Necessity of Behavioral Finance in Everyday Life

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Muhammed Faraz Ashraf

Necessity of Behavioral Finance in Everyday Life

EXECUTIVE SUMMARY

The following dissertation hopes to provide a better understanding of some of the

anomalies (i.e., irregularities) that conventional financial theories have failed to explain. In

addition, layout some insights into the underlying reasons and biases that cause some people to

behave irrationally (and often against their best interests). Furthermore, it looks into the need for

an awareness in behavioral finance in the most basic level for people of every turf. Eventually, this

newfound knowledge shall come to the aid while making financial decisions.

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TABLE OF CONTENTS

0 Introduction ................................................................................................................................. 1

Background ................................................................................................................................. 1

Homo Economics .................................................................................................................... 2

Important Contributors .......................................................................................................... 3

Critics ...................................................................................................................................... 4

Anomalies .................................................................................................................................... 5

January Effect .......................................................................................................................... 5

The Winner's Curse ................................................................................................................ 6

Equity Premium Puzzle ........................................................................................................... 7

1 Literature Review ......................................................................................................................... 9

1.1 Anchoring ........................................................................................................................ 9

1.2 Mental Accounting ........................................................................................................ 11

1.3 Confirmation & Hindsight Bias .................................................................................... 12

1.3.1 Confirmation Bias ...................................................................................................... 12

1.3.2 Hindsight Bias ........................................................................................................... 13

1.4 Gambler’s Fallacy .......................................................................................................... 13

1.5 Herd Behavior ................................................................................................................ 14

1.6 Overconfidence .............................................................................................................. 15

1.7 Availability Bias ............................................................................................................. 16

1.8 Prospect Theory ............................................................................................................ 17

2 Research Methodology ............................................................................................................... 19

2.1 The General Approach .................................................................................................. 19

2.2 Choice of Method .......................................................................................................... 20

2.3 Data Collection .............................................................................................................. 21

2.3.1 Primary Data .............................................................................................................. 21

2.3.2 Secondary Data .......................................................................................................... 22

2.4 Criticism of the Sources ................................................................................................ 22

2.4.1 Criticism of Primary Data.......................................................................................... 22

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2.4.2 Criticism of Secondary Data ...................................................................................... 23

2.4.3 Validity ...................................................................................................................... 23

2.4.4 Reliability .................................................................................................................. 24

2.5 Data Collection and Analysis ........................................................................................ 25

2.5.1 Scale of Awareness .................................................................................................... 26

2.5.2 Anchoring .................................................................................................................. 28

2.5.3 Mental Accounting .................................................................................................... 29

2.5.4 Confirmation Bias ...................................................................................................... 31

2.5.6 Hindsight Bias ........................................................................................................... 32

2.6 Recommendation .......................................................................................................... 33

References ..................................................................................................................................... 36

Appendix A – Questionnaire ......................................................................................................... 38

Appendix B – Results Analysis ..................................................................................................... 40

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Acknowledgments

The process of writing and completing this dissertation has been challenging yet

very rewarding for me. I would like to express my sincere gratitude to several important

people. I thank Vinod Shukla, my program leader, for his guidance, support, and

confidence in me. I appreciate the guidance and help from the faculty at Amity University,

Dubai. I am grateful to my fellow students for their friendship and support throughout the

years of my study.

I would like to convey my deepest appreciation to my family, for their love and

support along every step of the way. They have always encouraged me to pursue what I

wanted to do with my life.

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0

Introduction

According to conventional financial theory, the world and its participants are, for

the most part, rational "wealth maximizers". However, there are many instances where

emotion and psychology influence people’s decisions, causing unpredictable or irrational

behavior.

Behavioral finance is a relatively new field that seeks to combine behavioral and

cognitive psychological theory with conventional economics and finance to provide

explanations as to why people make irrational financial decisions.

Background

Before going over the specific concepts behind behavioral finance, the following

paragraphs hope to show a much general look at this branch of finance. This section,

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examines a comparison between behavioral and conventional finance, give introduction to

the three important contributors to the field and runs an eye over the criticism it has

received.

Why is behavioral finance necessary?

When using the labels "conventional" or "modern" to describe finance, one aims to

talk about the type of finance that is based on rational and logical theories, such as the

capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These

theories assume that people, for the most part, behave rationally and predictably.

For a while, theoretical and empirical evidence suggested that CAPM, EMH and

other rational financial theories did a respectable job of predicting and explaining certain

events. However, as time went on, academics in both finance and economics began to find

anomalies and behaviors that couldn't be explained by theories available at the time.

While these theories could explain certain "idealized" events, the real world proved to be

a very messy place in which market participants often behaved very unpredictably.

Homo Economics

One of the most fundamental assumptions that conventional economics and

finance brands is that people are rational "wealth maximizers" who seek to increase their

own welfare. According to conventional economics, emotions and other minor factors do

not influence people when it comes to making economic choices.

