Lecture 3-Foundations of behavioural finance

Question 1

What are the 5 cognitive errors that affect how people make decisions?

Answer 1

Perception and Memory

Anchoring

Overconfidence

Conservatism

Emotions

Question 2

What is perception?

Answer 2

• process by which individuals organize and interpret their sensory impressions in order to give meaning to their environment” (Robbins, 2005, p. 134).
• We all see what we want to see

Question 3

What is cognitive dissonance?

Answer 3

-when they simultaneously hold two thoughts which are psychologically inconsistent

Question 4

Perception and the frame

Answer 4

Halo effects: Someone who likes one outstanding attribute of an individual likes everything about the individual

Question 5

The 2 role of memory in financial decisions

Answer 5

• Primacy effect

- Recency effect

Question 6

What is the primacy effect

Answer 6

This is the tendency for the first items presented in a series to be remembered better or more easily, or for them to be more influential than those presented later in the series

Question 7

What is the recency effect?

Answer 7

The phenomenon that when people are asked to recall in any order the items on a list, those that come at the end of the list are more likely to be recalled than the others

Question 8

Problem with memory tricks

Answer 8

Memory is not a simple matter of information retrieval i.e. is not stored as exact replicas of reality

• It is reconstructive
• Variable with intensity i.e emotions
• Prone to self-serving distortion (Hindsight effect)

Question 9

How could information affect investment decision?

Answer 9

-The feeling that “decision” is too complicated for immediate action given large volumes of information

Question 10

Heuristics in decision making

Answer 10

decision-making shortcuts

Necessary because the world, being a complicated place, must be simplified in order to allow decisions to be made

Question 11

What are some examples of heuristics?

Answer 11

familiarity,

ambiguity aversion,

status quo bias,

representativeness,

availability

Question 12

What is anchoring and how it affects investment decision?

Answer 12

• People are initially anchored on their prior belief.
• People often make estimates of probabilities by taking an initial value or anchor and remaining focused upon it (Tversky and Kahneman 1974)

Question 13

Example of anchoring

Answer 13

The more ambiguous the value of a commodity, the more important a suggestion is likely to be, and the more important anchoring is likely to be for price determination (Shiller, 1997

Question 14

What is overconfidence?

Answer 14

• Overconfidence is when you have an inflated sense of your abilities
• Can predict the market
• Regard successes arising from expertise, failure due to bad luck

Question 15

Name 2 aspects of overconfidence

Answer 15

• Miscalibration

- Better than average effect

Question 16

What is miscalibration?

Answer 16

-It implies that your knowledge is more accurate than it really is which is measured through calibration tests

Question 17

What is an example of miscalibration effect?

Answer 17

• Ask 50 multiple choice questions
• Ask how many they got right
• Compare the answers
• Overconfident if they think they got 25 however only 15

Question 18

What is the better than average effect

Answer 18

• Unrealistic positive view of our skills or knowledge

- Many of us feel we are smarter or more skilled than average. But only 50% of us can really be better than average

Question 19

What is an example of overconfidence?

Answer 19

Most new businesses fail
2,994 new business owners were asked about chance of success

Owners thought they had a 70% chance
Owners thought their competitors had a 39% chance

Question 20

Name 5 contributing biases to overconfidence

Answer 20

• Excessive optimism
• Hindsight bias
• Confirmation and assimilation biases
• Illusion of control
• Illusion of knowledge

Question 21

What is excessive optimism?

Answer 21

• Most people exaggerate their ability to foresee the future
• Most-people over-rate their own qualities
• They see their goals as more achievable than is the case

Question 22

Problems with excessive optimism

Answer 22

disappointment, loss of self-esteem and reduced social regard

And time and money can be wasted pursuing goals that are unrealistic

Question 23

What is hindsight bias?

Answer 23

Exaggeration of what could have been predicted (Fischhoff 1982)

• Past events are seen as predictable
• False memories of accurate predictions
• “I knew that would happen”

Question 24

What is an example of hindsight bias?

