Cognitive Biases Related To The Decision Process 2024 Lecture 3 PDF

Cognitive Biases Related to The Decision Process Faiza Majid School of Banking and Finance, UNSW Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Successes and Limits of Prospect Theory To Predict Human Behavior...

Cognitive Biases Related to The Decision Process Faiza Majid School of Banking and Finance, UNSW Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Successes and Limits of Prospect Theory To Predict Human Behavior We’ve seen how PT can predict key violations of EU utility and the 4-fold pattern of risk aversion. Let’s look at some examples of how PT can explain/predict some of the consistent human behaviors. The Disposition Eect Framing Eects Myopic Loss Aversion Equity Premium Puzzle The Endowment Eect Faiza Majid FINS3655 Behavioral Finance Prospect Theory & The Disposition eect Game 1, you are given $30,000. It’s yours to keep. Then you are asked to choose between the following two possibilities: A: Receive an additional $10,000 for sure B: Toss a coin: if it comes up Heads, you get an additional $20,000; if tails, you get nothing. Game 2, you are given $50,000. It’s yours to keep. Then you are asked to choose between the following two possibilities: C: A guaranteed loss of $10,000 D: Toss a coin: if it comes up heads, you lose $20,000; if tails, you lose nothing. Faiza Majid FINS3655 Behavioral Finance Prospect Theory & The Disposition eect Game 1: A; Game 2: D However, the outcomes in the combination (A) and (C) are identical: in both cases, you walk away $40,000 richer. Similarly, (B) and (D) are identical: together, they generate a 50% chance of either $30,000 or $50,000. This preference switch is known as the Disposition Eect. Faiza Majid FINS3655 Behavioral Finance The Disposition eect The Disposition Eect is the tendency for individuals to be risk averse over gains, but risk seeking over losses. In the context of investing, is a phenomenon observed in nancial decision-making where investors tend to sell assets that have gained value too early while holding on to assets that have lost value for too long. This behavior is rooted in prospect theory and loss aversion, where people prefer to lock in gains but are reluctant to realize losses because it feels more painful. The disposition eect is one of the most common and well-documented behavioral biases in nance. Faiza Majid FINS3655 Behavioral Finance Framing Eects Dependence of preferences on the formulation of decision problems. Remember people focus on gains and losses, not nal wealth levels. Framing Eects Manner in which information is presented aects the frame people adopt in their decision making. Seemingly minor changes in the way the choice is framed generates changes in behavior. Faiza Majid FINS3655 Behavioral Finance Framing Eects- Asian Disease Example Faiza Majid FINS3655 Behavioral Finance Framing Eects- Asian Disease Example Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Framing Eects- Asian Disease Example Majority choice reported in Tversky and Kahneman, 1981 Risk avoidance in 1st problem: A preferred to B Risk taking in 2nd problem: C less acceptable than D The two problems are eectively identical - except that outcomes described in 1st problem by the number of lives saved vs. in 2nd problem by the number of lives lost. Change of frame reverses the preference between the options : violation of EU. Illustrates pattern of risk seeking for losses and risk averse for gains. Faiza Majid FINS3655 Behavioral Finance Framing Eects Some real life examples of Framing Eects Investment decisions. Framing of investment options can signicantly aect investor choices. Retirement plans (opt-in opt-out) Insurance (framing premiums vs deductibles) Consumer behaviour (sales and discounts) Healthcare (treatment choices) Faiza Majid FINS3655 Behavioral Finance Framing Eect: Inuence of The Frequency of Evaluations on Behavior Not only the way information is presented but how frequently it is presented inuences choice. Faiza Majid FINS3655 Behavioral Finance Framing Eect: Inuence of The Frequency of Evaluations on Behavior Thaler, Tversky, Kahneman and Schwartz (1997) Subjects asked to imagine they are portfolio managers; allocate their portfolio between two funds, A (bond) and B (stock). Three groups: Group 1: sees monthly observations on the returns of B. After each observation, allocate portfolio between A and B over the next month. See realized return over that month, and allocate once again. Group 2: shown exactly the same series of returns, except that it is aggregated at the annual level, i.e., does not see the monthly uctuations, only the cumulative annual