfolio should be the
same for all the investors
• Since all the investors face the same efficient set, the only reason they choose
different portfolios is that they have different indifference curves
• Expected utility will increase as one moves from lower indifference curve to a higher
indifference curve. But on the same indifference curve, any point on the curve gives
the same utility
• different investors will choose different portfolios from the same efficient set
because they have different preference towards risk and return
• no security can in equilibrium have a tangency to touch, either axis on risk return
space
• There by causing the expected returns of these securities to rise until the
resulting tangency portfolio has a non-zero proportion
• When all the price adjustments stop, the market will be brought into equilibrium,
subject to the following conditions:
o Each investor will like to hold a certain positive amount of each risky security
o The current market price of each security will be fixed at a level where the
number of shares demanded equals the number of shares outstanding
o The risk free rate will be fixed at a level where the total amount of borrowings
will be equal to the total amount of money lent
• For any individual investor, security prices and returns are fixed,
whereas the quantities held can be altered
• For the market as a whole, however, these quantities are fixed (at
least in the short run) and prices are variable
• As in any competitive market, equilibrium requires the adjustment of
each security’s price till there is consistency between the quantity
desired and quantity available
• but reasonable and logical that historical returns on securities should
be examined to determine whether or not securities have been priced
in equilibrium as suggested by the CAPM
Limitations of CAPM
• One of the main limitations of CAPM is that it is impossible to test the
model’s validity due to problems in defining market portfolio
• Another limitation is that the theoretical grounds on which it is based
cannot stand up to empirical scrutiny
• It is also suggested that b is not the only risk that mattered
• The CAPM is based on expectations about the future. Expectations
cannot be observed but we do have access to actual returns.
• Due to the unstable nature of beta it may not reflect the future
volatility of returns although it is based on the post history
limitations
• total risk has been found to be more relevant and both types of risk appear to be
positively related to returns
• Investors do not seem to follow the postulation of CAPM and do not diversify in a
planned manner
• The analysis of SML is not applicable to the bond analysis, although bonds are a part of
the portfolio of the investors.
Two types of Risk
• Systematic risk: These are market risks—that is, general perils of investing—that
cannot be diversified away. Interest rates, recessions, and wars are examples of
systematic risks
• Unsystematic risk: Risk that is peculiar to a specific firm and can be diversified away is
called unsystematic risk
The MM hypothesis of Capital Structure
• The Modigliani and Miller approach to capital theory, devised in the 1950s
• Companies have only three ways to raise money to finance their operations
and fuel their growth and expansion. They can borrow money by issuing
bonds or obtaining loans; they can re-invest their profits in their operations,
or they can issue new stock shares to investors
• The Modigliani-Miller theorem argues that the option or combination of
options that a company chooses has no effect on its real market value
• This suggests that the valuation of a firm is irrelevant to the capital structure of
a company
• Whether a firm is highly leveraged or has a lower debt component has no
bearing on its market value
content
• the market value of a firm is solely dependent on the operating profits of
the company
• The capital structure of a company is the way a company finances its
assets. A company can finance its operations by either equity or different
combinations of debt and equity.
• The capital structure of a company can have a majority of the debt
component or a majority of equity, or an even mix of both debt and equity
• There are various capital structure theories that attempt to establish a
relationship between the financial leverage of a company (the proportion
of debt in the company’s capital structure) with its market value
• Think of the firm as a gigantic tub of whole milk. The farmer can sell
the whole milk as is. Or he can separate out the cream and sell it at a
considerably higher price than the whole milk would bring. (That's
the analog of a firm selling low-yield and hence high-priced 
debt securities.) But, of course, what the farmer would have left
would be skim milk with low butterfat content and that would sell
for much less than whole milk. That corresponds to the levered
equity. The M and M proposition says that if there were no costs of
separation (and, of course, no government dairy-support programs),
the cream plus the skim milk would bring the same price as the
whole milk
ASSUMPTIONS OF MODIGLIANI AND MILLER
APPROACH
• There are no taxes
• Transaction cost for buying and selling securities, as well as the
bankruptcy cost, is nil.
• There is a symmetry of information. This means that an investor will have
access to the same information that a corporation would and investors
will thus behave rationally.
