Foundations of Finance

1.Equity Shares: Securitized Ownership

2.Debentures/Bonds/ Debt: Securitized
Borrowings
3. Mixing and Matching of Assets: Portfolio of
Assets/Investments
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?
Dividend Decisions

 Dividend policies in practice, Bonus shares. Forms of dividends.

Dividend practices of Indian companies.

 Concepts of Working Capital. Estimation of working capital, Inventory

management, Cash Management, Receivable management. Working
capital financing.
Concepts-Dividend Decisions
 Dividend is that portion of profit which is distributed among the shareholders

 Dividend decision involves: whether dividends to be paid? How Much? When? Form (Scrip
Dividend or Bonus Share)?

 Bonus share cash outflow reduces, partly use the profits, goodwill increases, market price per
share reduces and capital increases

 As the value of the share is defined to be the present value of expected dividends, hence
dividends are very relevant to effect market value of share and value of the firms.

 Dividend policy is also known as “ Dividend Puzzle”.

Concepts-Dividend Decisions
 Walter’s Model: says that dividend policy has relevance with the value of firm under below
assumptions:
No External financing Available
r and ke remains constant.
Firm has infinite life.
 According to Walter’s Model Investment Decisions and Dividend decisions of firm are
interrelated.

if, r>ke, firm should retain earnings, DP=0%

if, r<ke, firm should have 100% Dividend payout,
if, r=ke, indifferent/irrelevant
P=(D/ke)+{(r/ke)*(E-D)}/ke
Concepts-Dividend Decisions

 Gordon’s Model: says that dividend policy has relevance with the
value of firm under below assumptions:
No External financing Available
r and ke remains constant.
Firm has infinite life.
Additional Assumptions are:
growth rate of firm (g)=b*r (retention ratio*rate of return)
ke>g

“Bird-in-the-hand” theory
Concepts-Dividend Decisions

 Gordon’s Model: says that investors prefer current dividends, hence there is
direct relationship between dividends and market value of the share.

Investors are basically risk averse.

The incremental risk with capital gains is cause of higher rate of return
expected on capital gains.

As the investors are more certain of current dividends, they discount the
earnings of firm with lower rate, leading to higher value of firm.

P=E(1-b)/ke-br
Concepts-Dividend Decisions

 Irrelevance of Dividend Policy: says that dividend policy has no effect

on market value of share
 Preconditions are:
No Transaction Cost and No Flotation Cost
Financing and Investment decisions are not altered by
Dividend paid by firms
Markets are Perfect
 Two theories are: Residuals Theory of Dividends
MM Approach
Concepts-Dividend Decisions

 Residuals Theory Of Dividends: assumes that firm is funded by

internal financing only. If reinvestment opportunity is there, no
dividends are to be paid out, in absence of such opportunity,
dividends are paid.
 Considers dividends as “passive decision”, as if the dividends are not
paid this benefit is compensated by future capital gains.
 Hence though market price of firm matters on present value of
dividends, but not the pattern.
 Concepts-Dividend Decisions
 MM Approach: supports that market price is affected by earnings of firm and not by pattern of
income distribution.
 Assumptions:
Capital Markets are perfect and investors are rational
No Taxes and transaction cost
Securities are infinitely divisible
firm’s have defined investment policies.
The theory says that if firm pays the dividend, it finances itself with issuing new shares. Increase in
market price by paying dividend is set off by decrease in terminal value due to issue of new shares.
 Modern Approach-Markowitz
Model
Assumptions:
 An investor is risk averse.
 Estimate of risk is based on variability/variance of returns
 For a given risk, a higher return is preferred and for a given return, a lower risk is
preferred
 An investor prefers to increase the size of the portfolio.
 The investor’s utility function is concave and increasing, due to their risk aversion
and consumption preference
 Investor is Rational

Concept:
 For a given expected Return, reducing the portfolio
variance using covariance of securities
 The Markowitz Model is the answer to minimize
Systematic Risk

