CHAPTER 22

BEHAVIORAL FINANCE: IMPLICATIONS FOR

FINANCIAL MANAGEMENT

KEY CONCEPTS AND SKILLS

Identify behavioral biases and understand
how they impact decision-making
Understand how framing effects can result in
inconsistent and/or incorrect decisions
Understand how the use of heuristics can
lead to suboptimal financial decisions
Recognize the shortcomings and limitations
to market efficiency from the behavioral
finance viewpoint
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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
Professional Money Managers
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POOR OUTCOMES
A suboptimal result in an investment decision can
stem from one of two issues:
You made a good decision, but an unlikely negative event
occurred
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
Business decisions require judgment of an
unknown future
Overconfidence results in assuming forecasts are
more precise than they actually are

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OVERCONFIDENCE
AND STOCK MARKET TRADING
It has been shown that overconfidence
by investors leads to overestimation of
their own ability to pick the best stocks,
leading to excessive trading.
Investors hurt themselves by trading.
The accounts that have the most trading
underperform the accounts with the least trading.
This is primarily because of the costs associated with
trades.

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OVERCONFIDENCE AND GENDER

It has also been shown that investor
accounts registered to men
underperform those registered to
women.
The reason is that men trade more on average.
This extra trading is consistent with evidence
from psychology that men have greater degrees
of overconfidence than women.

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OVEROPTIMISM
Example: overstating projected cash flows
from a project, resulting in a higher than
realistic NPV
Overestimate the likelihood of a good
outcome
Not the same as overconfidence, as
someone could be overconfident of a
negative outcome (i.e., overpessimistic)

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CONFIRMATION BIAS
More weight is given to information that agrees
with a preexisting opinion
Confirmation bias exists when a person tends to
spend too much time trying to prove themselves
correct rather than searching for information that
might prove them wrong

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FRAMING EFFECTS
How a question is framed may impact the
answer given or choice selected
Loss aversion (or break-even effect)
Retain losing investments too long (violation of
the sunk cost principle)

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

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EXAMPLE: FRAME DEPENDENCE

Consider the following example:
A disaster has occurred, 600 people are at risk,
and you are in charge. You must choose
between the two following rescue operations:
SCENARIO 1
Option A: Exactly 200 people will be saved.
Option B: There is a 1/3 chance that all 600
people will be saved and a 2/3 chance that no
people will be saved.
Which would you choose? There is no necessarily right
answer, but most people will choose option A.

EXAMPLE: FRAME DEPENDENCE,

CONTINUED
Now suppose your choices are as follows:
SCENARIO 2
Option C: Exactly 400 people will die.
Option D: There is a 1/3 chance that nobody will
die and a 2/3 chance that all 600 will die.
Now which do you pick? Again, there is no right answer, but
most people will choose option D.

It turns out that A and C are the same, and that B

and D are the same. This means Scenarios 1 and
2 are actually the same. Be careful! Framing
makes them appear different.

EXAMPLE: LOSS AVERSION

Here is another example that illustrates a particular type of frame
dependence:
SCENARIO 1: Suppose we give you $1,000. You have the following
choices:
Option A: You can receive another $500 for sure.
Option B: You can flip a fair coin. If the coin flip comes up heads,
you get another $1,000, but if it comes up tails, you get
nothing.
SCENARIO 2: Suppose we give you $2,000. You have the following
choices:
Option C: You can lose $500 for sure.
Option D: You can flip a fair coin. If the coin flip comes up heads,
you lose $1,000, but if it comes up tails, you lose nothing.

EXAMPLE: LOSS AVERSION

CONTINUED
Which do you choose in each scenario?
About 85 percent of the people who are presented with
the first scenario choose option A.
About 70 percent of the people who are presented with
the second scenario choose option D.
Careful observation will reveal that A and C are the same,
and that B and D are the same.
Focusing on gains and losses instead of overall wealth is an
example of narrow framing, and it leads to phenomenon
called loss aversion.
Loss aversion is also known as get-evenitus or the break-even
effect.

EXAMPLE: MENTAL ACCOUNTING

Lets consider another common situation to illustrate
several of the ideas we have explored thus far.
Consider the following two investments:
Investment 1: You bought 100 shares in Moore
Enterprises for $35 per share. The shares
immediately fell to $20 each.
Investment 2: At the same time, you bought 100
shares in Miller Co. for $5 per share. The shares
immediately jumped to $20 each.
Be careful how you react to these outcomes or you
may suffer from Mental Accounting,

EXAMPLE: MENTAL ACCOUNTING,

CONTINUED
You might tell yourself that your Miller investment was a
great idea on your part. The drop in value on the Moore
shares wasnt your faultit was just bad luck.
This is a form a confirmation bias, and it also illustrates
selfattribution bias, which is taking credit for good outcomes that
occur for reasons beyond your control, while attributing bad
outcomes to bad luck or misfortune.

You might be inclined to sell your Miller stock to realize the

gain, but hold on to your Moore stock in hopes of avoiding the
loss (which is, of course, loss aversion).
The tendency to sell winners and hold losers is known as the
disposition effect.
The rational thing to do is to decide if the stocks are attractive
investments at their new prices and react accordingly.

OTHER RELATED TYPES OF

JUDGMENT ERRORS
Myopic loss aversion. This behavior is the
tendency to focus on avoiding short-term losses,
even at the expense of long-term gains.
For example, you might fail to invest in stocks
for long-term retirement purposes because you
have a fear of loss in the near term.
Regret aversion. This aversion is the tendency
to avoid making a decision because you fear that,
in hindsight, the decision would have been less
than optimal. Regret aversion relates to myopic
loss aversion.

OTHER RELATED TYPES OF JUDGMENT

ERRORS, CONTINUED
Endowment effect. This effect is the tendency
to consider something that you own to be worth
more than it would be if you did not own it.
Because of the endowment effect, people
sometimes demand more money to give up
something than they would be willing to pay to
acquire it.
Money illusion. If you suffer from a money
illusion, you are confused between real buying
power and nominal buying power (i.e., you do not
account for the effects of inflation).

HEURISTICS
Rules of thumb, mental shortcuts
The 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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EXAMPLE: REPRESENTATIVENESS AND

RANDOMNESS
HOT HAND IN BASKETBALL
Shooting Percentages and
the History of Previous Attempts
Shooting Percentage
History of
on Next Shot
Previous Attempts
46%
Has made 3 in a row
50%
Has made 2 in a row
51%
Has made 1 in a row
52%
First shot of the game
54%
Has missed 1 in a row
53%
Has missed 2 in a row
56%
Has missed 3 in a row

The clustering illusion is our human belief that random

events that occur in clusters are not really random.

THE GAMBLERS FALLACY

Heuristic that assumes a departure from the
average will be corrected in the short-term
Related biases
Law of small numbers
Recency bias
Anchoring and adjustment
Aversion to ambiguity
False consensus
Availability bias
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BEHAVIORAL FINANCE AND

MARKET EFFICIENCY
Can 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 ARBITRAGE
Firm-specific risk
Reluctant to take large positions in a single security
due to the possibility of an unsystematic event

Noise trader risk, or Sentiment-based risk

Keynes: Markets can remain irrational longer than
you can remain insolvent.

Implementation costs
Transaction costs may outweigh potential arbitrage
profit

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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 28, 1929

October 19, 1987
Asian (Nikkei) crash
Dot-com bubble and crash

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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 returns
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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MONEY MANAGER PERFORMANCE

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.
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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