FINS3655 Week 7 Lecture PDF

Cognitive Biases Related to Perception and Learning Faiza Majid School of Banking and Finance, UNSW Faiza Majid FINS3655 Behavioral Finance Key Learning Objectives in This Chapter Understand behavioral biases related to Process 1:...

Cognitive Biases Related to Perception and Learning Faiza Majid School of Banking and Finance, UNSW Faiza Majid FINS3655 Behavioral Finance Key Learning Objectives in This Chapter Understand behavioral biases related to Process 1: how individuals form beliefs about uncertain payoffs. Understand why different economic agents perceive very differently the same level of risk Faiza Majid FINS3655 Behavioral Finance Information Acquisition and Information Processing Stock market: Vast quantity of information from diverse sources Process 1 involved to forecast future returns Process 1 requires information processing Faiza Majid FINS3655 Behavioral Finance Information Processing Faiza Majid FINS3655 Behavioral Finance Information : The more, the better ? Faiza Majid FINS3655 Behavioral Finance Experts Judgment Tetlock (2005): Expert Political Judgment: How Good Is It? How Can We Know? “The accuracy of expert predictions was not significantly better than that of non-experts, or even random guesses, leading to the well-known analogy that ’a dart-throwing chimpanzee could have matched the accuracy of the experts.” Plenty of evidence support the notion that expert predictions, particularly those by financial analysts and forecasters, can often be inaccurate or inconsistent. Jegadeesh, Kim, Krische, and Lee (2004): “Analyzing the Analysts: When do recommendations add value?” Welch (2000): “Herding among security analysts” Faiza Majid FINS3655 Behavioral Finance Experts Judgment Slovic et al., (1972): They have poor self-insight on the way they combine information from diverse sources The longer brokers had been in the business, the less accurate was their self-insight 13 Stockbrokers asked to estimate the relative weights they have been using: strongly overestimate importance they place on minor cues strongly underestimate importance they place on a few major factors Faiza Majid FINS3655 Behavioral Finance Experts Judgment Oskamp, 1965: Increasing the amount of information available did not increase clinical psychologists’ performance.... but it did significantly increase confidence! Same finding in Slovic, 1973: treatment in which bookmakers were asked to predict outcome of 45 races using the 10 variables they found most useful vs. treatment with 10 additional variables Predictions did not improve in 2nd treatment... but confidence did increase a lot Faiza Majid FINS3655 Behavioral Finance So? Is more information always better? Faiza Majid FINS3655 Behavioral Finance Limited Ability to Process Information Dijksterhuis et al., (2007): Subjects asked to choose between 4 different cars; 2 conditions: 4 attributes per car or 12 attributes. One of the cars was better than the others, with 75% of its attributes being positive; 2 cars had 50% positive attributes and 1 car had 25% With a low level of information, 60% of subjects chose the best car vs. when faced with information overload, only 20% did Similar outcome found among financial analysts: information increases forecast error (Montier, 2007) Faiza Majid FINS3655 Behavioral Finance Limited Ability to Process Information In the realm of finance, we gather information from multiple sources: economic data, company reports, and news. But we don’t always process this information perfectly. The limits of human cognition play a significant role in how we interpret and use this information to make decisions. Bounded rationality. Instead of being perfectly rational, as assumed in traditional economics, humans are ‘bounded’ by their cognitive limits. Cognitive load — how much information we can process effectively at once. When overloaded with data, decisions tend to become worse, leading to information fatigue. Faiza Majid FINS3655 Behavioral Finance Information Overload and Limited Attention Information overload. This occurs when investors are bombarded with so much data that they struggle to process it effectively. In finance, this might mean overlooking crucial details or reacting emotionally to overwhelming information. When we are overloaded, we often rely on simplified heuristics—such as 1buying stocks with good news’ - instead of deeper analysis. This can cause both overreaction (overbuying) and underreaction (ignoring significant information). Faiza Majid FINS3655 Behavioral Finance Lets play a game! Guess the Rule Experiment Consider the following sequence: 2 4 6 Guess the rule that generated this sequence, by producing other three-number