Meeting 3: Tutorial – Human Decision Making
Behavioral Finance = application of psychology to financial behaviors and studies how investors (individuals and groups) behave
and why. It provides insight into how emotional and cognitive biases and errors may influence investment decisions.
Standard finance Behavioral finance
• Rational investors • Normal investors
• MV efficient portfolios (MVPT) • Behavioral-wants efficient portfolios (BPT)
• Standard asset pricing theory where • Behavioral asset pricing theory where returns are determined
returns are determined by only risk by not only risk, but also social status or responsibility
• Markets are efficient as in prices equal • Market are not efficient as in prices equal values, but are
values, and are impossible to beat efficient in that they are hard to beat
SF: rational people do not buy lottery tickets
BF: normal people buy lottery tickets for the emotional benefits of hope of winning and the utilitarian benefits of the miniscule
odds of winning
Chapter 1: Normal People
Example: $10 rose as a gift, which has no utilitarian benefits so a rational person would give the $10 so the woman can buy
something for herself and maximize her utility function. But normal people don’t think like this and know a rose has expressive,
and emotional benefits. Investments are like roses, i.e. have utilitarian, expressive and emotional benefits, and we would miss
many insight into behavior if we only look at them as utilitarian. Normal people want more than purely the utilitarian benefits of
wealth.
Rational people Normal people
• Seeking only utilitarian benefits. Never sacrifice • Seeking utilitarian but also emotional and expressive
wealth for emotional or expressive. benefits. Can sacrifice wealth for emotional or expressive.
• Immune to cognitive and emotional errors (markets • Susceptible to cognitive and emotional errors, such as
are efficient) overconfidence, exaggerated fear or hope; difficult to
overcome (not irrational but can make errors)
• Indifferent how wealth is realized, only portfolios on • Care about how wealth is accumulated such as social
the efficient frontier based on mean-variance trade- responsibility, status. Portfolio constructed as described by
off. MVPT BPT.
• Never commit framing errors, has perfect • Frame wealth into distinct mental accounts, imperfect
knowledge, unlimited processing power and speed knowledge/ignorance, limited processing power and speed
Example framing error: rational people are indifferent between capital gain or dividend, while normal people however are not
indifferent because they perceive capital gain and dividend different i.e. follow the rule spend dividends, but don’t touch into
capital. They are not indifferent to company paid dividends and ‘homemade’ dividends as rational investors.
1. Cognitive and Emotional Shortcuts and Errors
Rational people’s brains are never full i.e. able to rank all relevant variables according to sets of benefits and costs and make the
best decision. E.g., ranking all restaurants on all available variables.
Normal people’s brains are often full and cope by creating a cognitive shortcut simplifying the problem i.e. decrease the number
of variables or levels within variables and emotional shortcut (preferences) = heuristics, quick and possibly dirty decision rule.
E.g., normal people limit restaurant options to 2km, or dishwasher to 1 brand. Good shortcuts take us close to the best choices,
but can turn into errors when they don’t (= bias).
2. System 1 and System 2
System 1 = intuition (blink), automatic, fast, effortless (= cognitive and emotional shortcuts); System 2 = reflection (think),
controlled, slow, effortful (when intuition misleads).
System 1 is necessary when you’re attacked by a lion. But system 1 can induce you into thinking dividend paying stock give
higher returns, while System 2 says this is not necessarily the case.
Rational people use System 2 whenever System 1 misleads. Normal people disregard System 2 outcomes whenever System 1
provides the answer. However, normal people differ from ignorant to knowledgeable, and knowledgeable people can learn to
use System 2.
3. Three Kinds of Knowledge in the context of finance
1. Financial-facts knowledge: includes facts about financial markets; stocks, bonds, other investments; benefits of diversification,
drawbacks of investment fees, difficulty of beating the market
2. Human-behavior knowledge: includes knowledge about
a. wants e.g. riches, social status, adherence to values (Chapter 2)
b. cognitive shortcuts and errors, e.g. framing, hindsight, confirmation (Chapter 3)
c. emotional shortcuts and errors e.g. hope, fear, pride, regret (Chapter 4)
1
, 3. Information knowledge (separated on availability)
d. Exclusively available (private/inside information): to 1 person such as the CEO
e. Narrowly available: to 2,3, a dozen executives of a company, analysts, readers of publications geared to
industry or technology experts
f. Widely available: to everyone but does not imply everyone actually knows that information such as major
newspapers
4. From Ignorant to Knowledgeable (transformation)
Sunk costs = have already been incurred and cannot be salvaged. Because they cannot be recovered, they should not be taken
into consideration when making rational decisions only avoiding further sunk costs, even when probed otherwise by cognitive
and emotional errors (“I can’t sell now etc.”).
