Chapter 11 BEHAVIOURAL FINANCE The Irrational Influence

1. Chapter 11 BEHAVIOURAL FINANCE The Irrational Influence

2. OUTLINE • Key Differences between Traditional Finance and • Behavioural Finance • Heuristic – Driven Biases • Frame Dependence • Emotional and Social Influences • Market Inefficiency • Strategies for Overcoming Psychological Biases

3. TRADITIONAL FINANCE • People process data appropriately and correctly • People view all decisions through the transparent and • objective lens of risk and return • People are guided by reason and logic and independent • judgment • Market price of a security is an unbiased estimate of its • intrinsic value.

4. BEHAVIOURAL FINANCE • People employ imperfect rules of thumb that predispose • them to errors • Perceptions of risk and return are influenced by how • decision problems are framed • Emotions and herd instincts play on important role in • decisions • Often, there is a discrepancy between market price and • fundamental value

5. HEURISTIC-DRIVEN BIASES • The important heuristic – driven biases and cognitive • errors that impair judgment are : • Representativeness • Overconfidence • Anchoring • Aversion to ambiguity • Innumeracy

6. REPRESENTATIVENESS • Representativeness refers to the tendency to form judgments based on stereotypes. While representativeness may be a good rule of thumb, it can lead people astray. For example: • Investors may be too quick to detect patterns in data • that are in fact random • Investors may become overly optimistic about past • winners and overly pessimistic about past losers • Investors generally assume that good companies are • good stocks

7. OVERCONFIDENCE • People tend to be overconfident and hence overestimate • the accuracy of their forecasts. • Overconfidence stems partly from the illusion of • knowledge and partly from the illusion of control • People remain overconfident despite failures because • they tend to ascribe their success to their skill and their • failure to bad luck. • Overconfidence manifests itself in excessive trading and • the dominance of active portfolio management.

8. ANCHORING • After forming an opinion people are unwilling to change • it, even though they receive new information that is • relevant. • Anchoring manifests itself in a phenomenon called the • “post-earnings announcement drift”. Stock market • reacts gradually, not instantaneously, to unexpectedly • bad (good) earnings.

9. AVERSION TO AMBIGUITY • People are fearful of ambiguous situations where they • feel they have little information about the possible • outcomes. • Aversion to ambiguity means that investors are wary of • stocks that they feel they don’t understand. On the flip • side it means that investors have a preference for the • familiar.

10. INNUMERACY • People have difficulty with numbers. Trouble with numbers is reflected in the following: • People confuse between “nominal” changes and “real” • changes. • People have difficulty in figuring out the “true” • probabilities. • People ignore the ‘base rate’ and go more by the ‘case • rate’

11. FRAME DEPENDENCE • Frame independent investors pay attention to changes in • their total wealth. • In reality, behaviour is frame-dependent. This means • that the form used to describe a problem has a bearing • on decision-making. • Frame dependence stems from a mix of cognitive and • emotional factors.

12. PROSPECT THEORY According to the prospect theory people value gains/losses according to a S-shaped utility function shown below Utility Losses Gains

13. LOSS AVERSION • The utility 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 2 ½ times as strongly, according to Kahneman • and Tversky. This phenomenon is referred to as • loss aversion • Because of loss aversion, the manner in which an • outcome is described — either in the vocabulary of gains • or in the vocabulary of losses — has an important • bearing on decision making

14. MENTAL ACCOUNTING • People separate their money into various mental • accounts and treat a rupee in one account differently • from a rupee in another because each account has a • different significance for them • Mental accounting manifests itself in various ways: • Investors tend to ride the losers • People are more venturesome with money received • as bonus • People often have an irrational preference for stock • paying high dividends.

