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Introduction to Behavioral Finance
BEHAVIOURAL FINANCE – ADANI MDP Thursday, 4 April Introduction to Behavioral Finance
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BEHAVIOURAL FINANCE – ADANI MDP 20.04.2019
“Don’t fool yourself, and remember you are the easiest person to fool.” Richard Feynman
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PROBABILITY v/s POSSIBILITY
BEHAVIOURAL FINANCE – ADANI MDP PROBABILITY v/s POSSIBILITY
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Recency Bias while looking at the the Nifty 50
BEHAVIOURAL FINANCE – ADANI MDP Reversion to the Mean & Recency Bias while looking at the the Nifty 50
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Is it a Stock Market or Is it a Market of Stocks
BEHAVIOURAL FINANCE – ADANI MDP Is it a Stock Market or Is it a Market of Stocks
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BEHAVIOURAL FINANCE – ADANI MDP 20.04.2019
"All investment is, is laying out some money now to get more money back in the future. Now, there’s two ways of looking at the getting the money back. One is from what the asset itself will produce. That’s investment. One is from what somebody else will pay you for it later on, irrespective of what the asset produces, and I call that speculation. So, if you are looking to the asset itself, you don’t care about the quote because the asset is going to produce the money for you." --Warren Buffett
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We are the market - since we can’t beat ourselves, it follows that we can’t beat the market over the long-term
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Behavioral Finance is the study of the influence of psychology on the behaviour of investors and their effect on the markets
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“Stocks are ownership shares of businesses; they are not pieces of paper that bounce around on which you calculate Sharpe and Sortino ratios. They are ownership shares of businesses that we value, and either buy at a discount or short when they are overpriced.” Joel Greenblatt
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Humans are Irrational 90 percent of the time
BEHAVIOURAL FINANCE – ADANI MDP Humans are Irrational 90 percent of the time We make Emotional Decisions, not Rational Ones
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“Investing isn’t about beating others at their game.
BEHAVIOURAL FINANCE – ADANI MDP “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.“ B E N J A M I N G R A H A M
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"The investor's chief problem—
BEHAVIOURAL FINANCE – ADANI MDP "The investor's chief problem— and even his worst enemy— is likely to be himself." – B e n j a m i n G r a h a m
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We make Emotional Decisions, not Rational ones
BEHAVIOURAL FINANCE – ADANI MDP We make Emotional Decisions, not Rational ones
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BEHAVIOURAL FINANCE – ADANI MDP 20.04.2019
Pendulum Swing
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ECONOMY AND THE STOCK MARKET
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BROWNIAN MOTION BEHAVIOURAL FINANCE – ADANI MDP
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An Investing Edge is defined as ‘a technique,
BEHAVIOURAL FINANCE – ADANI MDP An Investing Edge is defined as ‘a technique, observation or approach that creates a cash advantage over other market players. It doesn’t have to be elaborate; anything that adds a few points to the winning side of an equation builds an edge that lasts a lifetime’.
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Informational Edge Analytical Edge Time Horizon Edge Behavioral Edge
Behavioral Finance – ADANI MDP Informational Edge Analytical Edge Time Horizon Edge Behavioral Edge
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Things that are known to everyone aren’t worth knowing.
BEHAVIOURAL FINANCE – ADANI MDP Things that are known to everyone aren’t worth knowing.
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There is someone on the other side of the Trade. Who are the they?
BEHAVIOURAL FINANCE – ADANI MDP There is someone on the other side of the Trade. Who are the they?
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Time isn’t the main thing. It’s the only thing. Miles Davis
BEHAVIOURAL FINANCE – ADANI MDP Time isn’t the main thing. It’s the only thing. Miles Davis
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Life has hidden information, not so in Chess
Life ≠ Chess Life has hidden information, not so in Chess There is no element of Luck in Chess, not so in Life. BEHAVIOURAL FINANCE – ADANI MDP
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Unknowingly, we treat our life decisions as if they were Chess decisions
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BEHAVIOURAL FINANCE – ADANI MDP 20.04.2019
Outcome Quality ≠ Decision Quality Decisions & Outcomes are not PERFECTLY Correlated
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Net, Net – Chess cannot be a model for decision-making in our lives
BEHAVIOURAL FINANCE – ADANI MDP Net, Net – Chess cannot be a model for decision-making in our lives
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BEHAVIOURAL FINANCE – ADANI MDP 20.04.2019
Socionomics is defined as the study of social mood and its influence over social attitudes and actions.
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Socionomics Socionomics Socionomics
Behavioral Finance - Adani MDP BEHAVIOURAL FINANCE – ADANI MDP Socionomics Socionomics Socionomics The chicken of economic weakness produced the Brexit egg from which further economic woe is hatching.
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Herd Mentality – Following the Crowd
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“Rationality resides in what you do, not in what you think or in what you “believe” (skin in the game).... Rationality is about survival.” — Nassim Taleb
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Rational Behaviour is one that is based on (a) our ability to think in a logical way and (b) our capacity to change according to our thoughts
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Rational Investing in Irrational Markets is what Behavioral Finance is All about.
