Behavioral Finance
Content
HAMAYOON AKHTAR CHEEMA MBA 5th
overconfidencecan be summarized as unwarranted faith in one’s intuitive reasoning, judgments,and cognitive abilities. The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information they’ve been given. Specifically, the confidence intervals that investors assign to their investment predictions are too narrow. This type of overconfidence can be called prediction overconfidence. Investors are often also too certain of their judgments. We will refer to this type of overconfidence as certainty overconfidence Repreentative: In order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts. Similarly, people tend to perceive probabilities and odds that resonate with their own preexisting ideas—even when the resulting conclusions drawn are statistically invalid. In base-rate neglect, investors attempt to determine the potential success of, say, an investment in Company A by contextualizing the venture in a familiar, easy-to-understand classification scheme. In sample-size neglect, investors, when judging the likelihood of a particular investment outcome, often fail to accurately consider the sample size of the data on which they base their judgments. When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis. Anchoring and adjustmentis a psychological heuristic that influences the way people intuit probabilities. Rational investors treat these new pieces of information objectively and do not reflect on purchase prices or target prices in deciding how to act. When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort— a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology,represent attitudes, emotions, beliefs, or values;and cognitive dissonanceis a state of imbalance that occurs when contradictory cognitions intersect. Selective perception. Subjects suffering from selective perception only register information that appears to affirm a chosen course, thus producing a view of reality that is incomplete and, hence, inaccurate. Selective decision making. Selective decision making usually occurs when commitment to an original decision course is high. Selective decision making rationalizes actions that enable a person to adhere to that course, even if at an exorbitant economic cost. The availability bias is a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives. People often inadvertently assume that readily available thoughts, ideas, or images represent unbiased indicators of statistical probabilities. There are several categories of availability bias, of which the four that apply most to investors are: (1)retrievability, Retrievability.Ideas that are retrievedmost easily also seem to be the most credible, though this is not necessarily the case. (2) categorization, Here, we will discuss how people attempt to categorize or summon information that matches a certain reference. (3) narrow range of experience, and : Narrow range of experience.When a person possesses a toorestrictive frame of reference from which to formulate an objective estimate, then narrow range of experience biasoften results. (4)resonance. Resonance. The extent to which certain, given situations resonate vis-à-vis individuals’ own, personal situations can also influence judgment. Self-attribution bias(or self-serving attributional bias) refers to the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck. Selfattribution is a cognitive phenomenon by which people attribute failures to situational factors and successes to dispositional factors. Self-serving bias can actually be broken down into twoconstituent tendencies or subsidiary biases. 1.Self-enhancing bias represents people’s propensity to claim an irrational degree of credit for their succession 2.Selfprotecting bias represents the corollary effect—the irrational denial of responsibility for failure. The illusion of control bias describes the tendency of human beings to believe that they can control or at least influence outcomes when, in fact, they cannot. This bias can be observed in Las Vegas…Ellen Langer, Ph.D., of Harvard
University’s psychology department, defines the illusion of control bias as the “expectancy of a personal success probability inappropriately higher than the objective probability would warrant. Conservatism biasis a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information. Conservatism bias may cause the investor to underreactto the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information. Conservatism causes individuals to overweight base rates and to underreact to sample evidence. People do not like to gamble when probability distributions seem uncertain. In general, people hesitate in situations of ambiguity, a tendency referred to as ambiguity aversion. people dislike uncertainty (ambiguity) more than they dislike risk. Frank H. Knight,of the University of Chicag o, was one of the twentieth century’s most eclectic, thoughtful economists and one of the first to write on ambiguity aversion. Knight’s 1921 dissertation, entitled “Risk, Uncertainty, and Profit,” Leonard J. Savage, author of the classic 1954 book The Foundations of Statistics, developed “Subjective Expected Utility Theory” (SEUT) as a counterpart to the expected utility concept in economics. This theory states that, under certain conditions, an individual’s expectation of utility is weighted by that individual’s subjective probability assessment. The experiment suggests that people do not like situations where they are uncertain about the probability distribution of a gamble. People who exhibit endowment bias value an asset more when they hold property rights to it than when they don’t.Endowment bias can affect attitudes tEndowment biasis described as a mental process in which a differential weight is placed on the value of an object. That value depends on whether one possesses the object and is faced with its loss or whether one does not possess the object and has the potential to gain it.oward items owned over long periods of time or can crop up immediately as the item is acquired. Simply put, self-control biasis a human behavioral tendency that causes people to consume today at the expense of saving for tomorrow. Money is an area in which people are notorious for displaying a lack of self-control. The technical description of self-control