Behavioral Finance:
Implications for Financial Management
Chapter 26
Behavioral Finance
• Proposes psychology-based theories to explain financial market
anomalies.
 identify and understand why rational people make irrational and/or
unpredictable financial choices
 understand and explain how reasoning errors influence financial decisions
taken by seemingly rational individuals
Conclusion drawn from Behavioral Finance - errors in reasoning leads
to cognitive errors and suboptimal decisions
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Poor Outcomes – Luck or Error?
• A suboptimal (bad) result in an investment decision can
stem from one of two issues:
 You made a good decision, but an unlikely negative event occurred
(you had bad luck)
 You simply made a bad decision (also called a cognitive error)
If managers can identify the circumstances that lead to poor
decisions, they can attempt to cut down on the damage done
by financial blunders and make fewer ‘bad’ decisions
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Cognitive Errors
Behavioral finance attempts to explain how
cognitive errors influence financial decisions
Three types of cognitive errors:
1.
Biases
2.
Framing Effects
3.
Heuristics
4
Key Concepts and Skills
• Identify how biases affect decision making
 Overconfidence
 Over-optimism
 Confirmation bias
• Understand how framing effects can result in inconsistent and/or incorrect
decisions
• Understand how the use of heuristics can lead to suboptimal financial
decisions
• Recognize the shortcomings and limitations to market efficiency from the
behavioral finance viewpoint
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1. Biases
•
Systematic biases lead to
systematic errors in judgment.
•
The type of error depends on the
type of bias
 Overconfidence
 Overoptimism
 Confirmation Bias
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Overconfidence
• Overconfidence results when you overestimate your ability to make the
correct choice or decision.
 Example: Manager’s belief that s/he can forecast the future with precision
 Everyday life example: 80 percent of drivers consider themselves to be above average
 Stock market example: Overconfidence by investors cause them to overestimate their
ability to pick the best stocks, leading to excessive trading and subsequent
underperformance
 Anecdotes: Men trade more often than women; Education is not a ‘game-changer’ in
controlling overconfidence
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Overoptimism
• Overestimating the likelihood of a good outcome and underestimating the
likelihood of a bad outcome, i.e., taking an overly optimistic view of potential
outcomes
 Example: In project evaluation, optimistic analysts consistently overestimate cash flows and
underestimate the probability of failure leading to upward-biased estimates of project NPV
 Anecdote: Studies suggest that stock traders around the globe are more risk averse during the
darker months (pessimistic) and are willing to take more risk during months with longer
sunlight (optimistic)
• Not the same as overconfidence, as someone could be overconfident of a
negative outcome (i.e., “over pessimistic”)
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Confirmation Bias
• When making a decision, more weight is given to information that agrees with a
preexisting opinion while contradictory information is deemed less reliable.
• People with such bias spend a lot of time trying to prove themselves correct
rather than searching for information that might prove them wrong.
Evaluate the following statement: “Any card with a vowel on one side has an even
number on the other.” Turning each card costs you $100.
• You picked two stocks to invest. One has been doing well, the other one is
bleeding. Confirmation bias leads you to believe that you’re a great stock-picker
(self-attribution to good events) while poor luck is blamed for the losing stock.
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2. Framing Effects
Frame dependence is the tendency of individuals to make different (and even
inconsistent) decisions depending on how a question is framed
Example: A disaster has occurred, 600 people are at risk, and you are in charge. You must choose
between the two following rescue operations:
Scenario 1
Option A
Exactly 200 people will be saved.
Option B
2/3 chance that no people will be saved and 1/3 chance that all 600 people will be saved.
Scenario 2
Option C
Exactly 400 people will die.
Option D
1/3 chance that nobody will die and 2/3 chance that all 600 will die.
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Loss Aversion – Narrow Framing
• Focusing on gains and losses, and not paying attention to the impact on wealth
Scenario 1: You are given $1,000. Then,
Option A
You can receive another $500 for sure (you’ll get a tax rebate).
Option B
You flip a fair coin. Head - you gain another $1,000; Tail - you gain nothing.
Scenario 2: You are given $2,000. Then,
Option C
You can lose $500 for sure (you’ll have to pay tax of $500).
Option D
You flip a fair coin. Head - you lose $1,000; Tail - you lose nothing.
