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Chapter 22 - Behavioral Finance: Implications for Financial Management
Chapter 22
BEHAVIORAL FINANCE: IMPLICATIONS FOR
FINANCIAL MANAGEMENT
CHAPTER WEB SITES
Section Web Address
22.4 www.behavioralfinance.net
22.5 www.zakon.org/robert/internet/timeline
CHAPTER ORGANIZATION
22.1 Introduction to Behavioral Finance
22.2 Biases
Overconfidence
Overoptimism
Confirmation Bias
22.3 Framing Effects
Loss Aversion
House Money
22.4 Heuristics
The Affect Heuristic
The Representativeness Heuristic
Representativeness and Randomness
The Gambler’s Fallacy
22.5 Behavioral Finance and Market Efficiency
Limits to Arbitrage
Bubbles and Crashes
22.6 Market Efficiency and the Performance of Professional Money Managers
22.7 Summary and Conclusions
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Chapter 22 - Behavioral Finance: Implications for Financial Management
ANNOTATED CHAPTER OUTLINE
Lecture Tip: In the chapter opener, the issue of market bubbles is presented,
providing the specific example of the internet bubble in the late 1990s. Other
similar situations exist; for example, consider the run in commodities (oil,
gold, etc.) in 2007 and early 2008. However, it is good to point out to students
that the same condition may occur on the downside as well. So, just as
investors may “herd” into an asset, they may also herd out of an asset. Being
able to identify these biased actions may provide an “unbiased” investor (if
one exists) a competitive advantage.
1. Introduction to Behavioral Finance
Poor outcomes may result from one of two issues:
-you have made a good decision, but something happens that was an
extremely unlikely event (i.e., you were unlucky)
-you simply made a bad decision (cognitive error)
Lecture Tip: Sometimes events occur that are beyond our control. We have
previously discussed ways to review the potential outcomes of such
occurrences. Thus, it may be helpful to remind students about activities such
as sensitivity and scenario analysis, as well as simulation techniques. This
chapter, hopefully, will help alleviate (or at lest reduce) the second cause of
poor outcomes.
In the remainder of the chapter, we will explore three main categories of
cognitive error (often referred to as behavioral bias):
-biases
-framing effects
-heuristics
2. Biases
A. Overconfidence
Most all people are overconfident about one or more of their
abilities:
-80 percent of drivers consider themselves to be above
average
-individual investors (particularly men) tend to trade
excessively, which actually produces underperformance
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Chapter 22 - Behavioral Finance: Implications for Financial Management
Lecture Tip: Overconfidence is tied to self-attribution bias, which
leads people to attribute success to their own skill, while poor
results are attributed to bad luck.
Most business decisions require us to make judgments about the
future, which is unknown. The most common occurrence of
overconfidence is assuming that these forecasts about the future
can be made with precision.
B. Overoptimism
-overestimate the likelihood of a good outcome. In the context of
business decisions, this would imply forecasting a higher NPV
than actually exists.
-related to overconfidence, but not exactly the same. For example,
we could be overconfident of a negative occurrence (i.e.,
overpessimistic)
C. Confirmation Bias
-occurs when more weight is given to information that agrees with
our preexisting opinions
3. Framing Effects
How a question is framed may determine the most likely response
that is given.
Ethics Note: Ask students to consider a political election with two
competing candidates, one who is pro-life and the other who is
pro-choice. Notice that both sides use the prefix pro to frame the
position in a positive light. Ask the students how a pollster
representing one side may frame a question differently than
someone from the competing political camp. What does this say for
the potential accuracy of reported survey results? This issue has a
similar application for a company that is researching consumer
opinions regarding its product. I.e., make sure that questions are
not worded (framed) so as to elicit a biased response.
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Chapter 22 - Behavioral Finance: Implications for Financial Management
Lecture Tip: Historically, employees who were offered a company-
sponsored retirement plan (such as a 401(k)) were required to opt
into the plan. Thus, the default option was no participation. Under
this approach, less than 1/3 of employees participated. The
government changed the allowable approach earlier this decade,
allowing companies to default employees into the plan, while
offering the choice to opt out. While there was no change to the
choice the employees faced, the way in which the situation was
framed significantly changed the participation rate, with over 2/3
of employees participating. This is also an example of what is
referred to as the “endowment” effect.
A. Loss Aversion
-focusing on gains and losses, rather than overall wealth, is a type
of narrow framing that leads to loss aversion
-also referred to as the “break-even” effect, as individuals and
companies hang on to bad investments too long, hoping something
will happen to help them avoid a loss. Obviously, this is in direct
contrast to the issue of not including sunk costs in our decision-
making process.
Lecture Tip: Terrance Odean, in “Are Investors Reluctant to
Realize Their Losses” (Journal of Finance, 1998), finds that
investors sell winning stocks to early and retain poorly performing
stocks too long, resulting in a lower portfolio return.