• The cost of borrowing is the same for investors and companies
• There is no floatation cost, such as an underwriting commission, payment
to merchant bankers, advertisement expenses, etc
• There is no corporate dividend tax
Numerical example
• Two firms A and B falling in the identical risk class have net operating
income of Rs. 2,00,000 each. Firm A is an unlevered concern having all
equity but Firm B is levered concern as it has Rs. 10,00,000 of 10%
bonds outstanding. The equity capitalisation rate of firm A is 12.5%
and of firm B is 16.0%.
Answer
Calculation of total value of the firns A and B
Firm A Firm B
Net operating income Rs 200000 200000
Less: Interest Nil 100000
Equity earnings 200000 100000
Equity cost % .125 .16
Total market value of equity 1600000 625000
Total market value of debt - 1000000
Total value of entire firm 1600000 1625000
Cost of capiital of overall firm % 12.50 12.30
conclusion
• It may be noted from the above that the total value of firm B which is
levered is higher than the unlevered firm A. However, this state of
affairs cannot exist for a long time as the rational investors according
to M-M approach will substitute personal leverage for corporate
leverage and adjust their portfolios to take advantage of price
differential and thereby improve their earnings.
Limitations of MM approach 
• MM model assumes that there are perfect capital markets. Such
perfect markets do not exist in the practical world
• MM model assumes that there are no floatation costs and no time
gaps are required in raising new equity capital. In the practical
world, floatation costs must be incurred and legal formalities must
be completed and then issues can be floated in the market
• Although the model assumes that there are no transaction costs in
the real world there is an expense leading to commission and
brokerage to sell shares. Therefore, shareholders do have a
preference for current dividends.
• The model assumes that there is no tax. This assumption is not
realistic as taxes have to be paid when shares are sold and there
is a capital gain. Thus, investor prefers current dividends
• This means that the firm will have to sell more shares if it does
not want to give a dividend. In this condition, the firm should be
retaining the profits and not pay dividends. Therefore, the
model is not applicable in uncertain conditions
Random Walk theory
• Random walk theory suggests that changes in stock prices have the
same distribution and are independent of each other.
• Random walk theory infers that the past movement or trend of a
stock price or market cannot be used to predict its future
movement.
• Random walk theory believes it's impossible to outperform the
market without assuming additional risk.
• Random walk theory considers technical analysis undependable
because it results in chartists only buying or selling a security after a
move has occurred.
• Random walk theory considers fundamental analysis undependable
due to the often-poor quality of information collected and its ability
to be misinterpreted.
• Random walk theory claims that investment advisors add little or no
value to an investor’s portfolio.
• Random walk theory believes it's impossible to outperform the
market without assuming additional risk
• Critics of the theory contend that stocks do maintain price trends over
time – in other words, that it is possible to outperform the market by
carefully selecting entry and exit points for equity investments
• Say there is a garments company whose stock is trading at $100. Suddenly
there was news of the fire in the factory, and Stock Price fell by 10%. The
next day when the market started, the stock price fell by another 10%. So
what Random Walk Theory says is that they fall on the fire day was due to
the news of the fire, but they fall on the next day was not on the news of
fire again. Due to any updated news on fire, say, an exact number of fabrics
burned that caused the fall on the next day.
• So Stock Prices are not dependent on each other. Each day stock reacts to
various news and is independent of each other.
• Random Walk Theory is practical and has proven correct in most cases. The
theory says that if Stock Prices are random, we need to waste money and hire
fund managers to manage our money. It may happen that a fund manager has
managed to provide an alpha return, but it may be due to luck, and luck may
not sustain, and it may not provide an alpha return in the next year
• Alpha return is the extra return that a fund manager promises to pay over and
above a benchmark return. Suppose all the other theories that provide ways
to predict future stock prices were true. How can so many fund managers
who apply both technical and fundamental analysis end up earning the
negative or same return as the benchmark? So, if, after applying all theories,
the stock prices can’t be predicted, then obviously, it is random
• It means today’s stock price is not dependent on what the stock price was
yesterday. Yesterday’s price was based on available information, and today,
the stock price is based on available information. Everyone has access to
all the information. Insider information is not included in this theory.
