Emotions and Decision Making

Behavioural Finance
Unit - V
Emotions and Decision Making
Substance of Emotion, Theories of Emotion, Types and
Dimensions of Emotions, Emotional Styles; Fairness,
Reciprocity and Trust; Conformity; Bayesian Decision Making,
Heuristics and Cognitive Biases; Neuro Finance and Trader’s
Heuristics and Cognitive Biases; Neuro Finance and Trader’s
Brain.
Prepared by
Mr. Dayananda Huded M.Com NET, KSET
Department of Studies in Commerce
Rani Channamma University, PG Centre, Jamkhandi-01
E-mail: dayanandch65@gmail.com
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Mr. Dayananda Huded

Substance of Emotion
• The concept of emotion may seem simple, but scientists often have trouble agreeing
on what it really means. Most scientists believe that emotions involve things other
than just feelings
• The way that someone experiences an emotion. A feeling is something that you
experience internally, in your own mind, and that other people can understand based
on your behavior. You can help other people understand how you feel using emotion
terms, like “anger” or “sadness”—the subject of this study—or by using analogies,
like “I feel the way a kid would feel if her dad took away her Halloween candy.”
• They involve bodily reactions, like when your heart races because you feel excited.
They also involve expressive movements, including facial expressions and sounds—
They also involve expressive movements, including facial expressions and sounds—
for example, when you say “woah” because you are fascinated by something. And
emotions involve behaviors, like yelling at someone when you are angry.
• People use many different words to describe the emotions that they feel.
• The patterns of emotion that we found corresponded to 25 different categories of
emotion: admiration, adoration, appreciation of beauty, amusement, anger, anxiety,
awe, awkwardness, boredom, calmness, confusion, craving, disgust, empathic pain,
entrancement, excitement, fear, horror, interest, joy, nostalgia, relief, sadness,
satisfaction, and surprise.
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Mr. Dayananda Huded

Theories of Emotion
• 1. Evolutionary Theory
• According to the evolutionary theory of emotion, our emotions exist
because they serve an adaptive role. Emotions motivate people to respond
quickly to stimuli in the environment, which helps improve the chances of
success and survival.
• Naturalist Charles Darwin proposed that emotions evolved because they
were adaptive and allowed humans and animals to survive and reproduce.
Feelings of love and affection lead people to seek mates and reproduce.
Feelings of love and affection lead people to seek mates and reproduce.
Feelings of fear compel people to fight or flee the source of danger.
• Understanding the emotions of other people and animals also plays a
crucial role in safety and survival. If you encounter a hissing, spitting, and
clawing animal, chances are you will quickly realize that the animal is
frightened or defensive and leave it alone. Being able to interpret
correctly the emotional displays of other people and animals allows you
to respond correctly and avoid danger.
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2. James Lange Theory
• The James-Lange theory is one of the best-known examples of a physiological
theory of emotion. Independently proposed by psychologist William James and
physiologist Carl Lange, the James-Lange theory of emotion suggests that
emotions occur as a result of physiological reactions to events.
• According to the James-Lange theory of emotion, an external stimulus leads to a
physiological reaction. Your emotional reaction depends upon how you interpret
those physical reactions.
• For example, suppose you are walking in the woods and see a grizzly bear. You
begin to tremble, and your heart begins to race. The James-Lange theory
begin to tremble, and your heart begins to race. The James-Lange theory
proposes that you will conclude that you are frightened ("I am trembling.
Therefore, I am afraid"). According to this theory of emotion, you are not
trembling because you are frightened. Instead, you feel frightened because you
are trembling.
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Mr. Dayananda Huded

