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Study Of Behavioral Finance A Project Report Batch
STUDY OF BEHAVIORAL FINANCE A PROJECT REPORT BATCH: 2010-12 To Dr. Sampada Kapse Program Co-ordinator (PGDM) In partial fulfillment of the requirements of Tolani Institute of Management Studies, Adipur For the award of the degree of Post Graduate Diploma in Management [pic] Tolani Institute of Management Studies PB No. 11, LilashahKutiya Road, Adipur – 370 205 (Kachchh). Ph: (02836) 261466, 262187 Email: [email protected] org, www. tolani. org/tims JUNE 2011 acknowledgement With deep respect and immense gratitude, we express our profound sense of thanks to DR. SAMPADA S.
KAPSE OF TOLANI INSTITUTE OF MANAGEMENT STUDIES ADIPUR for her supportive role and guidance, who give her precious time, thanking special interest in our final project. Secondly, we thank all the professors of TOLANI INSTITUTE OF MANAGEMENT STUDIES ADIPUR for their support and co-operation during our project. Thirdly, we thank all investors of Bhuj and Adipur who filled our long questionnaire and also who directly or indirectly helped at the time of need. – Sachin Abda -Pratik Chothani DECLARATION
We Sachin Abda & Pratik Chothani, the student of M. B. A. 6TH Trimester TIMS (TOLANI INSTITUTE OF MANAGEMENT STUDIES) hereby declare that the Project Report on “Behavioral Finance” Is our original work and has not been submitted by any other person. We also declare that We have done our work sincerely and accurately even then if any mistake or error had kept in, We request to the readers to point out these errors and guide us to remove theses errors in future. – Sachin Abda -Pratik Chothani
EXECUTIVE SUMMARY Basically we were interested in stock market and we have read some theories related to stock market but never understand that why people take irrational decision when coming to real situations. They speak in a different way and act in a different way. So we were curious to know the answers of this question. In our 4th trimester we come to know about the theory from Internet so we thought it might be interesting and may be helpful to answer our question. Behavioral finance is an emerging field.
Many things have researched but still it is new, different types of behavior have been studied. In our project we have tried to understand theories, history and answers to our questions. We had also carried survey in Adipur and Bhuj to know how investors of bhuj and adipur react in different situation and how these various anomalies can be relate to them. one of main good reason for finalizing this project as per name suggest finance but it is very less related to balance sheet, accounting and figures . t is mainly related to pshcycology of investor. TABLE OF CONTENTS |Sr. No. |Contents Name |Page No | |1 |Introduction of behavioral finance |8 | |2 |Literature review |13 | |3 Objectives |38 | |4 |Methodology |39 | |5 |Findings & analysis |40 | |6 |Conclusion |116 | |7 |Appendix |118 | |8 |Bibliography |156 | LIST OF FIGURE/CHART/IMAGE |Sr. No. Title of Figure/Chart |Page No | |1 |Analysis and finding related charts and tables |40 | |2 |Analysis and finding related charts and tables(In Appendix) |126 | Introduction of Behavioural Finance Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Sewell (2005) ‘I think of behavioral finance as simply “open-minded finance”. ’Thaler (1993) ‘This area of enquiry is sometimes referred to as “behavioral finance,” but we call it “behavioral economics. ” Behavioral economics combines the twin disciplines of psychology and economics to explain why and how people make seemimgly irrational or illogical decisions when they spend, invest, save, and borrow money. Belsky and Gilovich (1999) ‘This paper examines the case for major changes in the behavioral assumptions underlying economic models, based on apparent anomalies in financial economics. Arguments for such changes based on claims of “excess volatility” in stock prices appear flawed for two main reasons: there are serious questions whether the phenomenon exists in the first place and, even if it did exist, whether radical change in behavioral assumptions is the best avenue for current research. The paper also examines other apparent anomalies and suggests conditions under which such behavioral changes are more or less likely to be adopted. ’ Kleidon (1986) For most economists it is an article of faith that financial markets reach rational aggregate outcomes, despite the irrational behavior of some participants, since sophisticated players stande ready to capitalize on the mistakes of the naive. (This process, which we camm poaching, includes but is not limited to arbitrage. ) Yet financial markets have been subject to speculative fads, from Dutch tulip mania to junk bonds, and to occasional dramatic losses in value, such as occurred in October 1987, that are hard to interpret as rational. Descriptive decision theory, especially psychology (see D. Kahneman et al. , 1982), can help to explain such aberrant macrophenomena.
