Behavioural Finance

Jindal School of Banking and Finance

April-May, 2024

Lecture 6: Confidence
Amlan Das Gupta
Origins of Confidence
 How well do we understand the process.
 How good is the data we are basing our judgement on.
 Do we have this from an expert?
 Do we have an unbiased view?
However in reality our confidence is based on:

 How elegant is the story?

 If it is coherent it gives us a sense of inevitability.
 Prone to major pitfalls where we attribute more weight to
talent, stupidity, and deliberate action than to luck.
Illusion of Understanding
Illusion of Understanding

 Consider any successful company: Google, Amazon, Facebook

etc.
 Studying their challenges and how they went about tackling
them can be deceptively illuminating.
 It is easy to attribute too much importance to the brilliance
of the protagonists.
 True causality needs to look at counter-factuals.
Hind-sight and judgement.

 Experiments show that people revise prior probabilities of

events favourably in hindsight if the event has actually
occurred.

 “I knew it all along” syndrome works to bias our judgements

in favour of success and against failures.

 Particularly problematic for people who take decisions for

others, people in public office, doctors, coaches, CEOs.
System 1’s search for understanding

 We humans, find it comforting to feel that we understand a process and can

predict it.
 Even if we are stumped we convince ourselves that we aren’t.
 So many of the theories and stories we believe put more emphasis on
predictable traits rather than luck.
Ask how much difference does it make?
 Do leaders and management practices influence the
outcomes of firms in the market?

 The answer is yes, but the correlation between the success

of the firm and the quality of its CEO might be as high as 0.3

 This means that a good CEO can get you a 10% better chance
of success.
The Halo Effect, Philip Rosenzweig
Demand for illusory certainty is met in two popular genres of
business writing:

 Stories of the rise and fall of individuals

 Stories that compare successful firms to failures.

Built to Last,
In Search of Excellence
 On average, the gap in corporate profitability and stock returns between the
outstanding firms and the less successful firms studied in Built to Last shrank
to almost nothing in the period following the study.

 A study of Fortune’s “Most Admired Companies” finds that over a twenty-year

period, the firms with the worst ratings went on to earn much higher stock
returns than the most admired firms.
Illusion of Validity
Confidence from bad data.
 We already know that system 1 and system 2 do not fact-check, cite
sources or worry about data quality.

 Instead validity = coherence of the story.

 As such we stick to many versions, considering them valid when they are
obviously not.

 The best illustration of this is in the stock market.

Stock-pickers – study by Terry Odean
 On average, the shares that individual traders sold did better than those
they bought, by a very substantial margin: 3.2 percentage points per
year, above and beyond the significant costs of executing the two trades.

 “Trading Is Hazardous to Your Wealth,”

 “Boys Will Be Boys,”

 Mistakes – Selling winners, buying losers.

Experts

 Professional fund managers do not demonstrate the ability

to persistently beat the market.

 To test: look at average returns, compared to the market

over the years.

 What is the correlation between years?

Results
 Typically at least two out of every three mutual funds
underperform the overall market in any given year.

 Important: The year-to-year correlation between the

outcomes of mutual funds is very small, barely higher than
zero.
What sustains illusions of validity?
 The weight of history or expertise.

 Peer effects.
Illusion due to knowledge
“Give me a one-handed economist. All my economists say 'on
one hand...', then 'but on the other...”
― Harry Truman

 A person with more knowledge will make better predictions

unless the person starts believing in her own brilliance.
 An experiment interviewed 284 people who made their
living “commenting or offering advice on political and
economic trends”.

 Asked to predict political or economic events they did

worse than a random selection.

 Also, they were reluctant to admit their mistake.

Consider the questions:

 Should the government increase spending on education to boost growth?

 Was the better performance of India in recent years due to good foreign
policy?
 Are the subsidies demanded by farmers pulling our economy back?

 Is it possible to know??
Trusting Expert Intuition
Consider the following:

 A firefighter suddenly gets an unexplainable urge to leave the burning

apartment right before the floor collapses.
 Intuition as recollection

Herbert Simon’s definition of intuition :

“The situation has provided a cue; this cue has given the
expert access to information stored in memory, and the
information provides the answer. Intuition is nothing more
and nothing less than recognition.”
Acquiring skills

 Simple emotional skills are easy to acquire.

