Lecture 6 .

Finance and Investment.

Prepared by:
Dr/ Nourhan Tarek.
Lecture 6.
Behavioral
Investing.
 Learning Goals.
▪ Through this lecture , we will learn
how individuals and firms make
financial decisions, and how those
decisions might deviate from those
predicted by traditional financial or
economic theory.
▪ We will explore the nature of these
biases and their origins, using
insights from psychology,
neurosciences and experimental
economics on how the human mind
works. From these biases, you will
be able to examine how the insights
of behavioral finance complement
the traditional finance paradigm.
 Lecture Outline.
1. Behavioral Investing.
2. Behavioral Biases (Behavioral
Factors).
3. Decision Making Process and
Behavioral Biases.
4. Classifications of Behavioral Biases.
5. Cognitive Biases.
6. Emotional Biases.
 Lecture Outline.
7. Another Classification of Behavioral
Biases.
8. Some Examples of Emotional Biases.
9. Some Examples of Information
Processing Biases.
10. Some Examples of Belief
Perseverance Biases.
11. Overconfidence Bias Test.
Lecture Outline.
12. Success and Failure stories of
Overconfidence in Investment and
business world.
13. The Endowment Effect Test.
14. The meaning of Endowment Effect.
15. The endowment effect and investing.
16. How companies benefit from the
endowment effect?
Lecture Outline.
17. Framing Bias “Framing Effect” Test.
18. The meaning of Framing Effect.
19. The Framing Effect and Investing.
20. How companies benefit from
Framing Effect?
 Finance Triangle.

▪ There are three angles for finance

triangle: Market

1) Market.
2) Human Beings.
3) Technology.

Technology Human Beings.

 Behavioral Investing.

▪ Behavioral investing seeks to bridge the gap between psychology and investing. All too
many investors are unaware of the mental pitfalls that await them. Even once we are
aware of our biases, we must recognize that knowledge does not equal behavior. The
solution lies are designing and adopting an investment process that is at least partially
robust to behavioural decision-making errors.
▪ The importance of human behavior in the investing process had been recognized by
Benjamin Graham in the 1930s. Since human behavior seldom changes, what he said
then is true as on date and will remain so in the future as well.
 Behavioral Investing.

▪ The human mind being what it is, once all of you have finished this part, you will be able
to see and identify many of the biases among others , but you will be blind to these very
biases in so far as they relate to you. Please do not convince yourself that you are in
any way immune from bias. You are not and in fact, nobody is. If any of you think that
you are immune from the biases that you see in others, banish the thought. That would be
tantamount to saying that you are not human, you are an alien.
 Behavioral Biases “Behavioral
Factors”.

▪ We all view the world through different lenses. This has to do with our upbringing, our
collective experiences, and our subconscious behavioral biases.
▪ Inherent biases cause us to make snap judgments based on bad information, to be
unfair and to waste time. This is clearly problematic for investors, managers, and people
in general. Behavioral factors (Behavioral biases), included in prospect and heuristics
theories and affecting individual investment decision.
 Decision making process and
Behavioral Biases.
▪ We have to say that all the evidence is in
the favor that the decision- making
process is affected by different
behavioral biases.
▪ Human beings have two organs that is
responsible for these behavioral biases
which are:
1) Heart (Emotional Biases).
2) Brain (Cognitive Biases).
 Decision making process and
Behavioral Biases.
▪ Everybody has biases. We make judgments about
people, opportunities, government policies, and
of course, the markets.
▪ In general, all kinds of day-to-day activities
are primarily driven by behavioral patterns.
These same behavioral patterns can also
influence investing actions.
▪ For most people, it is impossible to be unbiased
in investment decision-making. However,
investors can mitigate biases by understanding
and identifying them, then creating trading
and investing rules that mitigate them when
necessary. Broadly, investing biases fall into two
main categories: cognitive and emotional. Both
biases are usually the result of a prejudice for
choosing one thing over the other.
Classifications ▪ The behavioral biases are classified as follows:

of Behavioral 1. Emotional Biases.