Here we propose some behavioral explanations of overall market outcomes—specifically of financial flows, that are of considerable practical consequence to both policymakers and finance practitioners. ’Patel, Zeckhauser and Hendricks (1991) ‘Because psychology systematically explores human judgment, behavior, and well-being, it can teach us important facts about how humans differ from traditional economic assumptions. In this essay I discuss a selection of psychological findings relevant to economics. Standard economics assumes that each person has stable, well-defined preferences, and that she rationally maximizes those preferences. Section 2 considers what psychological research teaches us about the true form of preferences, allowing us to make economics more realistic within the rationalchoice framework.
Section 3 reviews research on biases in judgment under uncertainty; because those biases lead people to make systematic errors in their attempts to maximize their preferences, this research poses a more radical challenge to the economics model. The array of psychological findings reviewed in Section 4 points to an even more radical critique of the economics model: Even if we are willing to modify our familiar assumptions about preferences, or allow that people make systematic errors in their attempts to maximize those preferences, it is sometimes misleading to conceptualize people as attempting to maximize well-defined, coherent, or stable preferences. ’Rabin (1996) ‘Market effciency survives the challenge from the literature on long-term return anomalies.
Consistent with the market effciency hypothesis that the anomalies are chance results, apparent overreaction to information is about as common as underreaction, and post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal. Most important, consistent with the market effciency prediction that apparent anomalies can be due to methodology, most long-term return anomalies tend to disappear with reasonable changes in technique. ’ Fama (1998) ‘Recent literature in empirical finance is surveyed in its relation to underlying behavioral principles, principles which come primarily from psychology, sociology and anthropology.
The behavioral principles discussed are: prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and underreaction, representativeness heuristic, the disjunction effect, gambling behavior and speculation, perceived irrelevance of history, magical thinking, quasimagical thinking, attention anomalies, the availability heuristic, culture and social contagion, and global culture. ’ Shiller (1998) ‘The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, people’s deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology.
The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second. ’ Barber and Odean (1999) ‘Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications. We begin with a preliminary question about relevance. Does some combination of market forces, learning and evolution render these human qualities irrelevant? No. Because of limits of arbitrage less than perfect agents survive and influence market outcomes. We then discuss three important ways in which humans deviate from the standard economic model.
Bounded rationality reflects the limited cognitive abilities that constrain human problem solving. Bounded willpower captures the fact that people sometimes make choices that are not in their long-run interest. Bounded self-interest incorporates the comforting fact that humans are often willing to sacrifice their own interests to help others. We then illustrate how these concepts can be applied in two settings: finance and savings. Financial markets have greater arbitrage opportunities than other markets, so behavioral factors might be thought to be less important here, but we show that even here the limits of arbitrage create anomalies that the psychology of decision making helps explain.
Since saving for retirement requires both complex calculations and willpower, behavioral factors are essential elements of any complete descriptive theory. ’ Mullainathan and Thaler (2000) ‘Behavioral finance is a rapidly growing area that deals with the influence of psychology on the behavior of financial practitioners. ’Shefrin (2000) ‘Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners. ’Shefrin (2000) ‘Behavioral finance is the study of how psychology affects financial decision making and financial markets. ’Shefrin (2001) ‘Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational.
The field has two building blocks: limits to arbitrage, which argues that it can be diffcult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then present a number of behavioral finance applications: to the aggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate finance. We close by assessing progress in the field and speculating about its future course. ’ Barberis and Thaler (2001) ‘This essay provides a perspective on the trend towards integrating psychology into economics.
Some topics are discussed, and arguments are provided for why movement towards greater psychological realism in economics will improve mainstream economics. ’ Rabin (2001) ‘The basic paradigm of asset pricing is in vibrant flux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models. ’ Hirshleifer (2001) Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. ’ Literature Review (1)Title: Testing Behavioral Finance Theories Using Trends and Sequences in Financial Performance Author: Wesley S. Chan, Richard Frankel and S. P. Kothari Objective: to examine a central psychological bias, representativeness, which underlies many behavioral-finance theories? According to this bias, individuals form predictions about future outcomes based on how closely past outcomes fit certain categories Methodology: Secondary Data
Conclusion: Overall, these results suggest that multi-month momentum and long-term reversal are not due investors’ mental biases as modeled in the behavioral theories and/or the maintained hypothesis of limited arbitrage is not descriptive. Our results suggest pricing is not as if investors extrapolate firms’ growth rates too far into the future. Nor do investors seem to under react to incipient trends in performance. All of these conclusions cast doubt on the representativeness heuristic-based theories of behavioral finance. One could conclude that representativeness has no place in describing stock return behavior (and also perhaps investor behavior). However, the predictability of returns documented in the literature remains an interesting and problematic phenomenon potentially at odds with market efficiency.
