Behavioural Finance-B.V.Raghunandan, SVS College, Bantwal

MBA Department,

Alva’s College of Engineering,

Moodbidri

August 20, 2013

Bi-Polar World

• Physical Sciences like Physics, Chemistry, Mathematics-Precision and Quantitative

• Non-Physical Sciences like Botany, Zoology, Medicines and Social Sciences- Imprecise and Qualitative

Bi-Polar Finance

• Standard Finance -Adding Precision to the Art of Investment-Homo Economicus

• Behavioural Finance- The Imprecise Art and the Heuristic Attitude

Standard Finance

• Modigliani and Miller’s Arbitrage Theory• Markowitz’s Diversified Portfolio• Asset Allocation of Sharpe• Black-Schole’s Option Pricing

Miller-Modigliani Arbitrage

Arbitrage

Theory of

Franco

Modigliani

&

Merton

Miller

Harry Max Markowitz

• Modern Portfolio Theory- Risk, Return, Correlation and Diversification

William Forsyth Sharpe

• Capital Asset Pricing Model

• Sharpe Ratio for risk adjusted performance analysis

• Binomial Method of Option Valuation

• Returns Based Style Analysis

Fischer Black-Myron S.Scholes• Valuation of Options• Hedging• Wide Usage• Option Price Calculator

Efficient Market Hypothesis

• People behave rationally (Homo Economicus)• Maximise the expected profit or utility• Trying to predict future value of individual securities• Important current information is freely available to all the

participants (Weak, Semi-Strong and Strong Markets)• Free Availability of information means there is no cost involved

in getting the information

Behavioural Finance

• BF is the study of the impact created by psychological factor on the activities of the investing public, traders, companies and the financial intermediaries

Why Psychology?• Crowd Mentality• Childishness• Tension• Need to be Praised• Prove Smartness• Short Term View• Intolerance• Moody• Refusing to Take

Decision• Acting on Tips

• Escaping from Reality• TV/Internet• Individualistic• Creating a Virtual World• Destruction of Family• Diplomacy inside the

House• Self-Centered Parents• Nuclear Personalities• Failing Health• Blinkers on the Eyes

Authorities on Behavioural Finance

• 1896- Gustave le Bon-’A Study of Popular Mind’• 1912- Seldon-’Psychology of the Stock Market’-price

changes depend upon mental attitude of the investing and trading public

• 1956- Leon Festinger introduced Theory of Cognitive Dissonance in social psychology

Prospect Theory• 1974-Amos Tversky

& Daniel Kahneman described three heuristics when making judgement under uncertainty:

• Representativeness • Availability:

occurrences• anchoring and

adjustment• Risk Aversion

Import of the Theory

– Explaining the apparent regularity in human behaviors when assessing risk under uncertainty.

– People respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain.

– Computation is based on losses and gains rather than final asset values– Investors are risk hesitant when chasing gains but become risk lovers

when trying to avoid a loss

Risk Aversion

& Risk

Seeking• Situation 1

Option a) A sure gain of Rs.2,000

Option b) 25% Chance to gain Rs.10,000 and 75% chance to gain nothing

• Situation 2

a) A sure loss of Rs.5000b) 75% chance to loss Rs.10,000 and 25% chance to lose nothing

• A large majority of people Choose A in situation 2(i) and b in situation 2(ii).

• 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.

Richard Thaler: Regret Theory• Mental Accounting-1980

a) underweighting of opportunity costs

b) failure to ignore sunk costs

c) search behaviour, choosing not to choose and regret

d) precommitment and self-control.

Further Theories• 1980- Tversky and Kahneman- Problem

Framing and preferences• 1981-Shiller- Volatility is too high for the future

dividend• 1985- F.M.De Pont and Thaler-Overreaction of

Stcok Market• 1988- Samuelson and Zeckhauser- Status Quo

Bias• Many other Theories like Overconfidence etc

Changes in Stock Market

• Mutual Funds & Other Institutions

• HNI• FII Activity• F & O Market• Regulation by SEBI• Monetary Policy of RBI• Government Policies• Scams• Consultants, Advisors and

Media

• Investment Trusts• Disinvestment• Technology• Many Players• Dominant Financial Services• Free Pricing of IPOs• Technical Analysis• Irrelevance of PE Ratios• Tips and Sentiments• Interim Financial Reporting

THANK YOU