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Key Principles of

Behavioral
Finance
Meera Seshanna
Assistant Professor, Dayananda Sagar
Business Academy
1 Table Of Contents

i. Prospect Theory & Loss-Aversion


ii. Anchoring
iii. Mental Accounting
iv. Confirmation & Hindsight Bias
v. Gambler’s Fallacy
vi. Herd Behaviour
vii. Overconfidence
viii. Overreaction & Availability Bias
2 Introduction
Behavioral Finance

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

Why is it important?
 It is necessary because “technical analysis” assumes that people act
rationally
3 Anomalies
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.
 Winner’s 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

been roughly 6% for the past


century.
4 Key Concepts
Prospect Theory and Loss-Aversion

 Investor decision weights tend to overweigh small probabilities and under-


weigh moderate and high probabilities.

 Basing decisions on perceived gains rather than perceived losses.

Anchoring

 Using irrelevant info as a reference for evaluation.


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

Mental Accounting

 Dividing current and future assets in separate portions.


 Results in different level of utility of each portion
 provokes bias and other behaviors.
5 Key Concepts
Confirmation & Hindsight Bias

 Confirmation Bias – having preconceived opinion which serves as self-fulfilling


prophecies.

 Hindsight Bias – believing that past event was predictable and obvious

Gamblers Fallacy

 Lack of understanding resulting in incorrect assumptions and predictions


about the onset of events.
 E.g investors viewing further declines and improbable.
 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.”
6 Key Concepts
Herd Behaviour

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

 Being overconfident in your stock-picking ability


 Results in increased number of trades
 Eg: Investors - “I know exactly how to evaluate stocks”.
Thus, I don’t need a second opinion.
 Entrepreneurs – despite knowing the statistics, they strongly believe “their
chance of failing is zero”
7 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.
8 Conclusion
Concluding Comments

 Being consciously aware of these biases or irrational behaviour will allow us to make
better investment decisions
 One emerging strand of research is the field of neuroeconomics. Medical imaging
technology now allows us to look at brain activity as decisions are being made. This
helps us to understand the nature and reasons for certain behavioural biases
 A recent study demonstrated that individuals with brain lesions ( Abrasions) that impaired
emotional decision-making were more likely to behave as rational investors than
individuals with normal brains.
 Other imaging studies have confirmed that the rational parts of our brain are in tension
with the emotional or limbic sections of our brain. This line of enquiry offers the possibility
of understanding and improving decision making.
 As humans, we are effective decision-makers, but with flaws that can cause problems in
realms such as investing. An understanding of the nature of these flaws can help us
avoid these problems and invest better