MN3138 - Behavioural Finance: Capital Gains & Investor Biases

This report delves into behavioural finance and its impact on investment strategies. It begins by examining capital gain overhang, its calculation for stocks A and B, and provides investment advice based on the volatility analysis. The report further discusses how understanding investor biases, such as self-deception, heuristics, and cognitive biases, can be leveraged for successful investing. Concepts like value investing and momentum investing are explored, along with the role of overconfidence. The report concludes by emphasizing that recognizing and understanding these biases allows investors and wealth managers to make more informed financial decisions, mitigating potential errors and improving overall investment outcomes. Desklib offers a platform for students to access similar solved assignments and past papers.

Behavioural finance and
investment strategy

TABLE OF CONTENTS
QUESTION 1.............................................................................................................................3
QUESTION 2.............................................................................................................................4
REFERENCES...........................................................................................................................7

QUESTION 1
Capital gain overhang referred to as the measure of the potential dilution to which
the shareholders are mainly exposed because of the possible stock-based compensation. It is
presented in the percentage form. The options overhangs decline after the public offering as
the number of shares outstanding rises. In case, the company is having high outstanding
options then the company has to generate more business and rise the EPS in order to
minimise the dilutive effects of options. Due to the dilutive effects of the stock option, the
organizations mainly prefer to give its employees performance based options rather than the
traditional stock options (Riley, Summers and Duxbury, 2020). The company which was
having the significant employee ownership results int performing even more better
financially. Under the situation or the circumstance where the company is having high
option overhang, then the management of the firm might take more risk which may involve
additional debt in order to expand the business ad pay fewer dividend. Because of the
increase in the debt component and reduction in dividend, the volatility in the stock prices
might increase. On the other hand, a company having a strong financial performance and is
also making payment for higher dividends, then they would see less stock price volatility.
The options overhand declines after the public offering due to the reason that the number of
shares outstanding rises. In case the company is having very high options overhangs then it
might result into generating high level of growth and profits in order to compensate for the
overhang’s dilutive effects on EPS.
This, thusly, can lead managers to face more challenge, deliver out less in profits,
and assume more obligation—all of which can bring about more prominent instability in the
organization's stock cost. Organizations with undeniable degrees of worker stock
proprietorship, then again, will in general have more grounded monetary execution, deliver
higher profits, and see less stock value instability. In respect t determining the reference
point, variables like highs, lows in the stock price plays an important role in addition to the
purchase ad the final price (Huang, Liu and Yin, 2019). The purchase price is not the only
point of reference that is predictive of one month future return when incorporated into the
capital gain overhang model. In addition to this, there are certain alternative capital gain
overhang variables which involves the max, min, 52-week max or 52-week min are equally
good predictors. It has been determined that the traditional CG overhang variables are no
longer positive predictor of returns. An investor takes into account number of points in the
process of forming a reference point so that reference point adjusts with the time and the

overhand variables are the good predictors of the future returns and the trading volume as
against the traditional CG overhang variable.
The words dilution and overhang are frequently utilized conversely to allude to a
similar investigation and computation. At the point when an organization utilizes portions of
stock through investment opportunities, restricted shares, performance shares or other offer
based plans, income and power of voting of existing investors are diluted (Goh, Jeong and
Kang, 2018). Utilizing a basic illustration of an organization with 100 outstanding shares,
each offer qualifies the proprietor for 1% of organization income and 1% of the voting right
of the organization. On the off chance that Sue held 5 portions of stock, he would possess 5%
of the organization. Presently expect the organization saves 10 new portions of stock to be
utilized for investment opportunities to the executives. In the event that those offers are
given, the organization will have 110 offers remarkable, and Sue’s 5 shares will presently
command a smaller portion of the profits and casting a voting power of the organization.
Month Stock A Stock B
CGO
Stock A
CGO
Stock B
1 12 15
2 15 18 50 72
3 17 18 120 90
4 17 20 170 100
5 14 22 140 88
6 12 20 80 200
Based upon the above Capital gain overhaul computed among the two stocks it can
be stated that the Stock a is highly volatile in comparison to the stock B, therefore, it is
beneficial for the investor to make an investment in the Stock B as it is subjected to less
risk.
QUESTION 2
Critically analyzing how the knowledge of investor biases can be used to successfully
invest money
The behavioral finance simply refers to the study of the influence of the psychology
on the behavior of the investors. In addition to this, it also incorporates the subsequent impact
on the markets. It is basically concentrated on the fact that the investors are not always
rational and therefore, have limited their self-control and is also affected by their own biases.
The behavioral financial considers humans to be normal but are also subjected to the
decision-making bias and the errors which are categorized into few parts. The first is self-

