UNIT 1 Notes on Behavioural Finance

UNIT 1 INTRODUCTION a. To understand the reasons for market anomalies b. To identify investor's personality c. To enhance the skill set of investment advisors d. Helps to identify the risks and develop hedging strategies **Q2) History and objectives of behavioural finance** History of beh...

UNIT 1 INTRODUCTION a. To understand the reasons for market anomalies b. To identify investor's personality c. To enhance the skill set of investment advisors d. Helps to identify the risks and develop hedging strategies **Q2) History and objectives of behavioural finance** History of behavioural finance The concept of behavioral finance dates to 1912 when George Seldon published "Psychology of the Stock Market." However, the theory gained popularity and momentum in 1979 when Daniel Kahneman and Amos Tversky proposed that most investors tend to make decisions based on subjective reference points rather than objectively choosing the best option. A year later, Richard Thaler introduced the notion of "mental accounting," which is the idea that people view their money differently based on its function, such as whether it's for retirement or a college fund. Eventually, their work became the basis for the study of cognitive psychology and behavioral biases in finance, which features prominently in the field of behavioral finance. Objective of behavioural finance Behavioural finance encompasses insights from behavioural economics, psychology, and microeconomic theory, and is more than just a discipline of finance. Because of the influence of his or her varied psychological and mental filters, investors frequently struggle to identify the most cost-effective alternative when making financial investments. When an investor seeks financial advice from a broker or a professional, their decisions may be influenced by market information or the techniques of other brokers or experts. Behavioural finance assumes that investors are not rational in the real world. When it comes to investing, investors make mistakes. They not only make mistakes, but they make them frequently. As a result, behavioural finance is the study of investors\' and financial markets\' psychological influences. It explains why investors often lose control, act against their interests, and make decisions based on personal prejudices rather than facts. Behavioural finance explains how human emotion, biases, and the mind\'s cognitive limitations in processing and responding to information affect financial decisions, such as investments, payments, risk, and personal debt, and it may be analysed from a variety of viewpoints. Stock market returns are one area of finance where psychological factors have an influence on market outcomes and returns, although there are several other aspects to consider. Behavioural finance is a word coined by psychologists and economists to represent a concept that integrates the two areas. Its goal is to better understand the several puzzling aspects and anomalies in asset markets to design for better returns and lower the risk. These traits or abnormalities were previously labelled as market anomalies since they could not be explained traditionally. **Q3) Assumptions and characteristics of behavioural finance** Approaches to decision making Behavioural finance advocates two approaches to decision-making: Reflexive -- Following your gut feeling and inherent beliefs. In fact, this is the default option. Reflective -- This approach is logical and methodical, something that requires a deep thought process. The more investors rely on reflexive decision-making, the more exposed they are to behavioural biases like self-deception biases, heuristic simplification, excess emotions and herding. Assumptions of behavioural finance Loss aversion: Loss aversion is a tendency in Behavioural finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains i.e. for them it is better to avoid a loss of 5000 than to gain 5000. Bounded rationality: The manner in which human being behave, limits the irrationality. It is the idea that people make decisions based on the information available to them and these decisions are limited by cognitive and environmental factors. Denial of risk: They may know statistical odds but refuse to believe these odds. Characteristics Behavioural finance is typically characterised by the following key features: a\) Framing The decision-makers' perception about a problem and its possible outcomes is what is referred to as the decision frame. It is affected by the presentation, person's characteristics, and perception about the question despite the fact remaining the same. Psychologists refer to it as 'frame dependence' behaviour. Though the objective fact remains constant the market participants are subject to context sensitivity, simply failing to see how questions are asked. In stock markets, framing has to a great extent affected the choices of participants adversely. Heuristics Heuristics: it refers to a process by which people find out things for themselves, developing 'rules of thumb'. This often leads to other errors. Heuristics can also be defined as the "use of experience and practical efforts to answer questions or to improve performance". The irrational way markets act at times can be explained with the help of heuristics. Interpretation of new information requires identification and understanding of all heuristics that affect financial decision making. Some of these are anchoring, representativeness, conservatism, etc. Emotions Most human decisions are driven by human needs, desires, fear, fantasies, etc. The term 'animal spirit' given by John Keynes's indicates the inner urge of market participants to engage in more investment and consumption. Emotions have a very important role in explaining investor choices, which thereby shape the financial markets. The psychological reality that affects investment decisions is determined by our emotions. Most of the times emotions are the main reason for people not making a rational choice. Behavioural considerations There are certain points that an investor should consider while investing like: a. Biases and heuristics apply to all Human beings are usually imperfect, as psychological, and emotional biases like overconfidence, anchoring, representativeness, etc., are