Chapter 22 behavioral finance implications for financial management

Chapter 22 Behavioral Finance: Implications for Financial Management McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 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 22-2 Chapter Outline • Introduction to Behavioral Finance • Biases • Framing Effects • Heuristics • Behavioral Finance and Market Efficiency • Market Efficiency and the Performance of Professional Money Managers 22-3 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) 22-4 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 22-5 Overoptimism • Example: overstating projected cash flows from a project, resulting in a high 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”) 22-6 Confirmation Bias • More weight is given to information that agrees with a preexisting opinion • Contradictory information is deemed less reliable 22-7 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) 22-8 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 22-9 The Gambler’s 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 22-10 [...]... 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? 22- 17 End of Chapter 22- 18 ... potential arbitrage profit 22- 12 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 22- 13 Money Manager Performance • If markets are... Performance • If markets are inefficient as a result of behavioral factors, then investment managers should be able to generate excess return • 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 22- 14 Quick Quiz • Describe the similarities and... inefficient? 22- 15 Ethics Issues • Consider a political election with two competing candidates, one who is pro-life and the other who is pro-choice – 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? 22- 16 Comprehensive.. .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 22- 11 Limits to Arbitrage • Firm-specific risk . Chapter 22 Behavioral Finance: Implications for Financial Management McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies,. suboptimal financial decisions • Recognize the shortcomings and limitations to market efficiency from the behavioral finance viewpoint 22- 2 Chapter Outline • Introduction to Behavioral Finance • Biases • Framing. Finance • Biases • Framing Effects • Heuristics • Behavioral Finance and Market Efficiency • Market Efficiency and the Performance of Professional Money Managers 22- 3 Poor Outcomes • A suboptimal result