INDEX
S. No
Topic
Week 1
Page No
1
Introduction to Behavioral Economics and Finance
1
2
Introduction to Behavioral Economics and Finance (Contd.)
14
3
Economics of Decision Making
23
4
Economics of Decision Making (Contd.)
36
5
Decision Making Under Risk and Uncertainty
44
6
Decision Making Under Risk and Uncertainty (Contd.)
58
7
Non-expected Utility Preferences
69
8
Non-expected Utility Preferences (Contd.)
80
9
Prospect Theory and Behavioral Biases
90
10
Prospect Theory and Behavioral Finance
102
Week 2
11
Prospect Theory and Behavioral Finance (Contd.)
114
12
Beliefs, Biases and Heuristics
126
13
Beliefs, Biases and Heuristics (Contd.)
136
14
Beliefs, Biases and Heuristics (Contd.)
150
Week 3
15
Biases and Financial Decision-Making
163
16
Biases and Financial Decision-Making (Contd.)
176
17
Overconfidence and Investor Behavior
188
18
Valuation of Financial Assets
200
19
Valuation of Financial Assets (Contd.)
211
Week 4
20
Valuation of Financial Assets (Contd.)
222
21
Portfolio Return and Risk
232
22
Portfolio Return and Risk (Contd.)
243
23
Personal Financial Goals
256
24
Planning Personal Finances
269
Week 5
25
Personal Financial Statements
283
26
Taxes and Financial Planning
293
27
Taxes and Financial Planning (Contd.)
306
28
Portfolios for Individual Investors
315
Week 6
29
Investment Alternatives for Individual Investors
330
30
Investing in Mutual Funds
345
31
Fixed Income Investments
360
32
Fixed Income Investments (Contd.)
378
Week 7
33
Purchasing Decisons
388
34
Consumer Credit Decisions
402
35
Loans and Amortization
416
36
Loans and Amortization (Contd.)
430
Week 8
37
Credit Card as Source of Consumer Credit
438
38
Alternative Investments
450
39
Alternative Investments (Contd.)
462
40
Structured Finance: An Overview, Securitization
476
41
Wealth Managment
489
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 01
Introduction to Behavioral Economics and Finance
Hello there, welcome to the course Behavioral and Personal Finance. Today’s topic is the basics
of finance, the theories that binds them together and how these financial theories and decision
making helps us in our day to day life. If we talk about financial decision making in general and
personal finance and behavioral finance in particular; we basically talk about how individual
specific characteristics affect the decision making and how these decisions are actually affecting
our financial wellbeing. Today I am here with the topic basic of finance and financial theories
which have been developed over the years.
1
(Refer Slide Time: 01:21)
So, let us start the course with understanding of basic of finance. Most of the financial decisionmaking framework are based on some cash flows that we expect from future or the future value
of the investment that we make today. If we talk about basic financial decision making for
example, whether to invest in stock market or to make a choice whether to go for an MBA or
let us say whether to buy a house or live in a rented one.
All these decisions basically involve some cash flows that are incurred at present and that have
some implications about the cash flows that might be incurring tomorrow or in future time. So,
the basic framework explains that the utility or the benefit that we are going to derive from these
decisions in future time should be calculated in terms of today’s value. And, then if the benefits
are derived are more than the cost or the investment that we are making today then we should
go ahead with the decisions.
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For example, suppose you want to decide whether to go for an MBA. So, going for an MBA
requires a minimum of 2 years of time and some investment in terms of tuition fee and your
cost of living for these 2 years. The benefits that you are expecting from doing an MBA would
be a higher career growth and increased salary in future. Suppose, the future salary in today’s
terms becomes greater than the investment that you are making for these 2 years, then it’s
worthwhile for going for an MBA.
Similarly, let us say you want to decide whether to buy a house or live in a rented one and you
know that if you are continuing to live in a rented one, you have to pay rent. And, if you would
go for buying a new house then you have to make a payment in terms of the cost of the house.
So, if the benefits that derived from the expected value of rent saved that you would not pay if
you buy a house are greater than the cost of buying a house, then definitely one should go for
buying a house instead of continuing to live in a rented one.
So, if we try to put it in a very simple framework it should look like this. Suppose you are this
is time 0 and the timeline where you have time 1, time 2 time 3 and so on; till let us say time n.
If you are expecting from your decision that you will be getting some cashflow at
different point of time, let us say cash flow 1 at time 1, then cashflow 2 at time 2, cash flow 3
at time 3 and so on till cash flow n at time n.
You need to make an investment today so; you have to decide whether to go for an MBA or to
buy a house or to invest in stock market. So, your decisions should be based on the present
value of all these cash flows brought to the present time. Now, if the present value of all these
future cash flows is greater than what you are expecting to invest today, then you should go for
a decision.
This particular approach is basically known as present value of future cash flows or also known
as net present value, where you have some initial investment to make that will be adjusted with
the. So, this approach of financial decision making is based on a concept called time value of
money which basically explains that the value of money incurring at different points of time
have different values. And if you try to make a decision at a single point of
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time then you should bring all the cash flows or future expected value of benefits to present
time.
And, then compare it with the initial investment or the cost of initial decision. And, if the cost
of initial decision is less than the benefit derived in future you should go ahead with the
decision. Let me give you a little more practical example here. Suppose, you are 22 years
today and 3 years down the line you are expecting to complete your education and get a job.
So, at the age of 25 you will be entering the job market.
So, you start earning salary at the age of 25 and you expect that you would be continuing to do
the job for next 30 years. And, at the age of 55 years you want to leave the job and go for a
world trip, for next 5 years once every year. So, at the age of 55 you will start going for world
tour every year for next 5 years and at the age of 60 you want to retire peacefully in a monastery
in Bhutan or some other place. So, this is your future plan. Now, let me put this plan on a
timeline.
4
(Refer Slide Time: 08:59)
Suppose, you are starting the job at the age of 25 today (t25) and you continue to do the job for
next 30 years which will be t55. And, next 5 years you want to go for a world tour every year
which will be t60 and then after t60 you want to retire and of course, I do not know how long a
person can be living. So, let us call it infinite a period.
So, for first 30 years you should be getting some salary every year. So, this is your cash inflow,
you are expecting to get some salary or from salary you can continue you can save some money
and invest that in some investment avenues. So, suppose you get a salary of 1 lakh per annum;
so, this is your cash inflow. So, positive cash flow period, next 5 years you are expecting to
spend let us say 2 lakh per year for 5 years.
Every year you are spending 2 lakhs; so, negative cash flow and at the age of 60 you want to
retire and settle down in a monastery. So, every year you need let us say 50,000, living in a
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monastery will not require a lot of money. So, you can manage in 50,000 per annum of expenses
and that will continue till infinity.
Now, this is a typical personal finance problem where you have to decide today that is at the
age of t25; you have to invest some money and you continue to work for next few years. And,
then you want to use that saved money for holidays or travel or some other personal goals and
then you need some money for settling down after retirement.
So, if I put certain more numbers in this example, let us say if you earned some money and want
to invest in some investment avenues for example, bank deposit or stock market or maybe real
estate you will get certain amount of income that is return. So, if you put your money in bank
you will get bank interest, bank will pay you some interest rate at the rate of 8%. If you put your
money in a stock market, probably you will be getting a 15% of average return and if you invest
in real estate you will be getting 30% of average return.
Now, you have to make a choice, you have to make a choice today whether to go for job a or
job b that will pay you some incremental salary and from that salary you will be saving some
money. And, there you have to make a decision whether to invest that saved money in bank or
real estate or stock market or any other avenues. Now, this is where your theoretical financial
concepts merge with the behavioral aspects of decision making.
If you are a very risk seeker person which means you can take lot of risk for certain reasons,
you would like to invest your money in risky investment avenues such as stock market or real
estate. And, if you are risk averse which implies that you do not want to take a lot of risks then
you would like to invest your money in safe bank deposits. So, this course will basically focus
and try to help you understand how this traditional finance theory can be merged with behavioral
aspect of decision making to make better financial decisions.
6
(Refer Slide Time: 13:55)
So, when it comes to financial decision making and investment decisions more often, we hear
about terms like stock market, shares, bonds, debentures, portfolios and so on. So, let me try to
explain little bit about these terms and then we will move on. So, I will try to explain these
terms with the help of an example. Suppose, I know a guy let us say Ram and Ram is a very
brilliant student in my class. He has a wonderful business idea and he is convinced that this idea
can be converted into a successful business venture.
But, being a student, he does not have a lot of money and you know to start a business you need
some money. So, what Ram does is he goes to his friend Mohan and ask for some money.
Now, Mohan come from a very privileged background and he has lot of money inherited from
his great grandfathers’ royalty. So, Ram goes to Mohan and ask for some
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money to start his business and Mohan agrees to give him money. Now Ram gets money, he
starts business and everything is going well.
Suddenly, after sometime Mohan wants his money back from Ram, now Ram does not have a
choice; he has to give his money back, but he also wants to continue his business. So, he goes
to let us say another friend Shyam who also agrees to fund his business. So, Ram cancels the
old contract with Mohan and writes a new contract to get money from Shyam. Imagine this case
for a businessman who has a brilliant business idea, but does not have funds. So, he his most of
the time will be spent in cancelling old contract and writing new contracts to find some source
of money.
To keep this process simple if Ram and Mohan agree to write a piece of paper which will say
that whosoever owns this piece of paper will be owning a part of the business that Ram is
running. So, in first instance when Mohan wants his money back, he instead of going to Ram
he can just go to anyone else and says that if you want a piece of business that Ram is running
you can just buy this piece of paper from me. And, that will make you the owner part owner of
the business that Ram is running. So, this particular process in a very crude way is known as
securitization.
If that piece of paper is about the ownership of the business, this is known as securitized
ownership which most of us know as shares or stocks. And, if this piece of paper is about some
borrowing that Ram has taken from different sources that is known as securitized borrowings
and we know it as bonds or debentures. And, as an investor if I am buying some piece of paper
in the form of securitized ownership or securitized debt; I am basically trying to create an
investment portfolio that will have some component of investment avenues that will be
available in the market for investment.
So, suppose I have some ownership in Tata Motors stock and some ownership in National
Highway Authorities of India bonds. So, my portfolio will be comprising of stocks and bonds,
but then how do we decide about how much to buy from shares and how much to invest in
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bonds. So, basically it is about decision making with respect to allocation of our assets to
different investment avenues.
For an investor it is always important to understand whether to invest in asset A or asset B and
so on. These decisions are driven by two major factors known as risk and return. So, return as
we know is basically the income or the benefit that we derive from the investment and risk is
defined as the uncertainty, that is associated with the return that we are expecting.
So, if you relate to previous examples: if I have to invest in stock market let us say stock of Tata
Motors and I am expecting that Tata Motors continue to pay me some return in the form of
dividends or capital appreciation. And, there is certain amount of risk that is uncertainty about
expectation of return, then I am considering my decision of investment keeping in mind these
two factors.
However, these two factors are very much interrelated; whenever we have to make a decision
about investment or in general any financial decision, we need to keep in mind that higher the
risk, the return should be higher. For example, if you have to take a decision that will pay you
x amount of benefit or return, but it is guaranteed and then you have to make a decision that
will pay you 2 x amount of benefit. But, it has very uncertain expectation which means you are
not sure if you are actually going to get 2 x amount of benefit.
Then of course, you have to make a choice whether to go for higher return with higher risk or
lower return with lower risk or in no risk in certain cases. This is where behavioral aspect of
decision making comes into the picture. Let me try to show this particular concept with the help
of an example. Let me try to show certain more concepts that we need to understand before we
go on to discuss more about behavioral decision making.
9
(Refer Slide Time: 21:11)
Suppose, you have to start a business or you have to make a decision about going for an MBA
or buying a house or any other such major decision. So, you have to decide whether the
benefit that you are going to derive from this decision is financially feasible or not; which means
you need to understand, if the benefits or the income or the utility that you are going to derive
from this decision is higher than the cost that you need to incur.
And, this particular type of decisions when in major chunk, this particular type of decision when
carries a lot of investment and very high amount of risk are known as capital busting or
investment decisions which implies that you have to decide whether to go for a particular
decision or not. For example, if a particular company let us say Reliance Industries Limited
wants to set up a new project in oil refinery business in Middle East.
10
This kind of decision would require huge amount of investment and it also carries lot of risks.
So, this kind of decisions are basically driven by the factors that affect investment decisions
which means it has to be financially feasible and it has to add value to the investor that is who
is making an investment. In a personal context if I have to make a decision whether to go for
an MBA or to go for a job, it will be very critical for me to decide at this point of time.
Because, going for an MBA means losing 2 years of salary which I can generate if I go for a
job, also going for an MBA carries certain amount of risk which means I might not be getting
the kind of job that I am getting right now after 2 years of MBA. So, these decisions
are basically investment decisions and it has to be analyzed critically to understand whether the
benefits that we derive are higher than the cost that we are going to incur. Once you are done
with such decision, we need to understand how are we going to finance such decisions.
Let us say in the example of going for an MBA case, if you have decided that you want to go
for an MBA and MBA would cost you all put together let us say ₹20 lakh; how are you going
to fund that MBA cost of 20 lakh? So, the choice that you have is whether to borrow money
from loan sorry. The choice that you have is to go for borrowing from a bank or to invest your
own saving or the savings of your parents and the benefits that you might be expecting
is of course, a higher salary after an MBA.
So, in the context of corporations let us say the Reliance Industry’s case, if they want to set up
a project in Middle East; they can either use their own resources that they have saved over the
years or they can just borrow money from different financial institutions and invest that
money into the business. This can this type of decision is known as capital structure decisions
or financing decisions. After you are done with financing decisions, you need to understand
how do I run the business or the investment decision that I have taken on a day to day basis.
For example, if Reliance Industries Limited decide to go for setting up the project; it has to
understand how the business will be run on a day to day basis. Similarly, if you decide to go for
an MBA you need to understand how are you going to continue for 2 years. Because, that
11
will involve certain cost in terms of living expenditure and the cost of tuition fee and books and
other resources that an MBA requires.
These types of decisions are known as working capital decisions. And for god sake if you are
successfully done through all three types of decisions at the end of the day you will
have some benefits, some profits, some income that you can either keep with you or pay back
to those who have invested in your business or in your idea or in your venture. These decisions
are known as payout decisions which means we have to decide whether to pay back to the
people who have invested in your business or keep it with you.
For example, in the context of Reliance Industries Limited you can decide whether to keep the
profit in the business to expand it. Or use that profit to pay back to the shareholders who have
invested in your shares or to pay back to the banks who have lent you money for running the
business. So, these are four major decisions that any individual or corporation need to take.
So, to sum up this session let me highlight that we have discussed about the basic framework
of financial decision making through net present value approach, where we calculate the
present value of all future cash flows and compare it with initial investment to understand if the
benefits are more than the cost.
And therefore, we should go ahead with the decision and we also understand that these decisions
could be of different types; ranging from capital busting decision to payout decision, where we
need to understand different aspects. And to conclude these decisions can be relevant to
individuals as well as corporations.
And, the concept that we have discussed and we will continue to discuss in the next session will
also cover the basic theories of corporate finance and certain inputs from behavioral finance to
understand how financial decision making can be made better.
Thank you.
12
13
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 02
Introduction to Behavioral Economics and Finance
(Contd.)
Hello there, welcome back to the course Behavioral and Personal Finance. To continue
where we had left in last session, we have so far covered the topics related to different
type of decisions that involve financial implications for individuals as well as for
corporations.
To bind all these individual financial decision making structures together, there are
theories and concepts that we need to understand. So, to explain the important financial
theories and concepts in a historical framework; let’s try to touch upon the topics that
actually connects all those financial theories together.
(Refer Slide Time: 00:59)
So, the history of financial decision making or finance theory in general starts when
economists started talking about utility theory and they started assuming that individual
human beings are basically Homo economicus, which means, they try to evaluate all the
14
alternatives in terms of utility that they expect to derive and weigh each of the options
that are available in a ranking framework and then make a decision.
So, these decision making theories or economic theories are basically based on expected
utility theory given by Bernoulli and later on by Von Neumann-Morgenstern. After the
basic utility theory has been used in several research and to explain how individuals
make decision, certain financial theories and concepts are important to understand.
So, if we try to focus on several major finance theories, one of the most important
finance theories is actually efficient market hypothesis. In 1970, Eugene Fama gave this
proposition that financial markets are efficient and the level of efficiency of financial
markets ranges from weak efficient markets to strong efficient markets. The underlying
idea was whether individuals or any decision maker can understand from the prices of
any asset in a financial market to determine the level of information efficiency.
For example, if a financial market in general and an economy in particular reflects all the
information that are historical in nature in the prices of the assets, this kind of financial
market is known as weakly efficient markets. If the markets reflect all the historical and
present information in the prices of the assets, this market is known as semi strong
efficient market. And, if the markets reflect all the prices and information that have
historical nature and the information that are present as well as expected in the market,
this type of market is known as strongly efficient market.
The implication of this market efficiency hypothesis was basically in terms of the
valuation of assets. When an individual or an investor wants to invest his or her money in
financial instruments or financial assets, he or she wants to determine the right value of
the asset. And, the value can be determined on the basis of the information that are
available to the decision maker and the prices that reflect the historical or present or
expected information. If you could recall, in the net present value approach also, most of
our decisions are based on the present value of expected future cash flows.
So, if the present value of any assets reflects the correct value of expected cash flows
generated from different investment or any decision, then the markets actually reward the
investor appropriately. Having developed this efficient market hypothesis, Fama and
other researchers started proposing the implication of this market efficiency hypothesis
to different asset pricing theories. So, several researchers including Markowitz, Treynor,
15
Sharpe and Lintner started working on utilizing this efficient market hypothesis to
explain the pricing model in financial markets.
So, they gave theories such as Capital Asset Pricing Model and Markowitz Portfolio
theory that try to assess the value of an asset, and how the risk and return characteristics
of an asset could be used to determine how much to invest in which assets. These
theories led to the development of the pricing theories and models for different type of
assets such as options and futures.
In late 70’s, several researchers proposed a framework that will help to understand
pricing of financial derivatives which has certain underlying assets, such as equity shares
or bonds or maybe over the time we have seen that there are financial derivatives that
could be related to any other asset in general.
These financial theories actually led to the development of financial markets across the
world and over time, we have seen that many upgraded theories in terms of more
sophisticated calculation methods, more recent tools and techniques in terms of
econometric analysis and vast amount of data have been used to develop these theories
and model.
And, some of the examples if you can see include factor models which actually consider
several risk factors to determine the value of assets and all these theories actually
contribute to the development of the field of finance, and, finance theory in general that
will ultimately help us understand how financial decision making can be based on one or
more of these theories. How these theories can help us understand the better financial
decision making process and a behavioral aspect of financial decision making can be
understood with the help of behavioral approach of expected utility theory given by
vNM, that actually adds all these traditional finance theories and behavioral economic
theories together. Now, the question here is why a behavioral aspect of financial decision
making is important, which actually implies why behavior actually matters.
16
(Refer Slide Time: 08:43)
So, let me try to show an example here. Suppose you have the following choices, choice
A will expect you to choose a 50 % chance of winning $100 and choice B will expect
you to get a sure short gain of $50. Between these two choices which one will you
prefer? Most of us actually go for B.
If you try to understand why, because we are risk averse which means we think that we
are conservative and it is very general tendency that a bird in hand is better than two in
bush, so, why should we gamble! This is the reason why we choose a sure shot gain of
$50 instead of a 50 % chance of winning $100. Now, let me tweak this example little bit
and try to help you make a difference between how changing the context might affect
your decision making.
17
(Refer Slide Time: 09:59)
Assume that the choices are as following. A will give you a 50 % chance of losing $100
and B will actually make you lose $50 for sure. Now, when it comes to losing you
actually go for A and the reasons are we hate taking losses which means we are loss
averse and we also believe that we might turn lucky and we do not lose anything else.
So, why not gamble here!
The inference from these two alternative examples is actually how our behavior is
affected by the context or the change in presentation or the change in nature of the
situation that we are in. This particular illustration explains why we behave in a risky
situation differently than we behave in a certain situation. So, the argument here is our
decision making process is influenced by different factors including financial and
behavioral ones.
So, it is important for us to understand how behavioral financial decision making is
actually helping us become a better decision maker.
18
(Refer Slide Time: 11:47)
Now, what could be the reason our behavior is important in financial decision making?
Most of the conservative finance theories are based on three major assumptions. First
assumption is that the prices in financial markets are correct which means the financial
markets are in equilibrium and they reflect the correct prices of the assets that you want
to invest.
At the same time it also assumes that resources are allocated efficiently which means
individual human beings cannot affect the process of resource allocation too much. And,
the market itself will be taking care of itself which is based on the great Adam Smith’s
invisible hand theory, which tells us that the world is fair and in long run the market will
be achieving equilibrium anyway. So, we cannot influence the market too much at any
given point of time.
All these assumptions are very important, but recently we have seen in research that
human behavior cannot be considered to be rational. And, the reason being people are
homo-sapiens and not homo-economicus as assumed by the traditional economic theory.
And the second reason is the human being are not rational and that is why they are not
expected to behave in a self interest way all the time and supposed to make mistakes that
are systematic, and making such mistakes would eventually affect the financial markets
in general and the economic wellbeing of the individual in particular.
19
(Refer Slide Time: 13:49)
So, if we try to summarize what are some major mistakes that we as individuals might be
making. I have highlighted 3 major systematic errors that individuals might be making.
The first one is explained by certain recent events. For example, if you recall in India we
had tsunami few years back and after tsunami, lot of people living in those regions
started buying insurance policies.
Now, tsunami is basically a low probability and high impact event. It does not occur on a
very frequent basis, but individual investors or individuals in general based their decision
on their recent experiences and they assign higher probability to the recent events that
they have witnessed. This is known as forecasting errors or this is basically reflected in
the decision making of individuals when they make their financial decisions.
And, this can be explained from an older example where people have who have seen the
great depression or great financial crisis, they always are apprehensive about the
financial markets and they have not been investing their savings or their money in
financial instruments in the stock market. So, most of their decisions with respect to
financial asset allocation are based on their recent experiences. This is one major
systematic error that we make.
Second systematic error that we might be making is overconfidence. For example,
overconfidence as a mistake explain that people tend to over rate their abilities and skills,
and in the process they make choices that might cost them heavily in terms of financial
20
implications. For example: if you ask individuals who are active in stock markets about
their abilities to trade in financial markets, they would consider themselves to be over
smart and they believe that they are better than many others. In fact, they might rate
themselves as better than average, but when you aggregate the data of individual
investors you would probably see that a lot many investors are losing money.
So, if they are smarter than many others and they are better than average then why
should they be losing money? A similar example was explained in a survey conducted on
drivers in a certain region of USA, where they were asked to rate their driving skills.
And, when their rating was compared with the accident data, it was seen that people
rated themselves to be a better than average drivers whereas, there were a lot of
accidents. So, of course, there might be certain other reasons of accidents, but if drivers
are better than average then then that should not definitely affect the accidents data in
that particular region.
So, the summary here is people typically behave over confidently when it comes to their
own decision making abilities and this is basically a systematic error that we might
observe in financial decision making as well. Last systematic error that we will discuss
here is the tendency of conservatism. The tendency of conservatism explains that people
are very slow to update their skills and they do not want to change their belief.
Essentially, it is related to inertia which means if you have certain beliefs about certain
events you do not want to change it immediately. Unless you have experienced some
dramatic incidents, you do not want to upgrade your beliefs and in the process you might
be making some financially fatal decisions.
For example, if I buy a share in stock market for ₹100 and a couple of days down the line
the price of that share falls to ₹95. Ideally, I should be selling that share, because I am
losing money, but since I am anchored to the price that at which I have purchased that
share, I would rather stick to that price and wait for the time when the price reaches back
to ₹100 to sell. Now, this is a very common mistake that we see in stock market in
particular and in financial decision making in general, where we wait for certain prices to
reach at a level at which we are stuck. This particular tendency is known as anchoring
and these results in holding on to losers and selling the winners.
21
So, this kind of tendency has been seen among several categories of investors where they
prefer to hold the stocks which are losing their value, but they want to sell the stocks that
have been appreciating over time and make money in the process. So, essentially they
are selling the winners and holding on to the losers.
(Refer Slide Time: 20:09)
There are several other systematic errors that individuals make. If you observe around
you or if you observe your own behaviour, you might see that you will be making one or
the other systematic errors in your traditional decision making in life in general and in
financial decision-making in particular.
This course will discuss the theories and concepts of behavioral economics and finance
which are derived basically from major works of researchers such as Daniel Kahneman,
Richard Thaler and Robert Shiller. So, these are three major research streams in
behavioral economics and behavioral finance that is the basis of financial decision
making process in the context of behavioral theories. And, we will be learning several
aspects of behavioral decision making in throughout this course.
22
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 03
Economics of Decision Making
Hi there, I am Abhijeet Chandra and welcome back to the course Behavioral and Personal
Finance. This week we are going to discuss the Economics of Decision Making and we will
also touch upon the utility theory, both the neoclassical economic utility theory and the VNM
framework of utility theory. How many times has it happened to you that you come across
several alternatives and you have to struggle among them to make a decision? For example,
you go to a shopping mall and see a variety of items that you want to buy from, and you are not
sure how you are going to choose the best among them.
Similarly, suppose you have some money and you want to invest in stock market instruments;
let us say shares of different companies, how do you decide which company to invest in? These
are some economic decisions which we face in our regular decision-making processes and we
try to understand how to make the best decision with the help of the utility theory in its classical
framework and the VNM framework.
23
(Refer Slide Time: 1:55)
So, today’s topics are basically the discussion on the economics of decision-making process
and the utility theory in its classical framework.
24
(Refer Slide Time: 2:13)
So, the utility theory in its standard format claims that individuals try to optimize the choices
and options that they have and they want to determine the value and prices of the choices or the
outcomes that they want to take. Now, that this basic framework of neoclassical utility theory
is based upon three major assumptions.
These assumptions are as follows. The first assumptions suggest that individuals as economic
agents have rational preferences. Now, what does rational preferences mean, it simply assumes
that people have standard and constant choices over different outcomes and situations. Now,
when we are discussing this neoclassical economic utility theory; I would also want you to
consider thinking in terms of how these assumptions and the theory itself are relevant in the
present context and also in the context of economic decision making that we often come across.
25
So, the first assumption that is rational preferences among individuals who are economic agents
is followed by another assumption that suggest that these agents basically try to maximize
utility. Essentially, these economic agents want to gain maximum benefit or the happiness or
the profits out of the decision that they are making. Suppose you want to buy a shirt and you
have gone to a shop, where there are several shirts displayed and you have a constraint in terms
of the money that you can spend on buying a shirt.
So, here the objective is to maximize the happiness which is essentially the utility by paying on
an amount that has limited resources and you cannot spend more amount on the same item that
you want to buy. So, the constraint is the amount that you can spend on the shirt and the utility
is the happiness or the benefit that you will get out of buying the shirt the outcome will be
buying the shirt itself.
So, here an economic agent would try to maximize the benefit by paying the minimum price
for the best possible shirt available in the market. So, this is the second assumption of the utility
theory. Now, third assumption that the utility theory is based on is that information is available
in the market to all economic agents and these economic agents make independent economic
decisions considering all the information. Now, let us try to understand the relevance of these
economic assumptions for this utility theory.
26
(Refer Slide Time: 05:57)
So, when it comes to rational preferences there are three states of economic preferences among
economic agents. An economic agent can be strictly preferring one alternative over other;
which means there is no choice, which means there is no choice dilemma and the economic
agent ensure which one choice he would like to go for.
Second alternative explanation of rationally preferences is the economic agent is indifferent
between two choices, which means if there are more than one alternative let us say there are
two alternatives the utility or the benefit that the economic agent wants to derive from it is equal
among these two choices that he has.
So, whether an economic agent makes a choice of alternative a or alternative b it does not make
any difference in terms of the utility or the benefit derived. The third state of rational economic
preferences the in unsurely of the economic agent. The third state implies that the
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person or the economic agent is not sure whether he is indifferent or he is going to strictly prefer
one alternative over the other, which essentially means that it could be strictly preferred choice
of A over B or it could be indifferent between A and B. And ultimately it does not make any
difference in terms of utility derived by the economic agent.
Apart from these three states of rational economic preferences, the economic utility theory
also assumes that whatever alternatives are available to him are compared with among each
other and on the basis of the benefits or the utility derived from each of them they are ranked
and preferred over others; which means if you have five alternatives you will find the benefit
or the utility derived from each of them, rank them in the order of increasing or decreasing
utility and prefer the best one which has the highest utility in your terms.
Essentially, this leads to another assumption which implies that there exists a transitivity, which
means if there are three alternatives let us say x, y and z, and x is greater than y in terms of
utility. Similarly, y is greater than z, which means x in terms of utility is better or more preferred
than y similarly y is more preferred than z. It will automatically lead to the preference of y over
z; which means x is better than z in terms of utility derived. These are three major decisions;
these are three major assumptions upon which the utility theory is based.
28
(Refer Slide Time: 09:47)
Now, when it comes to decision making economic agents want to maximize the utility,
essentially, they try to maximize the benefit derived out of the outcomes that they have and
based on their derived utility they prefer the highest utility, they prefer the outcome with the
highest utility. Let us try to understand how this kind of utility theory framework can be
applicable in our financial decision making.
Let us say you are earning an amount of money, suppose you have x amount of money and the
choices or the outcomes that you have is whether to spend more amount of money right now
and expect the utility derived in present time or you save the money and spend it in
future; which means, the utility that you will derive out of the outcome in future will
be different from the utility that you are going to derive in present.
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Let me try to show you with the example that we had discussed in previous session. Suppose,
you have ₹100 and you have two choices to spend now and save it later. So, in the context of
the previous example we have a timeline which is t0 which is present time and this is let us say
ti which is sometime in future.
Now, you have ₹100 here at present time, you can either spend it right now and get the utility
or you can save it and get the utility of this ₹100 in future. But remember in the previous
framework we know that whatever decisions we have to make, we need to be on a single
timeline to make that decision. So, if you want to have the utility of the amount of money that
we are saving now and investing for future that utility must be brought back to present time to
compare whether that choice is better or the choice that we are having right now.
So, in that context the utility of ₹100 at time i should be brought back to present time that is t0,
and whatever utility that you get out of it should be compared with utility of ₹100 to be spent
right now. And then accordingly the decision should be made. So, let us contextualize
this example in financial markets. Suppose, you have 100 rupees and you can spend it right now
on a movie and derived utility in terms of happiness, you can also save it this 100 rupees and
deposit in bank, the bank will give you certain interest on the deposited money.
So, suppose after 1 month you get that ₹100 plus the interest. So, let us say ₹100 of your money
and an interest of ₹5; so, ₹105 at the end of 1 month. So, if you can gain more utility at the end
of 1 month out of this ₹105 and that utility is higher than the utility that you are deriving by
spending it right now on a movie then definitely saving it for later make sense.
So, this is the kind of decision-making framework that utility theory helps us to understand. So,
given this neoclassical economic framework of utility theory we can implement this
approach to make choices and make better economic decisions, let us say in terms of whether
to buy a house or to live in a rented house, whether to invest for future or spend right now or
whether to invest in a career or keep working wherever you are working.
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Once we understand this framework, we would like to know how we can quantify this utility.
To understand the utility function and to simplify it in terms of some quantitative approach
there is one of the simplest of methods to quantify the utility derived out of any decision. So, to
keep it simple we are trying to explain the quantification of utility in terms of wealth.
(Refer Slide Time: 15:25)
If you look at the table you observe that in one column the numbers represent the wealth that
an individual or economic agent might have or the outcomes might yield and on the other
column the numbers represent the logarithmic function of the numbers given in left column. If
you try to see it in more continuous framework, let me try to show it with the help of a
spreadsheet.
31
(Refer Slide Time: 16:01)
So, in column A, if you see the numbers are representing the wealth that an individual has and
column B has the logarithmic utility function which is the simplest way to explain the utility in
terms of numbers.
So, if we try to find the logarithmic value of the wealth that is given in column A, we will
simply try to put log natural log of the numbers that we have here in column A. Similarly, if
you try to calculate a logarithmic utility function for all these numbers given in column a we
will find a series of numbers that will be basically the logarithmic value of the numbers given
in column A.
To understand it if we plot these values in a graph, we can simply show the curve representing
the logarithmic utility function. If you look at the graph this is basically a concave curve
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which essentially shows the logarithmic utility function. Now, let us try to understand what
does, it means for economic decision making. Suppose, you are given two alternatives,
alternative a would want you to do a task that will get you a sheer a short return of ₹100 whereas,
alternative b would want you to do a task that is slightly more risky, but it will also give you a
reward of ₹200.
Now, if you want to go for a riskier activity or riskier task that is alternative b you would
certainly demand a higher payoff or higher return out of the activity. So, how much higher is
the question? Let me put this in a context of a very simple example. Suppose, you have ₹100
and you have an alternative to invest that ₹100 in bank deposit or fixed deposit where you are
sure to get a return of let us say 6%.
Now, you can use that ₹100 to invest in stock market, let us say the share of a company and that
share of a company has over period given a return of let us say 15% on an annual basis. But
there is also uncertainty; in some years the share of that company has given very little return as
much as let us say 2%. So, the uncertainty is involved in alternative b. So, if you face a situation
where there are uncertain outcomes, you would certainly expect a higher payoff from that
outcome and that is what this utility function explains.
It suggests that if an individual is going for higher risky choices, the expected utility for that
individual is going to be higher and this particular nature of the individual or the economic
agent is known as risk aversion. Basically, risk aversion implies that if you face a situation
which is uncertain and riskier you would demand a higher payoff or higher return to compensate
the risk that you are taking.
In the example of stock market investment versus bank deposit, since you are likely to take
higher risk in stock market investment you would want that the share of that company should
give you higher return than the fixed deposit return if you have gone for a bank deposit. This
particular risk aversion characteristic has been the baseline of many theories of finance and
personal financial decision making, where people would want to understand what should be
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the reward for the additional risk that an individual is taking in terms of assuming higher risky
choices.
Having understood the utility theory and the utility function with the help of logarithmic
values, we know that after understanding the rational preferences of economic agent and the
choices that they can make based on the derived utility in terms of logarithmic utility
function. They must incorporate as much information as available in the market before they
make the final decision; that is the third pillar of expected utility theory.
The third assumption that the utility theory is based on is basically the availability of
information for all the economic agent.
(Refer Slide Time: 22:07)
34
Basically, when you try to maximize your utility and you understand that you are just one of
the economic agents available in the entire market, you would want to incorporate all the
information that are prevailing. Now, the utility theory assumes that all the information are
available for each and every economic agents equally and freely and they also try to incorporate
every piece of information in their decision making without any constraint.
Now, when we look from the neoclassical economic framework, this assumption is perfectly
fine, but when we try to understand in the context of realistic decision-making processes, it does
not make sense. Because, when it comes to incorporating economic information and basing
decisions on that essentially not all of us are equally capable of incorporating each and every
piece of information. Also, every piece of information comes with a cost and not all of us are
able to incorporate that cost in our decision making.
Based on these arguments there are some contradictions to the basic understanding of
availability of information assumption for utility theory. These two issues which are basically
the cost related to information and the capability of economic agents to incorporate and process
all the available information in their decision making have been explained by Herbert Simon in
his classical work on Bounded rationality.
This theory explains the limitations of individual economic agents in terms of processing of
information and incorporating that information in their decision-making process. With this we
conclude this session by suggesting that we learn about utility theory under the neo classical
economic assumptions, but we also try to incorporate what are more realistic assumptions in
the context of new utility theory given by the Van Neumann and Morgenstern.
Thank you very much.
35
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture – 04
Economics of Decision Making (Cond.)
Hi there. Welcome back, continuing from the previous session where we discussed the basic
framework of Economic Decision Making in the context of utility theory. Let me try to
highlight certain issues which actually explains the utility theory in a better framework known
as VNM approach. So, utility theory is basically a normative theory, it suggests that people or
economic agents should behave in a certain way.
(Refer Slide Time: 00:54)
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Basically, utility theory indicates that people should have rational constant preferences, they
should try to find the utility and maximize it in all circumstances. And, also, they try to rank
their choices and they should go for the choice that gives them the highest utility. So, in that
context basically utility theory is a normative theory which suggests how people should behave.
But, when it comes to VNM approach that was given by John von Neumann and Morgenstern
two economists, the behavioral theory given by VNM framework essentially explains how
people actually behave. Let me try to explain this with the help of an example. Suppose, you
have to make a decision to invest in the share of a company.
You have got some money and you want to invest in share market. Now, the ideal approach is
you have a list of stocks or shares that you want to invest in, go for their analysis which means
you have to calculate all the numbers pertaining to their risk and return. Rank all the stocks in
a particular fashion on the basis of either risk or return and then go for the choice that fits the
best in your framework.
Now, that is what utility theory suggests. It always indicates that options or outcomes should
be ranked in preferential order and then the outcome with the highest utility should be taken up.
But if you observe about the behavior of people trading or buying and selling shares in stock
market you would understand that majority of them do not follow this normative approach.
They do not do the entire set of analysis and they mostly go by heuristics. Even if you consider
yourself as one of the stock market traders probably you would not have sufficient amount of
time, resources and energy to do all this analysis, rather you go by the heuristics or certain other
indicators.
Probably, you can also go by a thumb rule which will indicate that the stocks whose name
begins with that later that matches with the later of your name and probably your investment
would be doing wonders in future. So, you know less light note I want to indicate here that
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the behavioral theory given by VNM is essentially more to realistic and it explains the expected
utility theory in a better way, in order to make a better economic decision.
Now, when you talk about VNM framework of expected utility theory essentially it is a theory
of decision making under risk and uncertainty. Now, these are two terms risk and uncertainty.
There is a subtle difference between the two, although these two are used simultaneously.
However, there is a subtle difference between risk and uncertainty. Now, when we talk about
risky situations, we know what the outcomes are and we can assign certain probability to those
outcomes.
For example: if you want to invest in stock market you know there could be two possibilities
either the stock price would go up or it could go down. In worst case probably it may remain at
where it is, but these are the only three possibilities and you also can understand or try to infer
the possibilities in terms of probability of these three outcomes.
So, this kind of situation is known as risky situation. But, imagine a situation where you are not
aware of the outcomes, you do not know what outcomes this particular path or this particular
decision would lead to and therefore, you cannot assign probability as well. These situations
are known as uncertain situations for example, weather forecasts you do not know whether
tomorrow is it going to be sunny or rainy or foggy or cloudy.
So, that is particularly a situation which can be said to be uncertain. Now, VNM framework of
expected utility theory is essentially a theory of decision making under risk not uncertainty
which means you have to have certain possible outcomes and you should be able to assign
probabilities to those outcomes in order to make a decision. Let me try to explain this particular
expected utility theory in the context of VNM framework with the help of a simple example.
38
(Refer Slide Time: 07:00)
Suppose, you have to take a decision and that decision will take you two different
states which means if you have to invest right now it could either take you to a low wealth state
in future or a high wealth state in future which means if you invest right now you can either get
let us say 50,000 in worse case or 10,00,000 in best case.
And, if you are smart enough and you believe in probabilities you can assign certain
probabilities to these two outcomes. And, if you are very optimistic about the future you would
probably assign higher probability to high wealth state and lower probability to low wealth
state. So, let us assume that there is a 60% chance of high wealth state being there and remaining
40% chance to low wealth state being in future.
If I want to express this particular situation in a prospect way, let us say I have a prospect 1
indicated as P1 which is basically a 40% probability of getting 50,000 in future out of
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this decision and remaining probability is getting 10,00,000 out of this decision. So, the first
term basically is the probability of the first outcome and second outcome is given and remaining
probability would be give attached to the second outcome.
For example, if I state something like P that is prospect of 30% getting ₹100 i.e. P(0.3., ₹100);
it means that 0.3 is the probability of first outcome that is ₹100. And, the second outcome here
is essentially 0 which means there is a 30% chance of getting
100 rupees and remaining 70 percent chance of getting 0.
Similarly, so, coming back to the P1 that is prospect 1, if you want to use the utility theory
framework to explain what should be the utility derived from this choice, we can refer to the
same approach where utility of prospect 1 will be
𝑢(𝑃1) = 0.40 × 𝑢(50000) + 0.6 × 𝑢(1000000)
Now, if we refer to the table which we had just calculated with the help of logarithmic function
we can express this in terms of the probability assigned to each of the outcomes which is 50,000
here. So, going by the previous assumption which we had seen in the table of logarithmic utility
function we can see that the utility of 50,000 can be written as 1.6094 whereas, the utility of
10,00,000 can be written as 4.6052.
So, effectively the utility of prospect 1 that is 40% chance of getting 50,000 and 60% chance of
getting 10,00,000. The utility of this particular state of outcomes can be
3.4069. Now, this is what the utility theory suggests. Simply, if you have an alternative state of
outcome let us say you have a choice where you can invest the same amount of money and there
are two outcomes given as let us say low wealth situation as 100,000 and high wealth situation
as 10,00,000.
And, this time the probability is equal between these two outcomes. So, if this is your prospect
2, where you if you invest the same amount of money you can get either ₹1,00,000 or
₹10,00,000. And, the possibility of these two situations is given by the equal probabilities of
50-50. If you calculate the utility in the same approach which we have just
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discussed, the utility of prospect 2 can be calculated as
𝑢(𝑃2) = 0.50 (2.3026) + 0.50 (4.6052) = 3.4539
So, imagine a situation where you have these two prospects which means these two decision
choices prospect 1 which is 40% chance of getting 50,000 and 60 chance of getting 10,00,000.
And, prospect 2 where you have 50% chance of getting 1,00,000 and 50% chance of getting
10,00,000. Going by the utility theory framework we calculated the utility as utility of prospect
1 to be 3.4069 and utility of prospect 2 as 3.4539. If you follow logarithmic utility function and
you have constant preference, you should always go for the second prospect because it has
higher utility.
This is how we can calculate utilities associated with the decision choices that we have
particularly, the decisions where we have some economic values attached. And, we can rank
these situations on the basis of their utility and make our decisions to find the highest utility
choices. And, accordingly we will find the alternative which yields the highest utility. Now,
there are certain constraint.
This particular approach of utility theory is based on the assumption that individuals have
preference for higher utility, it does not talk about the risk. We all know that given a choice
most of us do not want to take any risk which means we do not want to go for risky situations.
At the same time, if for some reason we are willing to assume some risk we would like to be
compensated for it which means if we take higher risk we should also be paid of higher return.
Given that most of the economic agents are risk averse and for any additional risk that they take
assume they would like to be compensated for it. We understand that in general we would like
to prefer the prospect or the expectation of the prospect itself rather than the expectation of the
chances of different prospects which means if we have two scenarios,
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where we would have a certain gain of an amount x and another scenario where we have two
choices or two probabilities 50% probability of getting 1,00,000 and 50% probability of getting
10,00,000 as shown in the previous example.
As risk averse individual we would want to go for the first choice which gives us the sure short
gain of 1,00,000 instead of going for a chance which has two probabilities of 50-50 over two
different outcomes. This particular nature of individual economic agents is known as risk
aversion. A typical risk averse investor will have a utility function as a concave curve whereas,
if you want to take a higher risk and would like to be compensated for it, the utility function
will be shown as a convex curve.
And, if you are indifferent between risk, if you are indifferent between the choices with higher
risk and the lower risk then you are basically a risk neutral individual. So, the curve of a risk
neutral individual would be shown as a straight line. Just to showcase how does the utility
functions of three different type of individuals would look like let me try to explain here.
If you are a risk seeker basically you want to be compensated for the risk that you are
assuming then your utility function would be a curve something like this where you
have wealth and then you have utility. So, your curve would look something like this. In case
you are an individual who does not want to assume risk which means you are risk
averse, the utility function that you will carry should look like a curve something like this where
your utility function would be increasing in the beginning and then stabilizing.
And, if you are a risk neutral individual which means you do not differentiate between high risk
choices and low risk prices, then utility curve should look like this for you. So, this basically
is risk seeker, this is risk averse and this is risk neutral.
So, far we have understood what expected utility theory improvises over and above the basic
assumption of utility theory given by the new classical economics. We have also understood
what should be the implication of different risk attitudes of individual economic agents. We
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understand here that based on this VNM framework of expected utility individual financial
decision-making processes can be improved and that we will learn in next session.
Thank you.
43
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 05
Decision Making Under Risk and Uncertainty
Hello, hello welcome back to the course Behavioral and Personal Finance, the world would
have been a better place if we were homo economicus. But, fortunately or unfortunately we are
homo sapiens and most of our decisions are based on the environment and the circumstances
that we are in and that is where we deviate from the traditional economic decision-making
theories. Today we are going to discuss the decision-making framework under the expected
utility theory, where risk and uncertainty play an important role.
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(Refer Slide Time: 1:03)
Today’s topics for discussion are the examples of expected utility theory, where risk attitude of
the economic agents and the decision-making framework play a major role. At the same time,
we will also see how we incorporate those risk and uncertain situations in our decision-making
processes. So, far we have learned that our decisions where economic payoffs are associated
are based on the utility derived from those payoffs.
For example: if you have an investment that is going to yield different payoffs with different
probabilities, we will try to understand what should be our expected payoff from those outcomes
and based on that we take our decisions. Let us have a look at the following example.
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(Refer Slide Time: 2:13)
Suppose there are two prospects P1 and P2 and we assume that we follow logarithmic utility
function which we discussed in previous session and the pay offs that prospect 1 has include
40% probability of having 50000 and 60% probability of having 10,00,000. At the same time,
we have a different prospect P2 which has 50% probability of having 1 lakh and remaining 50%
probability of having 10,00,000. Going by the expected utility theory proposed by von
Neumann and Morgenstern; we would try to calculate the utilities associated with these
prospects and then we come up with the ranking of these prospects to arrive at a decision.
If we go by the standard utility theory, we calculate the utility derived from these two different
payoffs and associated probabilities and thereby we come to a set of utilities associated with
these two payoffs. Let me try to show how we derive the payoffs probabilities
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and the associated utility, where we can rank these two prospects according to their utility
derived from the utility theory. For referring to the expected utility function as suggested in
previous sessions, we are referring to the table given at the top right and to calculate the utility
is associated with these two prospects we are using the values given in the table.
So, if you try to calculate the utility associated with prospect 1 it will be looking like this,
𝑢(𝑃1) = 0.40 × 𝑢(50000) + 0.6 × 𝑢(1000000)
= 0.40 × 1.6094 + 0.60 × 4.605
= 3.4069
Similarly, for another prospect that is utility of prospect 2, the utility can be calculated as
probability into utility of payoff and this will give us the utility of prospect 2 as
𝑢(𝑃2) = 0.50 × 𝑢(100000) + 0.50 × 𝑢(1000000) = 3.4539
Now, if we try to understand from the expected utility theory, we will take this example to a
different context where the associated risk and uncertainty can be incorporated. But, going by
the standard utility theory if a person faces these two prospects and he is indifferent in terms of
the choices that he would be making.
The best prospect that he would go for would be prospect 2 because, the utility derived from
prospect 2 is higher than the utility derived from prospect 1. This is what the standard utility
theory explains. When we try to incorporate the risky situations which where the outcomes are
known and associated probabilities are given, we can incorporate VNM framework of utility
theory. And, we try to come up with payoffs or the out outcomes which will incorporate the
probability as well as the risk and uncertainties. Let me try to show this with another example
in the same context.
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(Refer Slide Time: 07:57)
The VNM framework of expected utility theory says that, if a person is given two choices where
one choice includes the probability weighted, choices and another choice give offers a confirm
outcome. Given that the person follows a lognormal utility function he would go for the sure
shot or the certain outcome that is offered to him. Now this can be explained with the help of
the following example, taking the information from the previous example of prospect 1 we will
try to explain how this can be incorporated in an expected utility theory framework.
If you look at the information given the prospect 1 has two outcomes 50000 and 100000. So,
these are the two outcomes of prospects 1 and these two outcomes have associated probability
as 40% and 60%. And, if we try to find the expected wealth we can calculate by the given
probabilities of expected wealth as 620000 that is the expected wealth of the prospect
that is offered to the person.
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Now, if we try to use standard utility theory, the expected utility expected payoff of these two
values 50000 and 100000 will yield a utility of 3.4069 which we have just calculated. The
values are given here and if you try to calculate the utility of the expected wealth which is
620000 referring to the previous table. We will come up with a utility value of 4.1271.
So, this value has been calculated referring to the previous table that we had shown earlier and
this is this 62 is actually coming from 620000 because the table has values in terms of
10000 dollars or rupees. Now, if we compare these two values the utility derived from the
prospect of two outcomes with two different probabilities 40 % and 60% and another prospect
which is a sure shot calculated value of 620000. Under normal circumstances an
individual who would go for the one which has higher utility and in this case the prospect with
620000 of expected wealth is giving a higher utility for the individual and that is why he would
prefer this choice.
Now this leads to a very interesting observation, which implies that the individuals
under normal circumstances tend to prefer the prospect itself rather than the expectation of
prospect; which means they behave such that they prefer the shore short outcomes which
means the certain outcomes rather than going for the outcomes which have certain risk
component or uncertain components. For example, in the P1 we had two possibilities and these
two possibilities have certain probabilities of 40% and 60% and that is why they were uncertain.
So, a person would not go for uncertain choices rather he would go for the choice that is offering
him sure shot expected wealth of 620000. This particular characteristic of individual decision
makers is known as risk aversion. Now, an individual can be risk averse which means he
would not like to take risk or he can also become risk seeker; which means he would
like to take risk given certain circumstances or he can be risk neutral which implies that he is
indifferent between risky or certain situations.
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When we try to understand the decision-making process in terms of individual behavior such
as risk averse risk seeker or risk neutral. We will start with our focus on risk averse behavior.
In financial decision making we often observe that people do not want to take risk, which
implies they do not want to take decisions with uncertain outcomes. And, if they are forced or
they are likely to take decisions which are uncertain or the decisions which have certain risky
outcomes. The individual would like to be paid of a reward or to be compensated for the risk
that he or she is assuming this is where the expected utility theory comes into the picture.
It also suggests that when a person is willing to assume a risk what should be the level of reward
or the compensation that should be given to him for taking the risk that is assuming in the
decision making. We will try to understand this with the help of another example where we will
try to calculate the extra payoff or additional payoff that a person would like to get where he or
she is taking an additional risk. When we talk about decision making under risk and uncertainty
we try to understand.
50
(Refer Slide Time: 14:43)
That decision making is largely based on the expected outcomes which are to be occurring in
future and there is certain likelihood or probability associated with each of those outcomes.
And, we try to incorporate the possibilities or likelihood of those outcomes in our decisionmaking framework and that is where we use expected utility theory in our decision-making
processes. As we discussed risk aversion is a natural human tendency empirical and scientific
research over the years have shown that individuals as human being or economic agents tend to
be risk averse by design, they do not want to take any uncertain decisions or those decisions
which include uncertain payoffs.
Let us say for example, a person has certain amount of money and that money can be invested
in different investment avenues. Now, given the natural choice of individual human being, the
money can be invested in most safe investment avenues such as bank deposits or fixed
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deposit. And, if the person is risk seeker it can be invested in different risky investment avenues,
such as share market or bonds or mutual funds. Depending on what level of risk seeking
behavior the individual is exhibiting the in money can be invested in different risky investment
avenues.
This framework is actually based on the expected utility theory under VNM
framework, where they incorporate risk aversion as a natural characteristic of individual
decision maker. And that is where they try to explain how this disk decision making process
can be improved.
Now, that we know risk aversion is a natural tendency, why should an individual take an
additional risk. For example, if you know that there is a set career path which means there is no
uncertain future outcomes you would not like to take any risky career choices. Or for example,
if an individual knows that going by a certain career choice, he or she would make a better
future, why would he go for more risky choices such as entrepreneurship. Similarly, an investor
if he or she knows that the money can be safely invested in certain instruments such as bank
deposits or government bonds, why would he or she be investing money in stock market
instrument or other similar risky instruments.
The answer is they would be compensated for the risk that they should be assuming. Now, what
should be the extent of compensation or the payoff that should be rewarded in terms of the risk
premium. Suppose you have x amount of return to be expected from an investment. For
example, you have an investment horizon of 5 years, which means if you invest money today
you will be expecting some amount of money as returned in future for next 5 years. But you are
not sure whether the future is going to be as stable as present or as certain as you believe so.
So, if you expect that you are going to get certain amount of return let us say 5% of return from
your investment in some investment avenues. So, for first two years you get 5% of return and
suddenly there are certain changes in economic policies or global market scenario or any other
macroeconomic factors. And, the return that you are hoping to get from your investment would
fall from 5% to 3%. So, earlier you were expecting 5%, but now this is going to be 3 percent.
And this is very common maybe if you observe around you would find people who had invested
10 years back, hoping that they would get a certain amount of return every year to support their
livelihood.
52
But over the years they realized that the return on their investment have started falling down
from what they had expected, because of several macroeconomic factors or other reasons. Now,
if you are trying to go for traditional methods of equal utility theory, you would have
incorporated this payoff with associated probabilities to come to the conclusion where you
would have some utility derived and then that utility can be used to make the decision
whether to invest or not. Now in a change scenario where the rate of return has fallen from 5%
to 3%, the calculations that you had done earlier would be required to improvised,
And, now the utility that you had derived in the beginning would be revised as well. This is
where you need to understand the amalgamation of traditional economic theories along with
the more sophisticated financial calculations and the implications of behavioral and
psychological factors in financial decision making. An implication of such scenario would can
be seen in different stock market context.
For example: if you try to understand or observe a behavior of an individual investor, the
investor has invested in the stocks of a company and he had expected certain return from that
investment. Now, after some time of the investment decision the investor realized that the
return on the stock that he owns has started falling down, which is basically the result of the
price fall. Now, the situation could be the investor should sell the stocks that he owns or he can
continue holding that stock, so that he can get whatever he is getting in terms of share stock
returns.
Now, if he is a very normal individual a very traditional human being, the change in return
would essentially reflect in his decision making and he would be likely to sell off his shares.
But if you try to understand from the psychological point of view you would notice that most
of us do not want to sell such assets. Essentially when we have certain assets or investment that
have started losing values, we want to stick to this investment and try to hope that the
53
investment would recover value in coming future and once it reaches the price at which we had
bought we would be selling it off.
This tendency is also known as anchoring in behavioral finance theory, but to understand it
from the expected utility framework we know that unless we revise our utility derivation or the
value of utility that we had derived initially, our decisions would be flawed and we would not
be making a sensible and financially feasible decisions.
(Refer Slide Time: 24:35)
Now, coming back to the question how should we incorporate the additional risk that we are
assuming in our decision making, so that we should be compensated enough for the risk that
we have taken. One approach is to understand the Certainty equivalent, certainty equivalent is
essentially a factor or an approach that suggests that. The wealth level of the decision maker is
indifferent between a risky and a certain choice. So, if you have two choices where one
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choice is risky and another choice is another choice is certain. The wealth level of these two
choices becoming equal implies that this is certainty equivalent situation.
If you try to understand with the help of an example. Suppose that you have purchased a lottery
ticket and the lottery has two possible outcomes outcome one is you can win ₹100000 and
outcome two is you lose ₹10. Now, these two outcomes have equal probabilities that is 50% in
each case. Now, what should be the minimum amount at which you should be selling this lottery
ticket to anyone. The situation here is you can either hold on to the lottery ticket which is a
gamble or an uncertain choice or you could sell this off to anyone for a price which is certain.
Again, you have two choices so either you can so this is the decision point, you can keep
holding the lottery ticket and this will be taking you to two different choices or rather two
different outcomes. One is 100000 of gain and another is ₹10 of loss and in these two cases you
have 50% probability for each of the outcomes. Another outcome is or another choice that you
have is sell the ticket that you have, sell the lottery ticket that you have for a price. Now what
should be the price now what should be the price that you should be selling it off.
If we go by the standard utility theory framework, we will first try to find the utility derived
from the first option that we have, which means if we hold on to the lottery ticket the uncertain
situation should yield in certain utility and that utility can be calculated as follows. So, you can
have the utility of lottery ticket as the probability of these two outcomes into utility of the
associated payoff.
𝑢(𝐿) = 0.5 × 𝑢(100000) − 0.5 × 𝑢(10) = 4.6052
Apparently, this ₹10 is a loss so we need to revise this value as a negative value because you
are likely to lose money. So, you have to reduce the extent of utility that you would be deriving.
If you calculate these values the utility that you will be getting is essentially 4.6052.
So, this is the utility that you are likely to get when you hold on to the lottery ticket. Now
certainty equivalent principle says that the utility of the wealth level or the outcome should be
equal when you are trying to calculate the certainty equivalent which means at the point
where the wealth level or the utility value of these two wealth levels are equal you should be
indifferent between the choices of risky in nature and certain choice.
55
So, utility of this lottery ticket is 4.6052 and the choices that you have in order to sell your
tickets are ₹50, ₹100, ₹500, and ₹1000. So, if you try to calculate the utility of these payoffs
which are certain, we can refer to the table again and we see that the value of the each of these
utility of the first price that you have an option is basically 2.9120 another choice you have to
sell your ticket is 100 rupees. So, utility of this ₹100 will be
4.6052 for utility of 500, you have 6.2146 and similarly for utility of 1000, the value will be
6.907. Now, you may ask where do these values come from these values are actually coming
from the logarithmic utility function table, which we had discussed in the beginning and these
values are nothing but the natural log value of the numbers given in the brackets.
So, if you observe the prices that are available ₹50, ₹100, ₹500 and ₹1000, the utility of the
second option which is ₹100 of price is exactly same as the utility that you are deriving from
holding the tickets for future which means the payoff or the utility that you are going to get out
of these two options. Option a is hold on to the ticket with
50% probability of winning ₹100000 and 50% probability of losing ₹10. And, another option
as sell the ticket right now for ₹100 the utility levels in these two cases are same and this is
where you can be indifferent between holding on to the ticket vis a vis selling it off for ₹100.
So, this is one point where you could understand about the extent of risk that can be mitigated
in terms of finding the wealth level at which the utility is as much as the utility associated with
a risky choice. And, this is where we try to start incorporating more from practical
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implication in terms of decision making and this is where the expected utility theory can be
incorporated in our decision-making framework from a more realistic point of view, for now
this is it.
Thank you very much.
57
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 06
Decision Making under Risk and Uncertainty
(Contd.)
Welcome back, continuing from the previous discussion on expected utility theory and risk
aversion. We will discuss more about different examples where we incorporate risk aversion
and a related concept known as certainty equivalent. So, here we understand that certainty
equivalent is a point where the utility derived from a risky choice is equal to the choice to the
utility derived from the choice if you hold on to that.
In last example, we understood that if we keep on holding the lottery ticket with two different
payoffs and associated probabilities and we have an alternative choice to sell it off, we need to
find a price at which the expected utility of these two alternatives are same. And, if we are able
to find that price or the level at which the expected utility of these two alternatives are same
that is where we become indifferent. Now, how does that translate into our decision making?
Because we know that our decisions where risk and uncertainties are involved are not very
linear. By linear we mean that it does not go in a very straight-line fashion.
So, let me try to put this through a silly example; suppose you are a very adventurous person
and you would like to do high trekking or let us say jumping from a different heights and in a
game someone is offering you some payoff for jumping off from different level of heights. And
if you are offered let us say ₹200 from for jumping off; let us say 15 feet of height, would you
be willing to jump from 30 feet of heights for double the price that being offered that is 400.
So, if you understand the risk of jumping from 15 feet of heights; vis a vis the risk associated
with jumping from 30 feet of heights; you would definitely not go for just double the reward
from; for these two different alternatives. And, that is what we mean when we say
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that the risk associated with different payoffs are not linear in nature. Let me try to show this
with the help of the example where we stopped in a certainty equivalent case.
(Refer Slide Time: 03:23)
What we were trying to say here is; if we have some risky choices and we can try to find the
certainty equivalent associated with that risky choices, the extra return or extra payoff or extra
benefit that we are going to get because of taking the additional risk that will be known as risk
premium.
So, when you are taking a jump from 15 feet of height and in a different situation you are asked
to jump from 30 feet of heights; you are taking an additional risk and that risk must be
compensated for in terms of the payoff that is being offered. So, how do we compensate that
additional risk can be understood with the help of the certainty equivalent example.
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So, if we try to show it through a graph; suppose this is our utility and value curve. So, we have
value on one axis and utility on another axis; we should be having a level where the expected
payoff can be. So, this is basically the expected value of the payoff and if we try to show the
curve which is basically the logarithmic utility function curve; it should look like this.
We have seen that it is typically very much similar to a curve like this and if we are able to find
the certainty equivalent; so, basically this is utility curve, this particular axis can be noted as
expected utility. So, we have expected utility on one axis, value at another axis. So, we have
expected value at certain point and if we are able to find certainty equivalent which let us say
lies here. i.e. CE (refer 5:50).
So, certainty equivalent is basically the value of wealth where the expected utility is equal to
the value of expected utility derived from the risky choice which means the expected utility in
these two cases will be similar. And, CE is the point from certainty equivalent to the expected
value is essentially the risk premium that is being paid off.
So, which means the expected utility derived from the risky option and the expected utility
derived from the shear short option is equal where certainty equivalent point is lying which can
be summarized in a way that expected utility of the gamble or the risky option is basically equal
to the utility of the certainty equivalent. This is where the relationship between the expected
utility of a risky choice and utility of a shear short gain can be connected.
So, this particular point is known as certainty equivalent and anything over and above this point
that you are demanding is basically the risk premium for taking the additional risk in your
decision making. This particular illustration can be shown with the help of another numerical
example that I have here.
60
(Refer Slide Time: 07:57)
If you look at the example shown here; this is a particular case of a gamble, where there are
four outcomes. Outcome 1 has ₹4000 of gain with a probability of 40%. Outcome
2 has ₹2000 of gain with a probability of 20%.
Outcome 3 has ₹0 of gain, which means you will get nothing in this case with a probability of
15% and outcome 4 has a loss of ₹200 with a probability of 25%. Now, the particular case here
is being discussed in the context of a utility function curve which is given here. So, the
individual for which we are trying to understand this particular process follows a logarithmic
normal distribution; logarithmic utility function as shown in the graph.
If we try to calculate the utility, basically we will try to calculate the utility associated with
these four payoffs and we will come up with the value of expectation which means the
61
expected value as shown in the previous graph. We will also try to understand the value of
certainty equivalent and then we will come up with the amount as the difference between the
certainty equivalent and the expected value which could be considered as the risk premium.
So, with this example we can understand two things; first we will be able to know what should
be the price, if we want to trade this particular gamble right now for a certain payoff. And
second, we will also try to know what is the additional reward or compensation or the benefit
the individual is getting for holding on to the risky choice. So, first of all we will try to calculate
the value of expected cash flows which is basically 4000, 2000, 0 and -200. So, the way to
calculate the expected value EV is as follows. So, expected value of these cash flows are 40
percent probability of having 4000, 20 percent probability of having 2000, 15 percent
probability of having 0 and 25 percent probability of having -200.
Again, if we refer to the log normal utility function table as shown here; the value for expected
cash flows would be coming out to be 0.72. So, that is the value of expectation associated with
these four different cash flows given here; second step is to find the certainty equivalent. So,
when we try to calculate certainty equivalent; we can refer to the graph itself. So, if we try to
see the expected utility associated with these for cash flows 4000, 2000, 0 and -200; we have
calculated the expected utility for these four cash flows as 0.72.
So, if you would refer to the graph and find 0.72 as a point: where the wealth level can be
determined as certainty equivalent. So, if this is a point where we have 0.72 as the expected
utility, this actually gets us to the wealth level of close to 400. So, we can say that certainty
equivalent is 400. Third step to explain this example would be to calculate the expected value
which is basically the value of the cash flows which you will get if you hold on to the risky
choice. So, expected value calculation can be done in a very standard format which is
𝐸𝑥𝑝. 𝑉𝑎𝑙𝑢𝑒 = (0.4 × 4000) + (0.2 × 2000) + (0.15 × 0) + (0.25 × −200) = 1500
These numbers will take us to the value of 1500; if you do the calculation you will get 1500
here. And as discussed previously we know that if this is where you have this expected value
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and this is where you have certainty equivalent; basically, this is the extra reward or benefit that
you are getting as risk premium.
So, this particular example helps us in understanding two things as mentioned earlier; one is
how much should we ask for if you want to exchange or trade this particular gamble right now
and the answer is certainty equivalent value is 400; so 400 should be the price of this gamble if
you want to trade it right away. And if you hold on to this particular gamble, the expected value
that we are going to get at the end of the period is 1500; out of which risk premium is basically
how much? Risk premium is 1500 - 400 of certainty equivalent that is 1100.
So, this is where certainty equivalent helps us. So, with this example we can understand that
given certain risky situations what should be our approach to arrive at the value of the wealth,
where the expected utility is equal to the value of the wealth if we stick to the risky choices. So,
with the help of certainty equivalent and risk premium; we can understand what should be the
price of certain payoff verses the price of the risky; risky payoff or risky choices and what
should be the risk premium associated with different risky situations.
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(Refer Slide Time: 17:01)
Going back to the theoretical framework of risk aversion and decision-making framework under
risk and uncertainty; we understand that economic agents that are basically individual decision
makers or investors or corporate executives or any human being can be risk averse which means
he would not like to take risk. And in a given circumstances the utility that he is going to derive
typically increases with the level of increase in the wealth.
The first graph actually indicates the utility function of a risk seek risk averse investor; where
the expected utility increases with an increase in the level of wealth. Second graph shows the
utility function of a risk seeker where the increase in wealth essentially increases the utility, but
in a decreasing fashion.
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So, it is basically a convex curve and if we continue to understand the utility and wealth
relationship; we understand that for a risk neutral investor, the utility function would be
a straight line something like this where the individual or the decision maker will be indifferent
for different level of wealth and different levels of utility.
(Refer Slide Time: 18:47)
So, essentially, he will not make any difference between a risky choice and a certain choice.
Now, bringing all these things together in a more relevant framework is given by the prospect
theory of Daniel Kahneman and Amos Tversky. What they sincerely suggested was
individuals might be behaving differently under different circumstances. Essentially, it means
that if it is a situation where you are likely to gain something your behavior would be different
from the situation where you are likely to lose something.
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If you remember the examples that we had discussed in the beginning sessions; you remember
that when you are likely to lose a money or you are likely to lose something valuable; you
behave as you are going to be risk seeker. Whereas, if you were likely to gain something; you
tend to behave as risk averse. So, all these concepts combined together is given in the prospect
theory framework; where the behavior of individuals might be different under the situations of
gain and losses.
This can be shown with the help of a combined graph, where I can take clues from the research
done by Daniel Kahneman and Amos Tversky and the graph is as follows. So, if this is my
utility line and this is basically the wealth or value line; this particular zone is for gain whereas,
this is for losses which means the value will be negative here and value will be positive here.
If you refer to the utility function curve of a risk averse person; it looks something like this
where you tend to behave as a risk averse. And if you are a risk seeker person, your behavior
would be in a different way which is given by the utility function curve as explained earlier.
This is what is known as the prospect theory curve or the utility function for a human being
which is different from homo economicus. And it indicates that the utility function for an
individual would be different for situations where gains are involved and it will be different
from circumstances where the losses are involved which means if you are likely to lose
economic value you would behave like a risk seeker and you tend to take more risk.
And, if you are under situations where you are going to get something, you will behave like you
are risk averse. And, this can be seen in examples in the stock market where people try to hold
on to the stocks, where they are losing value and they sell the winners or the sell the stocks
which have gained in value and this is a typical example of a prospect theory in real life.
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(Refer Slide Time: 23:09)
So, far we have discussed the standard utility theory. We have also incorporated the expected
utility theory as proposed by VNM framework, where we understood that the expectation of the
prospect is more preferable than the prospect itself. And this is where the risk aversion
characteristics of individual decision makers become more important.
And further we discussed that risk aversion characteristic can be of different situations.
Subsequently, we also discussed that individuals can be either risk averse or risk seeker or risk
neutral under different circumstances.
And all these characteristic of individual decision makers can be clubbed to understand a better
economic decision-making framework; where we will try to incorporate factors such as
certainty equivalent and risk premium along with the behavioral characteristics such as risk
67
aversion and similarly loss aversion as shown by Daniel Kahneman and Amos Tversky in
their prospect theory framework. For now, this is it.
Thank you very much.
68
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 07
Non–Expected Utility Preferences
Welcome back to the course Behavioral and Personal Finance. Smoking is injurious to
health! Have you heard this before? Of course you have, but you must have seen people
around you smoking very often. What do you think would be driving their behavior? Do
you think they do not know if smoking is injurious to health? Well of course, many a
times we know that some things are going to harm us still we behave in a certain fashion.
This is because we tend to be biased or influenced by certain circumstances and that
drives our behavior in a particular fashion. Now, that is where you can relate to how the
expected utility theory is not meeting it is goal. Expected utility theory suggests that
peoples behaviors should be driven by the objective framework of utility derived from all
choices and then they go to the best choice that they have.