3. Cannon Bard Theory
• According to the Cannon-Bard theory of emotion, we feel emotions and experience
physiological reactions such as sweating, trembling, and muscle tension
simultaneously.
• Another well-known physiological theory is the Cannon-Bard theory of emotion.
Walter Cannon disagreed with the James-Lange theory of emotion on several
different grounds. First, he suggested, people can experience physiological reactions
linked to emotions without actually feeling those emotions. For example, your heart
might race because you have been exercising, not because you are afraid.
• Cannon also suggested that emotional responses occur much too quickly to be simply
products of physical states. When you encounter a danger in the environment, you
products of physical states. When you encounter a danger in the environment, you
will often feel afraid before you start to experience the physical symptoms associated
with fear, such as shaking hands, rapid breathing, and a racing heart.
• Cannon and Bard’s theory suggests that the physical and psychological experience of
emotion happen at the same time and that one does not cause the other.
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4. Schachter Singer Two Factor Theory
• Also known as the two-factor theory of emotion, the Schachter-Singer theory is an
example of a cognitive theory of emotion. This theory suggests that the physiological
arousal occurs first, and then the individual must identify the reason for this arousal to
experience and label it as an emotion. A stimulus leads to a physiological response that is
then cognitively interpreted and labeled, resulting in an emotion.
• Schachter and Singer’s theory draws on both the James-Lange theory and the Cannon-
Bard theory. Like the James-Lange theory, the Schachter-Singer theory proposes that
people infer emotions based on physiological responses. The critical factor is the situation
and the cognitive interpretation that people use to label that emotion.
• Like the Cannon-Bard theory, the Schachter-Singer theory also suggests that similar
• Like the Cannon-Bard theory, the Schachter-Singer theory also suggests that similar
physiological responses can produce varying emotions. For example, if you experience a
racing heart and sweating palms during an important exam, you will probably identify the
emotion as anxiety. If you experience the same physical responses on a date, you might
interpret those responses as love, affection, or arousal.
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Mr. Dayananda Huded

5. Cognitive Appraisal Theory
• According to appraisal theories of emotion, thinking must occur first
before experiencing emotion. Richard Lazarus was a pioneer in this area
of emotion, and this theory is often referred to as the Lazarus theory of
emotion.
• The cognitive appraisal theory asserts that your brain first appraises a
situation, and the resulting response is an emotion.
• According to this theory, the sequence of events first involves a stimulus,
followed by thought, which then leads to the simultaneous experience of a
followed by thought, which then leads to the simultaneous experience of a
physiological response and the emotion. For example, if you encounter a
bear in the woods, you might immediately begin to think that you are in
great danger. This then leads to the emotional experience of fear and the
physical reactions associated with the fight-or-flight response.
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Mr. Dayananda Huded

6. The Facial Feedback Theory
• The facial-feedback theory of emotions suggests that facial expressions are
connected to experiencing emotions. Charles Darwin and William James both
noted early on that, sometimes, physiological responses often have a direct
impact on emotion, rather than simply being a consequence of the emotion.
• The facial-feedback theory suggests that emotions are directly tied to changes in
facial muscles.
• For example, people who are forced to smile pleasantly at a social function will
have a better time at the event than they would if they had frowned or carried a
more neutral facial expression.
more neutral facial expression.
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Mr. Dayananda Huded

Types of Emotions
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1. Happiness
• Of all the different types of emotions, happiness tends to be the one that
people strive for the most.
• Happiness is often defined as a “pleasant emotional state” that is
characterized by feelings of contentment, joy, gratification, satisfaction,
and well-being.
• Research on happiness has increased significantly since the 1960s within
a number of disciplines, including the branch of psychology known
as positive psychology. This type of emotion is sometimes expressed
as positive psychology. This type of emotion is sometimes expressed
through:
• Facial expressions: such as smiling
• Body language: such as a relaxed stance
• Tone of voice: an upbeat, pleasant way of speaking
• Happiness has been linked to a variety of outcomes including increased
longevity and increased marital satisfaction. Conversely, unhappiness has
been linked to a variety of poor health outcomes.
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2. Sadness
• Sadness is another type of emotion often defined as a “transient
(impermanent) emotional state” characterized by feelings of
disappointment, grief (intense Sorrow), hopelessness, disinterest, and
dampened mood (make slightly wet).
• Like other emotions, sadness is something that all people experience from
time to time. In some cases, people can experience prolonged and severe
periods of sadness that can turn into depression.
• Sadness can be expressed in a number of ways including:
– Crying
– Crying
– Dampened mood
– Lethargy
– Quietness
– Withdrawal from others
• Sadness can often lead people to engage in coping mechanisms such as
avoiding other people, self-medicating, and ruminating (think deeply about
something) on negative thoughts.
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3. Fear
• Fear is a powerful emotion that can also play an important role in
survival. When you face some sort of danger and experience fear,
you go through what is known as the fight or flight response.
• Your muscles become tense, your heart rate and respiration
increase, and your mind becomes more alert, priming your body to
either run from the danger or stand and fight.
• Expressions of this type of emotion can include:
– Facial expressions: such as widening the eyes and pulling back the chin
– Body language: attempts to hide or flea from the threat
– Physiological reactions: such as rapid breathing and heartbeat
• Of course, not everyone experiences fear in the same way. Some
people may be more sensitive to fear and certain situations or
objects may be more likely to trigger this emotion.
• Fear is the emotional response to an immediate threat.
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Mr. Dayananda Huded

