Introduction
Behavioural finance is the study of the way in which psychology influences the behavior of market participants both at the individual and group level and the subsequent effects on financial markets.
It is a part of behavioural economics which deals with biases and cognitive errors affecting investors’ investing behavior. It makes an attempt to explain the gaps and market anomalies. Standard finance theories and framework does not explain this. Standard finance theories and models are based on certain assumptions
- investors are rational
- investors are risk averse
- investors are self interested utility maximizers
- investors update their belief, as new information comes in
- investors have access to all available information
Real life behaviour of investors is different from what traditional finance models assume. Some of the example in daily life are
- investors hold concentrated portfolio instead of diversifying
- investors show greed and fear instead of making rationale choice of risk return
- instead of accepting randomness with winning investments, investor attribute it to their skill
- investors getting confused between a good company and a good stock
- investors perceive domestic companies because they perceive the risk is low due to familiarity of the company
So real life investors are very different from those in standard finance theory.
Nobel laureates Daniel kahneman and Richard Thaler brought behavioural finance to forefront and attempt to integrate it with standard finance.
Bounded rationality
Most investors have limited 1.time Or 2.information or 3.ability to comprehend complex information at the time of decision making. Similarly when selecting one of many options requires meticulous analysis incorporating all the available information, people get confused.
They settle with an option possibly suboptimal which seems to be satisfactory and sufficient based on quick analysis governed by ‘thumb rules’. In other words, instead of optimizing as suggested by theories in finance, investors “satisfice” (seemingly satisfactory and sufficient).
Bounded Rationality, therefore, is the cognitive limitation of mind where in absence of time or complete information, decision making favours satisficing solution (satisficing is combination of satisfactory and sufficient) instead of an optimal (or maximising) one. It is important to note here that bounded rationality is not irrational decision making, but rational decision making under certain boundary conditions.
Nobel laureate Herbert Simon (1978) created the concept of Bounded Rationality.
Prospect Theory
Daniel Kahneman and Amos Tversky (1979) introduced Prospect Theory. It describes how individuals make choices in situations where they have to decide between alternatives that involve risk (e.g. financial decision) and how individuals evaluate potential losses and gains. Prospect theory considers how prospects are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
There are two phases of making choices:
• an early phase in which prospects are framed
• a subsequent phase in which prospects are evaluated and chosen.
The framing phase consists of using heuristics to do a preliminary analysis of the prospects. In the second phase, the edited prospects are evaluated and the prospect of highest perceived value is chosen.
Categorization of Biases
Individuals as well as institutions process information based on their experiences and preferences, in which psychology are referred to as biases. Such intentional errors often lead to systematic favouring.
While people desire to follow rational decision making. It involves evaluating all the options with all the information available, individual biases hold them from doing so. Rational decisions often get circumstantial. While you can’t always maintain impartiality, maintaining discipline and checklists can help in mitigating them.
Broadly, investing biases fall into two main categories:
• Emotional biases – based on feeling or emotions
• Cognitive errors – based on faulty cognitive reasoning
Emotional biases
At the time of decision making, individual’s feelings or emotions occur spontaneously which is a result of deep-rooted personal experiences. It is important to note that emotional bias does not mean making errors. On the contrary, it has an underlying of being protective and taking suitable and comfortable decision for oneself.
Following are some of the emotional biases:
Loss Aversion Bias:
People prefer taking chances for avoiding losses. However, they do not like taking chances with certain gains. Losses are significantly more powerful than gains.
Shefrin and Statman (1985) proposed Disposition Effect for holding “losers” too long and selling “winners” too early. They noted that “people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses.” Consequently, “investors will hold onto stocks that have lost value and will be eager to sell stocks that have risen in value.”
Stereo Typing Bias:
Investors, while dealing with uncertainties, look for representative characteristics and base their decisions on the general perception about those characteristics. For example, belief that a high-profile manager is equals to a better managed company and that makes good investments, is a stereo type bias.
Overconfidence Bias:
Overconfidence Bias is a bias in which people demonstrate unwarranted larger faith in their own intuitive reasoning, judgments and cognitive abilities. Most people rate themselves better than average in their skills, expertise, knowledge etc. With illusion of superior knowledge, overconfidence bias is intensified when combined with self-attribution bias, where people confuse brain with bull market. Overconfidence often results in underestimating the losses. This unwarranted confidence often leads to sub-optimal decisions in investments. Overconfidence leads to misguided conviction and often blurs the difference between skill and luck.
