20-Aug-23

BAC6030
Contemporary Finance

Overview

 Behavioural finance
 Is the study of how psychology affects the behaviour of practitioners
and the impact that this has on financial markets
 Discipline that uses insights from psychology to understand how human
behaviour influences the decisions of individual and professional investors,
managers and markets
 Psychological principles of decision making, to explain why people buy or sell
the stocks as they do

Overview

■ Human Behaviour is not a cool or coherent process as depicted in

management psychology or neuroscience
– Chaotic: It is a mix of rational and intuitive and sometimes irrational
decisions
■ When humans make decisions, we are often unaware of our own behavioural
or cognitive biases and invisible pressures in our environment
■ Once decisions are made they are rationalised and casually implemented with
confidence
■ Even our traits, such as honesty, are malleable and can be manipulated by
subtle cues in the environment.

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Example

■ A group of psychologists at an English university tested their colleagues on

their honesty.
■ To measure the importance of visual cues in decision-making, the researchers
placed a small notice over the ‘honesty box’ in their shared coffee room and,
over a period of several weeks, monitored how much people contributed for
their coffee.
■ What they found was that if a picture of staring eyes was pinned to the
notice the contributions went up.
■ However, if a less threating picture of a bunch of flowers was displayed,
contributions went down, by a factor of three! Even though the participants
reported being aware of the visual cues

Overview

 Behavioral Finance uses insights from Psychology, Finance and Economics

 Financial economists have been aware for a long time that in laboratory
settings, humans often make systematic mistakes and choices that cannot be
explained by traditional models of choice under uncertainty.”
– Paul Pfleiderer

Introduction

 Human Behavior is influenced by psychology

 Simple decisions/ choices
 How hard are we going to study for the next test for BAC6013?
 What type of soda ?
 Harder financial choices or decisions
 Should we buy bonds or stocks
 How do we allocate £1m among alternative investments

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Introduction

 BF gives insights into investment/ market puzzles

 Why do investors choose to invest in local companies
 Why do investors confuse a good company with a good stock
 Why do investors trade as often as they do ?
 Why do people follow a crowd

 BF gives an insight into some concepts that can help answer some of these
questions and the subsequent impact on markets

Central question of irrational versus

rational behaviour
 Do individual investors behave rationally, or do cognitive (relating to conscious
intellectual activity such as thinking, reasoning and remembering) and
emotional errors affect their financial decisions?
 Answer
 The ‘rational’ decision- maker is then supposed to make a choice based
on the best alternative according to their pre-determined appetite for
risk and reward.
 However, this does not happen mostly because human because
behaviour is not that straight forward
 Perfect Rationality does not exist

Criticisms of Perfect Rationality

 When humans are rational, they have the ability to make logical and self-
interested judgments.
 However, many agree that rationality is not the sole driver of human
behaviour.
 Many psychologists believe that the human intellect is subordinate to human
emotion.
 human behaviour is less the product of logic than of subjective impulses
such as fear, love, hate, pleasure and pain.
 We use our intellect only to achieve or avoid emotional outcomes.
 Thus, perfect rationality is only a theoretical construct, not a practical
occurrence.

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Behavioural Finance

 Human rationality and irrationality doesn’t manifest itself in scenarios that are
either black or white.
 People are neither perfectly rational nor perfectly irrational, but possess
diverse combinations of rational and irrational characteristics
 If humans are perfectly rational, with perfect information and perfect self-
interest, then perhaps their behaviour can be quantified

Three strands of Finance

 There are three sub fields to modern financial research.

 Standard finance is the body of knowledge built on the pillars of the
arbitrage principles of Miller and Modigliani, the portfolio principles of
Markowitz, the capital asset pricing theory of Sharpe, Lintner and Black,
and the option-pricing theory of Black, Scholes and Merton
 Empirical finance deals with the study of data in order to infer
relationships.
 Behavioral finance integrates psychology into the investment process.

Traditional vs Behavioural Finance

■ Traditional Finance ■ Behavioural Finance

■ Models people as ‘rational’ ■ Models people as ‘normal’
■ Individuals are risk averse and utility maximising
■ Observed investor and market
■ Traditional Finance focuses on how individuals behaviour
should behave.
■ Recognizes that the way the giá trị nồi tại của cổ phiếu
■ Individuals are considered as being “Rational Beings information is presented to investors không thể hiện đúng
”.
can affect how they make decisions and
– This leads to markets where prices reflect all it can lead to emotional and cognitive
available relevant information
->báo cáo tài chính chính xác, giá trị nội tại của cổ phiếu thể hiện đúng biases.
– It assumes individuals are risk-averse, have
perfect utility function and focus on ■ Since investors’ decisions are not
maximizing the personal utility function always optimal, this results in markets
cognitive bias that are temporary or persistently
quyết định của con người thường là phi lí trí inefficient.
■ Focuses on why investors behave the
way they do.

