1A - Week 1 Behavioral Finance 2022.

Behavioral Finance.
Week 1.
Introduction to Behavioral Finance.
Prepared by:
Dr/ Nourhan Tarek.
Introduction to Behavioral Finance. By/ DR. Nourhan Tarek. 1
Behavioral Finance.

Course Description.
During several decades financial theories
have been guided by efficient markets
theory. The key assumption of the major
financial models is the rational behavior
of investors and other agents. But in
reality, this assumption is regularly being
broken. Markets are often inefficient.
Information disclosure is expensive.
Sunny weather or upcoming vacations
may change the investors’ behavior and
bias their decisions.

Course Description.
Each investment decision depends on our
previous investment decisions: we are anchored.
We do not live in vacuum. Behavioral biases
attracted the attention of the academia and
investors’ world in late 1990s. The key question
was whether these biases from the rational
behavior might have significant impact over
market estimations and investment decisions.
Empirical tests demonstrate that behavioral
biases may significantly change even classical
asset pricing models. Several bestsellers were
written on the behavioral finance issues during
2000s. CFA curriculum part devoted to
behavioral finance becomes larger and larger
every year. Introduction to Behavioral Finance. By/ DR. Nourhan Tarek. 4
Course Description.
Behavioral biases do matter. So, if you
want to be successful as a portfolio
manager or individual investor, as a CFO
or independent director and of course as a
consulter, you should take into account
different behavioral biases.
Based on key concepts of cognitive
psychology decision theory, behavioral
finance studies how real-life investors
interpret and act on available information.
This course is a finance course of
advanced level.
The Key Goal of the Course.
This course provides the students with
enough knowledge to understand
difference between the classical financial
theory and behavioral finance. The course
is focused on the specific features of
decision-making process in a market that
is not strongly efficient.

Course Objectives.
After the course student will know:
1. Bounded rationality concept.
2. Main assumptions and ideas of prospect theory.
3. Theoretical and empirical foundations and
challenges to the efficient market. hypothesis.
4. Key behavioral biases of individual and
professional investors.
5. Key anomalies in the markets proving the
behavioral biases.
6. Key behavioral biases of top managers.
Course Objectives.
After the course student will be able to:
1. Compare expected utility theory with the prospect
theory.
2. Explain and demonstrate using empirical data the
challenges to the efficient market hypothesis.
3. Explain the nature and forecast the consequences
of key behavioral biases of investors.
4. Describe the process of behavioral biases
contribution to the asset prices models.
5. Describe how behavioral biases of managers affect
the decision-making process in a corporation.
Course Sources.
The students will take two sources:
1. Book (PDF File).
2. Presentation Slides (Power point).

Google Drive.
By using this link, you can get all course
materials:
1. Course syllabus.
2. Lectures slides.
3. Course Task.
4. Books. https://drive.google.com/drive/fo
lders/1fUIrL_s7Vn4AiIQ8Afu6
YI83PGWUG7MS?usp=sharing

Course Plan.
Week Topic
1 Introduction to Behavioral Finance.
2 Efficient Market Hypothesis (EMH).
Failing EMH. Evidence of motivating phenomena.
3 The Emergence of Behavioral finance and behavioral biases.
prospect theory and asset pricing.
4-5 Heuristics and behavioral biases of investors.
Case studies for each bias.
6 Midterm Exam.
7 Continue Heuristics and behavioral biases of investors.
Case studies for each bias.
8-9 Behavioral corporate finance.
Course Plan.
Week Topic
10 Demonstrating behavioral biases in action: Empirical evidence from Stock
market markets (Implications of behavioral biases on investors’ decision).
How to overcome behavioral biases in investment decision.
11 Course conclusion.
Final Presentations.
12 Final Exam.

Course Project.
After the end of our course, it will be
required from each student to choose one
of behavioral biases we have learned
during the course or any other behavioral
biases and talk about it. Mentioning the
reasons for choosing this bias. Providing
a general and financial example for this
bias.

Lecture 1.
Introduction to
Behavioral
Finance.