Investors may think in categories, but using current theory as our guide, we are unable to the stock price implications predicted in those theories. Alternatively, we failed to identify the correct categories, metrics, or horizons necessary to document the consequences of behavioral information processing biases. Our evidence poses a challenge to behavioral finance theories and therefore researchers should consider refining their models to guide further empirical work. (2) Title: Lessons from Behavioral Finance for Retirement Plan Design Author: Olivia Mitchell and Stephen Utkus Objective: to evaluate some of the key lessons of behavioral economics and finance research over the last decade for pension plan design
Methodology: Secondary Data Conclusion: by outlining plan design alternatives that would be of use to plan sponsors and policymakers seeking to design more cost-effective and efficient retirement plans for the future. (3) Title: Risk Perception Primer: A Narrative Research Review of the Risk Perception Literature in Behavioral Accounting and Behavioral Finance Author: Victor Ricciardi Objective: to provides an overview of the concepts of risk, perception, and risk perception To present concept of behavioral finance and themes that might influence an individual’. s perception of risk for different types of financial services Methodology:Secondary Data
Conclusion: author has developed a structured approach known as the Statistically Significant Method for Risk Perception Studies With the utilization of an 18-step process from the Statistically Significant Method for Risk Perception Studies has resulted in the development of 6 financial risk indicators based on 15 proxy risk measurements from accounting, finance, and investments The 6 financial risk indicators are (1) A company’s balance sheet liquidity (2) The financial condition (health) of the firm (3) The degree of volatility (4) The concern for downside risk in percentage term (5) The significance of earnings (6) The expected investment performance for the stock.
The selection of the 6 behavioral risk characteristics and the 5 decision-making Attributes was based on the narrative review of the 17 works from the risk perception studies in Psychology associated with hazardous activities. The 6 psychological risk indicators are: (1) The role of affect or feelings, (2) The influence of worry, (3) The notion of perceived control, (4) The significance of expert knowledge, (5) The issues of overconfidence, (6) The concern or potential losses in dollar terms. The 5 judgment attributes are: (1) The role of familiarity, (2) The overall perceived riskiness of a stock, (3) The overall perceived return of a stock, (4) The significance of the investment time horizon (short-term vs. ong run), (5) The likelihood of investing in the stock. Title: A Research Starting Point for the New Scholar: A Unique Perspective of Behavioral Finance Author: Victor Ricciardi Objective: to provide an extensive catalog of the concepts, and books by behavioral finance which investigates the cognitive factors and emotional issues those individuals, financial experts, and traders exhibit within the securities markets. Methodology: Secondary Data Conclusion: Although modern finance has been the established theory of academics since the 1960s, the discipline of behavioral finance offers a new point of view of finance and investments for the new research scholar.
In the early to mid-1990s, the literature on behavioral finance that began to emerge challenged many of the assumptions and theories of standard finance. The foundation for this body of work was created from earlier research by behavioralists during the decades of the 1960s and 1970s particularly from their dissertation work. The new behavioral finance researcher should appreciate that the discipline is based on the notion of an interdisciplinary perspective that incorporates the philosophies from the social sciences and business fields. (4) Title: Behavioral Finance and Retirement Plan Contributions: How Participants Behave, and Prescriptive Solutions Author: by Jodi DiCenzo
Objective: to offer new retirement plan design alternatives and empirically tested their efficacy in overcoming identified suboptimal behavior Methodology: Secondary Data Conclusion: Behavioral research has made important, relevant contributions to retirement saving and investing. This work has cast a new light on participant behavior and its underpinnings: By and large, individuals are inert—with good intentions, poor follow-through, and bounded rationality. Loss aversion and decision-making biases often lead to unfortunate outcomes, including a poorly funded retirement. Further, behavioral economists have demonstrated that education and communication programs alone may not be effective in changing behavior.
Instead, with their behavioral insights, they have offered new retirement plan design alternatives and empirically tested their efficacy in overcoming identified suboptimal behavior. These efforts are helping to pave a path of least resistance that should lead to greater retirement security. (5) Title: A SURVEY OF BEHAVIORAL FINANCE Author: Othmar M. Lehner Objective: present a survey of this huge, vastly expanding field of research by summarizing working papers recently published at the “National Bureau of Economic Research” Methodology: Secondary Data Conclusion: Many of the studies presented above show evidence that, although the EMH in principle works, there are many factors that have been left out of consideration, like for example costs and risks.
