Behavioral Finance

There are two schools of thought regarding investor behavior in the markets. One is the Classical Economic Theory, which suggests that markets are efficient and no one can take advantage of its movements. It also assumes that we humans are rational and hence would maximize the gains.

In contrast, Behavioral Economics believes that the markets are inefficient and human beings are not rational.

“Success in investing doesn’t correlate with IQ once you are above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing” ~ Warren Buffet

Behavioral economists believe that humans are not rational & they can definitely prove it. For example, we all must have paid tips to waiters at the restaurant. The full form of TIPS is To Insure Prompt Service. By its very nature, it should be paid at the start in order to ensure that the service is up to the mark. However, it's always paid at the end as a custom. This is not a rational action.

Therefore, the study of behavioral economics helps individuals to exploit the irrationality and inefficiency in the markets. The study bridges the gap between how decisions should be made and how we actually make decisions.

Behavioral finance students and proponents develop financial techniques that take advantage of irrational investor behavior.

There are three sources of alpha-

• The first is to exploit the information. Traditional managers had access to privy information through their network. This gave them an edge over the general public. With the advent of the internet and the democratization of knowledge added to the SEBI regulations on insider information, this has become more and more difficult to exploit.
• Big data analytics and other machine learning mechanisms have given an edge to investors. Information processing has become faster these days and those with these capabilities can generate higher returns.
• The third source is used by behavioral managers who concentrate on finding mispriced securities due to behavioral factors. Therefore, these are the ones who study behavioral economics and try to take advantage of various anomalies that exist in the markets. For example, it is usually seen that holding companies (For example, HDFC Limited, trades at a discount to the sum of market cap of its holdings in subsidiaries such as HDFC Bank, HDFC Life Insurance, HDFC AMC, etc.) This is an anomaly that needs investor attention.

In the next 3 chapters, we will look at various behavioral anomalies and how to overcome them to become better behavioral managers.