Whereas, in reality we observe that our choices are driven by different heuristics and
biases including our personal experiences, societal factors and of course, cognitive
issues. Today we are going to discuss about the issues that expected utility theory is
suffering from and how an improvised approach known as the Prospect theory can
address the issues related to Expected utility theory.
I am Abhijeet Chandra and this is the course Behavioral and Personal Finance where we
are going to discuss Non-Expected Utility Theory Preferences in the context of decision
making framework.
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(Refer Slide Time: 02:24)
This session will focus on the contradictions of expected utility preferences which means
the issues that expected utility preferences are not related with its original idea and how
the behavior of people are driven by different issues. We will also discuss briefly about
the prospect theory which was proposed by Daniel Kahneman and Amos Tversky. The
prospect theory addresses the issues faced by the utility theory.
(Refer Slide Time: 03:09)
Let us begin with some theoretical issues that expected utility theory faces. We
understood that expected utility theory is basically a normative framework of decision
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making where it is based on how people should ideally behave. Whereas, in real world
we know that people fail to behave in an ideal way and their behavior might be far away
from the ideal or the realistic framework which they can understand.
We also understand that expected utility theory is basically axiomatic treatment of
choices which is based on assumptions such as constant rational choices and preferences
based on the probabilities associated with it. Expected utility theory is very helpful in
decision making, but we have seen through various examples that it fails to cater to the
realistic approach of decision making process, wherein our behavior might not be very
consistent which could be reflected in our preferences as well.
If you could recall the typical way to find the value or let’s say utility of the choices or
the options that we have is through a simple expression which is
P (pr, x, y)
.. (1)
It’s basically the prospect which has certain probability of different outcomes. So, in the
given example here we have a prospect that has a probability of pr and the outcomes are
x and y.
So, if we denote it in a more quantitative way the prospect can be illustrated with some
numerical example like this. So, if I say prospect is given as probability and outcomes of
x and y which means equation (1) is basically our prospect, pr is probability of the first
outcome. So, x is basically your first outcome and y is outcome 2.
If we denote it in a way where there is no outcome 2 which means prospect is given as
probability and outcome x which means in this case outcome 2 is basically 0 and if the
prospect is denoted as P(x) which means this is certain outcome, which implies that the
prospect x has 100 % certainty which means there is no uncertainty involved and you are
likely to get it for sure.
This is the way we denote the different prospects under expected utility theory
framework. We have already learned how do we find the utility associated with these
prospects where we assign the probability or we get the probability from our experiences
and the probability can be used to find the wealth value of outcomes x and y.
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We have learnt that the value of these prospects are driven by the probability and under
different circumstances, the situations or the conditions that we face might drive the
value or the wealth that we are attaching with these prospects might be differing. Let us
go through few examples which will indicate where and how we deviate from the
expected utility theory.
(Refer Slide Time: 08:16)
So, the first example of non consistent observed behavior of individuals is drawn from
one of the seminal research work of Daniel Kahneman and Amos Tversky. Here the
example presents 2 different decision choices:
D1: Choose between P1 (₹240) and P2 (0.25, ₹1000)
D2: Choose between P3 (−₹750) and P4 (0.75, −₹1000)
As you see, you have to make decisions with respect to the 2 concurrent situations,
decision 1 involves two prospects P1 and P2, where P 1 includes a sure shot gain of ₹250
and P 2 includes a 25% probability of getting ₹1000 rupees. In another case the decision
2 involves two prospects again P3 and P4, P3 has a sure shot loss of ₹750 and P4 has a
loss of ₹1000 with a probability of 75%.
Now, if you analyze these two decision choices and then come to a conclusion or come
to your analysis, you would realize that your behavior is different when it comes to sure
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short gain or rather when it comes to gains and it is some completely different when the
outcomes are in terms of losses.
Since we are referring to the research done by the Kahneman and Tversky I would
present the numbers that they found. The numbers in the experiment that they have
realized are as follows:
Decision
Preference
Risk attitude
D1
P1 (84%)
Consistent with risk aversion
D2
P4 (87%)
Consistent with risk seeking
For decision 1 most of the people in fact, to the extent of 84 percent of the people
experimented in this process went for prospect 1 which basically indicates their risk
aversion attitude that we have already discussed earlier.
In case of decision 2, 87 percent of the people whom they experimented preferred the
prospect 4 which is basically contradicting with risk aversion essentially it is risk seeking
behavior. Now what is happening here, as I said we behave in a risk averse way when we
faced with certain choices or gains, but we behave in a risk seeker away when we are
faced with losses, which means our behavior across losses and gains are not consistent.
So, we prefer to take risk when we are faced with losses and we prefer to be a risk averse
when we are faced with gains. This comes to an important conclusion of what we are
going to discuss as prospect theory. The conclusion is people sometimes exhibit risk
aversion and sometimes exhibit risk seeking behavior depending on the nature of the
prospect.
As we have seen these two prospects have different natures and that is why people whom
Kahneman and Tversky experimented they exhibit different behavior under different
circumstances. This is where expected utility theory failed to capture the realistic
behavior, under expected utility theory the choices that people would be making should
be consistent because the ultimate utility derived from these choices are same in both
prospects.
In decision 1 the ultimate utility would be 250 that is gain and indecision 2 the ultimate
utility is 750 in both P3 and P4 as losses. So, the behavior of people making choices
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should be consistent across these prospects, but in reality it is not so, that we have just
observed.
(Refer Slide Time: 13:04)
Another example of non consistent observed behavior has been drawn from another
piece of research by Daniel Kahneman and Amos Tversky. Again I am taking the
numbers and example drawn from that research and present it here, just go through the
choices that you have here and then think about it for a second
D1:
Assume yourself richer by ₹300 than you are today.
Then, choose between P5 (₹100) and P6 (0.50, ₹200)
D2:
Assume yourself richer by ₹500 than you are today.
Then choose between P7 (−₹100) and P8 (0.50, −₹200)
Now, the choices here that we have are again D1 and D2 which are basically decision
choices 1 and 2. Decision choice 1 says that you consider yourself richer by ₹300 than
you are today, which means if you have x amount of wealth today, the next period which
is let us say tomorrow you are x plus ₹300 and then you have to make a choice. The
choice is P5 and P6, P5 has a sure short gain of ₹100, P6 has a gamble of ₹200 with a 50
% probability.
In another decision choice you are supposed to be richer by ₹500 than you are today and
then you are faced with two prospects P7 and P8, where P7 is a sure shot loss of ₹100
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and P8 has a loss of ₹200 with a 50 % probability. Now this is an interesting situation
where the level of wealth or the change in the level of wealth becomes more critical
about what decision you make.
Suppose you are walking on the road and suddenly you find a note of ₹500 lying on the
road now; that means, the level of your wealth is increased by ₹500 today. If you observe
your spending behavior might be influenced by that additional ₹500 that you have just
got.
Similar situations might be seen in casinos, if you know people who have won certain
bets in casinos or in a lottery suddenly start behaving in a different way with their
money, that is also in a crude way known as house money effect where you get some
money for free and then the behavior the tendency of spending money or taking risk is
completely changed for you.
Here if you have calculated the value of these two prospects for decision 1 and two other
prospects for decision 2, you must have understood what I intend to show. Again I am
showing the numbers given in the research done by Kahneman and Tversky, the number
show for decision 1 about 72 % of people experimented go for prospect 5 which is again
consistent with risk aversion behavior and for decision 2, about 64 % of people go for
prospect 8 which is related to the risk seeking behavior.
Now, again what is going on here? If you think through it, you would realize that
depending on the change in level of wealth your behavior might be influenced in terms
of taking risk. The conclusion here from this piece of research is people’s evaluations of
prospects depend on gains and losses relative to a reference point and that reference
point could be possibly their status quo.
We also know this reference point in a different context as anchor. You must recall the
example where I had discussed about people’s tendency to stick to a stock or shares
whose value is decreasing, despite the fact that they are losing money they don’t want to
sell this stock because they are stuck with a price at which they had purchased and that is
why they do not want to deviate from that particular anchor and in the process they are
making losses and losing money.
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This is coming from the same phenomenon which we have just shown through this
example. We all have a reference point and our decisions about taking a particular choice
or taking a particular prospect is driven by whether we are gaining or losing from that
particular reference point and that reference point could ideally be the status quo, which
implies that we do not want to deviate from the status quo and if we are deviating, how
much we are deviating will determine whether we are going to take how much of risk.
Now, let us go through another piece of observed behavior where we would try to show
how the non consistent behavior of decision makers might determine the level of risk
that they might be taking.
(Refer Slide Time: 19:07)
This piece of example or this idea is also drawn from one of the research studies done by
Daniel Kahneman and Amos Tversky and this example is as follows.
Suppose you are given the following situation and the situation is you have to choose
between two prospects P9 which is a sure short gain of $0, which means you are not
going to get anything and P10 where you have a gamble that has 50 % probability of
getting $x and remaining 50 % probability of losing $25.
Now the question here is what should be the value of x that you would want to trade this
for? If you see P9 which is no gain or no loss is the status quo and as indicated earlier
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most of us do not want to deviate from the status quo and if we are deviating our choices
would be driven by gains and losses.
Now, this piece of research indicates that people are averse to losses because losses loom
larger than gains, that is the outcome and the explanation here is the average response in
this experiment that we had just shown whether to choose between P9 and P10. People’s
choices are going towards the value close to $61 and that is of course, driven by the
utility framework. If you could recall we know there is something called certainty
equivalent which is basically the value where people are indifferent between a sure shot
choice and a risky choice.
So, here we have two prospects P9 and P10 and you need to find at what value of x the
ultimate utility derived from the gamble which is P10 will be as much as the value of P9
which is 0 gain 0 loss.
So, the value that was concluded through the experiment done by Kahneman and
Tversky is $61 and that is where they actually come with a quantitative figure that the
upside of the prospect had to be more than two times the absolute value of the downside
in order to induce the indifference between two prospects, which implies that if you have
two prospects and you need to see whether you are losing money or gaining money, in
case of losses it has impact to the extent of more than two times.
Now, you can simply relate this with any typical example of our behavior. Let’s say we
have some money in our wallet and on an unfortunate day we lost ₹100. Now you can
understand the pain or the grief that you have because of losing that ₹100, on a different
lucky day you found ₹100 lying on the road, you must be feeling happy.
So, this piece of research indicates that the happiness or the places that you have
obtained by getting ₹100 for free is actually less than the loss or the grief or the sadness
that you have obtained because of losing ₹100.
So, that is what they mean to say when they say the upside had to be more than two
times of the downside absolute value of the prospect. This piece of research is another
important inference that would lead us to an important theory of an improvisation over
expected utility theory that is known as prospect theory given by Kahneman and
Tversky.
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Through these three examples we have learnt that people’s behavior would be different
under losses and gains and that behavior would be driven relative to a reference point
which could be their status quo and we understood that losses loom larger than gains.
(Refer Slide Time: 24:23)
So, far we discussed in this session that expected utility theory is basically a normative
framework of decision making, where it explains how people should ideally behave not
how people actually behave.
It is not very realistic in terms of decision making processes whereas, when Kahneman
and Tversky started proposing prospect theory over a expected utility theory in terms of
a better decision making framework they try to show how people should people actually
behave and whether their decisions are not driven by the utility alone rather it’s driven by
different other factors including the nature of the prospects, which means whether it is a
gain or a loss, the extent of the gain and loss which is basically deviation from a
reference point and which one has more impact on our decision whether it is loss that is
driving our decision in a different way or it is gain.
So, we come to a conclusion that there are three key notable behavior patterns. One,
people have different risk choices under losses than gains, which means if we face with
losses our choices would be completely different from the situation when we face gains.
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Our choices are driven by losses and gain of course, but this should be with reference to
a status quo or as we will discuss later anchoring, which implies that we always have
some anchor in our mind from where we try to relate our decisions when it comes to
make risky or certain choices.
And finally, we know that losses have more impact, about more than two times higher
than the gains that have impact on our decision making. With this I conclude this session,
next session we will focus on the more details about prospect theory given by Kahneman
and Tversky.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture – 08
Non-expected Utility Preferences (Contd.)
Hi there, welcome back to the course on Behavioral and Personal Finance. In this session
we will discuss more details about the prospect theory for which we had already
discussed the basic behavioral assumptions. And, we will also see how it is different
from the utility theory and the expected utility theory given by different economist in
classical economics as such.
(Refer Slide Time: 00:45)
This particular session will be covering two major topics, first, details about prospect
theory and second, how prospect theory improvises by replacing probabilities with the
decision weights. Now, here I can just start with a simple example that you might have
observed as well. If you notice people who are involved in risky behavior, let’s say as I
was giving example of people who smoke. Since, they know the risk of smoking, they
are involved in risky behavior; at the same time they are also involved in behavior which
are contrary to the risk seeking behavior and that is risk averse behavior.
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A simple example will be people who smoke also by insurance policies. If you know,
there are several people you might find who are involved in risky behaviors such as
smoking and at the same time they are also into risk averse behavior such as buying
insurance policies.
Basically, insurance policies are to mitigate the risk that they are undertaking in different
way; more contextual example would be a case of an investor. If you talk to some
investors who have some financial investments, you know that they have investment in
instruments such as shares, bonds, debentures, mutual funds, options, futures and other
instrument. At the same time they also have some money kept safely in the bank
deposits.
Now, these two types of instrument let say shares and bank deposits carries different type
of risk. Bank deposits are considered to be safe which means the risk is almost 0; share’s
investment is considered to be risky. So, this basically explains that people who are
involved in risk seeking behavior might also be involved in risk averse behavior at the
same time. Now, what could explain this particular behavior? Prospect theory has an
answer to this.
(Refer Slide Time: 03:27)
Prospect theory suggests that people’s behavior might be driven by different factors. We
have already discussed three measures three major behavioral assumptions, where we
know that people’s tendency to take risk would differ under losses and gains. Their
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perception of losses and gains and corresponding risk behavior and risk attitude is driven
by a reference point, that is basically the status quo and they also are affected by losses
more than by gains.
So, prospect theory explains this behavior of people having different type of investment
with different risk attitudes. Similarly, in general behavioral seen if we notice or as I
mentioned the example of people smoking buying health insurance would be explained
with the help of prospect theory. We already know that a person having risk averse
behavior would have a concave utility function and a person who is risk seeking
behavior will have a convex utility function. A person with risk neutral behavior which
means indifferent between risky and certain choices will have a straight line utility
function.
Prospect theory has improvised the utility function with a value function. And, as we
have known in utility calculation we assign probability to different outcomes. Prospect
theory has changed that probability with decision weights associated with the
probability.
Now, if I try to explain the example of risky behavior and risks averse behavior at the
same time; I could say that people assign different decision weights to the probability of
different events or outcomes that is why they take risky choices and risk averse choices
at the same time. For example, when people smoke, they know the consequences of
smoking which means they know that it might harm their health.
And, at the same time they buy health insurance because they know that if something
bad happens to them health insurance would be able to mitigate or minimize the risk
caused by the smoking. The problem here is individuals or human being in general is
myopic which means they fail to see beyond a certain point and that is reflected in their
decision making process as well and that is where decision weights actually becomes
more important.
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(Refer Slide Time: 06:41)
So, prospect theory has an improvised value function that is
V (pr, z1, z2) = V(P) = π(pr) x v(z1) + π(1 − pr) x v(z2)
…. (1)
if you see we have value of a prospect which is P given as probability and two different
outcomes. Basically, these are not outcomes as explained in terms of wealth in expected
utility theory, rather these are value associated with those wealth level because, prospect
theory is based on value function rather than the wealth utility function. So, here if I can
try to explain π(pr) is basically the decision weight associated with the probability pr
which we have already discussed in expected utility theory.
v(z1) is our different level of value of wealth. Similarly, v(z2) is again value of wealth
too and (1 − pr) is the probability that we have already discussed. So, prospect theory
explains this particular value function comprising of decision weights associated with the
probabilities as denoted in Equation (1) in terms of π. And, the probabilities associated
with different outcomes are given as pr and (1 – pr) and the outcomes are given in terms
of value of wealth, not the absolute wealth rather the value of wealth derived in terms of
the change relative to the status quo.
That is what we have observed in the experimental evidence given by Kahneman and
Tversky, where decisions are driven by value of wealth with a reference point. This is
given here as z1 and z2. This particular prospect theory can explain why certain
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behaviors are noticed under situation of risk and in a different case under situation of
certainty.
Let us go through an example that will explain why certain people behave differently
under same situation which means the example of people buying health insurance and
smoking at the same time would be explained with the help of this example.
(Refer Slide Time: 10:09)
Like previous examples, this example is also drawn from one of the classic research
papers published by Kahneman and Tversky. This example is intending to explain why
people buying lotteries are also buying insurance. Now, this is very much related to the
previous examples that we have discussed respective to the context. The example here
presents two choices and the choices are
D1 (Lottery): Choose between P11 (0.001, ₹5000) and P12 (1.0, ₹5)
D2 (Insurance): Choose between P13 (0.001, −₹5000) and P14 (1.0, −₹5)
D1 is a lottery situation where a person is buying a lottery and this lottery has two
prospects P 11 and P 12.
P11 has a probability of 0.1% and the outcome could be ₹5,000 and remaining
probability would be associated with the outcome ₹0. So, prospect 11 has a probability
of 0. 1% of winning ₹5,000, prospect 12 has 100% probability of winning ₹5. These two
prospects are associated with a lottery ticket. In second situation which is D2, it is related
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to the insurance buying decision and the prospects are P13 and P14. So, P13 has a 0.1%
probability of losing ₹5,000 and 99.9% probability of losing ₹5.
Now, think through these numbers and suggest what should be the choices that
individual should be making in these two decision situations. If I could relate to what
they have found in their research conducted on a set of people through an experiment;
the numbers and the results of the research indicate that for decision 1 which is a lottery
case majority of people experimented indicate their preference for prospect 11 over
prospect 12 which means the gains that they are going to get is ₹5,000 with a probability
of 0.1% which is effectively a very low probability event. And, this is consistent with the
risk seeking behavior which means they are taking risk.
Under decision 2 which is D2, most of the people experimented prefer this prospect 14
over prospect 13. Prospect 14 has two outcomes which is ₹5 of loss with 100%
probability and ₹0 loss with 0 probability which means a sure shot loss of ₹5. Whereas,
prospect 13 has an outcome of 0.1% probability for losing ₹5,000 and this particular
preference of prospect 14 over prospect 13 indicates the risk averse behavior. Basically,
this comes to an interesting observation which suggests that people exhibit risk averse
behavior for gains and risk seeking behavior for losses when it comes to a high
probability event. And their behavior changes to risk seeking for gains and risk averse
for losses when the outcome probability is low.
This basically implies that in case of high probability event we are risk averse for gains
and risk seeker for losses. And, in case of low probability event we become risk seeker
for gains and risk averse for losses. This particular example explains why people buy
lottery ticket and insurance policies at the same time, because they assign different
weights to the probability associated with the events.
For example, a lottery or insurance there are certain probabilities associated with success
and failure and that is why the decision weights associated with these two outcomes
could be biased because of individual preferences. The same can be explaining the
example that we had discussed earlier, if you could recall, people’s tendency to buy
insurance policies right after natural disaster. So, they basically assign high decision
weights to the recent events and that is why their decision to buy insurance policy is
driven by the experiences that they had recently in terms of facing the natural disaster.
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A similar example if you could recall was discussed earlier where people who had faced
difficult times in a stock market investment. Let’s say people who have seen the stock
market crisis of 1929; they have refrained from investing in stock markets for many
years. But, people who have experienced prosperity during stock market boom of late
1990s, they have always been optimistic and aggressive about stock market investment
for years to come.
So, this basically explains why our decisions are driven by our recent experiences and
the choices that we make in terms of risk averse behavior and risk seeking behavior. The
answer is we assign different probabilities with decision weights and those decision
weights are actually driven by our past experiences in fact, our recent experiences,
because we could assign higher decision weights to our recent experiences than to older
experiences, as we have already noticed that most of us are myopic in terms of decision
making processes.
(Refer Slide Time: 17:21)
Having discussed all these examples of risk averse and risk seeking behavior under
different circumstances of losses and gains, we have also understood that most of our
decisions are driven by a reference point which is basically a relative distance from the
status quo translated in terms of losses and gains.
And, we have discussed that our decisions and risk attitude is suffered with a situation
where losses affect us more than the gains. This comes to the summary of prospect
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theory that can be exhibited through a couple of graphs. Let me try to show this with the
help of two exhibits. One exhibit suggests how our value function is observed when it
comes to a different level of wealth in terms of losses and gains.
So, the value curve is denoted as the vertical axis and change in wealth is denoted as
horizontal axis. Prospect theory suggest that our value function for positive value and
positive wealth would be denoted such as this and for negative value and negative wealth
it is steeper denoted as this. We have also discussed briefly when we combine risk
seeking and risk averse behavior under different circumstances, our behavior could be
our utility function could look something like a concave curve and a convex curve in
terms of risk seeking and risk averse behavior.
Now, when we try to conclude what Daniel Kahneman and Amos Tversky research on
different situations of losses and gains indicate, it suggest that the extent of change in
wealth and the level of probability associated with the outcomes determine whether we
are going to behave in a risk seeking or risk averse way and that can be shown with the
help of the following matrix:
(Refer Slide Time: 20:41)
So, if we have a situation where probabilities are indicated in terms of high and low, this
is low probability and this is high probability. Similarly, value is also denoted in terms of
change of wealth from a reference point; so, this is high value and this is low value. So,
when it is about a situation where the probabilities are low and values are also low; then
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our behavior is basically in the nature of risk averse as we have seen through a previous
example.
If we have high probability of low value then our behavior would be risk seeker. So,
essentially when I talk about low value it implies that it is losses in value from a
reference point and if it is high value it implies gains which means the change of wealth
is positive from a reference point. Similarly, if we have low probabilities with gains or
high value from a reference point our behavior would be of risk seeking nature. And, if it
is about high probability with high value or high gain our behavior would be risk averse.
So, the matrix basically presents the summary of prospect theory in terms of individual
behavior when it comes to making choices related to risky and certain situations under
different level of probabilities.
(Refer Slide Time: 23:35)
To summarize the discussion that we have in this session, we have discussed about the
basic framework of prospect theory which is basically a positive theory in terms of
explaining how people actually behave. It is also about our decision making framework
that captures decision choices based on the value rather than utility or wealth and
decision weights rather than probabilities associated with the outcomes. But, this
particular prospect theory also presents a fourfold pattern of risk attitude.
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The fourfold pattern of risk attitude is the same that we have just explained, the four
blocks of a matrix where our decisions would not be consistent under high and low
probability event where the outcomes are losses and gains. So, we exhibit as individuals’
non-consistent behavior under risky and certain situations and under losses and gains.
With this we come to a conclusion that prospect theory is certainly closer to the realistic
decision making framework than the expected utility theory that has been proposed
under neoclassical economics. We will see more aspects of prospect theory and how it is
related to the financial decision making in coming sessions.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture – 09
Prospect Theory and Behavioral Biases
Hi, there. Welcome back to the course Behavioral and Personal Finance. In this module,
we will discuss the Prospect Theory and its application to finance and financial decision
making. So far, we have learnt about how prospect theory is an improvisation of the
expected utility theory that is very standard and how prospect theory can help us making
decisions which are more realistic and close to the real world situations.
In this session, we will discuss two major topics: one is framing effect and another is the
reference point. Before we move on to the topics let me give an example.
(Refer Slide Time: 01:11)
Suppose, you are given some amount of money and there is a coffee mug with the logo
of the university and you are asked to pay a price for this coffee mug. What price would
you like to pay for it? Make a mental note and imagine a different situation. Now, in a
different situation you already own the mug with the university logo on it and you are
asked to trade this mug for some amount of money.
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These are two different situations where in one case you own the money and you want to
buy the coffee mug, whereas, in a different situation you own the mug and you have to
quote a price for which you can trade this mug for. If you think carefully you would
realize that the prices or the economic value for the mug you would decide would be
different in these two scenarios.
This is where prospect theory comes in picture and explains why people value things
differently in different situations. We have already learnt that people are risk averse in
general and the losses or the situations with risk and uncertainties are valued completely
differently than the situations which are certain and in terms of gains.
We have discussed earlier that under prospect theory losses loom larger than gains which
means if you have something to lose you would quote a value which is different from
you have something to gain of the same economic value. In the example of coffee mug,
you have coffee mug with you and you would not like to part away with that is why you
would quote a higher price than the situation where you have to buy the coffee mug. This
phenomenon basically is known as endowment effect.
We will try to discuss with some examples the situations of similar nature that can be
explained with the help of prospect theory assumptions. The first example or the first
phenomena that we are going to discuss here is the framing effect.
(Refer Slide Time: 03:53)
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Now, what do I mean by framing effect? Basically, when we talk about framing effect
we talk in terms of a decision frame which basically is decision maker’s view of the
problem and possible outcomes. Implying that you have a situation where you have some
problem to handle and the possible outcomes if you go for certain decision path.
Now, that decision frame basically can be influenced by certain other characteristics. For
example, how the possible outcomes are presented to you would determine how you will
evaluate the outcomes and finally, make a decision. So, presentation of outcomes is an
important factor. At the same time how people perceive the outcomes and the problems
would also be important and of course, the individual characteristic of the decision
maker would be equally important.
So, when you are taking a decision within a decision frame, the presentation of the
decision and the possible outcomes and personal characteristics as well as the perception
of the problem in terms of decision maker’s point of view would be important in terms of
deciding the decision frame.
If we go by the standard expected utility theory, the choices irrespective of the
presentation matter similarly for the decision maker whereas, in real world as explained
by prospect theory decisions makers choice changes because of the change in frame
implying that if outcomes or possible choices are presented differently, the decision
makers ultimate decision would be influenced. Let’s try to understand this with some
examples.
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(Refer Slide Time: 06:05)
Here I am going to explain an example which is drawn from Daniel Kahneman and
Amos Tversky research work and it is basically explaining the implication of prospect
theory in non-monetary terms.
Imagine a situation where there is a country and the people in the administration are
planning to take a measure which will handle a disease and its possible impact. So, the
situation here is the country is planning for the outbreak of an unusual disease that could
possibly kill 600 people. Scientifically robust methods suggest two possible approaches
– A and B.
If the country goes with decision A, it will be able to save 200 people and if the country
goes for decision B it will be able to save 600 people with a probability of one third and
there is another remaining probability two-third that there will be no person saved from
that disease. If you are in this situation where you have to take a call between choice A
and choice B what would you favor?
The result of the experiment conducted by Kahneman and Tversky suggested that
majority of people here go for decision A which means people go for decision which will
give them a sure shot saving of 200 lives from that particular disease. This basically is
consistent with the risk averse behavior of individuals when it comes to certain decisions
and its outcome. This particular example is given in terms of survival frame. Let us
change the scenario and create the same situation in a mortality frame.
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(Refer Slide Time: 08:25)
A second dimension of the same problem would be imagining a country that is trying to
prepare for the outbreak of an unusual disease which could again possibly kill 600
people and there are two alternative methods. These two methods are scientifically
robust and the methods are C and D. If the country goes for method C, 400 people will
die and if the country goes for method D there is one third probability that nobody will
die and two third probability that 600 people will die.
Now, if you are a rational human being and you could compare the situation with the
previous example, you could understand that there are similar situations in these two
scenario as well, but the experimental results by Daniel Kahneman and Amos Tversky
suggest most of the people on whom experiment was conducted go for decision D.
Now, this particular decision D which is basically one third probability that no one will
be die and two third probability that 600 people will die is consistent with risk seeking
behavior which implies that when people face a situation where they are going to lose
something they look out for risk seeking behavior and this is very much consistent with
the prospect theory.
Now, these two scenarios explain how people behave under sure outcome and how they
behave differently under risky and uncertain outcomes. Experimental results over the
years suggest that this behavior is similar and observed in very much consistence across
students, professors and physicians alike.
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If you analyze this particular example a bit more carefully you would understand that
choices shown here are presented differently whereas, the outcome or the possible
outcomes of all the choices are consistent and same. But, thus framing of these two
examples are done differently.
In first case where choices A and B were presented, the framing was survival frame
which means people have to decide in a situation where we start from full mortality and
move towards partial survival which is basically a gain because whenever we talk about
saving life essentially we are talking in terms of gains and in another scenario C and D,
we were talking in terms of full survival and moving towards partial mortality.
So, when we talk about mortality or conceding death or casualty basically we are talking
about losses and prospect theory has already shown that when it comes to valuing
different alternatives we consider losses stronger than the gains and that is why in this
case also losses in terms of lives loom larger than gains in terms of saving lives.
And, if you could recall we remember that prospect theory as explained by a graph
basically suggest that the curve of gains is less steep than the curve of losses. Just to
highlight and the situation that we have been talking in these two examples we can refer
to the prospect theory graph that is shown as follows:
(Refer Slide Time: 11:07)
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So, we know that the prospect theory graph can be shown as a 2-dimensional curve
where basically we talk in terms of value which is positive and negative and we talk in
terms of change in wealth which is again and negative and we know that if we move
from origin towards gains the shape of the curve is less steep than the situation when we
move towards losses.
If we try to explain in terms of prospect theory with reference to these two examples a
loss of certain amount would have different value than a gain of same amount. This is
what prospect theory shows and we can consider through these two examples – one in
terms of mortality and survival frames and the another example of coffee mugs where
you have something with you and selling that coffee mug means losing.
So, when you try to lose something you value that loss almost twice more than the same
amount of gain you are going to have. These two things as discussed in examples suggest
that people make decisions with reference to a particular status which can also be known
as status quo.
In the graph that I have just shown that status quo is basically the central point which you
can refer to as reference point which means, people’s decision basically depends on
whether you are moving upward from the reference point in the region of gain or you are
moving downwards towards the loss region.
If you are moving towards loss region, you would value something stronger than the
same amount or same volume of movement in gain region. Let’s try to explain this
reference point phenomena with the help of another example.
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(Refer Slide Time: 16:13)
When we talk about reference point we basically mean the status quo or an anchor and
this is very much relevant in terms of financial decision. If you remember some
examples we have discussed earlier, we know that if we buy some something for a price,
let’s say a share of a company. If I have purchased the share of a company for ₹100 and I
am holding it for quite some time, meanwhile the price of that particular share in the
market keeps falling and currently it is available at ₹98.
So, I have two choices either I keep holding that share for which the value is low or
being lost or I can sell that share for ₹98 and realize the loss. Now, if you relate this
example with the phenomena that we have just discussed most of us would not like to
sell that for a lower price and rather wait for the price to recover to ₹100 and then
probably we would like to sell. This is basically known as anchor. So, most of our
decisions are stuck to an anchor or status quo and whatever decisions we are going to
make basically mean movement away from that status quo or anchor or in these terms
the reference point.
Now, let’s consider a similar situation here. Suppose an outcome is perceived a positive
or negative deviation from the reference point. In this example imagine a person who is
playing a game and so far he has already lost $140. Now, this is the last bet of the game
and after that the game would be closed. So, the last bet would cost $10 additionally and
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the last bet has an odd of 15 is to 1 which means if you win you will get 15 times the cost
or if you lose you actually lose the cost of that particular bet.
So, basically the decision choices here you have is you have 15 is to 1 means either for
this $10 of cost you would get $150 or you would lose $10 altogether. Now, this
situation shows that for that particular player who has already lost $140 in the game
during the day and this is the last $10 he is going to bet on.
There are two possible scenarios; in one scenario the person would consider that he
would win and he would get $150 which would basically break even his total loss
implying that $140 of loss so far and $10 of cost for this particular last bet total of $150
if he wins will be recovered which means there will be no profit no loss and he will
break even. And if he loses he loses $150 because so far he has lost $140 and if he loses
the last bet this last $10 would be added to the loss and it will become $150.
In another scenario, if he gains he would get $150 and if he loses, he will lose only $10.
Depending on how he considers the reference point or how he decided the reference
point for his decisions, his scenario would change. Let us call these two scenarios
integration and segregation. So, if he is following integration it implies that he would
consider the total loss for the day as the loss and accordingly he will make a decision and
if he consider follows segregation the last bet would be the independent bet for which
$150 of the gain versus $10 of loss.
Now, imagine yourself in the situation if you are facing two different scenarios in one of
which is basically $150 of gain versus $150 of loss and in another scenario $150 of gain
versus $10 of loss how your risk attitude would change? Now, in these two scenarios
depending on whether the person is following integration or segregation of risk or the
losses, his risk taking ability would change.
In cases of integration peoples risk behavior turns towards risk seeking and they would
consider the losses and they would start taking higher risk. When it comes to segregation
people exhibit risk averse behavior because it is in the domain of gains.
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(Refer Slide Time: 22:23)
Now, if you try to relate this with prospect theory again and with help of the graph that
we had discussed in one of the last sessions we know that situations could be on twodimension, one is probability of outcome which is high or low and the value of the
outcome: it could be gain or losses.
Now, the prospect theory suggests that most of our behavior is basically fourfold pattern
that we exhibit. When we have low probability and loss reason, basically the decisions
which carries low probability and loss, our behavior is basically risk averse whereas if
we are facing low probability event with gains our behavior becomes risk seeking and on
the contrary, if we have high probability loss outcomes our behavior is risk seeking. And
if we face situations with high probability and gains we behave risk averse which is
basically nothing, but sure shot outcomes. So, when we face sure shot outcomes our
behavior is risk averse.
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(Refer Slide Time: 24:13)
This particular phenomenon can be explained with the help of another graph that is
directly coming from prospect theory. If you could relate that game example where
person either integrates or segregates the losses or the gains. As you integrate your
outcome after a win you move up in the value function on the right hand side and if you
integrate after a loss you move down to a value function on the negative region.
And, if you segregate which means you are changing your reference point and going
back to that particular reference point again and again. You can see the impact of these
behavioral changes in different scenarios. And, some of the classic examples are house
money effect which basically implies that when you are in a casino and you have won
few bets in a row you start taking higher risk.
So, house many effect indicates the tendency to assume higher risk after a prior gain.
And, if you have losses before and after that you are making a decision and you are
trying to integrate you would show a phenomenon that would basically determine your
risk taking ability and this is known as breakeven effect.
So, these two effects are most common when you talk about integration or segregation of
value in terms of losses or gains. And, most of the time we always go back to the
reference point again and again be it the financial decision in stock market or our
household financing decisions or any other decision where we have some economic
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values attached and that is why keeping in mind the prospect theory becomes more
important. These are two major points that we have discussed in this session.
(Refer Slide Time: 26:37)
To sum up basically we learnt about how prospect theory can be applied in terms of
framing effect where decision frames influence our final decisions and it is affected by
the presentation of the outcomes and perception as well as personal characteristics of the
decision maker.
We know that framing of choices matter. For example, if you have seen the document
given along with the insurance policy you know that you have to go through a lot of
terms and conditions that are applicable for buying that insurance policy, but most of us
do not probably read it thoroughly. Now, if only that terms and condition document is
simplified and summarized in a table somewhere in the beginning or at the end probably
that would definitely ease out our decisions.
So, what basically implies that if the presentation of outcome is changed to more
conducive way, probably it will make the decision maker’s job easy. We also learnt that
decision maker’s job is always with respect to a reference point which in most cases is
the status quo or an anchor. People also tend to segregate or integrate losses or gains and
based on that their reference point change.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 10
Prospect Theory and Behavioral Finance
Hi there, welcome back to the course Behavioral and Personal Finance. In this session
we will touch upon two important issues of the application of behavioral theory of utility
which is basically the prospect theory. So, far we have learnt that prospect theory
explains how individual’s behavior changes depending on the certainty and uncertainty
associated with any outcome. And we have also learned that presentation of choices or
outcomes determine the people’s ability to undertake risk and decision.
(Refer Slide Time: 01:00)
This particular session covers two topics. We will touch upon the mental accounting bias
and few other issues related to behavioral finance. So, far we have known that framing of
choices and framing of decision situations affect individual’s decision making process.
Let’s try to contextualize this particular bias towards more of financial decision making
perspective. When we talk about mental accounting we basically talk in terms of mental
or cognitive blockings of individual decision making processes.
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(Refer Slide Time: 01:37)
We know that decision making process is very complicated and as we add more
cognitive complexities, the decision making process for individuals become even more
complicated. The reason behind these decisions are complicated are as follows. We
know that we are faced with several outcomes with varying probabilities; we know that
there are many outcomes of our decisions and we tend to assign different probabilities or
likelihood of those outcomes.
So, the uncertainty involved in those possible outcomes becomes even higher. We know
that situations that we face might be presented differently in different circumstances and
the presentation of outcomes would determine whether a person is going to take that
decision or not. And at the end we all are human beings and in the words of Simone, we
are suffering from bounded rationality which means we have limited ability to process
the information and if we are bombarded with a lot of information our decision making
process gets affected.
So, these are three major reasons for which the decision making becomes complicated.
We as human being tend to evolve through different situations and mental accounting is
one such situation, which basically decision maker undertakes to make the decision
making process manageable. So, Richard Thaler in his work in 1999 defined mental
accounting as a set of cognitive operations used by individuals or households to
organize, evaluate and keep track of financial activities.
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Now, if we go little further, basically mental accounting is most relevant in terms of
household and personal finance decisions. Let’s try to understand how we keep different
mental accounts for different set of its activities with respect to economic and financial
decisions.
(Refer Slide Time: 04:20)
Suppose, you are managing your own money, basically you are making financial
personal finance decisions or household finance decisions; we tend to keep a separate set
of expenses and similarly for investment and incomes in different blocks. We could keep
it physically or in our minds.
So, we keep let us say maintain three different accounts one account is meant for
expenditure such as food, rent, vacation, entertainment. Second account is meant for
investment; let us say savings for retirement or savings for education or maybe buying a
car or possibly savings for marriages. So, these are certain investment to be incurred in
future and the third account is basically income where we try to associate salary, bonuses
or other income that we get.
Most of us maintain these accounts in our mind. So, these are mental account which is
basically cognitive constructs rather than real account. When I say real account I mean
that when we try to maintain separate accounts for let us say entertainment, we do not set
up specific bank account for entertainment or vacation rather we maintain, let’s say in
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most cases one account only in our bank, but the expenses that we incur on different
activities are associated with each of these activities separately.
The underlying assumption is funds are fungible which means you can substitute 1 rupee
today with another rupee coming from a different source and that is why it is fungible,
which basically in a lighter way you can known as money does not have color, caste or
creed and it does not discriminate. But in real, money does have these things, which
means you in your mind maintained separate accounts and treat money separately in
different context.
Let me cite an example here. Suppose you have ₹100 of money and you want to invest in
three different investment of venues let’s say stock market, bank deposit and precious
metals. So, you invest ₹50 in stock market, ₹20 in bank deposit and ₹30 in gold. So, I
have ₹100 of investable fund and this has been invested in ₹50 in stock, ₹30 in gold and
₹20 in let us say FD. This could be in terms of percentage or in terms of real money.
Now this is at time 0. Now time 1 your stock market has grown of from 50 to 55. So, the
value of your stock investment becomes ₹55, the value of your gold in investment
becomes ₹25, you lose some money on the value of gold and you get ₹22 rupees value in
your fixed deposit basically you have gained ₹2.
So, if you look at the investment in in terms of segregation of the losses or gains, you
actually hold a portfolio or an investment value worth ₹102 which is definitely higher
than the initial investment that you had made on time 0, but most of us tend to integrate
our losses also or in the same time we tend to segregate our losses or gains.
So, here in this case probably your decision to buy more gold or invest more money in
fixed deposit or invest more money in stock market would be determined by the
experiences that you have in these respective investments. So, in this context since you
have had a better experience in investing in stock market, next time if you get some
additional money to invest, you would allocate more funds to stock market and less
funds to gold which might not be beneficial in next term; which means in next period
probably stock market would not do as well and gold market do better.
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So, this is how we treat our money differently and this is because of the cognitive
construct that we have in our mind in terms of mental accounting separately for each of
these avenues.
Let us try to understand this with a more sophisticated example.
(Refer Slide Time: 10:26)
Suppose, you are in a situation where you have decided to go for a movie and the ticket
is priced at ₹100 per ticket. So, if you want to take admission in that movie you have to
pay ₹100. As you enter the movie premise the theatre, you found that you have lost ₹100
of note from your wallet.
Now if I ask you whether you would still pay ₹100 for a ticket and go for the movie,
what would be your answer? Take a minute think about it and keep that answer in your
mind. And as you think over this particular situation where you have to decide whether
to go for a movie or not or even after losing ₹100 of note, let me ask you another
question with similar yes or no response.
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(Refer Slide Time: 11:30)
Now the situation here is you are again going for a movie and you have already paid the
ticket price which is ₹100 and the moment you entered the movie theater you found that,
the ticket has been lost which means the seat was not marked and the ticket cannot be
recovered. So, you have lost the ticket effectively. Now the question here is would you
still pay ₹100 for another ticket and go for a movie.
These two situations in terms of economic value lost are same, in first case you lost ₹100
from your wallet and in second case you lost the ticket that you have purchased for ₹100.
So, the lost economic value is same in both cases that is ₹100. So, the certain amount of
money ₹100 has been lost and it is irrelevant whether it has been lost in terms of a
currency note or the ticket and you have to decide whether the theatre experience is
worth ₹100 or not.
In the experiment conducted by Kanheman and Tversky, they found an interesting
observation. If you look at the outcome of that experiment you see that the situation
where people lost ₹100 of currency note and they are asked if they would buy a ticket, 88
% of respondent would say yes they would buy their ticket and go for a movie and here
basically you can relate to the previous example that shows people are segregating their
losses.
In second scenario, where the ticket was lost and they are asked if they would buy the
ticket again 46 % would agree that they would buy which means majority would say that
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they would not buy the ticket because they are integrating the losses. So, effectively they
are tagging the lost ticket to the entertainment account and that is why they are not
willing to buy another ticket for watching that movie.
(Refer Slide Time: 13:47)
This is a very simple and interesting example of mental accounting. We have seen that
loss of ₹100 which was lost from wealth account which is basically your wallet in terms
of currency notes is not linked with the entertainment account that you might be
maintaining in your mind and that is why people agree to buy a ticket again and go for
the movie.
In second scenario, where the ticket was lost people had already purchased the ticket and
their ticket purchase account was opened. So, it could be closed only if you completed
watching the movie. Now, the situation is you have lost the ticket and that is why
account is closed. So, once the account is closed buying an additional ticket would mean
that you are opening another account.
So, if you have allocated certain funds for entertainment, buying another ticket would
mean that you would exceed that allocation of money for entertainment whereas, in the
first case it was not allocated to entertainment as yet because he had not purchased the
ticket and that is why you would probably agree to buy a ticket even after losing ₹100 of
currency note.
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So, mental accounting influences our personal and financial decisions very much and we
know that it also helps in exercising self control. So, if you have heard somewhere that
do not dip into retirement savings or pay for luxuries like vacation trip out of the savings
that you have made, these are basically tools for self control and creating mental
accounts to help you make better personal finance decisions.
(Refer Slide Time: 15:44)
When you talk about the implication of these biases and heuristics such as framing effect
or reference point or mental accounting, we basically try to understand how these things
would affect the financial decision making in individual or household context. Now
when we talk about behavioral finance, we essentially mean the integration of
psychology with financial decision making.
Now, that financial decision making would be relevant for corporations as well. As we
know financial decision making in case of businesses and corporation would have
implications on several aspects, three of which has been mentioned here. So, let me try to
touch upon the issues related to financial decision making with respect to asset pricing
which basically is finding the right value of an asset or corporate finance which is
basically the financial decision making for corporation and businesses and then personal
finance.
These behavioral biases and learning from prospect theory or similar theories coming
from behavioral economics and finance domain essentially mean a lot for financial
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decision making in terms of corporations and businesses. So, if you have heard of these
terms its fine, if you have not let me try to explain some of these terms with the help of
learning from the previous lessons. So, if we talk about behavioral finance and it is
implication in asset pricing, one of the most important phenomenon that we see is pricing
anomalies.
So, when we talk about pricing anomalies we essentially mean that, a particular asset
being priced differently by different set of people. So, in the context of a stock market,
let us say there is a share of a company which needs to be priced for selling or buying.
Now there are two different sets of investors, one set of investor is let’s say retail or
individual investors; another set of investors is basically institutional investors. Now
these two investors have different attributes meaning that they will have different amount
of money to invest, they will have different investment horizon.
They should have different risk bearing capabilities and they will have different
information processing abilities. And that is why the value of the asset that they arrive or
calculate would be different and this will result in one set of investors being right and
another set of investor going wrong. And the person or the set of investor that goes
wrong would probably lose money in the stock market.
So, pricing anomaly basically implies that different people have different understanding
of the valuation of assets and that is why they might make money or lose money in the
process. Similarly another behavioral phenomenon that we see in asset pricing context is
IPO performances. So, IPO is Initial Public Offering which is basically the first time a
company offers the share of itself and that is sold to common investors for which the
price prices are determined by the standard processes.
Now, when the IPO is released and people are asked to invest their money in the IPO,
they arrive at a price at which the share is listed in the stock exchange. Now the moment
share is listed in the stock exchange, it becomes public and then there are multiple people
trying to trade that particular stock. Depending on the perception of those people about
the company and its valuation, they would quote a higher or a lower price.
In many cases we have seen that right after IPO listing share values or the prices of the
share go down and people who have invested lose money in the process. Similarly
another behavioral phenomena that is commonly observed is investor sentiment that
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determines the asset pricing again, because how people perceive a particular outcome or
the situation would determine how much they are willing to take risk and how much they
are willing to pay in terms of price and that is dependent on the investor sentiment
whether about a particular outcome.
So, there are several other behavioral phenomena here which can influence decision
making in asset pricing context. Similarly, if you talk about decisions with respect to
corporate finance, we know that markets mood and investors behavior determine
whether it is right time for an IPO or people who trade in stock market understand that
they sometime behave in terms of herd behavior and maybe we can also observe
overconfidence and other similar behavioral biases where people behave non rationally
and that will affect the overall economic gains or losses for the investor as well as other
stakeholders in the market.
Behavioral biases influence significantly too in individuals and household and that is
why personal finance decisions are mostly affected by how we understand the situation
and how we perceive a particular decision choices. Some of the major behavioral biases
that we face in personal finance include loss aversion which we have already discussed
where people do not take to under assumed loss and to avoid loss they start taking higher
risk.
We have also understood briefly about narrow focusing of individuals, which essentially
is a myopic decision making framework where people do not think beyond certain point
of time and they miss calculate the probabilities or the possible outcomes and in the
process they lose money or gain less than optimal money.
In markets we have also seen that people are return chasers which means that people go
for winners and pay over price and they sometimes lose money in the process, because if
you have purchased something for the higher price than its actual price, you are less
likely to gain positively in future. Another behavioral phenomenon that we observe in
personal finance decision making is home bias which is again individual bias towards
preferring or favoring familiar or known outcomes and giving higher value to them, and
avoiding the situations which are more uncertain and assigning lower value to them.
Situations like procrastination or wishful thinking or overconfidence are another few
examples of behavioral biases that individuals and households suffer when they take
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personal and financial decision making. Essentially what I mean to indicate here is,
having learnt the implications and applications of prospect theory in individual economic
decision making, we could shift our focus towards more financial decision making in the
context of individuals, household or corporations and these are some of the biases that
we might observe very frequently.
So, in next few sessions we will touch upon these biases in more details with several
examples and different context.
(Refer Slide Time: 25:11)
In this particular session we have discussed two major concepts; one being mental
accounting where we observe that people create cognitive constructs and they maintain
separate mental accounts for different activities with economic value and this is done in
order to make the decision making process more manageable.
Mental accounting can be beneficial for individuals if exercised with self-control. It is
more important for personal and household financing decisions. We have also touched
upon different biases and heuristics with respect to corporations and in financial markets.
This is basically the beginning of a discussion on behavioral finance topics where we
learned that psychological factors affect asset pricing in financial markets, corporate
finance decisions and of course, personal finance decisions.
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We have just exhibited few biases and heuristics that might be important to understand
before we expedite our discussion to behavioral finance and financial decision making.
This is all for now.
Thank you very much.
113
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 11
Prospect Theory and Behavioral Finance (Contd.)
Hi there, welcome back to the course Behavioral and Personal Finance. So, far we have
discussed about the standard utility theory and how prospect theory is deviating from the
standard utility theory in terms of considering decision making scenario with risk and
uncertainty. Earlier we have discussed the implication of behavioral biases in standard
financial decision making and we have also touched upon various issues and factors that
might affect the decision making with respect to asset pricing, corporate finance and
personal finance.
In today’s session we will discuss about how these factors affect the market efficiency
hypothesis which is basically the backbone of finance theory. And, we will also try to
understand in mathematical terms how this irrational behavior of investors or deviation
from the expected utility theory can influence the return generation process in financial
markets.
(Refer Slide Time: 01:31)
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The topic that we are going to discuss today are the market inefficiency or rather the
issues with market efficiency hypothesis in the context of behavioral finance. And we
will also discuss in this session some basic mathematical framework of Shiller’s model.
(Refer Slide Time: 01:53)
In last session we had discussed how psychology when mixed with finance effect the
decision making in financial markets where we see the economic agent suffering from
several biases, in terms of, in appropriate valuation of financial assets and in corporate
finance context taking suboptimal financial decisions and similarly in personal finance
context individual investors and retail investors suffering from several behavioral biases
and heuristics.
If you look at the standard finance theory, most of the theories are based on some
standard economic assumptions where economic agents i.e. individuals are supposed to
undertake decisions which are in their based interest.
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(Refer Slide Time: 02:55)
Basically the major assumptions of efficient market hypothesis are as follows:
1. all economic agents, basically in terms of financial markets these are investors,
are always rational, which implies that they always consider all the information
and make decisions which are in their based economic interest.
2. Another assumption based on which efficient market hypothesis was developed is
investors’ errors are uncorrelated. This means that when there are some investors
who make some mistakes on the positive side, there are similar set of investors
who make in mistakes on the negative side and thereby the mistakes are cancelled
out and effect on the prices are very negligible.
3. And, another assumptions based on which the efficient market hypothesis was
proposed is unlimited arbitrage.This particular assumption assumes that markets
offer unlimited arbitrage opportunities to investors and those with arbitrage
opportunity can make suboptimal returns and thereby can beat the market in long
run.
But, when we talk about market as a whole we know that there could be several types of
investors in the markets. If we keep it simple and start with the assumption that markets
comprises of two major categories of investors, one being smart money investors and
second: noise traders.
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So, smart money investors are those people who consider all the information into their
decision making process, they always rely on research and analysis before they take final
decision. They incorporate all information available and arrive at the right valuation of
the financial assets that they consider for investing or buying. This means people’s
behaviors are uncorrelated and their decisions are random in their own context and that
will lead to negligible impact on prices of securities. Securities here imply the assets of
financial natures such as stocks, bonds and other financial securities.
The other set of investors who are active in stock markets are noise traders. Noise traders
are those people who take their investment decision based on some heuristics or intuition
or guts. They really do not care about the information that they can get or the research or
advice that they can obtain from different reliable sources.
One example could be housewives trading in stock markets, they probably would not
like to go into detailed research of any company and rather go with the gut feeling before
they invest in any stock. Such investors basically follow similar psychology that result in
similar judgment errors. When there are judgment errors of similar nature in large
volume, that will result in correlated behavior and that will further lead to the systematic
deviation from the normal.
Basically, it implies that when there are too many people behaving in a similar fashion
that will lead the valuation or the prices of financial securities in a particular direction
and that deviation from the standard or the normal would probably be not justified by the
fundamental data. These two set of investors when interact, the markets show different
characteristics. Smart money investors always rely on financial assets with fundamental
valuation whereas, noise traders rely on news, information, biases, heuristics, rumors or
anything that comes in their decision making process.
If you recall, we discussed in the very beginning of this course was how information
travel from one corner of the market to another corner and how it deviate people from
taking the right decision. If you remember this example we understand that when people
get access to information they interpret that particular information in their own way.
And, in the process probably sometimes they make mistakes which are systematic and
when there are several people of this kind that will drive the market towards a rational
valuation.
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One of the basic arguments that Robert Shiller give was how these irrational investors or
the investors with irrational expectations and valuation could affect the pricing of the
market and that makes the situation for rational investors, who are basically in terms of
Robert Shiller, smart money investors’ valuation even more difficult.
(Refer Slide Time: 08:58)
When we talk about Robert Shiller model of financial asset pricing we will start with the
assumption that market comprises of two major sets of investors, smart money investors
and noise traders and going by the standard economic rule that suggests that supply
equals demand we can understand that the market clearing argument would lead us to
explain this in a very simplistic framework such as
… (0)
Where
qt = the demand of smart-money investors for stocks as a %age of total demand at time t
nt = the percentage of total demand for stocks by the noise traders at time t
If I try to explain this particular framework in more detailed way we will get to
understand how smart money investors would find it difficult to find the right valuation
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of any financial asset given that noise traders behave in a very systematic erroneous way
and that makes the whole pricing framework even more difficult. Let me try to show you
this particular equation in a more detailed way that will help us to understand how
investor sentiment or rather investor behavior would become an important input for
pricing of the financial assets that we are considering for investment.
So, I was telling that according to Shiller’s model the market comprises of two sets of
investors, one being noise traders and another set of investors being smart money
investors.
(Refer Slide Time: 11:11)
So, going by the argument given by Shiller if we represent them as qt and nt it should be
expressed as equation (0) because of the market clearing argument where supply equals
demand. We can say that if demand from smart money investor that is
qt
can be
expressed as expectation of the return for a smart money investors minus the expectation
of return represented as ρ divided by let's say φ which is basically the risk premium.
So, if I can explain the notations here, ρ represents the expected return and φ represents
the risk premium for the equity income. Now, if we can denote this particular equation as
equation 1 and we know that for noise traders the demand can be explained as
nt which
is the percentage of demand of stocks by the noise traders, we know that the total value
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of a stock demanded by noise traders could be a function of the demand for stocks which
is the number of stocks or percentage of stocks times the price demanded at time t.
So,
yt= nt * pt
…(2)
Demand for stocks by noise traders could be written as total value of the demand by the
noise traders divided by price by price of the stock that they are demanding. So, if we
can go back the argument we understood in the very beginning of this course that price
of any financial securities is basically nothing, but the present value of all future cash
flows and when we talk about cash flows associated with financial securities such as
stocks it could be the present value of all future dividends.
So,

Pt  
k 1
Et * d t  k
1 
if we can denote this in terms of price of a financial security at time t it could be the
expected dividend at time t divided by (1 + δk) if the time period considered here is k and
this being summed for total time period that we are considering here till infinite period.
So, we are considering here infinite period because when we start investing in a
company’s equity which is basically share of a company we assume that the company is
going to be there forever and we are going to get the dividend from that company’s
investment for forever.
And, that is why we consider this pricing model which is basically also known in finance
theory as the dividend discount model as pt is equal to the sum total of all dividends
receipt to be received in future divided by (1 + δ) here which is basically the discount
rate. So, if I can give further explanation, δ is the discount rate and d is dividend to be
received in dividend to be received in future and pt of course, is price of the share.
So, we understand so far that according to Shiller’s argument total demand would be
equal to 1 and demand by noise traders can be expressed as nt is equal to yt which is
basically the total value of the shares being demanded divided by pt which is the price of
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the share and demand by the smart money investors can be expressed as qt which is a
function of return expected and the risk premium that they are seeking in terms of equity
investment.
Now, if we go back to the argument to this particular equation let’s say equation 0. So, if
we try to substitute, so let us say if we substitute using equation 1 and equation 2 a.
We get
Et * Rt 1


yt
1
pt
… (3)
So, this is just the substitution of the term qt and nt in the market clearing argument
modeled by the Shiller’s framework.
Now, if we try to extend this argument and rewrite this particular function. We know that
return of any asset that is expectation of return at time (t+1) is return on capital
appreciation which is basically difference in price and the dividend expectation divided
by the price at which we have purchased i.e.
We know that:
Et * Rt 1 
Et * Pt  2  Pt  Et * d t 1
Pt
… (4)
So, in equation 4 we define return expectation of an investor as the capital appreciation
and the dividend income. So, we have already discussed in one of the previous sessions
that when you invest in a share of a company you expect some dividend during the
holding period and at the same time you also expect that if you are going to sell that
share in future you get some capital appreciation. So, return on any share investment is
basically comprising of two parts, one is dividend income and another is capital
appreciation.
So, capital appreciation is basically the growth in value of the stock from the price at
which it is purchased and dividend income is any intermediary income that you have
received in terms of dividend. So, if I can say this through a simple example, if you have
invested in a company and let’s say purchase at ₹100 and you hold it for let us say 1
year, after 1 year you sell this stock for let us say ₹110 and in the meantime you have
received a dividend of ₹5.
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So, your total income from this investment would be ₹110 minus ₹100 which is basically
sale price minus buy price that is ₹10 and dividend income of ₹5. So, equation 4 explains
the same phenomenon.
(Refer Slide Time: 23:12)
Now, if we extend the same argument further we have seen that the final equation that
we have is
Et * Rt 1


yt
1
pt
… (3)
We had also seen that the return equation is
Et * Rt 1 
Et * Pt  2  Pt  Et * d t 1
Pt
… (4)
If we substitute again equation 4 into equation 3 and rearranging slightly, we would get
the following expression
If we simplify further, we get price formula which is
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Now, we know that one period ahead, if we take it further to one period ahead this
should look something like this
If we use recursive substitution which is basically we repeat it many times we will be
getting a function which can be expressed as
… (5)
So, if we substitute this repeatedly and we do this as a recursive substitution framework
we will get Equation (5).
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(Refer Slide Time: 29:30)
Here if you could see this here if you could look at the final function that we have final
expression in terms of equation 5, this equation has two major components one dividend
and another is the valuation value of shares demanded by the noise traders. Now, for a
rational investor it is very important to forecast not only the dividend that is based on
fundamental value of shares, but also the demand expected by the noise traders. And,
that is how forecasting of price for rational investors would become more difficult unless
they are very good in it is calculating or forecasting the value of dividend as well as the
sentiment.
So, for investors who are rational and who are smart monetary investors for them it
becomes more important to understand how irrational investors are behaving in the
market, because that is how they can arrive at a reasonable price at the end of the day.
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(Refer Slide Time: 30:53)
If we have understood this model given by Shiller which explains that price of a financial
asset can be determined by forecasting the fundamental value of financial asset as well as
the value deviations due to the noise traders expectation in terms of their sentiment or
behavioral biases then only they we can arrive at the right valuation of a financial
security.
Now, for this session we have discussed the problems or the issues associated with
market efficiency hypothesis given by Eugene Fama and we can all we have also seen
that the assumptions which based on which efficient market hypothesis was evolved was
not justified in the change scenario. And, because of which when noise traders start
behaving irrationally the fundamental value of the shares are dependent on not only the
dividend, but also on the sentiment of investors, that is all for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Lecture – 12
Beliefs, Biases and Heuristics
Hi there, welcome back to the course Behavioral and Personal Finance. Let me begin
with this session with a simple question. Have you undertaken a course by a professor in
your university or a college? Well, if you have not performed well in that course; did you
try to take another course by the same professor? Well, think about it and then try to
connect with whatever we are going to discuss in this particular session.
(Refer Slide Time: 00:53)
This session we will focus more on Beliefs, Biases and Heuristics. We will touch upon
two major topics. How beliefs and biases and heuristics affect our decision making and
we will also touch upon some of the heuristics that significantly affect our understanding
of a problem scenario. Let us start with understanding how beliefs and biases can
influence our decision making process and why it is important to understand those biases
and heuristics in the context of financial decision making.
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(Refer Slide Time: 01:29)
When we talk about heuristics and biases, basically, we start with the argument that most
of the traditional economic and finance theories are developed with an assumption that
individuals basically considered as economic agents are blessed with unlimited cerebral
RAM which is basically Random Access Memory. It implies that the economic and
finance models in traditional framework assumes that people can process unlimited
information and they can take complex decisions in a flash.
When we connect this theoretical argument with the realistic situations, we realize that
we are blessed with limited information processing capability and we cannot take
complex decision quickly. For example, if you like to play puzzles; you can play puzzles
and in your leisure time and perform really well, but when you are asked to play the
same puzzle while taking the stairs probably you cannot perform equally well.
The reason is your brain is preoccupied with puzzles and at the same time part of it is
occupied with you taking the right stairs. Now, when your brain is divided into two
different tasks each of which take equal or rather more or less amount of your
brainpower probably your decision making gets influenced.
Similarly, when we talk in terms of financial decision making, we can contextualize the
same argument when people are preoccupied with some other task and they are given an
additional task to perform be it buying or selling a share or deciding whether to invest in
a particular investment avenue or not; their decisions are always influenced.
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At the same time, we have already learned that scenarios or the context in which the
problem situations are given also effect the decision making process. We have already
seen through examples that people’s past experiences also affect their decision making
process.
Now, if we take a simple example of one of the best or most used finance models which
is known as capital asset pricing model. Now, capital asset pricing model is used to
explain the return expectation of investors as a function of the minimum risk free rate of
return and how sensitive that particular investment is with respect to the market return.
Now, this capital asset pricing model, also known as CAPM, given by Sharpe in 1990’s
Nobel laureate. It is based on the assumption that investors study all the stocks available
in their investment universe and their returns associated variance and covariances. Now,
if you start with a small market such as let us say nifty. So, Nifty has 50 stocks, you will
have 50 stocks, their returns for several periods, their variances and covariances. So, you
will have so many data points to consider before you finally, arrive at an optimal
portfolio that will fit into your investment objective.
Now, we realize that this particular assumption of investors being able to understand the
universe of investment opportunities is not right. Let us try to understand how this kind
of behavior be influenced by their several context or several heuristics and biases. One of
the major reasons for people not being able to take complex decisions is information
overload.
We know that we are bombarded with lots of information and our mind is not able to
take all the information into account before making a decision. In general, when we have
a lot of information around us, we see what we want to see or we expect to see and this is
basically referred to as perception. For example, you see pattern in something when there
is no pattern at all. So, similarly if we had some relevant past experience that past
experience can be written in our brain and that affects our current decision choices
because memory is reconstructive.
These kind of factors such as past experiences or our perception and memory influence
our decision making in terms of forming the heuristics and biases because these are
intertwined with our decision making process at every point of time.
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(Refer Slide Time: 07:09)
Let us say one of the heuristics and biases that we have already touched upon in the
context of discussing prospect theory is framing effect. We have learnt that presentation
of outcome, perception of decision maker and the personal characteristic of the decision
maker can influence the final outcome or the choice by the decision maker.
So, if we see framing effect in a more detailed way, we understand that perception and
memory can be influenced by the context or the presentation of the situation. One nonmonetary example here could be a sports interviewer or a sports reporter of an average
height reports or interviews, let us say a basketball player and in some other point of time
he or she interviews a jockey.
If you look at the video or images of this nature where a sports journalist interviewing a
basketball player versus the same journalist interviewing a jockey player, you would
realize that the person the sports journalist looks short when he or she interviews the
basketball player and he looks tall when he or she interviews jockey in that situation.
Now, that person’s height is not changing, but the context is changing and that is why he
looks differently into these two contexts. This is also known as contrast effect given by
Coren and Miller in 1974.
A similar example could be given through Muller-Lyer illusion which you must have
come across, if you have not let me try to show you this illusion here. There are two
parallel lines on the right hand side; if you look at the screen, you see two parallel lines
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with arrows attached to it at each of the two ends. Now, if we ask which line is bigger or
which line basically seems to be longer, you can try to see and answer this particular
question.
Apparently if you look closely, you will realize that both lines are of equal length only
the context is changing and that is why it seems to be longer in terms of line B. Now, this
is one of the illusions that we often come across and this kind of illusion or the change in
context affect our decision making processes. Now, you may ask how to identify or how
to come across similar situations when we have decision scenarios in front of us.
Now, before we go to answer this question let me try to highlight some more similar, but
contrasting examples. So, two of similar effects could be primacy and recency effect. So,
primacy effect basically is when you stuck to the things that you first come across and
recency effect is basically the situation where you are stuck with the scenarios or the
options or the context which has been the most recent in your experience.
For example, if you will look at the list of stocks listed in stock exchange, these are
arranged typically in an alphabetical way and if you observe closely you might see that
in some markets, there are more trading for stocks whose name starts with a, b, c, d and
so on. And as you move further in the alphabets, the trading volume or the interest of
investors might start reducing.
Now, this cannot be generalized as of now, but we can say that if you have a list of
alternatives in front of you and you are asked to make a choice as you move further in
the list, you probably would start getting bored or getting tired and your cognitive
abilities start reducing. And, that is why probably you do not want to look at the later
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part of the alternatives as seriously as you have seen the former part of the alternatives
and this further declines your decision making abilities.
We can also see in terms of recency effect when people buy accidental insurance or
health insurance when we see someone else suffering from some accident or some health
issues, because they have seen some recent incident and their decision is influenced by
their recent experience. Similar experience can be observed in marketing when
companies promote different products and they try to influence the decision making of
buyers.
(Refer Slide Time: 12:37)
If you look at some example which basically explains the overload of information for
individual investor or individual decision makers, we can see that ease of information
processing is very important for a decision maker to make the right decision. When we
talk about information overload, we know that if we have lots of information it creates a
state of confusion for the decision maker and it puts certain cognitive limits. Because, we
are suffering with bounded rationality or rather I would say that we are having limited
information processing capabilities and that is why when we are overloaded with
information, we do not process it appropriately.
One of the experiences you must have come across of this nature is when you go in
shopping aisle for buying certain products in a supermarket. We all know that having
more choices in our life is always better, but when it comes to decision making
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particularly the appropriate or more justified and rational decision making having more
and more choices would create the situation further complex.
For example, if you have walk through the aisle of a shopping mall or a supermarket,
you must have come across a variety of products of similar genre and that definitely
makes our decision choice more complicated. So, when we try to explain this
phenomenon where we have difficulty in making the right choice, it is basically followed
by certain behavioral issues. So, we know that when we have large amount of
information from which we have to make certain choice, we are in fact, overloaded by
the information and that basically creates certain cognitive dissonance.
So, cognitive dissonance is behavioral phenomena where people try to avoid conflicting
choices and they try to identify or find certain shortcuts to arrive at a decision. So, when
you are overloaded with information and you suffer from cognitive dissonance you either
make bad choices which is basically suboptimal decision or decisions which are not
really in your best interest or you tend to procrastinate.
For example, if you go to buy a health insurance and the health insurance salesman or the
person who is intending to sales health insurance to you, present a load of information in
terms of several forms and documents and terms and condition listing to you and want
you to read thoroughly before you actually buy the insurance.
When you face this kind of situation, you either do not want to go through all the
disclosures or terms and condition and just sign which might not be really a good
decision in terms of financial decision or you tend to procrastinate which means you can
just defer the decision for now because you believe that when you have more time you
will go through the disclosures and terms and condition properly and then make the
decision.
So, having more and more choices would not always be helpful. But, as we have
discussed in previous sessions having more choices can be beneficial for retail and
individual investors and households if we exercise certain tools such as self control
before we make the decision.
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(Refer Slide Time: 16:39)
Moving further, taking the issue of information overload and cognitive dissonance, we
try to understand what are the heuristics or biases that we typically tend to face. One of
the initial issues that we face when we are going to make a decision is familiarity
heuristics. We all know that we love being in comfort zone and we tend to like the
familiar. Basically, we do not want to take uncertain or ambiguous choices, we basically
want to maintain the status quo and avoid risk or basically avoid the risk of unknown.
This is basic human tendency.
Now, if you look at the cognitive biases or heuristics that apparently creeps into our
decision making process because of this familiarity heuristics, we can identify several
heuristics and biases in here. Some of the heuristics and biases originating from
familiarity heuristics can be identified as follows.
So, when we suppose you have multiple choices to choose from and each of the outcome
is associated with certain probability. If one of the outcomes does not have very high
probability, but you are not very familiar with that particular outcome, you would rather
tend to choose an outcome with lower probability, but known in terms of familiarity.
And that is why, how you make the decision making process simple and easy for
yourself which basically leads to a phenomena known as ambiguity aversion.
Individuals and households tend to avoid ambiguity and that is why they choose
suboptimal decisions and thereby make certain economic compromises. Another bias or
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associated heuristics can be status quo bias that we have already discussed. It implies that
you hold on to the situation wherein you have been for quite some time and do not want
to change. This phenomenon can be observed in people holding losing stocks. When the
value of shares they are holding keeps declining they do not want to sell. It could be
because of loss aversion, but this is also associated with the status quo bias.
A similar example we have seen when we discussed the experiment conducted with the
students where a coffee mug is given to them and asked to trade this coffee mug for a
price and they started quoting higher price than the actual price of the coffee mug in
terms of endowment effect. This is again coming from familiarity heuristics because you
are familiar with the product that you are holding and that is why you are giving it higher
or lower value depending on the context.
A similar phenomena can be observed in your personal finance decision making where
let us say some company is giving you a trial product and you get used to of using this
particular product and start using it regularly. Now, this product might not be the most
optimal product for you, but since you have been familiar with that particular product,
you do not want to change that status and that is how endowment effect creeps into your
final decision making.
