Key Principles of Behavioural Finance

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Key Principles of Behavioural Finance

1. Introduction
2. Anomalies
3. Key Concepts
Prospect Theory & Loss-Aversion
Anchoring
Mental Accounting
Confirmation & Hindsight Bias
Gambler’s Fallacy
Herd Behaviour
Overconfidence
Overreaction & Availability Bias
4. Conclusion

Published in: Economy & Finance, Business

Key Principles of Behavioural Finance

  1. 1. Key Principles of Behavioral Finance Jawwad Siddiqui, CSC Research Assistant, The Finkelstein Group
  2. 2. 1 i. ii. iii. iv. v. vi. vii. viii. Table Of Contents Prospect Theory & Loss-Aversion Anchoring Mental Accounting Confirmation & Hindsight Bias Gambler’s Fallacy Herd Behaviour Overconfidence Overreaction & Availability Bias
  3. 3. 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
  4. 4. 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
  5. 5. Anomalies 3 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 Source: The Economist been roughly 6% for the past century.
  6. 6. 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.
  7. 7. 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 message’s content rather than its relevance when making financial decisions.
  8. 8. 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.
  9. 9. 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.
  10. 10. 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.”
  11. 11. 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
  12. 12. 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 don’t need a second opinion.  Entrepreneurs – despite knowing the statistics, they strongly believe “their chance of failing is zero”
  13. 13. Key Concepts 6 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.
  14. 14. Conclusion 6 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)
  15. 15. Thank-You. Questions? Jawwad Siddiqui, CSC Research Assistant, The Finkelstein Group

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