15. NARROW FRAMING • Investors engage in “narrow framing” — they focus on • changes in wealth that are narrowly defined, both in a • cross-sectional as well as in a temporal sense. • Narrow framing in a cross-sectional sense means that • investors tend to look at each investment separately • rather than the portfolio in its totality

16. NARROW FRAMING • Narrow framing in a temporal sense means that • investors pay undue attention to short-term gains and • losses, even when their investment horizon is long. • Since people are loss-averse, narrow framing leads to • myopic risk aversion. So investors tend to allocate too • little of their money to stocks

17. BEHAVIOURAL PORTFOLIO The psychological tendencies of investors prods them to build their portfolios as a pyramid of assets as shown below Options Commercial property Stocks Bonds Residential house Cash

18. SHADOW OF THE PAST • People seem to consider a past outcome as a factor in evaluating a current risky decision. In general, people are willing to take more risk after earning gains and less risk after incurring losses. Experimental studies suggest the following: • House-money effect • Snake-bite effect • Other influences of the past are: • Trying-to-break-even effect • Endowment effect • Status quo bias • Cognitive dissonance

19. EMOTIONAL TIME LINE Hope Pride Decisions Goals Fear Regret Investors experience a variety of emotions, positive and negative. Positive emotions are shown above the emotional time line and negative emotions below the emotional time line. Hope and fear have a bearing on how investors evaluate alternatives. The relative importance of these conflicting emotions determines the tolerance for risk Anticipation Anxiety

20. HERD INSTINCTS AND OVERREACTION • People tend to herd together. Moving with the herd, • however, magnifies the psychological biases. • The heightened sensitivity to what others are doing • squares well with a recent theory about fads, trends and • crowd behaviour. Called the “information cascade”, this • theory says that large trends or fads begin when • individuals ignore their private information but take • cues from the action of others. • Information cascades lead investors to overreact to both • good and bad news, causing stock market bubbles and • crashes.

21. MARKET INEFFICIENCY • Behavioural finance argues that, thanks to various behavioural influences, often there is a discrepancy between market price and intrinsic value. This argument rests on two key assumptions: • Noise trading • Limits to arbitrage

22. NOISE TRADING • NOISE TRADERS MAY SUFFER FROM SIMILAR JUDGMENTAL BIASES WHILE PROCESSING INFORMATION. FOR EXAMPLE : • THEY TEND TO BE OVERCONFIDENT AND HENCE TAKE MORE RISK • THEY CHASE TRENDS • THEY TEND TO PUT LESSER WEIGHT ON BASE RATES AND MORE WEIGHT ON NEW INFORMATION AND HENCE OVERREACT TO NEWS • THEY FOLLOW MARKET GURUS AND FORECASTS AND ACT IN A SIMILAR FASHION • CORRELATED BEHAVIOUR AGGREGATE SHIFTS IN DEMAND

23. LIMITS TO ARBITRAGE • ARBITRAGE . . REAL WORLD IS LIMITED OF TWO TYPES OF RISK • FUNDAMENTAL RISK : BUYING ‘UNDERVALUED’ SECURITIES TENDS … RISKY .. BECAUSE .. MARKET MAY FALL FURTHER & INFLICIT LOSSES • RESALE PRICE RISK : . . ARISES MAINLY . . FACT . . ARBITRAGEURS HAVE FINITE HORIZONS : • · ARBITRAGEURS USUALLY BORROW MONEY / SECURITIES . . PAY FEES PERIODICALLY • · PORTFOLIO MANAGERS . . EVALUATED EVERY FEW MONTHS. THIS LIMITS . . HORIZON OF ARBITRAGE