deception which is referred to as a limit in the way of learning (Kapoor and Prosad, 2017).
For example, under the situation when one mistakenly thinks that he/she knows more than
they what actually knows, it results into losing information which helps in making informed
decision. Another is heuristics which is the subfield of cognitive psychology and is used as an
assessment of probabilities in respect to the decision making. This method is more flexible
and is mainly utilized for the purpose of quick decision making mainly while finding out the
optimal solution to the thing which is either impossible or impractical.
Cognitive bias refers to the systematic error or mistake in thinking which generally
encountered by the people while processing and interpreting the information in the world
around them. This results into having a huge impact over the decisions and judgements being
made by them. This bias can also be the outcome of an attempt which is being made for
simplifying the processing. A cognitive bias might occur from the heuristic which is mostly
being ignored, that is, the base rate of events which is being occurring when making the
decision. For instance, person is afraid of flying but it is more likely that he might be in a car
crash than in a plane crash.
One of the important concepts in regard to the value investing refers to the stock
investing methodology which is basically practiced by number of investors. The value
investing works on providing the investor the information or forming a belief that the stock
market is not efficient and also there are certain risks to the value investing. The
psychological aspects of the human mind results into affecting the stock market behavior. For
example, when buying the stocks with the idea that it is selling below its intrinsic value, then
a lot of assumptions are required to be made in order to come at a conclusion. Thus, there are
risks that investor might be wrong in their judgement (Dickason and Ferreira, 2018). In
addition to this, another important concept is the momentum investing which more into
reaction to the market information. The idea of selling losers and buying the winners is
seductive. The momentum investing seeks to take the advantage of the market volatility
through the way of taking the short term position in the stocks which are going upward and
selling them as and when there is sign that the price might go down. Under such case the
investor shifts the capital in the new position.
The best momentum trade comes when the new shock hits the market which results
into triggering the rapid and instant movement in the price from the one level to another. In
turn, this results int setting off the buying and the selling signals for the investors or the
market players who are rewarded with the instant profits (Ángeles López-Cabarcos, M Pérez-
Pico and López Perez, 2020). Under this, the early position can provide greater rewards along

with the least risk as against the aging trends which should be avoided at all costs. But this
situation does not arise in real world as the investor didn’t see the opportunity until it is late
in the cycle. The behavioral finance application has been increasing at a higher rate all across
the industry. For example, Barclays appears to have been the earlier mover and has been
building up the behavioral team in the past 11 years. From that time, behavioral researchers
have fund other companies as well like Merrill Lynch, Allianz, UBS and recently, at the two
colossuses in the field, Blackrock and Vanguard.
Another important point which results into contributing towards the biases is the
overconfidence of the investor. In most of the cases, the trader overestimates it own abilities
which results into making them think they are above average and knows much more which
extents to a higher degree than normal laypersons do. Such overconfidence is mainly seen
under the circumstances when the market is rising. Investors who are overconfident
consequently leads to excessive or active trading which might led to underperformance. This
factor usually has a huge impact over the financial decision making. All the above stated
concepts and the terms possess as a biggest challenge in the way of attaining success. But,
identifying such behavior or investor bias results into making it easy to attain the success
(Cruciani, 2017). For example, through the way of having a complete knowledge and proper
information regarding the bias to which investors are exposed to results into making the
investors well aware of the mistakes that they might make which will result into making them
more conscious while undertaking can be of the financial decision. Cognitive bias is
basically the limitation in the objective thinking which is being caused due to the tendency
for the human brain in order to perceive information by the filtration of the personal
experience. Thus, it can affect the decision making skills and can also limit the problem
solving abilities. But on the other hand, in advance grabbing knowledge of all the potential
investor bias helps the wealth managers and the advisors to be aware f the potential impact
of the same the decision making and through the way of learning about the nuances of the
observed behavior within the market, people might learn to mitigate and prevent the future
errors.

REFERENCES
Books and Journals
Ángeles López-Cabarcos, M., M Pérez-Pico, A. and López Perez, M. L., 2020. Investor
sentiment in the theoretical field of behavioural finance. Economic research-
Ekonomska istraživanja. 33(1). pp.0-0.
Cruciani, C., 2017. Investor decision-making and the role of the financial advisor: A
behavioural finance approach. Springer.
Dickason, Z. and Ferreira, S., 2018. Establishing a link between risk tolerance, investor
personality and behavioural finance in South Africa. Cogent Economics &
Finance. 6(1). p.1519898.
Goh, J., Jeong, G. and Kang, J., 2018. The Reference Dependency of Short-Term Reversal.
Huang, S., Liu, X. and Yin, C., 2019. Investor target prices. Journal of Empirical
Finance. 54. pp.39-57.
Kapoor, S. and Prosad, J. M., 2017. Behavioural finance: A review. Procedia computer
science. 122. pp.50-54.
Riley, C., Summers, B. and Duxbury, D., 2020. Capital gains overhang with a dynamic
reference point. Management Science. 66(10). pp.4726-4745.