Even the feedback loop in such cases further fuels the overconfidence bias and investor easily gets swayed away from risk-return trade off principles. Some of the observed behaviour of overconfidence biases is visible in portfolio concentration, sector or country bias, excessive trading, sticking with loss making stocks in sectors which investor believes to know more etc.
Endowment Bias:
Endowment Bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not. When the investor believes that the stock(s) she owns is more valuable than others and when the market will recognise, she would make superior returns. Endowment bias has two attributes: valuing ownership and loss aversion. It has been generally observed that inherited stocks are rarely sold even if they do not fit into the overall investment strategy.
Status Quo Bias:
When an individual has second thoughts or want to avoid regrets in decision making, often left with taking no decision at all and maintaining status quo. Status Quo Bias is closely linked to Regret Aversion bias in which people tend to avoid making decisions that will result in-action out of fear that the decision will turn out poorly.
Regrets have two dimensions –
• actions that people take (Error of commission)
• actions that people could have taken (Error of omission)
Regret is more intense due to error of commission than omissions and hence people prefer the status quo. Sometimes complexity in understanding or execution also leads to status quo. Richard Thaler explained a simple nudge resulted into employees enrolling for pension plans, which otherwise had poor enrolment only due to status quo bias.
Cognitive Errors
Cognitive errors are statistical, information-processing or memory errors that cause a person to deviate from rational behaviour. It result from reasoning based on faulty thinking whereas emotional biases result from reasoning influenced by feelings.
Depending on thumb rules instead of doing exact calculations, is an example of cognitive bias. People are less likely to make cognitive errors if they remain vigilant. Unlike emotional bias, cognitive biases can be considered as short-cut approach to decision making where one avoids going through the pains of analysing and evaluating options. Also at times, it can be factually incorrect.
Mental Accounting
Mental Accounting Bias is an information processing bias in which people treat one sum of money differently from another equal-sized sum, based on which mental account the money is kept. Richard Thaler developed the concept of ‘mental accounting’ in 1999. People code, categorize and evaluate economic outcomes by grouping their assets into any number of non-fungible mental accounts. When people keep mental accounts, they treat money less fungible than it really is, which often leads to sub optimal decisions. People link their spending to specific budgets. They are willing to take more risk with money that is perceived as windfall gain or lottery winnings. People end up spending their non-regular income extravagantly. This treatment of salary income differently from tax refunds and bonus amount etc., leads to irrational spending.
Thaler recommended that people should consider money as fungible and treat all money the same, regardless of its origin or use.
Investors think about their wealth as if it consists of various buckets e.g. retirement fund, children’s education fund and marriage fund etc. It mentally helps them to keep a tab on it. This often results into selection of assets under each bucket. Investor could have been avoid that on a broader level if they consider their overall investments together and work towards optimizing portfolio.
Framing:
Framing Bias is an information-processing bias in which a person answers a question differently based on how you ask them(framed). The presentation of information influence investors’ decision. Different types of framing approaches are present, including risky choice framing (e.g. the risk of losing 10 out of 100 lives vs. the opportunity to save 90 out of 100 lives), attribute framing (e.g. beef that is 95% lean vs. 5% fat).
As the outcomes of both the choices in both the scenarios is the same, however people mostly opted for second options in both the scenarios. Prospect theory describes how individuals make decision when they have to decide between choices that involve risk (e.g., financial decisions) and how individuals evaluate potential losses and gains.
Prospect theory considers how to perceive prospects (alternatives) based on their framing, how to evaluate gains and losses and how to weigh uncertain outcomes.
Investors have to rise above of this bias while filling risk tolerance questionnaire for the purpose of determining the risk appetite as that would influence the asset allocation choices greatly. Also at the time of evaluating the performance of the portfolio, decision making frames may lead to sub-optimal judgments.
Anchoring:
Anchoring bias occurs when people rely on pre-existing information when they make decisions. Most of the investors anchor their investments around some initial information, which they so heavily rely upon. This makes all the subsequent information to be seen in light of the anchor information. For example, during negotiations, the first price mentioned becomes anchor price during the entire negotiations. Making a judgement about where the prices of the stock could be on the basis of its past performance, is another example of anchoring.
Choice paralysis:
The availability of too many options for investment can lead to a situation of not wanting to evaluate and make the decision. Too much of information also leads to a similar outcome on taking action.
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