Behavioral Finance and Real Estate Lectures
Lecture 1 - Introduction
Traditional Finance Theory:
• Standard assumptions:
§ Investors and managers perfectly resemble the Homo Economicus
§ Markets are perfect and informationally efficient
• Some implications:
§ Financial incentives can eliminate systematic suboptimal behavior
§ Passive investing in a low-cost diversified index fund is optimal
Three views on market efficiency:
• Efficient market fanatic:
§ Security prices are always equal to intrinsic value
§ It is impossible to accurately predict (risk-adjustments) returns
• Behavioral finance fanatic:
§ Stock prices only depend on market psychology
§ It is easy to predict stock price movements
• Sensible middle ground:
§ Security prices are highly correlated with intrinsic value, but sometimes
diverge to a significant degree
§ It is possible to predict (risk-adjusted) returns, but not with great precision
The Homo Economicus: self-regarding maximizer with unlimited and costless information
processing capacity and unbreakable willpower
Behavioral Finance (BF):
• Behavioral finance is the study of how psychological phenomena impact financial
behavior and markets
Behavioral Finance approach:
• Examine systematic deviations from rational behavior
• Relax assumptions of rationality
• Relax assumptions of perfect capital markets
BF extends finance, does not replace it
Insights apply to many areas, including:
• Corporate finance
• Investments
• Real estate
,Individual decision making:
• Important building blocks of decisions:
§ Beliefs (outcomes, probabilities, alternatives, etcetera)
§ Preferences
• Traditional approach:
§ Beliefs are “rational”
§ Preferences are “normatively acceptable”
• Problem: people deviate systematically from rational norms
Þ Many phenomena are NOT understood in the traditional framework
Cross-Fertilization:
• Various types of actors
• Many different kinds of decisions
• Difference in expertise and experience
• Stakes often large
• Research hindered by unknowns, lack of control
Heuristic:
• Heuristic: experience-based rule of thumb or “mental shortcut”
• Why do we use heuristics?
§ Limited information
§ Limited memory
§ Limited information processing ability
§ Limited time
è Heuristics are often oké, but not always
How we think: two systems:
• System 1: intuitive and automatic
• System 2: reflective and deliberate
Intuitive system Reflective system
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Self-aware
Skilled Rule-following
Priming:
• Priming is a phenomenon in which a recent experience activates thoughts that
subconsciously influence future thoughts and actions
• Important: priming has become the subject of skepticism after many studies were
not able to be independently replicated
• Kahneman in 2017: “I still believe that actions can be primed, sometimes even by
stimuli of which the person is unaware. There is adequate evidence for all the
, building blocks: semantic priming, significant processing of stimuli that are not
consciously perceived, and ideomotor activation. I see no reason to draw a sharp line
between the priming of thoughts and the priming of actions. A case can therefore be
made for priming on this indirect evidence. But I have changed my views about the
size of behavioral priming effects – they cannot be as large and as robust as my
chapter suggested.”
Lecture 2 – Overconfidence and Optimism
The beliefs of the Homo Economicus:
• Observes all that is observable
• Cognitively processes all that has been observed correctly
• Holds rational expectations (no systematic error)
Biases in beliefs:
• Overconfidence and optimism
• Base rate neglect
• Gambler’s fallacy Representativeness biases
• Hot hand fallacy
• Confirmation bias
• Anchoring bias
• Availability bias
• Bounded awareness
è This is only a selection, there are much more biases
Overconfidence and Optimism:
• Overconfidence:
§ Bias in which subjective confidence in judgements is greater than their
objective accuracy
§ Regardless of how much we know, we overestimate how well we know our
limits
è Overconfident people are often surprised
• Optimism:
§ Bias in which the likelihood of positive outcomes of actions is overestimated
and the likelihood of negative outcomes is underestimated
è Optimistic people are often disappointed
, The two biases drawn
graphically
Overconfidence and optimism:
• In practice: blurry line between overconfidence and optimism
• Alternative classification (used in Bazerman & Moore:
§ Overprecision or miscalibration: excessive precision in one’s beliefs
Overconfidence
§ Overestimation: of one’s actual performance
§ Overplacement: of one’s performance relative to others Optimism
(better-than-average)
Are overconfidence and optimism beneficial?
• Overconfidence and optimism are blamed for serious problems:
§ Wars, fatal accidents, wrongful convictions
• Examples in financial decision making:
§ Stock market bubbles, unnecessary lawsuits, overleveraging and
bankruptcies, excessive trading in securities, failed mergers and acquisitions
• More innocent examples:
§ Popularity poker, some being poorly prepared for the exam
• There may be some benefits, but for decision making purposes we want accurate
probability assessments!
