22 APRIL, 2021: Prof. Joshy Jacob, Associate Professor, Finance & Accounting area, IIM Ahmedabad, led a discussion on the behavioral biases affecting investments in markets, hosted by the Center for Capital Markets and Risk Management at IIM Bangalore.
Prof. Jacob is actively associated with research on market microstructure, corporate finance and other related contemporary topics like corporate governance as well as bankruptcy and credit risk. He is a well-rated tenured faculty; he teaches behavioral finance to the students of management.
During the session, it was discussed that behavioral biases cause the market to sway from fundamental values. Price discovery instruments like equity valuation, credit spread and quantities of financial assets exposed to boom and bust cycles develop due to irrationality of traders in financial markets. Likelihood of occurrence of an event, distorted beliefs about future outcomes associated with reasoning, switching risk preferences, herd mentality, recency bias, all cloud up to an investor’s choice making ability. With an increase in incoming cash flow, the investor’s risk-taking ability increases.
The discussion highlighted that behavioral finance is based on institutional mechanism which reinforces the bubble of irrationality and distortion in an investor’s choice of spending ability. This could be accentuated at individual levels, group dynamics or various mechanisms catered by firms and institutions. Market analysis by companies, growth outlook by firms can perpetuate this bubble without getting deflated in a short span. This is done by firms for their own benefit. Certain biases can be studied with experimental data and demonstrated in the classes to understand the underlying factors playing in the minds of people. Primarily people have an affinity towards loss or risk aversion and higher returns. Ideally man should be utilitarian, but he has moulded his life state in accord to the income scenario. Prospect Theory argues that man looks at every gain and loss individually and not as a whole with a higher emphasis on the loss that could be incurred. Man treads on eggshells if there exists a chance of encountering a probabilistic loss. Individuals pass on a lot of opportunities because they fear that losses may happen. This is broadly known as loss aversion. This tendency of staying away from losses is far greater when we are looking at investments for a short horizon. Encountering losses has a higher chance in the short run. This in turn leads to investments in the short run at a lower principle value.
A simple framework of decision making could be the product of potential value outcomes that we can get and their chance of occurrence. A second aspect of prospect theory is ‘waiting function’. This is essentially how much there is a chance of occurrence of a certain outcome. It is observed that if the theoretical probability of an outcome is low, the chances of the event occurring is higher, which is called exaggerated probability. For instance, if an optimist looks at a company like Tesla, he may predict that hydrogen fuel cell company will be the future; whereas a pessimist would say that the likelihood of failure would be far higher in this case.
There are two different facets of human decision making, namely, fear of losses in the short run and the chance of exaggerating the probabilistic outcomes. Behavioral finance handles recency bias, framing, herd mentality, angering, overconfidence, loss-aversion, hindsight bias, to name a few. It is difficult to predict what exactly drives the market trend or which news would affect the price discovery or information dissemination.
Pof Joshy demonstrated a simulator to understand the market setup. This demonstrates a real-time trading account with a certain amount of cash or shares to begin with. The market scenario is created with the following: order matching, order visibility (bid-ask spread), short-selling, market wide limit, individual limit and transaction cost. Short selling if allowed, there is a greater chance of irrational optimism prevailing in the market.
Experimental learning has a strong gamification effect in class participation. It helps in real-time market learning and in turn helps to find the secular differences between the two groups, the one which makes a loss and the other which makes a gain, based on the following:
-
Average prices under different market situations
-
Gains and losses of the groups
-
Extent of asset allocation to the stock (vs cash)
-
Order placement strategies (limit vs market orders)
Prof. Joshy attempts to create ownership through gamification and real-time experiments to inculcate the trading scenarios amongst the students and drive away the fear of losing out in the markets.
This software will be ready to use as an open source free of cost entity. It will be put up on the ‘Platform for Investors’ Education’ for free access. People can register on the software free of cost and use the order matching engine to run different experiments for a mock trading atmosphere.
