Understanding Human Behavior Helps Us

Understand Investor Behavior

MA2N0246Tsatsral Dorjsuren

Behavioural FinanceO Behavioural Finance is the study of influence of

psychology on the financial decision making and it argues that the emotions of and mental errors cause the Mispricing.

O Behavioural finance argues that emotions and sentiment play a crucial role in determining the behaviour of investors in the market place and very often they act irrationally due to influence of psychological factor

OBehavioral finance is a new paradigm of finance, which seeks to supplement the standard theories of finance by introducing behavioral aspects to the decision-making process.

Theories of Behavioural Finance

OProspect Theory ORegret Theory OAnchoring OHerding

Prospect TheoryO Meaning: O Explaining the apparent regularity in

human behaviors when assessing risk under uncertainty.

O People respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain.

O Investors are risk hesitant when chasing gains but become risk lovers when trying to avoid a loss.

For example:

SITUATION (i): a) A sure gain of $2000 b) 25% chance to gain $1000 and 75% chance to gain nothing

SITUATION (ii): a) A sure loss of $7,500 b) 75% chance to loss $10,000 and 25% chance to lose nothing O A large majority of people Choose A in situation (i) and b in

situation (ii). O In first situation the sure GAIN OF 2000 seems most

attractive whereas in second situation the sure loss is repellent and the chance to lose nothing induces a preference for taking risk.

Regret TheoryO Meaning :O Emotional reaction to having made an error of

judgment. O Investors avoid selling stocks that have gone

down in order to avoid the regret of having made a bad investment and the embarrassment of reporting the loss.

O They find it easier to follow the crowd and buy a popular stock : if it subsequently goes down ,it can be rationalized as everyone else owned it.

O Investors defer selling stock that have gone down in value and accelerate the selling of stock that has gone up.

O For example : Sales professionals typically attempt to capitalize on this behaviour by offering an inferior option simply to make the primary option appear more attract.

Anchoring TheoryO MeaningO Anchoring is a phenomenon in which in the absence of

better information, investors assume current prices are about right.

O Anchoring describes how individuals tend to focus on recent behavior and give less weight to longer time trends.

O People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long run average and probabilities.

O In the absence of any better information, past prices are likely to be important determinants of prices today. Therefore, the anchor is the most recently remembered price.

Mental AccountingO Dividing current and future assets in

separate portions.O Results in different level of utility of

each portionO Provokes bias and other behaviors.

O For example, you aim to catch a show at the local theater, and tickets are $20 each. When you get there you realize you've lost a $20 bill. Do you buy a $20 ticket for the show anyway?

O Behavior finance has found that roughly 88% of people in this situation would do so.

O When you arrive at the door, you realize your ticket is at home. Would you pay $20 to purchase another?

O Only 40% of respondents would buy another. Notice, however, that in both scenarios you're out $40: different scenarios, same amount of money, different mental compartments.

HerdingO A fundamental observation about human

society is that people who communicate regularly with one another think similarly

O There are two primary reasons why herd behavior happens

O The first is the social pressure of conformity indeed being a powerful force.

O This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast

O The second reason is the common rationale that it’s unlikely that such a large group could be wrong.

O This is especially prevalent in situation in which an individual has very little experience.

ConclusionO Behavioral finance certainly reflects some

of the attitudes embedded in the investment. 

O Being consciously aware of these biases or irrational behaviour will allow us to better make investment decisions

O Practise critical thinking and study your thought process during investment decision making

O Allows you to provide better investment recommendations to your clients