sequences. The experimenter will respond ‘yes’ or ‘no’ depending on whether the new sequences are consistent with the rule Once confident with your answer, formulate the rule Faiza Majid FINS3655 Behavioral Finance Belief Perseverance People tend to stick to their prior beliefs (“belief perseverance”) First interpretation is very sticky, difficulty of rejecting incorrect hypotheses Guess the Rule Experiment Consider the following sequence: 2 4 6 Guess the rule that generated this sequence, by producing other three-number sequences. The experimenter will respond ‘yes’ or ‘no’ depending on whether the new sequences are consistent with the rule Once confident with your answer, formulate the rule Faiza Majid FINS3655 Behavioral Finance Belief Perseverance - Confirmation Bias P C Wason, 1960: Very few subjects discovered the correct rule = “numbers in ascending order” To discover it, need to test a series in descending order Subjects gave series aimed at confirming their guess: only looked for corroboration and failed to eliminate hypotheses To test a rule, one has to look for instances where it does not work But we look at the world looking for signs that we are right Faiza Majid FINS3655 Behavioral Finance  You’re going to watch a movie showing 3 people wearing white shirts passing a basketball to each other, and 3 people wearing black shirts passing a different ball to each other Your task is to count the total number of times the people wearing white shirts pass the ball Faiza Majid FINS3655 Behavioral Finance  [MOVIE] Faiza Majid FINS3655 Behavioral Finance How many times the people wearing white shirts passed the ball? Did anyone see or hear anything other than the players? Faiza Majid FINS3655 Behavioral Finance Main Takeaway of the Experiment This experiment is called “The Selective Attention Task” (Simons & Chabris, 1999). Simons & Chabris report that 70% of their subjects failed to notice the gorilla in the midst. Attention is a scarce resource (kahneman, 1973). When people are engaged in an attention-demanding task, they often fail to notice unexpected objects or events. We notice what we’re looking for and we don’t see things that are unexpected. Faiza Majid FINS3655 Behavioral Finance Main Takeaway of the Experiment The experiment tells us something fundamental about human perception: Rather than passively recording everything directly in front of us, humans instead actively look for things. What we see depends on our expectations and questions. The question ‘How many basketball passes’ primes us to see certain aspects of the scene at the expense of others. Faiza Majid FINS3655 Behavioral Finance Inattentional Blindness in the Field Investors are blind to asset categories and information sources they are not focusing on: Frazzini & Cohen, 2008 focus on firms that have customer-supplier links: any shock to one firm translates into shocks to the linked firm Individual investors inattentive to the link because rarely hold both firms! Prices of the partner firm have a predictable lag in updating to new information about the linked firm. For investors, difficulty of searching the thousands of stocks they can potentially buy ⇒ Limit their search to stocks that caught their attention: Heuristic-based familiarity: Vivid information about a stock makes the stock more remarkable Attention-grabbing events: news, unusual trading volume, extreme past returns Faiza Majid FINS3655 Behavioral Finance We’ve just seen that when they have to process many informational inputs at once, people have a difficult time processing information because of information overload and the belief perseverance bias. Let’s now focus on contexts in which people have to process many informational inputs sequentially, through sampling. How should people process information to form beliefs? Faiza Majid FINS3655 Behavioral Finance Bayes’ Rule When people are judging conditional probabilities, they should update according to Bayes rule: 1 in 100 people have a disease We have a test for it If someone has the disease, she has a 99% chance of testing positive. If someone doesn’t have the disease, she has a 99% chance of testing negative. Amy took the test, and tested positive. Faiza Majid FINS3655 Behavioral Finance Bayes’ Rule Assuming that Amy was drawn randomly from the population, what is the probability that she has the disease? Faiza Majid FINS3655 Behavioral Finance Apply Bayes’ Rule If D = “has the disease” and N = “doesn’t have the disease”, T+ = “the test is positive”, then, Pr (D∩T +) Pr (D|T +) = Pr (T +) Pr (D|T +)∗Pr (D) = Pr (T +) Pr (D|T +)∗Pr (D) = Pr (T +|D)∗Pr (D)+Pr (T +|N)∗Pr (N) (0.99)∗(0.01) = (0.99)∗(0.01)+(0.01)∗(0.99) 1 = 2 Faiza Majid FINS3655 