In most cases, however, this assumption does not reflect how people behave in the

real world. The fact is people habitually behave irrationally. Consider how many people

purchase lottery tickets in the hope of hitting the big jackpot. From a purely logical

standpoint, it does not make sense to buy a lottery ticket when the odds of winning are

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overwhelming against the ticket holder (roughly 1 in 146 million, or 0.0000006849%, for

the famous Powerball jackpot). Despite this, millions of people spend countless dollars on

this activity.

Such anomalies prompted academics to look to cognitive psychology to account

for the irrational and illogical behaviors that modern finance had failed to explain. Thus,

Behavioral Finance seeks to explain our actions, whereas Modern Finance seeks to explain

the actions of the "economic man" (Homo economics).

Important Contributors

As in every other branch of finance, the field of behavioral finance have certain

brilliant minds that have provided significant theoretical and empirical contributions. The

following section provides a brief introduction to three of the biggest names associated

with the field.

Daniel Kahneman and Amos Tversky

Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the

fathers of behavioral economics/finance. Since their initial collaborations in the late 1960s,

the duo have published roughly 200 works, most of which relate to psychological concepts

with implications for behavioral finance. In 2002, Kahneman received the Nobel Memorial

Prize in Economic Sciences for his contributions to the study of rationality in economics.

Kahneman and Tversky have focused much of their research on the cognitive biases

and heuristics (i.e. approaches to problem solving) that cause people to engage in

unanticipated irrational behavior. Their most popular and notable works include writings

about prospect theory and loss aversion - topics that shall be examined later.

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Richard Thaler

While Kahneman and Tversky provided the early psychological theories that set

the foundation for behavioral finance, it would not have evolved if it weren't for economist

Richard Thaler.

During his research, Thaler became more and more mindful of the shortcomings in

conventional economic theories as they relate to people's behaviors. After reading a draft

version of Kahneman and Tversky's work on prospect theory, Thaler realized that, unlike

conventional economic theory, psychological theory could be used to account for the

irrationality in behaviors.

Thaler went on to collaborate with Kahneman and Tversky, blending economics

and finance with psychology to present concepts, such as mental accounting, the

endowment effect and other biases.

Critics

Although behavioral finance has been gaining support in recent years, it is not

without its own share of criticism. For example, few of the supporters of Efficient Market

Hypothesis, are vocal critics of Behavioral Finance.

The efficient market hypothesis is considered one of the foundations of modern

financial theory. However, the hypothesis does not account for irrationality because it

assumes that the market price of a security reflects the impact of all relevant information

as it is released.

The most notable critic of behavioral finance is Eugene Fama, the founder of

market efficiency theory. Professor Fama suggests that even though there are some

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anomalies that cannot be explained by modern financial theory, market efficiency should

not be totally abandoned in favor of behavioral finance.

In fact, he notes that many of the anomalies found in conventional theories could

be considered shorter-term chance events that are eventually corrected over time. In Fama

(1998), he argues that many of the findings in behavioral finance appear to contradict each

other, and that all in all, behavioral finance itself appears to be a collection of anomalies

that can be explained by market efficiency.

Anomalies

The presence of frequently occurring anomalies in conventional economic theory

was a big contributor to the formation of behavioral finance. These so-called anomalies,

and their continued existence, directly violate modern financial and economic theories,

which assume rational and logical behavior. The following is a quick summary of some of

the anomalies found in the financial literature.

January Effect

The January effect is named after the phenomenon in which the average monthly

return for small firms is consistently higher in January than any other month of the year.

This is at odds with the efficient market hypothesis, which predicts that stocks should

move at a "random walk".

However, Rozeff and Kinney (1976), found that from 1904-74 the average amount

of January returns for small firms was around 3.5%, whereas returns for all other months

was closer to 0.5%. This suggests that the monthly performance of small stocks follows a

relatively consistent pattern, which is contrary to what is predicted by conventional

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financial theory. Therefore, some unconventional factor (other than the random-walk

process) must be creating this regular pattern.

One explanation is that the surge in January returns is a result of investors selling

loser stocks in December to lock in tax losses, causing returns to bounce back up in

January, when investors have less incentive to sell. While the year-end tax selloff may

explain some of the January effect, it does not account for the fact that the phenomenon

still exists in places where capital gains taxes do not occur. This anomaly sets the stage for

the line of thinking that conventional theories do not and cannot account for everything

that happens in the real world.

The Winner's Curse

One assumption found in finance and economics is that investors and traders are

rational enough to be aware of the true value of some asset and will bid or pay accordingly.

However, anomalies such as the winner's curse - a tendency for the winning bid in

an auction setting to exceed the intrinsic value of the item purchased - suggest that this is

not the case.

Rational-based theories assume that all participants involved in the bidding

process will have access to all relevant information and will all come to the same valuation.

Any differences in the pricing would suggest that some other factor not directly tied to the

asset is affecting the bidding.

According Thaler (1988), there are two primary factors that undermine the rational

bidding process: the number of bidders and the aggressiveness of bidding.

