Chapter 10

BEHAVIOURAL FINANCE

The Irrational Influence

Outline

• Key Differences between Traditional Finance and

Behavioural Finance

• Heuristic – Driven Biases

• Frame Dependence

• Emotional and Social Influences

• Market Inefficiency

• Strategies for Overcoming Psychological Biases

Traditional Finance

• People process data appropriately and correctly

• People view all decisions through the transparent and

objective lens of risk and return

• People are guided by reason and logic and independent judgment

• Market price of a security is an unbiased estimate of its intrinsic value.

Behavioural Finance

• People employ imperfect rules of thumb that predispose them to errors

• Perceptions of risk and return are influenced by how decision problems are framed

• Emotions and herd instincts play on important role in decisions

• Often, there is a discrepancy between market price and fundamental value

Heuristic-Driven Biases

The important heuristic-driven biases and cognitive errors that

impair judgement are

• Representativeness

• Overconfidence

• Anchoring

• Familiarity

• Confirmation bias

• Illusion of Control

• Affect heuristic

• Regret aversion

• Aversion to ambiguity

• Innumeracy

RepresentativenessRepresentativeness refers to the tendency to form judgments based on stereotypes. While representativeness may be a good rule of thumb, it can lead people astray. For example:

• Investors may be too quick to detect patterns in data that are in fact random

• Investors may become overly optimistic about past winners and overly pessimistic about past losers

• Investors generally assume that good companies are good stocks

Over Confidence

• People tend to be overconfident and hence overestimate the accuracy of their forecasts.

• Overconfidence stems partly from the illusion of knowledge and partly from the illusion of control

• People remain overconfident despite failures because they tend to ascribe their success to their skill and their failure to bad luck.

• Overconfidence manifests itself in excessive trading and the dominance of active portfolio management.

Anchoring

• After forming an opinion people are unwilling to change it, even though they receive new information that is relevant.

• Anchoring manifests itself in a phenomenon called the “post- earnings announcement drift”. Stock market reacts gradually, not instantaneously, to unexpectedly bad (good) earnings.

Aversion To Ambiguity

• People are fearful of ambiguous situations where they feel

they have little information about the possible outcomes.

• Aversion to ambiguity means that investors are wary of

stocks that they feel they don’t understand. On the flip

side it means that investors have a preference for the familiar.

Innumeracy

People have difficulty with numbers. Trouble with numbers is reflected in the following:

• People confuse between “nominal” changes and “real” changes.

• People have difficulty in figuring out the “true” probabilities.

• People ignore the ‘base rate’ and go more by the ‘case rate’.

Familiarity

People are comfortable with things that are familiar to them. The

human brain often uses the familiarity shortcut in choosing

investments. Indeed, familiarity breeds investment. That is why

people tend to invest more in the stocks of their employer company

local companies, and domestic companies.

Confirmation Bias

People tend to overlook information that is contrary to their views in

favour of information that confirms their views. Investors often only

hear what they want to hear. They spend more time searching for

reasons supporting their views and less time searching for reasons

opposing their views.

Illusion of Control

The outcome of an investment decision typically depends on a

combination of luck and skill. In general, investors have an inflated

view of how much control they have over outcomes. This bias is

called the illusion of control and leads to over-optimism.

Affect Heuristic

People decide mostly on what feels right to them emotionally. They

rely heavily on “intuition” and gut feeling. Psychologists refer to this

as the affect heuristic. Like other heuristics, the affect heuristic

involves mental shortcuts that can cause bias.

Regret Aversion

Regret is the emotional pain a person experiences when his decision

turns sour. Regret of commission is the disappointment from taking

an action, whereas the regret of omission is the disappointment from

not taking an action. Regret of commission is typically more painful

than the regret of omission. People avoid actions that cause regret.

Frame Dependence

• Frame independent investors pay attention to changes in

their total wealth.

• In reality, behaviour is frame-dependent. This means that

the form used to describe a problem has a bearing on

decision- making.

• Frame dependence stems from a mix of cognitive and

emotional factors.

Prospect TheoryAccording to the prospect theory people value gains/losses according to a S-shaped utility function shown below

Losses Gains

Utility

Loss Aversion

• The utility function is steeper for losses than for gains. This

means that people feel more strongly about the pain from a

loss than the pleasure from an equal gain about 2 ½ times as

strongly, according to Kahneman and Tversky. This

phenomenon is referred to as loss aversion

• Because of loss aversion, the manner in which an outcome

is described — either in the vocabulary of gains or in the

vocabulary of losses — has an important bearing on decision

making.

