MODULE 1 – Conventional Finance, prospect (BFMA) irregularities in the

Theory and Market Efficiency: The pricing of risk –
Market efficiency – Agency Theory – Prospect
Theory – Challenges to market efficiency –
Behavioural v/s Neo Classical Finance – Irrational
Preference and Cumulative Prospect Theory
Introduction to Behavioural Finance
Finance emerged as a separate discipline from
Economics in late 1950’s and early 60’s. In the
traditional finance theories, the central assumption is
that people are rational. Rational investors are those
who take decisions by evaluating risk and returns.
They will try to minimize risk and maximize returns
and will try to act to protect self interest. Traditional
finance theories are also based on the assumption that
markets are efficient. Traditional finance theories are
‘normative’ in nature and they suggest ‘how to behave
in an investment scenario’ rather than going for a
positive approach which suggest ‘how will they
actually behave’.
Human behavior is diverse and complex and,
unfortunately, despite our best intentions, it is not
always governed exclusively by rationality. In
particular, our judgment and decision-making can be
significantly affected by intuition, a form of abstract,
automatic thinking that can override our reason.
Decades of research in psychology have shown that
intuition is often systematically biased, and follows
identifiable patterns, causing us to reach conclusions
that are predictable wrong, since they are based on our
gut or instincts, rather than on logic. An important
aspect of behavioral biases is that they affect us in
areas of our lives where it is very important that we be
purely rational, such as in investing. The decisions
taken by humans are influenced by cognitive biases,
emotional filters and emotional shortcuts. This results
in irrational patterns in the market.
Behavioural Finance is the field of study which argues
that people are not nearly as rational as traditional
finance theory makes out. For investors who are
curious about how emotions and biases drive share
prices, behavioural finance offers some interesting
descriptions and explanations. Behavioural finance is
commonly defined as the application of psychology to
understand human behaviour in finance or investing.
To make things easy, we will take the traditional
approach to teaching behavioural finance and break
behavioural finance into two subtopics:
 Behavioural finance micro, and
 Behavioural finance macro
Behavioural finance micro examines the
(BFMI) behavioral biases (that
is, the irrational
behaviors) of
individual investors.
Behavioural finance macro describes anomalies or
overall market that
contradict the efficient
market hypothesis
Definition of Behavioural Finance:
Behavioural finance is a relatively new field that seeks
to combine behavioural and cognitive psychological
theory with conventional economics and finance to
provide explanations for why people make irrational
financial decisions. “Behavioural finance, an offshoot
of behavioural psychology, looks at the economic
decision making process of investors including
engrained thought patterns and behavioural biases, and
its impact upon the performance of securities and
markets”. In 2002, Daniel Kanheman and Vernon
Smith had won Nobel Prize for their work in
behavioural finance. They have found that investors’
decisions are guided by shortcuts and emotional filters.
Linter G (1998) “Behavioural finance is the study of
how human interprets and act on information to make
informed investment decisions”
Olsen R (1998) asserts that behavioural finance seeks
to understand and predict systematic financial market
implications of psychological decision process.
Assumptions of Behavioural Finance:
1. Loss Aversion – Seek to limit the size of potential
loss rather than seek to minimise the variability of
potential returns
2. Bounded rationality – The manner in which humans
behave limits their rationality
3. Denial of risk – They may know statistical odds but
refuse to believe these odds.
Standard Finance / Behavioural Finance
Neoclassical Finance
1 Assumes that people People employ imperfect
process data rules of thumb
appropriately and (heuristics) to process
correctly data
2 Assumes that people Perceptions of risk and
view all decisions returns are significantly
through objective lens influenced by how
of risk and return decisions are framed
3 People are guided by Emotions and herd
reasons and logic and behaviour play an
independent important role
judgement
4 Markets are efficient Heuristics, frame
and price will be dependence, emotions
equal to intrinsic etc. will cause a
value difference between price
and intrinsic value
5 Price follow random Prices are pushed by
walk, though prices investors to
fluctuate they will be unsustainable levels in
brought back to both directions
equilibrium position
The Pricing of Risk
Several models were suggested in traditional finance /
standard finance for the pricing of risk. The following
are the major ones.
1. Modern Portfolio Theory
2. Miller and Modigliani Theory
3. CAPM
4. Arbitrage Pricing Theory
5. Random Walk Hypothesis
6. Expected Utility Theory
7. Efficient Market Hypothesis
1. Modern Portfolio Theory:MPT was postulated by
Harry Markowitz. MPT is based on the following
concepts.
 The expected return of a stock or portfolio and,
 The standard deviation and its correlation with
other stocks within a portfolio
The theory states that with the above concepts known,
it is possible to create an efficient portfolio for any
group of stock. The efficient portfolio is the portfolio
which maximises the returns and minimises the risk.
The main premise of MPT is that risk is central to the
whole investment process and risky investments offer
higher returns so that the investor is compensated for
bearing the extra risk. The risk of a security is
measured in terms of variability of returns. When a
portfolio is formed with a combination of assets that
provide the maximum expected return for different
levels of risk and minimum risk for different levels of
expected returns, it becomes efficient.
2. Miller and Modigliani Theory
Modigliani and Miller, two professors in the 1950s,
studied capital-structure theory intensely. From their
analysis, they developed the capital-structure
irrelevance proposition. Essentially, they hypothesized
that in perfect markets, it does not matter what capital
structure a company uses to finance its operations.
They theorized that the market value of a firm is
determined by its earning power and by the risk of its
underlying assets, and that its value is independent of
the way it chooses to finance its investments or
distribute dividends. The basic M&M proposition is
based on the following key assumptions:
 No taxes
 No transaction costs
 No bankruptcy costs
 Equivalence in borrowing costs for both
companies and investors
 Symmetry of market information, meaning
companies and investors have the same
information
 No effect of debt on a company's earnings
before interest and taxes
Of course, in the real world, there are taxes, transaction
costs, bankruptcy costs, differences in borrowing costs,
information asymmetries and effects of debt on
earnings. The Modigliani-Miller theorem (M&M)
states that the market value of a company is calculated
using its earning power and the risk of its underlying
assets and is independent of the way it finances
investments or distributes dividends. There are three
methods a firm can choose to finance: borrowing,
spending profits (versus handing them out to
shareholders in the form of dividends), and straight
issuance of shares. While complicated, the theorem in
its simplest form is based on the idea that with certain
assumptions in place, there is no difference between a
firm financing itself with debt or equity.