bias is best understood in the context of the life-cycle hypothesis, which describes a welldefined link between the savings and consumption tendencies Most people have heard of “rose-colored glasses”and know that those who wear them tend to view the world with undue optimism. Empirical studies referred to in previous chapters demonstrate that, with respect to almost any personal trait perceived as positive—driving ability, good looks, sense of humor, physique, expected longevity,and so on—most people tend to rate themselves as surpassing the population mean. Many overly optimistic investors believe that bad investments will not happen to them—they will only afflict “others.Nobel Prize winner Daniel Kahneman, of Princeton University, and Daniel Lovallo, of the University of New South Wales, Australia, describe optimism biasin more technical terms. They note a tendency of investors to adopt an inside view, in lieu of the outside view that is often more appropriate when making financial decisions.1 An inside view is one that focuses on a current situation and reflects personal involvement. An outside view, however, dispassionately assesses a current situation in the context of results obtained in past, related situations. First coined by University of Chicago professorRichard Thaler, mental accounting describes people’s tendency to code categorize, and evaluate economic outcomes by grouping their assets into any number of nonfungible (noninterchangeable) mental accounts. A completely rational person would never succumb to this sort of psychological process because mental accounting causes subjects to take the irrational step of treating various sums of money differently based on where these sums are mentally categorized, In framing, people alter their perspectives on money and investments according to the surrounding circumstances that they face. Mental accounting refers to the coding, categorization, and evaluation of financial decisions. Confirmation biasrefers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs. To describe this phenomenon another way, we might say that confirmation bias refers to our all-too-natural ability to convince ourselves of whatever it is that we want to believe. Confirmation bias can be
thought of as a form of selection bias in collecting evidence for supporting certain beliefs, whereby decision makers observe, overvalue, or actively seek out information that confirms their claims, while simultaneously ignoring or devaluing evidence that might discount their claims. Described in simple terms, hindsight biasis the impulse that insists: “I knew it all along!” Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable—even if it wasn’t.Hindsight bias has been demonstrated in experiments involving investing—a few of which will be examined shortly—as well as in other diverse settings, ranging from politics to medicine. Hindsight bias is the tendency of people, with the benefit of hindsight following an event, to falsely believe that they predicted the outcome of that event in the beginning. Hindsight bias affects future forecasting. Loss aversion biaswas developed by Daniel Kahneman and Amos Tversky in 1979 as part of the original prospect theory 1 specifically, in response to prospect theory’s observation that people generally feel a stronger impulse to avoid losses than to acquire gains. Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. According to Kahneman and Tversky, people weigh all potential gains and losses in relation to some benchmark reference point Recency biasis a cognitive predisposition that causes people to more prominently recall and emphasize recent events and observations than those that occurred in the near or distant past . In order to best understand the technical description of recency bias, it is helpful to examine human memory recall testing, the two main components of which are primacy effect and therecency effect. The primacy effectdescribes the left portion of the U shape, that is, the elevated portion at the beginning of the curve, which precedes the concavity at the middle The recency effectdescribes the right portion of the serial position curve. People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision making. Regret aversion also makes people unduly apprehensive about breaking into financial markets that have recently generated losses. An extensive body of literature in experimental psychology suggests that regret does influence decision making under conditions of uncertainty. Regret causes people to challenge past decisions and to question their beliefs. People who are regret averse try to avoid distress arising from two types of mistakes: (1) errors of commission and (2) errors of omission. Errors of commissionoccur when we take misguided actions. Errors of omissionarise from misguided inaction, that is, opportunities overlooked or foregone. Regret is different from disappointment.. Framing biasnotes the tendency of decision makers to respond to various situations differently based on the context inwhich a choice is presented (framed). In real life, people usually benefit from some flexibility in determining how to address the problems they face. People subject to framing experience an optical illusion, which leads them to insist that the line on the bottom is longer. A decision frameis the decision maker’s subjective conception of the acts, outcomes, and contingencies associated with a particular choice. Framing bias also encompasses a subcategorical phenomenon known as narrow framing, which occurs when people focus too restrictively on one or two aspects of a situation, excluding other crucial aspects and thus compromising their decision making. Status quo bias, a term coined by William Samuelson and Richard Zeckhauser in 1988, 1 is an emotional bias that predisposes people facing an array of choice options to elect whatever option ratifies or extends the existing condition in lieu of alternative options that might bring about change. In other words, status quo bias operates in people who prefer for things to stay relatively the same. Status quo bias refers to the finding that an option is more desirable if it is designated as the “status quo” than when it is not. Status quo bias is often discussed in tandem with other biases, namely endowment bias (see Chapter 13) and loss aversion bias