One of such biases originating from endowment effect or familiarity heuristics is home
bias. We all know that we tend to choose things which we are familiar with and this can
be seen in stock market where people start investing or like to invest in companies they
are familiar with in terms of the management of the company or the location of the
company or maybe the product range of the company.
So, as they are familiar with the company and its culture and products, they prefer
investing their money in those companies stock rather than companies which are
unknown or unfamiliar to them. This is very much seen in terms of retail shareholding
participation in indigenous companies rather than MNCs or foreign companies. All these
biases and heuristics are very important in terms of making an optimal decision and we
will discuss with more contextual details in a future sessions.
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(Refer Slide Time: 21:55)
For now we have understood that these heuristics and biases are actually based on the
prospect theory which could be viewed as an implication of the prospect theory
assumption which says that people behave differently in different situations, because
they see risk and uncertainty differently or it could be considered as heuristics with
potential for bias. Now, ambiguity aversion or as embodied in emotional a component in
decision making or it could be home bias or endowment effect. All these are possible
biases which could influence our decision making.
And we know that these heuristics and biases stem from comfort seeking tendency of
human being which is basically the original idea of Charles Dakin who says that human
gene is basically selfish and it does not want to change the comfort zone where it have
been surviving for quite some time. As a closing note we would say that distinction
between prospect theory heuristics and biases and emotions can be very blurred and we
cannot discriminate between each of them rather we should try to focus on understanding
the implication of all of them together or individually on our decision making to make
sub optimal choices; that is all for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 13
Beliefs, Biases and Heuristics (Contd.)
Hi there, welcome back to the course Behavioral and Personal Finance. So, far we have
discussed about this expected utility theory, its improvisation in terms of the prospect theory
and its applications. We have also touched upon several heuristics and biases that might be
affecting the decision-making process and how these affect biases and heuristics affect our
financial decision making.
In today’s session we will discuss about behavioral investing approaches and loss aversion that
might be the key input for any behavioral decision-making processes in terms of financial
decision making.
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(Refer Slide Time: 01:09)
Today’s topics are different aspects of behavioral aspect, behavioral investing and loss aversion.
When we talk about behavioral investing it is certainly different from the traditional investing
approaches.
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(Refer Slide Time: 01:25)
In traditional investing approaches, we understand that we have to follow the fundamentals
which means that when we want to invest our money in any investment avenue; let us say stock
or bond or any other investment alternative that we are presented with. We need to understand
the fundamental value of that particular asset. By fundamental value we mean that we need to
calculate what kind of returns we are going to generate over the holding period and whether the
current price that we are about to pay is commensurate with the return that we are expecting as
well as the risk that we are going to assume.
This is very much in line with the smart money investor approach by Graham and Dodd and
Warren Buffett. These people Benjamin Graham, David Dodd and Warren Buffett and other
people like them focus more on understanding the fundamental value of investments and
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consider the prices that we are about to pay as a return for the risk that we are going to assume
by investing in those assets.
Behavioral investing is different from traditional investing. In the sense that we not only
consider the economics and finance of any decision related to investment, but also, we try to
understand the psychology, sociology, politics and anything else that might be relevant. This
implies that when we are about to take a financial decision, we not only consider what the
fundamentals value are, but we also consider whether the person who is making the investment
decision is able to assume the risk that is associated. And, other factors in terms of sociological
and political factors that might be affecting the decision process in future.
Here I am going to highlight three different approaches of behavioral investing. These
approaches are given by Ellis in his keynote address in 1996 which was later published as a
book with Vertin in 1997. They highlight three major behavioral investing approaches namely,
the intellectually difficult path, the physically difficult path and the emotionally difficult path.
Let us try to understand each one of these three different approaches and highlight how
behavioral, economics and finance can affect the decision making in investment processes.
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(Refer Slide Time: 04:29)
The first approach of behavioral investing is the intellectually difficult path to investment.
Basically, this path focuses on understanding the fundamentals and businesses where we want
to invest. This path is adopted by very few people who are very smart in terms of understanding
the business and environment.
They have a profound understanding of investment processes and they can easily see the future
trends. They can comprehend the business, politics and economics and we can easily identify
people who are associated with this approach of investing. In successful investors such as
Warren Buffett, Charlie Munger, John Templeton and very few people like them are those
people who invest in intellectually difficult pathway.
If we go to the root of this path, we know that this path is basically based on cash flow approach.
By mean of cash flow people try to understand the right valuation of this particular
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investment avenue that they are presented with and they try to evaluate whether the initial
investment that they are making is going to be returned with sufficient risk premium and it is
going to be successful investment in future.
Basically, cash flow approach of investment requires good grasp of businesses, management,
social and political aspects. People who follow these fundamental paths basically are supposed
to not to be disturbed by event, news, rumors or any other short-term fluctuations. Sometimes
these approaches particularly the approach, that are intellectually difficult might take months
or even years to be successful. This is basically what is the fundamental approach of investing.
Here investors or the individuals making decisions are expected to stick to the decision after
considering the fundamental analysis as well as understanding the right valuation.
Investors like Warren Buffett evaluate each and every investment alternative before they make
the decision and then they make they make investment and stick to it. This particular path is
adopted by very few people because not all of us are blessed with that intellect which will result
in successful investment identification. Many of us would try to deviate from this intellectually
difficult path and take up the physically difficult path of investment.
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(Refer Slide Time: 07:47)
Physically difficult path of investment indicates that investors are supposed to a spend
considerable amount of time in gathering information, analyzing and incorporating that
information in the investment decision making process. This requires the people to spend lot of
time in meeting, reading and doing research to identify the right investment opportunities.
Basically, this is an information driven decision where people are overloaded with information
that they have gathered from different sources and based on that information they are supposed
to take investment decisions. Examples of this particular approach of investment could be day
traders or active fund managers who are supposed to be spending lot of their active time on
information gathering process and subsequently incorporating that information into their
decision making for investment.
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The underlying assumption of this physically difficult path is that there are lot
of opportunities out there and unless you spend huge amount of time and resources on digging
those opportunities you cannot be successful in investment. And, that is why you are expected
to do lot of research, keep an eye on each and every new information that is coming to the
market.
You are supposed to be busy with meeting with people gathering information get lot and lot of
input for your decision-making process, but here you should remember that there are lot many
other people who might be doing the same thing. So, if you are expecting that this decision
process is going to make you successful probably you are one of very many people who might
be adopting this approach of physically difficult path to investing.
Having understood the intellectually difficult path and physically difficult path we know that
in one case it requires lot of mental understanding and intellect to understand the investment
identification process. In another second case it requires lot of physical effort and lot of time
before you actually make investment decision. Now, third approach of behavioral investing is
the emotionally difficult path to investing.
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(Refer Slide Time: 10:37)
Emotionally difficult path of investment is very much straightforward. It requires you to
identify on a long-term investment opportunity, make the investment and stick to it for long
term. This is essentially implying that when you make an investment you are expected to stick
over it for the long term because in long run you are going to get the return that you have desired
for. The basic expectation is you should not deviate from it once you have committed to it.
So, the key to success here is do not listen to any advice or news or event or rumor that you can
come across, stay calm and unconcerned when you are invested and it of course, requires you
to be patient and in discipline for very long term. Basically the philosophy here is learn to think
with emotions and not let the emotion do the thinking, because in a typical decision
making process whenever you come across with a new information or news it translates into
sentiment which further reflect into the behavior of people and result in decision making by
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those people affected by those news or new information and we call it sentiment when lot of
people collectively take decisions based on information or let us call it sentiment, it is
reflecting in the market in terms of certain biases or anomalies and some of these biases or
anomalies could be herding or bubble or even crashes.
One famous recent example could be on 9th November 2016, the next day to the
demonetization announcement by the Government of India Sensex fell down to 6 percent and
similarly Nifty also fell down significantly to the extent that 541 points. And, if you analyze
fundamentally you would see that it had a lot of thing to do with the announcement, but in sort
to long run not immediately. Whereas, the market reacted so sharply that lot of people lost their
money and subsequently lot of people got panic and make bad decisions in the stock market.
So, the idea here is if you are adopting emotionally difficult paths if you cannot adopt the other
two that is physically difficult path and intellectually difficult path then you have to be
exercising self control and discipline in terms of investment decision making.
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(Refer Slide Time: 13:45)
All these issues related to behavioral investing ultimately get transferred into one or the other
behavioral biases or heuristics and one of the major heuristics and biases that we have discussed
earlier is loss aversion. Fundamentally loss aversion is a phenomenon where individuals exhibit
different risk behavior when presented with different situations. In situations where they have
shown short gain, they show risk averse behavior whereas, under situation where the outcome
is very uncertain, they show risk seeking behaviour.
Now, these biases can actually affect your decision making and that can be shown with the help
of a very standard of structure given by research done at UNDP in 2014 where they try to exhibit
the decision-making process of individuals who are facing resource constraint. In their
constraint, if you look at the graph the process shows that when people are faced with poverty
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they basically exhibit lack of control which implies that if you are facing resource constraint
and this resource could be anything it could be time, money or any other resource.
So, when you have resource constraint you tend to behave with lack of self-control which will
further result in stress, cognitive load and your narrowed focus and all these things put together
will encourage you to take decisions which are sub optimal. And, ultimately you make bad
economic decisions which will eventually lead to further poverty or further resource constraint.
For example: if you are a manager and you are running short of time, but you have to make a
decision in hurry probably you would lose self-control and under stress and cognitive load you
make choices that might result in losses or suboptimal gains and that will further lead you to
more resource constraint stage or more cognitive load. So, this is basically a loop a cycle that
might affect the decision-making process. Loss aversion is one such factor that might affect
your thinking process and decision-making process and we have seen that people in the stock
market basically tend to prefer fixed income over stocks or other risky investment.
For example, after post after dot com bubble in 2003 people used to invest in fixed income
securities rather than in stock because in their opinion the stock market was too risky and they
used to invest their money in secured investment such as bonds or fixed income securities
instead some opinion was that it was the right time to invest in securities particularly stock
markets because of attractive valuation and higher dividend yields. So, if the market is down it
is not always necessary that you will be losing money if you invest rather it is right time to buy
at a cheaper price and subsequently if the market goes up you would eventually make some
money.
Loss aversion also result in people realizing their profit too early which means that if you are
suffering from loss aversion you would tend to sell your winner stocks and keep holding the
looser ones. It also may lead you to tax aversion which basically implies that you might not
consider taxes in your decision making. So, when you are considering a decision making on
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the basis of net gains or net profits, you should consider the net profit after taxes or net gains
after considering taxes as a deduction.
These are some of the factors related to loss aversion that influence our decision making. We
have known through several examples where investors or other individuals take more risk when
threatened with losses and this is because of the cognitive load that they have. We see in several
other biases where this loss aversion or in some context risk aversion might be resulting in
several other associated biases. And, subsequently the decision-making process get in affected
because of which the individuals or the economic agents in general will be suffering from sub
optimal gains and less than the optimal profits and returns in their investment.
(Refer Slide Time: 19:29)
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With the help of understanding loss aversion and other biases associated with it such as
endowment effect or risk aversion, we could implement it in our decision-making process
through any of the behavioral investing approaches as discussed in this session earlier.
Basically, the choice of an individual to go for intellectually physically or emotionally difficult
pathway investment can be improved with the help of exercising self-control and mental
accounting in a positive way. So, when everyone tries to beat the market and you are
considering psychological factors or behavioral biases into account before making a decision
you would probably have an edge over others who are just taking the decision based on the
standard output variables.
Now, to conclude this session I would quote Warren Buffett who says that I will tell you how
to become rich make an investment close the doors be fearful when others are greedy and be
greedy when others are fearful. These sentences basically highlight how important it is to
exercise self-control particularly in stock market investment decisions where most of us get
influenced by biases and heuristics as well as external factors such as news rumors events and
any other information that we may come across.
So, when you are making a decision in investment particularly in the stock market where
multiple agents are acting at the same time, it is very important for you to consider
psychological biases proactively and try to avoid getting influenced by the rumours or news or
any other new information without properly analyzing it. This is it for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Lecture - 14
Beliefs, Biases and Heuristics (Contd.)
Hi there, welcome again. In previous session we discussed about Behavioral approach of
investing and loss aversion. We have discussed that most of the investment decision
making process is based on cash flow approach, where you have to consider expected
cash flows from your investment and subsequently you try to compare it with the initial
price that we are paying for that particular investment.
Now, we try to connect this approach with the context of loss aversion. In today’s
session we will discuss loss aversion with other behavioral biases such as sunk cost
fallacy and endowment effect.
(Refer Slide Time: 01:07)
The topics that we are going to discuss today include loss aversion and such sunk cost
fallacy in general will also try to touch upon the endowment effect and some other
examples of behavioral biases. Taking the discussion from the previous session, we
know that most of our decision making is driven by cash flow analysis of any investment
avenues. To keep it in a very generic framework, if I can show that when we have to
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make a decision, we start with analyzing the cash flow, which is basically the flow of
cash on a time line:
(Refer Slide Time: 01:59)
So, taking the example which we have discussed earlier, if this is a time line where t 0
represents time today t1 represents next period, t2 represents next to next period and so
on. So, there are several time points and it ends with ti which is at certain point of time in
future. We know that we will be getting CF1 at time 1, CF2 at time 2 and so on in future
till CFi at time i.
Today, we have to make a decision, which means that we have to decide whether to pay
for this investment or not. Y or N implies that whether we are going to make the
investment or not. Consider this case as an example of investing some money in any
project.
So, companies typically have to make some investment in a new project and they expect
that the particular project might be yielding certain cash flows in future. So, if it is a
project with a timeline of i years and every year the company is expecting to get certain
cash flow in terms of CF1, CF2 and so on.
Today, it has to make certain investment and has to justify whether the investment is
good enough to go ahead or not. The standard approach is you try to calculate the value
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of these cash flows occurring at future dates, bring it to the present time and then
compare the total value of expected cash flows with the initial investment.
We have discussed about net present value approach earlier, where we do the same
exercise. This is also known as NPV approach. The idea here basically is you have to
calculate the present value of the future cash flows, in terms of you have to consider cash
flow at time i divided by (1+r) n where r is the discounting rate and n is the period for
which you are investing.
So, which implies that when we are discounting cash flow at time 1, we will be using
cash flow at time 1 divided by 1 plus discounting rate and n would be 1. Similarly, cash
flow at time 2 will be discounted with the discounting rate for 2 years and so on. So, cash
i
flow at time I would be discounted with (1 + discounting rate) .
This summation of these discounted cash flows will be equated with the initial
investment that we are going to make. If, it is greater or equal to than this initial
investment, then we will go ahead with the project. If it is not greater or equal to then we
will try not to pursue that project. So, this is the basic approach of cash flow based
method of investment decisions.
Now, let us consider behavioral biases that might be affecting. Now, these cash flows
which we are talking about here would be coming from certain calculations. Those
calculations could be done on the basis of the revenue that we can expect to generate
from the business. For example, if a company takes up a project to set up a new
production plant in a different location and that production plant is expected to generate
certain revenues and consume certain cost.
So, this cash flow is basically cash flow generated after considering all the cost of
production and net of all expenses that might be incurred at that particular plant. So, this
cash flow at different years would be discounted at the rate r, for the number of years for
which the product is the production is continuing.
Now, the calculation of cash flow might be conservative or aggressive depending on who
is calculating the cash flow. Now, if the person who is doing the estimates estimation of
the cash flows from that particular plant is very risk averse, he would like to consider
this, in his calculation and if he is risk seeker his calculation would change accordingly.
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Similarly, the discounting rate basically determines the cost of capital and the risk
premium that the company might be considering. Here also the behavioral biases such as
risk aversion or loss aversion might be incorporated in determining the discounting rate r
and accordingly the calculation might change.
So, the behavioral biases might affect the calculation of CF as well as the r and
subsequently this will in effect your decision whether to go ahead with the project or not.
In a similar yet different example, if I can show you a situation where a company who is
investing in a RnD project.
(Refer Slide Time: 08:27)
Let us say the company is investing in RnD project of a new product. So, certain amount
of money is to be invested and the possibility that this project might succeed is 50 % and
this probability that it might fail is also 50%. Now, if it fails you get 0 at the end of let
say 1 period hence.
If it succeed you start getting some money from that particular successful product. So,
again you go ahead with t2, t3 and so on till ti. So, every time you get some positive cash
flow, till the time your product is being sold in the market.
But, if the RnD project fails you get nothing. Now, at this point you have to decide,
whether to put more money in the project, which means if it fails after 1 year would you
be considering investing more money. So, that the project might revive or it might be
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successful and subsequently you might get certain revenue or certain income out of it.
Which means, some additional investment has to be done and this investment might
again lead to a success or failure of a project?
So, certain probability will be there of success and failure. Probability of success is
defined as p and probability of failure is defined as (1-p). And, if you succeed you start
getting certain cash flows here, for some future period and if you do not succeed you get
nothing.
Now, consider yourself as the decision maker. In the beginning you have already
invested some amount of money at t0. Now, if you have invested and you failed after 1
period hence, would you like to invest some more money and consider this project to be
reviving in future?
Well, many a times we do things which we do not like to do and that is where the
psychological bias becomes more prominent. In investment decisions particularly you
might observe that people make some bad decisions and to cover up those decisions they
make even more bad decisions.
And that is why this example highlights the problem of something which is known as
sunk cost fallacy. Let us try to discuss with the theoretical inputs of sunk cost fallacy in a
similar case.
(Refer Slide Time: 11:57)
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Let me begin with posing a situation before you. So, the situation here is suppose you
have got a complimentary ticket for a movie in situation one and that just before just
before the program starts on the evening there is a severe rainstorm and floods affecting
the traffic in the city, and you probably would not like to go for the movie. And, the
reason is the distance from your home to the venue of the program is quite far and you
are likely to be stuck in traffic because of rainstorm and resulting floods.
The question here is would you like to go? Yes or No? Now, considering this situation
let us consider a different situation in scenario B; where you have purchased that movie
ticket for a price of let us say ₹500. And, the situation is same there is a heavy rain storm
and the floods that is affecting the traffic and the venue is quite far and the decision
choice here is whether you would like to go for the movie or not.
Now, what would be your response? In general we have observed through some
experimental evidence, that when people spent money on buying the tickets, they would
tend to go for the event and where they have received the ticket for free, which is
basically the complimentary ticket, they would not like to go for attending the movie.
Now, if you consider in a very homo economicus sense, which is very rational way of
thinking, you know that ticket is already purchased for whosoever and whoever paid the
price money is already spent, which means even if you have got that movie ticket for free
someone must have paid for it and it has some economic value. And, if you have paid it
you have paid it from your own pocket.
Why do people behave differently when it is coming for free and when it is coming for a
price that you have paid? The reason is people tip tend to take more risk when they are
spending money from their own pocket. And, they take more risk by braving rains and
traffic in this case; this particular example highlights a tendency of sunk cost fallacy.
Where people tend to justify the decisions or rather bad decisions that they have made
and thereby they make even further bad decisions.
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(Refer Slide Time: 14:47)
The argument here is it is a case of loss aversion where you increase your commitment to
justify your past action. In the example shown here shows that you have purchased a
ticket and thereby you had committed some amount of money to go for a movie and
when the situation is riskier, in that sense that there is rain and traffic in the city, you take
even more risk by going for the movie in this situation, because you want to justify your
past action.
Richard Thaler calls this as sunk cost fallacy. Basically, the reason for which this
behaviour is exhibited is people tend to cover up their past mistakes and in the process
they try to satisfy their ego and justify the bad decisions. Not that sunk cost fallacy is
always bad, if we try to understand the resulting effect of sunk cost fallacy in a positive
way, we can see the people’s behaviour when they go for a gym regularly, and they have
to choose between pay as you use versus pay for the annual subscription.
If you want to maintain the discipline and rigor of going for the gym regularly, it is better
for you if you stick to annual subscription plan, because in that sense you would realize
that you have already paid some amount of money for the annual subscription. And to
justify your prior commitment you increase your commitment further by going to the
gym regularly. Whereas, if you stick to the pay as you use plan, the commitment level is
satisfied immediately and there is no further commitment required from your side.
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So, if you want to maintain that discipline you probably would like to pay for the annual
subscription plan. This is a positive example of sunk cost fallacy. Similarly, you might
observe the behaviour of students when they start reading a bad book. So, bad book
means a book that is boring.
For example, if a student has purchased a book for let us say a price of ₹300 and after
reading 30 pages, the student realize that the book is very boring. But since the student
has already paid some amount of money in buying that book, the commitment level
should be increased to complete that book because of justification of the prior
commitment and thereby completing the book. So, this is another example of sunk cost
fallacy in our day to day life.
In a different case, if you try to relate this sunk cost fallacy in financial market or rather
stock markets, investor tend to buy more stocks when the prices fall, the underlying
argument is buy cheaper and sell high. Whereas, when we try to see this example from a
sunk cost fallacy case, people suppose there is an investor who purchased a stock for
some amount of money and the price was ₹x.
Tomorrow or next period if the price falls to lower than ₹x, the investor would probably
try to buy more shares saying that it will average the cost in terms of overall cost of
purchase shares. Whereas, at the root it is basically the evidence of sunk cost fallacy
where the investor is basically trying to justify the price that he had already paid the first
time by paying a lower price at the second time. So, he is actually trying to cover the
previous mistakes by committing further amount of money in the investment.
This particular phenomenon is very common in stock market where investors tend to
over commit after they realize that they have made some mistake.
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(Refer Slide Time: 19:21)
Now, if you want to know whether you are suffering from sunk cost fallacy in stock
market or in your generic day to day decision making, you ask yourself the following
questions. So, the questions here indicate whether you might be prone to sunk cost
fallacy or not. The question is whether you prefer to save more amounts in fixed deposits
than in mutual funds.
So, we all know that fixed deposits are safe investment where you are guaranteed a fixed
return whereas, mutual funds are subject to market risk and the returns might be varying
over several periods. So, you might prefer fixed deposits over mutual funds and if yes it
shows that you are basically affected by loss aversion and resulting in some other
behavioral biases.
Second question is whether you are tempted to move out of the stock market when the
prices keep falling. If you realize that the prices are falling continuously you are tempted
to sell everything and quit the market that is again a case of loss aversion where you try
to justify by selling your stock just by looking at the falling prices.
If your investment portfolio consists of more losers than winners it again indicates your
loss aversion tendency, which means that you sell your stocks, who have been
performing well, because you want to realize the profits. And, if the stocks are not doing
well, you keep on holding them with the hope that the prices will recover and then you
will sell to make the profit.
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Another, situation could be when you get excited because the profits of one or more of
your stocks that you have in your portfolio increases and you want to sell that stock to
realize the profit. This is again very much related to the previous example, where you
tend to sell the winners who have performed well in the stock market and keep on
holding the losers who have been doing really bad and letting you lose money.
Another question could be whether you make your spending decisions, the major
spending decisions based on the prior experiences or prior spending decisions. If yes
then again you are suffering from your sunk cost fallacy as well as loss aversion. So,
when you have certain previous expenses and the decision to spend your money is
affected by your previous experiences. Essentially it implies that your decision making is
not objective rather it is affected by the experiences of the recent past.
If answer to these questions are more of yes than no then you are essentially affected by
loss aversion as well as sunk cost fallacy in some cases. Now, having learnt that whether
we are affected by sunk cost fallacy or loss aversion or other behavioral biases, we
should also highlight how we can take care of these issues when we take financial
investment decisions.
(Refer Slide Time: 23:11)
So, we know that sunk cost fallacy basically is in stock market reflected in terms of
averaging the cost of buying shares, where people tend to buy more and more shares
every time the price falls. In the hope that the overall cost of purchasing shares would be
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averaged out, essentially they are trying to over commit or rather they are trying to
commit, even further after realizing that they have made some mistakes in investment
decisions.
Similarly, if government have made some decisions related to public policy or public
welfare and because of bureaucratic delays or any other political or economic factors, the
decisions are not implemented in time thereby increasing the cost of the decision.
Government tend to spend even further amount of money in order to cover up that
mistake and that is a perfect example of sunk cost fallacy in government mechanism.
This is basically an attempt to cover up the prior mistakes or previous commitment by
committing even further and trying to justify the previous actions. The suggestions for
taking over of issues related to sunk cost fallacy are as follows. So, for individual
investors the first thing that we should keep in mind is your risk taking capacity.
It implies that if you would be able to understand how much risk you can undertake, it
will determine how much return you should expect. So, going by the standard finance
theory we know that if we can ascertain the amount of risk we can undertake it will
affect the return determination that we are going to expect. So, the first step towards
overcoming this sunk cost fallacy or loss aversion is to understand how hungry or how
risk seeker you are.
Second step is to diversify as much as possible. As it is said that do not put all your eggs
in a single basket, to overcome sunk cost fallacy and loss aversion, you should diversify
across all assets and across asset classes. When we mention all assets and asset classes
we imply that you should diversify your investment, not only in different types of asset
classes such as stocks, bonds, fixed deposits, precious metals like gold and silver and
other investment of venues such as real state, precious arts and so on. You should also
diversified within asset classes such as within stocks you should invest in stocks of
different companies, which are not very correlated such as you invest in consumer goods
stock, you also invest in real state stock, you also invest in manufacturing or automobile
stock and so on.
So, the idea is to diversify as much as possible in your investment avenues. At any point
of time if you understand or you realize that there is some mistake just let it go. So, the
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idea here is to move on from the mistakes that you have committed. Do not cover up by
making more mistakes. So, let bygone be bygone.
So, if we have made some investment mistakes and you see that the investment is letting
you lose money, you just escape that investment by selling it off or keeping it as it is do
not keep on holding on to for long time by which you will lose even more money.
And of course, to counter the one behavioral bias you should or you would rather prefer
to apply another behavioral bias that is known as mental accounting. So, we have
discussed that mental accounting helps us in segregating or integrating gains and losses.
So, if you want to use mental accounting for positive output, you should segregate gains
and integrate losses, which means that when it is about decisions which have some gains
associated with it, you segregate it and if it is about losses you try to integrate all the
losses before you take the decision further.
And, already we have discussed that when we try to integrate losses or segregate gains
we essentially try to change our reference point and that reference point makes a very
important contribution to our final decision making.
(Refer Slide Time: 28:41)
In this session we have discussed about certain example of loss aversion with the help of
some cash flow based approach examples. And, we also touched upon a resulting
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behavioral bias known as sunk cost fallacy, where people tend to spend more money
after realizing that they have already committed to a wrong decision.
This is tendency is basically resulting in more economically fatal decisions. Essentially,
it is about the tendency to over commit or rather commit to a wrong decision and to
cover up, committing even further resulting as because of loss aversion attitude. And in
stock market we have understood that it could be resulting in selling winners and holding
onto losers.
We should not justify this decision by holding on to losers in a falling market, because
sunk cost fallacy can be positively implemented when we try to incorporate in our
decision making. Essentially, this sums up the effect of loss aversion and risk aversion in
terms of the biases affecting our decision making process. And, the ways to take care of
these biases namely loss aversion and sunk cost fallacy is to exercise self-control and
diversify as much as possible. This is all for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 15
Biases and Financial Decision-Making
Hi there. Welcome back to the course Behavioral and Personal Finance. Have you ever
lost or have you ever felt to be lost in a crowd of lot of people? Well, when you face such
situations, the first reaction you do is to try to find familiar faces. Imagine an investor
being in the same situation. When an investor is lost in the host of information what he
or she tries to do is to find the familiar information and based on that takes a decision.
Today’s session is based on these phenomena. Today we are going to discuss two of the
mental heuristics or behavioral biases that might be affecting the investment decision
making process.
(Refer Slide Time: 01:15)
The biases that we are going to discuss today are home bias and representativeness.
Basically we are going to discuss briefly about how heuristics can affect our decision
making in the context of familiarity and the availability of information.
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(Refer Slide Time: 01:43)
First we will talk about home bias. When we mention home bias we understand that
people prefer information or assets or securities for investment which are familiar to
them. Basically it’s about individual’s preference of familiar information or familiar
decision over unfamiliar decision. We have already discussed earlier that unfamiliarity
breeds risk and uncertainty and people always prefer to take decisions which are familiar
and less uncertain.
To begin with I am going to discuss briefly about some experimental evidence conducted
through a research in early 90’s by a couple of economists.
Country
Market value
weights
U.S. Investors
Japanese
investors
U.K. Investors
U.S.
47.8
93.8
1.3
5.9
Japan
26.5
3.1
98.1
4.8
U.K.
13.8
1.1
0.2
82.0
France
4.3
0.5
0.1
3.2
Germany
3.8
0.5
0.1
3.5
Canada
3.8
0.1
0.1
0.6
Source: French, K.R. & J.M. Poterba (1991), “Investor diversification and
international equity markets”, American Economic Review, 81: 222-226.
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The numbers in the table represent the market weights of different financial markets
across the world. The first column represents the country name, second column in the
table represent the market weight. Basically this is the weight of the market of each of
the respective countries given in first column as the market value in the world.
And, then there are three different columns representing three categories of investors
belonging to three different origins. Here the researchers try to show that people
belonging to a particular country prefer investing in the stocks which are originating in
the same country.
For example, if I am an Indian and I have some spare money to invest, I would like to
invest in a company that is Indian and my investment decision will be biased because of
the reason that I am familiar with the company and I prefer this company over other
companies which are non-Indian. This particular phenomenon is known as home bias. If
you look at the table it shows that US market is value weighted to the extent of 47.8
which is the largest financial market in the world. And, about 93.8% of US investors
prefer to trade in US markets which means the remaining 6.2% of investors are coming
from non-US origins. Of these 1.3% is Japanese and 5.9% is UK origin investors.
Basically, it is this indicates that the preference of investors from the home origin over
stocks or markets which are there from their non-home country is very significantly high.
In the case of Japanese market you can see that most number of traders are coming from
the Japanese origin to the extent of 98.1 and in case of UK also you see 82 % of market
trading is coming from the people or the investors who are UK origin.
This is a very interesting phenomenon because this goes against the philosophy of true
diversification. When we talk about diversification if you could recall we discussed
earlier that investors should diversify their investment in the sense that they should not
put all their money in same risk profile of assets and they should invest in investment
avenues which are different from each other in terms of correlation or other relation
measures.
Suppose, I have some money to invest I should put my money in risky and risk free
assets in certain proportion, so that if one asset goes well that is fine the other might even
if the other might goes go down my overall investment performance would be reasonably
well.
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(Refer Slide Time: 06:27)
As we have seen through the empirical evidence earlier, people prefer to invest in the
securities or the stocks which are coming from their home country and in the process
they somehow exhibit of a behavior which goes against the diversification philosophy.
Investors are supposed to diversify their investment to reduce the risk because
diversifying across assets in terms of asset classes as well as asset properties helps in
minimizing the risk and optimize the return.
If you try to see the overall correlation characteristic of these markets that we have
discussed earlier US, Japan, UK Germany and so on. The sample correlation as
calculated with respective pairs in 1975 to 1989 was 0.502 and over recent years with a
data from 2001 to 2018 the sample correlation was 0.721. It implies that over recent
years the pair wise correlation across different markets have increased and this indicates
that if you diversify your investment across markets you would probably not get the
desired benefit in terms of reducing the risk or optimizing the return.
Now, if that is the case then why do investors prefer home stocks over stocks of nonhome country? Basically, there are certain explanations behind this behavioral
phenomenon. If you look at the behavior of investors, essentially they are optimistic
about their local countries or local economies and that is why they prefer companies or
forms which are local over forms which are of foreign origin.
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For example: if I am going to invest in Indian stock market, I would prefer companies
which are Indian because I am familiar with their businesses and their management and
that is why I am more comfortable investing my money in Indian origin companies. This
behavior can also be explained with the help of the belief of investors that was
empirically proven by researchers that and the investors believe that their home market
would beat the next best market to significant extent.
What it implies that if I am an Indian investor and you ask me whether I would like to
invest in Indian stocks or the stocks of some non-Indian companies I would prefer Indian
stocks over non-Indian stocks. Because, I believe that during my holding period Indian
stocks and Indian markets would outperform the stocks which are non-Indian origin and
that is basically because of home bias.
Another reason of this home bias could possibly be the information asymmetry or
behavioral and governance issues as well as cross border taxations. What in information
asymmetry means is as we were discussing earlier people are more familiar about local
companies than companies of non-Indian origin in the Indian context. Because, they
have access to more information about the businesses the management the economic
environment of the country and other related relevant information; that’s why they have
more information about the companies which are of Indian origin than the companies
which are non-Indian origin.
This information asymmetry might drive their behavior of preference towards Indian
companies for investment purposes. Similarly, there they have more information with
respect to the governance and other factors such as taxation. It was also shown in some
empirical research that in some countries government used to withhold taxes for foreign
investors and that is why foreign investors would prefer to invest in the stocks which are
of their home country origin.
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(Refer Slide Time: 11:29)
We could try to understand this home bias phenomenon among investors in financial
markets with a different context. There are certain qualitative features of markets as well
as investors that might explain this behavior of home bias. One of the most prominent
factors that might be driving this home bias among investors could be distance, culture
and languages.
In some research it was proven that people prefer local stocks because they want to
invest intra-nationally not internationally. Also in some other research it was seen that
when annual reports of the companies are published in local language compared to an
international language such as English, investors’ preference for local companies
increases.
Similarly, if companies are headed by CEOs of home country origin, investor’s
preference for such a stock always show significant increase in long to medium run.
These examples of cultural, language and distance related factors explain the investor’s
preference of local companies over non local companies.
Some other examples or factors that might explain this behavior would be information
informational advantages, what happens in case of mutual fund managers. Because
mutual fund managers are expected to have more information than the retail or individual
investors and that is why they can use this information to make decisions about asset
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allocation towards companies which are of home origin and that explain their home bias
behavior.
One factor might be observed in terms of over weighting of information which are local
and related to local companies over companies which are of non-local origin. This may
be explained in terms of under-weighting of foreign companies or non-local companies
and this essentially makes the diversification process flawed.
Some other reasons for home bias among investors could be geographical proximity
because they believe that geographical proximity would lead to seemingly more access
to information. And, this will make them in a very comfortable position for decision
making and that is why they prefer companies which are of home origin than companies
which are non home origin.
Unlike several other behavioral heuristics and biases, this bias can be used positively as
well. So, if we try to explain the rational motivation of home bias, it increases or to some
extent influences the hedging demand among investors for example. Suppose you are
living in a locality where you have a company in the business of haircut and since this is
a non-tradable commodity or service you prefer to go to the same shop or same outlet for
your haircut again and again.
So, if you invest your money in the company of this type which is providing haircut
services in your locality, it increases the hedging demand and serves the purpose. So, on
one side you are familiar with the product, service and business processes of the
company. So, you are comfortable you have more information. On the other side your
trust in the company would lead them to provide better services and keep doing well in
economic terms.
This can be generalized in terms of people’s behavior to consume local goods that boost
local economy and subsequently it boosts the investors benefit in terms of more
investment returns from the local investments. And, that is why probably there is a recent
phenomenon where people are motivated to invest in the local companies and consume
local products and services so that this loop or the process keeps on going.
When we talk about home bias we can also consider another bias or heuristics that may
be originating from the familiarity heuristics. So, we started the discussion with
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familiarity heuristics where people have more information or they have better
information with respect to a particular outcome and that is why their decision making
process is affected by the availability of more information in terms of stock evaluation or
buying or selling of a particular stock in financial markets.
(Refer Slide Time: 17:23)
This bias can be named as representativeness heuristic. When we talk about availability
of information and people’s decision making process based on those information we
sometimes feel that people make systematic mistakes in terms of considering the
information for their decision making.
For example: if we consider a company that is known to be a good company and when
we say a good company it means that it has a very good quality of management
personnel, they have very good governance system, they are known for their good brand
image or goodwill which means they have strong market share and they keep growing. It
also has consistent growth in earnings and this implies that their future cash flow will
keep growing and that is why these companies are known to be good companies.
Now, if I ask you as an investor, do you consider a good company to be a good
investment opportunity as well? Think for a second and consider whether a good
company is always a good valuation opportunity. If we go to the basic economics, we
understand that products which are considered to be good are sold at a higher price with
whereas; products which are considered to be of lesser quality are sold at lower price.
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So, the moment when we contextualize this example in financial market good company’s
stocks are sold at a higher price whereas, bad companies stocks are sold at a lower price.
This is basic economics. Now, the moment this information about a company being good
or bad it adjusted in the prices in the stock market the overall information adjustment is
done.
So, there is no further reason for favoring a good company or a bad company which
means that if a particular company is traded in the stock market for ₹10 and another
company which is considered to be a very good company is traded in the stock market at
₹100. There should be no reason to favor for an investor a particular company which is
trading at ₹100, because the prices themselves have reflected the good or bad
characteristics of the company.
Then why investors prefer good companies over bad companies. Let us try to understand
this in the context of availability of information and heuristics bias.
(Refer Slide Time: 20:25)
So, the basic question, that we are asking here is are good companies always good
investment? Now, when we contextualize this in the sense that availability of
information determine peoples preferences. So, we have seen that prices of a stock could
be reflection of the information that are available and information on companies
management quality or any other attributes such as earnings growth or brand value or
market share or any other factors.
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So, these information have already been incorporated in the prices of these stocks which
means that if a company is traded at ₹5 or ₹10 for that matter, this ₹10 valuation has
already incorporated all the information pertaining to companies management market
share or earnings growth and that is why it is traded at ₹10. Whereas, some other
company which is considered to be a good company might be trading at ₹100 because of
the same reason having good management with better brand image, higher market share
or higher growth in earnings and cash flows.
So, these two types of companies bad ones and good ones are equally good investment
opportunities. It means that if a company is considered to be a bad company because of
lower quality or lower attributes it is being sold at a lower price. So, you are paying a
price which is commensurate with the quality of the company. So, there should be no
reason for favoring a particular company which is good over a company which is bad
just because of this management quality or financial attributes or market share or brand
value because it is already incorporated in the prices.
Then the question is why some people or some investors prefer good companies over
bad companies. So, the reason here is representativeness bias. What representativeness
bias indicates is people are more likely to invest in assets or finance investment
opportunities with good image or positive image over negative image. And, here they
make a mistake of considering good image to be of good value and that is why their
investment decisions are affected by this good quality company versus bad quality
company.
So, when they invest in a company with a negative image they considered this company
to be of bad quality and bad quality here is taken as a proxy for bad valuation. Whereas,
if we go back to the basic economic argument, the lower price of a bad stock of a bad
company itself is a reflection of the true valuation of it is quality of management or
market share or earnings growth or any other factors.
So, in that sense for a rational investor, stocks of a good company or that of a bad
company should be equally good for an investment opportunity. This is where heuristics
such as representativeness bias might affect our decision. So, in case you are making a
decision with respect to asset allocation across bad or good companies, consider this
heuristics to be an important factor before you make the final decision.
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(Refer Slide Time: 24:39)
Similarly, when we talk about the impact of information availability on financial
decision making, we know that the ease of information access determine our choices.
And, we have also discussed earlier that in human beings are affected by their
experiences in the past and if the experience is from the recent past it is given higher
weightage compared to the experience that is that was experienced in later past.
So, people tend to give over weight to recency over the latency and that is why people’s
behavior towards choosing a particular asset is dependent on how they had experienced
in the recent past and that experience would explain their final financial decision making
behavior. This tendency of individuals being affected by their recent experiences or
access to the recent information can be seen in the survey conducted by American
Association of Individual Investors where they are surveyed every fortnightly and asked
whether they are positive or negative or neutral about the movement of the stock market.
And it was observed in some research studies that people tend to be more bullish towards
stocks which have been performing really well in the recent past, and that is where they
give more weightage to the recent experiences or recent performance of the companies.
This phenomena has also been observed and empirically proven among mutual fund
investors where their decision to allocate the funds across different assets is affected by
their recent performance.
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For example, if they had experienced positive performance in certain asset classes, they
over allocate their funds to that particular asset class whereas, if they had experienced
negative performance in some other asset class they under allocate to that particular asset
class. The reason for this kind of behavior could be explained in terms of information
search which is a very costly affair because the moment you are overlaid loaded with
information you tend to find shortcuts or heuristics which will help you in decision
making and in the process you rely on the recent information or the information that is
coming very easily.
Another explanation could be the bounded rationality because when we are loaded with
information we need to understand and analyze the information appropriately. So, we
tend to find shortcuts and heuristics and that is why we rely on the information that has
most easily available and incorporate that information in our decision making.
(Refer Slide Time: 28:13)
So, in this session we have discussed two major phenomena of investor’s behavior. We
have understood and explained with the help of some examples where we witness
investor’s preference over companies which are of non-local origin for companies which
are local origin and this bias is known as home bias where investors try to seek comfort
zone in terms of investment decision making. And, that is why they rely on more
information and proximity in terms of geographical proximity or information availability
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and prefer companies which are local and they tend to invest more investment in local
companies or homegrown companies.
This might lead to people’s tendency to find shortcuts for information access and this
may translate into representativeness bias where people consider one thing to be the
other and in the process they might make systematic mistakes. In the example that we
discussed we highlighted that people might consider good companies to be good of
investment opportunities whereas, the prices of those good or bad companies have
already been incorporated all the information and attributes that is publicly available.
So, it is advised to consider this representativeness bias in a positive way when an
investor has access to private information and that is where they can have a better
valuation of the investment opportunity. That is all for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 01
Behavioral Economics and Finance
Lecture - 16
Biases and Financial Decision-Making (Contd.)
Hi, there taking further from the previous discussion. In this session we will discuss two
more behavioral biases that essentially affect our investment decision making processes.
(Refer Slide Time: 00:33)
The biases that we are going to discuss today are availability heuristics and anchoring
bias. Before I begin the discussion on these two biases, let me start with a very simple
situation, or rather I would ask a simple question why do you watch YouTube videos or
OTT platforms like Netflix prime or any other similar platforms.
Well, have you ever thought, why the quality of content over Netflix or Amazon prime is
better than the qualities of contents available on YouTube. Well, I would answer it
simply by saying that all that glitters is not gold, which means the things which are
available for free or with less effort are not considered to be of really good value. This
leads to one of the behavioral biases that investors face in the stock market.
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Many a times investors find themselves in the floods of information and most of the
information are freely available. For example, if you are an investment analyst or
individual investor looking for information for analysis of the investment opportunities.
You go to the internet type a simple Google query you are given a lot of information in
terms of search results.
Now, whenever you come across information that are freely available or easily
accessible, you consider them to be of less value and if you come across some
information which are available with more effort or more cost in terms of time or
resources or subscription price, you consider those information to be more valuable. This
might lead us to certain behavioral tendencies and that could be considered as a bias in
investment decision making process.
What happens in this kind of situation is we try to rely sometimes on freely available
information, when we are scarce facing a scarcity of resources, but we overweight the
information that are available for some cost in terms of time or resources, and that is how
we deviate from the true valuation of investment opportunities. Let us try to understand
the basic concept of this availability bias first.
(Refer Slide Time: 03:28)
Suppose, you come across information which are freely available and whenever
something some things are freely available, you find them to be used often more often by
people who are making decisions. And, the moment you have more information this
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increases the cognitive load on your decision making process and you tend to find
shortcut or you start finding heuristics which will help you manage your decision making
process.
And, eventually you are more likely to take decisions based on information that are
highly provable or the information which are coming again and again. If we
contextualize this situation in financial market, we are suppose we are going to identify
companies for investment process. Which means, if I have some money, I want to
identify some stocks or some shares of companies for investment and I am analyzing the
stocks.
The human tendency which is very commonly observed is we tend to identify stocks
which are more in use or which are getting more media attention and in the process what
happens is retail or individual investors tend to give more attention to such stocks, which
are coming in the news media frequently and they start trading more and more of such
stocks. That will lead further to more buying of these type of stocks and extreme cases of
return in both positive and negative ways.
Whereas, you might observe those institutional investors such as mutual funds or foreign
institutional investors and other institutional investors, they are less affected by news
reports or these external prompts and that’s why they do not get swayed away by such
phenomena easily. Whereas, retail or individual investors are affected by these biases
more frequently.
If we try to contextualize this situation in a very simple example; where an individual is
supposed to take a decision, whether to invest in a particular investment opportunity or
not, we can consider this as a case of finding present value of future cash flows. We have
already seen that the basic of financial decision making can start with finding the value
of all future cash flows, which are expected.
And, comparing that value of future cash flows with the initial investment to understand,
whether we are getting more than what we are supposed to invest now or less than what
we are going to get, if it is more, we should go ahead and invest and if it is less we
should ignore that opportunity.
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Now, if we take that situation of cash flow analysis, we can try to understand how this
can influence our decision making process.
(Refer Slide Time: 07:11)
Suppose we have a series of cash flows and as explained earlier this is the timeline,
where you have different times, this could be year or month or any period and these are
cash flows associated with the time line. Now, the basic framework says that the cash
flow should be brought to the present time in terms of discounting their actual value with
the discounting rate.
So, when we try to discount the cash flows, we try to see if cash flows are discounted
with some discounting rate. So, PV is the present value of all future cash flows
originating at different points of time. And, because money has different values at
different point of time, we discount those future cash flows with a discount rate known
as r here.
So, if r is our discount rate and CFi is our cash flows, how we can show that the decision
making process of discounting these future cash flows might be affected by the
availability of information or any other such behavioral biases is as follows.
Suppose, you wake up in the morning and you read the newspaper and come across that,
the average cost of capital or cost of funding for individual investors is going to be 6 %.
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So, this information is easily available in the news; in the news format and you consider
that the cost of funds for individuals is going to be 6%.
Now, when you try to start using this information for discounting the cash flows that we
have here, this selection of r or basically the choice of discounting rate would be affected
by the information that you had in the form of news item. So, news says that 6% is the
average cost of funds or cost of capital for individuals.
So, you would probably tend to choose a discounting rate that is very much close or very
much a function of this 6% of cost of funds and that might not be necessarily true in this
case, because earlier we had discussed that this r could be a function of not only the cost
of capital but also the riskiness of the decision that you are going to take as well as the
desired risk premium that you might be expecting.
We had already touched upon on the concept where this r can be determined as a
function of the rate that you can get easily and some risk sensitive measure. And the risk
premium that the market is offering over and above the risk free rate. This particular
approach is known as capital asset pricing model which we will discuss briefly later on.
Here, we know that this rf is basically indicating risk free asset implying that, this is the
minimum return that you can get without taking any risk. ßiM is the risk sensitive
measure and this basically indicates the market premium. So, when we try to consider r
as a discounting rate, we should keep in mind that it should not be just a function of cost
of fund, but also the risk sensitivity that you are assuming in the form of taking this
decision and the market risk premium that is offered by the market.
But, as an individual we tend to be affected by the information that we get and that is
where the information which is easily available might influence our choice in terms of
discounting rate. We will see more such examples when we discuss the issues and
concepts related to personal finance in the second module of the course. For, now I
wanted to highlight that the decision of individuals might be affected by the information
which are freely available and that’s where we make systematic mistakes.
Taking the discussion further to explain how availability bias might affect people’s
choices. Let us try to understand this with the help of an empirical experiment.
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(Refer Slide Time: 13:14)
We have already turned upon the idea that people tend to overweight the information
which they can easily access to and underweight the information that comes with cost in
terms of resources or time. This kind of behavioral tendency might be observed in terms
of experience as well, where people’s decision might be affected by their recent
experiences, we had discussed about recency effect.
Here, I would like to cite an example, where a set of real estate agents were assigned a
task to evaluate the property, in terms of financial valuation. And to be more specific two
sets of real estate agents were given the task to assign the value of same properties,
which means there are two sets of real estate agents, they are going to find the value or
they are going to assign the financial value of two sets of same properties.
Now, properties have same features so, theoretically their valuation should be same by
whoever is doing the valuation. Actually, the difference between these two sets of real
estate agents is in terms of the information that they were given a priori. One set of real
estate agents was given the information apart from the traditional information in terms of
the characteristic and features of the properties, they were given a list price which was let
us say x.
So, if I can say that the two sets of real estate agents were given two different lists price;
one of the two sets were given a list price of x whereas, the other set of real estate agents
was given the list price of y. And, then they were assigned the task independently, when
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they were asked to give the valuation of those same properties, their valuation were
different.
Now, if the property real estate agents were rational, the valuation of that particular set of
properties should be identical and it should not be affected by any other factors.
Whereas, the reality was or the experimental evidence shows that, the valuation that they
had come up with was a function of their own appraisal in terms of their valuation
estimates plus some estimate that was driven by the list price that they had shown.
So, their valuations of properties were a function of
Appraisal estimate = a * Personal Appraisal Estimate + (1 – a) * List Price Shown
So, this equation indicates that they were given to list prices. So, let’s say X or Y where,
X was smaller than Y. So, the first set of real estate agents came up with a property
valuation which was consisting of their own valuation plus some function of X that were
shown to them.
And, the other set of people who were real estate agent they came up with a different set
of valuation, which was again some valuation of their own estimates and some function
of Y which was different from X. So, this experiment indicates that, if you are given
some task or you are assigned some problem where you have to make a decision about
let us say investment or finding the value of an asset, your decision would be affected by
the information that is available to you.
This phenomena has also been observed by a concept called nudge that was given by
Richard Thaler which suggests that when we are given some additional information our
decision making process gets affected. Here in the case of real estate valuation agents,
assessment of properties was affected by the list price that was given. And, this shows
that people’s choices or decisions get affected by the information that they have access
to.
Now, if you try to explain why real estate agents came up with different valuation for the
same set of properties, it could be explained in terms of the their tendency to seek
shortcuts, because even if they came up with their own valuation estimates, they were
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nudged or they were affected by the information that was given to them in different list
prices.
They might have been anchored to certain information, which they had access to or they
might be having information overload, because of which they started seeking shortcuts
and the best shortcut was their own evaluation plus some anchor coming from list prices.
This kind of tendency is very commonly observed in stock market, we had already
mentioned a couple of examples, which suggests that when investors buy a stock for
certain value and the prices start falling, people might not be interested in selling that
stock, because they are anchored to the information or the price that they had purchased.
Similarly, if you are given the task to assign the value of a particular commodity or a
product, let’s say a coffee mug. And you were told that this coffee mug is available in the
market for ₹50, your decision to assign the value to that coffee mug will be influenced by
that information. And you would probably give a valuation which is some sort of
function of that information in terms of ₹50 market price.
(Refer Slide Time: 20:24)
When we talk about people’s tendency to anchor to the information that they have, if this
anchoring tendency gets accumulated in terms of collective behavior of a set of people,
this result in herding. When we talk in the context of stock market, investors would be
accessing the information that is freely or easily available to them. And, at the same time
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they would be sharing that information across different set of people or in across
investors.
Now, the valuation gets affected by the information that they have and when the
information is accessed by a large set of people, probably all of them start behaving in a
similar fashion and that leads to the herding behavior or the crowd behavior in stock
market. We have seen from stock market data and it is observed that when certain set of
investors start behaving in a particular fashion, other people might start following them
and this leads to a phenomenon of bubble building in the stock market or it is also known
in a certain way as herding in stock market.
This particular phenomenon is more popular or more obvious in fund manager’s
behavior or analyst behavior, in terms of their recommendation or earnings forecast, or
other financial estimates, where they share the information across different media.
For example, if you watch business new channel, when the market opens a lot of experts
start giving recommendations or valuation for different financial assets or securities and
as the day progresses, their recommendation might get revised or it might get updated
because of additional information that are available to them.
And, many times the information to them would be coming in the form of
recommendations by other analysts or other experts. So, essentially they tend to update
the information or they tend to stick to the information that they have, after receiving
some additional information in the form of others opinion. This might be an evidence of
herding or anti herding in some cases where people do not update their belief.
Essentially, there the job of a financial analyst or an investment analyst is to assign some
value of a financial security and then give recommendation for buy or sell or hold. And,
if they update their information based on some inputs that they see from some other
analyst’s opinion. There their behavior might be leading to herd mentality, and that is
where the financial markets might be showing some anomalies in terms of herding or
miss-evaluation of financial securities.
Most of the time this herd behavior is evident as a function of publicly available
information, where analysts adjust their forecasts or their opinion based on the
information that are available easily. So, that is why we started with the argument that
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when information is available easily or for free, most of the time people’s behavior in
terms of investment decision making is affected by the information availability and that
is where this representativeness bias and availability heuristics might lead to anchoring
as well as non anchoring or rather herding behavior in stock market.
(Refer Slide Time: 24:42)
When, we talk about availability of information and anchoring we just discussed an
example where analysts might be accessing information across different platforms, in the
in terms of the opinion of their fellow colleagues or fellow analysts. And, based on that
they might update or might not update their recommendations or investment forecast, if
they revise their opinions basically they are following the herd, this could be explained
by the phenomenon that they might want to play safe and that is why they are going
ahead with the popular opinion.
Whereas, if they do not want to update the belief it could be because of some reason such
as they might have access to private information and that is why they are not going ahead
with the popular opinion, or they might want to save or create a reputation of being
different from others.
So, this tendency of anchoring among investment analysts could be explained in terms of
herding or anti herding. Herding when they go by the popular opinion and revise their
recommendations of buy sell or hold, when they receive additional information from
other analysts.
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If, they do not herd and they do not update their belief which is basically they do when
they have private information or they have some reputational concerns. So, essentially
when we talk about heuristics and behavioral biases affecting investment decision
making, originating from information availability or familiarity we try to merge 4 major
issues; representativeness, homebuyers, availability heuristics and anchoring. And, all
these things might lead to herding behavior which is a behavioral anomaly in financial
market.
(Refer Slide Time: 27:05)
To sum up the discussion of this session, we know that investors tend to buy stocks,
which are more in news recently the reason is they are more familiar and the information
is easily available, that is why they overweight the information which are available for
free. Another reason could be the bounded rationality argument where people do not
want to get involved in complex decision making process, and they tend to seek shortcuts
and that is where the recent information or the information which are freely available
comes into the decision making process and they take the decision accordingly.
This might also lead to the availability heuristics, where people give higher weights to
the information coming from the recent experiences and that might lead to the anchoring
behavior of investors, where they try to manipulate the asset valuation or they do not
want to change their belief when they are anchored to the prices or the information that
they have access to.
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Anchoring makes sense perfectly when you have private information and it also makes
sense when individual or analyst or investors are confident about their decision and that
is why they do not want to update their belief. It does not make sense, if you are going
ahead with the unjustifiable calculations or analysis of the data or the information that
you have.
So, whenever you have information available, it is always wise to analyze the
information appropriately and incorporate in the decision making that you have done in
the process. That is all for now.
Thank you very much.
187
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture – 17
Overconfidence Bias in Financial Markets
Welcome back to the course Behavioral and Personal Finance. How many times has it
happened to you that you have made some estimates or forecasting and you have gone
wrong? Well, it happens to most of us more often. In stock market it happens even more.
Particularly, when individual investors try to estimate some forecasts and base their
decision on those forecast values. Many a times it so happens that their forecasts go
wrong and in the process they make money mistakes which causes losses to them.
This session is focusing on this particular bias where people tend to make over valuation
or under valuation based on their own forecasts and have gone wrong. This tendency is
known as Overconfidence Bias.
(Refer Slide Time: 01:25)
In this session, we will touch upon two major topics: one – how overconfidence bias
effects individual investors decision making process, and we will also try to understand
through a simple quantitative framework where we will explain how overconfidence
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level of investors might influence their decision making in terms of the demand for
shares.
(Refer Slide Time: 01:59)
When you talk about overconfidence we basically understand the tendency of individuals
to put higher weight is to their own calculations or their own opinion. Basically it comes
from the tendency that we think of our own opinion of higher value compared to the
opinion that we received from some external prompt. This kind of bias where people
assign overweight to their own judgment and calculation and put lesser weight to the
judgment or opinion or the information coming from different sources and thereby they
base their decision on these calculations.
We all know that attention is a rare cognitive resource and many a times we have to
divide our attention to different activities. When it comes to making financial decisions
our attention is divided to several tasks such as gathering information, analyzing those
information and then making the final decision. When we try to gather information, we
gather information from different sources as we have earlier discussed that sources
which are freely and easily available are preferred by individuals in terms of the source
of information.
And, when they try to incorporate the decision with the help of that information they
tend to assign higher weights to the information that comes for free or with less effort.
Similarly, because of less attention available for the decision making they tend to assign
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higher weights to their own judgment of the information. Suppose you receive some
information in the form of the management quality of a particular company where you
are planning to invest your money.
Now, when you hear this information about the management quality you make your own
judgment of that information. And, when you make a decision whether or not to invest
you consider your own judgment of significantly higher value compared to the judgment
that is given by some other analysts or some other sources.
So, this kind of bias leads to investors value estimates as a function of some likelihood or
some weights through the market wide information which they are getting from different
sources and the information that is specific to firm. Now, when we try to understand the
firm specific information the information might contain the financial, non-financial such
as quality of management, market share and other features of a company. And, when we
talk about market wide or sector wide information we basically mean the information
pertaining to the macroeconomic issues.
This type of bifurcation of the value estimates coming from two different sources would
indicate whether or not individual investor’s attention is going towards overconfidence
or under confidence. If it is either of the two cases where the calibration is not done
properly, their valuation will be biased.
(Refer Slide Time: 05:49)
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If you try to extend this discussion further we know that investors rely more on their own
judgment or signals compared to the signals that they are getting from external sources.
In stock markets such a judgment bias basically lead to higher volume of trading by
individual investors because institutional investors are not affected by these biases as
much as the individual investors.
When individual investors trade higher which means the trading volume in individual
investor category would be significantly higher as influenced by overconfidence bias,
that would lead to market overreactions or under reactions and ultimately it will also
incur higher cost for individual investors and thereby their net portfolio returns would be
reduced. Essentially when an investor trade more often they incur certain cost in terms of
transaction cost or security transaction taxes or any other cost in the form of taxes or
brokerage charges or any other similar expenses.
So, whatever money you are going to make after doing the trading the net profit or the
net return from the portfolio investment or from that particular investment strategy is
reduced by the extent of the cost that you are incurring in that particular transaction,
which implies that if you trade more the transaction cost would be higher and your net
return would be lower to that extent.
When we discuss about a judgment or overconfidence bias, essentially it could be
attributed to several factors including availability of information or representativeness
bias or other behavioral heuristics which we have discussed earlier. Some other factors
that might be affecting individual’s judgment error or overconfidence bias in this case
could be their demographic features.
In one of the landmark studies carried out by Barber and Odean (2001) suggested that
gender specific features might affect the trading behavior of individual investors. They
carried out empirical research and found that men trade 45% more often than women do
which means that men seem to be overconfident in their trading capabilities and
information processing abilities and that is why they trade more often compared to
women to the extent of 45% higher than the women do.
When they talk about the marital status of those men and women, the result was even
more striking. They found that in their sample single men trade 67% more often than
single women. When we considered this higher trading by men compared to trading by
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women we can understand how it would affect their net return. In their study they found
that the net return for men who trade more often was 0.94% lower than for women,
which means men ultimately made lesser amount of money compared to women because
of higher trading.
And, the result for single men and single women was even more surprising because
single men made 1.44% less return in terms of net return compared to the single women.
This is just one of the demographic attributes that might explain why certain people trade
more often than some other people.
In some studies that we have conducted earlier, it was indicated that people with
professional qualifications such as an MBA or chartered accountancy or investment
certifications are more confident about their abilities to trade and time the market and
that is how they trade more often than those with no such professional qualification. This
overconfidence behavior ultimately makes people or individual investors to lose more
money.
(Refer Slide Time: 11:05)
We can try to understand how this overconfidence tendency or the overconfidence bias
among individual investors would determine how much they are going to demand in
terms of trading volume. We have just seen that higher trading volume might lead to
lower net returns because traders would ultimately incur certain transaction costs and
that will reduce their net returns. Here we are going to discuss briefly simple
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overconfidence investor’s model where we will try to explain how individual investors’
overconfidence in terms of high or low overconfidence would determine the trading
volume a certain by that particular type of investors.
•
•
Consider the demand for a particular security j.
At micro-level (i.e., for individual trader i):
= demand for the security j
= investor’s estimate of security j’s intrinsic value
If
> Market Price → i wishes to hold more of security j (than if j is
fairly priced).
•
Let qn = number of shares investor i would hold if price and value were
equivalent.
If
> Market Price → hold more than qn.
If
< Market Price → hold less than qn.
To begin with I will start explaining each and every term here first. Suppose that the
demand for any particular security j is given as dj and it is a function of intrinsic value of
that particular security. So, the security j is intrinsic value IV basically determines how
much demand the investor I is going to seek. So, there is an investor I who would be
demanding certain amount of shares for security j and that is basically a function of
intrinsic value.
If we quantify this demand to be qn in terms of number of shares for that particular
security j it would be high if the price and values are not matching. So, if market value of
the market price of the security j is higher than intrinsic value, the investor would expect
to hold less than qn and if intrinsic value is higher than the market price then investor
would hold more than qn.
So, basically qn indicates here the number of shares investor would hold if the price and
intrinsic value were equivalent. So, it implies that if intrinsic value is higher than the
market price the investor would hold more than qn and if intrinsic value is less than the
market price then investor would hold less than qn for the security j.
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(Refer Slide Time: 13:49)
If we extend this argument further, we know that different investors respond differently
to the information pertaining to prices and value estimates. For example, if an investor
holds us here and price goes up by a certain extent, his reaction would be different from
a different investor who would also be facing the same situation and that depends on his
or her demographic characteristics or expectation from the market or any other such
features.
So, assuming that all investors are price takers here, in this particular market all investors
are price takers and investors use two sources of information or basically two types of
information. One information is his own opinion of prior estimate basically the prior
value estimate of the security j which is given as vi and the other piece of information
that the investor uses is the market price that is p which is basically nothing, but
weighted average of all investors opinion.
So, we can say that the value estimate for investor i would be given as
= the (posterior) estimate of value of investor i.
= same investor’s prior estimate of security j’s intrinsic value
= weight that investor i puts on his prior estimate relative to p.
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So, there are two pieces of information – investors own value estimate and the price
coming from the market which is a weighted average function of all investors estimate.
Here, a could be ranging from 0 to 1, if you try to use this argument of value estimate for
an investor we can take this further.
(Refer Slide Time: 16:41)
So, we have just explained that for an investor i the value estimate for a particular
security would be the weight assigned to the value estimate of that security a priori and
the remaining weight will be assigned to the information that is coming in the form of
price of that particular security where the value the weight ai would be ranging from 0 to
1.
Now, we know that the higher weight is assigned that is the higher a is, the higher will be
the weight given to the investors own opinion. So, basically the first component of this
function is the weight assigned to his own opinion and the second part of this equation is
the weight assigned to market opinion or market information.
We know that since there are a large number of investors in the market and that they are
viewing the system to determine the p basically which is the weighted average opinion of
all investors in the market, any value of a being greater than 0 will indicate some sort of
overconfidence. So, if a is going to be non-zero basically more than 0 it indicates some
sort of overconfidence and higher the a is, the higher overconfidence it indicates.
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Which means, if I am an investor and I am putting more value to my own judgment or
own opinion which is given as v star, the a will be higher and it indicates that I am more
confident about my own opinion or my own calculations. So, the higher the weights
assigned to a in terms of weight for my own opinion the lower will be the weight
assigned for the market opinion.
So, if we take this argument further and next we suppose that the demand for investor i is
quantified as q i where qn is the standard demand for all investors individually plus θ,
where θ is the sensitivity of demand to a divergence, let us call it a divergence between
the value estimate, the posterior value estimate and the price.
So, we can see here that θ is the sensitivity of value estimate which the investor was
making earlier and p is the market price which is basically a weighted average function
of all investors’ opinion. So, your demand as an investor your demand would be driven
by the standard demand function which is qn plus any sensitivity that you assign because
of the divergence between your own posterior estimate and the price which is basically
the weighted average estimate of the entire market.
Now, we try to substitute equation 1 into equation 2 what we are going to get here is the
demand function qi = qn + θ* ( ai* vi* + (1-ai)*p) - p.
On simplifying,
qi = qn + θai* ( vi* - p)
--- (3)
Further, if we take the from here if we take partial derivative of qi with respect to p we
get
dqi /dp = - θai
--- (4)
So, if you look at equation 3 and 4 you we know that the higher the investor confidence
is the more responsive demand is to the change in price which means if an investor is
overconfident the demand for particular share or security will be very much responsive
to the price which is prevailing in the market. If we try to show it graphically this
particular function as the demand function force investor i we will get to see a curve
something like this:
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(Refer Slide Time: 26:29)
So, if the price and quantity curve is shown where q is the quantity and p is the price. So,
let us say if the investor which has done the right calibration which is basically the
perfect calibration in terms of there is no bias towards over confidence or under
confidence that investor would be, so, if we say that D1 is demand 1 for perfectly
calibrated investor. So, demand for perfectly calibrated investor which means he is not
affected by the bias and D2 is low overconfidence investor.
D3 as a high overconfidence investor this will be demand for an investor with high
overconfidence and we follow the same equation which is basically the equation 4 which
was the quantity with respect to the price is a function of negative sensitivity of price and
value divergence with the weight you assign.
So, if this is the final function the graph for these three investors with perfectly
calibration, low over confidence and high over confidence would look something like
this for perfectly calibrated investor the demand function would not be changing as a
response to the price. So, this is the demand function 1 for perfectly calibrated investor
and if it is demand for coming from an investor with low over confidence the response
will be very steep and it would look something like this where it will be demand 2 for
low over confidence investor.
And, if we have an investor who is highly overconfident or high overconfident the
demand would be less steeper and it will look like this where demand for high
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overconfident investor would be here and since most of the investor would agree to a
common value. So, the price will be common at this point of time where you can say the
value is common for all these investors.
So, this is how investor’s overconfidence can be modeled in a very simple framework
where you can determine whether an individual investors is low overconfident, high
overconfident or not affected by overconfidence and thereby you can determine the
demand for that particular investor given the level of overconfidence. We can also
discuss more examples with some realistic numbers.
(Refer Slide Time: 31:07)
But, for this session we will like to conclude here by saying that the overconfidence is
basically a behavioral bias that determine the investors response to certain information
and whether the information is coming from his own estimates or is coming from some
external prompts, investor would assign higher weight to the own calculation and own
estimates compared to the information that is coming from external sources.
As a result of this overconfidence in his own judgment and opinion investors tend to
trade more in the process they incur more cost and their net returns from their investment
would be reduced to that extent. Another result of this overconfidence bias could be the
under diversification of investments which means when investors are overconfident in
their own abilities they tend to under diversify and their investment will be concentrated
around certain things where investor would feel comfortable and more confident about.
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And, that is where features are attributes such as gender, profession, education and other
demographic inputs might matter more for determining the level of overconfidence or
under confidence in an investor. With this I conclude the session.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture - 18
Valuation of Financial Assets
Hello there, welcome back to the course Behavioral and Personal Finance. In this course
we have so far discussed the expected utility theory as a deviation from the standard
utility theory. We have also seen how Kahneman and Tversky proposed an improvised
version of expected utility theory, where the prospect theory shows how behavioral
biases can influence people’s decision-making processes. Recently we have discussed in
previous sessions that these behavioral biases can translate into our financial decisionmaking processes and cause us to incur financial losses as well.
This session focuses on understanding the valuation of financial decision processes in
terms of valuation of securities and how different type of securities can be valued with
some standard approaches which we will discuss today. The topics that we are going to
discuss today include valuation of financial assets and present value method of
calculating financial securities prices.
(Refer Slide Time: 01:49)
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Essentially when we talk about valuation of financial securities, we imply that we are
going to invest some amount of money in financial securities or financial assets. And as
we progress in future, we are going to receive some return where which can be utilized
as a criterion for deciding whether to invest at first place or not. So, what comes to our
mind when we talk about financial assets? So, the financial assets that we are primarily
focusing in this session include securities in stock market and financial market in
general, and the assets where typically individual and retail investors tend to invest.
So, first we will discuss what are those financial assets and their attributes in terms of
financial features, and how these features can be incorporated in a decision-making
model, where we can understand the cash flow generated by these financial securities
and the valuation of those cash flows in terms of present value. So, when we talk about
financial securities essentially we mean that there will be some obligation or
commitment in financial market which can pay back an amount of money either in lump
sum or as a periodical cash flow which can be considered as return on the investment.
So, let us understand what are those financial securities that we are going to focus in this
session. So, first we will touch upon the types of financial securities that we are going to
talk, and then we will understand their features, and subsequently we will incorporate
those features into the decision-making model of financial evaluation. So, let’s say we
have an amount of money to invest, and we are going to invest that amount of money in
some financial security which will pay back the return to us in future.
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(Refer Slide Time: 04:31)
As we have already touched upon the typical characteristic of such a financial security
would look something like this. It will be basically in a cash flow framework where we
have some time line which begins with t0, t1 and so on to let us say tn. And every time at
every point of time if we invest some amount of money now, we are going to get some
amount of money at every periodical time period. So, there will be cash flows which will
be generated in future. So, C here represents the cash flows and t represents time period.
So, when we have such a cash flow associated with a financial security essentially when
we have to make a decision whether to invest at first place or not, the first thing that we
do is to understand what are the values in terms of present value of these cash flows
which are incurring in future time. So, essentially it should be brought back to one single
time line to understand whether the present value of these future cash flows is
comparable with the initial investment that we are making.