22 APRIL, 2021: Prof. Joshy Jacob, Associate Professor, Finance & Accounting area, IIM Ahmedabad, led a discussion on the behavioral biases affecting investments in markets, hosted by the Center for Capital Markets and Risk Management at IIM Bangalore.
Prof. Jacob is actively associated with research on market microstructure, corporate finance and other related contemporary topics like corporate governance as well as bankruptcy and credit risk. He is a well-rated tenured faculty; he teaches behavioral finance to the students of management.
During the session, it was discussed that behavioral biases cause the market to sway from fundamental values. Price discovery instruments like equity valuation, credit spread and quantities of financial assets exposed to boom and bust cycles develop due to irrationality of traders in financial markets. Likelihood of occurrence of an event, distorted beliefs about future outcomes associated with reasoning, switching risk preferences, herd mentality, recency bias, all cloud up to an investor’s choice making ability. With an increase in incoming cash flow, the investor’s risk-taking ability increases.
The discussion highlighted that behavioral finance is based on institutional mechanism which reinforces the bubble of irrationality and distortion in an investor’s choice of spending ability. This could be accentuated at individual levels, group dynamics or various mechanisms catered by firms and institutions. Market analysis by companies, growth outlook by firms can perpetuate this bubble without getting deflated in a short span. This is done by firms for their own benefit. Certain biases can be studied with experimental data and demonstrated in the classes to understand the underlying factors playing in the minds of people. Primarily people have an affinity towards loss or risk aversion and higher returns. Ideally man should be utilitarian, but he has moulded his life state in accord to the income scenario. Prospect Theory argues that man looks at every gain and loss individually and not as a whole with a higher emphasis on the loss that could be incurred. Man treads on eggshells if there exists a chance of encountering a probabilistic loss. Individuals pass on a lot of opportunities because they fear that losses may happen. This is broadly known as loss aversion. This tendency of staying away from losses is far greater when we are looking at investments for a short horizon. Encountering losses has a higher chance in the short run. This in turn leads to investments in the short run at a lower principle value.
A simple framework of decision making could be the product of potential value outcomes that we can get and their chance of occurrence. A second aspect of prospect theory is ‘waiting function’. This is essentially how much there is a chance of occurrence of a certain outcome. It is observed that if the theoretical probability of an outcome is low, the chances of the event occurring is higher, which is called exaggerated probability. For instance, if an optimist looks at a company like Tesla, he may predict that hydrogen fuel cell company will be the future; whereas a pessimist would say that the likelihood of failure would be far higher in this case.
There are two different facets of human decision making, namely, fear of losses in the short run and the chance of exaggerating the probabilistic outcomes. Behavioral finance handles recency bias, framing, herd mentality, angering, overconfidence, loss-aversion, hindsight bias, to name a few. It is difficult to predict what exactly drives the market trend or which news would affect the price discovery or information dissemination.
Pof Joshy demonstrated a simulator to understand the market setup. This demonstrates a real-time trading account with a certain amount of cash or shares to begin with. The market scenario is created with the following: order matching, order visibility (bid-ask spread), short-selling, market wide limit, individual limit and transaction cost. Short selling if allowed, there is a greater chance of irrational optimism prevailing in the market.
Experimental learning has a strong gamification effect in class participation. It helps in real-time market learning and in turn helps to find the secular differences between the two groups, the one which makes a loss and the other which makes a gain, based on the following:
-
Average prices under different market situations
-
Gains and losses of the groups
-
Extent of asset allocation to the stock (vs cash)
-
Order placement strategies (limit vs market orders)
Prof. Joshy attempts to create ownership through gamification and real-time experiments to inculcate the trading scenarios amongst the students and drive away the fear of losing out in the markets.
This software will be ready to use as an open source free of cost entity. It will be put up on the ‘Platform for Investors’ Education’ for free access. People can register on the software free of cost and use the order matching engine to run different experiments for a mock trading atmosphere.