Behavioral Finance Overview

Behavioral Finance-An Overview

Today’s Contents• Course overview and group formation• Interaction about previous knowledge on risk and

return• Discuss on how they make decision on share trading• CAPM discussion• APT discussion• Perfect market and prerequisites• Need of behavioral finance• Terms in behavioral finance• Article for reading

“The investor’s chief problem, and even his worst

enemy, is likely to be himself.”

“There are three factors that influence the market: Fear, Greed, and Greed.”

— Benjamin Graham

— Market folklore

Precursors to Behavioral FinanceValue investors proposed that markets over reacted to

negative news.Benjamin Graham and David Dodd in their classic book,

Security Analysis, asserted that over reaction was the basis for a value investing style.

David Dreman in 1978 argued that stocks with low P/E ratios were undervalued, coining the phrase overreaction hypothesis to explain why investors tend to be pessimistic about low P/E stocks.

Tversky and Daniel Kahneman published two articles in 1974 in Science. They showed heuristic driven errors, and in 1979 in Econometrica, they focused on representativeness heuristic and frame dependence.

Behavioral Finance DefinitionsBehavioral Finance, a study of investor market behavior that derives from psychological principles of decision making, to explain why people buy or sell the stocks they do.The linkage of behavioral cognitive psychology, which studies human decision making, and financial market economics. Behavioral Finance focuses upon how investors interpret and act on information to make informed investment decisions. Investors do not always behave in a rational, predictable and an unbiased manner indicated by the quantitative models. Behavioral finance places an emphasis upon investor behavior leading to various market anomalies.

Behavioral FinanceUse psychology and economics to understand finance:

Asset pricing:

• Price Anomalies• IPO underperformance• Sentiment• Equity premium• PEA drift• Momentum : riding "hot"

stocks and selling "cold" ones

• Bubbles

Corporate finance:

• IPO timing• Winner’s curse• Cash-flow sensitivity• Overconfidence • Superstar CEO’s

Personal finance:

• Procrastination• Emotional choice• Loss aversion• Narrow Framing • Return chasing • Passivity• Financial illiteracy• Home bias• Overconfidence• Wishful thinking

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An Introduction to Behavioral Finance

• Efficient markets hypothesis• Large number of market participants• Incentives to gather and process information about securities

and trade on the basis of their analysis until individual participant’s valuation is similar to the observed market price• Prices in such markets reflect information available to the

participants, which means opportunities to earn above-normal rates of return on a consistent basis are limited• Prediction: Stock returns are (almost) impossible to predict • Except that riskier securities on average earn higher rates of

returns compared to less risky firms

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• Behavioral finance• Widespread evidence of anomalies is inconsistent with

the efficient markets theory • Bad models, data mining, and results by chance• Alternatively, invalid theory

• Anomalies as a pre-cursor to behavioral finance• Challenge in developing a behavioral finance theory of

markets• Evidence of both over- and under-reaction to events

• Event-dependent over- and under-reaction, e.g., IPOs, dividend initiations, seasoned equity issues, earnings announcements, accounting accruals

• Horizon dependent phenomenon: short-term overreaction, medium-term momentum, and long-run overreaction

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• Behavioral finance theory rests on the following three assumptions/characteristics• Investors exhibit information processing biases that cause

them to over- and under-react• Individual investors’ errors/biases in processing information

must be correlated across investors so that they are not averaged out• Limited arbitrage: Existence of rational investors should not

be sufficient to make markets efficient

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Behavioral finance theories• Human information processing biases• Information processing biases are generally relative to

the Bayes rule for updating our priors on the basis of new information• Two biases are central to behavioral finance theories

• Representativeness bias (Kahneman and Tversky, 1982) • Conservatism bias (Edwards, 1968). • Other biases: Over confidence and biased self-attribution

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Behavioral finance theories• Human information processing biases• Representativeness bias causes people to over-weight

recent information and deemphasize base rates or priors• E.g., conclude too quickly that a yellow object found on the

street is gold (i.e., ignore the low base rate of finding gold)• People over-infer the properties of the underlying

distribution on the basis of sample information • For example, investors might extrapolate a firm’s recent high

sales growth and thus overreact to news in sales growth • Representativeness bias underlies many recent behavioral

finance models of market inefficiency

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Behavioral finance theories

• Human information processing biases• Conservatism bias: Investors are slow to update their

beliefs, i.e., they underweight sample information which contributes to investor under-reaction to news• Conservatism bias implies investor underreaction to

new information• Conservatism bias can generate

• short-term momentum in stock returns • The post-earnings announcement drift, i.e., the tendency of

stock prices to drift in the direction of earnings news for three-to-twelve months following an earnings announcement also entails investor under-reaction