So, the typical approaches we have C0 which is basically a negative cash flow because
you are paying the price right now and it is going out of your pocket, and then we have
cash flows which are generated in future. So, we will take a simple approach as
discounting method where we will use these cash flows to discount it to present value,
and we will find what the present value of these future cash flows is. So, essentially the
approach is when we have to find present value, we are trying to see if the sum of all
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cash flows are with discounted value using a discount rate r, where the sum should be
greater than the initial investment that we are making.
Here r is the discounting rate. So, discounting rate means this is a rate which can be used
to discount the future cash flows to present time. So, present value is given as the sum
total of all the present value of future cash flows. And when we try to calculate the net
present value which is the decision criteria here, essentially it’s your initial investment
which is a negative cash flow of C0, and the sum total of all future cash flows present
value. Here C0 is your initial investment, and
Ci
ir
i
your present value of all future
cash flows.
Now, if NPV which is basically net present value is going to be greater than 0, you can
go ahead with the decision. And if it is negative, then you should not typically pursue
that decision. So, if NPV is less than 0, in some cases equal to also, then we should not
take the decision.
Now, let me explain this approach with some practical examples. So, this typical
approach of calculating NPV for future cash flows indicate that if we invest an amount of
money today which is time 0 and the amount of money that we are investing is C0. If we
invest an amount of money as C 0 and we expect that that amount of money will
generate future cash flows in terms of C1, C2, C3 and so on.
Then given that we have a discounting rate which is basically your cutoff criteria we can
discount the future cash flows of C1, C2, C3 and so on to present time to find the present
value as given by this particular formula. And if we have the present value of all future
cash flows, we can use this amount to be compared with C0 to find the net present value.
And if net present value is found and it is greater than 0, we can simply go ahead with
the decision.
This approach can be utilized with slight modifications in different context. So, once we
understand this generalized up of finding net present value of future cash flows we can
contextualize this with different situations in financial market. So, what are those
situations which are presented in financial market? Let us try to understand those
situations.
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(Refer Slide Time: 12:13)
In financial markets typically investors find different types of financial securities, for
example, they might find stock which is basically share of a company. They might find
bonds which are an instrument where you invest some money for long term and fixed
return, then you can find something called zero coupon bond. I will discuss the
properties of these assets subsequently. And then you may find some let us say
convertible bonds; you may have insurance policies; you may have investment project.
Now, these financials opportunities or securities essentially present different type of
scenarios.
So, in stocks when you invest some money, you are actually buying the share of a
company in terms of the ownership, and you expect that whenever company makes a
profit, you will be shared with that of some amount of money from that profit, and that
profit share given to you typically is considered as the dividend. So, in stock market, if
you invest in stock you get a dividend as a return. In bond, you get coupon or interest
which is basically you return.
So, if it is bond of standard nature which is you invest some money today for 20 years,
and every period you get a fixed amount of return from the investment, you will get a
fixed income. If this is a zero coupon bond, essentially zero coupon bond means you are
not liable to get any amount of money in the holding period, but as their bond matures
you get an amount of money as fixed by in the initial period.
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Similarly, if it is a convertible bond, typically it means that you have an investment in
the bond which will be paying you for certain amount of period a fixed rate of return and
after that it becomes another security typically a share. Similarly, if you have insurance
policy you pay some money for certain number of periods, and after that period you are
going to get some amount of money or some financial securities in terms of life
insurance or health insurance. If you have an investment project you invest some money
today, and in future you are expected to get some amount of money in terms of return
from that investment.
So, if we try to explain the unique features of these financial securities, we can show in
terms of timeline. And the approach will be if you have a dividend, you typically invest
some money today, and every period you are expecting some return. So, basically this
period this investment period is infinite, and here you are getting dividend every year.
Now, the dividend might be different in different years, and you have to pay a price
today. So, what is your price today?
So, if you pay a price of some share today, you are expecting to get dividend in future
and that dividend is not necessarily going to be fixed; it could be a vary from one year to
another year. If you invest in bond, typically bonds pay you some fixed amount of return.
So, you have to pay some money today that is t0 and every period you are expecting
some coupon. So, coupon will be in terms of interest payment to you. And then there will
be maturity period which is typically defined in the beginning itself, where you not only
get coupon, but also get redemption value.
So, if you invest in bond which specifies that it will pay you a 7 percent of interest every
year, and after 10 years when it gets matured you will get a fixed amount of money in
terms of redemption value. So, this is a typical feature of bond, where they pay you
interim interest as well as the redemption value. So, the RV basically indicates the
redemption value.
If it is a zero coupon bond where you have to pay some amount of money today, and you
are not going to get any amount of money in interim period. And at time of maturity,
when the zero coupon bond matures, you get a lump sum value in terms of redemption
value. So, here there is no cash flow in interim period, but a single cash flow at the end
of the maturity of this zero coupon bond.
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Similarly, in insurance policy, for example, if you pay some amount of money for buying
an insurance policy or the insurance policy has some features such as the endowment in
nature. So, you have to pay some premium. So, premium basically is going out of your
pocket from day 1, which is basically a premium.
So, premium 1, then premium 2, again negative, premium 3, suppose you pay for 5 years
insurance premium, and then from 5th year onwards you start getting some endowment
back in terms of either cash back or in terms of the insurance coverage for your asset
which you have purchased for. So, this is a typical feature of insurance policy.
Now, a similar characteristic can be generalized for an investment project, where you
have as already explained, you have to invest some money today which is typically
negative value, and then you expect some cash flows generated in future, and there will
be a different time period for those cash flows. Now, it may so happen that in
investment, if you make some initial investment today which is basically negative cash
flow, you have to make certain further investment some later time period as well.
So, for example, if you have set up a business plant or production plant, you have to
make some investment today to start the production or to set up the plant. And after five
years probably, you have to make another investment to improve, improve the machinery
or plant or maintenance of that plant for next 10 years. So, in that case probably the cash
flow might look like in year 5, you have another negative cash flow which is basically a
reinvest investment of some money to the project. This might also have some period. So,
if we can say that it is going to be for infinite period, it could be defined as such, and this
is what a typical flow of cash might look like with respect to different type of financial
securities.
Now, if I can define or categorize these cash flows, I would say that there are two types
of cash flows and these two types of cash flows could be considered as, either a perpetual
cash flow or an annuity cash flow. Perpetual cash flow means the cash flow which is
going to incur for perpetuity, for example, in case of stocks.
So, when you invest in a share of a company you expect that the company will keep
running for perpetuity, and you are going to get dividend for perpetual period. Annuity is
basically cash flow which is generated or incurred after every year. So, which is
basically the annual nature of cash flows, for example, annual interest bearing bonds or
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maybe insurance policy, where you have to pay in annual insurance premium or it could
be an investment project which is going to yield you an annual rate of return.
If we try to categorize it further probably both type of cash flows might look like
growing, growing cash flows or delayed cash flows. For example, if you have a cash
flow which grows every period, it is a typical growing cash flow let us say if you invest
some amount of money in the stock of a company or share of a company, and every year
company is increasing the dividend by certain proportion.
So, basically in year 1, you get x amount of dividend; and year 2, the dividend amount
increases to x + some growth as decided by the company’s management, so that is the
typical growing cash flows and delayed cash flow indicate that you have hold onto the
cash flows for certain number of period. So, for example, if you are evaluating the
insurance policy first 5 years, you are getting to pay the insurance premium which is a 5
year cash flow; and after that your cash flow in terms of income is starting so which is
basically indicating the delayed cash flows on the part of insurance policy.
If we try to explain this nature of cash flows with different type of examples, we can
show a simple personal finance problem, and this can be understood with the help of a
realistic financial situation an individual might be in.
(Refer Slide Time: 25:25)
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So, if I highlight this here, suppose you have to pay some amount of money to invest in a
particular project. So, I give the situation here. This is time 0. Keep in mind whenever
you are trying to evaluate a financial situation or financial decision-making, you have to
plot this particular situation on a timeline because it should involve time value of money
at different point of time.
So, this is a typical cash flow timeline. And the decision typically holds is you have to
pay some amount of money now, and then you expect some cash flows in future. Most of
the situations you can come across with in financial decision-making are of these this
nature, where you have to decide how much to pay, or whether to pay or not, to pay or
not.
So, for example, if you are buying a share, you need to decide how much to pay or
whether to pay for that particular share or not, whether to invest or not. So, or you are
buying an insurance policy you need to know how much is the right price for that
insurance policy or insurance premium that you are going to expect that will of course,
depend on how much endowment you want to create. So, you can consider either these
two questions how much or whether to pay or not.
Now, if you assume or in a simplistic framework that an individual is in a college, so
basically the person is about to complete his or her education, and the individual
essentially is trying to include some financial knowledge to decide about his financial
planning. So, a situation I am giving here is the person is going to enter the job market
next year. And at the end of certain number of years, he would stop working and then he
his retirement period will begin. So, I give you a situation here to think through that well
discuss in next session, but before that I present the problem here which will try to
incorporate situations which we have discussed from different financial securities.
So, the situation here is there is a person let us call her Ms. Hiflyer. So, I am presenting
the problem of Ms. Hiflyer here. So, Ms. Hiflyer is a very ambitious lady and she is
entering the job market in 2020, January 1. And she is expecting that she is going to earn
some money from that year onward. And since she is very ambitious, she believes that
she will continue to live for eternity or she will continue to live very long which is very
long time in future.
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So, the problem here is she is entering the job market in 2020, and she is expecting that
for next 20 years, she will continue working. So, let us say she will continue working till
2040, and for next 5 years she will be vacationing. And after that she will settle down in
some retirement home or some or let us say monastery. So, I tagged this period as
working period, this period as vacation period. And finally, this period is a retirement
period.
Now, she is going to expect certain amount of income during her working period and
then she will be spending some money in vacation period and retirement period also. So,
if we say there will be some positive cash flows here, which she can invest in some
amount of money, and then there will be negative cash flows. Now, the problem here is
if she earn some money and she has to decide whether she will be having enough for the
vacation and the retirement after she ends up working, how much money should she
save.
So, the situation here is what amount of money she should save every year, so that she
will have sufficient amount of money during her vacation period and retirement period.
So, if we put some hypothetical numbers here, let us say if we say that for vacation
period she needs ₹5 lakh every year. So, what it means that for every year vacation she
will spend ₹5 lakh. And for retirement although this is a very generous retirement
scheme, but still she will need ₹2 lakh per year for her retirement plan.
Now, if you believe that certain more information is needed, we will present that
information. You have to tell how much amount of money she is going to invest every
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year, so that that sum total of this investment sum total of all cash flows should be equal
to sum total of, so basically this is positive cash flows and this is negative cash flows. Let
us present some additional information here. The rate of return that a person can get in
on investment, rate of return on investment here during this period is 7 %.
Now, I stopped here by presenting this problem which I highlight again there is an
ambitious lady Ms. Hiflyer who would like to earn for 20 years. So, time period is
twenty years and she would spend her all savings which will be invested in different type
of assets, for next 5 years on vacationing which will be requiring ₹5 lakh per year as an
expenses. And after 5 years, she will settle down in a monastery somewhere or in a
retirement home which will require her to spend about ₹2 lakh per year of expenses.
So, your job is to advise Ms. Hiflyer how much money she should save every year from
2021 till 2040, so that the amount saved and invested should be sufficient to cover all her
expenses during her 5 years of vacation period and in finite period of her retirement. This
is a typical personal finance problem where a financial adviser is expected to advise her
client on savings and investment approaches, and this is what is going to be the thrust of
next module of the course. For now this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture - 19
Valuation of Financial Assets (Contd.)
Hi there, welcome back to the course Behavioral and Personal Finance. If, you recall
from the last lecture, we were discussing about how the valuation of financial securities
such as shares, bonds or insurance policies, or for that matter any investment projects,
can be evaluated using a simple cash flow evaluation approach. Where, what we try to do
is to analyze the present value or the future value of different cash flows be it negative or
positive, and then based on their present value or future value in some cases we decide
whether to invest in that project or take that decision or not.
Taking the discussion forward, we will continue discussing about different methods of
cash flow evaluation for financial investment decision making. And today’s session is
focused on understanding different approaches for net present value, where we will try to
understand, how present value of different cash flows occurring at different points of
time can be used to determine the decision criteria.
(Refer Slide Time: 01:38)
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That, the topics that we are going to cover today are the simple approaches of net present
value and how the valuation decision making can be done using the net present value of
different nature?
Essentially, in a last session we touched upon the different characteristic of cash flows,
such as the cash flows which are generated as annual cash flow or cash flows which are
generated as perpetual cash flows. We also shown some examples, where the cash flows
are of growth in their nature can also be used to associate with financial decision making.
Let us start today’s discussion with understanding the nature of different cash flows of
growth, annuity and perpetuity characteristics. First, we will start with simple illustration
of how discounting or a compounding method can be used to understand the net present
value of cash flows. And, then we will move on to different techniques that we apply for
understanding the cash flows occurring from different investment choices.
In previous session I had highlighted that a cash flow occurring at different times of
point and future can be associated with different investment opportunities such as
investment in shares or bonds or zero coupon bonds, in some cases convertible bonds, it
could be insurance policies and corporate finance projects. There we understand that if
we invest some amount in today’s time that is present time and we are expecting some
cash flows to be generated in future, we can understand the net present value of those
future cash flows to compare with the present cash flow that we are incurring today and
then make the decision.
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(Refer Slide Time: 03:52)
So, the whole the basic idea was to understand whether you have a timeline of cash
flows, where the time can be explained in terms of t which we have explained earlier
also, and then associated cash flows will be again given as different cash flows occurring
at different points of time, where in general the initial cash flow is negative. Essentially,
what it means is when you have initial investment, the initial cash flows can be
considered negative and then subsequent cash flows are positive. So, the approach was
let’s say you have some amount of money now and that amount of money is to be
invested in bank today.
So, if you have an amount of let us say ₹100 which is investment in bank. So, let us say
you invest this money ₹100 and bank gives you a rate of interest of let us say 7 %per
annum. So, after 1 year or 1 period if that period is defined you get ₹100 of your money
plus the interest that you are generating on ₹100 right, it is very simple. So, the amount
of money that you are going to get is basically the amount of money that you have
invested and the amount of money that you have earned as promised.
So, basically you are going to get ₹107 in this case after one period. So, if we want to
understand the same approach in reverse calculation mode, then we can say that if you
have some amount of money in future and you expect that the future amount of money
can be brought to present time in terms of their economic value, the same can be
calculated in a reciprocal way.
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So, if it is future value that is defined as cash flow into 1+ r that is the rate of interest
here and then time, which is basically the time of period you have invested the money for
then present value can be shown as a reciprocal of that. So, basically it will be the cash
flow that you are generating in future and then (1+r) which is the rate of interest and n.
So, if you have some amount of money in future that is CF you can discount it using the
rate of interest that is given here and the period for which it has been invested.
So, if you try to give it a name here as given. So, this is known as compounding method
and this particular thing is known as discounting method. So, when we have
compounding, we try to calculate the future value of cash flows, which are basically
present cash flows and if you are using discounting method, we are using basically the
present value of future cash flows.
In case of financial decision making most of the time we try to use discounting method,
because typically the decisions are based on the initial investment that we are making
today versus the future promised cash flows which we are expecting to generate in future
point of time. So, we use discounting method here in most cases.
Now, when we try to use discounting method there are two major assumptions. So, if we
can highlight those assumptions before we move on. So, the assumptions here are the
first assumption is the lending and borrowing rates are same. So, you can say that rate of
lending and rate of borrowing are equal.
So, what it implies that, when you are investing some money in the market, you can
borrow as much money as you want at the same rate at which you are investing it for. So,
if suppose here in this case you are investing it for 7% rate of interest ₹100 of money in
your bank deposit. So, you can borrow as much money from the same bank or any other
bank at the same rate of interest.
So, that it what this assumption means; of course, this assumptions might not be realistic,
but to begin with we can have this assumption in our hand. So, the first assumption is
lending and borrowing rates are to be same. And, second assumption that we base our
approaches here is the amount that we are making the amount that you are making in the
process are basically reinvested, which means if you are making some amount of money
in future in terms of rate of interest or the interest income, you are reinvesting that
amount of money in future.
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So, basically what it means that, if I try to highlight this assumption on the time line.
Suppose, you have some amount of money to be generated in future in CF 3, which is
basically your cash flow at time period 3. And, you are reinvesting that money, in future
in the business or the bank where you are basically considering it to generate some
return. So, that when you try to calculate that present value of future, you are actually
bringing all future cash flows to present time with the interest income that is being
generated for that period at the rate of r.
So, basically these are two major assumptions based on which the methods or the tools
and techniques of present value calculation are formulated. Now, let us move on to
understand the methods that we are going to use for different financial decisions.
(Refer Slide Time: 11:57)
To start with let us say we had discussed earlier, that cash flows could be perpetual cash
flows, which basically means the cash flows are going to be incurred in future for
perpetual time period.
So, basically you have perpetual cash flows and then you have annuity cash flows or
annual cash flows. Perpetual cash flows implies that the cash flows are to be generated
for a perpetual time period in future and annuity cash flow or annual cash flows implies
that, the cash flows will be generated for certain number of years and then after that it
will stop.
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I can quote some example suppose you invested some money in the stock of a company,
the dividend that you are expecting from that investment is basically a perpetual kind of
cash flow, which means that the company is expected to be doing business in future for
perpetuity and the dividend income that is being generated are also considered to be
perpetual in nature. This is an example of perpetual cash flow.
Now, if you invest some amount of money in fixed deposit. Let us say you invest some
of money in bank in fixed deposit that fixed deposit will have certain tenure, let us say it
is a 10 years fixed deposit. What it means that you will generate interest income every
year for next 10 years. So, this is an annuity cash flow.
Similarly, if you have purchased an insurance premium which you are paying to secure
an insurance policy, this is a kind of annuity or annual cash flows, which are going to be
generated for certain number of years in future and after which it will stop. Similarly, if
there are cases where cash flows are growing, which means if you are paying some
money or earning some money at certain rate of interest, every period it is expected to
grow at some growth rate and that could be the case of annuity as well as perpetuity cash
flows.
So, perpetuity cash flows are basically the cash flows which are going to be in future. So,
this is t0, t1 and so on and annuity cash flow will be given as for certain number of time
periods. So, these are two examples of cash flows that we are going to discuss with.
Now, the first case here is the simple perpetuity cash flows.
In perpetuity cash flow, we expect that the cash flow is going to be there forever. So,
suppose if I have to invest some want of money today and I expect that, I should be
generating an income forever in future, this is a perpetual cash flow example.
Now, the amount of money that we are going to invest now and the amount of money
that we are going to expect in future for perpetuity should be connected with in terms of
some functional relation. Now, the situation here is I want to invest an amount of money
today and this is basically perpetuity. So, what example I am trying to give here is I want
to invest an amount of money, let us say this amount of money is ₹X and I want to get a
cash flow every year in future, where every cash flow is same.
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So, basically this is a perpetual cash flow, where we are expecting to generate a cash
flow of C and we want to invest an amount of ₹X. So, let’s give an example here.
Suppose, you have been approached by an alumnus of your institute and that alumnus
wants to set up an scholarship in the college. So, in the college the alumnus desires to be
a set up a scholarship that will be given to the topper of the batch every year for a certain
amount of money. And, that amount of money is let’s say C. So, the scholarship amount
is C and the amount of money that has to be invested need to be found out. So, how do
you calculate that?
Now, let us get through this example. So, suppose you have asked the alumnus to invest
an amount of money X today and after 1 year so, this is basically today after 1 year you
are expecting that you should get a return or an a value of your investment to be X into 1
plus r, right. So, x*(1+r) is basically X amount of money invested and r is basically your
rate of return. So, here X is amount invested today and r is rate of return.
So, if you expect that an amount of X is invested today and you are supposed to generate
a return of r. At the end of the period which is basically at the end of year 1, you are also
expected to pay a scholarship amount to the extent of C. So, which means next at the end
of period 1, the amount of money that you had invested in the beginning plus the amount
of money that you have generated minus cash flow which is basically the scholarship
amount should be equal to X, right which means this scholarship amount cash flow.
Basically here the outflow, so, if you have sufficient amount of money in your
investment at the end of period 1 and you have given out the scholarship amount of C at
the beginning of next year you should have an amount of X here. So, that next period
when you start you will again generate X you have a return of rate of return of r, again
next year you will pay a scholarship amount of C and then it should be left with X, right.
If, this process is repeated you should be able to pay out the scholarship money till
perpetuity and that our scholarship money is C.
So, if we try to simplify this formula or this function, basically we can write it here like
this X plus X r minus C is equal to X which is basically X r minus C or rather X r is
equal to C, because these two X will cancel out.
So,
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X 
C
r
So, this is a formula which will give you given that, this is the perpetual cash flow, given
that r is the rate of return this let us call it discounting rate and X is the initial investment.
So, given that perpetual cash flow amount of C and discounting rate of r, you can
calculate what amount of money should be invested today? That is X so, that you should
generate C amount of money every year or every period till perpetuity. So, this is the
formula you can use to calculate the value of investment to be made today to generate a
perpetual in return or perpetual cash flow in future to the extent of C.
So, going back to the scholarship example, if the alumnus wants to create a fund today so
that every year from next year onwards as a scholarship amount of C should be paid till
perpetuity, this should be given as
X 
C
r
where C is the amount of scholarship r is the discounting rate and X is the amount of
money invested today. So, this is an example where we can calculate the present value of
situation or cash flows which can be considered for making a financial decision.
These kinds of decisions are very commonly used in stock market. For example, if you
are using C as the dividend income from the stock investment, you can use this C equal
to the annual dividend income that you are expecting from the investment, r will be the
discounting rate that will be the cutoff rate for you. And using this dividend discounted
with r, you can calculate what should be the price that of that stock, which you should be
paying in order to generate a return of C.
So, this is one approach. Now, let us move on to next approach. So, after perpetual cash
flows we can understand how this perpetual cash flow can be delayed?
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(Refer Slide Time: 24:07)
So, for example, if the cash flow is generated 1 year after, so, let us move on to the next
situation where we discuss delayed perpetual cash flows. So, for example, if you have a
timeline where you are actually investing some amount of money today and the amount
of return that are being generated is coming in future. But, actually the situation, which is
different here is you have to invest some amount of money today, but that first amount of
money that you are generating is not at the time point of t1 rather t2, which means this is
your first cash flow and then second cash flow and so on.
This kind of example can be seen in endowment based insurance policies, where you pay
some investment for a certain number of years and after that you start generating income.
This can also be considered to be an example of investment in education for individuals.
So, you invest some amount of money for first 2 years and after graduation or after
graduating from the college you expect some amount of return or income to be
generated.
So, this is a case of delayed cash flows, where the calculation can be done. In this
situation if we assume that this is our t0 hypothetically. So, at this t0, the present value of
all these cash flow will be C by r as calculated earlier. And, if we try to take this present
value back to one more period which is basically actual t0, then present value of this cash
flow will be
C
.
r * (1  r )
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So, since the cash flow is delayed for 1 year or 1 period in this case, we will discount it
for one more period that is divided by 1 plus r as we have seen earlier. So, the situation
here is if you have a delayed cash flow, you can discount it for the number of years for
which it is delayed and this will be giving you the present value at current time.
Now, take a situation of growing cash flows, where the cash flow is growing at certain
growth rate. So, if; so, earlier we discussed perpetual cash flow then we touched upon
the delayed perpetual cash flows. Now, let us get into the growing perpetual cash flows
the situation will be like this. So, suppose you have a time line for which you have
different point of time and it is going to be there for forever.
And, the situation here is in year 1 you have CF1 which is your first cash flow, in year 2,
you do not have only CF1 you have CF1 growing at let us say growth rate g, where g is
growth rate of cash flow. Which means if you have invested some amount of money in
some investment, in first year it will generate a cash flow of CF1, in second year it will
generate a cash flow of CF1 with a growth rate of g, which is CF1*(1+ g) and in year 2 it
will generate CF1*(1+g)2 and so on.
So, it will keep on growing this kind of example can be seen in some cases, where
dividends typically grow given by the companies as companies make more profit they
start giving more dividends year after year. Similarly, if you have invested some money
in some investment avenue and that investment avenue is growing in base value that
could be a return with growth.
So, if you have situation like this, you can simply use the same approach that we have
shown earlier. We have shown that as the present value of perpetual cash flow can be
calculated using a formula known as X is equal to C by r, where X is the present value
and C is the future expected cash flows are is the discounting rate.
So, if we repeat the same situation here, we can show that if a person has an investment
X, which is to be growing at a rate of r which is basically the interest income. And, if
you pay out the cash flow this whole should be sufficient enough to pay out the amount
of money to be invested in next period.
So, essentially when we try to simplify this function it will be X into 1 minus r sorry, 1
plus r minus C which is your cash flow is equal to X into 1 plus g which is basically the
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growth in cash flows. And, if you simplify it further X plus X r minus C on the right
hand side it will be X plus X g. If, we try to simplify it further these two X will cancel.
So, what you are going to get next is X r minus C is equal to X g.
So, if you bring the X factors on one side so, you will have X r minus X g is equal to C
and to simplify, it even further you have X r minus g, which is X common outside and C.
So, the amount of money which is given by X should be equal to
X = C / (r-g)
So, basically what it means is if you have to find an investment of X that is to be made
today and you expect that the cash flow will be C and discounting rate is going to be r.
Given the growth rate of g you should be able to find using this function of X is equal to
C by r minus g to in terms of the present value of growing cash flows. This situation is a
cash flow which is growing for perpetuity at the rate of g.
Now, these three situations of simple perpetuity, delayed perpetuity and growing
perpetuity can be used to find the present value of annuity as well which we will see in
next session.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture - 20
Valuation of Financial Assets (Contd.)
Hi there, continuing from the previous session where we were discussing about different
types of cash flows and we touched upon the approaches which we use for calculating
the present value of cash flows of perpetual nature such as the simple perpetuity cash
flows and then we also discussed how we can evaluate the present value of delayed
perpetual cash flows and subsequently, the cash flows which are growing in future and
how to calculate the present value of these cash flows.
(Refer Slide Time: 00:53)
Taking the discussion further we understood that the formula that we have discussed
earlier was given as the present value of growing perpetual cash flow can be determined
using
X 
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C
rg
where we should understand that r is the discounting rate and g is the growth rate of cash
flows.
So, if the discounting rate is as far as greater than g it is always going to be continuing in
future, but if the discounting rate becomes smaller than g then the cash flow will not
continue for perpetuity. You take a simple example here, suppose you invest some
amount of money today in in an investment which is supposed to give you a perpetual
income and that income is C, the investment that you are making today is X.
So, if you expect that the growth rate in your income is more than r which is g being
greater than r, it implies that every period you are getting more money than your
investment is generating, and that is why it will not continue for perpetuity in future. So,
the basic assumption of this growing perpetuity approach is the growth rate should be
less than the rate of discounting which we are using; which is given by our should be
always greater than g.
Now, let us move on to the different type of cash flows that we have touched upon
earlier that is annuity cash flows. Before, you move on to annuity cash flow let me jot
down the formula that we have discussed.
(Refer Slide Time: 02:51)
So, we have known that perpetuity cash flow is; perpetual cash flow is given as
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PV 
C
r
where, C is your cash flow and r is your discounting rate
Growing perpetuity is given as
PV 
C
rg
Delayed perpetuity is given as
PV 
C
r * (1  r ) n
where n is the number of years for which it is delayed
Now, let us move on to annuity cash flows. So, annuity cash flows are cash flows which
are being generated for certain number of years only, it will not move in the future for
perpetuity. And, we have seen that it has a predefined maturity period or number of years
for which we need to calculate examples could be investment in your fixed deposits,
insurance premium or any other investment which has a fixed tenure such as maturable
bond.
If you have investment in bond with certain number of years of maturity, you are
expecting to generate a cash flow for certain number of years and then you can stop
getting the cash flows. So, how do we find the present value of such annuity cash flows?
So, instead of directly jumping to the formula of annuity cash flows, let me specify the
formula using the methods that we have learned so far.
So, so far we have learnt methods to calculate the present value of perpetual cash flows
given as
C
. We have also learned that if the perpetual cash flow is growing, we can
r
calculate the present value given by
can use the formula
C
and if the perpetual cash flow is delayed. We
rg
C
to calculate the present value of such a delayed perpetual
r * (1  r ) n
cash flows.
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So, let us combine these methods to understand how we can calculate the annuity cash
flows. Going back the same methodology, we will first have a time line example. So,
suppose we have a time line example where the periods are defined as t0, t1, t2 and so on
and it continues till perpetuity. So, cash flows are also generated in a similar fashion, let
us take a normal cash flows. Let us call this situation 1 i.e project 1.
So, if this is project 1, let’s have a project 2 where a similar time line for perpetuity given
time given as t1, t2 and so on, but this difference in this scenario is the cash flow is
occurring after let say this is t100. So, at t101 year; so, let us say this is given as t100, t101
and so on. So, in project 2 the first cash flow is coming at t101 which is after 100 years.
Now, if we try to understand the difference between these two basically first project P 1
gives you a cash flow which is generating being generated at year 1 that is t1, t2 and so
on; in second situation which is project 2, the cash flow is delayed for first 100 years or
100 periods and after that the first cash flow originates. So, the second example is
delayed cash flow of perpetual in nature and first exam first situation which is project 1
is the typical simple perpetuity cash flow.
Now, if we have already discussed the formula to calculate the present value. So, we can
say that present value of project 1 will be
be
C
. In case of present value of project 2, it will
r
C
because this has delayed for 100 years and it is starting at t101.
r * (1  r )100
So, if we simplify this formula to understand the net present value of situations for which
the perpetuity is gone and the cash flow is generated for certain number of years. So, it
will be as simple as that. So, in first case the cash flow is occurring at perpetuity, in
second case the cash flow is occurring from t100 till perpetuity, right.
So, the difference between these two cash flows will be basically the cash flow which is
basically generated as t1 till t100. So, basically this will be an annuity for 100 years, right.
So, when you try to understand the nature of cash flows for first 100 years, then it will be
P2 and P1 the difference. So the basically, if you try to understand the present value of
annuity it will be the present value of P 1 minus present value of P 2.
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Basically, present value of P1 implies that you are getting a cash flow for the whole
perpetual period present value of P2 implies that you are going to get the present value of
cash flows originated after 100 years; so, t101 and so on. So, when you try to calculate the
present value of first 100 years it is basically giving you an annuity formula.
So, annuity formula will be if we try to simplify the formula present value of annuity for
100 years, in this case it will be
C
C
because we are delaying it for first 100

r r * (1  r )100
years. So, the formula would be C by r into, if you simplify this
PV 
C
1
)
* (1 
r
(1  r )100
If you try to understand this from this time line point of view, the present value of first
100 years of cash flows can be calculated using the present value of each of the cash
flow that are being generated at t1, t2, t3 in project 1 case, and that those cash flows are
brought back to the present time at time 0 which is basically the today’s time; and, that is
how we calculate the formula for present value of 100 years annuity.
So, basically if we simplify this formula present value of annuity will be
PV 
C
1
)
* (1 
r
(1  r ) n1
So, this is the formula that you can use to calculate the present value of annuity cash
flows for certain number of years. You have to be careful while calculating this present
value of future cash flows, because this becomes very critical when you try to understand
at what year the first cash flow is being generated which basically means that the number
of years for which it has been delayed. So, this is for understanding how the annuity cash
flows can be calculated in terms of present value.
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(Refer Slide Time: 14:39)
If you try to simplify the same formula using the growing annuity, so, if we go back to
the growing annuity case where the time line would be something like this. So, you have
time as defined as t0, t1, t2 and so on and this is limited for certain number of years let us
say n and cash flow are growing. So, basically in year 1, you are getting CF1, in year 2
you are getting CF1 * (1  g ) which is basically your growth rate, in year 3 you are getting
CF1 * (1  g ) 2 with increment and so on.
Then, the formula for this present value of growing annuity will be
PVgrowingann. 
C
1 g n
) )
* (1  (
rg
1 r
So, basically we are trying to discuss the present value of cash flows of perpetual in
nature and annual in nature. In perpetual we discussed simple perpetuity which is
basically given as
C
. Then we discussed delayed perpetuity where we discuss
r
C
where n is the time period for which it is delayed.
r * (1  r ) n
And, we discussed growing perpetuity where we came up with a came up with the
formula
C
where g is the growth rate, and then in annual we discussed simple
rg
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annuity and growing annuity. Delayed will be the same case, you have to just delay it for
certain number of years if it is given and these 2 formula are already discussed in this
session.
Now, having learnt these 2 methods or these approaches to calculate the present value of
expected cash flows of different nature. We can also implement these methods to
understand some very simplistic or realistic financial decision making problems.
Particularly when it comes to personal finance decisions these approaches of calculating
present value becomes more critical.
If you recall from one of the previous sessions, we presented you a situation where Miss
Hiflyer was about to make her financial planning decision and the situation was like this.
So, I will go back and try to represent the situation here.
(Refer Slide Time: 18:37)
So, the situation was Miss Hiflyer was about to plan for her future and it is she is going
to graduate in 2020 which is the immediate year. And, she is expected to work for 20
years then see is planning for some vacation trips for next 5 years and after that she will
be retiring.
So, basically we had defined earlier that this will be her working period which is going to
be 20 years, this is going to be her vacation period or holidays and this is going to be her
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retirement. If you recall we said that in holiday period she will need ₹5 lakh very year
and in her retirement she will be needing ₹2 lakh every year for her survival.
The question was how much amount of money to be saved every year investment per
year for 20 years. So, that it should be equal to her holidays for of ₹5 lakh per annum for
5 years and retirement requirement for of ₹2 lakh per year for perpetuity.
Now, this is the situation and additional information was given as the rate of interest that
can be used as borrowing or lending rate to be let’s say 7%, if you recall this was a
situation given to you. Now, if you try to calculate the present value of these cash flows
using the methods that we had discussed in this session and earlier session. We know
that this is an annuity situation where annuity cash flow, this is a perpetuity cash flow
and this is again an annuity cash flow.
So, when you try to implement the tools that we have learned for calculating present
value, you can simply use these functions to calculate the present value of future cash
flows. The point here is for every set of cash flows you have to bring it to a common
time line. For example, these 5 years of cash flows should be calculated at this point of
time which is basically t being 2040 and for these cash flows, this will be the time line
where you can calculate where t is going to be 2045 and for these cash flows t will be 0.
Now, when you try to apply the formula that we have learned the formula for this cash
flow will be; so, present value of this cash flow will be
C
which is ₹2 lakh of every year
r
requirement by r. So, we are using the same r here 7 % which is basically the rate of
discounting. So, whatever present value you are going to get is at this point of time, now
this has to be brought it to one common point of time.
So, if you calculate this value C by r using this ₹2 lakh of cash flows and 7 percent of
discounting rate, this will be let us say ₹28,57,143. So, this is the present value at t 2045,
if you bring it back to this point of time which is basically again bringing back for 5
years. This will be basically calculated as so, present value will be ₹28,57,143 this is
your present value, and has to be discounted with (1 + 7%) for 5 years which is going to
be basically ₹20,37,103. Please crosscheck the calculations although I am trying to be as
precise as possible.
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So, this is the present value at t2040 for this cash flow this retirement requirement. So, let
us name this retirement, this is the present value of retirement fund; similarly, we can
calculate the present value of this holiday funds. So, holiday funds will be calculated
present value of annuity cash flow of ₹5 lakh.
So, we have ₹5 lakh here that is
C
which is 7 % into 1 – (1/1.07) which is 1 plus r to the
r
power n which is 5. So, the calculated value is given as ₹20,50,099 ; this let us call this
holiday fund. So, as explained earlier if you are doing a financial planning for miss high
flyer you know that at time t2040 this which is basically this point of time, she will be
needing cash flow 1 and cash flow 2, right. So, the requirement for her will be cash flow
1 and cash flow 2.
And, the total sum total of cash flow 1 and cash flow 2 should basically be total of this
amount of money which is basically X into, X is the amount of money that she has
invested into (1+7%) which is r to the power 20 years; which is basically, the
compounded value of the investment that she has made and this should be equal to C1
plus C2, right. Because, this is the value that will be the value of investment X that is to
be met at this point of time and it should be equal to C1 and C2. So, that her investment
should be sufficient enough to cover her holiday requirement and in future for her
retirement requirement.
Now, if you equate this value; so, X into 1 plus 0.07 for 20 years is equal to C1 and C2,
C1 and C2 sums up together to ₹40,87,202. So, if you equate this you should be able to
find the value of X and it should be giving it to the value of investment that is to be met
per annum to get the financial planning done. Or an alternative way could be to bring all
these C1 and C2 back to present value that is today, and instead of this compounding you
can use it for discounting it to
C
1
) to the power n that is 20 years.
* (1 
r
(1  r ) n
So, that will be an alternative approach. I hope you try to calculate the value and come
up with some solution. We will discuss more similar examples and of financial planning
in next session and till now we have already touched upon the calculation of present
value of different type of cash flows including perpetuity and annuity cash flows. This
230
example was illustrated to highlight the situations of personal finance problems. That is
it for now.
Thank you very much.
231
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture - 21
Portfolio Return and Risk
Welcome back to the course Behavioral and Personal Finance. Having discussed the
basics of behavioral economics and finance concepts, let’s move towards personal
finance domain, where we will try to understand, how these behavioral factors influence
our financial decision making? But, before we move on to personal finance topics, let’s
try to understand how the different theories of finance can influence the understanding of
investments and personal finance decisions.
In this session we will discuss the methods and concepts of understanding the risk and
return associated with an investment.
(Refer Slide Time: 01:06)
The topics that we are going to discuss here are the basics of risk and return, what it
implies for financial decision making and what are the quantitative relationship between
risk and return associated with a financial asset or investment? When we try to
understand the relationship between different factors associated with a financial decision,
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mainly we talk about two aspects; one return which is basically the income or the
revenue that we generate from the investment and another is the uncertainty associated
with that return. Basically, what it implies is the risk part of the return. Essentially, it
means that if we are expecting to get some return out of an investment and there is an
uncertainty associated with it of which we know, the possibility of that uncertainty we
call it as risk associated with that investment.
There is a structured way to explain how the return and risk could be related in a broad
framework. To begin with I present an example, which is associated with a business idea
or a business project and how risk and return can be related with different other factors
associated with a financial decision making.
(Refer Slide Time: 02:44)
The idea that I am going to discuss briefly here starts with the proposal to set up a
business in terms of making an investment of substantial amount. Suppose, you have to
make an investment in a business idea or a project or for that matter any investment
avenues, such as stocks, bonds or any other factors. The business idea typically has a
series of cash flows that we have already discussed, in previous sessions that an
investment or a project having certain cash flows associated with it might be evaluated
for the feasibility.
So, how we start with the feasibility of a business idea or an investment choice?
Typically, we try to understand what are the cash flows that are associated with the
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business project or the investment avenues? And, if those cash flows can be brought back
to the present time to understand what is the present value of those future cash flows?
Basically, in previous session we learned that there is the method of net present value,
where we try to understand the present value of future cash flows in comparison with the
initial investment that we are making.
And, if the net present value is positive we understand that the project or the investment
is worth taking up. So, for calculating net present value we need to understand how we
discount those future cash flows. To discount those future cash flows, we need to find
cash flows and the discounting rate and, if there is any growth rate that we have already
discussed that can also be included.
To find that discounting rate we need to understand, how we are proposing to invest in
that business for the proposal or the investment avenue, whether we are going to use our
own money or we are going to borrow these factors also determine how we are going to
evaluate the business proposal or the investment project? If you try to look at the graph
we start with the cash flow that we have here, that is basically coming from different
investment choices and these cash flows could be presented in a timeline.
So, if you remember we had discussed earlier that there could be different points of time
where cash flows might be generated and then based on those cash flows; we calculate
the present value of those cash flows to understand the worth of that business project or
investment idea. So, basically we know that the cash flows could be discounted using a
method called Net Present Value and that was a cash flow discounted by a rate that we
use.
So, this is the way we use cash flows and discounting rate to calculate the net present
value. Here, the net present value is the final outcome, but to calculate the net present
value we need to find two major factors; one is what rate to use basically it implies what
should be the r for discounting and how the cash flows are coming.
So, cash flow we can calculate, but r need to be understood using the financing structure
of that business. Suppose, you are investing that business idea or the investment proposal
using borrowed money, which is basically a sort of loan. This borrowed money will have
certain cost of the fund, which will be basically the interest rate that you are going to pay
to the institution from where you have borrowed the money.
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Similarly, if you want to use your own money which is basically in the form of equity or
your own money you can invest that money as well in the business idea. So, the structure
of financing in terms of borrowed money and equity would determine how the rate of
discounting is calculated.
Once you have the financing structure basically also known as debt equity ratio. So,
basically this particular part is technically known as debt equity ratio implying that the
money of the investment is funded by a combination of debt equity structure, which is
basically a combination of borrowed money and your own money. Then you come to
calculate the total cost of funds. And, total cost of funds can be calculated by using the
cost of borrowed money and the cost of equity.
Since, cost of borrowed money is mostly fixed, because it is a loan where you have to
pay a fixed rate of interest, we know that this could be indicated as cost of debt which is
rd. And, if it is funded by a component of equity we can say that this is re, which is
basically cost of equity. And, this is cost of debt; a combination of these two would make
the total cost of fund.
And, we know that the cost of debt which is indicated is fixed mostly or known
beforehand. For re; we don’t know what is going to be the expected rate of cost in terms
of cost of equity. And, that is basically a function of the riskiness that the project carries
or the riskiness of the business idea that we are pursuing.
So, that is where we say that if the business is highly risky we should give high return to
the equity holders or the owners, because they are taking up too much of risk. And, that
technically is expressed as higher the risk higher should be the return. So, higher risk
lead to higher return and that is where the cost of equity as indicated here would go up, if
the total risk of the business proposal or the investment idea is high.
This particular thing can be derived using a framework known as modern portfolio
theory that is known as MPT, which we have touched upon in the very beginning of this
course. And, modern portfolio theory gives us what should be the return for the level of
risk that an investor or an individual is taking up. And, this tells us the higher risks
should lead towards higher return.
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Once, we understand the cost of equity in terms of re, we can also use another alternative
framework known as capital asset pricing model, which tells us the rate of return that
investors would be expecting given that the risk of the project. So, if we touch upon the
capital asset pricing model theory, it says that rate of return expected by the equity
investors is given by the rate of return that an investor can earn for sure that is risk free
rate and the riskiness of the project and the market with premium that the market is
paying for the investor:
Ra=Rf + β∗ (Rm−Rf)
So, if we try to break up this formula
Rf tells us the risk free rate, β
is known as beta or
we also call it riskiness of the project, Rm indicates the market return. So, when we talk
about capital asset pricing model, it suggests that given the beta here given that we have
the beta value or the riskiness of the project, and the return on the market along with the
return on risk free securities, we can calculate how much an investor should expect for
his or her investment.
So, now that we have models which can help us to determine the rate of return expected
by equity investors, we know that these two components would be clubbed together in
the proportion of the funding structure and can be used to calculate the net present value
of an investment. So, this graph particularly explains how the risk and return of any
investment or any business project can be functionally related with each other, and can
be determined using market return and the financing structure of the investment.
So, basically to summarize we can say that this graph shows the relationship between the
present value calculation approach with financing structure and the risk return
relationship in financial projects. These things are related to showcase how return of an
investment can be related to the risk associated with that investment.
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(Refer Slide Time: 14:59)
Speaking of return and risk we know that higher return should be a function of higher
risk or alternatively, if we carry higher risk we should be expecting higher return. And,
when we talk about higher return it basically means higher expected return whereas,
higher risk essentially means in terms of mathematical function the standard deviation of
returns. We know that standard deviation basically is the deviation from the average of
any data series or any observations.
So, when we talk about the risk return relationship, basically we try to understand the
relationship between the return in terms of expected return from an investment and the
risk in terms of standard deviation of the expected return. When, we talk about return it
can also indicate the return on bank deposit, or return on equity, or return on any other
investment, but essentially what it implies is the change of prices fall from one period to
another period.
Essentially, when we talk about return in financial context, it is the rate of change at
which the security prices vary from one period to another period, we can also indicate in
very simple terms. So, this particular return can be calculated as
(Price1 – Price0 / Price0)
What it shows that the change in price from time 0 to time 1? So, for example, if we
purchase our security or an asset at time 0 for ₹100 and we hold it for one period and at
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time 1 we sell it for ₹110. Essentially, the return that we are making here is (₹110 ₹100)/₹100 which is basically 10% of return. So, this is how we calculate return
associated with financial assets or financial investment.
And, when we talk about risk essentially it is the standard deviation of returns, which
means the deviation of observations or deviation of returns from the average return that
we have generated over a period of time.
(Refer Slide Time: 18:22)
If we try to illustrate this through a numerical example, we can see here that the return is
basically a function of price over period or over time and a risk is essentially the standard
deviation. So, if we take a numerical example here, if you look at the graph the first
column has time period from 1 to 10. So, these are time periods you can call it number of
days, or number of months, or number of years, as per the convenience. And, in second
column we have the average rate of return.
Basically, the change in price from 0 period to one period and one period to two period
and so on. Third column has the deviations, basically the deviation from the mean and
mean has been calculated using the values given in second column. So, we know that the
mean is total divided by number of observation gives us the mean.
So, this is our average return for the period that we are holding the investment the
deviations are calculated using. The deviation from the mean for each of the observation
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or each of the return on those 10 respective days, and square deviation has been
calculated using the squared value of the deviations. And, this gives us a value of this
particularly for square deviation, which is also known as the variance and the standard
deviation is calculated using this square root of the variance, and this is basically the risk
that we are talking about here.
So, this is how we calculate the return and risk for a security or an asset given that we
have some observed returns or observed prices, which we can use to calculate the return
and risk.
(Refer Slide Time: 20:37)
If we have a long observations of prices and it is subsequent returns, and we try to plot it
in a distribution framework, and we try to know what kind of distribution the returns
would look like, this is how the returns distribution typically look like particularly in
financial market context. So, the graph here shows that the return distribution of stock
market return index, basically the change in value of stock market index, over a long
period of time has exhibited a distribution that looks like a bell-shaped curve, which is
basically a normal distribution.
And, that is the basic assumption of all financial investment models, where we try to
understand how the returns on different securities or different financial assets might
behave will depend on what kind of distribution it follows. So, typically the stock market
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returns follow a normal distribution as shown in the graph, it might be skewed towards
positive or negative side, but typically it looks like a normal distribution curve.
(Refer Slide Time: 22:01)
If we try to understand the riskiness in different type of investment in stock market this is
how it looks like. So, the graph here shows a large number of observations from 1928 to
2010, the variation or the fluctuations of return for different type of assets. The asset that
we are considering here are stocks which is basically the stock market index and treasury
bills and treasury bonds.
So, basically these are three different type of investment avenues that we mostly talk
about in financial markets one is stocks which is basically a risky asset, so, a red line
indicate a risky asset T Bill and T bond are basically risk free asset or it has less risk. So,
if you look at the variation or the fluctuation in the graph, we can see that the redline or
the curve in red basically fluctuates more frequently than other two asset lines.
This implies that the variation in stock market investment or the fluctuation in stock
market investment is very frequent and very high compared to the fluctuations in
treasury bills and treasury bonds. This is why we say that stock market investments are
more risky or more uncertain compared to the treasury bills or treasury bonds
investment.
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So, it essentially implies that if you put a sum of money in stock market you expect more
fluctuations both towards positive or negative sides. So, this shows the possibility of
getting return on both positive side and negative side is very much fluctuating compared
to the investment done in bonds or treasury bills.
(Refer Slide Time: 24:30)
Now, that we have learned how we calculate the return and risk associated with a single
asset. We know that the return typically implies the change in price or change in value of
the asset over a period of time, and risk essentially implies the variation or the standard
deviation associated with those expected return over the period.
So, in technical terms we define return as the change in price, basically the percentage
rate of change in price of assets or financial security and risk is defined as the standard
deviation of the returns. These are the simplest definition that we use for understanding
the financial market investment factors and so far we have touched upon the methods to
calculate or the approaches to understand the return and risk associated with a single
investment or single assets, but the life is not really so simple.
So, we have to understand if there is more than one asset in the market, how do we
calculate the return and risk in terms of the portfolio return and risk that is what we call
it. So, let us have a look at the combination of assets where we try to understand the risk
and return associated with more than one asset.
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So, portfolio when we talk about it essentially it is a combination of assets or collection
of financial securities or assets, that we have in different proportion these assets could be
stocks bonds or any other assets financial securities such as cash, or fixed deposit, or
precious metals, or anything else which has some economic value.
These combination can be manipulated or changed according to the convenience of the
investor and investment objectives, because the factors such as risk tolerance or the
ability to bear risk that investment horizon or the timeframe for which the investment is
being made and the investment objective basically the goals for making the investment
are major determinants of the combination of different assets.
For example, if an investor wants to set up an investment for purchasing a house 10 years
down the line, then the combination of different assets would be varying from the
combination of assets for an investor that wants to set up an investment for his retirement
plans. So, basically risk tolerance or the capability to be at the risk investment horizon,
and investment objective these are three factors that determine the portfolio combination.
And, the ultimate objective of having a portfolio is essentially to diversify the risk, which
means that an investor wants to minimize risk and maximize return in through his or her
investment portfolios. When we talk about portfolio we know that we are trying to
combine return and risk associated with different assets which are combined together in
unique proportion for creating the portfolio.
And, when we understand the risk and return can be related with each other, what we are
talking about essentially at the end of the process is an investor wants to have an
objective, which basically can be translated into investor’s dream of having the highest
possible return with lowest possible risk.
So, this is the ultimate objective an investor for which the investor is trying to construct
or create of investment portfolio of different assets in different proportion. The ultimate
objective is to achieve the maximum possible return for minimum possible risk. How
this can be achieved or cannot be achieved will be discussed later when we talk more
about personal finance context. For now this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 01
Behavioral Economics and Finance
Lecture – 22
Portfolio Return and Risk (Contd.)
Hi there, welcome back to the course Behavioral and Personal Finance. Previously, we
were discussing about how to calculate return and risk associated with a single asset. In
this session, we will touch upon the methods and formulae to calculate the return and
risk associated with more than one asset. Previously we have discussed how combining
different assets, basically more than one asset together construct a portfolio and this
portfolio can be constructed to mitigate or minimize the risk and maximize the return.
Basically, this is how we diversify our risk to achieve higher rate of return from our
investment. In this session we will touch upon the two topics.
(Refer Slide Time: 01:07)
Mainly, we will focus on how to calculate a return and risk associated with a portfolio of
assets. Here, we will deal with two asset case, where a combination of two assets will be
used for showcasing the portfolio returns and risk calculation. We will also touch upon
the diversification concept, where we will try to understand how diversifying the risk
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through investing in different assets of unique characteristics can achieve the objective of
risk minimization.
(Refer Slide Time: 01:47)
If, we talk about risk and return relationship particularly in two asset case, it becomes
very important to understand the relationship between these two assets, because if we
have only one asset in the market, we don’t have our any other choice, but to put our all
investment and savings in the same assets. Suppose, the scenario, where you have just
one investment a venue that is bank fixed deposit. Whatever money you will save will be
deposited in that same fixed deposit because you have no other choice.
So, if there is only one asset in the market or in economy, all the investment would go to
that particular asset only, but since the world is more complicated. So, let us start with a
two asset scenario, where you assume that there are at least two assets, you can call it
stock and bonds or you can call it asset one asset two or stock or bonds or any other
combination of two assets. So, the two asset scenario if we try to present here, would
look like this where there are two assets A1 and A2 with different risk and return
attributes.
So, when we talk about risk and return attributes basically we indicate that asset A has a
return of this level. So, this is basically return for asset 1 and this is the risk associated
with asset 1. So, risk is denoted by sigma which is the standard deviation and return is
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denoted by r associated with investment or asset 1. Similarly, for asset 2 we have
returned for asset 2 as given and associated risk associate with the asset 2.
Now, if there is more assets scenario, where you have more than two assets and the asset
would look something like this, so, for example, if there is an asset which lies here. So,
let us call it asset 3. Typically, this asset might not exist in the market because we know
that for the same level of risk, which is basically the risk for asset 3, we have lower
return from asset 3.
So, no investor would want to invest money in asset 3, because it offers lower rate of
return for the same amount of risk because for the same amount of risk that is σA2, the
investor has a choice to invest in asset 2 where he can get a higher rate of return. So, in
this scenario the asset 3 would not exist. So, it will disappear from the market. Basically,
this is how information efficiency and the competitiveness of the market are determining
the availability of investment choices that we have. So, when we have two assets and
associated return and risk characteristics, we can also indicate this through a simple
numerical example.
(Refer Slide Time: 05:43)
So, for example, here we have the numbers associated with these two assets. So, suppose
asset 1 has a return of 10% with a σ of 5 % and asset 2 has a return of 20 % with a σ of
10 %. These are just arbitrary numbers this could be anything else, but for the sake of
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simplicity we have used these numbers for illustrate the relationship between risk and
return on a portfolio of two assets.
So, if we try to create a portfolio of these two assets we can assign weights. So, for
example, if we have 100 rupees to invest and we have choice to invest in either A or B or
a combination of A or B, we have multiple scenarios and the scenarios could be we have
a choice. So, scenario one would be, we have a choice to invest in A1 ₹100 and A2 ₹0.
Similarly, scenario two would be we have investment in A1 ₹0 and A2 ₹100 and then we
have multiple scenarios starting from in A1 we have ₹10, in A2 we have ₹90 and so on.
So, essentially it indicates the weight. So, for the sake of simplicity we assume that we
invest 50-50 percent of our investable money in each of the two assets. So, the weights
assigned to each of the two assets are 50 % for investment asset A and 50 % for asset B.
(Refer Slide Time: 07:45)
Now, if you try to calculate the return on such a portfolio of two assets the return can be
calculated using the weighted average rate of return for the two assets, which means if
we put 50 % of our money in asset A and 50 % of our money in asset B. A has 10 % of
return and B has 20 % of return. We can calculate the weighted average rate of return for
the portfolio of asset A and B. The same can be used for calculating the return for a
portfolio of any number of assets.
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So, if we try to calculate the return here the return on this portfolio, return on this
portfolio would be
Return = 0.5 * 10% + 0.5 * 20 %
So, we know that that rate of return on portfolio for these two assets would be 15 %, this
is the rate of return that we can calculate using the numbers given in the example.
If we try to illustrate through the graph method we have already shown that, the risk and
return can be plotted on a two dimensional graph and we know that this is A1 and this is
A2 where this has 10 % of risk, this has percent of risk, this has 10 % of return and this is
20 % of return. If, we invest our money in A1 and A2 somewhere 50-50 % so, the
portfolio will be giving us a return of 15 % in average.
So, this is what it happens when we invest our asset in 50 % in A1 and remaining 50 %
in A2. So, if you know the weights to be assigned to different assets you can calculate
the return on the portfolio in this particular approach. So, suppose you want to change
the weight of the assets to a different combination. So, now, you want to invest less
amount of money in A because it is giving you less amount of return. So, the amount of
money you have invested in A is 20 % and the remaining 80 % is invested in B,
(Refer Slide Time: 11:01)
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Then, the calculation of return would take you to a different value of return on portfolio.
And, that will be 17 % or actually it is basically, if we try to calculate this, this will be
this much of return for investment A and this much of return from investment B. So,
basically the total return would be 18 % from the investment that we are making.
So, this is how you can change the return by changing the weights associated with each
of the investment avenues that you have. So, since the returns are random variables. So,
we can calculate the return by linearly aligning them and combining them to the
proportion that we prefer. Suppose, you want to invest in 5 different assets, let us say
stocks of a company bond of a company and gold and let us say fixed deposit in a bank
and you want to have some cash.
So, all these assets will have certain amount of return and you have to decide how much
money has to go in each of these investment avenues and subsequently you can calculate
the rate of return for the entire portfolio that you are holding.
(Refer Slide Time: 13:01)
So, the example that I am trying to show here is if you have 5 different assets let’s say
stock, that is share of a company, bond and then fixed deposit, then you want to have
some money in terms of gold and then cash.
So, these are 5 assets in your portfolio. So, you have to decide how much of total
investment should go to stock. So, let us say 30% of your money should go to stock, 10
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% of your money goes to bond, 20 % should go to fixed deposit, 20 % should go to gold
or any other precious metal, and remaining 20 % you want to keep in cash. So, each of
the assets that you have will have some amount of return over the period that for which
you are holding and then you can try to calculate the average rate of return for the
investment that you have made.
Typically, cash does not have returned because cash you are holding is not yielding you
any return or any benefit. In some cases it might cost you some money because you have
to spend some money on maintaining the cash; other investment avenues might be giving
you some return. So, if you have the return for example, if you have the return on stock,
return on bond, return on FD, return on gold and then if you have any return at all in cash
you can combine these with the associated weights, for the inverse for the each of the
investments and calculate the portfolio return using this approach.
So, portfolio return is basically or sum of weighted average sum of each of the return of
your portfolio. Now, this is simple, because we know that returns are random variables
and we can linearly add them to find the weighted average rate of return on portfolio of
different assets.
(Refer Slide Time: 15:33)
But, what if the risk associated with these assets or this portfolio of different assets can
be calculated as well. So, we know that a risk of a two portfolio, two asset portfolio is
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dependent on how these assets are related or how the covariance of these assets are
related with each other.
So, we can try to calculate the variance of a two asset portfolio using
Var(RP) = w12 σ12+(1-w)2 σ22+2*w1*(1-w)*Cov(R1, R2)
Var(RP) = w12 σ12+(1-w)2 σ22+2*w1*(1-w)*ρ12 σ1 σ2
What is more important is the covariance of returns on the two assets. What it implies is
when we have two different assets in our portfolio; let us say stock and bond.
We need to understand how these two assets are correlated which means if I have some
amount of money invested in stock and some amount of money invested in bond. If, my
investment in stock is going up I need to understand whether the investment in bond is
also going up or it is going down. If, it is going up then we can say that this is positively
correlated, because both are moving in same direction. If it is going down which is the
opposite direction of the return direction of stock, then we can say that this is negatively
correlated, because it is going in the opposite direction.
So, the relationship between assets that we have in our portfolio determines how they are
correlated and, whether the total risk of the asset can be reduced or increased.
(Refer Slide Time: 18:03)
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So, if we take this particular approach further, we can rewrite that variance of the two
2
asset portfolio case can be rewritten as the weight of individual assets and σ of
individual assets along with the correlation expressed as the covariance factor, which is
ρ12 here. If, you see the factor that we have here is in terms of rho which is basically the
correlation between a return on asset A1 and asset A2.
And, that is where we can use this correlation or the relationship between two assets A1
and A2 here as it spans between minus 1 to plus 1, which is basically the two assets are
extremely negatively correlated or extremely positively correlated or anything in
between. So, if we have two assets A1 and A2 which are correlated to the extent of
minus 1 to plus 1; if it is minus 1 we know that, it is perfectly negatively correlated; if it
is plus 1, it is perfectly positively correlated and if it is 0, it is not correlated at all.
Taking this example in the real life, if we know that you have some money invested in
stock market and thus some other amount of money invested in gold. Typically, we
observe that when gold prices go up stock market goes down or vice versa. And, that is
why we say that stock, and stock market and gold investment are negatively correlated.
So, when you have in your investment distributed across stock market and gold
investment then you have your correlation factor to be negative.
This essentially helps us in minimizing or reducing the risk, because we know that when
we have two assets, the correlation will determine the total risk of the portfolio.
(Refer Slide Time: 20:27)
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In this way, if we try to understand it we can show case that the two-asset case, let us say
stock A1 and stock A2 these are two assets for which we have calculated or we have
expressed how we can calculate the risk associated with each of the scenarios. And, if we
sum it up together we have get the total variance of the portfolio of two assets as such
given in the formula. And, if we square root it we know the σ of the portfolio which is
basically the risk of portfolio.
So, this basically indicates portfolio risk so, when we have a sigma of the portfolio
calculated using the components. So, the input required to calculate for, inputs that we
need to calculate the risk of portfolio are basically weights assigned to each of the
investments, sigma of investment returns and the correlation between which is basically
the correlation coefficient between the assets.
So, if we have two assets, we will have one correlation factor, if you have more than two
assets we will have more than one correlation factor. So, for example, this is the two
assets scenario case where you have asset A1 and A2 and you can calculate the sigma of
the portfolio of asset 1 and 2 by using the same formula given as the portfolio risk. If,
you have sigma associated with each of the, for each of the assets in the portfolio, you
have weights associated with each of the assets in the portfolio and you have the
correlation factor given for the two assets.
(Refer Slide Time: 23:27)
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So, if we take the example that we had started in the beginning, we had two assets A 1, A
2 for which we had return as 10%, and 20%, sigma as 5 % and 10 % and weight as 5050. So, if we try to calculate a portfolio of these two assets and the associated risk,
basically what we can do is we can calculate it as weight, which is basically the 50 %
weight of asset A1 into 5 % of risk, and then we have 50 % of weight for asset 2 into 10
% of sigma for asset 2. We can calculate the sigma of portfolio for the given data.
Now, if we assume that this correlation is plus 1. So, if we assume here that the
correlation between A 1 and A 2 is plus 1, this will add more risk to the individual risk of
the assets. If we assume that this is going to be minus 1, this factor is if it is minus 1,
then this entire factor will become a negative or the reduction for from the total risk of
each of the assets individual risk. And, if it is 0, which means the entire factor will be
removed and it will be as much as the risk associated with each of the individual assets.
This is how this sigma can be minimized or increased depending on how correlated the
assets in your portfolio are.
So, this leads to the concept called a diversification, where you try to include the assets
in your portfolio, which are mostly negatively correlated or not correlated at all. Now,
practically there are no assets which are not correlated or which have zero correlation
with each other. However, we can try to have assets in our portfolio that will have less
positive correlation or at max negative correlation so, that our risk or the sigma of the
portfolio can be minimized or reduced.
This particular diversification concept essentially leads to the saying that goes as do not
put all your eggs in the same basket, which implies that if you have assets of similar
nature in terms of riskiness and correlation, then if one asset goes down other asset will
also go down. And, subsequently your total return on the portfolio will go down and total
risk of the portfolio will increase.
If, you have assets in your portfolio which are negatively correlated, it implies that if one
asset goes down, the other asset would go up and the return on the other asset will
compensate for the loss on the first asset. That is how we can use this correlation factor
to understand, the riskiness of the portfolio of different assets.
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(Refer Slide Time: 28:07)
Before, we wind up the technical tools for calculating portfolio risk and return we should
highlight the expected return on the portfolio is basically weighted average rate of return
of individual assets. And, if you try to calculate return on portfolio of N assets, we will
have N variance term and (N2 – N) as covariance terms. So, it implies that if we have
more number of assets in our portfolio, we will have more number of variance and
covariance terms.
So, if the number of stocks or number of assets in the portfolio is very large then the
portfolio variance tends toward the average covariance. For example, if there are 10
stock portfolios, there will be 10 variance terms and 90 covariance term and 90
correlation coefficients, which means you will have a very complicated computation that
cannot be possibly done by individuals.
So, when you have a portfolio of multiple assets or assets in huge numbers, then the
calculation of this variance and covariance term is very complicated and the ultimate
effect on your decision making might be very significant. To sum this session up we
would highlight by saying that having understood behavioral economics and finance
concepts, and learning the basic tools and techniques of present value calculation of
future cash flows, and risk and return associated with individual and portfolio of assets,
we can move towards how the personal finance decisions can be taken keeping in mind
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the behavioral economic concept and the traditional financial tools and techniques. We
will take up these issues in next session.
Thank you very much.
255
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 23
Personal Financial Goals
Hi, there welcome back to the course Behavioral and Personal Finance. In this course, we have
so far discussed the first module on behavioral economics and finance theories and how those
behavioral finance theories can influence our financial decision making. As we are progressing
towards the second module of the course, that is focusing on the personal finance and decision
making in personal finance context. We will discuss in the beginning, the basic theories or the
basic concepts of personal finance and how these personal finance concepts can be related to
the real money-making decisions.
In this session, we will touch upon the basic concepts of personal finance and how Personal
Finance Goals can be set keeping in mind the individual goals and objectives and certain other
factors.
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Two topics that we will touch upon in this session are how to set personal finance goals and
how personal finance planning is designed. And we will also discuss in brief the factors that
influence personal financial planning.
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To begin with it, we want to start the discussion on how personal financial goals are set.
Basically, we will try to understand why personal finance financial planning is important. As
a nation India has always been the nation of the savers. If we look at the statistics, we
understand that about 40% of the young millennials have savings in more than that they earn
and they are one of the big savers in the world. If you look at the data, India stands in top 30
countries, where people save about 30% of the income that they earn.
Basically, in global ranking India stands in a list of savers nation, where people of the country
save almost 30% of the GDP of the nation. It indicates that people in India have focused more
on savings of their income. If you look at the recent survey done by NCAER which is National
Council for Applied Economic Research in coordination with Max Life new insurance, we
have seen that almost 60000 people who have been surveyed in this study, they save 40% of
their income as investment.
However, they have not been able to save it say use their savings as proper investment because
they lack financial planning. That is where, we can conclude or indicate that India is a savers
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nation; however, we are bad in financial planning and that is why most of us are always
unhappy with our investment and financial planning decisions.
If we want to understand how financial planning goals can be set and designed in such a way
that the savings that we accumulate over our earning life can be invested properly and used for
securing financially beneficial future. There are two major types of financial goals, if we can
try to categorize them. One being the time driven goals or time-based financial goals and the
second which is objective or need based financial goals.
If we understand time driven or time-based financial goals, basically they are short term goals
versus long term goals. For example, if we have to invest our savings in such a way that we
should have sufficient amount of money on our short-term goals such as vacation or
entertainment or food. If we save our investment for long term basically, we save the money
that, we have earned and invest that money in long term goals for example, the retirement or
education or maybe children’s marriage.
If we categorize the financial goals in such a way that it is driven by the needs or the objectives,
it could be consumption driven goals and can in particularly the consumption which are of
short term which is consumable product goals and the other category could be the durable
product goals.
If we are saving and investing the money that we have earned for the goals such as food or
other consumable products basically, these are consumable product driven goals and if we are
saving our money in investment such that, we are trying to achieve goals of buying a car or a
bigger house or any other such long term decisions they are durable product driven goals.
Basically, the process of designing financial planning it starts with the definition of the goals
that we want to achieve. No planning can be successful unless the goals have been defined in
advance. And then we will set up with the goals in order to achieve through the proper financial
planning.
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(Refer Slide Time: 06:19)
If we want to understand how the financial planning goals are set, we will have to understand
what could be the possible areas or possible financial goals that we have to understand and
implement. Basically, there are certain issues before we set financial planning goals and these
issues could be taken care of well in advance. So, that the goals are achieved in a systematic
way.
The first thing that is most important in setting up the financial goals is the goals should be
realistic, when we are setting up our financial planning or we are trying to establish the financial
goals that we want to achieve, we should make sure that these goals are realistic. For example,
if I am a student and I want to set up a financial goal that I will buy a new mobile phone every
year that is not realistic given that I am a student and I do not have a regular cash flow.
So, the goals that we are setting in terms of financial goals should be realistic enough to be
achieved. Now, once we have set a goal which are realistic it should be stated in a very specific
and measurable terms. For example, if we are saying that we would save money, this is not a
more specific goal rather we should say that we will save ₹500 every month as a student and
this will accumulate over a period of our savings and create an asset.
So, the goals in terms of financial objectives should be defined in a very measurable and
specific terms. Third issue that, we have to take care of is the timeframe. When we are setting
the financial goal, that goals should be specified for a time frame to be achieved and when we
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are setting up the financial goal basically, the goal has to be achieved within a particular time
and that is why it should have a specific time frame.
For example, if I say that my financial goal is to double my income, saying this much will not
be sufficient because it does not have any specific measurable criteria or it does not have a
specific time frame. So, if I say that I will double my income in next one year, then it meets
both the criteria of specific measurable terms and timeframe for the achieving of the financial
goal.
Next objective that we should keep in mind, when we design our financial goals, it that it should
be indicating the course of action which implies that if we are setting up a financial goal, we
should also keep in mind in a very explicit terms that how we are going to achieve the goal
should be clearly defined.
For example, if I am a person using a credit card and I set up a financial goal that I will reduce
my credit card bills, it should be specified in such a way that I should implement in an action
plan that will suggest that I should reduce my expenses or credit card uses. Then only I should
be able to reduce the credit card bills.
And finally, the most important issue is, to exercise self-control. Even if we are able to define
the financial goal, we have clearly indicated the measurable unit and specified the time frame
along with the course of action that need to be taken to achieve the financial goal, if we fail to
exercise self-control, we should not be able to achieve the financial goal that we have started
with.
So, first of all we should keep a mental account for all the expenses or incomes while we are
setting up the financial goal and that is why where self-control becomes very important. These
are the issues that we have to keep in mind, when we are designing our financial planning goals
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(Refer Slide Time: 10:48)
Moving further if we are setting up financial goals there are certain issues which we have to
keep in mind along with the issues that we have discussed. There could be situations where
they, we will design our financial goal keeping in mind certain objectives. For example, if we
are trying to set up a financial goal that states that I will double my income in next one year; I
should be clearly defining how we are going to achieve that financial goal.
