Behavioral Finance
Lecture 1 – Introduction
Three decision making perspectives:
- Normative: how should people make decisions?
E.g., NPV of a project.
- Descriptive: How do people make decisions?
Biases:
Systematic (predictable) deviations from normative standards.
- Prescriptive: how can we help make people decisions?
Traditional finance theory:
Standard assumptions:
- Investors and managers perfectly resemble the Homo Economicus.
- Markets are perfect and informationally efficient.
Some implications:
- Financial incentives can eliminate systematic suboptimal behaviour.
- Passive investing in a low-cost diversified index fund is optimal.
Three Views on Market Efficiency:
Efficient Market Fanatic:
- Security prices are always equal to intrinsic value.
- It is impossible to accurately predict (risk-adjusted) returns.
Behavioural Finance Fanatic:
- Stock prices only depend on market psychology.
- It is easy to predict stock price movements.
Sensible middle ground:
- Security prices are highly correlated with intrinsic value, but sometimes diverge to a
significant degree.
- It is possible to predict (risk-adjusted) returns, but not with great precision.
The Homo Economicus:
Self-regarding maximiser with unlimited and costless information processing capacity and
unbreakable willpower.
Heuristic:
Heuristic: Experience-based rule of thumb or mental shortcut.
Why do we use heuristics?
- Limited information;
- Limited memory;
- Limited information processing ability;
- Limited time.
Heuristics are often ok, but not always…
,How we think: Two Systems:
How can people simultaneously be smart and dumb?
Distinction between two types of thinking:
- System 1: intuitive and automatic.
- System 2: reflective and deliberative.
Intuitive system Reflective system
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Self-aware
Skilled Rule-following
Priming:
Priming is a phenomenon in which a recent experience activates thoughts that
subconsciously influence future thoughts and actions.
Important: Priming has become the subject of scepticism after many studies were not able
to be independently replicated.
Homo sapiens:
A “wise man”, but with…
- Bounded rationality;
- Bounded awareness;
- Bounded willpower;
- Bounded self-interest.
Traditional Finance Theory:
Why emerge? Why persist?
- Desire for field like natural sciences;
- Rise of computers;
- “As if” defence Friedman;
- “Market forces solve irrationalities”.
Behavioral Finance:
BF is the study of how psychological phenomena impact financial behaviour (Shefrin, 2005).
BF approach:
- Examine systematic deviations from rational behaviour.
- Relax assumptions of rationality.
- Relax assumptions of perfect capital markets.
BF extends Finance, does not replace.
Insights apply to all areas of Finance, including main two:
- Corporate Finance
- Investments
,Lecture 2: Overconfidence & Optimism
The beliefs of the Homo Economicus:
- Uses all relevant available information (if marginal benefits > marginal costs).
- Holds rational expectations (no systematic error).
Biases in beliefs:
- Overconfidence and optimism;
- Base rate neglect;
- Sample size neglect;
- Gambler’s fallacy;
- Hot hand fallacy;
- Confirmation bias;
- Anchoring bias;
- Availability bias;
- Bounded awareness.
Overconfidence and Optimism:
Overconfidence:
- Bias in which subjective confidence in judgments is greater than their objective
accuracy.
- Regardless of how much we know, we overestimate how well we know our limits.
Optimism:
- Bias in which the likelihood of positive outcomes of actions is overestimated and the
likelihood of negative outcomes is underestimated.
Overconfident people are often surprised.
Optimistic people are often disappointed.
In practice: blurry lines between overconfidence and optimism.
Alternative classification (used in Bazerman & Moore):
Three groups, all grouped under the label of overconfidence:
- Overprecision or miscalibration: excessive precision in one’s beliefs.
- Overestimation of one’s actual performance (absolute sense).
- Overplacement of one’s performance relative to others (better-than-average).
, Why important?
Are overconfidence and optimism beneficial?
Overconfidence and optimism blamed for serious problems: Wars, fatal accidents, wrongful
convictions…
Examples in financial decision making:
- Stock market bubbles, unnecessary lawsuits,
overleveraging and bankruptcies, excessive trading in
securities, failed mergers and acquisitions.
More innocent examples:
- Popularity poker, some being poorly prepared for the
exam.
There may be some benefits, but for decision making purposes
we want accurate probability assessments!
Possible explanations:
- Hindsight bias: Tendency for people with outcome knowledge to believe falsely that
they would have predicted the outcome.
- Desire to feel sure of ourselves.
- Desire to make others feel sure about us: Being accurate comes at the expense of
being informative, and others often prefer informativeness over accuracy.
- Confirmation bias.
- Representativeness biases.
- Anchoring.
Weather forecasters (before computer algorithms) were
nearly perfectly calibrated. Why were they not
overconfident?
Feedback (they automatically found out if they were
right). Accountability (held accountable if they’re wrong,
incentive for improvement).
Optimism: Weinstein (1980):
“The future will be great, especially for me.”
People ought themselves 15% more likely for good
things, and 20% less likely for bad things.
People seemed to:
- Have a biased idea of personal actions or plans that might affect their chances of
experiencing the event, and;
- Compare themselves to a person who does nothing to improve his or her chances.
Related concept: Illusion of control:
Illusion of control: Tendency to overestimate the degree of control in situations that are
governed mostly or even purely by chance.
Conditions for illusion of control: intended outcome + connection.
