INVESTORS

BEHAVIOUR

BY:
SNEH PRABHA (MBA/10010/18)
HARSH BHATIA (MBA/10012/18)
PORTRAIT OF AN INDIVIDUAL INVESTORS

It suggests four classes of the weaknesses characterising individual investors behaviour.

• Perception of price movements

• Perception of Value
• Managing risk and return
• Trading practices

PERCEPTION OF PRICE MOVEMENTS

People tend to:

 Spot trends and see patterns where none exist.

 Naively extrapolate recent behaviour on the future.
 Perceive likely variation in equity returns to be too narrow.
 Be overconfident of their perception because they anchor too much on their most
likely forecast.
PERCEPTION OF VALUES:

Most individuals
 Do not have an adequate understanding of or ability to use the valuation technique
mentioned in the finance texts.
 Perceives value on the basis of the popular models or mental frames that are socially
shared through stories in the news media.
 Cannot distinguish good stocks from good companies.
The basic problem is that too many people have a short term orientation and judge a book
by its cover.

MANAGING RISK AND RETURNS

People do not manage their risk and return optimally. This is manifested in the
following:
 Many households are under-diversified, ignoring the important lessons of modern
portfolio that ‘diversification pays.’
 The idea that risk is defined at the portfolio level-and not at the level of individual
assets- and that risk depends on co-variation between returns is alien to many
investors.
 Many people believe that after committing their funds they can manage risk through
knowledge and trading skills.
 Most households over-invest in riskless assets, foregoing the attractive log-term returns
offered by stocks. When confronted with price volatility, they act myopically. Prospect
theory explains this puzzle.

TRADING PRACTICES

 Seasoned traders use a variety of rules and pre-commitment techniques, such as stop-loss
order to control emotion and discipline themselves.
 They trade shares on impulse or on random tips from acquaintances , without prior
planning.
 Their trading sentiment trails the market: they tend to buy when the market rises and sell
when the market falls.
 Such trading mistakes suggest that people are unjustifiably optimistic about almost
everything that concerns their personal lives.
WHAT THE HEURISTIC AND BIASES MEAN FOR FINANCIAL DECISION
MAKING

Heuristics are excellent mechanisms for saving time and effort, but they sometimes lead
investors astray.

FAMILIARITY

The familiarity heuristic induces the following financial behaviour:

Home country Bias
• While preferences seem to be changing gradually, it is still true that domestic investors
hold mostly domestic securities- Indian investors hold mostly Indian securities , same
with U.K,U.S.A. such behaviour reflects home country bias.
• HCB flies in face of evidence suggesting that international diversification reduces risk
without compromising returns.
• one reason for HCB may be that people are optimistic about their markets relative to
foreign markets. Another behavioural reason is comfort and familiarity.
• According to the rational explanation , international investment is less attractive,
compared to domestic investment, because of the factors like restrictions on capital
movement, differential costs of trading and varying tax rates.
• Kenneth French and James Poterba, however dismiss this arguments. Barriers to capital
movement have substantially diminished.
• As far as differential costs of trading are concerned, one would expect all investors to
gravitate to the low-cost country, but this does not seems to be happening.

• Bias towards Employer or known brands

• Investors tend to overweight the stocks of companies they work for or whose brands they
are familiar with.

REPRESENTATIVENESS

Representativeness and related biases lead to inappropriate investment decisions.

 Good companies vs. Good investment

• An interesting study done by Hersh shefrin and Meir Statman revealed that executives
believes that good companies are good stocks.They uesd ‘quality of management’ as
judged by the surveys of Fortune magzines as proxy for company quality.
• They found that management quality (i.e good company measures) and long term
investment values (i.e good stocks measures) to be highly correlated.
• This finding is inconsistent with efficient market hypothesis. In an efficient market,
no company attribute is associated with the investment value. Since all companies
information is embedded in the stock price on an ex ante basis, all companies (good
ones and bad ones) represent the equally good investments.

 Chasing winners
• Investors tend to choose securities and mutual funds based on past performance. They
regard recent past performance as the representative of future performance. This form
of representativeness may called be called as recency bias.
• Such momentum-chasing or trend following is a popular strategy and an inportant
cornerstone of technical analysis. Survey suggests that momentum-chasing is a
popular international phenomenon.
• I momentum-chasing profitable? The answer seems to be both yes or no. Emperical
evidence suggests that risk-adjusted returns are positively serially correlated over
intervals of 3 to 12 months. However over longer periods of three years or more, the
evidence indicates that there is a negative correlation. Put simply there seems to be a
pattern of intermediate term momentum followed by long term reversal.
 Availability
• When information on certain types of events is freely available, people tend to believe
that such events are more likely to be occur. For example prominent news coverage of
violent crime persuades people to overestimate their subjective probabilities of violent
attacks.
• Brad Barber and Terrance Odeon found that transactions of retail investors tend to be
concentrated on stocks where information is free available.
• News reports on a stock, exceptionally high trading volume, and extreme returns tend to
grab investors attention and stimulate trading.

