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Chapter- II

Behavioral Finance and Behavioral Bias - Conceptual Parameters

Introduction:

Behavioral Finance is becoming an integral part of decision making process


because it heavily influences the investors‘ performance. Investors may be inclined
toward various types of behavioral biases which lead them to make cognitive errors.
They may make predictable non-optimal choices when faced of heuristic
simplifications. Behavioral biases abstractly are defined in the same was as systematic
errors in judgments. (Chen at al 2007).

The discussion in this part of the thesis is focused on the various dimensions
of Behavioral Finance and Behavioral Biases viz.

 Concept of Behavioral Finance and the related field


 Evolution of the discipline of Behavioral Finance.
 Application of Behavioral Finance.
 Behavioral Finance and Investment Decisions
 Behavioral Biases Theoretical Framework
 Prospect Theory and Heuristics
 Behavioral Biases

Financial Decision Making and Behavioral Biases

Introduction:

In rational world investors make financial decisions to maximize their risk-


return-trade off. But modern theory of investor decision making suggests that
investors do not always act rationally while making an investment decision.
Behavioral finance identifies various concepts that makes a human being behave
irrationally thus leading to suboptimal decisions. Bernstein (1998) says ―evidence
reveals repeated patterns of irrationality, inconsistency and incompetence in the ways
human beings arrive at decisions and choices when faced with uncertainly‖ Nofsinger
(2001) says that that assumptions of rationality and un-biasedness of people have
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been drubbed by psychologists for a long time. Investors are found to deal with
several cognitive and psychological errors. Tversky (1990) found that (1) investors
are not always risk averse but often risk seeking while they make an investment
decision 2) investors interpret outcomes of various decisions differently 3) the
expectations of investors rather than rational.

Behavioral finance and in related field:

Behavioral finance study the effects of social, cognitive and emotional factors
on the economic decisions of individuals and institutions and the consequences for
market prices returns, the resource allocation in the investment field are primarily
concerned with the bonds of rationality of economic agents. Behavioral model,
typically integrate insights from psychology with neoclassical economics theory. In
this direction Behavioral models cover a range of concepts methods and fields.

Behavior finance has been perceived by different writers in varied ways. Some
authors perceived behavioral finance as the study of the influence of psychology on
the behavior of practitioners and the subsequent effect on markets. The science deals
with theories and experiments focused on what happens when investors make
decisions based on hunches and emotions. Shefrin (2000) comprehends behavioral
finance as a rapidly growing art that deals with the influences of psychology on the
behavior financial practitioners. Belsky and Gilovich (1999) emphasizes that
behavioral economics explain why and how people make seemingly irrational or
illogical decisions when they spend, invest, save and borrow money. Barber and
Odean (1999) have observed ―Behavioral finance relaxes the traditional assumption of
financial economics by incorporating these observable systematic by incorporating
these observable systematic and very human departures from rationality into standard
models of financial markets. The tendency for human beings to be overconfident
causes the human desire to avoid regret prompts the second.‖ Fama (1998) has
described ―Behavioral finance‖ as a field of finance that proposes explanation of stock
market anomalies using identified psychological biases rather than dismissing them as
―chance results consistent with the market efficiency hypothesis‖.

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Behavioral Finance Evolution of the Discipline:

Behavioral finance emerged as a branch of social psychology that captures the


human side of decision making. Research in this field are traced to the eighteenth
century with significant works like theory of Moral Sentiment‘ (1759) and ―Wealth of
Nations‘ that guides individuals in marking social economic and even financial
decisions. Adam Smith in theory of moral sentiments emphasizes on the role of
sentiments like pride, shame, insecurity and egotism. A Bentham (1789) high light the
psychological aspects of utility function and argues that human concern for happiness
makes it impossible for them to make a decision that is entirely devoid of emotions.
This aspect of social psychology was revived in the twentieth century. Selden G.C.
(1912) in ‗Psychology of Stock Market: Human impulses lead to speculative disasters
identifies that the stock price movements on the exchanges are dependent on the
mental attitude of investors. M. Keynes in his book ―General Theory of Employment
Interest and Money‖ (1936) has observed that the role of sentiment is the ‗animal
spirit‘ of individuals. Keynes criticized the concept of homo economics and argued
that human beings cannot be completely informed of every situation in order to
maximize their expected utility. Ewell (2007) has described behavioral finance as the
study of influence of psychology on the behavior of financial practitioners and the
subsequent effect on markets

PSYCHOLOGY SOCIOLOGY

BEHAVIOURAL FINANCE

FINANCE

Evolution of Behavioral Finance

Source – Schindler (2007)

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Behavioral finance is comprehended in the following ways:

 Behavioral finance is the integration of classical economics and finance with


psychology and the decision making sciences.
 Behavioral finance is an attempt to explain what causes some of the anomalies
that have been observed and reported in the finance literature.
 Behavioral finance is the study of how investors systematically make errors in
judgments or mental mistake.