2. Cognitive Biases.
Biases.
 Cognitive Biases.
▪ Cognitive biases generally involve
decision-making based on established
concepts that may or may not be
accurate. Think of a cognitive bias as a
rule of thumb that may or may not be
factual.
▪ Here are some examples: confirmation
bias, Framing Bias, Mental
Accounting, Hindsight and Availability
Bias.
 Emotional Biases.
▪ Emotional biases typically occur spontaneously
based on the personal feelings of an individual at
the time a decision is made. They may also be
deeply rooted in personal experiences that also
influence decision-making.
▪ Emotional biases are usually ingrained in the
psychology of investors and can generally be
harder to overcome than cognitive biases.
▪ Emotional biases are not necessarily always
errors. In some cases, an investor’s emotional
bias may help them to make a more protective
and suitable decision for themselves.
▪ some examples of emotional biases are: Loss
aversion bias, Overconfidence bias, Endowment
bias.
 Another Behavioral Biases
(Behavioral factors) Classification.

▪ There is another way to classify Behavioral biases (behavioral factors) which is as

follows:

1.Emotional
Biases.
 Some Examples of Emotional
Biases.
▪ Loss aversion bias.
▪ Over-confidence bias.
▪ Self-control bias.
▪ Status Quo bias.
▪ Endowment bias.
▪ Regret aversion bias.
▪ Affinity bias.
 Some Examples of Information
Processing Biases.
▪ Mental accounting bias.
▪ Anchoring and adjustment bias.
▪ Framing bias.
▪ Availability bias.
▪ Self-attribution bias.
▪ Outcome bias.
▪ Recency bias.
 Some Examples of Belief
Perseverance Biases.
▪ Cognitive dissonance bias.
▪ Conservatism bias.
▪ Confirmation bias.
▪ Representativeness bias.
▪ Illusion of control bias.
▪ Hindsight bias.
▪ Gambler fallacy.
First: Overconfidence Bias.
 Overconfidence Bias Test.

▪ Take a 5 minutes to answer the

following questions, testing your
Overconfidence bias.
 Overconfidence Bias Test.

1. Relative to other drivers on the road, how good a driver are you?
a. Below average.
b. Average.
c. Above average.
d. Well above average.
 Overconfidence Bias Test.

2. How would you characterize your personal level of investment

sophistication?
a. Unsophisticated.
b. Somewhat sophisticated.
c. Sophisticated.
d. Very sophisticated.
 Overconfidence Bias Test.

3. To which degree do you believe your skills are superior to others and
that you have information advantages?.
a. I have extraordinary skills.
b. I have superior skills.
c. I have normal skills.
d. I have low skills.
 ▪ If your answer in question 1 and question 2 are “d” and
Overconfidence your answer in question 3 is “a” or “b”, then you fall in:

Bias Test. “Overconfidence bias Trap.”

 Overconfidence Bias.

“You Are Not As Smart As

You Think”
 Overconfidence Bias.
▪ Overconfidence is one of the most popular
bias all over the world.
▪ The heuristic of overconfidence needs to be
clearly defined from any personality trait
that might lead to overconfidence.
▪ The heuristic of overconfidence is an
internal process that relates to how we
assess the accuracy of our stored
knowledge and our perceptual models.
 Overconfidence Bias Meaning.
▪ Overconfidence can be defined as: “a tendency to
hold a false and misleading assessment of our
skills, intellect, or talent. In short, it’s an
egotistical belief that we’re better than we are.
It can be a dangerous bias and is very prolific
in behavioral finance and capital markets”.
▪ In 2000, Daniel and Titman, overconfidence is one
of the most documented biases in the behavioral
finance literature.
▪ Ricardi and Simon in 2002, also described
confidence as: Confidence can be described as the
“belief in oneself and one‘s abilities with full
conviction”.
 Overconfidence Bias Example.

▪ Example for the overconfidence bias stated by James Montier. James Montier conducted
a survey of 300 professional fund managers, asking if they believe themselves above
average in their ability. Some 74% of fund managers responded in the affirmative.
74% believed that they were above average at investing. And of the remaining 26%,
most thought they were average. In short, virtually no one thought they were below
average. Again, these figures represent a statistical impossibility.
 Forms of Overconfidence Bias.
▪ There are three primary forms of the
overconfidence bias:
1. Overestimation one’s future
performance.
2. Over placement of one’s performance in
comparison to others.
3. Expressing faith in the accuracy of one’s
ability to predict to future.
Failure stories of Overconfidence in
investment and business world.
Failure stories of
Overconfidence.
▪ In the world of business, where
decisions are usually made after
much analysis, bad decisions
have wiped out successful giants.
From these examples are Nokia
and Kodak.
 One of the most popular cases of
Overconfidence is Nokia.

