Chapter 1 Behavioral Foundations

Learning Objectives
1. Identify key biases that typically arise when people make judgments about risk.
2. Explain why reliance on heuristics, while unavoidable, leaves people vulnerable to
making biased judgments.
3. Recognize that framing effects lead people’s attitudes toward taking risk to be highly
dependent on the circumstances in which they find themselves.
Traditional Treatment
• Standard textbook approach to project selection revolves around DCF.
– Example: Spend $3.2 million this year,
– Discount future cash flows at 35%.

Questions to Set the Stage

• Would you feel that you have enough information to make an informed decision about
whether to adopt the project?
• What do you think about the managers’ probability assessments?
• How does framing the cash flow outcomes as potential gains and losses impact the
firm’s decision about whether or not to adopt the project?
• Does the project qualify as high risk?
• Should the prior year stock market performance impact the project adoption decision?
Psychological Issues
• Not much information on which to generate precise probabilities or cash flows.
• Clear overweighting of probabilities of extreme events (from comparing columns 2
and 3 in Exhibit).
• Possible excess optimism, as interchanging the 1% and 2% recession probabilities,
and altering the 1%/6% growth probabilities to 4%/3%, produces a negative NPV (-
$100K).
• Conceivably, the perceived 93% probability of a loss could override the perceived
positive NPV.
 • The project qualifies as high risk, as reflected by the high 35% discount rate.
• Plausible that firm’s stock market underperformance relative to the industry and
market induced value destructive risk seeking behavior by aspirational managers.
• Above are issues that form the broad subject matter of psychological foundations
discussed in Chapter 1.
Psychological Foundations
• 10 psychological phenomena, grouped into three categories:
– biases, heuristics, framing effects.
• Our brain have two systems, System 1 vs System 2.
• System 1 is fast, automatic and intuitive 直观 process.
• System 2 is slow, deliberate 深思熟虑 conscious process.
• Intuition is imperfect, so the remedy is to rely on System 2.
• However, we may lack mental resources and capabilities to apply System 2
Psychological Phenomena
• Bias
• Heuristic
• Framing effect
• Biases and heuristics relate to human’s imperfect judgement, while framing relates to
choices among alternatives.
Biases
• Def: A predisposition (tendency) towards making a specific type of error. This
psychological bias is also known as cognitive bias, which manifest some irrationality
of people. 犯特定类型错误的倾向（倾向）。 这种心理偏差也称为认知偏差，
是人的某些非理性行为的表现。
1. Excessive optimism 过度乐观
2. Overconfidence
3. Confirmation bias 确认偏差
4. Illusion of control 控制错觉
Excessive optimism
• People overestimate how frequently they will experience favorable outcomes and
under-estimate unfavorable outcomes
 • An experiment/study found that people assign low probability they will experience
unfavorable event e.g. being fired from a job but higher probability for favorable
event e.g. living past 80
• A similar concept is dispositional optimism 性格乐观
Overconfidence
• The thinking that people know more than what they actually know.
• People are overconfident of their knowledge and complete difficult task.
• Experiments done asking for undergraduates how well will they perform, reveal that
more than half believe they will be average or above average.
Confirmation bias
• People attach too much importance to information that support the position they hold
and overlook disconfirming information. 人们过分重视支持他们所持立场的信息，
而忽视了否定信息。
• Seeking and highlighting only confirming information.
• It pertains to the manner in which people either seek information or make use of
information at heir disposal.
Illusion of control
• People tend to believe that they exert control or influence over outcomes.
• Reality is, there may be other forces or even chance, that produce outcomes.
• Throwing pair toss of dice in casino is a good example. Instead of pure chance, the
gambler is confident that he/she can influence such random outcomes.
Heuristics
• Def: A process by which humans use mental short-cuts (or rule-of-thumb) to arrive at
decisions. They simplify problems and avoid cognitive overloads. 人类使用思维捷径
（或经验法则）做出决定的过程。 他们简化问题并避免认知超载。
1. Representativeness
2. Availability 获得性启发
3. Anchoring and adjustment 锚定与调整性启发法
4. Affect
Representativeness
• People stereotype, asking how representative an object/idea/event is for the class to