3. Capital Asset Pricing Model (CAPM)
It is proposed by Sharpe and Lintner in 1960. The
Capital Asset Pricing Model (CAPM) is a model that
describes the relationship between expected return and
risk of a security. It shows that the return on a security
is equal to the risk-free return plus a risk premium,
which is based on the beta of that security. CAPM is
calculated according to the following formula:
Ra = Expected return Ra = Rrf + [Ba x (Rm – Rrf)]
Where:
on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market
Note: Risk Premium = (Rm – Rrf)
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. The core idea of
this model is that investors used to be compensated for
the time value of money and market specific risk. As
per CAPM, the difference in the expected returns of
any two assets can be related to the difference in their
betas. The higher the value of beta, higher would be
the risk of the security and the consequent expected
returns. The model states that the only important
ingredient that determines expected returns is the
systematic risk. 4. Arbitrage
Pricing Theory Proposed by
Ross in 1976. According to this theory, an attractive
opportunity is created by irrational or noise traders
through creation of mispriced securities. The rational
traders or arbitrageurs will be quick enough to grab the
opportunity and the mispricing created by the irrational
investors will be corrected. Though arbitrage does not
subscribe to the view that all investors are skilled and
well-informed, in well – developed and liquid capital
markets, there are enough rational investors who
ensure that the price of any security will be equal to its
fundamental value.Arbitrage pricing theory is an asset
pricing model based on the idea that an asset's returns
can be predicted using the relationship between that
asset and many common risk factors. Created in 1976
by Stephen Ross, this theory predicts a relationship
between the returns of a portfolio and the returns of a
single asset through a linear combination of many
independent macroeconomic variables
Where today's price is too low:
The implication is that at the end of the period the
portfolio would have appreciated at the rate implied by
the APT, whereas the mispriced asset would have
appreciated at more than this rate. The arbitrageur
could therefore:
Today:
 1 short sell the portfolio
 2 buy the mispriced asset with the
proceeds.
At the end of the period:
 1 sell the mispriced asset
 2 use the proceeds to buy back the
portfolio
 3 pocket the difference.
Where today's price is too high:
The implication is that at the end of the period
the portfolio would have appreciated at the
rate implied by the APT, whereas the
mispriced asset would have appreciated at less
than this rate. The arbitrageur could therefore:
Today:
 short sell the mispriced asset
 buy the portfolio with the proceeds.
At the end of the period:
 sell the portfolio
 2 .use the proceeds to buy back the
mispriced asset
 pocket the difference
5. Random Walk Hypothesis
The random walk theory is the occurrence of an event
determined by a series of random movements - in other
words, events that cannot be predicted. For example,
one might consider a drunken person's path of walking
to be a random walk because the person is impaired
and his walk would not follow any predictable path.
Applying the random walk theory to finance and
stocks suggests that stock prices change randomly,
making it impossible to predict stock prices. The
random walk theory corresponds to the belief that
markets are efficient, and that it is not possible to beat
or predict the market because stock prices reflect all
available information and the occurrence of new
information is seemingly random as well. The random
walk theory is in direct opposition to technical analysis,
which contends that a stock's future price can be
forecasted based on historical information through
observing chart patterns and technical indicators.
Academics cannot conclusively prove or agree on
whether the stock market truly operates via a random
walk or based on predictable trends because there are
published studies that support both sides of the issue.
A follower of the random walk theory believes it's
impossible to outperform the market without assuming
additional risk. Critics of the theory, however, 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.
Basic assumptions of Random Walk Theory are as
follows:
 Markets are efficient and competitive with
impeccable communication
 Investors have full knowledge and information
about the performance of any given company.
 A change in stock price is triggered by
information.
 All known information is reflected in prices.
 The returns on securities are independently
and identically distributed random variables
that have a finite variance.
6. Expected Utility Theory
The expected utility theory deals with the analysis of
situations where individuals must make a decision
without knowing which outcomes may result from that
decision, this is, decision making under uncertainty.
These individuals will choose the act that will result in
the highest expected utility, being this the sum of the
products of probability and utility over all possible
outcomes. The decision made will also depend on the
agent’s risk aversion and the utility of other agents.
The term expected utility was first introduced by
Daniel Bernoulli.
According to Expected Utility Theory,
 When faced with various actions,
 The result of each could give rise to more than
one possible outcome with different
probabilities
 It is normal to rationally identify and
determine the values of all possible outcomes
and probabilities that will result from each
course of action
 multiply the two to get an expected value
 after providing due weightage to the element
of risk, the action that may give rise to the
highest total expected value would be chosen.
According to Expected Utility Theory, investors are
 completely rational
 able to deal with complex situations
 risk averse
 try to maximise wealth.
7. Efficient Market Hypothesis
Efficient market hypothesis is proposed by Eugene
Fama in the year 1960. Efficient market is a market
where in there are large numbers of rational profit
maximisers actively competing with each other trying
to predict future market values of individual securities,
and where important current information is freely
available to all participants.
Three arguments of EMH
 Investors are rational
 Careful account of all available information is
taken by everyone before making investment
decisions.
 The decision maker always pursues his interest.
Depending upon the information available, forms of
market efficiency are of three types
  Weak form of efficiency – deals with
information regarding the past sequence of
security movements
 Semi strong form of efficiency – deals with
publicly available information
 Strong form of efficiency – deals with all
information, both public and private which
includes even the insider information.
The tests of the weak form hypothesis are essentially
tests of whether all information contained in historical
share prices of securities is fully reflected in the
current prices. This hypothesis contradicts the
statements of technical analysts who state that
historical price movements can help the forecast the
future price trends and prices move in a predictable
manner. Semi strong form of efficiency is tested by
checking whether all the publically available
information is fully reflected in the current stock prices.
