Behavioral Finance

Finance for Normal People:

Course Instructor
Mazhar Farid Chishti
 Three Important Decisions
• Investing Decisions

• Financing Decisions

• Asset Management Decisions

Mapping of Ideas
Interdisciplinary Approach
What is Behavioral Finance?

Behavioral finance is the study of the influence

of psychology on the behavior of investors or
financial analysts. It also includes the. It focuses
on the fact of subsequent effects on the
markets that investors are not always rational,
have limits to their self-control, and are
influenced by their own biases.
 Differences in Two Theories

Traditional Financial Theory Behavioral Finance Theory

• Both the market and investors are • Investors are treated as “normal”
perfectly rational not “rational”
• Investors truly care about • They actually have limits to their
utilitarian characteristics self-control
• Investors have perfect self-control • Investors are influenced by their
• They are not confused by own biases
cognitive errors or information • Investors make cognitive errors
processing errors that can lead to wrong decisions
 Decision-Making Errors and Biases
• Behavioral finance views investors as “normal” but being subject to decision-
making biases and errors. We can break down the decision-making biases and
errors into at least four buckets.
 Decision-Making Errors and Biases
#1 Self-Deception
The concept of self-deception is a limit to the way we learn. When we mistakenly
think we know more than we actually do, we tend to miss information that we
need to make an informed decision.

#2 Heuristic Simplification
We can also scope out a bucket that is often called heuristic simplification.
Heuristic simplification refers to information-processing errors.

#3 Emotion
Another behavioral finance bucket is related to emotion, but we’re not going to
dwell on this bucket in this introductory session. Basically, emotion in behavioral
finance refers to our making decisions based on our current emotional state. Our
current mood may take our decision-making off track from rational thinking.

