Behavioural Corporate Finance (biggest part of the theory)
What is behavioural finance?
System 1 – Intuition
- Intuition ‘Blink’ system
- Automatic, fast, and effortless
- It is reflected in cognitive and emotional shortcuts, lead us well most of the time
System 2 – Think
- Reflective ‘think’ system
- Controlled, slow and effortful
- Search for logic and evidence
Although system 1 mostly leading to good choices, they may lead us to some errors.
Behavioral finance is finance of normal people, like us. Financial products may also give you
utilitarian (what increase my wealth), expressive (what does something say about me to others
and myself) and emotional benefits (how does something make me feel good, or virtues)
Wants and benefits
There are conflicts in our wants:
1. Common wants
Everyone wants to avoid poverty and to be rich, we balance our wants and divide our money
into layers of portfolio pyramid.
We seek for emotional and expressive benefit of playing
Why do we try to solve puzzles? Puzzles are time taking; they impose utilitarian cost but
expressive and emotional benefit.
A typical example is moral money: combining the benefits of doing good with those with doing
well.
We also seek for fairness
2. Varying wants
Five mostly accepted determinants:
1. Social class
2. Identities
3. Culture
4. Political leanings
5. Religion
Houses combines investment & consumption
When our houses gain value, we perceive them as investment
When our house lose value, we consider them as consumption
, Our errors and conflicts
Who buys lottery tickets?
- Ignorant
Having a cognitive error
Assigning higher probability of winning than the actual one
Blind to errors
Overconfidence in abilities
Ignorant of the price of sensation seeking
- Knowledgeable
Enjoying
Benefit of expressive & emotional is bigger than disutility from buying the ticket
Acknowledge overconfidence; and ready to pay for the price of seeking for joy
Managers enjoys emotional & expressive benefits of high social status
Conflict can arise between wants of money managers and investors.
Heuristic simplification is the way human evolution has hardwired or brains to enable us to
make decision in a complex environment as we typically do not have sufficient time and
sufficient cognitive resources to analyse decision problems in an optimal way
Cognitive shortcuts and errors:
1. Framing
There is a danger of so-called narrow framing or packaging. This danger consists of the fact that
the way the information is presented to the decisions maker may influence the actual decision.
Typical framing errors
- Frames in mental accounting, keeping two separate accounts in their brains; one for
gains and one for losses.
- Frames in the winner’s curse
- Frames in the money illusion
2. Hindsight
We commit hindsight errors when we believe (erroneously) that we can reliably predict future
events from past events, and when we believe (erroneously) that we can predict reliably
outcomes of actions.
3. Confirmation
Confirmation errors is widespread among investors. Many investors believe they can pick
winning stocks, but do not aware of their losing records.
We commit confirmation error when we search for confirming evidence while overlooking
disconfirming evidence, and when we assign lower weigh to disconfirming evidence than to
confirming evidence.
4. Anchoring and adjustment
We use anchoring and adjustments shortcuts when we estimate prices, distances, weights, and
other numerical values. We commit anchoring and adjustment errors when we begin with
faulty anchors and adjust from them improperly.
What is behavioural finance?
System 1 – Intuition
- Intuition ‘Blink’ system
- Automatic, fast, and effortless
- It is reflected in cognitive and emotional shortcuts, lead us well most of the time
System 2 – Think
- Reflective ‘think’ system
- Controlled, slow and effortful
- Search for logic and evidence
Although system 1 mostly leading to good choices, they may lead us to some errors.
Behavioral finance is finance of normal people, like us. Financial products may also give you
utilitarian (what increase my wealth), expressive (what does something say about me to others
and myself) and emotional benefits (how does something make me feel good, or virtues)
Wants and benefits
There are conflicts in our wants:
1. Common wants
Everyone wants to avoid poverty and to be rich, we balance our wants and divide our money
into layers of portfolio pyramid.
We seek for emotional and expressive benefit of playing
Why do we try to solve puzzles? Puzzles are time taking; they impose utilitarian cost but
expressive and emotional benefit.
A typical example is moral money: combining the benefits of doing good with those with doing
well.
We also seek for fairness
2. Varying wants
Five mostly accepted determinants:
1. Social class
2. Identities
3. Culture
4. Political leanings
5. Religion
Houses combines investment & consumption
When our houses gain value, we perceive them as investment
When our house lose value, we consider them as consumption
, Our errors and conflicts
Who buys lottery tickets?
- Ignorant
Having a cognitive error
Assigning higher probability of winning than the actual one
Blind to errors
Overconfidence in abilities
Ignorant of the price of sensation seeking
- Knowledgeable
Enjoying
Benefit of expressive & emotional is bigger than disutility from buying the ticket
Acknowledge overconfidence; and ready to pay for the price of seeking for joy
Managers enjoys emotional & expressive benefits of high social status
Conflict can arise between wants of money managers and investors.
Heuristic simplification is the way human evolution has hardwired or brains to enable us to
make decision in a complex environment as we typically do not have sufficient time and
sufficient cognitive resources to analyse decision problems in an optimal way
Cognitive shortcuts and errors:
1. Framing
There is a danger of so-called narrow framing or packaging. This danger consists of the fact that
the way the information is presented to the decisions maker may influence the actual decision.
Typical framing errors
- Frames in mental accounting, keeping two separate accounts in their brains; one for
gains and one for losses.
- Frames in the winner’s curse
- Frames in the money illusion
2. Hindsight
We commit hindsight errors when we believe (erroneously) that we can reliably predict future
events from past events, and when we believe (erroneously) that we can predict reliably
outcomes of actions.
3. Confirmation
Confirmation errors is widespread among investors. Many investors believe they can pick
winning stocks, but do not aware of their losing records.
We commit confirmation error when we search for confirming evidence while overlooking
disconfirming evidence, and when we assign lower weigh to disconfirming evidence than to
confirming evidence.
4. Anchoring and adjustment
We use anchoring and adjustments shortcuts when we estimate prices, distances, weights, and
other numerical values. We commit anchoring and adjustment errors when we begin with
faulty anchors and adjust from them improperly.