Example: Carrying losers in the market
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Loss Aversion - Effects
• Research shows that individuals are reluctant to realize losses and will, for
example, gamble at unfavorable odds to avoid doing so: disposition effect
• Get-evenitis/break-even effect: individuals and companies hang on to bad
investments and projects (and perhaps even invest more) hoping that something
will happen that will allow them to break even and thereby escape without a loss
– “throw good money after bad”
• Poor capital budgeting: Managers may bypass positive NPV projects even if they
have very low probability of large losses (regret aversion)
• Poor financing choice: Managers may avoid debt financing as increases the
likelihood of losses and even bankruptcy
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House Money
House money: Money won from the casino
• gamblers are far more likely to take big risks with
house money - more likely to risk money that has been
“won” than that which has been “earned” (even
though both represent wealth)
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Mental Accounting
• Mental Accounting: process how people code, categorize and evaluate economic
outcomes.
 Guided by our recollection and perception of various expenditures, MA makes us keep track of
our money-related decisions so as to give us a model with which to evaluate future financial
decisions.
 Mental accounting leads to ‘personal relationship’ with each of your investments.
 Don’t get married to your investments.
• Disposition effect – tendency to sell winners and hold losers
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Biases and Frame-dependence In Play
• Investment 1: You bought 100 shares in Moore Co. for $35 per share. The shares
immediately fell to $20 each.
• Investment 2: At the same time, you bought 100 shares of Miller, Inc. for $5 per share. The
shares jumped to $20 each immediately.
• Identify the following biases and framing errors:
 Self-attribution bias: You as the great stock-picker picked a winner in Miller, Inc. Moore Co. share
price drop is just bad luck.
 Confirmation bias: You’re a genius in stock picking – see Miller, Inc.
 Disposition effect: Sell Miller, Inc. shares to realize gains; hold on to Moore Co. shares hoping for a
turnaround.
 Get-evenitis: Invest more in Moore Co. shares from the sale proceeds of Miller shares. Now the
average purchase price of Moore Co. shares are much lower.
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Other Judgment Errors with Framing
• Myopic Loss Aversion – tendency to focus on avoiding short-term losses at the
expense of long-term gains. Example: choosing safe/steady growth portfolios for
retirement savings.
• Regret Aversion – tendency to avoid making a decision to avoid making a mistake.
Example: not taking a positive NPV project because of a small probability of large
loss.
• Endowment Effect – tendency to value something you own more than something you
don’t own (mental accounting). Example: valuing stocks in your portfolio higher than
similar stocks in others’ portfolio.
• Money Illusion – tendency to not account for time value of money (i.e. ignoring
inflation)
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3. Heuristics
• Using rules of thumb, mental shortcuts, gut instinct in decision making.
Example: PBP cutoff; investment in certain geographical locations/industry.
• Types:
A.
Affect Heuristic
B.
Representativeness
Heuristic
C.
Representativeness and
Randomness
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Heuristics
A.
Affect Heuristic - Making decisions based on whether the chosen outcome or path feels “right”
emotionally - reliance on gut instinct or emotional feeling
 Instinct, intuition, and experience should be viewed as complements to formal analysis, not
substitutes
 Example: capital budgeting decisions taken based on gut instinct bypassing the market analysis
and projection of cash flows
B.
Representativeness Heuristic - Making decisions relying on stereotypes, analogies, or limited
samples to form opinions about an entire class
 Example: Expecting that any investment in cannabis industry would have a high positive NPV.
C.
Representativeness and Randomness - Perceiving patterns where none exist - clustering
illusion leading to the belief that random events that occur in clusters are not really random
 Example: Projection about the economic conditions in near future. Hot-hand illusion.
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The Gambler’s Fallacy
assumption that a departure from the average will be corrected in the short-term because an event has not happened recently, it has become overdue and is more
likely to occur.
• Law of small numbers – belief that a small sample of outcomes always resembles the
long-run distribution of outcomes
• Recency bias - recent events awarded more importance than less-recent events
• Anchoring and adjustment – staying “anchored” to old prices and inability to account for
new information in a correct way
• Aversion to ambiguity – shying away from unknown/difficult calculations and opting for
less optimal certain results
• False consensus - tendency to think that other people are thinking the same thing you
are thinking (with no real evidence). Related to confirmation bias.
• Availability bias - too much reliance on easily available information and too little weight
on information that is hard to obtain
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Summary
Behavioural finance examines how managers and investors make cognitive errors
in financial decisions
Overconfidence, overoptimism and confirmation bias are three types of biases
that can cause managers and investors to make suboptimal financial decisions
Frame dependence is the tendency to make different and inconsistent decisions
based on how a question is framed.
Heuristics are rules of thumb that can aid financial analysis in making a decision
Despite market inefficiencies, professional money managers don’t consistently
outperform the market index
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