Investor Behavior and the

Financial Market

Beliefs, Heuristics, and Biases

Prof. Seungho Choi

Department of Finance
Hanyang University Business School
Starting Point: Standard Model

In the previous lecture, we have examined how people form preferences

and make choices in real life, often in contrast with the predictions of the
standard model.

We now turn our attention to probabilities and beliefs.

Starting point: according to the standard model, how should people

estimate probabilities of unknown events and form beliefs about them?

Two components: (1) perfect rationality, and (2) Bayesian updating

Perfect Rationality

Perfect rationality requires two crucial conditions:

1. People have all the relevant information for making a decision

2. People have the right cognitive resources to process such information
without cost and effort

But in reality, people are more likely to have “bounded rationality”

▪ People resort to heuristics (경험에 기반한 결정 방법):
“Methods for arriving at satisfactory solutions with modest amounts of
computation (Simon, 1990)”
i.e., shortcuts for accelerated decisionmaking
Perfect Rationality

▪ If you are taking someone out to a dinner to close a business deal, the
general etiquette is to avoid the MOST and LEAST expensive wines
on the list, choosing a bottle of wine in the middle of the list

▪ This is an example of a heuristic decision: it simplifies your

decisionmaking process

▪ But using heuristics often lead to biases

▪ People end up misestimating the true probabilities of an event

Bayesian Updating

This requires that people should be able to update their beliefs correctly
given a series of prior outcomes.

P( E H ) P( H )
Bayes’ Theorem: P( H E ) =
P( E )

▪ H is your hypothesis, E is the observed evidence

▪ P (H ) is your initial belief of H happening, i.e., prior prob.
▪ P( E H ) gives how likely would E occur if H was true: conditional prob.
▪ P (E ) tells us the likelihood of E under all possible cases: marginal prob.
▪ P( H E ) is our main variable of interest: after observing E, what is the
posterior prob. of H being true?
Bayesian Updating

Example:
Suppose that John and Wes are arguing about whether a coin brought to
class by a student has two heads or whether it is fair. Imagine that there are
no other possibilities. For whatever reason, the student will not let them
inspect the coin, but she will allow them to observe the outcome of coin flips.
Let H be the hypothesis that the coin has two heads, so that ¬ H means that
the coin is fair. Let us consider John first. He thinks the coin is unlikely to
have two heads: his prior probability, Pr (H), is only 0.01. Now suppose the
student flips the coin, and that it comes up heads. Let E mean “The coin
comes up heads.”
Q. What probability should John assign to H given that E is true?
Bayesian Updating

Example:
Pr (H) = 0.01
Q. What probability should John assign to H given that E is true?
➔ What is P(H|E), which is the posterior probability?
➔ P(not H) = 0.99
➔ P(E|H) = 1, P(E|not H) = 0.5

𝑃 𝐸 𝐻 ∗𝑃 𝐻 1∗0.01
➔𝑃 𝐻𝐸 = = =
𝑃 𝐸𝐻 ∗𝑃 𝐻 + 𝑃 𝐸 𝑛𝑜𝑡 𝐻 ∗𝑃 𝑛𝑜𝑡 𝐻 1∗0.01 + 0.5∗0.99

0.0198 ≅ 0.02
Bayesian Updating

Example:
You are conducting an exit poll at the 2016 U.S. presidential election.
Prior to voting, 50% of people say they would vote for Hillary Clinton, with
the rest 50% supporting Donald Trump.
However, Trump supporters tend not to reveal their preferences so openly,
so they lie 20% of the time at exit poll and say they voted for Clinton. Clinton
supporters, on the other hand, lie only 5% of the time, correctly saying they
voted for Clinton 95% of the time.

Q. If someone tells you at the exit poll that he/she voted for Clinton, what is
the probability that he actually voted for Clinton at polling booth?
Bayesian Updating

Example:
H: The person actually voted for Clinton at the polling booth.
E: The person says they voted for Clinton at the exit poll.
P(H) = Probability of actually voting for Clinton = 0.5, P(not H) = 0.5
P(E|not H) = 0.2, P(E|H) = 0.95
Q. If someone tells you at the exit poll that he/she voted for Clinton, what is
the probability that he actually voted for Clinton at polling booth?
➔ What is P(H|E), which is the posterior probability?