ANCHORING

• In experimental studies, when subjects are asked to estimate an uncertain magnitude,

their estimate are anchored on meaningless red herrings.
• When the potential anchor prime facie has economic content, anchor is even more likely
to occur.
• Since anchoring and herding are related, a word about latter is in order.
• Financial analysts who publicly estimate target price, forecast earnings, and make
buy/sell recommendation tend to anchor or herd. Likewise economic forecasters who
publicly estimate growth rates, interest rates, and exchange rates, tend to anchor or herd.
IMPLICATIONS OF OVERCONFIDENCE FOR DECISION MAKING

Overconfidence is a pervasive phenomenon. There is sufficient, though not conclusive,

evidence that:
• Overconfidence leads to excessive trading.
• Overconfidence causes investors to have under-diversified portfolios.
• Analysts tend to be overly optimistic about the prospects of companies they follow.

 EXCESSIVE TRADING
• Overconfidence seems to induce excessive trading. Theoretical models, survey evidence,
and laboratory suggests that there is a potential nexus between overconfidence and
trading activity.
• Brad Barber and Terrance Odean examined the trading histories of over 60,000 U.S
discount brokerage investors between 1991 and 1996 to study link between trading
intensity and return performance. They divided their sample of individual investors into
five equal groups (quintiles) on the basis of trading turnover (or intensity). Q1
represented the 20% of the investors who traded the least; Q2 represented the 20% of the
investors who traded the next least; so on, all the way up to Q5, who represented the 20%
of the investors who traded the most.
• The gross and net returns for the groups with different trading intensity are shown in
exhibit.
• From this exhibit , it is clear that additional trading resulted in the slight improvement in
the gross return, the net return declined.
• It appears that trades were not based on the superior information; rather they were often
based on the misinformation and misplaced overconfidence.

Apart from the overconfidence, trading activity is stimulated by sensation seeking.

According to M. Zuckerman, sensation seeking is a personality trait that has four
dimension:
• Thrill and adventure seeking A desire to engage in thrilling activities which may be
even dangerous.

• Experience seeking A desire for novel and exciting activities, even if they are illegal.

• Disinhibition A behaviour that is not inhibited by social norms and taboos.

• Boredom susceptibility An aversion for routine and repetitive activity.

 UNDER- DIVERSIFICATION
• Another investment error that is likely to stem from overconfidence is under-
diversification.
• Overconfident people quickly tend to weight overweight/underweight securities
when they receive positive/negative signal. As a result they have an under-
diversified portfolio.
A study by William Goetzmann and Alok Jumar found that

• Financially sophisticated people were less prone to under-diversification

• Diversification increased with income, wealth, and age,
• Those who traded the most tended also to be the least diversified-overconfidence
seems to be drive both excessive trading and under-diversification,
• People who were sensitive to price trends to be under-diversified.
 EXCESSIVE OPTIMISM OF ANALYSTS:
• Analysts tend to be overly optimistic about the companies they are tracking.
• Exhibit shows how the recommendation of the analysts are distributed among four
categories, viz, strong buy, buy, hold, and sell/strong sell. It is evident that analysts
are much more likely to recommend a purchase than a sell.
INFLUENCE OF EMOTIONS

 Investor Mood and Market mood

• In his book Irrational Exuberance, Nobel laureate Robert Shiller argues that, “the
emotional state of investors when they decide on their investments is no doubt one of the
most important factors causing the bull market.” This was experienced the world over
around 1990s.
• At a fundamental level, however, one wonders whether there is a simple relationship
between investors mood and risk attitude. As we learnt earlier, risk attitude is important to
determining how a person values an asset.
• Does a person take more risk or less risk when he is in a good mood or bad mood? The
answer perhaps depends on the context and the personality of the individual.
• While person in sour mood may shun risk, another may become reckless. Likewise there
is no evidence about the relationship between positive mood and risk aversion.
• While a person in good mood may become less risk-tolerant another may be less likely to
be gamble. Lest he should jeopardise the good mood.
• On the whole it is unclear how good and bad mood affect risk attitude and in return,
market behaviour.
 Regret pride and anger

