Understanding Human
Behavior Helps Us
Understand Investor Behavior
MA2N0246
Tsatsral Dorjsuren
Behavioural Finance
O Behavioural Finance is the study of influence of
psychology on the financial decision making and it
argues that the emotions of and mental errors cause the
Mispricing.
O Behavioural finance argues that emotions and sentiment
play a crucial role in determining the behaviour of
investors in the market place and very often they act
irrationally due to influence of psychological factor
O Behavioral finance is a new
paradigm of finance, which seeks
to supplement the standard
theories of finance by introducing
behavioral aspects to the
decision-making process.
Theories of Behavioural
Finance
O Prospect Theory
O Regret Theory
O Anchoring
O Herding
Prospect Theory
O Meaning:
O Explaining the apparent regularity in human
behaviors when assessing risk under
uncertainty.
O People respond differently to equivalent
situations depending on whether it is
presented in the context of a loss or a gain.
O Investors are risk hesitant when chasing
gains but become risk lovers when trying to
avoid a loss.
For example:
SITUATION (i):
a) A sure gain of $2000
b) 25% chance to gain $1000 and 75% chance to gain nothing
SITUATION (ii):
a) A sure loss of $7,500
b) 75% chance to loss $10,000 and 25% chance to lose nothing
O A large majority of people Choose A in situation (i) and b in
situation (ii).
O In first situation the sure GAIN OF 2000 seems most attractive
whereas in second situation the sure loss is repellent and the
chance to lose nothing induces a preference for taking risk.
Regret Theory
O Meaning :
O Emotional reaction to having made an error of judgment.
O Investors avoid selling stocks that have gone down in order
to avoid the regret of having made a bad investment and
the embarrassment of reporting the loss.
O They find it easier to follow the crowd and buy a popular
stock : if it subsequently goes down ,it can be rationalized
as everyone else owned it.
O Investors defer selling stock that have gone down in value
and accelerate the selling of stock that has gone up.
O For example : Sales professionals typically attempt to
capitalize on this behaviour by offering an inferior option
simply to make the primary option appear more attract.
Anchoring Theory
O Meaning
O Anchoring is a phenomenon in which in the absence of
better information, investors assume current prices are
about right.
O Anchoring describes how individuals tend to focus on
recent behavior and give less weight to longer time
trends.
O People tend to give too much weight to recent
experience, extrapolating recent trends that are often at
odds with long run average and probabilities.
O In the absence of any better information, past prices are
likely to be important determinants of prices today.
Therefore, the anchor is the most recently remembered
price.
Mental Accounting
O Dividing current and future assets in
separate portions.
O Results in different level of utility of each
portion
O Provokes bias and other behaviors.
O For example, you aim to catch a show at the
local theater, and tickets are $20 each. When
you get there you realize you've lost a $20 bill.
Do you buy a $20 ticket for the show anyway?
O Behavior finance has found that roughly 88% of
people in this situation would do so.
O When you arrive at the door, you realize your
ticket is at home. Would you pay $20 to
purchase another?
O Only 40% of respondents would buy another.
Notice, however, that in both scenarios you're
out $40: different scenarios, same amount of
money, different mental compartments.
Herding
O A fundamental observation about human society
is that people who communicate regularly with
one another think similarly
O There are two primary reasons why herd
behavior happens
O The first is the social pressure of conformity
indeed being a powerful force.
O This is because most people are very sociable
and have a natural desire to be accepted by a
group, rather than be branded as an outcast
O The second reason is the common rationale
that it’s unlikely that such a large group
could be wrong.
O This is especially prevalent in situation in
which an individual has very little
experience.
Conclusion
O Behavioral finance certainly reflects some of
the attitudes embedded in the investment.
O Being consciously aware of these biases or
irrational behaviour will allow us to better
make investment decisions
O Practise critical thinking and study your
thought process during investment decision
making
O Allows you to provide better investment
recommendations to your clients