This hypothesis contradicts the statements of
fundamental analysts who state that analysis of
fundamental factors related to the company like
earnings, dividends, rights issues etc. can help the
forecast the future price trends and prices move in a
predictable manner. Strong form hypothesis are tests of
whether all information, both public and private is
fully reflected in security prices and whether any type
of investor is not able to earn excess returns. The
strong form states two conditions to be met: first that
successive price changes or returns are independent
and second these successive price changes or return
changes are identically distributed, like Random Walk
theory.
Challenges to Market Efficiency
1. Small firm effect – Long term historical data have
suggested that small firm portfolios have always
helped the investors to gain higher returns compared to
large firm portfolios. This goes against the market
efficiency theory.
2. Monday effect (Weekend effect) – Across stock
exchanges around the world, it was noticed that stock
prices tend to be lower on Monday and they keep on
rising till Friday. An investor who sells those stocks on
Friday can make around 13% returns, if he has bought
the same on Monday.
3. Overreaction of market to new information –
Many at times it is noticed that the market overreacts
to news. For ‘good’ news supernormal profits can be
reaped in the market and for ‘bad’ news ‘abnormal’
losses are witnessed by the market.
4. Market timing ability of the fund managers –
People tend to follow the advises given by the fund
managers and when there is an advice to buy, herding
tendencies push the market prices of those stocks in
the upward direction.
Prospect Theory
This theory was presented by Kahneman and Tversky
(1979). As per this theory, investors feel more stressed
in the event of a loss than the happiness that he or she
may derive in case of a profit. This theory states that
investors provide bigger weight to losses than the
profits. This is, in a way, risk avoidance. According to
this theory, investors tend to give a bigger weight to
their losses than to their gains, thus avoiding risks.
However, according to Geva and Mintz (1997), an
investor normally tends to become a risk taker when he
or she incurs a loss. In addition to this, most investors,
during the course of taking investment decisions,
exhibit certain behavioural biases, which often lead to
systematic errors. Prospect theory is designed to better
describe, explain and predict the choices that the
typical person makes especially in a world of
uncertainty.
Characteristics of Prospect Theory
1. Certainty – People have a strong preference to
certainty and are willing to sacrifice income to achieve
more certainty.
2. Loss aversion – People tend to give more weights
to losses than gains. They are loss averse.
3. Relative positioning – People tend to be more
interested in their relative gains and losses as opposed
to their final income and wealth. If your relative
position doesn’t improve, you feel better off.
4. Small probabilities – People tend to under react to
low probability events especially in case of losses. So
you may completely discount the probability of losing
all your wealth if the probability is very small. This
tendency can result in people making super risky
choices.
Cumulative Prospect Theory it is a model for
descriptive decisions under risk and crisis which was
introduced by Amos Tversky and Daniel Kahneman in
1992 (Tversky, Kahneman, 1992). It is a further
development and variant of prospect theory. The
difference between this version and the original
version of prospect theory is that weighting is applied
to the cumulative probability distribution function. The
main observation of CPT (and its predecessor Prospect
Theory) is that people tend to think of possible
outcomes usually relative to a certain reference point
(often the status quo) rather than to the final status, a
phenomenon which is called framing effect. Moreover,
they have different risk attitudes towards gains (i.e.
outcomes above the reference point) and losses (i.e.
outcomes below the reference point) and care
generally more about potential losses than potential
gains (loss aversion). Finally, people tend to
overweight extreme, but unlikely events, but
underweight "average" events. The last point is in
contrast to Prospect Theory which assumes that people
overweight unlikely events, independently of their
relative outcomes.
MODULE 2– Perception, Memory and Heuristics –
Representatives and related biases – Irrationality and
 Adaptation – Miscalibration – Other strains of
overconfidence – Brief history of rational thought –
Pascal – Femat to Friedman – Savage – Prerequisites
for rational choice and Quasi Rational Choice.
Perception – The way in which something is regarded,
understood, or interpreted is perception. It is ‘the
awareness of the elements of environment through
physical sensation’. The following are the few
variables in the process of perception.
a. Inputs – Includes the objects, events, people etc. that
the perceiver receives through senses.
b. Process – The inputs received by the perceiver are
then processed. This processing takes place through
selection, organisation and interpretation.
c. Outputs – the feelings, actions, attitudes etc. derived
through processing mechanism are known as output.
d. Behaviour – Any behaviour is based on perceived
outputs.
Factors affecting perception
• Internal factors
1. Needs and desires – Perception of any
individual is based on his or her needs and
desires.
2. Personality – Personality of individuals varies
substantially and it influences perception.
3. Experience – Previous experience plays a
major role with respect to perception.
• External Factors
1. Size – Larger the size of an object or stimuli,
higher the chances of being perceived.
2. Intensity – As in the case of size, higher the
intensity of a stimuli, better the chances of
being noticed.
3. Frequency – A repeated stimulus stands the
chance of being attracted and selected over an
occasional one.
4. Status – The status of the person being
perceived exerts considerable influence on
perception.
5. Contrast – stimuli that contrast sharply with
the environment stands a better chance of
being noticed.
Errors in Perception
1. Halo effect – Process of drawing of general
impressions or concision about an individual
based on a single characteristic / trait is known
as halo effect.
2. Stereo typing – Judging a conclusion about a
person based on the perception of the group to
which he or she belongs to is stereotyping.
3. Attribution – Is defined as the process that an
observer uses to infer the causes of another’s
behaviour.
4. Impression – Everybody forms impressions
about other people without having any
knowledge about the characteristics or traits of
the individual. This may lead to perceptual
errors.
5. Selective perception – While indulging in
selective perception the perceiver tends to
ignore the finer details.
6. Primary effect – The error of perception is
based on the fact that the first impressions are
lasting impressions.
7. Recency effect – It is a perceptual error,
wherein the most recent information
dominates one’s perception.
8. Inference – Perceiver draws conclusions
without adequate information.
9. Self fulfilling prophecy – This occurs when
the expectation about a situation or person
leads the perceiver to act in a way that is
consistent with the expectation.
10. Projection bias - This error occurs when one
believes that other persons too have similar
beliefs and behaviours as that of the perceiver.
COGNITION, COGNITIVE BIASES,
COGNITIVE DISSONANCE
Cognition is defined as Bits of knowledge that pertain
to any variety of thoughts, values and facts.
