Review
Biases?
Heuristics?
Overconfidence
Optimism
Hindsight bias
Overreaction
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Which Circle is larger?
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Biases
Intuition can not be trusted!
Must be supplemented by analytical thinking
Use a ruler to dispel the illusion!
Systematic errors of judgement:bias
Normative analysis
rational solution to a decision problem
Descriptive analysis
how real people actually make decisons
Prescriptive analysis
practical advice that you can use for rational
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decisions
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Decision Making Process
Decision: a choice between gambles
outcomes of possible options are not known
in advance!
You make judgements about probabilities
You assign values to outcomes
• You combine these beliefs and values to form
preferences
Judgements can be systematically wrong!
Systematic errors of judgement are called biases!
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Which is?
The more frequent cause of death?
Homicide?
Stroke?
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Heuristics
The process by which people find things
out for themselves
Usually by trial and error!
Trial and error leads to rules of thumb
This process leads to errors
sometimes systematic errors!
These rules of thumbs themselves
came to be called heuristics!
Availability heuristic
availability bias!
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What is your best estimate?
Dow Jones 1998
Closed at 9181
DJIA does not include reinvested dividends
What would be the closing value of DJIA be?
If DJIA were redefined
• to reflect the reinvestment of all dividends?
Since May 1896
• when its value was 40
Give your Best Guess, Low guess, High Guess
• so that you feel 90% confident that true value lies
between your low guess and high guess
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Overconfidence
Highly systematic bias
• forecasts of stock prices
• forecasts of earnings per share
• trades of investors (trading too much)
People set narrow confidence bands
• high guess is too low
• low guess is too high!
Well calibrated professionals
meteorologists
• face similar problems every day
• make explicit probabilistic predictions
Gulnur Muradoglu• obtain precise and immediate feedback on outcome
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How good are you?
How good a driver are you?
Compared to drivers you encounter on the
road are you
Above-average?
Average?
Below average?
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Optimism
Optimists
exaggerate their talents
underestimate the likelihood of bad outcomes
are prone to an illusion of control
• underestimate the role of chance in human affairs
• misperceive games of chance as games of skill
Overconfidence and Optimism combined
• overestimate knowledge
• underestimate risks
• exaggerate their ability to control events
Vulnerable to statistical surprises?
Gulnur Muradoglu•
DeBondt, 1998
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Did you know?
On the day before the Bank of England
announcement, what was your estimate of the
probability that interest rates would remain
constant?
Do you think you have estimated the direction
of change in FTSE100 correctly last week?
Now, have a look at the forecasts you made last
week, have you estimated the direction of
change for FTSE100 correctly?
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Hindsight Bias
Reality looks much more obvious in
hindsight than in foresight!
People with hindsight bias
perceive events that occurred to have been
more predictable
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Hindsight Bias
People can rarely reconstruct,
after the fact, what they thought about the
probability of an event before it occurred
• Earlier estimate of probability is exaggerated after the
event occurs
Events that were not anticipated
• often appear almost inevitable after they appear
Hindsight
promotes overconfidence
• creates the illusion that the world is more predictable
than it really is
turns reasonable gambles into foolish mistakes
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Which one is more likely?
You are tossing a coin six times. Which of
the following sequences is more likely to
occur?
HHHTTT
HTHTTH
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Which one is more likely?
You have tossed five coins and observed
the following sequence
HHHHH
Now, you are tossing the sixth coin.
Heads or Tails?
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Overreaction
Human mind is pattern-seeking
biased to think that a casual factor is at work!
• perceive patterns where non exists
• have too much confidence in their judgements of
uncertain events
Fund managers that were successful
• for a few years in a row?
Odean, 1998
Individual Investors
• who sold a stock and bought an other one immediately
• the stock they sold outperformed the one they bought
by 3.5% in a year!
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Overreaction
DeBondt and Thaler, 1984
Question:
Does overreaction affect stock prices?
Answer:
Yes!
• Loser portfolios experience exceptionally larger returns
than winner portfolios (25%!)
Implication
Weak form market inefficiency
• Explanation to the January Phenomenon
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Research Design
Monthly stock price data
excess returns calculated using 3 different
benchmarks
research period 1926-1982
Portfolio formation
Start in December 1932 (t=0)
• compute excess returns for the previous 3 years
• repeat this for all non-overlapping 3 year periods
• for each portfolio formation date rank cumulative
abnormal returns from high to low
– firms in top decile constitute winner portfolio
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– firms in bottom decile constitute loser portfolio
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Analysis
Compute
cumulative abnormal returns
for all portfolios for the next 36 months
Compare
winner versus loser portfolios
Cumulative abnormal returns at t=36
each portfolios’ returns
at t=0 and t=36
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Results
Cumulative
Abnormal Returns
Loser portfolio
Winner portfolio
Months after portfolio formation
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Summary
Biases?
Heuristics?
Overconfidence
Optimism
Hindsight bias
Overreaction
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