Intro.

To Behavioral Finance
Factors Influences on Decision Making

Framing Aspects Heuristics Self-Concept

Mental Accounting Representativeness Overconfidence
Prospect Theory Availability Self-Attribution
Anchoring Cognitive Dissonanz
Self-Control
Confirmation Bias
Herding
Conservatism
I. FRAME
Which of the two programs would you favor?

Imagine that the UN is preparing for the outbreak of an

unusual Asian disease, which is expected to kill 600 people.
Two alternative programs to combat the disease have been
proposed. Assume that the exact scientific estimate of the
consequences of the program as follows;

If Program A is adopted, 200 people will be saved.

72 %
If Program B is adopted, there is 1/3 probability that 600
people will be saved, and 2/3 probability that no people will be
saved. 28 %
Mental Accounting
 Definition:
Mental Accounting is the set of cognitive operations used by individuals,
and the households to organize, evaluate, and keep tract of financial
activities (Thaler, 1999).
For example, an investor may take a lot of risk with one investment
account, but establish a very conservative position with another account
that dedicated to her child’s education.
Problem 3 A&B Problem 4
Lottery A Lottery B Lottery A+D Lottery B+C

Two
mental +
accou
nts
Problem 3 C&D =
One
Lottery C Lottery D
mental
account

Frame 1 Frame 2
Prospect Theory

 Value Function : Gains and

losses treated differently:
1. Risk aversion for gains
(concave)
2. Risk seeking for losses (convex)
3. Loss aversion (people feel
more pain when they loss than
they gain)
Steeper for loss than gains
4. Reference points
Who do investors like dividend than capital gain?

 Why do firms pay dividends, not stock

repurchase?
1.Investors like dividends because the regular cash
payment provides a simple self-control rule: spend
the dividends and leave the principal alone (Shefrin
and Statman, 1984)
2.The dividend acts like an allowance.
II. HEURISTICS

 Heuristics, often referred to as rules of thumb,

– are means of reducing the search necessary to
find a solution to a problem.

 Types of Heuristics
– Representativeness, availability, and anchoring
(Tversky and Kahneman 1982)
Representative

 Mental short cut to make decision based on

past events , that are representative or similar
to current situation
 Judging based on similarity not statistically
Representative

 Tom W is of high intelligence, although lacking in true

creativity. He has a need for order and clarity, and for neat
and tidy systems in which every detail finds its appropriate
place. His writing is rather dull and mechanical, occasionally
enlivened by somewhat corny puns and flashes of imagination
of the sci-fi type. He has a strong drive for competence. He
seems to have little feel and little sympathy for other people,
and does not enjoy interacting with others. Self-centered, he
nonetheless has a deep moral sense.
 Business administration, computer science, engineering,
humanities and education, law, medicine, library science,
physical and life sciences, social science and social work
Representative
You are the sales forecaster for a
department store chain. All stores are
similar in size and merchandise
selection, but their sales differ because
of location, competition, and random
factors. You are given the results for
2011 and asked to forecast sales for
2012. You have been instructed to
accept the overall forecast of
economists that sales will increase
overall by 10%. How would you
complete the following table? (Max
Bazerman, Judgment in Managerial
Decision Making)
Availability

 Death by accidents vs. Death by diabetes

Death by accidents was judged to be more than 300 times more likely than
death by diabetes, but the true ratio is 1:4.

 Availability is the heuristic reflecting the weight given to

information in place of probability or frequency
 The main bias of availability is due to its extreme lack of
sensitivity to sample size; by its nature, information that is
dramatically available may reflect a small sample.
 Anchoring

The median estimate was 512

The median estimate was 2,250

The correct answer was 40,320.

 Anchoring or focalism is a cognitive bias that describes the

common human tendency to rely too heavily on the first piece
of information offered (the "anchor") when making decisions.
III. SELF-CONCEPT
We are Overconfident

 Do you drive well? How do you evaluate your driving ability,

average, above, or below?
– 82% answered they are above
 If you starts new business, how big the probability of success
for yourself and how about others?
– His own success probability 70%. Others 39%
The Two Main Facets of Overconfidence
 Mis-calibration
– What is the lower and upper bound of stock price of TLKM
during past 1 years in 90% confidence interval?
– The confidence intervals are too narrow compared to the
actual variability of prices. (DeBondt, 1998; Glaser, Langer,
and Weber 2009)
 The better-than average effect.
– Consider your driving skills. Do you think that you have
above-average skills compared to the other people in this
room?
– 82 percent of a group of students rank themselves among
the 30 percent of drivers with the highest driving safety
(Svenson, 1981)
Factors Influence Overconfidence Level