COGNITIVE BIASES are classified into
1. Attentional Bias – Selective attention towards
threat related stimuli
2. Interpretive Bias – Tendency of an individual
to interpret ambigious stimuli in a threatening
way
3. Explicit memory Bias – Tendency to retrieve
negative or unpleasant information than
positive information. This bias may be
depended on conscious recollection
4. Implicit Memory Bias – Tendency to have
better memory performance for relative
negative information; Not involving conscious
recollection
COGNITIVE DISSONANCE
It is defined as the inconsistency in thoughts and
actions. Dissonance gets in the way of finding some
truth. If we want to understand the world, we want a
clear, consistent picture of it.Anything which is
inconsistent is a problem and we are motivated to
restore consistency again.
Cognitive dissonance can be overcome in the
following manner.
1. You change one of your thoughts
2. Change your behaviour
3. Add a thought to rationalise
4. Trivialise the inconsistency
MEMORY
Memory is the faculty of the brain by which
information is encoded (process often known as
Learning), stored, and retrieved when needed. Memory
is reconstructive and varies intensity. Reconstructive
memory - the act of remembering is influenced by
various other cognitive processes
including perception, imagination, semantic
memory and beliefs, amongst others
HEURISTICS
A heuristic is a mental shortcut that allows people to
solve problems and make judgments quickly and
efficiently. These rule-of-thumb strategies shorten
decision-making time and allow people to function
without constantly stopping to think about their next
course of action. Heuristics are helpful in many
situations, but they can also lead to cognitive biases.
Why Do We Use Heuristics?Psychologists have
suggested a few different theories:
 Effort reduction: According to this theory,
people utilize heuristics as a type of cognitive
laziness. Heuristics reduce the mental effort
required to make choices and decisions.
 Attribute substitution: Other theories suggest
people substitute simpler but related questions
in place of more complex and difficult
questions.
 Fast and frugal: Still other theories argue that
heuristics are actually more accurate than they
are biased. In other words, we use heuristics
because they are fast and usually correct.
Heuristics play important roles in both problem-
solving and decision-making. When we are trying to
solve a problem or make a decision, we often turn to
these mental shortcuts when we need a quick
solution.The world is full of information, yet our
brains are only capable of processing a certain amount.
If you tried to analyze every single aspect of every
situation or decision, you would never get anything
done.In order to cope with the tremendous amount of
information we encounter and to speed up the
decision-making process, the brain relies on these
mental strategies to simplify things so we don't have to
spend endless amounts of time analyzing every detail.
BOUNDED RATIONALITY MODEL
It was proposed by Simon in the 1950s. Also termed as
the ‘Administrative Man Model’, this theory fetched
him a Nobel Prize in 1978. The model elucidates the
behavioural concepts that underlie economic decision
making. According to bounded rationality, decision
makers are limited by constraints. Some of them
include aspects like values, unconscious reflexes, skills
and habits. Further it is also assumed that human
rationality has certain inherent limitations, particularly
when it is operating in substantial risk and uncertainty
situations. In such situations decision makers force
themselves to be less than completely rational and
settle for much lower levels. In the other sense, they
seek a kind of bounded or limited rationality while
making decisions.
DIFFERENT TYPES OF HEURISTICS
Familiarity and Related Heuristics:The familiarity
heuristic stems from the availability heuristic, which
was studied by Tversky and Kahneman. The
availability heuristic suggests that the likelihood of
events is estimated based on how many examples of
such events come to mind. Thus the familiarity
heuristic shows how "bias of availability is related to
the ease of recall.
Ambiguity Aversion
Ambiguity aversion (also known as uncertainty
aversion) is a preference for known risks over
unknown risks. An ambiguity-averse individual would
rather choose an alternative where the probability
distribution of the outcomes is known over one where
the probabilities are unknown. This behavior was first
introduced through the Ellsberg paradox (people prefer
to bet on the outcome of an urn with 50 red and 50
blue balls rather than to bet on one with 100 total balls
but for which the number of blue or red balls is
unknown).
Diversification Heuristics
People seek more variety when they choose multiple
items for future consumption simultaneously than
when they make choices sequentially, i.e. on an ‘in the
moment’ basis. Diversification is non-optimal when
people overestimate their need for diversity.
Status Quo Bias and Endowment Effect
Status quo bias is an emotional bias; a preference for
the current state of affairs. Status quo bias has been
attributed to a combination of loss aversion and
the endowment effect, two ideas relevant to prospect
theory. An individual weighs the potential losses of
switching from the status quo more heavily than the
potential gains
Endowment Effect
The endowment effect (also known as divestiture
aversion and related to the mere ownership
effect in social psychology) is the hypothesis that
people assign more value to things merely because
they own them.
Representativeness and related biases
The representativeness heuristic is simply described as
assessing similarity of objects and organizing them
based around the category prototype (e.g., like goes
with like, and causes and effects should resemble each
other). This heuristic is used because it is an easy
computation.
Related biases of Representativeness
• Ignorance of base rates -
• Conjunction fallacy
• Ignorance of sample size
• Dilution effect
• Misperception of randomness
Anchoring
Anchoring or focalism is a cognitive bias for an
individual to rely too heavily on an initial piece of
information offered (known as the "anchor") when
making decisions. Anchoring and adjustment is a
heuristic used in many situations where people
estimate a number. People did not shift far enough
away from the anchor. Hence the anchor contaminates
the estimate, even if it is clearly irrelevant.
Availability (Recency and Salience)
Availability Heuristics – events that are called to mind
easily are believed to have a greater likelihood of
occurring. Two factors abet availability – Recency &
Salience. Salience could get influenced by egocentric
judgments. Recency effect - The Recency Effect is the
finish. You remember the end the best.
Gambler’s Fallacy
The gambler's fallacy, also known as the Monte Carlo
fallacy or the fallacy of the maturity of chances, is the
mistaken belief that, if something happens more
frequently than normal during a given period, it will
happen less frequently in the future (or vice versa).
OVERCONFIDENCE
Is the tendency for people to overestimate their
knowledge, abilities and the precision of their
information, or to be overly sanguine of the future and
their ability to control it.
