This course intends to provide the in-depth knowledge of behavioral finance

in the scope of saving and investment.

UNIT 2: Behavioral Biases

Syllabus: Categorization of biases, Heuristics, Anchoring, Self-deception, Frame

dependent biases, Role of regret, responsibility and expert advice

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

1. Categorization of Biases
The rationality of investors became debatable from the time standard finance theories could
not give sufficient explanation for the stock market anomalies.. The mental processes that are a
part of cognitive psychology have been examined by various experts with respect to decision
making under uncertainty. One of the significant contributions to this body of literature is by
Raiffa (1968). The author analyzes decisions under three approaches that provide a more
pragmatic view of an individual’s thought process. These approaches are mentioned as follows.
 Normative Approach: It is concerned with rational decision making process. It provides
ideal solution which a decision making process should strive to achieve.
 Descriptive Approach: It deals with the manner in which people actually make
decisions in the real life situations.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

 Prescriptive Approach: It provides the individuals with practical advice and tools that
might help them in achieving results that are in close approximation to the normative
analysis.

Behavioral finance captures the role of behavioral biases in investor decision making. Shefrin
(2000) broadly classifies these biases into two types: heuristic driven biases and frame
dependent biases

 Heuristic driven biases: Shefrin (2000) recognizes that financial practitioners use rules
of thumb or heuristics to process data and make decisions. For instance, people believe
that future performance of the stock can be best predicted by past performance. The
author categorizes such biases under heuristic theme which includes overconfidence,
anchoring and adjustment, reinforcement learning, excessive optimism and pessimism.

 Frame dependent biases: The decision process of financial practitioners is also

influenced by the way they frame their options. This theme includes biases like narrow
framing, mental accounting and the disposition effect.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

2. Overconfidence

It is defined as the investors’ tendency to overestimate the precision of their knowledge about
the value of a security. Gervais and Odean (2001) formulate a multi-period market model to
estimate overconfidence. They propose that overconfidence is enhanced in those investors who
have experienced high returns; as a result they trade more frequently. Therefore
overconfidence leads to increase in trading volume. On the other hand, a loss in the market
reduces overconfidence level and subsequently the transaction volume.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

Most of these researches reveal that overconfidence is an illusion of superior knowledge in

investors, which is strengthened by their past successes. This tendency makes them trade more
as they become sure of the positive outcome. However increase in trading volume comes with
high a trading cost which proves to be detrimental to the portfolio performance.

3. Optimism

In financial context optimism (pessimism) is defined as the propensity of investors to

overestimate (underestimate) the expected mean returns of the risky asset. Researchers have
studied this bias with respect to its impact on the stock markets as well as the factors that drive
this bias. Toshino and Suto (2004) investigate optimism bias in Japanese institutional investors.
They use survey based data and find that the optimistic investors are more sensitive towards
positive market news. They selectively incorporate only good news in their decision making
process. Further, investors affected by optimism bias tend to undervalue the risk of familiar
investment products such that they are more optimistic towards the domestic market than
foreign markets.
Shefrin and Statman (2011) find that excessive optimism can create speculative bubbles in
financial markets by inflating the prices of securities above their intrinsic values. They further
state that if bubbles last long enough, some pessimists might become convinced that they are
wrong and can convert into optimists and in the process they are likely to intensify this
phenomenon.
Optimism (pessimism) is a very influential bias. It is responsible for setting the mood of the
financial markets. This bias is driven by past returns that have an impact on return expectations
return tolerance and risk perception of investors. This bias is so potent that it can create stock
market bubbles and can convert even pessimists to optimists.

4. Representativeness

It is the tendency of individuals to estimate the likelihood of an event by comparing it to a

previous incident that already exists in their minds. This existing incident is generally what they
consider to be the most relevant or typical example of the current event.
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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

The empirical evidence of representativeness has been given by Dhar and Kumar (2001) who
examines the stock price trend for stocks bought by more than 62,000 households at a discount
brokerage during a 5-year period. The author finds that investors tend to buy stocks with
recent positive abnormal returns. This is consistent with the heuristic that the past price trend
is representative of the future price trend.

Another instance is presented by Kaestner (2005) who uses the data on current and past
earnings for U.S. listed companies for the period of 1983-1999 and suggest that investor
overreaction to earnings announcement could be attributed to representativeness bias. The
author states that investors initially extrapolate the recent earnings surprise and hence
overreact to subsequent earnings surprise.

