Foundations of Behavioural Finance

Bahavioural Finance
Unit-II: Foundations of Behavioural Finance
Heuristics and Biases - Two Systems Approach; Familiarity and
Related Heuristics; Biases, Hyperbolic Discounting; Self-Deception
- Over Confidence - Forms and Causes; Success Equation;
Prospect Theory and Mental Accounting. EMH-Theoretical
Foundations and Challenges to EMH; Emotional Factors and
Social Forces-Theories of Emotion; Types and Dimensions of
Emotion; Social Influence on Investment and Consumption;
Neuro Scientific and Evolutionary Perspective - Brain Basics,
Neuro Scientific and Evolutionary Perspective - Brain Basics,
Adaptive Market Hypothesis: CAPM; Arbitrage Model - Asset
Management and Behavioral Factors - Active Portfolio
Management.
Prepared by
Mr. Dayananda H. Huded M.Com NET, KSET
Teaching Assistant,
Rani Channamma University, PG Centre, Jamkhandi
E-Mail: dayanandch65@gmail.com
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Mr. Dayananda Huded, Teaching Assistant, Rani Channamma University, PG Centre, Jamkhandi, Karnataka

Heuristics and Biases
• https://thedecisionlab.com/biases
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Two Systems Approach
• System 1 is automatic and uses short-cuts to make quick decisions, often based
on common sense estimates and emotional reactions to choice.
• System 2: is a more deliberate decision making process, using conscious
thinking an reflection.
• System 2 is much slower than System 1, and hence, in situations where a quick
decision is required, System 1 is often the dominant system.
• While System 1 is often more convenient, it is subject to biases and errors
which can lead to irrational decision making.
• System 2 is, however, more easily manipulated – perhaps towards decision
• System 2 is, however, more easily manipulated – perhaps towards decision
making that is harmful to individual consumers, and to third parties.
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Familiarity and Related Heuristics; Biases
1. Availability Heuristic:
• In psychology, a heuristic is an easy-to-compute procedure or "rule of
thumb" that people use when forming beliefs, judgments or decisions.
• The familiarity heuristic was developed based on the discovery of
the availability heuristic by psychologists Amos Tversky and Daniel
Kahneman; it happens when the familiar is favored over novel places,
people, or things.
• The familiarity heuristic can be applied to various situations that
individuals experience in day-to-day life.
• When these situations appear similar to previous situations, especially if the
• When these situations appear similar to previous situations, especially if the
individuals are experiencing a high cognitive load, they may regress to the
state of mind in which they have felt or behaved before.
• The familiarity heuristic stems from the availability heuristic, which was
studied by Tversky and Kahneman. The availability heuristic suggests that
the likelihood of events is estimated based on how many examples of such
events come to mind. Thus the familiarity heuristic shows how "bias of
availability is related to the ease of recall.
• Individuals automatically assume that their previous behavior will yield the
same results when a similar situation arises.
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For understanding we can go through a small experiment
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Contd.
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• Tversky and Kahneman created an experiment in order to test this
heuristic. They devised four lists of 39 names. Each list contained 19
female names and 20 male names. Half of the lists had famous
female names, and the other half had famous male names.
• They showed the lists to two test groups.
• The first group was shown a list and asked to recall as many names
as possible.
• The second group was shown a list and asked to determine if there
• The second group was shown a list and asked to determine if there
were more female or more male names.
• The subjects who heard the list with famous female names said
there were more female names than there were male names.
• Similarly, the subjects who heard the list with famous male names
recalled more male names than female names.
• Thus the familiarity heuristic is defined as "judging events as more
frequent or important because they are more familiar in memory.
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• 2. Hindsight: The hindsight bias is the inclination to see events
that have already occurred as being more predictable than
they were before they took place.
• For example, after a situation occurs for the first time, you
begin to notice it when it reoccurs and therefore because you
have now experienced it, it's more readily available in your
consciousness and you pull information and predict aspects of
the future because of this and think that you "knew it all
the future because of this and think that you "knew it all
along."
• "Hindsight bias results from a biased reconstruction of the
original memory trace, using the outcome as a cue"
• Hindsight bias can alter memories and therefore future
predictions.
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Familiarity Biases
• Familiarity is the close knowledge of something.
• For example, people are more likely to accept a gamble if they feel they have a
better understanding of the relevant context, that is, if they feel more competent.
Chip Health and Amos Tversky conducted an experiment whose first stage
involved a series of general
• 1. Home Bias
• Though preferences are slowly changing in this regard, it continues to be true that
domestic investors hold mostly domestic securities—that is, American investors
hold mostly U.S. securities; Japanese investors hold mostly Japanese securities;
British investors hold mostly U.K. securities; and so on.
British investors hold mostly U.K. securities; and so on.
• For example the aggregate market values of the six biggest stock markets in the
world, i.e., The united States, as of January, 2022, had 59.9% of world market
capitalization, Japan 6.2%, the U.K. 3.9%, China 3.6%, France 2.8%, and
Switzerland 2.6%.
• Example: Nevertheless, a typical U.S. investor held 93.8% in U.S. stocks; a typical Japanese
investor held 98.1% in Japanese stocks; and a typical U.K. investor held 82.0% in U.K.
stocks.
• Domestic investors overweight domestic stocks. This behavior is called Home Bias.
• One reason why investors might hold more domestic securities is because they are optimistic
about their markets relative to foreign markets.
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• 2. Distance, Culture and Language: The argument that institutional considerations
cause investors to shy away from foreign investments becomes weak if it can be
demonstrated that people prefer to invest locally, even within their own country
• 3. Local Investing and Informational Advantages: One reason why investors may
favor local markets—where local is interpreted as either domestic or close-to-
home, but within the same country—is because they may possess, or may feel that
they possess, informational advantages. Gains from being geographically close to a
company may appear in improved monitoring capability and access to private
information.
• 4. Investing in Your Employer or Brands that You Know: There is also abundant
evidence that investors overweight the stocks of companies whose brands are
familiar or that they work for.
familiar or that they work for.
• As for the first, Laura Frieder and Avanidhar Subrahmanyam looked at survey data
on perceived brand quality and brand familiarity (recognition) and asked whether
these attributes impacted investor preferences.
• To answer this question, they correlated institutional holdings with these factors.
Note that high institutional holding in a stock implies low retail holding in that
same stock.
• These researchers found that institutional holdings are significantly and negatively
related to brand recognition, but no discernible impact was present for brand
quality. The former implies that retail investors have a higher demand for firms
with brand recognition, which is consistent with comfort seeking and familiarity.
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Hyperbolic Discounting
• Hyperbolic discounting is our inclination to choose immediate rewards over rewards
that come later in the future, even when these immediate rewards are smaller.
• Consider the following Example: John buys a lottery ticket every week. He hopes to
someday win big. One fortunate day, against all odds, he does. John is now worth
just over ₹ 5 million.
• After a frenzy of celebrations, John drove to the lottery offices to claim his prize.
When he arrived, the lottery director gave him a choice: he could either claim the ₹ 5
million now, or he could choose to receive ₹ 250,000 every year for the rest of his
