Introduction to Behavioural Finance

-Introduction, Evolution, difference

between traditional finance and
Behavioural Finance (BF),
Characteristics
 Investment Decision
Fundamental Analysis Technical Analysis
 Traditional Finance
• Investors are rational.
– Expected Utility Theory
• Utility (Psychological Value)
• Wealth (Current state)
• Rational Choice Model
– CAPM
– Markowitz Model
– MM Theorem
Utility
Markowitz Model
What is the most difficult task in the
life as far as choices are concerned?
 Introduction

• Behavioural Finance- Investors are

normal/irrational.
– Why does investor make decision?
– How does investor make decision?
– How does investor compose portfolio?
– How he perceives the investment choices?
Relating TF with BF
 Psycho-social Theories
• Maslaw’s Need Hierarchy Theory (1943)
 Psycho-social Theories
• Transtheoretical Model of Behavioural Change
• Prochaska (1979)
– Pre-contemplation (no intention to change behavior),
– Contemplation (aware of problem but not committed
to changing behavior),
– Preparation (intending to change within a month),
– Action (changing the problem behavior by employing
a variety of strategies), and
– Maintenance (working to prevent relapse).
 Psycho-social Theories
• Human Ecological Model
• Bronfrenbrenner (1979)describes individuals as
dynamic factors that often influence and are
influenced by interaction with and within larger
and interdependent systems.

– The microsystem
– The mesosystem,
– The exosystem,
– The macro system
 Psycho-social Theories
• Goal Setting Theory (Edwin Locke, 1960)
• Goal setting is essentially linked to the task
performance.
• Not only specific goals and challenging goals
along with the appropriate feedback can
contribute to higher and better task
performance.
• SMART
Evolution of Behavioural Finance
Behavioural Finance
 Background
• Behaviour finance was considered first by the
psychologist Daniel Kahneman and economist
Vernon Smith, who were awarded the Nobel
Prize in Economics in 2002.
• This was the time when financial economist
started to believe that the investor behaves
irrationally. Human brains process information
using shortcuts and emotional filters even in
investment decisions
 Meaning
• Linter (1998) has defined behavioural finance as
being study of how human interprets and act on
information to make informed investment decisions.

• Olsen R. (1998) asserts that behavioural finance seeks

to understand and predict systematic financial market
implications of psychological decision process.

• “Behavioural Finance is the study of how psychology

affects financial decision making and financial
markets” (Shefrin, 2001)
 Introduction
Traditional Finance Behavioural Finance

People process data appropriately and
correctly.
People view all decisions based on risk and
return.
People are guided by reasons and logic.
Markets are efficient.
People employ imperfect rules of thumb
(heuristics) to process data which includes
biases in their beliefs may lead them to
commit errors.
Perceptions of risk and return are
significantly influenced by how they are
framed.
Emotions and herd heuristics play an
important role in influencing decisions.
There is a discrepancy in market prices and
fundamental value.
 Traditional Finance Perspectives on
Individual Behavior
• Expected Utility Theory –Maximization of
utility (Bernoulli, 1738, 1954)
• Assumptionsions
– Completeness
– Transitivity
– Independence
 Behavioural Finance Perspectives on
Individual Behaviour
• Challenges to Rational Economic Man
– Human Behaviour depends upon feelings
– Inner conflicts- Prioritizing aspirations (Family
financial management system)
– Do we really have perfect information – Bounded
rationality
 Why Psychology matters?
• Choose following?
A. A 50 % chance of winning Rs. 1000 (the
Gamble), or
B. A sure gain of Rs. 500 (the sure gain)
 Why Psychology matters?
• Choose following?
A. A 50 % chance of winning Rs. 1000 (the
Gamble), or
B. A sure gain of Rs. 500 (the sure gain)
Most of us go for (B )
- We think of ourselves as conservative
- So, why Gamble?
 Why Psychology Matters?
• Now, choose between the following:
• A. A 50 % chance of loosing Rs. 1000
• B. A sure loss of Rs. 500 (the sure thing)
 Why Psychology Matters?
• Now, choose between the following:
• A. A 50 % chance of loosing Rs. 1000
• B. A sure loss of Rs. 500 (the sure thing)
• Most of us prefer to go for (A)
- Because we hate taking losses
- God forbid, we may turn lucky?
- Then, Why not to Gamble?
 Two Building Blocks of BF

Behavioural Finance

Limits to Arbitrage
Cognitive Psychology
(When market will be
(How people think?)
inefficient?
 Investor’s Psychology
• Investors often do not participate in all assets
and security categories
• Individual investors loss-averse behaviour.
• Investors always sees past performance as an
indicator of future performance
• Investors trade too aggresively
 Market Psychology
• Meaning
– Greed
– Fear
– Expectations
– Circumstances and events
 Theoretical Background
• Applications of BF,
• Overview of theoretical framework
 Background
• Neoclassical economics makes some
fundamental assumptions about people:
• 1. People have rational preferences across
possible outcomes or states of nature.
• 2. People maximize utility and firms maximize
profits.
• 3. People make independent decisions based
on all relevant information.
 Issues with Expected Utility Theory
• People have irrational tendency to be less
willing to gamble with profits than with losses
(Prospect Theory)
• People use shortcuts instead of calculating all
possible options (Heuristics)
 Prospect Theory
• Kaenman & Tversky (1979)
• People do not always make rational decisions
because they value gains and losses
differently.
• Centered around loss aversion
Prospect Theory
 Prospect Theory
• People sometimes exhibit risk aversion and
sometimes risk seeking, depending on the nature of
the prospect.
• Decision (i): Choose between P1(Rs. 240) and
P2(.25, Rs. 1000)
• Decision (ii): Choose between P3(-Rs. 750) and
P4(.75, -Rs. 1000)
 Prospect Theory
• People’s valuations of prospects depend on gains
and losses relative to a reference point.
• Decision (i): Assume yourself richer by Rs. 300, than
you are today, than,
Choose P5(Rs. 100) and P6(.50, Rs. 200)
• Decision (ii): Assume yourself richer by Rs. 500,
than you are today, than,
• Choose between P7(-Rs. 100) and P8(.50, -Rs. 200)
 Fourfold pattern of risk attitudes
Examples Gains
High 95% chance to win $10,000 or
probability 100% chance to obtain $9,499. So,
(certainty 95% × $10,000 = $9,500 > $9,499.
effect) Fear of disappointment. Risk
averse.
Accept unfavorable settlement of
100% chance to obtain $9,499
Low 5% chance to win $10,000 or
probability 100% chance to obtain $501. So,
(possibility 5% × $10,000 = $500 < $501.
effect) Hope of large gain. Risk seeking.
Rejects favorable settlement,
chooses 5% chance to win
$10,000
Losses
95% chance to lose $10,000 or
100% chance to lose $9,499.
So, 95% × −$10,000 = −$9,500 <
−$9,499. Hope to avoid loss. Risk
seeking.
Rejects favorable settlement, chooses
95% chance to lose $10,000
5% chance to lose $10,000 or
100% chance to lose $501. So, 5% ×
−$10,000 = −$500 > −$501. Fear of
large loss. Risk averse.
Accept unfavorable settlement of
100% chance to lose $501
 Characteristics of BF
• 1. Heuristics
• 2. Framing
• 3. Emotions
• 4. Market Impact
 Framing (Survival Frame)
• There are two programs to battle a Corona
Disease
1. In Program A, 200 people will be saved.
2. In Program B, there is a 1/3 probability that
600 people will be saved, and 2/3 probability
that none will be saved.
Which one you prefer?
 Framing (Survival Frame)
• There are two programs to battle a Corona
Disease
1. In Program A, 200 people will be saved.
2. In Program B, there is a 1/3 probability that
600 people will be saved, and 2/3 probability
that none will be saved.