returns. After each observation, allocate portfolio between A and B over the next year. Faiza Majid FINS3655 Behavioral Finance Framing Eect: Inuence of The Frequency of Evaluations on Behavior Group 1: sees monthly observations on the returns of B. After each observation, allocate portfolio between A and B over the next month. See realized return over that month, and allocate once again. Group 2: shown exactly the same series of returns, except that it is aggregated at the annual level, i.e., does not see the monthly uctuations, only the cumulative annual returns. After each observation, allocate portfolio between A and B over the next year. Faiza Majid FINS3655 Behavioral Finance Framing Eect: Inuence of The Frequency of Evaluations on Behavior Thaler, Tversky, Kahneman and Schwartz (1997) Subjects asked to imagine they are portfolio managers; allocate their portfolio between two funds, A (bond) and B (stock). Three groups: Group 1: sees monthly observations on the returns of B. After each observation, allocate portfolio between A and B over the next month. See realized return over that month, and allocate once again. Group 2: shown exactly the same series of returns, except that it is aggregated at the annual level, i.e., does not see the monthly uctuations, only the cumulative annual returns. After each observation, allocate portfolio between A and B over the next year. Group 3: same series, this time aggregated at the 5-year level. Faiza Majid FINS3655 Behavioral Finance Framing Eect: Inuence of The Frequency of Evaluations on Behavior After going through 200 months of observations, each group makes a nal allocation decision, which is to apply over the next 400 months. Average nal allocation chosen by subjects in Group 1 was much less tilted towards the stock. Subjects in Group 1 adopted the monthly return distribution as a frame. Hence, they saw more frequent losses → were more wary of the stock! Note: We saw earlier that people are loss averse: Examining returns at a high frequency is painful because losses are felt more strongly than gains Faiza Majid FINS3655 Behavioral Finance Example: Risk Perception at Dierent Time Scales - Taleb(2001) Consider a speculative portfolio expected to yield a return of 15% in excess of Treasury Bills, with a 10% error rate per annum (10% volatility). It means that 93% probability of a positive return in any given year. Use a simulator and assess the probability of a positive return at narrow time scales: Probability of positive return is 50% over any given second, 50.1% over any minute, and 51% over any hour, 54% in any given day, 67% in any given month. → Noise is higher at high-frequency horizons. Faiza Majid FINS3655 Behavioral Finance Example: Risk Perception at Dierent Time Scales - Taleb(2001) Minute-by-minute observation of the returns: each day (8 hours), will have 241 pleasurable minutes against 239 unpleasurable ones → 60688 and 60271 pleasurable and unpleasurable experiences per year. Monthly observation: since 67% of monthly returns are positive, 8 gains experienced per year, and 4 losses. Annual observation: since 93% of annual returns are positive, so over the next 20 years, will experience 1 pain for 19 positive experiences per year. Faiza Majid FINS3655 Behavioral Finance Myopic Loss Aversion Myopic Loss Aversion Combination of loss aversion and frequent evaluations of risky returns: pleasure felt after observing a gain is inferior to the pain experienced after a loss of an equivalent amount. losses are experienced more frequently at narrow time scales. ⇒ More frequent evaluations lead to increased risk aversion → One explanation of why employees have historically foregone substantial nancial gains by investing their retirement in safe bonds rather than in equities, even though LT return of equities often many times higher (Benartzi & Thaler, 1995) Faiza Majid FINS3655 Behavioral Finance Equity Risk Premium Puzzle The pricing of any nancial asset is equal to the risk-free rate, plus a risk premium Return = Risk Free Rate + Risk Premium For example, consider an investment with a guaranteed 3% return, so the return is just the risk-free rate: 3% + 0% = 3% Consider a risky asset with an average return of 3%. Risk-averse investors would never hold it, since they would prefer the guaranteed 3%. In equilibrium, the risky asset will thus return MORE than 3%. If the asset returns 5%, then there is a 2% risk premium: 3% + 2% = 5% Faiza Majid FINS3655 Behavioral Finance Equity Risk Premium Puzzle Since 1926 the average real annual return on stocks has been about 7%; the real return on treasury bills has been ¡ 1%. In 2020, ERP was about 6%. It is reasonable that stocks