Key Principles of Behavioural Finance 1. Introduction 2. Anomalies 3. Key Concepts Prospect Theory & Loss-Aversion Anchoring Mental Accounting Confirmation & Hindsight Bias Gambler’s Fallacy Herd Behaviour Overconfidence Overreaction & Availability Bias 4. Conclusion

1. Key Principles of
Behavioral
Finance
Jawwad Siddiqui, CSC
Research Assistant, The Finkelstein Group

2. 1
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Table Of Contents
Prospect Theory & Loss-Aversion
Anchoring
Mental Accounting
Confirmation & Hindsight Bias
Gambler’s Fallacy
Herd Behaviour
Overconfidence
Overreaction & Availability Bias

3. Introduction
2
Behavioral Finance
What is it?
 Study that seeks to combine psychology,
sociology, and traditional finance.
 Helps explain why people make irrational
financial decision
Source: Yale University
Why is it important?
 It is necessary because “technical analysis” assumes that people
act rationally

4. Introduction
2
History of Behavioral Finance
 Over last 40 years, standard finance has
been the dominant theory
 Academic Finance emphasized theories
such as modern portfolio theory and the
efficient market hypothesis
 These theories failed to explain 2008
crash, dot com bubble etc.
Source: Yale University
 Only recently, evolving and of increasing importance field of neuroscience
has also won appreciation from the finance industry.
 Works of Kahneman (Nobel Prize Winner) is considered most creditworthy

5. Anomalies
3
Anomalies
 Regular occurring anomalies is a big factor that contributed to the formation of
behavioral finance.
 January Effect: Financial security
prices rise in the month of January.
 Winner’s Curse: a tendency for the
winning bid in an auction that
exceed the intrinsic value of item
purchased.
 Equity Premium Puzzle: Equity
returns less bond returns have
Source: The Economist
been roughly 6% for the past
century.

6. Key Concepts
6
Prospect Theory and Loss-Aversion
 Investor decision weights tend to overweigh small probabilities and underweigh moderate and high probabilities.
 Basing decisions on perceived gains rather than perceived losses.
Example
Option 1
Guaranteed Profit of $5,000
Option 2
80% chance of gaining $7,000
20% chance of gaining $0
Question: Which option would give the best chance to maximize your profits?
 Correct Answer – Option 2
 If investors are faced with possibility of losing money, they often take riskier
decisions aimed at loss aversion.

7. Key Concepts
4
Anchoring
 Using irrelevant info as a reference for evaluation.
 For example, assuming decline in a stock price is only temporary.
Example
Source: Thinking Fast & Slow
 Thus, investors tends to focus on message’s content rather than its relevance
when making financial decisions.

8. Key Concepts
4
Mental Accounting
 Dividing current and future assets in separate portions.
 Results in different level of utility of each portion

provokes bias and other behaviors.
Examples
Option 1
Would you drive 20 min to save $5 on a
$15 calculator?
Option 2
Would you drive 20 min to save $5 on a
$125 jacket?
Question: What option will you choose?
 This theory helps explain irrational financial behavior. For example, why you
bought so many calculators on sale when you only needed one.

9. Key Concepts
4
Confirmation & Hindsight Bias
 Confirmation Bias – having preconceived opinion which serves as self-fulfilling
prophecies.
 Hindsight Bias – believing that past event was predictable and obvious
Examples
 Investors will be overly
optimistic and overvalue their
talents when sharing stories.
 Investors will put greater
weight on their knowledge
than it should have.

10. Key Concepts
5
Gamblers Fallacy
 Lack of understanding resulting in incorrect assumptions and predictions about
the onset of events.
 E.g investors viewing further declines and improbable.
Examples
 Investors – “After all those losses, I am due to WIN!”
 Parents – already have three daughters but are overly optimistic that their next
child will be a male.
 Entrepreneurs – “I have failed so many times, success is around the corner.”

11. Key Concepts
5
Herd Behaviour
 We are programmed to feel that the consensus view must be the correct one
 Imitating behavior and actions of others.
Examples
 Health Choices – Eating habits of the western
world, smoking of groups etc.
 From US Housing Bubble, Dot Com Crash in
2001and the Credit Crisis of 2008.
Source: The Economist

12. Key Concepts
5
Overconfidence
 Being overconfident in your stock-picking ability
 Results in increased number of trades
Examples
 Investors - “I know exactly how to evaluate stocks”.
Thus, I don’t need a second opinion.
 Entrepreneurs – despite knowing the statistics, they
strongly believe “their chance of failing is zero”

13. Key Concepts
6
Overreaction and Availability Bias
 Overreaction - Investors overreact to news and create larger than appropriate
effect on a security price
 Availability – our thinking is strongly influenced by what is personally most
relevant, recent or dramatic.
Examples
 Investors – weighing their financial decision on most
recent news.
 Lottery Winners – buy it because they recall memory
of people who won.

14. Conclusion
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Closing Comments
 Being consciously aware of these biases or irrational behaviour will allow us to
better make investment decisions
 Practise critical thinking and study your thought process during investment
decision making
 Allows you to provide better investment recommendations to your clients
Suggested Reading
 Book: Thinking Fast and Slow
By: Daniel Kahneman
(Noble Prize Winner in Economics)

15. Thank-You.
Questions?
Jawwad Siddiqui, CSC
Research Assistant, The Finkelstein Group