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Lecture 1 notes B&M summary CH 1 + 2 Article Russo & Schoemaker 1992
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Behavioural FinanceWeek 1
Monday: B&M CH.1
Wednesday: B&M CH.2 Russo & Schoemaker 1992
Chapter 1: Introduction to managerial decision making
Judgement = Cognitive aspects of our decision-making process
Rational decision-making process:
1. Define the problem
2. Identify the criteria
3. Weigh the criteria
4. Generate alternatives
5. Rate each alternative on each criterion
6. Compute the optimal decision
System 1 thinking: Intuitive system, which is fast, automatic, effortless, implicit and
emotional
System 2 thinking: Reasoning that is slower, conscious, effortful, explicit, logical. Steps
above provide a prototype for this thinking
Rationality = Decision-making process that is logically expected to lead to the optimal result,
given an accurate assessment of the decision maker’s value and risk preferences.
Two schools of thought:
- Study of prescriptive models: Methods for making optimal decisions
- Study of descriptive models: Consider how decisions are actually made
Heuristics = People rely on a number of simplifying strategies, or rules of thumb, when
making decisions.
The Availability Heuristic: People assess the frequency, probability or likely causes of an
event by the degree to which instances or occurrences of that event are readily ‘available’ in
the memory.
The Representativeness Heuristic: When making a judgment about an individual, people
tend to look for traits that the individual may have that correspond with previously formed
stereotypes.
The Confirmation Heuristic: The use of selective data when testing hypotheses, such as
instances in which the variable of interest is present.
,The Affect Heuristic: Most of our judgements follow an affective, or emotional, evaluation
that occurs even before any higher-level reasoning takes place.
Chapter 2: Overconfidence
Overconfidence is the mother of all biases
- Effects are the most potent, pervasive and pernicious of any of the biases
- Facilitates many other biases
It has been studied in three ways:
1) Over precision: Tendency to be too sure our judgments and decisions are accurate
2) Overestimation: Common tendency to think we’re better, smarter, faster etc than
we actually are
3) Over placement: We think we rank higher than others on certain dimensions,
particularly competitive contexts.
What are the causes of over precision?
- Desire to relieve internal dissonance, state of tension regarding the right decision or
course of action
- Our outward expressions of confidence help others feel sure about us
What are the consequences of over precision?
- Makes us too sure about our judgment, even often in error
- Ignore feedback from others
- Can make investors too interested in trading
- People belief that their beliefs are more accurate
Manifestations of overestimation:
- Self-enhancement: People view themselves positively, as opposed to accurately. We
tend to believe that our groups are superior to other groups
- Illusion of control: Sometimes people think we have more control over
circumstances than they actually do
- The planning fallacy: Common tendency to overestimate the speed at which we will
complete projects and tasks.
Unrealistic optimism = The tendency to overestimate the rosiness of our future
Article 1: Managing overconfidence (Russo & Schoemaker, 1992)
The paper examines the costs, causes and remedies for overconfidence. It distorts decision
making, but it can also serve a purpose during decision implementation.
Metaknowledge = An appreciation of what we do know and what we don’t know. It
concerns a higher level of expertise, understanding the nature, scope and limits of our basis,
or primary knowledge. Includes the uncertainty of our estimates and predications, and the
ambiguity inherent in our premises and world views.
, Two elements of overconfidence are essential:
- Feedback – Accurate, timely and precise tells us by how much our estimates missed
the mark
- Accountability – Forces us to confront that feedback, recalibrate our perceptions,
temper opinions accordingly
Experience is inevitable; learning is not
What are the cognitive causes of overconfidence?
- Availability: People have difficulty in imagining all the ways that events can unfold
- Anchoring: A tendency to anchor on one value or idea and not adjust away from it
- The Confirmation bias: One-sided support
- Hindsight: Makes us believe the world is more predictable than it really is. What
happens often seems more likely afterwards than it did beforehand, fail to
appreciate the full uncertainty that existed at the time
What are the cognitive remedies to overconfidence?
- Accelerated Feedback
- Counter argumentation
- Paths to Trouble: fault tree – hierarchical diagram designed to help identify all the
paths to some specific ‘fault’ or problem
- Paths to the Future: Explicit scenario analysis
- Awareness Alone
General awareness vs. specific blindness
What are the physiological causes of overconfidence? Euphoria, the elated feeling of well-
being hat commonly follows personal or professional success. Also, cocaine and alcohol can
produce it.
Overconfidence in group judgement: Mixed results: Can be better because forced to
recognize others or groups may bolster the majority opinion to even more extreme levels.
Delphi techniques and other procedures for sharing and averaging opinions are feasible.
Managers – Be aware of when you are functioning as a decider and your primary role is that
of doer, motivator or implementer.
Lecture 1: Introduction Behavioral Finance
Prof Dr. Martijn J. van den Assem
020 59 86234 (7A-58)
m.j.vanden.assem@vu.nl
What are we going to do in the next 6 weeks?
Emphasis is about decision making – how do people make decisions?
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