Behavioral finance indicates that investor‘s behavior in market depends on


psychological principles of decision making which explains why people buy and sell
investments. It focuses on how investors interpret information and act on information
to implement their financial investment decisions. In fact psychological process and
biases influences investors decision making and influence the market outcomes.

Behavioral Finance and Traditional Finance:

The two approaches are characterized by some differences. Behaviorists argue


that behavioral theories are necessary to explain. Traditional finance theory does not
accommodate this argument. Traditionalist uses a philosophy of instrumental
positions to argue that the competitive institutions in finance make deviation from
Homo Economics. Traditional finance incorporates no element of human psychology.
Behavioral finance usually incorporates human psychology while making investment
decisions. The key differences relate to the following

 Traditional finance assumes that people process data appropriately and


correctly whereas behavioral finance recognizes that people employ imperfect
rules of thumb (heuristics) to process data which induces biases to their belief
and predisposes them to commit errors.
 Traditional finance presupposes that people view all decisions through
transparent and objective angle. Behavioral finance postulates that perception
of risk and return are significantly influenced by how decision problem is
framed.

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 Traditional finance assumes that people are guided by reasons and logic and
independent judgment whereas behavioral finance recognizes that emotions
and herd instincts play on important role in influencing decisions.
 Traditional finance argues that markets are efficient implying that the price of
each security is an unbiased estimate of its intrinsic value. Behavioral finance
contends that heuristic driven biases and errors form effects on emotions and
social influence often lead to discrepancy between market price and
fundamental value
 Traditional finance views that price follow random walk though prices
fluctuate to extent they are brought back to equilibrium in time. Behavioral
finance views that prices are pushed by investors to unsustainable levels in
both directions. Investor optimists are disappointed and pessimists are
surprised.

Application of Behavioral Finance:

Behavioral finance actually equips professionals with insights which allow


them to understand and overcome many proven psychological traps that are present
involving human cognition and emotions. This includes Corporate Board, Fund
Managers, and Individuals, Institutional Investors, Portfolio Managers, Financial
Analysts, Advisors and even policy makers. Behavioral theories exist and occur
across all decision spectrums because of the psychological phenomena and factors are
systematic in nature and can move markets for prolonged periods. It applies to:

1. Investors
2. Corporations
3. Markets
4. Regulators
5. Education

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Behavioral Finance and Investment Decisions:

Decisions making is a process of choosing a particular alternative among a


number of possible courses of actions. Investor‘s decision making differs based on
their demographic factors and socio economic factors like educational levels, age,
gender and race. In view of the run up to stock (capital) market boom in 2007 and
subsequent downturn of financial markets, understanding irrational investor behavior
is as important as it has ever been in the present scenario. Behavioral finance becomes
integral part of decision making process due to its influence on performance of
investment in stock market as well as mutual funds. Participants in the market cannot
behave rationally always. They deviate from rationality and expected utility
assumptions while really making investment decisions. Thus, behavioral finance helps
investors as well as market participants to understand biases and other psychological
constraints in their interplay in market.

Behavioral Biases Theoretical Framework:

Research in psychology has documented a range of decision making behaviors


known as behavioral biases. These biases can affect all types of decision making but
have particular implications in relation to money and investing. The biases related to
how we process information to reach decisions and the preferences we have (Shefrin
Hersh 2000). The biases tend to sit deep within our psyche and may serve us well in
certain circumstances. However, in investments they may lead us to unhelpful or even
hurtful decisions. As a part of human nature these biases affect all types of investors
both professional and private. However if the biases and their effects are understood
we may be able to reduce their influence and learn to work around them. It is found
that a variety of documented biases arise in particular circumstances some of which
contradict others.

Behavioral economists have tried to explain various irrational investor


behaviors in financial markets. They draw on the knowledge of human cognitive
behavioral theories from psychology, sociology and anthropology two major theories
in this context are prospect theory and Heuristics.

