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Behavioral Finance: Implications for Financial

Management

Chapter 22

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• Introduction to Behavioral Finance

• Biases• Framing Effects• Heuristics• Behavioral Finance and Market

Efficiency• Market Efficiency and the

Performance of Money Managers

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Chapter Outline

• Introduction to Behavioral Finance

• Biases• Framing Effects• Heuristics• Behavioral Finance and Market

Efficiency• Market Efficiency and the

Performance of Money Managers

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Poor OutcomesA suboptimal result in an investment decision can stem from one of two issues:

1. You made a good decision, but an unlikely negative event occurred

2. You simply made a bad decision (i.e., cognitive error)

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Overconfidence

Example: 80 percent of drivers consider themselves to be above average drivers.

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Overconfidence

Business decisions require judgment of an unknown future.

Overconfidence results in assuming forecasts are more precise than they actually are.

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Over-optimismExample: overstating projected cash flows from a project, resulting in a unrealistically high NPV, overestimating the likelihood of a good outcome.

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Over-optimism

Not the same as overconfidence, as someone could be overconfident of a negative outcome (i.e., “over-pessimistic”)

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Chapter Outline

• Introduction to Behavioral Finance

• Biases• Framing Effects• Heuristics• Behavioral Finance and Market

Efficiency• Market Efficiency and the

Performance of Money Managers

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Confirmation Bias

More weight is given to information that agrees with a preexisting opinion

Contradictory information is deemed less reliable

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Chapter Outline

•Introduction to Behavioral Finance•Biases•Framing Effects•Heuristics•Behavioral Finance and Market Efficiency•Market Efficiency and the Performance of Money Managers

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How a question is framed may

impact the answer given or choice selected

Framing Effects

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Framing Effects

Loss aversion (or break-even

effect)Retain losing

investments too long (violation of the sunk cost principle)

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House moneyMore likely to risk money that has been “won” than that which has been “earned” (even though both represent wealth)

Framing Effects

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Chapter Outline

•Introduction to Behavioral Finance•Biases•Framing Effects•Heuristics•Behavioral Finance and Market Efficiency•Market Efficiency and the Performance of Money Managers

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Heuristics

Definition of “Heuristic”: Doing things by “Rules of

Thumb” or using mental shortcuts to make a business decision.

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HeuristicsThe “Affect” Heuristic:

Reliance on instinct or emotions

Representativeness Heuristic:Reliance on stereotypes or limited samples to form opinions of an entire group

Representativeness and Randomness:

Perceiving patterns where none exist

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The Gambler’s Fallacy

Heuristic that assumes a departure from the average will be corrected in the short-term.

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The Gambler’s Fallacy

Related biasesLaw of small numbersRecency biasAnchoring and adjustment

Aversion to ambiguityFalse consensusAvailability bias

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Chapter Outline

•Introduction to Behavioral Finance•Biases•Framing Effects•Heuristics•Behavioral Finance and Market Efficiency•Market Efficiency and the Performance of Money Managers

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Behavioral Finance and

Market EfficiencyCan markets be efficient if many traders

exhibit economically irrational (biased) behavior?

The efficient markets hypothesis does not require every investor to be rational!

However, even rational investors may face constraints on arbitraging irrational behavior

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Limits to ArbitrageFirm-specific risk

Reluctant to take large positions in a single security due to the possibility of an unsystematic event

Noise trader riskKeynes: “Markets can remain irrational longer than you can remain insolvent.”

Implementation costsTransaction costs may outweigh potential arbitrage profit

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Bursting BubblesBursting Bubble – market prices exceed the level that normal, rational analysis would suggest.

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Crashes

Crash: a significant, sudden drop in market-wide values; generally associated with the end of a bubble.

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Crashes

Some examples of crashes:October 29, 1929October 19, 1987Asian crash“Dot-com” bubble and crash of the 1990’s

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Chapter Outline

•Introduction to Behavioral Finance•Biases•Framing Effects•Heuristics•Behavioral Finance and Market Efficiency•Market Efficiency and the Performance of Money Managers

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Money Manager Performance

If markets are inefficient as a result of behavioral factors, then investment managers should be able to generate excess return.

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Money Manager Performance

However, historical results suggest that passive index funds, on average, outperform actively managed funds.

Even if markets are not perfectly efficient, there does appear to be a relatively high degree of efficiency.

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Ethics Issues

Consider a political election with two competing candidates, one who is pro-national health care insurance and the other who is pro- “free-market” insurance.

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Ethics Issues

How might a pollster representing one side frame a survey question differently than someone from the competing political camp?

What does this say for the potential accuracy of reported survey results?

How might this situation apply to a company?

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Quick Quiz

Describe the similarities and differences between overconfidence and over-optimism.

How might the framing effect impact a company conducting market research.

What are heuristics, and why might they lead to incorrect decisions?

Why does the existence of cognitive error not necessarily make the market inefficient?

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Comprehensive Problem

Warren Buffett, CEO of Berkshire Hathaway, is often viewed as one of the greatest investors of all time. His strategy is to take large positions in companies that he views as having a good, understandable product but whose value has been unfairly lowered by the market.

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Comprehensive Problem

What behavioral biases is Buffett attempting to identify?

If he successfully identifies these, will he be able to outperform the market?

How might we analyze whether Buffett has, in fact, outperformed the market?

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Terminology

OverconfidenceOver-optimismConfirmation BiasFraming EffectsHeuristicsGambler’s FallacyBubblesCrashes

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Key Concepts and Skills

•Identify behavioral biases and discuss how they impact decision-making.

•Explain how framing effects can result in inconsistent and/or incorrect decisions.

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Key Concepts and Skills

•Describe how heuristics can lead to sub-optimal financial decisions.

•Critique the shortcomings and limitations to market efficiency from the behavioral finance viewpoint.

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1. Financial managers are people and as such they can make good or bad financial decisions.

2. Factors like overconfidence, over-optimism, and biases effect decisions.

3. Sometimes, just the framing of the question impacts the final decision made.

What are the most important topics of this chapter?

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4. Rational and irrational behavior by individuals can sway how the market performs.

5. Historically, passive index funds, on average, outperform actively managed funds by money managers.

What are the most important topics of this chapter?

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Questions?