Especially when it comes to arbitrage, this is very seldom a guaranteed profit, as the EMH would propose, but rather almost all real world arbitrage activity is risky, with the expected profit highly relative to the risk involved. So without a suitable tool to reverse irrational trading, mispricing will be able to occur and more important – persist for quite long time-ps. (6) Title: Cognitive biases and instability of preferences in the portfoliochoices of retail investors Policy implications of behavioral finance Author: R. Linciano Objective: to stimulate debate on the behavioral analysis of the abovementioned policy issues, in order to strengthen the efficiency of instruments made available to investors to understand the characteristics of financial products. Methodology: Secondary Data
Conclusion: Financial market regulation is based on the classical theoretical paradigm of individual rationality, which requires, among other things, that investment choices be made after acquiring and processing all the available information, on the basis of pre-existent, stable and Consistent preferences and by using a cognitive process of utility maximization. This theoretical apparatus underpin the measures enacted for investor’s protection, based on rules of conduct and on very detailed disclosure obligations which the issuers offinancial products and brokers have to apply so that investors can decide on an informed basis. Moreover, when advising on investments or portfolio management, intermediaries are obliged to acquire from the investors the required information on knowledge and xperiences on investments, financial situation and objectives of investment in order to be able to recommend suitable products. However, individuals do not act rationally, nor do they seem able to acquire and correctly process the available information. Vice versa, when choosing under uncertainty, they seem inclined to apply rules of thumb that allow simplifying problems. Moreover, preferences do not appear stable and well-defined, since they may change depending on whether prospects of loss or gains prevail and according to the presentation format. These factors lead to systematic evaluation errors as well as violations of the assumption of rationality. (7) Title: NBER WORKING PAPER SERIES: A SURVEY OF BEHAVIORAL FINANCE
Author: Nicholas Barberis,Richard Thaler Objective: to discuss these two topics, and then present a number of behavioral finance applications: to the aggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate finance Methodology: Secondary Data Conclusion: most of the empirical facts are agreed upon by most of the profession, although the interpretation of those facts is still in dispute. Limits of arbitrage can permit substantial mispricing. Also the absence of a profitable investment strategy, because of risks and costs doesn’t imply the absence of mispricing. UNDERSTANDING BOUNDED RATIONALITY:
Models of bounded rationality are both possible and also much more accurate descriptions of behavior than purely rational model. (8) Title: What explains the market: finance theories or psychology? Author: Sampada Kapse, Mamta Keswani Objective: To understand investor’s behavior while investing in stock market and to find out the behavioral influences ,on the investment decisions of retail individual investors in the Indian stock market Methodology: This is empirical research arguing mainly on two parameters 🙁 1) anomalies in the stock market and (2) analysis of the human behavior while investing in stock market. The tool used for this is survey and the instrument was questionnaire.
Conclusion: The application of behavioral finance is still to explore like how can an investor beat the market and can make the money. It tell us that psychology causes market prices and fundamental values to diverge for a long time and can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their behavior personal wealth. Behavioral finance does give insights relating to the investor decision making process. However, its utility as an investment tool is yet to be proved. (9) Title: Factors Influencing Individual Investor Behavior: An Empirical study of the UAE Financial Markets Author: Hussein A. Hassan Al-Tamimi
Objective: This paper aims at identifying the most and the least influencing factors on the UAE Investor behavior. Methodology: In order to get responses on the research questions, 350 questionnaires were Randomly distributed to 350 individual investors in both Dubai Financial Market and Abu Dhabi Securities Market. Conclusion: The main findings: (i) accounting information or the classical wealth–maximization criteria is the most influencing group on the UAE investor behavior; (ii) neutral information is the least influencing group on the UAE investor behavior; (iii) two factors unexpectedly had the least influence on the behavior of the UAE investors’ behavior, namely religious reasons and the factor of family member opinions. (10)
Title: Behavioral finance and the change of investor behavior during and after the speculative bubble at the end of the 1990s Author: Malena Johnsson,Henrik Lindblom,Peter Platan Objective: to conduct a research on how private as well as institutional investors have changed their investment behavior and human judgment as a consequence of the speculative bubble during the period from fall 1998 to march 2000. To establish what factors lies behind the speculative bubble and further investigate whether the investment objectives and factors influencing decision making are different today than speculative bubble. Methodology: To achieve purpose they had apply a quantitative as well as qualitative method.
Quantitative method to refer questionnaire form. Qualitative method is implemented through their attempt to describe the reasons and existence of the speculative bubble during the end of 1990’s with the help of existing theories. Conclusion: the result obtained suggests that the behavior of market participants during the speculative bubble was to some extent irrational and that the composition of investments has changed as consequences of speculative bubble. However company’s information considered as the least significant reason for overvaluation of the market. After speculative bubble information from companies gain importance for both group especial institutional investor.
