evolution of behavioral finance theories issues and challenges

1. Behavioural finance : Recent trends
By Ajay Kumar
(Research Scholar)

2. Content to be discussed….
 Introduction to Financial Market.
 Evolution of behavioural finance.
 Introduction to behavioural finance.
 Current issue in behavioural finance.

3. Introduction to Financial Market
 A financial market is a market in which
people trade financial securities, commodities, and value
at low transaction costs and at prices that reflect supply
and demand. Securities include stocks and bonds, and
commodities include precious metals or agricultural
products.
 A financial market facilitates transactions between buyers
and sellers, as well as between producers and consumers.

4. Functions of Financial Market
Financial market serves six basic functions:
 Borrowing and Lending: Financial markets permit the transfer
of funds (purchasing power) from one agent to another for
either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by
which prices are set both for newly issued financial assets and
for the existing stock of financial assets.
 Information Aggregation and Coordination: Financial
markets act as collectors and aggregators of information about
financial asset values and the flow of funds from lenders to
borrowers.

5. Cont…
 Risk Sharing: Financial markets allow a transfer of risk
from those who undertake investments to those who provide
funds for those investments.
 Liquidity: Financial markets provide the holders of financial
assets with a chance to resell or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and
information costs.

6. Standard Theory of Finance
V/s
Behavioural Finance

7. Standard Theory of Finance
 Investors
 Are rational beings
 Consider all information and accurately assess its meaning.
 Some individuals/agents may behave irrationally or against
predictions, but in the aggregate they become irrelevant.
 Markets
 Quickly incorporate all known information
 Represent the true value of all securities.

8. Behavioral Finance
 Investors
 Are not totally rational.
 Often act based on imperfect information.
 There are systematic patterns or cognitive errors that do not
go away in the aggregate, such that there is a positive
probability that the ‘marginal investor’ will exhibit a
cognitive bias.
 Markets
 May be difficult to beat in the long term.
 In the short term, there are anomalies and excesses.

9. Evolution of behavioural finance
 Back in 1896, Gustave le Bon wrote “The Crowd: A Study of the
Popular Mind”, one of the greatest and most influential books of
social psychology.
 In 1956 the US psychologist Leon Festinger introduced a new concept
in social psychology: the theory of cognitive dissonance.
 Tversky and Kahneman (1973) introduced the availability
heuristic. In 1974, two brilliant psychologists, Amos Tversky and
Daniel Kahneman, described three heuristics that are employed when
making judgments under Uncertainty. psychologists Kahneman and
Tversky, in 1979 presented a critique of expected utility theory .

10. Cont..
 Thaler (1985) developed a new model of consumer behaviour.
Kahneman, Knetsch and Thaler (1991) discuss three anomalies: the
endowment effect, loss aversion and status quo bias. Banerjee (1992)
develop a simple model of herd behaviour. Plous (1993) wrote “The
Psychology of Judgment and Decision Making”.
 Shleifer (2000) published the “book Inefficient Markets”. An
Introduction to Behavioral Finance. Shleifer (2000) wrote Beyond
“Greed and Fear”, an excellent book on behavioural finance and the
psychology of investing.
 Zweig, Jason was Published a book on “Your money and your
brain” in 2007.
 In 2017 Nobel prize in economics was awarded to Richard H. Thaler,
an American economist at the University of Chicago, for his
contributions to behavioral economics.

11. Introduction to Behavioural finance
Behavioural finance studies the psychology of financial
decision-making. Most people know that emotions affect
investment decisions. People in the industry commonly
talk about the role greed and fear play in driving stock
markets. Behavioural finance extends this analysis to the
role of biases in decision making, such as the use of
simple rules of thumb for making complex investment
decisions.
In other words, behavioural finance takes the insights of
psychological research and applies them to financial
decision-making.

12. Characteristics of behavioural
finance
 Heuristics – In psychology, heuristics are simple efficient
rules which people often use to form judgments and make
decisions. They are mental shortcuts that usually involve
focusing on one aspect of a complex problem and ignoring
others. For example Stereotyping is a type of heuristic that
all people use to form opinions or make judgments about
things they have never seen or experienced .

