Behavioral Finance Module 1 PDF

Behavioral Finance Module 1 What is Behavioral Finance? Behavioral finance is a subfield of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the sourc...

Behavioral Finance Module 1 What is Behavioral Finance? Behavioral finance is a subfield of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source for the explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price. The purpose of the classification of behavioral finance is to help understand why people make certain financial choices and how those choices can affect markets. Within behavioral finance, it is assumed that financial participants are not perfectly rational and self-controlled but rather psychologically influential with somewhat normal and self-controlling tendencies. Financial decision- making often relies on the investor’s mental and physical health.  Key Concepts in Behavioral Finance 1.Mental Accounting 2.Herd behavior 3.Emotional Gap 4.Anchoring 5.Self-attribution MENTAL ACCOUNTING Refers to the different values a person places on the same amount of money based on subjective criteria. Mental accounting is a concept in the field of behavioral economics. Developed by economist Richard H. Thaler, it contends that individuals classify funds differently and are therefore prone to irrational decision- making in their spending and investment behavior. For example, some people keep a special “money jar” or similar fund set aside for a vacation or a new home, while at the same time carrying substantial credit card debt. They are likely to treat the money in this special fund differently from the money that is being used to pay down debt, in spite of the fact that diverting funds from the debt-repayment process increases interest payments, thereby reducing their total net worth.  The solution to this problem seems straightforward yet many people do not behave in this way. The reason has to do with the type of personal value that individual place on particular assets. Many people feel, for example, that money saved for a new house or a child’s college fund is simply “too important” to relinquish, even if doing so would be the most logical and beneficial move. So, the practice of maintaining money in a low- or no-interest account while also carrying outstanding debt remains common. HERD BEHAVIOR States that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. It also refers to a phenomenon where people join groups and follow the actions of others under the assumption that other individuals have already done their research. Herd instincts are common in all aspects of society, even within the financial sector, where investors follow what they perceive other investors are doing, rather than relying on their own analysis. Human beings are prone to a heard mentality, conforming to the activities and direction of others in multiple ways, from the way we shop to the way we invest. The fear of missing out on a profitable investment idea is often the driving force behind herd instinct, especially in the wake of good news or after an analyst release a research note. But this can be a mistake.  How to Avoid Herd Instinct: Stop looking at others to do the research and take the steps to study the facts yourself; Do your due diligence and then develop your own opinions and your final decision; Ask questions about how and why people are taking certain actions and make your own decisions; Delay making decisions if you are distracted, whether that’s because of stress or any other external factor; and Take the initiative, be daring, and don’t be afraid to stand out from the crowd. EMOTIONAL GAP Refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices. There is an old saying on Wall Street that the market is driven by just two (2) emotions: Fear; and Greed. Succumbing to these emotions, however, can also profoundly harm investor portfolios, the stock market’s stability, and even the economy on the whole. ANCHORING Refers to attaching a spending level to a certain reference. It describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security. For example, traders are typically anchored to the price at which they bought a security. If a trader bought stock ABC for $100, then they will be psychologically fixated on that price for judging when to sell or make additional purchases of the same stock, regardless of ABC’s actual value based on an assessment of relevant factors or fundamentals affecting it.  Another example is when a salesman offer a very high price to start a negotiation that is objectively well above fair value. Yet, because the high price is an anchor, the final selling price will also tend to be higher than if the salesman had offered a fair or low price to start. SELF-ATTRIBUTION Refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. In behavioral finance, this can impact investors negatively because they become overconfident about their abilities; they will attribute past success to their own skill and reject the role of timing or other factors in those outcomes. These biases can lead investors into mistaken decisions and prevent them from learning and improving their skills and strategies over time.  