This indicate that increase in importance of fundamental data and valuations today than during the speculative bubble when intuition and other more vogue valuation method seem to have influenced more. Theory of Behavioral Finance Definition of ‘Efficient Market Hypothesis – EMH’ An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments Theory of Behavioral finance Key Concept No. 1. Anchoring Similar to how a house should be built upon a good, solid foundation, our ideas and opinions Should also be based on relevant and correct facts in order to be considered valid. However, this is not always so. The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point – even though it may have no logical relevance to the decision at hand.
Although it may seem an unlikely phenomenon, anchoring is fairly prevalent in situations where people are dealing with concepts that are new and novel. A Diamond Anchor Consider this classic example: Conventional wisdom dictates that a diamond engagement ring should cost around two months’ worth of salary. Believe it or not, this “standard” is one of the most illogical examples of anchoring. While spending two months worth of salary can serve as a benchmark, it is a completely irrelevant reference point created by the jewelry industry to maximize profits, and not a valuation of love. Many men can’t afford to devote two months of salary towards a ring while paying for living expenses. Consequently, many go into debt in order to meet the “standard”.
In many cases, the “diamond anchor” will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt. Although the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two-month standard. Because buying jewelry is a “novel” experience for many men, they are more likely to purchase something that is around the “standard”, despite the expense. This is the power of anchoring. Academic Evidence admittedly, the two-month standard used in the previous example does sound relatively plausible. However, academic studies have shown the anchoring effect to be so strong that it still occurs in situations where the anchor is absolutely random. Investment Anchoring
Anchoring can also be a source of frustration in the financial world, as investors base their decisions on irrelevant figures and statistics. For example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. In this case, the investor is anchoring on a recent “high” that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. Anchoring While, it is true that the fickleness of the overall market can cause some stocks to drop substantially in value, allowing investors to take advantage of this short- term volatility. However, stocks quite often also decline in value due to changes in their underlying fundamentals.
For instance, suppose that XYZ stock had very strong revenue in the last year, causing its share price to shoot up from $25 to $80. Unfortunately, one of the company’s major customers, who contributed to 50% of XYZ’s revenue, had decided not to renew its purchasing agreement with XYZ. This change of events causes a drop in XYZ’s share price from $80 to $40. By anchoring to the previous high of $80 and the current price of $40, the investor erroneously believes that XYZ is undervalued. Keep in mind that XYZ is not being sold at a discount, instead the drop in share value is attributed to a change to XYZ’s fundamentals (loss of revenue from a big customer).
In this example, the investor has fallen prey to the dangers of anchoring. AvoidingAnchoring When it comes to avoiding anchoring, 1. There’s no substitute for rigorous critical thinking. Be especially careful about which figures you use to evaluate a stock’s potential. 2. Successful investors don’t just base their decisions on one or two benchmarks, they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape. 3. For novice investors especially, it’s never a bad idea to seek out other perspectives. Listening to a few “devil’s advocates” could identify incorrect benchmarks that are causing your strategy to fail. Key Concept No. 2: Mental Accounting
Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account . According to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviors. Although many people use mental accounting, they may not realize how illogical this line of thinking really is. For example, people often have a special “money jar” or fund set aside for a vacation or a new home, while still carrying substantial credit card debt.
In this example, money in the special fund is being treated differently from the money that the same person is using to pay down his or her debt, despite the fact that diverting funds from debt repayment increases interest payments and reduces the person’s net worth. Simply put, it’s illogical (and detrimental) to have savings in a jar earning little to no interest while carrying credit-card debt accruing at 20% annually. In this case, rather than saving for a holiday, the most logical course of action would be to use the funds in the jar (and any other available monies) to pay off the expensive debt. This seems simple enough, but why don’t people behave this way? The answer lies with the personal value that people place on particular assets. For instance, people may feel that money saved for a new house or their children’s college fund is too “important” to relinquish.
As a result, this “important” account may not be touched at all, even if doing so would provide added financial benefit. The Different Accounts Dilemma To illustrate the importance of different accounts as it relates to mental accounting, consider this real-life example: You have recently subjected yourself to a weekly lunch budget and are going to purchase a $6 sandwich for lunch. As you are waiting in line, one of the following things occurs: 1) You find that you have a hole in your pocket and have lost $6; or 2) You buy the sandwich, but as you plan to take a bite, you stumble and your delicious sandwich ends up on the floor. In either case (assuming you still have enough money), would you buy another sandwich? (To read more, see The Beauty Of Budgeting. )
Logically speaking, your answer in both scenarios should be the same; the dilemma is whether you should spend $6 for a sandwich. However, because of the mental accounting bias, this isn’t so. Because of the mental accounting bias, most people in the first scenario wouldn’t consider the lost money to be part of their lunch budget because the money had not yet been spent or allocated to that account. Consequently, they’d be more likely to buy another sandwich, whereas in the second scenario, the money had already been spent. Different Source, Different Purpose Another aspect of mental accounting is that people also treat money differently depending on its source.