present in most of us. Better awareness about how to control our emotional responses will not only let us get rid of those but will also increase the awareness of investors at the time of investing. b. Limitation of knowing There is a tendency among people to think that the forecast made by them are increasing in accuracy with the increase of information. The quantum of information is not important rather what you do with it matters. One should not get paralysed by the overload of information and not confuse familiarity with knowledge. c. Focus on Facts Asset prices should be judged on facts and not on their prices. Market participants should tune out investor noise and should focus on hard facts. One must think in terms of enterprise value and not stock price. d. Overcoming Loss Aversion An important quality that market participants can have is to sell-off his/her mistakes (loss-making investments) and move on without coming back the same way the person has made a loss. Investors should examine their mistakes as it is not always due to bad luck. One should admit one's mistakes and learn from them but do not preoccupy the mind with them. e. Information not to be taken at face value One should think carefully about how the information is being presented, because even easy to recall events are less likely, so investors should avoid projecting the immediate events into the future. Market participants should not strongly hold on to historical perceptions or irrelevant data, avoiding seeing patterns in the market that don't exist. f. Don't allow emotions to control you It is important to be aware of the inherent limitations of the human mind and behaviour. Investors need to be aware of strong group psychological behaviours like herd investing and mental accounting which usually don't seem to be good investment strategies. One should not be afraid of making an incorrect investment decision and feeling stupid: it was very simple that you didn't know it anyway just happened. g. Know the Investment Horizon No market participant should try to become rich quickly. Investors should go for investments in stocks rather than options, forgetting a leverage-based investment strategy. Investors must diversify their portfolios and trading could be minimized. Targets for buying and selling are to be set and adhered to. **Q4) CAPM AND EEH** Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) are based on rational and logical assumptions. These theories assume that people, for the most part, behave rationally and predictably. Theoretical and empirical evidence suggested that CAPM, EMH, and other rational theories did a respectable and commendable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviours that could not be explained by the theories available. The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta (how volatile a stock relative to the market) of that security. The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alpha (how well an investment performs relative to the market) generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.  Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing. The only way an investor can obtain higher returns is by purchasing riskier investments. While these theories could explain certain 'idealized' events, the real world proved to be a complex place in which market participants often behaved very unpredictably Thus, people are not always rational, and markets are not always efficient. Behavioural finance explains why individuals do not always make the decisions they are expected to make and why markets do not reliably behave the way as they are expected to behave. Recent research shows that the average investors make decisions based on emotion, not logic. Most investors buy high on speculation and sell low in panic mode Behavioural Finance is a new academic discipline that seeks to apply the insights of psychologists to understand the behaviour of both investors and financial markets emerged. It helps us to avoid emotion-driven speculation leading to losses, and thus devises an appropriate wealth management strategy **Q5) Factors that affect investor psychology** Investor psychology is also called as behavioural risk tolerance. By measuring investor personality, advisors can identify which clients may be prone to cognitive biases. These insights can also help advisors coach and educate clients to become effective investors. Investor personality characteristics can be divided into stable and not so stable. [Stable Investor Personality Characteristics] a. Risk Personality Risk personality is one of the main personality characteristics. This factor refers to the client's propensity and desire to make decisions without a clear and guaranteed outcome. The best approach is to understand risk personality is to examine how clients have made decisions that have involved risk in the past. b. Risk Preference Most risk tolerance measures measure risk preference. This factor refers to a general preference for and experience with a certain level of risk in one's portfolio. c. Volatility Composure Investors differ in how they experience fear, anxiety, or worry.  Volatility composure is the emotional side of investing. This personality factor is closely related to The Big Five personality factor of Neuroticism (or its polar opposite, Emotional Stability). This factor refers to an investor's ability to emotionally manage declines in the value of investments or the market in general. This factor can help identify which clients may be prone to cognitive biases (e.g., herd mentality). d. Investor Confidence There are two factors influence an investor's confidence. One is the client's general self-esteem (e.g., "I'm a good or capable person."). The other is self-efficacy, or the investor's belief that she is proficient or capable when it comes to making investment decisions. Both factors impact outcomes like trading. Investors who are high on the confidence factor, while also being low on Volatility Composure and Judgment, can be particularly prone to investing-related biases, like herd mentality or loss aversion. e. Investor Judgment Attitudes towards and beliefs about investing also influence how investors make decisions. Investor judgment refers to how