BEHAVIOURAL FINANCE

R.Vaidyanathan Professor of Finance & Control Indian Institute of Management Bangalore.

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Risk Management

THE WORD "RISK" IS DERIVED FROM THE EARLY ITALIAN risicare, WHICH MEANS, "TO DARE". IN THIS SENSE RISK IS A CHOICE RATHER THAN FATE.
THE DICTIONARY DEFINITION "CHANCE OF LOSS OR INJURY". HENCE THE CONCEPT OF LOSS IS INTRINSIC TO THE IDEA OF RISK.

FOR MEASURING RISK WE NEED A SYSTEMATIC DOCUMENTATION OF THE PAST AND A SENSE OF HISTORY.
MANY SOCIETIES DO NOT HAVE A SENSE OF HISTORY OR DOCUMENTATION OF ANECDOTAL EVIDENCE. THE ABSENCE OF THESE ; KEENLY FELT IN A MARKET DRIVEN FINANCIAL SYSTEM WHERE RISK MANAGEMENT BECOMES AN ASPECT OF COMPETITIVE ADVANTAGE.
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Types of Risk
Enterprise-Wide Risks

Business Risks

Non-Business Risks Event Risks Financial Risks Market Risk Credit Loss Liquidity Risk Operational Risk Foreign Exchange 3

Product Risk Macroeconomic Risk Legal Risk Reputation Risk Technological Risk Disaster Risk Regulatory/Political
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Markowitz Framework
MARKOWITZ RATIONAL INVESTOR BENEFITS ARE MEASURED BY RETURN AND ARE PROBABILISTIC IN NATURE RISK IS MEASURED BY STANDARD DEVIATION UTILITY FUNCTION IS A TWO-PARAMETER DISTRIBUTION I.E U=F(r,) INVESTOR PREFER LARGER RETURN FOR A GIVEN RISK CLASS AND LESSER RISK FOR A GIVEN RETURN CLASS I.E u/ r > 0 & u/ < 0

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TVERSKY & KAHNEMAN

PROSPECT THEORY

HIGHLIGHT THE FOLLOWING ASPECTS OF HUMAN BEHAVIOUR. EMOTIONS OVERCOME RATIONALITY. DIFFICULTY IN UNDERSTANDING FULLY THE ALTERNATIVES. -COGNITIVE DIFFICULTIES PROBLEMS IN SAMPLING.

WE DISPLAY RISK AVERSION WHEN OFFERED A CHOICE IN ONE SETTING AND TURN INTO RISK TAKERS WHEN WE ARE OFFERED THE SAME CHOICE IN A DIFFERENT SETTING.
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Prospect Theory
WE PAY MORE (EXCESSIVE) ATTENTION TO LOW PROBABILITY EVENTS ACCOMPANIED BY HIGH DRAMA AND OVER-LOOK EVENTS THAT HAPPEN IN ROUTINE FASHION. WE TREAT COSTS AND UN-COMPENSATED LOSSES DIFFERENTLY EVEN THOUGH THEIR IMPACT ON WEALTH IS IDENTICAL. WE START OUT WITH A PURELY RATIONAL DECISION ABOUT HOW TO MANAGE OUR RISKS AND THEN EXTRAPOLATE FROM WHAT MAY BE ONLY A RUN OF GOOD LUCK .AS A RESULT, WE FORGET ABOUT REGRESSION TO THE MEAN, OVERSTAY OUR POSITION AND END UP IN TROUBLE.
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ASYMMETRY IN DECISION MAKING

RS.100, 000 CERTAIN IS PREFERABLE TO 50-50 CHANCE OF RS.200, 000 OR NOTHING. WE ARE RISK AVERSE. WHAT ABOUT LOSSES? OUR CHOICE BETWEEN NEGATIVE OUTCOMES IS MIRROR IMAGE OF OUR CHOICES BETWEEN POSITIVE OUTCOMES. ALT A 1) 80% CHANCE OF WINNING RS.4000 20% CHANCE OF WINNING RS.0 VERSUS 2) 100% CHANCE OF RECEIVING RS.3000 EXP (1) =3200 BUT 80% OF THE RESPONDENTS [KAHNEMAN AND TVERSKY (1979)] CHOSE (2). THEY ARE RISK AVERSE A LA BERNOULLI.
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ASYMMETRY --Contd
ALT B VERSUS 1) 80% CHANCE OF LOSING RS.4000 20% CHANCE OF BREAKING EVEN

2) 100% CHANCE OF LOSING RS.3000

NOW 92% OF RESPONDENTS CHOSE THE GAMBLE.

EXP (1)=RS.3200 I.E. EXPECTED LOSS IS GREATER THAN CERTAIN LOSS OF RS.3000.
WHEN THE CHOICE INVOLVE LOSSES WE ARE NOT RISK AVERSORS. WE DO NOT WANT CERTAIN LOSS.

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Loss Aversion Vs Risk aversion

TVERSKY (1990) WRITES " THAT THE MAJOR DRIVING FORCE IS LOSS AVERSION "AND ADDS THAT " IT IS NOT SO MUCH THAT PEOPLE HATE UNCERTAINTY BUT RATHER THEY HATE LOSING." HE OFFERS AN INTERESTING SPECULATION ON THIS CURIOUS BEHAVIOUR." PROBABLY THE MOST SIGNIFICANT AND PERVASIVE CHARACTERISTIC OF THE HUMAN PLEASURE MACHINE IS THAT PEOPLE ARE MUCH MORE SENSITIVE TO NEGATIVE THAN TO POSITIVE STIMULI.... THINK ABOUT HOW WELL YOU FEEL TODAY, AND THEN TRY TO IMAGINE HOW MUCH BETTER YOU COULD FEEL...THERE ARE FEW THINGS THAT WOULD MAKE YOU FEEL BETTER BUT THE NUMBER OF THINGS THAT WOULD MAKE YOU FEEL WORSE IS UNBOUNDED."