return a higher amount than t-bills or bonds, since risk-averse investors should require higher compensation for holding the risky asset. Faiza Majid FINS3655 Behavioral Finance Equity Risk Premium Puzzle Equity Risk Premium: the return earned by a risky security in excess of that earned by a relatively risk free US T-bill. Puzzle: It is an order of magnitude greater than can be rationalized by standard economic models Mehra and Prescott estimate that investors would need absurdly high coecients of risk aversion, α ∼ -30, to explain the higher premium for stocks over riskless assets. This is known as the Equity premium puzzle. That is, people would have to be implausibly risk-averse to justify the returns on equities over the returns for t-bills. Faiza Majid FINS3655 Behavioral Finance Myopic Loss Aversion and Equity Risk Premium Puzzle Benartzi and Thaler (1993): oer an answer based on Prospect Theory Two components: Investors are loss averse (meaning distinctly more sensitive to losses than to gains) Investors evaluate their portfolios frequently That is, for a given gamble, since stocks have the probability of yielding negative returns, loss aversion makes stocks much less attractive than the sure return from t-bills. Hence, investors appear to choose portfolios as if they were operating with a time horizon of about one year. Faiza Majid FINS3655 Behavioral Finance The Endowment Eect The Endowment Eect The endowment eect refers to a phenomenon where people tend to assign more value to things simply because they own them, even if they only acquired the item recently or if the object’s market value is objectively much lower. In other words, once something becomes part of our endowment (our possessions), we irrationally consider it more valuable than we did before ownership. Faiza Majid FINS3655 Behavioral Finance The Endowment Eect Willingness to Pay (WTP) vs Willingness to Accept (WTA) WTP is how much you would buy the good for; WTA is how much you would sell the good for. According to standard economic theory, WTP ≈ WTA. Faiza Majid FINS3655 Behavioral Finance The Endowment Eect: Problem Suppose your neighbor has a chicken coop in his backyard. There is a.001 chance (1 in 1000) you will get Avian Bird Flu and die because of this. How much would you be willing to pay for him to eliminate this risk? Suppose your new neighbor is moving in and wants to install a chicken coop in his backyard. There is a.001 chance you will get Avian Bird Flu and die because of this. How much would he have to pay you for you to be willing to accept this risk? Faiza Majid FINS3655 Behavioral Finance The Endowment Eect: Problem Faiza Majid FINS3655 Behavioral Finance Experiment 1/2 of students in a class were randomly given an inexpensive desirable object, such as a coee mug or a nice pen. Students who did not receive anything were asked how much they would pay for the [mug/pen], their maximum buying price (WTP) Students who did receive the good were asked their minimum selling price (WTA) The professors would then carry out any trades between students whose values overlapped. Since the goods were randomly assigned, 1/2 of the mugs/pens should change hands. Faiza Majid FINS3655 Behavioral Finance Experiment- The Endowment Eect In reality, virtually no one traded. The WTA values given were much higher than the WTP values. That is, sellers require much more to part with the item than buyers are willing to pay. The Endowment eect : The phenomenon whereby people value a good or service once they actually possess it or the property right to it. Where does the eect come from: buyers or sellers? In a follow-up, there was a 3rd group known as Choosers. Choosers were not endowed with a mug. Instead at each of the prices that buyers and sellers considered, the Chooser was given the choice between receiving that amount of money or the mug. Choosers behaved much closer to buyers than to sellers. This suggests that the endowment eect does not stem from buyers, but from sellers over-valuing the good once they own it. Faiza Majid FINS3655 Behavioral Finance Endowment Aect How the Endowment Eect relates to prospect theory? Loss aversion makes us feel like giving up something we own is a loss, even though economically it might not be signicant. According to reference dependence, once an object becomes part of your endowment, you view it as a reference point. Any decision to sell or give it up is framed as a loss, rather than a neutral transaction. For calculating WTA, the individual requires enough $ to oset moving from mug to no mug. Loss aversion towards the object implies that this will be higher than WTP. Faiza Majid FINS3655 Behavioral Finance The Endowment Eect Some real-life examples of the Endowment Eect? Stock ownership Real Estate Consumer behaviour Collectibles such as Sports Memorabilia Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory Empirically, some types of Framing Eects are not predicted by Prospect Theory The Default Option bias Choice-pricing preference reversal (next slide) House-money eect Theoretically, Prospect Theory does not describe how the reference point is adjusted dynamically in a sequence of gambles. Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory Lichtenstein and Slovic (1971) : Choice vs Pricing Problem 1: Choose between A = (4, 0.9; -2, 0.1) and B = (16, 0.3; -2, 0.7) Problem 2: Assume you own a ticket to play each gamble A = (4, 0.9; -2, 0.1) and B = (16, 0.3; -2, 0.7). State the lowest price for which you would sell the ticket. Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory- Choice vs Pricing Yet another example of interaction between the information format and the choice we make Preference Reversal : Choice-Pricing Subjects often chose A, yet stated a higher price for B Problem 1 is a choice problem: Focus on the probabilities Problem 2 is a pricing problem: Setting a price is expressed in terms of monetary units so subjects focus on the monetary aspect of the gamble (the payos) Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory- Adjusting Reference Point How is reference point adjusted? KT (1979) focus on one-shot gambles. How is the reference point adjusted after prior gains and losses? Key question! Answer determines whether, after losing at a one-shot gamble, people are subsequently more risk averse vs. less risk averse. We don’t know the answer! Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory - House Money Eect House Money Eect The House Money Eect is a concept that describes how people tend to take greater risks when they perceive they are playing with money that isn’t theirs, such as recent gains or windfalls. Thaler & Johnson (1990) After prior gains, subjects take on gambles they normally do not (house money eect) After prior losses, they refuse gambles they normally accept Note: This contradicts the hypothesis proposed by KT, 1979 (discussed earlier): after prior losses, the reference point is increased so the agent is more risk taker. Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory - House Money Eect Real life examples of House Money Eect? Stock Market gains, Casino gambling, Bonuses or Lottery wins, Sports betting. The House Money Eect helps explain why individuals might make irrationally risky investment or spending decisions following nancial gains. In nancial markets, it can lead to speculative bubbles, where investors who have experienced gains start chasing even riskier assets. Understanding this bias is important for managing personal nances and avoiding overcondence in investment decisions. Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory Imagine you have to make two concurrent decisions. Below are the options. Take a look at both and answer please. Decisions (i): Choose between A. sure gain of $240 B. 25% chance to gain $1,000 and 75% chance to gain nothing Decisions (ii): Choose between C. sure loss of $750 D. 75% chance to lose $1,000 and 25% chance to lose nothing Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory Large majorities prefer A to B and D to C. People tend to be risk averse in the domain of gains and risk seeking in the domain of losses. In the original experiment carried out, 73% of respondents chose A in decision(i) and D in decision(ii) and only 3% favored the combination of B and C. Now look at the following choice problem AD. 25% chance to win $240 and 75% chance to lose $760 BC. 25% chance to win $250 and 75% chance to lose $750 Option BC (which was preferred by 73% of respondents) actually dominates option AD (that only 3% of respondents favored) Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory- Narrow framing This set of choices has a lot to tell us about the limits of human rationality. Every simple choice formulated in terms of gains and losses can be deconstructed in innumerable ways into a combination of choices, yielding preferences that are likely to be inconsistent It is costly to be risk averse for gains and risk seeking for losses. These attitudes make you willing to pay a premium to obtain a sure gain rather than face a gamble, and also willing to pay a premium (in expected value) to avoid a sure loss. Faiza Majid FINS3655 Behavioral Finance Limits of Prospect Theory- Narrow framing Narrow framing: a sequence of two simple decisions, considered separately Broad framing: a single comprehensive