Behavioral Finance

Prepared By : DR. Wael Shams EL-Din

Course Objectives
❑ In this course, we will examine how people make predictable and
repeatable mistakes in financial decision-making.
❑ We will describe the nature of these mistakes and their origin,
using insights from psychology, neurosciences and experimental
economics on how the human mind works.
❑ We will then discuss how incorporating these mistakes into our
finance theories can obviously improve standard finance models
studied in other courses.
❑ We will also consider how to understand the functioning of the
human mind allows us to design a better world –in particular,
better stock markets, retirement and economic system.
❑ This course has multi dimension that cover financial economics
and cognitive sciences, with both experimental and theoretical
components.
Course Contents
Ser. Name of the Topic Type Chapter
1 What is Behavioral Finance ? 1
2 The History of Behavioral Finance ? Introduction and 2
back ground
3 Investor Behavior & Asset Allocation 3

4 Anchoring Bias 6
5 Availability Bias Cognitive Biases- 8
Information
6 Mental Accounting Bias Processing errors 16
7 Framing Bias 22

8 Endowment Bias 13
9 Self Control Bias 14
Emotional
10 Optimism Bias Biases 15
11 Loss Aversion Bias 19
12 Regret Aversion Bias 21
13 Status Quo Bias 23
Grading System
Description Grade
Attendance 10%
First Presentation - (Group) 20%
Second Presentation ( Group) 20%
Final Project (Group) 50%
Total 100%
Suggested Topics for Reading
❑ Classical Theories vs. Behavioral Finance Theories
1. The Efficient Market Hypothesis (EMH)
2. Behavioral Portfolio Theory
3. Capital Asset Pricing Model (CAPM)
4. Behavioral Asset Pricing Model (BAPM)
5. Arbitrage Pricing Theory
6. Limited Arbitrage Model

❑ Corporate Finance
1. Rational Managers Vs. Irrational Managers
2. Rational Investor Vs. Irrational Investors
3. Rational Capital Budgeting in an Irrational World
4. Capital Structure and cost of Capital
Suggested Topics for Reading
❑ Risk & Return ( Classical Finance Vs. Behavioral Finance)
1. Classical Finance view of Risk & Return
2. Behavioral Finance view of Risk & Return
3. Perceived Risk and Risk Perception

❑ Anomalies (Irregularity)
1. January Effect
2. The Winner's Curse
3. Myopic Loss Aversion and the Equity Premium Puzzle

❑ Investor Psychology and Security Markets

1. The psychology of personal investment decisions
2. Money Market & Capital Market investments
3. Property investment and mortgages
Suggested Topics for Reading
❑ Cognitive Biases - Belief Perseverance errors
1. Cognitive dissonance Bias
2. Illusion of Control Bias
3. Self attribution Bias
4. Conservatism Bias
5. Overconfidence Bias
6. Confirmation Bias
7. Ambiguity aversion Bias
8. Representativeness Bias
9. Hindsight Bias
10. Recency Bias
 Chapter 1
What is Behavioral Finance?
Prepared By : DR. Wael Shams EL-Din
Overview
❑ Over the past decade, behavioral finance has become a familiar name in
finance industry. Many institutions use results from behavioral finance
to improve their investment strategies as well as their decisions.
❑ 2002 & 2017 Nobel Prize in Economics have been awarded to
psychologist Prof. Daniel Kahneman and Prof. Richard Thaler
respectively for their experiments

❑ Behavioral finance is a relatively new field that seeks to combine

behavioral and psychological theory with conventional economics and
finance to provide explanations for why people make irrational financial
decisions.

❑ Behavioral finance will help investor for better understanding of some of

the anomalies (irregularities) that conventional financial theories have
failed to explain.

❑ Behavioral finance will support decision maker to have a clear vision

toward various biases that cause irrational decisions.
What is Behavioral Finance ?
❑ A theory stating that there are important psychological and behavioral
variables involved in investing in the market that provide opportunities
for smart investors to make profit.

❑ Behavioral finance combines psychology and economics and

explain why and how investors act, therefore behavior finance will help
to analyze how that affects the market.