Overconfidence can be measured in different ways –
one among it is miscalibration.
Miscalibration is the tendency for people to
overestimate the precision of their knowledge.
OTHER STRAINS OF OVER CONFIDENCE
• Better than average effect - Individuals
evaluating themselves as above average in a
self-serving manner
• Illusion of control - The illusion of control is
the tendency for people to overestimate their
ability to control events
• Excessive optimism – It is a cognitive bias that
causes a person to believe that they are at a
lesser risk of experiencing a negative event
compared to others.
BRIEF HISTORY OF RATIONAL THOUGHT
Rationality is the quality or state of being rational –
that is, being based on or agreeable
to reason Rationality implies the conformity of one's
beliefs with one's reasons to believe, and of one's
actions with one's reasons for action.
The conceptual development of a current‐day
comprehension of “rationality” by using four
episodes:
 Ancient thinking towards wise leadership;
 The Greek idea of logos;
 The nineteenth century modernist belief in
positivism;
 And the twentieth century “postmodernist”
debate
QUASI RATIONAL CHOICE
Imagine that you purchased a ticket to a concert given
by your favourite musical group. On the evening of the
concert, a blizzard makes travel extremely hazardous.
Would you go? Now imagine that you had been given
this same ticket. Would you be more or less likely to
travel to the concert in this case than in the previous
case?if you are like most people, you would be less
likely to go to the concert if the ticket were given to
you. However, this response is, according to the logic
of economics, irrational.There are cases in which
people deviate from the behavior that the simple
calculus of utility maximization says they should
follow, and these deviations are predictable. Richard
Thaler said that this behaviour was "quasi-rational”.
Module3– Investor Behaviour: Financial Behaviour
stemming from Familiarity, Financial Behaviour
stemming from Representativeness-Over confidence
and Excessive Trading- Under diversification and
Excessive Risk Taking- Investor Decision cycle-
Decision making under risk and uncertainty-Expected
utility theory- Decision making in Historical
prospective-Allais and Elsberg’s paradoxes-Errors in
Decision making.
1. Explain Financial behaviour stemming from
Familiarity:The familiarity heuristic stems from
the availability heuristic, which was studied
by Tversky and Kahneman. The availability heuristic
suggests that the likelihood of events is estimated
based on how many examples of such events come to
mind. Thus the familiarity heuristic shows how "bias
of availability is related to the ease of recall.
The following are different types of financial
behaviour as a result of ‘Familiarity Heiristics’.
Home Bias – Tendency to overinvest domestically and
locally. Related to home bias is the tendency to invest
in companies you work for or brands you know.
People tend to concentrate in home country with
respect to their investments. This could be because of
the following reasons (a) Preference for familiarity of
language and culture (b) Local investing and
informational advantages (c) Invest more in a stock on
which you have more precise information.
Tendency to overestimate predictability induces
investors to believe that good companies are good
investments.
Recency effect – People believe that good recent stock
market performers are good buys.
Availability bias – Pushes people to concentrate on
investments in securities on which information is
freely available.
2. Explain Financial behaviour stemming from
Representativeness
The representativeness heuristic is simply described as
assessing similarity of objects and organizing them
based around the category prototype (e.g., like goes
with like, and causes and effects should resemble each
other). This heuristic is used because it is an easy
computation.
The following are some of the investor behaviour
which come from ‘Representativeness Heuristics’
• Overestimating the predictability - Also
known as Hindsight bias, also known as
the knew-it-all-along effect . It is the
behaviour shown by an individual, after an
event has occurred, to see the event as having
been predictable, despite there having been
little or no objective basis for predicting it
• Chasing winners (Recency effect) - An
investor suffering from recency bias would
most likely make their investment decisions
solely based on the past 1-3-year performance.
This behavior has come to be known as
“strategy chasing,” and often resembles a
 counterintuitive practice of buying high and
selling low.
• Trend following / Momentum chasing -
Instead of identifying the continuation or
reversal pattern, momentum investors focus on
the trend created by the most recent price
break. Momentum investors like
to chase performance. They attempt to achieve
alpha returns by investing in stocks
that trend one way or another.
• Momentum chasers vs. Contrarians - While
momentum investing is a method that attempts
to take advantage of the most recent market
trends, contrarian investing takes the opposite
approach.Market contrarians invest on the
premise that the most recent market conditions
aren't realistic, and therefore they make
investment decisions that deviate from the
general direction of the markets.
• Availability and attention grabbling -
Attention-grabbing remark or activity is one
that is intended to make people notice. This
could be made possible by spreading the
awareness or information on investment
options / assets. Availability of information
will grab attention of the investors.
• Anchoring to available cues – Another
behavioural pattern which stems from
Representativeness Heuristics is the anchoring
effect. People tend to anchor their decisions on
the available figures and numbers, instead of
searching for the complete information.
• Herding effect - – herd mentality is
characterised by a lack of individual decision
making or thoughtfulness, causing people to
think and act in the same way as majority of
those around them. Small investors keep
watching participants for confirmation and
then end up entering the market when the
markets are overheated and poised for
corrections.
3. Explain the term ‘Overconfidence’ in the context
of financial behaviour.
• Is the tendency for people to overestimate their
knowledge, abilities and the precision of their
information, or to be overly sanguine of the
future and their ability to control it.
• Overconfidence can be measured in different
ways – one among it is miscalibration.
• Miscalibration is the tendency for people to
overestimate the precision of their knowledge.
4. What are the common traps for an overconfident
investor?
• Excessive trading (Thrill seeking, Experience
seeking, Disinhibition, Boredom
susceptibility)
• Under diversification – overconfident
investors will be reluctant to diversify
• Analysts tend to be overly optimistic about the
prospects of the companies they follow
(Excessive risk taking)
5. Explain the influence of emotions on investor
behaviour.
While we cannot understand every factor that
affects decision- making, some emotions have
proven to be useful in understanding the
financial choices people make. The following
are a few among them
• Regret, Pride and Anger – Regret is a
negative emotion. You might regret a bad
investment decision and wish you had made a
different choice. Pride is the flip side of regret.