Cognitive Biases in Financial Decision-Making An error in cognition that arises in a person’s line of reasoning when making a decision is flawed by personal beliefs. It is an unconscious error in thinking that arises from the way people perceive the world and the information around them that determines how they make decisions. The following are the common types of cognitive biases: 1. Representativeness Bias 2. Conservatism Bias 3. Hindsight Bias 4. Recency Bias 5. Self-Serving Bias 6. Endowment Effect 7. Regret Aversion 8. Disposition Effect 9. Gambler’s Fallacy REPRESENTATIVE BIAS Refers to the inclination to assess the probability of an occurrence or the validity of a proposition by comparing it to a certain category or prototype. Within the realm of finance, this bias can lead investors to inaccurately evaluate the performance of an investment or company by relying on surface-level similarities to previous successful investments or organizations. CONSERVATISM BIAS The inclination to respond inadequately to new information, persisting in previous ideas or predictions despite being confronted with data that contradicts them. Conservatism bias in financial decision-making can result in a sluggish adaption of investment strategies and a missed chance to take advantage of market opportunities. HINDSIGHT BIAS Refers to the tendency to assume, in retrospect, that one would have accurately foreseen or anticipated the result of an event. This bias has the potential to skew the impression of investment performance and lead to an excessive sense of confidence in future decision- making. RECENCY BIAS Refers to the inclination to give excessive weight to recent events or facts while making judgments. Recency bias in finance can lead investors to pursue current market trends or overreact to short-term performance, disregarding long-term fundamentals. SELF-SERVING BIAS Refers to the inclination to ascribe personal accomplishments to one’s own talents or activities, while attributing failures to external reasons. Self-serving bias in finance can result in excessive confidence, underestimate of risks, and an unwillingness to acknowledge or gain from errors. ENDOWMENT EFFECT Refers to the inclination to assign a higher value to an asset when one possesses it, as opposed to when one does not own it. This bias might result in investors retaining failing assets or requesting higher prices during sales, which can lead to inefficient management of their investment portfolios. REGRET AVERSION Refers to the inclination to avoid making choices that may result in experiencing regret, frequently leading individuals to be excessively cautious or to conform to the majority. Regret aversion in finance can lead to a lack of action, missed chances, or the tendency to follow the crowd. DISPOSITION EFFECT Pertains to the inclination of investors to prematurely sell profitable investments while retaining unprofitable investments for an extended period of time. This conduct is motivated by the inclination to evade remorse and the consequences of loss aversion and mental accounting. GAMBLER’S FALLACY The erroneous notion that the likelihood of future events is affected by previous events, even when these events are unrelated. Within the real of finance, this fallacy has the potential to lead investors to make illogical decisions by relying on apparent patterns in market data or stock prices.  Emotional Biases in Financial Decision-Making Refer to illogical inclinations toward decision-making that are influenced by emotions, such as fear, greed, or hope, rather than being based on objective facts or analysis. The following are the common types of emotional biases: 1. Overreaction and Underreaction 2. Overoptimism and Pessimism 3. Fear and Greed 4. Affect Heuristic 5. Sunk-Cost Fallacy 6. Status Quo Bias OVERREACTION and UNDERREACTION Pertain to the inclination of investors to respond excessively or inadequately to new information, frequently influenced by emotions. Excessive response can cause market bubbles or collapses, while insufficient response can lead to lost opportunities or delayed adaptations to evolving market circumstances. OVEROPTIMISM and PESSIMISM Result in persons having an excessively enthusiastic or negative perspective on future events or investment results. These biases may result in an increased propensity for taking excessive risks, insufficient diversification, or excessively cautious investing techniques. FEAR and GREED Both fear and greed exert a strong impact on the process of making financial decisions. Investors may be inclined to eschew risks, prematurely divest assets, or refrain from taking advantage of market opportunities due to fear. Avarice can result in imprudent risk-taking, excessive trading, or pursuing market trends. AFFECT HEURISTIC Refers to the inclination to make judgments by relying on emotional responses or feelings linked to a certain option, rather than doing an objective analysis or considering factual facts. Within the realm of finance, the affect heuristic can result in illogical investment choices influenced by emotions such as fear, enthusiasm, or strong emotional connection to certain assets or firms. SUNK-COST FALLACY Refers to the inclination to persist in allocating resources to a project or asset based on the amount of resources previously committed, rather than assessing the present and future worth of the investment. This bias might result in suboptimal investment decisions and a reluctance to reduce losses when required. STATUS QUO BIAS Refers to the inclination to uphold existing conditions, especially in situations where making changes may lead to better results. Within the real of finance, the status quo bias can lead investors to uphold portfolios that are less than ideal, oppose altering their investing methods, or fail to see fresh possibilities. Market Anomalies and Behavioral Finance Market anomalies refer to patterns or events in financial markets that depart from the predictions made by classic finance models. These deviations are generally linked to the effect of behavioral biases. The following are common kinds of Market Anomalies: 1. Momentum Effect; 2. Reversal Effect; 3. Calendar Anomalies; 4. Value and Growth Stocks; 5. Size Effect; and 6. Post-earnings Announcement Drift. MOMENTUM EFFECT Describes the tendency for assets that have recently seen substantial gains to continually outperform, whereas assets with modest returns tend to continuously underperform. This phenomenon can be explained by the investors’ inclination to overreact, underreact to new information, and participate in herding behavior. REVERSAL EFFECT Refers to the phenomena in which assets that have had significant