𝑃 𝐸 𝐻 ∗𝑃 𝐻 0.95∗0.5
➔𝑃 𝐻𝐸 = = =
𝑃 𝐸𝐻 ∗𝑃 𝐻 + 𝑃 𝐸 𝑛𝑜𝑡 𝐻 ∗𝑃 𝑛𝑜𝑡 𝐻 0.95∗0.5 + 0.2∗0.5

0.8261 ≅ 0.826
Deviations (1): Availability Heuristic

Availability heuristic (가용성 휴리스틱, 가용성 편향)

▪ People are generally very bad at estimating probabilities of rare events
▪ More importantly, people believe an event is more likely to happen
if they can recall examples of such event more easily

Tversky and Kahneman’s (1973) famous question:

If a random word is taken from an English text, is it more likely that the
word begins with a K or the word has letter K on its third letter?

What do you think?

Deviations (1): Availability Heuristic

▪ It is very easy to think of words beginning with K:

king, kangaroo, kale, kite, kilometer, killer…

▪ But finding a word with K on the third letter takes more effort!
take, fake, make, acknowledge……….

▪ This causes people to overestimate the possibility of words

beginning with K and underestimate the other

▪ Ease of availability in people’s memories leads to overestimation,

i.e., exaggerated probabilities
Deviations (1): Availability Heuristic

Example:
Your optometrist tells you that your new contacts are so good that you can
wear them night and day for up to 30 days straight. She warns you that there
is some chance that you will develop serious problems but says that she has
seen many clients and that the probability is low. After a week, you
develop problems and see an ophthalmologist. The ophthalmologist tells
you that he is the doctor who removes people’s eyes when they have been
injured as a result of improper contact use. He tells you that the probability
of developing serious problems is high.
Q. Explain how they can report such different views about the likelihood of
developing serious problems as a result of wearing contacts.
Deviations (1): Availability Heuristic

Example:
Q. Explain how they can report such different views about the likelihood of
developing serious problems as a result of wearing contacts.
➔ Given that the optometrist mainly sees contact users without problems,
an image of a healthy user is most available to her. Given that the
ophthalmologist mainly sees users with problems, an image of an
unhealthy user is most available to him.
➔ The two are prone to the availability bias, the optometrist is likely to
underestimate, and the ophthalmologist to overestimate, the probability
of developing serious problems as a results of wearing contacts.
Deviations (1): Availability Heuristic

Examples in the financial market:

• Dot-com bubble: investors were influenced by the information about tech
firms achieving significant increase in stock prices. These vivid examples
of success led to a rush into tech stocks, contributing to the bubble

• Housing market bubble: Prior to the recent financial crisis, investors were
influenced by stories of others who had made significant profits by
flipping homes or investing in real estate, leading to a dramatic surge in
housing demand and overvalued properties
Deviations (2): Representativeness Heuristic

Representativeness heuristic (대표성 휴리스틱): the “Linda problem”

Yeji is 27 years old. Her father is a renowned church minister famous for
handing out free meal to homeless people in Yongsan area. Yeji has always
been deeply concerned about social injustice in Korea, so she took a degree
in social welfare at university, where she was also involved in the hunger
awareness movement and wrote more than 200 personal letters to the
president about it.
Q. Out of the two scenarios below, which is more likely?
(A) Yeji works for Samsung.
(B) Yeji works for Samsung and is an active charity volunteer.
Deviations (2): Representativeness Heuristic

In a similar version of the study by Tversky and Kahneman (1983),

85% of interviewees said (B) was more likely.

But we know this cannot be true! Why?

Deviations (2): Representativeness Heuristic

But we know this cannot be true! Why?