overconfidencecan be summarized as unwarranted faith in one’s intuitive reasoning, judgments,and cognitive abilities. The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information they’ve been given. Specifically, the confidence intervals that investors assign to their investment predictions are too narrow. This type of overconfidence can be called prediction overconfidence. Investors are often also too certain of their judgments. We will refer to this type of overconfidence as certainty overconfidence Repreentative: In order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts. Similarly, people tend to perceive probabilities and odds that resonate with their own preexisting ideas—even when the resulting conclusions drawn are statistically invalid. In base-rate neglect, investors attempt to determine the potential success of, say, an investment in Company A by contextualizing the venture in a familiar, easy-to-understand classification scheme. In sample-size neglect, investors, when judging the likelihood of a particular investment outcome, often fail to accurately consider the sample size of the data on which they base their judgments. When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis. Anchoring and adjustmentis a psychological heuristic that influences the way people intuit probabilities. Rational investors treat these new pieces of information objectively and do not reflect on purchase prices or target prices in deciding how to act. When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort— a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology,represent attitudes, emotions, beliefs, or values;and cognitive dissonanceis a state of imbalance that occurs when contradictory cognitions intersect. Selective perception. Subjects suffering from selective perception only register information that appears to affirm a chosen course, thus producing a view of reality that is incomplete and, hence, inaccurate. Selective decision making. Selective decision making usually occurs when commitment to an original decision course is high. Selective decision making rationalizes actions that enable a person to adhere to that course, even if at an exorbitant economic cost. The availability bias is a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives. People often inadvertently assume that readily available thoughts, ideas, or images represent unbiased indicators of statistical probabilities. There are several categories of availability bias, of which the four that apply most to investors are: (1)retrievability, Retrievability.Ideas that are retrievedmost easily also seem to be the most credible, though this is not necessarily the case. (2) categorization, Here, we will discuss how people attempt to categorize or summon information that matches a certain reference. (3) narrow range of experience, and : Narrow range of experience.When a person possesses a toorestrictive frame of reference from which to formulate an objective estimate, then narrow range of experience biasoften results. (4)resonance. Resonance. The extent to which certain, given situations resonate vis-à-vis individuals’ own, personal situations can also influence judgment. Self-attribution bias(or self-serving attributional bias) refers to the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck. Selfattribution is a cognitive phenomenon by which people attribute failures to situational factors and successes to dispositional factors. Self-serving bias can actually be broken down into twoconstituent tendencies or subsidiary biases. 1.Self-enhancing bias represents people’s propensity to claim an irrational degree of credit for their succession 2.Selfprotecting bias represents the corollary effect—the irrational denial of responsibility for failure. The illusion of control bias describes the tendency of human beings to believe that they can control or at least influence outcomes when, in fact, they cannot. This bias can be observed in Las Vegas…Ellen Langer, Ph.D., of Harvard
University’s psychology department, defines the illusion of control bias as the “expectancy of a personal success probability inappropriately higher than the objective probability would warrant. Conservatism biasis a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information. Conservatism bias may cause the investor to underreactto the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information. Conservatism causes individuals to overweight base rates and to underreact to sample evidence. People do not like to gamble when probability distributions seem uncertain. In general, people hesitate in situations of ambiguity, a tendency referred to as ambiguity aversion. people dislike uncertainty (ambiguity) more than they dislike risk. Frank H. Knight,of the University of Chicag o, was one of the twentieth century’s most eclectic, thoughtful economists and one of the first to write on ambiguity aversion. Knight’s 1921 dissertation, entitled “Risk, Uncertainty, and Profit,” Leonard J. Savage, author of the classic 1954 book The Foundations of Statistics, developed “Subjective Expected Utility Theory” (SEUT) as a counterpart to the expected utility concept in economics. This theory states that, under certain conditions, an individual’s expectation of utility is weighted by that individual’s subjective probability assessment. The experiment suggests that people do not like situations where they are uncertain about the probability distribution of a gamble. People who exhibit endowment bias value an asset more when they hold property rights to it than when they don’t.Endowment bias can affect attitudes tEndowment biasis described as a mental process in which a differential weight is placed on the value of an object. That value depends on whether one possesses the object and is faced with its loss or whether one does not possess the object and has the potential to gain it.oward items owned over long periods of time or can crop up immediately as the item is acquired. Simply put, self-control biasis a human behavioral tendency that causes people to consume today at the expense of saving for tomorrow. Money is an area in which people are notorious for displaying a lack of self-control. The technical description of self-control bias is best understood in the