Failure Stories In the beginning of 2000s Nokia was the leading

of company in the field of the mobile phones.

overconfidence Nokia managed the world of mobile phones in

this time.
Story 1.
Nokia. The Overconfidence Nokia had let them reject
and refuse the idea of Andriod.

Guess what happened Nokia lose its control over

the mobile phone world.
 ▪ Kodak is a company that made a devastating wrong
decision despite overwhelming evidence to the contrary.
▪ Everyone knows that Kodak couldn’t survive as digital
Failure Stories photography replaced film.
▪ What is so ironic that Alanis Morissette could have sung
of about it, is that the digital camera was first invented by an

Overconfidence
engineer at Kodak as early as 1975.
▪ In 1981, an extensive study commissioned by Kodak
Story 2. showed that digital was likely to replace Kodak’s film
camera business in about 10 years.
Kodak. ▪ Astonishingly, Kodak did not use this time to capitalize
on their invention of digital cameras – rather they focused
on making their film cameras even better.
 ▪ In 1996, they released a combined camera – the Advantix,
which let users preview their shots digitally to decide
which ones to print. Quite understandably, no one wanted

Failure Stories
to spend on printing when they could view, store and
share photos digitally.

of ▪ The Advantix failed, but the company’s unwillingness to

shift focus to digital technology continued.
Overconfidence ▪ Kodak went from a 90% market share in US camera
sales in 1976 to less than 10% in 2012, when it filed for
Story 2. bankruptcy.

Kodak. ▪ It sold off many of its biggest businesses and patents and
is now a shell of its former self.
 Failure Stories that turn
into success stories Later in
business world.
1. Walt Disney.
▪ The Founder of Disney Land “Walt
Disney” get fired from his job in news
paper for “lacking imagination and
having no original ideas”.
▪ Later he founded Walt Disney
Studio, where he created cartoon
characters. Later on, he founded
Disney Land which became one of
the most popular amusement park
in the world.
 Failure stories that turn into
success Later in business world.
2. Failed Traffic Software
Designers: Bill Gates and Paul
Allen.
▪ Before Microsoft would change the world of
software, there was Traf-O-Data. Classmates at
Seattle’s Lakeside High School, Bill Gates and Paul
Allen designed a computerized microprocessor that
would analyze traffic data from the black rubber
traffic counters that are placed on roads,
creating reports for Washington state highway
department’s traffic engineers. The idea was to
optimize traffic and end road congestion. Lofty
goal, but the pair’s first demo for local county
officials didn’t work. And the idea would later
become obsolete when the state of Washington
offered to tabulate the tapes for cities for free.
 Failure stories that turn into success Later in business
world.
2. Failed Traffic Software Designers: Bill Gates and Paul
Allen.
▪ But Gates and Allen didn’t let their lessons go
unlearned. They learned how to write
software and in 1975, they formed a new
startup called “Micro-Soft.”
▪ In 2011, Paul Allen told Newsweek: “Since
then, I have made my share of business
mistakes, but Traf-O-Data remains my
favorite mistake because it confirmed to me
that every failure contains the seeds of your
next success. It bolstered my conviction
that micro-processors would soon run the
same programs as larger computers, but at
a much lower cost.”
 Failure stories that turns into success story in
business world.
3. Steve Jobs.
▪ Apple’s late founder is arguably the poster
child for transitioning from failure to
success: The tech mastermind dropped out
of college, launched a business, got kicked
out of it and later rejoined when it was
failing.
▪ Each failure, however, brought Jobs one
step closer to Apple’s success.
 Overconfidence.
▪ We have to say that without overconfidence and beating their fear, these people may
not be able to be where they are now.
▪ Overconfidence is one of the most dangerous bias that can damage any investment.
▪ You can be your own worst enemy.
▪ But sometimes, we need overconfidence.
▪ There is a fine line between confidence and vanity. We should be aware of that.
▪ Do not destroy your dream by your bias.
Second: Endowment Effect.
 Endowment Effect Bias Test.

▪ Take a 5 minutes to answer the following

questions, testing your Endowment
Effect bias.
 Endowment Effect Bias Test.

