Behavioral and Personal Finance

Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 01 : Introduction to behavioral economics and finance
 Foundations of finance
 Behavioral aspects of financial decision making
Foundations of Finance
Equity shares
• Securitized ownership
Debentures/Bonds (Debt)
• Securitized borrowings
Mixing and matching of assets
• Portfolio of assets/investments

Risk and return!!

Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 02 : Introduction to behavioral economics and finance (cont.)
Foundations of Finance
Investment decisions
• To be (in the game) or not to be?
Financing decisions
• Where to get the money, honey?
Working capital decisions
• The show must go on!

Payout decisions
• Who will get the cheese?
 Modern Portfolio Theory
Homo Economicus
(Markowitz, 1952)
(Milli, 1844) Efficient Market
Capital Asset Pricing Model
Expected Utility Theory Hypothesis
(Treynor, 1962; Sharpe, 1964;
(Bernoulli, 1738, 1954) (Fama, 1970)
Lintner, 1965)

Behavioral
Approach
(vonNeumann Three-factor Models Pricing of Financial
-Morgenstern, (Fama-French, 1992) Derivatives
1944) Four-factor Model (Black-Scholes, 1973;
(Carhart, 1997) Merton, 1973)
Foundations of Finance
Why psychology matters?
Choose between the following:
A. A 50% chance of winning $100 (the gamble); or,
B. A sure shot gain of $50 (the sure thing).

Most of us go for: B
• Because we think of ourselves as conservative, and
• After all a bird in hand is worth two in bush, right?
• So, why gamble?
Foundations of Finance
Why psychology matters?
Now, choose between the following:
A. A 50% chance of loosing $100 (the gamble); or,
B. A sure shot loss of $50 (the sure thing).

Most of us prefer to go for: A

• Because we hate taking losses, and
• God forbid, we may turn lucky, right?
• So, why not gamble?
Foundations of Finance
Why psychology matters?
Conventional finance:
• Prices of assets are correct, i.e., equal to their intrinsic values;
• Resources are allocated efficiently;
• The world is fair, and so are the markets (Adam Smith’s Invisible Hand)

Behavioral finance:
1. People are Homo Sapiens, not Homo Economicus!
2. What if individuals don’t behave rationally?
Foundations of Finance
3 (or more) mistakes we might make:
Forecasting errors:
• Too much weight placed on recent experiences
• Ex.: Great Depression experiences, Tsunami in Chennai
Overconfidence:
• People overestimate their abilities and the precisions of their forecasts.
• Ex.: Driving skills survey, Stock market experiences

Conservatism:
• People are slow to update their beliefs and tend to underreact to new information.
• Ex.: Anchoring to prices, holding onto the losers.
Foundations of Finance
Behavioralising Finance:
• Conventional finance theory helps understand financial decision making with
certain assumptions.
• Decision makers suffer from biases and behavioral limitations.
• Biases lead to Suboptimal decisions.
• Finance theories with a flavor of psychology provides reasonably acceptable
explanations to real world financial phenomena.
• Understanding psyche of market participants makes much more sense.
• Helps in interpretations to financial crises and bubbles.
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 01 : Introduction to behavioral economics and finance
 Foundations of finance
 Economics of decision making
 The utility theory
Foundations of Finance
Investment decisions
• To be (in the game) or not to be?
Financing decisions
• Where to get the money, honey?
Working capital decisions
• The show must go on!

Payout decisions
• Who will get the cheese?
Foundations of Finance
Equity shares
• Securitized ownership
Debentures/Bonds (Debt)
• Securitized borrowings
Mixing and matching of assets
• Portfolio of assets/investments

Risk and return!!

 Modern Portfolio Theory
Homo Economicus
(Markowitz, 1952)
(Milli, 1844) Efficient Market
Capital Asset Pricing Model
Expected Utility Theory Hypothesis
(Treynor, 1962; Sharpe, 1964;
(Bernoulli, 1738, 1954) (Fama, 1970)
Lintner, 1965)

Behavioral
Approach
(vonNeumann Three-factor Models Pricing of Financial
-Morgenstern, (Fama-French, 1992) Derivatives
1944) Four-factor Model (Black-Scholes, 1973;
(Carhart, 1997) Merton, 1973)
Foundations of Finance
Why psychology matters?
Choose between the following:
A. A 50% chance of winning $100 (the gamble); or,
B. A sure shot gain of $50 (the sure thing).

Most of us go for: B
• Because we think of ourselves as conservative, and
• After all a bird in hand is worth two in bush, right?
• So, why gamble?
Foundations of Finance
Why psychology matters?
Now, choose between the following:
A. A 50% chance of loosing $100 (the gamble); or,
B. A sure shot loss of $50 (the sure thing).