Behavioral Finance Heuristics In practice, the Bayes’ rule is rarely used. Throughout this chapter, we will refer to “heuristics.” A heuristic is a rule of thumb; a mental shortcut to help us navigate the enormous amount of information we encounter on a daily basis. If you look out of the window and the sky is gray, you might grab an umbrella on your way out of the door, rather than stopping to carry out an extensive analysis of the likelihood of rain. Faiza Majid FINS3655 Behavioral Finance Heuristics Heuristics are mental shortcuts or ”rules of thumb” that people use to make decisions quickly and efficiently. While these shortcuts are useful in everyday life, they can lead to systematic biases and errors in certain contexts. Kahneman and Tversky identified three important judgment heuristics in the 1970’s. Representativeness, Availability, Anchoring Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic Decision makers use similarity or representativeness as a proxy for probabilistic thinking. “Steve is very shy and withdrawn, invariably helpful, but with little interest in people. He is meek and tidy, and has a need for order and structure, and a passion for detail.” What is the probability that Steve is a farmer? A salesman? An airline pilot? A librarian? A physician? How similar is Steve to a farmer? A salesman? An airline pilot? A librarian? A physician? Subject rankings of probability and similarity turn out to be the same. which would be OK, if similarity predict true probability. Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic - Base Rate Neglect Because Steve is similar to the stereotype of a librarian, people will say that Steve is more likely to be a librarian than a salesman, despite the fact that there are many more salesmen than librarians. This is known as base rate neglect - over-weighting the importance of information and under-weighting the natural base rates. Another example: Subjects were shown brief personality descriptions of several individuals, allegedly sampled at random from 100 professionals – engineers and lawyers 1/2 the subjects were told the group was 70 engineers and 30 lawyers. 1/2 the subjects were told the group was 30 engineers and 70 lawyers. Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic - Base Rate Neglect Subjects were asked to choose, for a given personality description, whether a person was likely to be an engineer or lawyer. Subjects in the 1st group should rate any given questions as more likely to be an engineer than in the 2nd group. In fact, the two groups produced essentially identical answers: they basically ignored the prior likelihoods. Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic - Sample Size Neglect Representativeness also implies misperceptions of the importance of sample size.(A small sample size can represent its process or population just as well as a large one) People tend to believe that ALL samples will closely resemble the process that generated them. This is known as the “law of small numbers” i.e., belief that small samples are representative of the population from which they are drawn. Faiza Majid FINS3655 Behavioral Finance The Portfolio Manager’s Performance Faiza Majid FINS3655 Behavioral Finance The Portfolio Manager’s Performance The most common choice among respondents was (2) But look closely at (1). Is has the same five letters, in the same order, as the last five letters in (2). Both are BMBBB. So if the manager achieved (2), she also achieved (1). In fact, (2) additionally requires an M prior to BMBBB. So (1) must be more probable than (2). So why do so many people pick (2)? It’s because (2) appears representative of the long run pattern: that the manager beats her benchmark two thirds of the time. We are inclined to look for patterns, and to assume that short-run sequences should show the same pattern as what we believe applies in the long-run. Faiza Majid FINS3655 Behavioral Finance Sample size neglect/ Law of small numbers Faiza Majid FINS3655 Behavioral Finance Law of small numbers Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Law of Small Numbers People are bad at generating random sequences - if asked to write the results of 100 imaginary coin flips, their generated sequences will have too few runs of H H H H or T T T T. When flipping a coin, people think H T H T H T is more likely than the sequence H H H T T T. Belief in the Law of Small Numbers induces two related biases: 1 Gambler’s Fallacy : belief that the probability of heads is greater after a long sequence of tails than after a long sequence of heads 2 Hot hand Fallacy: After four heads in a row in a sequence of 20 tosses, people think the sequence is not