Chapter 6(a) Behavioural Economics

Question 1

What are the TWO modes of thought

- For each use (6) adjectives

Answer 1

• Intuition:
  Fast, automatic, effortless, associative, difficult to control
• Reasoning
  Slow, deliberate, demanding, rule-governed, flexible

Examples of question substituted by intuition:
Is this a good IFA - Does he come across as a nice person
How likely is it a bad event will occur( evaluating insurance) - How easily do events like this spring to mind
(People are usually blind to biases and trust intuitions)

Question 2

Why do biases affect consumer choices in retail finance more (5)

Answer 2

• Most find products complex: decisions are hard and time consuming. Can’t easily evaluate. Little inherent interest for most. Difficult to understand concepts
• Many financial decisions require assessing risk and uncertainty
• Financial decisions may require trade offs between present and future. Eg over borrow on credit card
• Many financial decisions are emotional: stress, anxiety, fear of losses and regret can drive decisions rather than cost and benefits. Eg fear might drive of expensive insurance on mobile
• difficult to learn about financial products: decisions made infrequently without consequences revealed for a long time

Question 3

• Three Preference Bias

Answer 3

• Present Bias: immediate gratification. Overvalue present over future. Can lead to procrastination . Example taking a loan without thought to how repay
• Reference dependence and loss aversion: GAins and losses relative to a reference point .Losses felt x2 as gains - underweight gains and overweight losses. Same outcome can be frames as gain or loss depending on reference point. Example add on insurance PE received cheap to reference of higher value
• Regret and other emotion: act to avoid ambiguity or stress. DIstorted by temporary emotions (Fear)
  Example: buying expensive insurance for peace of mind even though unlikely to need it

Question 4

Three Belief Bias

Answer 4

• Overconfidence: of good events or own ability, including accuracy of judgement
  Example - excessive belief in ability to pick winning stocks
• Over extrapolation: Predictions on back of few observations when these aren’t representative
  Example - using just a few years returns to base decisions , without considering if they are representative or special circumstances, for instance
• Projection Bias: expectation current tastes and preferences will stay same in future. Underestimate possibility of change
  Example- tying up funds without considering need for money if needed in short term,

Question 5

Decision Making

Answer 5

Mental Accounting- Treat money allocated for different purposes differently, rather than all the same

Framing - Can determine what and how information is processed. Consumer may make different choice to two identical situations depending on how framed eg What draws attention to. Attention drawn to particularly salient aspects of situation which can influence
Example - overestimating value of packaged product because presented in attractive way, highlighting benefits and under emphasising charges

Question 6

Prospect Theory
Regret Theory
Overconfidence and over/.under reaction
Cognitive bias & cognitive confirmation
Loss aversion
Inertia

Answer 6

• Prospect Theory - Investors not always rational - gains/losses viewed differently
• Regret Theory : reluctance t realise losses, loss more distressing than equivalent gain is rewarding - sell winners /hold losers
• Overconfidence and over/under reaction
  Overestimate own skills in predicting success, underestimate inability to influence negative outcomes. Eg driving skills, ability to pick investments
  Assume short terms trends will be the norm, without reference to historical data or statistics
• Cognitive Bias & Cognitive confirmation
• Anchoring = rounding
  Loss Aversion - Fear of loss. Fear of loss outweighs potential gains
  People delay locking in a loss - strong desire to recover rather than take loss
• Inertia : fail to take action - Have second thoughts “wait and see”

Question 7

Framing

Present bias

Answer 7

-Framing: 80% fat free - contains 20% fat. Pick 80% fat free.
People will pick up on positive message

• Present bias - £20 now or £40 in a week. Biggest influence between present self and future self.Immediate gratification
• Confirmation bias - Where you have an opinion, seek out evidence that only supports that view, whilst ignoring evidence that could prove you wrong

Question 8

Loss Aversion

Overconfidence

Mental accounting
Anchoring _

Answer 8

Loss aversion- Fear of losing money on investments. Markets falling - make you act. Underweight gains and overweight losses

Overconfidence - Timing market/convinced prices will fall or their own ability (pick winning stocks)

Mental accounting - compartmentalising each asset/ not looking at overall position

Anchoring - place too much emphasis on first piece of information you see.Anchor to a figure/value

Question 9

Biases are likely to affect decisions in financial markets (5)

Answer 9

• Consumers find products complex
• Many decisions require assessing risk and uncertainty - people are bad at this
• Decisions may require trade off between present & future - procrastination
• Many financial decisions are emotional
• difficult to lear about financioal products

Question 10

Over extrapolation

Projection bias

Answer 10

• people making decisions on the basis of a few observations eg using just a few years past returns to base judgement
• People expect tastes and preferences to continue and underestimate possibility of change