Chapter 22

Behavioral Finance:
Implications for
Financial Management

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Identify behavioral biases and understand
how they impact decision-making
• Understand how framing effects can
result in inconsistent and/or incorrect
decisions
• Understand how the use of heuristics can
lead to suboptimal financial decisions
• Recognize the shortcomings and
limitations to market efficiency from the
behavioral finance viewpoint

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 Chapter Outline
• Introduction to Behavioral Finance
• Biases
• Framing Effects
• Heuristics
• Behavioral Finance and Market Efficiency
• Market Efficiency and the Performance of
Professional Money Managers

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 Poor Outcomes
• A suboptimal result in an investment
decision can stem from one of two
issues:
– You made a good decision, but an
unlikely negative event occurred
– You simply made a bad decision (i.e.,
cognitive error)

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 Overconfidence
• Example: 80 percent of drivers
consider themselves to be above
average
• Business decisions require judgment
of an unknown future
• Overconfidence results in assuming
forecasts are more precise than they
actually are

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 Overoptimism
• Example: overstating projected cash
flows from a project, resulting in a high
NPV
• Overestimate the likelihood of a good
outcome
• Not the same as overconfidence, as
someone could be overconfident of a
negative outcome (i.e.,
“overpessimistic”)
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 Confirmation Bias
• More weight is given to information
that agrees with a preexisting
opinion
• Contradictory information is deemed
less reliable

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 Framing Effects
• How a question is framed may impact
the answer given or choice selected
• Loss aversion (or break-even effect)
– Retain losing investments too long
(violation of the sunk cost principle)
• House money
– More likely to risk money that has been
“won” than that which has been “earned”
(even though both represent wealth)

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 Heuristics
• Rules of thumb, mental shortcuts
• The “Affect” Heuristic
– Reliance on instinct or emotions
• Representativeness Heuristic
– Reliance on stereotypes or limited samples
to form opinions of an entire group
• Representativeness and Randomness
– Perceiving patterns where none exist

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 The Gambler’s Fallacy
• Heuristic that assumes a departure from
the average will be corrected in the short-
term
• Related biases
– Law of small numbers
– Recency bias
– Anchoring and adjustment
– Aversion to ambiguity
– False consensus
– Availability bias

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 Behavioral Finance and
Market Efficiency
• Can markets be efficient if many traders
exhibit economically irrational (biased)
behavior?
• The efficient markets hypothesis does not
require every investor to be rational
• However, even rational investors may
face constraints on arbitraging irrational
behavior

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 Limits to Arbitrage
• Firm-specific risk
– Reluctant to take large positions in a single
security due to the possibility of an
unsystematic event
• Noise trader risk
– Keynes: “Markets can remain irrational longer
than you can remain insolvent.”
• Implementation costs
– Transaction costs may outweigh potential
arbitrage profit

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 Bubbles and Crashes
• Bubble – market prices exceed the level
that normal, rational analysis would
suggest
• Crash – significant, sudden drop in
market-wide values; generally associated
with the end of a bubble
• Some examples of crashes:
– October 29, 1929
– October 19, 1987
– Asian crash
– “Dot-com” bubble and crash

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 Money Manager
Performance
• If markets are inefficient as a result of
behavioral factors, then investment
managers should be able to generate
excess return
• However, historical results suggest that
passive index funds, on average,
outperform actively managed funds
• Even if markets are not perfectly efficient,
there does appear to be a relatively high
degree of efficiency
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 Quick Quiz
• Describe the similarities and differences
between overconfidence and overoptimism.
• How might the framing effect impact a
company conducting market research.
• What are heuristics, and why might they
lead to incorrect decisions?
• Why does the existence of cognitive error
not necessarily make the market inefficient?

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 Ethics Issues
• Consider a political election with two
competing candidates, one who is pro-life
and the other who is pro-choice.
– How might a pollster representing one side
frame a survey question differently than
someone from the competing political camp?
– What does this say for the potential accuracy of
reported survey results?
– How might this situation apply to a company?

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 Comprehensive Problem
• Warren Buffett, CEO of Berkshire Hathaway, is
often viewed as one of the greatest investors of
all time. His strategy is to take large positions in
companies that he views as having a good,
understandable product but whose value has
been unfairly lowered by the market.
– What behavioral biases is Buffett attempting to
identify?
– If he successfully identifies these, will he be able
to outperform the market?
– How might we analyze whether Buffett has, in fact,
outperformed the market?

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End of Chapter

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