Mental Accounting

• People separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance for them

• Mental accounting manifests itself in various ways:

• Investors tend to ride the losers

•People are more venturesome with money received as bonus

•People often have an irrational preference for stock paying high dividends.

Narrow Framing

• Investors engage in “narrow framing” — they focus on

changes in wealth that are narrowly defined, both in a cross-

sectional as well as in a temporal sense.

• Narrow framing in a cross-sectional sense means that

investors tend to look at each investment separately rather

than the portfolio in its totality

Narrow Framing

• Narrow framing in a temporal sense means that investors

pay undue attention to short-term gains and losses, even when

their investment horizon is long.

• Since people are loss-averse, narrow framing leads to

myopic risk aversion. So investors tend to allocate too little

of their money to stocks

Behavioural PortfolioThe psychological tendencies of investors prods them to build their portfolios as a pyramid of assets as shown below

Cash

Residential house

Bonds

Stocks

Commercial property

Options

Shadow Of The PastPeople seem to consider a past outcome as a factor in evaluating a current risky decision. In general, people are willing to take more risk after earning gains and less risk after incurring losses. Experimental studies suggest the following:

• House-money effect

• Snake-bite effect

Other influences of the past are:

• Trying-to-break-even effect

• Endowment effect

• Status quo bias

• Cognitive dissonance

Emotional Time Line

Hope Pride Decisions Goals Fear Regret

Investors experience a variety of emotions, positive and negative. Positive emotions are shown above the emotional time line and negative emotions below the emotional time line.

Hope and fear have a bearing on how investors evaluate alternatives. The relative importance of these conflicting emotions determines the tolerance for risk

Anticipation

Anxiety

Herd Instincts And Overreaction

• People tend to herd together. Moving with the herd, however, magnifies the psychological biases.

• The heightened sensitivity to what others are doing squares well with a recent theory about fads, trends and crowd behaviour. Called the “information cascade”, this theory says that large trends or fads begin when individuals ignore their private information but take cues from the action of others.

• Information cascades lead investors to overreact to both good and bad news, causing stock market bubbles and crashes.

Market Inefficiency

Behavioural finance argues that, thanks to various behavioural

influences, often there is a discrepancy between market price and

intrinsic value. This argument rests on two key assumptions:

• Noise trading

• Limits to arbitrage

Noise Trading Noise traders may suffer from similar judgmental biases while

processing information. For example :

• They tend to be overconfident and hence take more risk

• They chase trends

• They tend to put lesser weight on base rates and more weight on new information and hence overreact to news

• They follow market gurus and forecasts and act in a similar fashion

Correlated behaviour aggregate shifts in demand

Limits To ArbitrageArbitrage . . real world is limited of two types of risk

• Fundamental risk : buying ‘undervalued’ securities tends … risky .. because .. market may fall further & inflict losses

• Resale price risk : . . arises mainly . . fact . .

Arbitrageurs have finite horizons :

· Arbitrageurs usually borrow money / securities . . pay fees periodically

· Portfolio managers . . evaluated every few months. This limits . . horizon of arbitrage.

Price Behaviour

Presence . . noise traders . . & limits to arbitrage . . Investor sentiment … does influence prices

Prices vary more … warranted by changes . . fundamentals

Indeed, arbitrageurs may also contribute to price volatility as they try to take adv … mood swings of noise traders

• Returns over horizons of few weeks or months … positively correlated . . arbitrageurs … positive feedback trading

• Returns … horizons . . few years . . negatively correlated … arbitrageurs . . eventually help prices … return to fundamentals.

Returns . . mean reverting .. emp . . evidence

L. Summers, “does the stock market rationally reflect fundamental values”, J. Finance (1986), 591-601

He proposes . . a plausible alternative . . emh

Pt = Pt* + ut Pt = Price

ut = α ut-1 + vt Pt* = Fund … Value

ut and vt Random stocks

IF 0 < α < 1 … Errors … security prices persist but fade away. This is clearly consistent . . Shiller’s & de Bondt & Thaler’s evidence, & more generally with overreactions, ‘fads’ . . mkt, & speculative bubbles

Critique of Behavioral Finance

Apart from presenting evidence of investor under-reaction (or over-reaction), they must demonstrate that such investor behaviour is firmly grounded in human psychology.

True, behaviouralists talk about things like ‘representativeness heuristic’ and ‘conservatism’. But, a substantial proportion of academic finance community regards such links with skepticism. As Nicholas Barberies put it: “They accuse behavioral finance theorists of going on a ‘fishing’ expedition, sifting through texts of human psychology until they found something that could be related to the effects they are trying to explain.”