- Examples are investing in the market, slot machines, lottery numbers…
Lecture 1 – Introduction
Three decision making perspectives:
- Normative: how should people make decisions?
E.g., NPV of a project.
- Descriptive: How do people make decisions?
Biases:
Systematic (predictable) deviations from normative standards.
- Prescriptive: how can we help make people decisions?
Traditional finance theory:
Standard assumptions:
- Investors and managers perfectly resemble the Homo Economicus.
- Markets are perfect and informationally efficient.
Some implications:
- Financial incentives can eliminate systematic suboptimal behaviour.
- Passive investing in a low-cost diversified index fund is optimal.
Three Views on Market Efficiency:
Efficient Market Fanatic:
- Security prices are always equal to intrinsic value.
- It is impossible to accurately predict (risk-adjusted) returns.
Behavioural Finance Fanatic:
- Stock prices only depend on market psychology.
- It is easy to predict stock price movements.
Sensible middle ground:
- Security prices are highly correlated with intrinsic value, but sometimes diverge to a
significant degree.
- It is possible to predict (risk-adjusted) returns, but not with great precision.
The Homo Economicus:
Self-regarding maximiser with unlimited and costless information processing capacity and
unbreakable willpower.
Heuristic:
Heuristic: Experience-based rule of thumb or mental shortcut.
Why do we use heuristics?
- Limited information;
- Limited memory;
- Limited information processing ability;
- Limited time.
Heuristics are often ok, but not always…
,How we think: Two Systems:
How can people simultaneously be smart and dumb?
Distinction between two types of thinking:
- System 1: intuitive and automatic.
- System 2: reflective and deliberative.
Intuitive system Reflective system
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Self-aware
Skilled Rule-following
Priming:
Priming is a phenomenon in which a recent experience activates thoughts that
subconsciously influence future thoughts and actions.
Important: Priming has become the subject of scepticism after many studies were not able
to be independently replicated.
Homo sapiens:
A “wise man”, but with…
- Bounded rationality;
- Bounded awareness;
- Bounded willpower;
- Bounded self-interest.
Traditional Finance Theory:
Why emerge? Why persist?
- Desire for field like natural sciences;
- Rise of computers;
- “As if” defence Friedman;
- “Market forces solve irrationalities”.
Behavioral Finance:
BF is the study of how psychological phenomena impact financial behaviour (Shefrin, 2005).
BF approach:
- Examine systematic deviations from rational behaviour.
- Relax assumptions of rationality.
- Relax assumptions of perfect capital markets.
BF extends Finance, does not replace.
Insights apply to all areas of Finance, including main two:
- Corporate Finance
- Investments
,Lecture 2: Overconfidence & Optimism
The beliefs of the Homo Economicus:
- Uses all relevant available information (if marginal benefits > marginal costs).
- Holds rational expectations (no systematic error).
Biases in beliefs:
- Overconfidence and optimism;
- Base rate neglect;
- Sample size neglect;
- Gambler’s fallacy;
- Hot hand fallacy;
- Confirmation bias;
- Anchoring bias;
- Availability bias;
- Bounded awareness.
Overconfidence and Optimism:
Overconfidence:
- Bias in which subjective confidence in judgments is greater than their objective
accuracy.
- Regardless of how much we know, we overestimate how well we know our limits.
Optimism:
- Bias in which the likelihood of positive outcomes of actions is overestimated and the
likelihood of negative outcomes is underestimated.
Overconfident people are often surprised.
Optimistic people are often disappointed.
In practice: blurry lines between overconfidence and optimism.
Alternative classification (used in Bazerman & Moore):
Three groups, all grouped under the label of overconfidence:
- Overprecision or miscalibration: excessive precision in one’s beliefs.
- Overestimation of one’s actual performance (absolute sense).
- Overplacement of one’s performance relative to others (better-than-average).
, Why important?
Are overconfidence and optimism beneficial?
Overconfidence and optimism blamed for serious problems: Wars, fatal accidents, wrongful
convictions…
Examples in financial decision making:
- Stock market bubbles, unnecessary lawsuits,
overleveraging and bankruptcies, excessive trading in
securities, failed mergers and acquisitions.
More innocent examples:
- Popularity poker, some being poorly prepared for the
exam.
There may be some benefits, but for decision making purposes
we want accurate probability assessments!
Possible explanations:
- Hindsight bias: Tendency for people with outcome knowledge to believe falsely that
they would have predicted the outcome.
- Desire to feel sure of ourselves.
- Desire to make others feel sure about us: Being accurate comes at the expense of
being informative, and others often prefer informativeness over accuracy.
- Confirmation bias.
- Representativeness biases.
- Anchoring.
Weather forecasters (before computer algorithms) were
nearly perfectly calibrated. Why were they not
overconfident?
Feedback (they automatically found out if they were
right). Accountability (held accountable if they’re wrong,
incentive for improvement).
Optimism: Weinstein (1980):
“The future will be great, especially for me.”
People ought themselves 15% more likely for good
things, and 20% less likely for bad things.
People seemed to:
- Have a biased idea of personal actions or plans that might affect their chances of
experiencing the event, and;
- Compare themselves to a person who does nothing to improve his or her chances.
Related concept: Illusion of control:
Illusion of control: Tendency to overestimate the degree of control in situations that are
governed mostly or even purely by chance.
Conditions for illusion of control: intended outcome + connection.
- Examples are investing in the market, slot machines, lottery numbers…