5. Availability bias:

In this case people evaluate the probability of an outcome based on the familiarity or
prevalence of that particular outcome. People prone to availability bias give higher likelihood to
the events which they can easily recall as compared to the ones that difficult to remember or
comprehend. Kliger and Kudryavtsev (2010) identify this bias in investors’ reaction to analysts’
recommendation revisions. They use daily market returns as a proxy for information on
outcome availability. They find that stock price reaction to recommendation revisions (up or
down) is stronger when accompanied by index returns in the same direction.

6. Anchoring and Adjustment bias:

This bias comes into play when people have to estimate an unknown value or magnitude. Here
people start their estimation by guessing some initial value or an “anchor”. This anchor is then
adjusted and refined to arrive at the final estimate. Campbell and Sharpe (2009) investigate the
presence of anchoring bias in analysts’ forecasts of monthly economic releases for a period of
1991 to 2006.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

They find that forecasts of any given release were anchored towards the recent months’
realized values of that release, thereby giving rise to predictable surprises. This effect is
consistent for each of the key releases. The aforementioned researches substantiate the
importance of the representativeness, availability and anchoring bias. It can be observed that
representativeness is based on stereotypes and it causes positive earnings surprises to be
followed by more positive surprises and negative surprises by more negative surprises.

7. Loss aversion:

It is introduced by Kahneman and Tversky (1979) and refers to the tendency of individuals to
strongly avoid losses as compared obtaining gains. This is because loss brings regret and impact
is much greater than that of gains.

Several researchers have studied the impact of loss aversion in financial markets. Joshua D.
Coval and Tyler Shumway (2005) analyze the effect of loss aversion bias in terms of risk taking
in market makers. They show that in intra-day trading, a loss in the morning leads to higher risk
taking behavior in the afternoon. Berkelaar and Kouwenberg (2008) examine the impact of
heterogeneous loss averse investors on asset prices using annual U.S. consumption data for a
period of 1889 to 1985. Their study shows that in a good state loss averse investor gradually
become less risk averse as wealth rises above their reference point, pushing equity prices up.
On the other hand, when wealth drops below the reference point the investors become risk
seeking and demand for stock increases drastically.

These studies reveal that there is a differential impact of gains and losses on decision outcome.
Further, the pain of loss is described to be greater than pleasure of an equal amount of gain,
which makes the investors more sensitive to a change in the loss. These researches also throw
light on the risk attitude pattern of individuals. It is seen that people become risk seeker or less
risk averse in the prospect experiencing loss of high probability.

8. Narrow framing:

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

Shefrin (2000) describes narrow framing as the tendency of investors to treat repeated risks as
if they were a one-shot deal. Barberis and Huang (2006) elaborate this bias in the context of
gambling. They state that, it is the phenomenon wherein people evaluate each new gamble in
isolation, separating it from their other risks. In other words, people will ignore all the previous
choices that determine their overall wealth risk and directly derive the utility from their
current risk. Liu and Wang (2010) document the presence of narrow framing effect in the
options trading market. They used the daily trading volume data of Taiwan Futures Exchange
for a period of 2001 to 2004. The findings of this study indicate that investors could easily
become susceptible to narrow framing when trading in the complex derivatives market. They
simplify complicated trading strategies into understandable trading decisions. The study also
supports the fact that traders’ professionalism, sophistication and experience can reduce this
bias to a certain extent.

9. Mental accounting:

Its concept is given by Thaler (1999). It is defined as the tendency of individuals to separate
their information into manageable mental accounts. Thaler (1999) explains that mental
accounting is a set of cognitive operations used by individuals to organize, evaluate, and keep
track of financial activities. Mental accounting comprises of three components. First component
captures how outcomes are perceived and experienced, how decisions are made and
subsequently evaluated. Second component involves the assignment of activities to specific
accounts. The final component focuses on the frequency with which accounts are evaluated and
‘choice bracketing’.

