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Brief description of behavioural finance and biases

According to Thaler (1993), “Behavioural finance is an open-minded finance because it entertains the possibility that some agents in the economy behave less than fully rationally some of the time.” Investor's decision is based on psychological biases and emotions, and they end up taking risks which are unanticipated and unacknowledged. According to Kahneman and Twersky (1979), these biases come from prospect theory- “a descriptive framework for the way people make choices in the face of risk and uncertainty.” 




1.      Overconfidence- Investors feel their knowledge is more accurate, and forecasts by them are more precise. The investor is overconfident when the private signals associated with information causes a reaction (the illusion of knowledge and illusion of control). Overconfidence is complemented by self-attribution, which creates momentum. Momentum leads to continuation in overreaction or under the reaction of price. The reaction also arises because of extrapolation and conservatism. Extrapolation results in overreaction as the pattern is observed from small samples, whereas conservatism results in under-reaction (just opposite of extrapolation). Many researchers suggest models that predicted patterns based on gradual diffusion of news, prior uncertainty, overly simplified algorithm, trade imbalances, and heuristically categorizing objects. Additionally, overconfidence often interacts with short-sale constraints by understanding positive and negative sentiments while buying overvalued assets. One of the advantages of overconfidence bias is the facilitation of entrepreneurs who are risk-takers. And the disadvantage is high or large trading followed by buying wrong stocks.



2.  Loss aversion- It is the notion when investors feel disutility from loss more as compared to the utility from gain. This results in volatility as there are excess stock price fluctuations. Loss aversion also explains momentum, i.e., past winners are undervalued as they are under the constant pressure of selling, and past losers are overvalued as they avoid selling.



   3.  Disposition effect- It tends to sell winners soon and hold losers long based on the proposition of "avoiding regret and seeking pride." The notion arises from the realized profits, which build self-esteem and realizes losses lead to the wrong investment decision. There are reference price effects in which individuals sell stock that were high during the month or when the stock volume increases. There have been many studies by academicians and practitioners supporting both sides of the debate, i.e., winners continue to win, losers continue to lose, and winner-loser effect based on overconfidence, anchoring, salience, and adjustment. The disposition effect is also affected by investors' type and their ultimate motive of investing- individual investor, foreign investor, government as an investor, and bank as an investor.

  


    4.  Representative bias- It is the judgment arising from the stereotype. For example, glamour or growth stocks leave investors with too much optimism. Similarly, stocks with poor performance in the past may be considered losers (pessimism). According to Baker and Nofsinger (2005), investors buy a stock that performed in the past as they think "past price trend" is the representative of "future price trend." Thus, investors are overly optimistic with winners in the past and are overly pessimistic with winners in the past. 


 

    5.  Cognitive dissonance. It is the disagreement of mental state with pre-conceived beliefs, i.e., investors ignore information that does not align with a particular belief. The investors want to "feel good" about their investment by adjusting beliefs and filtering contradictory information about past investment choices' success.


    6. Familiarity bias- The notion of riskiness is less for familiar stocks (existing knowledge or already worked in the company) than the diversified portfolio. This bias is also known as home bias, as some investors prefer to invest in companies from their country or region/local.


7.  Mood- The direct relation between mood and investor behavior is difficult to establish, but optimism and pessimism arise out of various reasons (weather and seasons) that make the mood. The mood affects judgment when there is a lack of information. Good mood leads an investor to invest without any detailed analysis, whereas bad mood forces an investor to make a critical analysis of the availed information or choices. Both may end up with regret.


     8.  The endowment effect- According to Thaler (1980), people do not value things they own, but at the time of giving, they get affected, i.e., investors intend to sell more than the willingness to buy.


     9.  The status quo- Also known as "do-nothing" bias leads the investor to opt for default choice. Investors tend to hold previous investments as they justify it as a good one, especially in the scenario when the particular stock price has fallen.

     

   10.  Reference points and anchoring- The reference points are the (highest) stock prices defined by investors compared to the current stock price. The reference points decide whether investors want to feel the happiness of profit or sadness of the loss. The process of fixing the price is known as anchoring.

     

     11.   Law of small numbers- The faulty predictions happen when investors consider the small samples as an accurate representation of the population. The predictions are based on patterns seen in the past data. Gambler's fallacy is the belief that makes this bias vulnerable to investors. In the gambler fallacy, the game is considered fair if it happens for a short duration and involves itself in the process of self-correction.   

     

     12.  Mental accounting- Mental accounting is based on three important characteristics: the expected return rate, level of risk perceived, and correlation with other investments. The brain decides on some goals and takes action according to those goals exclusively. Although mental accounting helps with self-control, it also accounts for other biases like disposition effect, familiarity bias, cognitive dissonance, etc. The level of risk increases as mental accounting overlooks the interaction between investments and fails to diverse portfolios.

      

      13.  Attachment bias- The investors get emotionally attached to some stocks based on their good traits and deeds and overlook bad traits. Attachment bias has both advantages and disadvantages. The advantage is investors focus on tax and transaction cost effects and involve in rational trading. The disadvantage is to ignore the bad news associated with stock or company, which ends up in a loss.

     

      14.  Changing risk preferences- The preferences change if the expectations are not met. For example, the investor with a winning trend will refuse to change preferences, whereas gamblers playing on others' money might change preferences if not winning and may take more risk or chance. In winning, investors ensure decisions to deal with greed effects where losing may land up investors in two situations- loss aversion or evenitis. In loss aversion, investors avoid risk entirely by not owning any stock, whereas in evenitis, investors take more risk to recoup the loss.  

      

   15.  Heuristics- It is a thumb rule or 1/N rule to make suboptimal decisions. For example, if investors decided to invest money in three funds, one-third would go to each fund. From these three funds, if one of them is stock funds, then one-third goes into equity. Similarly, if two are stock funds, then two-thirds goes into equity.

    

    16.  Framing- It is the notion of presenting the concept in a unique way to individuals. For example, early-bird discounts, after theatre discounts instead of “peak period” surcharges.

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