People tend to project if they have earned
profit during the trade. The effects of pride and
regret are asymmetric. People are more
motivated to avoid the feeling of regret than
getting a feeling of pride.
• Disposition effect – Researchers have
recognized the tendency of investors to sell
superior – performing stocks too early while
holding onto losers. This is called disposition
effect. It happens because investors will have a
feeling that the losers will bounce back.
• House money effect- This is the tendency of
an investor to assume more risk if he has
achieved a profit or gain earlier. This is
normally seen in gambling or casinos.
• Snake bit effect- An initial loss can increase
the risk aversion of a person and it is called
snake bit effect
• Trying to break even effect – Sometimes
person with a prior loss may take a risky
gamble in order to try to break even.
6. Explain the term ‘Mental Accounting’.
Mental accounting refers to the way people categorize
money. According to mental accounting, people place
value based on which category the money falls into.
Some categories are worth more than other categories.
This can sometimes go against logic.
You are taking a break from work and are at the local
hamburger joint. You are about to purchase your
favourite bacon cheeseburger with fries combo meal
for $8. As you get ready to pay for your meal, however,
you notice that you are short by $8 in your wallet.
Thinking back, you realize that you might have lost
that money when you were jogging this morning. You
think about it, and you decide to purchase your meal.
The $8 was lost, and there's nothing you can do about
it.
Now, what if, after purchasing your cheeseburger and
fries combo meal, you trip and your food ends up all
over the floor. Would you go ahead and purchase
another cheeseburger and fries combo meal?
Traditional economics says that you would react in the
same manner in both scenarios since you have lost the
same amount of money, $8. But surprisingly, research
shows that more people, 88 percent actually, end up
buying when the money is lost, and only 46 percent
buy when they have to replace a lost item that has
already been purchased.
7. Explain the different manifestations of the same.
• Investors have a tendency to ride the losers as
they are reluctant to realize losses. Mentally
they treat unrealized “paper loss” and realized
“loss” differently.
• Investors often integrate the sale of losers so
that the feeling of regret is confined to one
time period
• Investors tend to stagger the sale of winners
over time to prolong the favourable experience.
• People are more venturesome with money
received as bonus, but very conservative with
money set aside for children’s education.
• Irrational preference for stocks paying high
dividends (they don’t mind spending the
dividend income), but do not prefer to sell a
few shares and spend the capital.
8. Define ‘Expected utility theory’
The expected utility theory deals with the analysis of
situations where individuals must make a decision
without knowing which outcomes may result from that
decision, this is, decision making under uncertainty.
These individuals will choose the act that will result in
the highest expected utility, being this the sum of the
products of probability and utility over all possible
outcomes. The decision made will also depend on the
agent’s risk aversion and the utility of other agents.
Expected Utility = p1*u1 + p2*u2 + … + pn*un.
p: probability of an event
u: utility derived from the event
9. Explain Allais paradox
Allias paradox is an inconsistency which you can see
in the case of Expected Utility Theory.
This paradox relies in the fact that in certain types of
gambling, although people usually prefer certainty
to uncertainty, if they are approached differently, they
will prefer the uncertainty that was previously
rejected.
10. Explain Elsberg’s paradoxes
The Ellsberg paradox is a paradox in decision
theory in which people's choices violate the postulates
of subjective expected utility. It is generally taken to
be evidence for ambiguity aversion. People will
always choose a known probability of winning over an
unknown probability of winning even if the known
probability is low and the unknown probability could
be a guarantee of winning.
That is, given a choice of risks to take (such as bets),
people "prefer the devil they know" rather than
assuming a risk where odds are difficult or impossible
to calculate.
6. Explain Investor Decision Cycle and various
emotions attached to market cycles.
Module-4 – Corporate Finance: Mispricing and Goals
of Managers- Irrational Managers or Irrational
Investors. Investor psychology-Forecasting Bias-
Emotional Decision Making- Errors in Decision
making- Behavioural corporate finance and
Managerial decision making- Investing style and
Behaviour Finance.
1. Why behavioural finance matters in corporate
finance setting?
Behavioural factors may matter for two reasons (1)
Managers, like investors and other financial market
participants appear to sometimes act in a less than fully
rational fashion due to cognitive limitations,
overconfidence and force of emotions. (2) Rational
managers may at times take advantage of the valuation
mistakes made by irrational investors.
2. What are the examples of managerial actions
taking advantage of mispricing (caused by
irrational investors)?
Managers can take advantage of mispricing by
a. Changing the company name – A strategy at
negligible cost is to change the company name to
something with greater appeal to investors. During the
internet crazy period in late 1990s there were many
companies that changed their names to “dotcom”.
These firms saw their shares appreciate, even when
their underlying business had little or nothing to do
with internet.
2. Explaining dividend patterns – In a world of perfect
market, payment of dividends could be irrelevant. But
in the real world it is much more complicated.
Managers use dividends are catering tools.
3. Share Issues and repurchases – When shares are
overvalued, current long run shareholders benefit when
management issues shares. Conversly, when shares are
undervalued, long run shareholders benefit when
managers repurchase stock.
4. Mergers and Acquisitions – Cash acquisitions make
sense when undervalued assets can be acquired. The
hostility of target management in such cases serves the
interests of their own shareholders.
3. Explain the term ‘mispricing’
The definition of a mispricing is something that has
the wrong price on it. Mispricing could lead to
underpricing or overpricing of shares.
4. How do behavioural mistakes (flaws) of
managers (irrational managers) impact capital
budgeting decisions in corporate finance scenario?
The following are the prominent errors which may
influence capital budgeting decisions as a result of
behavioural flaws of the managers.
a). Due to ease of processing, Pay Back Period is
often used to evaluate the capital budgeting decisions
rather than using more scientific techniques like Net
Present Value or IRR. The desirability to get your
money back quickly is a clear concept even to a not so
knowledgeable person. Psychology is playing a role
here in choosing a less sophisticated method like Pay
Back Period, due to its ease of processing.
b). Disposition effect is a behavioural flaw which tend
to influence the abandonment of loss making projects
by the managers. Managers tend to continue loss
making projects, on the hope that things will
eventually turn around. It is seen that the abandonment
of loss making projects are well received by the market,
rather than continuing the same.
c). Overconfidence of managers can lead to
overinvestment in projects which will eventually lead
to unutilised idle capital. Overconfidence of the
managers will also result in ignoring a project’s
sensitivity to cashflows. Overconfident manager tends
to overestimate the returns from their projects.
