Information Processing Biases

Introduction
 Traditional finance theorists believe that investors think
and behave rationally when buying and selling financial
securities.
 However, behaviorists/psychologists challenged the
assumptions of Efficient Market Hypothesis (EMH).
 They opine that investors do not think and behave
rationally in real life situations as a consequence of
cognitive and emotional biases.
 As per Prospect theory, people make decisions based on
the potential value of losses and gains instead of the
final outcome, and they evaluate these losses and gains
using certain heuristics.
 Nature of Biases-BF Perspective
 Biases may be grouped into: Information processing
biases and Behavioral biases.

Biases

Information processing
biases (i.e. Investors‟ Behavioral Biases
biases)
 Choice with uncertainty in real life

Kahneman & Tversky

Kahneman’s Nobel Prize

diploma
 A Prospect Theory
• Certainty: People have a strong preference for certainty and
are willing to sacrifice income to achieve more certainty. For
example, if option A is a guaranteed win of $1,000, and
option B is an 80 percent chance of winning $1,400 but a 20
percent chance of winning nothing, people tend to prefer
option A.
• Loss aversion: People tend to give losses more weight than
gains — they’re loss averse. So, if you gain $100 and lose $80,
it may be considered a net loss in terms of satisfaction, even
though you came out $20 ahead, because you’ll tend to focus
on how much you lost, not on how much you gained.
• Relative positioning: People tend to be most interested in
their relative gains and losses as opposed to their final
income and wealth. If your relative position doesn’t improve,
you won’t feel any better off, even if your income increases
dramatically. In other words, if you get a 10 percent raise and
your neighbor gets a 10 percent raise, you won’t feel better
off. But if you get a 10 percent raise and your neighbor
doesn’t get a raise at all, you’ll feel rich.
 A Prospect Theory
Small probabilities: People tend to under-react to low-probability
events. So, you may completely discount the probability of losing all
your wealth if the probability is very small. This tendency can result
in people making super-risky choices.
Example
You have $1,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of gaining $1,000, and a 50%
chance of gaining $0.
Choice B: You have a 100% chance of gaining $500.
You have $2,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of losing $1,000, and 50% of losing
$0.
Choice B: You have a 100% chance of losing $500.
The implication is that people are willing to settle for a reasonable
level of gains (even if they have a reasonable chance of earning
more), but are willing to engage in risk-seeking behaviors where
they can limit their losses.
Prospect Theory

"We have an irrational tendency to be less willing to gamble with profits than with
losses."

Kahneman & Tversky (1981)

 Information Processing Biases
(Investors’ Biases)
 Errors in information processing can lead investors to
misestimate the true probabilities of possible events or
associated rates of return.

 Here are four of the more important ones: Forecasting

errors, Overconfidence, Conservatism, and Sample
size neglect and Representativeness
Forecasting Errors
• A large number of studies in accounting and
finance find that analysts use information
inefficiently in forecasting future earnings.
• Dechow, Hutton and Sloan [2000], find that
analysts are overly optimistic in making long term
growth forecasts for firms issuing stocks, and that
the levels of these forecasts are negatively
correlated with future returns.
• Abnormal return in previous time is less likely to be
repeated in future.
 Forecasting Errors
Over forecast and under forecast
• Anchoring and adjusting: When making an estimate people often start
with an initial value – the anchor – and then adjust from this. People
use more judgment than statistics in forecasting.
What is the number of hair in your head? Any guess?
• Seeing patterns in randomness : People love storytelling and are
brilliant at inventing explanation for random movements in graphs.
• Attaching too much weight to judgment relative to statistical forecasts
• Recency bias (Party effect): People may be using very short period of
data to make forecast
• Optimism bias : It contributes to the creation of economic bubbles;
during periods of rising prices investors are overoptimistic about their
investments.
• Group biases : Having statistical forecasts adjusted by a group of people
can be dangerous as most people don’t feel comfortable going against
group decisions.
 Over confidence
• I am well informed about the stock
market
• I am familiar with the stocks I trade
(e.g., their business, financial
status)
• I am well informed about the major
economic news that impacts the
stock market
• I experience more gain than loss in
market
Overconfidence
• Overconfidence is also demonstrated by the many
examples of people expressing confidence about things
that are subsequently proven wrong.
• For example, British mathematician Lord Kelvin said,
"Heavier-than-air flying machines are impossible."
• Thomas Watson, founding Chairman of IBM, reportedly
said, "I think there is a world market for about five
computers."
• The Titanic was the ship that couldn't sink.
• Likewise, surveys show that most drivers report that
they are better than average, and most companies
believe their brands to be of "above-average" value.
 Overconfidence
 The problem with the world is that the intelligent people
are full of doubts while the stupid ones are full of
confidence.
 “Overconfidence will drown you in the sea of reality”.
- Nortain
 “Confidence is good, but overconfidence always sinks the
ship”.
- Oscar Wilde
 The overconfidence effect is a well-established bias in
which a person‟s subjective confidence in his or her
judgments is reliably greater than the objective accuracy
of those judgments, especially when confidence is
relatively high.
Overconfidence Bias in Human Judgment
 Confidence is essentially a feeling of certainty, the strength
of this feeling being the level of confidence.
 A feeling of certainty can remain within a person or be
translated from a feeling to a more concrete form and
communicated to other people via verbal expressions such as
“I’m certain that Rome is the Capital of Italy” or “I think that
Rome is probably the Capital of Italy”.
 In common use is the term “Self-confidence” which relates
to beliefs about ourselves, for example, how certain we are
about our own abilities in different situations.
 Indeed, confidence is a feeling of certainty about the state of
reality, but this feeling is internal to the person and may not
be actually correspond with external reality.
Overconfidence Bias in Human Judgment
 It may be the case that a person has high confidence in a fact which
turns out not to be true, or high confidence in a prediction which
then does not occur.
 Kahneman and Tversky (1982) stated that “confidence is the
subjective probability or degree of belief associated with what we
„think‟ will happen”.
 When people are overconfident they believe that they knew more
than they in fact do know, or believe their accuracy to be higher
than it in fact is.
• Male investors are generally found to be more likely to perceive
themselves as knowledgeable or skillful than females (Graham et
al., 2009).
• Barber and Odean (2001) use trading frequencies and gain and
found that Men trade 45% more than women, and excessive
trading reduces their net returns by 2.65% per year as opposed to
1.72% for women.
• In a 1998 study entitled "Volume, Volatility, Price, and Profit When
All Traders Are Above Average", researcher Terrence Odean found
that overconfident investors generally conduct more trades than
their less-confident counterparts.
 Overconfidence-Example
 Too little diversification, because of a tendency to invest too
much in what one is familiar with.

