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– The microsystem
– The mesosystem,
– The exosystem,
– The macro system
Psycho-social Theories
• Goal Setting Theory (Edwin Locke, 1960)
• Goal setting is essentially linked to the task
performance.
• Not only specific goals and challenging goals
along with the appropriate feedback can
contribute to higher and better task
performance.
• SMART
Evolution of Behavioural Finance
Behavioural Finance
Background
• Behaviour finance was considered first by the
psychologist Daniel Kahneman and economist
Vernon Smith, who were awarded the Nobel
Prize in Economics in 2002.
• This was the time when financial economist
started to believe that the investor behaves
irrationally. Human brains process information
using shortcuts and emotional filters even in
investment decisions
Meaning
• Linter (1998) has defined behavioural finance as
being study of how human interprets and act on
information to make informed investment decisions.
People process data appropriately and People employ imperfect rules of thumb
correctly. (heuristics) to process data which includes
biases in their beliefs may lead them to
commit errors.
People view all decisions based on risk and Perceptions of risk and return are
return. significantly influenced by how they are
framed.
People are guided by reasons and logic. Emotions and herd heuristics play an
important role in influencing decisions.
Markets are efficient. There is a discrepancy in market prices and
fundamental value.
Traditional Finance Perspectives on
Individual Behavior
• Expected Utility Theory –Maximization of
utility (Bernoulli, 1738, 1954)
• Assumptionsions
– Completeness
– Transitivity
– Independence
Behavioural Finance Perspectives on
Individual Behaviour
• Challenges to Rational Economic Man
– Human Behaviour depends upon feelings
– Inner conflicts- Prioritizing aspirations (Family
financial management system)
– Do we really have perfect information – Bounded
rationality
Why Psychology matters?
• Choose following?
A. A 50 % chance of winning Rs. 1000 (the
Gamble), or
B. A sure gain of Rs. 500 (the sure gain)
Why Psychology matters?
• Choose following?
A. A 50 % chance of winning Rs. 1000 (the
Gamble), or
B. A sure gain of Rs. 500 (the sure gain)
Most of us go for (B )
- We think of ourselves as conservative
- So, why Gamble?
Why Psychology Matters?
• Now, choose between the following:
• A. A 50 % chance of loosing Rs. 1000
• B. A sure loss of Rs. 500 (the sure thing)
Why Psychology Matters?
• Now, choose between the following:
• A. A 50 % chance of loosing Rs. 1000
• B. A sure loss of Rs. 500 (the sure thing)
• Most of us prefer to go for (A)
- Because we hate taking losses
- God forbid, we may turn lucky?
- Then, Why not to Gamble?
Two Building Blocks of BF
Behavioural Finance
Limits to Arbitrage
Cognitive Psychology
(When market will be
(How people think?)
inefficient?
Investor’s Psychology
• Investors often do not participate in all assets
and security categories
• Individual investors loss-averse behaviour.
• Investors always sees past performance as an
indicator of future performance
• Investors trade too aggresively
Market Psychology
• Meaning
– Greed
– Fear
– Expectations
– Circumstances and events
Theoretical Background
• Applications of BF,
• Overview of theoretical framework
Background
• Neoclassical economics makes some
fundamental assumptions about people:
• 1. People have rational preferences across
possible outcomes or states of nature.
• 2. People maximize utility and firms maximize
profits.
• 3. People make independent decisions based
on all relevant information.
Issues with Expected Utility Theory
• People have irrational tendency to be less
willing to gamble with profits than with losses
(Prospect Theory)
• People use shortcuts instead of calculating all
possible options (Heuristics)
Prospect Theory
• Kaenman & Tversky (1979)
• People do not always make rational decisions
because they value gains and losses
differently.
• Centered around loss aversion
Prospect Theory
Prospect Theory
• People sometimes exhibit risk aversion and
sometimes risk seeking, depending on the nature of
the prospect.
• Decision (i): Choose between P1(Rs. 240) and
P2(.25, Rs. 1000)
• Decision (ii): Choose between P3(-Rs. 750) and
P4(.75, -Rs. 1000)
Prospect Theory
• People’s valuations of prospects depend on gains
and losses relative to a reference point.