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Behavioral finance theories• Human information processing biases• Investor overconfidence

• Overconfident investors place too much faith in their ability to process information

• Investors overreact to their private information about the company’s prospects

• Biased self-attribution• Overreact to public information that confirms an investor’s

private information• Underreact to public signals that disconfirm an investor’s

private information• Contradictory evidence is viewed as due to chance• Genrate underreaction to public signals

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Behavioral finance theories• Human information processing biases• Investor overconfidence and biased self-attribution

• In the short run, overconfidence and biased self-attribution together result in a continuing overreaction that induces momentum.

• Subsequent earnings outcomes eventually reveal the investor overconfidence, however, resulting in predictable price reversals over long horizons.

• Since biased self-attribution causes investors to down play the importance of some publicly disseminated information, information releases like earnings announcements generate incomplete price adjustments.

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Behavioral finance theories• In addition to exhibiting information-processing biases, the biases

must be correlated across investors so that they are not averaged out• People share similar heuristics• Focus on those that worked well in our evolutionary past• Therefore, people are subject to similar biases• Experimental psychology literature confirms systematic biases among

people

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• Limited arbitrage• Efficient markets theory is predicated on the assumption

that market participants with incentives to gather, process, and trade on information will arbitrage away systematic mispricing of securities caused by investors’ information processing biases• Arbitrageurs will earn only a normal rate of return on their

information-gathering activities• Market efficiency and arbitrage: EMH assumes arbitrage forces are

constantly at work• Economic incentive to arbitrageurs exists only if there is mispricing,

i.e., mispricing exists in equilibrium

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• Behavioral finance assumes arbitrage is limited. What would cause limited arbitrage?• Economic incentive to arbitrageurs exists only if there is

mispricing• Therefore, mispricing must exist in equilibrium• Existence of rational investors must not be sufficient • Notwithstanding arbitrageurs, inefficiency can persist for

long periods because arbitrage is costly • Trading costs: Brokerage, B-A spreads, price impact/slippage• Holding costs: Duration of the arbitrage and cost of short selling• Information costs: Information acquisition, analysis and monitoring

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• Why can’t large firms end limited arbitrage?• Arbitrage requires gathering of information about a firm’s prospects,

spotting of mispriced securities, and trading in the securities until the mispricing is eliminated

• Analysts with the information typically do not have the capital needed for trading

• Firms (principals) supply the capital, but they must also delegate decision making (i.e., trading) authority to those who possess the information (agents)• Agents cannot transfer their information to the principal, so decisions must

be made by those who possess information• Agents are compensated on the basis of outcomes, but the principal

sets limits on the amount of capital at the agent’s disposal (the book)• Limited capital means arbitrage can be limited

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• Like the efficient markets theory, behavioral finance makes predictions about pricing behavior that must be tested• Need for additional careful work in this respect

• Only then can we embrace behavioral finance as an adequate descriptor of the stock market behavior• Recent research in finance is in this spirit just as the

anomalies literature documents inconsistencies with the efficient markets hypothesis

Introduction Economic theorists believe that investors think and

behave “rationally’ when buying and selling of stocks.

Specifically, they are presumed to use all available information to form “rational expectations” about the future in determining the value of companies and the general health of the economy.

Consequently, stock prices should accurately reflect fundamental mental values and will only move up and down when there is unexpected positive or negative news, respectively.

Introduction Conti…

Thus, economists have concluded that financial markets are stable and efficient, stock prices follow a “random walk” and the overall economy tends toward “general equilibrium”.

In reality however, according to Shiller (1999) investors do not think and behave rationally. In the contrary, investors are driven by greed and fear under uncertainty.

In other words, investors are misinformed by extremes of emotion, subjective thinking, and the whims of the crowd, consistently from irrational expectation for the future performance of companies and the overall economy.