short-term gains or losses tend to return to their average performance over a period of time. This anomaly can be ascribed to investors’ excessive response to recent events and the subsequent rectification of mis-valuation. CALENDAR ANOMALIES Asset return patterns associated with specific calendar period or events. Some common calendar anomalies include: January Effect The tendency for stocks, particularly small-cap stocks, to experience higher returns in January compared to other months. Weekend Effect The phenomenon in financial markets in which stock returns on Mondays are often significantly lower than those of the immediately preceding Friday. Holiday Effect Refers to the tendency for stock prices to increase around holidays or during shortened trading week. VALUE and GROWTH STOCKS Value stocks are equities that are deemed to be discounted based on their financial fundamentals, such as their earnings, cash flow, and book value. On the other hand, growth stocks are companies that have a higher-than-average potential for growth in terms of their earnings, revenue, and market share. Behavioral finance theories propose that value companies have a tendency to outperform growth equities because investors tend to overreact to negative news or underreact to favorable news, resulting in mispricing. SIZE EFFECT Refers to the propensity of smaller organizations to produce superior risk-adjusted returns in comparison to bigger ones. This oddity might be ascribed to behavioral biases, including investors’ disregard for small- cap firms and their overestimation of the growth potential of large-cap business. POST-EARNINGS ANNOUNCEMENT DRIFT Refers to the persistent movement of stock prices in the same direction as an unexpected earnings report, even after the initial market response. The oddity of underreaction by investors can be attributed to the sluggish absorption of fresh information into stock prices.  The Role of Market Anomalies in Behavioral Finance Market anomalies provide empirical support for the impact of behavioral biases on financial markets, questioning the underlying assumptions of market efficiency and rationality in conventional financial models. Through the examination of these irregularities, scholars and professionals may gain a deeper comprehension of how cognitive and emotional influence the valuation of assets and the process of making investment decisions. Applications of Behavioral Finance The following are the applications of Behavioral Finance: 1. Personal Finance and Investing 2. Corporate Finance 3. Portfolio Management 4. Retirement Planning 5. Risk Management 6. Financial Planning 7. Market Efficiency and Pricing 8. Behavioral Economics and Public Policy PERSONAL FINANCE and INVESTING Behavioral finance may assist individuals in identifying and managing their cognitive biases and emotional inclinations, resulting in enhanced financial decision-making and superior investing results. CORPORATE FINANCE Managers may make better informed judgments about capital allocation, risk management, and mergers and acquisitions in corporate finance by recognizing behavioral biases. PORTFOLIO MANAGEMENT Portfolio managers can utilize behavioral finance concepts to create diversified portfolios, considering aspects such as investors’ risk tolerance, loss aversion, and other behavioral traits. RETIREMENT PLANNING Behavioral finance can enhance retirement planning by assisting individuals in identifying and overcoming cognitive biases that can impede their capacity to save sufficiently, invest prudently, and make sound choices concerning pensions and annuities. RISK MANAGEMENT Integrating behavioral finance into risk management enables business and individuals to recognize and tackle biases that might result in excessive risk-taking or underestimation of possible dangers. FINANCIAL PLANNING Advisors utilize knowledge from behavioral finance to steer clients away from making emotionally-driven decisions that have the potential to negatively impact their financial well-being. MARKET EFFICIENCY and PRICING Gaining insight into the influence of behavioral biases on market efficiency and asset pricing can assist investors, financial professionals, and policymakers in formulating tactics to reduce market inefficiencies and enhance overall market stability. BEHAVIORAL ECONOMICS and PUBLIC POLICY Insight from behavioral finance may be utilized in public policy efforts, such as the development of pension systems, the promotion of financial literacy, and the implementation of rules aimed at safeguarding investors against the repercussions of irrational decision-making.  Critiques and Limitations of Behavioral Finance The following are the critiques and limitations of Behavioral Finance: 1.Overemphasis on Biases and Irrationality 2.Difficulty in Quantifying Behavioral Factors 3.Potential for Misuse 4.Challenges in Integrating Behavioral Finance with Traditional Finance OVEREMPHASIS on BIASES and IRRATIONALITY Skeptics contend that behavioral finance may exaggerate the frequency and significance of cognitive biases and emotional impacts, resulting in an excessively pessimistic perspective on human decision-making capabilities. DIFFICULTY in QUANTIFYING BEHAVIORAL FACTORS Measuring the impact of behavioral biases on financial decision-making and market outcomes can be difficult, making it though to create accurate models or evaluate the success of initiatives aimed at addressing these biases. POTENTIAL for MISUSE Financial professionals or organizations may abuse consumers’ cognitive biases and emotional dispositions for their own gain by utilizing the knowledge and principles of behavioral finance. CHALLENGES in INTEGRATING BEHAVIORAL FINANCE with TRADITIONAL FINANCE Combining behavioral finance insights with standard finance models and processes may be intricate, since it necessitates reassessing deeply ingrained assumptions and creating novel tools and frameworks. - END -