• Regret and pride have an important bearing on investment decision-making. Regret is a

negative emotion and pride is a positive emotion. If a decision turns sour, you suffer
regret. Your negative feelings are accentuated, if you have to report your loss to others.
You experience pride the flip side of regret, if your decision pays off.
• Researchers have found that people are strongly motivated to minimise regret. Further,
the effects of regret and pride are asymmetric. It seems that regret is felt more strongly in
comparison to pride.
• In the discussion of prospect theory, we learnt that while people in general are risk-
averse, they sometimes seek risk. People seek risk in the domain of losses, to avoid the
negative feelings of regret associated with the recognition of a loss. So they move away
from their natural tendency to avoid risk.
• In lottery effect is concerned, a big low probability gain and its associated pride may
motivate people to take risk. It is evident that pride and regret are powerful emotions that
influence the decision people make.
• Anger too is a powerful emotion that can distort investment decision-making. I
 The Disposition Effect

• Investors tend to sell superior performing stocks too early and hold losing stocks too long.
This tendency is called the disposition effect.
• Let us look at an empirical study documenting the existence of the disposition effect. Using
a database that included trading records for 10,000 discount brokerage accounts with nearly
100,000 transactions during the period 1987–1993, Terrance Odean provided evidence of
disposition effect. Odean used the purchase price of each security (or the average purchase
price when there were multiple transactions) as the reference point, in accordance with
prospect theory. In a rising market many stocks tend to be winners. So, it is natural that
more winners will be sold relative to winners. To address this issue, Odean looked at the
frequency of the winner/loser sales relative to the opportunities for winner/loser sales. More
specifically, he calculated the proportion of gains realised (PGR) and the proportion of loss
realised (PLR) as follows:

• PGR= Realised gains /Realised gains + paper gains

• PLR= Realised losses/ Realised losses + paper losses
 From Exhibit 9.3, which aggregates over all investor accounts, it is clear that investors tend
to sell winners over losers (PGR > PLR) over the entire year, even though for tax reasons
investors should sell losers, rather than winners. Except for the month of December, when
investors are likely to sell losers than winners for tax reasons, the disposition effect dominates
in the remaining eleven months (January - November).
 What Explains the Disposition Effect

Investors tend to sell winners too early and ride losers too long. In their classic paper, "The
Disposition to Sell Winners Too Early and Ride Losers Too Long Theory and Evidence,”
published in Journal of Finance, Vol. XL, No. 3, Hersh M. Shefrin and Meir Statman provide
an explanation for this phenomenon in terms of four ideas prospect theory, mental accounting,
seeking pride and avoiding regret, and self-control.

Prospect Theory

There are two stages of decision making; editing stage and evaluation stage. In the editing
stage, decision-makers frame the choice in terms of potential gain or loss in relation to a fied
reference point in the evaluation stage, the decision makers employ an S-shaped value curve.
To understand how the disposition to sell winners and ride losers emerges in prospect theory,
consider an investor who bought a stock a month ago for 100, but the stock is currently selling
for 80. Let us assume the investor expect the stock to go back to 100 or fall further to 60, both
outcomes being equi-probable. The possibilities are displayed in Exhibit 9.4.
 According to the prospect theory, the investor frames his choice as a choice between two
lotteries:
A. Sell the stock now and realise what had been a "paper loss” of 20.
B. Hold the stock for one more period with equal odds of "breaking-even" and losing an
additional 20.
The choice between these lotteries falls in the loss region of Exhibit 9.5. So, it is
associated with the convex portion of the S-shaped value function. This implies that B
will be preferred to A.

Exhibit 9.4 Equi-probable Outcome Exhibit 9.5 Value Function

Mental Accounting

According to the mental accounting principle, decision-makers segregate the different types
of gambles they face into separate mental accounts. Then they apply decision rules based
on prospect theory to each account, ignoring the possible interaction. This explains their
reluctance to engage in a tax swap, when they have a paper loss.

Seeking Pride and Avoiding Regret

People seek pride and avoid regret. So, they are disposed to realise gains and defer losses.
However, the asymmetry between the strength of pride and regret (regret is stronger than
pride) leads to inaction, rather than action. This explains why investors are often reluctant
to realise both gains and Losses.