For example, people tend to spend a lot more “found” money, such as tax returns and work bonuses and gifts, compared to a similar amount of money that is normally expected, such as from their paychecks. This represents another instance of how mental accounting can cause illogical use of money. Logically speaking, money should be interchangeable, regardless of its origin. Treating money differently because it comes from a different source violates that logical premise. Where the money came from should not be a factor in how much of it you spend – regardless of the money’s source, spending it will represent a drop in your overall wealth. Mental Accounting In Investing
The mental accounting bias also enters into investing. For example, some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. The problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio, his net wealth will be no different than if he had held one larger portfolio. Avoiding Mental Accounting The key point to consider for mental accounting is that money is fungible; regardless of its origins or intended use, all money is the same.
You can cut down on frivolous spending of “found” money, by realizing that “found” money is no different than money that you earned by working. As an extension of money being fungible, realize that saving money in a low- or no-interest account is fruitless if you still have outstanding debt. In most cases, the interest on your debt will erode any interest that you can earn in most savings accounts. While having savings is important, sometimes it makes more sense to forgo your savings in order to pay off debt. Key Concept No. 3: Confirmation and Hindsight Biases Confirmation Bias It can be difficult to encounter something or someone without having a preconceived opinion.
This first impression can be hard to shake because people also tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationalizing the rest. This type of selective thinking is often referred to as the confirmation bias. In investing, the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. As a result, this bias can often result in faulty decision making because one-sided information tends to skew an investor’s frame of reference, leaving them with an incomplete picture of the situation.
Consider, for example, an investor that hears about a hot stock from an unverified source and is intrigued by the potential returns. That investor might choose to research the stock in order to “prove” its touted potential is real. What ends up happening is that the investor finds all sorts of green flags about the investment (such as growing cash flow or a low debt/equity ratio), while glossing over financially disastrous red flags, such as loss of critical customers or dwindling markets. Hindsight Bias where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicte
For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s were very obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn’t have escalated and eventually burst. For investors and other participants in the financial world, the hindsight bias is a cause for one of the most potentially dangerous mindsets that an investor or trader can have: overconfidence. In this case, overconfidence refers to investors’ or traders’ unfounded belief that they possess superior stock-picking abilities. Avoiding Confirmation Bias Confirmation bias represents a tendency for us to focus on information that confirms some pre-existing thought.
Part of the problem with confirmation bias is that being aware of it isn’t good enough to prevent you from doing it. One solution to overcoming this bias would be finding someone to act as a “dissenting voice of reason”. That way you’ll be confronted with a contrary viewpoint to examine. Key Concept No. 4: Gambler’s Fallacy In the gambler’s fallacy, an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. For example, consider a series of 20 coin flips that have all landed with the “heads” side up.
Under the gambler’s fallacy, a person might predict that the next coin flip is more likely to land with the “tails” side up. This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%. Each coin flip is an independent event, which means that any and all previous flips have no bearing on future flips. Another common example of the gambler’s fallacy can be found with people’s relationship with slot machines. We’ve all heard about people who situate themselves at a single machine for hours at a time. Most of these people believe that every losing pull will bring them that much closer to the jackpot.
What these gamblers don’t realize is that due to the way the machines are programmed, the odds of winning a jackpot from a slot machine are equal with every pull (just like flipping a coin), so it doesn’t matter if you play with a machine that just hit the jackpot or one that hasn’t recently paid out. Gambler’s Fallacy In Investing It’s not hard to imagine that under certain circumstances, investors or traders can easily fall prey to the gambler’s fallacy. For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don’t believe that the position is likely to continue going up.
Conversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as “improbable”. Just because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session. Avoiding Gambler’s Fallacy With the amount of noise inherent in the stock market, the same logic applies: Buying a stock because you believe that the prolonged trend is likely to reverse at any second is irrational. 1. Investors should instead base their decisions on fundamental and/or technical analysis before determining what will happen to a trend. Key Concept No. 5: Herd Behavior
One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn’t the first time that events like this have happened in the markets. How could something so catastrophic be allowed to happen over and over again? The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. There are a couple of reasons why herd behavior happens. (1)social pressure of conformity: You probably know from experience that this can be a powerful force.
This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Therefore, following the group is an ideal way of becoming a member. (2) common rationale that it’s unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don’t. This is especially prevalent in situations in which an individual has very little experience. The Dotcom Herd A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client’s invested wealth.
The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. For example, a wealthy client may have heard about an investment gimmick that’s gaining notoriety and inquires about whether the money manager employs a similar “strategy”. In many cases, it’s tempting for a money manager to follow the herd of investment professionals. After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn’t, that money manager can justify his poor decision by pointing out just how many others were led astray. The Costs of Being Led Astray Herd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy.
Investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. For example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. If biotech stocks are all the rage six months later, he’ll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments. Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction costs, which can eat away at available profits. Furthermore, it’s extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting.
By the time a herd investor knows about the newest trend, most other investors have already taken advantage of this news, and the strategy’s wealth-maximizing potential has probably already peaked. This means that many herd-following investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies. Avoiding the Herd Mentality 1. While it’s tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment “bandwagon” doesn’t necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your homework before following any trend. 2.
Just remember that particular investments favored by the herd can easily become overvalued because the investment’s high values are usually based on optimism and not on the underlying fundamentals. KeyConcept No. 6: Overconfidence In a 2006 study entitled “Behaving Badly”, researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.
As you can imagine, overconfidence (i. e. , overestimating or exaggerating one’s ability to successfully perform a particular task) is not a trait that applies only to fund managers. Consider the number of times that you’ve participated in a competition or contest with the attitude that you have what it takes to win – regardless of the number of competitors or the fact that there can only be one winner. Keep in mind that there’s a fine line between confidence and overconfidence. Confidence implies realistically trusting in one’s abilities, while overconfidence usually implies an overly optimistic assessment of one’s knowledge or control over a situation. Overconfident Investing
In terms of investing, overconfidence can be detrimental to your stock-picking ability in the long run. In a 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average”, researcher Terrence Odean found that overconfident investors generally conduct more trades than their less-confident counterparts. Odean found that overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. Unfortunately, Odean also found that traders that conducted the most trades tended, on average, to receive significantly lower yields than the market. Avoiding Overconfidence 1.
Keep in mind that professional fund managers, who have access to the best investment/industry reports and computational models in the business, can still struggle at achieving market-beating returns. 2. The best fund managers know that each investment day presents a new set of challenges and that investment techniques constantly need refining. Just about every overconfident investor is only a trade away from a very humbling wake-up call. Key Concept No. 7: Overreaction and the Availability Bias One consequence of having emotion in the stock market is the overreaction toward new information. According to market efficiency, new information should more or less be reflected instantly in a security’s price.
For example, good news should raise a business’ share price accordingly, and that gain in share price should not decline if no new information has been released since. Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security’s price. Furthermore, it also appears that this price surge is not a permanent trend – although the price change is usually sudden and sizable, the surge erodes over time. Winners and Losers In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called “Does the Market Overreact? ” In this study, the two examined returns on the New York Stock Exchange for a three-year period.
From these stocks, they separated the best 35 performing stocks into a “winners portfolio” and the worst 35 performing stocks were then added to a “losers portfolio”. De Bondt and Thaler then tracked each portfolio’s performance against a representative market index for three years. Surprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time p. In other words, it appears that the original “winners” would became “losers”, and vice versa. According to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news.
This happens in real life all the time. For example, suppose you see a car accident along a stretch of road that you regularly drive to work. Chances are, you’ll begin driving extra cautiously for the next week or so. Although the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you’ll be back to your old driving habits by the following week. Avoiding Availability Bias Perhaps the most important lesson to be learned here is to retain a sense of perspective. While it’s easy to get caught up in the latest news, short-term approaches don’t usually yield the best investment results. If you Objectives To study the influence of behavioral finance on investor’s decisions. • To explore the area of behavioral finance and analyze behavioral finance’s potential and understanding the investment practices in specified area of Bhuj and Adipur • To study a specified type of people within specified income level Methodology • Type of data required ? Primary and secondary both • Data collection method ? Survey through questionnaire ? Study of secondary data • Sample design ? Target population: Investors of Bhuj and Adipur ? Sampling method: Convenient sampling ? Sample size : 150 investors of Bhuj and Adipur FINDING Introduction to questionnaire