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Risk and return with different Correlation

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 Efficient Frontier:

[email protected] 29/11/2024
CAPM Theory
Assumptions:

• Perfectly Competitive Market

• Decisions are based on return, Std. deviation and Co variance
• Investors have homogenous expectations
• Lending and Borrowing is possible
• Assets are infinitely Divisible
• No transaction Cost and No Personal Income Tax
• Short Sale is Allowed

Er= Rfr+beta(Rm-Rfr) for single

stock
Rp= Rf*Xf+Rm(1-Xf), for
portfolio
[email protected] 29/11/2024

where Rp= Portfolio Return, Rf=Risk free return, Rm=

 Random Walk Theory
and
Efficient market Hypothesis by FAMA
In efficient
markets
MP= Intrinsic
Value

Strong
form
Semi
Strong
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 Theories of Behavioural Finance
Efficient
Market
Hypothesis
based on Modern Portfolio
Homo Economicus
Random Walk Theory
(Milli, 1844)
(Fama, 1970) (Markowitz, 1952)
Expected Utility
Effect of Capital Asset Pricing
Theory (Bernoulli, 1738,
Information Model (Treynor, 1962;
1954)
Sharpe, 1964; Lintner,
1965)

Behavioral
Approach
(Von Modern Corporate
Neumann-
Finance (Dividend
Morgenstern
, 1944), Distribution
addresses Approach by Miller
UNCERTAIN and Modigliani,)
TY
Impact of Behavioral Finance Theory

 Index Funds
 Rise of Derivatives
 Emergence of Shareholder value principle by ensuring proper Corporate
Governance

Challenges for Behaviouralists

 Deviation from Rationality, in case of Heuristics

 Possibility to beat markets
 Degree of Divergence from Fundamental Value, depends on spread of
information
 Deal with Irrational Forces, presence of noise makers, limits to arbitrage
Behavioral aspects of financial decision making

 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?

Behavioral aspects of financial decision
making

 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?

Expected Utility
Theory
 Prospect Theory
In an Intraday trade you started with
500/-, made 500/- in another hour.
Next day with 500/- , made 1000/- by
lunch and lost 500/- by closing time

29/11/2024
Behavioral aspects of financial decision
making

 Conventional finance: Rational Market Theory

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 which maintains the equilibrium)

 Behavioral finance:

1. People are Homo Sapiens, not Homo Economicus!

2. What if individuals don’t behave rationally?

Behavioral aspects of financial decision
making
3 (or more) mistakes we might make:

 Forecasting errors:

Too much weight placed on recent experiences

Ex.: Global crisis in 2008 vs. Corona 19 world wide

 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.

Conclusion: Comparison Points
between Conventional and
Behavioral 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.

Standard Finance vs Behavioral
Finance
Standard Finance Behavioral Finance

Markets Efficient Partly Efficient

Investors Rational Partly Rational

Basis of Decision Risk-Return Certainty

Life cycle Standard Behavioral

Major Theories CAPM Behavioural Asset prising

Model
Optimize
Focus on Satifice (Satisfaction +
Suffice)
 Economics of Decision Making
 Neoclassical Economics: Led by Irving Fisher

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.

 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.
 Neoclassical Economics and Utility
Maximization
 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.

Utility Function
 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);

• It is clear from the graph below, that the increment in the utility of wealth
happens at the decremental rate.
Bounded Rationality

 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)

 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.
 Calculation of Expected Utility

 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.

• 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)

• u(E(P)) < U(P) For Risk Seekers

• u(E(P)) = U(P) For Risk Neutrals

Graphical Presentation of Utility Function

Risk
Averse Risk
Seeker

Risk
Neutral
Some issues with Expected utility theory (EUT)
• Normative model of economic behavior

How people should act rather than how they actually act.