• Decision (i): Assume yourself richer by Rs. 300, than
you are today, than,
Choose P5(Rs. 100) and P6(.50, Rs. 200)
• Decision (ii): Assume yourself richer by Rs. 500,
than you are today, than,
• Choose between P7(-Rs. 100) and P8(.50, -Rs. 200)
Fourfold pattern of risk attitudes
Examples Gains Losses
High 95% chance to win $10,000 or 95% chance to lose $10,000 or
probability 100% chance to obtain $9,499. So, 100% chance to lose $9,499.
(certainty 95% × $10,000 = $9,500 > $9,499. So, 95% × −$10,000 = −$9,500 <
effect) Fear of disappointment. Risk −$9,499. Hope to avoid loss. Risk
averse. seeking.
18,446,744,073,709,551,615
Diversification
• PV= F___
(1+r * t)
Let’s assume we’re determining the present value of an asset
with cash flows of $100 per year for 10 years. We’ll stick with an
8% discount rate.
Imagine you’re given 2 choices. Get a
$100 today or $120 in a week.
But when the same question is asked with the same 1
week interval, but a year in the future, we largely
choose the bigger reward.
Crux
• We are impatient-and prefer immediate
rewards in the short term. But we’re more
patient and wait for better rewards in the long
term.
What kind of trading strategy should we use Buy and Seek for
Hold abnormal
return
Theoretical Challenges to EMH
• Investors Irrationality
– Attitude towards risk
– Sensitivity to decision makers
• Correlated investor Behavior
• Limits to Arbitrage
Human Fallacies & Key Anamolies
March (1994) identified four human fallacies:
• (i)Limited attention
• (ii)Faulty memory
• (iii)Limited comprehension capacities
• (iv)Limited communication capacities
Thaler (1999)identified most commonly seen anomalies as
under:
• (i)Volume
• (ii)Volatility
• (iii)Cash Dividends
• (iv)The Equity Premium Puzzle
• (v)Predictability
Behavioural EMH
• The price-equals to value market hypothesis
• The Hard to beat Market Hypothesis
Arbitrage
• Concept
• Arbitrageur
• Types
– Uninformed Arbitrageur
– Informed Arbitrageur
• Informed Trading
– Fundamental Traders
– Technical Traders
– High Frequency Traders
Limits to Arbitrage
• Concept
– Fundamental Risk
– Noise Traders Risk
– Horizon Risk
– Implementation cost
• Noise Traders
Glamour Anomaly
• Glamour Anomaly means when investors
assume that value (high book-to-market)
investment strategies yield superior returns
relative to glamour (low book-to-market)
strategies. But actually the return advantage
of value investing strategies reflects the
compensation for bearing risk.
Thank you
Behavioural Factors and Financial
Markets:
-Asset Management & Behavioural
Factors
-Implications of Heuristic Biases on
Portfolio Management
-Fundamental , Technical and
Behavioural Factors
Types of Investors
• According to market..
– Regular investors
– Only savers
– Seasonal traders
– Angel Investors
– Business Investors
– Risk-taker investors
Type of Investors
• Based on Risk
– Risk Averse
– Risk Neutral
– Risk Seeker/ Lover
Types of Decisions makers/Investors
• Based on personality type (MBTI)
– A theory developed by Carl Jung (1923)
– Extroversion/Introversion: The extraversion/intro-
version set of preferences defines how people are
energized.
– Sensing/Intuitive: Sensing and intuitive preferences
describe the process that people rely on to gather
information.
– Thinking/Feeling: Thinking and feeling preferences
describe how people make decisions.
– Judging/Perceiving: Judging and perceiving
preferences describe lifestyle orientations.
Portrait of an individual investor
• 1. Perception of price movement
• 2. Perception of value
• 3. Managing risk and return
• 4. Trading practices
• 5. Indian investors tend to lose in stock market
What heuristics and Biases mean for Financial
Decision Making
• Familiarity
– Home country bias
– Bias towards employer brand
• Representativeness
– Good companies ..good investments
– Chasing winners
– Availability
Implication of overconfidence in Financial
Decision Making
Bonds
Residential
Property
Cash
Behavioral Life Cycle Theory
Stage Consumption Pattern
Single
Retirees
Life Cycle Hypothesis of Savings
Life Cycle Hypothesis of Savings
Objective Need Proposed Financial Behavior
Stage 1- To protect Protection against risks of Setting up of emergency fund or to
yourself and your unexpected circumstances and the purchase adequate amount of insurance
family risk related to life, disability,
health etc.