➔ (B) is essentially a subset of (A)!
➔ This is a violation of the laws of probability because the probability of two
events occurring together (B) is always equal to or less than the
probability of either event occurring alone.
➔ It highlights how people tend to use stereotypes and base their
judgments on the representativeness of the description (e.g., Yeji seems
more like an active charity volunteer) rather than applying logical
probabilistic reasoning (working for Samsung is more probable than
working for Samsung and an active charity volunteer).
Deviations (2): Representativeness Heuristic

This is called the conjunction fallacy (결합편향):

By making Yeji a perfect example of an active charity volunteer, people
instinctively respond to what they perceive to be a representative illustration
of Yeji, forgetting in the process basic rules of probability.
Deviations (2): Representativeness Heuristic

Example in the financial market:

Two mutual funds with the same beta, A and B, have both managed to
outperform the S&P 500 by the same amount over the past five years. If
performance was monitored on a monthly basis, which fund do you think
had more months during this period when it beat the S&P 500 in that month
by a minimum of 1 percent if mutual fund A held an average of 100 stocks,
and mutual fund B an average of 25 stocks?
(a) Fund A.
(b) Fund B.
(c) About the same.
Deviations (2): Representativeness Heuristic

Example in the financial market:

• On average, more than 50 percent of respondents selected answer (c).
• The lack of correct responses, answer (b), can be explained by
respondents suffering from insensitivity to sample size.
• Sampling theory indicates the return of fund B containing 25 stocks will
be more volatile from month to month, and therefore have a higher
standard deviation, than portfolio A with 100 stocks.
• As such, fund B is likely to have experienced more months when it beats
the market index than fund A, but also more months when it earns a
below–the-market return.
Deviations (3): Base Rate Fallacy (기저율 오류)

Example 1. Doctors encourage women over a certain age to participate in

routine mammogram screening for breast cancer. Suppose that the
following is known. At any one time, 1 percent of women have breast
cancer. The test administered is correct in 90 percent of the cases. That
is, if the woman does have cancer, there is a 90 percent probability that
the test will be positive and a 10 percent probability that it will be negative.
If the woman does not have cancer, there is a 10 percent probability that
the test will be positive and a 90 percent probability that it will be negative.
Q. (Without calculating) Suppose a woman has a positive test during a
routine mammogram screening. Without knowing any other symptoms,
what is the probability that she has breast cancer?
Deviations (3): Base Rate Fallacy (기저율 오류)

Example 2. The ‘false positive’ problem (Schoenberger and Grayboys, 1978)

There is a 0.1% chance of contracting MERS virus. Now, suppose there is
a new medical test, which is quite powerful. If you have the MERS virus, the
test will return a positive result 100% of the time. If you don’t have the MERS
virus, the test is 95% accurate and will yield a negative result.

Q. (Without calculating) Suppose a patient’s test result returned positive.

What do you think is the probability that the patient actually have MERS?
Deviations (3): Base Rate Fallacy (기저율 오류)

Example 3. The taxicab problem (Tversky and Kahneman, 1982)

A cab was involved in a hit-and-run accident at night: Two cab companies ,
the Green and the Blue, operate in the city. You are given the following data:
(1) 85% of the cabs in the city are Green and 15% are Blue.
(2) A witness identified the cab as a Blue cab. The court tested his ability to
identify cabs under the appropriate visibility conditions. When presented
with a sample of cabs (half of which were Blue and half of which were
Green) the witness made correct identifications in 80% of the cases and
erred in 20% of the cases.
Q. (Without calculating) What is the probability that the cab involved in the
accident was Blue rather than Green?
Deviations (3): Base Rate Fallacy (기저율 오류)

The three examples reveal an important fact.

▪ The examples deal with a situation where the evidence is observed with
a high probability when your initial hypothesis is right.

▪ However, the “base rate,” i.e., prior probability, is extremely low.

▪ In this instance, even after observing the evidence, the posterior

probability will still be quite low.

▪ People often fail to fully realize this, leading to overestimation.