decision, with four options Humans are by nature narrow framers real-life examples? Faiza Majid FINS3655 Behavioral Finance Limitations of Prospect Theory - Disjunction Eect Decision under uncertainty is a disjunction of possible states: Either one state will obtain or another. Sure-thing Principle If you prefer x to y given any possible state of the world, then you should prefer x to y even when the exact state is not known yet Faiza Majid FINS3655 Behavioral Finance Violation of Sure-thing Principle - Tversky & Shar, 1992 Imagine that you have just taken a tough qualifying examination. It is the end of the semester, you feel tired and run-down, and you nd out that you passed the exam. You now have an opportunity to buy a very attractive 5-day vacation package to Hawaii at an exceptionally low price. The special oer expires tomorrow. Would you: 1 buy the vacation package 2 not buy the vacation package 3 pay a $5 fee to retain the right to buy the vacation package at the same price the day after tomorrow Faiza Majid FINS3655 Behavioral Finance Violation of Sure-thing Principle - Tversky & Shar, 1992 Imagine that you have just taken a tough qualifying examination. It is the end of the semester, you feel tired and run-down, and you nd out that you failed the exam. You now have an opportunity to buy a very attractive 5-day vacation package to Hawaii at an exceptionally low price. The special oer expires tomorrow. Would you: 1 buy the vacation package 2 not buy the vacation package 3 pay a $5 fee to retain the right to buy the vacation package at the same price the day after tomorrow Faiza Majid FINS3655 Behavioral Finance Violation of Sure-thing Principle - Tversky & Shar, 1992 Imagine that you have just taken a tough qualifying examination. It is the end of the semester, you feel tired and run-down, and you will nd out the day after tomorrow whether you passed the exam. You now have an opportunity to buy a very attractive 5-day vacation package to Hawaii at an exceptionally low price. The special oer expires tomorrow. Would you 1 buy the vacation package 2 not buy the vacation package 3 pay a $5 fee to retain the right to buy the vacation package at the same price the day after tomorrow- when the results will be known Faiza Majid FINS3655 Behavioral Finance Violation of Sure-thing Principle - Tversky & Shar, 1992 Results: Pass Version: 54% of the subjects (N=66) chose the package, 30% chose to wait (57% chose to buy and 37% chose to wait) Fail Version: same thing (not for this class! 22% chose to buy and 29% chose to wait) Two thirds of the subjects made the same choice in the pass and fail conditions (21% chose buy and 6% chose not buy in both conditions) Version with uncertainty: Less than a third chose the package, 61% chose to wait (28% chose to buy and 60% chose to wait) → Violation of the sure-thing principle! Faiza Majid FINS3655 Behavioral Finance Disjunction Eect Once the outcome of the exam is known, the student has good reasons for taking the package: if has has passed the exam: trip seen as a reward following a successful semester, if has failed the exam: trip seen as a consolation. A student who does not know the outcome has less clear reasons for taking the package Presence of uncertainty tends to blur the picture Hard for people to see through the implications of each outcome Faiza Majid FINS3655 Behavioral Finance Disjunction Eect Disjunction Eect A disjunction eect occurs when people prefer x over y when they know that event A obtains, and they also prefer x over y when they know that event A does not obtain, but they prefer y over x when it is unknown whether or not A obtains Faiza Majid FINS3655 Behavioral Finance Disjunction Eect- Example 2 Imagine that you played the gamble (200, 0.5;-100, 0.5). You don’t know the result of the gamble. Do you want to play it a second time? Alternatively, how would you feel about playing the second gamble if you knew you had lost 100 on the rst gamble? Finally, would you accept to play the second gamble if you knew you had won 200 on the rst gamble? Faiza Majid FINS3655 Behavioral Finance Disjunction Eect- Example 2 Faiza Majid FINS3655 Behavioral Finance While prospect theory provides valuable insights into how people evaluate gains and losses and make decisions under risk, it has limitations in explaining all aspects of human behavior. It may not fully address temporal eects, extreme risk behaviors, social inuences, and biases like hyperbolic discounting or overcondence. Understanding these limitations helps in applying behavioral nance theories more eectively and in developing a more comprehensive view of decision-making. Faiza Majid FINS3655 Behavioral Finance