Answer 24

• Buy long and short stocks
• As longing a stock hopes that it will grow in value and it went the other way, they said “I knew this was always going to happen”

Question 25

What are confirmation biases?

Answer 25

-Confirmation bias entails giving high importance to information that supports the person’s self interest or existing opinions Confirmation bias may entail looking for information that supports one’s self interest or existing opinions while ignoring conflicting data

Question 26

What is assimilation biases?

Answer 26

Assimilation bias causes people to interpret ambiguous information in a way that supports their self interest or existing opinions

Question 27

What is illusion of control

Answer 27

People often find it difficult to accept that events happen by chance (are random). They believe that they have influence over the outcome of uncontrollable events

Question 28

What is an example of illusion of control?

Answer 28

People choose their own lottery numbers, thinking they can pick the winners These illusions may cause investors to trade too much and eventually experience lower returns!

Question 29

What is illusion of knowledge

Answer 29

The illusion of knowledge entails the belief that additional information inevitably enhances decision making or better predictions The information may be irrelevant, unreliable, or beyond the person’s ability to interpret i.e the internet

Question 30

Empirical evidence for overconfidence by Fischoff 1978

Answer 30

Even when individuals express absolute certainty of being right, they were only correct in about 80% of cases (Fischhoff et al. 1978)

Question 31

What are the problems with overconfidence?

Answer 31

- Seem confident all the time | - No universally accepted way to measure overconfidence

Question 32

How does demographic impact overconfidence?

Answer 32

- The greatest offenders are men (Barber and Odean 2001 - On a survey men and women were asked what they expected the market return and their own portfolio return to be in the following 12 months Both men and women expected their portfolios to outperform the market – but gap is greater for men -Highly educated, high income are more overconfident

Question 33

Impact of overconfidence on financial decision making

Answer 33

-Because of overconfidence it is argued that investors trade securities too much, becoming undiversified

Question 34

How overconfidence affects financial managers

Answer 34

Are too ready to enter markets Overinvest Allow cash flows to dictate investment Acquire other companies too quickly Take on too much debt

Question 35

What is conservatism as a contributing bias?

Answer 35

It is defined as the observable fact that people only slowly adjust their beliefs to new information (Edwards, 1968) -Experimental research shows that it takes two to five observations to bring about a change of information or belief where in the case of Bayesian learning one observation would have been enough

Question 36

Conservatism in relation to new information?

Answer 36

The more valuable the new information, the stronger is the conservatism This is because new information that is inconsistent with existing knowledge is harder to accept

Question 37

What is emotion in relation to behavioural finance?

Answer 37

- If something is seen as good (or bad) in one respect, emotional consistency requires it to be seen as good (or bad) in other respects (i.e. you completely like it or you completely dislike it) - For example, someone who thinks that a stock will have a high return is likely to think that it has low risk (Shefrin 2001)

Question 38

Moods in relation to emotion

Answer 38

Positive moods are linked with emotions such as; Happiness hope Optimism Negative moods are linked with Happiness hope Optimism

Question 39

Categorisation of the sources of cognitive errors

Answer 39

Self-Deception Heuristic Simplification Emotions & Moods and Social/Networking Effect

Question 40

What is self deception

Answer 40

Self-deception is the process whereby people exaggerate their abilities. They think that they are better than they really are Redhead 2008:24)

Question 41

Examples of self deception

Answer 41

``` overconfidence bias conservatism bias the hindsight bias optimism or self-enhancement bias confirmation bias illusion of control ```

Question 42

What are social networking effects?

Answer 42

-Social and Networking effects produce biases from social influence The degree to which a person is influenced by the actions and thinking of others is related to a number of social factors

Question 43

Social networking effects is influence by

Answer 43

-status expertise and social mood The combination of these features can be described as socionomics