• Axiomatic treatment of individual choices

• Very helpful in describing ideal decision-making process

• Fails as a realistic model

 Non-consistent observed behavior: Illustration 1*

• Imagine the following pair of concurrent decisions:

• D1: Choose between P1(₹240) and P2(0.25, ₹1000)

• D2: Choose between P3(−₹750) and P4(0.75, −₹1000)

 People sometimes exhibit risk aversion and sometimes exhibit risk seeking,
depending on the nature of the prospect.

• EUT fails to capture such changes in risk attitude.

Agency Theory
 Applies in large Public and Private companies
 Managers are entrusted to work on behalf of Stakeholders
 Due to disconnect between Managers (Agents) personal goals and
wealth maximization of stakeholders, Agency Cost may arise.
 Agency cost is difference between firm’s actual value and value of a
hypothetical firm for which the managers (agents) and stakeholders
are in perfect harmony.
 Appropriate compensation structure, motivation to managers,
corporate governance needs to be practised to control Agency Cost in
the firm.
Neo Classical vs Behavioural
Economics
Neo Classical Framework works under consistent preferences, emotionless
deliberations, and equilibrium approach.
 Behavioural Economics considers the emotional, psychological and sociological
effects on financial decisions.
 Behavioural economies is more successful in explaining the concepts of neo
classical finance under real life situations.

Additional Links to be referred:

 https://onlinecourses.nptel.ac.in/noc20_mg33/unit?unit=2&lesson=10

 https://onlinecourses.nptel.ac.in/noc20_mg33/unit?unit=3&lesson=37
 Taxonomy of Biases
Self-
Heuristic Deceptio Emotion Social
Social
n
representativenes Overconfidence Mood
Mood
s Contagion
Optimism

Availability Self Control Mood

Confirmation Herding

Hindsight
Anchoring Ambiguity
Cognitive
Dissonance
Framing Regret
Self Attribution
 Major Biases and effect on portfolio
Overconfidence

Effect on Portfolio
The effect of overconfidence bias can be seen as follows:

 Ignorance to negative information and downsizing the portfolio risk

 Excessive trading leading to higher cost and poor return to the
portfolio
 Overextended bull phase of markets
 Holding undiversified portfolio and carrying more risk than their
tolerance level
 Illusion to control the market
 Investors become prey of “planning fallacy”
Major Biases and effect on portfolio
Representativeness Bias

“Gambler’s fallacy” is also an example of representativeness, where it is

perceived that “luck runs in streaks”, where mathematical explanation
does not support the same.
Effect on Investors
Following is the effect of investors:
 Giving too much weightage to the past performance for future
decision-making.
 Assessing investment advisor’s performance on his past success
rather than judging his aptitude.
Major Biases and effect on portfolio
Herd Behaviour

Effect on Investor
 Suffer to bear huge transaction cost
 Face difficulty to time the market for entering into any security.

Leads to

 Bandwagon Effect: Bandwagon effect is related with herd behaviour. The effect
is seen when investors do activities which are being done by a group of people.
 Herd Instinct: Herd instinct is the tendency to adopt the opinion and follow the
behaviour of majority, to feel safer and to avoid conflict.
 Noise Trader Risk: When the investors of short-time horizon manipulate the
price of stock more than long-time horizon traders, they are exposed to more
noise trade risk. Also the investors who do not have any inside information, they
irrationally react to the noise, as if this is the edge over others, which actually
expose them to more risk.
Major Biases and effect on portfolio
Anchoring Bias

Factors that influence anchoring are as follows:

 Mood: People in happier mood are more susceptible to anchoring bias than those who are in depressed mood.
 Experience: More experienced people suffer more from the anchoring bias.
 Personality: Based on big five personality trait model, people high in agreeableness and conscientiousness are
more likely to be affected by anchoring and adjustment bias, while those high in extroversion are less likely to be
affected with anchoring. Another study found that those high in openness to new experiences were more
susceptible to the anchoring effect.
 Cognitive Ability: Various studies have proven that anchoring decreased as the cognitive ability increases.

Effect on Investors
Following are the effects on investors:

 Investors forecast the markets near to current market levels.