So, in that process probably I would like to obtain a suitable career training or professional
training or certification that will improve my job prospect. So, that my income will be increased
and subsequently my savings will be increased and my investment will also be increased
accordingly. And that then only I should be able to achieve the objective of doubling my
income in next one year. There are certain other issues for example, if we have certain financial
goals to achieve, we should also have an effective financial record keeping system at a personal
level.
When, we talk about record keeping system basically, we indicate the bookkeeping mechanism
of all the expenses and incomes. We believe that you must have heard of bookkeeping system
in businesses, where business entities maintain records of all their transactions, where they
maintain records in terms of trading and profit and loss account and balance sheet.
If you are familiar with these terms, you should be knowing that trading and profit and loss
account of a company showcase the business transactions of economic values over a period of
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time and balance sheet of a company states the financial status of a company on a particular
date or at a particular point of time.
So, if we contextualize this situation of bookkeeping to a personal level, it would be important
for any individual to maintain a systematic record of all their incomes and expenses and assets
and liabilities. Just like profit and loss account and balance sheet in a business. The good thing
is there are a lot of technical tools and software’s that are available for individual’s health.
For example, you can use spreadsheet for keeping a record of all your transactions or all your
incomes and losses and expenses. Similarly, there are several apps applications available on
internet, where you can use your transactions for record keeping and making a systematic
budget for the expenses and incomes of your financial planning.
Next issue that we have to keep in terms of common financial goal for people like us is to
develop a systematic and regular savings and investment plan. When, we talk about common
financial goals basically, it should be driven by a regular and systematic savings and investment
plan.
For example, if a person is earning x amount of rupee a fraction of x amount should regularly
be saved in such a way that it is available for investment in all possible avenues according to
the preference of the individual. And this regular investment will over the years accumulate
into a large chunk of investment that will create an asset for that particular individual. So,
developing a systematic and regular savings and investment plan would help an individual to
achieve the financial goals.
Next issue that is important is to accumulate an adequate emergency fund for contingencies.
Basically, what it indicates is, if you are designing a personal financial plan. There should be
adequate provision for emergencies which means if there are certain contingent situation,
where you need some amount of money immediately for taking care of those situations. There
should be a proper provisioning for those emergency situations and that can be achieved
through a proper planning. It helps individuals to reduce the unwarranted burden that comes
suddenly.
For example, expenses related to health hazards or some other unwarranted expenses that might
come up come across suddenly. So, for individual to have a successful financial plan it is
important to have an emergency fund to be saved aside. Along with these issues it is important
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for individuals to buy suitable and appropriate insurance coverage for health, life and
properties.
Suppose, you are entering the job market and you are expecting that you will start earning
money; you should have sufficient insurance coverage. So, that your contingent situation can
be taken care of or if you have any dependent to take care of that situation can also be taken
care of in case of an unwarranted situation. So, having insurance plan or insurance coverage
for individuals and their family members will always support the financial planning in a
positive way.
Another important issue that individuals should take care of is to encourage the smart budgeting
for future income and expenses. What it implies is if you are trying to plan a financial goal and
you have to make sure that, the financial goals are achieved in a successful way; you should
have a proper budgeting for that particular purpose. When we talk about budgeting, it actually
indicates that individuals should start estimating the expenses and the incomes that they are
expecting in future and these incomes and expenses are incorporated in their decision making.
So, smart budgeting always helps in having a successful and achievable financial plan. And
finally, having understood the process of financial planning and common financial goal for
individuals, it should also be considering the design and implement implementation part of the
retirement funds and savings that that might be required at a later stage of life. So, for
individuals to have a successful financial planning, it is important to have a retirement savings
or the financial planning for retirement. So, that the fund requirement or the monetary
requirement at a later stage of life is well taken care off.
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(Refer Slide Time: 18:25)
Subsequently, if we try to understand whether these financial goals are achievable or it has
certain situations, where some other factors both in internal and external might influence the
goals and financial planning of individuals, we should understand it from two different
perspectives.
The factors that might influence your financial planning particularly in individual context are
categorized into two broad divisions; first it is related to or it is influenced by the life situations
and the value associated with the individual and second category is economic factors. So, when
we are setting up a financial plan for an individual or we are designing a financial goal for
individuals basically, it could be affected by the life situations and personal values.
Life situations such as the stage of life cycle might be an important factor to influence the
financial planning of individuals. And on the other hand, the value and culture from which that
person can is coming can also influence the financial planning and decision making related to
financial goals.
We have already discussed in behavioral economics and finance module that individuals’
demographic characteristics and the value system and the culture to which the person belongs
influence their understanding and decision-making processes with respect to the financial
decision making. Here also, we can relate to the fact that if an individual is in the early stage
of life the person can take more risk and take decisions which are involving higher return with
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higher risk. Whereas, the individual being in a later stage of life, might be influenced by risk
aversion and their decisions can be affected by the factors that might influence their life at a
later stage.
Other set of factors that influence the personal financial goals are the economic factors. For
example, if I am making a personal financial goal for myself it can be influenced by factors
such as the inflation. Inflation as we all know is basically, the change in price or change in
value of the currency because of the change in purchase purchasing power of that particular
currency or we can also say in a simple term inflation is basically the reduction in value of the
purchasing power of a currency or an economic unit of transaction.
So, when we say that the consumer price inflation or inflation in general affects the personal
financial goal, we basically mean that if I have to set a financial goal of buying a house 10
years down the line. The value of the money that I am saving today can be different in future
and that is why the amount that we are trying to save in the process or in the period that we are
targeting for should be designed or should be estimated in such a way that it is it becomes
adequate for buying the house 10 year down the line.
We have already learnt about the time value of money, where we have understood that if the
cash flows or the money flow occurs at different points of time. Before we make a decision,
the cash flow should be brought at a common point of time and then compared with each other
to understand whether the decision should be taken or not. If you could recall you would
remember that in a situation, where the cash flow is on a time line I would repeat if the time
line is designed in such a way that this time is time 0 on timeline and other time are time 1,
time 2, time 3 and so on. And time till n and I knew that I want to buy a house let us say 3 years
down the line (i.e. at time 3).
So, time 3 is the time when I want to purchase a house in that case, I should start saving money
right from time 0, time 1 and time 2 and then next period we will buy house. And this money
will be deposited in some investment or some savings instrument which will be available in
future at time 3. So, going by the argument that we had discussed in previous module we know
that if the amount of money is saved and invested is X, then we know that X has to be deposited
or invested in an instrument , where we would get a return or rate of return r and the period for
which we are investing that will be used for calculating the value at this point of time.
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So, this is basically the future value of rupee X that we had invested in the beginning of the
period. Similarly, for the next amount of money that we have saved in time 1, this can also be
brought to time 3, similarly for the amount of money that we have saved in time 2 will be
brought to the time 3 and all these money in terms of future value, we will be used to buy the
house that we intend to purchase at this point of time.
So, when we talk about consumer inflation or the inflation in general, what we mean is that the
value of money that we are saving today might not be sufficient to buy the house 3 years down
the line. So, we should have a provision to adjust for this inflation which means the value the
amount of money that we are saving in year 0, year 1 and year 2 these three amounts should be
sufficiently estimated to cover the amount of money that we are going to need to buy the house
at time 3.
Similarly, other factors in terms of economic inputs that might affect our personal financial
goals are consumer spending which basically indicate that how much money are spent by
consumers that also depends on several other factors such as interest rate and money supply. If
we understand the basic economic arguments, we know that if the interest rates are changing
that will change the money supply in the system in the economy of the country and that is
where the consumer spending will also be affected.
In a very crude way, we can understand that if interest rate by banks are increased which means
if you save the same amount of money in bank, if you deposit your savings in the bank, you
will get higher rate of interest than the previous period. Then people will start saving more
because they will save that money and deposit that money in the bank to earn higher rate of
interest.
If the rate of interest is reduced by the banks, then the people who would want to save their
money they would try to find some alternative and the money will not be deposited to that
extent in banks rather they might would like to spend and that is where the money supply
changes because of the interest rate and it also influences the consumer spending.
Other economic factor is unemployment which essentially translates into the purchasing power
of individuals in the economy or in the market, where if people are employed gainfully
employed they would be having purchasing power in terms of the money to spend on different
goods and services and that is where their personal financial goals will also be affected.
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Similarly, GDP growth has an influence on the purchasing power of the individuals living in
that economy. There are other factors that might influence the financial goals or personal
financial decision making such as global economic indicators. For example, foreign exchange
rates, international trade and other similar factors which might be relevant for decision making
in terms of personal financial goals.
(Refer Slide Time: 28:22)
Having learnt these things, we know that these things can be translated to the factors specific
to individual’s needs and objectives. Here, we try to highlight four categories or four classes
of personal financial goals, these four classes are for different people or people of different age
groups. for example, the first situation or the first case is young individuals who are single or
rather unmarried and they are in the age group of let us say 18 to 30.
So, personal financial goals for people of this age group or this category can be designed in
such a way that it has some component of gaining financial independence and buying a house
for tax benefits or other similar assets which will get them some tax benefits and tax advantage.
And then also to get some insurance coverage for themselves.
If you talk about another category of people, let us say those who are young and married, but
do not have any kids which is popularly known as DINK; Dual Income No Kids, these people
should focus in terms of financial goals on coordinating more insurance coverage for
themselves and the family. Their savings and investments should also be directed towards
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achieving the life goals. For example, they would want to have a bigger house for as the family
grows, they should have a better car for a commute and similarly they should also plan for kids
and their retirement funds in long run.
If you look at third category of individuals, let us say the people who are young couple and
they have kids of teenage and their age group might be 30 to 40. So, the financial goals that
they should achieve should be directed towards having an increased life and health insurance
coverage for themselves and family. They should also manage to increase the household
expenses and they should try to use credit available for them in a very smart way. So, that the
credit does not increase their liabilities in long run.
Another objective that they should keep in mind should be developing a savings plan for
themselves and their kids in such a way that, when the kids grow their education and other
requirement in terms of funding would be met from their savings. Another category that here
that is highlighted here, is the older people those who are in their late 50s or early 50s and they
do not have any dependent.
People of this age group should have their financial assets consolidated because they do not
have any dependent. This would also make a will or if they have already made a will, they
should review the will and use the revenues and other savings that they have for their life saving
life expenses and they may also consider having a reverse mortgage plan if needed. They should
keep in mind the long-term living expenses and health coverage for themselves and the family
if they have.
So, here I try to highlight four cases of different age groups in terms of individual financial
goals and these are some subtle indicators which individuals should keep in mind before
designing the financial goals for personal finances. Although this list is not exhaustive and it
totally depends on the category of the individual and their personal requirement and these
things will be discussed in next session, when we will try to discuss more about how should
we design personal financial planning and what are the processes that we should follow, when
we design a personal financial goals. That is all for now.
Thank you.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture - 24
Planning Personal Finances
Hi, there welcome back to the course Behavioral and Personal Finance. How often do
you feel that you have worked hard, but you did not achieve the goals that you have
started for? Well the reason could be the lack of planning. In the second module of this
course behavioral and personal finance we will discuss more about financial planning
and how personal financial decision making can be improved with the help of behavioral
finance theories.
(Refer Slide Time: 00:52)
This session is focused on two objectives; first we will discuss the personal financial
planning process where we will see how different steps can be undertaken to achieve the
personal financial goals. And second, we will discuss briefly about how financial goals
should be set in order to achieve the goals or the objectives of financial decision making.
Well, this session is mostly based on a narrative. I will start with a simple example where
I will showcase how a person is in the need of financial planning, and then I will take
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you through a case where you would see at different stages of personal financial
planning process, how different factors should be undertaken to achieve the goals that a
person has desired for.
(Refer Slide Time: 01:47)
Well, let us start with a simple case. The case is if you have got some money what
should be done or what needs to be done? So, that the money should be optimally
utilized and the utility and the benefit of that money can be achieved in a most suitable
way. So, the case here today I am presenting is an individual name Lakshmi. Lakshmi is
an individual a female of 25 years of age and on one fine morning she was surprised to
receive a gift from her maternal aunt.
Now, see this was a pleasantly surprised that she has got a gift of ₹100000. Now what
should be her reaction? Of course, she would want this money to be used for most of her
needs and she might need some advice and that is when her friend came into the picture
and started giving some advice. Now, that advice the friend was trying to give was not
liked by Lakshmi, because she herself considered that she is competent enough to
understand the utility of the money and the decision-making process.
Well, what all choices does Lakshmi have? If you try to put yourself in the situation in
which Lakshmi is currently, she came up with the following situations where she can use
this money that she has got suddenly as a gift, and then she can achieve some goals of
utilizing this money for the personal financial process. Now, the options that she has got
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are as following; she can start by paying off the loan that she has taken from the bank, so
a part of the money that she has received can be used for paying of the bank loan.
Then being an being a modern lady she would want to get some jewelry for herself and
she would buy a gold bangle for herself. Since she in the beginning of her career she
wants to spend some of the money that she has received on some certification and career
training program for example, any online course she can enroll for.
She can also use some money to donate into a charity for example, she can donate some
money to the nearby NGO, she would also want to buy an insurance policy because that
would cover her from some unwarranted risk in future and then if left with some more
money she would be saving that money in some bank account.
Now, these are some indicated choices that Lakshmi might have. Well, each of the
choices for example, buying an insurance policy, to buying a gold bangle or paying of
the bank loan or paying for a career training program, the choices that are presented here
include a different characteristic in terms of risk and return. So, Lakshmi would want to
make best of the money that she has received and that is why she is in the need of some
financial advice.
Now what could be the advice that you can offer to her? Well if you try to analyze the
potential options that Lakshmi has for example, the first choice of paying of the loan,
since she has already taken the loan and loan has a cost, so cost need to be borrowed by
Lakshmi.
Now, if Lakshmi chooses to pay off the loan, she would reduce the cost for future and if
she does not choose the option of paying loan back then the cost would continue to
increase. If she chooses to buy a gold bangle, she is trying to create an asset for herself
that she can utilize for wearing on different occasions so if she is in the process creating
an asset which would be used in future in under any contingent situation. If she buys an
insurance policy, she would probably be covering herself from some risk which might
occur at a later point of time.
Similarly, if she enrolls for an online course or any career training program, she is
creating more opportunity for herself in future so, that her income in future can be
increased. So, to summarize the choices that are presented to Lakshmi here are including
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all sort of assets and reducing the liabilities essentially mean that she can best utilize the
money that she has received as a gift.
Now, this kind of situation where you have got some money and you need to make
decisions regarding the money that you have received so, that you can utilize the money
in productive output. Well this type of decisions requires a process which we call
personal financial planning.
(Refer Slide Time: 07:27)
Now, personal financial planning is a process involving different steps where you try to
understand the background of the money that you have received and their individual for
which you are making the personal financial planning, also the situations which in which
you are living in and the situations that you are going to get in future should be
considered before you make a personal financial planning process.
Here I am going to discuss briefly the indicative steps towards effective personal
financial planning process. So, when you have got some money before we discuss the
sources of money let us try to understand what should be the steps next. So, the first step
towards making a better personal financial decision is to determine the current financial
situation, which implies that the money that you have got at this point of time before you
make any financial decision for future.
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Now, if you have borrowed some money or you have taken some loan from some
institution or some individual and you have got that money, you need to be careful that
particular money coming as a loan carries some cost and you have to invest that money
in such a way that you get a return which can be utilized for paying of the cost, as well as
you get some money out of it for yourself.
If you try to understand in a very subtle way here probably you would like to know that,
if you have got 100 rupees of money from as current financial situation and this money is
actually coming in as a loan. So, for example, you have got ₹80 as loan and ₹20 of your
own, and this ₹80 of loan requires you to pay 5% of interest. So, for example, if you
have borrowed money from bank you have to pay some amount of money as interest and
then you need to keep whatever you are earning for yourself.
So, here if you try to invest this ₹100 in some financial decision or in some investment
avenue, so this investment should give you some money which is going to cover not only
this cost of loan, but also something for yourself. So, whatever suppose; if you earned
some money at let us say 10%, which is basically ₹10 of this ₹100. So, this out of this
₹10, ₹4 will go towards the interest payment for the loan (as 5% of ₹80 is ₹4) and
remaining ₹6 will be going towards your own income.
So, this is what you have to consider when you are considering the current financial
situation, what it means is the money that is coming from different sources need to be
invested in such a way that, the return that you are earning out of that investment should
be able to cover the cost of the money that you have borrowed, as well as some money
that is available for yourself.
So, once you are able to take care of the current financial situation; which means you
know where the money is coming from and where you want to invest in you should try to
develop a personal financial goal. So, personal financial goal should be developed in
order to understand the needs and objective of the financial decision making, and then it
should be taken forward for decision making. Once you are ready with the personal
financial goal you can identify different alternatives, which means the courses of action
that you have to take before you go further.
So, you need to identify several alternatives for which you can take the decision. For
example, if Lakshmi has got ₹100000 as a gift, she needs to understand what are the
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course alternative courses of action that she has before she makes a decision. Once you
are able to identify different courses of action; which means different investment
avenues that you have you should evaluate the alternatives. Now, evaluation will
comprise of two steps basically; first is assess certain attributes of the alternatives for
example, the risk the time value of money and the opportunity cost.
So, if you have come up with certain number of alternative courses of action for each
course of action you need to assess the risk, which is basically the uncertainty with
known probability or the possibility of losing the money in the process or the fraction of
money that you might lose in the process. So, you need to consider the risk part. Second
component is time value of money, we have already discussed that time value of money
matters among the most in terms of financial making, because money as cash flows
occur at different points of time and rupee today is not equal to a rupee tomorrow.
So, when we consider the evaluation of alternatives, we need to consider time value of
money as well. Third thing that you need to consider while making decision is the
opportunity cost. Basically, the opportunity cost implies that, if you have not taken a
decision what should be the next best alternative or the decision that you can go for. For
example, if Lakshmi does not want to invest her part of her money that, she has received
as a gift into buying a gold bangle what is the next best alternative that she can use this
money for that is the opportunity cost.
Once you are able to understand the risk time value of money and opportunity cost in the
process you need to understand the different attributes that we have discussed in last
session. For example, the life situation which means; the basic demographic
characteristics for example, the age, the educational background, the need of the money
in future and so on. Also, we need to consider the value which is basically the value
system a person is coming from that is also important before you take a decision and
then you consider the assessment of economic factors.
So, these three things life situations personal values and economic factors, are to be
considered before you move on to the next step of the personal financial planning
process. The next step is to create and implement a financial action plan; for example, if
you have evaluated different alternatives and decided that Lakshmi should invest some
amount of money in insurance policy, some amount of money in upgrading her skill set
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by taking up any online certification or career training program, and some amount of
money should go for paying off the loan.
Then you need to decide how to implement this plan, like what part of money should be
going for paying of the loan and what part of money should be spent on career training
and what part of money should be used for buying insurance policy. Now, that action
plan has to be designed in such a way that it is optimally utilized. Once you have taken
the decision you need to assess the performance of the decision that you have taken for
example, if she has bought an insurance plan after some point of time she should see
whether her insurance plan is going according to her wishes that she started with.
Similarly, if she has spent some money on career training program, she can understand
by assessment of the performance that career training program is going to be helpful in
her advancing career in future or not, and similarly other investment plans or other action
plans should be evaluated for the performance measurement.
And finally, once you have measured the performance and assess their evaluation you
can review and revise the financial plan according to the feedback or the input that you
have received after assessment. This is a broad picture of personal financial planning
process. Now, I will try to take you through an example where each of these steps are
discussed or indicated in a very direct way for an individual who is let us say a student.
(Refer Slide Time: 17:31)
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So, from here I am trying to show and the example of an individual who is a college
student. So, let us assume that I am the college student and I am trying to understand
how personal financial planning process can be designed for me. Now, let us assume that
in another two months I will be graduating my undergraduate degree so, I will be
completing my undergraduate course with a major in business studies. So, I would be a
student of B COM or BBA or similar courses even engineering and I have a degree in
with a major in any subject domain.
Now, I have completed some of the recent research projects and internships in during my
program of undergraduate studies, I have a small savings account for example, let us say
I have some ₹25000 of money in my savings bank account; however, I have an education
loan to the extent of ₹400000, this number could be anything these are just arbitrary
numbers.
So, I have an asset of ₹25000 in terms of savings bank account. I have so, basically
₹25000 is my asset and ₹400000 is my liability. So, if you look at the first step of the
personal financial planning process, the first step is to determine the current financial
status. So, here the current financial status is, I have an asset of ₹25000 and a liability of
₹400000 in terms of education loan. What more information should be needed? So, the
other information that might be needed is what should be the next course of action or
what are the alternatives that I have.
I do not have any of anything else in my hand currently so, my asset and liabilities are
completely mismatched. So, I have ₹25000 of assets ₹400000 of loan and I will be
graduating in another two months from the college so, the choices that I have can be as
follows. So, first I need to define or I need to understand my personal financial goals. So,
the personal financial goals could be quite a few; for example, I should be targeting to
pay off the education loan because for education loan, the moment I graduate I will have
to start paying the education loan, otherwise I will have to incur cost in terms of interest
payment and the principal payment repayment as well.
So, my first target or first financial planning goal should be to pay off my education loan,
then I would also want to obtain an advanced degree in business management for
example, I may go for an MBA or a masters in finance or any other similar domain so,
that would be my next financial goal. And then one of the major financial goals that I
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should be targeting for is to work in a big city for an MNC or a reputed company so, that
I can improve my living standards. What could be the other goals that you may consider?
Maybe you can think for it, but these are three major goals that I can start with.
(Refer Slide Time: 21:31)
Once we are able to assess the current financial status and develop my financial goal for
near future, I can go ahead with next step that is; identifying our alternative courses of
action for myself. Now, the courses of action that I have for myself are as follows. So,
the first choice I have is upon graduation, I could work full time and save some money.
So, that I can pay the fee for my MBA so, that is my first choice that I have. Second
choice that I have is I could go for a business school and in order to fund the education
fee, or the cost of education in terms of MBA fees, I can take an additional loan so, that
is my second choice.
I the third choice that I have is I could go for a full-time part-time MBA and work
simultaneously. So, I can go for a job, and in the evening or some other mode of
education I can take the part time MBA program. Now, if you try to understand this the
implication of this these choices or these alternative courses of action, you can try to
understand in terms of the amount of money that I have currently and the amount of
money that I will be needing.
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So, as discussed earlier I have a savings account in terms of assets of ₹25000, and then I
have liabilities which is basically the education loan, ₹400000 for my undergraduate
education loan. So, if I go for either of these alternative courses of action, the moment I
go for first action which is working full time and waiting for some more years to go for
an MBA, meanwhile I could save some money.
So, in that case I will be adding more money towards my asset side because I would be
earning and saving some money. At the same time part of this money can be used to
reduce the liabilities, which is basically paying of the education loan. If I go for second
option for example, if I go for business school by taking an additional loan, I would need
more education loan so, I will be increasing my liabilities by taking an additional loan,
and at the same time I need to spend some money on my living.
So, I would be reducing my assets as well which is basically spending my own money on
livelihood. If I go for third option which is basically part time MBA and work
simultaneously, that could probably be add some money towards asset side and reduce
some money some liability by way of paying some loans off and then adding some
liabilities because, I will be doing some MBA simultaneously, so, I will have to pay the
fee and so on.
So, these are the choices that I have if I go for either of these alternative courses of
action. Now, there are there could be several other courses of action, but maybe you can
think of more courses of action here for now, I can discuss the next step which is, what
are the issues and challenges or factors that would be considered before you take these
courses of action? Now, first issue that is coming from the behavioral economics and
finance part is the status quo bias.
Most of the time we are stuck with our status quo and we do not want to continue with a
new decision at all, and that could be the reason why we continue the same course of
action for a long time because we do not want to take any risky outcome. Another issue
that we need to understand or we need to consider is the availability heuristics which is
basically the information availability and the limitations of individuals processing the
information.
So, the issues that you might come across when you are evaluating different alternative
courses of action is; people would say that come on I do not know this enough. And
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maybe someone would say that you know I do not know whom to trust for taking my
financial decisions or maybe they will say personal financial planning is too complex so,
I do not want to take any decision on my own.
So, these are certain issues which one person might come across while taking financial
decision making in fact, identifying courses of action would require to address these
issues and for which personal financial planning is even more important.
(Refer Slide Time: 26:35)
Once you are able to identify alternative courses of action you can go ahead with the
next step which is basically the evaluation of alternative courses, so, a while evaluation
of alternative courses we must consider the requirement of funds, for both short term and
long term. So, this step basically indicates that what are the requirement of funds in
future for short term and long term as well.
And at the same time I should also assess what are the career opportunities that could be
available if we go for the different courses of action. For example, if we go for an
advanced degree in business management let us say MBA, the courses of action this
course of action would require some additional education loan, but it will increase my
employability and career opportunities in future, substantially and thereby I can increase
my income generation capabilities in future to large extent.
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If I go for let us say part time MBA and work simultaneously, I should be working for a
lower pay and my job employability or the career opportunities in future might not go as
planned. So, there are certain issues and of risk and return trade off or the economic trade
off that we need to consider, and these issues are as follows.
So, first of all we should be ready to consider or evaluate the consequences of choices,
and which is basically in one term the opportunity cost that is if we give up something
for taking a decision that thing is basically the opportunity cost in economic terms, which
is as discussed earlier the next best opportunity or the alternative that you have for
making a decision is your opportunity cost.
So, if you are making a choice of going for an MBA, the next best alternative that you
have is to for doing the job full time, which means the money that you will be making in
the process of doing job full time is the opportunity cost for doing an MBA. If you go for
a part time MBA probably, that would reduce the opportunity cost; however, there will
still be opportunity cost associated with the decision. Second issue that you need to
consider as a trade off is incorporating risk into your decisions.
Now, risk could be of different types for example, the interest rate risk such as if you go
for an MBA right now the rate of interest on education loan would be lower than the rate
of interest on education loan that might happen 2 years down the line. So, that would be
the simple example of interest rate risk. Which means the cost of money that you are
spending today would be different from the cost of money that you would be spending 2
years hence.
So, interest rate risk is one such factor, there are other risks such as inflation risk,
liquidity risk and exchange rate risk more particularly when you are going abroad for
education or career then exchange rate risk is very important. Third factor that we need
to consider while taking personal financial decision in terms of evaluation of alternative
courses of action, is per financial planning information.
Now, the factor here is the sources of information that we are considering for making our
decision typically are business newspapers and magazines, books and courses that we
attend in different institutions and organizations. And personal financial institutions such
as banks, mutual funds, brokerage firms, and trading firms are also financial advisors.
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So, now you should also always consider a trusted source of information for making your
financial decision or evaluating your alternative courses of action.
(Refer Slide Time: 31:03)
Once, we are done with our identifying alternative courses of action the next step is to
create an implement financial action plan, which means in the case of the student that has
just graduated or is about to graduate. The case that I was starting with is that the
individual has taken a decision to work full time and wait for a few years before going
for an MBA.
So, the choice that I have as an individual is I will be able to pay off my education loans,
I will be able to save some money for business school education which is for MBA and I
can simultaneously take a couple of courses online and in evening or weekend classes so,
that the chances to improve my career alternatives or career opportunities in near future
could be improved.
So, these are the three associated tradeoffs that I have, what could be the other benefits
or drawbacks that you can think of maybe we will see. Finally, once we have taken a
decision maybe in 6 month or 12 months, we should always reassess my personal,
financial and career situations just as the beginning. And in the process, we need to
consider the employment opportunities that we will be getting in future or the family
circumstances that we are living in because all these factors might affect my needs and
desires to take a different course of action.
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For example, if I start decided to work for a few years before I go for an MBA maybe if
the job market is really bad probably, I would not like to continue with the job rather try
for an MBA by taking an additional loan, and hope that in next 2 years the job market
would improve and then my career would take a better direction. So, these are some
things which one should consider before making the personal financial planning.
(Refer Slide Time: 33:18)
We have just discussed how personal financial planning can be done in a systematic
process, and what factors one should consider while making personal financial plans. So,
we have already discussed how different sources of information for personal financial
planning can be utilized for making a better decision. We know that a successful
personal financial planning is required to achieve a secure financial future, and it also
involves not only savings, but investments, career decisions and personal choices that
might involve money. That is all for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture - 25
Personal Financial Statements
Hi there, welcome back to the personal finance module of the course Behavioral and
Personal Finance. I start with this session with a simple question without looking into
your pocket can you tell me how much money do you have? An associated question
would be how much money have you spent or earned during the day or the month or
maybe the year? Can you tell the answer to these questions? Well if your answer is no
then probably you need to be more careful while discussing or listening to the session
that we are starting, now. This session focuses on two major ideas or issues.
(Refer Slide Time: 00:58)
The first thing that we are going to discuss is the cash flow statement in terms of
personal finance and the then the personal balance sheet. Basically, we are trying to
discuss here the financial statements in the personal finance context well if you are not
able to tell me how much money do you have in your pocket, it implies that you do not
know what is your current financial status. And if you are not able to tell me how much
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money you have earned or spent in last 1 day or 1 week or 1 month or for that matter 1
year.
Then you are not able to trace or recall the cash flow that is associated with your
personal financial income and expenses. Well this session discusses on these two aspects
cash flow statement and personal balance sheet well.
(Refer Slide Time: 01:56)
Cash flow statements basically any financial statement is an indicator of what is the
current financial status of the organization or the individual and what is the flow of
money associated with different activities. In the context of business management, we
learn about different financial statements. In accounting we know that for businesses we
try to maintain different accounting statements. For example, daybook where we mention
or include all transactions that we have done in the and the transactions that have some
economic values.
And then we convert all these transactions into a journal book where we systematically,
record all these transactions into debit or credit. I am sure you must have heard of debit
and credit or you know a little bit about debit and credit system. Once we have done the
journal entries, we summarize all these transactions from journal entries to ledger and the
ledger book has some balance at the end which is taken to the trial balance.
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Once you transfer all the ledger balances to trial balance, we are ready for taking these
numbers from trial balance to financial statements and the financial statements, that we
typically focus in any business organization include trading account profit and loss
account cash flow statement and balance sheet. So, typically financial transactions during
a particular period is reflected in trading profit and loss account and cash flow statement
and financial status at a given point of time is reflected in the balance sheet.
Which means if for a given business you are looking at the cash flow statement or profit
and loss account you are actually trying to understand what all type transactions or
money flow has happened during the particular period and if you are checking the
balance sheet of a company. It is going to give you an idea about the financial status at a
particular date or particular point of time.
So, typically profit and loss account and cash flow statement tell us where the money has
come from and where the money has gone and balance sheet tells us what we owe and
what we own basically in cash flow statement. We include all cash inflows and outflows
and in balance sheet we try to understand what are the assets and liabilities that we have.
For personal finance context also maintaining a cash flow statement and balance sheet is
very important, because it helps you to measure the progress towards your financial goal.
For example, if you do not maintain the records of all cash inflows and outflows which
are basically expenses and incomes for yourself then you should not be able to track
where are you spending most of your money or where the money is coming from in your
pocket. So, to achieve the financial goals it is very important to maintain financial
statements for personal financial decision making as well.
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(Refer Slide Time: 05:40)
Now, to briefly discuss cash flow statement we know that this is personal income and
expenditure statement. So, basically cash flow statements indicate at the total cash that
we have received during a particular period minus total cash that we have paid out during
a particular period. So, if we have left with something out of the money that we have
received this basically tells us cash surplus or cash deficit.
So, for example, if we have received some money as salary that is our cash inflow and if
we have spent some money on rent or travel or any other expenses, that is our cash
outflow. So, at the end of the day if our cash inflow is more than cash outflow then we
will be left with cash surplus if the inflow is less than the outflow then we will be left
with the cash deficit.
So, if you try to understand this is basically our cash inflow, which is basically positive
cash this is our cash outflows which is negative cash and this is surplus or deficit that
you have at the end of the period. Now, for an individual to be financially happy it is
important to have cash surplus the so, that this can be saved or invested in some
investment of avenues.
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(Refer Slide Time: 07:30)
So, if you try to understand what could be the cash inflow and outflow look like for
individuals, it basically includes all incomes or all cash inflows on one hand. So, inflows
could be for example, wages, salaries pension incomes or business income or any other
such in flow that you have you may have some interest earned on your deposits, on your
bank investment dividends, on your share investment.
Rent that you have received from the property that you have rented to someone and
commissions that you have received as the process of your business or other activities it
could also include gifts, grants, scholarship and education loans if you have taken any.
So, these are your cash inflows.
On the other hand, the cash outflows are all the expenditures that we spend on different
activities, these expenditures could be of two types: fixed expenses and variable
expenses. Fixed expenses are basically the expenses that we mandatorily have to make
for example, rent that we have to pay more if we have we are living in a rented house
mortgages that we have to pay if we have purchased the house on a loan and loan
repayments if we have taken any for example, education loan.
So, you have to pay and school fees, because if you are attending the school then these
are fixed expenses insurance premium, which we are paying for taking the insurance
policy or insurance coverage on the other hand variable expenses are those expenses
which vary from one period to another period. So, for example, food expenses it depends
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on how much and how many how often do you take food. So, food expenditure will be
variable expenses entertainment expenses, electricity and telephone bills.
Because it depends on the uses, medical expenses and gifts these are some of the
example of variable expenses. So, once you have recorded all the incomes on one side
and all the expenditure on other side you should be able to know, what is the status of
cash at the end of the period. So, if your income is more than your expenses then you
will be left with surplus and if your income is less than the expenses then your you are
left with cash deficit and cash deficit means it has to be compensated through some loans
or borrowings or any other source of money, because you cannot live in cash deficit for
long time.
So, once you have cash surplus by determining the net cash flow, that is basically the
difference between cash inflow and cash outflow. So, you can use this as savings and
savings can further be invested in some investment avenues. So, this is what a personal
cash flow statement should consider when you make a personal financial plan.
(Refer Slide Time: 10:43)
On the other hand, if you try to understand the balance sheet for personal financial status.
Basically, it indicates the financial status of an individual at a particular point of time, it
means that the status of the individual in terms of what he or she owns and what he or
she owes at a given point of time. So, personal balance sheets should include the assets
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which basically include the things or the resources that a person owns and the liabilities
that he owes to some other person or other organization.
So, basically if you see the total assets minus total liabilities you are talking about the net
worth of that individual. So, when we try to understand the balance sheet of individuals
or personal balance sheet and we have the data or information related to assets and the
liabilities, we can easily determine the net worth of the company or the individual. So,
what are the things that might come under assets and liabilities basically as following.
So, if you try to list the assets that an individual hold that could be liquid assets for
example, cash or savings or investment in different accounts or different assets that will
be your liquid assets. So, when I say liquid assets it means that the asset that can easily
be converted into cash without much loss in value. So, these are the liquid assets then
you have real assets basically real estate for example, house land properties and so on
you have personal possessions like vehicles cars, two wheelers, four wheelers,
appliances for example, TV, audio system and jewelry
These are your personal possessions, which are basically listed under assets and then
investment assets for example, shares, you have invested for retirement children’s
education and other objectives. So, these are your investment assets. If you look at the
items or account or amount that you have listed under liabilities basically liabilities can
be of two types current liabilities and long-term liabilities or fixed liabilities.
So, current liabilities are liabilities that are to be paid within 1 year or within short frame
of time. For example, the electricity telephone bills insurance premium cash loans and
tax payments. So, all these liabilities are to be paid within a short frame of time on the
other hand long term liabilities could be auto loan, mortgages, education loan and so on.
Basically, those liabilities which are to be paid beyond 1 year are known as long term
liabilities.
So, when you try to understand the personal balance sheet you try to see what are the
different what are the assets and liabilities that you have under different categories and
once you are able to estimate the items and amount of assets and liabilities under
different categories, you should be able to determine the net worth of the individual. So,
when we talk about net worth, basically it implies that assets should be equal to liabilities
plus net worth and that will determine the balance of balance sheet of an individual.
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So, one important thing that we need to consider here is the duration or the length of the
assets and liabilities that we have. So, for example, if an individual has assets and
liability completely balanced. Which means his or her assets are more than liabilities that
does not necessarily mean that that person has always a positive net worth, what I mean
to say by positive net worth here is that the assets might be having a different tenure. For
example, short term and liquid assets versus the long term and fixed assets, whereas, the
liability will also have different tenures for example, current liabilities and fixed
liabilities.
So, if there is a mismatch between the tenures of assets and liabilities that might be a
problem. For example, if I have more liquid assets let us say in terms of cash and bank
balances and less current liabilities. Which are which I have to pay in sort a frame of
time, for example, bills and tax payments and other short-term liabilities this is not a
good situation for an individual.
So, we should try to make sure that we have sufficient amount of liquid assets just
enough to cover the current liabilities and similarly sufficient amount of long-term
investment or fixed assets to cover the long-term liabilities. How do we evaluate this
situation of different mismatch or matching of liabilities and asset in terms of tenure can
be determined using certain financial calculations?
(Refer Slide Time: 16:32)
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Which for which we can consider these ratios for example, here I have indicated for
risky financial ratios that an individual should consider before financial planning or
taking a financial at a plan action these ratios are as follows. So, the first ratio that we
may consider in making financial decision is debt ratio, which is basically defined as the
total liabilities divided by net worth it shows that a relationship between debt that a
person carries and the net worth of that person.
So, for decision making purposes the lower debt ratio, the better it is which means, if you
have lower debt ratio it implies that you are in a better position to cover your debt with
your net worth. Similarly, second ratio is current ratio which basically can be calculated
using liquid assets divided by current liabilities it shows the availability of liquid assets
to pay off your current liability.
And the higher it is the better it is for an individual it essentially shows your comfortable
position to pay off your short-term liabilities or obligations with your current or liquid
assets. Similarly, there the third ratio is liquidity ratio which basically is calculated as
liquid assets divided by monthly expenses which shows the number of months in which
living expenses can be paid in emergency. Which essentially shows or indicates that you
have sufficient amount of liquid assets to cover your living monthly expenses for certain
number of peak months.
Even in case of emergency when your cash inflows start reducing or you do not get
salary for some time or you do not have any regular income for some time you can use
your liquid assets to pay off your monthly living expenses. A higher ratio of liquidity
ratio is desirable and that is comfortable for an individual another ratio that we can
consider is debt payment ratio, basically it is calculated using monthly credit payment
divided by take home pay or the net salary it shows how much of earning goes towards
debt payment if it is less than 20%.
It is always recommended because it implies that one fifth of your net home pay is going
towards the debt payment and debt could be short term as well as long term. So, these are
certain ratios that we need to consider while making personal financial decisions and
these things help in understanding our financial status as well as the flow of money that
are associated with our lives in very productive way.
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(Refer Slide Time: 19:38)
So, to summarize we can say that for individuals’ personal financial statements and
maintenance maintaining these personal financial statements is very important, these
statements could be cash flow statement balance sheet as well as the calculation of
financial ratios. So, cash flow statement indicates the financial progress of cash flow or
the inflow or outflow of cash for a given period of time balance. It indicates our financial
status for a given date or a particular point of time financial ratios suggest, our financial
well being all these things are important to maintain or to measure the progress of
financial decisions towards other financial objectives.
Because all our decisions related to finance must be targeted towards achieving certain
financial goals. Now, in the process the most common advice that anyone would give
you is you need to save more and save as much as you can so, that you can invest as
much as possible and by cutting all you are spending or unnecessary expenses you can
save more. So, that more can be invested.
Now, one important factor that is coming here is the taxes. So, how taxes can influence
our personal financial decisions is also an important issue to understand for this session
that is it we will discuss more about taxes and their implication in next session.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 26
Taxes and Financial Planning
Hi, there. Welcome back to the second module of the course Behavioral and Personal
Finance. How many times do you consider taxes as one of the important factors in
making your financial decisions? Well, this session focuses on the income tax basics and
how income tax rules or provisions can help us in making better financial decisions. This
session starts with an example of how taxes or tax provisions in prevailing economy can
contribute towards a better financial decision making for individuals and what are the
factors that we should consider before we take a financial decision making in terms of
tax considerations.
(Refer Slide Time: 01:07)
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(Refer Slide Time: 01:10)
So, taxes as we know are basically the financial and legal obligations for individuals. If
you are making some economic transaction or the transactions that have economic value
and you are contributing towards activities that an economy considers as part of the
GDP, you are liable to pay taxes on it. Well, taxes can be of several types, broadly
categorized into direct taxes and indirect taxes. The examples of indirect taxes are GST,
which we as individuals do not pay directly to the government rather, we subscribe some
product or services or we buy some item for which we pay some price and the price
includes taxes that are paid to the government by the seller.
Well, the second category of taxes is direct taxes, where people pay taxes directly to the
government and income tax is one such tax where individuals are supposed to pay
directly to the government authorities. So, that the tax records of individuals can be
incorporated while making economic policies and other related decisions. When we are
making tax payments or making financial decisions that have certain relationship with
tax payments, we should have knowledge of current tax regulations and prevailing rules
and provisions related to taxes and how saving taxes could be an important factor for
making better financial decision.
The first rule of understanding the tax provisions is to maintain a complete and accurate
financial transactions and records thereof. Particularly when you are making a tax
payment or you are trying to calculate the value of tax liability that you are supposed to
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pay to the government, you need to rely on a complete and accurate records of financial
transactions that you have made during a particular period.
Typically, taxes are required to be paid annually, but if the volume of transaction is very
high government encourage people to pay taxes on a quarterly basis. Now, unless you
maintain an accurate and complete financial transactions record, you cannot establish
how much tax liability you have. So, once you have the accurate transaction records, you
can assess or determine what is your tax liability and how this can determine your cash
flow, both inflows and outflows and help you make better financial planning.
For example, the provisions that are prevailing these days in current financial year
related to the taxes could be seen as follows. So, for individuals who have an income up
to ₹2.5 lakh per annum, the tax liability for that individual is nil, but if the income is
above 2.5 lakh, but below 5 lakh the tax liability is 5% of income tax and 4% of all cess.
So, when the income crosses ₹5 lakh that is ₹5 lakh and 1 onwards up to ₹10 lakh the tax
liability is considered to be 12500 and 20% of total income minus 5 lakhs plus 4 percent
of cess.
So, if suppose you have an income of 9 lakh, so, your tax liability would be 112500 +
20% of (9 lakh - 5 lakh) that is 4 lakhs. So, that will be your tax liability on the
remaining income, 20% of 4 lakh plus 4% of total tax due as cess. If your income crosses
₹10 lakh, you are supposed to pay a base tax of 112500 and 30% of tax on total income
minus 10 lakh and 4 percent of cess.
So, suppose your income is 15 lakhs then your tax liability is to the tune of 112500 plus
30 percent of (15 lakh - 10 lakh) which is 5 lakh plus 4% of tax. So, these are the
prevailing rules for taxes with respect to the individuals. Now, government has given
some additional provisions for senior citizens and women as far as tax rules are
concerned.
Since, this course does not cover tax taxes as the major component of the course, we will
not discuss much details rather we will focus on how taxes can influence our financial
planning and can help us make better financial decisions.
So, when we talk about financial decisions basically, we consider both purchasing and
investment decision also, investment decisions are a function of savings decisions. So,
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taxes can help us make better savings decision that will subsequently lead to a better
investment decision and all these decisions should be driving towards reducing or
minimizing tax liabilities for the individual we are considering.
When you talk about taxes on different transactions of economic value, these
transactions could be purchases in terms of consumables or the purchases of consumer
items, purchases on properties and assets such as land and buildings, purchases of items
which are of luxury and even flight ticket or any other similar services. These taxes are
calculated on the gross value of properties or real estate or luxurious goods, flight ticket
or bus ticket, even personal properties or the properties or the houses where we live in.
There are taxes on wealth, such as wealth taxes or taxes on assets at the time of death of
an individual, which other kins are supposed to pay to the government. Similarly, taxes
on earnings that is another category of taxes such as taxes on salaries, interest, dividend
income and any other income that a person receives. So, these are four broader
categories of taxes; taxes on purchases, taxes on property, taxes on wealth and taxes on
earnings.
(Refer Slide Time: 08:47)
If you look further, we understand that taxes are playing an important role in terms of
making financial decisions. Essentially, the reason for taxes being so important is that
taxes are basically reducing our net gain. For example, if we are saving some money in
an investment avenue that does not get any advantage in terms of tax reduction, we are
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getting an income which is going to be considered as the total taxable income for us and
then we have to pay taxes on the total taxable income.
Instead, if we are investing our money in tax saving instruments, such as tax saver bonds
or tax saving insurance policies or any other such tax saving instrument, the income that
we are getting will not be counted to the large extent or in some cases totally in the
computation of total taxable income and that is why the total tax liability will be lesser.
So, if we consider that we are getting an income and that income should be considered
for taxes in our total income, we should follow a simple approach to understand the net
value of that income as such. For example, if you receive an interest on the deposits that
you have made in your savings bank account and that savings bank account provides you
an interest rate of certain percentage. First, you should determine the tax bracket that you
are falling in.
We know that there are three tax brackets mostly, the income below 2.5 lakh, no tax, 2.5
lakh to 5 lakh and so on. So, if we consider our total taxable income and we can
determine whether we fall in 10% tax bracket or 20% tax bracket or 30% tax bracket or
so on, we will first determine the tax bracket that we fall in, because the interest income
that you are getting from bank basically are charged against the tax bracket that you are
falling at the top, which means if you are getting an interest income of ₹100 from bank
banks typically charged a flat 30% tax on that interest income.
It is your responsibility to later claim that you do not belong to 30% tax bracket rather
you are in a bracket with lower tax rate. So, you should get a refund of the tax deducted
by the bank.
So, first you determine your tax bracket then you use this tax bracket rate that is 30% for
example, ( 1 - 0.3) and then multiply the remaining number the result by the yield on
your savings account or the income that you have generated in terms of percentage and
this number will be expressed as a percentage and can be considered as your after tax
return.
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(Refer Slide Time: 12:18)
A simple example could be let us say, a case of Miss Do Good. So, Miss Do Good
maintains a savings bank account with a bank, the bank offers her an interest rate of
6.5% per annum. So, she receives a 6.5% per annum rate of return on her savings bank
account deposits.
And she also has some other sources of income that is why she falls in the top tax
bracket which is 30%. So, if we want to advise her whether her return rate of return of
6.5% is actual or not, we should follow the structure that we have just discussed. So, the
structure says that first you determine the top tax bracket, then you subtract that
percentage rate from one and multiply with your yield or the return that we have
generated on your savings or investment and then this number when expressed as
percentage can be considered as the after tax return.
So, in case of Miss Do Good if we try to understand the numbers that are given here, we
know that she falls in 30% tax bracket. So, first step is Miss Do Good is in 30% tax
bracket. So, the second step is we will deduct this 30% from 1. So, this is 1 minus 0.30
which gives us 0.7. The third step is, here we multiply this 0.7 with the return that she is
getting the return that she is getting is 0.065, because the returns she is earning is 6.5
percent. So, this should be 0.065.
So, this is the third step and this value gives us a number which is 0.0455. So, this
number when expressed as percentage is actually the after-tax return. So, this is basically
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4.55 percent. So, if a bank tells you that you are earning a 6.5 percent rate of return on
your savings bank account actually, the return that you are getting is just 4.55 percent,
because of the tax effect. This is how taxes can influence our net earnings or net gain.
So, when we try to understand the implication of tax on our financial decision, we have
to keep in mind several other factors. The factors that we should keep in mind or we
should consider while making financial planning will be discussed now.
(Refer Slide Time: 16:02)
So, the step to understand the tax calculation purpose as discussed earlier, will be as
follows. So, first we will start with the gross income and the gross income can be
considered as all income that a person is receiving. The income such as salary income or
any other income that a person is receiving will be included in calculation of gross
income. So, if we know the gross income can be computed with the help of different type
of income that the individual is receiving and these incomes can be earned income,
portfolio income or investment income and passive income.
So, when we talk about earned income. It includes salaries, wages, fees for services
provided, commission received and bonuses that are received by the individual. So, these
factors are essentially comprising in earned income category. When we talk about
portfolio income it includes dividends, interest on deposits, a rental income if the person
has any property that property will be given on rent and the rent income will be
considered as investment income or portfolio income. Similarly, gain on sale of any
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asset. So, suppose a person has purchased a land few years ago and now, he has sold the
piece of land for some money and that money is higher than the money that he has spent
on purchasing that land. So, that will be considered as gain on sale of that land and it is
investment income or portfolio income.
If you recall, portfolio is basically a combination of different assets including shares,
bank deposits, property such as real estate, land, precious metals and any other asset
which the person is holding. So, portfolio income or investment income will also be
considered as part of the gross income then you have passive income. Passive income by
definition are the income for which you are not putting much effort or you are not
creating a lot of processes or decisions with respect to earning that income.
So, for example, if you are into a partnership business and you are you have just got into
partnership passively which means you are not an active partner, but the profit that the
business is generating is shared with you. So, that income from limited partnership will
be considered as passive income. Suppose, you got an award or some lottery or
something like some amount of money that you have won in a game show like Kaun
Banega Crorepati, then that award money or the money that you have earned in lottery
will be considered as passive income.
Similarly, an endowment fund income, where you had spent some money long time back
and now it is paying you off in terms of income. So, this endowment income can also be
considered as passive income and of course, insurance gains, such as you have claimed
some insurance and that insurance gain has come to you as income that will be your
passive income to be considered for calculation of gross income. Once, you have
calculated the gross income, you need to do certain calculation further to understand
what incomes are tax exempt income and what incomes are tax deferred income.
Now, by definition tax exempt income are those incomes where tax is not charged at all.
For example, if you have earned some money or some income from your agriculture
activity that income is to large extent not chargeable for tax. So, in an income where you
do not have to pay any tax will be considered as tax exempt income and tax deferred
income are incomes where you have to pay taxes later. For example, if you are doing a
job and your employer is contributing certain amount of money towards your pension
fund or any other retirement investment, currently you are not entitled to pay taxes on
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those savings or those income rather when at the time of retirement or in future when
you take away that money, then you have to pay certain tax on that income.
So, this kind of income is known as tax deferred income. These two types of income are
considered to get the gross income calculated and once, you are ready with the gross in
gross income you have to do certain adjustments with the gross income and these
adjustments are basically, adjustment for the investments or decisions that you have
taken to save taxes. For example, if you have invested some money in tax saving
instrument such as post-office deposits or maybe certain instrument where you have to
get some tax advantage in terms of tax saving certificate of any bank or any government
entity.
Similarly, government issued bonds are also carrying some tax exemption. So, you need
to consider, if you have invested some money in these instruments where you get some
tax deferment or tax saving, you make the adjustment for calculation of gross income
and this will get you a net value of adjusted gross income.
(Refer Slide Time: 22:12)
So, once you calculate the adjusted gross income, you need to do certain more
calculation such as incorporating standard deductions as per the law of the land, such as
the income tax department in India provides certain standard deductions in terms of a
fixed amount of money is waved off for tax chargeability and that is known as standard
deduction.
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Similarly, there are some other deductions such as or deduction in terms of expenses on
health or medical facilities of self or your family members, similarly deductions related
to education expenses of your family members or kids or deductions related to the
interest payment on your home loans or education loans. So, these are some unique
deductions or exemptions which need to be incorporated into adjusted gross income this
will lead you to net taxable income on which you will calculate the taxes based on the
tax bracket or the tax rate for, you are supposed to pay.
Once, you calculate the tax rate or tax bracket for yourself, you need to see if you have
any tax credit which means you have get some advantage in terms of some tax credit and
any other taxes or cess has to be included as well to get the total value of tax playability.
So, this will get you the total taxes including cess and other liabilities due to the
government authorities. This is how we consider calculation of taxable income and taxes
for financial planning purpose.
Now, this is a very generic approach to calculate the taxable income, because once you
have some income be it from whatever sources you need to understand the tax
implication in terms of the example that we have discussed earlier of Miss Do Good,
where we showed that the income that you are receiving is not the exact income that you
are going to get at the end of the day, because you have to pay certain amount of tax on it
and when you are doing a financial planning the tax amount has to be incorporated
beforehand to know the actual benefit or the real return that you are getting from that
investment or the financial decision.
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(Refer Slide Time: 24:47)
Now, when we talk about the implication of taxes on personal financial planning, we
need to understand as elaborated earlier, that there are certain decisions which
individuals take and these decisions should incorporate the implications of taxes as
prevailing in that particular year or in future. So, that the decisions are most optimal for
the individuals. Now, when you try to calculate tax implication on your financial
decision basically, it is determined, it is determined by the level of income that you are
earning which will basically determine your tax bracket and also some other factors.
The financial decisions such as purchasing decision or investment decisions, these
decisions will have certain stronger tax implications. For example, if you are making a
purchasing decision, let us say a purchase of car or purchase of home the factors that are
going to determine your purchasing decisions are the place of residence or the business
or work. For example, if you are buying a house that is very close to your workplace is
basically going to help you a lot in terms of saving money on transportation or commute
cost.
So, when you try to make a personal decision particularly, in terms of personal financial
decision with respect to purchasing of an asset then you keep these things in mind and
this will save you some money which will ultimately save you some tax also. Some other
factors such as personal debt, these are also important to understand, because if you have
debt for example, education loan or home loan or any other type of loan, you are paying
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some fixed interest on these loans and these interest will be considered as certain exempt,
certain amount of exemption from your total taxable income and this is how you save
some money on tax part.
Similarly, if you are doing a job or a business there will expenses related to the job or the
business will also be considered for tax exemption or deduction from the total taxable
income. Health related expenses as are explained earlier for example, if you have
incurred some amount of money on your own health care or health care of your
dependent, this money will be considered as tax deductible income from your total
taxable income and this will help you make a better purchasing decision.
Similarly, if there are investment decisions to be made, you know that investment
decisions in tax exempt avenues such as national savings certificates or any other
government bond which are tax exempt will help you save some taxes and determine
your net return to be higher, because we understand that the net return as shown on paper
or on the record is not going to be the exact amount of money or exact rate of return that
we are going to receive, because of tax implications. So, if we are saving our money in
tax exempt instruments, we are saving more money for ourselves and paying less taxes in
the process.
Similarly, there are tax deferred instruments, where we can invest and save some money.
for example, capital gain gains taxes are one tax one type of tax which are supposed to
be paid when you are making some capital gain transactions. So, capital gain transactions
are basically transactions involving capital goods; such as house property or cars or for
that matter shares which are to be purchased for long time, but if you are not holding it
for long time and selling it within a year this is known as short term capital gain.
For example if you purchase a house and sell it within a year the profit that you have
made in that transaction is to be considered for short term capital gains and if we have
sold it for after many years, then this the gain that you have made out of this transaction
will be considered as long term capital gain. So, these tax rates on short term capital
gains or long-term capital gains or any other such transactions will determine your
investment decisions as well.
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So, as a summary we understand that taxes play an important role and considering taxes
as part of the financial planning process is very important to make better financial
planning and personal finance decisions. That is, it for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 27
Taxes and Financial Planning (Contd.)
Hi, there continuing with the previous session, where we were discussing about how
taxes influence our personal finance decisions and it is an important part of personal
financial planning. We will discuss in this session how the Taxes and Financial Planning
can be integrated together and we also discuss the behavioural factors that are important
for incorporating financial planning and making a better financial future.
(Refer Slide Time: 00:46)
So, the topics that we are discussing in this session now are the role of taxes as part of
better financial planning and how behavioural factors can influence the choices related to
taxes and personal financing together.
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(Refer Slide Time: 01:08)
Before I move further or we discuss more about the nitty-gritty of personal financial
process with respect to taxes, I would like to highlight a sequence from the book Alice in
Wonderland. Now, if you remember in that book as well as in the movie if you have
seen, it shows that the protagonist is confused and is in dilemma and asking her advisor a
simple question and the question is would you tell me please which way I ought to go
from here. So, the individual is in dilemma and asking the advisor to some way out.
Now, the advisor being a cat asks that totally depends on a good deal on where you want
to get to which is basically the final goal or the final objective to achieve. The
protagonist says I really do not know or I just do not care much about it, to which the cat
or the advisor response that it does not matter which way to you go. Now, this sequence
essentially show case that, if you are trying to achieve certain objectives and you are not
sure which objectives are important or which type objectives are prioritized, then it does
not matter which path you are taking to achieve those objectives. Or in worst case if you
do not have an objective at all, then it really does not matter which path you are taking.
So, taking this into the context of financial planning; if you do not have an objective to
achieve, it does not matter how much you earn, how much you save and how much you
invest. So, keeping this issue in mind most of our financial decisions or rather all of our
financial decisions should be targeted towards achieving some financial goals.
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(Refer Slide Time: 03:20)
Now, taxes deviate us from achieving those goals in a timely manner. Now, if we try to
understand the role of taxes on our financial decision, we have already discussed that a
tax of 30 percent reduces our net income in the hand or the net gain that we are expecting
from an investment.
So, if we have incorporated it into our financial planning or our financial decisions, we
are basically avoiding that loss in gain or the loss in value from that investment. So, as a
general rule taxes should not be seen as a separate activity rather it should be integrated
with personal financial planning and it should be done simultaneously. So, that the
objective that you have started with for example, achieving a financial goal or any other
financial objective should be achieved in a systematic manner.
Now, we all know that in general financial planning has three major goals to achieve or
rather three dilemma or three decision the choices that are to be achieved. The first one
is, if you have some money, or if you have some income what to do with that income? If
you recall from the first module of the course, we have already discussed these things in
a very generic way. Now in the context of tax implication on personal finances, we are
trying to explain this to contextualise how taxes can affect our personal financial
planning.
So, the first decision choice that we have is whether to consume now or save for future.
If you have got some money, you have a choice to consume the money right now or save
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it for future so, that you can have better utility in future or less uncertainty in future.
Second dilemma that we all often face is whether to create asset versus reduced liability,
essentially what it means is to use the money or the economic resources that we have for
creating some assets right now or for reducing the liabilities that we have.
So, this is second dilemma that we have and the third dilemma or the third decision
choice we have is to pay more taxes right now or to have something which will help us
in having differ tax liabilities. So, these three decision choices are actually important to
understand in the context of tax implications. Suppose, you have to save some money for
future; now another alternative is you can use that money for now and do something
which will get you some utility. If you remember the concept there is always a trade off
between consuming now versus saving for future. If we try to incorporate behavioural
issues in here, we know that immediate gratification comes into the picture when it is
about assuming the economic resources.
Most of us tend to consume the economic resources or in particular and the resources in
general immediately so, that we can achieve the utility or we can obtain the utility that
are available. And this is pertaining to savings versus consumption. Second choice is can
be contextualized or explained in terms of let us say buying a house versus paying rent or
creating some asset in terms of having an asset with you or reducing the liability. If you
recall the example which we discussed while discussing the financial planning, we know
that if you are going to get a job and you are getting a salary, you can use that salary to
create some asset or reduce the liability in terms of reducing the education loan this trade
off is always there for any individual.
Similarly, if we have got some money, you can invest in something which is not tax
exempted versus you can invest in investment of venues which are tax exempted or tax
deferred. So, that you pay less taxes in future. So, paying more taxes in present versus
paying more taxes in future that is a third choice that we have.
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(Refer Slide Time: 08:24)
Now, what are the factors that determine these choices? The choices with respect to
consume versus save, buy versus rent or pay more taxes now versus pay more taxes in
future.
The factors that we are going to discuss here are as follows. The first factor is time value
of money. If you remember from previous discussion, time value of money is a concept
that explains why a rupee today is not equal to a rupee tomorrow. So, if you try to
contextualize this time value of money factor in a very simple example, we know that
individuals make decisions that have economic consequences at different points of time.
For example, if I make a career choice today, it will have economic consequences in
future.
For example, if I take up a job that pays me certain amount of salary today and I stick to
that job for a long time probably I get a better recognition and better promotion in future,
but my salary would not grow as much if I had jumped from a one job A to job B.
Similarly, if I have an income today and that income can be saved and invested that will
yield me some return and that return will be occurring in future. So, I will have higher
income in future. So, the decisions that we make are basically having consequences of
economic terms in future. And this is where this time value of money understanding
helps us. So, we know that if we are going to make some decisions with respect to some
financial choices, the time value of money in future.
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For example, on timeline Let’s say t0 is today, t20 is 20 years down the line and t25 is 25
year down the line and so on. So, let us say t60 is 60 year down. The line the economic
decisions that we are making today will have some consequences in future. Let us say if
we prefer to buy a house instead of living in a rented house, we might have to pay a
higher EMI which is Equal Monthly Instalments for next 20 years, but after 20 years we
will be relieved off paying the rent rental income or E M I rather we will have an asset.
On the other side that asset might require some maintenance or some reinvestment after
20 years. So, we will have to incur some more money. So, these choices at different
points of time in the timeline has to be considered for better decisions and to understand
it in a more practical way we should incorporate the time value of money attribute, when
we are making a decision that have economic consequences in future.
Second factor that are important are basically demographic attributes or the demographic
features. For example, the stage of life cycle that you are living in will be an important
factor of making financial decision or incorporating taxes into financial planning.
Similarly, the household features such as the size of family or the number of people
living in your household will also be an important demographic factor or feature which
will help you or which should be incorporated in your financial decision. One factor that
are most important rather is financial literacy, research have shown that a higher
financial literacy among individuals basically, leads to better personal financial
decisions. There have been several attempts to understand those impact of financial
literacy on personal financial decisions. And over and over again it has been shown that
if an individual has gained some financial literacy through some training or some
education or some courses, they make better choices and better personal financial
decisions.
So, if you have to make a better financial decision, it is very important for you to
understand the economic consequences of all your decisions through some training or
any other financial literacy process. On the top of everything, we have discussed earlier
as well that behavioural biases significantly affect our decisions with respect to personal
financial planning. For example, if an individual is of young age, versus an individual of
retired age will have different risk choices. We know that young people are risk seeker.
So, they can make investment or financial planning which might be seemingly very risky
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whereas, people who are pensioners would not like to take up that much risk. So, risk
seeking versus risk averse behaviour is one of the significant factors that influence your
personal financial planning in the context of tax implications.
Another factor in terms of behavioural bias is availability heuristics, we have all also
discussed that investment information or financial information availability as well as the
choices that are available to individuals would be determining the personal financing
process and similarly the factor such as bounded rationality or overconfidence or under
confidence or loss aversion, these are some factors which will make your choices biased
and in many cases, you end up making decisions that are not so optimal.
So, when you are trying to incorporate taxes into personal financial planning decisions,
you should be aware of these factors namely, time value of money which is the value of
money over time changes and your decision should incorporated demographic and
cultural attributes and behavioural biases significantly affect the personal financing
decisions as well.
(Refer Slide Time: 15:19)
To bring all the discussions in past two sessions in one context of tax implications into
personal financial planning process. Let us highlight some tax saving tips which will be
in incorporated in your personal financing decisions. So, first important thing that an
individual must consider is to invest in tax exempt and tax deferred investments. So,
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whenever you have got some money to invest in you first look out for investment of
venues which are tax exempt or in different case tax deferred.
So, the tax deferred or tax exempted investment avenues are basically those investment
avenues where you save some taxes and you pay less taxes so, that the net gain that you
have at the end of the investment cycle is higher compared to the tax taxable regime.
So, we should always start or increase use of tax deferred investment such as retirement
plan or saving plan or any other investment avenues. Second tip that we must keep in our
mind is that, if you expect to have the same or lower taxes in future which is let us say
next year, we should always try to accelerate deductions into the current year Which
means, if I am hoping that next year my tax rate is going to be low be it for my lower tax
slab or the government policy change or any other factor, if I hope that I will be falling in
a lower tax rate next year. I should try to accelerate all the deduction in current year that
is I increase the deduction in this year.
And on the contrary, if we expect that the tax rate is going to be higher in next year, we
should try to delay the deduction because they will have a greater benefits for you which
means, if we are paying taxes ₹100 this year and next we are we are likely to pay more
than that, then deduction should be taken to next year so, that the tax liability next year
will be reduced. Similarly, if you expect that you have same or lower taxes rate next
year, we should try to delay the receipt of income until next year which means if you
have low tax next year and the income will be received next year, the total tax liability
on that income will be lower.
On the other hand, if we expect that the next year tax rate will be higher or we will have
to pay a higher rate of tax, we should try to accelerate the receipt of all income to this
year only so, that the tax at current year will be paid at a lower rate. So, these are some
important tips that can save you some money out of tax payments, but then after all these
consideration of tax implications on our income and our financial planning process what
is the next challenge that we should keep in our mind.
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(Refer Slide Time: 19:05)
The next thing that will that discussed is basically the decisions pertaining to savings
investment and purchasing activities of individuals and household. So, that the tax
liability or future income taxes can be minimized and more money can be saved for
individuals or the household. This is it for now; we will discuss more about the
behavioural aspect of investing, savings and purchasing decisions and in next session.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture - 28
Portfolios for Individual Investors
Hello Hello, welcome back to the course Behavioral and Personal Finance. So far, in this
course; we have learned about different biases and heuristics that might affect our
understanding of economic theories and how these biases and heuristics can affect our personal
finance decisions.
(Refer Slide Time: 00:34)
This week, we will learn more about what are different tools and techniques and investment
strategies that are available for Individual Investors and how we can implement those strategies
and investment tools and techniques in the interest of our financial security and to get a better
return on the investment that we make.
This session of the module focuses on what are the portfolio strategies or tools that an
individual investor can consider while making personal financial decisions and how these
portfolio strategies can be contextualized to individual preferences of risk and return.
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(Refer Slide Time: 01:29)
The topics that we are considering this week are the construction of investment portfolios. And
how different risk and return choices associated with the investment opportunities available to
us can be taken into account while making a tradeoff for our own investment objectives. We
all understand that, investment portfolio is basically a combination of different assets in
different proportion.
(Refer Slide Time: 02:00)
Suppose, I have certain disposable amount of money to invest in different financial securities
or financial assets. I will have to first choose the set of assets or financials securities where I
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would like to invest my savings. Now, those securities will offer unique combination of risk
and return. What it implies is that; the risk and return characteristic of all the choices that we
have are unique and are preferences for going into one direction or choosing a particular
investment asset depends on our ability to take risk and return associated with those investment.
Basically, when we try to identify a combination of different assets to form a portfolio, we
intend to achieve one or both of these two objectives. The objectives that we want to achieve
through investment is either minimize the risk or maximize the return.
In many cases we also try to achieve a dual objective of minimizing risk as well as maximizing
return. This these two objectives can be achieved through in appropriate asset allocation
strategies wherein we try to find suitable weights for each of the assets being considered to
form a portfolio. And the tradeoff between risk and return associated with those assets. The
question here is; what should be the right amount or right weight of individual securities or
assets that should be combined together in order to form a portfolio that are able to maximize
return and or minimize risk.
If we go back to few sessions ago where we discussed risk and return of different portfolios or
a combination of assets we had learnt earlier; that risk can be defined as the standard deviation
of individual securities where we try to calculate the standard deviation of returns over a period
of time and return is basically the average rate of return that we try to calculate from the given
data or the prices that we observe.
We had learnt that a return can be calculated as the mean or the average value of the price
changes and risk can be calculated as the standard deviation of the changes in price. When we
try to combine different assets in proportion, what we get to form or to calculate risk and return
is as follows.
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(Refer Slide Time: 05:23)
So, return and risk of individual securities can be defined as follows, return of individual
security is basically change in price over the price that we had purchased at. So, we basically
have the price at time t0 and price at time t1, where the return of that asset can be calculated as
𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑃1 − 𝑃0
𝑃0
(Refer Slide Time: 06:53)
Similarly, we learned how to calculate the risk which is given by sigma and if you try to
understand it in the context of a portfolio, we know that return of a portfolio is basically sum
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of all the returns of individual assets and weight of individual assets which means if we have 5
assets in our portfolio. The return of those 5 assets over a period of time during which we have
held the assets with us and the weight of individual assets in the portfolio will be combined
together to understand the weighted average rate of return for the portfolio that we hold.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = ∑ 𝑟𝑖 𝑤𝑖
And risk of a portfolio can be calculated as portfolio sigma as a function of individual risk of
asset. So, if there are 2 assets, we have asset 1 and asset 2; where we calculate the individual
risk weight of each of the two assets that we have.
𝑅𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝜎𝑝 = √𝜎12 𝑤12 + 𝜎22 𝑤22 + 2𝑃12 𝜎1 𝑤1 𝜎2 𝑤2
This is how we calculate the risk of a portfolio, which is basically, the risk of individual assets
where 𝜎1 is risk of asset 1, 𝜎2 is basically risk of asset 2, similarly W1 is weight assigned to
asset 1 and W2 is weight assigned to asset 2.
Here we have one more function known as rho or correlation factor. So, 𝜌 is basically, the
correlation coefficient of the 2 assets that we hold. Now, if you try to understand this on a risk
return graph, we can explain this as follows. So, suppose if I have two assets which I can try to
explain with a visual way. (refer 9:55) So, X axis is the risk and Y axis is the return that we
hold. So, if we have two assets which let us say asset 1 which is giving me a 𝜎1 and return r1
and similarly, if I have second asset which is giving me a sigma of risk of 𝜎2 and return r2.
