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BEHAVIOURAL FINANCE
The Irrational Influence
Outline
Key Differences between Traditional Finance and Behavioural
Finance
Heuristic Driven Biases
Frame Dependence
Traditional Finance
People process data appropriately and correctly
Behavioural Finance
People employ imperfect rules of thumb that predispose
them to errors
fundamental value
Heuristic-Driven Biases
The important heuristic-driven biases and cognitive errors that
impair judgement are
Representativeness
Illusion of Control
Overconfidence
Affect heuristic
Anchoring
Regret aversion
Familiarity
Aversion to ambiguity
Confirmation bias
Innumeracy
Representativeness
Representativeness refers to the tendency to form judgments based
on stereotypes. While representativeness may be a good rule of
thumb, it can lead people astray. For example:
Over Confidence
People tend to be overconfident and hence overestimate the
accuracy of their forecasts.
Anchoring
After forming an opinion people are unwilling to change it,
even though they receive new information that is relevant.
Anchoring manifests itself in a phenomenon called the postearnings announcement drift. Stock market reacts
gradually, not instantaneously, to unexpectedly bad (good)
earnings.
Aversion To Ambiguity
People are fearful of ambiguous situations where they feel
they have little information about the possible outcomes.
Innumeracy
People have difficulty with numbers. Trouble with numbers is
reflected in the following:
People ignore the base rate and go more by the case rate.
Familiarity
People are comfortable with things that are familiar to them. The
human brain often uses the familiarity shortcut in choosing
investments. Indeed, familiarity breeds investment. That is why
people tend to invest more in the stocks of their employer company
local companies, and domestic companies.
Confirmation Bias
Illusion of Control
The outcome of an investment decision typically depends on a
combination of luck and skill. In general, investors have an inflated
view of how much control they have over outcomes. This bias is
called the illusion of control and leads to over-optimism.
Affect Heuristic
People decide mostly on what feels right to them emotionally. They
rely heavily on intuition and gut feeling. Psychologists refer to this
as the affect heuristic. Like other heuristics, the affect heuristic
involves mental shortcuts that can cause bias.
Regret Aversion
Regret is the emotional pain a person experiences when his decision
turns sour. Regret of commission is the disappointment from taking
an action, whereas the regret of omission is the disappointment from
not taking an action. Regret of commission is typically more painful
than the regret of omission. People avoid actions that cause regret.
Frame Dependence
Frame independent investors pay attention to changes in
their total wealth.
emotional factors.
Prospect Theory
According to the prospect theory people value gains/losses according
to a S-shaped utility function shown below
Utility
Losses
Gains
Loss Aversion
The utility function is steeper for losses than for gains. This
means that people feel more strongly about the pain from a
loss than the pleasure from an equal gain about 2 times as
strongly, according to Kahneman and Tversky. This
phenomenon is referred to as loss aversion
making.
Mental Accounting
People separate their money into various mental accounts
and treat a rupee in one account differently from a rupee in
another because each account has a different significance for
them
Narrow Framing
Investors engage in narrow framing they focus on
changes in wealth that are narrowly defined, both in a crosssectional as well as in a temporal sense.
Narrow Framing
Narrow framing in a temporal sense means that investors pay
undue attention to short-term gains and losses, even when
their investment horizon is long.
Behavioural Portfolio
The psychological tendencies of investors prods them to build their
portfolios as a pyramid of assets as shown below
Options
Commercial
property
Stocks
Bonds
Residential house
Cash
Anticipation
Anxiety
Pride
Goals
Regret
Market Inefficiency
Behavioural finance argues that, thanks to various behavioural
influences, often there is a discrepancy between market price and
Noise trading
Limits to arbitrage
Noise Trading
Noise traders may suffer from similar judgmental biases while
processing information. For example :
They tend to put lesser weight on base rates and more weight
on new information and hence overreact to news
Limits To Arbitrage
Arbitrage . . real world is limited of two types of risk
Fundamental risk : buying undervalued securities tends
risky .. because .. market may fall further & inflict losses
Resale price risk : . . arises mainly . . fact . .
Arbitrageurs have finite horizons :
Price Behaviour
Presence . . noise traders . . & limits to arbitrage . . Investor
sentiment does influence prices
Prices vary more warranted by changes . . fundamentals
Pt = Price
ut = ut-1 + vt
Pt*
= Fund Value
Views Of Experts
J.M. Keynes : in point of fact, all sorts of considerations
enter into the market valuation which are in no way relevant to the
prospective yield
Irwin Friend : a broad overview of the past half century
suggests that there have been numerous occasions when large bodies
of investors have been emotionally affected by fads & fashions in
wall street
William Baumol : we have all seen cases where the
behaviour of prices on the stock market has apparently been
capricious or even worse, cases where hysteria has magnified largely
irrelevant events into controlling influences
Summing Up
The central assumption of the traditional finance model is
that people are rational. However, psychologists argue that
people suffer from cognitive and emotional biases.
impair
judgment
are:
representativeness,
innumeracy.
People feel more strongly about the pain from a loss than the
another.
required.
Appendix 10 A
NEUROECONOMICS
In Theory
Investors have well-defined goals.
In Practice
Investors are not sure about their
goals.
