1. By: Mohamed Ismail Megahed
DBA, Finance

2. Definition of Behavioral Finance
 A field of finance that proposes psychology-based theories
to explain stock market anomalies. Within behavioral
finance, it is assumed that the information structure and
the characteristics of market participants systematically
influence individuals' investment decisions as well as
market outcomes.

3. Investors
 Are rational beings
 Consider all information
and accurately assess its
meaning
 Some individuals/agents
may behave irrationally or
against predictions, but in
the aggregate they become
irrelevant.
Markets
 Quickly incorporate all
known information
 Represent the true value
of all securities
 May be difficult to beat
in the long term
Standard Theory of Finance

4. Investors
 Are not totally rational
 Often act based on
imperfect information
Markets
 In the short term, there
are anomalies and
excesses
Standard Theory of Finance

5. Conventional Finance
• Prices are correct; equal to
intrinsic value.
• Resources are allocated
efficiently.
• Consistent with Efficient
Market Hypothesis
Behavioral Finance
• What if investors don’t
behave rationally?
Behavioral Finance & Conventional Finance

6. The Behavioral Critique
There are two categories of irrationalities:
1. Investors do not always process information correctly.
 Result: Incorrect probability distributions
of future returns.
2. Even when given a probability distribution of returns,
investors may make inconsistent or suboptimal
decisions.
 Result: They have behavioral biases.

7. Information Processing Critique
1. Forecasting Errors: Too much weight is placed on
recent experiences.
2. Overconfidence: Investors overestimate their
abilities and the precision of their forecasts.
3. Conservatism: Investors are slow to update their
beliefs and under react to new information.
4. Sample Size Neglect and Representativeness:
Investors are too quick to infer a pattern or trend
from a small sample.

8. Behavioral Characteristics
1. Loss aversion
2. Anchoring
3. Diversification
4. Disposition effect
5. Herding
6. Media response
7. Optimism

9. Behavioral Characteristics
 Loss aversion
 Devote significant attention to assessing risk
 Assess risk tolerance at least once per year possibly using
a risk tolerance questionnaire
 Assess gains and losses less frequently

10. Behavioral Characteristics
 Anchoring:
 describes the common human tendency to rely too
heavily on the first piece of information offered (the
"anchor") when making decisions.
 Be aware of investment anchors
 Use relevant benchmarks in comparing the investment
portfolio
 Be cognizant of long-term goals, not short-term
fluctuations

11. Behavioral Characteristics
 Diversification
 Make sure you are properly diversified
 Don’t let investment options dictate the asset allocation
 Work with the financial advisor to determine asset
classes that will maximize return and reduce risk

12. Behavioral Characteristics
 Disposition effect
 The disposition effect refers to people’s tendency to:
 Hang on to losers too long
 Sell the winners too soon
 This allows them to enjoy the feeling of winning faster
and defer the pain of loss

13. Behavioral Characteristics
 Herding
 Investors have a tendency toward “herd behavior”
 “Line” study on the effects of herd behavior
 Disproportionate flow of money into four and five-star
rated mutual funds
 Ratings have a lack of predictive value

14. Behavioral Characteristics
 Media response
 Study of the effects of news on investment decisions:
 Two groups: one received news and one did not
 The group with no news outperformed
the group that received news
 People often feel the need to react to new information
 News is often irrelevant to long-term performance and is
often misinterpreted
 Information overload can cause stress

15. Behavioral Characteristics
 Optimism
 People believe it is likely that:
 Good things will happen to them
 Bad things will happen to others
 They believe others are more likely to:
 Have a heart attack
 Develop cancer
 They believe others are less likely to:
 Become rich
 Become famous

16. Behavioral Biases
1. Narrow Framing
2. Mental accounting
3. Regret avoidance
4. Prospect theory

17. Behavioral Biases
 Narrow Framing
 How the risk is described, “risky losses” vs. “risky gains”, can
affect investor decisions
 Investing is a series of “propositions,” not a single event
 Performance should always be viewed within the context of
the total net worth
 Look at long-term goals, not short-term results
 Mental accounting
 Investors may segregate accounts or monies and take risks
with their gains that they would not take with their
principal.

18. Behavioral Biases
 Regret avoidance
 Investors blame themselves more when an
unconventional or risky bet turns out badly.
 Prospect theory
 Conventional view: Utility depends on level of wealth.
 Behavioral view: Utility depends on changes in current
wealth.

19. Limits to Arbitrage
 Behavioral biases would not matter if rational
arbitrageurs could fully exploit the mistakes of
behavioral investors.
 Fundamental Risk:
 “Markets can remain irrational longer than you can
remain solvent.”
 Intrinsic value and market value may take too long to
converge.

20. Limits to Arbitrage
 Implementation Costs:
 Transactions costs and restrictions on short selling can
limit arbitrage activity.
 Model Risk:
 What if you have a bad model and the market value is
actually correct?

21. Limits to Arbitrage and the Law of One Price
 Siamese Twin Companies
 Royal Dutch should sell for 1.5 times Shell
 Have deviated from parity ratio for extended periods
 Example of fundamental risk
 Equity Carve-outs
 3Com and Palm
 Arbitrage limited by availability of shares for shorting

22. Limits to Arbitrage and the Law of One Price
 Closed-End Funds
 May sell at premium or discount to NAV
 Can also be explained by rational return expectations

23. Bubbles and Behavioral Economics
 As the dot-com boom developed, it seemed to feed
on itself
 Investors were increasingly confident of their
investment prowess
 Bubbles are easier to spot after they end.
 Dot-com bubble
 Housing bubble

24. Technical Analysis and Behavioral Finance
 Technical analysis attempts to exploit recurring and
predictable patterns in stock prices.
 Prices adjust gradually to a new equilibrium.
 Market values and intrinsic values converge slowly.
 Disposition effect: The tendency of investors to hold
on to losing investments.
 Demand for shares depends on price history
 Can lead to momentum in stock prices

25. Trends and Corrections: The Search for Momentum
Dow Theory
1. Primary trend : Long-term movement of prices, lasting
from several months to several years.
2. Secondary or intermediate trend: short-term deviations of
prices from the underlying trend line and are eliminated by
corrections.
3. Tertiary or minor trends: Daily fluctuations of little
importance.

26. Sentiment Indicators
 Trin Statistics:
 Relative strength
 Measures the extent to which a security has
outperformed or underperformed either the market or
its industry
advancingnumber
advancingvolume
decliningnumber
decliningvolume
trin
.
.
.
.


27. Sentiment Indicators
 Confidence index
 Ratio of the average yield on 10 top-rated corporate
bonds divided by the average yield on 10 intermediate-
grade corporate bonds
 Put/call ratio
 Call options give investors the right to buy at a fixed
exercise price and a put is the right to sell at a fixed
exercise price
 Change in ratio can be given a bullish or bearish
interpretation

28. Sentiment Indicators
 Short Interest - total number of shares that are sold
short
 When short sales are high a signal occurs
 Bullish interpretation
 Bearish interpretation

29. A Warning
 Although the ability to discern apparent patterns with
stock market prices is irresistible—it is also possible to
perceive patterns that may not exist