If you try to understand this the portfolio that we would like to construct with this these two
assets 1 and 2. If the correlation factor is 1; as portfolio would look something like this where,
we will try to have a portfolio along with the line joining asset 1 and asset 2. And if the
correlation between 1 and 2 is minus 1; the portfolio curve would look like a curve (refer
11:03). And if the correlation factor is to be 0 which is very rare case, then the value of the
curve of portfolio might look like small curve (refer 11:27) and if we assume that correlation
between 1 and 2 is average of 0.5, it should look like curve between both the curves (refer
11:31)
So, this is how the portfolio looks on a risk return graph. When I try to understand the position
of the portfolio of two assets, asset 1 and asset 2, it will be shown on these graphs or these
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curves basically where depending on how much weight we put on asset 1 and what is the
remaining weight to be put in asset 2 will determine the position of my portfolio on curve of
these natures.
So, basically if I have, let us say an asset which has weight in asset 1 is equal to 0.5 which is
my 50% of money is invested in asset 1 and the remaining 50% is in asset 2, then my portfolio
would assuming that the correlation between these 2 assets is basically 0.5. Then my asset
would look will be along the curve of correlation 0.5 line somewhere between where my asset
would my portfolio would be positioned. If I try to change this weight of asset 1 to be 0.
(Refer Slide Time: 13:13)
So, if the weight of asset 1 becomes 0; which means, weight of asset 2 will become 100%
which is essentially 1. Assuming that; this is the same correlation between these two assets, my
portfolio would be lying along curve with correlation 0.5 line close at this particular point
where the value of the asset 1 will be 0 and value of asset 2 or the weight of asset 2 will be 1.
So, if we try to explain this on a risk return graph, weight of asset 1 being 0 and weight of asset
2 being 1. Which implies that; if we put 100% of our money in asset 2, my portfolio would be
positioned at point 2 if I reverse this situation, my portfolio would be positioned at point 1, if I
have 50% in these two assets; my portfolio would be lying somewhere between.
So, based on these movement along with the curves based depending on what is the correlation
between the assets that we are holding, our portfolio would move along with the curves on
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these risk return graph. Now, this is too simplistic because the world is not so simple to have
just two assets there might be multiple assets where you want to invest and the moment you
have multiple assets you have to consider multiple combinations of risk and return.
So, if you try to expand this idea; it should look like as follows. Suppose, we have to show the
combination of risk return of different assets depending on the weights.
(Refer Slide Time: 15:25)
So, if we would like to plot the return weight graph. It should look something like this (refer
15:50). So, on X axis we have weight of individual asset and on Y axis we have a return on
individual asset.
So, my portfolio the curve would look something like this where the moment we move towards
a particular assets weight I will be moving along the line. (refer 16:35) Similarly, so we can
say that this is linear to the weight that we are holding. So, it implies that the return of portfolio
would be
𝑅𝑝 = 𝑊1 𝑟1 + (1 − 𝑊1 )𝑟2
If we try to find the relationship between the standard deviation which is basically the risk
measure and weight graph which is another way to look at the same graph, it should look like,
(refer18:20) first it will come down and then it will start going up because the moment you put
all your money in a particular asset; the risk of that asset will be dominant and depending on
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the correlation coefficient of this these 2 assets basically the curve of the portfolio would be
looking like this.
So, here the sigma would be sigma of a portfolio which is basically the risk of the portfolio
would be
𝜎𝑝 = 𝑊1 𝜎1 + (1 − 𝑊1 )𝜎2
So, if the correlation changes then the shape of this curve will also keep on changing. Suppose,
the graph of risk and return with a positive correlation factor which is correlation being plus 1,
then the graph would of risk and return would always look like linear. (refer 19:40)
Now, in this case the return and risk both will be linear because, return we know that is always
the function of weighted average rate of return and risk is a function of both weight as well as
sigma along with the correlation coefficient which is given as the sigma of portfolio as
explained earlier.
𝑅𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝜎𝑝 = √𝜎12 𝑤12 + 𝜎22 𝑤22 + 2𝑃12 𝜎1 𝑤1 𝜎2 𝑤2
Now, if you want to expand this argument for a situation where multiple asset are there, the
scenario would be as following.
(Refer Slide Time: 21:38)
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We know that in a situation where there are two assets the curve of the risk return of two asset
portfolio would be as following; where we have two assets, A and B and the correlation
coefficient between A and B or any two assets is assumed to be moderate which is 0.5.
Given this assumption; we can assume that the curve of the portfolio would look like this (refer
22:20) where my portfolio would be moving along this line depending on, how much money
we have put in which of the asset. So, suppose if we put all our money in asset B, then portfolio
would be the case where the 100% weight in B and if you put all our money in asset A it will
be 100% of weight to A.
So, if A has 10% of return and 5% of risk, then it I will be getting 10% of return if I invest in
this portfolio here. If B has 20% of return and if I put all my money in B, the return that I will
be getting is 20% at this much of risk, but if I want to combine these two assets to the extent
of 50-50, then my portfolio would be lying somewhere between the graph, where I can generate
a return with lower amount of risk. So, this is how it should be looking like. (refer 23:00)
Now, assume a situation where you have a provision or an opportunity to short sell. So, short
selling if I assume that; if short selling is allowed, so short selling basically is provision in the
market, where you can sell something that you do not own; which is basically allowing an
investor to take a position where the person can sell a stock or an investment even if he or she
does not own that particular stock. And this is done with the hope that if the prices fall
tomorrow or in future, he or she will buy that asset at a lower price and deliver that asset to the
person to whom he sold.
This is a very crude way to explain short selling, but short selling essentially implies that; if
you have if you do not have a particular asset and still you want to take up position you can
simply sell it at a higher price and buy it at a lower price in future to settle the deal. So, if short
selling is allowed; the curve that we are talking about should look like this where this will be
sigma which is basically risk and return and if there are two assets A and B.
And they are correlated moderately, then if short selling is allowed this curve can be expanded
further where depending on the short selling of the asset A or B they can move along this line.
(refer 25:25) Now, the (dotted) region is basically short selling region, similarly this also is
short selling and this is basically long where you invest your own money.
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Now, if we use this argument of short selling of assets that you are holding in your portfolio or
that you want to hold in your portfolio what you can do simply is you can consider this short
selling provision and then take the argument further to create more portfolios.
Now, assume that we have this portfolio where we have a combination of risk and return in
different quantities or different values. So the two portfolios have different risk and return.
(Refer Slide Time: 26:14)
So, can I say that if I have an investment portfolio here (refer 26:50) which is giving me a
higher rate of return for a lower level of risk. So, this is the risk that I am talking about this
particular point of this curve is basically giving me a return at a lower level of risk. So, any
individual who would like to hold a portfolio where he or she gets a higher rate of return at a
lower rate of risk. (refer 26:50)
But, if you move along this curve, no one would like to have a portfolio here where for the
same level of risk. So, let us say this star, the return that he or she is getting is much lower than
or the return that could possibly he or she get in this situation. So, for this risk only a person
has a choice to invest here or here where he will get this return or this return. So, no one would
like to have a portfolio here where the return is lower for the same amount of risk. (refer 28:30)
So, it means that, an investor would like to invest anywhere that is giving him the best return
for the same level of risk. For example, if I have a return a risk here which is basically let us
say sigma hat, I can invest here or here or here anywhere along this line, but my best portfolio
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would be here where I will get highest level of return at this point of time; at this point of the
curve.
Now, if you try to take this argument in a more general generalist way or the argument of
combining two or more assets together, we can simply take an example where there are more
than two assets. So, which means if I have two asset, I presented the scenario of two portfolios,
but if I have more than two asset if I can combine it like let us say A B and then I have an asset
which is C and I know that these three assets can be correlated to a moderate level with each
other.
Which means if I have a portfolio of A B, it will be along this line and if I have a portfolio of
A C it will be along this line and if I have a portfolio of BC it will be along this line (refer
29:30). Now, assuming that the correlation between these assets or the pair of assets is moderate
the portfolio curve it will look like this. If you want to have an as a portfolio of A and C you
will invest somewhere along this line.
So, if I invest 50-50% in A and C, my portfolio would be here, if I invest 50% in A and B my
portfolio would be here and if I invest 50% in B and 50% in C my portfolio would be here.(refer
30:05) Now, imagine a case where you have ₹100 to invest and ₹100 is invested in portfolio
A B to the tune of ₹50 and portfolio C or rather asset C to the tune of 50.
Now, in this case where my portfolio is going to lie? So, A B basically is this curve, so I invest
somewhere here and me for my assets C investment is here. So, my portfolio should lie along
this curve right. Similarly, if I have instead of A B, I have A C and here I have B, so my
portfolio of a C will be along this line and B will be here. So, my portfolio would be lying
along this curve. (Refer 30:54)
If I have a portfolio where instead of A B, I put in ₹50 in B C and remaining 50 in A, then my
portfolio would be somewhere here that is B C and then this A. So, my portfolio would be lying
along this line, because this particular combination is B and C and this is my asset A.
So, if we generalize this argument and assume that you can create as many combinations as
possible you can create as many portfolios as possible along this entire region. Which means
each of the points within this region is basically a combination of assets available in the market
and the assets available in the market essentially in this example is A, B and C.
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So, given the fact that you have 3 assets in the market and these 3 assets are moderately
correlated with each other. You can create as many portfolios as possible within this region.
And if you take this argument of short selling. So, if short selling argument is taken to this
example, then I can extend this reason further to find a combination where I can create as many
portfolios as possible in the entire region. So, entire region is basically a combination where
you can find a portfolio. Now, this particular reason is known as feasible region where you find
combination of assets available in the market.
So, if I could say that the entire area this particular area is a possible area where you can create
as many portfolios as possible. Now, for a sane investor as I explained in this example; if you
want to take this much of risk, you have a choice to invest anywhere along this line right. So,
you can invest here where you will get this return, you can invest here where you will get this
much of return and you can also invest here where you are going to get this much of return.
Now, for a sane investor; it is always preferable for investing in the point where he is getting
the highest level of return for the same amount of risk. So, we can say that even though this
particular entire reason is a possible feasible reason for investment or for portfolio construction
for an investor to choose for portfolio construction, it is always preferable to find combination
of assets that are lying at the external boundary or upper boundary of this entire region.
So, this boundary or this upper boundary is known as efficient frontier. Basically, what it means
is these the points along with this curve are the points or the combination of all the assets
available in the market where you can invest your money and get the highest level of return for
a given level of risk. So, if I can simplify this, I can say that this is the upper boundary of the
entire combinations of A B and C which are the available assets in the market. This can be used
as the reference point or a or a set of points where you can put your money and decide, how
much is the weight for asset A, B and C or any combination thereof.
Now if I take this argument further, I can say that this is the entire set of points efficient frontier.
Now, if I know that I can bear only this much of risk, this is my risk that I can bear. (refer
36:15)
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(Refer Slide Time: 36:00)
I know that for me the best combination of assets available in the market is this point where I
am going to get the best return. So, this is my point at which I am going to get the best return.
So, in that sense again the lower boundary of this particular feasible external boundary of
feasible region is of no use rather just the upper boundary is useful.
So, if I simplify this graph further, I can say that if given that 2 dimensional graph of risk and
return and there are multiple assets available in the market; the efficient frontier that an investor
has is basically going to look like this where you have a combination of assets along this line
with the best possible risk return combination. So, this is going to be your risk and this is going
to be your return. (refer 36:40)
Now, just to add one more point, I would show how adding one more asset in the scenario
would make the decision making even more efficient.
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(Refer Slide Time: 37:34)
So, assuming that you have a situation where you have a combination of risk and return. So,
this is your risk and this is your return and we just showed that the efficient frontier is going to
be like this. (refer 37:40)
So, we know this is going to be the efficient frontier of combination of assets given their risk
return characteristic, this is our risk dimension, this is our return dimension. So, if we believe
that there is a risk-free asset; risk free asset. For example, an asset that gives you some amount
of return with zero risk. So, there will be some return and risk will be zero which means it
should be lying along this line. So, if this is assumed to be the risk-free rate.
So, basically the risk-free rate is going to be rf. So, this is your risk-free rate where you have
no risk at all with some amount of return and if you want to combine a portfolio of risky asset.
So, efficient frontier of risky asset, because all the assets and their combination on this frontier
is carrying some amount of risk right. If you have here your portfolio here you have some risk
and some return, if we have your portfolio here you have some risk and some return. (refer
39:20)
So, if this the efficient frontier of risky assets and this is your risk free asset and if you want to
combine your portfolio with a risky asset and risk free asset, the portfolio is going to be like
this where it will intersect or it will be tangent with the risky portfolio and the risky risk free
portfolio. (refer 39:40)
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So, for an individual let us say deciding or wanting to create a portfolio where he or she can
put some amount of money in risky assets and some amount of money in risk free asset.
Because, you do not want to put all your money on in risky assets, then this is the portfolio
curve that he or she should be following. Which means; that your portfolio should lie along
this line where you have some exposure to risk free asset and some exposure to risky asset in
the market.
This tangent portfolio basically represents the market portfolio also which is basically
representing the best combination of asset and this market portfolio basically indicates the best
combination of assets that are available in the market for a given level of risk and return. So, if
we can conclude this session by saying that given the fact that individual would want to increase
or maximize the return and minimize the risk together it is in best interest or it is most likely
that he or she would try to maximize the return for a given level of risk or minimize the risk
for a given level of return.
On a graph it looks like this. So, if I am an investor who has this much of risk bearing capacity.
So, let us say sigma star, I know that or I can tell that how much return I am going to get given
that these factors are available or if I know that an individual investor or an investor who has a
desire to earn this much of return r and this return is basically earned through investment in
risky and risk free asset. Then I can tell that this is the risk that he or she should be ready to
bear. (refer 41:50)
So, this is the advantage of having a portfolio of construction using assets available for
investment in the market and combining the assets of risky in nature with a risk-free asset given
as rf. And then we try to find a combination of assets that are best suitable for the investment
objective and risk bearing capacity of the individual for which we are making the decision. I
stop it here.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 29
Investment Alternatives for Individuals
Hi there, continuing with the previous discussion on portfolio construction, in this session we
will discuss about how portfolio construction can be optimized or the benefit can be maximized
with the help of using different assets and different investment avenues in our decision making.
This session basically focuses on 2 concepts; the concepts that we are going to discuss in this
session are why specific and focused investment strategies should be designed for individual
investors and how one of the investment avenues, that is quite popular in financial markets and
investment domain is more important and suitable for individual investors.
So, the topic that we are going to cover is the distinction between individual and institutional
investors in general.
(Refer Slide Time: 01:17).
And how a unique type of investment products, which is known as mutual funds, can be used
for getting the financial planning of individuals in a better way?
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(Refer Slide Time: 01:30).
So, when we talk about the distinction between individual and institutional investors, we all
know that institutional investors are a big player in financial markets and investment domain
basically, they are at advantage on many frontiers and some of these frontiers or the factors at
which institutional investors are at advantage can be as follows. The first thing, that comes as
advantage for institutional investors is the availability of resources and skill sets.
So, when we try to understand the investment decision making for individuals and institutional
in different contexts, we know that the level of resources or the availability of resources with
respect to institutional investors is huge as they can have huge amount of money pooled
together from different sources. And that amount of money can be invested in different assets
that are available to them, they have deep pockets they can take more risk so, they are at
advantage in terms of scale of operations.
When it comes to individual investors, we know that, individual investors have their savings
and they cannot invest huge amount of money in financial securities or financial assets. So,
their scale of operation is very marginal.
Second factor that comes to the advantage of institutional investors is the access to information.
And at the same time the technical skill and expertise that are available to them. Institutional
investors can access to information which are publicly available as well as the information that
are privately available in some cases whereas, individual investors cannot have access to most
of the information or even if they have access to information it comes to them very late.
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Similarly, if it is about individual investors they are not able to, they are not able to optimize
the choices or incorporate all the information that they have access to in their decision making
whereas, institutional investors are having technical skill set and experts who can take better
decisions and make informed investment choices for on behalf of their investors.
So, this is how the first thing that distinguishes institutional and individual investors. Second
factor or rather second most important factor is about the process of decision making that are
followed in case of individual and institutional investors. Individual investors are basically
focusing their decision making with the help of different organized, the committees and stake
stakeholders for example, most of the institutional investors have board of directors who are
themselves very much expert in their domain and they have committees who take care of
different aspect of the businesses and fund management.
So, if you talk about any financial institution or any financial investor in terms of institutional
domain, they have structured decision-making bodies, such as board of directors, sub
committees, sub committees and so on. They also have accountable decision makers who take
decisions on behalf of their investors and they are accountable and responsible for the
performance of those decisions.
So, referring to fund managers or research analysts who take the decisions on the basis of the
information that they can get access to and they are responsible for the decisions that they take.
On when we talk about individual investors their decisions mostly are driven by the heuristics,
they are more likely to be biased in terms of decision making because, they are more
apprehensive about their skill set and technical expertise. They do not have access to all the
technical tools and methods that can be applied for better decision making.
So, their decisions are less efficient compared to the decisions taken by institutional investors.
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(Refer Slide Time: 06:21).
If we move this discussion further, we know that, there are certain other inputs and factors
which might be distinguishing the institutional investors from the individual investors for
example, taxes and other cost. Because, of their scale of operations the institutional investors
have the economies of scale and that is why they have expertise as well as the advantage to
save cost, and taxes, and other trading costs such as brokerage charges or transaction cost
institutional investors can also have very structured way of benchmarking their performance.
They know that they can track each of the asset’s strategies, fund managers, decision maker,
markets and economies as well. They know that their performances have been observed by
their managers and superiors who are actually looking at what they are doing, and that is why
their decision-making has to be most efficient to their knowledge. They also realize that it is
them who are actually leading the market most of the time and other investors, who are
marginal investor or retail investors they are basically trying to consider them as benchmark in
most cases.
So, institutional investors tend to be the return leaders which means that they determine the
return achieved by the individual investors because, individual investors alone or in general
cannot drag the volume as well as the prices in their favor. Another factor that is most important
for understanding the differences between individual and institutional investors is the
availability of products, in most of the markets across the world the products that are available
to institutional investors might not be available for individual investors as well.
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Whereas individual investors can invest in equity bonds and other products in financial markets
they cannot take part in to investment choices that are considered to be highly risky. Such as,
trading in options market or short selling for by investors these are exclusively available for
institutional investors and that comes to their advantage because they can mix money at a
shorter cost and time duration.
So, institutional investors can exclusively exploit these opportunities which are not available
for individual investors. Given that these factors that comes to the advantage of institutional
investors we can say that individual investors have to be served better products or the
investment products which are more suitable for their risk, bearing capabilities and other
contextual factors such as, their fund size or the investable amount that they have to invest their
ability to incorporate information into their decision making And similar other factors which
are important for making the financial decision making more optimal.
Now, when we understand that individual investors might be biased, might not be able to take
into account all the information that they have they have typically a shorter amount of money
for investment. We should focus our discussion towards products or investment avenues where
individual investors can gain the advantage of the market movement by using the expertise of
finance institutional investors.
One such product or investment avenue that are available
for individual investors at large is mutual funds.
So, when we talk about investment opportunities available for individual investors, the first
thing that we should discuss is about the availability of mutual funds investment where
individual investors can invest their savings and gain the advantage of the market movement.
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(Refer Slide Time: 10:52).
So, mutual funds basically are investment companies or institutions, we that pool money or
resources from definite individual investors or other small investors and use their financial and
professional expertise to invest that pooled money for the gain of their shareholders.
So, basically it is a kind of fund or an investment company where people like you and me can
give the, our savings and they pool the all these savings together to create a huge fund and then
they invest this huge fund into different assets and securities. And after they earned the return
on this investment, they keep their cut or their expenses, and commission, and other charges
and the remaining amount of profit is distributed back to investors like you and me who had
initially invested. The advantage that comes to mutual fund is they are they are considered to
be an under institutional investor category. So, they can take advantage of the markets in a
better way than we as individual can take.
So, basically, they have access to the assets all the assets class, that are available they invest in
a different type of assets such as stocks, bonds, commodities, money market instruments. The
decision to invest in these assets or a combination of these assets can be determined by the fund
objective or the investment objective of the fund and the risk bearing capabilities of the
investors, who have pooled in their money for this mutual fund. Now investment objective can
be depending on the type of customers or the type of investors that the funds target.
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For example, mutual funds can be completely focusing on equity or it can be totally investing
in bonds or fixed income securities there can be hybrid funds, which means that they can invest
in both equity and fixed income. There could be tax saving funds where they will be investing
the pooled money in tax saving instruments such as, government bonds and so on. There would
be funds which are considered to be growth fund, there could be value fund and there are
numerous categorizations of mutual funds which basically determine their investment
objectives.
Since, they are managed by professional money managers so; it is always in favor of the
investors who have pooled in their money. Each of the investors while pooling the money gets
the proportionate amount of share or the units in the mutual fund. And after the return is
generated the expenses and management fee as well as any other cost associated with managing
that mutual fund is kept by the mutual fund organization and the remaining amount of return
is, returned to the or given back to the shareholders who have initially pooled the money to
create this mutual fund.
Now, mutual fund can be of different types as well for example, closed ended mutual fund as
well as open ended mutual funds these categorizations will be discussed later.
(Refer Slide Time: 14:41).
To understand the benefit for individual investors for these mutual funds as an investment
avenue we should focus our discussion on the factors that matters most to the individuals. Now,
if you are an individual and you are willing to make some investment in financial market or a
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stock market through mutual fund because this is how you can passively participate in the
advantage of market.
You should understand the structure and pricing of mutual fund which means you should
always try to understand the advantage and disadvantage along with the investment objective
for which mutual fund is created. If you want to save your money, in terms of tax saving then
invest in tax saving funds. Similarly, if you have let us say planning for savings to achieve a
better life after retirement you pool your money in mutual funds which are going to give you
some advantage in long run.
So, there are certain factors which we should always keep in mind before we take decisions
with respect to investment in mutual funds. These factors are basically some indicators such
as, net asset value, then unit price and management fee or expense ratio also known as the
expenses that are incurred by the mutual funds in order to manage the money. These funds or
mutual funds can be assessed with the help of managers performance and other governance
related issues.
For example, who are the people, who are managing the money? What are their qualifications
are they qualified enough to manage our money? Whether there is any conflict of interest, in
terms of people managing the money having the investment decision, which are conflicting
with their personal interest? And what are the incentives that are being promised or given to
the managers and other people sitting in the management of the mutual fund. These are some
qualitative factors that we should always consider before making a mutual fund investment.
As discussed earlier we should also keep in mind that if we are making some investment in
mutual fund this should also be considered in terms of tax savings and tax advantage for
individual investors because, in long run taxes affect our decision-making.
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(Refer Slide Time: 17:21).
Talking about the fact one of the most important factors to understand the decision criteria for
mutual fund it is net asset value, also known as NAV.
𝑁𝐴𝑉 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
This function gives us the net asset value of that mutual fund.
If you look at the example given at the screen (refer 18:12) you can see that; if a mutual fund
has ₹100 million in assets, which is basically the amount pooled from different investors. 3
million in short term liabilities so, assets are basically money pooled from investors and their
value.
So, this is the money that is pooled from investors or the shareholders who are holding the units
of this mutual fund and this is the liabilities which are basically including the expenses, or any
other commission, or fee, or any other fees, that is chargeable for managing the mutual fund.
So, if these 2 are the values considered to be assets and liabilities and the number of units issued
to shareholders is 10.765 million, we can calculate the net asset value of this mutual fund as
follows.
𝑁𝐴𝑉 =
₹100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − ₹3 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
= ₹9.0107 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
10.765 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
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So, this gives the net asset value of this mutual fund that we are talking about. So, NAV is
basically an important factor while taking decisions to invest in mutual funds. So, if you are
considering mutual fund as a possible investment, you should always consider or compare
NAVs of different mutual funds so that you make a better decision in terms of value of the
mutual fund that you are investing in.
(Refer Slide Time: 20:23).
The advantage or the benefits for individuals or individual investors of investing their money
in mutual fund is basically coming from the broad diversification. As discussed earlier we know
that individual investors cannot be at advantage if they directly invest in markets because of
certain reasons. These reasons are the lack of professional and technical expertise and the size
of funds that are available with them for investment and some other factors such as,
susceptibility to heuristics and biases while taking decisions.
Given these factors we can understand that if a mutual fund is available for individuals the
broad diversification advantage comes handy. So, mutual funds can technically invest in as
many assets as possible across industries, sectors, economies and markets sometime they can
also invest in equity as well as bonds with different maturity and coupon rate and other credit
qualities.
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So, they know that if they have to create a mutual fund for just fixed income which is basically
bond mutual fund, they can put their money in bond mutual fund, by keeping in mind or
keeping the criteria such as maturity and credit quality and coupon rate as preferable.
At the same time, they have this professional in money management expertise they can source
different inputs and data as well as information from different sources and make a betterinformed decision for their investor at a reasonable cost. So, cost saving is also one of the
advantages for individuals to invest in mutual funds. Another important factor that is at
advantage for individual investor is the convenience and passive decision making. So, they
essentially do not have to take any direct decision with respect to allocation of assets across
different markets or asset classes. Many times, there are fund families which are basically
variety of funds available for investment.
So, even if you want to stick to a particular fund promoter you can find multiples fund offerings
where you can invest your money that saves your cost and effort in terms of asset allocation.
(Refer Slide Time: 23:12).
The disadvantages although are the basically the lack of, lack of uncertainty about volatility
exposure, which means that if you invest in mutual fund and the markets are volatile you are
still going to suffer the loss.
Because of the market volatility so that cannot be avoided in even if you invest in mutual fund
and the reason for it is. It is always exposed to the financial market or the stock market in
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general, that is why the losses that you are going to suffer because of market volatility cannot
be avoided even if you are investing in typical mutual fund.
And second disadvantage is basically the higher cost at times because some of the fund
managers charge extremely high fee and management charges, which might reduce the ultimate
return that an individual investor in mutual fund is going to get. The returns that we are talking
about here for individual investors might come from two major sources.
One is the dividend or the unit gain that investor is getting and second is the capital appreciation
in terms of value increase of the unit. So, capital appreciation might be realized and unrealized.
Realized when the individual investor is selling the units or the share and if it is not realized,
which means the value is notional and the day when the individual investor is going to sell the
unit, he or she will get the capital appreciation part as well. So, there are two sources of return
capital appreciation and dividend or in interest income.
(Refer Slide Time: 25:07).
If we talk about returns, we should not ignore the part of expenses or the cost of maintaining
that mutual fund. So, here is a once in a factor which is important to keep in mind while you
invest your money in mutual fund.
It is about the expenses or the in-management charges and fees that is incurred in managing
the money pooled from different investors. So, the term that is known as the total expense ratio
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essentially indicates that total investment advisory fee and cost of legal and financial services
that is given to manage the funds. And it is expressed as a percentage of the funds average net
asset value.
Typically, in India the scenario is up to ₹500 crore the total expense ratio is going to be 2%
and if the mutual fund has more than ₹500 crore of assets, it is going to be fixed at 2.25%.
Lowest for money market mutual fund the TER that Total expense ratio becomes the lowest
for money market fund, because it does not require lot of money management tools and efforts.
And it is highest for the international stock funds because it requires lot of research and inputs
on part of the management of fund and that is why; the total expense ratio is the highest for
international stock funds. Typically, total expense ratio tends to be lowest for large and liquid
funds because it essentially requires lot of turnover and churning of portfolio that is why
management of the fund charges high fee. Another factor that we keep in mind is the load
charges, which is basically 1-time sales commission when the mutual fund is floated.
Typically, it is accounted in terms of front-end load which is charged at the time of purchase
or back end load when you are selling the units of the share, basically this of back end load is
charged as sales commission. Low end funds typically have sales fee or this load ranging from
1% to 3% it is also including the operational expenses typically marketing and distribution cost
of 0.25% to 0.75% in general.
However, there are few funds which are available and for the individual investors and carry no
loads which means there are no charges in terms of sales commission at the time of buying as
well as at the time of selling. These types of funds are very rare and if you are a smart investor
you would like to find a fund where there is no load charged for individual investors.
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(Refer Slide Time: 28:16).
If I would like to give an example where the charges or the loads actually determine the ultimate
return that individuals are going to get, if we look at the example, there are 3 funds; Fund A
Fund B and Fund C. In 3 funds the overall initial investment is same that is ₹10,000 and in long
run the return or the value of that ₹10,000 is changing. So, if you look at the situation here the
initial investment of ₹10,000 in these 3 funds in Day 1 is ₹10,000, ₹10,000 and ₹9,525
respectively.
Given that Fund A is basically a typical cost-efficient index fund, where not much management
expertise is required. Fund B is conventional no load stock mutual fund, which means there is
no load on buying or selling. And Fund C basically is low load stock mutual fund with less
than typical annual operating expenses.
So, load is reducing your initial value of the investment that you are making which essentially
mean if you are investing ₹10,000 some amount of money which is basically ₹475 is taken as
frontend load. So, Day 1 investment value is ₹9,525 if you stay invested for 5 year the value
keeps on increasing and 10 years, 15 years, 20 years.
So, if we assume that, the gross return on these mutual funds or these 3 funds are same that is
13% because of these unique characteristics the operating expenses would vary. So, in first
case it is 0.29%, in second case it is 1.22% and in third case it is 0.96%. Because it is low load
stock mutual fund with less than typical annual operating expenses. So, the net return available
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for individual or the investor who has invested ₹10,000 thousand in the beginning is going to
be 12.71% in case 1. 11.78% in case 2 and 12.04% in case 3.
This essentially shows which type of funds you should look for when you are trying to make
an investment decision in mutual fund with different time horizon. So, keeping in mind that
the different time horizon of 5-year, 10-year, 15-year and 20-years this percentage of rate of
return would definitely lead to significant amount of monetary value. And that is why you
should keep in mind when you make decisions.
(Refer Slide Time: 31:07).
So, in this session we discussed why individual investors are unique compared to the
institutional investors and the reasons are the scale of operations and their expertise in
managing the money. We also discussed how mutual funds can be a better and more suitable
investment products available for individual investors and different characteristic of mutual
funds that we have discussed.
In coming session, we will discuss about other investment opportunities available for individual
investors so, that their financial goals can be achieved. That is all.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module - 02
Personal Finance
Lecture – 30
Investing in Mutual Funds
Hi there. Welcome back to the course Behavioural and Personal Finance. Continuing with the
previous discussion that we were having on Mutual Funds and other similar investment
alternative for individual investors. This session will focus on topics that are the basics of
Mutual Fund investment for individual investors, and how we can evaluate the performance,
and where do we find the information related to the Mutual Funds that we can consider for
investment.
(Refer Slide Time: 00:35)
Also, we will touch upon the related topic which is basically the exchange traded fund which
are very much similar to Mutual Funds, but have unique characteristics and how it can help
individuals in making a better financial portfolio.
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(Refer Slide Time: 01:12)
When we are talking about Mutual Funds, basically we understand that Mutual Funds are an
asset investment company or an organization in financial services sector that pool investment
or investible funds from individuals in large number. And then use their professional money
management skills and expertise to invest that pooled money in different resources.
The governance of a Mutual Fund company or an organization that floats the Mutual Fund as
investment avenue, basically follows a structure just like a similar financial services company,
such as the people who hold their units or shares are the Mutual Fund holders and these shares
could also be known as unit. So, basically the unit holders or the shareholders of Mutual Fund
Company are the owner of the company and they elect a set of people to be representing them
as the board of directors.
So, board of directors is the apex decision making body in Mutual Fund Company and most of
them the members of the board of directors are basically independent directors. So, that there
is no conflict of interest and the decisions that they take pertain to the service of the
stakeholders.
Second, decision making body or the people who are responsible for making, right decision in
the interest of the shareholders are the investment advisors. Basically, these are the people with,
right kind of expertise for managing the fund or the money that they have pooled from different
investors and they basically manage day to day operations in terms of buying or selling or
investing and disinvesting the portfolio that they are managing.
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Other people who are associated with Mutual Fund body are those who are responsible for
managing risk and ensuring that the interest of the shareholders is taken care of in the process
of managing money and these people include principal underwriters who are basically those
who underwrite the issue or the fund offering. Then there are administrators, transfer agents,
custodian of the assets and independent accountant. All these people put together make the
decisions that are in the best interest of the shareholders.
Now, when you have an investment in Mutual Fund you are also likely to be interested in
knowing what tax consideration or implications these Mutual Fund investments have. Earlier
we have discussed that taxes affect our decisions and before taking any financial decision we
must consider taxes as an important input. In fact, taxes are tax planning is as important as a
successful financial planning, so in the in case of Mutual Fund investment decision as well we
will consider taxes as an important input for decision making.
(Refer Slide Time: 04:49)
When we talk about taxes on distribution of Mutual Fund gains basically, we mean that the
money invests taken from shareholders and pool together to make investment decisions are
invested in assets as decided and advised by shareholders. And with the input by the research
analysts and investment advisors, the invested money yield some return over the period of
holding of that investment and then that return is used for distribution of dividend to the
shareholders. So, basically when shareholders receive money as the return on their investment,
they pay taxes due once the income as dividends and capital gains are received.
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If you recall, we know that the source of return for any investment belongs to two categories,
one is capital appreciation or the capital gains and second is the dividend or the interim income.
Basically, it is in terms of the appreciation of value due to capital gain and the return on
investment. So, when the shareholders receive their investment return due to whatever of the
two reasons, they pay taxes as due to the tax authorities. All income and capital gains taxes are
generally subject to the income tax prevailing in the land where they belong to.
For example, there are certain securities which are exempted from taxes as per the tax laws of
the land and such assets or such investment are mutual municipal bonds and government
securities as and when issued by the governing authority. These assets are exempted from taxes
in the hands of the recipients.
Whereas, in most cases when the taxes are due be essentially it is more relevant to the capital
gains in the hands of the recipient. Which means if I have invested ₹100 at time 0 and I received
some income at time 1 in that same period I also received some capital gains we can pay taxes
on dividend income as well as on the capital gains. And we have all earlier discussed that
capital gains taxes are subject to the prevailing law.
For example, typically short term capital gains are subject to higher tax rates compared to the
long term capital gains, which means if you buy a Mutual Fund investment and sell it within a
year and in that period you are getting some capital gains you are subject to pay higher taxes
compared to the taxes that might be due if you hold that Mutual Fund investment for more than
1 year.
Another factor that are important to consider taxes on distribution of dividend income or
income on Mutual Fund investment is the turnover rate because that determines the acceptance
or the popularity of the particular Mutual Fund. Basically, turnover rate is expressed as a
percentage of the funds average asset and in general basically in Indian market the average
turnover over rate for stock Mutual Fund is 79%. So, when we consider Mutual Fund as an
investment avenue, we should also look for the turnover rate applicable to the Mutual Fund
that we are considering for investment.
Having understood the basic governance structure of Mutual Fund and how taxes are affecting
the decisions with respect to Mutual Fund gains, we should understand what are the alternatives
or the types of funds that we have where we can choose from and include in our investment
portfolio.
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(Refer Slide Time: 09:24)
If you look at the table it shows the types of Mutual Funds that are typically offered to the
individual investors and these funds have unique characteristics. So, for example, if we classify
the overall Mutual Fund offerings in three broad domains namely money market fund, bond
funds and common stock funds each of these categories have their own unique characteristic
such as if we consider money market funds and we be have two types of Mutual Funds based
on their characteristic of the assets or the investment.
There are two types of funds being offered in money market fund category and if we have three
categories of Mutual Fund offerings namely money market fund, bond funds and common
stock fund, basically these three categories belong to three different type of assets.
First category is money market fund that includes assets which are belonging to the risk-free
asset category or the assets which are offered in short term market. Second category is bond
market bond funds which are basically funds where investments are made to the bonds or fixed
income category of assets. And third is common stock fund where assets are invested in
common stock or the share pertaining to different companies.
Within money market fund category, we have two funds basically taxable money market fund
and tax-exempt money market fund. The first characteristic is the objective of the funds for
which the fund has been floated and offered to the investors. Taxable money market fund has
an objective to give current income with the stability of principal which means it will ensure
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that the principal amount that you have invested remains secured and it also gives you some
income.
So, basically it is cash investment and it is invested in assets which are very liquid. There is no
growth potential because the cash is saved in terms of safety of principal amount. The income
potential is moderate because as the value of liquid asset grows which is very slow the growth
of the fund also occurs and stability is very high.
Whereas, when you talk about tax exempt money market fund which means there is no taxes
on the growth or the income that you will receive from these funds and these are invested in
typically in investment which are typically municipal cash investment. And there is no growth
potential as such, but there might be moderate income potential and stability is again very high.
So, if you are an investor who is very risk averse and does not want to assume any risk for you
these types of funds are most suitable.
If you are an investor who would like to take moderate risk then you can consider bond market
funds as your potential investment source. So, bond market funds are basically funds such as
taxable bond funds and tax-exempt bond fund. So, tax exempt bond fund basically are funds
which have no tax liability on the income that you generate and these funds are basically
invested in government bonds or in most cases corporate bonds as well, where the growth of
the fund or the investment is very low or almost negligible whereas, the income is moderate to
high.
The stability is low to moderate because of the secured investment that are made in government
securities or government bonds and corporate bonds as depending on the objective of the
Mutual Fund.
For people who would like to take certain risks and they do not shy away from taking some
risk of the stock market they can consider common stock fund and these funds are basically
categorized into balanced fund, equity income fund, value fund and growth and income fund.
So, these four categories of funds are basically focused at the objective which is being achieved
through the investment. So, if I am an investor who would like to have my money invested in
funds which give me value addition in future and it the value grows in long run, I would like
to consider value funds as my target investment.
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Typically, these funds target to achieve the current income through investment in capital
markets, and these are invested in stocks and bonds, they can be invested in high yielding stock
or convertible bonds the assets or the stocks which have low price equity and price to book
value ratio and the stocks which are paying dividends. So, if I want to have my investment
done in growth and income fund, I would like to have investment in stocks which are dividend
paying stocks.
If I have my money invested in balanced fund where I can get some current income as well as
the stability of my investment I would like to invest in a mixture of stock and bond fund. So,
growth potential in these funds are typically moderate to high because they are exposed to stock
market and stock market is supposed to give growth to the investment that are being made.
Income potential is also moderate. If you take more risk the potential of generating higher
income is high and that is why people who are in the earlier stage of their life, they invest in
assets which give them high income potential. Similarly, if you would like to see if the stability
of your investment is low or low to moderate then you can consider investing in these funds.
If you take another category of these funds for example, let us say you want to invest your
money in international stocks or a fund which invest in international stocks the stability will
become very low because the international markets are more volatile and the exposure of your
investment to international stocks would lead to a lower stability. So, these are some examples
of different type of funds that are on offer for individual investors to invest their money.
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(Refer Slide Time: 16:50)
If you try to understand how these funds can be evaluated or how you can identify the right
fund for you, here is one proprietary thing that was developed by a Mutual Fund database
Morningstar which gives you an idea how to choose the, right investment from the offers that
you have. So, it is basically known as a style box, and this style box give you gives you an idea
how you can categorize a particular fund where you want to invest your money.
So, the first step is you want to see if the stock where the Mutual Fund has invested that is that
can be characterized by the market capitalization and when I say market capitalization basically
it means that the number of shares that has been floated by the fund into the market price is
basically giving you the market capitalization, and this could be large cap, mid cap and small
cap. These three categories of market capitalization can be identified. So, you can see that the
style box gives you an idea about the large cap mid cap and small cap.
Similarly, if you have already identified the market capitalization of the Mutual Fund you can
see if they are cheap or expensive in terms of their holding. So, you can compare their holdings
relative to the overall market using price equity or price to book value ratio and based on their
strategy you can assign the particular fund in a style box. So, the strategy could be value or
hybrid or growth. So, these are three value propositions that Mutual Funds typically can be
categorized and depending on their strategy of investment they can be considered under value
category or blend category or growth category. Blend is basically also known as hybrid
category of Mutual Funds or investment.
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So, this style box gives you an idea of identifying a particular Mutual Fund that falls under
either of these categories and based on your risk taking potential and investment worth you can
choose the right fund for you.
(Refer Slide Time: 19:28)
Next step is once you have identified the Mutual Fund and made some investment you would
like to see if the Mutual Fund has performed well or as per your expectation. So, here are
certain measures that we should keep in our mind and use it for evaluation of the performance
of our investment. These are some popular measures namely Sharpe ratio, Information ratio,
Treynor’s ratio, Jensen alpha and Sortino ratio.
If we talk about these ratios or these performance indicators one by one, here first I would like
to highlight that these ratios or these indicators have certain notations, where rp is basically
return on portfolio. So, portfolio that your holding is going to give you some return, so you can
consider rp to be the return on portfolio. rf is risk free rate of return which means the return that
is being given if you invest your money in assets which are considered to be risk free such as
government bond or treasury bills.
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Then there is beta which we have already discussed earlier that beta is basically the indicator
of system at systematic risk.
𝛽𝑖 =
𝜎𝑖 . 𝜎𝑚
2
𝜎𝑚
So, this is your beta of equity or the portfolio that you are holding.
So, then there are certain other indicators such as tracking error and the excess noise or return
and other two indicators.
Sharpe ratio:
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 =
(𝑟𝑝 − 𝑟𝑓 )
𝜎𝑝
This is basically the risk of portfolio that you are holding is gives you the risk adjusted return
for comparison of different investment alternatives. And the thumb rule is higher the Sharpe
ratio the superior excess return that your investment is generating for every unit of risk over
the period. So, if you are taking higher risk you can consider how much higher return it should
be generating if you keep an eye on the Sharpe ratio.
Information ratio:
𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 =
(𝑟𝑝 − 𝑟𝑏 )
𝑇𝐸𝑝
So, in denominator of Information ratio there is tracking error which is basically is standard
deviation of the differential return between the portfolio and the benchmark. So, basically this
will tell you each unit of tracking error is leading to how much of excess return.
Similarly, Treynor’s ratio this is also similar, but it is different from a Sharpe ratio in the sense
that it gives you excess return per unit of systematic risk. And systematic risk is basically with
respect to the market covariance, so that is why it gives you an idea of how much extra return
that you get for every unit of systematic risk.
𝑇𝑟𝑒𝑦𝑛𝑜𝑟 𝐼𝑛𝑑𝑒𝑥 =
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(𝑟𝑝 − 𝑟𝑓 )
𝛽𝑝
Another measure is Jensen’s alpha, which also tells you about the risk in terms of rate of return
that you are generating on your portfolio. So, it tells you about the incremental rate of return
per unit of period in excess of the return that is attributed to the risk.
𝐽𝑒𝑛𝑠𝑒𝑛′ 𝑠 𝐴𝑙𝑝ℎ𝑎 (𝛼) = (𝑟𝑝 − 𝑟𝑓 ) − 𝛽𝑝 (𝑟𝑚 − 𝑟𝑓 ). 𝜀
And finally, the Sortino ratio which is again another measure of considering your evaluation
of performance of your investment is basically how much return that you have generated minus
the minimum acceptable return with respect to the downside deviation which you can calculate
by using this approach which is basically the returns smaller than the minimum acceptable
return.
𝑆𝑜𝑟𝑡𝑖𝑛𝑜 𝑟𝑎𝑡𝑖𝑜 =
(𝑟𝑝 − 𝑀𝐴𝑅)
𝐷𝐷𝑝
So, if you have minimum acceptable return of 10% on your investment you can see how much
extra your portfolio has given with respect to the all less than ten percent returns that the
investment had generated. So, these measures can be used for calculation of performance
evaluation for investment be it in Mutual Fund or any other similar assets.
(Refer Slide Time: 25:11)
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If you move further to understand more about Mutual Funds here is one indicative idea or
evidence that shows that in last 4 years how much growth the investment in different type of
funds has been achieved in the Indian market.
So, this is basically an evidence of last few years, where if you had invested in 32 months back,
if you have invested your money in terms of ₹100 if you have invested your money to the tune
of ₹100 32 months ago then that the value of that money would have become this much in
terms of the growth of your investment. So, you can see that these are the categories of funds
that we are considering.
So, this is categories of funds which we are considering for investment and these funds are
based on different characteristics. So, and this is our benchmark return which is the market
return and you can see that this is your nifty market return here where which gives you an idea
how much the market has given in terms of return, if you had invested ₹100, how much you
would have got today. And if you invest in these funds basically then you would have gotten
more return than the market has given, and if you had invested in these investments or these
funds this would have given you less than what the market has given.
In most cases your investment is more than ₹100, but if you choose your investments wisely
which is what are these funds that are going to give you more than your investment that has
been done in other side of the investment choices, you would have got a better return for your
investment than the other side of the set of investment.
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(Refer Slide Time: 27:35)
Here is the list of top 10 Mutual Funds in India as on December 2019. If you look at the list
these funds belong to different categories and offered by different financial institutions, but
one thing is very clear that most of the funds are not focused on one particular type of assets
rather they have asset composition which can be mixed or combined or rather have a more
wide range of assets for investment of the fund that they pool from different investors.
(Refer Slide Time: 28:15)
So, moving on towards the extension of Mutual Fund category, there is another asset which is
very much similar to Mutual Funds in nomenclature and the characteristics, but they are very
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unique in terms of the offering of risk and return combinations for the investors. These are
known as exchange traded funds. Basically, they are assets or they are tradable funds in the
basket of stocks that closely track broad market averages. They can also track market sectors
major stock markets from around the world and the duty is they can be traded over exchanges.
So, here is the list of top 5 Indian exchange traded funds. If you see and try to relate from the
discussion we had done in previous session where we touch upon the characteristic of every
Mutual Fund, we know that three characteristic that we should always keep in mind while
selecting the Mutual Fund are net asset value which is NAV, total expense ratio which is TER
and the yield that is return that you get for holding that investment.
So, these are the top 5 exchange traded funds that people can consider for investment, given
the fact that they have the highest amount of net asset value or highest net asset value compared
to other funds available in the market. They have very low or comparable total exchange
expense ratio which means they are not costly and they are non-expensive for holding. And
yield is also better than many other investments of opportunities available in this category.
Now, that we have understood or we have discussed a lot about Mutual Funds and their
associated characteristics and what should be kept in mind before selecting a Mutual Fund, you
might be wondering where do we get the data for understanding or making a decision related
to Mutual Fund.
(Refer Slide Time: 30:31)
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So, The list of sources( refer 30:31)given in the lecture, where you can get the information
related to Mutual Funds that you would like to consider for investment. One of the largest
source sources of information for Mutual Fund is Morningstar which is a financial service form
and it provides lot of information related to each and every fund that are offered across markets
and you can get this information related to your Mutual Fund queries on Morningstar.
There are other sources such as Lipper and Vanguard. In India which are serving the Indian
markets and Indian investors we have Ace Mutual Fund and finally, the government of India
has given this mandate for an organization called association of Mutual Fund of India which is
AMFI and on their website also you can get lot of information related to Mutual Funds.
These sources will provide you adequate amount of information related to the Mutual Funds
that are offered in Indian market and in some cases the Mutual Funds or similar funds which
are offered for markets in abroad and you can use this information for making a sensible
financial decision related to Mutual Funds.
That is, it for now.
Thank you very much.
359
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 31
Fixed Income Investments
Hello, hello; welcome back to the course Behavioral and Personal Finance. In last session
we discussed about, what factors to consider while investing in equity funds, or funds
which are typically known as mutual funds, with basically our instruments or investment
avenues, where funds from different investors are pooled together. And, expert’s financial
managers invest those funds for better returns and better risk management purposes.
Now, we have already discussed that mutual fund investments carries some risk, because
the investment is exposed to financial markets. And, the basic concept of investment says
that we have to diversify our risk. So, that the return can be optimized and the return that
we generate out of our investment should be considered as per the risk-taking ability of
the investor.
So, when we diversify our portfolio or when we diversify our investment portfolio, we
basically try to gain as much return as possible for a given level of risk. To adjust to the
risk management purposes, we consider investment avenues which are basically low risky
and they get some assured return.
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(Refer Slide Time: 01:52)
So, that our return cannot be compromised too much, but risk can be adjusted. Today’s
session focuses on that aspect. In this session we will discuss about fixed income
investment.
(Refer Slide Time: 02:02)
And, basically, we will try to cover topics, which are fixed income instruments, where we
will discuss different instruments of fixed income investments. Mainly, we will discuss
about bonds and certain other fixed instrument investment instruments known as money
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market instruments. Now, the first question that comes to our mind is why should we
consider fixed income investment as an investment choice at all.
(Refer Slide Time: 02:36)
The reason for which we can consider our choices of investment of avenues towards fixed
income investment are as follows. First of all, fixed income in investment gives you
assured return, basically it guarantees that you are going to get a fixed amount of return in
terms of interest or coupon that comes to you as cash flow on a periodical basis. So, you
are assured of certain cash flows every period.
So, if you are hoping to get some fixed return on your investment you should consider
fixed income instruments. Second reason for which people prefer fixed income instrument
is the maturity. Typically, the instrument of fixed income carries of a maturity period,
which implies that the investment will become mature after certain number of years or
after certain period.
It basically assures you that at the end of maturity, you are going to get the investment that
you have made in terms of principal repayment. At the same time fixed income instrument
typically carries lower risk, which means there are less interest rate risk or in some cases
no risk at all and lower credit risk and default risk, which indicates that the investment,
that you have made is assured of getting back to you after maturity period.
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However, when we invest in some fixed income securities, these investments carry certain
market risk and in some cases exchange rate risk as well. So, we are fixed income
investments are not assured of these risks, that carries through markets and in international
financial markets. And, finally, the diversification aspect of fixed income security suggests
that, if we include fixed income investment instruments in our portfolio, we try to reduce
the risk exposure whereas, we maintain certain amount of fixed return in our portfolio.
Now, when we try to discuss and consider different type of fixed income securities; the
factors that we should always keep in our mind are time value of money, opportunity cost
and risk return trade-off. We have already discussed how time value of money determines
the present value of cash flows occurring at different points of time. And, just like any
other investments fixed income investments also provides you return, or cash flows at
different points of time, which should be considered with a perspective of time value of
money.
Second thing is opportunity cost, which basically indicates the cost of next best
opportunity that you have suggesting that, if you have taken a decision, what is the cost
associated with the next decision that you could have taken. If that opportunity cost is
lower than the gain that you are getting from this investment, this investment should
always be preferred. So, if you are losing and you are not investing this money anywhere,
you should consider this as investment choice.
Third aspect that we should always keep in our mind while taking a decision with regard
to fixed income securities is the risk return trade-off. Basically, it implies that every
investor has a risk bearing capability and for that given risk level, he should get the best
return that are available in the market. And, this risk return trade-off suggests that when
you include your risk, less or risk-free investment in your portfolio you try to minimize
the risk to certain extent.
For example: if you recall the discussion on portfolio and risk return discussed topics, we
have understood that in a two-asset case, where we have two different assets which are
risky and carries certain risk return combination. And, we try to create a portfolio in terms
of efficient frontier. And, then we include the risk-free asset we get a frontier which carries
the same amount of risk, but with lower rate of return.
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For example, if you refer to that session where we had discussed that given a risk return
domain. So, risk return domain as represented by the two-dimensional graph, where you
have returned ‘r’ as your expected return and sigma as your risk basically and this is your
return, which you are expecting from your investment.
And, you know that you have a risk efficient frontier that carries a curve (refer 8:35), where
all points along this risk of efficient frontier are basically combination of some assets,
which are available in the market. For example, A particular point on this risk frontier is a
combination of a risk (equal to x coordinate) and of return (equal to y coordinate).
Similarly, if you try to find a point on frontier, which carries another amount of risk and
another amount of return.
So, basically when you are moving along this risk return frontier, you are trying to get the
best possible combination of risk and return in the market. Now, we had discussed that if
we have a risk-free asset or an asset that carries no risk, but certain amount of return. The
frontier would look like a straight line (refer 9:40) where you have risk-free asset, which
carries no return, that is 0 sigma this particular point. And, if the line passes through the
risky frontier, where it carries the combination of all risky assets and the tangent point is
basically the market portfolio.
And, you invest some amount of money in your risk-free asset and some amount of money
in market frontier or the combination of this risky asset, your portfolio moves along the
line, which means, if you have 50-50 percent of investment in risk-free asset and market
portfolio. Your portfolio lies somewhere between the both points and on the straight line,
which gives you an amount of return( equal to y coordinate of that point) and amount of
risk (equal to x coordinate of the point) , which is certainly better than a portfolio, which
lies here for the same amount of return, but higher level of risk.
So, this is why risk return tradeoff is a better factor to consider when you try to diversify
your portfolio. It essentially means that you are trying to minimize the risk and maximize
the return for a given level of risk. Now, that we understand the importance of fixed income
securities and the factors that we consider while including the fixed income securities in
our portfolio.
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(Refer Slide Time: 11:17)
Let us try to understand, what fixed income securities should we consider. So, the first and
most important fixed income security that we consider is the bonds. Basically, bonds are
financial claims or financial securities, by which the borrower or the issuer basically
commits some amount of money to pay back to the lender from whom it has borrowed.
So, there are issuer and the borrower which basically issue the bonds and then the lender
or the bond holder. Basically, gives his or her money to the borrower and that amount
typically is known as principal, which carries some interest paid periodically during the
holding period.
So, basically bonds are pieces of paper which specifies a principal amount a periodic
interest, the issuer and the holder. Of course, it will always have a maturity period
associated with it. For a given bond the factors such as issuer and borrower remain
irrelevant, because what matters most is the principal amount, which is the value of the
bond, the interest rate or the coupon rate, which basically is the payment of interest paid
towards the lender and the maturity period.
Typically, a standard bond is a fixed coupon bond, without any embedded option and it
delivers periodical coupon on specified date, which is basically interest payment or coupon
payment at every period. And, it has a principal amount and a maturity date at which the
principal amount has to be repaid.
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So, when we try to understand the timeline of a bond, basically a timeline of a bond has
the same framework as we understood from the time value of money concept, if we you
are living here today and you borrow money from someone. So, you issue bond and then
bond pays some coupon fixed coupon every period. And, after certain number of years at
the time of maturity, you basically pay coupon and the principal amount that you have
borrowed back to the lender.
For example: if you look at a bond issued by Government of India in the name of savings
taxable bonds which was issued in 2018. It carries the following features the coupon rate
of this bond is 7.75% per annum. The bond matures in 7 years, which is basically the
tenure of the bond given as 7 years. The rating of the bond, which is basically the credit
rating or credit worthiness of the bond is triple a given by certain credit rating agencies.
So, this basically indicates the creditworthiness of the bond, which is basically associated
with the creditworthiness of the issuer as well. This bond has a face value of ₹1000 and
liquidity is non-taxable, which implies that this bond cannot be traded in the market. So,
once you buy that bond or once you invest your money in this bond you cannot trade it or
you cannot transfer it to someone else unless specified in advance. So, here in this timeline
basically you are paying 7.7% of coupon per annum on ₹1000 which is your face value.
And, then at the maturity you are paying 7.75% which is basically amount plus ₹1000 at
the end of the maturity period. So, basically you are paying ₹1077.50 at the end of
maturity. So, every period the investor would get ₹77.50 of interest or coupon and at the
end of the maturity, the person the bond holder will receive ₹1077.50 for 7 years. This is
how a bond function? Now, if you try to understand more technical terms related to bonds
we can see, how these bonds can be evaluated and their pricing can be done.
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(Refer Slide Time: 16:40)
Here is an example of a bond issued by some agency or an organization. So, if you look at
the bond characteristic, this is basically known as bond certificate. The issuer is national
highway authority of India, which is basically given at the top of the bond certificate. This
bond has certain data certain information embedded in it.
So, the information that are of the interest of the bondholder of those who are interested in
buying the bonds are basically number of bonds, which is basically the number of bonds
that the bond certificate carries or bond certificate specifies in terms of the holding. Then,
tenure of the bond basically this indicates the maturity of the bond in terms of number of
years.
So, here if you see the bond has a maturity of 10 years, then it has a face value or issue
price which is basically the price per in terms of rupee per bond. Here, it is given as
thousand rupees per bond and then finally, it is the frequency of interest payment which is
annual so, which is given here. So, these are other factors that we should consider at the
same time we should also be interested in knowing the coupon rate per annum.
So, coupon rate given here is 7.14% for this particular bond and number of bond allotted
is 100 and total amount paid is ₹1 lakh. So, face value is ₹1000 per bond number of bonds
allotted is 100 bonds, which means you have paid 100 into 1000, that is ₹100000 rupee in
terms of the total value of the bonds. So, if you are holding this bond every year you are
going to get 7.14% of coupon paid annually.
367
(Refer Slide Time: 19:06)
So, how a bond looks like when we talk about the creditworthiness of the bond’s
creditworthiness are recorded or represented in terms of credit rating. There are certain
credit rating agencies in the financial world, who basically gives credit rating to different
financial instruments including bonds. In this case there are two categories of credit rating
of bonds.
First type of credit rating is basic indicated as investment grade, which indicates high
creditworthiness of the financial instrument or the bonds and these are as following. So,
there are two companies or two agencies which provide credit rating Moody’s and S&P.
So, Moody’s provides certain credit rating two investment instruments, in terms of AAA
AA1, AA 2 and so on. And, associated characteristic the comparable ratings of S&P that
is standard and poor’s company are also given.
And, you can see if a bond is rated triple A by either moody or S&P, it is considered to be
gilt edged best quality and extremely creditworthy instruments, which indicate that if you
invest in these bonds the likelihood of losing your money, and not pay receiving the
interest or coupon payments is very limit low or almost nil. These are the best rated or
highest rated financial instruments for investment.
368
(Refer Slide Time: 21:07)
As you move further towards other credit rating, you see that the quality of instrument is
decreasing with every rating given by either Moody’s or S&P. And, when we move on to
speculative grade of bond rating or credit rating of bonds, we see that it starts with BA1
by Moody’s or BB+ by S&P. And, every rating has certain explanation which are
associated with those ratings such as, if you buy or if you invest your money in D rated
bond D given by S&P rating agency.
You know that these are default grade in investments and it is very unlikely that you are
going to get your money back. Now, the question comes that, if we know that these are
the rating given to bonds or any other financial instrument in general, why would anyone
want to invest our money in such instruments. Well the reason is these bonds, which are
basically known as speculative grade bonds, offer a huge amount of return or very high
coupon rate or rate of return on investment.
Such that, if you are able to take calculated risk and you are able to take this risk and this
turns out to be positive for you, you get multi time return compared to the investment grade
bonds, that are going to give you in terms of coupon rate. So, it always goes along with
the level of risk that you are taking with the level of return that you are receiving. So, high
risky bonds or high risky financial instruments in general are liable to pay you higher rate
of return, but along with a very high level of risk.
369
(Refer Slide Time: 22:53)
Taking our discussion further, there are other fixed income instruments of fixed income
securities, which we should always consider while investing our money in portfolio. And,
these instruments are money market instruments. Money market instruments are typically
short-term debt instruments, which have maturity of typically less than a year, which
means the maturity of these instruments are typically spanning between two days to a 1
year.
In some cases, it goes beyond one year as well, but generally the maturity lies within 1
year. These instruments include treasury bills certificate of deposits and commercial
papers, there are certain other instruments, which are not typically popular among
individual investors, they are mostly invested by institutional investors or financial
institution, such as repo contract, forward contracts.
And, these instruments such as treasury bills also known as T-bills, certificate of deposits,
or commercial papers are also popular among individual investors. The unique
characteristic of these money market instruments is such that, these instruments are very
sensitive to the central bank monetary policies. In India’s case the monetary policy as
specified by Reserve Bank of India always affects the valuation and the popularity of these
money market instruments.
Mainly, because RBI is responsible for setting up the official rate of interest for the
country, or for the Indian market in general, RBI does this through buying and selling of
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government securities while making some funds available for financial institutions to do
their business. And, by this way RBI also maintains or attempts to control money supply
in the system, which basically means, that if it try to control the supply outwards ,it will
control the interest rates such that not many people are interested in taking money from
banks and if it tries to reduce that it takes a decision other way around.
So, the idea of RBI controlling this money supply is to control the key interest rate,
basically the rate at which banks can borrow from RBI overnight, overnight typically in
indicates one trading day. So, if banks needed some money they will go to RBI and borrow
some funds for one trading day, which is overnight and next day they will have to adjust
for that. So, these instrument money market instruments that we are discussing now are
affected by the policies governed or designed by the Central Bank, which is reserve bank
of India in our case.
And, the major issues that, they face are the varying interest rate or the policy of interest
rate as decided by the reserve bank of India. These instruments are issued by government
typically both state and central government, financial institutions mainly by banks and in
some cases corporations as well. These organization and institutions issue money market
instruments to raise funds for short term duration.
(Refer Slide Time: 26:51)
When you talk about money market fund such that the example that we discussed earlier,
the first thing comes to our mind is the treasury bills or T-bills. So, T-bills basically our
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financial instruments of short-term fund requirements, which carries no default risk
because the government has the backing and it has a guaranteed payback by the
government. So, T-bills or treasury bills, basically carries no default risk its maturities
range between 1 day to 1 year.
And, it carries no interest basically it provides no interest rate as such, because it is traded
or quoted using the yield. So, if we take an example of treasury bills, what is the, what is
the way we can calculate the yield or the return that a person can hold and get this is the
example. So, if you see there is a government of India Treasury bill that is offered for a
maturity of 90 days and market price is 980, but the face value is 1000? So, it indicates
that the face value of that Treasury bill is 1000 market price is 980.
And, the maturity basically the time for which it is going to mature is 90 days. So, if you
try to calculate yield
𝑌𝑖𝑒𝑙𝑑 =
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
Which is basically the difference between the face value and market price, with respect to
the face value. Or, this indicates the premium that you are getting into number of days for
which the year is considered typically 360 days divided by number of days for which the
instrument is maturing.
So, if you consider this formula you can obtain the rate of interest or the rate of yield for
which this particular instrument or this particular T bill is traded. So, the T-bill trading
percentage of yield is given as 8%. This is how T bills are traded you can find the yield by
using the formula as given, basically the inputs are the market price at which it is bought
or sold. And, the face value which is typically the face value of the instrument and the
maturity period for which it is being traded. This gives you the yield of the T bills.
Next instrument that we can consider or we can discuss is certificate of deposits. Basically,
certificate of deposits are debt instruments issued by banks to finance their lending
activities, again it carries no credit risk as such for the borrowers, but it has certain interest
rate risk. And, the interest rate risk that is offered to the lender basically has some
implications coming out of the RBI is monetary policy.
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So, the maturity for this certificate of deposit ranges from a few weeks to 3 months in
general and in some cases, it may span for couple of years as well. When we try to
understand the price of a certificate of deposit or this particular instrument CD, it can be
calculated as given formula where the price is a function of face value and coupon rate.
𝑛
(1 + 𝑐 × 𝐵𝑐 )
𝑃=𝐹×
𝑛
(1 + 𝑦𝑚 × 𝐵𝑚 )
And, basically if we try to indicate this these factors in the formula, P is the price of the
certificate of deposit, F is face value, you have C as the yield rate at the time of issuing
this instrument.
You have Ym which basically is yield on a money market instrument, which is your
reference rate. And, then you have nc, which basically indicates number of days between
the time when it was issued, between issue date and maturity. And, “nm” indicates number
of days between settlement and maturity B is number of days considered in a year.
So, typically it is 360 or 365 can also be considered, but typically this is considered as 360.
So, when we try to calculate the price of certificate of deposit, we follow this particular
formula, which basically is a function of a face value, the coupon or the yield which is
committed at the time of issuing that particular certificate of deposit. And, then we have a
reference rate as ym, which is nothing, but yield on a money market instrument.
And, then we consider that number of days between the time when it was issued and the
time it is going to mature and number of days between the settlement and maturity date. If
we keep this particular formula in our mind, we can calculate the price of certificate of
deposit.
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(Refer Slide Time: 34:43)
For example, if we see this particular case where we have this certificate of deposit
instance in this particular example, which suggests that a bank issued a certificate of
deposit on 27 July, 2019 and maturing at 29th April 2020. The face value is amounting to
₹80 million and interest rate issuance at the time of issuing that say, certificate of deposit
is 4.27%, and maturity at the reference yield as 4.19%, which is on 13 August 2019.
So, if we follow the formula that we just discussed, which has face value and coupon rate
at the time of issuance, reference rate at the time of bond money market instrument number
of days between issuance and maturity, and number of days at from settlement to maturity,
and B is basically the number of days in a year. So, we have these numbers fixed in the
particular formula.
Let us assume that if the instrument is of 100 rupees and we plug in these numbers in the
formula,
𝑃 = 100 ×
276
(1 + 4.27% × 360)
259
(1 + 4.19% × 360)
= 100.25
The price 100.25 corresponds to a market value of 80.201 million rupees, which basically
is a function of 80 million of face value and 100.25 rupee of the price that we have obtained
on the date of settlement. So, this is the market value of the certificate of deposit as on
13th August 2019. This is how we can calculate the price of a certificate of deposit.
374
(Refer Slide Time: 37:08)
Moving our discussion forward there is another example of commercial paper, which is
basically another way to raise money for a short-term period. These are also unsecured a
debt instrument issued for short term. Typically, commercial papers are issued by
corporations including financial and industrial companies. Maturity ranges from 2 days to
270 days that is less than a year. Commercial papers, typically carries no interest rate or
no specified interest rate; rather it is traded on discount basis.
And, to some extent it carries credit risk of the issuer. Companies use this for short term
fund requirement or the funding requirement which are for interim activities or interim
loans. In some cases, they also use for long term capital requirements, in terms of bridge
financing, which are basically another way of financing your business activities. For
example, if you are setting up a business and you are hoping that some investor would
pump in lot of capital in some time. Before that capital actually comes in your business
you try to find a short-term source of money.
So, that you can start your business immediately and that certain source of money is known
as bridge financing. So, commercial papers are issued as form of bridge financing as well.
If you look at the example given here, the example suggest that consider commercial paper
issued by Hindustan Unilever Limited on 11th November 2019 and maturing on 15
January 2020, which basically entails 96 calendar days. At issuance the money market
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yield amount to 3.62% and nominal value is 70 million. So, if you try to calculate the value
of this particular commercial paper.
The market value can be calculated as
𝑀𝑉 =
₹70000000
= ₹69330727
96
(1 + 3.62% × 360)
So, we have seen that commercial paper worth 70 million is trading or available for
investment at today’s market value of 69.33 million of market value.
(Refer Slide Time: 40:47)
So, this is how we can calculate the value market value of commercial paper to some of
the discussion that we have had in this session, basically we discussed that to diversify the
investment portfolio, investors should also consider along with risky investment choices
such as mutual fund and equity investment. The funds or the investment avenues, which
carries lesser risk or no risk at all and fixed income securities or instrument of investment
offer this combination of lower or in some cases no risk with certain guaranteed return.
And, this helps investor in diversifying the portfolio. In this session we have discussed
some basic idea about the bond, its associated features. And, other money market
instruments such as treasury bills, certificate of deposits and commercial papers. These
three are popular choices among investors both institutional and individuals. The best part
is as an individual investor you can also invest part of your investment, part of your savings
376
in the instruments which are fixed income securities, such as treasury bills, commercial
paper and certificate of deposits. Investment in bonds is always popular in retail and
individual investors, because it offers fixed income with lesser risk.
In next session we will discuss how do we determine the prices of a bond, for now this is
it.
Thank you very much.
377
Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 32
Fixed Income Investments (Contd.)
Hi there, continuing with the previous discussion that we were having on fixed income
securities, in this session; we will discuss more about the pricing of the bonds and how bonds
are evaluated in terms of their value in our portfolio.
(Refer Slide Time: 00:38)
The topic that we are focusing in this session is the pricing of the bond; basically, based on the
argument that we have built earlier when we discussed about the present value discounting
method where we try to understand, how the present value of future cash flows can be
determined with the help of a discounting factor or a rate which is used for discounting future
values and how these methods or the method of discounting of future cash flows can be
implemented in terms of valuation of bonds.
The idea of understanding the valuation of bonds is to make sure that when you try to diversify
your investment portfolios and include fixed income securities, particularly bonds in your
378
portfolio so that you can earn a decent amount of return or a fixed return from your investment
without compromising much on the risk.
(Refer Slide Time: 01:51)
So, the discussion or the understanding of valuation of bonds is basically a three-step process.
So, the bond or as any similar financial asset can be evaluated by following these three steps
and the steps include the calculation of cash flows associated with the bond or the instrument
that you are holding, basically, cash flows coming to the bondholder that he or she is expecting
in terms of cash flows coming from the lender and expected to get over the holding period.
Basically, the cash flows that the investor is expecting from the bond investment over the
holding period should be determined first, then it should be decided what are the maturities
associated with different instruments or different bonds that he or she has invested in and with
maturities; the discount rate should also be determined. Because, we know that cash flows in
terms of coupon rate or interest rate are coming at different points of time in future. So, for
every time of point we need to understand the maturity as well as the timeframe and associated
discount rate.
And third step is to use the present value of all those future cash flows to obtain the bond price
as a result of discounted cash flow value.