 Hard Versus Easy Questions

– The overconfidence bias is most prevalent for particularly difficult
questions (Erev et al., 1994; Dawes and Mulford, 1996; Soll, 1996).
 Gender
 Generally males are more overconfident than female (Barber and
Odean, 2001).
 Culture
– Chinese subjects are more overconfident than American subjects,
while Americans are more overconfident than Japanese people in
general knowledge studies. (Yates, Lee, Shinotsuka, Patalano, and
Sieck, 1998)
– Asians are consistently more overconfident than the British (Acker
and Duck, 2008).
Disposition Effects

 Investors tend to quickly sell stocks that have appreciated in

price since purchase and hold on to losing stocks.
 Odean (1998) develops a method for measuring the
disposition effect
– (1) sold for a gain, (2) sold for a loss, (3) not sold
and showing a gain, and (4) not sold and showing
a loss.
What causes the disposition effect ?
 Prospect theory:
– An investor with preferences given by prospect theory would become more
risk-averse after experiencing gains and more risk-seeking after experiencing
losses.
 Mental accounting :
– When investors buy a stock, they create a new mental account for that stock.
Investors would then consider the value of each stock separately and
compare it to the purchase price.
 Regret aversion:
– Closing a stock position at a loss and thus having to admit a mistake may
cause regret over the initial decision to buy the stock.
 Self-control:
– Investors may find getting rid of loss-making stocks easier when faced with
explicit self-control mechanisms, such as the end of the tax year.
by Shefrin and Statman (1985)
Self Attribution

 Self Atribution is considered to underlie and

reinforce investor overconfidence whether
good (vs. bad) returns indeed make investors
believe more (vs. less) strongly that skills drive
their performance.
Avengers Effect!

Mei 2019
-3.81%
Cognitive Dissonane

 When newly acquired information conflicts with

preexisting understandings, people often
experience mental discomfort.
 An example, when we make investment decisions
that result in losses and often rationalize to relieve
dissonance. However, rationalizing to ease
cognitive dissonance (e.g. “My broker bought it for
me.” or “Its stock price hit new highs, so everyone
thought it was a good bet.”) prevents us from
learning how to avoid similar mistakes.
Self Control

 human behavioral tendency that causes people fail to

act in pursuit of their long‐term goals because of a lack
of self‐discipline.
 people are notorious for displaying a lack of self‐control
when it comes to money.
 Self‐control bias can cause investors :
– to spend more today at the expense of saving for tomorrow
& fail to plan for retirement.
– can cause asset‐allocation imbalance problem
– can also cause investors to lose sight of basic financial
principles
Confirmation Bias

 investor behavior tendencies that only want to

accept other people's input in accordance
with their thoughts, so that the input is used
to reinforce their decision.
Herding

 Herd behavior represents the tendency for an individual

to mimic the actions of a larger group, whether those
actions are rational or irrational. In many cases, herd
behavior is a set of decisions and actions that an
individual would not necessarily make on his or her own.
 Why does herd behavior happen? One reason is a strong
social pressure afforded to conformity, as most people are
very sociable and have a natural desire to be accepted by
a group, rather than be branded as an outcast.
 Example : financial crisis of 2008, which involved a real
estate bubble which burst.
Conservatism

 happens when we see an investor clinging on

to an initial opinion about an investment
without properly incorporating new
information. They consider their original view
to be more meaningful and important than
any information they learn afterwards.
Limits to Arbitrage

1. Implementation costs, example: shorselling

security entails cots.
2. Model Risk
3. Law of one Price, example : equity carve out
4. Closed End Fund, often sell for discount or
premium
Equity Carve Outs

 On 2/3/2000,
3Com sold a
fraction of its
stake in Palm
via IPO. 3Com
retained 95%
of the Palm
shares, (3Com
investors
would receive about 1.5 shares of Palm for every 3Com share they owned)
 The first day Palm trading, Palm closed at $95.06, and 3Com’s share price
fell to $ 81.81
Conclusions

 Investors
• We have bounded rationality.
• We often act based on imperfect information
• we have systematic patterns or cognitive errors in
decision making process that do not go away in the
aggregate, such that there is a positive probability
that the ‘marginal investor’ will exhibit a cognitive
bias.
 Markets
• Markets has much frictions.
Questions?