1. Assume that your dearly departed Aunt Sally has bequeathed to you 100 shares of
IBM. Your financial advisor tells you that you are too “tech heavy” and recommends
that you sell Aunt Sally’s shares. What is your most likely course of action?
a. I will likely hold the IBM shares because Aunt Sally bequeathed them to me.
b. I will likely listen to my financial advisor and sell the shares.
 Endowment Effect Bias Test.
2. Assume that you have purchased a high-quality municipal bond for your portfolio. It has
been providing income for you, and you are happy with it. Your financial advisor analyzes
your bond holdings and recommends switching to a corporate bond, of comparable quality,
with which you are unfamiliar. Your advisor explains that, after taxes and fees, the
corporate bond can be expected to provide a slightly better return than your current
municipal bond. What is your most likely response?
a. I will stick with the municipal bond because I am familiar with it.
b. I will sell the municipal bond and purchase the corporate bond, even though I am
unfamiliar with the corporate bond.
 Endowment Effect Bias Test.

▪ If your answer in both questions 1 and 2

is “a” , then you fall in:
“Endowment Effect Bias Trap.”
 Endowment Effect Bias meaning.
▪ The endowment effect refers to an
emotional bias that causes individuals to
value an owned object higher, often
irrationally, than its market value.
▪ In behavioral finance, the endowment effect
describes a circumstance in which an
individual place a higher value on an
object that they already own than the
value they would place on that same
object if they did not own it.
 Endowment Effect Bias meaning.
▪ Endowment effect can be clearly seen with
items that have an emotional or symbolic
significance to the individual.
▪ Sometimes referred to as “divestiture
aversion”.
▪ One of the most well-known examples is the
endowment effect, which describes our
tendency to value things more highly when
we already own them. If I'm trying to sell
you my car, I might think it's worth $10,000,
while you might think it's only worth
$7,000.
 Endowment Effect and Investing.

▪ Endowment Effect has a significant impact on investment especially I the stock market.
▪ They found that the investors hold the stocks that they value as they are a gift from
someone who is special to us even though they are lose in the market.
▪ Let us take an example. Assume that Ryan’s Uncle Richard has bequeathed to him 200
shares of Microsoft . Ryan financial advisor tells him that he is too “tech heavy” and
recommends that he sells Uncle Richard’s shares. But Ryan decides to hold the
Microsoft shares because Uncle Richard bequeathed them to him. In this case, Ryan is
affected by “Endowment Effect”. He does not want to get rid of the shares for the
reason only that they are a gift from his uncle.
 How Companies Apple Company
▪ Studies have shown that the role of touch-based interfaces magnifies the
Benefit from Endowment Effect. This happens through what is called “Haptic
Imagery”.
Endowment effect? ▪ Apple’s showroom lets visitors touch and use all the products without a
Example 1. time-limit. Staff is told not to pressure anyone to leave, and the
showroom itself is open and accommodating to support the effect of
belonging.
 How Companies
Benefit from
Endowment effect?
Example 2.
Lush
▪ Using the haptic imagery online, Lush
describes to their customers how they will
feel and what their skin will look like after
using the product.
▪ They even include directions on how to
use it in the product description, so we are
taken through the whole experience.
 How Companies Benefit From the
Endowment effect?
Example 3.
Converse
▪ Converse allows you to choose the color and
design of certain shoes, and the act of
creation makes you feel like the product has
been yours all along. You are personalizing
it and it becomes more difficult to abandon
as a result.
 How Companies Benefit from the
Endowment effect?
Example 4
Way Fair
▪ Wayfair goes one step further by completely
innovating the way we shop for home decor
by transforming it into a VR-Sims like
experience. Just like in the Sims, you can
build your own rooms but this time using
Wayfair products (which also tell you their
ratings and price).
Third: Framing Bias “Framing Effect”.
 Framing Bias (Framing Effect) Test.

▪ Take a 5 minutes to answer the

following questions, testing your
Framing bias.
 Framing Bias (Framing Effect) Test.
1. Suppose that you have the opportunity to invest in a fund called Micro Trend. Over the
past 10 years, Micro Trend has had an average annual return of 6 percent, with a standard
deviation of 10 percent. So if Micro-Trend continues to perform consistently, you can
expect two-thirds of all returns to fall between –4 percent and 16 percent. How comfortable
would you feel about investing in Micro Trend?
a. Comfortable.
b. Somewhat comfortable.
c. Uncomfortable.
 Framing Bias (Framing Effect) Test.

2. Suppose that you have the opportunity to invest in a fund called Micro Trend. Over the
past 10 years, Micro Trend has had an average annual return of 6 percent, with a standard
deviation of 10 percent. So if Micro Trend continues to perform consistently, you can
expect 95 percent of all returns to fall between –14 percent and 26 percent. How
comfortable would you feel about investing in Micro Trend?
a. Comfortable.
b. Somewhat comfortable.
c. Uncomfortable.
 Framing Bias (Framing Effect) Test.