 Investors tend to stick too closely to their original estimates.
 Investor’s forecast is with reference to some predefined base level.
 Even the investment advisors are not immune to this bias when they put forth their analysis strategy, it can also
be leveraged. This effect is known as “bonus discussion”.
 Major Biases and effect on portfolio
Action Changed Belief

Dissonance

Inconsistent Dissonance Changed Action

Belief Changed Action

Perception

Cognitive Dissonance
Effect on Investors

Following are the effects on investors:

 Cognitive dissonance bias prevents investors from taking rational decisions as

it prevents them from realizing loss for tax purpose.
 It enhances self-esteem needs and stops investors learning from mistakes.
 Those who have missed opportunities in past are more prone to miss them
again.
 Cognitive dissonance causes investors to “throwing good money after bad”.
Major Biases and effect on portfolio
Availability Bias

Effect on Investment Markets

 Following are the effect on investment markets:

 If representativeness is shown by the herd, it leads to unequal weight
age across industries and can cause bubble creation.
 To avoid availability bias, it is better to understand the true
significance of recent news and act accordingly keeping the long-term
of investing in view.
Major Biases and effect on portfolio
Self Attribution Bias

Effect on Investors
Following are the effects on investors:

 When investors trade successfully in markets for some time, they consider
themselves to be fully equipped and trained for investing, which makes them
overconfident about themselves and lead them to take much risk.
 Periods of general prosperity are followed by periods of higher than expected
trading volumes, which is because of overconfident behaviour of investors
 When overconfidence increases, then the trading volume itself lowers the net
profit because of high transaction charges.
 Self-attribution bias leads investors “to hear what they want” and causes investors
to buy or hold investments which they should not.
 Self-attribution bias can also lead to holding an undiversified portfolio because
investors may attribute the success of stock to their analytical skills.
Major Biases and effect on portfolio
Ambiguity Aversion

Effect on Investors

 The effects of ambiguity aversion on the investors in financial markets is as

follows:
 Over expectation from the portfolio and the securities included as the
investors are uncertain about the risk-return trade-off of the security.
 The non-diversification of portfolio, in terms of focusing more on the
domestic markets, as it seems less ambiguous, than the foreign markets.
 Also the investors who feel more competent about themselves as compared
to others, often trade excessively. This effect is known as competence effect.
 Ambiguity aversion can cause investors to believe more in their employer’s
stocks than the other company’s stocks.
Major Biases and effect on portfolio
 Self-Control Bias
The technical description of self-control bias can be seen in context of “life cycle
hypothesis” in which a division of income is done between consumption and saving. For
the purpose of maintaining balance, some people like higher standard of life in peak
earning years, while low standard of living at retirement age. While some other class of
investors may maintain a stable and constant standard of living throughout their lives.
Professors Richard H Thalor and Shlomo Benartzi developed the concept “Save More
Tomorrow Program” in which they mentioned the following points:
 The retirement savings are to be imposed on the investors.
 The contribution increases with time.
 The contribution keeps increasing till the maximum contribution
Major Biases and effect on portfolio
Self-Control bias