life instead. John was only 35.
• Quick mental math pointed to the second option generating more revenue for John
• Quick mental math pointed to the second option generating more revenue for John
if he lived past the age of 55— which he planned on. But, John imagined having a
seven figure total in his bank account and relished at all the things he could
buy today.
• He decided to take the first option, even though he would receive less money from it
in the long-run. His preference towards immediate benefits over future gain can be
attributed to hyperbolic discounting.
• Effect on Individual:
• Hyperbolic discounting can result in poor decision-making, because it incentivizes
impulsivity and immediate gratification.1 Decisions that prioritize short-term
gratification often neglect and detract from our long-term well-being.
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Self-Deception
• Self deception is seeing the world the way we wish it to be rather than the way it is
in reality.
• When people have self deception they use their experiences hopes, needs desires,
expectations memories and other psychological elements to construct the way they
see the world.
• Self-deception is a process of denying or rationalizing away the relevance,
significance, or importance of opposing evidence and logical argument. Self-
deception involves convincing oneself of a truth (or lack of truth) so that one does
not reveal any self-knowledge of the deception.
• Example: Fast Food is not good for health
• Example: Fast Food is not good for health
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Over Confidence
• Overconfidence is the tendency for people to overestimate their
knowledge, abilities, and the precision of their information, or to be
overly sanguine (optimistic) of the future and their ability to control it. It is
found that most people most of the time are overconfident is well
documented by researchers in the psychology literature.
• Overconfidence comes in different forms one of them is miscalibration, the
tendency to believe that your knowledge is more precise (accuracy) than it
really is.
• Overconfidence is a pervasive phenomenon and can have severe
• Overconfidence is a pervasive phenomenon and can have severe
consequences.
• Too many people overvalue what they are not and undervalue what they
are.” - Malcolm S. Forbes
• Overconfidence means that people tend to place too much confidence in
their ability to predict. One way of illustrating this is asking investors to
predict a confidence interval around the expected return on a stock.
• Overconfidence is a bias in which investors have too much faith in the
precision of their estimates, causing them to underestimate the range of
possibilities that actually exist.
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Causes of Overconfidence
• Overconfident people are usually loud and noisy.
• Always seek validation and attention from outside.
• People display overconfidence because they do not feel
good about themselves.
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Forms of Overconfidence
• 1. Optimism is a perfectly sensible coping strategy for life but can be problematic
when investing. We routinely underestimate the likelihood of falling ill for
instance, yet, overestimate the probability of good events happening to us,
which goes a long way to explaining lottery ticket sales.
• 2. The illusion of knowledge is the tendency for people to believe that the
accuracy of their forecasts necessarily increases with more information. This
however is not necessarily the case given information is not the same as insight.
• 3. The illusion of control, is the tendency to overestimate our ability to influence
events over which we have little control. Today, investors are bombarded daily
with financial information, and every twist and turn in stock markets is discussed
with financial information, and every twist and turn in stock markets is discussed
at length. This information encourages some investors to make frequent changes
to their portfolios. However, studies suggest that these investors are in fact
overtrading and virtually guaranteeing themselves mediocre returns after
transaction costs.2 One explanation for overtrading is that investors feel
motivated to master the environment -The illusion of control.
• 4. Hindsight bias can feed confidence levels further. By extrapolating recent
experience into the future, (often based on limited data), investors are often
guilty of making confident predictions that are regularly shown to be flawed.
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Types of Overconfidence
• 5. Overconfidence becomes particularly problematic in bull markets and in periods
of sustained stability. During these periods, the “good times” are widely expected
to continue forever, and overconfidence becomes prevalent among allocators of
investment capital.
• 6. Overestimation: One manifestation of the overconfidence effect is the tendency
to overestimate one's standing on a dimension of judgment or performance. This
subsection of overconfidence focuses on the certainty one feels in their own ability,
performance, level of control, or chance of success. This phenomenon is most likely
to occur on hard tasks, hard items, when failure is likely or when the individual
making the estimate is not especially skilled. Overestimation has been seen to occur
making the estimate is not especially skilled. Overestimation has been seen to occur
across domains other than those pertaining to one's own performance. This
includes the illusion of control, planning fallacy.
• 6.1 Planning fallacy
• The planning fallacy describes the tendency for people to overestimate their rate of
work or to underestimate how long it will take them to get things done. It is
strongest for long and complicated tasks, and disappears or reverses for simple
tasks that are quick to complete.
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Success Equation
• Sources of success: Skill, Luck and Prediction
• Measure the contributions of skill and luck to any success or failure.
• Luck is a chance occurrence that affects a person or a group.. [and]
can be good or bad [it] is out of one’s control and unpredictable
• Skill is defined as the “ability to use one’s knowledge effectively and
readily in execution or performance.”
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Mr. Dayananda Huded, Teaching Assistant,
Rani Channamma University, PG Centre,
Jamkhandi, Karnataka
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Prospect Theory
• It is the founding theory of Behavioural economics and of Behavioural
finance.
• This theory was formulated in 1979 and further developed in 1992 by
Amos Tversky and Daniel Kahneman
• The theory describes how individuals assess in an asymmetric manner their
loss and gain perspectives and aims to describe the actual behaviour of
people.
• Prospect theory assumes that losses and gains are valued differently, and
thus individuals make decisions based on perceived gains instead of
thus individuals make decisions based on perceived gains instead of
perceived losses. Also known as the "loss-aversion" theory, the general
concept is that if two choices are put before an individual, both equal,
with one presented in terms of potential gains and the other in terms of
possible losses, the former option will be chosen.
• The prospect theory says that investors value gains and losses differently,
placing more weight on perceived gains versus perceived losses.
• The prospect theory is part of behavioral economics, suggesting investors
chose perceived gains because losses cause a greater emotional impact.
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• 1. Example of Prospect Theory
• Consider an investor who is given two pitches for the same mutual
fund. The first advisor presents the fund to Sam, highlighting that it has
an average return of 10% for the last three years. Meanwhile, a second
advisor tells the investor that the fund has had above-average returns
over the last decade, but has been in decline for the last three years.
• Prospect theory says that although the investor has been pitched the
exact same mutual fund, they are likely to buy from the first advisor.
That is, the investor is more likely to buy the fund from the advisor
That is, the investor is more likely to buy the fund from the advisor
that expresses the fund's rate of return in terms of only gains, while the
second advisor presented the fund as having high returns, but also
losses.
• Why Is Prospect Theory Important?
• It's useful for investors to understand their biases, where losses tend to
cause greater emotional impact than the equivalent gain. The prospect
theory helps describe hows decisions are made by investors.
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• 2. Prospect Theory Example
• A study in 1995 by the American Psychological Association looked at the 1992
