Behavioral Finance Total Summary
Week 1
Standard assumptions: we are homo economicus (self-regarding maximizer with unlimited
and costless information processing capacity and unbreakable willpower), markets are
perfect and informationally efficient. Homo economicus uses marginal benefits > marginal
costs and holds rational expectations (no systematic error)
Results in: financial incentives can eliminate suboptimal behavior and passive index fund
investing is best.
Efficient market:
-security prices equal to intrinsic value
-impossible to accurately predict returns
Behavioral finance:
-stock prices depend only on market psychology
-easy to predict stock price movements
Middle ground:
-stock prices highly correlated with intrinsic value, but sometimes diverge to a significant
degree
-it is possible to predict returns but not with great precision
Six steps rational decision making:
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
Rationality: decision-making progress that is logically expected to lead to the optimal result
(given values and risk-preferences)
Simon: descriptive and prescriptive. Let’s use descriptive. Because understanding helps as
motivation to change and understanding others is important.
Normative is how people should make decisions. Bias = systematic deviation from normative
standards.
System 1 keywords: fast, automatic, effortless, implicit, emotional, intuitive, skilled,
unconscious
System 2 keywords: slower, conscious, effortful, explicit, logical, reflective, rule-following
People trust their intuition (system 1) this should be challenged
,We satisfice: we look for a solution that suffices because it is good enough. Simon identified
this. Then Kahneman and Tversky studies the specific biases. People use rules of thumb:
heuristics. (because we have limited info, memory, information processing ability, and time)
Availability heuristic: how readily available is something in memory (news: war).
Representativeness heuristic: stereotypes (salesman is extravert)
Confirmation heuristic: there are always 4 separate situations to consider when looking at
the association between two events, but we ignore this and use selective data. ‘Positive
hypothesis testing’
Affect heuristic: before deep analysis you get an emotional evaluation of something which
usually forms the basis of your further analysis (stock market positive on sunny days)
Priming a recent experience activates thoughts that subconsciously influence future
thoughts and actions
We are not economicus but sapiens, with bounded rationality, awareness, willpower and
self-interest
Behavioral finance (extends finance, applies to all areas):
-relax assumptions of rationality and perfect capital markets
-examine systematic deviations from rational behavior
H2 Overconfidence
Overconfidence can be the mother of all biases, and it means confidence in judgement is
greater than objective accuracy. (Overconfident people are often surprised)
Optimism: likelihood positive outcomes overestimated, and negative outcomes
underestimated. (Optimistic people are often disappointed)
Can result in market bubbles, unnecessary lawsuits, excessive trading etc.
It is split in 3 ways.
Overprecision (= overconfidence) we are too sure our judgements are accurate, and not
interested in testing our assumptions and evidence suggesting otherwise
-this finding continues for experts, they just narrow their confidence interval so still same hit
rate
Possible causes:
-relieve a state of dissonance (tension regarding the right decision) makes us feel sure about
ourselves
-also makes others feel sure about us, as we find confident people more capable and prefer
to put them in important positions
,-human memory is better at retrieving confirming than disconfirming evidence. If we find
out we were wrong about something, we instantly change our opinion, which is why most of
the time we think everything we know is right
-hindsight bias (can make us confident, believe we would have predicted it)
-confirmation bias
-representativeness bias
-anchoring
The crowd average is usually right, however.
Consequences:
-reluctant to take advice from others, suspicious of people who view things differently, too
quick to act on opinions and too slow to update beliefs. It can also make investors too
interested in trading.
(volgende week ff kijken of dit herhaald wordt met voorbeelden)
Overestimation (= optimism) we’re better, smarter, etc than we actually are
-self-enhancement: we tend to believe our groups are superior to other groups (we even
like our name’s letters more) but these are mostly system 1 thinking, and that we are better
at our good qualities than we actually are.
-illusion of control: people think they have more control than they actually do, especially in
situations with less control. (pick own lottery numbers) (but when you have a lot of control
you think you have less control, like with health) Condition for illusion of control: intended
outcome + connection
-planning fallacy: we always overestimate speed at which we will complete things. (even
though we know similar projects don’t meet such deadlines). Happens more with large
complex projects, but we overestimate time we need for simple tasks.
Possible explanations: we focus on plans, and neglect past experiences:
-prediction has a forward nature
-it is hard to define similar experiences
-people tend to ‘explain away’ relevance of the past. For example, self-serving bias
self-serving bias:
-success is due to personal factors and internal, failures were external and beyond control
-optimistic biases: sometimes we use defensive pessimism, because we do not like when our
ideas do not collide with reality. (we start extremely confident, and when the moment of
truth becomes nearer we turn more pessimistic)
Overplacement (= optimism) we/re better than others/ think we rank higher than others on
certain dimensions in particularly competitive contexts. (driving)
-mostly demonstrated by ‘better-than-average’ effect
-could be M&A research topic
-underplacement also happens, with very difficult tasks
, -we also believe we are more likely than others to experience common events but less likely
to experience rare events
-we usually compare ourselves to general population instead of the specific group we
belong to
-easier to find evidence that we are better tennis players than that we are more honest. So,
it is also easier to believe we are more honest, as evidence against it is less easy to find.
Fischhoff et al: diseases and odds (instead of percentages) (which one is more likely)
Weinstein: optimism: people have a biased idea of personal actions or plans that might
affect their chances of experiencing an event and compare themselves to a person who
does nothing to improve his or her chances
There is an inside view and an outside view
Inside view: more natural, optimistic, focuses on specifics of the case and anchored on plans
and impressions
Outside view: more accurate, sees the case as a member of a category and uses baseline
statistics as a starting point (your business succeeding / any business like yours succeeding)
Defensive pessimism and underconfidence for difficult tasks are exceptions to optimism.
Another exception is learning, but for learning we need feedback and accountability.
H3 Common Biases
AVAILABILITY HEURISTIC BIASES:
Availability heuristic: frequency or probability is estimated by the ease with which instances
or associations can be brought to mind
Biases occur when availability and frequency diverge, and can be due to:
-ease of recall
-retrievability
-imaginability
Bias 1: ease of recall
(list with names of different genders and one group is fewer but famous)
-people that are asked to list more examples of when they were assertive thought they were
less assertive (difficult thing to remember)
important factors are familiarity, salience and recency (salience: watching a house burn >
reading about a fire)
Bias 2: retrievability
(ease with which to retrieve word starting with r than word with third letter r)