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For example, the more bidders involved in the process means that you have to bid

more aggressively in order to dissuade others from bidding. Unfortunately, increasing your

aggressiveness will also increase the likelihood in that your winning bid will exceed the

value of the asset.

Consider the example of prospective homebuyers bidding for a house. It is possible

that all the parties involved are rational and know the property’s true value from studying

recent sales of comparative houses in the area. However, variables irrelevant to the asset

(aggressive bidding and the amount of bidders) can cause valuation error, oftentimes

driving up the sale price more than 25% above the property’s true value. In this example,

the curse aspect is twofold: not only has the winning bidder overpaid for the house, but

now that buyer might have a difficult time obtaining financing.

Equity Premium Puzzle

An anomaly that has left academics in finance and economics scratching their

heads is the equity premium puzzle. According to the capital asset pricing model (CAPM),

investors that hold riskier financial assets should be compensated with higher rates of

returns.

Studies have shown that over a 70-year period, stocks yield average returns that

exceed government bond returns by 6-7%. Stock real returns are 10%, whereas bond real

returns are 3%. However, academics believe that an equity premium of 6% is extremely

large and would imply that stocks are considerably risky to hold over bonds. Conventional

economic models have determined that this premium should be much lower. This lack of

convergence between theoretical models and empirical results represents a stumbling

block for academics to explain why the equity premium is so large.

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Behavioral finance's answer to the equity premium puzzle revolves around the

tendency for people to have "myopic loss aversion", a situation in which investors - overly

preoccupied by the negative effects of losses in comparison to an equivalent amount of

gains - take a very short-term view on an investment. What happens is that investors are

paying too much attention to the short-term volatility of their stock portfolios. While it is

not uncommon for an average stock to fluctuate a few percentage points in a very short

period of time, a myopic (i.e., shortsighted) investor may not react too favorably to the

downside changes. Therefore, it is believed that equities must yield a high-enough

premium to compensate for the investor's considerable aversion to loss. Thus, the

premium is seen as an incentive for market participants to invest in stocks instead of

marginally safer government bonds.

Conventional financial theory does not account for all situations that happen in

the real world. This is not to say that conventional theory is not valuable, but rather that

the addition of behavioral finance can further clarify how the financial markets work.

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Literature Review

In the following section, the study will explore eight key concepts that pioneers in

the field of behavioral finance have identified as contributing to irrational and often

unfavorable financial decision making. Chances are, at one point or another, most people

have fallen prey to some of these biases.

1.1 Anchoring

Similar to how a house should be built upon a good, solid foundation, our ideas and

opinions should also be based on relevant and correct facts in order to be considered valid.

However, this is not always so. The concept of anchoring draws on the tendency to attach

or "anchor" our thoughts to a reference point - even though it may have no logical relevance

to the decision at hand (Fromlet, 2001).

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Although it may seem an unlikely phenomenon, anchoring is fairly prevalent in

situations where people are dealing with concepts that are new and novel.

Anchoring is one of the root psychological flaws that pushes otherwise brilliant

people to make financial mistakes (Belsky & Gilovich, 2010). It is critical to admit this

heuristic is hardwired in ones’ brain or else people will continue to succumb to it. To avoid

making serious financial mistakes, one must become a vigilant contrarian.

In the mental process of anchoring, it begins with some tentative solution to the

problem and then seek for a better or more accurate solution. For example, a person walks

into a car lot and notes the sticker price, and he then uses that number as the starting point

for negotiations. It is well known that the car can be purchased for that amount, however,

the same person shall start the process of seeking to get a better price.

Studies have shown that the higher the first price is for an item, the higher will be

the final price one ends up paying for the exact same item (Kauffman & Wood, 2005).

Stores sometimes bump their prices 30% higher before a 30% off sale because they

understand this principle. Sellers on eBay may set a "buy-it-now" price artificially high

simply to induce higher competitive bids.

Avoiding Anchoring

According to Marotta (2008), the antidote for anchoring is doing the extra analysis

to evaluate the answer more rationally. “Anchoring is like finding ourselves sitting in a chair in a

pitch-black room. When we stand up, we keep one hand on the chair and reach as far as we can in each

direction to try to get a feel for our location. The anchor of the chair keeps us from straying too far from

our original point. The answer, of course, is to turn on the lights” Marotta (2008).

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For rookie investors especially, it is never a bad idea to seek out other perspectives.

Listening to a few "devil's advocates" could identify incorrect benchmarks that causes their

strategy to fail.

1.2 Mental Accounting

According to Foulke (2014), mental accounting, also known as “two-pocket”

theory, is a behavioral bias that occurs when people put their money into separate

categories, separating them into different mental accounts, based on, say, the source of the

money, or the intent of the account.

“Mr. and Mrs. L and Mr. and Mrs. H went on a fishing trip in the northwest and caught some

salmon. They packed the fish and sent it home on an airline, but the fish were lost in transit.

They received $300 from the airline. The couples take the money, go out to dinner and spend

$225. They had never spent that much at a restaurant before.”