The debate over the findings of behaviouralists continues. As Nicholas Barberis put it: “Researchers in behavioural finance are trying to build more robust and convincing models of the interplay of psychology and finance. On another front, firm believers in efficient markets are trying to understand the relationship between risk and return better in the hope this might shed light on the evidence.”

Views Of ExpertsJ.M. Keynes : “in point of fact, all sorts of considerations

enter into the market valuation which are in no way relevant to the prospective yield”

Irwin Friend : “a broad overview of the past half century suggests that there have been numerous occasions when large bodies of investors have been emotionally affected by fads & fashions in wall street”

William Baumol : “we have all seen cases where the behaviour of prices on the stock market has apparently been capricious or even worse, cases where hysteria has magnified largely irrelevant events into controlling influences”

Strategies For Overcoming Psychological Biases

• Understand the biases

• Focus on the big picture

• Follow a set of quantitative investment criteria

• Diversify

• Control your investment environment

• Strive to earn market returns

• Review your biases periodically

Summing Up

• The central assumption of the traditional finance model is

that people are rational. However, psychologists argue

that people suffer from cognitive and emotional biases.

• The important heuristic-driven biases and cognitive

errors that impair judgment are: representativeness,

overconfidence, anchoring, aversion to ambiguity, and

innumeracy.

• The form used to describe a problem has a bearing on

decision making. Frame dependence stems from a mix of

cognitive and emotional factors.

• People feel more strongly about the pain from a loss than

the pleasure from an equal gain – about 2½ times as strongly,

according to Kahneman and Tversky. This phenomenon

is referred to as loss aversion.

• People separate their money into various mental accounts

and treat a rupee in one account differently from a rupee

in another.

• Investors engage in “narrow-framing” – they focus on

changes in wealth that are narrowly defined, both in a cross-

sectional as well as a temporal sense.

• The psychological tendencies of investors prod them to

build their portfolios as a pyramid of assets.

• People seem to consider a past outcome as factor in

evaluating a current risky decision.

• The emotions experienced by a person with respect to

investment may be expressed along an emotional time line.

• Thanks to “information cascade”, large trends or fads

begin when individuals ignore their private information but

take cues from the action of others.

• Due to various behavioural influences, often there is a

discrepancy between market price and intrinsic value.

• To overcome psychological biases, a disciplined approach

is required.

Appendix 10 A

NEUROECONOMICS

Divide between Theory and Practice

There seems to be a deep divide between the theory and practice of investing as the following table suggests:

In Theory In Practice Investors have well-defined goals. Investors are not sure about their

goals. Investors carefully weigh the odds of

success and failure.

Investors often act impulsively.

Investors know how much risk they are comfortable with.

The risk tolerance of investors varies with the market conditions.

The smarter an investor is, the more money he’ll make.

Many smart people commit dumb investment mistakes. For example, Sir Isaac Newton was financially wiped out in a stock market crash in 1720.

People who monitor their investments closely tend to make more money.

People who pay almost no attention to their investments tend to do better.

Greater effort leads to superior performance.

On average, professional investors do not outperform amateur investors.

What Causes the Divide

What causes this divide? Neuroeconomics, a new-born

discipline, helps in explaining this divide. A hybrid of neuroscience,

economics, and psychology, neuroeconomics seeks to understand

what drives investment behaviour, not only at a theoretical and

practical level, but also at a biological level.

This appendix presents some of the important insights and

findings of neuroeconomics in a very condensed fashion and suggests

some guidelines for improving the odds of investment performance.

It draws mainly from a fascinating book titled Your Money & Your

Brain written by Jason Zweig and published by Simon & Schuster.

Reflexive and Reflective Brain

There are two aspects of human brain, the reflexive (or intuitive) system and the reflective (or analytical) system. The reflexive system has served us for millions of years in an environment characterised by immediate threats. But in the modern world, characterised by considerable complexity, it is not enough.

The reflective (or analytical) system resides largely in the prefrontal lobe of the brain. Neuroscientist Jordan Grafman calls it as “the CEO of the brain.” Jason Zweig describes its functioning as follows: “Here, neurons that are intricately connected with the rest of the brain draw general conclusions from scraps of information, organise your past experiences into recognisable categories, from theories about the causes of change around you, and plan for the future.”

Amygdala

Deep inside the brain is an almond-shaped tissue called the

amygdala. When you face a potential risk, the amygdala (which is a

part of your reflexive brain) acts as an alarm system. As Jason

Zweig explains: “The amygdala helps focus your attention, in a

flash, on anything that’s new, out of place, changing fast, or just

plain scary. That helps why we overreact to rare but vivid risks.