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Prospect Theory:

The theory was originally conceived by Kahneman and Tversky (1979) and
later resulted in Daniel Kaheman being awarded the Nobel Prize for Economics. The
work by the authors is considered as path breaking in behavioral finance. They
introduced the concept of prospect theory for the analysis of decision making under
risk. This theory is considered to be seminal in the literature of behavioral finance. It
was developed as an alternative model for expected utility theory. It throws light on
how individual evaluate gain or losses. The theory has three key aspects.

1. People sometimes exhibit risk aversion and sometimes risk loving


behaviors depending on the nature of the prospect. This is due to the fact
that people give lower weight age to the outcomes which are probable as
compared to those that are certain. This makes them risk averse for choices
with sure gains while risk seekers for choices with sure losses.
2. People assign value to losses or gains rather than final assets. Here two
thought processes come into play. These are editing and evaluation.
During the editing stage the prospects are ranked as per the rules of thumb
(heuristics) and in evaluation stage some reference point is taken into
account that provides a relative basis for determining gain or loses
3. The weight age given to losses is higher than given to gains of the same
amount this is because people are averse to losses as they loom large than
gains this is called loss aversion.

The value function in the prospect theory replaces the utility function in the
expected utility theory. Further instead of using simple probabilities as in the expected
utility theory it uses decision weights which are a function of probability. The
following figure shows the value function of the prospect theory the S-shaped value
function depicted in the figure is the central element of the prospect theory.

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Value

Losses Gains outcomes

Reference Point

Prospect Theory value function

(Kahneman and Tversky 1979)

The shape of the S shaped valued function is concave in the region of gain and
convex in the loss region reflecting risk aversion in the domain of gains and risk
seeking in the domain of losses. The interesting property of the value function is that
it is steepest at the reference point. It implies that a given change in gains or losses has
a smaller effect on the value experienced by an investor when the distance to the
reference point is large. Prospect theory maintains that when choosing between
gambles people compare the gain and losses for each one and selects the one with the
highest perspective utility. This argument indicates that people may choose a portfolio
allocation by computing for each allocation the potential gains and losses in the value
of their holdings and then taking the allocation with the highest prospective utility.
Prospective theory has another element relating to weighing function. The value of
each outcome is multiplied by decision weight. Decision weight measures the impact
of events on the desirability of an investment. Kahneman and Tversky (1979) call this
property as sub certainly decision weight age generally repressive with respect to true
probabilities implying that preferences are less sensitive to variations in probability
than the rational benchmark would suggest. Prospect theory describes several states of
mind that can be expected to influences on individual‘s decision making process.

Heuristics:

Heuristics is a strategy which can be applied to a variety of problems that


usually but not always yields a correct solution. People often use heuristics that

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reduce complex problem solving to more simple judgmental operations (Tversky and
Kahneman 1981). Heuristic decision process is the process by which the investors
find things out for themselves usually by trial and error lead to the development of
rules of thumb. In other words it refers to rules of thumb which humans use to make
decisions in complex uncertain environment (Brabazon 2000). Heuristics is relevant
in modern trading when the number of instrument and the density of information have
increased significantly. Using heuristics allows for speeding up the decision making.
Traditional financial models assume the exclusion of heuristics and assume all
decisions being based on rational statistical tools. (Shefrin -2000)

Behavior Biases:

Modern theory of investors decision making suggests that investors do not


always act rationally while making an investment decision they deal with several
cognitive and psychology errors. These errors are called behavioral biases. Behavioral
bias is defined as a pattern of variation in judgment that occurs in particular situations
which may sometimes lead to perpetual alteration, inaccurate judgment, illogical
interpretation or what is largely called irrationality (Gordon 2011).

Investors may be inclined towards various types of behavioral biases which


lead them to make cognitive errors. People may make predictable non-optimal choice
when faced with difficult and uncertain decisions because of heuristic simplifications.
Behavioral biases abstractly are defined in the way as systematic errors in judgments.
(Chen et al 2006)

Researchers‘ distinguish a long list of biases applying over fifty of these to


individual investor behavior. Recent studies categorize the biases according to some
kind of meaningful framework. Some authors refer to biases heuristics (rules of
thumb) while others call them beliefs, judgments or preferences; still other scholars
classify biases along cognitive or emotional lines. Instead of a universal theory of
investment behavior, behavioral finance research relies on broad collection of
evidence pointing to the ineffectiveness of human decision making in various
economic decision making circumstance‖

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1) Overconfidence Bias:

Overconfidence bias has been considered as the most basic form by Pompian
(2006), Overconfidence according to him can be measurable as unwarranted faith in
ones intuitive reasoning, judgment and cognitive abilities. Overconfidence derives
from a large body of cognitive psychological experiments both their own predictive
abilities and the precision of the information they have been given. Shefrin (2000)
comprehends that overconfidence pertains to how well people understand their own
abilities and the limits of their knowledge. A common trait among investors is a
general overconfidence of their own ability when it comes to picking stock and to
decide when to enter or exit a position. Odean (1998) researched these tendencies and
found that traders that conducted the most trades tended on average to received
significantly lower yields than the market. Barber and Odean (2000) partitioned
investors based on gender and based on the previous psychological research found
that men are more overconfident than women and overconfident investors trade
excessively.