Introduction Conti… Since 1950s, the field of finance has been dominated by traditional

finance model (Standard finance model). Key assumption-people are rational. However, Behaviorists/Psychologists challenged this assumption. People often suffer from cognitive and emotional biases and act in

a seemingly irrational manner. The finance field was reluctant to accept this view of psychologist

who proposed behavioral finance model. As the evidence of the influence of psychology and emotions on

decisions became more convincing, behavioral finance has received greater acceptance. 2002 Nobel Prize in Economics-to psychologists Daniel Kahneman and experimental economist Vernon Smith- vindication of the field of Behavioral Finance.

Behavioral Finance-Definition Behavioral Finance (BF) is a field of finance that

proposes psychology based theories to explain stock market anomalies.

Investors behavior is part of academic discipline known as “behavior finance” which explains how emotions and cognitive errors influence investors and decision making process.

BF involves research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets.

BF is of interest because it helps to explain why and how markets might be inefficient.

Two Building blocks of Behavioral Finance

Behavioral Finance

Cognitive psychology(How people think?)

Limits to arbitrage(When markets will be

inefficient?)

Behavioral Finance has two building blocks: cognitive psychology and the limits to arbitrage.

Cognitive refers to how people think. There is a huge psychology literature that people make systematic errors in the way that they think.

They seem to be overconfident and basically put too much weight on recent experience. Their preferences may also create distortions/misrepresentations.

Limits to arbitrage refers to predicting in what circumstances arbitrage forces will be effective, and when they won’t be.

Traditional Finance vs. Behavioral Finance

oTraditional finance falls into the following basic paradigms: a) portfolio is based on the expected return and risk, b) is subject to risk based on CAPM, c) the pricing of contingent claims, d) Modigliani-Miller theorem.oAll of these ideas came from investors’ rationality. However, the

traditional finance does not respond to the following questions: a) why does an investor trade? b) how does an investor trade? c) how does an investor compose portfolios? d) and finally, why do stock returns vary not due to the risk?

Traditional Finance Behavioral Finance

1. People process data appropriately and correctly.

1. People employ imperfect rules of thumb (heuristics) to process data which includes biases in their beliefs and predisposes them to commit errors.

2. People view all decisions through the transparent and objective lens of risk and return (inconsequential frame definition).

2.Perceptions of risk and return are significantly influenced by how decisions problems are framed (frame dependence).

3.People are guided by reason and logic and independent judgement.

3. Emotions and herd instincts play an important role in influencing decisions.

4. Markets are efficient. Market price of each security is an unbiased estimate of its intrinsic value.

4. Heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value.

Investors’ psychology BF is an important subfield of finance which combines

psychology and economics to explain why and how investors act and to analyze how that behavior affects the market.

Indeed, it attempts to explain the decisions of investors by viewing them as rational actors looking out of their self-interest, given the sometimes inefficient nature of the market.

Tracing its origins to Adam Smith’s “The Theory of Moral Sentiments”, one of its primary observations holds that investors (and people in general) make decisions on imprecise impressions and beliefs rather than rational analysis.

Investors’ psychology Conti… A second observation states that the way a question or

problem is framed to an investor will influence the decision he/she ultimately makes.

These two observations largely explain market inefficiencies, that is BF holds that markets are sometimes inefficient because people are not mathematical equations. BF stands in stark contrast to the efficient market theory.

Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as outcomes.

Investors’ psychology Conti…• According to Kent, et.al. (2001), the most common behavior

that most investors do when making investment decision are: Investors often do not participate in all asset and security

categories,Individual investors exhibit loss-averse behavior,Investors use past performance as an indicator of future

performance in stock purchase decisions,Investors trade too aggressively,Investors behave in status quo,Investors do not always form efficient portfolios,Investors behave parallel to each other, andInvestors are influenced by historical high or low trading stocks.

Market Psychology-Definition Market psychology refers to the overall sentiment or feeling that

the market is experiencing at any particular time. The factors driving the group's overall investing mentality or

sentiment are:oGreedoFearoExpectations, andoCircumstances Whereas conventional financial theory describes situations in

which all the players in the market behave rationally. Technical analysts use trends, patterns, and other indicators to

anticipate whether the market is heading in an upward or downward direction.

How Market Psychology Works?

Peoples’ perceptions of the market directly impact price movements and trends.

Market psychology is the overall feeling among market participants that impels them to buy or sell.

For this reason, an upward or bullish trend is associated with feelings of positive expectations expressed by optimism and hopefulness.

By contrast, a downward or bearish trend correlates with feelings of pessimistic expectations expressed by anxiety and fear.