Risk averse in gain scenario

 Framing (Mortality Frame)
• There are two programs to battle a Corona
Disease
1. In Program C, 400 people will die.
2. In Program D, there is a 1/3 probability that
no one will die, and 2/3 probability that 600
will die.
Which one you prefer?
 Framing (Mortality Frame)
• There are two programs to battle a Corona
Disease
1. In Program C, 400 people will die.
2. In Program D, there is a 1/3 probability that
no one will die, and 2/3 probability that 600
will die.
Risk seeking when facing potential loss
Expected Utility
 Allais Paradox

89 % chances to live for 12 years

100 % chance for living 12 years 10% chance of living 18 years
1% chance of sudden death
A B

11 % chance for living 12 years 10% chance for living 18 years

89 % chance of sudden death 90% chances for sudden death
C D
Allais Paradox
 Why Individuals behave irrationally?
• Mental Accounting
• Over confidence
• Home Bias
• Regret
• Herd Behaviour
• Representativeness
• Availability Bias
 Mental Accounting
• Rational expectation hypothesis money is fungible that
means Re.1 is exactly equals to any Re.1, but,
• Situation 1. Suppose you have paid Rs. 100 for ticket of
theatre to see a play but after reaching at theatre you
have noticed that the ticket have been lost. Would you
pay another Rs. 100 to see play? Yes or No?
• Situation 2. Suppose you are on the way to see a play
but you have not purchase a ticket of theatre in
advance. On arriving at the theatre you have come to
know that you have lost Rs. 100 cash in that case would
you buy a ticket to see a play? Yes or No?
 Mental Accounting
• Suppose, an investor holding 2000 shares
each of two stocks X and Y and both the share
is currently trading at market price of Rs.10
per share. X company’s stock was purchased
at Rs.5 and the Y at Rs.13.
 Representativeness
• Investors often try to detect patterns in data which is
random number.
• Investors extrapolate past returns which actually follow
randomness.
• Investors may be drawn to MFs with good track record
because such funds are believed to be representative
of well –performing funds.They forget that
evenunskilled manager can earn higher return by
chance.60
• Investors are overly optimistic about past winners.
• Good companies -good stock syndrome.
 Application BF
• 1. Investors
• 2. Corporations
• 3. Markets
• 4. Regulators
• 5. Educations
Biases
Behavioral Biases
 Confirmation Bias
• Confirmation bias is the tendency to search
for, interpret, favour, and recall information
that confirms or supports one's prior beliefs or
values.
• It is the most common and we even don’t
know we are committing it.
• Cheery-pick information
• Examples
 Optimism Bias
• Optimism bias (or the optimistic bias) is a
cognitive bias that causes someone to believe
that they themselves are less likely to
experience a negative event. It is also known
as unrealistic optimism or comparative
optimism.
• For eg. Bad investments can not happen to
them.
 Loss Aversion Bias
• Loss aversion refers to people's tendency to
prefer avoiding losses to acquiring equivalent
gains.
• Loss aversion is a cognitive bias that suggests
that for individuals the pain of losing is
psychologically twice as powerful as the
pleasure of gaining.
 Self-attribution Bias
• It refers to individuals' tendency to attribute
successes to personal skills and failures to
factors beyond their control. ... less) strongly
that skills drive their performance.
– Self- enhancing bias
– Self-protecting bias
 Choice Paralysis Bias
• Choice Paralysis occurs when investors experience information
overload. Choice Paralysis delays any potential value growth.
 Endowment Bias
• The endowment effect refers to an emotional
bias that causes individuals to value an owned
object higher, often irrationally, than its
market value
 Sunk Cost Bias
• The Sunk Cost bias is a mental shortcut that would force an
individual to continue investing his or her time, money,
emotion in a losing activity because of their earlier
investments.
• Investors often refuse to sell their stocks at a loss as they had
already invested so much money and time with that stock.
 Anchoring Bias
• Anchoring bias is the tendency to rely too
heavily on, or anchor to, a past reference or
one piece of information when making a
decision.
 Information Bias
• Information bias is the tendency to evaluate
information even when it is useless in
understanding a problem or issue.
• The key in investing is to see the wood from
the trees and to carefully evaluate information
that is relevant to making a more informed
investment decision and to discard (and
hopefully ignore) irrelevant information.
 Availability Bias
• According to Availability bias, people tend to base their
decisions more on recent information rather than any detailed
study of past events and thereby become biased to that latest
news.
 Familiarity Bias
• Familiarity bias is the preference of the individuals to remain
confined to what is familiar to them.
• They wish to remain within their comfort zone and do not want to
take the path never taken. Humans have a tendency to believe
more in the choice that they recognise and are aware of.
Unfamiliarity makes them uncomfortable and unsure.
• Familiarity bias is an inclination or prejudice that alters an
individuals’ perception of risk. The phrase familiarity has been
described as to denote “a degree of knowledge or experience a
person has respect to a task or object”(Gigerenger and Todd, 1999)
• Familiarity is a mental short-cut that treats the familiar things as
better than less familiar things.
 Representativeness Bias
• Representativeness bias is a belief perseverance bias in
which people tend to classify new information based on
past experiences and classifications. They believe their
classifications are appropriate and place undue weight on
them.
• This bias occurs because people attempting to derive
meaning from their experiences tend to classify objects and
thoughts into personalized categories.
• When confronted with new information, they use those
categories even if the new information does not necessarily
fit. They rely on a best-fit approximation to determine
which category should provide a frame of reference from
which to understand the new information.
 Representativeness Bias
• When evaluating investment managers, FMPs
may place undue emphasis on high returns
during a one-, two-, or three-year period,
ignoring the base probability of such a return
occurring.
• Update beliefs using simple classifications rather
than deal with the mental stress of updating
beliefs given complex data. This issue relates to
an underlying difficulty (cognitive cost) in
properly processing new information.
 Illusion of control bias
• Illusion of control bias is a bias in which people tend
to believe that they can control or influence
outcomes when, in fact, they cannot.
• Langer defines the illusion of control bias as the
“expectancy of a personal success probability
inappropriately higher than the objective
probability would warrant.”
• Langer finds that choices, task familiarity,
competition, and active involvement can all inflate
confidence and generate such illusions.
 Illusion of control bias
• Trade more than is prudent.
• Lead investors to inadequately diversify
portfolios.
 Cognitive Dissonance Bias
• When newly acquired information conflicts with
pre existing understandings, people often
experience mental discomfort—a psychological
phenomenon known as cognitive dissonance.
Cognitions, in psychology, represent attitudes,
emotions, beliefs, or values; and cognitive
dissonance is a state of imbalance that occurs
when contradictory cognitions intersect.
 Disposition Effect
• The disposition effect refers to the pattern that