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Being Irrational is not always a bad thing
BEHAVIOURAL FINANCE – ADANI MDP Being Irrational is not always a bad thing
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Type 1 Error - False Positive Type 2 Error - False Negative
BEHAVIOURAL FINANCE – ADANI MDP Type 1 Error - False Positive Type 2 Error - False Negative
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Our Beliefs form the basis of our decision-making
BEHAVIOURAL FINANCE – ADANI MDP Our Beliefs form the basis of our decision-making
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How do we form our beliefs How do we change our beliefs
BEHAVIOURAL FINANCE – ADANI MDP Beliefs and Filters How do we form our beliefs How do we change our beliefs
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Experience is a hard teacher because she gives the test first,
BEHAVIOURAL FINANCE – ADANI MDP Experience is a hard teacher because she gives the test first, the lesson afterwards.
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We love predictions and follow those who we think can predict
BEHAVIOURAL FINANCE – ADANI MDP Human Minds are emotional - Once the emotions creep in, irrationality follows. We love predictions and follow those who we think can predict
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Heuristics v/s Probabilities Humans make decisions on the basis of
BEHAVIOURAL FINANCE – ADANI MDP Heuristics v/s Probabilities Humans make decisions on the basis of instinct using Heuristics / Shortcuts.
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A cognitive bias is defined as a mistake in reasoning, evaluating or remembering often occurring as a result of a deviation from our judgment and leading to irrational behaviour on our part.
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Cognitive Dissonance is the mental condition in which people rationalize why their actions are inconsistent with their thoughts and beliefs.
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A belief must be held with deep conviction.
BEHAVIOURAL FINANCE – ADANI MDP A belief must be held with deep conviction. The person holding the belief must have committed himself to it. The belief must be sufficiently specific and sufficiently concerned. Such undeniable dis-confirmatory evidence must occur. The individual believer must have social support.
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Justify your beliefs and your behaviours.
BEHAVIOURAL FINANCE – ADANI MDP Change your behaviour. Change your beliefs. Justify your beliefs and your behaviours.
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Confirmation Bias is the human tendency to see all evidence as supporting your beliefs, even if the evidence is nothing more than coincidence. Again we believe it happens only to others and not to ourselves.
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Effects of Confirmation Bias Encourages homogeneity of thought
BEHAVIOURAL FINANCE – ADANI MDP Effects of Confirmation Bias Encourages homogeneity of thought Leads to poor decision making
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Remedies to Confirmation Bias Open mindedness Viewpoint diversity
BEHAVIOURAL FINANCE – ADANI MDP Remedies to Confirmation Bias Open mindedness Viewpoint diversity
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where the system is built to prey on one of our deepest biases.
BEHAVIOURAL FINANCE – ADANI MDP Unseen algorithms push us more of what we like, so that we’ll spend more time on the host sites. It’s a dangerous feedback loop, where the system is built to prey on one of our deepest biases.
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Filter Bubbles Filter Bubbles are defined as: a phenomenon in which a person is exposed to ideas , people, facts or news that adhere to or are consistent with a particular political or social ideology.
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Filter bubbles may not seem that real to us, because we see these views from a distance, but that is not real engagement, and does more harm than good.
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Motivated Reasoning Francis Bacon summed it up in 1629, as succinctly as any modern behavioural scientist: The human understanding when it has once adopted an opinion draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found o the other side, yet these it either neglects or despises.
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Behavioral Finance - Adani MDP 20.04.2019
BEHAVIOURAL FINANCE – ADANI MDP Emotion: Greed v/s Fear
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You can take the monkey out of the status-seeking game,
BEHAVIOURAL FINANCE – ADANI MDP You can take the monkey out of the status-seeking game, but you can’t take status-seeking out of the monkey
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The Stock Market has become a spectator sport. As a result, the Signal to Noise ratio is very low
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1 % Rule – Everyone else is a lurker, as in any spectator sport – no Skin in the Game
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Keynes Beauty Contest as a means to explain price fluctuations in the stock market.
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Each participant had to pick, not those faces which he (or she) finds prettiest, but those which he thinks likeliest to catch the fancy of the other participants. The prize was awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.
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‘We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.’ (Keynes, General Theory of Employment Interest and Money, 1936).”
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Mindfulness v/s Mindlessness
BEHAVIOURAL FINANCE – ADANI MDP Mindfulness v/s Mindlessness
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Mindlessness is an act in which we fail to possess control over our thoughts and the individual intellect that we possess.
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When there is nothing clever to do the mistake lies in trying to be clever - Howard Marks
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We can say the same about markets - whenever in doubt, stay out.
BEHAVIOURAL FINANCE – ADANI MDP It’s better to be on the ground wishing you were in the air, than in the air wishing you were on the ground”. We can say the same about markets - whenever in doubt, stay out.
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We are behaving like Pavlovs Dogs
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Man in the Mirror – How to Generate Behavioural Alpha
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The Experts are not immune from Behavioral Biases
BEHAVIOURAL FINANCE – ADANI MDP The Experts are not immune from Behavioral Biases Keep the experts on tap, not on top
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Confidence is knowing that you can make it through the day without screwing up. Overconfidence is thinking that you can do it again tomorrow.
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