Behavioral Finance

By: Mohamed Ismail Megahed

DBA, Finance
Definition of Behavioral Finance

A field of finance that proposes psychology-based

theories to explain stock market anomalies. Within
behavioral finance, it is assumed that the information
structure and the characteristics of market participants
systematically influence individuals' investment decisions
as well as market outcomes.
Standard Theory of Finance
Investors Markets
Are rational beings Quickly incorporate
Consider all information all known information
and accurately assess Represent the true
its meaning
value of all securities
Some individuals/agents
May be difficult to
may behave irrationally
or against predictions, beat in the long term
but in the aggregate
they become irrelevant.
Standard Theory of Finance
Investors Markets
Are not totally In the short term,
rational there are anomalies
Often act based on and excesses
imperfect
information
Behavioral Finance & Conventional Finance

Conventional Finance Behavioral Finance

Prices are correct; What if investors dont
equal to intrinsic behave rationally?
value.
Resources are
allocated efficiently.
Consistent with
Efficient Market
Hypothesis
The Behavioral Critique

There are two categories of irrationalities:

1. Investors do not always process information
correctly.
Result: Incorrect probability
distributions of future returns.
2. Even when given a probability distribution of
returns, investors may make inconsistent or
suboptimal decisions.
Result: They have behavioral biases.
Information Processing Critique

1. Forecasting Errors: Too much weight is placed

on recent experiences.

2. Overconfidence: Investors overestimate their

abilities and the precision of their forecasts.

3. Conservatism: Investors are slow to update

their beliefs and under react to new
information.

4. Sample Size Neglect and Representativeness:

Investors are too quick to infer a pattern or
trend from a small sample.
Behavioral Characteristics

1. Loss aversion
2. Anchoring
3. Diversification
4. Disposition effect
5. Herding
6. Media response
7. Optimism
Behavioral Characteristics

Loss aversion
Devote significant attention to assessing risk
Assess risk tolerance at least once per year
possibly using a risk tolerance questionnaire
Assess gains and losses less frequently
Behavioral Characteristics

Anchoring:
describes the common human tendency to rely
too heavily on the first piece of information
offered (the "anchor") when making decisions.
Be aware of investment anchors
Use relevant benchmarks in comparing the
investment portfolio
Be cognizant of long-term goals, not short-term
fluctuations
Behavioral Characteristics

Diversification
Make sure you are properly diversified
Dont let investment options dictate the asset
allocation
Work with the financial advisor to determine
asset classes that will maximize return and
reduce risk
Behavioral Characteristics

Disposition effect
The disposition effect refers to peoples
tendency to:
Hang on to losers too long
Sell the winners too soon

This allows them to enjoy the feeling of winning

faster and defer the pain of loss
Behavioral Characteristics

Herding
Investors have a tendency toward herd
behavior
Line study on the effects of herd behavior
Disproportionate flow of money into four and
five-star rated mutual funds
Ratings have a lack of predictive value
Behavioral Characteristics

Media response
Study of the effects of news on investment
decisions:
Two groups: one received news and one did not
The group with no news outperformed
the group that received news
People often feel the need to react to new
information
News is often irrelevant to long-term
performance and is often misinterpreted
Information overload can cause stress
Behavioral Characteristics

Optimism
People believe it is likely that:
Good things will happen to them
Bad things will happen to others

They believe others are more likely to:

Have a heart attack

Develop cancer

They believe others are less likely to:

Become rich

Become famous
Behavioral Biases

1. Narrow Framing
2. Mental accounting
3. Regret avoidance
4. Prospect theory
Behavioral Biases

Narrow Framing
How the risk is described, risky losses vs. risky
gains, can affect investor decisions
Investing is a series of propositions, not a single event
Performance should always be viewed within the
context of the total net worth
Look at long-term goals, not short-term results

Mental accounting
Investors may segregate accounts or monies and take
risks with their gains that they would not take with their
principal.
Behavioral Biases

Regret avoidance
Investors blame themselves more when an
unconventional or risky bet turns out badly.

Prospect theory
Conventional view: Utility depends on level of
wealth.
Behavioral view: Utility depends on changes in
current wealth.
Limits to Arbitrage

Behavioral biases would not matter if rational

arbitrageurs could fully exploit the mistakes of
behavioral investors.

Fundamental Risk:
Markets can remain irrational longer than you
can remain solvent.
Intrinsic value and market value may take too
long to converge.
Limits to Arbitrage

Implementation Costs:
Transactions costs and restrictions on short
selling can limit arbitrage activity.

Model Risk:
What if you have a bad model and the market
value is actually correct?
Limits to Arbitrage and the Law of One Price

Siamese Twin Companies

Royal Dutch should sell for 1.5 times Shell
Have deviated from parity ratio for extended
periods
Example of fundamental risk

Equity Carve-outs
3Com and Palm
Arbitrage limited by availability of shares for
shorting
Limits to Arbitrage and the Law of One Price

Closed-End Funds
May sell at premium or discount to NAV
Can also be explained by rational return
expectations
Bubbles and Behavioral Economics

As the dot-com boom developed, it

seemed to feed on itself
Investors were increasingly confident of
their investment prowess
Bubbles are easier to spot after they end.
Dot-com bubble
Housing bubble
Technical Analysis and Behavioral Finance

Technical analysis attempts to exploit recurring

and predictable patterns in stock prices.
Prices adjust gradually to a new equilibrium.
Market values and intrinsic values converge
slowly.

Disposition effect: The tendency of investors to

hold on to losing investments.
Demand for shares depends on price history
Can lead to momentum in stock prices
Trends and Corrections: The Search for Momentum

Dow Theory
1.Primary trend : Long-term movement of prices,
lasting from several months to several years.
2.Secondary or intermediate trend: short-term
deviations of prices from the underlying trend line
and are eliminated by corrections.
3.Tertiary or minor trends: Daily fluctuations of little
importance.
Sentiment Indicators

Trin Statistics:

volume.declining
number.declining
trin
volume.advancing
number.advancing

Relative strength
Measures the extent to which a security has
outperformed or underperformed either the
market or its industry
Sentiment Indicators

Confidence index
Ratio of the average yield on 10 top-rated
corporate bonds divided by the average yield
on 10 intermediate-grade corporate bonds

Put/call ratio
Call options give investors the right to buy at a
fixed exercise price and a put is the right to sell
at a fixed exercise price
Change in ratio can be given a bullish or
bearish interpretation
Sentiment Indicators

Short Interest - total number of shares that

are sold short
When short sales are high a signal occurs
Bullish interpretation
Bearish interpretation
A Warning

Although the ability to discern apparent

patterns with stock market prices is irresistible
it is also possible to perceive patterns that
may not exist
Thanks