2) Representativeness Bias:

Representativeness is an assessment of the degree of correspondence between a


sample and a population, an instance and a category, an act and an actor, more
generally between an outcome and a model (Gilovich et al (1983). Representativeness
is concerned with determining conditional probabilities. Using the heuristics the
probability that an objector event A belongs to a class or process B is determined.
Representativeness is said to be usually employed while making judgment under
uncertainty when people are asked to judge the probability that A belongs to B
(Tvesky and Kahneman 1983)

Representativeness is judgment based on evidence stereotypes. The investors


recent success; tend to continue into the future also. The tendency of decisions of the
investors to make based on experiences is known as stereotype (Shefrin 200). Ritter
(1991) noted another interesting consequence of judgment by representativeness bias
where he attributes long run under performance of IPOs to the investors‘ short term
orientation. This has many implications to investment decision making, while making
investments, individuals tend to attribute good characteristics of a company directly to

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good characteristic of its stock. These companies turn out to be poor investments
more often than not (Lokonishok et al 1994)

3) Herding Bias:

Herding bias in financial market is identified as tendency of investor‘s


behavior to follow others action. Practitioners usually consider carefully the existence
of herding due to the fact investors rely on collective information more than private
information can result in the prize deviation of the securities from fundamental value.
Therefore many good chances for investment at the present can be impacted.
Academic researchers also pay their attention to herding. Herding impacts on stock
price changes and can influence the attributes of risk and return models and this has
impact on the view points of asset prizing theories. Herding can cause some emotional
biases including conformity congruity and cognitive conflict. Investor may prefer
herding if they believe that herding can help to extract useful and reliable information.

In the security market herding investors base their investment decisions on the
masses decisions of buying or selling stocks. In contrasts informed and rational
investors usually ignore following the slow of masses and this makes the market
efficient. Herding causes a state of inefficient market which is usually recognized by
speculative bubbles.

4) Anchoring Bias:

Anchoring bias comes into play when people have to estimate an unknown
value or magnitude. Here people start their estimation by guessing some initial values
or an ‗anchor‘. This anchor is then adjusted and refined to arrive at the final estimate.
Compbells and Sharpes (2007) have investigated the presence of anchoring bias in
analysts‘ forecasts of monthly economic release for a period 1991 to 2006 and found
that forecasts of any given release were anchored towards recent months realized
values of that release thereby giving rise to predictable surprise.

Anchoring bias is a psychological heuristics which can be said to occur when


investors give unnecessary importance to statistically random and psychologically
determined ‗anchor‘s which lead them to investment decisions that are not essentially

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‗rational‘ when required to estimate a good buy price for a share and lives for is likely
to start by using an initial values called the ‗anchor‘ without much analysis then they
adjust ‗anchor‘ up or down to reflect their analysis or new information. But studies
have shown that this adjustment is insufficient and ends producing results that are
biased. Investors exhibiting this bias are likely to be influenced by these anchors
while answering key questions like ―Is this a good time to buy or sell the stock or is
the stock fairly priced? The concept of Anchoring can thus be explained by the
tendency of investors to ‗anchor‘ their thoughts to a logically irrelevant reference
point while making on investment decision (Pompian 2006).

5) Cognitive Dissonance Bias:

―Cognitive dissonance is the inconsistent mental state that precedes the


adjustment process. That is people tend to ignore, reject or minimize any information
that conflicts with particular belief. An investor‘s brain will reduce psychological pain
by adjusting the beliefs about the success of past investment choice that is investors
may remember past performance as better than it actually was, people want to believe
that their investment decisions are good. In the face of evidence to the contrary, the
brain‘s defense mechanisms filter contradictory information and after the recollection
of the decision‖. (Kent Baker and John Nofsinger 2007)

Cognitive dissonance refers to the conflict caused by holding conflicting


cognitions simultaneously. This concept was introduced by psychologist Festinger
(1956). Since the experience of dissonance is unpleasant the person will strive to
reduce it by changing their beliefs. Later research shows that when people are
confronted with new information they want to keep current understanding of the
world and reject or avoid the new information. Or they convince themselves that there
is no conflict at all cognitive dissonance is considered as an explanation for attitude
change. It is the mental conflict investors have to deal with when they realize they
made a mistake. Investors do not want to change their decisions so they persuade
themselves that they made a rational decision.