13. Loss aversion
 In cognitive psychology and decision theory, loss aversion
refers to people's tendency to prefer avoiding losses to
acquiring equivalent gains: it is better to not lose 1000 Rs.
than to find 1000Rs . It is thought that the pain of losing is
psychologically about twice as powerful as the pleasure of
gaining. Most people want to gain between 2 and 2.5
times as much as they put at risk Most people will want a
chance to win at least 20,000 Rs before they will play
simply put, people don’t like to lose money.

14. Regret
 Regret is a feeling of sadness or disappointment, which
is caused by something that has happened or
something that you have done or not done. You can say
that you regret something as a polite way of saying that
you are sorry about it. For example-
 The near-miss effect- The nearer one comes to achieve
a goal, the greater the regret one experiences. For
example, missing a train by 5 minutes seems worse to
most of us than missing it by half an hour. Bronze
medalists, on average, tend to be happier when
receiving their medals than silver medalists .

15. Emotions
Emotions and associated human unconscious needs,
fantasies, and fears drive much decision of human
beings. How these needs, fantasies, and fears influence
financial decision?
Behavioural finance recognise the role Keynes’s “animal
spirit” plays in explaining investor choices, and thus
shaping financial markets (Akerlof and Shiller, 2009).
Underlying premises is that our feeling determine
psychic reality affect investment judgment.

16. Disposition effect
Disposition effect-
Disposition effect refers to people’s tendency to hang on to loser
too long sell the winners to soon. This allows them to enjoy the
feeling of winning faster and defer the pain of loss.

17. Recent trends in
behavioural finance

18. 1. Nudging Policy- Prize linked savings
accounts (lottery-linked accounts)-
Nudging Policy- Prize linked savings accounts (lottery-linked
accounts)-
A prize-linked savings account or PLSA (also called a lottery-
linked deposit account) is a savings account where some of
the interest payment on bank deposits is distributed in larger amounts to
fewer people according to a periodic lottery. They are attractive to
consumers as they function both as a lottery (as there is a chance of a
large prize) and as savings (the deposit is never lost, unlike normal
lotteries) vehicle. PLSAs are similar to lottery bonds except they are
offered by banks and can be held for a period of time determined by the
consumer. Sometimes the returns are in-kind prizes rather than cash.

19. Cont..
 Is nudging and retirement savings a good idea?-
Yes nudge and retirement saving a good idea . Thaler
championed the idea that employees should be “nudged”
into joining retirement plans, a concept known as automatic
enrollment. Rather than waiting for workers to fill out
401(k) paperwork, employers should automatically sign
them up for the plans. If the employees aren’t interested,
they can always opt out. In a survey by the Plan Sponsor
Council of America (PSCA) last year, 58 percent of plans
were automatically signing up workers.

20. 2. Mental accounting
Mental accounting – refers to the tendency for people to
separate accounts bases on a Varity of subjective criteria like the
sources of money and intent for each account. 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.
 For example, if we win Rs.1000 on a lottery ticket, we may
feel that this bonus win enables us to spend on going out for a
meal. However, if we got a tax rebate of Rs.1000, we would be
more likely just to save it.

21. 3. Cognitive bias
 A cognitive bias is a mistake in reasoning, evaluating,
remembering, or other cognitive process, often occurring as a
result of holding onto one's preferences and beliefs regardless
of contrary information. Psychologists study cognitive biases
as they relate to memory, reasoning, and decision-making.
Many kinds of cognitive biases exist.
 For example, a confirmation bias is the tendency to seek only
information that matches what one already believes. Memory
biases influence what and how easily one remembers. For
example, people are more likely to recall events they find
humorous and better remember information they produce
themselves.
 People are also more likely to regard as accurate memories
associated with significant events or emotions (such as the
memory of what one was doing when a catastrophe occurred).

22. 4. Framing issues
 Framing issues- Framing refers to the fact that we tend to draw
different conclusions from information depending on how it’s
presented to us. For example-Let’s take a look at a classic experiment
on framing carried out by Amos Tversky and Daniel Kahneman.
 In this experiment, 600 people were deemed to be affected by a
hypothetical deadly disease and participants were asked to choose
between two alternative solutions in order to deal with the outbreak:
 If option A is chosen then 200 people will be saved.
 If option B is chosen then there is a one in three chance of saving all
600 people and a two in three chance that no-one will be saved 72%
of the respondents chose option A.