#4 Social Influence
What we mean by the social bucket is how our decision-making is influenced by
others.
 What is Cognitive Bias?
A cognitive bias is an error in cognition that arises in a person’s line of reasoning
when making a decision is flawed by personal beliefs. Cognitive errors play a
major role in behavioral finance theory and are studied by investors and
academics alike.
 Top 10 Common Cognitive Biases in Behavioral
Finance
Behavioral finance seeks an understanding of the impact of personal biases on investors.
Here is a list of common financial biases.
Common biases include:
#1 Overconfidence Bias
Overconfidence results from someone’s false sense of their skill, talent, or self-belief. It can
be a dangerous bias and is very prolific in behavioral finance and capital markets. The most
common manifestations of overconfidence include the illusion of control, timing optimism,
and the desirability effect. (The desirability effect is the belief that something will happen
because you want it to.)
 An Example
• In the context of behavioral finance, overconfidence bias occurs when an
investor overestimates their capacity to forecast future market moves or
choose profitable investments because they believe they are more
knowledgeable or skilled than others. For example, an overconfident investor
who thinks they have a unique insight into the market that others do not may
trade frequently or take on excessive risk in their portfolio. But an
overconfident investor may fail to diversify their portfolio enough or ignore
possible hazards, which can result in less than ideal investment choices. This
bias has the potential to cause losses in value and poor investment
performance over time.
 #2 Self Serving Bias
Self-serving cognitive bias is the propensity to attribute positive outcomes to skill and
negative outcomes to luck. In other words, we attribute the cause of something to whatever
is in our own best interest. Many of us can recall times that we’ve done something and
decided that if everything is going to plan, it’s due to skill, and if things go the other way,
then it’s just bad luck.
• When an investor places the blame for their investment losses on outside
variables like market volatility or economic conditions while attributing their
investment wins to their own talent or intellect, this is an example of self-
serving bias in behavioral finance. An investor may credit their earnings to
their clever decision-making alone if, for example, their portfolio performs
well during a bull market. In contrast, they can blame outside forces beyond
their control for portfolio losses in the event of a market downturn rather than
owning up to any flaws in their investing plan or decision-making technique.
This prejudice may prevent the investor from learning from mistakes and
making more educated decisions by causing overconfidence and a resistance
to assume accountability for investing losses.
 #3 Herd Mentality
• Herd mentality is when investors blindly copy and follow what other famous investors
are doing. When they do this, they are being influenced by emotion, rather than by
independent analysis.
• Herding bias is the term used in behavioral finance to describe people's
propensity to follow the actions or behaviors of the crowd rather than coming
to their independent conclusions through analysis or judgment. Herding bias
can be scientifically demonstrated in market bubbles, as the dot-com bubble of
the late 1990s. Because they were afraid of missing out on possible gains, a lot
of investors around this time followed the crowd and made significant
investments in internet-related stocks. Prices surged to unaffordable heights as
more investors bought these equities, driven by speculative activity and
irrational excitement. But when the bubble finally burst, stock prices crashed,
causing serious losses for many who had followed the herd mindlessly. This
example illustrates how herding bias can lead to market inefficiencies and
contribute to the formation of asset bubbles, highlighting the importance of
independent thinking and analysis in investment decision-making.
 #4 Loss Aversion
• Loss aversion is a tendency for investors to fear losses and avoid them more
than they focus on trying to make profits. Many investors would rather not
lose $2,000 than earn $3,000. The more losses one experiences, the more loss
averse they likely become.
• In behavioral finance, loss aversion bias refers to the tendency of individuals
to strongly prefer avoiding losses over acquiring equivalent gains. A scholarly
example of loss aversion bias can be observed in investor behavior during
periods of market volatility. Research has shown that investors are often more
sensitive to losses than gains, leading them to make decisions that prioritize
minimizing losses, even at the expense of missing out on potential gains. For
instance, during a market downturn, investors may panic and sell their
investments to avoid further losses, despite evidence suggesting that staying
invested over the long term may lead to eventual recovery and gains. This
tendency to prioritize loss avoidance can result in suboptimal investment
decisions and may contribute to increased market volatility as investors react
emotionally to short-term fluctuations in asset prices.
 #5 Framing Cognitive Bias
• Framing is when someone makes a decision because of the way information
is presented to them, rather than based just on the facts. In other words, if
someone sees the same facts presented in a different way, they are likely to
come to a different conclusion about the information. Investors may pick
investments differently, depending on how the opportunity is presented to
them.
• In behavioral finance, framing cognitive bias refers to the phenomenon where
individuals' decisions are influenced by the way information is presented or
framed. A scholarly example of framing bias can be observed in investment
decisions based on how financial information is communicated. For instance,
consider a study where investors are presented with two investment options:
Option A, which is described as having a 70% chance of success, and Option
B, which is described as having a 30% chance of failure. Despite representing
the same underlying probabilities, investors may exhibit a preference for
Option A when it is framed in terms of success, and a preference for Option B
when it is framed in terms of failure. This example illustrates how the framing
of information can influence investors' perceptions and decisions, leading to
biases in investment behavior.
 #6 Narrative Fallacy
• The narrative fallacy occurs because we naturally like stories and find them
easier to make sense of and relate to. It means we can be prone to choose less
desirable outcomes due to the fact they have a better story behind them. This
cognitive bias is similar to the framing bias.
• In behavioral finance, the narrative fallacy bias refers to the tendency of
individuals to create coherent narratives or stories to explain past events, even
when the events are random or unrelated. A scholarly example of narrative
fallacy bias can be observed in the analysis of historical stock market trends.
For instance, suppose an investor observes that a particular stock consistently
outperformed the market over the past decade. The investor may attribute this
outperformance to the company's exceptional management, innovative
products, or strong market positioning, constructing a narrative that explains
the stock's success. However, the investor may overlook other factors such as
luck, industry trends, or macroeconomic conditions that also played a role in
the stock's performance. This example illustrates how the narrative fallacy bias
can lead investors to form simplistic or biased interpretations of complex
phenomena, potentially influencing their investment decisions.
 #7 Anchoring Bias
• Anchoring is the idea that we use pre-existing data as a reference point for
all subsequent data, which can skew our decision-making processes. If you
see a car that costs $85,000 and then another car that costs $30,000, you could
be influenced to think the second car is very cheap. Whereas, if you saw a
$5,000 car first and the $30,000 one second, you might think it’s very
expensive.
The tendency for people to too depend on preliminary information or "anchors"
when making decisions, even when that information is arbitrary or irrelevant, is
known as anchoring bias in behavioral finance. An academic illustration of
anchoring bias is shown in the context of stock price projections. Let's say an
expert projects that, based on past performance and industry trends, a specific
stock will hit $100 per share. Investors may then use this forecast as an anchor to
set their own price expectations, modifying their stock value based on the $100
per share starting anchor. A different valuation, nevertheless, can be justified by
new facts or changing market conditions. Even yet, investors can still be swayed
by the original anchor, which could cause them to overvalue or undervalue the
company.
 #8 Confirmation Bias
• Confirmation bias is the idea that people seek out information and data that
confirms their pre-existing ideas. They tend to ignore contrary information.
This can be a very dangerous cognitive bias in business and investing.
• Confirmation bias, as used in behavioral finance, is people's propensity to
ignore or minimize contradicting data in favor of information that supports
their preexisting ideas or assumptions. An academic illustration of
confirmation bias can be seen in trend analysis for stocks. Let's say an investor
has a strong conviction that a specific stock will perform well because of its
cutting-edge goods and capable management. The investor selectively ignores
or rationalizes any negative news while focusing on information that supports
their positive view despite getting conflicting data about the company's
financial health and market prospects. Consequently, even if the stock's
performance declines, the investor can decide to hang onto it, incurring losses.
This example demonstrates how confirmation bias can distort investors'
perceptions and decision-making processes, potentially undermining their
ability to make rational and informed investment choices.
 #9 Hindsight Bias
• Hindsight bias is the theory that when people predict a correct outcome, they
wrongly believe that they “knew it all along”.
• The propensity for people to overestimate the predictability of past events
after learning the outcome is known as hindsight bias in behavioral finance.
An academic illustration of hindsight bias is seen in the study of market
forecasts. Let's say an investor believes that, after analyzing market patterns
and company fundamentals, a certain stock will see a notable increase in
value. When the stock doesn't perform as anticipated, though, the investor
might look back and consider the result to be evident or inevitable, attributing
their wrong prediction to things that are evident to them now. Due to this
retroactive distortion of perception, investors may overestimate their capacity
to correctly forecast future market moves, which could result in
overconfidence and less-than-ideal investing decisions.
 #10 Representativeness Heuristic