Why it matters?

The nature of market psychology suggests that any given trend may be more indicative of market sentiment than of fundamental gains or losses in the value of the stocks.

Personality Traits and Risk Profile Influencing Attitude of Investor

The five factor model delineates five broad traits:

These traits, sometimes designated as domains, were originally derived from a categorization of the adjectives that are commonly used to describe individuals.

Personality Traits and Risk Profile of Investors

Extraversion Neuroticism Agreeableness Conscientiousness OpennessTo experience

Personality Traits and Risk Profile Influencing Attitude of Investor Conti…

1. Extraversion: A person high in extraversion tends to be more sociable, active, optimistic, fun loving and talkative while someone low in extraversion tends to be reserved, aloof and quiet.

2. Agreeableness: An individual high in agreeableness tends to be trusting altruistic, good natured, empathic and helpful. Yet someone low in agreeableness tends to be clinical rude, suspicious uncooperative, irritable and even manipulative vengeful and ruthless. 3. Conscientiousness: It refers to the degree of organization control, persistence and motivation to goal directed behavior. A person high in conscientiousness tends to be lazy, aimless, hedonistic careless

Personality Traits and Risk Profile Influencing Attitude of Investor Conti…

4. Neuroticism: It refers to a person’s level of emotional stability. Individuals high in neuroticism are more prone to psychological, distress including negative affectivity such as anger, hostility depression and anxiety. 5. Openness to experience: It refers to the active seeking and appreciation for their own sake. People high in openness are imaginative, curious and openness to unconventional ideas and values. On the other hand, those low in openness tend to be conventional and dogmatic in beliefs and attitudes, set in their ways and emotionally unresponsive. The five-factor model of personality is the dominant paradigm in

personality research (Mc crae 2009). It encapsulates individual’s personalities using five traits, the ‘Big

Five’ model. These personality traits are strongly rooted in biology and are genetically based. Neuroscience uses traits to provide a common structure to map the structure of the brain on to certain behaviors.

Literature Review-Behavioral Finance

• Gustave le Bon (1896) Wrote ‘The Crowd: A Study of the Popular Mind’, one of the greatest and most influential books of social psychology ever written.• Selden (1912) wrote ‘Psychology of the Stock Market’. He

based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’.• In 1956 the US psychologist Leon Festinger introduced a new

concept in Social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter, 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs.

Literature Review-Behavioral Finance Conti…

• Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets.• Tversky and Kahneman (1973) introduced the

availability heuristic: ‘a judgmental heuristic’ in which a person evaluates the frequency of classes or the probability of events by availability, i.e. by the ease with which relevant instances com to mind’. The reliance on the availability heuristic leads to systematic biases. • In 1974, two brilliant psychologists, Amos Tversky and

Daniel Kahneman, described three heuristics that are employed when making judgements under uncertainty (Tversky and Kahneman, 1974): representativeness, availability, and anchoring and adjustment.


• In another important paper Tversky and Kahneman (1981) introduced framing. They showed that the psychological principles that govern the perception of decision problems and the evaluation of probabilities and outcomes produce predictable shifts of preference when the same problem is framed in different ways. • Shiller (1981) discovered that stock market volatility is

far too high to be to new information about future real dividends.• Kahneman, Slovie, and Tversky (1982) edit Judgement

Under Uncertainty: Heuristics and Biases, which describe various judgmental heuristics and the biases they produce.


• In 1985 Werner F. M. De Bondt and Richard Thaler published ‘Does the stock market overreact?’ in The Journal of Finance. They discovered that people systematically overreacting to unexpected and dramatic news events results in substantial weak-form inefficiencies in the stock market.• Thaler (1985) developed a new model of consumer behavior

involving mental accounting which is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.• Tversky and Kahneman (1986) argue that, due to framing and

prospect theory, the rational theory of choice does not provide an adequate foundation for a descriptive theory of decision making. • Yaari (1987) proposes a modification to expected utility theory

and obtains a so-called ‘dual theory’ of choice under risk. De Bondt and Thaler (1987) report additional evidence that supports the overreaction hypothesis.


• Samuelson and Zeckhauser (1988) perform a series of decision-making experiments and find evidence of status quo bias.

• Kahneman, Knetsch and Thaler (1990) report several experiments that demonstrate that Loss aversion and the endowment effect persist even in market settings with opportunities to learn and conclude that they are fundamental characteristics of preferences.