– Richard H. Thaler (2008)

Although many people use mental accounting, they may not realize how illogical

this line of thinking really is.

Another aspect of mental accounting is that people also treat money differently

depending on its source (Belsky & Gilovich, 2010). For example, people tend to spend a

lot more "found" money, such as tax returns and work bonuses and gifts, compared to a

similar amount of money that is normally expected, such as from their paychecks. This

represents another instance of how mental accounting can cause illogical use of money.

Avoiding Mental Accounting Bias

The key point to consider for mental accounting is that money is fungible;

regardless of its origins or intended use, all money is the same. One can cut down on

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frivolous spending of "found" money, by realizing that "found" money is no different than

money that is earned by working.

As an extension of money being fungible, realize that saving money in a low- or no-

interest account is fruitless if one still has outstanding debt. In most cases, the interest on

debt will erode any interest that can be earned in most savings accounts. While having

savings is important, sometimes it makes more sense to forgo savings in order to pay off

debt (Ritter, 2003).

1.3 Confirmation & Hindsight Bias

It's often said that "seeing is believing". While this is often the case, in certain

situations perception is not necessarily a true representation of reality. This is not to say

that there is something wrong with the senses, but rather that the minds have a tendency

to introduce biases in processing certain kinds of information and events.

1.3.1 Confirmation Bias

It can be difficult to encounter something or someone without having a

predetermined opinion. This first impression can be hard to shake because people also

tend to selectively filter and pay more attention to information that supports their

opinions, while ignoring or rationalizing the rest (Tripathy, 2013). This type of selective

thinking is often referred to as the confirmation bias.

In investing, the confirmation bias suggests that an investor would be more likely

to look for information that supports his or her original idea about an investment rather

than seek out information that contradicts it. As a result, this bias can often result in faulty

decision making because one-sided information tends to angle an investor's frame of

reference, leaving them with an incomplete picture of the situation (Shefrin, 2002).

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Consider, for example, an investor that hears about a hot stock from an unverified source

and is intrigued by the potential returns. That investor might choose to research the stock

in order to "prove" its advertised potential is real. What ends up happening is that the

investor finds all sorts of green flags about the investment (such as growing cash flow or a

low debt/equity ratio), while glossing over financially disastrous red flags, such as loss of

critical customers or deteriorating markets.

1.3.2 Hindsight Bias

Another common perception bias is hindsight bias, which tends to occur in

situations where a person believes (after the fact) that the onset of some past event was

predictable and completely obvious, whereas in fact, the event could not have been

reasonably predicted (Gilson & Kraakman, 2002).

Many events seem obvious in hindsight. Psychologists attribute hindsight bias to

the inborn need in people to find order in the world by creating explanations that allow

us to believe that events are predictable. While this sense of curiosity is useful in many

cases (take science, for example), finding inaccurate links between the cause and effect of

an event may result in incorrect oversimplifications (Kartašova, 2013).

1.4 Gambler’s Fallacy

When it comes to probability, a lack of understanding can lead to incorrect

assumptions and predictions about the onset of events. One of these incorrect

assumptions is called the gambler's fallacy.

In the gambler's fallacy, an individual erroneously believes that the onset of a

certain random event is less likely to happen following an event or a series of events. This

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line of thinking is incorrect because past events do not change the probability that certain

events will occur in the future (Shefrin, 2002).

For example, consider a series of 20 coin flips that have all landed with the "heads"

side up. Under the gambler's fallacy, a person might predict that the next coin flip is more

likely to land with the "tails" side up. This line of thinking represents an inaccurate

understanding of probability because the likelihood of a fair coin turning up heads is

always 50%. Each coin flip is an independent event, which means that any and all previous

flips have no bearing on future flips.

Avoiding Gambler’s Fallacy

It's important to understand that in the case of independent events, the odds of

any specific outcome happening on the next chance remains the same regardless of what

preceded it (Johnson, et al., 2005).

1.5 Herd Behavior

One of the most infamous financial events in recent memory would be the bursting

of the internet bubble. However, this wasn't the first time that events like this have

happened in the markets. This leads one to ask the question of how something so

catastrophic can be allowed to happen repeatedly.

The answer to that question can be found in what some people believe to be a

hardwired human attribute: herd behavior, which is the tendency for individuals to mimic

the actions (rational or irrational) of a larger group. Individually, however, most people

would not necessarily make the same choice.

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There are a couple of reasons why herd behavior happens. The first is the social

pressure of conformity (Shiller, 2001). 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.

Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group

could be wrong (Hirshleifer & Teoh, 2003). . Despite a conviction that an idea or a course

of action may be wrong or irrational, one tends to follow the herd due to the belief that

they could be privy to some information that one does not have. This is very well sighted

in situations where a person has minimal experience.

Avoiding Herd Behavior

While it is tempting to follow the newest investment trends, an investor is

generally better off steering clear of the herd. Just because everyone is jumping on a certain

investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore, the

soundest advice is to always do the needed homework before following any trend.

