Behavioral Finance PDF - Confirmation Bias

FINMAN E2: BEHAVIORAL FINANCE Sources of Confirmation Bias TOPIC 1: CONFIRMATION BIAS Popular Narratives Cultural Beliefs Refers to a type of selective Family Values perc...

FINMAN E2: BEHAVIORAL FINANCE Sources of Confirmation Bias TOPIC 1: CONFIRMATION BIAS Popular Narratives Cultural Beliefs Refers to a type of selective Family Values perception that emphasizes ideas that confirm our beliefs while Implications to Investor devaluing whatever contradicts our beliefs. Investors often fail to acknowledge Refers to our all too-natural ability anything negative about investments to convince ourselves of whatever they’ve just made, even when it is we want to believe. substantial evidence begins to argue against these investments. In Confirmation Bias… Can cause investors to continue to hold under diversified portfolios. You are not seeking out objective Many practitioners have seen clients facts become infatuated with certain Interpreting information to support stocks. your existing belief Only remember details that uphold The Case of Gold Investor (2010) your belief Ignoring information that challenges Selective Information your belief ○ Jim focused on reports that predicted continued Why does it matter? economic uncertainty and inflation. Both of which push Confirmation Bias may lead to gold prices. clients overinvesting a particular stock or sector. Ignoring signs by 2011 May lead to clients' biased ○ Some analyst began warning interpretation, this is when we that gold market was consciously interpret information in a overheated and that prices way that confirms our belief. could fall as the global economy stabilized Who has Confirmation Bias? Instead of diversifying According to Charles Schwab of ○ jim bought even more gold Cerulli Associates: 93% are as prices climb around 1,900 affected by confirmation bias. per ounce confident that it Gen X 58% surpass 2,000 Millennials 54% Silent Generation 53% Consequences Baby Boomers 49% ○ Gold prices began to decline in 2012 as global economy  conditions improve by 2015. Subject to suffer from Endowment Bias By 2015, gold had dropped to around 1,050 per ounce Older people/Sentimental Person causing Jim significant Celebrity losses. Collectors Investors How to avoid Confirmation Bias? ○ Generally, endowment bias tends to impact investors in 2 First and foremost, accept that you main context: have biases that impact your Inherited Securities decision-making. Purchased Securities Do your research thoroughly when searching for information. Implications to Investor Make sure you read entire articles, not just the headline, prior to First, investors may hold onto drawing any conclusions. securities they already own. Second, investors hold onto TOPIC 2: ENDOWMENT BIAS securities because of familiarity. - A wise man should have money in TOPIC 3: OVERCONFIDENCE BIAS his head, but not in his heart. -Jonathan Swift - Too many people overvalue what they are not and undervalue what Endowment Bias they are. - Malcolm S. Forbes People who exhibit endowment bias value an asset more when they hold Confidence - is a belief in oneself, the property rights to it than when they conviction that one has the ability to meet don’t. life’s challenges and to succeed–and the Is inconsistent with standard willingness to act accordingly. economic theory, which asserts that a person’s willingness to pay for a Characteristics of a confident person: good or an object should always equal the person’s willingness to 1. Acts responsible and ask for help accept the dispossession of the when needed. good or object. 2. Don’t make excuses 3. Never worry about what others think Example: of them When a person is selling a car at 4. Is not afraid to make decision. $40.000. However, the sales price for the same model at a local Why overconfidence occur? dea;ership is $20,000. In this case, the person perceives the car as As human beings, we like to feel more valuable since they own it. good about ourselves. We hate being looked down upon.  We like to win and feel the best. comparing yourself to others The problem is, we consider with regards to a skill or ourselves as a part of the best even ability and making the when we are not. assumption that you are better than the majority of What is overconfidence? other people at something. 3. Over-precision The tendency to overestimate our - Sense of certainty that you, talents and abilities. We believe than more so than others, know what we actually are. the truth or reality of what is A bias where the subjective going to occur in the future. confidence of your assumptions is - A special edge of knowing greater than the objective accuracy. what is to come. May lead clients to make risky investments TOPIC 4: REPRESENTATIVE BIAS Overestimation of one’s actual ability to perform a task successfully, by a It is a mental shortcut that we use belief that one’s performance is when estimating probabilities. We better than that of others, or by often make our decision by excessive certainty in the accuracy assessing how similar it is to an of one’s belief. existing mental prototype. Example: Prototype Theory Most of the new investors who are People use unconscious mental beginners to the investment world, statistics to figure out what the are very overconfident. - barber and “average” member of a category odeon. looks like. When we are trying to make As level of overconfidence rises, decisions about unfamiliar things or cost of a mistake also increases. people, we refer to this average– the prototype– as a representative Types of Overconfidence example of the entire category. 