29-11-2019

Behavioural Finance
(Understanding Behavioural Finance & the Psychology of Investing)

Dr. Manas Mayur

manasmayur@gim.ac.in
behfin@gim.ac.in
Powerpoint Templates

1
 29-11-2019

The Evolution of Academic Finance

The Old Finance

1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

The Old Finance

Theme: Analysis of Financial Statements and the Value of Firm

Paradigms: Security Analysis Value of Firm
(Graham & Dodd) (Williams)
Foundation: Economics

2
 29-11-2019

The Evolution of Academic Finance

The Old Finance

1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

Modern Finance

Modern Finance

Theme: Valuation Based on Rational Economic Behavior

Paradigms: Optimization CAPM EMH Irrelevance
(Markowitz, Tobin) (Sharpe) (Fama) (Modigliani & Miller)
Foundation: Financial Economics

Harry Markowitz

3
 29-11-2019

Expected Return (taste)

Risk (health)

Expected Return (taste)

Risk (health)

4
 29-11-2019

Expected Return
Maruti Suzuki

ITC

Risk

5
 29-11-2019

Efficient frontier: the set of portfolios offering the highest

expected return for any given standard deviation.

Expected Return

efficient frontier

Risk

James Tobin

6
 29-11-2019

Efficient portfolios with risky and

risk free assets

Expected Return

Rf efficient portfolios
of risky assets

Risk

William Sharpe

• Most stocks move together, most of the time. Hence, it is natural

to think that a single factor determines most of the cross-
sectional variation in returns.

7
 29-11-2019

E (Rs)

Rm

Rf

E (Rm)

E (Rs)

βs
Security Market Line (SML)

Rf

E (Rm)

E(Rs)= Rf + βs ( E(Rm)- Rf )

8
 29-11-2019

The Evolution of Academic Finance

The Old Finance The New Finance

1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond

Modern Finance

The New Finance

Theme: Inefficient Markets

Paradigms: Behavioral Models (Kahneman & Tversky)
Irrational behaviors Choice architect
(Shiller) (Thaler)
Foundation: Statistics, Econometrics, and Psychology

9
 29-11-2019

H = +Rs.100
T = - Rs. 100
600
500
Jaggu
400
300
Kailash
200
100
Prabhakar
0
-100
Deepak
-200
Leslie
-300
-400

Brownian motion

10
 29-11-2019

Random walk

Drunkard’s walk

11
 29-11-2019

Behavioural Finance

• Behavioural Finance attempts to explain

market anomalies and other market activity
that is not explained by the efficient market
hypothesis
– A market is said to be efficient with respect to
an information set if the price ‘fully reflects’ that
information set, i.e. if the price would be
unaffected by revealing the information set to
all market participants. The efficient market
hypothesis (EMH) asserts that financial
markets are efficient.

12
 29-11-2019

• Three economic conditions that lead to market

efficiency:
– Investor rationality
– Independent deviations from rationality
– Arbitrage
• For market to be inefficient, all three of these
conditions must be absent.

• The definition of rationality has been much debated,

but there is general agreement that rational choices
should satisfy some elementary requirements of
consistency and coherence.

13
 29-11-2019

Rational Choice Theory

Rational choice theory is an economic principle

that states that individuals always make prudent
and logical decisions. These decisions provide
people with the greatest benefit or satisfaction
— given the choices available — and are also in
their highest self-interest.
Most mainstream academic assumptions and
theories are based on rational choice theory.

ECON vs Humans

14
 29-11-2019

• Bounded rationality reflects the limited cognitive

abilities that constrain human problem solving.
• Bounded willpower captures the fact that people
sometimes make choices that are not in their long-run
interest.

• Bounded self-interest incorporates the comforting

fact that humans are often willing to sacrifice their own
interests to help others.

Our minds are tuned with the

laws of Physics.

15
 29-11-2019

Higher return = higher risk

What is Behavioural Finance

• Behaviour finance is the application of

psychology to financial behavior – the
behavior of practitioners, investors,
managers etc.
• This course is about recognizing the
influence of psychology on oneself, on
others, and on the financial environment
at large.

16
 29-11-2019

• People are the fundamental units of capital markets.

• Therefore, our understanidng about market can only
be as good as our understanding of human nature
• Your brain (1,50,000 years old) is much older than the
markets (400 years old) it seeks to navigate
• Our brains have remained relatively stagnant over the
last 1,50,000 years, but the complexity of the world in
which they operate has exponentiated

What is Behavioural Finance

• This course will draw heavily from key ideas

from multiple disciplines like economics,
psychology, accounting, chemistry, physics,
mathematics and evolutionary biology.

• Learning about these key ideas will help you

understand how the world really works.

17
 29-11-2019

Syllabus
• Introduction to Behavioural Finance: Why we care: The roles of securities
prices in the Economy and Efficient markets hypothesis (EMH).
• Market efficiency and Behavioural Finance: Patterns in historical return and
Patterns of Return Predictability in Stocks, Emotion and Neuroscience.
• Mental models and mental tricks: Value and Probability Weighting functions
and Framing effects.
• Psychology of misjudgements: Review of Charlie Munger’s framework for
psychology misjudgement as it relates to business and investing.
• Behavioural Biases: Reading on various biases and their effect on investment
behaviours.
• Sentiment: Understanding investor behaviour (Savings & Investment), what
“Intelligence” means for investors (Self-Control, Theory of Mind, Adaptation skills
etc.).
• Bubbles: Dotcom bubble, how long irrationality persist and what factors cause
these bubbles to burst.
• Anomalies: Behavioural explanations, other puzzles, closed end funds puzzle
and, Comovement.

Evaluation Scheme

Weekly Assignments* 30 %

Presentation (Crashes) 20%

End Term 40 %
Class Participation 10%

*
• Each week each student will write a short (one-paragraph to one-
page) discussion of the impact of at least one of the topics/biases
covered in that week session on the situation. The situation can
be personal, professional, or something from current events.
• Movie analysis submission.

18
 29-11-2019

Learning outcomes

• Get familiar with psychology foundations that underlie

investors’ behaviour

• Recognize and describe behavioural biases, heuristics

and emotions in the context of their effect on investor’s
decision making.

• Understand the processes of financial markets; be able to

identify market anomalies and to detect the opportunities
for their profitable exploitation.

• Demonstrate familiarity with social influences on judgment

and decision making and its effect on the market

Disclaimers
• The course does not intend to hurt the sentiments of any
individual, community, short term traders, financial modelers,
analysts etc. All names, characters and incidents portrayed in this
course are actual….fictitious. Any resemblance to any person,
living or dead, is purely deliberate… coincidental.

• This course is not about stock recommendations or stock tips. Do

not consider any of the name as recommendation. I may or may
not be invested in the stock I discuss.

• Most of the jokes are intended for general humor purpose only.
The professor assumes no responsibility for whether or not you
‘get it’.

19