a client views long-term investing. Clients who tend to enjoy trading or view investing more like gambling tend to have a harder time investing for the long-term. [Not So Stable characteristics] Include Investor perceptions and investor moods The investor's current feelings or mood about investing also influences investment decisions. This is referred to as risk perception, which can change frequently, depending on what's happening in the markets or what happened in that particular day for the investor. Investor perceptions help advisors to demonstrate empathy and understanding when presenting an investment strategy or communicating that a change is needed. **Q6) Cognitive information perception** Information perception can come under information overload, limited information and information avoidance [Information overload] Humans' bounded rationality is particularly well illustrated by the concept of choice overload. Also referred to as 'overchoice', this phenomenon occurs as a result of too many choices being available to consumers. Overchoice has been associated with unhappiness, decision fatigue, going with the default option, as well as choice deferral---avoiding making a decision altogether, such as not buying a product. Many different factors may contribute to perceived choice overload, including the number of options and attributes, time constraints, decision accountability, alignability and complementarity of options, consumers' preference uncertainty, among other factors. Choice overload can be counteracted by simplifying choice attributes or the number of available options. [Limited information] Experience, good information, and prompt feedback are key factors that enable people to make good decisions. Consider climate change, for example, which has been cited as a particularly challenging problem in relation to experience and feedback. Climate change is invisible, diffuse, and a long-term process.  Pro-environmental behavior by an individual, such as reducing carbon emissions, does not lead to a noticeable change. The same is true in the domain of health. Feedback in this area is often poor, and we are more likely to get feedback on previously chosen options than rejected ones. The impact of smoking, for example, is at best noticeable over the course of years, while its effect on cells and internal organs is usually not evident to the individual. Traditionally, generic feedback aimed at inducing behavioral change has been limited to information ranging from the economic costs of the unhealthy behavior to its potential health consequences. More recent behavior change programs, such as those employing smartphone apps to stop smoking, now usually provide positive and personalized behavioral feedback, which may include the number of cigarettes not smoked and money saved, along with information about health improvement and disease avoidance. [Information avoidance] Behavioral economics assumes that people are boundedly rational actors with a limited ability to process information. While a great deal of research has been devoted to exploring how available information affects the quality and outcomes of decisions, a newer strand of research has also explored situations where people avoid information altogether. Information avoidance in behavioral economics refers to situations in which people choose not to obtain knowledge that is freely available. Active information avoidance includes physical avoidance, inattention, the biased interpretation of information (see also confirmation bias) and even some forms of forgetting. In behavioral finance, for example, research has shown that investors are less likely to check their portfolio online when the stock market is down than when it is up, which has been termed the ***ostrich effect***. More serious cases of avoidance happen when people fail to return to clinics to get medical test results, for instance. While information avoidance is sometimes strategic, it can have immediate benefits for people if it prevents the negative (usually psychological) consequences of knowing the information. It usually carries negative utility in the long term, because it deprives people of potentially useful information for decision making and feedback for future behavior. Furthermore, information avoidance can contribute to a polarization of political opinions and media bias. Boundedly rational choices are made due to limits in our thinking processes, especially those we make as consumers. Dan Ariely introduces the concept of the **zero price effect,** namely when a product is advertised as 'Free', consumers perceive it as intrinsically more valuable. A free chocolate is disproportionately more attractive relative to a Rs.10 chocolate than a Rs. 10 chocolate is compared to one priced at Rs. 11. To a 'rational' economic decision maker, a price difference of 1 rupee should always provide the same magnitude of change in incentive to choose the product. Finally, price is often taken as an indicator of quality, and it can even serve as a cue with physical consequences, just like a placebo in medical studies. One experiment, for instance, gave participants a drink that purportedly helped mental acuity. When people received a discounted drink their performance in solving puzzles was significantly lower compared to regular-priced and control conditions. Price can also be an ingredient for a **decoy effect**. Choices often occur relative to what is on offer rather than based on absolute preferences. The decoy effect is technically known as an 'asymmetrically dominated choice' and occurs when people's preference for one option over another- changes as a result of adding a third (similar but less attractive) option.  **Conclusion** The notion about human beings that we are rational and selfish individuals with relatively stable preferences---has been challenged, by behavioural finance (economics). The field of behavioral economics (BE), suggests that human decisions are strongly influenced by context, including the way in whichchoices are presented to us. Behaviour varies across time and space, and it is subject to cognitive biases, emotions, and social influences. Decisions are the result of less deliberative, linear, and controlled processes than we would like to believe.