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LOSS AVERSION
PLAGUE IN A COMMUNITY. IT IS EXPECTED TO KILL 600.

ALT X

1) IF PROGRAMME A IS ADOPTED 200 WILL BE SAVED. 2) IF PROGRAMME B IS ADOPTED THEN 33% CHANCE ALL WILL BE SAVED AND 67% CHANCE NONE WILL SURVIVE.

72% OF THE RESPONDENTS CHOSE PROGRAMME A, WHICH IS CERTAIN TO SAVE 200 THAN 67% CHANCE OF ALL DYING.

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Loss aversion-- contd

ALT Y 1) IF PROGRAMME C IS ADOPTED 400 OF THE 600 WILL DIE. 2) IF PROGRAMME D IS UNDERTAKEN THEN 33% CHANCE THAT NOBODY WILL DIE AND 67% CHANCE THAT 600 WILL DIE. K AND T REPORT THAT 78% OF THE RESPONDENTS WERE RISKSEEKERS AND OPTED FOR THE GAMBLE. SURE LOSS OF 400 LIVES WAS NOT ACCEPTABLE. IT IS 'LOSS AVERSION' (MORE THAN RISK AVERSION). PEOPLE HATE LOSING MORE THAN THEY HATE UNCERTAINTY. IN A DEVELOPING ECONOMY WE CAN FIND THAT LOSS AVERSION WOULD BE MORE DOMINANT THAN RISK AVERSION SINCE IT STARTS FROM A SMALLER FINANCIAL BASE.
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FAILURE OF INVARIANCE

K AND T USE THE EXPRESSION "FAILURE OF INVARIANCE" TO DESCRIBE INCONSISTENT (NOT NECESSARILY INCORRECT) CHOICES WHEN THE SAME PROBLEM APPEAR IN DIFFERENT FRAMES. INVARIANCE MEANS A IS PREFERABLE TO B AND B IS TO C THEN A TO C. THIS IS THE CORE OF VON NEUMANN AND MORGENSTERNS' APPROACH TO UTILITY. 200 LIVES SAVED IN FIRST SET SHOULD BE THE RATIONAL DECISION IN THE SECOND SET ALSO. BUT INVARIANCE FAILS.
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INITIAL WEALTH OR HOUSE MONEY EFFECT.

ALT A STUDENTS IN A CLASS HAD JUST WON RS.30 AND WERE NOW OFFERED THE CHOICE OF

COIN FLIP WHERE AN INDIVIDUAL WINS RS.9 ON HEADS AND LOSSES RS. 9 ON TAILS.
VERSUS NO COIN FLIP.

70% SELECTED THE COIN FLIP.

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Initial wealth Effect--contd

ALT B STARTING WITH WEALTH ZERO. COIN FLIP WHERE AN INDIVIDUAL WINS RS.39 ON HEADS AND WINS RS.21 ON TAILS. VERSUS RS.30 FOR CERTAIN. 57% SELECTED CERTAIN OUTCOME. OBSERVE THE PAY-OFF IS EITHER RS.39 OR RS.21 VERSUS RS.30 FOR SURE IN BOTH SITUATIONS. PEOPLE WHO START WITH MONEY CHOOSE THE GAMBLE AND WHO START WITH EMPTY POCKETS REJECT IT. REFERENCE POINT OF RS.30 IN THE FIRST CASE AND '0' IN THE SECOND.

THIS IDEA OF INITIAL WEALTH IS IMPORTANT SINCE INVESTORS' ENTRY AND EXIT FROM THE MARKET IS ALSO LINKED TO THE INITIAL WEALTH RATHER THAN EXCLUSIVELY ANTICIPATED GAINS.

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MENTAL ACCOUNTING.

THE FAILURE OF INVARIANCE FREQUENTLY TAKES THE FORM OF WHAT IS KNOWN AS MENTAL ACCOUNTING. ALT A GOING TO PLAY. BOUGHT A TICKET COSTING RS.50. ARRIVE AT THEATER TO FIND THAT YOU HAVE LOST THE TICKET. WOULD YOU BUY ANOTHER FOR RS 50?

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Mental accounting--contd
ALT B YOU PLAN TO BUY A TICKET WHEN YOU ARRIVE AT THE THEATRE. AS YOU REACH THE COUNTER YOU REALISE THAT YOU HAVE LOST RS. 50 FROM YOUR PURSE.

WOULD YOU STILL BUY THE TICKET?

OBSERVE IN BOTH SITUATIONS TOTAL OUTFLOW IS RS. 100 OR RS 50 (DEPENDING ON WHETHER YOU SEE THE PLAY OR NOT). BUT RESEARCH SUGGESTS THAT MOST PEOPLE ARE RELUCTANT TO SPEND RS 50 TO REPLACE THE TICKET. BUT ARE PERFECTLY WILLING TO LAYOUT A SECOND RS 50 TO BUY THE TICKET. THE INCONSISTENCY IS DUE TO TWO SEPARATE MENTAL ACCOUNTS. WE FIND THIS TYPE OF SITUATION WHERE EACH INVESTMENT IS LOOKED UPON AS A SEPARATE ACTIVITY AND GAINS AND LOSSES ARE COMPUTED. TO THAT EXTENT TRADITIONAL ASSUMPTIONS OF RATIONAL INVESTOR MAY NOT HOLD GOOD.

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