Effect on Investors
Following are the effects on investors:
 Self-control bias cause investors to spend more and simultaneously investors incur inappropriate
degree of risk in their portfolio which is further more hazardous for them in future.
 Investors either fail to plan for their retirement, or they save insufficient funds for future.
 Self-control bias can also lead “mental accounting”, which is ultimately responsible for imbalanced
asset allocation.
 Self-control bias may also deviate investors from the basic financial principles, such as avoiding
compounding interest, which is significant for creating long-term wealth.
Advice for Investors
 Investors are advised to set aside a fixed amount consistently, to ensure that they are able to meet
with their requirements in later stages of their life. Also it is to be kept in mind that a careful
balance must be maintained between saving, investment, and consumption. After visualizing their
retirement needs, investors should adjust their earning avenues.
 Investors must consider equity as an instrument of long-term investment planning and an efficient
tool to hedge investments against inflation, even if they are quite risk-averse by nature.
 Major Biases and effect on portfolio
Optimism Bias
Effect on Investors
Following are the effects on investors:
 Optimism bias can cause investors to potentially overload themselves with the stocks of
those companies in which they are working, assuming that the stocks of other
companies are more likely to see the downturn, than the stocks which they own.
 Optimism bias may also cause in more casual attitude and less supervision of the
portfolio, making their portfolio exposed to threats of inflation, improper taxes and high
transaction costs, etc.
 Investors become used to of looking at the “rosy forecasts”, giving lesser attention to
the real picture of the investment world.
 Optimism bias can also be a root cause of overconfidence bias, as investors may be
more optimist about their portfolios than others.
 Optimism bias can also cause investors to invest near their geographic region, because
they are more optimist about the prospect of their local geographic area.
Major Biases and effect on portfolio
Effect on Investors
Following is the effect on investors:
 Insufficient research done on the stocks may lead in losing money, as affected
investors are interested in only partial (positive) information about their investments.
 When investors believe in investing in stocks which are breaking high record, this is
also an effect of confirmation bias, when investors blind themselves by confirming only
the information which is in line with their beliefs.
 Confirmation bias may also lead investors to invest in company stocks.
 Confirmation bias may also cause investors to hold undiversified portfolios, single-
minded thinking that their positions will pay off well.
 To overcome the confirmation bias, investors should critically evaluate the information
about the stock and should be equally keen to look for negative aspects of the stock
under consideration. Investors should also identify if they are suffering from selection
bias. At the time of portfolio revision investors should keep extra caution for well-
diversification of the stocks.
Prospect theory
Defines Value function and decision weights

• A model of decision making that incorporates observed behaviors.

• Incorporates how people actually behave.

• The value function replaces the utility function (of EUT)

• Utility measured in terms of wealth,

• Value defined by gains and losses relative to a reference point

• Key observed behaviors:

• Risk aversion and risk seeking under different situations

• Preferences relative to the reference point (change in level of wealth)

• Losses loom larger than gains

 Non-expected Utility Preferences
Non-consistent observed behavior

• Imagine the following pair of concurrent decisions:

• D1 (Lottery): Choose between P11(0.001, ₹5000) and P12(1.0, ₹5)

• D2 (Insurance): Choose between P13(0.001, −₹5000) and P14(1.0,

−₹5)
 People exhibit the following behaviors:

• Risk aversion for gains and risk seeking for losses when outcome probability
is high;

• Risk seeking for gains and risk aversion for losses when outcome probability
is low.

• Prospect theory: fourfold pattern of risk attitudes

Conclusion
• Prospect theory

• Captures actual behaviors of economic agents

• Provides realistic framework for decision making

• Decisions based on value driven by decision weights instead of

prob.

• Fourfold pattern of risk attitudes

• Non-consistent behaviors

• under risky and certain situations and

• under losses and gains

Framing effect
Reference point
Prospect Theory and its Applications

 Framing Effect

• Decision frame: a decision maker’s view of a problem and the possible

outcomes

• Decision frame affected by:

• Presentation,

• Person’s perception of the question, and

• Personal characteristics

• If a person’s decision changes because of a change in frame:

• EUT violated (EUT assumes consistent choices regardless of

presentation)
Prospect Theory and its Applications

Framing matters: Illustration 1*

• Imagine that a country is preparing for the outbreak of

an usual disease which could kill 600 people. Two
alternative programs to combat it (with scientifically
estimated results) are:

• A: If adopted, 200 people will be saved.

• B: If adopted, there is a 1/3 probability that 600

people will be saved, and a 2/3 probability that no
people will be saved.
 People exhibit risk aversion here (in survival frame).
Framing matters: Illustration 1*
contd.

• Now imagine that a country is preparing for the

outbreak of an usual disease which could kill 600
people. Two alternative programs to combat it (with
scientifically estimated results) are:

• C: If adopted, 400 people will die.