Self-control

There is a conflict between the rational part (planner) and the emotional part (agent) of the
individual. The planner may not be able to prevail over the agent. For example, even though
a trader may be aware that riding a loser is irrational, he may not exhibit enough self-
control, thanks to the force of emotion, and close his position and limit the loss.
 Other Manifestations of Path-Dependent Behaviour

Path-dependent behaviour, of which disposition effect is an example, means that a person's

decisions are influenced by what transpired earlier. There are other manifestations of path
dependent behaviour. To understand them, consider this bet on a coin toss: If it shows heads,
you win 100; if it shows tails, you lose 100. Would you accept this bet? Suppose you had won
500 earlier. Now would you accept this bet? What if you had lost 500 earlier? Would this
make the bet look any different to you? While the odds of winning 100 do not change in the
different scenarios, many people will take the bet in one situation, but not in the other. Put
differently, people 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 a house-money effect, a snake bite effect, and a
trying-to-break-even effect. After experiencing a gain, people are willing to take more risk.
After winning money in a gamble, amateur gamblers somehow don't fully consider the
winning as their own and are hence are tempted to risk it in further gambles. Gamblers refer
to this as the house-money effect. After incurring a loss, people are less inclined to take risk.
This is sometimes referred to as the snake bite (or risk aversion) effect. A loss is akin to a
snake bite that makes a person more cautious.
Losers, however, do not always shun risk. People often jump at the chance to recover their
losses. This is referred to as trying-to-break-even effect. In fact, this effect may be strong
than the snake bite effect. As Kahneman and Tversky put it, "A person who has not made
peace with his losses is likely to accept gambles that would be unacceptable to him
otherwise. There are other ways in which what has happened in the past has a bearing on
present decisions, actions, and beliefs. Some of the well-known effects are the endowment
effect, status quo bias, and the avoidance of cognitive dissonance. The endowment effect
says that people tend to place greater value on what belongs to them relative to the value
they would place on the same thing if it belonged to someone else. A concomitant tendency
is to put too much emphasis on out-of-pocket expenses and too little on opportunity costs.
Status quo bias implies that people are comfortable with the familiar and would like to keep
things the way they have been.

Cognitive dissonance arises when the brain is struggling with two opposite ideas-I'm
smart, but I'm not smart. Since cognitive dissonance is psychologically painful, people tend
to reject information that conflicts with their positive image.
IMPLICATIONS OF MENTAL ACCOUNTING

Traditional finance holds that wealth, in general, and money in particular, must be
regarded as "fungible" and every financial decision should be based on a rational
calculation of its effects on overall wealth position. In reality, however, people do not have
the computational skills and willpower to evaluate decisions in terms of their impact on
overall wealth. It is intellectually difficult and emotionally burdensome to figure out how
every short-term decision (like buying a new camera or throwing a party) will bear on what
will happen to wealth position in the long run. So, as a practical expedient, 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 to them. The concept of
mental accounting was proposed by Richard Thaler, one of the brightest stars of
behavioural finance.

So, as a practical expedient 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 to them. The concept of mental accounting was proposed by Richard
Thaler, one of the brightest stars of behavioural finance.
Mental accounting manifests itself in various ways:
• Investors have a tendency to ride the losers as they are reluctant to realise losses.
Mentally, they treat unrealised “paper loss” and realised “loss” differently, although from
a rational economic point of view they are the same.
• Investors often integrate the sale of losers so that the feeling of regret is confined to one
time period.
• Investors tend to stagger the sale of winners over time to prolong the favourable
experience.
• People are more venturesome with money received as bonus but very conservative with
money set aside for children's education.
• Investors often have an irrational preference for stocks paying high dividends, because
they don't mind spending the dividend income, but are not inclined to sell a few shares
and “dip into the capitol”.

 Narrow Framing
Ideally, investors should pay attention to changes in their total wealth (comprising of real
estate, stocks, bonds, capitalised future income, and other assets) over their investment
horizon because it is this that determines how much they can spend on goods and services,
which is what ultimately matters to them.
In reality, however, 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.
Narrow framing in a cross-sectional sense means that investors tend to look at each
investment separately rather than the portfolio in its totality. Hence, they are more focused on
price changes in individual stocks and less concerned about the behaviour of the overall
portfolio. 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 (such as saving for
son's college education which may be ten years away and saving for retirement which may be
many years away).
Narrow framing can lead people to overestimate risk. This happens because the more
narrowly an investor frames the more often the investor sees losses. While several individual
securities in a portfolio may have negative returns, the portfolio as a whole is likely to have a
positive return. Similarly, although the stock market often produces negative returns in the
short run, it rarely delivers negative returns in the long run. Since people are loss-averse,
narrow framing leads to myopic risk aversion
.
Narrow framing manifests itself in the following ways:
• Investors allocate too little of their money to stocks due to myopic risk aversion.
• When investors sell stocks, they typically sell stocks that have appreciated, rather than
stocks that have depreciated.
THANK YOU