1.6 Overconfidence

According to a survey (Montier, 2006), 74% of the 300 professional fund managers

believed that they had delivered above-average job performance. Of the remaining 26%

surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey

group believed that their job performance was average or better. Clearly, only 50% of the

sample can be above average, suggesting the irrationally high level of overconfidence these

fund managers exhibited.

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As one can imagine, overconfidence (i.e., overestimating or exaggerating one's

ability to successfully perform a particular task) is not a trait that applies only to fund

managers (Barberis & Thaler, 2003). Consider the number of times that a person

participated in a competition or contest with the attitude “I have what it takes to win!”;

regardless of the number of competitors or the fact that there can only be one winner.

Keep in mind that there is a fine line between confidence and overconfidence.

Confidence implies realistically trusting in one's abilities, while overconfidence usually

implies an overly optimistic assessment of one's knowledge or control over a situation

(Ritter, 2003).

Avoiding Over Confidence

Professional fund managers, who have access to the best investment/industry

reports and computational models in the business, can still struggle at achieving market-

beating returns. The best fund managers know that each investment day presents a new

set of challenges and that investment techniques constantly need refining. Just about every

overconfident investor is only a trade away from a very humbling wake-up call.

1.7 Availability Bias

According to the availability bias, people tend to heavily weight their decisions

toward more recent information, making any new opinion biased toward that latest news

(De Bondt, et al., 2008).

This happens in real life all the time. For example, seeing a car accident on a route

that is usually used by someone to go to work to, could lead to a tendency to drive extra

carefully the next time they are using it. Even though the danger level for that route was

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always the same as it had always been, having sighted the accident can lead a person to

overreact. Eventually one would even return to the same driving habit once they have

gotten over it.

Avoiding Availability Bias

Perhaps the most important lesson to be learned here is to retain a sense of

perspective. While it's easy to get caught up in the latest news, short-term approaches

don't usually yield the best investment results (Carter, et al., 2007). A thorough job of

researching investments, can bring about better understanding of the true significance of

recent news. It is important to remember to focus on the long-term picture.

1.8 Prospect Theory

Prospect theory, contends that people value gains and losses differently, and, as

such, will base decisions on perceived gains rather than perceived losses (Kahneman and

Tversky, 1979). Thus, if a person were given two equal choices, one expressed in terms of

possible gains and the other in possible losses, people would choose the former - even

when they achieve the same economic end result.

According to prospect theory, losses have more emotional impact than an

equivalent amount of gains. For example, in a traditional way of thinking, the amount of

utility gained from receiving $50 should be equal to a situation in which you gained $100

and then lost $50. In both situations, the end result is a net gain of $50.

However, despite the fact that one may end up with a $50 gain in either case, most

people view a single gain of $50 more favorably than gaining $100 and then losing $50.

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The prospect theory can be used to explain quite a few illogical financial behaviors

(Olsen, 1998). For example, there are people who do not wish to put their money in the

bank to earn interest or who refuse to work overtime because they don't want to pay more

taxes. Although these people would benefit financially from the additional after-tax

income, prospect theory suggests that the benefit (or utility gained) from the extra money

is not enough to overcome the feelings of loss incurred by paying taxes.

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2

Research Methodology

This chapter describes the overall approach of the thesis as well as the choice of

method, data collection and criticism of the sources.

A method can be escribed as an instrument in solving problems and in arriving at

new knowledge of the subject in question. Everything that contributes in achieving these

goals is a part of the method. It is important that the method is consistent with the reality

that is being researched. Furthermore, the achieved results should generate increased

comprehension and understanding of the problem being examined (Holme and Solvang,

1996).

2.1 The General Approach

The general approach of a study is affected by the researcher’s frame of reference,

which refers to one’s overall knowledge, norms and values (Wiedersheim-Paul and

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Eriksson, 1997). The approach of this dissertation is based upon the frame of reference,

which works as an individual scale. The applied theories and models themselves affect the

individual scale of the research. Therefore, it is important that the researcher maintains an

objective approach. To achieve objectivity, a wide range of theories and literature in the

field of Behavioral Finance have been studied. However, interpretations and opinions in

literature and scientific articles that influence people might make it difficult to achieve an

entirely objective approach.

According to Wiedersheim-Paul and Eriksson (1997) the scientific approach of a

study can be described by two fundamental perspectives: rationalism and empiricism. The

rationalistic perspective refers to a deductive method where the researcher bases the study

on a theory, creates a hypothesis and subsequently reaches a logical conclusion through

observations. On the other hand, the empirical perspective refers to an inductive method

where general conclusions are based on empirical data. In contrast to the deductive

method the research first takes an empirical point of view (data collection) and thereafter

relates the findings to a theory. This dissertation chooses a deductive method as the

research is based on a theoretical framework of finance with an emphasis on behavioral

finance. It then tests the empirical findings with the existing theories. However, a part of

the theory that the dissertation is based on, such as the prospect theory by Kahneman and

Tversky, is based on an inductive framework.