people avoid realizing paper losses and seek to
realize paper gains. The disposition effect
manifests itself in lots of small gains being
realized, and few small losses.
• Regret aversion and pride seeking behaviour can
cause investors to be predisposed to selling
winners too early and riding losers too long.
• This is referred as Disposition effect.
 Cognitive Dissonance Bias- Effect
• This can cause investors to hold losing securities
positions
• This can cause investors to continue to invest in
a security that they already own after it has
gone down
• This can cause investors to get caught up in
herds of behaviour;
• This can cause investors to believe “it's different
this time.”
 Disposition Effect
• 1985 paper in the Journal of Finance, Shefrin and
Statman investigated the disposition that investors
have to holding on to losing positions longer than
winning positions.
• The disposition effect is an anomaly discovered in
behavioural finance. It relates to the tendency of
investors to sell assets that have increased in value,
while keeping assets that have dropped in value.
• This became known as the disposition effect.
Investors dislike the losses more than the gain that
they get.
 Disposition Effect
• “This stock has really shot up so I better sell
now and realize the gain?” Or, can you
imagine yourself thinking, “I have lost a lot of
money on this stock already, but I can’t sell it
now because it has to turn around some day?”
The tendency to sell winners and hold losers is
called the disposition effect.
 Disposition Effect
• Disposition effect is one of the most robust
regularities documented in trading behaviour.
• It imposes substantial costs on investors.
• First, Disposition investors pay more capital
gain taxes than necessary.
• Second, focusing on the purchase price may
interfere with rational forward looking
decision making and may result in inferior
performance.
 Implications of Disposition Effect
• Trade Volume
• Asset Pricing
• Welfare Cost
 Limited Attention
• According to this bias, investors tend to consider
only stocks that come to their attention through
websites, financial media, friends and family, or
other sources outside of their own research.
• For example, if a certain biotech stock gains FDA
approval for a blockbuster drug, the move to the
upside could be magnified because the reported
news catches the eye of investors.
• Smaller news about the same stock may cause very
little market reaction because it doesn't reach the
media.
 Weber Law
• Weber’s Law says the “just noticeable”
difference in something is proportional to how
big the original thing was.
• Charm Pricing (number 9)
• Price Anchoring
• Using precise Pricing (odd numbers or
decimals)
 Subjective Probability
• Subjective probability refers to the probability of
something happening based on an individual’s own
experience or personal judgment.
• A subjective probability is not based on market data
or historical information and differs from person to
person. In other words, it is created from the
opinion of an individual and is not based on fact.
• subjective probability does not base its probability
on quantitative information, is affected by personal
beliefs, and contains no formal calculations.
 Subjective Probability
• A study finds that people seem to believe that
they know themselves better than their peers
know themselves and that their social group
knows and understands other social groups
better than other social groups know them
Thank you,,
 Investment Decision Cycle:
- Weber Law,
- Subjective Probability
- Representativeness
- Anchoring
- Asymmetric Perceptions
-Exponential Discounting
- Human Economic Behaviour and
Discount Factors
-Hyperbolic discounting
 Disposition Effect
• The disposition effect refers to the pattern that
people avoid realizing paper losses and seek to
realize paper gains. The disposition effect
manifests itself in lots of small gains being
realized, and few small losses.
• Regret aversion and pride seeking behaviour can
cause investors to be predisposed to selling
winners too early and riding losers too long.
• This is referred as Disposition effect.
 Cognitive Dissonance Bias- Effect
• This can cause investors to hold losing securities
positions
• This can cause investors to continue to invest in
a security that they already own after it has
gone down
• This can cause investors to get caught up in
herds of behaviour;
• This can cause investors to believe “it's different
this time.”
 Disposition Effect
• 1985 paper in the Journal of Finance, Shefrin and
Statman investigated the disposition that investors
have to holding on to losing positions longer than
winning positions.
• The disposition effect is an anomaly discovered in
behavioural finance. It relates to the tendency of
investors to sell assets that have increased in value,
while keeping assets that have dropped in value.
• This became known as the disposition effect.
Investors dislike the losses more than the gain that
they get.
 Disposition Effect
• “This stock has really shot up so I better sell
now and realize the gain?” Or, can you
imagine yourself thinking, “I have lost a lot of
money on this stock already, but I can’t sell it
now because it has to turn around some day?”
The tendency to sell winners and hold losers is
called the disposition effect.
 Disposition Effect
• Disposition effect is one of the most robust
regularities documented in trading behaviour.
• It imposes substantial costs on investors.
• First, Disposition investors pay more capital
gain taxes than necessary.
• Second, focusing on the purchase price may
interfere with rational forward looking
decision making and may result in inferior
performance.
 Implications of Disposition Effect
• Trade Volume
• Asset Pricing
• Welfare Cost
 Limited Attention
• According to this bias, investors tend to consider
only stocks that come to their attention through
websites, financial media, friends and family, or
other sources outside of their own research.
• For example, if a certain biotech stock gains FDA
approval for a blockbuster drug, the move to the
upside could be magnified because the reported
news catches the eye of investors.
• Smaller news about the same stock may cause very
little market reaction because it doesn't reach the
media.
 Weber Law
• Weber’s Law says the “just noticeable”
difference in something is proportional to how
big the original thing was.
• Charm Pricing (number 9)
• Price Anchoring
• Using precise Pricing (odd numbers or
decimals)
 Subjective Probability
• Subjective probability refers to the probability of
something happening based on an individual’s own
experience or personal judgment.
• A subjective probability is not based on market data
or historical information and differs from person to
person. In other words, it is created from the
opinion of an individual and is not based on fact.
• Subjective probability does not base its probability
on quantitative information, is affected by personal
beliefs, and contains no formal calculations.
 Subjective Probability
• A study finds that people seem to believe that
they know themselves better than their peers
know themselves and that their social group
knows and understands other social groups
better than other social groups know them
 Investment Decision Cycle
• Collect the data
• Develop the financial goals
• Identify the risk appetite
• Develop the investment alternatives
• Evaluate the investment alternatives
• Create and implement the portfolio
• Review the performance
 Collect the data
1. Calculate your income
2. Determine your bills for essentials
3. Note down your total debts
4. Determine your bills for non essential
5. Calculate your saving
SMART GOALS
Check Mate!!!!!!
 Check Mate!!!!!!