which it belongs.
• Estimating likelihood based on similar prototype we know.
 • For e.g., what kind of music does a long-haired person with tattoo, wearing faded
jeans and t-shirt listen to?
Availability
• People overweight information that is readily available in their mind especially from
their experience, memory and media.
• For e.g. who do you think commit more crimes in Malaysia, locals or foreigners?
Anchoring and adjustment
• A heuristic where a person uses a specific number or value as a starting point, known
as an anchor, and subsequently adjusts that information until an acceptable value is
reached over time.
• However, they tend to make insufficient adjustment relative to that number.
• Moreover, the original number may also deviate from true value.
Affect
• Making decision primarily based on intuition, instinct 本能 and gut-feelings.
• More ‘quick and dirty’ short-cut than representativeness or availability heuristics.
• Our current emotional states or mood may influence affect.
• Perhaps due to urgency or lack of time or information to make decisions.
Interactions of Heuristics
• Psychologists believe that one heuristic may affect the other(s).
• Being familiar with certain event (availability) can increase the sense of optimism
(excessive optimism)
• Believing that one is in control of the situation/outcome may also lead to excessive
optimism.
Framing Effect
Def: A person’s decision is influenced by the manner in which the setting for the decision is
described. How the problem or situation is framed determine how one looks at the
problem/situation. 一个人的决定受到描述决定背景的方式的影响。 问题或情况的框架
决定了人们如何看待问题/情况。
1. Loss Aversion 损失规避
2. Fourfold Pattern
Loss Aversion
• People feel a loss more intensely compared to a gain of the same magnitude. 与同等
数量的收益相比，人们对损失的感受更强烈。
 • For instance, the pain of losing $100 is often far greater than the joy gained in finding
the same amount.
• Can cause investors to behave irrationally and make bad decisions, such as holding
onto a stock for too long (called disposition effect 处置效应-投资者趋于过长时间地
持有正在损失的股票，而过快地卖掉正在盈利的股票)
Fourfold Pattern
• Risk preference when people face risk whose possible outcome are either only gains
or only losses. 当人们面临可能的结果要么只有收益要么只有损失的风险时的风
险偏好。
• suggests that when faced with a risky choice, people will be
– (1) risk seeking over low-probability gains,
– (2) risk averse over high-probability gains,
– (3) risk averse over low-probability loss, and
– (4) risk seeking over high-probability loss.
• This is based on Prospect Theory
• Pattern One: For risk in which the probabilities attached to non-zero gains are not too
small, people are inclined to be risk-averse.
• Between A and B, which one you choose?
A: 90% chance of winning $2,000
10% chance of zero
B: 45% chance of winning $4,000
55% chance of zero
• Pattern Two: For risk in which the probabilities attached to non-zero gains are quite
small, people are inclined to be risk-seeking.
• Between C and D, which one you choose?
A: $2,000 with probability 0.002
$0 with probability 0.998
B: $4,000 with probability 0.001
$0 with probability 0.999
Consequences of Psychological Traits
• Our perception of reality can be distorted.
• Lead to poor (especially when assessing risks) and bias decision-making
• Lead to sub-optimal choices.
Prospect Theory
• A theory describing how people make choices among risky alternatives.
• Mental sensations associated with an anticipated loss is greater than a gain.
• People frame choices in terms of gains and losses relative to a reference point (such as
acceptable cash flows, which however may be ambiguous in the first place).
• Hence, PT tells us how attitude towards risk depends on circumstances.
Mitigating Psychological Pitfalls 减轻心理陷阱
• Faulty judgements and decisions are parts of human experience.
• How to mitigate? Through interventions:
– Nudges 助推理论 (small-scale intervention)
– Debiasing 去偏
– Cognitive repairs 认知修复
• Choice architecture 选择架构 – purposeful design of decision frames to facilitate
effective decision making 一种以可预期的方式改变行为，但不做具体限制，也不
必明显改变诱因的方法
Summary
• Traditional corporate finance textbooks focus more on what corporate managers
should do rather than what they actually do.
• This chapter introduces 10 psychological phenomena that are hardwired.
– biases, heuristics, and framing effects.
• Like everyone else, managers make professional decisions using the processes of both
System 1 and System 2.
• Effective nudges and interventions require knowledge of choice architecture.