According to Pompain (2006) there are two identified aspects of cognitive


dissonance that are related to decision making 1) selective perception where investors
only register information which affirms their beliefs thus creating an incomplete

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view of the real picture ii) selective decision making investors are likely to reinforce
commitment previously made even though it might be visible that it is the wrong
thing to do. This occurs because of commitment to the original decision forcing the
investor to rationalize actions which would allow him to stick to it even though these
actions are suboptimal.

6) Regret Aversion:

Regret aversion is described as the emotion of regret experienced after making


a choice that either turns out to be bad choice or at least an inferior one. Repeat
aversion is primarily concerned with how a priori participation of possible regret can
influence decision making (Loomes and Sugden -1982) repeat is the emotion
experienced for not having made the right decision. It is the feeling of responsibility
for loss (Shefrin-2000). In a financial context the minimization of possible future
regret plays an important role in portfolio allocation. It is also related with preference
for dividend in financing consumer expenditures because selling a stock that may rise
in the future carries a huge potential for regret. Regret avoidance is the tendency to
avoid actions of interest that could create discomfort over prior decision. This
explained why investors defer selling loosing positions. In order to avoid the investor
holds on to the loosing position and hoped for recovery.

Various psychology experimental studies suggest that regret influences


decision making under uncertainly. People who are regret averse tend to avoid
distress arising out of two types of mistakes.

I) Errors of commission which occur as a result of misguided action where


the investor reflects on this decision and rue the fact that he made it, thus
questioning his beliefs.
II) Errors of Omission: which occur as a result of missing an opportunity
which existed (Pompian 2006)

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7) Gambler‟s Fallacy:

Tversky and Kahnemann describe the heart of Gambler‘s fallacy as a


misconception of the fairness of the laws of chance. When losing a coin with far
chance head or tail most people think the probability of getting a tail increase after a
run of five heads in a row. This is a common but completely false perception. Robin
(2002) describes the gambler‘s fallacy from fund manager‘s perspective consider that
a fund manager has 50% chance of investing successfully over a one year period. If a
person believes that a head will cancel out a tail in a toss with a fair coin he with also
think that a fund manager that has 50% chance of investing successfully in one year
will have less than 50% chance of investing successfully next year. One major impact
of Gambler‘s Fallacy on the financial market is that investors suffering from this bias
are likely to be biased towards predicting reversals in stock prices. Gambler‘s Fallacy
arises when investors inappropriately predict that trend will reverse and are drawn
into contrarian thinking. Gambler‘s Fallacy is said to occur when an investor operates
under the perception that errors in random events are self correcting. In 1998, Robert
Citron former treasurer of orange country forecasted a recession during the summer.
He did this because according to him the economic expansion had been two years
longer than normal. Citron was biased by the law of small numbers and his prediction
of a recession was of similar state of confidence as assuming a tail would turn up after
a strike of five heads in a row with a four coin (Shefrin-2000).

8) Mental Accounting Bias:

Mental accounting was coined by Richard Thaler (1999) and defined by him
as the ―set of cognitive operations used by individuals and households to organize,
evaluate and keep intact of financial activities. Mental accounting is described as the
tendency of people to place particular event into different mental account based on
superficial attributes (Shiller -1998)

Mental accounting can serve to explain why investors are likely to refrain for a
stock (Shefrin and Statman 1985) this result in a tendency for people to separate
accounts based on a variety of subjective reasons. Individuals tend to assign different
functions to each asset group which has an often irrational and negative effect on their

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consumption decisions and other behaviors. Mental accounting refers to the codes
people use when evaluating an investment decision.

9) Hindsight Bias:

Shiller (2000) has described Hindsight bias as ―the tendency to think that one
would happen had once been present then or had (2009) investigated the relationship
between investment decision making and Hindsight bias. They maintain that
economic studies consider the agent‘s foresight perspective only without taking into
account the Hindsight bias possible effects in the decision making process. They
collected data from 25 master and Ph.D.. students attending courses in Finance and
Economics at Bocconi University and from 35 financial Managers from a leading
Italian bank by circulating two sets of questionnaire. Their study found strong
evidence for the consequence that Hindsight bias can have on the investor‘s decisions
the portfolio allocation perception and therefore the risk exposure.

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