Deviations (3): Base Rate Fallacy (기저율 오류)

Example 1.
H: The woman has breast cancer.
E: The mammogram test is positive.
P(H) = Probability of actually having breast cancer = 0.01, P(¬H) = 0.99
P(E|H) = Probability of testing positive given that the woman has breast
cancer = 90% = 0.90
P(E|¬H) = Probability of testing positive given that the woman does not
have breast cancer = 10% = 0.10

𝑃 𝐸 𝐻 ∗𝑃 𝐻 0.9∗0.01
➔ 𝑃 𝐻𝐸 = = =
𝑃 𝐸𝐻 ∗𝑃 𝐻 + 𝑃 𝐸 𝑛𝑜𝑡 𝐻 ∗𝑃 𝑛𝑜𝑡 𝐻 0.9∗0.01 + 0.1∗0.99

0.08333 ≅ 8%
Deviations (3): Base Rate Fallacy (기저율 오류)

Example 2.
H: The patient has the MERS virus.
E: The test is positive.
P(H) = Probability of actually having MERS = 0.001, P(¬H) = 0.999
P(E|H) = Probability of testing positive given that you have the MERS = 1
P(E|¬H) = Probability of testing positive given that you do not have the
MERS = 5% = 0.05

𝑃 𝐸 𝐻 ∗𝑃 𝐻 1∗0.001
➔ 𝑃 𝐻𝐸 = = =
𝑃 𝐸𝐻 ∗𝑃 𝐻 + 𝑃 𝐸 𝑛𝑜𝑡 𝐻 ∗𝑃 𝑛𝑜𝑡 𝐻 1∗0.001 + 0.05∗0.999

0.0196 ≅ 1.96%
Deviations (3): Base Rate Fallacy (기저율 오류)

Example 3.
H: The cab involved in the accident was Blue.
E: The witness identified the cab as Blue.
P(H) = Probability that a cab involved in the accident is Blue = 0.15, P(¬H) =
0.85
P(E|H) = Probability that the witness correctly identifies a Blue cab as Blue =
0.80
P(E|¬H) = Probability that the witness incorrectly identifies a Green cab as
Blue = 0.20

𝑃 𝐸 𝐻 ∗𝑃 𝐻 0.80∗0.15
➔ 𝑃 𝐻𝐸 = = =
𝑃 𝐸𝐻 ∗𝑃 𝐻 + 𝑃 𝐸 𝑛𝑜𝑡 𝐻 ∗𝑃 𝑛𝑜𝑡 𝐻 0.80∗0.15 + 0.20∗0.85

0.414 ≅ 41.4%
Deviations (4): Gambler’s Fallacy

▪ Suppose you tossed a coin three times and you get Head, Head, Head.
What is the probability of getting a Head on the fourth toss?
Deviations (4): Gambler’s Fallacy

▪ Suppose you tossed a coin three times and you get Head, Head, Head.
What is the probability of getting a Head on the fourth toss?

▪ Still 0.5!

▪ Yet, human minds often think “it’s about time a Tail came up.”

▪ This is like drawing a ball from an urn of finite size (without replacing).
If an urn contains 5 “Heads” and 5 “Tails,” the probability of getting
a Head on the fourth toss becomes 2/7. or 28.6%.
→ Human mind is more comfortable with this idea.
Deviations (4): Gambler’s Fallacy

This is often observed in casinos.

▪ Much fewer people tend
to place money on, say,
18, after the number 18
has just come up.
▪ But it should always be
completely random!

▪ Gambler’s fallacy, however, has a strong evolutionary perspective.

▪ In early societies, human beings found out that a series of common
outcomes would be broken eventually.
e.g., rain would eventually come after a long drought.
Deviations (5): Hot Hand Effect

The “hot hand effect” is the seeming opposite of the gambler’s fallacy.

▪ This belief is popular among sports players and fans alike.

▪ If a player has made two hits in his first two at-bats, fans and colleagues
believe he is having a “hot” day and more likely to make a hit on his third.

▪ In other words, there is a tendency to “over-infer” from a trend.

▪ A “trending” regime rather than a “mean-reverting” regime.