After all, in the presence of danger, he who hesitates is lost; a

fraction of a second can make the difference between life and

death.”

Two Minds

Humans literally have two minds when it comes to time. On the one

hand, we are impatient, fixated on the short run, eager to spend now,

and keen on becoming rich quickly. On the other hand, we save

money for distant goals (like children’s college education and our

retirement) and build wealth gradually. Invoking the Aesop’s fable,

neuroscientist Jonathan Cohen argues that a grasshopper and an ant

battle within our brains to dominate over our decisions about time.

The emotional grasshopper represents the reflexive brain and the

analytical ant symbolises the reflective brain. To be a successful

investor or a happy person you should learn to check the impulsive

power of your inner grasshopper.

Emotion and Reason

Pure rationality without emotions can be as bad as sheer

emotions without reason. According to neuroeconomics, you get

best investment results when you strike the right balance between

emotion and reason.

Our investing brains often drive us to do things that make

emotional sense, not logical sense. This is because emotional circuits

developed tens of millions of years ago make us crave for whatever

feels like rewarding and shun whatever feels risky.

Intuition

Most judgments are driven by intuition. People who buy stocks rarely analyse the underlying business. Instead, they rely on a feeling, a sensation : amateur investors as well as professional investors. Portfolio managers constantly talk about their “gut feeling.”

Intuition can yield fast and accurate judgments only when the rules for reaching a good decision are simple and stable. Unfortunately, investment choices are not simple and the key to success, at least in the short run, is seldom stable. As Jason Zweig put it: “In the madhouse of the financial markets, the only rule that appears to apply is Murphy’s Law. And even that guideline comes with a devilish twist: Whatever can go wrong will go wrong, but only when you least expect it to.”

Monetary Gains and Losses

A monetary gain or loss is not merely a financial or psychological

outcome. It is also a biological change that has profound physical

effects on the brain and the body.

The neural activity of someone whose investments are making

money is no different from that of someone who is on cocaine or

morphine. The brain responds to financial losses the way it responds

to mortal danger.

Expectation and Experience

Anticipation of a gain and its actual receipt are expressed in very

different ways in the brain. This explains why “money does not buy

happiness.”

Expectation, both good and bad, is more intense than actual experience.

It often feels better to anticipate making money than actually making it.

There is an old saying, ‘tis better to hope than to receive.’ Why do we

imagine that money will matter more than it really does? Jason Zweig

explains: “It’s how the brain is built…. The nucleus accumbens in your

reflexive brain becomes intensively aroused when you anticipate a financial

gain. But that hot state of anticipation cools down as soon as you actually

earn the money, yielding a lukewarm satisfaction in the reflective brain

that pales by comparison.”

Expectation and Experience

The brain’s anticipation circuitry does not evaluate potential gains

in isolation. Evolution has designed the human brain to pay closer

attention to rewards when they are characterised by risks – we know

that we have to be more careful in plucking a rose than picking a

daisy. Psychologist Mellers has demonstrated that a gamble that can

result in either a gain or a loss provides more “relative pleasure”

than a gamble that offers only gain.

Pattern Seeking

•The human brain incorrigibly searches for patterns even when

none exist.

•There appears to be module in the left hemisphere of the brain that

drives humans to search for patterns and to see causal relationships,

even when none exist: Gazzamicga has named it “the interpreter.”

Dopamine and Reward

Wolfram Schultz, a neuropsychologist, and others have made important discoveries about dopamine and reward: 

1. Getting what you expected does not provide a dopamine kick. Put differently, it is neutrally unexciting. That explains why drug addicts yearn for an even larger fix to get the same kick or investors hanker for fast rising stocks with a “positive momentum.”

2. An unexpected gain provides a dopamine kick or neural excitement. This makes people willing to take risks.

3. Dopamine dries up if the expected reward does not materialise.

4. Predictions and rewards of an earlier period evoke a fainter response of dopamine neurons.

Dopamine-drunk Wanting

Over millions of years our brains have developed a dopamine –

drunk wanting system that prods us to compete for more money,

power, and material things. We are drawn to these things not

because they bring happiness but because those who managed to get

the stone-age equivalent of these things are our ancestors, and those

did not , turned out be biological dead ends. As psychologist Daniel

Nettle put it: “I will argue that we are programmed for by evolution

in not happiness itself, but a set of beliefs about the kinds of things

that will bring happiness, and a disposition to pursue them.”

Aversion to Randomness and Ignorance

• Human beings hate randomness. So they compulsively predict

the unpredictable.