• D: If adopted, there is a 1/3 probability that nobody

will die, and a 2/3 probability that 600 people will
die.
 People exhibit risk seeking behavior here (in mortality
frame). Similar change in risk attitude for students, faculty,
Framing matters: Illustration 1*
contd.
 Framing matters (cont.)

• Choices shown consistent with prospect theory

• Two problems shown earlier use different reference points:

• The survival frame (A & B) starts from full mortality and moves towards partial
survival;

• The mortality frame (C & D) starts from full survival and moves towards partial
mortality.

• In survival frame: Saving lives → Gain

• In mortality frame: Conceding casualties → Loss

• Loss aversion:

• Lost lives in mortality frame loom larger than the lives saved in survival frame.
Prospect Theory and Reference
Point
Conclusion

• Framing effect

• Includes presentation (of options), perception (of individuals),

and personal characteristics;

• Framing of choices matters (e.g., insurance policy documents)

• Reference point

• Decisions depend on a reference point (and positive/negative

deviation therefrom)

• People integrate or segregate the losses/gains to find reference

points
Mental accounting
Behavioral finance: Issues
Mental Accounting

• Framing of outcomes affects decisions.

• Decision-making process gets complicated with increasing cognitive complexity.

• Multiple outcomes with varying probabilities,

• Outcomes presented differently,

• Bounded rationality

• Mental accounting used to make decision-making manageable.

• A set of cognitive operations used by individuals and households to

organize, evaluate, and keep track of financial activities (Thaler, 1999)
Mental Accounting (cont.)

Expenditure Investment
Income
Food, rent, vacation Savings for Retirement, Marriage
Salary, Bonus
• Mental “accounts”: Cognitive constructs than real
account.
• No one sets up a specific bank account got
entertainment/vacation!
• Funds are fungible (substitutable: money does not
have color, caste, creed?)
Mental Accounting: Illustration
1*
• Imagine that you have decided to see a movie where the ticket is priced at ₹100
per ticket.

• As you enter the theater, you found that you have lost a ₹100 currency note.

• Would you still pay ₹100 for a ticket to the movie?. YES/NO?
 Mentally note your response and then answer the next yes-or-no question:

• Imagine that you have decided to see a movie and have paid the ticket price ₹100
for your ticket.

• As you enter the theater, you found that you have lost the ticket;

• the seat was not marked and the ticket cannot be recovered.

• Would you pay ₹100 for another ticket to the movie?. YES/NO?
 People exhibit risk aversion here (in survival frame).
Mental Accounting: Illustration 1 (cont.)*

• Imagine that you have decided to see a movie and have paid the ticket price
₹100 for your ticket.

• As you enter the theater, you found that you have lost the ticket;

• the seat was not marked and the ticket cannot be recovered.

• Would you pay ₹100 for another ticket to the movie?. YES/NO?

• Nothing has changed in these two situations, in economic terms.

• A certain amount of money (₹100) has been irretrievably lost (cash or

kind, irrelevant);

• You have to decide whether the theater experience is worth ₹100 to

you.
• For actual decisions, money is not always fungible.

• In previous example:

• Loss of ₹100: lost from ‘wealth account’, not linked with ‘entertainment
account’, hence they still buy a ticket.

• Loss of ticket: ‘ticket purchase account’ opened → ticket lost → account

closed. Buying another ticket would open another ‘ticket purchase
account’, hence NO;

• Mental accounting beneficial when self-control is exercised:

• ‘Don’t dip into retirement savings’

• ‘Pay for luxuries like vacation trip out of savings’

 Behavioral Finance

Psychology Finance

Corporate
Asset Pricing Finance
 Personal Finance
IPO Timing
Price Loss Aversion
Herding
Anomalies Myopia
Overconfide
IPO Return
nce
Performance Chasing
Superstar
Sentiment Home Bias
CEOs
Equity Wishful
Winner’s
Premium Thinking
Curse
Bubbles Overconfidenc
CF
Momentum e
Sensitivity