random. Barberis et al. (1998) showed how representativeness can lead to overreaction in stock prices when investors believe that short-term trends will continue indefinitely. Faiza Majid FINS3655 Behavioral Finance Gambler’s Fallacy Gambler’s Fallacy: the belief that, after the roulette wheel has generated a series of Red numbers, that a Black number must be “due”. In reality, of course, each spin of the wheel is independent of the last. Gambler’s Fallacy manifests in the financial markets with participants believing that equity market returns should “regress to the mean” (return to a perceived long-run average) after a series of strongly positive years. There are, in fact, two fallacies here: 1 The belief that we know the true “long run mean return” of the equity markets. We don’t. We only know the long run historic mean (around 7% higher than putting your money in the bank, on average, over the last 50 years). No one can promise that this mean will stay consistent in future years (or decades, or centuries... ) 2 The belief that the “boom-bust cycle” (from the beginning of one bull market until the beginning of the next) has some pre-specified duration. It hasn’t. It has varied considerably over the last few decades. Faiza Majid FINS3655 Behavioral Finance Gambler’s Fallacy Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Conservatism- Stock Picker Game Suppose you have 100 bags, each of which contains 1,000 poker chips: 55 bags contain 300 red chips and 700 black ones 45 bags contain 700 red chips and 300 black ones One bag is chosen at random: What is the probability that the bag has predominantly red chips? Now suppose there is a random draw of 12 chips, with replacement, from the chosen bag. These 12 draws produce 8 red chips and 4 black ones. what is your revised estimate of the probability that the bag has predominantly red chips? Faiza Majid FINS3655 Behavioral Finance Conservatism- Stock Picker Game Faiza Majid FINS3655 Behavioral Finance Conservatism- Stock Picker Game Faiza Majid FINS3655 Behavioral Finance Conservatism- Stock Picker Game The answer to question (i), the probability that the bag has predominantly red chips is, of course, 45% Given that we don’t know precisely how to incorporate the new information, we typically under-react to it (conservatism). In fact, the probability that the bag is red, given the draw of 4 Blacks, 8 Reds, is: 96% Faiza Majid FINS3655 Behavioral Finance The Representativeness Heuristic We have learned about how our natural, human desire to see patterns can cause us to make significant errors in our assessment of probability. Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic The Availability Heuristic is a rule of thumb in which decision makers assess the probability of an event by the ease with which instances can be brought to mind. 1 Individuals overweight the probability of a rare event when: Examples are easy to recall There has been a recent, highly publicized, occurrence 2 Individuals underweight higher probability risks if: They are not personally aware of any recent occurrences. Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic Key factors Influencing Availability: 1 Recency: Recent events are more likely to be recalled. Fear of Flying vs. Driving: After hearing about a plane crash, people might temporarily believe air travel is more dangerous than it actually is. Recency Bias in Performance Evaluation: Managers carrying out annual performance reviews tend to give more weight to performance during the 3 months prior to the evaluation than the 9 months prior to that. Recency Bias in Performance Evaluation: Investment decisions are influenced by recent fund performance, neglecting long-term results. For example, investors flock to funds with recent high returns, assuming the trend will continue 2 Vividness: Events that evoke strong emotions (e.g., natural disasters, terror attacks) are easier to recall, making them seem more frequent. Insurance salespeople rely on vividness to sell insurance for low probability outcomes. When managers conduct performance reviews of their staff, they often rely heavily on memory rather than documented evidence. Vivid instances that are easy to recall will be weighted more heavily. Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic 4 Personal Experience: People tend to recall their own experiences more easily than impersonal statistics. You’re in the market for a new Honda. You check a site for reviews and of 500 reviews, 80% are positive. You’re going to purchase the car. Then, someone tells you that their brother-in-law had a Honda, and it was a lemon and always breaking. You don’t purchase the car. People’s estimates of the likelihood of traffic accidents will rise after seeing an overturned car on the side of the road. Seeing a house burning is more salient than just reading about it in the paper. 