Table of Contents
Behavioural Finance versus Standard Finance-
Behavioral Finance is a study of how psychology influences the behavior of investors and subsequently affects the financial markets. In contrast, Standard Finance is based on certain assumptions like investors are rational, risk-averse, self-interested utility maximizer, and have access to all available information. However, real-life behavior of investors is far from these assumptions, and they tend to make decisions based on biases and cognitive errors. The table below highlights the main differences between Standard Finance and Behavioral Finance:
| Standard Finance | Behavioral Finance |
|---|---|
| Economics at core | Psychology at core |
| Investors are rational and process new information without any bias. Efficient market hypothesis describes random movement in prices. | Biases (decision making behavior) guide investments. Every new information is seen with the same lens. Collective bias or herd mentality is responsible for sharp movements. |
| Decision making is rule-driven and consistent under different scenarios. | Decision making is inconsistent given the experience, recency, or loss aversion. |
| Risk-return trade-off is the foundation of investment. | Loss aversion is the basis, which in turn makes an investor oversensitive to losses. |
| Decision is rational based on detailed analysis. | Decision is ad-hoc based on thumb rules. |
The integration of Behavioral Finance with Standard Finance attempts to provide a more realistic and comprehensive understanding of financial markets. Nobel laureates Daniel Kahneman and Richard Thaler are credited for their work in bringing Behavioral Finance to the forefront.
how individuals make decisions:
Bounded Rationality:
- Investors often have limited time, information, or ability to comprehend complex information at the time of decision making
- Instead of optimizing, investors “satisfice” or settle with a sub-optimal solution that seems satisfactory and sufficient
- Bounded rationality is not irrational decision making, but rational decision making under certain boundary conditions
- Nobel laureate Herbert Simon is credited with the concept of bounded rationality
- Steps involved in decision making according to bounded rationality: process manageable information, apply quick approaches while processing, and select a satisfactory and sufficient solution
Prospect Theory:
- Describes how individuals make choices in situations involving risk and how they evaluate potential losses and gains
- Choices are evaluated relative to a reference point (their well-being)
- People are risk-averse about gains but risk-seeking about losses
- Monetary losses hurt more than monetary gains
- Developed by Nobel laureates Daniel Kahneman and Amos Tversky
- Consists of two phases: framing phase where prospects are analyzed using heuristics, and an evaluation phase where edited prospects are evaluated and the prospect of highest perceived value is chosen
Categorization of Biases-
| Biases | Definition |
|---|---|
| Emotional biases | These biases are based on emotions, such as fear, greed, or excitement. They can lead to impulsive and irrational decision making, causing investors to buy or sell based on feelings rather than facts. Examples include loss aversion, herd mentality, and overconfidence. |
| Cognitive errors | These biases are based on faulty cognitive reasoning and can occur even when emotions are not involved. They include errors such as confirmation bias, where investors seek out information that confirms their existing beliefs, and anchoring bias, where investors fixate on one piece of information. |
Emotional Bias-
| Emotional Bias | Description |
|---|---|
| Loss Aversion Bias | Preference for avoiding losses over taking chances with certain gains. People hold onto losing stocks too long and sell winning stocks too early. |
| Stereotyping Bias | Decision-making based on representative characteristics and general perceptions about those characteristics. For example, believing that a high-profile manager equals a well-managed company and makes for good investments. |
| Overconfidence Bias | Unwarranted faith in one’s own reasoning, judgments, and cognitive abilities, leading to sub-optimal decisions in investments. Often results in underestimating losses and confusing skill with luck. |
| Endowment Bias | Valuing an asset more when one holds rights to it, leading to a reluctance to sell even if it does not fit in overall investment strategy. |
| Status Quo Bias | A reluctance to make a decision and maintaining the status quo. Often linked to regret aversion bias and fear of error of commission. Nudges can help overcome this bias. |
Cognitive Bias-
| Cognitive Bias | Definition | Example |
|---|---|---|
| Cognitive Errors | Statistical, information-processing or memory errors that cause a person to deviate from rational behaviour | Relying on thumb rules instead of exact calculations |
| Mental Accounting | Treating one sum of money differently from another equal-sized sum based on which mental account the money is kept | Spending non-regular income extravagantly |
| Framing | Answering a question differently based on the way in which it is asked (framed) | Choosing the second option in both scenarios despite the outcomes being the same |
| Anchoring | Relying on pre-existing information when making decisions | Judging where the prices of a stock could be based on its past performance |
| Choice Paralysis | Being overwhelmed by too many options or information, leading to not wanting to make a decision | Not wanting to evaluate and choose from a large number of investment options |
Fusion Investing
Fusion investing is an investment strategy that integrates traditional and behavioural paradigms to create investment strategies. It combines fundamental analysis with behavioural finance.