Barberis and Huang (2001) study investors’ mental accounting using simulated data of
equilibrium firm-level stock returns. They find that the investors’ system of mental accounting
affects asset prices. They track the changes in portfolio performance as the individual’s decision
frame shifts from stock accounting to portfolio accounting. Their results reveal that when this
happens, the mean value of individual stock return falls, the stocks become less volatile and
more correlated with each other.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

Both narrow framing and mental accounting are cognitive processes that simplify the complex
decision making problem for investors. In narrow framing, individuals treat their risks in
isolation rather than taking a holistic view. This bias can lead to overestimation of risk and
make the investors myopic in their investment outlook. On the other hand, during mental
accounting people segregate the information into different mental accounts. They evaluate the
performance of each account separately instead of evaluating the performance of their portfolio
as a whole. So although, this bias helps the investors in managing complex information, it can
create distortion in asset prices.

10. The disposition effect:

Shefrin and Statman (1985) introduce the concept of the disposition effect. It is defined as the
tendency of investors to hold on to losing stocks and sell winning stocks early. This concept is
built on the implications of prospect theory (Kanheman & Tversky, 1979). The possible reasons
for this effect as proposed by the authors are loss aversion, seeking pride, mental accounting
and regret avoidance. Odean (1998b) documents the presence of the disposition effect using
market data on 10000 discount brokerage accounts of individual investors. In his study, the
ratio of realized gain over total gains, (i.e. proportion of gains realized or PGR) and the ratio of
realized loss over total loss (i.e. proportion of loss realized PLR) are taken as measures to
calculate the disposition effect. He finds that a majority of investors are reluctant to realize their
losses.

Grinblatt and Keloharju (2001) find evidence of the disposition effect in the Finnish stock
market using a data set of shareholdings and trades of individual and institutional investors
between 1994 and 1997. Shumway and Wu (2006) using a sample of 13,460 Chinese investors
note that a majority of these investors exhibit the disposition effect and it drives momentum in
the Shanghai stock exchange. Kumar (2009) uses multiple measures of valuation uncertainty
and behavioral bias proxies to find that individual investors exhibit stronger disposition effect
when stocks are harder to value and when market-level uncertainty is higher.

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

The above mentioned empirical evidences on the disposition effect show that this bias has an
impact on trading volume of stocks. Further, this bias gets intensified in the presence of
uncertainty and has the strength to drive momentum in the stock market.

11. Re g r e t
Investor confidence, emotions and psychology play a powerful role in driving
share markets. Past experiences, pre-conceived ideas and fear of regret are just a few of the
biases and behaviours that can lead investors to make emotional and often irrational decisions.

Regret theory, studied in behavioral finance, is a concept stating that investors will feel regret if
a wrong decision is made and thus will consider this anticipated regret when making
investment decisions.

Regret theory can adversely impact an investor’s rational behavior, such as dissuading them
from acting or motivating them to act. As a result, regret theory can impair an investor’s ability
to make decisions that would be beneficial.

Regret Theory Example: Being More Risk Seeking

Akash is a conservative investor who prefers to put his money into low beta stocks. Recently, he
notices the meme stock craze that is unfolding in the financial markets, with numerous meme
stocks surging by over 100%.

Akash further sees his colleagues purchasing meme stocks, and he decides to purchase some
meme stocks himself, ignoring potential risks, to avoid the regret of not purchasing it if it runs up
further.

An example of regret is an investor’s difficulty in selling a losing stock. The feeling of regret is
strongest when the loss is crystallised – until that point the investor holds out hope of the stock
returning to its ‘former glory’ and avoids generating feelings of regret by holding onto
it. Another aspect to this is that if the investor made the original investment decision by
themselves, the feeling of regret is much greater than if they were following someone’s advice.
It’s not so much about the pain of making a loss, but rather the pain of being responsible for
making the decision. This could explain why investors sometimes find it easier to outsource

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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.

their investment decisions (ie to a financial adviser) – apart from needing professional advice, it
also means some of the burden of making decisions is shared.

12 . Expert Advice

Emotion and the human psyche are indeed powerful forces, often leading investors to make
irrational decisions, or sometimes even worse, not making any decisions – both of which can be
detrimental to the long-term performance of an investor’s investment portfolio. By removing
these emotions and psychological behaviours from the decision making process, investors are
in a better position to make logical and rational decisions. Seeking professional investment
advice from a financial adviser, taking a long-term view, constructing portfolios based on an
investor’s risk/return profile and investing with professional fund managers are steps an
investor can take to help them achieve this.

Just like a fitness coach, a financial expert or a financial advisor or an investment helps
investors. They determine investor’s investment goals, create a balanced plan to meet those
goals, keep a check on investment portfolio. They also ensure regular monitoring of progress to
ensure that it is aligned with end goals.

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