Most of us prefer to go for: A

• Because we hate taking losses, and
• God forbid, we may turn lucky, right?
• So, why not gamble?
Foundations of Finance
Why psychology matters?
Conventional finance:
• Prices of assets are correct, i.e., equal to their intrinsic values;
• Resources are allocated efficiently;
• The world is fair, and so are the markets (Adam Smith’s Invisible Hand)

Behavioral finance:
1. People are Homo Sapiens, not Homo Economicus!
2. What if individuals don’t behave rationally?
Foundations of Finance
3 (or more) mistakes we might make:
Forecasting errors:
• Too much weight placed on recent experiences
• Ex.: Great Depression experiences, Tsunami in Chennai
Overconfidence:
• People overestimate their abilities and the precisions of their forecasts.
• Ex.: Driving skills survey, Stock market experiences

Conservatism:
• People are slow to update their beliefs and tend to underreact to new information.
• Ex.: Anchoring to prices, holding onto the losers.
Foundations of Finance
Behavioralising Finance:
Economics of Decision Making
Neoclassical economics
Individuals as self-interested agents who:
• Attempt to optimize to their best ability in the face of constraints on resources;
• Determine the value/price of an asset subject to the influences of supply and demand.

Underlying fundamental assumptions:

1. People have rational preferences across possible outcomes or states of nature.
2. Economic agents (i.e., people or firms) maximize utility (e.g., happiness or profits).
3. People make independent decisions based on all relevant information.
Economics of Decision Making
Neoclassical economics
Three states of rational preferences:
• One choice is strictly and always preferred (≻) to another;
• Two choices are values the same, indicating indifference (~) between choices.
• The person has weak preference (≽), that is, is unsure of strict preference or indifference.
People’s preferences are complete:
• All possible choices compared before preference or indifference.
Transitivity exists:
• When confronted with a choice among three outcomes: x, y, and z, where x ≻ y and
y ≻ z, then x ≻ z.
Economics of Decision Making
Neoclassical economics
Utility maximization:
• Used to describe preferences, denoted as u(•) as a utility function;
• Utility as the satisfaction received from a particular outcome.
• Ex.: u(1 Oreo cookie, 2 cups of milk) > u(2 Oreo cookies, 1 cup of milk).
In financial decision-making:
• Making a choice between:
• Spending more now and save less for future, versus
• Spending less now and save more for future.
Economics of Decision Making
Neoclassical economics
In its simplest form, a utility function can be specified mathematically as a logarithmic function.
• E.g., the utility derived from wealth level w is u(w) = ln(w);
Wealth (in $10,000s) U(w) = ln(w)

1 0
2 0.6931
5 1.6094
7 1.9459
10 2.3026
20 2.9957
30 3.4012
50 3.9120
100 4.6052
Economics of Decision Making
Neoclassical economics
Relevant Information:
• People maximizing their utility use full information of the choice set.
• Information available to all economic agents, but for free?
• Not only are there costs associated with acquiring information, but there are also costs of:
• Assimilating and understanding information at hand.
• Bounded rationality (Simon, 1957)
• Conventional finance theory helps understand financial decision making with
certain assumptions.
• Decision makers suffer from biases and behavioral limitations.
• Biases lead to Suboptimal decisions.
• Finance theories with a flavor of psychology provides reasonably acceptable
explanations to real world financial phenomena.
• Understanding psyche of market participants makes much more sense.
• Helps in interpretations to financial crises and bubbles.
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 03 : Economics of decision making
 Economics of decision making
 The utility theory
Economics of Decision Making
Neoclassical economics
Individuals as self-interested agents who:
• Attempt to optimize to their best ability in the face of constraints on resources;
• Determine the value/price of an asset subject to the influences of supply and demand.

Underlying fundamental assumptions:

1. People have rational preferences across possible outcomes or states of nature.
2. Economic agents (i.e., people or firms) maximize utility (e.g., happiness or profits).
3. People make independent decisions based on all relevant information.
Economics of Decision Making
Neoclassical economics
Three states of rational preferences:
• One choice is strictly and always preferred (≻) to another;
• Two choices are valued the same, indicating indifference (~) between choices.
• The person has weak preference (≽), that is, is unsure of strict preference or indifference.
People’s preferences are complete:
• All possible choices compared before preference or indifference.
Transitivity exists:
• When confronted with a choice among three outcomes: x, y, and z, where x ≻ y and
y ≻ z, then x ≻ z.
Economics of Decision Making
Neoclassical economics
Utility maximization:
• Used to describe preferences, denoted as u(•) as a utility function;
• Utility as the satisfaction received from a particular outcome.
• Ex.: u(1 Oreo cookie, 2 cups of milk) > u(2 Oreo cookies, 1 cup of milk).
In financial decision-making:
• Making a choice between:
• Spending more now and save less for future, versus
• Spending less now and save more for future.
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 04 : Economics of decision making (cont.)
Economics of Decision Making
Neoclassical economics
In its simplest form, a utility function can be specified mathematically as a logarithmic function.
• E.g., the utility derived from wealth level w is u(w) = ln(w);
Wealth (in $10,000s) U(w) = ln(w)