24. PRICE BEHAVIOUR • PRESENCE . . NOISE TRADERS . . & LIMITS TO ARBITRAGE . . INVESTOR SENTIMENT … DOES INFLUENCE PRICES • PRICES VARY MORE … WARRANTED BY CHANGES . . FUNDAMENTALS • INDEED, ARBITRAGEURS MAY ALSO CONTRIBUTE TO PRICE VOLATILITY AS THEY TRY TO TAKE ADV … MOOD SWINGS OF NOISE TRADERS • RETURNS OVER HORIZONS OF FEW WEEKS OR MONTHS … POSITIVELY CORRELATED . . ARBITRAGEURS … POSITIVE FEEDBACK TRADING • RETURNS … HORIZONS . . FEW YEARS . . NEGATIVELY CORRELATED … ARBITRAGEURS . . EVENTUALLY HELP PRICES … RETURN TO FUNDAMENTALS. • RETURNS . . MEAN REVERTING .. EMP . . EVIDENCE

25. L.SUMMERS, “DOES THE STOCK MARKET RATIONALLY REFLECT FUNDAMENTAL VALUES”, J.FINANCE (1986), 591-601 HE PROPOSES . . A PLAUSIBLE ALTERNATIVE . . EMH Pt = Pt* + utPt = PRICE ut = α ut-1 + vtPt* = FUND … VALUE ut AND vt RANDOM STOCKS IF 0 < α < 1 … ERRORS … SECURITY PRICES PERSIST BUT FADE AWAY. THIS IS CLEARLY CONSISTENT . . SHILLER’S & DE BONDT & THALER’S EVIDENCE, & MORE GENERALLY WITH OVERREACTIONS, ‘FADS’ . . MKT, & SPECULATIVE BUBBLES

26. VIEWS OF EXPERTS J.M. KEYNES : “IN POINT OF FACT, ALL SORTS OF CONSIDERATIONS ENTER INTO THE MARKET VALUATION WHICH ARE IN NO WAY RELEVANT TO THE PROSPECTIVE YIELD” IRWIN FRIEND : “A BROAD OVERVIEW OF THE PAST HALF CENTURY SUGGESTS THAT THERE HAVE BEEN NUMEROUS OCCASIONS WHEN LARGE BODIES OF INVESTORS HAVE BEEN EMOTIONALLY AFFECTED BY FADS & FASHIONS IN WALL STREET” WILLIAM BAUMOL : “WE HAVE ALL SEEN CASES WHERE THE BEHAVIOUR OF PRICES ON THE STOCK MARKET HAS APPARENTLY BEEN CAPRICIOUS OR EVEN WORSE, CASES WHERE HYSTERIA HAS MAGNIFIED LARGELY IRRELEVANT EVENTS INTO CONTROLLING INFLUENCES”

27. STRATEGIES FOR OVERCOMING PSYCHOLOGICAL BIASES • Understand the biases • Focus on the big picture • Follow a set of quantitative investment criteria • Diversify • Control your investment environment • Strive to earn market returns • Review your biases periodically

28. SUMMING UP • The central assumption of the traditional finance model is that people • are rational. However, psychologists argue that people suffer from • cognitive and emotional biases. • The important heuristic-driven biases and cognitive errors that impair • judgment are: representativeness, overconfidence, anchoring, aversion • to ambiguity, and innumeracy. • The form used to describe a problem has a bearing on decision making. • Frame dependence stems from a mix of cognitive and emotional factors. • People feel more strongly about the pain from a loss than the pleasure • from an equal gain – about 2½ times as strongly, according to • Kahneman and Tversky. This phenomenon is referred to as loss • aversion • People separate their money into various mental accounts and treat a • rupee in one account differently from a rupee in another.

29. Investors engage in “narrow-framing” – they focus on changes in wealth • that are narrowly defined, both in a cross-sectional as well as a temporal • sense. • The psychological tendencies of investors prod them to build their • portfolios as a pyramid of assets • People seem to consider a past outcome as factor in evaluating a current • risky decision. • The emotions experienced by a person with respect to investment may be • expressed along an emotional time line. • Thanks to “information cascade”, large trends or fads begin when • individuals ignore their private information but take cues from the • action of others. • Due to various behavioural influences, often there is a discrepancy • between market price and intrinsic value. • To overcome psychological biases, a disciplined approach is required.