• Gilovich (1991) wrote How We Know What Isn’t So, a book about the fallibility of human reason in everyday life.

• Fernandez and Rodrik (1991) model an economy and show how uncertainty regarding the identities of gainers and losers can lead to status quo bias. Kahneman, Knetsch and Thaler (1991) discuss three anomalies: the endowment effect, loss aversion, and status quo bias. Banerjee (1992) develop a simple model of herd behavior.

• Plous (1993) wrote ‘The Psychology of Judgement and Decision Making’ which gives a comprehensive introduction to the field with a strong focus on the social aspects of decision making processes.


• A value strategy involves buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. • Lakonishok, Shleifer and Vishnty (1994) conjecture that value

strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor.• The equity premium puzzle refers to the empirical fact that stocks have

outperformed bonds over the last century by a far greater degree than would be expected under the standard expected utility maximizing paradigm.• Grinblatt, Titman and Wermers (1995) analyzed the behavior of

mutual funds and found evidence of momentum strategies and herding.• Chan, Jagadeesh and Lakonishok (1996) found that both price and

earnings momentum strategies were profitable, implying that the market responds only gradually to new information, i.e. there is underreaction.

Literature Review-Behavioral Finance Conti…• Basu (1997) finds evidence for the conservatism principle, which he

interprets as earnings reflecting ‘bad news’ more quickly than ‘good news’.• Barberis, Shleifer and Vishny (1998) present a model of investor

sentiment that displays underreaction of stock prices to news such as earnings announcements and overreaction of stock prices to a series of good or bad news.• Odean (1998) tested and found evidence for the disposition effect,

the tendency of investors to sell winning investments too soon and hold losing investments for too long.• Daniel, Hirshleifer and Subrahmanyam (1998) propose a theory

of security markets based on investor overconfidence (about the precision of private information) and biased self-attribution (which causes changes in investors’ confidence as function of their investment outcomes) which leads to market under and overreactions. Camerer and Lovallo (1999) found experimentally that overconfidence and optimism lead to excessive business activity.


• There is a commonly observed but unexpected negative correlation between perceived risk and perceived benefit. Finucane, et. al. (2000) concluded that this was due to the affect heuristic-people tend to derive both risk and benefit evaluations from a common source.

• Shefrin (2000) wrote ‘Beyond Greed and Fear’, an excellent book on behavioral finance and the psychology of investing.

• Lee and Swaminathan (2000) showed that past trading volume provides an important link between ‘momentum’ and ‘value’ strategies and these findings help to reconcile intermediate-horizon ‘underreaction’ and long-horizon ‘overreaction’ effects.

• Psychological research has established that men are more prone to overconfidence than women (especially in male-dominated areas such as finance), whilst theoretical models predict that overconfident investors trade excessively. Barber and Odean (2001) found that men trade 45 per cent more than women and thereby reduce their returns more so than women and conclude that this is due to overconfidence.


• Barberis, Huang and Santos (2001) incorporate prospect theory in a model of asset prices in an economy. • Grinblatt and Keloharju (2001) identify the

determinants of buying and selling activity and find evidence that past returns, reference price effects, tax-loss selling and the fact that investors are reluctant to realize losses are all determinants of trading. • Huberman (2001) provide compelling evidence that

people have a propensity to invest in the familiar, while often ignoring the principles of portfolio theory.


• Gilovich and Griffin (2002) identify six general purpose heuristics (affect, availability, causality, fluency, similarity, and surprise) and six special purpose heuristics (attribution, substitution, outrage, prototype, recognition, choosing by liking and choosing by default), whilst two heuristics have been superseded (representativeness (replaced by attribution-substitution (prototype heuristic and similarity heuristic)) and anchoring and adjustment (replaced by the affect heuristic).

• Holt and Laury (2002) conducted a simple lottery choice experiment and found differences in risk aversion between behavior under hypothetical and real incentives.

• Barberis and Thaler (2003) publish a survey of behavioral finance. More recent developments in decision making under risk have improved upon cumulative prospect theory, such as the transfer of attention exchange model (Birnbaum, 2008).

• Harrison and Rutstrom (2009) proposed a reconciliation of expected utility theory and prospect theory by using a mixture model.

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Behavioral Finance Overview

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Transcript of Behavioral Finance Overview