context of the life-cycle hypothesis, which describes a welldefined link between the savings and consumption tendencies Most people have heard of “rose-colored glasses”and know that those who wear them tend to view the world with undue optimism. Empirical studies referred to in previous chapters demonstrate that, with respect to almost any personal trait perceived as positive—driving ability, good looks, sense of humor, physique, expected longevity,and so on—most people tend to rate themselves as surpassing the population mean. Many overly optimistic investors believe that bad investments will not happen to them—they will only afflict “others.Nobel Prize winner Daniel Kahneman, of Princeton University, and Daniel Lovallo, of the University of New South Wales, Australia, describe optimism biasin more technical terms. They note a tendency of investors to adopt an inside view, in lieu of the outside view that is often more appropriate when making financial decisions.1 An inside view is one that focuses on a current situation and reflects personal involvement. An outside view, however, dispassionately assesses a current situation in the context of results obtained in past, related situations. First coined by University of Chicago professorRichard Thaler, mental accounting describes people’s tendency to code categorize, and evaluate economic outcomes by grouping their assets into any number of nonfungible (noninterchangeable) mental accounts. A completely rational person would never succumb to this sort of psychological process because mental accounting causes subjects to take the irrational step of treating various sums of money differently based on where these sums are mentally categorized, In framing, people alter their perspectives on money and investments according to the surrounding circumstances that they face. Mental accounting refers to the coding, categorization, and evaluation of financial decisions. Confirmation biasrefers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs. To describe this phenomenon another way, we might say that confirmation bias refers to our all-too-natural ability to convince ourselves of whatever it is that we want to believe. Confirmation bias can be
thought of as a form of selection bias in collecting evidence for supporting certain beliefs, whereby decision makers observe, overvalue, or actively seek out information that confirms their claims, while simultaneously ignoring or devaluing evidence that might discount their claims. Described in simple terms, hindsight biasis the impulse that insists: “I knew it all along!” Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable—even if it wasn’t.Hindsight bias has been demonstrated in experiments involving investing—a few of which will be examined shortly—as well as in other diverse settings, ranging from politics to medicine. Hindsight bias is the tendency of people, with the benefit of hindsight following an event, to falsely believe that they predicted the outcome of that event in the beginning. Hindsight bias affects future forecasting. Loss aversion biaswas developed by Daniel Kahneman and Amos Tversky in 1979 as part of the original prospect theory 1 specifically, in response to prospect theory’s observation that people generally feel a stronger impulse to avoid losses than to acquire gains. Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. According to Kahneman and Tversky, people weigh all potential gains and losses in relation to some benchmark reference point Recency biasis a cognitive predisposition that causes people to more prominently recall and emphasize recent events and observations than those that occurred in the near or distant past . In order to best understand the technical description of recency bias, it is helpful to examine human memory recall testing, the two main components of which are primacy effect and therecency effect. The primacy effectdescribes the left portion of the U shape, that is, the elevated portion at the beginning of the curve, which precedes the concavity at the middle The recency effectdescribes the right portion of the serial position curve. People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision making. Regret aversion also makes people unduly apprehensive about breaking into financial markets that have recently generated losses. An extensive body of literature in experimental psychology suggests that regret does influence decision making under conditions of uncertainty. Regret causes people to challenge past decisions and to question their beliefs. People who are regret averse try to avoid distress arising from two types of mistakes: (1) errors of commission and (2) errors of omission. Errors of commissionoccur when we take misguided actions. Errors of omissionarise from misguided inaction, that is, opportunities overlooked or foregone. Regret is different from disappointment.. Framing biasnotes the tendency of decision makers to respond to various situations differently based on the context inwhich a choice is presented (framed). In real life, people usually benefit from some flexibility in determining how to address the problems they face. People subject to framing experience an optical illusion, which leads them to insist that the line on the bottom is longer. A decision frameis the decision maker’s subjective conception of the acts, outcomes, and contingencies associated with a particular choice. Framing bias also encompasses a subcategorical phenomenon known as narrow framing, which occurs when people focus too restrictively on one or two aspects of a situation, excluding other crucial aspects and thus compromising their decision making. Status quo bias, a term coined by William Samuelson and Richard Zeckhauser in 1988, 1 is an emotional bias that predisposes people facing an array of choice options to elect whatever option ratifies or extends the existing condition in lieu of alternative options that might bring about change. In other words, status quo bias operates in people who prefer for things to stay relatively the same. Status quo bias refers to the finding that an option is more desirable if it is designated as the “status quo” than when it is not. Status quo bias is often discussed in tandem with other biases, namely endowment bias (see Chapter 13) and loss aversion bias