❑ A field of finance that suggests

psychology-based theories to
explain stock market anomalies.
❑ behavioral finance assumed that
information structure and the
characteristics of participants are
influencing investment decisions
as well as market outcomes
Key Figures (Big Contributors)
Name Name of the work Year
Robert Shiller, PhD Book: Irrational Exuberance 1989
Yale University professor
Richard Thaler, Ph.D Advances in Behavioral Finance 1993
University of Chicago “Can the Market Add and Subtract?
Mispricing in Tech Stock Carve-Outs 1999
Hersh Shefrin, Ph.D Book 2000
Professor of finance at the Leavey Beyond Greed and Fear: Understanding
School of Business at Santa Clara Behavioral Finance and the Psychology
University in Santa Clara, California of Investing
Andrei Shleifer, Ph.D., Book 2000
professor at Harvard University Inefficient Markets
Meir Statman, Ph.D., of the Leavey Research Paper 2000
School of Business, Santa Clara “Behavioral Finance: Past Battles and
University Future Engagements
What are the cognitive errors and
emotions that influence investors?
Daniel Kahneman, & Amos Tversky Formulated prospect theory 1996
Daniel Kahneman & Vernon Smith human judgment and decision-making 2002
under uncertainty
Important Contributors
Daniel Kahneman and Amos Tversky
❑ Daniel Kahneman and Amos Tversky are considered the fathers of
behavioral economics/finance. Since their initial collaborations in the
late 1960s, this duo has published about 200 works, most of which
relate to psychological concepts with implications for behavioral
finance. most popular and notable works include writings about
prospect theory and loss aversion topics that will be covered later.
Important Contributors
Richard Thaler
❑ Richard Thaler during his
studies, became aware of the
limitations in conventional
economic theories.
❑ He realized that psychological
theory could account for the
irrationality in behaviors.
❑ Thaler combine economics
and finance with psychology
to present new concepts, such
as mental accounting, the
endowment effect and other
biases.
Efficient Markets versus Irrational
Market
❑ The Efficient Market Hypothesis theory has been developed by DR.
Eugene Fama during (1970) , He demonstrated that securities market are
populated by many well-informed investors, accordingly investments
will be appropriately priced and will reflect all available information.
❑ Fama stated that there are 3 forms of the efficient market hypothesis:-
❑The “Weak” Form
EMH
All past prices and data are fully
reflected in securities prices; so
technical analysis in this stage have
little or no value. Semi
Weak Form Strong Form
Strong Form
❑The “Semi- Strong” Form
All publicly available information is
fully reflected in securities prices; so
Past Publicly All
fundamental analysis have no value . Available Info. Are Information
Info.& Data are
❑The “Strong” Form Reflected Reflected Are Reflected

All information is fully reflected in

securities prices; so insider
information have no value
Efficient Markets versus Irrational
Markets
❑ So, efficient market can basically be defined as a market where large
numbers of rational investors act to maximize profits in the direction of
individual securities. A key assumption is that relevant information is
easily available to all participants. So at any given time in an efficient
market, the Price of a Security will match that security’s intrinsic value.

❑ The EMH theory has inspired thousands of studies to determine whether

market is in fact “Efficient or NOT ” and acknowledge that If market is
truly efficient and current prices fully reflect all related information, then
trading of securities is just a game of luck, not skill.
❑ also researchers have documented various of anomalies, that contradict
the efficient market hypothesis and classify those anomalies into three
main types: -
1. Fundamental Anomalies
2. Technical Anomalies
3. Calendar Anomalies
Fundamental Anomalies (P/BV)
❑ Price/Book Value (P/BV) = Price ( Market Value)
Book Value
Low price to book value indicate that stock is undervalue , however it
might be something fundamentally wrong.
Fama and French performed a study of Low price-to book value ratios
that covered around 28 years for the period between (1963 and 1990) for
equities listed on the NYSE, AMEX, and the Nasdaq, The result has
shown that stocks with below-average price-to-book ratios tend to beat
the market i.e. have average rate of return > Average market rate of return.
Explanation
❑ The cheap stocks should attract buyers' attention , but this is
unfortunately a relatively weak anomaly since The low price-to-book
value stocks outperform as a group but Not individual performance
and it takes very large portfolios of low price-to-book stocks to see the
benefits.
Fundamental Anomalies (Equity
Premium Puzzle)
❑ Studies have shown that over a 70-year period, stocks yield average
returns exceed government bond returns by Minimum 7%. i.e. The
equity premium, is defined ( Equity returns minus bond returns= 7%)
on average for the past 70 years. However most of investor prefer to
purchase “risk-free”