Barcelona Olympics. More precisely, it looked at the psychological impacts
between finishing in silver and bronze place.
• The study compiled video footage of the medal ceremony as well as the moments
after the positions were announced. So imagine the reaction of a 100m runner just
finding they won by 0.1 of a second.
• The video footage was then shown to a group of undergraduate students who
were asked to rank the happiness display on a scale of 1 to 10. 1 signified agony
(extreme physical or mental suffering), whilst 10 was complete ecstasy (joyful
(extreme physical or mental suffering), whilst 10 was complete ecstasy (joyful
excitement).
• The study found that bronze medalists were significantly happier following the
results than those who won a silver medal. Bronze medalists scored 7.1, whilst
silver medalists scored 4.8.
• Even after the announcement, bronze medalists were much happier at the
ceremony, ranking 5.7. Still higher than silver medalists who scored 4.3.
• So why were bronze medalists happier? Well, the answer is explained by counterfactual
thinking. Simply put, the silver medalist was expecting and aiming for gold, so was therefore
disappointed to not have met that aim. However, the bronze medalist expects to finish
around 4th or 5th, so a bronze medal exceeded expectations.
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Features of Prospect Theory
• 1. Certainty
• When presented with several options to choose from, humans show
a strong preference for the option with certainty. They are willing
to sacrifice the option that offers more potential income in order to
achieve more certainty. For example, assume that a lottery provides
two options, A and B.
• Option A provides a guaranteed win of $100 while option B
provides the possibility of winning $200, with a 70% chance of
provides the possibility of winning $200, with a 70% chance of
winning and 30% chance of losing. Most people will choose option
A since it provides a guaranteed win, even though it offers a lower
return compared to B.
• 2. Small probabilities
• People tend to discount very small probabilities even if there is a
possibility of losing all their wealth. By discounting the small
probabilities, people end up choosing higher-risk options with
higher probabilities.
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• 3. Relative positioning: Relative positioning means that people tend to focus
less on their final income or wealth, and more on the relative gains or losses
that they will get. If their relative position does not improve with increases in
income, they will not feel better off. This means that people tend to compare
themselves to their neighbors, friends, and family members, and are less
interested in whether they are better off than they were some years back.
• For example, if everybody in the office gets a 20% raise, no individual will
feel better off. However, if the person gets a 10% raise, and other people fail
to get a raise, that person will feel better off and richer than everyone else.
• 4. Loss aversion: People tend to give more weight to losses rather than gains
• 4. Loss aversion: People tend to give more weight to losses rather than gains
made by taking a certain option. For example, if a person makes ₹ 200 in
profits and ₹ 100 in losses, the person will focus on the loss even though they
emerged with a ₹ 100 net gain. This shows that people are more concerned
about losses rather than gains.
• 5. Isolation Effect: In prospect theory, the isolation effect occurs when people
focus on differences between options rather than similarities. This is to reduce
the cognitive strain placed on our brains and simplify the decision-making
process.
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Key Tenets/Principles of Prospect Theory
• 1. Reference Dependence: In prospect theory, people evaluate
outcomes relative to a reference point and then classify gains and
losses. The value of a prospect depends on gains and losses relative to
reference point, which is usually the status quo. This is termed as
reference dependence.
• Ex. Sticking with your current cable/satellite provider. Even though
another provider might offer more channels at a cheaper price, you are
already familiar with the rates, choices, and customer service offered
by your current provider.
by your current provider.
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• 2. Diminishing Sensitivity: People value gains and losses according to an S-
shaped value function as shown in panel B of below chart, notice the
following features of the value function.
• The value function is concave for gains. This means that people feel good
when they gain, but twice the gain does not make them feel twice as
good. The concavity over gains means that people tend to be risk-averse
over moderate probability gains: they prefer a certain gain of ₹ 1000 to a
50 per cent chance of ₹ 2000.
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• 3. Loss Aversion : The value function is steeper for losses than for
gains. This means that people feel more strongly about the pain
from a loss than the pleasure from an equal gain - about two and
half times as strongly, according to Kahneman and Tversky. This
phenomenon is referred to as loss aversion. It is quite different from
risk aversion.
• 4. Changes in Risk Attitude : Depending on the nature of the
prospect, people sometimes display risk aversion and sometimes
display risk seeking.
display risk seeking.
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Mental Accounting
• The human brain is similar to a file cabinet in which there is a separate
folder (account) for each decision, which contains the costs and benefits
associated with that decision. Once an outcome is assigned to a mental
account, it is difficult to view it in any other way. Mental accounting can
influence a person’s decisions in unexpected ways.
• Ex. Mr. and Mrs. Sharma have saved ₹ 10 lakhs for their daughter’s
wedding that may take place 3 years from now. The money earns interest
at the rate of 9% in a bank fixed deposit account. They just bought a new
car for ₹ 6 lakhs on which they have taken a 3 year car loan at 12%
car for ₹ 6 lakhs on which they have taken a 3 year car loan at 12%
• The above example suggests that people often have money in a fixed
deposit account (earmarked for a certain purpose) that earns a low rate of
interest and yet they borrow money at a high rate of interest for some
other purpose.
• While money does not come with labels, the human mind puts labels on
it. Mr. and Mrs. Sharma labelled their fixed deposit as “daughter’s wedding
provision” in a separate mental account and did not want to draw on it to
finance a car even though it made sense to do that.
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Efficient Market
• Efficient Market is a market in which share price follow an
independent path.
• Price of security is influenced by demand and supply.
• Market efficiency refers to the degree to which market prices reflect
all available, relevant information.
• If markets are efficient, then all information is already incorporated
into prices, and so there is no way to beat the market because there
are no undervalued or overvalued securities available.
are no undervalued or overvalued securities available.
• Fama defined Efficient Market as, “A market where there are large
numbers of rational profit maximisers actively competing, with each
trying to predict future market values of individual securities, and
where important current information is almost freely available to all
participants”.
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EMH-Theoretical Foundations
• The Efficient Markets Hypothesis (EMH) that was proposed in the 1960s
reached its height of dominance in the academic circles in the 1970s.
• The pioneer of EMH was Eugene Fama.
• EMH is based on the fundamental that market are efficient and price make
an independent movement in these market.
• EMH is an investment theory which suggests that the prices of financial
instruments reflect all available market information.
• Investors can only yield high returns by taking more significant risks in the
market.
market.
• Efficient market theory states that the price fluctuations are random and
do not follow any regular pattern. Fama suggested that efficient market
hypothesis can be divided into three categories.
• They are: (1) the weak form,
• (2) The semi strong form,
• (3) The strong form.
• The level of information being considered in the market is the basis for this
segregation.
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1. Weak Form of EMH
• The weak form of EMH implies that technical trading strategies
cannot provide consistent excess returns because past price
performance can’t predict the future price action that will be based
on new information.
• The weak form hypothesis says that the current prices of stocks
already fully reflect all the information that is contained in the