• Representativeness heuristic is a cognitive bias that happens when people

falsely believe that if two objects are similar then they are also correlated
with each other. That is not always the case.
• The term "representative heuristic" in behavioral finance describes people's
propensity to base judgments on how much an event or circumstance fits a
prototype or stereotype. An academic illustration of a representative heuristic
is seen in how investors evaluate opportunities in the stock market. Let's say
an investor comes across a fresh technological startup with a compelling
product and a charming CEO. If an investor believes that the company is
similar to successful tech giants like Apple or Google, even with insufficient
financial evidence or market analysis, they may invest substantially based on
this perception. Nevertheless, this choice can ignore important elements like
the company's financial soundness, regulatory issues, or market competition,
which would result in less than ideal investment outcomes. This illustration
shows how the representational heuristic might affect investors' judgment and
choices.
 Overcoming Behavioral Finance Issues
There are ways to overcome negative behavioral tendencies in relation to
investing. Here are some strategies you can use to guard against biases.
#1 Focus on the Process
There are two approaches to decision-making:
• Reflexive – Going with your gut, which is effortless, automatic and, in fact, is
our default option
• Reflective – Logical and methodical, but requires effort to engage in actively.
• Establishing logical decision-making processes can help protect you from such
errors.
• Get yourself focused on the process rather than the outcome. If you’re
advising others, try to encourage the people you’re advising to think about the
process rather than just the possible outcomes. Focusing on the process will
lead to better decisions because the process helps you engage in reflective
decision-making.
 Overcoming Behavioral Finance Issues

#2 Prepare, Plan and Pre-Commit

Behavioral finance teaches us to invest by preparing, by planning, and by
making sure we pre-commit. Let’s finish with a quote from Warren
Buffett.
“Investing success doesn’t correlate with IQ after you’re above a
score of 25. Once you have ordinary intelligence, then what you need
is the temperament to control urges that get others into trouble.”
 References
https://corporatefinanceinstitute.com/
resources/knowledge/trading-investing/
behavioral-finance/

https://corporatefinanceinstitute.com/
resources/knowledge/trading-investing/list-
top-10-types-cognitive-bias/