18,446,744,073,709,551,615
 Diversification

Between the asset classes

&
Within the asset classes
Mental Accounting and Financial
Needs
 Basis of Diversification

Risk/ return involved in the Asset/

investment
Risk appetite of the investor
Time horizon
Tax consideration
Personal Circumstances
Understanding of the investor
 Evaluate the investmentt alternatives
Investment Objectives and Constraints
• Investment Objectives
– Income
– Growth
– Stability
• Constraints
– Liquidity
– Investment Horizon
– Taxes
– Regulations
– Unique circumstances
Exponential Discounting
 Exponential Discounting
• Traditional Finance assumes exponential
discounting.
• It is a time consistent model of discounting,
implying that the constant discount rate is
assumed across time.
• It means that valuation falls by a constant
factor per unit of delay, irrespective of the
total length of the delay.
Exponential Discounting
 Hyperbolic Discounting
• The valuation falls very rapidly for small delay
periods, but then falls slowly for longer delay
periods.

• In economics, hyperbolic discounting is a time-

inconsistent model of delay discounting.
 Hyperbolic Discounting
• Hyperbolic discounting is a person’s desire for an
immediate reward rather than a higher-value, delayed
reward.
• This is a incorrect application of DCF.
• This is driven by temporal myopia.
• If someone were to offer you the choice between Rs.
50 right now or Rs. 100 tomorrow, the latter would
seem the clear choice. But, as the delay gap widens,
the importance of the extra Rs. 50 quickly diminishes
for most people, despite the fact that its actual value is
constant.
• But, the pattern follows a hyperbola, so once a certain
time threshold is crossed, the devaluing effect of time
diminishes.
 Difference between ED and HD
• A rational actor will discount future rewards at an
exponential rate, as illustrated by the present value
formula most investors will recognize:
• P.V. = F___
(1+r) t
• Hyperbolic discounting is a fancy way of saying
that people discount the near future more than
the distant future. Hyperbolic Discounting

• PV= F___
(1+r * t)
Let’s assume we’re determining the present value of an asset
with cash flows of $100 per year for 10 years. We’ll stick with an
8% discount rate.
Imagine you’re given 2 choices. Get a
$100 today or $120 in a week.
But when the same question is asked with the same 1
week interval, but a year in the future, we largely
choose the bigger reward.
 Crux
• We are impatient-and prefer immediate
rewards in the short term. But we’re more
patient and wait for better rewards in the long
term.

• It shows preference for immediate

gratification.
 Applications
1. Make a limited-time offer
• The lesson: Urgency sells. Communicate to your
prospects that right now is the time to purchase
whatever you’re selling. A headline as simple as “Last
Chance: Order Today for Free Shipping” is enough to
activate the drive for immediacy.
2. Create a point system

• Entice your prospects by

offering points for every
item they purchase. Due
to hyperbolic
discounting, most people
prefer the reward of
points today over the
reward of more money in
their bank accounts in
the future.
 3. Offer free shipping for orders over
X Rupees
• You select the items you want, head to checkout,
and realize that you’ve fallen just short of the
order size required to qualify for free shipping.
 4. Allow prospects to delay payment
• Hyperbolic discounting tells us that someone
is more likely to convert if she’s allowed to
delay payment. The reward of not paying
today outweighs the reward of not having to
pay at some point down the line.
 5. Offer multiple pricing options
• weekly plan can cough up either $15/week for
30 minutes or $48/week for 120 minutes.
6. Let prospects try your product at home
• Instant gratification with free trials
Implications
 Overcoming Hyperbolic Discounting
• 1 . Empathize with your future self
• 2. Pre-commitment
• 3. Break down big goals into small
manageable chunks
 Economics of Decision Making
• Expected Utility Theory (Normative Approach)
• Expected Utility Theory (VNT Approach)
• Decision making under risk and uncertainty
 Expected Utility Theory
• Expected Utility Theory –Maximization of
utility
• Assumptionsions
– Completeness
– Transitivity
– Independence
 Expected Utility Theory (EUT)
• Neoclassical Economics
• Individual as self-interested agents who:
– Attempt to optimize the choices and options to their
best ability in the face of constraints on resources.
– Determine value/ price of an asset subject to the
influence of supply and demand.
– Underlying assumptions:
• People have rational preferences across possible of nature.
• Economic agents maximize utility.
• People make independent decisions based on relevant
information.
 Economics of Decision Making - EUT
• Neoclassical Economics
• Three states of rational preferences:
– Once choice is strictly and always preferred (>) to
another.
– Two choices are valued the same, indicating
indifference (≈) between choices.
– The person has weak preference (≥), that is unsure of
strict preference of indifference.
• People’s preferences are complete:
– All possible choices compared before preferences or
indifferences
• Transitivity exists
– When confronted with a choice among three
outcomes, x,y,z; where x>y, and y> z, then x> z.
 Economics of Decision Making - EUT
• Neoclassical Economics
• Utility maximization
– Used to describe preferences, denoted as u(*) as the
utility function;
– Utility as the satisfaction received from particular
outcome.
– For eg. u(1 cup coffee+ one plate Idli) > u(1 cup tea +
one plate upma)
• In financial decision making (making a choice
between)
– Spending more now and save less for future
– Spending less now and saving more for future
 Economics of Decision Making - EUT
• Neoclassical Economics
• Quantifying Utility
– Utility is the function that is expressed as a logarithmic
function
 Economics of Decision Making - EUT
• Relevant Information
– People maximizing their utility use full information
of the choice set
– Information available to all economic agents, but
for free?
– There is a cost also,
• Assimilating and understanding the information
• Bounded rationality (Simon, 1957)
 Economics of Decision Making
Decision making under Risk and Uncertainty
• John von Neumann & Oskar Morgenstern (vNM) attempted to
define rational behaviour when people face uncertainty.
• Normative Theory: How people should rationally behave
• Behavioral Theory: Considering how people actually behave?
• EUT set up to deal a with risk, not uncertainty
– Risky situation: Outcome(s) are known and we can assign a probability
to each outcome
– Uncertainty: Not sure about the list of all possible outcomes,
 Economics of Decision Making-
Decision making under Risk