 Investors tend to invest in local companies, even though this

a bad from a diversification point view.
 Young investors are expected to be more overconfident,
especially highly educated ones (Heath and Tversky, 1991).
This could be also true in Nepali capital market.
Factors influencing over-confidence
Task difficulty and hard easy effect
Information
Practice and expertise
Base rate
The locus of uncertainty
Motivation and self-presentation biases
Making decisions/Choices
Individual differences
Mood/Depression
Overconfidence in visual perception
Sex differences-Men tend to be more overconfident than
women.
Overconfidence in Stock Market
 Overconfidence Bias-Literature review
 According Shefrin (2000), Overconfidence “pertains to
how well people understand their own abilities and the
limits of their knowledge”.
 Overconfidence can be summarized as unwarranted faith
in one‟s intuitive reasoning, judgments, and cognitive
abilities (Pompain, 2006).
 Daniel, Hirshleifer and Subrahmanyam (1998) propose
a theory of security markets based on investor
overconfidence and biased self-attribution, which leads to
market under and overreactions.
 Camerer and Lovallo (1999) found experimentally that
overconfidence and optimism lead to excessive business
activity.
Overconfidence Bias-Literature review
Conti…
 Psychological research has established that men are more
prone to overconfidence than women (especially in male-
dominated areas such as finance), whilst theoretical
models predict that overconfident investors trade
excessively.
 Barber and Odean (2001) found that more people trade,
the worse they did, on average. And men traded more,
and did worse than, women investors. This is due to
overconfidence.
 Psychologists have determined that overconfidence
causes people to overestimate their knowledge,
underestimate risks, and exaggerate their ability to
control events.
 Conservatism Bias
 The term “Conservatism bias” refers to that investors are
too slow (too conservative) in updating their beliefs in
response to new evidence. In other words, it implies
investors‟ under-reaction to new information.
 When things change, people might underreact (tend to be
slow to pick up on the changes) because of the
conservatism.
 But if there is a long enough pattern, then they will adjust
to it and possibly overreact, underweighting the long term
average.
 Conservatism Bias Conti.
 Investors are slow to update their beliefs, i.e., they
underweight sample information which contributes to
investor under-reaction to news.
 It can generate:
- Short-term momentum in stock market returns.
-The post-earnings announcement drift, i.e., the
tendency of stock prices to drift in the direction of
earnings news for three to twelve months following an
earnings announcement also entails investor under-
reaction.
 Disposition Effect
• The tendency to sell winners too early and ride losers too
long is referred to as the „disposition effect‟
 It may be deified as the people‟s tendency to:
- Sell winners too soon and
- Hang on losers too long.
 The „disposition effect‟ has four major elements:
1. The prospect theory
2. Mental accounting
3. Regret aversion
4. Self-control
 2. Mental Accounting
 A concept first named by Shefrin and Thaler (1988), mental
accounting (or Psychological accounting) attempts to
describe the process whereby people code, categorize, and
evaluate economic outcomes.
 In mental accounting theory, framing means that the way a
person subjectively frames a transaction in their mind will
determine the utility they receive or expect.
 For example, restaurants may advertise “early-bird”
specials or “after-theatre” discounts, but they never use
peak-period “surcharges.” They get more business if people
feel they are getting a discount at off-peak times rather than
paying surcharge at peak periods, even if prices are identical.
 This concept is similarly used in Prospect theory, and many
mental accounting theorists adopt that theory as the value
function in their analysis.
 3. Seeking Pride & Avoiding Regret
 The simple fact is investors may resist the
realization of a loss because it stands as
proof that their first judgment was wrong.

 The quest for pride, and avoidance of

regret lead to a disposition to realize gains
and defer losses.
 Self-Control
 Self-control is portrayed as a conflict between a rational
part (planner) and a more primitive and emotional
individual action (agent).
 Planner may not be strong enough to prevent the
(emotional) reactions of the agent from interfering with
rational decision making.
 An example, traders clearly aware that riding losers was
not rational, but could not exhibit enough self-control to
close the position at a loss, thus limiting loss.
 Sample size neglect and Representativeness
 People prone to believe small sample is representative of
population, infer patterns too quickly
 For example, you might hear someone say “my broker gave
me three great stock picks over the past month, and each
stock is up by over 10%”. While this is enough to sway most
people, thinking that the broker is a genius, this assessment
is based on a very small sample size.
 When a sample size is too small, accurate and trustworthy
conclusions cannot be drawn
 Representativeness bias cause people to over-weight recent
information and deemphasize base rates or priors (e.g.,
conclude too quickly that a yellow object found on the street
is gold (i.e., ignore the low base rate of finding gold).
Thank You