• Random Walk Theory is based on the weak-form 
efficient market hypothesis, which states that all the available information
is already taught in the stock price. Suppose there is any prediction of
future earnings, then that earning’s present value is also taught in the stock
price. The trading is between informed buyers and informed sellers, and it
depends on what they would like to do. So ultimately, it is random.
Implications of Random Walk Theory

• Stock Prices are random, so instead of spending money on Fund

Managers, one should buy ETFs or spend on stocks in the exact
quantity of an index
• Technical analysis or fundamental analysis doesn’t work in predicting
the stock price as it is impossible to predict it.
• Stock prices are independent; today’s stock price has no relation to
yesterday’s stock price
• Markets are efficient, information is readily available, and informed
decisions are always taken
Advantages of Random Walk Theory

• It provides a cost-effective way of investing. That is an investment in

ETFs.
• In many situations, the market has not acted as predicted, proving that
stock prices are indeed random.
• Disadvantages of the Random Walk Theory
• Markets are not entirely efficient. Information asymmetry is there, and
many insiders react much earlier than other investors due to the
information edge.
• In many cases, stock prices have shown a trend year on year.
• One lousy news affects a stock price for several days, even months.
EXPECTED UTILITY THEORY
• Expected Utility Theory (EUT) was propounded by Neumann and
Morgenstern in 1944
• Expected utility refers to the utility of an entity or aggregate
economy over a future period of time, given unknowable
circumstances.
• Expected utility theory is used as a tool for analyzing situations in
which individuals must make a decision without knowing the
outcomes that may result from that decision
• Expected utility is also used to evaluate situations without
immediate payback, such as purchasing insurance
content
• The theory specified the necessary qualities that a rational decision
maker requires for the Expected Utility Hypothesis to hold
• when faced with various actions, the result of each could give rise to
more than one possible outcome with different probabilities
• therefore it is normal to rationally identify and determine the values
of all possible outcomes and probabilities that will result from each
course of action, and multiply the two to give an expected value
content
• After providing due weightage to the element of risk, the action that
may give rise to the highest total expected value would be chosen
• EUT states that decision makers choose between risky or uncertain
prospects after comparing their expected utility values
• by weighing the sums obtained by adding the utility values of
outcomes, multiplied by their respective probabilities
• Utility functions help in measuring investor’s preferences for wealth,
and the level of risk they are willing to take for attaining greater
wealth
Assumptions
1. Completely rational
2. Able to deal with complex choices
3. Risk averse and
4. Wealth maximising
The von Neumann-Morgenstern Axioms
(define a rational decision maker)
• Completeness: The individual has well defined preferences and can always
choose between any two alternatives
• Transitivity: As an individual decides according to the completeness axiom,
the individual also decides consistently
• Independence: If two gambles are mixed with a third one, the individual
will maintain the same preference order as when the two are presented
independently of the third one
• Continuity: When there are three lotteries (A, B, C) and the individual
prefers A to B and B to C, then it should be possible to mix A and C in such a
manner that the individual is indifferent between this mix and the lottery B
• Omission of Irrelevant Alternatives: The individual ignores irrelevant
alternatives in deciding between alternatives.
• Frame Independence: The individual cares only about outcomes and the
probabilities with which they occur and not how they are presented or
bundled
• Utility Maximisation Utility reflects the satisfaction derived from a particular
outcome - ordinarily an outcome is represented by a “bundle” of goods.
• Expected Monetary Value So far we ignored uncertainty. In the real world,
however, there is a great deal of uncertainty about outcomes. How should
one decide when faced with risky gambles
• Daniel Bernoulli pointed out that people do not evaluate gambles by their EMV.
He observed that most people abhor risk and hence, choose a sure thing that is
less than expected value
• Expected Utility : -Expected utility theory is really a theory that deals with risk,
not uncertainty. A risky situation is one where the possible outcomes are defined
with well-defined probabilities associated with them. An uncertain situation is
one where you cannot assign probabilities or define the list of possible outcomes
• Risk Attitude:- There is ample evidence that, in general, people are risk averse.
However, they are willing to assume risk, if they are compensated for the same.