4. Disgusting
• Disgust is another of the original six basic emotions described by Eckman.
• Disgust can be displayed in a number of ways including:
– Body language: turning away from the object of disgust
– Physical reactions: such as vomiting or retching
– Facial expressions:
• This sense of revulsion can originate from a number of things, including an unpleasant
taste, sight, or smell. Researchers believe that this emotion evolved as a reaction to foods
that might be harmful or fatal. When people smell or taste foods that have gone bad, for
example, disgust is a typical reaction.
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5. Anger
• Anger can be a particularly powerful emotion characterized by feelings of hostility,
agitation, frustration, and antagonism towards others. Like fear, anger can play a part in
your body's fight or flight response.
• Anger is often displayed through:
• Facial expressions: such as frowning or glaring
• Body language: such as taking a strong stance or turning away
• Tone of voice: such as speaking gruffly or yelling
• Physiological responses: such as sweating or turning red
• Aggressive behaviors: such as hitting, kicking, or throwing objects
6. Surprise
• Surprise is usually quite brief and is characterized by a physiological startle response
following something unexpected.
• This type of emotion can be positive, negative, or neutral. An unpleasant surprise, for
example, might involve someone jumping out from behind a tree and scaring you as you
walk to your car at night.
• An example of a pleasant surprise would be arriving home to find that your closest friends
have gathered to celebrate your birthday.
• Surprise can have important effects on human behavior. For example, research has shown
that people tend to disproportionately notice surprising events.
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6. Surprise

