Behavorial finance

1. RATIONALITY AND NON-
TRADITIONAL PREFERENCES
PRESENTED BY
SIMRAN KAUR
MBA 2ND YEAR

2. ELLSBERG’S PARADOXES
• Daniel Ellsberg in 1961
• Describes fundamental uncertainty about unknowable
probabilities
• “it is impossible to infer even the qualitative problems of one
over other”
• When uncertain events are associated with probabilities that
can’t be quantified, something else is needed to resolve the
paradox

3. FEATURES OF ELLSBERG’S PARADOX
• Ambiguity aversion
• Important basis point in decision making
• Signifies people are irrational
• Unclear decision making

4. RATIONALITY
• Regular tendency of acting by reason, which means in
accordance with the facts of reality
• Doesn’t mean being a perfectionist in one’s thoughts and ideas
• Using logic to eliminate any contradictions
• Recognition of the fact that existence exists, that nothing can
alter the truth

5. FEATURES OF RATIONALITY
• Well defined concept
• Discipline of subjecting choices
• Context-independent
• Exercise of power
• Helps in decision making

6. RATIONALITY FROM ECONOMIC
PERSPECTIVE
• 5 axioms of cardinal utility: comparability, consistency,
independence, measurability, ranking
• Aimed at making rational decisions that best match the
necessities of life of an individual, community or organization
under current conditions
• Completely conscious, calculated and optimization-oriented

7. RATIONALITY FROM EVOLUTIONARY
PERSPECTIVE
• Behaviour of actors is related to adaptation to the current
institutional conditions that form up the space for possible
actions
• Individuals follow two rules of thumb: “adherence to the
majority” and ”adherence to the minority”
• Diversity of behavorial patterns, on the one hand, increases
uncertainty in decision making, while on the other hand, it
improves the stability of the system against action of external
shocks.

8. DEPENDENCE ON TIME HORIZON
• Time horizon refers to the time period associated with
accomplishing an investment objective
• Time horizon is anticipated time span the investor will need
before beginning to use investment returns
• Always linked to asset allocation
• Risk grows as time horizon increases
• Problems of self-control are associated with short time
horizons

9. DEPENDENCE ON INDIVIDUAL AND GROUP
RATIONALITY
• Rationality characterizing activity of a society on various levels
must rely on a certain assumption which has been touched
upon the rule of competition
• Group rationality is of importance because it is easier to accept
the proposition that individuals are rational than that groups
are
• To describe an individual as rational is to say little or nothing
since only the person himself can be the judge and virtually any
kind of individual behavior can be rational

10. HERBERT SIMON AND BOUNDED
RATIONALITY
• Herbert Simon proposed the idea of bounded rationality as an
alternative basis for the mathematical modelling of decision
making
• Simon has coined the term “bounded rationality” in “Models of
Man”
• Procedural rationality is a form of psychological rationality
which constitutes the basic concept of Simon’s behavourial
theory
• Based on cognitive processes involving detailed empirical
explorations and procedures that are translated in algorithms

11. FEATURES OF BOUNDED RATIONALITY
• Superficial analysis
• Strategic reasoning and strategy construction based on
reciprocity and fairness
• Avoidance of circular concepts in step-by-step strategic
reasoning
• Ex-post rationality
• Goal incomparability

12. ASSUMPTIONS OF BOUNDED RATIONALITY
• Maximising strategy is the only way to get successful results
• Notion of bounded rationality refers to the extent to which
individual can employ the brute force strategy
• Notion of satisfying concerns the results that the limited
humans could get by employing the brute force strategy
• Humans can only partly employ this strategy since their limits
and the complexity of the environment

13. BOUNDED-RATIONALITY DECISION MAKING
MODEL
• Step1: Identify the problem to be solved or goal to be defined
• Step 2: Determine the minimum level or standard that all acceptable
alternatives will have to meet
• Step 3: Choose one feasible alternative that will resolve the issue
• Step 4: Appraise the acceptability that will resolve the issue
• Step 5: Determine if it meets the minimum levels that have been
established
• Step 6: If the alternative is not acceptable, identify another and put it
through evaluation process
• Step 7: If alternative is acceptable, implement it
• Step 8: After implementation, determine how easy(or difficult) it was
to discover alternative