How is it possible that we are predictably wrong in accessing the accuracy of
our judgements? Possible explanations:
• Hindsight bias: tendency for people with outcome knowledge to believe falsely that
they would have predicted the outcome
• Desire to feel sure of ourselves
• Desire to make others feel sure about us: being accurate comes at the expense of
being informative, and others often prefer informativeness over accuracy
• Confirmation bias
• Representativeness biases
• Anchoring
Lecture 1 - Introduction
Traditional Finance Theory:
• Standard assumptions:
§ Investors and managers perfectly resemble the Homo Economicus
§ Markets are perfect and informationally efficient
• Some implications:
§ Financial incentives can eliminate systematic suboptimal behavior
§ Passive investing in a low-cost diversified index fund is optimal
Three views on market efficiency:
• Efficient market fanatic:
§ Security prices are always equal to intrinsic value
§ It is impossible to accurately predict (risk-adjustments) returns
• Behavioral finance fanatic:
§ Stock prices only depend on market psychology
§ It is easy to predict stock price movements
• Sensible middle ground:
§ Security prices are highly correlated with intrinsic value, but sometimes
diverge to a significant degree
§ It is possible to predict (risk-adjusted) returns, but not with great precision
The Homo Economicus: self-regarding maximizer with unlimited and costless information
processing capacity and unbreakable willpower
Behavioral Finance (BF):
• Behavioral finance is the study of how psychological phenomena impact financial
behavior and markets
Behavioral Finance approach:
• Examine systematic deviations from rational behavior
• Relax assumptions of rationality
• Relax assumptions of perfect capital markets
BF extends finance, does not replace it
Insights apply to many areas, including:
• Corporate finance
• Investments
• Real estate
,Individual decision making:
• Important building blocks of decisions:
§ Beliefs (outcomes, probabilities, alternatives, etcetera)
§ Preferences
• Traditional approach:
§ Beliefs are “rational”
§ Preferences are “normatively acceptable”
• Problem: people deviate systematically from rational norms
Þ Many phenomena are NOT understood in the traditional framework
Cross-Fertilization:
• Various types of actors
• Many different kinds of decisions
• Difference in expertise and experience
• Stakes often large
• Research hindered by unknowns, lack of control
Heuristic:
• Heuristic: experience-based rule of thumb or “mental shortcut”
• Why do we use heuristics?
§ Limited information
§ Limited memory
§ Limited information processing ability
§ Limited time
è Heuristics are often oké, but not always
How we think: two systems:
• System 1: intuitive and automatic
• System 2: reflective and deliberate
Intuitive system Reflective system
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Self-aware
Skilled Rule-following
Priming:
• Priming is a phenomenon in which a recent experience activates thoughts that
subconsciously influence future thoughts and actions
• Important: priming has become the subject of skepticism after many studies were
not able to be independently replicated
• Kahneman in 2017: “I still believe that actions can be primed, sometimes even by
stimuli of which the person is unaware. There is adequate evidence for all the
, building blocks: semantic priming, significant processing of stimuli that are not
consciously perceived, and ideomotor activation. I see no reason to draw a sharp line
between the priming of thoughts and the priming of actions. A case can therefore be
made for priming on this indirect evidence. But I have changed my views about the
size of behavioral priming effects – they cannot be as large and as robust as my
chapter suggested.”
Lecture 2 – Overconfidence and Optimism
The beliefs of the Homo Economicus:
• Observes all that is observable
• Cognitively processes all that has been observed correctly
• Holds rational expectations (no systematic error)
Biases in beliefs:
• Overconfidence and optimism
• Base rate neglect
• Gambler’s fallacy Representativeness biases
• Hot hand fallacy
• Confirmation bias
• Anchoring bias
• Availability bias
• Bounded awareness
è This is only a selection, there are much more biases
Overconfidence and Optimism:
• Overconfidence:
§ Bias in which subjective confidence in judgements is greater than their
objective accuracy
§ Regardless of how much we know, we overestimate how well we know our
limits
è Overconfident people are often surprised
• Optimism:
§ Bias in which the likelihood of positive outcomes of actions is overestimated
and the likelihood of negative outcomes is underestimated
è Optimistic people are often disappointed
, The two biases drawn
graphically
Overconfidence and optimism:
• In practice: blurry line between overconfidence and optimism
• Alternative classification (used in Bazerman & Moore:
§ Overprecision or miscalibration: excessive precision in one’s beliefs
Overconfidence
§ Overestimation: of one’s actual performance
§ Overplacement: of one’s performance relative to others Optimism
(better-than-average)
Are overconfidence and optimism beneficial?
• Overconfidence and optimism are blamed for serious problems:
§ Wars, fatal accidents, wrongful convictions
• Examples in financial decision making:
§ Stock market bubbles, unnecessary lawsuits, overleveraging and
bankruptcies, excessive trading in securities, failed mergers and acquisitions
• More innocent examples:
§ Popularity poker, some being poorly prepared for the exam
• There may be some benefits, but for decision making purposes we want accurate
probability assessments!
How is it possible that we are predictably wrong in accessing the accuracy of
our judgements? Possible explanations:
• Hindsight bias: tendency for people with outcome knowledge to believe falsely that
they would have predicted the outcome
• Desire to feel sure of ourselves
• Desire to make others feel sure about us: being accurate comes at the expense of
being informative, and others often prefer informativeness over accuracy
• Confirmation bias
• Representativeness biases
• Anchoring