B. House Money
-gamblers are more likely to take big risks with money they have
won from the casino than with the money they brought from home
However, once the money is won, that money is yours, so there is
no difference, as they are both forms of wealth.
Just like investors associate a stock with its purchase price,
managers may associate a project with its original cost and
mentally account for relative gains and losses over time. This
creates a “personal relationship” with the investment that makes it
harder to liquidate, even if it were in the best financial interest to
do so.
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Chapter 22 - Behavioral Finance: Implications for Financial Management
4. Heuristics
-rules of thumb (or mental shortcuts) used to make decisions
An example is accepting projects with a payback of two years, without
performing any time value analysis. The decision may be right in many
cases, but it may lead to poor outcomes.
A. The Affect Heuristic
-the reliance on instinct (or emotions), rather than analysis, to
make decisions
B. The Representativeness Heuristic
-reliance on stereotypes or limited samples to form opinions about
an entire group
Lecture Tip: Consider a firm that makes a successful investment in
the country of Russia, then assumes that all future investments in
the country will be successful. Ask students what could be different
about subsequent investments that would render this assertion
incorrect.
C. Representativeness and Randomness
-perceiving patterns where none exist
Lecture Tip: Remind students about the implication of market
efficiency for technical analysis; then discuss how
representativeness may increase the perceived attractiveness of
such an approach.
D. The Gambler’s Fallacy
-assuming that a departure from average will be corrected in the
short-term
Suppose a coin is flipped five times in a row, each resulting in a
head. Someone experiencing gambler’s fallacy will be prone to
believe it is more likely that the next flip will be a tail, even though
it is an independent event with a 50/50 chance.
Other related biases include:
Law of small numbers – small sample always represents
long run distribution
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Chapter 22 - Behavioral Finance: Implications for Financial Management
Recency bias – recent events are given more importance
Lecture Tip: In 2008, there was a great amount of flooding
across the Midwest, with many areas experiencing “500-
year” floods. Ask what an individual exhibiting recency
bias would be prone to do regarding flood insurance (take
out added coverage). Contrast this to someone who is
displaying signs of gambler’s fallacy (reduce coverage).
Anchoring and adjustment – unable to appropriately
account for new information
Aversion to ambiguity – shy away from the unknown
False consensus – believe other people have the same
opinions as your own
Availability bias – put too much weight on information that
is easily available
5. Behavioral Finance and Market Efficiency
If many traders behave in a way that is economically irrational (i.e.,
exhibit behavioral bias), then are markets really efficient?
-the efficient markets hypothesis does not require every investor to
be rational
A. Limits to Arbitrage
If only one investor was rational, s/he could keep the market
efficient if s/he had sufficient resources to arbitrage irrational
pricing effects. However, this would require unlimited capital.
There are more basic limits to arbitrage:
Firm-specific risk: an unanticipated firm event could offset
any potential arbitrage gains
Noise trader risk: unsophisticated investors “herd” in their
decisions
Keynes: “Markets can remain irrational longer than
you can remain solvent.”
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Chapter 22 - Behavioral Finance: Implications for Financial Management
Implementation costs: transaction costs may make arbitrage
too costly
Examples:
(1) 3Com / Palm - shares of spinoff firm traded at a higher value
than the actual firm itself
Lecture Tip: A potential explanation is limited availability
made it effectively impossible to short the shares and bring
prices back to rational levels.
(2) Royal Dutch / Shell – prices consistently deviated from ratio of
merged firm values
B. Bubbles and Crashes
Bubble – market prices exceed the level that normal, rational
analysis would suggest
Crash – significant, sudden drop in market-wide values; generally
associated with the end of a bubble
Some examples of crashes:
-October 29, 1929
-October 19, 1987
-Asian crash
-“Dot-com” bubble and crash
Lecture Tip: Although the 1987 crash still represents the largest
single day percentage drop, the largest point drop (on the Dow)
occurred on September 29, 2008 (778 points) following the House
of Representatives refusal to pass the “bailout” package
associated with the mortgage and credit crisis.
Lecture Tip: The first bubble was recorded in 1637, as the Dutch
experienced “Tulip Mania,” pushing the price of the rarest tulip
bulb to 20 times that of a skilled craftsman’s yearly wage. The
market suddenly collapsed after approximately six months.
6. Market Efficiency and the Performance of Professional Money Managers
If markets are efficient, then passively managed index funds should be as
good an investment as an actively managed fund. Stated differently, it should
be difficult for active managers to outperform the market.
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Chapter 22 - Behavioral Finance: Implications for Financial Management
History suggests that this is what happens, as there are very few examples of
managers who have consistently outperformed the market. Further, it is
impossible to determine ahead of time who these managers will be.
So, even if markets are not perfectly efficient, there does appear to be a
relatively high degree of efficiency.
7. Summary and Conclusions
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