Ignorant people have not learned to move beyond intuitive System 1, even when it misleads and often mistrust financial-facts
knowledge e.g. it is a financial fact that it is difficult to forecast stock prices, but the average person thinks it is not so difficult.
Knowledgeable people learn from experience and financial facts knowledge, i.e. transform themselves from normal-ignorant to
normal-knowledgeable.
Heuristics and biases may cause harm but we can also use them to improve decision making, such as using framing to nudge
investors to make the right decision. Bias = negative outcome/ error because of heuristic
Conclusion:
Rational people want only utilitarian benefits from investments (wealth) and don’t make cognitive or emotional errors, whereas
normal people also want expressive and emotional benefits (social responsibility and status) and are susceptible to cognitive
and emotional errors. System 1 shortcuts can lead to good choices but also errors and should learn to use System 2.
Chapter 2: Wants for Utilitarian, Expressive, and Emotional Benefits
People want 3 kinds of benefits: 1. utilitarian (satisfaction/utility), 2. expressive (convey values, tastes and social status), and
3. emotional (give feelings). Utilitarian benefits of two investments are identical when they yield identical return, but
satisfaction they yield varies by expressive and emotional benefits. Therefore, preferences and satisfaction influences risk
preferences, return beliefs, trading decisions.
Trade-offs between wants, e.g. between utilitarian benefits of great wealth and expressive and emotional benefits of adherence
to values. Conflicts between our wants and wants of others, e.g. conflicts between benefits received by corporate managers and
shareholders, money managers and investors, financial advisors and clients.
1. Want for Riches and Protection from Poverty
Hope for riches: encourages people to invest entire portfolio in stocks and lottery tickets (upside potential)
Fear of poverty: encourages us to invest entire portfolio in government bonds and hold tightly to Social Security (downside
protection). We balance wants by dividing money into layers of portfolio pyramids (= BPT).
2. Want to nurture our children and families
Provide education, inheritance, and financial support to children.
3. Want to Play Games and Win
We want to satisfy wants for utilitarian, expressive and emotional benefits of playing and winning, e.g. trading. Traders prefer
lottery-like stocks whose return distributions are skewed toward high returns. We want to be aroused and entertained.
4. Want to Demonstrate Competence
Ambiguity (uncertainty) aversion = preference of known risks to unknown risks. May arise from expressive and emotional
benefits gained by demonstrating competence to others and ourselves. Consequences of bets include emotional payoffs of
satisfaction or embarrassment, either from self-evaluation or from an evaluation by others. Investors who perceive themselves
as more competent trade more frequently as they want to demonstrate this.
5. Want to Stay True to Our Values
Values of investors vary and direct our wants for particular utilitarian, expressive, and emotional benefits, e.g. mutual funds can
choose to invest only in socially responsible companies, exclude weapon manufacturers or companies polluting the environment
Changes in circumstances affect trade-offs between utilitarian, expressive, and emotional benefits. For example, during 2008
financial crisis, expressive and emotional cost of mortgage defaults weakened (less stigma/shame)
6. Wants for High Social Status
Some investments are done to convey social status, such as movies, paintings and other collectibles providing expressive and
emotional benefits. Commonly described as “emotional assets” paying “emotional dividends” which offset the low utilitarian
benefits. Also true for investment in start-ups, hedge funds or private banks.
7. Wants for Fairness
We want fairness but it can be considered differently among people, e.g. how we view insider trading. We want equal power
(income equality) and freedom from coercion.
8. Wants to Pay no Taxes
Tax-saving strategies deliver utilitarian, expressive and emotional benefits. People express themselves as high-income investors
with social status is as high as tax bracket, and smart to avoid taxes.