We had done literature review and found some interesting questions which were helpful and relevant to our topic and made a questionnaire with the help of literature review. The questionnaire which helped us to achieve our objective which was to understand Behavior of investors of Bhuj and Adipur. With this questionnaire we had tried to check out theory of Behavioral finance and also we tried to analyze Behavior of Bhuj and Adipur’s investors. Questionnaire Analysis Gender | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |Male |121 |80. 7 |80. 7 |80. | | |Female |29 |19. 3 |19. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | In our project 80% respondents are male and 20% females. because still males are more investing but no of women investors are surely increase in future as girls are getting more and more educated What is your current occupation? Age group | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |Under 25 years |90 |60. 0 |60. 0 |60. | | |26-35 years |42 |28. 0 |28. 0 |88. 0 | | |36-50 years |13 |8. 7 |8. 7 |96. 7 | | |51-60 years |3 |2. 0 |2. 0 |98. 7 | | |Above 60 |2 |1. 3 |1. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | In our project 60% respondents are under 25 years and 28% are in age group of 26-35 years. What is your current occupation? |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |Service |54 |36. 0 |36. 0 |36. 0 | | |Bussiness |24 |16. 0 |16. 0 |52. 0 | | |Independent professsion |16 |10. 7 |10. 7 |62. 7 | | |Students |56 |37. 3 |37. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Occupation
In our project 36% respondents are doing service where 37% are students What is your Education Qualification? | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |Under graduate |52 |34. 7 |34. 7 |34. 7 | | |Graduate |64 |42. 7 |42. 7 |77. 3 | | |Post graduate |34 |22. 7 |22. 7 |100. 0 | | |Total |150 |100. 0 |100. 0 | |
In our project 42% respondents are graduate and we also take 34% undergraduate to know their view What is your income per annum? | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |Less than 1. 5 Lacs |67 |44. 7 |44. 7 |44. 7 | | |1. 5-3 Lacs |46 |30. 7 |30. 7 |75. 3 | | |;3-5 Lacs |19 |12. 7 |12. 7 |88. 0 | | |;5-7 Lacs |9 |6. 0 |6. 0 |94. | | |;7-10 Lacs |4 |2. 7 |2. 7 |96. 7 | | |;10 Lacs |5 |3. 3 |3. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | In our project 75% respondents are having income less than 3 lacks while we also have 4%people who have income above 10 lacks. In normal condition, people who have high income are more risk taker and people who have low income are risk averse so, we can say that most of our respondent are risk averse
Since how many years do you invest in share market? | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |1 Year |61 |40. 7 |40. 7 |40. 7 | | |2 Year |45 |30. 0 |30. 0 |70. 7 | | |3 Year |24 |16. 0 |16. 0 |86. 7 | | |4 Year |11 |7. 3 |7. 3 |94. 0 | | |5 Year or more than 5|9 |6. 0 |6. 0 |100. | | |Years | | | | | | |Total |150 |100. 0 |100. 0 | | ? Purpose: To know that whether our respondents are experienced or they are in experienced. ? Analysis: In our project our 71% respondent have less than 2 year experience in share market and 6% have more than 5 year experience. What is the number of dependent members in your family? | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |0 |31 |20. 7 |20. 7 |20. | | |1 |28 |18. 7 |18. 7 |39. 3 | | |2 |29 |19. 3 |19. 3 |58. 7 | | |3 |30 |20. 0 |20. 0 |78. 7 | | |4 |24 |16. 0 |16. 0 |94. 7 | | |More than 5 |8 |5. 3 |5. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | |
In our project our 58% respondent have less than 2 dependent members in family and 5% have more than 5 dependent members in family 1 What is the objective of your investment? Stability of principle | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |121 |80. 7 |80. 7 |80. 7 | | |Yes |29 |19. 3 |19. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Income generation | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |62 |41. 3 |41. |41. 3 | | |Yes |88 |58. 7 |58. 7 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Capital appreciation | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |105 |70. 0 |70. 0 |70. 0 | | |Yes |45 |30. 0 |30. 0 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Growth in income |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |79 |52. 7 |52. 7 |52. 7 | | |Yes |71 |47. 3 |47. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Tax shelter | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |122 |81. 3 |81. 3 |81. 3 | | |Yes |28 |18. 7 |18. 7 |100. 0 | | |Total |150 |100. |100. 0 | | ? Purpose: To analyze about theory of mental accounting and to know the objective of investor while investing ? Analysis: In our project our 59% respondent have income generation as one of their objective of investment ,48% respondent have Capital appreciation as one of their objective of investment and only 18% have tax shelter as one of their objective of investment. We can relate the theory of Mental accounting with this question that investors have decided their objective according to their convenience. 2. What is your most preferable tool of investment? Bank deposit such as saving a/c and f. d |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |58 |38. 7 |38. 7 |38. 7 | | |Yes |92 |61. 3 |61. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Post office schemes | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |93 |62. 0 |62. 0 |62. 0 | | |Yes |57 |38 |38 |100. | | | | | | |100. 0 | | |Total |150 |100. 0 |100. 0 | | Government bonds | |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |130 |86. 7 |86. 7 |86. 7 | | |Yes |20 |13. 3 |13. 3 |100. 0 | | |Total |150 |100. 0 |100. 0 | | Corporate bonds, debentures and preference shares |Frequency |Percent |Valid Percent |Cumulative Percent | |Valid |No |143 |95. 3 |95. 3 |95. 3 | | |Yes |7 |4. 7 |4. 7 |100. 0 | | |Total |150 |1