Understanding Human Behavior Helps Us Understand Investor Behavior MA2N0246 Tsatsral Dorjsuren

Behavioural Finance O 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

O Behavioral 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 O Prospect Theory O Regret Theory O Anchoring O Herding

Prospect Theory O 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 Theory O 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 Theory O Meaning O 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 Accounting O Dividing current and future assets in separate portions. O Results in different level of utility of each portion O 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.

Herding O 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.

Conclusion O 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