1 0
2 0.6931
5 1.6094
7 1.9459
10 2.3026
20 2.9957
30 3.4012
50 3.9120
100 4.6052
Economics of Decision Making
Neoclassical economics
Relevant Information:
• People maximizing their utility use full information of the choice set.
• Information available to all economic agents, but for free?
• Not only are there costs associated with acquiring information, but there are also costs of:
• Assimilating and understanding information at hand.
• Bounded rationality (Simon, 1957)
Economics of Decision Making
Expected Utility Theory (EUT)
Decision making under risk and uncertainty
• John von Neumann and Oskar Morgenstern (vNM): attempt to define rational behavior when
people face uncertainty.
• Normative theory: how people should rationally behave.
• Behavioral theory: considering how people actually behave.
• EUT set up to deal with risk, not uncertainty:
• Risky situation: outcome(s) known and we can assign a probability to each outcome.
• Uncertainty: not sure about a list of possible outcomes, cannot assign probability.
• Examples: stock market investments, job interviews, weather forecast.
• Basic idea of utility-based approach of decision making
• Utility theory and economic decision making
• Normative versus positive behavior of economic agents
• Decision-making under risk
• Expected utility theory
• Uncertain situations
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 05: Decision making under risk and uncertainty
 EUT: Risk attitude and decision making
 Certainty equivalent and risk premium
 w (in ₹10,000s) U(w) = ln(w)
Economic Decisions under Risk 1 0
2 0.6931
Expected utility theory (EUT)
5 1.6094
7 1.9459
Decision making under risk:
10 2.3026
• For a given prospect, P1(0.40, ₹50,000, ₹1000000), the utility U(P1) = 3.4069 20 2.9957

• For another prospect, P2(0.50, ₹100000, ₹1000000), the utility U(P2) = 3.4539 30 3.4012
50 3.9120
• An individual with logarithmic utility function prefers P2 to P1. 100 4.6052
Economic Decisions under Risk
Risk attitude and decision making
Under a logarithmic utility function, an individual prefers the expected value of a prospect
to the prospect itself.
• For P1, expected wealth E(w) = .040(₹50,000) + 0.60(₹10,00,000) = ₹6,20,000.
• An the utility of this expected value of wealth is u(E(w)) = ln(62) = 4.1271.
• The expected utility of the prospect, U(P1) = 3.4069
• Risk averse person: the expected value of the prospect with certainty more preferred
than actually taking a gamble on the uncertain outcome.
• u(E(P)) > U(P)
Decision Making under Risk
• Utility theory → Expectations & Uncertainty → Expected Utility Theory
• Risk aversion: natural human tendency
• Zhang et al., PNAS, 2014; Hinze et al., Nature, 2015
• If so, then why should one assume risks?

1. Zhang, Brennan & Lo. The origin of risk aversion, PNAS, 2014: 111(5)
2. Hintze, Olson, Adami & Hertwig. Risk sensitivity as an evolutionary adaptation, Sci. Rep., 2015: 8242
Decision Making under Risk
Certainty equivalent
Wealth level at which the decision maker is indifferent between a risky and a certain choices.
• u(E(P)) = U(P)

Example: For (at least) how much should you sell this lottery that you own?
• Win ₹ 1,00,000 (probability 0.50)
• Lose ₹10 (probability 0.50)
(a) ₹50 (b) ₹100 (c) ₹500 (d) ₹1,000
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 06: Decision making under risk and uncertainty (cont.)
Decision Making under Risk
Risk premiums
Rewards for assuming risks, defined as:
• Risk premium = expected value of the payoff (EV) – certainty equivalent (CE)
Decision Making under Risk
Risk premium: Example
For a given utility function, what should be the risk premium of the following gamble?
• O1: Win ₹4,000 with probability 0.4 1
0,9
• O2: Win ₹2,000 with probability 0.2 0,85 0,86
0,8 0,82
0,77
0,7
• O3: Win ₹0 with probability 0.15
0,69
0,6

Utility
0,55
• O4: Lose ₹200 with probability 0.25 0,5
0,4
0,34
0,3
0,2
0,1
0 0
-3000 -2000 -1000 0 1000 2000 3000 4000
Wealth
Economic Decisions under Risk
Utility function in risk averse and risk seeker cases

(a) Utility function of a risk averse (b) Utility function of a risk seeker

Source: Behavioral Finance: Psychology, Decision-making, and Markets, Ackert & Deaves, Cengage South Western (2010)
Economic Decisions under Risk
Utility function of a risk neutral person

What if we behave differently under different situations?

• vanNeumann – Morgernstern approach of utility theory
• Expected utility theory
• Expectation of prospect > the prospect itself (risk aversion)
• Decision-making under risk
• Certainty equivalent
• Risk premiums