2.2 Choice of Method

A method can be either quantitative or qualitative. A quantitative method is

formalized, structured and is characterized by selectivity as well as a distance from the

source of information (Holme and Solvang, 1996). The approach centralizes on numerical

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observations and aims at generalizing a phenomenon through formalized analysis of

chosen data where statistical indicators play a central role. On the other hand, a qualitative

method is formalized to a lesser extent is directed at testing if the information is generally

valid. The approach is characterized by the use of verbal descriptions instead of purely

numerical data and aims to create a common understanding of the subject being studied.

In order to achieve the purpose, a quantitative as well as qualitative method has

been adopted for the dissertation. The quantitative method refers to the survey

implemented in the form of a questionnaire, which is directed at the common public (both

active investors and otherwise). The survey intends to determine how well the practical

decision-making framework and behavior of investors in reality are consistent with the

existing theories of finance. A qualitative method is implemented through the attempt to

describe the reasons and existence of behavioral biases with the help of existing theories.

2.3 Data Collection

Data for the dissertation was primarily collected through a survey in form of a

questionnaire as well as through research based on existing material concerning

behavioral finance.

2.3.1 Primary Data

Primary data refers to data, which is collected for a specific purpose and which was

required in order to complement secondary data (Wiedersheim-Paul and Eriksson, 1997).

The primary data in this dissertation consists of the survey in the form of a questionnaire

directed at the common public. The sample was randomly chosen, questionnaires handed

out and answered voluntarily by those who wished to participate.

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The questionnaire consists of questions concerning the fundamental factors

affecting financial decision-making and questions referring to the behavior of people. An

example of the survey is included in Appendix 1.

The questionnaires were first processed with the help of Microsoft Excel to get an

overview of the preliminary results. The analysis was divided into two parts. A regular

analysis with comparisons among questions, which were based on the same theory were

grouped with each appropriate theory. This was done in order to be able to analyze and

compare questions easily.

2.3.2 Secondary Data

Secondary data refers to the existing collected and summarized material of the

subject in question. This data originates from sources such as existing online database,

journal articles and books (Wiedersheim-Paul and Eriksson, 1997). The secondary data

used in the research refers to the existing theories in finance, more specifically behavioral

finance, such as articles in journals and literature on the subject as well as Internet data

sources. The emphasis was on finding material on the relatively new area of behavioral

finance.

2.4 Criticism of the Sources

Both the primary and secondary sources of data may contain factors influencing

the quality of the research. Furthermore, one must also consider the validity and reliability

of the research in order to establish the overall quality of the study.

2.4.1 Criticism of Primary Data

The survey conducted in the form of a questionnaire, is advantageous as the

collected data is unique and contemporary in nature and the questions may be formulated

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to specifically correspond to the area being researched. However, the questionnaire is

susceptible to the subjective opinions of the respondents. When asking about previous

events extending farther into the past, investors’ responses are exposed to their subjective

ability to recollect specific past events. The respondents may also have changed their

perception of past events. Therefore, the answers given by respondents can be biased

toward what they think would have been the right course of action if they were given the

same choice today instead of reflecting the actual decision that would have been made in

the past. This is called hindsight bias.

2.4.2 Criticism of Secondary Data

The theories and literature written on behavioral finance are relatively new. It is

currently an evolving branch of financial theory and thus subject to many interpretations

and, to some extent, controversy with standard finance. An objective perspective on

behavioral finance has been taken while describing and utilizing the existing theories in

explaining the behavior of market participants. The majority of the secondary data is

obtained from scientific sources and is contemporary in nature. Therefore the secondary

data is considered to be highly pertinent.

2.4.3 Validity

A research has high validity if the dissertation only contains what one wants to

study and nothing else (Thuren, 1991). Validity refers to how well the data collection and

data analysis of the research captures the reality being studied. Validity can be divided

into three subgroups: construct-, internal- and external validity (Yin, 1994). First,

construct validity refers to the data collection procedure, i.e. establishing correct

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operation measures for the concepts being studied. The dissertation concentrates on

financial decision-making in everyday lives on the basis of the observed phenomenon.

Internal validity refers to the process of establishing a casual relationship, whereby

certain conditions are shown to lead to other conditions, as distinguished from bogus

relationships (Yin, 1994). It also refers to the link between theory and the empirical

research (Svenning, 1997). The theories in behavioral finance, if not the only contributing

theory, are valid in explaining the empirical findings. However, it is difficult to show that

specific behavior among the investors observed would be the sole reason for the

phenomenon described.

2.4.4 Reliability

Reliability demonstrates that the operations of the dissertations, such as the data

collection procedures, can be repeated with the same outcome. The objective is to be sure

that if a later researcher followed exactly the same procedures as described by an earlier

researcher and conducted the same case study all over again; the later researcher should

arrive at the same findings and conclusions (Yin, 1994). One prerequisite for a repeated

case study is the need to document in detail the procedures in the relevant case. In this

study, a quantitative method has been utilized in the form of a questionnaire directed

toward the common public. It is considered easily applicable to another similar sample,

and should render the same results if directed toward the same sample group. Therefore,

it fulfills the reliability criteria.

