LESSON 2 introduction to behavioural finance
- 1. INTRODUCTION Behavioral Finance • Behavioral finance is an attempt to understand investors and the reflection of their interactions in financial markets.
- 2. • Standard finance, also known as modern portfolio theory, has four foundation blocks: (1) investors are rational; (2) markets are efficient; (3) investors should design their portfolios according to the rules of mean-variance portfolio theory and, in reality, do so; and (4) expected returns are a function of risk and risk alone
- 3. • Rational behavior: A decision-making process that is based on making choices that result in the most optimal level of benefit or utility for the individual
- 4. • market efficiency” says that a market for a stock is efficient if the price of a stock is always equal to its fundamental value.
- 5. • Modern portfolio theory is no longer very modern, dating back to the late 1950s and early 1960s. Merton Miller and Franco Modigliani described investors as rational in 1961. Eugene Fama described markets as efficient in 1965.
- 6. • Harry Markowitz prescribed mean- variance portfolio theory in its early form in 1952 and in its full form in 1959. William Sharpe adopted mean-variance portfolio theory as a description of investor behavior and in 1964 introduced the capital asset pricing theory (CAPM).
- 7. • According to this theory, differences in expected returns are determined only by differences in risk, and beta is the measure of risk. • Behavioral finance offers an alternative block for each of the foundation blocks of standard finance.
- 8. • According to behavioral finance, investors are “normal,” not rational. Markets are not efficient, even if they are difficult to beat. Investors design portfolios according to the rules of behavioral portfolio theory, not mean-variance portfolio theory.
- 9. • And expected returns follow behavioral asset • pricing theory, in which risk is not measured by beta and expected returns are determined by more than risk.
- 10. “Normal” Investors and Rational Ones • rational investors care Only about the substance of their wealth, not its form. In the absence of transaction costs and taxes, paper losses are different from realized losses only in form, not in substance. Moreover, tax considerations give an edge to realized losses overpaper losses because realized losses reduce taxes while paper losses do not.
- 11. • Shefrin and Statman (1985) presented the reluctance to realize losses in a behavioral framework. They argue that the reluctance stems from a combination of two cognitive biases and an emotion. One cognitive bias is faulty framing, where normal investors fail to mark their stocks to market prices. Investors open mental accounts when they buy stocks and continue to mark their value to purchase prices even after market prices have changed
- 12. • They mark stocks to market only when they sell their stocks and close their mental accounts. • Normal investors do not acknowledge paper losses because open accounts keep alive the hope that stock prices will rise and losses will turn into gains. But hope dies when stocks are sold and losses are realized.
- 13. • .The cognitive bias of hindsight is linked to the emotion of regret. Realization of losses brings the pain of regret when investors find, in hindsight, that they would have had happier outcomes if only they had avoided buying the losing stocks.
- 14. • The second cognitive bias that plays a role in the reluctance to realize losses is hindsight bias, which misleads investors into thinking that what is clear in hindsight was equally clear in foresight. Hindsight bias misleads investors into thinking that they could have seen losing stocks in foresight, not only in hindsight, and avoided them