 Skill in more complex tasks takes years of practice.

 Playing cricket, chess.

 Practice makes perfect.

When to trust an expert claiming to have a
skill?
 an environment that is sufficiently regular to be predictable

 an opportunity to learn these regularities through prolonged practice

 In regular environments, experts who have practiced long will
develop unconscious memories that become intuitions.

 In noisy environments, algorithms will do well as bias is minimised.

 However, noisy environments are in general difficult to predict.

Feedback and Practice

 To acquire skills we need opportunities to practice, and regular

feedback.

 Examples of such environments: Sport, pilots, art.

 Examples of others: Forecasting the economy, share market, long term

health, profitability of a company.
The Outside View
Inside vs Outside view

 Often when asked to estimate the probability of success of a project

we use insider information and ignore the information about the
category in which it belongs.

 This is especially true for long-term plans

 Planning Fallacy

 Estimates are unrealistically close to best-case scenarios

 Could be improved by consulting the statistics of similar cases.

Eg: In 2002, a survey of American homeowners who had remodelled their

kitchens found that, on average, they had expected the job to cost $18,658; in
fact, they ended up paying an average of $38,769
How to avoid?

 reference class forecasting.

 Identify an appropriate reference class

 Obtain the statistics of the reference class. Use the statistics to generate a
baseline prediction.
 Use specific information about the case to adjust the baseline
prediction.
Relation to risk
 Estimates that rely on inside view tend to take the best case scenario.

 Costs are under estimated and benefits overstated.

 As a result many risky projects are undertaken that should not have
been.
Sunk Cost Fallacy

 In economics we teach you to avoid including sunk costs

into the equation.

 However, interim project evaluations can seldom resist

falling into this trap.
Exuberance and the economy.
Optimism and the economy

 Animal Spirit: Confidence drives the economy.

 Optimism seems good for health, attitude, etc.
 However, optimists also make wrong decisions with confidence
 They take more risks and often believe that they are luckier or better than
others.
Entrepreneurial delusions

 The chances that a small business will survive for five years in the United
States are about 35%.
 Fully 81% of the entrepreneurs put their personal odds of success at 7 out of
10 or higher, and 33% said their chance of failing was zero.
When optimists get bad news

 Inventor’s Assistance Program – grades new ideas based on need, cost demand
and such 37 criterion.
 Almost 70% get D or E (fail) 5 out of 41 E grades got commercialized.
 Yet 46% of fail grade awardees persisted leading to substantial losses.
 Overall, the return on private invention was small
 More generally, the financial benefits of self-employment are mediocre.
Mergers and acquisitions

 CEOs often bet on being able to mange assets of a target concern better than
their previous managers.
 Most often the bet fails as evidenced from a fall in market value right after
acquisition.
 Optimistic risk taking of entrepreneurs surely contributes to the economic
dynamism of a capitalistic society, even if most risk takers end up
disappointed.
Competition Neglect

Chairman of Disney Studios - Asked why so many expensive big-budget movies are
released on the same days?

Hubris. Hubris. If you only think about your own business, you
think, “I’ve got a good story department, I’ve got a good
marketing department, we’re going to go out and do this.” And
you don’t think that everybody else is thinking the same way. In a
given weekend in a year you’ll have five movies open, and
there’s
certainly not enough people to go around
Processes of WYSIATI

 Information about ourselves is the most easily available and we base our
prediction on it.
 We normally don’t see what our competitors do and so we pretend they don’t
exist.
 As a result zero profit condition of a competitive market is routinely violated.
Overconfidence

 Kahneman points out that in some cases showing doubt can be socially and
professionally damaging.
 A CFO who predicts the market to have returns between -10 and +30 percent
hardly warrants her job.
 Confidence is encouraged and valued.
 Sometimes leads us to become blind to the uncertainties of the environment.
The Premortem: A Partial Remedy

 Imagine that your project has failed.

 Write an account of this imaginary failure.
Readings

 Thinking Fast and Slow – Chapters 19-24

 A Random Walk Down Wall Street – Chapter 7 “How good is fundamental
analysis?”