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Behavioral Finance
Use psychology and economics to understand finance:

Asset pricing: Corporate finance: Personal finance:

• Price Anomalies • IPO timing • Procrastination

• IPO underperformance • Winner’s curse • Emotional choice
• Value Anomaly • Cash-flow sensitivity • Loss aversion
• Sentiment • Overconfidence • Narrow Framing
• Equity premium • Superstar CEO’s • Return chasing
• PEA drift • Passivity
• Momentum • Financial illiteracy
• Bubbles • Home bias
• Overconfidence
• Wishful thinking

Behavioural Finance: re-emphasis

 Behavioral Finance focuses on how investors interpret and act on information to

make informed investment decisions.
 Behavioral finance places an emphasis upon investor behavior leading to various
market anomalies.
 how investors make decisions to buy and sell securities, and
 how they choose between alternatives.

Bounded Rationality

■ Bounded Rationality states that there are limits to what and how people
process information.
■ This removes the assumption of perfect information.
■ Individuals instead practice satisfice which creates outcomes that offer
sufficient satisfaction instead of optimal utility.
■

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Micro Behavioural Finance vs Macro

Behavioural Finance
■ Micro Behavioural Finance ■ Macro Behavioural Finance dùng tđể giải thích những

■ deals with individuals. ■ deals with markets. bất thường trên thị trường

■ attempts to explain why ■ attempts to explain why markets

individuals deviate from the deviate from efficient markets.
Traditional Finance theory and
assumptions
■ Cognitive errors VD: ảnh hưởng từ bố mẹ

■ emotional biases

VD: phân biệt chủng tộc

Behavioural finance and the 2007

Financial crisis
■ Many decisions that led to the financial crisis were bad
– because, although not fraudulent, were made without full consideration
of their consequences ( Micro behavioural finance)
– These decisions were bad because the decision-makers were subject to
cognitive biases, especially overconfidence or as Alan Greenspan, ex-
head of the US Federal Reserve named it, ‘irrational exuberance’.
■ The bad decisions were made throughout the whole of the financial industry(
Macro behavioural finance)

■ The bad decisions were made throughout the whole of the financial industry
from small town banks to global behemoths.

Behavioural finance and the

Financial crisis
■ Homeowners, overestimated their ability to repay their rising debts, were
extended even more credit by local bankers, who underestimated the
possibility that borrowers would fail to repay their excessive debts.
■ However, thanks to financial innovation, these ballooning household debts
were no longer held by local bankers but were packaged and sold on to
investment banks as mortgage-backed securities.
■ In their rush to sell these debts on to investors, such as insurance companies,
the investment bankers did not do the necessary due diligence on what they
had just bought but instead pooled the securities into ever

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Behavioural finance and the

Financial crisis
■ The GFC was not caused by a natural event or even economic turmoil, but by
the fact that thousands of people were caught up in the excitement of a new,
seemingly profitable market opportunity.
■ Bankers and brokers bent or broke the rules that they had dutifully followed
for many years previously. Worries about the possible consequences of a
‘housing bubble’ were raised, for example by the FBI,
– but concerns were buried in the euphoria.
■ As the presidential inquiry into the GFC concluded, the crisis was caused by
individuals not doing the due diligence they should have done, thus under-
mining the integrity of the global financial markets.
■ INFLUENCE OF HUMAN BEHAVIOUR ON MARKETS

Behavioural finance and the

Financial crisis
■ Economists and politicians have argued that the underlying cause of the GFC
was greed and this may be so to a greater or lesser degree.
■ But greed is an emotion that distorts the thinking of the greedy person, in
that the anticipation of reward over-whelms the perception of the risks
involved.
■ What would you say about this cake?

Illustration of Cognitive Biases

■ Christopher Chabris and Daniel Simons, two US psychologists, who videoed a

practice basketball session between two teams.
■ Groups of volunteers (subjects) were then asked to watch the video and count
the number of passes between members of the team in white shirts, which
they did diligently.
■ The subjects were then asked how many passes they had counted and whether
they noticed the gorilla!

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Illustration of Cognitive Biases

■ Almost nobody, across many experiments, reported they had seen a gorilla but
when the video was replayed, everyone immediately noticed someone in a
gorilla suit walking slowly across the court, waving at them.
■ While concentrating on counting the passes, the subject’s brains had
apparently blocked out the gorilla.
■ A range of cognitive biases, including blind spots that distort our judgements.
■ In business/investments, who could miss a gorilla?
– In the case of the GFC, the answer is almost everyone.

Summary

Academic Skills

■ http://study.cardiffmet.ac.uk/AcSkills/Pages/Workshops.aspx