Behavioral finance's answer to the equity Premium puzzle

❑ The tendency for people to have "myopic loss aversion", a situation in
which investor is overly worried by the negative effects of losses in
comparison to an equivalent amount of gains by taking very short-term
view on an investment. Therefore, it is believed that equities must
produce a high premiums to compensate for the investor's considerable
aversion to loss.
Technical Anomalies
❑ Another major debate in the investing world revolves around whether
past securities prices can be used to predict future securities prices.
❑ Technical analysis using a number of techniques that attempt to forecast
securities prices by studying past prices. For example moving averages,
as well as support and resistance. Sometimes, technical analysis
discloses discrepancies with the efficient market hypothesis; these are
technical anomalies.

❑ The majority of research-focused on weakness of technical analysis as a

trading methods finds that prices adjust rapidly in response to new stock
market information and that technical analysis techniques are not likely
to provide any advantage to investors who use them.

❑ However, supporters of technical analysis continue to argue the validity

of certain technical strategies
Calendar Anomalies-The
January Effect
❑ The January effect is a seasonal increase in stock prices during the
month of January.

Explanation
❑ Analysts relate this anomaly due to drop in price that typically happens
in December when investors sell loss stocks to offset realized capital
gains and minimize taxes.

❑ Another possible explanation is that investors use year-end cash bonuses/

Dividends to purchase stocks in the following month.

❑ Some investors believe that January is the best month to begin an

investment program or perhaps are following through on a New Year's
resolution to begin investing for the future.
Traditional vs. Behavioral Finance
Traditional Finance Behavioral Finance
Concept ❑ Traditional Finance focuses on how ❑ Behavioral Finance recognizes that the
individuals should behave. way the information is presented to
investor can affect his/her decision and
❑ Investors are considered as being it can lead to emotional and cognitive
“Rational Economic Men”. This biases.
leads to markets where prices ❑ Behavioral Finance focuses on why
reflect all available relevant investors behave the way they do. Since
information. investors’ decisions are not always
optimal, this results in markets that are
temporary inefficient.

Investor Investor is Rational Investor is Irrational

Market Market is efficient Market is Inefficient
Value of Price always reflect intrinsic value Framing, social influence and herd behavior
Instrument affect pricing

Decision Investor assess decisions based on Perception of risk and return are influenced
Process calculated risk and return. by how problem is framed.
i.e. objective & Transparent i.e. Subjective & emotional
Behavioral Finance Micro versus
Behavioral Finance Macro
❑ Behavioral Finance Micro (BFMI)
Behavioral Finance Micro examines behaviors or biases of individual
investors that differentiate them from the rational actors proposed by
classical economic theory.
❑ Behavioral Finance Macro (BFMA)
Behavioral Finance Macro (BFMA) detects and describe anomalies in the
efficient market hypothesis that behavioral models may explain.

Our main focus will be Behavioral Finance Micro (BFMI) to study the
individual investor behavior. Since we need to identify relevant
psychological biases and investigate their influence on financial decisions
e.g. asset allocation decisions, so that we can manage the effects of those
biases on the investment process.
Behavioral Finance in Brief
❑ Behavioral finance, is a branch of behavioral psychology,
looks at the financial decisions making processes done by
investors.
❑ These decisions include embedded thoughts and behavioral
biases that impact the performance of all markets.
Observations in Behavioral Finance
❑ Investors are more motivated by the
fear of loss than the rewards of
successful investing.
❑ People believe what they want to
believe.
❑ Investors are often overconfident when
they have small amounts of information
❑ Investors have a hard time for taking
decision with lots of choices.
❑ People emphasis on recent events rather
than considering all events together.
❑ Pressure to follow others’ beliefs.
❑ Detailed descriptions have greater
influence rather than little information
on investor decision and have more
relevant fact.
❑ People are using irrelevant factors to
assign value
How BF Create a Successful advisory
Relationship?
Wealth management practitioners have different ways of measuring the
success of an advisory relationship. Few could argue that every successful
relationship shares some fundamental characteristics:

❑ The financial advisor will understands the client’s financial goals well,
then financial advisor will Formulate Financial Goals Properly.

❑ The financial advisor will maintains a systematic (consistent) approach

to advise the client.
❑ The advisor delivers what the client expects

❑ The relationship benefits both client and advisor ( Mutual Benefits)

Thank You