We're Humane, We're (Calculatedly) Biased!

It is well accepted that Conservative Finance (I would prefer to call it so, rather calling it Traditional Finance!) theories derive their roots into the neo-classical economic theories, and the axioms of expected-utility (EU) theory, both assuming investors being rational and competent enough to take sound investment decisions. And if we further accept that intelligent (Huh!!), self-interested (Yeah! Perfect term!) individuals simply must be rational, then EU theory becomes a guide to positive or descriptive theories. Since the early 1950s academicians have been doing much of the theoretical work in economics and finance based on these joint assumptions. Lately, the assumptions which the mainstream financial theories are based on were challenged and behavioural economists contrast the EU paradigm to revise these models. 

Theorists in the new stream of "behavioural" finance do in fact allow for certain deviations from "rational" behaviour and thereby try to explain some of the empirical findings that seem contradict the standard finance theories. Supporters of behavioural finance have put aside the EU theory as a descriptive model and turned to the Prospect Theory or alternatives characterize human's decisions. Research by experimental economists, sociologists, and psychologists have made valuable contributions to the emerging field of behavioural finance. Let us now look at some of the driving factors [which have not been discussed so far in my blog, and] which are behind our (ir)rational behaviour in financial markets.

Image Source: http://www.riskpsychology.blogspot.com

(1) Allais' Paradox: Suppose you're faced with the following choices: In Case-1, Option A gives you Rs.100,000 for sure; and Option B gives Rs.500,000 with probability .10, Rs.100,000 with probability .89, and Rs.0 (Nil) with probability 0.01. You must choose either Option A or B. 

In Case-2, Option C gives Rs.100,000 with probability .11 and Rs.0 (Nil) with probability .89; Option D gives Rs.500,000 with probability .10 and Rs.0 (Nil) with probability .90. You must choose either of Option C and D.

It was noted that in Case-1, most people prefer Option A to Option B, evidently considering that the certainty of getting Rs.100,000 outweighs the chance of getting an extra Rs,400,000 at the risk of coming away empty handed. In Case-2, most people choose Option D, the Rs.500,000 gain over the Rs.100,000 gain offered by Option C and the probabilities looking about the same. It was pointed out that these model choices - A over B and D over C - violate the EU theory. 

This is how we, the humans, behave under certain conditions of risk!

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(2) The Certainty Effect: The certainty effect is documented by Kahneman and Tversky (1970) as the certainty of winning having some special significance to people. To show the impact of this bias on investor choice bias, let's take an example involving sums of money (because, we people deal with it in every day life). 

A series of cash prizes of, say X = {Rs.4000, Rs.3000, Rs.0}with two sets of probabilities, A = (.80, 0, .20) and B = (0, 1, 0). In this case, B is preferred to A. And if there is another sets of probabilities, say, C = (.20, 0, .80) and D = (0, .25, .75). Then C is preferred to D.

This choice preference for B over A is consistent with risk aversion (approving the phenomenon that one prefers the certainty of Rs.3000 to a gamble of higher expected payoff (i.e. Rs.3200). This example suggests that when people are faced with choices between a certain outcome (in first case, Rs.3000) and a risky one (Rs.3200), they prefer to go with the choice with certainty. But, when they are given to choose between two risky choices, they tend to prefer the one with higher gains (even if such choice involves lower probability). Here in second case, C (with expected outcome Rs.800; Rs.4000*.20+Rs.3000*0+Rs.0*.80) is preferred to D (with expected outcome Rs.750; Rs.4000*0+Rs.3000*.25+Rs.0*.75). It is interesting to note that the choice D has higher probability of positive outcome/gains (i.e. .25) than that of the choice C (i.e. .20). Again the EU theorem is violated! The Certainty Effect plays its role, doesn't it?

There are many other heuristics and other psychological biases at play in affecting choice behaviour of financial market participants. It's in the individual interest of ours that we identify those biases creating havoc in our investment decision making and avoid them as much as possible. What's up with you?