• Just as nature abhors a vacuum, the human mind abhors the

words, “ I don’t know” Inside each of us, there lurks a con

artist who is forever cajoling us into an inflated sense of our

powers.

• The Principal reason why we claim that we know more than

we do is that admitting our ignorance erodes our self-esteem.

Exposure Effect

Human beings tend to like what they experience most often. Psychologist Zajonc call this the “mere-exposure effect.” Says Zajonc: “The repetition of an experience is intrinsically pleasurable. It augments our mood, and that pleasure spills over anything which is in the vicinity.” Aesop got it wrong when he said “familiarity breeds contempt.” On the contrary “familiarity breeds contentment.”

Illustrating this, Jason Zweig says: “You might think you like Coke better for the taste, when in fact you like it better mainly because it’s more familiar. Likewise, investors plunk money into brand-name stocks, precisely because the brand name makes them feel good.”

Illusion of Control Humans suffer from illusion of control, an uncanny feeling that they

can exert influence over random choice with their actions. For example,

when a person wants to roll a high number, he shakes the dice and throws

them hard. The illusion of control tends to be stronger when an activity

appears at least partly random, offers multiple choices, requires effort, and

appears familiar. Since investing satisfies these tests, many investors suffer

from the illusion of control.

According to neuroeconomists, the caudate area which lies deep in the

centre of the brain serves as the coincidence detector. In this part of the

reflexive, emotional brain, actions are matched against the outcomes in the

world around us, irrespective of whether they are actually connected or

not.

Hindsight Bias

Once we learn what actually happened, we look back and believe

that we knew what was going to happen. Psychologists call this

“hindsight bias.” Says Nobel Laureate Daniel Kahneman “Hindsight

bias makes surprises vanish. People distort and misremember what

they formerly believed. Our sense of how uncertain the world really

is never fully developed, because after something happens, we

greatly increase out judgments of how likely it was to happen.”

Risk Tolerance

The conventional assumption that every person has a certain level of “risk

tolerance” is not correct because our perception about risk changes all the

time. As Jason Zweig puts it: “In reality, your perception of investment

risk is in constant flux, depending on your memories of past experiences,

whether you are alone or part of a group, how familiar and controllable

the risk feels to you, how it is described, and what mood you happen to be

in the moment.” Even a slight change in these elements can turn you from

an adventurous bull to a cautious bear. If you mindlessly rely on your

intuitive perception of risk, you are likely to assume risks that you should

avoid and shun risks that you should embrace.

Surprise

Humans and great apes – chimpanzees, gorillas, and organgutans –

have specialised neurons called spindle cells located in a central

forward region of the brain called the anterior cingulated cortex

(ACC). The ACC helps in generating the feeling of surprise when

normal expectations are belied – that is why some neuroscientists

call it the “Oops!” centre.

Some Guidelines

You can improve the odds of your investment performance by engaging more on the reflective side of the brain. Here are some guidelines to help you in doing so.

• Rely on words and numbers, not sights and sounds• Invest with rules• Count to ten• Take a global view• Control the controllable• Don’t obsess• Maintain an investment diary• Track your feelings• Rebalance• Be happy

Control the Controllable

While you have no control over whether the stocks or funds you pick will produce superior returns, you can control

• Your expectations (by setting realistic expectations)• Your risk (by asking how much can lose if you are wrong)•Your readiness (by making sure you adhere to an investing checklist)•Your expenses (by avoiding mutual funds with high management fees)•Your commissions (by trading infrequently)•Your taxes (by extending your investment period to at least one year)•Your own behaviour (by not succumbing to the “prediction addiction”)

Be Happy

A very powerful lesson from the new research into happiness suggests that managing your emotions and expectations is as important as managing your money to your sense of well-being. According to Martin Seligman, an eminent psychologist, having, doing, and being are three basic paths to happiness. Having is concerned about material purchases and possessions – what Martin Seligman calls “the pleasant life.” Doing centres around activities and experiences – what Seligman calls “the good life.” Being is about committing yourself to a larger cause – what Seligman calls “the meaningful life.” Money spent on having creates diminishing returns; the more accustomed you become to material possessions, the less happiness you derive from them. However, money spent on doing and being provides a much longer afterglow. As Jason Zweig puts it: “In the end, living a rich life depends less on how much you own than on how much you do, what you stand for, and how fully you reach your own potential.” There are many ways in which you can get happiness with minimal effort, such as learning new things, pursuing interesting hobbies, participating in social service, counting your blessings, breaking your routine and embracing new experiences, accentuating the positive, meditating, and so on.