379
𝑇
𝑇
𝑡=1
𝑡=1
𝐶𝐹𝑡
𝑃𝑉 = ∑
= ∑ 𝐵(𝑜, 𝑡)𝐶𝐹𝑡
[1 + 𝑅(0, 𝑡)]𝑡
So, the formula says that there is a cash flow associated with the investment and then there is
a rate. So, CFt basically indicates cash flow that as basically you are getting in terms of coupon
rate or interest rate that you are receiving on your bond investment coupon into face value,
because that is what you are going to get.
And then R (0, t) is your discounting rate. When you try to use discounting rate for multiple of
periods or multiple time points you get something known as discount factor. So, if you try to
find the present value of all coupon payments that the investor is receiving over a period of
time and the present value of all those future coupon payments are summed up together; you
find the value of or you can call it the present value of the bond. And when this present value
of bond is compared with the market price, you can decide whether the bond that is available
for investment is worth buying or not.
So, the whole idea is depending on the present value of all future cash flows in terms of coupon
payments that the investor is expecting to receive over holding period. Now, this is very simple.
This idea is or the process is very simple in theory and principle whereas, if you try to convert
this into a sound practice for the benefit of the investor. You need to discuss or understand
three pertinent questions and these questions are the source of discount factors.
Basically, how do we calculate or how do we know the discount factors, because everything is
depending on the discount factor as given in the function here. And second point that we
consider is whether the use of equation as specified here is only meant for considering bond
price or to calculate the implied discount factor. So, that we can calculate the present value of
bonds. And finally, can we deviate from the simple rule and if yes why and if no again why we
should not deviate from the simple rule.
The simple rule here is; we need to find the present value of all future coupon payments and
those coupon payments can lead us to the present value of bonds and that present value of
bonds can be compared with the market price or purchase price of that bond to make it a worthy
investment.
380
(Refer Slide Time: 07:22)
Let us try to understand this from the framework of time value of money. If we try to use this
to understand, the first concept that we should always keep in mind is time value of money,
because we have agreed that the value of money changes over time and this concept must be
considered when you are taking a financial decision that is spanning over multiple periods.
So, when you use time value of money concept to calculate the present value of future cash
flow; basically, you follow discounting method or discounting approach of finding present
value. So, the approach says that the price today of any financial security is basically the present
value of cash flows that you are receiving, discounted by a rate, for cash flow for a number of
period that you are holding the asset and this should be sum up together to know the present
value of all those future investment.
𝑇
𝑃=∑
𝑡=1
𝐶𝐹𝑖
𝐶𝐹
1
(
)
=
1
−
(1 + 𝑟)𝑇
(1 + 𝑟)𝑡
𝑟
. If you recall that our earlier discussion; this formula basically indicates the present value of
annuity cash flow with the assumption that C F 1 is equal to CF 2 is equal to CF 3 and so on.
So, all CFs are basically constant and you can find the present value of any cash flows
associated with an investment and you can sum it up to know the price today. In a more generic
framework; in a very simplified, we can obtain or we can write it such that the price of any
asset today is
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𝑃=
𝐶
1
𝑁
(1 −
)+
𝑇
(1 + 𝑟)
𝑟
(1 + 𝑟)𝑇
Now here, N is your nominal value or face value that you have invested in the beginning or the
face value that is the bond or the investment is carrying T is your tenure or maturity period and
r is discounting rate, C of course, is your coupon or interest that you are receiving. If you try
to see this through an example, maybe we can take up an example where let us take a let us
have a bond which has the following characteristic. So, a bond has annual coupon rate as 5%.
Maturity is given for this particular bond in example is 10 years and face value or nominal
value is let us say ₹1000.
If you remember, we showed in previous session; the example of a bond where I showed you
a bond certificate that carries all these characteristics. The face value was ₹1000, maturity was
in that case 10 years and coupon rate was in that example 7.1 for 4 %, here we have 5% for
example. And along with this, we also carry all discounting rate for our different maturity being
6%.
So, if we follow this particular case; remember the time line approach we discussed earlier. So,
we have a time line that is time 0 (t0), time 1 (t1), time 2 (t2) and so on till time 10, which is
basically number of years of maturity. And then you have cash flow coming in every period.
Here, you get cash flow as well as the nominal or face value.
So, when you try to find the price of the bond today; you actually get some of all coupon which
is 5% of ₹1000.
9
𝑃= ∑
𝑡=1
50
1050
+
= 926.39
𝑡
(1 + 6%)
(1 + 6%)10
So, we can say that a bond of ₹1000 face value is worth ₹926.39 today. So, that is the market,
that is the price of the bond based on the feature or the characteristic as explained. If you are
able to buy that bond for less than ₹926.39, it is always a wise investment decision. If you are
getting it for more than ₹926 9, it is not a good investment to make. Suppose, we take the same
example, but we replace this particular discount rate the 6% to be 5%.
382
(Refer Slide Time: 16:42)
So, let us take this example again, if we try to take this bond where we have face value of 1000,
coupon as 5%, maturity as 10 years and discount rate earlier it was 6%, but now instead of 6%
let us have its 5%.
So, we will do the same exercise again. We will have a timeline, where we will plot the all cash
flows that we are expecting to receive. The coupon that I am getting is 50 till tenth year. And
tenth year I am getting 50 + 1000, which is my coupon plus face value. And if we try to find
the price today; we can simply use either of the formula discussed earlier,
𝑃=
50
1
1000
(1 −
)
+
(1 + 5%)10
5%
(1 + 5%)10
If you try to use this particular; approach which is basically, the present value of coupon
payments that we receive and present value of nominal value that we are receiving at maturity.
So, if we use this particular approach what we are going to get is; ₹1000 and this gives us a
remark or the rule that if discounting rate which is basically the rate at which you discount the
future cash flows. Discounting rate are equals to coupon rate, which is basically the rate at
which interest are paid. The bond value is equal to the face value.
So, this rule is very simple, if you have to make a decision; whether to invest in bonds or not.
You need to find our discounting rate and a bond with some coupon rate that will give you an
opportunity to calculate the present value of this bond and then you can make a decision
whether to invest then in this particular bond or not.
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Moving forward, if we take this example of value calculation for bond investment and we know
that so far, we have discussed bonds which provide coupons paid annually. If you try to
calculate value of a bond that pays coupon semiannually which is basically twice a year then
we have to modify the formula that we consider.
(Refer Slide Time: 20:53)
So, suppose a bond that pays coupon which is basically the interest semiannually. So,
semiannually means; the coupon payment that is coming to you is twice a year. So, if it is
semiannually which results in the number of periods or the frequency of your coupon receipt
is multiplied by 2 and the rate of coupon that you are expecting to receive is divided by 2 right
because, the frequency of interest coming to you has increased twice and the coupon rate that
was promised by the issuer is divided by 2, because you are receiving twice. So, half of the
coupon rate will be paid after first 6 months and remaining half of the coupon will paid after
second 6 months.
If you try to modify the formula that we have discussed just now, we can calculate the present
value of a bond that pays and a coupon semiannually.
𝑃=
𝑁×𝐶
[1 −
𝑟
1
𝑁
]
+
𝑟 2𝑡
𝑟 2𝑇
(1 + 2)
(1 + 2)
So, this is how you can calculate the present value of bond which are paying you coupons twice
every year. A related concept is known as yield to maturity or also known as YTM basically,
384
this is yield to maturity the concept says that if you hold the bond for the period that you have
invested in and you consider a rate or discounting rate or a rate of reference at which the present
value of all coupon payments that you are expecting to receive is equal to the bond value that
you have invested then this rate is supposed to be YTM or yield to maturity.
That is one of the criteria for investing in bonds you should always try to compare yield to
maturity with different bond investments and you can use this as a decision criterion. So,
suppose in this example; if I have a bond which gives me a coupon of 8% and maturity is 2
years, where Face value or nominal value is ₹1000 the year which is paid as let us say
semiannually and sells for 103-23 which is basically the coat price.
So, this corresponds to the rate which can be calculated as 103+23/ 32. So, this gives you a rate
which can be equal to 103.72% which is basically a premium of 3.72%. So, we know that for
every ₹1000 of bond. We have a present value is equal to ₹1037.20 rupee is equal to the coupon
payment that you are receiving twice. So it is calculated as
1037.20 =
40
40
40
1040
+
+
+
2
3
𝑟
𝑟
𝑟 4
(1 + 2) (1 + 𝑟 )
(1
+
)
(1
+
2
2
2)
So, if you use trial and error; the method of equating the 2 sides. If you we use trial and error
method the rate at which we can find this to these 2 sides of the equation is basically r by 2 will
be 3 percent, where r is going to be 6 percent. So, this is my yield to maturity in this case. So,
this particular 6 percent is my yield to maturity, which indicates the rate at which the future
value of all these cash flows or coupon payments is equal to the present value of the bond.
So, present value is basically coming from that code or that price that we have received from
the market and this is how we calculate the present value of bonds and associated characteristic
in terms of yield to maturity. Another example of this particular sequence of discussion on
bonds and associated characteristics such as yield is given in terms of yield that is an important
input for decision making.
385
(Refer Slide Time: 29:59)
We have already discussed. So, for example, if you have a bond which has ₹1000 of face value
and annual coupon rate of 7%. If you want to buy this bond for ₹900, what the yield should be.
So, here 1000 is your market value or rather you can say N, which is nominal value, coupon
rate and price. So, yield is always given as 70 by 900. So, 7% of ₹1000 which is ₹70. So, this
is your ₹70 of coupon. This gives you and yield of 7.78%.
So, if you buy this bond for ₹1100. So, instead of 900 you buy it for ₹1100; your yield coupon
will remain same, this is your coupon. So, coupon will remain same 7% of 1000, but yield will
go down. So, this is another input that you can consider while making decisions to invest in
your bond portfolio.
So, far we have understood including the discussion that we have had earlier is the possibility
and advantage of including risky assets in your portfolio such as mutual fund and other equity
instruments. We have also discussed how to find the value of bonds to be included in your
portfolio and the advantage of including bonds and other money market instruments such as
treasury bills commercial papers and certificate of deposits as a risk lower risk and assured
return instrument.
These two these two approaches of including risky and risk free or rather a riskless asset in
your portfolio helps you diversify your investment. And thereby you can optimize your risk
return trade off subsequently, you can earn higher rate of return for a given level of risk.
386
(Refer Slide Time: 32:33)
So, to conclude this session; we know that fixed income instruments are fascinating part of
investment portfolios. Because, it carries no or less risk with certain gains or assured returns it
is fairly quantitative, but to keep it simple we have discussed some major concepts or ideas
associated with fixed income securities such as the characteristics and valuation of different of
fixed income securities such as bonds treasury bills commercial papers and certificate of
deposits which are available for investment by individual investors as well.
We should always keep in mind the rule of time value of money, because this is the first and
the last rule to consider when you try to include any financial assets in your portfolio. This is
it for now.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 33
Purchasing Decisions
Hi there, welcome back to the course Behavioral and Personal Finance. Second module on
personal finance where we have been discussing about different avenues for investment
for individuals. And what are the factors that influences our decision with respect to
choosing a particular investment avenue. So, far we have discussed about different
investment choices where people can invest their money such as, equity investment,
mutual funds, and bond investment. Now, we move on to the next topic which is basically
focused on purchasing decisions.
(Refer Slide Time: 01:00)
In this session we will discuss mainly two topics, these topics are the process of making
consumer purchasing decisions which is basically the buying process of individuals. And
we will also touch upon the financial implications of consumer purchases. Suppose you
have to buy some consumer durable goods such as a motor car, or a fridge, or a television,
or an audio system.
388
And to make this purchasing decision you depend on a lot of sources where you can get
information and make your decisions accordingly. Most of the time we spend lot of energy
and resources on gathering information on various sources where we can find relevant
inputs with respect to our decisions. Whereas, what we miss mostly is the financial
implication of such a decision. In this session we will try to integrate the process of
consumer buying behavior and the financial implications thereof.
(Refer Slide Time: 02:12)
When we start to understand the buyer decision process typically in a financial context,
we understand that it is very important. Because a particular decision with respect to
consumer durables or any consumer buying decision starts with understanding the personal
needs and wants which we have typically. And gathering relevant information through our
research, and in sources of information which can lead to the purchasing alternative
analysis and thereby making the decision finally.
If we make some mistake such as any unplanned and careless buying decision, we typically
tend to affect our own short term as well as long term financial goals. We end up hurting
ourselves financially if we make any incorrect financial decisions. We also observe that
impulse buying are habits related to impulse buying in short run can cost us a few hundred
rupees.
But if it is repeated for a couple of years or so it eventually led us to lose a thousand of
rupees of money. And no one would want to end up doing that this is why understanding
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the consumer buying process and the financial implications of these steps is very
important.
Typically, we understand that a buying decision making process begins with understanding
and identifying our own wants and needs where we try to gather information on these
needs and alternatives that we have to satisfy those needs. When we move on to buying
decision making our decision making is affected by several behavioural factors.
And if we are able to incorporate those behavioural factors in our consumer buying
process, we end up making better cost benefit analysis that eventually leads to an optimized
resource allocation and utilization. Thereby getting our financial goals closer to us, this is
why it is important to understand the whole consumer durable buying process.
(Refer Slide Time: 04:46)
According to John Dewey who proposed the idea of consumer buying process as a fivestep process. And this buying decision process is eventually validated and tested across
different markets and products across geographies by several research studies. So, we will
start with this standard five step consumer buying process the process as discussed earlier
starts with problem or need recognition which then further leads to information search.
And then we try to or find the alternatives which we evaluate subsequently we make
purchasing decisions. And accordingly, after making purchasing decisions we understand
or we try to highlight the post purchase behaviour. Now, the issue that we want to highlight
390
here is that at each and every step of this consumer buying process we as individuals are
affected by several factors including social, economic, and behavioural factors.
If you try to highlight the factors that affect our problem or need identification, we know
that herding is one such tendency among humans which is driven by how our people other
people around us are behaving. If we see that our neighbour neighbours have purchased
some consumer durable goods, we tend to feel that we need to buy that as well. Similarly,
if we see that there are a lot of people recommending a particular product or investment
choice, we feel that we should also go for that.
So, problem or need recognition in general is affected by several behavioural factors
including herding. So, we can say that problem identification is affected by herding
behaviour, it also gets affected by peer pressure which is basically resulting in a herd
behaviour. And subsequently a behavioural tendency that shows that the individual can
differ it for certain period of time.
So, these three factors might be important to understand when you are talking about
problem or need recognition. Now, once you are able to understand the problem and need
recognition process step which is basically identifying your own needs and wants. And
you know that the needs or wants that you have identified are less affected by these factors
such as herding, or peer pressure, or the ability, or tendency to differ it for a certain period
of time we move on to gather information.
Now, in first module of this course we have already discussed how information availability
lead to several heuristics or behavioural issues and also that information can be costly.
And if the information is not very costly which is let us say available for free this
information cannot be relied upon. So, when we talk about information search, we can say
that the behavioural factor that comes into play is availability heuristics.
Because the information that are available easily and freely in most cases are most used
by purchasing by individuals for their decision making. So, if information is available for
free or with less effort people tend to incorporate such information in their buying
behaviour.
At the same time if it is available for free the which is basically translate into cost of getting
or obtaining that information. If it is not very high then comes the issue of reliability. For
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example, if we are going to buy a second hand car and we rely on the information given
by the salesman himself or herself we are probably making a mistake. Because, we need
to be an expert to understand the efficiency and affordability of a second hand car.
We need to be expert or we need to be informed enough to understand the technical and
other aspect of a second hand vehicle and that is how we can make a better decision. If we
rely on the information that is easily available, let us say given by the salesman herself we
are making probably a mistake that might cost us quite a few of our money. Similarly, if
we incorporate the information availability and we try to avoid availability heuristics in
the process of information search we can make a better decision and move on to the next
step that is evaluation of alternatives.
Now, evaluation of alternatives could be affected or influenced by several behavioural
factor again and one prominently being herding. Because, herding is something which
affects our behaviour every now and then more particularly when we are making some
financial decision. At the same time, we can also be affected by heuristics; for example, if
you are buying let us say a financial product or you are buying a house which cost you a
lot of money.
You tend to buy a house that might be located in a very nice locality and cost you a lot of
money. But actually, the locality is very far away from your office location and that is how
you make a mistake by choosing a house that is away from your office. So, you cost you
spend lot of money on buying a good house in a locality that is far away and we have spent
eventually a lot of money on commuting from your home to your office and return.
So, that is how you tend to make a decision because of your herding influences or heuristics
which are easily available in your decision-making process. Once you have evaluated the
alternatives, we typically make our decision, we spend lot of money on making the
decision and in most cases these decisions are irreversible, so we have to stick to it for
quite some time.
Now, let us say we are buying a car and we have to spend a lot of money on purchasing
this vehicle. We have done the need recognition step we have collected information from
all possible sources we have evaluated the alternatives. And we decided that we will go
for a particular model of a car. Now, when we have to make a purchasing decision the
factors, we should be careful about is the source of money.
392
Where which is used for buying that car which essentially means if you are borrowing or
using your own money to buy this car. Similarly, you also consider time value of money
here, because you spend a lot of money at a time where for which benefit can be gained or
derived in future time. So, these two factors are most important while you consider
purchasing decision in general, and when it is of significant amount of money to be spent.
You should be more careful in these two factors namely the sources of funds, or sources
of money to be spent on this purchasing decision and the time value of money.
We have already discussed that time value of money is a factor or an input that makes a
better decision for individuals. Because you compare the present value of cash flows
occurring at future time and the present value of the investment that you are making today.
So, that you can compare both the cash flows in terms of inflows and outflows and make
a sensible financial decision.
Sources of money here imply that if you are buying a car and you are planning to buy it
on a vehicle loan from a bank. For example, you have to spent some money on interest
payment and you have to also spend some money on fuel and maintenance. So, it cost you
quite a substantial amount of money to own that car and maintain that as well.
Now, if the benefit that you are deriving is not sufficient enough to cover that cost then it
is not a wise decision to purchase this car. So, whereas, if you try to purchase this car with
your own money that you have saved over the years the cost of owning that car will be
less. Because, you do not have to pay the interest and the maintenance of the car will be
the only cost that you have to incur directly. And the benefit that we are going to derive
hence be compared with lesser cost of owning the car.
At the same time the opportunity cost is an important factor which you should always keep
in mind. Because, opportunity cost is going to determine whether the cost of purchasing
that car is lesser or more than the benefit that you are deriving from the ownership of the
car. Post purchase behaviour is the final step in the buying behaviour process and it
basically implies the tendencies or behaviour of individuals after making the decision.
We have discussed behavioural tendencies such as winners curse which we have
understood in behavioural finance context. Where we know that if you have purchased or
you have invested your money in a share and soon after investing your money or buying
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that share. You realize that it you should have waited for quite for some time, so that the
price would have gone down and then you could have owned or you could have bought.
Then that tendency is typically defined as winner’s curse. And in many consumer buying
behaviour steps we see that people make such decisions for which they slightly regret later
on because of this tendency of winner’s curse. They realize that if they had waited for little
more time probably, they would have got a better deal and bought that particular asset or
that particular item for a lower cost.
This is one of the examples of post purchase behaviour. Of course, other examples include
if you have already invested some money and you know that this cannot be recovered then
you spend some more money on it. And this tendency is known as in a very simple term
we can call it good money after bad money.
So, essentially this is coming from a concept called sunk cost where you have spent some
money that has already been spent and you cannot recover it. So, to justify this particular
sunk cost or to do this already spent money you spend little more money on it, hoping that
this money will result in some more benefit to justify your decision.
So, these are some behavioural factors and issues that you need to consider in while
making this buyer behaving behaviour process. If you are able to successfully incorporate
these factors into your decision-making process. It is more likely that your decision will
be more beneficial and the cost benefit analysis will result in a better informed and
financially rewarding decision.
394
(Refer Slide Time: 19:15)
Moving on, we try to understand the financial implication of any consumer buying
behaviour or consumer buying process. Here, I present an adopted form of the steps or the
flowchart of consumer buying behaviour process. Where if you are successfully doing
right things, you will end up achieving your financial goals. And if you are not following
the right path or right steps the financial goals will be not achieved and you will rather face
financial difficulties.
We start with a simple analytical approach where we understand that our decision making
with respect to any financial commitment such as buying finance consumer goods or
investing your money in some rewarding investment avenues. All these things start with
the simple analysis of the factors that influence your decision making. Here, the factors
that influence our decision making are economic factors, social factors, and personal
factors.
Now, economic factors such as inflation, interest rate, tax rate, government regulation, or
safety guidelines, these are some economic factors that affect our decision-making process
in general. I have already discussed more details about these things when we were
analyzing some investment of avenues in previous module. So, I am not going to elaborate
on this, social factors include lifestyle in interest personal interests, hobbies, and peer
groups behaviour, and social culture.
395
These factors influence your decision-making process. Because, these things will
determine whether you want to own a particular asset or a particular item or not and if you
are owning it what could be the possible reason? Third type of factors are personal factors
such as demographic issues including gender is, marital status, income investment savings,
size of the family and so on.
All these three factors together affect your budgeting decision or the decision related to
your planned spending and saving. If you as an individual in terms of budgeting are
moving towards a spending path which is basically the path where you spend lot of money
on actual activities. And you are involved in cash management process where you invest
some money in buying or selling some products or rather owning some products in return
of some money to be spent.
If you are on spending path you can either go for overspending, if you are not managing
your cash properly or you can follow a system where you spend appropriates money on
different items and different goods and services. So, from budgeting which are affected by
social, economic, and personal factors you move on to spending path where you spend
actual money on different goods and services.
And if you do not plan it properly you move towards overspending, if you plan it suitably
and you incorporate behavioural, and social, and cultural factors; you plan your spending
on appropriate systematic way. If you overspend you are likely to end up misusing your
credit which is basically leading towards financial difficulty.
In general overspending also leads you towards financial difficulty; whereas, if you are
following your appropriate spending pattern you can achieve your financial goals
successfully. If you are following saving path which is basically more saving and
investment rather than spending, you can achieve your financial goal very easily.
Now, here the point to be highlighted is if you are an individual that believes in more
spending now than saving versus a person who is more savings in present than spending.
Now, these are two categories of individuals that you can come across. So, people prefer
to spend more in present time than save because of several reasons. And one of the reasons
could be the availability of funds or money at a cheaper cost or the rate of return that can
be earned on the savings or the investment that individuals are making.
396
So, if you earn more interest on your savings you would like to invest your money rather
than a spend it. And if you see that the interest rate is not very high on your deposits or on
your savings you would rather spend it to gain utility then investing it in a different
investment of avenues. So, the economic factors such as interest rate and taxes and
inflation determine your choice to spend or save.
Similarly, social factors such as lifestyle, interest, hobbies, and peer group and culture also
determine whether you are moving on to spending path or saving path. For example, India
as an economy in general have always been a nation that have believed in saving more
than spending. Whereas, in western culture it is always encouraged to spend more than
save.
So, you have seen in data also that India has always had about 30% of savings rate for
quite a few years till recently. Whereas, in recent times the tendency or the behavior of the
next generation has changed from saving to spending pattern. So, these social and
economic factors depend on other factors such as personal factors including age, income,
marriage, family size and all.
For example, if there is a student who had just graduated from the college and got into job
market. And she has started earning that person would be likely to spend more money than
save in general. Whereas, if the financial planning is done right that person can save more
because she has no liability in beginning. So, more money can be saved for a better and
more financially rewarding future.
So, the factors such as economic factors, social factor, and personal factor can determine
your choice to go on saving path or spending path. If you move to saving path it is easy
for you to achieve your financial goals, if you go on a spending path and you do appropriate
spending by managing your cash appropriately still you can achieve your financial goals.
However, if you go on overspending path you end up in misusing your credit which is
often seen when you have a credit card you overspend in general. And end up having
higher debt compared to your other peers. If you have potential misuse of credit you end
up in financial difficulties.
397
(Refer Slide Time: 28:19)
Having understood this financial implication of consumer buying decision process we
must not forget that all these factors include one important aspect of financial implication
that is the time value of money. We know that consumer buying a choice gets affected by
several factors including the choice between investing a lot of money right now versus a
smaller amount of money infrequent a way. It is also affected by a personal choices or
desire to own something versus managing without owning it.
And of course, comparison of cash flows compared to different points of time. Here I have
got an example where we can discuss how a choice of owning something versus getting it
done without owning it can be evaluated for consumer buying decision. And the situation
here is as follows, suppose you have a task to do and the task is getting your clothes washed
at laundry versus buying a washing machine. You have two choices either get your clothes
done from outside and the second choice that you have is to own a washing machine.
Now, if you look at the financial side of this these two choices, if you spend average
amount of money of ₹100 per week on getting your clothes done from a laundry in a 52week year you end up spending about ₹5200. In general, on clothing on maintenance of
clothes. If you have the laundry little away from your place of living you spend some
money on traveling to the job to get it done that is let us say ₹10 per week extra or maybe
if you have the service of home delivery.
398
Let us assume that this ₹10 of extra charge charges are for home delivery. If you do not go
for this laundry services you own a washing machine which will cost you some ₹25000
and the cost of this washing machine is 10 years. If you buy it you have to spend some
money on water and detergent and electricity. So, let us say every time every week you do
it, so you cost you spend some ₹10 on an average per week for water electricity and
detergent.
Assuming that a time value of money factor rate is 3% which is basically the average rate
of return on your savings bank on savings bank account. What should we do? Whether we
should own the washing machine or we should get that clothes done from a laundry. If we
try to understand this from a finance perspective this is how we can actually evaluate it.
(Refer Slide Time: 31:39)
So, step 1 would be to understand all the cash flows which are associated with this
decision. So, first of all positive cash flow, and positive cash flow one is estimated savings
or rather estimated amount that you can save on weekly laundry services.
So, basically 52 weeks at ₹100 per week, so let us say that you have 5200 rupees of savings
on estimated amount that you can save without using that particular service. Another
saving that is positive cash flow is driving cost, let us say driving cost that is ₹10 per week
or home delivery cost that you can save.
399
So, 52 weeks at ₹10, so that is ₹520. So, positive cash flow that you have is ₹5720, and
negative cash flow that you have here is cost of water electricity and detergent. So, let us
say 52 weeks ₹10 again these are just arbitrary numbers, so you can assume any value
which are more realistic and relevant.
So, the total amount saved is going to be ₹5200 and annually. Now, let us consider step 2,
which says the present value should be found out find the present value of these savings.
So, ₹5200 of annual saving for 10 years at 3% of discounting rate or rate that we are
considering. So, if you remember we had derived a formula earlier for present values of
cash flows.
𝑃 = ∑𝑇𝑡=1
𝐶𝐹𝑖
(1+𝑟)𝑡
=
𝐶𝐹
𝑟
1
( 1 − (1+𝑟)𝑇 )
Putting values in formula we get,
5200
1
(1 −
) = 173333 × 0.2559 = 44356
0.03
(1.0310 )
Now, step 3 is, step 3 is we consider the cost of buying that machine. If you remember
from the example given the cost of buying that washing machine in today’s term was
25000. So, the total saving that we have total net present value of saving that we are going
to have out of this decision is basically 19356 in today’s term.
So, this is how we typically should evaluate all the financial decisions are related to any
consumer buying the item. For example, vehicle or consumer durable goods such as TV,
audio system, or washing machine any anything that cost us a substantial amount of
money. And can be used for several years or a longer period of time should be evaluated
on the basis of net present value and accordingly the decision should be made only if the
net present value is positive. So, this is one example of buying a consumer decision, if we
go back to make a summary of whatever we have discussed today.
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(Refer Slide Time: 38:53)
In this session we know that every decision of ours as an individual has some economic
value and these decisions should be evaluated in terms of cost benefit analysis. Where we
need to consider all the cost of owning or buying that in item and benefit in terms of
deriving the utility and any other benefit that are associated with the product or goods or
services.
Typically, consumer buying a decision are affected by economic social and personal
factors. And these factors make you choose the path of spending versus the path of saving
or is the path where you prefer to spend more money in present time than save money for
future. And if we do our decision-making process carefully in terms of comparing the cost
and benefits, we will achieve our financial goals more easily. More discussions about
buying decisions related to different scenarios will be discussed in coming lectures.
Thank you very much for now.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 34
Consumer Credit Decisions
Hello dear, welcome back to the course Behavioral and Personal Finance. If you have
made this far, I am sure you have understood a lot of factors that affect our behavior in
terms of financial decision making and how we make decisions related to our personal
financial management.
If you follow business and economic news, you must have come across issues and news
related to industrial slow down and how the country is progressing towards a possible
recession. Well one of the factors that was attributed in the news reports was the
availability of credit for individuals as well as for industries.
In fact, one specific example if you would like to cite here is the slow growth in sales of
automobiles. Well news report cited that the manufacturing companies associated with
automobile sectors are facing slump because of a low demand from the consumer side.
Whereas some other reports suggested that the availability of credit has been attributed to
the slow in demand coming from the consumers. Well this session will focus on how
consumer credit is an important issue in terms of personal financial management and how
these factors relate with a general economy as well as the specific financial goals and
objectives that we want to achieve.
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(Refer Slide Time: 02:05)
This particular session focuses on the following issues, we discussed briefly about the
basics of consumer credit and examples in the context of individuals and families. We also
try to understand credit cycle and the factors that affect this credit cycle specifically for
individuals. And the advantages and disadvantages of consumer credit in terms of personal
financial decision making.
(Refer Slide Time: 02:38)
When we try to talk about consumer credit, we first understand the definition of credit.
Basically, credit is an arrangement where individuals, or families, or entities receive some
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cash, or goods, or services for now and they are liable to pay back in future. Basically, the
individual or entities that offer such facilities of credit in terms of cash goods or services
are known as lenders.
Whereas, the individual’s household families and entities that avail this service or this
facility are known as borrowers. Typically, the borrowers tend to place their future income
that they expect to receive in future against the purchases and the uses of the facilities of
or goods or services in present time.
So, essentially it is about present consumption or immediate consumption in return for a
portion of their future income. The lenders include the banks, financial institutions,
retailers, service providers these are the providers of credit. Whereas, the individuals who
borrow or the set of borrowers include individuals, or families, or household.
Typically, the facility of credit is availed by individuals or household for purchases of
appliances, consumables, groceries, sometimes vacation tours. And other consumable
items in term including goods and services. When we try to focus more on consumer credit
basically this is the line of credit or the arrangement of credit for personal needs except for
a home mortgage. For example, individuals or household would like to borrow money or
avail the credit facility for buying electronic goods, furnishing items in their houses,
luxuries goods, and other related items.
Basically, this type of credit arrangement or the facility to avail goods or services for now
in return for a future payment is widely used by individuals and families with different
strata of society. In contrast to credit use for business purposes where business houses or
organizations procure raw material or other input material on credit. And pay back after
sales which typically is known as cash cycle.
The credit cycle or credit available for consumers or individuals has a different structure.
If we try to understand the cash cycle related to business organizations, we can see that the
cash cycle for businesses begin with cash. It passes through different phases of cash and
then it converts cash into some more amount of cash in the process.
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(Refer Slide Time: 06:17)
If you try to understand business cash cycle this follows certain pattern, where cash is
availed by businesses from different sources of money. And then cash is used for
purchasing of inputs which is put into production process for manufacturing of goods and
services. In the process cash is consumed for raw material, and labor, and other expenses.
And once the production process is complete the production of sales or goods or services
are available for sale. And the sales can be made for credit or cash and subsequently the
business organization generate further cash. Basically, this is a process where cash is
converted into cash. If we look at more specific examples, we can see that suppose a
business organization starts with an amount of ₹100 of cash, this cash is used for
purchasing raw material and labor and other expenses.
So, let us say raw material is consumed for ₹50, and labour is used for ₹30, and other
expenses is for ₹20. So, this these three inputs are put into production process and then the
cash is converted into product or service which is worth sale sales for more than ₹100. So,
this particular cash cycle when it is moved from raw material to production process and to
finished goods which are ready for sale is sold to and credit.
Or it can be sold for cash which is directly converting the cash into cash or if it is sold on
credit is finally, recovered and repaid by the buyers who have bought or availed your goods
or services. And subsequently it is converted into cash, this is a typical cash cycle for
businesses. If goods and services are sold only for cash which is basically this particular
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phase of cash for example, cash is converted into raw material, raw material is converted
into production process.
Production generates goods or services and then goods and services directly converted into
cash because there is no credit sale. Here, the credit availability is not a concern, but we
understand that most of the businesses function on credit.
So, they buy raw material on credit, they try to sell the final product or the goods or services
that they manufacture or produce on credit. And in the process, they consume lot of credit
availability. Similarly, if you try to contextualize this particular cash cycle in terms of
individuals, we know that individuals also have limited sources of cash.
But there are more than multitude of output where they have to utilize their cash sources.
And in the process, they may find some conflicting utilities for cash. Now, availability of
credit makes it very easy for them to make any purchasing or consumption decision.
For example, if they have to buy a home appliance such as a television and they have to
spend a lot of money a big part of their monthly salary on purchasing that particular
television. They will not be left with sufficient amount of money for spending on other
expenses such as groceries, education, rent, and other expenses.
In such cases the availability of credit becomes very important and that is why this cash
cycle in the context of individuals becomes even more critical. Where for every purchase
they have certain credit availability and when they have to buy certain items on credit, they
have to make sure that the repayment of that items or goods that they have purchased on
credit should be done in timely manner. So, that it does not accumulate and create a burden
on their future income.
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(Refer Slide Time: 11:37)
Now, that we understand the importance of credit let us try to focus on importance on
consumer credit. Basically, consumer credit is considered to be a significant force in any
economy. When you talk about the US economy, or European economy, or an emerging
economy such as India we know that consumer credit has become very important to force
the overall economic growth in these countries.
We know that several economic forecasts given by agencies like world bank or,
international monetary fund, or any other economic think tanks. It includes that consumer
spending and the trends in consumer credit and availability of credit for other stakeholders
in the economy basically drive the growth of the economy.
In fact, there is a metaphorical saying that suggests that as the consumer goes, so goes the
economy which implies that if the consumer is borrowing a lot of money. Basically,
economy also drives towards that particular direction. And if you look at some examples
in USA the baby boomers represent almost 30% of the population. But, on a on an average
basis they hold almost 60% of debt which is basically a result of industrial growth in late
1940s and early 1950s.
And that subsequently led to in more disposable income for those families who were
benefited from industrial growth. And later on, their consumption pattern has changed and
subsequently they used their money or their resources on buying and consuming more and
more goods and services.
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When it comes to India, we have seen that growth in credit card and personal loans has
substantially increased. And we have noticed that the percentage growth in credit card and
personal loan is substantially higher than the percentage growth in automobile and home
loans. Basically, it indicates that growth in number of consumers with access to credit has
exceeded 20% on year on year basis.
And if we look at some more numbers here credit in India as a as of 2019 has been to the
extent of ₹117 lakh crores out of which almost 55% that is more than ₹65 lakh crore of
loans and credit were held by corporates. Whereas, 45% of this credit exposure was held
by individuals that includes consumer and agriculture and other prime sector lending.
These data suggest that for any economy, the growth is driven by the consumption pattern
of its population. As well as how the population or the people living in the economy are
spending their money and whether they are driven by the availability of credit for their
consumption.
(Refer Slide Time: 15:10)
If you look at some more numbers here, we know that the emerging economies have
always focused on financial inclusion. And in a recent survey conducted by Indian council
for research in international economic and resources. They conducted a survey of almost
850 respondents and their findings are very interesting.
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If you look at the graph shown at the screen (refer 15:15), we see that in first graph the
quantum of consumer loans among the respondents is very low. And the growth or the
amount of loans that has been disbursed or that has been availed by the individuals who
have been part of the survey is varying from one city to another city.
So, basically the loans which are of lower value for example, if you look at Delhi graph.
The loan which are of a well lower value such as less than ₹100 are very low in terms of
penetration for cities like Delhi, Mumbai, Kolkata, and Bangalore. Whereas the loans
which are in the range of 10000 to 25000 they are also low in Delhi, Kolkata, and Mumbai.
But, in cities like Bangalore the amount of loan amount of consumer credit or consumer
loans to the extent of 10000 to 25000 is substantially higher. In terms of higher amount of
loan which is 25000 to 50000 again a city like Bhopal has substantial amount of exposure
towards a loan of that quantum. So, overall, we know that people who have no loans on an
average are basically comprising to the larger part of the survey respondents.
Whereas, people who have taken loan of 10000 to 25000 are basically falling in another
category. This indicates the credit availability for consumption purposes, basically the
respondents are middle class working people who have availed the loan of the range
between of between 10000 to 25000.
And this these loans are taken for immediate consumption or consumption of the home
appliances or home furnishing or any such immediate consumable goods. If you look at
the other side of the survey the other graph that is shown on the left side of the screen
(refer 15:15). In these 4, 5 cities we know that the source of these loans that have been
availed by the respondents in the survey are basically mixed in terms of the sources of
credit.
And mostly are coming from formal sources whereas, city in bigger cities they use all
sources of credit available. What all sources include is formal and informal sources such
as banks and other sources of credit. So, if you see in cities like Bhopal most of the people
have availed loans from formal sources. Whereas, in a city metro city like Delhi people
have availed loan from both a formal and informal and almost 25% of the respondents
have availed loan from both sources.
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In a city like Mumbai people have taken loan from both formal and informal sources and
the participant percentage of participant availing these loans are substantially higher than
other cities. So, on an average the most of the people have taken loan from formal sources.
Whereas, people who have taken loan from both formal and informal as well as people
who have taken loan from informal sources are more or less same.
These numbers indicate that the people’s tendency to avail credit for their immediate
consumption is totally dependent on the geography and the economic development of the
area and locality. And it is also directly related to the amount or the quantum of loans that
are available and that are accessible to them. When we look at some more summary
statistics or some summarized finding of the survey.
(Refer Slide Time: 20:21)
We can see that the objective of financial inclusion can be achieved through availability
of consumer credit. And we have seen that in this survey almost 89% of respondents are
those who have their regular bank accounts. Which means they have understood the
availability of banking services and the availability of consumer credit through formal and
informal sources and they maintain their bank account.
75% of respondents are open to consumer finance which means for buying items such as
television or mobile phone, they know that they can have access to formal and informal
sources of credit. So, consumer finance is easily available for them and then they can make
purchase decisions. 55% of respondents are those people who have bought at least one
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product or goods or services in last one year which has some exposure of consumer finance
or consumer credit.
And only 38% of people in the survey have used financial apps for availing these financial
services such as consumer loans or consumer finance services through mobile apps. The
finding of the survey indicates that financial inclusion as an objective in the economy can
be achieved with the help of more availability of consumer credit. And alternate channels
through which people can avail these consumer credit alternatives.
(Refer Slide Time: 22:15)
Now, when we talk about consumer credit and its advantages and disadvantages, we must
understand why is it important to use consumer credit as a source of finance. Now, we
know that consumer credits are meant for marginal consumers or those who have limited
access to credit or alternate sources of credit. Basically, these people are middle income
group who have limited access to formal channels of finance. And they have very stable
and regular source of income although not in high quantum.
But they can use this source of income as a guarantee for availing consumer credit. So, the
reasons for which consumer credit can be made available to them include the basic
purchases of goods and services. Because, when they use credit for purchasing goods and
services these services or these facilities of consumer credit allows individual to be more
efficient in terms of utilizing the available resources.
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So, by using consumer credit alternatives they can utilize the resources in a more effective
way. They can be more productive and disciplined in terms of financial planning, because
once they borrow money to purchase some goods or services, they can be more disciplined
in terms of paying the amount that they have borrowed from their future income. In some
cases, they can be moved they will be more materialistically happy because they will be
able to consume what they want to consume.
For example, if an individual wants to own a smart phone that person can avail consumer
credit to buy a smart phone and be happier and more productive at the same time. There
are several reasons for which credit access is an important factor for any society, we know
that credit access makes people help to upgrade their skill set and enhance productivity.
For example, if a person is going for a higher education or professional degree, he or she
needs to access consumer credit or any such facilities which require him or her to upgrade
their skill by buying let us say a computer that might be required for technical education
or a software that might be required for his educational degree.
At the same time access to consumer credit will help people in medical emergency where
they may have shortage of resources. And access to credit will save them from medical
emergency. It also makes people change their workplaces depending on their skill set and
upgraded skills and sources of income can be improved.
Because, if they can avail consumer credit the change in workplace if it is very far, they
can easily buy a car and commute to their workplace, so they can be more effective and
productive. We all understand that buying now will might cost less compared to buying in
future because the prices might go up. And it is always wise to buy at a lower price that is
current time.
If you buy at a later stage may be, we have to pay a higher price that is why consumer
credit makes it possible for individuals to buy at a lower price. If available in present time
compared to the product same product or service that might be available at a higher price
in future.
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(Refer Slide Time: 26:32)
There are certain things which we need to consider before we access consumer credit. The
questions that we must always ask ourselves or those who are availing consumer credits
are as follows. First of all, we must ask whether I have the sufficient amount of cash or
equivalent resources that I might need for making the down payment. For example, if I
want to buy a car and that requires me to pay upfront certain amount of money.
If I have that much amount of money or not, then only I can decide whether to go for a
consumer credit access option or not. Similarly, we can also ask if I should instead use my
savings for making this purchase. For example, if I want to buy a smart phone, I can use
my savings that I have made over previous months. And that can be used to buy that
particular commodity instead of going for consumer credit option.
Similarly, if I have to make a purchasing decision I will think if the purchasing fits into
my budget or financial planning. Because, sometimes we might end up buying things that
are not fitting into our budget or that are beyond our financial planning and that will be a
bad financial decision. We can also ask if we should deter this purchasing decision for
future maybe in future the prices of that particular commodity go down and I can get it for
a lower price.
This happens most of the time when the technology of up gradation happens the product
with product manufactured with better technology are available for a lower price, it may
happen vice versa as well. So, there are certain issues such as opportunity cost, and time
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value of money. Because opportunity cost makes it makes it easy for us to decide whether
to go for a particular purchasing decision or not. For example, if I have to buy a car for
commuting to my work.
I will consider buying or not buying a car to commute to work if I know that the higher
transport budget or difficulty with public transport is going to be a big deterrent or very
difficult for me to handle. In that case, I would rather buy a car even by accessing consumer
credit. For example, similarly if we have been unhappy with our lower salaries or growth
in our job we would like to go for a higher professional degree or a skill up gradation. In
that case accessing consumer credit will makes it possible for me to go for it.
There are certain monetary and non-monetary cost of using credit. For example, interest
and other charges are monetary cost if we avail consumer credit, we have to make certain
interest payment and other charges. At the same time non-monetary cost include peace of
mind, personal philosophy because some people might not like to borrow money to
consume.
(Refer Slide Time: 29:52)
So, these are some monetary and non-monetary factor that we must consider. As a whole
we must understand that consumer credit is a mean for purchasing consumer goods or
services on credit. Unlike organizations or business entities that have several lines of credit
for buying or selling of their product.
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Individuals have very limited sources of credit for example, banks, and financial
institutions, retailers, service providers, offer them some consumer credit for a very shortterm duration that can be availed for purchasing decisions. mainly consumer credit
decisions are influenced by factors such as cost of credit that is basically the interest rates,
or interest charges, and other expenses.
Timing and availability of credit are other factors such as the availability of credit
immediately at a lower cost, by vis a vis availability of credit later on at a higher cost and
vice versa. These factors affect the decision to go for consumer credit for individuals and
households. Another question that we must understand and try to answer whether
consumer credits brings a discipline in financial future planning.
Because, if we borrow money, we might end up paying part of our future income as a
payback to the money that we have borrowed. At the same time, we might be motivated
to earn more, so that we can reduce the burden of loans or consumer credit and improve
our livelihood. These are the factors that must be considered while considering or deciding
about the consumer credits; for now, this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 35
Loans and Amortization
Hi dear. Continuing with previous session, where we discussed about Consumer Credit as a
source of financing for individuals and household, when it comes to consumer purchase
decisions. We will talk about another alternative of source of money or source of finance for
individuals that is basically loans and how we can understand the basic mathematics of loans
to make better financial decisions. This session talks about Loans and Amortization, basically
we will in this particular session, we will try to understand the basics of loans as a source of
money for individuals and households.
(Refer Slide Time: 00:48)
And what are the factors that must be considered for making a decision with respect to loans
and their amortization. I guess you must have heard of the rule of 72. Well, the rule of 72 says
that if you divide 72 by the rate of interest, this will tell you the number of years which your
money will take to double, which means if you are investing your money somewhere and you
are getting a rate of return that is basically the rate of interest that you are going to receive on
your deposits or an investment and you use this rule of 72, you should be able to know how
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much time or how many years should it take for your money to turn into double the money that
you have invested.
For example, if you invest your money in avenues which is going to give you 5% rate of return
which is basically rate of interest and you follow this the rule of 72, which I was just mentioning
this will indicate that 72 divided by 5 which is basically 14.4. So, it this number indicates that
in 14, 14.4 years or in little more than 14 years your money should be growing into double the
amount that you have invested. Well, that is just one simple rule which is based on certain
assumptions and it tells you that the number of years it should take for your money to grow
into double is given by this rule of 72.
Another similar rule is the rule of 78. Well, we will discuss about the rule of 78 later on. For
now, we will try to understand what are such simple basic mathematical understanding, when
it comes to the decision making with respect to loans that we take as part of our financial
planning and financial decision making and the amortization process which is basically nothing
but repayment process of the loan so that after the tenure is over, the loan amount is 0.
(Refer Slide Time: 03:52)
First of all, we try to understand what the loan is and what are the basic generic features. So,
basically loans are the amount that we borrow from different sources and this amount is repaid
in different installments and this installment comprises of interest as well as the principal
payment. For example, if we borrow money from bank or any other financial institution, today
we have to make payment periodically and that payment in different periods could be monthly
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or annually and this payment amount should include interest charges that are defined in the
beginning itself and the principal amount or the part of principal amount that is basically the
amount of money that we have taken as loan.
As discussed, earlier loans are taken from lenders and the person or individuals who take that
money are known as borrowers, who pay the amount of loan in different installments which is
basically periodic payments that comprises of interest and the principal amount. Loans can be
taken for mortgage basically housing loans, car loans, personal loans and so on. Similarly, the
amount of money that is charged in terms of interest could be compounding in terms of simple
compounding or simple interest or compounding interest. The basic mathematics explains that
compounding interest is definitely more complicated than simple interest charge on the loan
that we borrow.
Another feature of loans is although not necessary, but typically the principal, the payment
intervals and the dates for which payments are made in terms of how often and when are you
making the payment of interest and principal amount, coincide with the interest compounding
intervals and dates. Basically, if it is a monthly installment or monthly compounding loan that
you have borrowed, the repayment period and interval will also be monthly. The interest rate
that is basically the charges of borrowing loan is calculated on the money that you have owed
for the past month and it has nothing to do with the payment that you are about to make. So,
when you understand the interest that has calculated from the overdue amount.
The amount that has been owed by you and it does not have any reflection on the expected
payment or the future payment. Having understood this basic feature of a loan, let us try to
understand how compounding of interest matters in terms of payment of loan and the future of
the loan process, the loan making process. Here, I have tried to explain an example with the
simple numbers.
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(Refer Slide Time: 07:05)
So, suppose that you have borrowed a loan or you have taken a loan of ₹30,000 which has an
annual interest rate of 8% compounding on a monthly basis and the tenure of the loan is 4
years. So, basically loan amount is ₹30000, tenure is 4 years and since it is compounding
monthly number of months that has been compounded in this particular scenario is 48 months.
Annual interest rate is 8% which is basically 0.08. Since, it is monthly compounding interest,
we know that monthly compounding interest will be divided by 12 and the rate of interest that
we are being charged for this loan is 0.006666.
So, the monthly interest that we the person who has taken this loan will be paying is 0.0066
multiplied by the amount of money that has been borrowed; so, ₹200 of monthly interest being
paid. If it is simple interest loan, then you pay ₹200 per month on the loan amount that you
have taken and total in amount that you might be paying will be ₹9600. If it is compounded
monthly over the period of the tenure of the loan, then the calculation might be slightly
different.
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(Refer Slide Time: 08:54)
So, here I have taken the numbers to one step ahead. The example is same we have borrowed
a money of 30000 rupees for 4 years which is basically 48 months at the rate of 8% annual
interest, compounded math monthly that is the rate of interest that is charged on a monthly
basis is 0.6666%. So, in period 1 which is basically starting from next period here, the amount
of interest being due is ₹200 because the loan amount previous month or previous period is
₹30000.
So, the balance in loan account will be 30000 + 200. So, the total balance as at the end of period
one will be 30,200 and interest that is charged on this amount at the rate of 0.6666% will be
accumulated over next period as ₹201.33 that will be added to the total previous amount
particular amount. So, total amount due at the end of second period will be ₹30401.33. Now,
similarly, the interest will be charged on this amount to the extent of 0.6666% that will lead us
to the interest payment calculated on this amount for next period that is 202.68 and so on. (refer
10:10)
So, this is how we calculate the monthly compounding of interest at the rate 0.6666% on the
amount balance in loan account. So, if you see that the loan amount that was taken on 0 day to
the extent of ₹30000 and compounding monthly at the rate of interest 8% per annum. The
amount of money that will be due till the end of 48th month that is end of 4 years 4₹1,269.98.
So, essentially, if you reduce this amount of loan that you have taken, the amount of interest
that you are paying is basically 11269.98 in terms of compounded interest.
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So, this is a simple example of how loan interest is charged on the balance of previous period,
balance in loan account d and this is calculated monthly or the periodically at which it is
compounded. Now, since loan is taken and every month you are committed or you are liable
to pay certain amount of money back to the lender, the numbers might look slightly different.
So, the numbers that will look when you have some amount of money to be paid every month
will be as follows.
(Refer Slide Time: 12:21)
Suppose, you decide to make a payment of ₹200 every month. So, you take the same loan 8%
per annum. So, ₹30000 of loan for 4 years at 8% per annum compounded monthly that is
interest will be charged on 0.6666%. So, ₹200 every month you are paying. So, at the end of
first compounding interval, the interest due is ₹200 that is basically 0.666% of this amount. So,
₹200 you pay that balances out. So, the amount left at the end of one period is ₹30000. Next
month again interest is calculated on the basis of 0.6666% on this amount, you paid off ₹200,
and the loan amount is again ₹30000. Again, interest is calculated on this amount and so on.
Your balance in loan account will always be ₹30000 because you have paid the interest charges
every month. You are paying just enough to cover the interest charges and that is why the
balance in loan account in this scenario is always ₹30000. Now, one of the simple examples of
this particular type will be a scenario, where individual buys a new house before selling the old
house. So, if you look at this example, where the individual buys a new house before selling
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the old house to reduce the monthly expenses, he will pay the interest charges every month till
the time he sells off the old house.
And the moment he says the old house, he can pay this principal amount from the sales proceed
of the old house and thereby, closes the loan. Closes basically when he sells of the old house,
he will get a substantial amount of money. So, he closes the loan account by using that money.
So, this is another example, where we can understand how loan can be paid off periodically,
just in case of interest only payments scenario. Another example is when you try to pay more
than what the interest charges are.
(Refer Slide Time: 15:25)
So, in this scenario, I try to explain interest and principal payment. Suppose, the scenario is
same ₹30000 loan account, 4 years that is a 48 months, 8% interest rate, monthly compounding
at 0.6666% and at the end of first compounding interval, the interest charges are due on the
balance of the previous month that is ₹30000 multiplied by 0.6666% which is almost ₹200. But
you decide to pay ₹300.
So, when you pay ₹300 rupees as your monthly payment; ₹200 will be charged towards interest
and remaining ₹100 will be charged towards principal which means at the end of one period,
the principal amount will be reduced by this ₹100 that you have paid towards principal. So,
your effective principal amount at the end of first period will become ₹29900 which is the case
here. For next period, the interest will be charged on this ₹29900 at the rate of 0.6666% and
that is why it is less than ₹200.
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So, every period, you pay ₹300 that is higher than the interest charges due and your principal
amount starts decreasing. Similarly, your interest charges also start decreasing. So, that is why
it is suggested that the larger the payment amount you pay, the better it is because it will also
reduce the interest charges as a result of lower principal amount. Now, let us try to expand the
same make this example to one steeped.
(Refer Slide Time: 18:00)
Now, suppose that we have a scenario, where the payment amount is ₹732.39. Case is same
₹30000 of loan, 4 years of tenure, 8% annual interest rate, monthly compounded at 0.6666%.
Now, here the monthly payment goes to the lender inter in 1 installment of ₹732.39, which
means for every ₹732.39 of payment basically ₹200 is going towards interest in the first month,
remaining ₹532.39 is going towards principal payment. And subsequently, this amount of
principal that is balanced in loan account keeps on decreasing and subsequent as a result, the
interest charges also keep on decreasing.
So, when you look carefully at the end of 4 years which is at the end of 48th month, the amount
of interest that has been charged on the previous months balance that is ₹727.41, it is just ₹4.85
and the remaining ₹727.5 actually goes towards paying the principal and thereby, principal
amount has become 0. So, the thing that is highlighted here is in first payment interest
component was ₹200; whereas, in last payment the interest component was ₹404.85. So, we
have seen that over the period, the interest component has gone down as a result of the principal
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amount going down because more of the money that that have been paid over every month has
gone towards principal amount due.
So, that is how the loans are paid off when the charges or the amount of payment that has been
paid to the lender by the borrower is more than the interest due on that in particular loan
account. This particular process is known as amortization. Basically, it indicates the process
through which the loan amount is reduced to nil over the period.
(Refer Slide Time: 21:03)
And if we try to understand this in a more generalized way, we know that every payment that
has been made towards on the loan account by the borrower includes an interest payment as
well as the balance towards the regular payment loan. And this essentially shows that for a
longer period time, the amount of interest that is going to be considered will reduce, you can
see that the amount of interest that has been gone towards the interest payment is reduced and
the balance reduction is upward because more of the money for from every payment is going
towards recovery of the main loan balance account. If you try to look this through a more
calculated numbers, it is shown here.
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(Refer Slide Time: 22:08)
If we look at this particular example, this is an example of the loan that has been to the extent
of ₹300000. So, if you see here this is ₹300000 of loan that is taken and interest charged is 8%,
interest monthly charged because it is compounded monthly is 0.0066%. So, monthly payment
is basically ₹2509.35, tenure is 20 years which converted into month becomes ₹240. So, if that
loan is taken on in July 2018. We know that the amount of money that has been paid is not
changing. So, for every month after that month ₹2509.32 was paid as payment. Out of which
in the first month ₹2000 was paid towards interest and ₹509.32 was paid towards reduction in
balance.
So, basically this ₹2000 is the interest charged on the due loan account. So, loan account here
is ₹300000 lakh, loan interest charges is 0.006666%. So, this amount has been calculated using
this principal amount into the percentage of interest charged on that loan overdue. So, this will
give us ₹2000 and this is basically the EMI that has been paid, the amount that has been paid
minus the interest charges and this is basically the principal amount minus contribution towards
balance reduction and that is how every month, it is growing the amount that is going towards
balance reduction.
So, when we try to calculate this number over the year. So, this is since this is a, 20 years
tenured loan which is 240 months. The calculation is shown here and we know that the amount
that we have been paying every year is also changing. So, in first year the total interest that has
been paid for first six months is ₹9965.82. And if you try to see for other number (refer 25:00),
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other years the balance is balanced is reducing is going and balance is substantially decreasing
over the months to the extent of the total balance amount becoming 0 at the end of 20 years.
(Refer Slide Time: 25:11)
(Refer Slide Time: 25:16)
And every year there is amount of money that has been paid towards interest. So, for let us say
in 20-25 December, the amount of my interest that has been paid was total towards ₹19535.
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(Refer Slide Time: 25:39)
So, this particular spreadsheet example shows that at the end of 20 year that is 240 months, the
total amount charged towards interest was ₹16.62 and the remaining amount of ₹2592.32 paisa
is going towards reduction in balance. And thereby, the total balance becoming almost 0. So,
if we try to plot this example, the graph that we get is basically the same graph that we were
trying to understand which shows that the amount of interest going to the interest component
is reducing.
(Refer Slide Time: 26:05)
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And the amount of money going towards balance reduction is increasing over the period. This
particular example shows this, but this relationship between the amount of money going
towards interest and the amount of money going towards balance reduction.
(Refer Slide Time: 26:38)
They have negative relationship and if it is very long period loan, it substantially changes the
amount of money going towards interest payment at the later part of the tenure.
(Refer Slide Time: 26:56)
So, in this session, we have understood that loans are basically amount of money borrowed by
individuals for different purposes and it is important to understand whether loans are
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compounded monthly or semiannually or annually because the compounding determines the
amount of money that has been paid by the borrowers to the lender and it also determines the
component of which basically interest are charged to and the principal amount has been
reduced to subsequently in nil.
The amount basically paid by borrowers to the lender includes principal amount and interest
payment and compounding schedule determines the extent to which principal amount has been
taken away from the payment schedule. One example that has been discussed here shows that
there is always a predetermined number or value of payment that has been discussed here. For
example, if you try to see these three examples. So, here the amount of money was ₹732.39. If
you try to see previous examples here, the amount of money that was going was 300 rupees. In
previous example, the amount of money that was paid was ₹200.
So, basically in all three examples that we discussed here, we essentially understood that the
amount of money that is going towards payment was given. Now, the question comes here how
do we arrive at this number of ₹732.39 or any amount that is going towards payment because
that amount only includes interest payment and part recovery of the loan balance account. So,
in next session, we will try to understand, how these amounts of payment are arrived at.
Because that is most important to understand how the loan has been repaid off in terms of
interest payment and the principal payment. For now, this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 36
Loans and Amortization (Contd.)
Hello. Welcome back to the course Behavioral and Personal Finance. And in the module of
personal finance; we have been discussing in previous few lectures about the sources of
consumer credit and as part of consumer credit we have discussed previously. The features and
mathematical understanding of loans and how loans are amortized for principal and interest
payment. So, that the loan can be paid off by that borrowers and lenders receive the interest
and principal amount.
In this session we will try to understand the basic mathematics behind the amount that is to be
paid by borrower to lenders at every compounding interval.
(Refer Slide Time: 01:03)
Basically, we try to understand how do we calculate the payment amount and if there are any
prepayment penalties that can be considered in that formula itself.
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(Refer Slide Time: 01:14)
So, previously, we have understood that if we have taken a loan of ₹30000 which is charged at
an interest rate of 8% and that interest rate is compounded monthly. We pay ₹200 of interest
in the very first month. And if we choose to pay ₹300 as first installment of this ₹300, ₹200
will go towards interest payment and ₹100, remaining ₹100 will go towards recovery of this
₹30000 of principal amount that will leave us with the principal amount in loan account to the
extent of ₹29900.
Now, the question here comes as; how do we determine this ₹300 to be paid that comprises of
interest and principle repayment? In this session; we will try to discuss with the help of some
basic understanding of mathematical features. First of all, let us start with the basic assumption.
Suppose that R given here is the annual interest rate which is basically the rate of interest that
is charged on in loan account and y is the number of payments per year. Essentially, here we
are assuming that the number of payments per year is equal to the number of compounding
intervals per year.
If we recall in previous session, we discussed that this is the typical feature of any loan
repayment condition terms, where the number of payments per year would be equal to the
number of compounding intervals per year. So, suppose if you have taken a loan that
compounds monthly; the number of payments that you will be making will be 12, because the
number of compounding intervals is 12 as well.
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So, if R is the annual interest rate and y is the number of payments per year, then basically the
payment that you are making in terms of interest rate is R divided by y that is interest per year.
In previous example, we know that 8% interest rate per annum compounded monthly becomes
0.0066666 in terms of percentage, which is basically 0.666666%.
So, here this interest payment which is basically given as i.
𝑖 =1+
𝑅
𝑦
Now, if we try to know the typical terms and conditions associated with a loan, the balance at
the time of taking loan that is when you have not made any payment which is basically no
payment has been made towards recovering the loan, it is just the principal amount. If you
recall from previous example it was ₹30000 in all cases. If we let Bn which is basically the
amount of balance after nth period then if principal P is the principal, then B0 which is basically
balance after 0th period is nothing but P.
Now, we have set the basic terms and condition and notations. Let us move further. So, we
have known that R is the rate of interest and y is basically the number of payments and S is the
payments.
(Refer Slide Time: 05: 53)
So, the payments that we will be making or if we go the to the balance of loan account in 1st
period which is the next after 0 will be nothing but B1 is equal to.
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𝑅
𝑅
𝐵𝑖 = 𝑃 + 𝑃 ( ) − 𝑆 = (1 + ) − 𝑆 = 𝑃𝑖 − 𝑆
𝑌
𝑦
To get B2:
𝐵2 = 𝐵1 𝑖 − 𝑆 = [𝑃𝑖 − 𝑆]𝑖 − 𝑆 = 𝑃𝑖 2 − 𝑆𝑖 − 𝑆
Then B3 is:
𝐵3 = 𝐵2 − 𝑆 = 𝑃𝑖 3 − 𝑆𝑖 2 − 𝑆𝑖 − 𝑆
So generalized expression of this particular sequence will be
𝑛−1
𝑛
𝐵𝑛 = 𝑃𝑖 − 𝑆 ∑ 𝑖 𝑘
… … … … 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 (1)
𝐾=0
Now, we know that this particular summation is a geometric progression or geometric series.
So, the sum of the geometric series will be,
𝑛−1
𝑓 = ∑ 𝑖 𝐾 = 1 + 𝑖 + 𝑖 2 + . . . . . . +𝑖 𝑛−1
𝐾=0
𝑇ℎ𝑒𝑛,
𝑖𝑓 = 𝑖 + 𝑖 2 + 𝑖 3 + . . . . . . +𝑖 𝑛
Now,
𝑖𝑓 − 𝑓 = 𝑓(𝑖 − 1) = ( 𝑖 + 𝑖 2 + 𝑖 3 + . . . . . . +𝑖 𝑛 ) − (1 + 𝑖 + 𝑖 2 + . . . . . . +𝑖 𝑛−1 ) = 𝑖 𝑛 − 1
𝑖𝑛 − 1
𝑓=
𝑖−1
Now putting this in equation (1) for Bn:
𝑖𝑛 − 1
)
𝐵𝑛 = 𝑃𝑖 𝑛 − 𝑆 (
𝑖−1
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If we want that the loan is paid off at the end of the ‘n’ Payment Periods, then we want
𝑛
0 = 𝑃𝑖 − 𝑆 (
𝑖𝑛 − 1
)
𝑖−1
From above two equations:
𝑅 𝑛
(1
+
𝑅
𝑦)
𝑆=𝑃
𝑌
𝑅 𝑛−1
(1 + 𝑦 )
(Refer Slide Time: 14:39)
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(Refer Slide Time: 22:37)
Once we understand this, this helps us the solution to the problem of amount of money to be
paid at every compounding interval. Although this formula as is very mathematically intense,
but when we try to understand a more simplified approaches to determine the amount of money
that is to be paid by borrowers to the lenders in terms of loan amortization or any other
amortization of loans or any other credit that the consumer has taken. There are several sources
online available which can be used for determining the amount of money to be paid by the
borrowers to the lender at every interval. (refer22:40)
There are some sources of amortization calculator which you can use if you have certain
information such as the amount of money that you are planning to borrow. The rate of interest
that is being charged the tenure and the type of compounding or frequency of compounding.
You can use these online calculators to understand the amount of money to be paid and then
compare across different loan alternatives that you have to determine which is most suitable or
most fitting into your budget and financial planning.
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(Refer Slide Time: 23:59)
To conclude this session; we have discussed that the payment amount of loan amortization
comprises of payments towards interest and principal and it is always better to have higher than
interest charges as payment because that will contribute towards interest payment as well as
towards the payment of principal amount. And if it is higher than it is always going to reduce
your due principal amount on which that interest will be calculated. And that is how the interest
charges will also lower down with every passing period.
Although there are several sources of online amortization calculator are available, but you can
always try to understand what is most suitable to your financial needs and monthly spending
and earning pattern that will take determine the amount of money to be paid for loan
amortization.
Here I would like to point out that although it is very rare these days that prepayment penalties
are charged to borrowers, but we should always try to consider this prepayment penalties
related to any loan or credit basically these are the penalties when you pay the loan amount
before the maturity.
Basically, if you have taken a loan for let us say 4 years and for some reason you have got a
more amount of money before 4 years you would like to pay off all the loans and in the process
certain financial institutions or sources of loan can charge you prepayment penalty because this
is perfectly making sense for their business model.
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Although, this is discouraged by most of the regulators in India and in some other countries as
well, but it is always bad for the borrower to be charged for prepayment penalty. That is why
when you are planning of our loan and repayment schedule you always consider this
prepayment penalty as part of your financial planning.
For now, this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 37
Credit Cards as Source of Consumer Credit
Hi, there. Continuing with the previous discussion on Consumer Credit and different
sources of loans and other credit sources for individuals and household, we have learnt
about consumer credit in terms of borrowings from different financial institutions. There
is another source of credit which is very popular these days among individuals and
families known as credit cards.
(Refer Slide Time: 00:51)
Basically, when we talk about Credit Card as Source of Consumer Credit, we have
basically tried to understand how credit cards can help individuals and families to plan
their financial needs and spending pattern in a more structured way. But, at the same
time it is also important to understand the advantages and disadvantages of having a
credit card as a source of consumer credit.
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(Refer Slide Time: 01:12)
When we talk about consumer credit in terms of credit card as a source of the credit
available for individuals, basically we mean that credit cards are sources of credit where
when you use credit card for making a payment of a purchase of goods or services. The
card issuer which is basically a financial institution or bank or a retailer in some cases
pays the merchant immediately and you are charged that amount in your credit card bills
and you pay that amount later on.
So, basically the flow of money that follows here is the amount of money that goes from
bank or the issuer of the credit card towards merchants when you make a payment
immediately, But the amount it charged to you on a later date and you pay that money to
the bank or to the card issuer at a later date.
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(Refer Slide Time: 02:39)
Which is slightly different because in case of debit card which is another way of making
payment at different merchants are the when you use debit cards for purchasing
something or making a purchase decision at any store or any other shopping outlet you
basically make the payment right away and the bank charges you instantly. And that
money goes from your bank accounts or savings account right away to the merchant.
So, with this basic difference we understand that one fundamental feature of current
payment versus future payment that comes into the picture is the time value of money.
So, if you try to connect this with the concept, if you make a purchase right now so, the
amount of money that goes from bank to the merchant is right away which is the money
has been going to the merchant immediately, but you pay the bank at a different time. So,
you pay bank back at a later date.
So, here you save some amount of cause towards keeping that money with you for some
time. The merchant gives you the product right away, but the amount of money that you
pay to the merchant through your card although goes instantaneously, but the bank
charges you that amount and you are liable to pay after certain number of days.
This feature makes the credit card uses very popular among people who have shopping
pattern and who uses cards at every retail outlet or any other shopping avenues.
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(Refer Slide Time: 04:35)
Basically, the advantage and disadvantages associated with credit cards are as follows.
Since you use credit card as a source of consumer credit, you have immediate access to
goods and services. So, even if you do not have cash in your wallet you can buy or make
that purchasing decision. It also offers you flexibility in terms of money management;
because you know the amount of money that you have been spending on goes to which
particular type of spending.
So, if you are spending more money on consumable goods or travel or hotel or food out
items or groceries that can be traced by with the help of your credit card bills. So, it helps
you in making your money management easier. It is safe and convenient because you do
not have to carry lot of cash in your pocket all the time. You can use cards wherever
possible. It also gives you a cushion in emergency because even if you do not have cash
in your pocket, you can use credit card for cash withdrawal.
Certain credit card companies and other retailers offer you some amount of money as
cash withdrawal facility for on credit cards. If you are a very regular consumer and a
very well-established consumer who is paying all the bills regularly your credit rating
also improves thereby it helps you in getting such credit facilities in future at a easier
way. Along with these advantages the issues that credit card uses offers or has are the
tendencies to overspend or excessive use of credit card leading to increased debt.
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So, if you have this habit of overspending or a reflexive decision making in terms of
buying something which you do not really need you might end up having a lot of debt in
terms of credit card over dues. If you try to manage your assets and liabilities in terms of
future income and current spending, it might distort that particular asset liability
matching process. Because you may spend more money in present time whereas, the
future income is not so much and thereby your liability will be higher than the asset that
you are going to hold or you are expecting to have.
If you do not pay the credit card bills regularly, it creates a very substantial amount of
obligation towards future income and that is how it deviates you from the financial goals
to be achieved in future.
(Refer Slide Time: 07:33)
To understand the types of credit which are available for individuals and household,
there are two types of credit – close end credit and open-end credit. So, close end credits
are basically crediting which are onetime credit available for individuals such as
automobile and mortgage loans and installment loans where individuals or offered loans
on credit in terms of one time the amount of money available for them.
Whereas, open end credit is card are basically cards which offer you to use that credit
facility as and when required. So, for example, if you use credit card you can use open
end credit feature, as in whenever you need to buy something or make any purchase
decision you can use that credit card as a mode of payment. And, these credit cards are
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issued by different institutions or financial institutions, banking institutions and other
retailers. Another similar feature of open-end credit is overdraft protection, where banks
allow you to withdraw money more than your savings account offers or your checking
account offers.
