LESSON 2 RECORD LECTURE Behavioral Finance also known as Behavioral Economist. WHY BEHAVIORAL FINANCE CAME ABOUT? People make rational decisions People are unbiased about their predictions of futures IN REALITY, PEOPLE MAKE IRRATIONAL DECISIONS AND PEOPLE HAVE BIASES Traditional finance Both the market and investors are perfectly rational Investors truly care about utilitarian characteristics Investors have perfect self-control They are not confused by cognitive errors or information processing errors Efficient and not biased Behavioral finance Investors are treated as "normal" not "rational" They actually have limits to their self-control Investors are influenced by their own biases Investors make cognitive errors that can lead to wrong decisions View people as normal individual and abnormal individual are imperfect They have behavioral biases. BEHAVIORAL FINANCE 1. MENTAL ALLOCATING - allocating money for specific purposes - money is considered fungible but is interchangeable. All funds are regardless with what they come from or use for. - According to Thiar- putting labels on money has long history and serves a purpose. Its start with sensible reasons but people take it to places that don’t make any sense. - in mental allocating we treat money differently 2. HERD BEHAVIOR -tend to mimic -para siyang go-with-the-flow -like trends ganun 3. EMOTIONAL GAP - decision-making, emotions -all biases has a psychological component, but some, especially reflect emotions and feelings. -OVERCONFIDENCE- part of emotional gap -tendency to think we know more than we do. 4. ANCHORING -attaching a spending level to a certain reference. -guide or basis -also tendency to estimate value based on whatever number we have access to. - for instance, people with a lot of money who mainly associate with other high net worth individuals. 5. SELF-ATTRIBUTION - tendency to make choices bases on overconfidence. -also called SELF-RATING. A habit of attributing favorable to expertise an unfavorable outcome to bad luck or exogenous events. DECISION MAKING ERRORS AND BIASES Self-Deception, Social Influence, Heuristic Simplification and Emotions. This are a bucket or building blocks that they make up for Behavioral Finance. 1. SELF-DECEPTION- limit to the way we learn. When we mistakenly think we know more than we do. We tend to misinformation that we need to make informed decisions. Tend to miss a certain information we need to know or need. 2. HEURISTIC SIMPLIFICATION- simply refers to Information processing Errors. 3. EMOTIONS- refers to our decisions based on our current emotional state. Our current mood may take away our decision making OFF track from rational thinking. 4. SOCIAL INFLUENCE- how our decision-making is influence by others. BIAS- impact of personal biases on investors. LIST OF COMMON BIASES 1. OVERCONFIDENCE AND ILLUSION CONTROL - tendency to make false and misleading assessment of your skills, intellect, or talents, in short it is egotistical belief. -can be very dangerous bias. -very prolific in behavioral finance. 2. SELF-ATTRIBUTION - Self-serving bias, which is your tendency to attribute good outcomes to your skill and bad outcomes to bad luck - we choose how to attribute the cost of the outcome base on what make us looks best. 3. HINDSIGHT BIAS - misconception after the fact that one always knew that they were right. - someone may mistakenly assume that they possess insight or talent on predicting an outcome. 4. CONFIRMATION BIAS - tendency of people to pay close attention to an information that confirms their beliefs and ignore information that contradicts it. 5. THE NARRATIVE FALLACY - limits to our ability to evaluate information objectively is what we call the NARRATIVE FALLACY 6. REPRESENTATIVE BIAS -nasa third module - occurs when the similarities of objects or events. -confuses peoples thinking regarding the probability outcome. - people frequently make the mistake of believing that two similar things or event are closely correlated then they actually are. 7. FRAMING BIAS - occurs when people make a decisions base on the way of incognition is presented as opposed to the fact. 8. ANCHORING - occurs when people rely to much on pre-existing information or the first information they find on making decisions. 9. LOSS AVERSION - tendency where investor are so fearful of losses that they focus on trying to avoid loss more so than making gains. 10. HERDING MENTALITY - tendency to follow and copy (mimic) the other investors are doing. ALTERNATIVES 1. COOPERATION AND ALTRUISM -people motives may lead to actions different than conventional rationality - different from the usual - learn to think outside the box. 2. BIDDING AND WINNERS CURSE - may lead suboptimal result when you bid you fare WHAT SHOULD WE DO -Be very careful on setting prices - Don’t bid your fare value. You must bid lower - Do not get emotional with your bidding fare. 3. ENDOWMENT -sometimes we perceive that in assets value increase by virtue of our ownership - we give value to something that we already own - don’t get emotionally attached with the assets. 4. STATUS QUO - individuals prefer the status quo over new or more favorable positions. - takot sa pagbabago - they prefer where they are. WHAT SHOULD BE THE SOLUTION? - Be open minded Open to change 5. AVERSION -tendency to investigate loss. Concentrate more on losses than potential gains * Look on loss and gains equally. 6. MENTAL ACCOUNTS -winning by losing - sometimes investors actively trades stocks instead of buying certain securities with lower cost and takes a lot less time to invest. 7. SEEKING SOLACE -abdicating responsibilities - we prefer to take others advice than doing our own homework. 8. FUN – we trade for fun and entertainment. 9. PERCENTAGES -individuals move in and out of assets classes - set specific percentage 10. CALENDAR EFFECTS -impact of tax and reporting which is not consistent with theory. * Income statement which is prepared annually - do not worry about calendar effects just invest in long term and consistent in your investment plan. 11. CASH DIVIDENDS -theory has shown that dividends are irrelevant in the absence of taxes and transaction costs. - emphasize CAPITAL gain over dividends 12. OVERREACTION - many investors sign probability to asset return based on pass theory . Appropriate reaction to negative events is to date a prior probability to the most recent event.