• EUT: Risk Attitude and Decision making

• Certainty Equivalent and Decision making
 Decision making under risk
• EUT: Decision making under risk
• For a given prospect P1(0.40, Rs. 10,00,000), the u (P1) =
3.4069
• For another prospect,
P2(0.50, Rs. 1,00,000, Rs. 10,00,000), the utility u(P2) = 3.4539
 Decision making under risk
• Risk attitude and decision making
• Under the logarithmic utility function, an individual prefers
the individual prefers the expected value of a prospect to the
prospect, itself
• For P1, expected wealth E(w) = 0.40 (5,00,000) + 0.60
(10,00,000) = Rs. 6,20,000 and u[E(w)] = ln (6,20,000) = 4.1271
• The expected utility of the prospect u(P1) = 3.4069
• For Risk averse person: The expected value of the prospect
certainty more preferred than actually taking a gamble on the
uncertain outcome.
• u[E(w)] > u(P1)
 Decision making under risk
• Certainty Equivalent
– Wealth level at which the decision maker is
indifferent between a risky and a certain choices.
– u[e(P)] = u(P)
– For eg: at least at which price you should sell the
lottery that you own has following choices?
– Win Rs. 1,00,000 (50% probability)
– Lose Rs. 10 (50% probability)
– (A) Rs. 50, (B) Rs. 100. (C) Rs. 500 (D) Rs. 1000
 Herbert Simon and Bounded
Rationality
• There is deviation from full rationality to
bounded rationality, introduced by Herbert
Simon in 1955
• Bounded rationality means that individuals
have biases and cognitive limitations which
prevent them from realizing full rationality at
the time of decision making.
• It assumes that individuals do not make fully
optimal decisions because of cognitive
limitations or information gathering costs.
 Herbert Simon and Bounded
Rationality
• Simon proposed that human are limited in their
rationality due to at least three factors as follows”
– Rationality requires complete knowledge and
understanding of the consequences of given action.
– It is difficult for decision makers to fully evaluate the
future worth of their decisions.
– Rationality requires that alternative actions are
known, but actual decision making processes , very
few alternatives are known.
Herbert Simon and Bounded Rationality
• Simon created Bounded Rationality model to
explain why limits exists and how rational decision
makers actually works in a decision making
environment.
• Assumptions:
– Managers select the very first alternative which is
satisfactory.
– Managers recognize that their conception of the world is
simple.
– Managers are comfortable making decisions without
determining all the alternatives
– Managers take decisions by rule of thumb or heuristics.
 Herbert Simon and Bounded
Rationality
• This theory is preferred to call as “satisficing”, a
combination of words, “satisfy” and “suffice”.
• Simon argued that these people do not seek to
maximize their benefits from a particular course
of actions
• Due to information and cognitive limitations,
people seek something that is “good enough” or
satisfactory.
• Illustrations: Shopping or ITC and TCS share
 EMH
Arbitrage
Limits to Arbitrage
Types of Arbitrageurs
Informed Trading
Noise Traders and Noise Trading
 Why we need to learn EMH?
• Among all possible reasons….
• Is share price in the market reflect value of the company?
• How can we take advantage of trading shares?
• What of trading strategy should we use?
• Efficient in which part?
– Business efficient?
– Operational efficiency?
– Information efficient?
• How fast the share price in the market reflect the new
information?
• Hw reliable is the market price in reflecting the situation of
the company?
 Market Efficiency
• The price of the all security reflects all the
information available about that security.

• “You can’t beat the market.”

 Market Efficiency
• The time lag when the information is available
to the time it is reflected in the price.
• Impact of new information

• Active strategy is costlier than passive

strategy.
 Why market is not efficient
• No. of market participants
• Availability of information
• Limits to trading (Arbitrage/ Short selling)
• Transaction cost and other cost associated
with trading and analysis
 Market Efficiency
• An efficient market is one where the market price is
an unbiased estimate of the true value of the
investment.
– Market efficiency does not require that the market price
be equal to true value at every point in time.
– The fact that the deviations from true value are random
implies, in a rough sense, that there is an equal chance
that stocks are under or over valued at any point in time,
and that these deviations are uncorrelated with any
observable variable.
– If the deviations of market price from true value are
random, it follows that no group of investors should be
able to consistently find under or over valued stocks
using any investment strategy.
 Implication of Market Efficiency
• In an efficient market, equity research and
valuation would be a costly task that provided no
benefits.
• In an efficient market, a strategy of randomly
diversifying across stocks or indexing to the
market, carrying little or no information cost and
minimal execution costs, would be superior to
any other strategy.
• In an efficient market, a strategy of minimizing
trading,
Forms of Market Efficiency
 Theoretical Foundations of the
Efficient Market Hypothesis
• Investor Rationality
• Independent Deviation from Rationality
• Effective Arbitrage
 EMH Questions
EMH BF

Is market price reflect value of the Yes Yes/NO

company?