Deviations (4 & 5): Synthesis

▪ While the gambler’s fallacy and the hot hand effect appear difficult to
reconcile, Barberis, Shleifer and Vishny (1998) show they are both at
work in stock markets.

▪ They posit investors believe in “gambler’s fallacy” in the short term.

So, if there is a favorable news for a stock, causing the stock price to rise
for a while, investors believe it will be followed by a fall, so they don’t buy
the stock as much as they should. Returns will continue to be high.

▪ But after a while, they begin to expect a “hot hand” regime, overinvesting
in the momentum stock and causing it to be overpriced (reversal).
Deviations (4 & 5): Synthesis

Another example of synthesis: buying a lottery ticket.

Guryan and Kearney (2008)

▪ Gambler’s fallacy: people
tend not to bet on the
previous week’s winning
numbers, but:
▪ Hot hand effect: people
become more willing to travel
to the store that sold the last
week’s winning tickets
Self-Evaluation Bias

Human beings are also prone to both overconfidence and underconfidence

about oneself relative to a particular situation.

3 revealing questions as examples

Q1. Do you think you are better than average as a driver?

Q2. Do you think you are better than average when in a karaoke?

Q3. Nakdong-gang is the longest river in Korea.

(a) What is your estimate of Nakdong-gang’s length?
(b) What is your 95% confidence interval for your estimate?
Self-Evaluation Bias

People are also prone to self-serving bias in different forms

▪ Students tend to overestimate their own contributions in team projects.

▪ People tend to attribute their successes in life to their own ability or skill,
but blame the situation or other people when they fail.

▪ Confirmatory bias is also prevalent, which refers to the people’s

tendency to interpret new information as being consistent with their initial
prior beliefs (or refusing to acknowledge any inconsistent information)
Self-Evaluation Bias

A famous example of a religious cult in Korea in 1992

When nothing happened on Oct. 28, 1992, they didn’t change their beliefs.
They instead claimed their “prayer” has been answered.
Self-Evaluation Bias

This confirmatory bias is important in finance, because:

▪ It explains short-term momentum: in the short term, traders tend to focus

only on information that confirms their beliefs, becoming overconfident
and trading excessively

▪ It may also explain people’s tendency to invest substantially in their own

company’s stock (assuming their prior beliefs are positive)

▪ It may also be relevant in explaining the “home bias,” where traders

prefer home rather than foreign companies.
Projection Bias

Projection bias refers to people’s incorrect beliefs that their future

preferences will be too close to their current ones.

Typical example:

Going to the mart

right before dinner vs.
straight after dinner

Look at your final bill!

Projection Bias

Colin, O’Donoghue and Vogelsang (2007)

Cold-weather apparel bought on

cold days are more likely to be
returned subsequently

▪ Evidence of “impulse” thinking,

mistakenly overestimating
the need for cold weather item
Superstitions

Superstitious beliefs also play a part in people’s decisions

e.g., Bhattacharya et al. (2015), Figure 1A

8 (considered lucky) is third most popular as a last digit on the limit order,
but 4 (symbol of death) is least popular.
Causes of Irrationality

Various causes for such irrationality have been proposed

▪ Emotional distress: e.g., anger leads to excessive risk taking.

But how can this behavior survive natural selection over generations?
Seeking revenge at all cost can be an effective “punishment”
mechanisms in negotiations – “reputation effect” (Frank, 1988)

▪ Cognitive dissonance (Festinger, 1957): people wish to avoid their

ingrained beliefs from being challenged and dissonant.
People may sometimes change their interpretation of hard facts instead.
Causes of Irrationality

▪ Threat to Self-Esteem: “peacock’s tail syndrome”

People with abnormally strong self-esteem may indulge in binge drinking
and drug abuse, mistakenly believing they are strong enough to
withstand the temptations.

▪ Failure of Self-Regulation: self-regulation refers to the ability to properly

reflect on the advantages and disadvantages of making a decision.
We all know this is difficult!

▪ Decision fatigue: people often dislike making a series of decisions,

one after another.