14. AVERAGE INVESTOR
• People who have some basic knowledge of the stock markets
and seeks to gather information on the stocks themselves
• Investors who are better at making consistent losses in the
market, instead of consistent profits
• Trade a lot on emotion and ego
• A good set of trading rules – Emotion = Consistent profits in
the stock market

15. FEATURES OF AVERAGE INVESTORS
• Limited gain
• Use simple rating devices
• Fear of loss
• Rely on others’ information
• Follow “buy and hold” strategy
• Self management of portfolio
• Lack of research

16. PROBLEMS OF AVERAGE INVESTORS
• Going with the crowd
• Lack of knowledge
• Lack of investment acumen
• Negative investors’ return
• Lack of diversification
• Counter-productive or biased behavior
• Poor timely decisions and inadequate planning

17. BELIEF BIASES
• Belief is a psychological state in which an individual holds a
proposition or premise to be true
• Belief-bias refers to the result that happen when an individual’s
own values, beliefs, prior knowledge, etc, affects or distorts,
the reasoning process through the acceptance of invalid
arguments or data
• Involves individual tendency to reject valid arguments with
seemingly-unbelievable conclusions

18. CONSERVATISM BIAS
• It states that people fail to incorporate new information by
continuing to hold their prior views/forecasts
• Leads to resistance to change
• May cause the trader to under-react to the new information,
maintaining impressions derived from the previous estimate
rather than acting on the updated information.
• Increased difficulty in dealing with new information

19. CONFIRMATION BIAS
• Investor would be more likely to look for information that
supports his/her original idea about an investment rather than
seek out information that contradicts it.
• Faulty decision making
• Selective thinking
• Peculiar and perpetual error

20. REPRESENTATIVENESS BIAS
• Investor rely on “best fit” to determine categories to which new
information is assigned
• Investors classify new information based on past experiences
and classification
• 2 types
a. Base-rate neglect
b. Sample-size neglect

21. LIMITED ATTENTION
• Explain tendency of firms to attract attention when their
earnings are growing rapidly, but be ignored when they
perform poorly for long periods
• Necessary consequence of the vast amount of information
available in the environment, and of limits to information
processing power
• Selective and requires effort
• Significant consequences for prices and portfolio allocation

22. CATEGORISATION
• Consequence of limited attention
• If investors assign greater values to particular categories, firms
make efforts to move into these categories
• Barberis and Shleifer: individuals do categorise – assets in the
same style such as growth and value co-move too much, while
assets in different styles co-move too little
• Implications for firm behaviour

23. PROSPECT THEORY AS NON-TRADITIONAL
PREFERENCE
• Prospect theory postulates utility function is concave over some
reference point
• Gains are treated in risk-averse way but losses in a risk loving
way
• It is hard to make clear distinction between non-classical
preferences and (potentially distorted) beliefs

24. LOSS AVERSION AS NON-TRADITIONAL
PREFERENCE
• Loss aversion suggests that it is much more difficult for people
to adjust to losses than to gains
• Induces a preference for the status quo in most situations
• It is exacerbated by psychological tendencies as well
• Noticeable in negotiating and bargaining contexts

25. BUBBLES
• Originated in 1711-1720 from British South Sea Bubble
• Connect situation where people have lost touch with reality
• Trade in high volumes at prices that are considerably at
variance with intrinsic values
• Trade in products or assets with inflated values
• Excessive optimism and overconfidence are the main causes of
bubbles

26. TYPES OF BUBBLES
• Commodity bubble
• Stock market bubble
• Credit bubble
• Speculative bubble
• Informational bubble
• Economic bubble

27. CAUSES OF BUBBLES
• Irrational exuberance
• Herding behavior
• Short-termism
• Adaptive expectations
• Financial instability hypothesis
• Monetary policy
• Global imbalance

28. SYSTEMATIC INVESTORS SENTIMENTS
• Measures how positive (bullish) or negative (bearish) groups of
investors are about the equity markets at any given point of
time
• Measured by examining flows into various asset classes of
mutual funds
• Can remain elevated for some time
• Contrarian indicator

29. FACTORS AFFECTING INVESTORS’
SENTIMENT
• Herd behavior
• Internet led access to information and trading
• Macroeconomic factors
• Risk and cost factors
• Best game in town
• Performance factor and confidence level of institutional
investors

30. THANK YOU!!!