How can we take advantage of trading No Private

shares? information

What kind of trading strategy should we use Buy and Seek for
Hold abnormal
return
 Theoretical Challenges to EMH
• Investors Irrationality
– Attitude towards risk
– Sensitivity to decision makers
• Correlated investor Behavior
• Limits to Arbitrage
 Human Fallacies & Key Anamolies
March (1994) identified four human fallacies:
• (i)Limited attention
• (ii)Faulty memory
• (iii)Limited comprehension capacities
• (iv)Limited communication capacities
Thaler (1999)identified most commonly seen anomalies as
under:
• (i)Volume
• (ii)Volatility
• (iii)Cash Dividends
• (iv)The Equity Premium Puzzle
• (v)Predictability
 Behavioural EMH
• The price-equals to value market hypothesis
• The Hard to beat Market Hypothesis
 Arbitrage
• Concept
• Arbitrageur
• Types
– Uninformed Arbitrageur
– Informed Arbitrageur
• Informed Trading
– Fundamental Traders
– Technical Traders
– High Frequency Traders
 Limits to Arbitrage
• Concept
– Fundamental Risk
– Noise Traders Risk
– Horizon Risk
– Implementation cost
• Noise Traders
 Glamour Anomaly
• Glamour Anomaly means when investors
assume that value (high book-to-market)
investment strategies yield superior returns
relative to glamour (low book-to-market)
strategies. But actually the return advantage
of value investing strategies reflects the
compensation for bearing risk.
Thank you
 Behavioural Factors and Financial
Markets:
-Asset Management & Behavioural
Factors
-Implications of Heuristic Biases on
Portfolio Management
-Fundamental , Technical and
Behavioural Factors
 Types of Investors
• According to market..
– Regular investors
– Only savers
– Seasonal traders
– Angel Investors
– Business Investors
– Risk-taker investors
 Type of Investors
• Based on Risk
– Risk Averse
– Risk Neutral
– Risk Seeker/ Lover
 Types of Decisions makers/Investors
• Based on personality type (MBTI)
– A theory developed by Carl Jung (1923)
– Extroversion/Introversion: The extraversion/intro-
version set of preferences defines how people are
energized.
– Sensing/Intuitive: Sensing and intuitive preferences
describe the process that people rely on to gather
information.
– Thinking/Feeling: Thinking and feeling preferences
describe how people make decisions.
– Judging/Perceiving: Judging and perceiving
preferences describe lifestyle orientations.
 Portrait of an individual investor
• 1. Perception of price movement
• 2. Perception of value
• 3. Managing risk and return
• 4. Trading practices
• 5. Indian investors tend to lose in stock market
 What heuristics and Biases mean for Financial
Decision Making
• Familiarity
– Home country bias
– Bias towards employer brand
• Representativeness
– Good companies ..good investments
– Chasing winners
– Availability
 Implication of overconfidence in Financial
Decision Making

• Overconfidence leads to excessive trading.

• Overconfidence causes investors to have
under diversified portfolio.
– Financially sophisticated people,
– those who are traded most, and
– people who are sensitive towards price trends
• Analyst tend to be overly optimistic about the
prospects of the company they follow.
 Influence of Emotions on FDM
• Investor mood and market mood
• Hope and fear
• Regret and Pride
• Emotional Time Line
• Greed, Ambition and Status seeking
• Happiness and Sadness
• Anger
• Self control
 Influence of Emotions on FDM
• Mood: Emotional state of investors when they decide on their
investment.
– Application: Mood and risk Attitude

• Hope and fear: Hope is a positive emotion in anticipation of

reward (pleasant),
– Application: high return with low risk
– Application: Past return and hope & fear

• Fear: Fear is a unpleasant, often strong negative emotion, of

anticipation or awareness of danger.
– Dot.com bubble and internet boom, zoom app.
 Influence of Emotions on FDM
• Regret and Pride: Regret is a negative, unpleasant cognitive
emotion. Pride is a positive, pleasant cognitive emotion.
– Application: Mood and risk Attitude

• Greed: It is an irresistible urge to possess more and more,

than the individual actually needs. This may be viewed as a
reflection of ambition and status seeking.
– Application: Scams
 Influence of Emotions on FDM
• Happiness, Sadness and Disgust:
– Gains and enjoyment provides happiness- promotes delayed
gratification, increased savings, and reduced risk aversion.
– Losses and helplessness leads to sadness – causes greater impatience,
high risk aversion, and heightened sensitivity to losses
– Proximity to distasteful objects or ideas causes disgust.
• Anger: A negative unpleasant emotion arising in response to a
threat
• Self Control: It refers to a situation where a person
experiences conflict because he thinks that he should take
one decision, but emotionally he is thinking of taking different
decision.
 Behavioral Portfolio
• Introduced by Hersh Shefrin and Meir Statman, is
a goal based theory
• Five determining factors:
– Investor goal
– Reference points
– Shape of the utility function
– Degree of inside information
– Degree of aversion to realization of losses
Pyramids of Spending Sources and
Spending uses
Behavioral Portfolio Theory
 Behavioral Portfolio
• Five factors determining the pyramids of Behavioral Portfolio
– Investor goals
– Reference points
– Shape of the utility function
– Degree of inside information
– Degree of aversion to realization of losses
Behavioral Portfolio
Options
Commercial
Property
Stocks

Bonds
Residential
Property
Cash
 Behavioral Life Cycle Theory
Stage Consumption Pattern

Single

Married w/o children

Married with children

Married with dependent

young children
Older Married without
dependent young children
Older Single / Married

Retirees
Life Cycle Hypothesis of Savings
 Life Cycle Hypothesis of Savings
Objective Need Proposed Financial Behavior
Stage 1- To protect Protection against risks of Setting up of emergency fund or to
yourself and your unexpected circumstances and the purchase adequate amount of insurance
family risk related to life, disability,
health etc.
Stage 2- To provide To provide financial security to Providing an adequate financial security
for financial security extended family members, without placing undue stress on your
for yourself and your fulfilling the needs for education, resources to cause financial crises,
family social events, or fulfilling other emphasis on proper credit & debt
needs management

Stage 3- To enjoy the To accumulate the wealth for Budgeting financial security for
comfortable standard secured retirement retirement,
of living
State 4- To be Being financially independent Enjoying the return made during the
financially and have comfortable retirement, stage 1 and stage 2
independent, with the same standard of living

Stage 5- To distribute To distribute the wealth to the Following up the strategy of estate
the wealth beneficiaries or next generation planning
 Behavioral Life Cycle Theory

• This theory says that we reconcile conflicts

between our desire to spend and the need to
save by framing, mental accounting self-
control rules.
• This theory is developed by Thaler and Shefrin
(1981)
 Standard Lifecycle Theory and
Behavioral Lifecycle Theory
Standard Lifecycle Theory Behavioral Lifecycle Theory
The sole reason for saving is utilitarian We save for deriving the range of
needs. utilitarian, expressive and emotional
benefits of wealth.
We want to smoothen our spending
during life cycle
We estimate accurately our lifecycle Not all the people accumulate the median
wealth, which is the present value of our wealth.
current income, current capital and future
income.
We do not require any tools for help in It states that we reconcile the conflict
resolving conflict between between our desire to spend and need to
save by framing, mental accounting, and
self-control rules.
 Behavioural Life Cycle Theory
• Thaler and Shefrin (1981) developed a theory of self control which
suggests that individuals have personality traits to be either a
planner who is concerned with lifetime utility or a doer who is
focused on the present.

