RATIONALITY AND NON-TRADITIONAL PREFERENCESPRESENTED BYSIMRAN KAURMBA 2ND YEAR

ELLSBERG’S PARADOXES

• Daniel Ellsberg in 1961• Describes fundamental uncertainty about unknowable

probabilities• “it is impossible to infer even the qualitative problems of one

over other”• When uncertain events are associated with probabilities that

can’t be quantified, something else is needed to resolve the paradox

FEATURES OF ELLSBERG’S PARADOX

• Ambiguity aversion• Important basis point in decision making• Signifies people are irrational• Unclear decision making

RATIONALITY

• Regular tendency of acting by reason, which means in accordance with the facts of reality• Doesn’t mean being a perfectionist in one’s thoughts and

ideas• Using logic to eliminate any contradictions• Recognition of the fact that existence exists, that nothing can

alter the truth

FEATURES OF RATIONALITY

• Well defined concept• Discipline of subjecting choices• Context-independent• Exercise of power• Helps in decision making

RATIONALITY FROM ECONOMIC PERSPECTIVE• 5 axioms of cardinal utility: comparability, consistency,

independence, measurability, ranking• Aimed at making rational decisions that best match the

necessities of life of an individual, community or organization under current conditions• Completely conscious, calculated and optimization-oriented

RATIONALITY FROM EVOLUTIONARY PERSPECTIVE• Behaviour of actors is related to adaptation to the current

institutional conditions that form up the space for possible actions• Individuals follow two rules of thumb: “adherence to the

majority” and ”adherence to the minority”• Diversity of behavorial patterns, on the one hand, increases

uncertainty in decision making, while on the other hand, it improves the stability of the system against action of external shocks.

DEPENDENCE ON TIME HORIZON

• Time horizon refers to the time period associated with accomplishing an investment objective• Time horizon is anticipated time span the investor will need

before beginning to use investment returns• Always linked to asset allocation• Risk grows as time horizon increases• Problems of self-control are associated with short time horizons

DEPENDENCE ON INDIVIDUAL AND GROUP RATIONALITY• Rationality characterizing activity of a society on various

levels must rely on a certain assumption which has been touched upon the rule of competition• Group rationality is of importance because it is easier to

accept the proposition that individuals are rational than that groups are• To describe an individual as rational is to say little or nothing

since only the person himself can be the judge and virtually any kind of individual behavior can be rational

HERBERT SIMON AND BOUNDED RATIONALITY• Herbert Simon proposed the idea of bounded rationality as an

alternative basis for the mathematical modelling of decision making• Simon has coined the term “bounded rationality” in “Models of Man”• Procedural rationality is a form of psychological rationality which

constitutes the basic concept of Simon’s behavourial theory• Based on cognitive processes involving detailed empirical explorations

and procedures that are translated in algorithms

FEATURES OF BOUNDED RATIONALITY

• Superficial analysis• Strategic reasoning and strategy construction based on

reciprocity and fairness• Avoidance of circular concepts in step-by-step strategic

reasoning• Ex-post rationality• Goal incomparability

ASSUMPTIONS OF BOUNDED RATIONALITY

• Maximising strategy is the only way to get successful results• Notion of bounded rationality refers to the extent to which

individual can employ the brute force strategy• Notion of satisfying concerns the results that the limited

humans could get by employing the brute force strategy• Humans can only partly employ this strategy since their limits

and the complexity of the environment

BOUNDED-RATIONALITY DECISION MAKING MODEL• Step1: Identify the problem to be solved or goal to be defined• Step 2: Determine the minimum level or standard that all acceptable

alternatives will have to meet• Step 3: Choose one feasible alternative that will resolve the issue• Step 4: Appraise the acceptability that will resolve the issue• Step 5: Determine if it meets the minimum levels that have been established• Step 6: If the alternative is not acceptable, identify another and put it through

evaluation process• Step 7: If alternative is acceptable, implement it• Step 8: After implementation, determine how easy(or difficult) it was to

discover alternative

AVERAGE INVESTOR

• People who have some basic knowledge of the stock markets and seeks to gather information on the stocks themselves• Investors who are better at making consistent losses in the

market, instead of consistent profits• Trade a lot on emotion and ego• A good set of trading rules – Emotion = Consistent profits in

the stock market

FEATURES OF AVERAGE INVESTORS

• Limited gain• Use simple rating devices• Fear of loss• Rely on others’ information• Follow “buy and hold” strategy• Self management of portfolio• Lack of research

