Unit 2: Behavioural aspects of investing
Behavioural Finance notes · PTU syllabus (MBA 913-18)
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Unit summary
Investors rely on mental shortcuts and are swayed by emotions and others, producing predictable errors and market anomalies. This unit covers heuristics and biases, self-deception, emotional and social forces, firm-size effects, momentum vs reversal, noise trader risk, mental accounting, overconfidence, excessive volatility, loss aversion and the gambler's fallacy.
After this unit you can
- Explain heuristics and biases in investing
- Explain self-deception, emotional and social forces
- Explain market anomalies — size, momentum, reversal, excess volatility, noise trader risk
- Explain mental accounting, overconfidence, loss aversion and the gambler's fallacy
PTU syllabus topics
- Heuristics and biases
- self-deception
- emotional and social forces
- firm-size effects
- momentum vs reversal
- noise trader risk
- mental accounting
- overconfidence
- excessive volatility
- loss aversion
- gambler's fallacy
Overconfidence
Too much trust in one's own judgement
Loss aversion
Losses hurt about twice as much as gains please
Mental accounting
Treating money differently by source
Anchoring
Fixing on a reference price
Herding
Following the crowd
Gambler's fallacy
Expecting a reversal after a streak
Topic 1
Heuristics and biases
Heuristics are mental shortcuts that simplify decisions but cause systematic errors (biases).
Representativeness
Judging by similarity to a stereotype — a good company is assumed to be a good stock
Availability
Overweighting recent or vivid information
Anchoring and adjustment
Sticking to an initial number such as the purchase price
Familiarity
Preferring known companies or home markets (home bias)
Affect
Judging by feelings about the company
Topic 2
Self-deception
- Self-deception biases protect self-image but distort judgement.
- Overconfidence, self-attribution bias (successes due to skill, failures due to bad luck), hindsight bias ("I knew it all along"), confirmation bias (seeking supporting evidence), illusion of control.
Topic 3
Emotional and social forces
- Emotional forces: fear and greed, regret aversion, pride, mood (sunny days and markets), disposition effect.
- Social forces: herding, social proof, information cascades, media and social media hype, peer comparison.
Example
The 2021 retail trading surge in India saw many new investors herd into IPOs and small-cap stocks based on social media tips.
Topic 4
Market anomalies
Firm-size effect
Small firms historically earned higher risk-adjusted returns (Banz, 1981)
Value effect
Low price-to-book and low P/E stocks outperform
Momentum
Recent winners keep winning for 3 to 12 months (Jegadeesh and Titman)
Long-term reversal
Past losers over 3 to 5 years outperform past winners (De Bondt and Thaler)
Calendar effects
January, day-of-week, turn-of-the-month effects
Post-earnings drift
Prices continue in the direction of earnings surprises
- Behavioural explanation: momentum from under-reaction (conservatism) to news; reversal from over-reaction (representativeness).
Topic 5
Noise trader risk and excessive volatility
- Noise traders: investors who trade on noise (rumours, sentiment) rather than information.
- Noise trader risk (De Long, Shleifer, Summers and Waldmann, 1990): the risk that mispricing worsens before it corrects, which deters arbitrageurs and lets mispricing persist.
- Excessive volatility (Shiller, 1981): stock prices move far more than can be justified by changes in expected dividends — evidence of sentiment-driven swings.
Topic 6
Mental accounting
- Thaler: people put money into separate mental "accounts" by source or purpose and treat them differently, even though money is fungible.
- Effects: spending bonuses and windfalls freely, holding low-yield savings while borrowing on credit cards, evaluating each investment separately rather than as a portfolio, "house money" effect after gains.
Topic 7
Overconfidence
- Forms: miscalibration (too-narrow forecast ranges), better-than-average effect, illusion of control.
- Consequences: excessive trading (Barber and Odean: the most active traders earn lower returns), under-diversification, ignoring risk.
Topic 8
Loss aversion and the disposition effect
- Loss aversion: losses loom larger than gains.
- Disposition effect (Shefrin and Statman): selling winners too early and holding losers too long to avoid realising losses.
- Myopic loss aversion (Benartzi and Thaler): frequent evaluation makes investors avoid equities — one explanation for the equity premium puzzle.
Topic 9
Gambler's fallacy
- Gambler's fallacy: believing that past random outcomes affect future ones — "the stock has fallen five days in a row, so it must rise tomorrow".
- Hot-hand fallacy is the opposite: believing a streak will continue.
- Remedy: understand independence of random events; rely on fundamentals and probabilities.
Key terms
- Heuristic
- Mental shortcut for decisions
- Representativeness
- Judging by similarity to a stereotype
- Momentum effect
- Continuation of recent price trends
- Noise trader
- Investor trading on sentiment rather than information
- Mental accounting
- Treating money differently by mental category
Quick revision
- Heuristics: representativeness, availability, anchoring, familiarity, affect.
- Self-deception: overconfidence, self-attribution, hindsight, confirmation.
- Emotional and social forces: fear, greed, regret, herding.
- Anomalies: size, value, momentum, reversal, calendar; noise trader risk; excess volatility.
- Mental accounting; overconfidence; loss aversion and disposition effect; gambler's fallacy.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is the anchoring heuristic?
- Q2.Distinguish momentum and reversal.
- Q3.What is noise trader risk?
- Q4.Give an example of mental accounting.
- Q5.What is the disposition effect?
- Q6.What is the gambler's fallacy?
Long-answer questions
- Q1.Explain heuristics and biases that affect investors.
- Q2.Discuss self-deception and emotional and social forces in investing.
- Q3.Explain firm-size effects, momentum, reversal and excess volatility as anomalies.
- Q4.Explain mental accounting, overconfidence and loss aversion with examples.
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