Behavioural Finance

Topic 3: Psychological traits

affecting behaviour
Reading: Chapters 1-3, Review Article,
‘Hidden Traps in Decision Making’
 Psychological traits lead to errors
in decision making

 All are vulnerable

 Errors arise from
 Heuristic-driven bias
 Frame dependence
 Errors cause market prices to deviate
from fundamental values

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 Heuristic-driven Bias
 People develop general principles as
they find things out for themselves,
usually by trial and error
 They rely on rule of thumb to draw
inference from the information at their
disposal
 Errors are caused as the principles
(heuristics) they use are imperfect as all
possibilities are not fully explored
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 Principles underlying
Heuristics
 Availability – decision based on recall –
tendency to consider events more
probable if they can easily be imagined
than if they cannot
 Universe of Stocks considered for acquisition
are those which are in the news
 Gadarowski (2001) investigated the
relationship between stock returns and press
coverage – stocks with high press coverage
underperformed in the subsequent two
years
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 Heuristics contd.
 Representativeness – stereotypes –
seeing a resemblance between
objects or events
 fail to recognise regression to the mean
 may apply the concept incorrectly -
gambler’s fallacy – law of small numbers
 where the data-generating process is not
known, inference is drawn too quickly on
the basis of too few data points
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 Heuristics contd.
HS GPA Avg. Predicted Actual College
College GPA GPA
2.20 2.07 2.70
3.00 2.77 2.93
3.80 3.46 3.30
Mean=3.44 Mean=3.08
SD=.36 SD=.4
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 Heuristics contd.
 Bloomfield and Hales (2001): People tend
to overreact to changes that were
preceded by many continuations and
under-react to changes that were preceded
by many reversals
 De Bondt (1992): long-term earnings
forecasts of analysts are much more
optimistic about recent winners than about
recent loosers
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 Heuristics contd.
 Overconfidence – set narrow confidence
bands to their estimates of quantities –
poorly calibrated in estimating probabilities
 Lichenstein and Fischoff (1977) gave people
market reports on 12 stocks and asked them
to predict whether the stocks would rise or fall
in a given period and also how confident they
are in their prediction – only 47% predictions
were correct, but the mean confidence rating
was 65%
 Confuse brains with bull market
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 Bookmakers and weathermen appear to be
better calibrated
 Heuristics contd.
 Anchoring – when faced with uncertainty
people catch at straws
 In the absence of any solid information, past
prices are likely to act as anchors for today’s
prices
 Relative Valuation method, for example
using industry PE ratio to judge the
cheapness of a stock
 Analysts’ valuations even using a bottom-up
approach often tend towards the comfort
9 zone of current price ± 5%
  Aversion to ambiguity – people prefer
the familiar to the unfamiliar
 ‘Home Bias’ in investments by fund
managers
 Coval and Moskowitz (1999) – 1 in 10 stocks
in a fund manager’s portfolio is chosen
because it is located in the same city as the
manager
 Hubermann (1999) – in 6 out of 7 states,
more people hold shares in local Baby Bell
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than in any other single operator
 Heuristics contd.
 Benartzi (2000) – own company stocks that
have done well in the past gets an allocation
of 40% (10% for low performers; 76% for
Coca-Cola employees) of discretionary
allocation of retirement savings of
employees, although allocations are
uncorrelated with subsequent performance
 Conservatism – people respond too
conservatively to new information vis-à-
vis their original anchored position
 Opposite to Representativeness – too much
emphasis on the prior as people fail to link
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new information with the prior
 Heuristics contd.
 Emotion – affects how people remember
events - emotional elements may lead to
cognitive error
 Self-attribution bias – ascribing success to
own talent and failure to bad luck
 Hindsight bias – tendency to believe, after an
event has occurred, that they predicted it
 Excessive Optimism – rosy view of their
abilities and prospects
 Belief perseverance – once people have
formed opinion, they do not search for
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contrary evidence and disbelieve it even if
they get it
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 Effect of Overconfidence and
Optimism on trading behaviour
 For individuals who sold a stock and
promptly purchased another, sold stock
outperformed the bought stock by 3.4%
in the first year
 One of the outcome is over-trading and
consequent loss
 Men trade 45% more than women and it
reduced returns 2.5% pps for men and 1.7
pps for women
 Single men trade 67% more than single
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women and this reduces their returns by 3.5
pps compared to single women
 Frame Dependence
 The form – as opposed to substance –
used to describe a problem affecting the
decision made
 Loss aversion – loss looms larger – about
2.5 times of the gain – at least, get even
 Hedonic editing – frame preference – risk
tolerance depends upon whether it is
about gain or loss and the recent
experience
 A zero net investment portfolio which is long
on low accrual firms and short on high
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accrual firms generated annual excess profit
of over 10%
 Prospect Theory (Kahneman
and Tversky, 1979)

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 Maximize Weighted Value

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 Prospect Theory
 Choices are made based on gain or loss
rather than on wealth
 Loss is weighted more than the gain
 Small probabilities are over-weighted
 Outcomes that are certain are over-
weighted compared to outcomes that are
just probable
 Prospects try to maximize the decision-
weighted value function
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 Frame Dependence contd….
 Separate Mental Accounting – prospects
put in a particular frame precludes
seeing through the opaque frame
 Self-control – lack of emotional control
makes a particular frame preferable
 Regret – pain of not having made the
right choice
 Money illusion – natural way is to think
in terms of nominal values
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 Summary
 Error in decision making by market
participants arise from two sources – use
of rules of thumb and influence of the
way the issue is presented
 These errors are pervasive
 This leads to market mis-pricing

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