historical sequence of prices. Therefore, there is no benefit in
examining the historical sequence of prices forecasting the future.
This weak form of the efficient market hypothesis is popularly
This weak form of the efficient market hypothesis is popularly
known as the random-walk theory.
• It leaves open the possibility that fundamental analysis may provide
a means of outperforming the overall market average return o
investment.
• Information regarding the past sequence of security movements is
dealt with.
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2. Semi Strong Form of EMH
• The semi strong from of the theory dismisses the usefulness of
both technical and fundamental analysis.
• Prices adjust quickly to any new public information that
become available, therefore rendering fundamental analysis
incapable of having any predictive power about future price
movements.
• If semi-strong form efficiency holds then neither technical
analysis nor fundamental analysis can be used to generate
analysis nor fundamental analysis can be used to generate
superior returns.
• Information that is publicly available is dealt with
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3. Strong Form of EMH
• According to the strong form of EMH, not even insider
knowledge can give investors a predictive edge that will
enable them to consistently generate returns that outperform
the overall market average.
• The strong form of EMH holds that prices always reflect the
entirety of both public and private information.
• This includes all publicly available information both historical
and new as well as insider information.
and new as well as insider information.
• Deals with all forms of information— public, private and
inside
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Challenges to EMH
• 1. In EMH it is assumed that investors make decisions based on the
rational expectations. According to this hypothesis, all investors
make investment decisions based on the same expectations. This
notion has been questioned by many.
• For it is pure common sense that security markets and trading
would not be possible if all investors had the same level of
expectations.
• Trading in stocks take place just because one investor creates a sales
• Trading in stocks take place just because one investor creates a sales
position based on his or her expectation that prices of the stock
would drop. The buyer in turn buys on the pretext that prices of
the particular stock would increase. Thus occurs trading in a
particular stock.
• 2. The assumption of EMH that all participants have equal access to
information is also questionable, as it is most unlikely.
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• 3. The fact that investors neither behave rationally nor
consider all the available information in the process of
decision making.
• 4. Market imperfections like delay in information and
transaction costs are unexplained.
• 5. Efficient market hypothesis deals with absolute price
changes but not the relative price changes of the stocks.
• 6. Random movement of stock prices does not indicate the
direction of movement.
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Emotional Factors and Social Forces
• Emotional Factors
• 1. Anchoring: “Anchoring is a cognitive heuristic in which decisions are
made based on an initial anchor. The concept of anchoring heuristic
can be thought as the tendency to make estimates and decisions on a
known reference point.
• 2. Gamblers Fallacy: “The gambler's fallacy also known as the Monte
Carlo fallacy is inaccurate understanding of probability that an
individual assumes a certain random event is less likely to occur
following a series of events. This assumption that what occurs on
following a series of events. This assumption that what occurs on
average will be corrected in the short term is incorrect because past
series of events do not change the certain fixed probability.
• For example, after serious of 10 coin tosses that have landed heads-up,
it is very tempting for a person to expect the next coin more likely toss
to land tails-up. But the probability of a fair coin to land tails up is
always 50 percent and is statistically independent and all previous coin
tosses has no effect on future outcomes of the next coin toss.”
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• 3. Herd Behaviour: “Herding behaviour can be described as tendency
for individuals to act together in periods of bubbles or crashes.”
• 4. Overconfidence: “Evidence shows that people tend to be
overconfident in their decisions and may overestimate their ability to
know what will happen. The belief of being more knowledgeable than
they actually are, causes investors to believe that diversification of
financial portfolios is unnecessary. Overconfidence bias is a frequent
trait and investors suffer from reduced returns, through shortcomings
of their decisions.”
of their decisions.”
• 5. Risk appetite: is the amount of risk an organization/individual is
willing to take in pursuit of objectives it deems have value.
• Risk appetite can also be described as an organization's/individual’s risk
capacity, or the maximum amount of residual risk it will accept after
controls and other measures have been put in place.
• Investor become Risk averse and risk seekers in certain situations.
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Social Factors Influencing Investment Decision
• 1. Market Experience: Financial decisions can be impacted by an individual’s
experience in financial markets, as well as those of that individual’s peer group.
Groups with more money to spend and a more sophisticated knowledge of
investment instruments have more access to capital than those from different socio-
economic groups.
• 2. Cultural Attitudes: Financial decisions may also be influenced by cultural norms.
Some religions, for example, forbid or limit the amount of interest that can be
charged on loans. Investors in those faiths therefore may find a religious objection to
investing in organizations that make their money via interest charges. A culture that
expects grown children to remain living at home until marriage likely will have a
different housing market than a society that expects children to leave the house and
different housing market than a society that expects children to leave the house and
find a place on their own as soon as possible.
• 3. Herd Behavior: Individual investors often follow the lead of larger groups, even
when the decision may make little financial sense for them.
• 4. Reference Groups: Individuals often make financial decisions based in part on what
their primary influence groups have done. For example, friends, family members,
relatives and co-workers can influence a person's financial decision based on their
own experiences. If someone's friends are in the market to buy houses, that may
influence his own decision as to whether to buy or rent. To take advantage of this
peer dynamic, businesses can reward existing customers for their referrals that lead to
new customers.
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Theories of Emotion
• Emotion is a complex, subjective experience accompanied by
biological and behavioral changes. Emotion involves feeling,
thinking, activation of the nervous system, physiological changes,
and behavioral changes such as facial expressions.
• In psychology, emotion is often defined as a complex state of
feeling that results in physical and psychological changes that
influence thought and behavior. Emotionality is associated with a
range of psychological phenomena, including
temperament, personality, mood, and motivation.
temperament, personality, mood, and motivation.
• According to author David G. Myers, human emotion involves “
physiological arousal, expressive behaviors, and conscious
experience."
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Theories
• 1. Evolutionary Theory
• According to the evolutionary theory of emotion, our emotions exist
because they serve an adaptive role. Emotions motivate people to
respond quickly to stimuli in the environment, which helps improve
the chances of success and survival.
• Naturalist Charles Darwin proposed that emotions evolved because
they were adaptive and allowed humans and animals to survive and
reproduce. Feelings of love and affection lead people to seek mates
and reproduce. Feelings of fear compel people to fight or flee the
and reproduce. Feelings of fear compel people to fight or flee the
source of danger.
• Understanding the emotions of other people and animals also plays a
crucial role in safety and survival. If you encounter a hissing, spitting,
and clawing animal, chances are you will quickly realize that the animal
is frightened or defensive and leave it alone. Being able to interpret
correctly the emotional displays of other people and animals allows
you to respond correctly and avoid danger.
40

