BF Lecture 2

8/7/2019 BF Lecture 2

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Behavioural FinanceTopic 3: Psychological traits

affecting behaviour

Reading: Chapters 1-3, Review Article,

Hidden Traps in Decision Making


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Psychological traits lead to errors

in decision making

All are vulnerable

Errors arise from Heuristic-driven bias

Frame dependence

Errors cause market prices to deviatefrom fundamental values


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Heuristic-driven Bias People develop general principles as

they find things out for themselves,

usually by trial and error They rely on rule of thumb to draw

inference from the information at theirdisposal

Errors are caused as the principles(heuristics) they use are imperfect as allpossibilities are not fully explored


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Principles underlying

Heuristics Availability decision based on recall

tendency to consider events more

probable if they can easily be imaginedthan if they cannot Universe of Stocks considered for acquisition

are those which are in the news Gadarowski (2001) investigated the

relationship between stock returns and presscoverage stocks with high press coverageunderperformed in the subsequent twoyears


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Heuristics contd. Representativeness stereotypes

seeing a resemblance betweenobjects or events fail to recognise regression to the mean

may apply the concept incorrectly -

gamblers fallacy law of small numbers where the data-generating process is not

known, inference is drawn too quickly onthe basis of too few data points


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Heuristics contd.HS GPA Avg. Predicted

College GPAActual CollegeGPA

2.20 2.07 2.70

3.00 2.77 2.93

3.80 3.46 3.30

Mean=3.44 Mean=3.08

SD=.36 SD=.4


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Heuristics contd. Bloomfield and Hales (2001): People tend

to overreact to changes that were

preceded by many continuations andunder-react to changes that were precededby many reversals

De Bondt (1992): long-term earningsforecasts of analysts are much moreoptimistic about recent winners than aboutrecent loosers


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Heuristics contd. Overconfidence set narrow confidence

bands to their estimates of quantities poorly calibrated in estimating probabilities Lichenstein and Fischoff (1977) gave people

market reports on 12 stocks and asked themto predict whether the stocks would rise or fallin a given period and also how confident they

are in their prediction only 47% predictionswere correct, but the mean confidence ratingwas 65%

Confuse brains with bull market Bookmakers and weathermen appear to be

better calibrated


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Heuristics contd. Anchoring when faced with uncertainty

people catch at straws

In the absence of any solid information,past prices are likely to act as anchors fortodays prices

Relative Valuation method, for example

using industry PE ratio to judge thecheapness of a stock

Analysts valuations even using a bottom-upapproach often tend towards the comfortzone of current price 5%


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Aversion to ambiguity people preferthe familiar to the unfamiliar

Home Bias in investments by fundmanagers

Coval and Moskowitz (1999) 1 in 10 stocksin a fund managers portfolio is chosenbecause it is located in the same city as themanager

Hubermann (1999) in 6 out of7 states,more people hold shares in local Baby Bellthan in any other single operator


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Heuristics contd. Benartzi (2000) own company stocks that

have done well in the past gets an allocationof40% (10% for low performers; 76% for

Coca-Cola employees) of discretionaryallocation of retirement savings ofemployees, although allocations areuncorrelated with subsequent performance

Conservatism people respond tooconservatively to new information vis--vis their original anchored position Opposite to Representativeness too much

emphasis on the prior as people fail to link

new information with the prior


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Heuristics contd. Emotion affects how people remember

events - emotional elements may lead tocognitive error

Self-attribution bias ascribing success toown talent and failure to bad luck

Hindsight bias tendency to believe, after anevent has occurred, that they predicted it

Excessive Optimism rosy view of theirabilities and prospects Belief perseverance once people have

formed opinion, they do not search forcontrary evidence and disbelieve it even ifthey get it


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Effect of Overconfidence and

Optimism on trading behaviour For individuals who sold a stock and

promptly purchased another, sold stock

outperformed the bought stock by 3.4%

in the first year One of the outcome is over-trading and

consequent loss Men trade 45% more than women and itreduced returns 2.5% pps for men and 1.7

pps for women Single men trade 67% more than single

women and this reduces their returns by 3.5pps compared to single women


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Frame Dependence The form as opposed to substance

used to describe a problem affecting thedecision made

Loss aversion loss looms larger about2.5 times of the gain at least, get even

Hedonic editing frame preference risktolerance depends upon whether it is

about gain or loss and the recentexperience A zero net investment portfolio which is long

on low accrual firms and short on high

accrual firms generated annual excess profitof over 10%


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Prospect Theory (Kahneman

and Tversky, 1979)


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Maximize Weighted Value


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Prospect Theory Choices are made based on gain or loss

rather than on wealth

Loss is weighted more than the gain Small probabilities are over-weighted

Outcomes that are certain are over-

weighted compared to outcomes that arejust probable

Prospects try to maximize the decision-weighted value function


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Frame Dependence contd. Separate Mental Accounting prospects

put in a particular frame precludesseeing through the opaque frame

Self-control lack of emotional controlmakes a particular frame preferable

Regret pain of not having made theright choice Money illusion natural way is to think

in terms of nominal values


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Summary Error in decision making by market

participants arise from two sources useof rules of thumb and influence of theway the issue is presented

These errors are pervasive

This leads to market mis-pricing

BF Lecture 2

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