23. Cont..
 The same scenario was the repeated with a second group of
participants but with slightly different wording:
 If option C is chosen then 400 people will die.
 If option D is chosen then there is a one in three chance that no-one
will die and a two in three chance that all 600 people will die 78%
of the respondents chose option D (even though this is equivalent to
option B).In fact, the two problems are effectively identical. The
only difference between them is how the outcomes are presented, or
framed. In the first set, the outcomes are given a positive frame by
emphasizing the amount of lives saved, whereas the second set is
presented in a much more negative way by concentrating on the
number of lives lost.
 This experiment clearly illustrates the effect that framing can have
on an individual and their decision making.

24. 5. Anchoring
Anchoring- Anchoring or Focalism is a cognitive bias that
describes the common human tendency to rely to heavily on
first piece of information offered when making decision.
Decision can be anchored by the way information is presented.
example, a person looking to buy a used car - they may focus
excessively on the odometer reading and the year of the car, and
use those criteria as a basis for evaluating the value of the car,
rather than considering how well the engine or the transmission
is maintained.

25. 6. Subconscious decision-making
and affective reactions
Subconscious decision-making and affective reactions -
Subconscious decision-making- A person thinks consciously and
his subconscious acts on it and produces the results. The
subconscious mind is more powerful than one can imagine. The
subconscious mind is a storehouse of data. The memories and
experience of every moment of one’s life is stored in it. There
have also been several experiments suggesting that the
unconscious mind might actually be better at decision making
than the conscious mind when there are multiple variables to take
into consideration. The subconscious is the part of the mind
which operates without awareness and over which one does not
have active control. The part of the mind that creates dreams is
an example of the subconscious mind.

26. Cont..
Affective reactions- An affective reaction is the physical
and emotional reaction that a person has to a situation. This
can be a reaction of happiness and pride in winning a
competition, the shock and sorrow of receiving bad news.
Paul Slovic developed the affect heuristic as a theory of
how people allow their initial emotional reaction or feelings
towards a decision to influence their subsequent evaluation
of its risks and benefits.

27. 7. Financial Sustainability and Social
Investing
Can behavioral finance develop an alternative to shareholder
maximization?
Impact investing - A term first coined by the Rockefeller
Foundation in 2007. Impact investing is investing that aims to
generate specific beneficial social or environmental effects in
addition to financial gain. Impact investing is a subset
of socially responsible investing (SRI), but while the definition
of socially responsible investing encompasses avoidance of
harm, impact investing actively seeks to make a positive impact
by investing, for example, in non-profits that benefit the
community or in clean technology enterprises.

28. 8. Risky Shift Effect
Risky Shift Effect -The risky-shift effect is a social
psychological term. It refers to the observed tendency of people
to make more daring decisions when they are in groups than
when they are alone. This phenomenon explains how riots and
gang violence start; from choices and actions that a person
would probably never take on their own but are willing to take
as part of a group. This is related to the concept of de-
individuation which is when individuals in groups lose their self
- identity which can lead to a loss of restraint and self-
awareness.

29. 9. Change in the sociological
behaviour
Change in the sociological frame since 2008 –
 Global demographic shifts.
 Gendered patterns of work and care.
 changes in the ecosystem.
 technological change.
 population growth and other demographic variables.

30. 10. Algorithmic trading
 Algorithmic trading, also referred as algo trading and black
box trading, is a trading system that utilizes advanced and
complex mathematical models and formulas to make high-
speed decisions and transactions in the financial markets.
Algorithmic trading involves the use of fast computer
programs and complex algorithms to create and determine
trading strategies for optimal returns.

31. 11.The relationship between risk
tolerance and risk perception
 Risk tolerance – is the degree of variability in investment
returns that an investor is willing to withstand. Risk tolerance is
an important component in investing . You should have an
realistic understanding of your ability and willingness to
stomach large swing in the value of your investments if you
take on too much risk ,you might panic and sell at the wrong
time .
 Risk perception is a highly personal process of decision
making, based on an individual’s frame of reference developed
over a lifetime, among many other factors. Risk perception is
the subjective judgment that people make about the
characteristics and severity of a risk.