2. James Lange Theory
• The James-Lange Theory of Emotion
• The James-Lange theory is one of the best-known examples of a physiological
theory of emotion. Independently proposed by psychologist William
James and physiologist Carl Lange, the James-Lange theory of emotion
suggests that emotions occur as a result of physiological reactions to events.
• According to the James-Lange theory of emotion, an external stimulus leads to
a physiological reaction. Your emotional reaction depends upon how you
interpret those physical reactions.
• For example, suppose you are walking in the woods and see a grizzly bear.
• For example, suppose you are walking in the woods and see a grizzly bear.
You begin to tremble, and your heart begins to race. The James-Lange theory
proposes that you will conclude that you are frightened ("I am trembling.
Therefore, I am afraid"). According to this theory of emotion, you are not
trembling because you are frightened. Instead, you feel frightened because you
are trembling.
41

3. The Cannon-Bard Theory of Emotion
• According to the Cannon-Bard theory of emotion, we feel emotions and
experience physiological reactions such as sweating, trembling, and muscle tension
simultaneously.
• Another well-known physiological theory is the Cannon-Bard theory of emotion.
Walter Cannon disagreed with the James-Lange theory of emotion on several
different grounds. First, he suggested, people can experience physiological reactions
linked to emotions without actually feeling those emotions. For example, your
heart might race because you have been exercising, not because you are afraid.
• Cannon also suggested that emotional responses occur much too quickly to be
simply products of physical states. When you encounter a danger in the
simply products of physical states. When you encounter a danger in the
environment, you will often feel afraid before you start to experience the physical
symptoms associated with fear, such as shaking hands, rapid breathing, and a racing
heart.
• Cannon and Bard’s theory suggests that the physical and psychological experience
of emotion happen at the same time and that one does not cause the other.
42