▪ If your answer in question 1 differ from your

answer in question 2 , then you fall in:
“Framing Bias (Framing Effect) Trap.”
 Framing Bias (Framing Effect)
meaning.
▪ The framing effect “is a phenomenon in
which people react to a particular choice
in various ways, depending on how the
choice has been presented to them”.
▪ The framing effect is a “cognitive bias
where people decide on options based on
whether the options are presented with
positive or negative connotations” e.g. as
a loss or as a gain
▪ The framing effect is an example of
something known as “cognitive bias”.
 Framing Bias (Framing Effect)
meaning.

▪ I will like to ask a question to each, in

your opinion which is the taller one, the
upper one or the lower one?
▪ If you choose that the upper one is taller
than the lower one, then you fall in the
trap of “Framing Bias”.
 Framing Bias (Framing Effect)and
investing.

▪ Framing effect, in general, is the tendency of the people’s decisions to get affected by the
way in which the choices are framed. The minds of individuals react differently to the
information based on the way it is presented. The perception changes as a function of
some variation in framing.
▪ The framing effect has significant impact on investment decisions. The investment
options are perceived differently by the investors based on whether is option presents
more gains or more losses. The ultimate outcome of two choices may be the same, but the
decision will depend upon which option is framed to present more positive outcome.
 Framing Bias (Framing Effect)and
investing.
▪ For example, an investor is presented with two scenarios:
▪ One in which he will gain $500 over the course of the year, but at the end of the year he
will lose $100 of his profit due to market volatility.
▪ The second option is the one in which he will gain $500 over the course of the year and at
the end of the year, he will be able to retain $400 of his profits.
▪ Now, the final outcome in both scenarios is a profit of $400, but since the second option
is framed to present gain instead of loss, it will be preferred over the first one. This is due
to the framing effect.
 Examples of How Branding Companies benefit
from the Framing Bias (Effect).
Example 1.
▪ Tesla, Inc., is an American electric vehicle
and clean energy company specializes in
electric vehicle manufacturing, battery
energy storage from home to grid scale and,
through its acquisition of SolarCity, solar
panel and solar roof tile manufacturing.
▪ Tesla speaks to people who value reducing
our dependence on fossil fuels and have the
goal of saving money on their transportation.
 Examples of How Branding Companies benefit
from the Framing Bias (Effect).
Example 2.
▪ Nike, Inc. is an American multinational
corporation that is engaged in the design,
development, manufacturing, and worldwide
marketing and sales of footwear, apparel,
equipment, accessories, and services.
▪ Nike speak directly to people who value
winning or have the goal of improving their
athletic performance.
 Examples of How ▪ The use of sunscreen is the perfect scenario for framing Bias. You
have a behavior that reduces the chance of a deadly illness. It
Branding involves risk and a negative outcome.
▪ The research on framing effect would predict that a loss frame
Companies benefit would result in the most significant behavior change. People will
from the Framing have the best chance of having a life without skin cancer.
▪ A loss-framed would be something like: “More than two people die
Bias (Effect). of skin cancer every hour. If you do not apply sunscreen, you could
Example 3. have twice as high a chance to develop the disease”.
 Examples of How Branding
Companies benefit from the
Framing Bias (Effect).
Example 4.
▪ One of the Brands that use Framing Bias is
McDonald.
▪ This 1991 advertisement from McDonalds is a
perfect example of how framing something in a
certain way can affect the way we look at it. By
labelling the McLean Deluxe burger as “91% fat
free” rather than “9% fat”, it frames the burger as
a healthy product.
▪ McDonalds knew that putting a positive spin on
their product and opting for the “glass half full”
approach would be a lot more popular with
people. Let’s face it, “fat-free” sounds a lot more
appealing than “contains fat” but either way you
frame it, it isn’t all that healthy.
 Examples of How Branding
Companies use the Framing Bias
(Effect).
Example 5.
▪ Marketers see different response rates based on the
framing of product features and statistics, especially
in advertising. That what happened with “Ford”
▪ Advertising the fuel economy of the Ford F-150 V6
as “22 Miles Per Gallon” may get an inadequate
response as the number is quite low when compared
to cars and midsized SUVs. Potential customers
will think about the money they will spend on gas if
they buy a truck. But framed as “Best in Class Fuel
Economy” makes the F-150 sound like a smart
choice and has a better response.