Lecture outlines.
1. Introduction.
2. Behavioral Finance Framework.
3. Psychology and Market People.
4. Are investors, managers and portfolios rational
decision makers?
5. The Foundation of Behavioral Finance.
6. Disciplines of Behavioral Finance.
7. Defining Behavioral Finance.
8. History of Behavioral Finance.
9. The Importance of Behavioral Finance (Why is
work in behavioral finance important for finance?).
10. The Problems (Challenges) that face Behavioral
Finance.
Finance Triangle.
oThere are three angles for finance triangle:
1. Market.
2. Human Beings.
3. Technology.

Test Your Knowledge.
What Do you Know About Behavioral Finance?
What do think you will learn during this course?
What are your expectations about this course?

Introduction.
Behavioral Finance is the Intersection
Point between “Finance and
Psychology”.

Introduction.
Why are we inclined to sell the shares in our portfolio that are
performing well, and hold onto those that are performing poorly?
Why we should always buy auto insurance and never buy electronics
insurance?
Why do we over-estimate the recent credit crisis, the worst recession
that US has seen since 1930’s, took place after the Great Depression?
The answer of this Question is in one term

“Behavioral Finance”.
Introduction.
Behavioral finance is relatively new school of thought that addresses
and provides insight into questions like these.
All of us have innate psychological biases that can lead to predictable
“errors” in how we can make important financial decisions.
Behavioral finance catalogues these errors and help us to anticipate,
and hopefully avoid these decision making “traps”.

Behavioral Finance Framework.

Behavioral Finance
Framework.
Behavioral finance is a connection between:
1. Finance.
2. Psychology.
3. Economics.

Do you think that the investors’
psychology can affect the market?

Psychology and Market People.

Early investment theories suggest that investors are rational and base
their decisions on maximizing returns while limiting the risks.
However, recent theories challenge these suggestions and assumptions.
Human mind does not always think rationally and neither do the
markets always perform efficiently.
Behavioral finance explains why individual do not always make the
decisions they are expected to make and why markets do not reliably
behave as they are expected to behave. Recent research shows that the
average investors make decisions based on emotion, not logic, most
investor’s buy high on speculations and sale low on panic mood.
There are different psychological factors that influence the investment decisions
of people. While rational thinking might suggest that investing in say, the stock
market is ideal for a kind of investor.
Psychological studies reveal that the pain of losing money from investment is
really three times greater than the joy of earning money. Emotions such as fear
and greed often play a pivotal role in investor’s decision; there are also other
causes of irrational behavior. It is observed that stock price moves up and down
daily without any change in fundamental of economies. It is also observed that
people in the stock market move in herds and this influence stock price.
Theoretically markets are efficient but in practice, they never move efficiently.

Do you think that investors, managers and portfolios
rational decision makers?

Are Investors, Managers and
Portfolios Rational Decision
Makers?

Portfolios Rational Decision Makers?
When it comes to money and investing, we're not always as rational as we think
we are—which is why there's a whole field of study that explains our sometimes-
strange behavior. Where do you, as an investor, fit in? Insight into the theory and
findings of behavioral finance may help you answer this question.
Behavioral Finance is a field of study that combines psychology, economics, and
finance to explain why investors make irrational financial decisions. Our emotions
are powerful forces that often override logical conclusions, and this struggle
typically leads to suboptimal results.

All market participants are prone to emotional forces in their investment making
decisions, which is why it’s so important to have an investment team consisting of
diverse opinions and skillsets.
Behavioral finance attempts to understand and explain how human emotions
influence investors in their decision-making process.
Behaviorists will argue that investors often behave irrationally, producing
inefficient markets and mispriced securities—not to mention opportunities to
make money.
That may be true for an instant, but consistently uncovering these inefficiencies is
a challenge. Questions remain over whether these behavioral finance theories can
be used to manage your money effectively and economically.
We have to say that investors can be their
own worst enemies.
Implementing a strategy that is well
thought out and sticking to it may help
you avoid many of these common
investing mistakes.

The Foundation of Behavioral
Finance.