2
Behavioral Finance = application of psychology to financial behaviors and studies how investors (individuals and groups) behave
and why. It provides insight into how emotional and cognitive biases and errors may influence investment decisions.
Standard finance Behavioral finance
• Rational investors • Normal investors
• MV efficient portfolios (MVPT) • Behavioral-wants efficient portfolios (BPT)
• Standard asset pricing theory where • Behavioral asset pricing theory where returns are determined
returns are determined by only risk by not only risk, but also social status or responsibility
• Markets are efficient as in prices equal • Market are not efficient as in prices equal values, but are
values, and are impossible to beat efficient in that they are hard to beat
SF: rational people do not buy lottery tickets
BF: normal people buy lottery tickets for the emotional benefits of hope of winning and the utilitarian benefits of the miniscule
odds of winning
Chapter 1: Normal People
Example: $10 rose as a gift, which has no utilitarian benefits so a rational person would give the $10 so the woman can buy
something for herself and maximize her utility function. But normal people don’t think like this and know a rose has expressive,
and emotional benefits. Investments are like roses, i.e. have utilitarian, expressive and emotional benefits, and we would miss
many insight into behavior if we only look at them as utilitarian. Normal people want more than purely the utilitarian benefits of
wealth.
Rational people Normal people
• Seeking only utilitarian benefits. Never sacrifice • Seeking utilitarian but also emotional and expressive
wealth for emotional or expressive. benefits. Can sacrifice wealth for emotional or expressive.
• Immune to cognitive and emotional errors (markets • Susceptible to cognitive and emotional errors, such as
are efficient) overconfidence, exaggerated fear or hope; difficult to
overcome (not irrational but can make errors)
• Indifferent how wealth is realized, only portfolios on • Care about how wealth is accumulated such as social
the efficient frontier based on mean-variance trade- responsibility, status. Portfolio constructed as described by
off. MVPT BPT.
• Never commit framing errors, has perfect • Frame wealth into distinct mental accounts, imperfect
knowledge, unlimited processing power and speed knowledge/ignorance, limited processing power and speed
Example framing error: rational people are indifferent between capital gain or dividend, while normal people however are not
indifferent because they perceive capital gain and dividend different i.e. follow the rule spend dividends, but don’t touch into
capital. They are not indifferent to company paid dividends and ‘homemade’ dividends as rational investors.
1. Cognitive and Emotional Shortcuts and Errors
Rational people’s brains are never full i.e. able to rank all relevant variables according to sets of benefits and costs and make the
best decision. E.g., ranking all restaurants on all available variables.
Normal people’s brains are often full and cope by creating a cognitive shortcut simplifying the problem i.e. decrease the number
of variables or levels within variables and emotional shortcut (preferences) = heuristics, quick and possibly dirty decision rule.
E.g., normal people limit restaurant options to 2km, or dishwasher to 1 brand. Good shortcuts take us close to the best choices,
but can turn into errors when they don’t (= bias).
2. System 1 and System 2
System 1 = intuition (blink), automatic, fast, effortless (= cognitive and emotional shortcuts); System 2 = reflection (think),
controlled, slow, effortful (when intuition misleads).
System 1 is necessary when you’re attacked by a lion. But system 1 can induce you into thinking dividend paying stock give
higher returns, while System 2 says this is not necessarily the case.
Rational people use System 2 whenever System 1 misleads. Normal people disregard System 2 outcomes whenever System 1
provides the answer. However, normal people differ from ignorant to knowledgeable, and knowledgeable people can learn to
use System 2.
3. Three Kinds of Knowledge in the context of finance
1. Financial-facts knowledge: includes facts about financial markets; stocks, bonds, other investments; benefits of diversification,
drawbacks of investment fees, difficulty of beating the market
2. Human-behavior knowledge: includes knowledge about
a. wants e.g. riches, social status, adherence to values (Chapter 2)
b. cognitive shortcuts and errors, e.g. framing, hindsight, confirmation (Chapter 3)
c. emotional shortcuts and errors e.g. hope, fear, pride, regret (Chapter 4)
1
, 3. Information knowledge (separated on availability)
d. Exclusively available (private/inside information): to 1 person such as the CEO
e. Narrowly available: to 2,3, a dozen executives of a company, analysts, readers of publications geared to
industry or technology experts
f. Widely available: to everyone but does not imply everyone actually knows that information such as major
newspapers
4. From Ignorant to Knowledgeable (transformation)
Sunk costs = have already been incurred and cannot be salvaged. Because they cannot be recovered, they should not be taken
into consideration when making rational decisions only avoiding further sunk costs, even when probed otherwise by cognitive
and emotional errors (“I can’t sell now etc.”).