Dimensions of Emotions
• 1. Pleasure (positive, negative)
• Emotions can be positive, pleasant and giving good feelings. Emotions
may also be negative, unpleasant and cause discomfort. Any emotion can
be placed on a scale between extreme pleasure and extreme discomfort,
with a zero point between where neither positive nor negative feelings are
experienced
• Positive Emotions: Happiness, Liking, respect, hope etc.
• Negative Emotions: Sadness, Anger, Fear, Shame and Disgust
• Negative Emotions: Sadness, Anger, Fear, Shame and Disgust
• 2. Focus (internal, external)
• Emotions may have a primary focus inside us or outside us, for example
being about ourselves or about the outer world. Sometimes these are very
much about one or the other and at other times they may be a bit of both.
A highly outward emotion is anger, as we project bad feelings toward
others. A highly inward one is contentment, for example in the way a
meditating person feels.
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• 3. Direction (attraction, repulsion): Emotions often have direction, bringing us
together with things or pushing us away from them. For example love is an attractive
emotion, while fear is repulsive. We can reduce distance by moving ourselves towards
object of interest or bringing it close. Likewise we can act on repulsion by pushing it
away or removing ourselves from its proximity.
• Direction is often about other people, such as when we like or dislike them. It can
also be about things and situations of danger or attraction. Greed, for example, may
pull us towards money, while fear may push us away from a dangerous place.
• 4. Intensity: Intensity is about how strongly we feel emotions. This is a uni-polar
dimension, as it can range from close to zero, for example when we feel flat or just a
bit irritated, to very intense, such as feelings of grief or extreme anger. Pleasure and
Locus are bi-polar scales as they have two poles with a 'zero' in between.
• 5. Arousal: Arousal is about activation, the energy and motivation that the emotions
give us towards taking action.
• Lower Arousal: Depression. High Arousal Emotion: Curiosity etc.
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Emotional Styles
• 1. Abandonment
• The ongoing fear that people will leave is at the root of this emotional style.
These people may fear that if they rock the boat in the smallest way, the ones
they love will leave. Or, they may adapt by running away from a relationship
before they can be hurt.
• 2. Entitlement
• People with this emotional style feel that rules don't apply to them. They may
have been spoiled as a child, or the love they received was based on a certain
quality — looks, academics, athletic skills. These people often exaggerate their
quality — looks, academics, athletic skills. These people often exaggerate their
prowess, usually to hide a feeling of inadequacy, or feel they are entitled to more
than their fair share of compensation. They also display a lack of self-discipline,
and the inability to delay gratification
• 3. Subjugation
• This emotional style revolves around the feeling that your own needs never take
priority in an intimate relationship. These people give in easily, but their hidden
resentment can smolder into anger and rage. Some will overreact at the least sign
of being controlled, while others are unable to make even a simple commitment.
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• 4. Exclusion
• Finding yourself on the outside of things often leads to this emotional
style. The perceived message is, "You're not like us." This feeling
typically causes a person to stay on the edge of the action, reinforcing the
feeling of exclusion. This may lead avoidance of groups in adulthood, or
conversely, cause someone to revel in their outcast role.
• 5. Mistrust
• Suspiciousness and a quick temper are typical of this emotional style.
Often the mistrust stems from having been physically, sexually, or
emotionally abused. People of this style tend to gravitate to relationships
emotionally abused. People of this style tend to gravitate to relationships
in which their worst fears are confirmed, getting involved with people
who treat them badly.
• 6. Failure
• A typical feeling in this emotional style is being deficient despite one's
accomplishments. This can lead people to push themselves extremely
hard, despite the constant fear of failure. Some fall prey to the imposter
phenomenon — you succeed, but secretly feel you're a fraud and will be
found out. Others discover that believing they will fail becomes a self-
fulfilling prophecy.
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• 7. Unlovability
• The automatic assumption that "I'm not lovable" typifies this emotional
style. Shame and humiliation, along with a feeling of being flawed, are
this style's prominent emotions. Two patterns are seen in people who feel
unlovable. Some give in to their deep feeling of unworthiness, while
others hide behind arrogance, seeking public recognition and adulation.
• 8. Perfectionism
• People with this emotional style unrelentingly hold themselves to the
highest standards. No matter how well they do, it's never good enough, so
highest standards. No matter how well they do, it's never good enough, so
they drive themselves until the rest of their life suffers. This emotional
style drives people to push themselves in sports, at school, in physical
appearance, or for social status.
• 9. Deprivation
• At the heart of this emotional style is the belief, "My needs won't be met."
No matter how much is given to people of this style, it never feels like
enough. Some people overindulge in an attempt to nurture themselves,
while others become the caretaker they never had, and may gravitate to
careers in which they help others, like social work or nursing.
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Fairness, Reciprocity and Trust
• Rabin's model of ‘fairness’ is widely interpreted as encapsulating
