BASICS OF BEHAVIOURAL FINANCE

Basics of Behavioural Finance (Part 1)

• Definition: Behavioural Finance is the study of how psychology influences the behavior of market participants and the subsequent effect on financial markets.
• Key Concepts:
  • Behavioural Finance is a part of Behavioural Economics, which deals with biases and cognitive errors affecting investors' behavior.
  • It attempts to explain gaps and market anomalies not explained by standard finance theories and frameworks.

Key Differences between Standard Finance and Behavioural Finance

• Standard Finance:
  • Assumes investors are rational, risk-averse, and self-interested utility maximizers.
  • Assumes investors have access to all available information and update their beliefs as new information becomes available.
  • Economics is at the core, with efficient market hypothesis describing random price movements.
• Behavioural Finance:
  • Recognizes that investors are subject to biases and cognitive errors.
  • Psychology is at the core, with biases guiding investments and collective bias leading to sharp market movements.
  • Decision-making is inconsistent, with loss aversion being a key factor.

How Individuals Make Decisions

• Bounded Rationality: Investors have limited time, information, or ability to comprehend complex information, leading to "satisficing" solutions rather than optimal ones.
• Prospect Theory: Describes how individuals make choices in situations involving risk, with two phases: framing and evaluation.
• Key Premises:
  • Choices are evaluated relative to a reference point.
  • People are risk-averse about gains but risk-seeking about losses.
  • Monetary losses hurt more than monetary gains.

Categorization of Biases

• Emotional Biases: Based on feelings or emotions, such as:
  • Loss Aversion Bias: People prefer avoiding losses to acquiring gains.
  • Stereo Typing Bias: Investors base decisions on general perceptions about characteristics.
  • Overconfidence Bias: Unwarranted faith in one's own intuitive reasoning and cognitive abilities.
  • Endowment Bias: Valuing an asset more when holding rights to it.
  • Status Quo Bias: Avoiding decisions due to fear of regret or maintaining the current state.
• Cognitive Errors: Statistical, information-processing, or memory errors causing deviation from rational behavior, such as:
  • Mental Accounting: Treating different sums of money differently based on mental accounts.

BASICS OF BEHAVIOURAL FINANCE (Part 2)

• Mental Accounting: People treat money differently based on its origin and intended use, rather than considering it as fungible.
• Framing Bias: Investors' choices are influenced by how information is presented, leading to different decisions based on the same outcome.
• Prospect Theory: Describes how individuals make decisions involving risk, evaluating potential losses and gains based on framing and uncertain outcomes.
• Anchoring Bias: Investors rely on pre-existing information, making subsequent decisions based on that initial anchor.
• Choice Paralysis: Too many investment options can lead to indecision and inaction.

Fusion Investing

• Definition: Combines traditional and behavioural finance paradigms to create investment strategies.
• Approach: Integrates fundamental analysis with behavioural finance, considering both value-growth and momentum factors.
• Steps:
  1. Identify stocks with promising value metrics (e.g., P/E, P/BV, P/S).
  2. Filter stocks based on fundamental strength (e.g., profitability, leverage, efficiency).
  3. Select stocks with strong momentum (e.g., price uptrend).

Behavioural Finance Explains Market Anomalies

• Market Anomaly: Departure of stock price from its expected value based on fundamentals.
• Causes: Behavioural biases, such as overconfidence, self-attribution bias, and disposition effect, can lead to systematic mistakes and market anomalies.
• Examples: Momentum in prices, where investors hold on to losers longer and sell winners faster.

Behavioural Finance Explains Bubbles and Crashes

• Bubble: A sharp rise in asset price, driven by expectations of further rises and attracting new buyers.
• Crash: A sharp decline in asset price, often triggered by negative news, change in opinion, or liquidity crunch.
• Factors Contributing to Bubbles:
  • Liquidity: Cheap borrowing costs and liquidity chasing stocks.
  • Celebrity Status: Media promotion and self-fulfilling expectations.
  • Momentum: Investors extrapolating uptrends and herd trading.
  • Illusion of Control: Familiarity and access to information creating a false sense of control.
• Characteristics of Speculative Bubbles:
  1. High proportion of inexperienced traders.
  2. High uncertainty about true value.
  3. Investment promises high potential profits.
  4. Easy financing options.
  5. Difficult short selling.