5 Media Coverage: Events that are heavily covered in the media are more accessible in memory, which may distort the actual risk associated with those events. Shark attacks: Shark attacks, although rare, are widely reported in the media when they occur. As a result, people may overestimate the likelihood of being attacked by a shark when visiting the beach, despite the extremely low statistical probability Overestimation of Crime Rates: Individuals may believe crime rates are increasing when they consume a lot of news about crimes. Violent crimes are heavily reported, creating a perception of higher prevalence. Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic in Financial Decision Making In finance, the availability heuristic can lead to misjudgments about market trends, risk, and investment opportunities, often influencing both individual and institutional investors. Stock Market Crashes: After a major market crash (e.g., the 2008 financial crisis), investors often overestimate the likelihood of another crash in the near future. This may lead to overly cautious investment strategies, as the dramatic event is still fresh in memory and thus overemphasized compared to the actual statistical risk. Bitcoin and Cryptocurrency Hype: During the rise of Bitcoin and other cryptocurrencies, especially around 2017, the availability of success stories of early investors who made substantial gains led many new investors to believe that they too could achieve similar profits. The ease of recalling these success stories, combined with intense media coverage, contributed to speculative bubbles in cryptocurrency markets. Faiza Majid FINS3655 Behavioral Finance The Availability Heuristic in Financial Decision Making Barber and Odean (2002) & Fang and Peress (2009) investors tend to invest in the attention grabbing stocks. investors tend to buy more stocks of companies that are in the news. the attention grabbing stocks which investors buy due to the availability bias did not beat the market and they never earn abnormal profits. Howe and Arena (2008): Firms that are the subject of a Who’s News article with a picture enjoy positive and significant abnormal short-horizon returns around the article date, compared to firms that are also covered by a Who’s News article but without a picture. Faiza Majid FINS3655 Behavioral Finance  Anchoring Faiza Majid FINS3655 Behavioral Finance Anchoring Anchors seem to matter. E.g., starting points, frames, defaults, etc.. Is the Mississippi River more or less than 70 miles long? How long is it? Is the Mississippi River more or less than 2000 miles long? How long is it? Faiza Majid FINS3655 Behavioral Finance Anchoring Is the Mississippi River more or less than 70 miles long? How long is it? average estimate = 300 miles Is the Mississippi River more or less than 2000 miles long? How long is it? average estimate = 1500 miles People make estimates by starting from an initial value that is adjusted to yield the final answer. Typically, these adjustments are insufficient i.e., different starting points will yield different estimates. Faiza Majid FINS3655 Behavioral Finance Anchoring- Insufficient adjustment Anchoring occurs not only when the starting point is given to the subject, but also when the subject bases his estimate on the result of some incomplete computation A study of intuitive numerical estimation illustrates this effect Two groups of high school students estimated, within 5 seconds, a numerical expression that was written on the blackboard 8x7x6x5x4x3x2x1 1x2x3x4x5x6x7x8 To rapidly answer such questions, people may perform a few steps of computation and estimate the product by extrapolation or adjustment. Faiza Majid FINS3655 Behavioral Finance Anchoring- Insufficient adjustment Because adjustments are typically insufficient, this procedure should lead to underestimation. Furthermore, because the result of the first few steps of multiplication (performed from left to right) is higher in the descending sequence than in the ascending sequence, the former expression should be judged larger than the latter. Both predictions were confirmed. The median estimate for the descending sequence was 2,250. The median estimate for the ascending sequence was 512. The correct answer is 40,320. Faiza Majid FINS3655 Behavioral Finance Example: Finance Stock Market: Market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original price rather than to fundamentals. Majority of market participants – even institutional investors who are financial market professionals – place significant weight on past forecast values (Yoshiyuki, 2012). Analysts make optimistic (pessimistic) forecasts when a firm’s FEPS is lower (higher) than the industry median (Cen et al., 2013). Faiza Majid FINS3655 Behavioral Finance Example: Price Anchoring Price anchoring refers to the practice of establishing a price point which customers can refer to when making decisions. Example: “Pay what you can” - prints out a receipt with a suggested price A discount with “$100 $75” , the $100 is the price anchor for the $75 sales price. Faiza Majid FINS3655 Behavioral Finance Price Anchoring Price Perception A 50 inch TV costs $1,000 while 48 inch costs $600. Power of Suggestion label choices as the “most popular”or the “flavor of the day”. Avoiding Extremes Surround the ideal option with a higher and a lower tier. Xerox corp. boosted sales of its high-volume copier to large corporations by introducing a higher priced model with a few extra bells and whistles. Faiza Majid FINS3655 Behavioral Finance Example: Real Estate Anchoring can even influence real estate prices (Gregory Northcraft and Margaret Neale, 1987) Real estate agents were given an opportunity to tour one of two houses for sale One that had been appraised at $74,900, or another that had been appraised at $135,000. The agents were given a 10-page packet that included all the information normally used to determine the value of a residential property (except the official appraisal). For some agents, the price of the home was listed at 11 to 12 percent below the true appraised value; for others it was 4 percent below value; for others it was 4 percent above the appraised value; and for still others it was 11 to 12 percent above value. Faiza Majid FINS3655 Behavioral Finance Anchoring - Real Estate Example The agents were given twenty minutes to walk through and around the property, after which time they provided their best estimate of the appraised value of the property, an appropriate advertised selling price, a reasonable price to pay for the house, the lowest offer they would accept for the house if they were the seller. Faiza Majid FINS3655 Behavioral Finance Anchoring - Real Estate Example All four estimates showed significant evidence of anchoring Interestingly, however, when asked what their top three considerations were in making these judgments, only 1 agent in 10 mentioned the listing price. These results are important demonstrate the power of anchoring in a real-world setting. Changing only one piece of information (listing price) in a 10-page packet of materials, shifted real estate appraisals by more than $10,000. Experts are not immune to the effects of anchoring. Most of the agents had sold real estate for several years, yet this expertise did not prevent their judgments from being anchored. Very few agents identified the listing price as an important consideration in their deliberations. Shows lack of awareness of being anchored. Faiza Majid FINS3655 Behavioral Finance Anchoring - Knowledge of Participants Expertise does not significantly reduce the anchoring bias in decisions. car experts (car mechanics and car dealers) with all the necessary information evaluated the value of a car based on the anchors provided (Mussweiler et al., 2000) experienced legal professionals, were significantly influenced by irrelevant anchors on their sentencing decisions (Englich and Mussweiler, 2001; Englich et al., 2005, 2006). estate agents made pricing estimations biased toward the anchor values (Northcraft and Neale, 1987) Faiza Majid FINS3655 Behavioral Finance Anchoring - Rewards or motivation for accuracy Surprisingly, the effects of anchoring do not disappear with monetary incentives for accuracy [or with outrageously extreme anchors (Quattrone et aI., 1984)]. Tversky and Kahneman (1974) offered payoffs for accuracy to motivate participants in order to reduce the anchoring effect, but to no effect. findings by Wilson et al. (1996) demonstrate that anchoring effects are not eliminated with incentives and forewarnings. some studies have found the effectiveness of forewarning in diminishing the effects of anchoring when warnings about insufficient adjustment (LeBoeuf and Shafir, 2009) Faiza Majid FINS3655 Behavioral Finance Faiza Majid FINS3655 Behavioral Finance Tversky and Kahneman (1974) Biases in the evaluation of conjunctive and disjunctive events Which of the following instances appears most likely? Which appears second most likely? A. Drawing a red marble from a bag containing 50 percent red marbles and 50 percent white marbles. [simple event] B. Drawing a red marble seven times in succession, with replacement (i.e., a selected marble is put back into the bag