4. Schachter Singer Two Factor Theory
• Also known as the two-factor theory of emotion, the Schachter-Singer theory is an
example of a cognitive theory of emotion. This theory suggests that the physiological
arousal occurs first, and then the individual must identify the reason for this arousal to
experience and label it as an emotion. A stimulus leads to a physiological response that
is then cognitively interpreted and labeled, resulting in an emotion.
• Schachter and Singer’s theory draws on both the James-Lange theory and the Cannon-
Bard theory. Like the James-Lange theory, the Schachter-Singer theory proposes that
people infer emotions based on physiological responses. The critical factor is the
situation and the cognitive interpretation that people use to label that emotion.
• Like the Cannon-Bard theory, the Schachter-Singer theory also suggests that similar
physiological responses can produce varying emotions. For example, if you experience a
physiological responses can produce varying emotions. For example, if you experience a
racing heart and sweating palms during an important exam, you will probably identify
the emotion as anxiety. If you experience the same physical responses on a date, you
might interpret those responses as love, affection, or arousal.
43

5. Cognitive Appraisal Theory
• According to appraisal theories of emotion, thinking must occur first
before experiencing emotion. Richard Lazarus was a pioneer in this area of
emotion, and this theory is often referred to as the Lazarus theory of
emotion.
• The cognitive appraisal theory asserts that your brain first appraises a
situation, and the resulting response is an emotion.
• According to this theory, the sequence of events first involves a stimulus,
followed by thought, which then leads to the simultaneous experience of a
physiological response and the emotion. For example, if you encounter a
physiological response and the emotion. For example, if you encounter a
bear in the woods, you might immediately begin to think that you are in
great danger. This then leads to the emotional experience of fear and the
physical reactions associated with the fight-or-flight response.
44