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2.5 Data Collection and Analysis

The core objective of this dissertation was to understand the concepts of

behavioral finance, as well as to test its awareness among people. Another aim was to also

pin-point how behavioral finance concepts can be linked to everyday decisions in life.

The data collection was done in the form of an online survey through the website

SurveyMonkey (see appendix for the questionnaire template). The questions were

targeted at the general public with a greater focus on working professionals from various

fields ranging from medicine to business. Due to a limited time frame the sample set

consists only of 60 responses. The age demographic was set from 18 to 60. Out of these,

the majority of the responses came from the 21-29 age group; which roughly makes them

the emerging generation who are the investors of tomorrow. Questions 1-3 were general

questions that illustrates the demographics such as age, gender and field of profession of

the sample set. The actual testing of the concepts begin from question 4 till question 10.

The questions have been designed with the purpose of identifying the key concepts

of behavioral finance such as Anchoring, Mental Accounting, and Confirmation &

Hindsight Bias.

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2.5.1 Scale of Awareness

There are two questions that come under this factor. One test’s the awareness of

the subject and the second looks at the awareness consumers have with regards to their

investment/purchase decisions.

The above question highlights the awareness of the subject among the general

public.

From the graph, it can be seen that out of the 59 responses, majority (47%) are not

aware about such a topic as behavioral finance. Another 27 % have heard about it but they

are not sure, which loosely translated, means that they do not know. This means that

roughly 75% of the general public do not know what behavioral finance means.

This clearly shows that there is an immense need to create an awareness regarding

the subject among the masses solely for their benefit with regards to future investments.

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This question was aimed at knowing how much people realize that there are external

factors that affect their investment/purchase decisions. It also shows that these external

factors are those the general public was not even aware of.

A staggering 86% admit that external factors affect their decisions as well as the fact that

they do not know them. It basically means that, most people do not make wise, informed

decisions by knowing all information beforehand. Only a small percent (15) of people take

the effort to know all the relevant information that is necessary to make a wise and

informed decision

This only highlights the need for people to become more proactive with regards to their

investment strategies and need to push themselves to be aware of all the information.

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2.5.2 Anchoring

Q6. How much did you/will you be willing to spend for an engagement ring?

This question was designed to test the presence of Anchoring in people’s mind.

Although 50% of the respondents believe the accepted average cost is reasonable for an

engagement ring. 45% believe in assigning a salary scale to the cost which is clearly an

irrelevant reference point is created by the jewelry industry to maximize profits, and not

a valuation of love.

Conventional wisdom dictates that a diamond engagement ring should cost

around two months' worth of salary (Cawley, 2014). Believe it or not, this "standard" is one

of the most illogical one, as most men can't afford to devote two months of salary towards

a ring while paying for living expenses. Consequently, many go into debt in order to meet

the "standard".

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2.5.3 Mental Accounting

Q7. Do you have special accounts/funds set aside for a vacation or a new home (or any specific purpose) and have a Credit Card at the same time?

This question was aimed at understanding the mental accounting bias among the

current general public. According to the figures, 66% of the populatio do not have a special

fund set aside while having a credit card as well.

This could mainly be due to the living condition experienced by the sample set

who’ve answered the survey. Since the majority of the respondents fell into the 21-29 age

category, it could also be that the current generation is less into saving and more into

making easier lifestyle choices that reduce their existing debts , if any.

By all means, it is a relief to see that there are lesser people out there affected by

Mental Accounting Bias. People often have a special "money jar" or fund set aside for a

vacation or a new home, while still carrying considerable credit card debt as discussed in

the literature review.

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Q8. Do/Would you spend “found money” (bonuses, incentives, raffle, etc.) in a much more lavish manner than compared to that of your salary?

Although not by a bigger margin, however, there are people out there affected well

by this concept. This refers to an example stated above for Mental Accounting, where

people tend to use ‘found money’ a lot more than their normal income, such as paychecks.

Logically speaking, money should be interchangeable, regardless of its origin.

Treating money differently because it comes from a different source violates that logical

premise. Where the money came from should not be a factor in how much of it has been

spend - regardless of the money's source, spending it will represent a drop in one’s overall

wealth.

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2.5.4 Confirmation Bias

Q9. For example, you hear about a product for the first time – excellent review with rich features that fit your requirements. While researching about the product, have you felt that you tend to pay more attention to information that support your original review and ignore or rationalize the rest (negatives)?

Confirmation bias represents a tendency to focus on information that confirms

some pre-existing thought (Shefrin, 2002). The above graph illustrates that 56% of people

tend to stick with the first information they received while researching about it. At the

same time there is an evidence of 44% to show that there is a tendency for people to

consider the negative factors as well. This is a hopeful scenario as it shows not all people

are thinking the same way. Part of the problem with confirmation bias is that being aware

of it isn't good enough to prevent it. One solution to overcoming this bias would be finding

someone to act as a "dissenting voice of reason". That way the investor shall be confronted

with a contrary viewpoint to examine.