reciprocity.
• Reciprocity is modelled as being kind to the kind and unkind to the
unkind.
• Paradoxically, this ‘reciprocal kindness’ cannot explain trust and
trustworthiness.
• We argue trust and trustworthiness should be understood as
• We argue trust and trustworthiness should be understood as
‘reciprocal cooperation’.
• Trust and trustworthiness are cooperative moves in the creation of
mutual benefit.
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Heuristics and Cognitive Biases
• 1. Confirmation Bias: Confirmation bias refers to the tendency to search for,
interpret, and remember information that confirms our beliefs. In short, we prefer
information that tells us we’re right…and we’re more likely to remember the hits and
forget the misses.
• A prime example of confirmation bias plays out in our modern media environment,
where we’re able to select news organizations and even the types of stories that
validate our worldview. With the help of algorithms that learn our preferences, we can
get trapped in filter bubbles, or personal information ecosystems, where we’re served
more and more content that reaffirms our existing beliefs and protected from evidence
that we’re wrong.
that we’re wrong.
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• 2. Availability Heuristics: The availability heuristic is a mental short-cut in
which we estimate how likely or important something is based on how easily
we can think of examples. However, because we are more likely to remember
events that are recent, vivid, or emotional, we overestimate the likelihood of
certain events and may make poor decisions.
• Consider the following examples:
• You’re at the beach, thinking about going into the water, and images of shark
attacks pop into your head. You sit and read a book instead.
• You recently saw a plane crash on the news, and you were already scared of
• You recently saw a plane crash on the news, and you were already scared of
flying, so you decide to drive on your next trip.
• You just watched a documentary about someone who won big on the slot
machines, so you plan a trip to the casino. Someone has to win…it might as
well be you!
• You’re worried about someone kidnapping your child because you saw news
coverage of an attempted abduction. Thankfully, the child wasn’t harmed, but
you don’t want to risk it. Today’s world is so much more dangerous than it
was when you were young.
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• 3. Anchoring Effect or Anchoring Heuristic: The anchoring effect
refers to our tendency to “anchor” to the first piece of information we
learn about something, and form our beliefs about that thing based on
the anchor. Newer information isn’t evaluated objectively, but, rather,
through the lens of the anchor. The anchoring effect is an extremely
common cognitive bias, and one that can interfere with our abilities to
make good decisions and objectively understand reality. Therefore,
understanding the anchoring effect can save us time, money, and
understanding the anchoring effect can save us time, money, and
improve the quality of our thinking.
• The anchoring effect occurs when we unwittingly cling to the first bit
of information we get about something. However, if we’re not careful,
anchoring can result in poor decisions that we may regret.
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• 4. Representativeness Heuristics: The representativeness
heuristic doesn’t exactly flow easily off the tongue. Nonetheless, this
heuristic is well worth our attention. Like all heuristics, the
representativeness heuristic is a mental shortcut our brains take to
preserve its limited resources, in this case to make quick judgments about
the likelihood of something based on how similar it is to existing mental
categories.
• The representativeness heuristic is an error of reasoning that occurs when
we make generalizations based on our mental models of reality.
we make generalizations based on our mental models of reality.
• To use a classic example, let’s say I told you that Mary is a quiet, shy
introvert who’s not very interested in getting to know people and is also
very detail oriented. Based on this description, is it more likely that Mary
is a librarian or a mechanic? Our gut tells us that Mary is much more
likely to be a librarian because her characteristics sound
more representative of our mental models of librarians.
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Bayesian Decision Making
• How can we use (probability) to make decisions?
• Examples of decision problems
– How to control a self driving vehicle
– How to invest money
– Select medicine to give to a patient
– Estimate a parameter vector (may represent tempurature, distance etc.)
• Basic Principles of Bayesian Decision Theory
• Basic Principles of Bayesian Decision Theory
• Minimise expected loss or equivalently.
• Maximise expected utility
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Example
• Choosing a Course:
• A Student wants to decide whether to take a course or not.
• Suppose there are three courses namely Good, Fair and Bad
• Probability for Good Course is 0.3, for Fair course 0.3 and for Bad course
is 0.4.
• If loss function is Good Fair Bad
Take 0 5 30
• Should he then take the course?
• Expected utility will be; (in this case expected loss)
• For taking course: (0.3x0)+(0.3x5)+(0.4x30) = 10.5
• For not taking course: (0.3x20)+(0.3x5)+(0.4x0) = 7.5
• The conclusion is the students should not attend the course because the
expected utility is low. We often study loss function instead of utility.
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Not take 20 5 0

Optimal Bayesian Decisions
• 1. Minimise the posterior expected loss
• To make an optimal Bayesian Decision it is sufficient to know;
• The prior probability likelihood and a loss function.
• The likelihood probability and a loss function
• The posterior distribution and a loss function
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