• Later, they proposed the behavioral life cycle hypothesis (Shefrin &
Thaler, 1988) suggesting that individuals practice mental
accounting, meaning that they have different propensities to save in
different categories of accounts.

• For example, they may think differently about funds in a retirement

account than those in a cash reserve for emergencies. Thus, this
theoretical framework suggests that individuals might be long- or
short-term planners and that they plan to use money in different
accounts for different purposes.
Thank you
 External Factors and Investor
Behaviour:
-Mechanism of External Factors, Risk
attitudes, and connection to Human
Psychology
-Misattribution
- Demographics and Dynamics
- Social forces
 External Factors and Investor Behaviour

Personal financial needs

Affordable minimum investment amount
Safety associated with investment
Ease of obtaining borrowed fund/ Availablity of funds
Preferred investment time horizon
Liquidity associated with investment
Availing the benefit of income tax deduction
Expected return on investment
 External Factors and Investor Behaviour
Advocate recommendation
Friends and Relatives
Family members
Present Investors

Operational feedback
Rating agencies’ report
Advisor/brokers/ analyst’s recommendation
Conversation/exchanges of views with Professional colleagues
Conversations/exchanges of views with company executives
and sector experts
 External Factors and Investor Behaviour
Economic and regulatory environment
Current economic indicators
Statements from politicians and Government officials
Contribution of firm towards social causes
Political party affiliation

Neutral Information
Recent price movements of the funds
Fluctuation and development in the capital market
Information from Government officials and & politicians
Economic indicators
Inflation
Social Responsibility
External Factors and Investor Behaviour

Overall group performance

Result of technical analysis
Result of fundamental analysis
Company’s position in the industry
Parent/sister company’s position in the industry

Factor 7: Credit features

Diversification needs
Minimizing risk
 External Factors and Investor Behaviour
Personal inclination
Perceived ethics of a company
Feeling for company's products/services

Demographic Factors
Age
Gender
Marital Status
Educational Qualification
Income
Occupation
 External Factors influencing the Stock
Markets
• Internal Developments
• World events
• Interest rates
• Exchange Rates
• Hype
• Inflaction and Deflation
• Foreign markets
• Economic growth
• Confidence and expectations
• Related markets
• Prices of crucial commodities
 Social Forces
• Reciprocation
• Social Proof
• Liking
• Obedience to Authority
 Brain Secretions and Investor
Behaviour
• Role of Dopamine and its implications in
investment decisions
• Role of Serotonin and its implication in
investment decision
Behavioural Corporate Finance

Lecture 10-11
 Crux of BCF
• AGENTS-
• Managers are the agents of the shareholders

• Rational Irrational
(owned)
(Supposed to be rationale, Theories,)
 Rational Managers with Irrational
Investors
• Managers’ goal (To maximize profit of the
company and wealth of the SHs)
• Balancing Three objectives
• Maximize Fundamental Value (Existing and
Potential)
• Maximize Current Market Value
• Market timings
 How to cater the mispricing
• Choosing investment projects or financing
packages
• so that the market prices > IV
• Fundamentally strong
• 1 accept the project which has smaller PBP
• 2. to invest in the companies project for which
current demand is there
• 3. Dot.com
 Capital Budgeting Decisions
• Discounted Methods
– NPV
– IRR
• Non-discounted Methods
– PBP
– ARR
– PI
 Behavioral Corporate Finance and
Capital Budgeting Decisions
• Biases
– Payback Period, IRR and NPV
– Affect heuristics
– Overconfidence
– Excessive Optimism
• Perceived Control
• Familiarity and Representativeness
• Desirability and wishful thinking
• Anchoring and adjustments
• Confirmation Bias
– Reluctance to terminate losing project
Informational Asymmetry and Capital
Budgeting
• Background
– Firms often ration capital and do not invest in all
projects that have positive NPV.
– Divisible

– Cant be Divisible
– A lot of attention is paid to the extent to which
the decisions are centralized
– Mix of financing is very important
 Informational Asymmetry and Capital
Budgeting
1. Information asymmetry between shareholders and
bondholders
• Equity shareholders – more risky projects
2. Information asymmetry between current
shareholders and prospective shareholders
– Preference for the projects with a shorter payback
period
– A greater degree of capital rationing
– Centralization of capital budgeting
 Informational Asymmetry and Capital
Budgeting
3. Information asymmetry between Managers
and Shareholders
– Visibility Bias
– Resolution Preference
– Mimicry and Avoidance

•
 Capital Structure and Behavioural
Finance
• Over and under capitalization
• MV 280 > BV 100 (Overcapitalized)
• MV 100 < BV 280 (Undercapitalizded))

• Issue of capital (Raising of fund)

• Perspectives towards future trend
• Perspective towards buy back
• Perspective towards issue of equity shares
 Dividend Policy and Behaviorual
Finance
• MM Approach
• Why company pays dividend
– Self control and dividend
– Aversion to regret and dividend
• You want buy a mobile phone of worth Rs. 16000
– Receive the dividend (16000) and buy the phone
– Sell the shares and buy mobile phone
– Information signaling
– Clientele Effect
– Agency Cost
 M&A and Behavioural Finance
• Understand the philosophy of the SHs
• Promoter’s feeling and emotions
• Motives of acquirer or target company
• Study of all uncontrollable factors
• Political envt. Cultural , demographich
• Thank you
Lecture 9-13-12
 Personality Traits and Risk Attitudes in
different domains
• Passive Managers – Believe that markets are efficient but they
cannot beat the market
• Active Mangers – Believe that right market strategies can lead
to outperform the portfolio.
• Bailard, Biehl and Kaiser five-way model
– Passive Investors: Those who have earned money by taking lesser risk or
take risk on someone else’s money.
– Active Investors: Who have earned money in their life times and then
taken risk on their capital for wealth creation.
Bailard, Biehl and Kaiser five-way model
 Bailard, Biehl and Kaiser five-way model
• Five Personality of investors
• Adventurers –
• They are confident about their skills and believe that don’t require
any advise. They are high risk takers and volatile in their actions.
• Adventurers generally go for only big bets. They have the resources
to do so and are willing to take risks.
• The investment made by this type of investors are generally
focused and not diversified.
• Celebrities – Celebrities are those who want to make good money
but they really don’t have ideas of their own.
• This category is the worst hit by Herd bias.
• They are the easiest target and victims of the volatile stock markets.
 Bailard, Biehl and Kaiser five-way model
• Five Personality of investors
• Individualists – They are confident and careful. They generally do
not go to a consultant to manage their investments but do it by
themselves.
• They make good money because of being confident about their
strategies and analytical skills.
• Guardians – Guardians are both anxious and careful. Lacking in
themselves, they approach investment counsels.
• They generally emphasize on safety of the capital while making the
investments and a significant proportion of their investments is
generally devoted to government securities and guaranteed return
investments.
• They are Risk averse
Bailard, Biehl and Kaiser five-way model

