Lecture 3-Foundations of behavioural finance Flashcards
What are the 5 cognitive errors that affect how people make decisions?
Perception and Memory
Anchoring
Overconfidence
Conservatism
Emotions
What is perception?
- 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
What is cognitive dissonance?
-when they simultaneously hold two thoughts which are psychologically inconsistent
Perception and the frame
Halo effects: Someone who likes one outstanding attribute of an individual likes everything about the individual
The 2 role of memory in financial decisions
- Primacy effect
- Recency effect
What is the primacy effect
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
What is the recency effect?
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
Problem with memory tricks
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)
How could information affect investment decision?
-The feeling that “decision” is too complicated for immediate action given large volumes of information
Heuristics in decision making
decision-making shortcuts
Necessary because the world, being a complicated place, must be simplified in order to allow decisions to be made
What are some examples of heuristics?
familiarity,
ambiguity aversion,
status quo bias,
representativeness,
availability
What is anchoring and how it affects investment decision?
- 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)
Example of anchoring
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
What is overconfidence?
- 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
Name 2 aspects of overconfidence
- Miscalibration
- Better than average effect
What is miscalibration?
-It implies that your knowledge is more accurate than it really is which is measured through calibration tests
What is an example of miscalibration effect?
- Ask 50 multiple choice questions
- Ask how many they got right
- Compare the answers
- Overconfident if they think they got 25 however only 15
What is the better than average effect
- 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
What is an example of overconfidence?
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
Name 5 contributing biases to overconfidence
- Excessive optimism
- Hindsight bias
- Confirmation and assimilation biases
- Illusion of control
- Illusion of knowledge
What is excessive optimism?
- 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
Problems with excessive optimism
disappointment, loss of self-esteem and reduced social regard
And time and money can be wasted pursuing goals that are unrealistic
What is hindsight bias?
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”
What is an example of hindsight bias?
- 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”
What are confirmation biases?
-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
What is assimilation biases?
Assimilation bias causes people to interpret ambiguous information in a way that supports their self interest or existing opinions
What is illusion of control
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
What is an example of illusion of control?
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!
What is illusion of knowledge
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
Empirical evidence for overconfidence by Fischoff 1978
Even when individuals express absolute certainty of being right, they were only correct in about 80% of cases (Fischhoff et al. 1978)
What are the problems with overconfidence?
- Seem confident all the time
- No universally accepted way to measure overconfidence
How does demographic impact overconfidence?
- 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
Impact of overconfidence on financial decision making
-Because of overconfidence it is argued that investors trade securities too much, becoming undiversified
How overconfidence affects financial managers
Are too ready to enter markets
Overinvest
Allow cash flows to dictate investment
Acquire other companies too quickly
Take on too much debt
What is conservatism as a contributing bias?
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
Conservatism in relation to new information?
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
What is emotion in relation to behavioural finance?
- 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)
Moods in relation to emotion
Positive moods are linked with emotions such as;
Happiness
hope
Optimism
Negative moods are linked with
Happiness
hope
Optimism
Categorisation of the sources of cognitive errors
Self-Deception
Heuristic Simplification
Emotions & Moods and
Social/Networking Effect
What is self deception
Self-deception is the process whereby people exaggerate their abilities. They think that they are better than they really are Redhead 2008:24)
Examples of self deception
overconfidence bias conservatism bias the hindsight bias optimism or self-enhancement bias confirmation bias illusion of control
What are social networking effects?
-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
Social networking effects is influence by
-status
expertise and
social mood
The combination of these features can be described as socionomics
