The document discusses various behavioral finance concepts like framing, loss aversion, disposition effect, and mental accounting that challenge the idea of rational economic decision making. It also explores how biases can be addressed through solutions like libertarian paternalism and default choices, as well as the growing field of neuroeconomics examining how the brain processes economic decisions. Overall, the document analyzes how psychological factors influence economic behavior.
The document discusses various behavioral finance concepts like framing, loss aversion, disposition effect, and mental accounting that challenge the idea of rational economic decision making. It also explores how biases can be addressed through solutions like libertarian paternalism and default choices, as well as the growing field of neuroeconomics examining how the brain processes economic decisions. Overall, the document analyzes how psychological factors influence economic behavior.
The document discusses various behavioral finance concepts like framing, loss aversion, disposition effect, and mental accounting that challenge the idea of rational economic decision making. It also explores how biases can be addressed through solutions like libertarian paternalism and default choices, as well as the growing field of neuroeconomics examining how the brain processes economic decisions. Overall, the document analyzes how psychological factors influence economic behavior.
AND GREED! Behavioral Finance DICK THALER TO RATIONAL ECONOMIC MAN
The difference between us is that:
You expect people to be as smart as you are, while I expect people to be as dumb as I am! SOME NOTIONS BECOMING POPULAR… Presumed consent: French organ donor policy.
Force opt-out of retirement plans. UK government requires this
now.
Save MORE Tomorrow=-- commits employees to a higher savings
rate each time they get a raise. BEHAVIORAL IDEAS- ORIGINS Relaxes assumptions of perfect rationality and investor use of ALL available information. Look at individuals – Framing, inertia, loss-aversion, mental accounting, disposition effect, hyperbolic discounting. Look at Corporations ; Overconfidence, IPO-winners curse, hubris. Look at institutions- herding, post-earnings drift, sentiment, momentum (growth) versus value. Cultural Differences: Nordic and Germanic are the most patient, Africans the least. Anglo-Saxons are more tolerant of loss, Eastern Europeans have the most loss aversion. FRAMING-1. Everyone frames to make sense of the world around them. Can be a psychological trick to trigger certain behavioral biases. Marketers do it all the time, media too! Long-term smoking increases terminal lung cancer likelihood from 1% to 1.3% OR There is a 30% greater chance of dying from lung cancer! “Sorry we have to let you go” FRAME POSITIVELY RATHER THAN NEGATIVELY- THINK IN TERMS OF GAINS RATHER THAN LOSSES. FRAMING-2 Equity risk premiums-- every risk is evaluated in isolation, and so overweighted, despite low correlation between portfolio components. Plus loss aversion makes them want larger premiums. The bulk of our activities are devoted to security selection, despite asset allocation known to be more important. Home bias and familiarity (invest in what you know). And links to human capital. THE NARROWER THE FRAME, THE GREATER THE BIAS LOSS AVERSION, DISPOSITION, REGRET Aversion => that losses are weighted twice as much as gains. People delay recognizing a loss, happy to break-even! Leads to a DISPOSITION effect--- sell winners too early, ride losers too long. This despite tax benefits in some regimes. Also loss realization creates REGRET. Even those who buy back winners only do at a lower price (not higher). Momentum! Averaging down is another manifestation-- there is the potential to increase the pleasure from success. CONFIRMATION BIAS AND ANCHORING
Information that supports an existing belief is used and
disconfirming evidence avoided. --Think Brexit, LEAVE and STAY groups didn’t talk to each other. --ANCHORING to specific purchase price, no amount of bad news can shake you out of your conviction. It has to come back! OVERCONFIDENCE, OVERTRADING, CONSERVATISM Familiar notions- driving, portfolio manager performance. Excessive trading is hazardous to one’s wealth. Conservatism- people take time to accept news --the slow gradualism of technical analysis Post-earnings announcement drift. Notion of thinking about categories. MENTAL ACCOUNTING Putting money in different “bucket “ savings/retirement/ college fund. Creates a feeling that not all money is equal. Spending from a “smaller” account harder than a “larger” one. Buying with credit card is easier than buying with cash. How do you spend tax refunds? Bonuses? Lottery winnings? One pernicious version is the house-money effect. After a double, you take half off the table and let the rest ride- (the two buckets not seen as equal), even though they should be. MENTAL TIME TRAVEL… (chocolate now, exercise later, spend now, save later, smaller-sooner rather than larger-later.) People are less inclined to wait as the time of decision gets closer. Many prefer 100 now to 110 in a day, but reverse that if it is 100 in 30 days versus 110 in 31 days (i.e. will wait one more day if that is further away)! Said differently, the rate at which people discount future rewards declines as the length of the delay increases. SOLUTIONS Generally to make CONSTRUCTIVE outcomes EASY and DESTRUCTIVE outcomes DIFFICULT. Libertarian Paternalism. Auto-Investing, SIPs and dollar-cost averaging Simplify choices for participating. Of course, education.
DO MULTIPLE BIASES CANCEL OUT?
LONGER TERM: KNOWLEDGE ADVANCEMENT. Scientific notions of “falsification” are supposed to go against this line of thinking.
But confirmation bias prevails until enough body of evidence
accumulates for a paradigm shift. Think efficient markets versus behavioral finance. OR as:
SCIENCE ADVANCES ONE FUNERAL AT A TIME!!
Somebody actually empirically examined Max Planck’s statement and found supporting evidence. NEURO-ECONOMICS NEUROLOGY – Predict human behavior from brain patterns.
PSYCHOLOGY – Predict human behavior from analyzing
people. ECONOMICS – Predict human behavior from analysis of data. Waterfall illusion: prolonged exposure to one stimulus (say high volatility) creates a sensory/perceptual bias towards expecting the opposite (low volatility). EVIDENCE FROM NEURO-ECONOMICS Neuronal activity measured by PET, EEG, now fMRI. Smart money seems to use the insular cortex. Framing seems to happen in the amygdala. Nacc (nucleus accumbens) activity associated with reward magnitude, is the place of irrational exuberance. Limbic system likes immediacy, cortex willing to wait. Decrease in brain activity (ventral striatum) when subject experiences a price increase for a recently sold stock (regret). BUT…. • Medically the brain is the least understood. • Neuronal activity may not be the only measure. • fMRI resolution is still too coarse, MRI’s well known for false positives. • Some of the studies confirm the obvious—older people make less rational choices!!! • This area of research still in early stages. Buffett: Be fearful when others are greedy and greedy when others are fearful.
Neuro-scientist: Activate your insular cortex when