6. The Facial Feedback Theory of Emotion
• The facial-feedback theory of emotions suggests that facial expressions are
connected to experiencing emotions. Charles Darwin and William James both
noted early on that, sometimes, physiological responses often have a direct impact
on emotion, rather than simply being a consequence of the emotion.
• The facial-feedback theory suggests that emotions are directly tied to changes in
facial muscles.
• For example, people who are forced to smile pleasantly at a social function will
have a better time at the event than they would if they had frowned or carried a
more neutral facial expression.
45

Types of Emotions
• There are many different types of emotions that have an
influence on how we live and interact with others. At times, it
may seem like we are ruled by these emotions. The choices we
make, the actions we take, and the perceptions we have are
all influenced by the emotions we are experiencing at any
given moment.
• Psychologists have also tried to identify the different types of
emotions that people experience. A few different theories
emotions that people experience. A few different theories
have emerged to categorize and explain the emotions that
people feel.
46

Types
47

1. Happiness
• Of all the different types of emotions, happiness tends to be the
one that people strive for the most.
• Happiness is often defined as a “pleasant emotional state” that is
characterized by feelings of contentment, joy, gratification,
satisfaction, and well-being.
• Research on happiness has increased significantly since the 1960s
within a number of disciplines, including the branch of psychology
known as positive psychology. This type of emotion is sometimes
known as positive psychology. This type of emotion is sometimes
expressed through:
• Facial expressions: such as smiling
• Body language: such as a relaxed stance
• Tone of voice: an upbeat, pleasant way of speaking
• Happiness has been linked to a variety of outcomes including
increased longevity and increased marital satisfaction. Conversely,
unhappiness has been linked to a variety of poor health outcomes.
48

2. Sadness
• Sadness is another type of emotion often defined as a “transient
(impermanent) emotional state” characterized by feelings of
disappointment, grief (intense Sorrow), hopelessness, disinterest, and
dampened mood (make slightly wet).
• Like other emotions, sadness is something that all people experience
from time to time. In some cases, people can experience prolonged
and severe periods of sadness that can turn into depression.
• Sadness can be expressed in a number of ways including:
Crying
– Crying
– Dampened mood
– Lethargy
– Quietness
– Withdrawal from others
• Sadness can often lead people to engage in coping mechanisms such as
avoiding other people, self-medicating, and ruminating (think deeply
about something) on negative thoughts.
49