Stage 2- To provide To provide financial security to Providing an adequate financial security
for financial security extended family members, without placing undue stress on your
for yourself and your fulfilling the needs for education, resources to cause financial crises,
family social events, or fulfilling other emphasis on proper credit & debt
needs management
Stage 3- To enjoy the To accumulate the wealth for Budgeting financial security for
comfortable standard secured retirement retirement,
of living
State 4- To be Being financially independent Enjoying the return made during the
financially and have comfortable retirement, stage 1 and stage 2
independent, with the same standard of living
Stage 5- To distribute To distribute the wealth to the Following up the strategy of estate
the wealth beneficiaries or next generation planning
Behavioral Life Cycle Theory
• Later, they proposed the behavioral life cycle hypothesis (Shefrin &
Thaler, 1988) suggesting that individuals practice mental
accounting, meaning that they have different propensities to save in
different categories of accounts.
Operational feedback
Rating agencies’ report
Advisor/brokers/ analyst’s recommendation
Conversation/exchanges of views with Professional colleagues
Conversations/exchanges of views with company executives
and sector experts
External Factors and Investor Behaviour
Economic and regulatory environment
Current economic indicators
Statements from politicians and Government officials
Contribution of firm towards social causes
Political party affiliation
Neutral Information
Recent price movements of the funds
Fluctuation and development in the capital market
Information from Government officials and & politicians
Economic indicators
Inflation
Social Responsibility
External Factors and Investor Behaviour
Demographic Factors
Age
Gender
Marital Status
Educational Qualification
Income
Occupation
External Factors influencing the Stock
Markets
• Internal Developments
• World events
• Interest rates
• Exchange Rates
• Hype
• Inflaction and Deflation
• Foreign markets
• Economic growth
• Confidence and expectations
• Related markets
• Prices of crucial commodities
Social Forces
• Reciprocation
• Social Proof
• Liking
• Obedience to Authority
Brain Secretions and Investor
Behaviour
• Role of Dopamine and its implications in
investment decisions
• Role of Serotonin and its implication in
investment decision
Behavioural Corporate Finance
Lecture 10-11
Crux of BCF
• AGENTS-
• Managers are the agents of the shareholders
• Rational Irrational
(owned)
(Supposed to be rationale, Theories,)
Rational Managers with Irrational
Investors
• Managers’ goal (To maximize profit of the
company and wealth of the SHs)
• Balancing Three objectives
• Maximize Fundamental Value (Existing and
Potential)
• Maximize Current Market Value
• Market timings
How to cater the mispricing
• Choosing investment projects or financing
packages
• so that the market prices > IV
• Fundamentally strong
• 1 accept the project which has smaller PBP
• 2. to invest in the companies project for which
current demand is there
• 3. Dot.com
Capital Budgeting Decisions
• Discounted Methods
– NPV
– IRR
• Non-discounted Methods
– PBP
– ARR
– PI
Behavioral Corporate Finance and
Capital Budgeting Decisions
• Biases
– Payback Period, IRR and NPV
– Affect heuristics
– Overconfidence
– Excessive Optimism
• Perceived Control
• Familiarity and Representativeness
• Desirability and wishful thinking
• Anchoring and adjustments
• Confirmation Bias
– Reluctance to terminate losing project
Informational Asymmetry and Capital
Budgeting
• Background
– Firms often ration capital and do not invest in all
projects that have positive NPV.
– Divisible
– Cant be Divisible
– A lot of attention is paid to the extent to which
the decisions are centralized
– Mix of financing is very important
Informational Asymmetry and Capital
Budgeting
1. Information asymmetry between shareholders and
bondholders
• Equity shareholders – more risky projects
2. Information asymmetry between current
shareholders and prospective shareholders
– Preference for the projects with a shorter payback
period
– A greater degree of capital rationing
– Centralization of capital budgeting
Informational Asymmetry and Capital
Budgeting
3. Information asymmetry between Managers
and Shareholders
– Visibility Bias
– Resolution Preference
– Mimicry and Avoidance
•
Capital Structure and Behavioural
Finance
• Over and under capitalization
• MV 280 > BV 100 (Overcapitalized)
• MV 100 < BV 280 (Undercapitalizded))