1. Overestimation Types of Representative Bias - It is the belief that you are better at something than the 1. Base-rate Neglect reality of your skills or Some investors tend to rely abilities would indicate. on stereotypes when making - Person overestimates what investment decisions. they are able to do. 2. Sample-size Neglect 2. Overplacement When judging the likelihood - Belief that you are better of a particular investment than other people. It involve outcome, often fail to  accurately consider the 2. Disregarding conflicting facts sample size of the data on 3. Being reluctant to accept new ideas. which they base their judgements. Tips for reducing Anchoring Bias Harmful effects of Representative Bias Use multiple sources - you need to on Investors collect more resources. Evaluate your reasoning - when When evaluating a money you arrive at a new conclusion, ask manager’s past performance, yourself how you came to that investors have the potential to make conclusion. costly mistakes. Ask for a second opinion Similar errors are made by investors when looking into the track histories of stock experts. For instance, they How to avoid Anchoring Bias? incorrectly judge an analysts’s skill based on the performance of their By becoming more aware of it, last few suggestions. anchoring bias happens subconsciously, and when one isn’t TOPIC 5: ANCHORING BIAS aware something is happening, it’s difficult to interrupt it. Psychologists have found that To look for reasons why that anchor people have tendencies to rely too is inappropriate for that situations heavily on the very first piece of the Considering alternative options information they learn, which can Delay your decision. have a serious impact on the decision they end up making. Example: Free promotion Simple prices Per-customer limits Effects of Anchoring Bias Poor decision-making Skewed expectations Dismissal of new information 3 ways to identify Anchoring Bias 1. Relying on a single source of information FINMAN 8: SPECIAL TOPICS IN FM products and services. This section of your plan CHAPTER 1: EQUITY RESEARCH needs to have specific information about the Primarily means analyzing the current state of the company’s financials, performing industry, and its target ratio analysis, forecasting the markets. financials and exploring scenarios to make buy/sell stock investment Business industry/sectors recommendation. Financials Mining and oil Purpose Media Services To study companies, analyze Logistics financials, and look at quantitative Construction and qualitative aspects mainly for Real Estate decision: whether to invest or not. Retail Agriculture Equity Research Analyst Manufacturing he/she works for both buy-side and 3. Company Analysis sell-side firms in the securities Examine’s a firm’s financial industry. condition, products and They produce research reports, services, and competitive projections, and recommendations strategy. concerning companies and stock. Uses SWOC and PESTEL analysis. Equity Research Process 4. Financial Statement Analysis 1. Economic Analysis involves gaining an Refers to as evaluating costs understanding of an and benefits to check the organization's viability of a project, financial situation by investment opportunity, event, or any other matter. reviewing its financial It involves identifying, reports. The results evaluating, and comparing can be used to make costs and benefits. investment and lending decisions. 2. Industry Analysis This review involves Is a marketing process q that provides statistics 5. Report writing about the market Includes all the components potential of your business of an equity research.  Can be used in the CFA shareholder value equity research competition. over time. Capital structure must be 6. Presentation and utilized in order to sustain Recommendations needs and wants Refer to decisions that Benefits of ER companies need to take It gives us a glimpse of what’s regarding what proportion of going on in the industry equity and debt capital to have in Provides information about their capital structure. private companies Serves as a credible tool in evaluating the “true” condition Capital Structure of a company. is the particular combination of Top Market Research Companies in the debt and equity used by a PH company to finance its overall 1. Stitch Marketing Research operations and growth. 2. Spectacle 3. Bixa How do firms raise the funding 4. Prestige Research they need? 5. Kadence International 6. Antedote Research Co. They borrow money (debt); internal / external financing Sell ownership (stocks / equity) Retained earnings (profit) CHAPTER 2: STRATEGIC AND TACTICAL The financial manager must FINANCING DECISIONS access all these sources and Strategic Financing Decisions choose the one most likely to help maximize firm’s value. Strategic financial management means Types of Financing not only managing a company's finances 1. Short-term Financing but managing them comes due within one with the intention to year succeed—that is, to EX. Trade credit, bank attain the company's loans, commercial paper long-term goals and objectives and maximize 2. Long-term Financing  due more than one year 6. Size of the business They carry lower rates of interest and are fixed. They require 7. Financial Risk - Financial risk is collateral to be the possibility of losing money provided. on an investment or business They are riskier because venture. Some more common the debt involved is huge. and distinct financial risks Factors influencing Capital include credit risk, liquidity risk, Structure and operational risk. May lead to insolvency 1. Business risk - Business risk is any exposure a company or organization has to factor(s) CHAPTER 3: BANKRUPTCY that may lower its profits or cause it to go bankrupt. Bankruptcy is a legal proceeding initiated when a person or business is unable to 2. Company tax exposure - A repay outstanding debts or corporate tax, also called obligations. corporation tax or company tax, is a type of direct tax levied on The bankruptcy process begins the income or capital of with a petition filed by the corporations and other similar debtor. All of the debtor's legal entities assets are measured and evaluated, and the assets may be used to repay a portion of 3. Financial flexibility - the ability the outstanding debt. of a firm to access and restructure its financing at a low Different from insolvency cost. Major causes of Business Failure 4. Market Condition - including the 1. Economic Factors number of competitors, a. Industry weakness competitiveness and market's b. Poor location/product growth during the situation for 2. Financial Factors a firm that enters the market or a. Too much debt introduces a new product. b. Insufficient capital 5. Cost of fixed assets Do business failure occur evenly over time? A large number of businesses fail each year, but the number in any one year has never been a large percentage of the total business population. The failure rate of business has tended to fluctuate with the state of economy. Key Issues managers face in a financial distress process Is the issue a temporary problem or a permanent problem? Who should bear the losses? Who are responsible / accountable Would the firm still become valuable if it continued to operate if it were liquidated? Should the business file bankruptcy, or should try to use informal procedures? Who are responsible for the liquidity or reorganization?