Investors often act impulsively.
Greater effort
performance.
leads
to
superior
Neuroeconomics, a new-born
Amygdala
Deep inside the brain is an almond-shaped tissue called the
amygdala. When you face a potential risk, the amygdala (which is a
fraction of a second can make the difference between life and death.
Two Minds
Humans literally have two minds when it comes to time. On the one
hand, we are impatient, fixated on the short run, eager to spend now,
Intuition
Most judgments are driven by intuition. People who buy stocks
rarely analyse the underlying business. Instead, they rely on a
feeling, a sensation : amateur investors as well as professional
investors. Portfolio managers constantly talk about their gut
feeling.
Intuition can yield fast and accurate judgments only when the
rules for reaching a good decision are simple and stable.
Unfortunately, investment choices are not simple and the key to
success, at least in the short run, is seldom stable. As Jason Zweig
put it: In the madhouse of the financial markets, the only rule that
appears to apply is Murphys Law. And even that guideline comes
with a devilish twist: Whatever can go wrong will go wrong, but
only when you least expect it to.
to mortal danger.
happiness.
Expectation, both good and bad, is more intense than actual experience.
It often feels better to anticipate making money than actually making it.
Pattern Seeking
The human brain incorrigibly searches for patterns even when
none exist.
There appears to be module in the left hemisphere of the brain that
Dopamine-drunk Wanting
Over millions of years our brains have developed a dopamine
drunk wanting system that prods us to compete for more money,
power, and material things.
because they bring happiness but because those who managed to get
the stone-age equivalent of these things are our ancestors, and those
did not , turned out be biological dead ends. As psychologist Daniel
Nettle put it: I will argue that we are programmed for by evolution
in not happiness itself, but a set of beliefs about the kinds of things
that will bring happiness, and a disposition to pursue them.
Exposure Effect
Human beings tend to like what they experience most often.
Psychologist Zajonc call this the mere-exposure effect. Says
Zajonc: The repetition of an experience is intrinsically pleasurable.
It augments our mood, and that pleasure spills over anything which
is in the vicinity. Aesop got it wrong when he said familiarity
breeds contempt. On the contrary familiarity breeds
contentment.
Illustrating this, Jason Zweig says: You might think you like
Coke better for the taste, when in fact you like it better mainly
because its more familiar. Likewise, investors plunk money into
brand-name stocks, precisely because the brand name makes them
feel good.
Illusion of Control
Humans suffer from illusion of control, an uncanny feeling that they
can exert influence over random choice with their actions. For example,
when a person wants to roll a high number, he shakes the dice and throws
them hard. The illusion of control tends to be stronger when an activity
appears at least partly random, offers multiple choices, requires effort, and
appears familiar. Since investing satisfies these tests, many investors suffer
from the illusion of control.
According to neuroeconomists, the caudate area which lies deep in the
centre of the brain serves as the coincidence detector. In this part of the
reflexive, emotional brain, actions are matched against the outcomes in the
world around us, irrespective of whether they are actually connected or
not.
Hindsight Bias
Once we learn what actually happened, we look back and believe
that we knew what was going to happen. Psychologists call this
Risk Tolerance
The conventional assumption that every person has a certain level of risk
tolerance is not correct because our perception about risk changes all the
time. As Jason Zweig puts it: In reality, your perception of investment
risk is in constant flux, depending on your memories of past experiences,
whether you are alone or part of a group, how familiar and controllable
the risk feels to you, how it is described, and what mood you happen to be
in the moment. Even a slight change in these elements can turn you from
an adventurous bull to a cautious bear. If you mindlessly rely on your
intuitive perception of risk, you are likely to assume risks that you should
avoid and shun risks that you should embrace.
Surprise
Humans and great apes chimpanzees, gorillas, and organgutans
have specialised neurons called spindle cells located in a central
forward region of the brain called the anterior cingulated cortex
(ACC).
Some Guidelines
You can improve the odds of your investment performance by
engaging more on the reflective side of the brain. Here are some
guidelines to help you in doing so.
Rely on words and numbers, not sights and sounds
Invest with rules
Count to ten
Take a global view
Control the controllable
Dont obsess
Maintain an investment diary
Track your feelings
Rebalance
Be happy
Be Happy
A very powerful lesson from the new research into happiness suggests that
managing your emotions and expectations is as important as managing your
money to your sense of well-being.
According to Martin Seligman, an eminent psychologist, having, doing, and
being are three basic paths to happiness. Having is concerned about material
purchases and possessions what Martin Seligman calls the pleasant life. Doing
centres around activities and experiences what Seligman calls the good life.
Being is about committing yourself to a larger cause what Seligman calls the
meaningful life.
Money spent on having creates diminishing returns; the more accustomed you
become to material possessions, the less happiness you derive from them.
However, money spent on doing and being provides a much longer afterglow. As
Jason Zweig puts it: In the end, living a rich life depends less on how much you
own than on how much you do, what you stand for, and how fully you reach your
own potential.
There are many ways in which you can get happiness with minimal effort, such
as learning new things, pursuing interesting hobbies, participating in social
service, counting your blessings, breaking your routine and embracing new
experiences, accentuating the positive, meditating, and so on.