These with these feature credit card has become extremely popular.
(Refer Slide Time: 08:56)
Now, the basic feature is you consume now and pay later. Typically, most of the credit
card companies or the issuing companies offer you a grace period of 25 days or so.
Which means that the moment you make purchasing decision or purchases with the help
of your credit card or your statement is generated or the bills are generated on your credit
card transactions you receive 25 days of period for making the payment without any
interest or financial charges.
If you fail to make the payment within that particular grace period, then credit card
issuing companies start charging interest and financial charges. So, based on these
features the users who are using credit cards are categorized into two types convenience
users who use credit card as convenience shopping and they pay their bills regularly.
And, the other category is borrowers who fail to make the payment within the time frame
allowed for some reason and thereby they have over dues. And, that over deuces charged
interest and other finance charges by the issuing bank or financial institution or other
card issuing companies.
443
Well, with the increase in online shopping and other transactions made by individuals
and households, the requirement for them to carry a credit card is increasing and this also
leads to the possibilities of frauds related to credit cards. One of such popular frauds are
very often reported frauds is identity theft wherein someone has taken the details of your
credit card and made transactions representing or pretending to be the cardholder and
thereby making the cardholder lose some amount of money.
(Refer Slide Time: 11:20)
With these things the features associated with credit card issuance and the usage of credit
card by individuals. We need to understand how these features actually translate into real
money transactions or the losses or gains for the users as well as for the card issuing
companies and other merchants.
So, one example here has been cited in terms of the grace period. We already discussed
that after the statement is generated and bills are charged to the credit card users a grace
period is allowed. So, if you look at this particular example, here it shows that suppose
the billing date for an individual’s credit card falls on 18th day of each month which
means that at the end at the 18th day of each month the credit card issuing company
generates the bills comprising of transactions in previous month.
His card carries an interest rate of 21.99% per annum and has 20 day of grace period. On
January 18th, the balance was ₹93,514. He made some transactions of ₹5,665 on January
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20th or another transaction of ₹30,925 on January 29th, yet another transaction of ₹8,117
on February 9th and finally, another transaction of ₹10,142 on February 17th.
Now, if you see here, the amount of money that was due on the previous date of bill
generation which is January 18th because on 18th day every month the bill is generated
the amount was due to the extent of ₹93,514. On February 3rd which is well within the
grace period; so, on January 18th + 20 days of grace period the amount of ₹93,514 was
paid.
If he pays the balance on his February 18 statement in full before the end of the grace
period, whether he has to pay any interest on or not? Well, the explanation is since
January 18th balance in full was paid within grace period he pays the February balance
also in full within the grace period he owes knows no interest. So, the answer is 0.
So, the idea here is if your statement is generated on 18th January, you are given a 20
days grace period, the amount of money that was due to the credit card company was
paid within that particular grace period then you pay no interest on the over dues amount.
(Refer Slide Time: 14:37)
Similarly, another example of this nature or the amount of money that has been paid or
that has been due to the credit card companies or other merchant is explained here. If you
see this particular example, suppose a guy Tahir bought a pair of shoes for ₹1077.90 and
paid the bill through his credit card. The credit card company charges the shoe store 45
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paisa for each transaction. So, basically this is the charge imposed by the credit card
issuing company to the vendor or the merchant.
So, there are credit card company and then the merchant and then the credit card owner
which is basically Tahir in this case. So, merchant has given the product right now and
our credit he has made the transaction with the help of credit card. So, this amount goes
to merchant immediately. So, credit card company charge some amount of money to
merchant. So, merchant has to pay certain amount of money, this is ₹0.45 per transaction
plus 1.25% of the amount charged.
Now, the question here is how much money the card issuing company will pay to the
shoe store? So, if the price of shoe was ₹1077.90 and the merchant has to pay ₹0.45 +
1.25% of the amount charged to the card issuing company how much money will go to
the merchant. So, the argument here is the amount of money that merchant has to pay is
0.45 + 1.25% of the bill charged. So, how much money should go towards this one this
particular credit card company to the merchant? Here the amount is paid ₹1077.90.
Now, the calculation is as follows. The percent portion of the commission shall be 1.25%
into the bill amount that were charged so, ₹13.47 + ₹0.45 was charged to arrive at the
total commission; ₹13.47 + ₹0.45 which is basically ₹13.92. So, the credit card company
will get ₹13.92.
So, the net amount that has gone to credit card company is the price that were charged to
Tahir minus the commission or the amount that credit card company will receive from
the merchant. So, ₹1063.98 will go towards merchant as the price of the shoe. So, that is
why sometimes you see that some companies charge certain higher fee or higher
commission for using their credit card and in some cases that money might be recovered
from the credit card user. In some other cases money is recovered from the merchant
where the credit card is used.
These are some of the features that can be considered while using the credit card by
individuals and household.
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(Refer Slide Time: 18:29)
There are certain other factors that we need to consider before using credit card. For
example, bank credit cards are offered through banks in terms of their customers savings
and loan accounts. So, if you have maintained a savings or loan account with any bank,
they will like to offer you credit card and the user charges or other financial charges are
very considerable in terms of a wide range of interest rate and financing charges are
imposed.
So, it might go from 6 % to 24% in India most of the cases. So, be considered these
financing and interest charges well before you decide which car to go for. If bills are paid
in full in a timely manner then you should better use the grace period because that grace
period is interest free where you can retain the money with you instead of paying
instantaneously. The period might typically go from 20 days to 25 days in most cases.
So, you can hold that cash with yourself for 20 – 25 days and save some amount of
money.
If you are using any monthly installment which is basically EMI sort of features
associated with credit card then try to look for a card that has lowest possible finance
charges because in that case the amount that is charged in terms of financed charges for
the overdue amount will be low ah. We should always be careful that some cards do not
charge annual fee, but they instead charge transaction costs recovered from the
consumers.
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Some cards whereas, charge no fee or low interest charges, but they charge right after the
purchase. So, try to understand the difference in terms of cost and charges that are
imposed on you for transaction as well as for the amount due.
(Refer Slide Time: 20:36)
There are some other features that we need to consider before we make a decision with
respect to opting for a particular credit card. If you are paying only the minimum
amount that is mentioned in the credit card statement, try to understand that implication
on your budget accordingly and you pay the amount that is due in full or if you are
making in terms of the minimum amount to be paid you try to pay it off as soon as
possible because the longer it takes for you to pay in the pay of the bill the more finance
charges and interest cost you have to bear.
And, it might so happen that the total amount paid in terms of interest and finance
charges might be higher than the total billed price. It is always best for any credit card
user to have regular and timely payment of credit card bills because that will be interest
free access to credit. It will also lead to a better credit history or credit rating that will
improve over the period. And, if you have better credit rating you might have ease in
accessing credit in future.
To conclude we should always keep in mind that credit cards are not credit cards, but
simply or substitute of a cash loan. Essentially it is a future obligation for the current
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consumption and that is why it might affect our savings and other financial planning or
decision making. For now, this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 38
Alternative Investment
Hi there, welcome back to the course Behavioral and Personal Finance. In this week, we
will learn about Alternative Investment and related portfolio strategies. I am sure you
must have heard of several a new asset classes that have emerged over the recent years,
because of the advent of technology.
Well, one of the new asset classes that has been in limelight in recent past is
cryptocurrencies. Have you heard of Bitcoins or any other cryptocurrencies? These
cryptocurrencies have emerged as new asset classes, where people would like to invest
their money and obtain substantially high return in short period of time.
There are several new asset classes that have emerged recently; including private equity,
venture capital, even the traditional asset classes or the medium of exchange in past that
is commodities, have also come up as new asset classes that people would like to invest
in.
This week we will learn about these asset classes and related characteristics and how we
can use these asset classes in our portfolios. (Refer Slide Time: 01:36)
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This session basically focuses on two concepts the basic idea of alternative investment
and how these alternative investments can serve as the asset allocation strategies over
and above the traditional asset classes. First of all, we would like to know why these new
asset classes have to be understood well before you actually incorporate in the portfolios
that you would like to hold.
Typically, we have learnt that the asset allocation strategies are done on the basis of
optimizing risk and return. Well, when we me when we talk about asset allocation, we
basically mean the amount of money distributed across different asset choices that you
have, and the money that you have kept aside for investment.
So essentially, asset allocation implies that if you have ₹100 of money and you want to
invest let us say certain amount of money in one asset class and remaining amount of
money in other asset class ; basically, it is kind of a pie chart, where suppose this portion
of your money has been invested in bonds.
Let us say, you want to keep it aside; so, bonds that gives you 6% of return. And then,
you would like to invest some part of money in equities. So, this is your equity
investment that might give a return anywhere suppose 12% to 15%.
And then, you would like to hold some amount of money in cash. So, this is your liquid
asset. So, let us call it cash or liquid asset. That has almost nil return or somewhere
maybe in certain cases you earn 2% to 4% of return on these assets also. And then, you
have certain assets in terms of money that you have put aside in.
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So, this is your investment in some other asset class. Let us say gold or real estate and so
on. So, when we talk about asset allocation, we essentially mean this kind of portfolio
that you are holding.
So, if you have certain amount of money you can keep some amount of money in cash,
some amount of money be invested in equities, some amount of money invested in bonds
and remaining money can be invested in other asset class such as gold or other precious
metals, real estate or any other assets that you want to hold as your portfolio investment.
Now, the allocation of this asset portfolio; where you have multiple assets, can be done
on the basis of a traditional method that we have already learned earlier; where, we know
that there is one method called mean variance optimization, where we try to optimize the
risk and return associated with portfolios. And then we try to find a suitable weight
which can give us some appropriate or optimal return on our investment. And if you
have you are able to recall; we had discussed earlier when we tried to learn about capital
asset pricing model.
We know that if this is how the risky portfolio frontier looks like, if we include a riskfree asset you have some point called the tangent point that is a market portfolio. And
this is your risk-free rate of return and, you can hold any portfolio that will be lying
across this line. And you can make optimal allocation of assets based on this mean
variance optimization given by Markowitz.
So, if you remember we had discussed this approach in detail. And we try to find a
method known as CAPM which is capital asset pricing model that gives us the expected
rate of return for any asset given certain risk-free rate and the return on market asset; and
the beta that we try to understand with the help of optimization of risk and return.
Now so far, these approaches and methods can be applied directly and with much ease to
the traditional investments or traditional avenues of investments. Such as equities, bonds
and other related assets. But when it comes to alternative investments, or the new asset
classes such as real estate, commodities, cryptocurrencies, private equity, venture capital
and other similar asset classes that have emerged because of the new technology and new
areas of investment, we try to understand how this traditional mean variance
optimization to form asset allocation can be modified with the help of new asset classes
to generate higher returns. Remember, the ultimate objective of any individual any
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investor would be or to earn more than a normal return, which is basically outperform
the benchmark and earn substantially higher return than the benchmark return.
With this objective, we try to learn more about alternative investment as investment
strategy and how these alternative investment avenues can be allocated in our portfolios.
(Refer Slide Time: 08:53)
So, to start with, alternative investments can be defined as the new asset classes that fall
outside of traditional investment such as stocks, bonds and cash. Well, here we highlight
new asset classes or many emerging asset classes including private equity, venture
capital, real estate commodities and so on. Because, they fall outside the purview of
traditional asset classes such as equities, which are basically investment in shares, bonds
which are fixed income investments and cash; which are basically no return or almost nil
return investment.
So, when we talk about alternative investment anything else in which an individual or
institution can invest may be called an alternative investment. Because, alternative
investment represents or rather it includes a wide range of offerings. But, limit the
discussion is limited to the various type of major categories that can be used as
investment avenue by the investors. The basic characteristic of alternative investment is
they provide an opportunity to earn a reasonable return with a manageable risk. Because,
remember the ultimate objective of any investor is to earn highest possible return with a
lowest possible risk; or at least, highest possible return for a given level of risk.
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So, even if you try to contextualize this with the traditional approach of asset allocation,
which is mean variance optimization. And subsequently, we derive the capital asset
pricing model. We know that, an investor can earn the highest possible return for a given
level of risk in such a way that can be derived like this.
So, if you have a 2-frontier portfolio case where you have risk and you have return. You
know that, there will be a risky asset frontier. And then you have a risk-free asset which
tan which is tangent from tangent with your risky frontier.
So, this portfolio will give you a frontier where you can invest at any point of time in
along with this particular curve. So, suppose, you want to invest here which gives you
this much amount of risk and this much amount of return. So, you know that for any
given level of return, you have to carry this much amount of risk.
Now similarly, if you have an objective to achieve certain level of risk, you know that
you cannot bear more than that that much of risk. You can figure out how much return
you are going to get. So, for example, suppose this is the maximum level of return risk
you can bear. So, for this level of risk you know that this is the return that you are going
to get.
So, this is why alternative investment also fulfills this objective of earning a reasonable
rate of return; or rather reasonable rate of high return at a manageable risk level for an
investor. Alternative investment also provides a good opportunity to participate in
different markets.
Because, with the help of alternative investments, you cannot only diversify your
portfolio across markets, you can also diversify your portfolio across asset classes and in
fact, across different countries as well. So, here what it provides you with is, you can
invest in assets which have exposure to markets other than your home market.
For example, if you are sitting in India, you can invest in assets as alternative investment
that have exposure to foreign countries or foreign economies. For example, if you invest
in Bitcoin, you know that Bitcoins are affected or the prices of Bitcoin are influenced by
several factors across globe. So, you are actually taking an exposure that have influence
or relevance across the border.
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Similarly, if you invest in alternative investment such as let us say, real estate or private
equity. You have an option to diversify your portfolio across assets and you can not only
invest in equity market, but also invest at the same time in private equity or private debt.
Or similarly, you can also invest in let us say distressed equity or any other asset class
that you would like to hold your investment in.
And finally, the alternative investment approaches provide you strategies or investment
methods that can be made available only to exclusive set of investors. And it is not the
set of assets or it is not typically available for general investing public as is the case with
stock, bond and other investment traditional investment avenues.
So, here alternative investment provides you an opportunity that are very exclusive and
you can invest and take advantage of that particular opportunity.
(Refer Slide Time: 14:59)
Now, let us discuss a bit about different types of alternative investments. So, these are
categorized into 2 broad themes; traditional alternative investments and modern
alternative investment. So, traditional alternative investments are basically Real Estate,
Private Equity and Commodities.
So, when we talk about real estate as an investment avenue; basically, it is the ownership
interest in land or structured build attached to the land. It could be direct ownership or
indirect ownership. So, when we talk about direct ownership in Real Estate, it is
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basically investment in residences, commercial real estate properties and agricultural
land.
It could be industrial it could be other type of land or properties built on land. And if it is
about indirect holding or indirect ownership in real estate, basically it includes REITs
which are real estate investment trusts.
These are investment channels or investment avenues which expose which are exposed
to real estate properties and real estate companies. But they are managed as separate
trusts just like mutual fund. Indirect ownership in real estate could also be a real estate
trust or infrastructure fund such as, funds or mutual funds which have investment in
companies, which are involved in infrastructure development. So basically, the idea of
having real estate as an alternative investment is to take an exposure for your investment
towards real estate or related companies. And it could be direct or indirect ownership.
Second type of traditional alternative investment is Private Equity. Basically, private
equity is the class of investment that has ownership interest in publicly traded
companies. It also includes venture capital firms. So, venture capital by definition are
equity financing or of new or growing companies which are privately held. It could be
closely held companies as well and buyout funds.
So, the buyout funds of established companies through private equity fund is also
possible to be held as alternative investment. So, when we talk about private equity, we
essentially mean that you hold some amount of ownership in a publicly traded company
or privately held company or companies that have ownership stake or that has some
investment as buyout funds.
These are basically more popular because smaller companies or companies which I have
not gone public yet; can raise funds through private equity, and they are considered to be
riskier, of course. But at the same time, there is a very high scope for earning substantial
amount of return in such investment.
Third type of traditional investment in alternative class is Commodities. Although,
commodities are traditionally used as investment and a medium of exchange since the
evolution of human civilization. But, in modern context commodities as an alternative
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investment are basically the agreements to buy or sell a tangible asset or an actual
physical good that is generally or relatively homogeneous in nature.
Basically, it includes 3 categories of commodities. It could be energy-related
commodities such as coal or crude oil, even electricity or power. It could be metal related
commodities such as gold, silver, aluminum, platinum, copper any other such commodity
metals. And third category is agriculture product related commodities; such as coffee
beans, wheat, soya bean and sugar. These are just in not exhaustive list.
They these are just indicative to different examples of 3 type of commodities energy,
metals and agricultural product of agricultural commodities. So basically, if you want to
hold investment directly or indirectly in commodities, you can either directly hold in
terms of buy or sell-off tangible asset or physical goods such as energy, metals or
agricultural product.
An alternative way to hold commodity investment is to invest in commodity related
funds because of free. In recent times, we have seen that there are funds which have
investment exposure in energy as a as an investment class. They also hold precious
metals such as gold, silver, platinum, copper and they also have some investment in
agricultural product; in order to help the companies involved in agricultural produce to
manage their risk.
So, these 3 examples are for traditional alternative investment.
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(Refer Slide Time: 20:46)
Now, let us move on to modern alternative investment. So, modern alternative
investment also consists of 3 broad examples. Basically, these are hedge funds. So,
hedge funds are loosely defined as the investment funds that are regulated to little less
rigorously. And, they are actively managed by expert financial managers and they collate
or compile pooled investment from a different type of investors or different investor
categories, as a special vehicle that uses a wide variety of investment strategies. And
these strategies include aggressive long or short positions and using arbitrage and
leverages.
So, if you talk about hedge fund in little more details, there are certain characteristic or
unique features of hedge funds. And first unique feature is they have very loose
regulation. In most of the markets, hedge funds are less stringently regulated than a
typical mutual fund or any other investment fund.
Just like any other fund it has pooled investments collected from different investors. And
then they can take strategies which are very aggressive typically, and they use arbitrage
and leverage. So, these are some important characteristic of hedge funds. So, when we
invest in hedge funds, we rely on the expertise of hedge fund managers who can take
aggressive positions both long and short. So, when we talk about long and short position,
which means they can either buy into such assets or such investments or they can take a
position of short-selling or holding that is not the in their own hands.
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As investment strategy their focus is always on arbitrage and leverage. Because,
arbitrage gives an them an opportunity to earn more than normal or more than the market
return always. And leverage basically gives them an advantage of using money that have
been borrowed from different sources and use that money to invest in assets which are
going to give them higher rate of return.
Second class of modern alternative investment is, distressed equity. So, by definition,
distressed equity includes securities of companies or government entities that are either
already in default or under bankruptcy product protection or in distress and heading
towards such a condition.
So, basically these are companies or entities that have been defunct or bankrupt or they
are almost on the verge of bankruptcy. So, the idea of any investment manager or
investor to invest in such asset, such as, distressed equity is to make sure that the asset is
worth taking up and the investment that they are going to make might be used for
reviving the company and earning some amount of return, that is substantially higher
than the traditional investment returns.
The most common feature or the most common approach of distressed securities are
bonds and bank debt. They are obviously, very risky because you are investing in almost
dead investment or dead assets, which might not revive. So, if you are investing in
distressed equity you typically rely on the management skill and the potential of the
manager or investment managers.
To be precise, in in order to revive that companies or at least get some return or earn
some return from that investment in distressed equity.
Many times, it might happen that Fund Managers or those who are investing in distressed
equity, they secure some expertise from outside; their fund, and use that management
expertise to revise that company or entities, so that they can generate substantially high
return for their investors.
An alternative approach could be; they buy-out into such distressed equity or entities
which are almost bankrupt or bankrupt already. And then they try to sell out whatever
assets that particular entity or company has. And then, the return is generated sufficiently
to gives exposure to the investors that they have a collector compiled on.
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Third example of alternative modern alternative investment is, managed features. So
basically, these are assets or these are investments which fall into a category that
includes privately pooled investment. They basically invest in cash or a spot or
derivative market for the benefit of their investors. They can take short or long position
in future contracts; and options in future contract in the global commodities, interest rate
derivatives, equity and other currency market.
So basically, when we intend to invest in managed features we want to invest in assets;
which has exposure to derivative market largely. And that derivative market exposure
could be related to commodities or interest rate derivatives, equity derivatives or even
currency derivatives.
(Refer Slide Time: 27:22)
So, these are 3 broad examples of modern alternative investment. Having understood the
traditional and modern alternative investment, basically, we want to know what more
characteristics can be understood in terms of the features or attributes of alternative
investments. So that, we can consider this as a potential tool to invest our money in.
So, the idea here is you have some amount of money to be invested in, and you have a
choice to invest your all your money in traditional investment; such as equities, bonds
and cash. Or you have a choice to invest part of your money in traditional assets and
remaining money in alternative investments such as real estate, commodities, private
equity, venture capital and so on.
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Most of us have some investment exposure to real estate in one way or the other. If we
have some investment in a real estate in the form of let us say second home or any other
house, land or building or any other house properties. It could be considered as part of
investment portfolio.
So, yes, we do have some alternative investment already in our portfolio. The reason or
the characteristic of these 2 separate categories of investment are the difference between
the return that typical alternative investment holds or generates.
So, if you know, typically alternative investment generates substantially high return
because, they are highly risky as well. So, suppose you invest in land or house property
20 years ago at a very reasonable price, today that property has become worth multiple
times your investment, because of several other social, economic and political factors.
So, you have a choice or you have a score for earning substantially high return.
Another feature is, it is also available to very specific set of investors. Not everyone can
invest in all alternative investment avenues. For several reason, including the amount of
money that is required to invest including the regulations and even information
asymmetry. Because, not all investing public might be knowing about the opportunities
to invest in alternate investment fund.
And then there are arbitrage opportunities that are available to investors of alternative
investment fund. So, these are 3 categories or 3 features basically. Because of which
alternative investment funds are more attractive to general investment public. And this is
why people should typically include alternative investment opportunities as part of their
traditional portfolio so that they can outperform the market and most of the other
investing public. In this session this is it.
Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 39
Alternative Investments (Contd.)
Hello there, to continue from the previous session where we were discussing about a different
type of Alternative Investments available for investors in this session we will focus more on
the role of alternative investment as strategic in asset allocation strategies.
(Refer Slide Time: 00:33)
Here we will talk about why investment in alternative assets or alternative investment asset
classes are important for diversifying your portfolio in order to achieve risk and return. So,
earlier we discussed that a traditional investment portfolio is invested on the basis of optimizing
risk and return where, we know that the risk and return could follow a certain trend based on
the portfolio optimization strategy.
In alternative investment as we know the classes of assets that are available for investors are
such that it would not follow a linear or a quadratic sort of a trend where, you will always have
a positive and increasingly growing rate of return with the level of risk. Here the situation might
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be such that in some time for certain amount of risk you will have a return that might move
like this.
On the other hand, you might have a return which will move like this. So, basically which could
be a return that is increasing with the level of risk that you assume a return that might be
growing for certain level of risk and then as you increase your risk level in investment the
return might go down.
And also, it could be a quadratic or exponentially growing such that the more return risk you
take the more return you generate. So, this is why alternative investments as investment avenue
or as the part of your portfolio should be always considered carefully before you actually invest
in.
(Refer Slide Time: 02:35)
Continuing that discussion would like to know more about why, what is the role of alternative
investment in portfolio allocation strategy? We have already discussed about different type of
alternative investments if you recall we discussed about hedge funds as alternative investment
in terms of modern alternative investments. Hedge fund could be Tactical or Even driven or
Relative value hedge funds. These are different type of hedge funds that are available for
investment.
So, when depending on your risk return choice you can invest your money in either of these
hedge funds. So, the ultimate objective is to have investment that will have a risk return
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optimization for any investor. So, the ultimate objective or ultimate criteria should be
optimizing risk and return which is basically, shown in the typical risk return frontier graph.
(Refer Slide Time: 03:10)
Now, based on your risk return you can choose either of these three categories of hedge funds.
There are several other hedge funds for example, but we include three hedge funds here, tactical
which are basically skill set based or the hedge fund that has certain objectives to achieve it
with the objective could be multiplied your return by 100 times or it could be a growing your
investment value to 100 times and so on.
There are hedge funds that will be dependent on certain events for example, if there is some
amount of default happening in banking sector a hedge fund can take a position based on that,
there are relative value hedge funds which has certain investment exposure to an asset which
will have some valuation connected with some other investment portfolio.
So, there are these are hedge funds where investor can invest their money, then second category
of hedge fund is private equity. As we know Private Equity is basically, the investment done
in companies which are publicly held or privately held or companies which have some
exposure to the investment pool available from private equity investors.
It could be in the form of venture capital or buyout capitals. So, venture capital we know that
they are investment channels or investment funds or a pool of investors that invest their money
in typically, privately held forms and they want to invest in privately held forms in order to
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secure certain amount of ownership. So, that when the firm goes public typically, they sell their
ownership and earn substantially high return.
It could be buyout capital as well. Then we have private debt could be in the form of distressed
debt or direct lending to any an existing an enterprise. We have already discussed about Real
Estate where we learnt about a direct or indirect investment in real estate for an investor could
be part of their alternative investment portfolio.
This investment is could be in commercial or residential or as indirect ownership through REIT
and so on, these are our ways of alternative investment in these asset category, there are other
alternative investment that we have already discussed in the form of commodities could be
hard commodities such as, gold silver platinum or agriculture product or could be soft
commodities.
Then we have investment choices in Infrastructure and other alternative asset classes such as,
art and wine these are also another form of investment for people who have substantially a high
amount of money or investable fund. So, they would like to invest in arts various forms of arts
and they also like to make some investment in wine.
Since these are assets where valuation is not very straightforward and simple. So, investing in
these types of assets or alternative investment would always carry a high amount of risk.
Having learnt these, different type of alternative investment we should focus more on the
reasons; why alternative investments should be held?
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(Refer Slide Time: 07:27)
Now, here we list down certain reasons for which investors should or would hold their
investment in alternative asset classes. So, first and foremost objective is to earn or the
possibility of earning above average return on investment because of information asymmetry
or any other reason alternative investment assets provide you an opportunity to earn
substantially higher return.
For example, in real estate or could be in commodities or another example could be investment
in bitcoins. So, these assets provide you an opportunity to earn substantially high return another
feature is it is very less liquid. So, when we talk about liquid essentially, we mean that there is
very less trading or less exchange happening in this these, type of mark asset markets.
And because of which there will be very few people participating in the exchange or trade of
such investments. So, less liquid or low liquidity in these asset classes increases the risk
because we know that the liquidity as we know liquidity is directly related to return and risk.
So, and then we also have another way to know is trading volume.
So, this (refer 07:30) type of relationship have already been established in empirical research
in finance which shows that if the trading volume is high the assets are known or the markets
are known to be highly liquid. And if they are highly liquid the possibility to earn substantially
high return is very low and this is also attributed to low amount of risk.
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But when there is no not much trading volume it implies that the markets are or the asset class
is less liquid that increases the chances of earning substantially high return at very high level
of risk, because for example, suppose you hold some investment in a piece of art now, if that
piece of art is unique you know that there will be very few people who would be interested in
buying that art from you.
So, unless you find an interested buyer who would be willing to pay the price that you would
want you cannot sell that piece of art in market which means there is less trading volume and
hence less liquidity. Now, less liquidity means unless you find a buyer who is interested in
willing interested and willing to pay the price that you want you cannot generate substantially
high amount of return and that is why it is very risky.
So, the moment a market is or an asset class is less liquid it implies that it has substantially
high amount of risk and at the same time in this example of art if you found a person who has
been desperately looking for that particular piece of art and he or she found that art with you
he or she would be willing to pay whatever price you would ask for.
So, in that case the amount of earning substantially high return on that investment is really
high. So, this is what this fewer liquid market in terms of alternative investment feature
provides these, scenario to the investors. At the same time such markets and asset classes also
have lower level of transparency because people in invest and trade at in a very low frequency.
So they do not exchange information and most of the time information is not available, you
must have heard of scams and other frauds related to pieces of art or paintings of famous
painters where, people have been sold the paintings of celebrated painters at a very high price,
but apparently those paintings turned out to be fake or counterfeit.
So, this this is another possibility or a result of lower level of transparency you can exploit
alternative investment class as high leverage potential market because, you have an opportunity
to leverage on the availability of debt and other sources of funds return is very skewed as usual
because you cannot have a symmetric distribution of return.
So, there is non-normally distribution of return associated with alternative investment and when
we talk about non normal distribution, we essentially mean that if this is the mean return of
certain asset the distribution is normal or not normal.
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So, basically the dispersion around both sides of the mean or the average return is not
symmetric it could be a function where, the return might be skew towards one side or it could
be skewed towards other side or it could be a spread for a wider range of dispersion.
Alternative investment market also suffers from data biases because for example, in private
equity markets stale prices could be one reason why investors might lose lot of money; it
originates from biased valuation or the data availability in terms of stale pricing.
Their return distributions have higher moment skewness and kurtosis might be distorted as
explained in these cases where, the return distributions are not normal and hence skewed or
leptokurtic or other similar features. So, these are reasons why alternative investment provide
higher amount of risk, but at the same time it also provides you an opportunity to earn higher
level of return.
(Refer Slide Time: 14:26)
Now, when we talk about a role in asset allocation for these alternative investments, we know
that asset allocation is ultimate and most critical decision for any investment process. It
basically, determines the portfolio return variability because it depending on how you choose
your asset allocation strategy you will generate certain the amount of return.
So, it determines your investment performance also typically, asset allocation is done by
optimizing mean variance if you recall from previous session, we have discussed that how
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mean and variance can be optimized to arrive at the weights allocated to different asset
component in our portfolio.
Here we assume that asset returns are normally distributed if this is not true then the possibility
of asset allocation based on mean variance optimization might also not be true. So, for
traditional assets such as equity and bonds asset allocation using mean variance optimization
might work well, but for alternative investment the strategy of asset allocation using mean
variance optimization might not be working perfectly.
Another factor that we should consider as an important for asset allocation is that investors
with an exposure to alternative investment must choose an appropriate strategic asset allocation
method basically, they should try to avoid generalizing asset classes. So, you cannot consider
equities or bonds or gold or real estate and other asset classes at par because return and
variability is differed across assets and markets.
So, you cannot assume that all asset classes have same distribution of return we have to be very
careful to generalize the asset class properties if you are considering extreme tail events
basically, the extreme tail events indicate the level of distribution of your assets and what is
happening at this type of tail or this type of return.
So, basically you are trying to understand the extreme tail events in this case and if you are
doing so you must be very careful as happens in alternative investment cases such as real estate
boom where, you were sold certain real estate properties with the hope that the property prices
might go really up in future and apparently because of certain regulatory restrictions or any
other reasons the property prices have gone down instead.
You must have come across news where certain real estate developers have been in trouble
because of availability of funds and now the properties are not sold and those who have already
invested in those properties are not getting their investment back.
Similar, case was of cryptocurrency where, in one a couple of years ago the cryptocurrency
market was booming like anything and people have been really bullish about investing in
cryptocurrencies but because of certain regulatory requirements or regulatory restrictions of
late the cryptocurrency market has gone down.
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There are certain other factors are responsible for crypto currency markets, but the point here
is if you are considering extreme tale events as a feature you must be really careful while, you
are trying to use this as asset allocation strategy. And finally, Mean Variance or Modern
Portfolio Theory given by Markowitz these optimization approaches are likely to be totally
inaccurate in case of alternate investment.
In traditional investment in asset classes such as equity bonds and other traditional investments
these approaches such as mean variance optimization or any other higher moment optimization
as well, they work perfectly fine. But here it might not work so well.
(Refer Slide Time: 18:49)
The basic mathematics behind why it might not work well is discussed here. So, we know that
traditionally we try to optimize portfolios based on mean and variance and we considered that
systematic risk factor such as beta might be relevant for traditional asset. So, if you remember
this is CAPM that is Capital Asset Pricing Model which gives us an expected rate of return as
a function of risk-free rate systematic risk and market risk premium.
So, if you recall (rm – rf ) is market risk premium, beta is our systematic risk factor and then rf
is a risk-free rate. So, here the argument is if you invest in asset I you are likely to get a return
that is over and above the return on risk free asset with respect to the beta or risk sensitivity or
since it is a systemic risk factor we multiplied with market risk premium.
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Now, for alternative investment the focus is on alpha which means, you try to outperform the
risk adjusted benchmark. So, alpha implies here that if you are trying to get a return over and
above your risk-free rate that is your excess return. So, excess returns should be a function of
certain systemic risk which is basically, beta market risk premium and then some factor which
gives you an advantage over and above these returns and there must be some error some noise
which you cannot capture.
So, for alternative investment case you may consider some alpha that is basically, a factor that
might outperform a risk adjusted benchmark and these risks adjusted benchmark could be
government bonds or may be market return or any other alternative investment return that you
might consider.
So, here given the factor that strategic risk in asset allocation strategies for alternative
investment could consider on certain factors that might be unique and independent of
traditional asset market so. There are several examples where traditional asset allocation
strategies have been able to generate more than normal return or better returns when they are
mixed with alternative investment or asset classes.
(Refer Slide Time: 21:34)
So, here I have mentioned few examples, of the effect of adding one investment class true
through to a traditional mixed asset portfolio. So, when you add hedge fund to your mixed asset
portfolio which means, you have as explained in the beginning of previous session if you have
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some amount of money in equity some amount of money in debt some you have cash so
remaining investment can be anything now this can be hedge fund.
So, you have a projected portfolio effect which means, the return on such a portfolio. So, this
is your portfolio the return on such a portfolio can be higher than the traditional portfolio if you
mix hedge fund with this portfolio if you add equity portfolio there are substantially high return
as well, if you include REIT which is basically an exposure to Real Estate Investment Trust
this part of your portfolio can be REIT and your return increases as well.
These are empirical evidences from different financial markets in U.S and Europe. You can
also include commodities REITs and treasury inflation protected securities which are also
known as TIPS more popular in Europe and Western markets. It provides you positive
diversification benefits to investor portfolio.
So, if you try to diversify your portfolios in such a way that your risk your equity investment
works well with the given level of risk. Similarly, you can have some investment in bonds or
fixed income portfolio which are basically your investment in assets which have more of fixed
income and then you can keep some amount of cash because cash is important for liquidity.
Then the remaining amount can be invested in any other asset class which has certain amount
of investment in these alternative investment classes. Now I must clarify here that the
proportion of your investment in this example is not necessarily going to be substantially high
as shown in this pie chart you can use this based on your risk bearing capacity and the amount
of money that you have for investment in these assets.
One unique characteristic of these mixed portfolio is basically, holding bonds to substantial
extent. So, this is a mixed portfolio and in these, mixed portfolio we should always hold bonds.
Because bonds provide you cushion for earning a basic level of return.
So, this is why it is important to hold bond we have also seen that emerging market and risk
aversion are negatively correlated. So, in emerging market this might work even better if you
have investment in these, alternative investment.
Now, that we have understood the features and benefits of adding alternative investment as
your portfolio strategy we can move on to discuss, why these are so relevant for people who
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have or who have intention to earn substantially higher return compared to the traditional
portfolio investment.
(Refer Slide Time: 25:48)
So, we know that alternative investments are important for strategic asset allocation, mainly
for institutional investors such as endowment funds or family offices. So, family offices
indicate the those, private companies that manage money for single wealthy family, it could be
pension also or high net worth individuals.
The restriction or the basic assumption is the family or the investment fund or such institutional
investors should have sufficient time horizon and investment capital it cannot work so well
with less amount of money. We should also keep in mind that not all alternative investments
should be equalized which means, you cannot generalize the characteristic of one alternative
investment assets with another alternative investment asset.
It would be inappropriate as substitute for traditional asset classes. So, you cannot have an asset
portfolio where you can substitute equity or bond or cash with alternative investment as
explained in previous example you should always have some cash that is most liquid asset and
a bonds in your portfolio and along with that equity and alternative investment could form
some proportion.
The reason is these are heterogeneous they have unique features and characteristics. So, you
cannot just replace one asset with another asset it also depends on the preferences of individual
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investors typically, alternative investment serves better as complement to achieve the desired
risk return profile and it provides an opportunity to earn superior returns, compared to
Markowitz in 1952 mean variance approach of portfolio optimization.
(Refer Slide Time: 28:00)
So, basically when we talk about the expectation of investors and how alternative investment
fit into their umbrella or their portfolio choices we typically depend on whether we can predict
the trend in alternative investment markets typically, the trends cannot be predicted as
efficiently as we do in traditional asset classes such as equity or bonds.
So, asset since, alternative investment market is very diverse and each of the asset in alternative
investment has unique features. For example, real estate could be one such market where the
financial characteristics or statistical properties of real estate market in one location might be
totally different from that in another location.
So, we cannot just generalize the characteristic of one real estate market or real estate market
in one area with the real estate market in another area. It totally depends on tests of investors
and other macroeconomic features. Similarly, commodities market is also innocent and we
have known it for forever. So, these cannot be generalized there are several other examples
including private equity and venture capital as well.
So, the idea is forecasting traditional asset market and forecasting alternative investment asset
market is a different ballgame. So, whenever we try to understand the role of alternative
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investment in strategic asset allocation, we should treat this issue with a very high amount of
sensitivity towards risk and return preferences of individual investors.
(Refer Slide Time: 30:02)
How we include these assets in our portfolios will be discussed in next lecture, for now this is
it all the references are listed here that is all.
Thank you.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 40
Structured Finance
Hello, welcome back to the course Behavioral and Personal Finance. And for last few weeks
we have been discussing about the concepts and application of finance theory, in the context
of behavioral and personal financial decision making. This week’s discussion is focused on
Structured Finance and alternative investment. We have already discussed about tools and
techniques of alternative investments in the context of individual and retail investors.
Today we will discuss about structured finance as a tool for financial management and decision
making for individuals and household. Structured finance by definition is related to an
emerging field or an interdisciplinary field known as financial engineering.
(Refer Slide Time: 01:07)
Basically, in this session we will talk about an overview of structured finance, such as tools
and techniques belonging to structured finance domain. And we will also touch upon the idea
of securitization of assets in the context of financial engineering industry.
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(Refer Slide Time: 01:26)
Structured finance is defined as the flexible financial engineering tool which is basically aiming
to cater the requirement of the industry for quite some time. Basically, these are techniques that
are employed whenever the requirements of the originator or the owner of the asset is not
fulfilled by the traditional financial tools. For example, if there is an organization or business
entity that requires some amount of money to fund its business activities.
But cannot raise that money from traditional sources of finance such as debt and equity. It will
typically aim to raise that amount of money with the help of structured finance in terms of
financial engineering tools that can be applied and the assets can be used for creating such a
tool for raising funds. Basically, the characteristic of financial engineering tools or structured
finance as a tool to raise finances is focused on funding that is the amount of money required
for financing the business activity.
Liquidity which is basically the ease of buying and selling that particular asset or the tool that
is created on the basis of the value of asset and risk transfer. So, risk transfer the transfer
indicates that the amount of risk that investors are taking is distributed across a wider pool of
assets or vice versa. Where the risk associated with a particular asset or an investment is
distributed across a larger pool of investors.
And it also focuses on tailor made product or services that will fulfill the requirement of funds
for business entities or organizations. Basically, if you have recall there was a time when
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business organizations used to fund their activities by traditional sources of finance; such as
debt and equity.
But as the business organizations and the economic environment becomes complex the
traditional route of raising funds through debt and equity was not sufficient. In that case the
complications arising in terms of the access to a wider pool of investors and the risk mitigation
practices adopted by different industries, in different context, become more important and that
is where financial engineering tools come handy.
In a simple example, financial engineering tool can be by designing an investment product,
where the product has a value that is derived from an underlying asset that is held by some
business organization. Whereas, the investment is taken care of by the mediator or financial
institution that is helping in the process.
And the tool is used to be sold across a wider set of investors. A simpler way to explain this
example would be as follows. Suppose you have to invest certain amount of money and you
have been looking for an investment tool where you can put that saved money that you have
kept aside for investment.
Now, a business organization will have some requirement of fund and that requirement of fund
will be communicated by business entity to the financial institution. So, business entity has
certain amount of money to raise and this amount of money will come from a financial
institution.
Which promises the business entity to give that money in return for the asset or the ownership
of the asset, or claims across over the asset for financial institutions to business entity, and in
return for the money that has been required by the business entity. Now financial institution
can raise that fund which it has promised to pay to business entity from different set of
investors.
So, that money might come from investors of different type and investor would get securitized
investment. So, essentially it is a flow of money from investor to financial institution to
business entity. And this investor would have different type of investor base, let us say pension
fund, mutual fund, retail investor, institutional investor and so on.
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Now all these types of investor would have claims over the assets that have been promised by
the business entity. So, basically business entity will have as the ownership of the asset, but the
ownership will be transferred or given on collateral to financial institution to investors and in
returned for the investor’s money that is coming to business entity through financial institution.
So, in this process of taking the money from investor to business entity.
The financial institution or intermediary will play a significant role in creating assets that will
have customized requirement for business entity, and customized tool of investment for
investors in terms of risk and return combinations. So, for example, here pension fund would
require an investment to be made where the return is assured or less volatile and risk is limited.
Whereas, institutional investor would like to invest in money that might be highly risky, but
also likely to give higher return.
So, financial institutions role here becomes important to create customized asset for investor’s
base also. Where they would create tranches of securities, where some securities will be of high
risk and return combination whereas the other set of securities will be low risk and low return
combination. And in the process financial institution or intermediary would make certain
amount of money to facilitate the business.
So, this is a generic explanation of how structured finance can help businesses to raise funds
depending on their customized need. Where they cannot raise the, that same amount of money
from a generic set of investors or from financial markets or any other traditional sources of
finance.
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(Refer Slide Time: 09:19)
So, continuing the discussion about structured finance, we know that it can be defined through
three key characteristics, as explained earlier. The first characteristic that we have to keep in
mind or we have to identify in terms of structured finance is pooling of asset.
Basically, it is an activity or a mechanism through which assets are pulled together either on
cash based or synthetically created. For example, assets for an infrastructure company can be
pooled together depending on their risk and return profile. And that can be put on for the
investment or similarly of assets can be created by financial institution that is in the business
of giving loans.
So, these loans could be club together or pool together to create a base of asset or pooling of
asset. So, it could be either cash based or synthetically created. Now at the same time the
liabilities have to be tranched in terms of the backing by the asset pool. So, for example, a
financial institution that is in the business of giving education loan or different types of loan
can be clubbing the all the loans that they have given.
And then on the basis of that asset pool they create a liability and these liabilities will be given
different tranches in terms of the differentiation, between the structured finance from traditional
finance or traditional sources of money. And third characteristic is de-linking the credit risk of
the collateral asset pool from the credit risk of the originator.
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As explained in previous example of businesses raising money through financial institutions,
and the money coming from different set of investors, for different unique set of assets.
Basically, the credit risk of collateral asset pool is de linked from the credit risk of the
originator.
Typically, it is done using a finite lived standalone special purpose vehicle. Which is basically
a sort of entity which is created in order to raise this particular set of money and it is created
especially for the purpose. And that is why it is known as special purpose vehicle, where it
serves as an intermediary for raising funds from investors of different types for the benefit of
the originator which is basically the business entity or financial institution.
(Refer Slide Time: 12:10)
Talking about structured finance following are the characteristics that we should understand. It
is basically a complex financial transaction that may involve actual or synthetic transfer of
assets. As explained earlier the ownership of the asset pool created by the originator or the
financial institution. Can be transferred in actual or it can be synthetically transferred by
creating unique assets or unique securitized instruments.
It could be a transfer of risk exposure as well; for example, if financial institutions have created
a pool of assets in terms of loans. That are given to different people they can collect all the
loans together they can create a pool of loans and transfer the risk exposure to other investors.
For example, if there are P number of people in that pool of borrowers that default risk can be
transferred to a pool of investors, who would be betting on their probability of default.
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This is basically aimed at achieving certain accounting regulatory or tax objectives most of the
time it is also created and implemented in order to mitigate the risk or transfer the risk from the
originator to the investors and vice versa.
Another characteristic has relationship with the transaction that is ring fenced in its own special
purpose vehicle. As we said this earlier the amount of money that is raised by business entity,
through financial institutions can directly be raised from financial institutions in return for the
ownership or the exposure of the asset. Or it can be raised through some special purpose vehicle
which is created just for that purpose, where special purpose vehicle will take the ownership
of that asset.
So, assets are given to the special purpose vehicle in terms of ownership or the transfer. And
then investor would be investing that money, through financial institutions or through a special
purpose vehicle which is basically taking the ownership of the asset in directly or it is taking
the risk exposure for the benefit of the investors.
Structured finance can also be a bond issue that is typically asset backed or externally
referenced indexed linked. For example, index related to any currency exchange, foreign
exchange or any other market-based index where the bond issue will be linked or connected
and based on that the risk can be transferred.
It is a combination of interest rate and credit derivative a typical example of derivatives. Where
they try to transfer the interest rate risk and credit risk from the originator to the investor or the
special purpose vehicle to financial institutions or investors and vice versa. Transaction in
structured finance typically is employed by banks or other financial institutions and
corporations as a source of funding.
And in terms of raising capital in favorable terms or trying to manage tax or accounting
regulations, many times the risk management becomes more critical. And that is one of the
major objectives of raising funds through structured finance. It is basically disintermediation
between banks and other corporate entities because banks cannot directly take the ownership
of assets. So, they take the ownership through, a special purpose vehicle and thereby mitigating
the risk or bypassing the risk exposure directly. So, these are basically the characteristic of
business finance structured finance in business context.
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(Refer Slide Time: 16:27)
One of the most common examples of structured finance is securitization of assets, basically
its standardizing the contract between the financier or the originator and the entities that is
raising fund and investors. So, typically securitization is a well-established practice in the
global debt capital markets.
It is also referring to the sale of assets with generate cash flows from the entity that owns them
to another entity that has been specifically set up for this purpose, also known as the special
purpose vehicle. And the issuing of notes or the standard contracts by the second entity.
So, these notes or standard contracts basically these are standard contracts written between the
two parties at and sometimes it is more than two parties also. So, these standard contracts are
basically backed by cash flow from the original asset sold to the second entity, and referred to
as asset backed securities in debt market or mortgage market as well.
So, basically this is about special purpose vehicle helping the business entities to raise funds
from investors and through assets that are backed by certain ownership of assets in the business
organization. Going by the history of securitization typically it was introduced in the very
beginning as a mean of funding for US depository institutions in 1969 since, then it has been
widely used in most of the markets across world. And major reason for the development of the
strong US housing financial market is structured finance through securitization. Subsequently,
its securitization approach is applied to other assets such as credit card payment and auto loan
receivables.
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Nowadays, it has been implemented or to almost each and every type of loan market or debt
market. It is also employed as a part of asset liability management in order to manage balance
sheet risk for financial institutions. So, looking at the securitization as a process of structured
finance for businesses the example can be shown as following, suppose there is a corporate
entity which is into the business of form manufacturing or form equipment manufacturing.
(Refer Slide Time: 19:11)
So, suppose there is a corporate entity or a business organization which is in to form an
equipment manufacturing. So, let us consider this as a company which is into this business.
And this business is basically in the need of funds and it is selling the form equipment to
customers.
So, customers would buy farm equipment, many times farm equipment will be sold on credit.
So, in that case the company makes a loan to the customers, because it is selling the product or
farm equipment on credit. Now since the company is in the manufacturing of farm equipment
it will be in the need of money and funds and that fund can be generated through special purpose
vehicle.
Let us consider this as financial engineering institutions or also known as asset management
trust. So, this farm equipment company will transfer all the loans, so basically it sells customers
loan to financial engineering organization or as asset management trust, and in return they
receive cash for these loans.
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Now this is a simple structure which can be understood with the help of this example. So, the
company is actually selling the product on credit, so it is using lot of money to manufacture the
product and sell it for no cash immediately. And the loan is actually transferred to financial
institutions or financial engineering company or asset management company which in terms of
paying the loan, paying the money in return for those loans.
So, for this company basically loan is asset and the money that they are paying in return for
loan is paid in return for the assets that they are holding. Now, since financial engineering or
asset management company is a in another business organization, they can also raise money
from investors. So, suppose there is another set of investors let us say people like you me and
all so, they have some spare funds and that fund can be invested in different investment
instrument.
So, financial engineering trust or asset management trust will sell securities in return for the
cash or investment. So, basically investor would invest cash in financial engineering or asset
management trust in return for the security, which are basically these securities are basically
backed by the loans which is coming from the farm equipment business.
So, as customers would start paying money this money will start coming to farm equipment
business, this money will be paid back to financial engineering company which will ultimately
pay the money back to the investors in terms of return. So, this is how this structured finance
through securitization process can be implemented in a three-party contract.
Where customers are the beneficiary of the loans that form equipment companies are making,
the loans are sold to financial engineering company. And financial engineering company
creates securities which are sold to investor in return for cash and when customers start paying
from the uses of the asset that money comes back to financial engineering company or asset
management company which will finally, pay that money to investors as a return.
Now, if you look at the scenario here, if this process is not done rightly the flow will breakdown
and there will be a chaos. So, if you imagine a scenario where customers do not pay any cash
so they do not have money and that is why company will default.
Now the moment the company default there will be no flow of cash coming to financial
engineering company, so financial engineering company will not have any cash at all which
means investor would not get any cash and their trust their faith in the asset management trust
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will also be gone. So, they will not like to invest further which means financial engineering
company will not have money to invest in loans that farm equipment company or any other
business entity is making.
So, in that process the company might not have sufficient cash to produce equipment and
thereby there will be shortage of equipment, so ultimately this whole chain might will be
affected. Now a more structured way of looking at this securitization process is to understand
with the help of incorporating more parties to it.
(Refer Slide Time: 26:18)
So, suppose you are the originator of the loan. And you have created an asset pool, so asset
pool is basically created by you for making the investment proposal.
Now you actually go to an issuer which is basically another financial engineering company or
another financial institution and this issuer will take the ownership of that asset pool and. So,
basically this issuer will have the ownership of that particular asset pool and in return for the
cash, so money will be given to the originator.
Now, issuer since it is in SPV which is special purpose vehicle created for this particular
purpose. We will be doing the contract between the parties which is basically the contract that
they have with the originator. So, let us say the contract is a note or piece of paper as a contract
between the issuer and the originator for ownership of the asset pool.
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So, note restructuring will be done, and in the same process credit enhancement will be
implemented because they will need funds to keep the asset liquid. So, issuer will be doing the
credit restructuring in return for the proceeds of sale of nodes.
And in return the issuer will issue securities basically the contract or the standardized contract
issued. Now that restructuring will be done with a purpose of credit tranching. So, tranching is
basically an exercise where different type of assets or different type of investments are created
or categorized according to the different tranches.
So, we will be trans in different categories of assets. Assuming that you have only four different
types of tranches you have class D notes, then you have class C notes, then you have class B
notes and class A notes. Now the unique characteristic of these class A, class B, class C, class
D notes are they are based on risk and return profile, which means some notes are highly risky
with a promise to provide you a high return whereas, some notes are less risky and it is
promising you a less amount of return.
So, basically if you look at the credit rating Class will be AAA rated investment, Class B will
be A rated investment. Class C will BBB related investment and Class D will be B- .
Now that money will flow from Classes to the issuer which is a special purpose vehicle and
then these tranches will be sold to different type of investor based on risk and return. So,
suppose you are an investor who would be willing to assume high amount of high level of risk.
An investor would be investor who is risk seeker, which means he would want to assume more
risk he would be investing in this type of investment which is highly risky. And at the same
time, it will promise a higher rate of return. If there, there are investor who are risk averse they
would invest in, there will be investor who are risk averse they will be investing in assets which
are less risky and they promise relatively lower return.
So, depending on your risk and return you would be investing in either of these notes or
contracts or standardized securities for investment. So, basically this is how a securitization
process happens, and anywhere if the due diligence or the investment procedure that is not
followed properly that might create problem for the entire system and the entire flow of
securitization process might break down.
So, with this I end the session here.
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Thank you very much.
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Behavioral and Personal Finance
Prof. Abhijeet Chandra
Vinod Gupta School of Management
Indian Institute of Technology, Kharagpur
Module – 02
Personal Finance
Lecture – 41
Wealth Management
Hello. Welcome back to this session of Wealth Management for the course Behavioral and
Personal Finance. In past session we have discussed about structured finance and the
instrument of a structured finance for the business and investors. Basically, we discussed
previously the tools and techniques of securitization and the process through which business
organizations raise funds with the help of securitized or financial engineering tools, where
investors can also participate and they can invest in alternative sources of investment avenues.
(Refer Slide Time: 00:49)
This session basically sums up most of the discussions that we have had so, far and to prepares
a summary where you should always consider the factors before you make a financial decision.
So, basically, we will wrap up this session with a discussion on wealth management and also
discuss how taxes can influence our financial decisions and actually influence our finances. So,
here the topics that we are going to discuss about the statement for wealth management and we
will also look at the tax effect on our returns as well as finances.
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(Refer Slide Time: 01:25)
So, when we talk about wealth management, basically we consider in our mind, the money that
we have for investment that money can be of our own or of our client. So, if we are acting as
investment advisor, we would be managing the money on behalf of our clients. And if we are
taking decisions for our self, we will be managing our own money and there by concerned
about the well financial wellbeing of ourselves.
So, to understand the wealth management or personal finance in a whole some picture, we need
to keep in mind the wealth management statement which captures almost every aspect of
financial decision making and wealth management for any investor. And that investor could be
you, me or any other of our clients.
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(Refer Slide Time: 02:32)
So, basically when we talk about wealth management statement, we start with the very
fundamental idea about the profiling of our investment policy statement. So, we try to
understand the investment policy statement in general and we begin with the profiling of our
client. So, if we are managing our own finances, we need to understand what is the profile of
ourselves as investor.
And if we are managing the money for our clients, we need to understand what the clients
profile seems to be. Now a brief client description or the invested description in general would
help us to understand what should be the decision criteria, what should be the goal and what
should be the mechanism to achieve that particular goal. So, in the in order to profile client or
investors description, we also need to understand his or her demographics and other
characteristics. This is where the social and psychological factors actually come into the
picture.
So, when we try to understand client description or in general investor the investors description
if we are ah managing our own money. So, basically, we need to keep in mind the following
things one is sociological issues or sociological factors and demographic factors. So, basically
in demographic factors we need to understand the age, gender, education, income and other
factors that might be responsible for that person’s profile or the investment statement.
And in sociological factors we can see what are the assets and liability that the person holds as
a fraction of the individual or the household asset and liability, what are the cultural
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backgrounds of the individual or the investor, what are the factors that might be responsible for
the behavior of a certain type at the same time we also need to understand the psychology
behind a particular clients profile.
So, psychological issues where we need to understand the profile of the investor and that is
where behavioral finance actually comes into the picture. We have already discussed about
factors that might affect individual’s behavior in terms of economic decision making such as
risk aversion, overconfidence and other factors coming from the research or in psychology and
economic decision making. So, for example, a person of young age with stable income might
be able to take more risk compare to a person who is on the verge of retiring with no immediate
income or stable income and for that person the risk taking will be a very difficult task.
So, we need to understand the demographic sociological and psychological aspects of
individual profiling before we understand the client goals. So, client goals could be defined in
terms of the achievement of goals for short term and long term. For example, the individual
might be interested in earning lot of money in short terms because he will be having more
liabilities to meet.
For example, a young person who has just married will be requiring more money to manage
the household rather than a person who is single or a person who is widow and so, on. So, we
need to understand the client profile accordingly we have to define the client goal. For example,
a young person who might be just entering the job market after graduation would want to go
for another higher degree after few years and that would be his one of the goals to achieve
through financial planning or financial investment.
So, client goals help us define the short term and long term goals in terms of achieving the
financial objectives and then we define the investment objective where we try to understand
the return and risk characteristic of the person whether he or she would like to take more risk
or less risk compare to the general investors or on average investor and based on that return
and risk objective, we can define other factors in terms of where to invest the money and for
how long we can be advising to invest that person.
Now, once we define investment objectives in terms of risk and return, we can move on to
discuss investment constraint. Because every objective should be optimized or achieved with
the help of some objective function, but there might be certain constraint. For example, a person
who is just starting the job might be interested in going for a second degree or a higher degree
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after 2 years. So, the investment horizon after his first job would be only 2 years because in 2
years, he needs to save sufficient amount of money so, that he can go for higher degree after 2
years of job.
Similarly, tax consideration is one of the constraints, some people invest for tax saving some
other people save for some other objectives. So, if individual is saving for tax or investing or
looking for investment avenues for tax consideration that has to be kept in mind, we will discuss
how taxes can influence our finances. Another objective or constraint basically is the liquidity
needs, as we understand the liquidity requirements for different types of investors at different
point of time might be varying and that is why the cash flow management for investor would
become more critical.
So, if you recall we have already discussed about personal balance sheet and cash flow
statement, where you know that the person need to record all the inflows and outflows of cash
from the past as well as the expected cash inflows and cash out flows to understand and relate
it to the balance sheet that he or she would maintain. So, liquidity needs should be defined and
identified as well as properly related to the assets and liabilities as of the individual for which
we are managing the investment.
It goes without saying that legal and regulatory norms have to be followed and the concern
related to legal and regulatory obligations relate of an individual or a household is to be taken
care of when we define the investment objective for our client or for our self.
(Refer Slide Time: 10:31)
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After understanding the investment constraint, we can decide on the asset location strategies.
We have already discussed that there are multiple tools through which we can allocate our
resources and one of the tools is known as an asset allocation strategy with the help of portfolio
optimization.
Where if we have identified a set of assets, where we would like to invest, we can optimize the
weights with the given constraint of returned risk and other constraint as such and then we can
allot the amount of money as optimized in different type of assets. Here we know that strategic
allocation focuses on three aspects first is asset class, second is investment constraint and third
is investment strategy and style.
So, asset class basically explains the asset allocation strategy across class for example you
would like to invest in equity or bonds which are basically fixed income or you want to keep
some amount of cash real estate or any other asset that you would like to invest in. Investment
constraint refers to the margin restrictions basically in each of the asset class when you are
investing or trading you need to maintain certain amount of money or liquidity as well as the
margin in order to meet the transactions and finally, the investment strategies and styles are
determined by the investment advisor in order to achieve the objective of strategic asset
allocation.
Next comes the implementation monitoring and review. Basically, it’s about performance
measurement and rebalancing guidelines. So, after every certain period which is basically
known as review schedule or rebalancing schedule, you need to measure the performance and
see which type of assets are doing well which type of assets are not doing well and accordingly
you rebalance your portfolio.
So, you need to advise your clients or you need to do it for yourself in terms of evaluating the
performance of different investment. For example, if you have invested in equity, bonds and
gold you need to see which market or which investment is doing better and if you want you
can increase your share or share of investment or a proportion of investment in that particular
asset and if certain asset class is not doing well in terms of return and the risk assumed then
you can reduce your exposure to that particular asset class.
So, this rebalancing basically indicates to the changing weights or changing proportion of
investment across different asset classes. In the process you need to understand the risk
management and insurance because there are different types of risk that an individual or an
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investor might be taking. So, most of the risk are covered in strategic asset allocation category
only where you need to consider a risk related to a loss of asset or loss of loss of value of assets
and the risk related to interest rate or market risk or any other risk.
Mainly along with those type of risk you need to consider the longevity, mortality and
unforeseen factors as risk. So, basically the risk of living too long for example, if you have
invested only for 20 years and apparently you start living or you hope happen to live for more
than 40 years, your investment might not be sufficient to support you for that long of life.
Similarly, or the opposite situation is mortality risk where if you invest for 50 years, but
apparently the life of that investor is not so, long. So, then the investment does not matter much.
So, these types of risk need to be considered before we plan for our investments and financial
resources. Along with that there are unforeseen factors such as certain healthcare bills or too
costly illness wills and other planning that we do for our next generation. So, these factors have
to be considered in a wealth management policy statement. Basically, when you are done with
policy statement you need to also see how investment in different assets and different asset
classes are actually doing in terms of financial performance and the risk returned combination
and then we need to also incorporate the taxes that we are likely to pay.
Basically, we have already discussed and understood that taxes affect our decision to large
extent.
And when we have to incorporate taxes in our financial planning, we need to see what is the
impact or the net impact of taxes on our final return that we are getting. So, many times for
investors who are actually investing in a wide class of assets such as equity debt, fixed deposit,
gold, real estate and other markets they will be getting income from different type of assets
investment and these different types of investment would require them to pay taxes at different
rates.
So, this is known as blended tax taxing environment and for this type of environment maybe
we need to take an example here to understand how these this type of environment of blended
tax might actually influence the net return that an investor is making.
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(Refer Slide Time: 16:20)
So, here we have taken a hypothetical example of Miss Sharma, she has a balanced portfolio
of stocks and bonds. And at the beginning of the year her portfolio had a market value of
₹100,000.
So, she had a portfolio of ₹100,000 and by in the beginning of the year and by the end of the
year the portfolio is worth ₹108,000 of value before taxes have been paid. So, before taxes have
been paid the money the value of that portfolio of ₹100,000 would become ₹108,000 and there
have been no contributions or withdrawal during the meantime.
The break off of the income or the growth of that portfolio is basically interest of ₹400
dividends of ₹2000; these are reinvested and during that particular year ₹3600 of realized long
term capital gain have been received by Miss Sharma these proceeds were also reinvested.
So, basically in the beginning of the year you had ₹100,000 of value of your portfolio and it in
at the end of the year you actually have ₹108,000 of value. Now out of this ₹8,000 you have
received ₹4,000 as interest, ₹2,000 as dividend which is basically coming from the stock
investment and ₹3,600 as long-term capital gains which is basically gains arising out of sale of
assets after 1 year.
So, suppose you buy a land or a piece of property in year 0 and you sell it after 1 year which is
basically in year 2 or year 3 and the gain that you have made out of this transaction is known
as long-term capital gains. We have already discussed about the basics of long term and short-
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term capital gains. So, this long-term capital gain is ₹3600. So, remaining if you see there is a
total gain that have been explicitly mentioned is ₹400 + ₹2000 + ₹3600.
So, basically ₹6000 of explicit gain and then remaining ₹2000 of unrealized gain is actually
included in the investment value of ₹108,000.
Now, the question here is what percentage of Misses Sharma’s return is in the form of interest
dividend, realized capital gains and unrealized or deferred capital gains? To understand this in
a very systematic way we can simply do a basic calculation.
(Refer Slide Time: 19:42)
We know that the value of portfolio is as on day 0 is ₹100,000 value of portfolio at the end of
period is ₹108,000 which means there is net gain of ₹8,000 on that investment.
So, the gain that is realized and unrealized on that portfolio is ₹8,000 out of which interest is
₹400, dividend is ₹2,000, long term capital gain realized is ₹3,600 and deferred capital gain is
₹2,000. Now the question is what is what proportion of these gains are basically are coming
for Misses Sharma? So, we know that ₹400 as a fraction of ₹8,000 of total gain which is 0.05.
Similarly, ₹2,000 as a fraction of ₹8,000 of total gain which is 0.25, ₹3,600 as a fraction of
total gain of ₹8,000 which is 0.45 and similarly ₹2,000 of gain on deferred capital gains as a
fraction of ₹8,000 of total gain which is 0.25.
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So, as total gain stands out to be ₹8,000, 5% is coming from investment in bonds, 25% is
coming from investment in equity, 45% is coming from long term capital gains realized and
25% is coming from capital gain deferred.
So, this is how the breakup of gains have been mentioned. Now this unrealized gain is actually
coming as a function of total gains coming from. So, let us say ₹8,000 - ₹400 of interest ₹2,000 of dividend - ₹3,600 of capital gain and this is actually giving us the gain that is deferred
of ₹2,000 of value.
Now, this is simple we know that we can find the breakup of total gain from coming out of
different investment and based on that we can decide. So, basically the implication for any
investor is to know the contribution of each investment in the total gain and if you analyze it
for period after period that is for year after year, you can see that for certain year you are getting
more income or more proportion of total income from one type of asset or the other type of
asset and based on that, you can decide whether to continue in that investment avenue or
increase or decrease the proportion.
(Refer Slide Time: 23:50)
A related example would be of the same situation where the lady has the same a ₹108,000 of
portfolio value out of which ₹400 is coming from interest, ₹2,000 from dividend and, ₹3,600
from long term realized capital gains. Now the question is what is the annual return after
realized taxes and assuming tax rate taxes are paid out of the investment account what is the
balance at the end of the year.
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Now, to explain this example, we need to find the annual return after realized taxes
(Refer Slide Time: 24:39)
So, we know that from ₹100,000 the asset has become the investment portfolio has become
₹108,000.
𝑟𝑒𝑡𝑢𝑟𝑛 =
108000 − 100000
× 100 = 8%
100000
Now the taxes are to be paid on different type of investment.
So, return with revise structured that is after paying taxes is
𝑟 ∗ = 𝑟(1 − 𝑃𝑖 𝑡𝑖 − 𝑃𝑑 𝑡𝑑 − 𝑃𝐶𝐺 𝑡𝐶𝐺 )
Here unrealized assets or unrealized gains which is basically 2000 rupees not taxed because
you have not realized it. So, you will not be taxed on that income.
Putting values in the formula
𝑟 ∗ = 8%(1 − (0.05 × 0.10) − (0.25 × 0) − (0.45 × 0.15) = 7.42%
So, ultimately you were earning 8 percent of return, but actually after paying tax you are having
only 7.42 percent of return. Now if you try to understand the tax implication after paying the
tax. So, you know that you have to pay taxes on income.
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So, total taxes you need to pay is 580 you had a balance of 108,000 out of which you paid out
580 rupees of tax. So, at the end of the first year your balance is 107,420. So, this is your net
balance in the account where you have kept all the investment portfolio. This is how we can
calculate the effect of taxes in a blended tax environment where your investment is distributed
across different assets and you can actually see if that net tax after tax in return that we are
making is competitive enough or reasonably good for your investment objectives.
(Refer Slide Time: 30:29)
A similar example we can take in a different context where the tax loss harvesting can be
understood. So, suppose that there is one person who has one million of portfolio held in a
taxable account the end of that 20-tax year is approaching and that person realize that ₹100,000
worth of capital gain is due. Now his portfolio has security that have experienced ₹60,000 of
loss. So, of this ₹100,000 of capital gains ₹60,000 has been considered as losses and this has
these securities have not been sold. So, their losses are unrecognized.
So, unrecognized or unrealized losses will not be considered for taxation purposes. So, he has
a choice to sell all these securities and replace them with similar securities where they can earn
identical return, capital gain tax is 20%. Now if we assume that there is no further transaction
how much tax does Mohit owe for this particular year? So, if we know that there is no
transaction the tax that Mohit will be earning or sorry Mohit will be owing is considered to be.
So, ₹100,000 of capital gains into 20% of tax which is basically ₹20,000.
500
So, ₹ 20,000 of money will be accruing as tax liability for Mohit. Second scenario says if Mohit
sells those security how much money or how much tax will be owing to the authorities? So, if
Mohit sells the securities then in that case (₹100,000 of capital gains) - (tax loss harvesting of
60,000) basically the loss on account of sale of assets. So, if he sale the assets or securities and
adjust for ₹60,000 of losses his net gain will be ₹40,000 on which he has to pay 20% of tax.
So, his tax liability will be only ₹8,000. So, thereby though third point says that if Mohit does.
So, how much money will Mohit save? So, basically savings will be (₹20,000 of tax if he did
not choose to sale those security) – (8,000 of tax if he sold those security). So, tax saving will
be ₹12,000 for that particular year.
So, this is how you can actually identify and recognize the losses on securities that you are
holding, sell those assets do the tax loss harvesting and save some amount of money in the
process. This is meant for managing your wealth in a more suitable way. Now having
understood all these things to conclude this session I would like to make certain observation
so, far that we have understood the behavioral finance and behavioral economic concept in
financial decision making.
We try to understand with the help of different examples and illustrations as well as some
theoretical explanation of different finance and economic theories that how financial decision
making can lead us to secure a better financial future and manage our resources and finances
in a better way.
(Refer Slide Time: 34:28)
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So, ultimately the lesson that will be given at the end of the session is to ensure that as an
investor you need to have one objective. And that objective should be maximizing your
investment performance basically that is the objective of any investor.
So, maximize your investor investment performance in terms of financial performance of the
investment that you have met and performance can be maximized. So, basically performance
maximization if it is one of the objectives that can be achieved through two approaches or two
or tools and these tools are you need to stop making silly mistakes. So, for example, do not put
your money in assets, which are going down or do not keep the assets that are losing value and
thereby make some silly mistakes.
So, basically try to reduce the silly mistakes and at the same time get some cool ideas which
are coming from different sources readings and other resources that you can refer to. So, get
cool ideas and these two things will be clubbed together to help you achieve your performance
in a better way.
So, with this I conclude this session as well as the course that we have been discussing for past
8 weeks. We hope that you have learnt or listen or too. And try to implement this in the financial
management and the planning of finance resources for yourself as well as your client. If you
have any and try to achieve the financial objectives and have a better financially secured future.
Thank you very much.
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