PROBLEMS OF AVERAGE INVESTORS• Going with the crowd• Lack of knowledge• Lack of investment acumen• Negative investors’ return• Lack of diversification• Counter-productive or biased behavior• Poor timely decisions and inadequate planning

BELIEF BIASES

• Belief is a psychological state in which an individual holds a proposition or premise to be true• Belief-bias refers to the result that happen when an

individual’s own values, beliefs, prior knowledge, etc, affects or distorts, the reasoning process through the acceptance of invalid arguments or data• Involves individual tendency to reject valid arguments with

seemingly-unbelievable conclusions

CONSERVATISM BIAS

• It states that people fail to incorporate new information by continuing to hold their prior views/forecasts• Leads to resistance to change• May cause the trader to under-react to the new information,

maintaining impressions derived from the previous estimate rather than acting on the updated information.• Increased difficulty in dealing with new information

CONFIRMATION BIAS

• Investor would be more likely to look for information that supports his/her original idea about an investment rather than seek out information that contradicts it.• Faulty decision making• Selective thinking• Peculiar and perpetual error

REPRESENTATIVENESS BIAS

• Investor rely on “best fit” to determine categories to which new information is assigned• Investors classify new information based on past experiences

and classification• 2 typesa. Base-rate neglectb. Sample-size neglect

LIMITED ATTENTION

• Explain tendency of firms to attract attention when their earnings are growing rapidly, but be ignored when they perform poorly for long periods• Necessary consequence of the vast amount of information

available in the environment, and of limits to information processing power• Selective and requires effort• Significant consequences for prices and portfolio allocation

CATEGORISATION

• Consequence of limited attention• If investors assign greater values to particular categories,

firms make efforts to move into these categories• Barberis and Shleifer: individuals do categorise – assets in

the same style such as growth and value co-move too much, while assets in different styles co-move too little • Implications for firm behaviour

PROSPECT THEORY AS NON-TRADITIONAL PREFERENCE• Prospect theory postulates utility function is concave over

some reference point• Gains are treated in risk-averse way but losses in a risk loving

way• It is hard to make clear distinction between non-classical

preferences and (potentially distorted) beliefs

LOSS AVERSION AS NON-TRADITIONAL PREFERENCE• Loss aversion suggests that it is much more difficult for

people to adjust to losses than to gains• Induces a preference for the status quo in most situations• It is exacerbated by psychological tendencies as well• Noticeable in negotiating and bargaining contexts

BUBBLES

• Originated in 1711-1720 from British South Sea Bubble• Connect situation where people have lost touch with reality• Trade in high volumes at prices that are considerably at

variance with intrinsic values• Trade in products or assets with inflated values• Excessive optimism and overconfidence are the main causes

of bubbles

TYPES OF BUBBLES

• Commodity bubble• Stock market bubble• Credit bubble• Speculative bubble• Informational bubble• Economic bubble

CAUSES OF BUBBLES

• Irrational exuberance• Herding behavior• Short-termism• Adaptive expectations• Financial instability hypothesis• Monetary policy• Global imbalance

SYSTEMATIC INVESTORS SENTIMENTS

• Measures how positive (bullish) or negative (bearish) groups of investors are about the equity markets at any given point of time• Measured by examining flows into various asset classes of

mutual funds• Can remain elevated for some time• Contrarian indicator

FACTORS AFFECTING INVESTORS’ SENTIMENT• Herd behavior• Internet led access to information and trading• Macroeconomic factors• Risk and cost factors• Best game in town• Performance factor and confidence level of institutional

investors

THANK YOU!!!