Overconfident managers tend to be more active in
merger and acquisition front without assessing the
market factors.
5. Explain the psychographic models which can be
used to explain investor psychology?
a) Barnewell Two Way Model
One of the oldest and most popular psychographic
models was developed by M.M. Barnewell to improve
the interface of investment advisors with clients. He
made a distinction between two relatively simple
investor types viz, passive investors and active
investors.
Passive Investor – (1) Passive investors have lesser
tolerance for risk and greater need and security (2) The
smaller the economic resources of the person, the
greater the likelihood that the person will be a passive
investor (3) Certain occupational groups tend to be
passive investors (4) A large proportion of the middle
and lower socio – economic classes are passive
investor
Active Investor – (1) Active investors have a high
tolerance for risk and lesser need for security (2)
Active investors prefer to control their investments (3)
By their active involvement, they believe that they can
reduce risk to an acceptable level
b) Bailard, Biehl and Kaiser (BB&K) Five way
model
• BB&K classify investor personalities along
two dimensions viz., level of confidence and
method of action.
• The first aspect of personality deals with how
confidently investor approaches life (approach
to his career, health and his money).
• The second element deals with whether the
investor is methodical, careful and analytical
in his approach or whether he is emotional,
intuitive and impetuous.
• Two axis – “Confident – anxious axis” &
“Careful – impetuous axis”
BB&K Five Way Model provides the following five
investor personality types.
1. The Individualist - An individualist tends to go
his own way and is typified by an independent
professional or the small business person.
Quite confident, an individual decides, in a
careful, methodical and analytical manner.
 Since he is rational, the investment counsel
can communicate well with him.
2. The Adventurer - A very confident person, the
adventurer, is willing to place huge bets. Since
he has his own ideas about investing, it is
difficult to advise him. From the point of view
of the investment counsel, the adventurer is a
volatile client.
3. The Celebrity - The celebrity prefers to be
where the action is and does not want to be left
out. Although he may have his own ideas
about other things in life, in the realm of
investing he does not have his own ideas. So
he is perhaps the best prey for maximum
broker turnover.
4. The Guardian - The guardian is careful and a
bit concerned about money. When people get
older and when they reach their retirement age,
they approach this personality type. The
guardian focuses on preserving his assets. He
is not interested in volatility or excitement.
5. The Straight Arrow - A straight arrow is well
balanced. Since he cannot be placed in any
specific quadrant, he falls near the centre. He
is a relatively balanced composite of the four
different investor types and is willing to be
exposed to moderate amounts of risk.
6. What do you mean by forecasting bias?
A forecast bias occurs when there are consistent
differences between actual outcomes and previously
generated forecasts of those quantities; that is:
forecasts may have a general tendency to be too high
or too low. A normal property of a good forecast is
that it is not biased.
7. Will emotions affect decision making?
Behaviour is different from emotions but is very
strongly influenced by them. One way
that behaviour is affected by emotions is through
motivation, which drives a person's behaviour. When a
person feels frustration, anger, tension or fear, they are
more likely to act aggressively towards others.
8. Explain the techniques which can be used to
overcome psychological biases.
• Understand the biases
• Focus on the big picture
• Rely on words and numbers, not sights and
sounds
• Follow a set of quantitative investment criteria
• Diversify
• Take care of the downside
• Control your investment environment
• Strive to earn market returns
• Track your feelings
• Review your biases periodically
• Rebalance
Module-5 – Anomaly Attenuation-style peer Groups
and style investing- Multivariate approach-Style
rotation-Neurofinance and the trader’s Brain-
Expertise and Implicit learning- Expertise and
Emotion- Gender, Personality Type, and Investor
Behaviour- Investor Personality Types-
Neuroeconomics- rational Managers and Irrational
investors
1. Explain the term “anomaly attenuation”
A number of anomalies (irregularities) once reported
in the market, either attenuated or fully disappeared
over a period of time. A number of research papers
have also documented a decline in the anomaly profits
in recent years. This could be because of the changes
in trading technologies and liquidity in the financial
markets.
2. What is an example of an anomaly that once
reported in research studies has attenuated? Is this
positive or negative from the stand point of market
efficiency?
Most of the financial anomalies have attenuated. A few
examples are the small firm effect, the January effect,
the weekend effect etc. The intensity of the anomaly
impact has significantly reduced and this is negative
from the standpoint of the market efficiency. As we
know, anomalies go against the assumptions of the
efficient market hypothesis and so if the intensity
reduces, it means the anomaly is headed towards the
provisions of the EMH as outlined by Fama (1970).
3. Explain the following terms
a. Style Peer Groups
Portfolio managers are commonly evaluated based on
their style. Style is usually defined in terms of firm
size and growth v/s value. Portfolio managers are
divided into nine groups based on three by three matrix,
where size changes from small – cap to mid – cap to
large – cap, and value v/s growth ranges from value to
blend to growth.
If a manager tilts towards small cap value (because
small cap value has performed well in the past) she
will be compared against other managers doing the
exact same thing (Style followed by the peer group).
b. Style Investing
Style investing is the study of asset prices in an
economy where some investors classify risky assets
into different styles and move funds back and forth
between these styles depending on their relative
performance. Style investing is an investment
approach in which rotation among different "styles" is
supposed to be important for successful investing. As
opposed to investing in individual securities, style
investors can decide to make portfolio allocation
decisions by placing their money in broad categories of
assets, such as "large-cap", "growth", "international",
or "emerging markets".
c. Style Tilting
A portfolio “tilt” is industry slang for an investment
strategy that overweighs a particular
investment style. An example would be tilting to
small-cap stocks or value stocks that have historically
delivered higher returns than the stock market.
d. Style rotation
This is the notion that there exist predictability in the
relative performance of "box style" portfolios, i.e.
those portfolios characterized by the factors of size
(small cap, mid cap, large cap) and growth vs. value
(value, blend, growth).