before the next marble is selected), from a bag containing 90 percent red marbles and 10 percent white marbles. [Conjunctive event] C. Drawing at least one red marble in seven tries, with replacement, from a bag containing 10 percent red marbles and 90 percent white marbles. [disjunctive event] The most common ordering of preference is B-A-C. The correct order of likelihood is C (52%), A (50%), and B (48%). Faiza Majid FINS3655 Behavioral Finance Evaluation of conjunctive and disjunctive events - continued This result illustrates a general bias to overestimate the probability of conjunctive events, or events that must occur in conjunction with one another and to underestimate the probability of disjunctive events, or events that occur independently. This bias is explained as an effect of anchoring. Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions Cognitive biases that frequently affect financial decisions Overconfidence The tendency of people to provide too narrow ranges when estimating the range that an uncertain value might fall within. Faiza Majid FINS3655 Behavioral Finance Over-Confidence How good a driver are you? Relative to the drivers you encounter on the road, are you: above average average below average In surveys of Americans of most ages and demographics (including college students), the majority of respondents respond that they are above-average. Faiza Majid FINS3655 Behavioral Finance Over-Confidence in Stock markets Overconfident Investors Faiza Majid FINS3655 Behavioral Finance Over-Confidence Theoretical models predict that overconfident investors trade excessively [Fischhoff, Slovic, and Lichtenstein 1977]. Overconfident investors tend to overestimate their future performance and the precision of their investment decisions (Glaser and Weber, 2007). Overconfidence is greatest for difficult tasks... [Yates 1990; Griffin and Tversky 1992]. Selecting common stocks that will outperform the market is a difficult task. Predictability is low; feedback is noisy. Thus, stock selection is the type of task for which people are overconfident. While both men and women exhibit overconfidence, men are generally more overconfident than women (Lundeberg et al.,1994) Several studies confirm that differences in confidence are greatest for tasks perceived to be in the masculine domain Men are inclined to feel more competent than women do in financial matters [Prince 1993] Men are more overconfident investors than women (Gallup survey conducted 15 times between June 1998 and January 2000 with 1000 respondents per survey) Faiza Majid FINS3655 Behavioral Finance Over-Confidence and Gender Boys will be boys – Overconfidence and Gender (Barber and Odean, 2001) Utilize trading activity of over 35,000 households from a large discount brokerage over a six year period. The results included the following observations: Men traded 45% more than women. Trading reduces men’s net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. Men bought stocks that underperformed the ones they sold by 20 bp and this figure was 17 for women Huang & Kisgen (2013) Male executives undertake more corporate acquisitions Male executives typically issue more debt Faiza Majid FINS3655 Behavioral Finance Over-Confidence and Self-Attribution Bias Individuals tend to ascribe their successes to their own talents, but their failures to bad luck News that confirms the investor’s own views is given considerable attention News that tends to dis-confirm the investor’s views is discounted Outcome: short-term market momentum as investors over-react to news that confirms their initial bias, and under-react to disconfirming information Self-attribution bias tends to generate increased over-confidence, as individuals give greater weight to outcomes that support their original hypothesis Self-fulfilling prophecy:if everyone believes that the market will go up, it will in fact go up, perpetuating investor over-confidence Overconfidence increases over time as a function of past investment success Faiza Majid FINS3655 Behavioral Finance Over-Confidence and Corporate Finance Over-confident executives underestimate the time and uncertainty with respect to a new project. This can become costly due to: Commitment escalation: misplaced persistence with a project because to cancel it means admitting to a mistake Sunk cost bias: continuing with a project despite its negative expected value, because of the amount of money that has already been spent. Overconfident CEOs are more likely to make acquisitions, over-invest in projects and invest in risky projects (Malmendier and Tate, 2005). Overconfident CFOs use lower discount rates to discount cash flows, Use more debt (especially long term