3. Fear
• Fear is a powerful emotion that can also play an important role
in survival. When you face some sort of danger and experience
fear, you go through what is known as the fight or flight
response.
• Your muscles become tense, your heart rate and respiration
increase, and your mind becomes more alert, priming your body
to either run from the danger or stand and fight.
• Expressions of this type of emotion can include:
– Facial expressions: such as widening the eyes and pulling back the
– Facial expressions: such as widening the eyes and pulling back the
chin
– Body language: attempts to hide or flea from the threat
– Physiological reactions: such as rapid breathing and heartbeat
• Of course, not everyone experiences fear in the same way. Some
people may be more sensitive to fear and certain situations or
objects may be more likely to trigger this emotion.
• Fear is the emotional response to an immediate threat.
50

4. Disgusting
• Disgust is another of the original six basic emotions described by Eckman.
• Disgust can be displayed in a number of ways including:
– Body language: turning away from the object of disgust
– Physical reactions: such as vomiting or retching
– Facial expressions:
• This sense of revulsion can originate from a number of things, including an
unpleasant taste, sight, or smell. Researchers believe that this emotion evolved as a
reaction to foods that might be harmful or fatal. When people smell or taste foods
that have gone bad, for example, disgust is a typical reaction.
51

5. Anger
• Anger can be a particularly powerful emotion characterized by feelings of hostility,
agitation, frustration, and antagonism towards others. Like fear, anger can play a
part in your body's fight or flight response.
• Anger is often displayed through:
• Facial expressions: such as frowning or glaring
• Body language: such as taking a strong stance or turning away
• Tone of voice: such as speaking gruffly or yelling
• Physiological responses: such as sweating or turning red
• Aggressive behaviors: such as hitting, kicking, or throwing objects
6. Surprise
• Surprise is usually quite brief and is characterized by a physiological startle response
following something unexpected.
• This type of emotion can be positive, negative, or neutral. An unpleasant surprise,
for example, might involve someone jumping out from behind a tree and scaring
you as you walk to your car at night.
• An example of a pleasant surprise would be arriving home to find that your closest
friends have gathered to celebrate your birthday.
• Surprise can have important effects on human behavior. For example, research has
shown that people tend to disproportionately notice surprising events.
52
6. Surprise

Dimensions of Emotion
• 1. Pleasure (positive, negative)
• Emotions can be positive, pleasant and giving good feelings.
Emotions may also be negative, unpleasant and cause discomfort.
Any emotion can be placed on a scale between extreme pleasure
and extreme discomfort, with a zero point between where neither
positive nor negative feelings are experienced
• Positive Emotions: Happiness, Liking, respect, hope etc.
• Negative Emotions: Sadness, Anger, Fear, Shame and Disgust
• Negative Emotions: Sadness, Anger, Fear, Shame and Disgust
• 2. Focus (internal, external)
• Emotions may have a primary focus inside us or outside us, for
example being about ourselves or about the outer world.
Sometimes these are very much about one or the other and at other
times they may be a bit of both. A highly outward emotion is anger,
as we project bad feelings toward others. A highly inward one is
contentment, for example in the way a meditating person feels.
53

• 3. Direction (attraction, repulsion): Emotions often have direction, bringing us
together with things or pushing us away from them. For example love is an
attractive emotion, while fear is repulsive. We can reduce distance by moving
ourselves towards object of interest or bringing it close. Likewise we can act on
repulsion by pushing it away or removing ourselves from its proximity.
• Direction is often about other people, such as when we like or dislike them. It can
also be about things and situations of danger or attraction. Greed, for example,
may pull us towards money, while fear may push us away from a dangerous place.
• 4. Intensity: Intensity is about how strongly we feel emotions. This is a uni-polar
• 4. Intensity: Intensity is about how strongly we feel emotions. This is a uni-polar
dimension, as it can range from close to zero, for example when we feel flat or just
a bit irritated, to very intense, such as feelings of grief or extreme anger. Pleasure
and Locus are bi-polar scales as they have two poles with a 'zero' in between.
• 5. Arousal: Arousal is about activation, the energy and motivation that the
emotions give us towards taking action.
• Lower Arousal: Depression. High Arousal Emotion: Curiosity etc.
54

Social Influence on Investment and Consumption
1. Social interaction can influence to take investment decision such as;
• I feel I am not as much happier as other people seem to be.
• I prefer to buy stocks if many "buy" orders were submitted to them from the
beginning of the trading session.
• I would prefer to sell stock if I find many people quitting from it.
55
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