• The Straight arrows –

• These are the most balanced as these are halfway between
complete confidence and anxiety and extreme carefulness
and impetuousness.
• They are confident on their strategies and take balanced risk
for their portfolio.
Bailard, Biehl and Kaiser five-way model

Personality Dominant Trait Attitudes towards Prone to Behavioral

Risk Bias
The Adventurer Volatility, Over Risk Takers Over confidence
confidence Bias
The Celebrity Advised by Agents, Take Calculated Risk Herd Bias
Follow the latest
investment Fad
The Individualist Carefulness, Low Risk Takers Hindsight Bias
Confident
The Guardians Depend on reliable Highly risk averse Mental Accounting
information Bias
The Straight Arrow Most balanced and Risk Likers Status Quo Bias
Active investors
 Big Five Model
• Neuretic Personality
• Extrovert Personality
• Agreeable Personality
• Conscientious Personality
• Open to Experience Personality
 Big Five Personality Model
• Neurotic Personality
– Such investors are emotionally unstable
characterized by anxiety, anger, depression, and
have intense reactions.
– They get stressed easily, and hence they are
unlikely to trade excessively.
– They are prone to loss aversion bias.
 Big Five Personality Model
• Extrovert Personality
– They are of full of energy and positive emotions
– They are confident, assertive and action oriented
– They trust easily to others and hence they prone
to heuristic bias
• Agreeable Personality
– They are friendly, considerate and go with the
people very well
– They follow the concepts of behavioral finance
and still explains the standard finance
 Big Five Personality Model
• Conscientious Personality
– Conscientious refers to the degree to which a person
is organized, systematic, punctual, achievement
oriented and dependable.
– They have strong need for achievement and are
impulsive and perfectionist by nature
– They are strongly affected by status quo bias as they
perceive the changes in investment envt. But miss to
give a timely decision.
• Open to experience Personality
– They are creative and imaginative
– They are not resistance to change and sensitive to
new experimentation
 Big Five Personality Model
• Open to experience Personality
– They are creative and imaginative
– They are not resistance to change and sensitive to
new experimentation
– Openness is the degree to which a person is
curious, original, intellectual, creative, and open
to new ideas.
 Proximal and Ultimate Mechanism
Framework
• A proximate cause is an event which is closest to, or
immediately responsible for causing, some observed
result. This exists in contrast to a higher-level ultimate
cause (or distal cause) which is usually thought of as
the "real" reason something occurred.
• Example: Why did the ship sink?
– Proximate cause: Because it was holed beneath the
waterline, water entered the hole and the ship became
denser than the water which supported it, so it could not
stay afloat.
– Ultimate cause: Because the ship hit a rock which tore
open the hole in the ship's hull.
• How and Why
• Driver of “Car A” runs a red light and hits “Car
B,” which had a green light, causing injury to
the driver of Car B. Driver of Car A had a duty
to not run the red light, and, assuming no
extenuating circumstances that excused
running the red light, his actions in doing so
directly (and therefore, proximately) caused
injuries to the driver of Car B.
• Driver of “Car A” runs a red light, and “Car B”
which has a green light, swerves to avoid being
hit. The driver of Car B is fuming and nervous,
with a racing pulse. Upset, the driver of Car B
continues driving, and three blocks later, hits a
parked car, injuring himself.
• The driver of Car B can try and claim that the
actions of the driver of Car A caused him to get
hurt when he hit the parked car. And it may well
be a remote cause; but it is probably not the
proximate cause.
Antonio Damasio and Somatic Markers

• According to Damasio (1994, 1999), somatic

markers are emotional reactions with a strong
somatic component that support decision
making, including rational decision making.
These reactions are based upon the
individual's previous experiences with similar
situations.
Antonio Damasio and Somatic Markers

• In economic theory, human decision-making is

often modelled as being devoid of emotions,
involving only logical reasoning based on cost-
benefits calculations.
• In contrast, the somatic marker hypothesis
proposes that emotions play a critical role in
the ability to make fast, rational decisions in
complex and uncertain situations
Antonio Damasio and Somatic Markers

• When individuals make decisions, they must

assess the incentive value of the choices
available to them, using cognitive and
emotional processes. When the individuals
face complex and conflicting choices, they
may be unable to decide using only cognitive
processes, which may become overloaded.
Emotions, consequently, are hypothesized to
guide decision-making.
Antonio Damasio and Somatic Markers

• Emotions, as defined by Damasio, are changes in both

body and brain states in response to stimuli.
Physiological changes (such as muscle tone, heart rate,
facial expression and so forth) occur in the body and
are relayed to the brain where they are transformed
into an emotion that tells the individual something
about the stimulus that they have encountered.
• Over time, emotions and their corresponding bodily
changes, which are called "somatic markers", become
associated with particular situations and their past
outcomes.
 Antonio Damasio and Somatic Markers
• According to the hypothesis, two distinct pathways reactivate
somatic marker responses.
• In the first pathway, emotion can be evoked by changes in the
body that are projected to the brain – called the "body loop". For
instance, encountering a feared object like a snake may initiate the
fight-or-flight response and cause fear.
• In the second pathway, cognitive representations of the emotions
(imagining an unpleasant situation "as-if" you were in that
particular situation) can be activated in the brain without being
directly elicited by a sensory stimulus – called the “as-if-body
loop”. Thus, the brain can anticipate expected bodily changes,
which allows the individual to respond faster to external stimuli
without waiting for an event to actually occur.
 Applications
• Over time, humans begin to associate
emotions with particular situations and
outcomes. A negative somatic marker
associated with a certain unpleasant situation
acts as a disincentive, but "when a positive
somatic marker is juxtaposed … it becomes a
beacon of incentive." This implies that you
should aim at appealing to emotions that
people associate with positive experiences if
you want them to complete a certain action.
 Overconfidence
• Overconfidence is the tendency for people to
overestimate their knowledge, abilities, and the
precision of their information, or to be overly
sanguine of the future and their ability to control
it
• Forms of Overconfidence
– Miscalibration (Tendency for people to overestimate
the precision of their knowledge)
– Better-than-average effect
– Excessive Optimism
 Causes of overconfidence
• Illusion of knowledge
• Illusion of Control
– Choice
– Information
– Outcome sequence
– Familiarity with tasks
• Illusion of understanding
• Illusion of skills