Key Principles of

Behavioral
Finance
Jawwad Siddiqui, CSC
Research Assistant, The Finkelstein Group

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Table Of Contents

Prospect Theory & Loss-Aversion

Anchoring
Mental Accounting
Confirmation & Hindsight Bias
Gamblers Fallacy
Herd Behaviour
Overconfidence
Overreaction & Availability Bias

Introduction

2
Behavioral Finance

What is it?
Study that seeks to combine psychology,
sociology, and traditional finance.
Helps explain why people make irrational
financial decision
Source: Yale University

Why is it important?
It is necessary because technical analysis assumes that people
act rationally

Introduction

2
History of Behavioral Finance

Over last 40 years, standard finance has

been the dominant theory
Academic Finance emphasized theories
such as modern portfolio theory and the
efficient market hypothesis

These theories failed to explain 2008

crash, dot com bubble etc.

Source: Yale University

Only recently, evolving and of increasing importance field of neuroscience

has also won appreciation from the finance industry.
Works of Kahneman (Nobel Prize Winner) is considered most creditworthy

Anomalies

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Anomalies

Regular occurring anomalies is a big factor that contributed to the formation of

behavioral finance.
January Effect: Financial security
prices rise in the month of January.
Winners Curse: a tendency for the
winning bid in an auction that
exceed the intrinsic value of item
purchased.
Equity Premium Puzzle: Equity
returns less bond returns have
Source: The Economist

been roughly 6% for the past

century.

Key Concepts

6
Prospect Theory and Loss-Aversion

Investor decision weights tend to overweigh small probabilities and underweigh moderate and high probabilities.
Basing decisions on perceived gains rather than perceived losses.
Example
Option 1

Guaranteed Profit of $5,000

Option 2

80% chance of gaining $7,000

20% chance of gaining $0

Question: Which option would give the best chance to maximize your profits?

Correct Answer Option 2

If investors are faced with possibility of losing money, they often take riskier
decisions aimed at loss aversion.

Key Concepts

4
Anchoring

Using irrelevant info as a reference for evaluation.

For example, assuming decline in a stock price is only temporary.
Example

Source: Thinking Fast & Slow

Thus, investors tends to focus on messages content rather than its relevance
when making financial decisions.

Key Concepts

4
Mental Accounting

Dividing current and future assets in separate portions.

Results in different level of utility of each portion

provokes bias and other behaviors.

Examples
Option 1

Would you drive 20 min to save $5 on a

$15 calculator?

Option 2

Would you drive 20 min to save $5 on a

$125 jacket?

Question: What option will you choose?

This theory helps explain irrational financial behavior. For example, why you
bought so many calculators on sale when you only needed one.

Key Concepts

4
Confirmation & Hindsight Bias

Confirmation Bias having preconceived opinion which serves as self-fulfilling

prophecies.
Hindsight Bias believing that past event was predictable and obvious
Examples

Investors will be overly

optimistic and overvalue their
talents when sharing stories.
Investors will put greater

weight on their knowledge

than it should have.

Key Concepts

5
Gamblers Fallacy

Lack of understanding resulting in incorrect assumptions and predictions about

the onset of events.

E.g investors viewing further declines and improbable.

Examples

Investors After all those losses, I am due to WIN!

Parents already have three daughters but are overly optimistic that their next
child will be a male.
Entrepreneurs I have failed so many times, success is around the corner.

Key Concepts

5
Herd Behaviour

We are programmed to feel that the consensus view must be the correct one
Imitating behavior and actions of others.
Examples

Health Choices Eating habits of the western

world, smoking of groups etc.
From US Housing Bubble, Dot Com Crash in
2001and the Credit Crisis of 2008.

Source: The Economist

Key Concepts

5
Overconfidence

Being overconfident in your stock-picking ability

Results in increased number of trades
Examples

Investors - I know exactly how to evaluate stocks.

Thus, I dont need a second opinion.
Entrepreneurs despite knowing the statistics, they
strongly believe their chance of failing is zero

Key Concepts

Overreaction and Availability Bias

Overreaction - Investors overreact to news and create larger than appropriate

effect on a security price

Availability our thinking is strongly influenced by what is personally most
relevant, recent or dramatic.
Examples

Investors weighing their financial decision on most

recent news.
Lottery Winners buy it because they recall memory
of people who won.

Conclusion

Closing Comments

Being consciously aware of these biases or irrational behaviour will allow us to

better make investment decisions
Practise critical thinking and study your thought process during investment

decision making
Allows you to provide better investment recommendations to your clients
Suggested Reading

Book: Thinking Fast and Slow

By: Daniel Kahneman
(Noble Prize Winner in Economics)

Thank-You.
Questions?
Jawwad Siddiqui, CSC
Research Assistant, The Finkelstein Group