The Foundation of Behavioral
Finance.
There are so many definitions of
behavioral finance. There are so many
theorists and economists that define the
behavioral finance.
Behavioral finance is a relatively new
field that seeks to combine behavioral and
cognitive psychological theory with
conventional economic and finance to
provide explanations for why people make
irrational financial decisions.
Behavioral Finance is very popular in
stock market across the world for
investment decisions. Introduction to Behavioral Finance. By/ DR. Nourhan Tarek. 33
Disciplines of Behavioral
Finance.

Disciplines of Behavioral Finance.
The following is a figure that describes the various disciplines of behavioral finance.
This figure demonstrates the important interdisciplinary relationships that integrate behavioral
finance. When studying the concepts of behavioral finance, traditional finance is still the
centerpiece, however the behavioral aspects of psychology and sociology are integral catalysts
within this field of study. Therefore, the person studying behavioral finance must have a basic
understanding of the concepts of psychology, sociology and finance to become acquainted with
overall concepts of behavioral finance.

Disciplines of Behavioral Finance.

Definitions of Behavioral Finance.

Defining Behavioral Finance.
There are so many definitions of behavioral finance. There are so many theorists and
economists that define the behavioral finance.
The following are some important definitions of behavioral finance according to different
theorists and economists.
According to Olsen in 1998: “Behavioral finance seeks to understand and predict
systematic financial market implications of psychological decision process.”
In 1999, Belsky and Gilowich have referred to behavioral finance as “a Behavioral Economics
and further defined as combining the twin discipline of psychology and economics to
explain why and how people make seemingly irrational or illogical decisions, why they
save, invest, spend and borrow money.”

In 2001, Shefrin says: “Behavioral Finance is the study of how psychology affects financial
decision making and financial markets.”
In 2004, Verma has defined “Behavioral Finance tries to understand how people forget
fundamentals and make investment based on emotions”.
In 2005, Swell asserts that “Behavioral Finance is the study of the influence of psychology
on the behavior of financial practitioners and the subsequent effect on markets”.
Further in 2007, Swell has stated that “Behavioral Finance challenges the theory of market
efficiency by providing insights into why and how market can be inefficient due to
irrationality in human behavior”.

Thus, behavioral finance is the
application of scientific research on the
psychological, social and emotional
contributions to market participants and
market price trends. It also studies the
psychological and sociological factors
that influence the financial decision-
making process of individual groups and
entities.

History of Behavioral Finance.

 Behavioral finance becomes no longer a stranger field.
 It has been around since the 1980’s, taking on even greater significance in the wake of the 2008
financial crisis.
 In 1912 , Behavioral finance has informal origins dating back to Selden’s Psychology of the
Stock Market.
 In 1956, Fessinger study of cognitive dissonance .
 In 1964, Pratt discussion on risk aversion and the utility function.
 However, the official start of behavioral finance is arguably 1979, which marks the release of
Daniel Kahneman and Amos Tversky’s Prospect Theory: A Study of Decision Making
Under Risk.
 They found that investors are loss adverse, which means they are willing to take on more risk
in the face of losses but become more afraid of risk when it comes to protecting their gains.
 Kahneman and Tversky were shortly thereafter joined by a third so-called founding father,
Richard Thaler. Introduction to Behavioral Finance. By/ DR. Nourhan Tarek.
42
 In 1980, Thaler published a paper about investors’ propensity towards mental accounting, a
phenomenon wherein they tended to view their money as being in separate and disparate pools
depending on function (retirement fund, vs. emergency fund vs. college fund, etc.).
 Together, Thaler, Kahneman, and Tversky began a robust body of literature on how people
make financial decisions, using psychology to bring the gap between real life and classic
economic theory.
 The work of the three “founding fathers” is frequently referred to as the “biases literature”,
the study of all the behavioral biases that trip up average and professional investors alike.
 Other researchers have since attempted to explain additional anomalies found in the markets,
providing counterevidence to the notion of market efficiency.
 The bottom line is that behavioral finance is a rich area of study, rife with implications for
financial advisors and their clients. However, understanding this broader landscape will
hopefully allow us to see the bigger picture when diving down some of the specific behavioral
rabbit holes in the coming weeks.
43
Introduction to Behavioral Finance. By/ DR. Nourhan Tarek.
From your point of view, what is the importance of
behavioral finance?