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2.5.6 Hindsight Bias

Q10. Think of a past event in your life where you had to make a financial decision and its outcome was unfavorable. Looking back on that event today, would you say that there were signs for it to have an unfavorable outcome and could have been avoided?

A staggering 83.33% of respondents are experiencing Hindsight Bias and most

likely a majority of those do not even know there exists such a psychological concept.

People should be careful when evaluating how past events affect the present, especially

when considering their own ability to predict how current events will impact the future.

Believing that one is able to predict future results can lead to overconfidence, and

overconfidence can lead to making choices that most often end up catastrophic.

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2.6 Recommendation

It is no rocket-science that the cause for recessions (in any form – DOTCOM, The

Great Recession, etc.) ultimately are investors as a whole – let it be small-time individual

investors or large-scale mutual/hedge funds. Considering the fact that, if not all, most of

the behavioral finance concepts help identifying the emotional factors that affect the

decision making process of such investors which clearly the majority is not aware of,

brings about the need for its awareness in the general public. The simple fact of being

aware that there are emotional factors which are most often not in their control shall make

them more conscious and reserved about their investment choices. It will urge them to do

further research and study in depth about their portfolio choices, which will eventually

result in favorable outcomes.

The one way this need for awareness about behavioral finance can be achieved is

through education. Currently, behavioral finance is still in its early stages of development

as a concrete theory. It is only included as a module, sometimes even a chapter, for those

opting to enter the world of finance.

Behavioral finance should be included on an academic level in its most basic form

for students of every field of study – be it engineering, medical, media etc. This is will help

the younger generation, presumably the future investors, to become much more rational

and efficient in their decision making. This in turn shall make the world of finance a much

better place and less prone to meltdowns and crashes.

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4 Conclusion

This brief introduction to behavioral finance has only touched a few points. More

extensive analysis can be found in Barberis and Thaler (2003), Hirshliefer (2001), Shefrin

(2000), and Shiller (2000).

So what can be done by knowing the many principles of behavioral finance? “Very

little; I have 40 years of experience with this, and I still commit these errors. Knowing the errors is not the

recipe to avoiding them,” said Daniel Kahneman, at CFA Institute’s 2012 Annual Conference.

In fact, he feels that organizations can improve the quality of thinking, but that individuals

cannot do as much.

Whether it's mental accounting, irrelevant anchoring or just following the herd,

chances are everyone is guilty of at least some of the biases and irrational behavior

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highlighted in this dissertation. Now that some of these biases can be identified, it's time

to apply that knowledge and if need be take corrective action. It will also help future

financial decisions be a bit more rational and lot more lucrative as well.

In conclusion, human element cannot be taken out of human decisions or

institutions. But an understanding of how the human mind works, can help make better

investment/purchase decisions.

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Appendix A – Questionnaire

“Your honest feedback is of highest importance in the course of my academic research. This

information will not be used to serve any other purpose.”

1. What is your Gender?

a. Male

b. Female

2. What is your age?

a. 17 or younger

b. 18 – 20

c. 21 – 29

d. 30 – 39

e. 40 – 49

f. 50 – 59

g. 60 and above

3. What is your major area of study/profession?

a. Business/Economics

b. Law

c. Engineering

d. Healthcare

e. Media/Culture

f. Education

g. Other (please specify)

4. Are you aware of the concept – Behavioral Finance?

a. Yes

b. No

c. Heard about it, not sure!

5. Do you believe that factors you're not aware of, affect your investment/purchase

decisions?

a. Yes (there are factors that I'm not aware of)

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b. No (I'm fully aware of all the factors)

6. How much did you/will you be willing to spend for your engagement ring?

a. One Month Salary

b. Two Months’ Salary

c. Three Months’ Salary

d. Average Accepted Cost

e. Others (please specify)

7. Do you have special accounts/funds set aside for a vacation or a new home (or any

specific purpose) AND have a Credit Card at the same time?

a. Yes

b. No

8. Do/Would you spend "found money" (bonuses, incentives, raffle, etc.) in a much

more lavish manner than compared to that of your salary?

a. Yes

b. No

9. For example, you hear about a product for the first time - excellent review with

rich features that fit your requirements. While researching about the product, have

you felt that you tend to pay more attention to information that support your

original review and ignore or rationalize the rest (negatives)?

a. Yes

b. No

10. Think of a past event in your life where you had to make a financial decision and

its outcome was unfavorable. Looking back on that event today, would you say

that there were signs for it to have an unfavorable outcome and could have been

avoided?

a. Yes

b. No

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Appendix B – Results Analysis This appendix presents all 10 questions results analysis. Seven of them have already been

presented in Data Collection and Analysis. Three of them were performed but the results

were not interesting enough to be presented and analyzed in the chapter. However, the

remaining three results are presented here for the completeness of the statistical research.

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42

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44

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