Suppose stocks A and B offer the same expected return, but stock B is riskier
than stock A. If you are like most people, you would choose stock A
The Efficient Markets Hypothesis (EMH)
• that was proposed in the 1960s reached its height of dominance in
the academic circles in the 1970s
• Efficient Market Hypothesis is the cornerstone of modern financial
theory
• The efficient-market hypothesis was developed by Eugene Fama who
argued that stocks always trade at their fair value, making it
impossible for investors to either purchase undervalued stocks or sell
stocks for inflated prices
There are three variants of the hypothesis:
“weak”, “semi-strong”, and “strong”
• The weak form of the EMH claims that trading information (levels and
changes of prices and volumes) of traded assets (e.g., stocks, bonds,
or property) are already incorporated in prices. If weak form
efficiency holds then technical analysis cannot be used to generate
superior returns.
• The semi-strong form of the EMH claims both that prices incorporate
all publicly available information (which also includes information
present in financial statements, other SEC filings etc.). If semi-strong
form efficiency holds then neither technical analysis nor fundamental
analysis can be used to generate superior returns.
• The semi-strong form of the EMH claims both that prices incorporate
all publicly available information (which also includes information
present in financial statements, other SEC filings etc.). If semi-strong
form efficiency holds then neither technical analysis nor fundamental
analysis can be used to generate superior returns.
• For most financial economists, however, the efficient markets
hypothesis is a central idea of modern finance that has profound
implications.
Behavioural finance
• INTRODUCTION
• Since the mid-1950s, the field of finance has been dominated by the
traditional finance model developed by the economists of the
University of Chicago.
• Cognitive error and extreme emotional bias can cause investors to
make bad investment decisions, thereby acting in irrational manner.
• Behavioural finance was considered first by the psychologist Daniel
Kahneman and economist Vernon Smith
• Behavioural finance is a concept developed with the inputs taken
from the field of psychology and finance. It tries to understand the
various puzzling factors in stock markets to offer better explanations
for the same.
• Behavioural finance is defined as the study of the influence of socio-
psychological factors on an asset’s price. It focuses on investor
behaviour and their investment decision-making process.
• Sewell has defined Behavioural finance as “the study of the influence
of psychology on the behaviour of financial practitioners and the
subsequent effect on markets”.
CONCEPT OF BEHAVIOURAL FINANCE
• Behavioural Finance (BF) is the study of investors’ psychology while
making financial decisions.
• Behavioural finance focuses upon how investor interprets and acts on
information to take various investment decisions.
NATURE OF BEHAVIOURAL FINANCE
• Behavioural finance is not just a part of finance but is broader and
wider in scope and includes insights from Behavioural economic,
psychology and microeconomic theory.
• In the process of making financial investments, investors often have
difficulty while choosing the most economic option because of the
impact of his/her various psychological and mental filters.
• Micro Behavioural Finance (BFMI) :- These rational investors are also
known as “homo economicus” or the rational economic man.
• Macro Behavioural Finance (BFMA):- macro behavioural finance deals
with the drawbacks of the efficient market hypothesis.
SCOPE OF BEHAVIOURAL FINANCE
• To understand the reasons of market anomalies.
• To identify investor’s personality
• To enhance the skill set of investment advisors
• Helps to identify the risks and develop hedging strategies
• Behavioural finance provides explanation to various corporate
activities.
OBJECTIVES OF BEHAVIOURAL
FINANCE
• To review the debatable issues in standard finance and to protect the
interests of stakeholders in volatile investment scenario.
• To examine the relationship between theories of standard finance and
Behavioural finance and to analyse the influence of biases on the
investment process because of different personalities playing in the
investment market.
• To examine the various social responsibilities of the subject.
• To discuss emerging issues in the financial world.
• To discuss the development of new financial instruments, which have
been developed because of the need of hedging the conventional
instruments against various market anomalies.
• To familiarize themselves with trend of changes over the years across
various economies.
• To examine the contagion (spreading one by one) effect of various events.
• An effort towards more elaborated identification of investor’s personality.
• More elaborate discussions on optimum asset allocation according to age,
sex, income and unique personality of investors.
APPLICATION OF BEHAVIOURAL
FINANCE
Main contributors
• Investors
• Corporations
• Markets
• Regulators
• Educations
Behavioural Biases that Influence Investment
Decisions
• Denial
• Information processing errors
• Emotions
• Loss Aversion
• Social influence/herd mentality
• Framing
• Anchoring