Ignorant people have not learned to move beyond intuitive System 1, even when it misleads and often mistrust financial-facts
knowledge e.g. it is a financial fact that it is difficult to forecast stock prices, but the average person thinks it is not so difficult.
Knowledgeable people learn from experience and financial facts knowledge, i.e. transform themselves from normal-ignorant to
normal-knowledgeable.
Heuristics and biases may cause harm but we can also use them to improve decision making, such as using framing to nudge
investors to make the right decision. Bias = negative outcome/ error because of heuristic
Conclusion:
Rational people want only utilitarian benefits from investments (wealth) and don’t make cognitive or emotional errors, whereas
normal people also want expressive and emotional benefits (social responsibility and status) and are susceptible to cognitive
and emotional errors. System 1 shortcuts can lead to good choices but also errors and should learn to use System 2.
Chapter 2: Wants for Utilitarian, Expressive, and Emotional Benefits
People want 3 kinds of benefits: 1. utilitarian (satisfaction/utility), 2. expressive (convey values, tastes and social status), and
3. emotional (give feelings). Utilitarian benefits of two investments are identical when they yield identical return, but
satisfaction they yield varies by expressive and emotional benefits. Therefore, preferences and satisfaction influences risk
preferences, return beliefs, trading decisions.
Trade-offs between wants, e.g. between utilitarian benefits of great wealth and expressive and emotional benefits of adherence
to values. Conflicts between our wants and wants of others, e.g. conflicts between benefits received by corporate managers and
shareholders, money managers and investors, financial advisors and clients.
1. Want for Riches and Protection from Poverty
Hope for riches: encourages people to invest entire portfolio in stocks and lottery tickets (upside potential)
Fear of poverty: encourages us to invest entire portfolio in government bonds and hold tightly to Social Security (downside
protection). We balance wants by dividing money into layers of portfolio pyramids (= BPT).
2. Want to nurture our children and families
Provide education, inheritance, and financial support to children.
3. Want to Play Games and Win
We want to satisfy wants for utilitarian, expressive and emotional benefits of playing and winning, e.g. trading. Traders prefer
lottery-like stocks whose return distributions are skewed toward high returns. We want to be aroused and entertained.
4. Want to Demonstrate Competence
Ambiguity (uncertainty) aversion = preference of known risks to unknown risks. May arise from expressive and emotional
benefits gained by demonstrating competence to others and ourselves. Consequences of bets include emotional payoffs of
satisfaction or embarrassment, either from self-evaluation or from an evaluation by others. Investors who perceive themselves
as more competent trade more frequently as they want to demonstrate this.
5. Want to Stay True to Our Values
Values of investors vary and direct our wants for particular utilitarian, expressive, and emotional benefits, e.g. mutual funds can
choose to invest only in socially responsible companies, exclude weapon manufacturers or companies polluting the environment
Changes in circumstances affect trade-offs between utilitarian, expressive, and emotional benefits. For example, during 2008
financial crisis, expressive and emotional cost of mortgage defaults weakened (less stigma/shame)
6. Wants for High Social Status
Some investments are done to convey social status, such as movies, paintings and other collectibles providing expressive and
emotional benefits. Commonly described as “emotional assets” paying “emotional dividends” which offset the low utilitarian
benefits. Also true for investment in start-ups, hedge funds or private banks.
7. Wants for Fairness
We want fairness but it can be considered differently among people, e.g. how we view insider trading. We want equal power
(income equality) and freedom from coercion.
8. Wants to Pay no Taxes
Tax-saving strategies deliver utilitarian, expressive and emotional benefits. People express themselves as high-income investors
with social status is as high as tax bracket, and smart to avoid taxes.
2
