NAME- ASRAN SHARIFF

CLASS- 3 BCOM-IFA
REGISTER NO- 20IFA074

Advanced financial management

Assignment-1

Behavioral finance attempts to explain how decision makers

take financial decisions in real life, and why their decisions
might not appear to be rational every time and, hence, have
unpredictable consequences. Behavioral finance has been
described as ‘the influence of psychology on the behavior of
financial practitioners. Behavioral finance seeks to examine the
following assumptions of rational decision-making by investors
and financial managers-

1. Financial decision-makers seek to maximize their utility and do

so by trying to maximize portfolio or company value.
2. They take financial decisions based on analysis of relevant
information.
3. The analysis of financial information that they undertake is
rational, objective, and risk-neutral.

There are various biases which influence the mentality of an

individual, they are -

1. Loss aversion bias is a tendency in behavioural finance

where investors are so fearful of losses that they focus on
trying to avoid a loss more so than on making gains. The
more one experiences losses, the more likely they are to
become prone to lose aversion. Ex- Investing in low-return,
guaranteed investments over more promising investments
that carry higher risk
2. Mental Accounting Bias refers to the different values a
person places on the same amount of money, based on
subjective criteria, often with detrimental results. Mental
accounting often leads people to make irrational
investment decisions and behave in financially
counterproductive or detrimental ways, such as funding
low-interest savings account while carrying large credit
card balances.

3. Anchoring and adjustment Bias is a heuristic in

behavioural finance that describes the subconscious use
of irrelevant information, such as the purchase price of a
security, as a fixed reference point (or anchor) for making
subsequent decisions about that security. Thus, people
are more likely to estimate the value of the same item
higher if the suggested sticker price is $100 than if it is
$50.

4. Illusion of control Bias describes the tendency of

human beings to believe that they can control or at least
influence outcomes when, in fact, they cannot. When
subject to illusion of control bias, people feel as if they can
exert more control over their environment than they
actually can. Illusion of control bias can lead investors to
trade more than is prudent, to maintain under-diversified
portfolios or to use limit orders and other such techniques
in order to experience a false sense of control over their
investments. This bias contributes, in general, to investor
overconfidence.

5. Endowment bias describes a circumstance in which an

individual places a higher value on an object that they
already own than the value they would place on that same
object if they did not own it. This type of behavior is
typically triggered with items that have an emotional or
symbolic significance to the individual. However, it can
also occur merely because the individual possesses the
object in question.
6. Snake bite Bias refers to when an investor has a bad
experience with an investment that leads him to become
overly conservative in his investment decisions going
forward, negatively impacting his return potential

7. Cognitive dissonance Bias The term cognitive

dissonance is made up of two words, i.e., cognitive, which
means relating to the brain, and dissonance, which means
turmoil or discomfort. Hence, cognitive dissonance bias is
related to the mental discomfort which investors have to
go through if they have to hold two conflicting views about
the market in their minds. An example of cognitive
dissonance bias is when an investor purchases the stock
believing that it will give a 15% per annum return.
However, over a period of three years, that does not
happen. Instead, other stocks provide the 15% per annum
return. In this situation, investors face mental discomfort.
On the one hand, he/she may believe in the stock that
they initially purchased in whereas, on the other hand,
he/she may want to liquidate the stock and buy the other
one in order to achieve their immediate investment goals .

8. Self- attribution Bias is a phenomenon in which a

person disregards the role of luck or external forces in
their own success and attributes success solely to their
own strengths and work. Attribute bias is a neutral
concept and is used as a descriptor to give information
about how a group of securities was chosen .

9. Self-control Bias is where individuals put their short-

term needs ahead of long-term goals. Investors may not
have enough saved for future goals such as retirement
and may resort to riskier assets to generate more income.

10. Overconfidence Bias is where here individuals

overestimate their knowledge. Investors may choose
stocks with little supporting evidence and consequently
underperform the markets’- Ann actively trades tech
stocks as she believes she can select undervalued
securities. Though some of her stocks yield high returns,
 her net returns are lower than the market because of
trading costs associated with frequent trading.

11. Paradox of choice of Bias describes how people

get overwhelmed when they are presented with a large
number of options to choose from. While we tend to
assume that more choice is a good thing, in many cases,
research has shown that we have a harder time choosing
from a larger array of options.

12. Hindsight Bias is where individuals believe they

could have anticipated the outcome of an event after it
happened. It’s the “knew-it-all-along” approach that can
lead investors to a false sense of overconfidence, causing
them to take additional risks’- In the early 2000s, Paul
wanted to invest in mortgage-backed securities in the US
but had too many expenses at the time. After the crisis
happened, Paul attributes his decision to not invest, to his
“belief” that the crash was inevitable

13. Representative Bias is where individuals use past

experiences to interpret new information. Consequently,
investors may make decisions based on a small sample
that results in more frequent trading, reducing returns. Ex-
Paul is invested in Manager A whose short-term
performance (1, 2, and 3-year returns) have
underperformed its benchmark. He decides to replace this
fund with Manager B who has outperformed over the same
period. At the end of the year, Manager A starts to
outperform Manager B.

Limitations of behavioural finance

Critics of the behavioural finance approach have argued that
even if individuals make irrational decisions when left by
themselves, participating in finance markets helps discipline
them to act rationally by giving them opportunities to learn
from their experiences. The consequences of irrational
decisions are short-term anomalies. In the longer-term general
theories, such as the efficient market hypothesis, will apply .

CONCLUSION
Behavioural finance has identified a number of factors that may
take individuals away from a process of taking decisions to
maximise economic utility on the basis of rational analysis of all
the information supplied. If these factors apply in practice, they
can lead to movements from what would be considered a fair
price for an individual company’s shares, and the market as a
whole to a period where share prices are collectively very high
or low.

It also states that the individuals may not necessarily make

decisions on the basis of a rational analysis of all the
information. As a result, one should constantly exercise caution
before making a choice. Advisors and asset managers may
outperform the competition by adopting behavioural finance
and making smarter judgements.