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

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

Chapter Outline

• Introduction to Behavioral Finance

• Biases

• Framing Effects

• Heuristics

• Behavioral Finance and Market Efficiency

• Market Efficiency and the Performance of Professional Money Managers

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)

• 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

• 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”)

Confirmation Bias

• More weight is given to information

that agrees with a preexisting

opinion

• Contradictory information is deemed less reliable

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)

• 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

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

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

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

– Keynes: “Markets can remain irrational longer than you can remain insolvent.”

• Implementation costs

– Transaction costs may outweigh potential

arbitrage profit

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

Money Manager 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

Quick Quiz

• Describe the similarities and differences

between overconfidence and overoptimism

• 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?

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?

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,

End of Chapter