4. Explain the role of neuro finance in describing a
trader’s brain
profesional securities traders experience emotional
states characterized by hugh
arousal market events such as high price volatility,
using peripheral measures of arousal, like skin
conductance and blood volume pulse.
profesional securities traders experience emotional
states characterized by hugh
arousal market events such as high price volatility,
using peripheral measures of arousal, like skin
conductance and blood volume pulse.
Neurofinance is one of the sub-fields in the area of
Behavioural Finance research. It’s the area which
focuses on how out brain works. In neurofinance, we
examine experimentally the nature of the cognitive
processes engaged in acquiring and processing
information in financial decision making.
To achieve this there are two types of actions.
 Look at behaviour
 Scan the brain of the subjects during the
experiment
When this was done in the case of traders, researchers
could understand a lot of behavioural factors. The two
prominent points which they have noted are as follows:
a. Greed actually turns off the fear centres in the brain.
This will eventually lead to risk taking behaviours by
the traders.
b. We are naturally inclined to want to “do something”
in times of stress. It gives us specific action items to do
so that our natural instincts – which rarely work in our
favour when trading. This is what most of the traders
do when they are exposed to stress.
5. Differentiate ‘Expertise’ and ‘Implicit Learning’.
Expertise is special skill or knowledge that is acquired
by training, study, or practice. Expertise in investing or
trading can be research expertise or pattern recognition
expertise.
Implicit learning is the learning of complex
information in an incidental manner, without
awareness of what has been learned. Example –
learning of language acquisition and learning the
process of socialization.
6. Explain the role of gender and personality type
on investor behaviour.
PERSONALITY TYPES AND INVESTOR
BEHAVIOUR
A) FIRST PERSONALITY TYPE MODEL
SUGGECTED BY POMPIAN
The three dimensions of personality types are idealist
versus pragmatist, framer versus integrator and
reflector versus realist.
Individual who fit into the idealists can be the theme
to the subsequent biases: overconfidence, optimism,
availability, illusion of control, confirmation, recency
and representativeness. Pragmatists being an investor
are classically not prone to the abovementioned biases.
While in second dimension, framers may be subject to
these biases: anchoring, conservatism, mental
accounting, framing and ambiguity. Integrators don’t
have aforesaid biases of framers.
In third dimension, reflectors prone to the following
biases: cognitive dissonance, loss aversion,
endowment, self-control, regret, status quo and
hindsight but realists do not prone to biases of
reflectors. Pragmatist, integrator and realist thinking
are opposite to the idealist, framer and reflector
B) SECOND PERSONALITY TYPE MODEL
SUGGESTED BY MYERS & BRIGGS
1. Rational(NT)- Attribute to the technical results.
They sell and buy according to Financial statements
and financial ratios; therefore, their strength in making
quick decision reduces.
2. Guardian(SJ) They trust consistent and clear
information that is available, such as: profitability
ratios. They make a better decision in stocks that have
obvious tends.
3. Idealist(NF) They do not interest to work as a direct
investor in stock exchange and if they participate, they
prefer to keep stocks.
4. Artisan (SP) Interested in executives opinions,
gossip and shareholders They are risky and prefer to
earn profits from the volatility.
GENDER AND INVESTOR BEHAVIOUR
Women are more conservative while investing and are
unwilling to take risk. Thus women should be offered
such financial products which are best suited for them
in terms of risk and return characteristics. Males are
more overconfident than females with respect to risk
taking in investment. Men have a stronger tendency
towards overconfident behaviour than women.
6. Explain the process of de-biasing
Some steps to eliminate bias
1. Awareness of bias
2. Motivation to eliminate bias
3. Direction and magnitude on awareness of bias
4. Ability to eliminate bias
But the steps taken to reduce / eliminate bias will
depend upon the personality of individuals.
For individuals who belong to ‘Perfectible judges’
category, debiasing can be done through
1. Warn of the problem
2. Describe problem
3. Provide personalized feedback
4. Train extensively
For individuals who belong to ‘Incorrigible Judges’,
debiasing can be done through
1. Replace them
2. Recalibrate their responses
3. Build error into your planning
7. Explain the different secretions of brain and how
they influence investment behaviour.
Role of Dopamine
Dopamine is a chemical secreted in brain at the time
of a feeling of pleasure. More quantity of dopamine is
secreted at the time of unexpected profits earned easily.
At the same time when investors face an unexpected
loss, the secretion of dopamine completely stops, and
the person feels depressed.
Dopamine is responsible for behavioural biases like
Herd Behaviour, Overconfidence and Optimism in the
investors.
Role of Serotonin
Serotonin is a transmitter available in central nervous
system and digestive tract. Serotonin is responsible for
the feelings of anxiety, depression and appetite.
Reduced levels of serotonin cause investors to sell
winning positions too early. Loss Aversion may be a
result of reduced levels of serotonin.
“Take the money and run” is the tendency developed
because of reduced supply of serotonin.
8. Explain the different parts of brain which play a
crucial role in investment behaviour.
a. Role of Amygdala
Almond shaped body situated in brain’s temporal
medial lobe is responsible for feeling of emotions like
fear, pleasure, developing phobia and post traumatic
stress. Amygdala is responsible for “fight or flight”
behaviour of investors. Selling behavior of investors
in falling markets are due to functioning of amygdale.
Investors want to flight away from the falling markets
because of the feeling of fear, but actually it is the time
to fight with the bear phase and add some
fundamentally strong stocks at corrected value.
b. Role of Prefrontal Cortex
The prefrontal cortex of brain is responsible of
complex cognitive decision making in social behaviour
and expression of personality. Whenever investors
commit cognitive errors, it means that prefrontal cortex
does not have proper data in form of accurate,
appropriate and update information for drawing
decisions.
c. Role of Nucleus Accumbens and Anterior
Cingulate
Nucleus Accumbens is a group of neurons located
behind the ears of a human being. This group of
neurons plays a role in developing addictive behaviour.
Anterior Cingulate, which is the frontal portion of
cingulated cortex plays important role in reward
anticipation and decision making.
Together, the Nucleus Accumbens and anterior
cingulated help people to identify patterns and evaluate
alternatives.