The strategy combines value-growth phenomenon from fundamental investing and the momentum effect from behavioural finance. The aim of the strategy is to exploit inefficiencies in the market.
The broad steps involved in identifying stocks for a Fusion strategy are:
- Identify stocks that are showing promising value terms such as Price Earnings (P/E), Price to Book Value (P/BV), and Price to Sales (P/S).
- Filter stocks that are fundamentally strong based on profitability, leverage, and efficiency parameters such as the Piotroski Score.
- Identify stocks that are showing strong momentum i.e. price uptrend.
- The stocks that are left after the third step qualify to be part of the portfolio.
Behavioral finance and market anomalies:
- Market anomaly: It is a deviation of a stock price from its expected value given its fundamentals.
- Behavioural finance: It explains market anomalies as the result of investors’ systematic mistakes caused by behavioural biases.
- Biases: Overconfidence, self-attribution, confirmation bias, and disposition effect are some of the common biases that can affect investment decisions.
- Overconfidence bias: It makes investors underestimate risks and overestimate their ability to predict the market.
- Self-attribution bias: It leads investors to take credit for successes and blame others for failures, which can affect their investment decisions.
- Confirmation bias: It causes investors to seek information that supports their beliefs and disregard conflicting information.
- Disposition effect: It explains why investors hold on to losing stocks longer and sell winning stocks faster, which creates momentum in stock prices.
- Persistence of anomalies: While some anomalies disappear as others try to exploit them, others persist for a longer period, indicating that they are caused by some underlying factors other than just market inefficiencies.
Table: Summary of common behavioural biases and their effects on investment decisions
| Behavioural Bias | Effect on investment decisions |
|---|---|
| Overconfidence | Underestimate risks and overestimate ability to predict market |
| Self-attribution | Take credit for successes and blame others for failures |
| Confirmation bias | Seek information that supports beliefs and ignore conflicting information |
| Disposition effect | Hold on to losing stocks longer and sell winning stocks faster |
Behavioral Finance and Bubbles/Crashes:
- Bubbles are a sharp rise in asset price generated by expectations of further rises and attracting new buyers interested in short-term profit.
- Psychology is as important as finance and economics in explaining financial market behaviour.
- Mispricing is exploited by rational arbitragers, but synchronisation problem and individual incentives lead to persistence of bubbles.
- Historical examples of bubbles and crashes include the Dutch Tulip mania, South Sea Bubble, and Tech bubble.
- Bubbles often emerge during structural change in productivity and begin with a justifiable rise in asset price.
- Potential reasons for bubbles include liquidity, celebrity status, momentum, and illusion of control.
- Speculative bubbles are more likely to emerge where the proportion of inexperienced traders is high, uncertainty about true value is high, investment promises small chance of profit but the amount of profit is very high, it is possible to finance purchases by borrowing money, and short selling is difficult.
- Crashes entail similar processes to bubbles but in reverse order and everyone comes to sell at the same time due to negative news, change in opinion, liquidity crunch, or return to fundamental pricing models.
Mock Tests-
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