The Importance of Behavioral
Finance.

The Importance of Behavioral Finance.
Why is work in behavioral finance important for finance?
Behavioral finance is used to make recommendations to finance professionals
about how to change their behavior or how to communicate with their clients.
Heuristics can provide an effective means of making complex decisions.
(heuristic can be defined as: “is a mental shortcut that allows people to solve
problems and make judgments quickly and efficiently”). We will talk about
heuristics in details later in the course.
 More generally, Ricciardi and Simon (2000) have argued that behavioral finance
enables those who invest in stock and mutual funds to avoid common “mental
mistakes and errors” and develop effective investment strategies.
46
The Importance of Behavioral Finance.
Why is work in behavioral finance important for finance?
 Knowledge of behavioral finance should enable investors to become aware of
how potential biases can affect investment their decisions and thereby to avoid
such errors.
Understanding Behavioral Finance helps us to avoid emotion-driven speculation
leading to losses, and thus devise an appropriate wealth management strategy.
47
 From your point of view, what are the problems
(challenges) that face behavioral finance?

The Problems “Challenges” that
face Behavioral Finance.

The Problems “Challenges” that face
Behavioral Finance.
As we mentioned before, when it comes to investing, trading or making financial
decisions, an individual is not always as rational as he thinks he is. The concluding
observation is that understanding of various behavioral key biases and traits can
help an individual to take sound financial decisions which is the key to successful
investing (Ricciardi and Simon, 2002).
 These biases can affect all types of decision-making but have implications in
relation to money and investing. .
 The biases tend to sit deep inside the human mind and may serve them well in
certain circumstances. However, in investment they may lead people to harmful
decisions.
50
Behavioral Finance.
 Rise in self-directed investor sector makes it important to raise the problem of
behavioral biases for this segment of investors. Behavioral finance claims that on
top of the usual investing skills the investor should be in control of his emotions if
he wants to succeed.
 Some people may argue that they are not emotionally biased, that they are in
control of their business, life, etc. A lot of studies prove the opposite; we all are
susceptible to biases.
 So, since it innates to us the only thing, we can do about it is to be aware of it and
try to control it. Since you are aware of the existence of a problem you can deal
with it in the most efficient way.
51
Behavioral Finance.
 From the perspective of the researcher the behavioral biases or decision-making
behaviors are the greatest challenges for this new and emerging type of an
investor.
 Firstly, most of them even are not aware of the existence of this type of issues
 Secondly, they usually do not know how to deal with them.
 We are unlikely to find a ‘cure’ for the biases, but if we are aware of the biases
and their effect, we can possibly avoid the major pitfalls.
52
 Do you know “what are the
behavioral biases?”
 From your point of view, do you
think that behavioral biases have an
impact on decision making process?

Decision making process and
Behavioral Biases.

Decision making process and Behavioral
Biases.
 We have to say that all the evidence is in
the favor that the decision- making process
is affected by different behavioral biases.
Human beings have two organs that is
responsible for these behavioral biases
which are:
1. Heart (Emotional Biases).
2. Brain (Cognitive Biases).
55
Biases.
 Everybody has biases. We make judgments about
people, opportunities, government policies, and of
course, the markets.
 In general, all kinds of day-to-day activities are
primarily driven by behavioral patterns. These same
behavioral patterns can also influence investing actions.
For most people, it is impossible to be unbiased in
investment decision-making. However, investors can
mitigate biases by understanding and identifying them,
then creating trading and investing rules that mitigate
them when necessary. Broadly, investing biases fall into
two main categories: cognitive and emotional. Both
biases are usually the result of a prejudice for choosing
one thing over the other.
56
Biases.
 In our next lectures we will talk in detail about

emotional and cognitive biases.
57

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Behavioral Finance.

Introduction to Behavioral Finance. By/ DR. Nourhan Tarek. 2

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The answer of this Question is in one term

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 In our next lectures we will talk in detail about

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