debt), invest more often in projects (Ben-David et al., 2013) Faiza Majid FINS3655 Behavioral Finance Over-Confidence Overconfidence in Stock market. Corporate executives also tend to over-estimate overall market returns, and also their expertise in predicting such returns. This is known as Illusion of Control Financial executives are miscalibrated: realized market returns are within the executives’ 80% confidence intervals only 38% of the time (Ben-David et al., 2013) Overconfidence in Household Finance. Overconfidence in household finance can lead to suboptimal savings and investment choices. Individuals may overestimate their future income or ability to repay loans, leading to excessive debt accumulation (Campbell, 2006). Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions Confirmation bias Confirmation bias refers to the tendency to seek out, interpret, and remember information that confirms one’s pre-existing beliefs, while disregarding information that contradicts them. Confirmation bias is sometimes linked to the availability heuristic, as investors may overweight information that is more accessible or prominent to them, reinforcing their existing beliefs. Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions Confirmation Bias in Stock Market Rabin and Schrag (1999): investors are more likely to interpret ambiguous information in ways that confirm their existing beliefs about a stock or the market. Daniel et al.,(1998): Confirmation bias can lead to “confirmation trades” resulting in investors holding onto overvalued stocks too long or miss opportunities to diversify. Confirmation Bias in Real Estate Markets Example, U.S. Housing Bubble (2000s) Shiller (2000); Brunnermeier and Oehmke (2014) Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions Confirmation Bias in Corporate Finance Example, M&As such as HP’s Acquisition of Autonomy (2011) Davis (2015) ; Roll and Bruner (2012) confirmation bias can lead to overconfident managerial decisions, such as continuing to invest in failing projects (escalation of commitment) because managers selectively interpret information as proof that the project will eventually succeed (Staw, 1976). Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions Herding Behaviour Herding bias is the tendency of individuals to follow the behavior of a larger group, often assuming that the majority’s actions are more informed. Investors may use the representativeness heuristic to assume that if a large number of people are investing in a certain stock or sector, it is representative of a successful opportunity, leading to herding behavior. This can lead to collective irrationality, particularly in financial markets. Faiza Majid FINS3655 Behavioral Finance Herding Behaviour Herding in Stock Market Herding can lead to stock price bubbles and crashes, as investors collectively buy or sell based on the actions of others rather than fundamentals. This behavior was notably observed during the dot-com bubble of the late 1990s. Herding in Real Estate Market Herding can be observed in real estate markets. For example, during housing booms, many buyers enter the market simply because others are buying, leading to price inflation that eventually collapses. Case & Shiller(2003). Herding and Market Trends e.g. Cryptocurrency Market The rise of Bitcoin and other cryptocurrencies saw significant herding behavior, where investors rushed to buy in as prices soared, often influenced by media hype and social media trends rather than fundamental analysis. Faiza Majid FINS3655 Behavioral Finance Cognitive Biases and Financial Decisions The disposition Effect The disposition effect refers to the tendency of investors to sell winning investments too early to lock in gains, while holding onto losing investments for too long in the hope of breaking even. The disposition effect is linked to anchoring, where investors anchor on the original purchase price of an investment. They are reluctant to sell below this price, even when it no longer reflects the asset’s true value. Faiza Majid FINS3655 Behavioral Finance The Disposition Effect The Disposition Effect in Stock Market The disposition effect can lead to suboptimal trading strategies where investors hold onto losing stocks in hopes of recovery, while prematurely selling winning stocks, thus limiting their potential gains. Shefrin & Statman (1985); Frazzini (2006) The disposition Effect in Corporate Finance Corporate managers may exhibit the disposition effect by holding onto failing projects for too long, refusing to admit defeat in the hope that they can turn things around, which can result in continued capital losses. Staw (1981) Faiza Majid FINS3655 Behavioral Finance