CHAPTER 8: IMPLICATIONS OF HEURISTICS AND BIASES FOR FINANCIAL DECISION-MAKING

Introduction
 Focusing on the potential impact on heuristics on the behavior of investors, future retirees, analysts,
and managers, and how they may potentially impact market outcomes.
 How heuristics influence investor financial decision-making.

I. Financial Behaviors Stemming from Familiarity

 Home bias – tendency to overinvest domestically and locally
 Investment close to home may result from an informational advantage.
 Related to home bias is the tendency to invest in companies you work for or brands you know.

Home Bias
 Tendency for domestic investors to overweight domestic stocks.
 Investors are optimistic about their market relative to foreign markets.
 Comfort-seeking and familiarity: people tend to favor that which is familiar.
 International investment may be less attractive because of institutional barriers
- Capital movement restrictions
- Differential trading costs
- Differential tax rates

Distance, Culture, and Language

 People prefer to invest locally, even within their own country.
 Case of intra-national home bias (Gur Huberman)
 Preference for familiarity extends to language and culture (Mark Grinblatt&MattiKeloharju)
 Institutional investors may not be immune from this tendency.

Local Investing and Informational Advantages

 Investors may favor local markets because they may possess, or may feel that they possess,
informational advantages
 Average manager invests in companies that are located about 10% closer to him than the average
firm he could have held.
 Local equity preference is related to firm size and leverage and output tradability

Rational motivations for investing locally

 Hedging demand
- If you consume local goods at local prices, it can make sense to hedge by investing locally
- Local equity preference is more pronounced among companies whose goods are not traded
internationally is consistent with hedging demand.
 Size and leverage
- Smaller, levered firms are likely to be ones for which local informational advantage may be
stronger.
- Stocks with high levels of local ownership tend to outperform remote investments.

Advantages of being geographically close to a company

 Improved monitoring capability
 Access to private information
Investing in Your Employer or Brands that You Know
 Investors overweight the stocks of companies whose brands are familiar or that they work for.
 Frieder&Subrahmanyam: conducted survey data on brand quality and brand familiarity
(recognition).
 Institutional holdings are significantly and negatively related to brand recognition (no discernible
impact for brand quality)
 Retail investors: higher demand for firms with brand recognition (consistent with comfort-seeking
and familiarity)
 Natural informational advantage may stem from familiarity.

II. Financial Behaviors Stemming from Representativeness

 Representativeness and related biases induce inappropriate investment decisions.

Good Companies vs. Good Investments

 COMMON MISTAKE: A good company is representative of a good investment.
 No company attribute should be associated with investment value
- All information on company quality should already be embedded in stock prices (ex
antebasis)
 Firm image impacts the perception of investment attractiveness.
- If firm image has such impact, one might expect the same would be true for perception of
brand quality.
- BUT there was NO evidence that perception of brand quality led to retail investors
increasing their demand for a stock.

Chasing Winners

 Recency- a form of representativeness where investment performance in the recent past is

representative of future investment performance.
 Trend Following or Momentum- popular strategy and at the heart of technical analysis.
 Trend following- international phenomenon
Example:
- Respondents were asked to start their pensions from scratch and allocate money between two stocks,
one with an average return over the last 5 years of 5% and a second
with an average return over the last 5 years of 15%.Further, they were told that
analysts forecast that both stocks should earn about 10% per year over the next
5years.

* Momentum chasers would put more than 50% in the second stock,
while contrarians would put more than 50% of their money in the first stock.

 There is evidence that riskadjusted returns are positively serially correlated for 3 to 12 month return
intervals. For longer periods of three years or more, the evidence favors reversals or negative serial
correlation.
Availability and Attention Grabbing

 Attention – scarce resource

 Attention grabbing is proxied in 3 ways
 news reports on a stock
 unusually high trading volume
 extreme returns
 Availability bias is evidenced when investors tend to buy stocks that are in
the news
Anchoring

 Anchoring is even more likely to occur when the potential anchor

appears prima facie to have economic content.

 Gregory Northcraft and Margaret Neale investigated whether anchoring might occur in the
context of real estate appraisals

Appraisal estimate = a Personal appraisal estimate + (1 – a) * List price

 Anchoring and Herding are closely related

 Example of herding:
- In the real estate appraisal experiment, if an
agent had been told that a second agent had come up with a certain appraisal,
and the first agent’s appraisal was pulled toward this value (even taking into
account the influence of the list price), this would be an example of herding or following the
crowd.

Overconfident traders

- value exceeds the market price–hold more of the security

- In estimating values traders use two items of information:

 Own opinion (prior value)

 Market price (weighted ave. of all investors opinion)

vi = aiv*i + (1− ai) p; 0 ≤ ai ≤ 1

Overconfident- miscalibrated - inflated view of the precision of one’s information or opinion.

 The higher the investor’ s level of overconfidence (ai)- the more responsive demand
is to changes in price

 PC-proper calibration
 LOC-low overconfidence
 HOC-high overconfidence

Example of over confidence:

Assume that there are 300 shares outstanding
(Q = 300).
 For this illustration, we will assume that the demand curves of the three
investors are as follows:
q1 = 100 (Investor 1)
p = 20 − 0:1 * q2 (Investor 2)
p = 15 − 0:05 * q3 (Investor 3)

*Notice that the more overconfident trader has a flatter, more price-responsive demand curve.

4 lessons about over confidence

 Volatility increases with overconfidence. The same value revision led to a greater price change when
one of the
traders was more overconfident
 Overconfidence induces greater trading activityas
well as higher levels of volume at the level of the market.
 Divergent views sometimes receive a lot of weight if the trader in question is wellcapitalized and
egregiously overconfident.
 Investors take on excess risk relative to those who are well calibrated.

Several predictions are derived from Odean’s model:

1) Expected Trading volume increases as overconfidence increases

2) Price Volatility increases with overconfidence
3) Overconfidence worsens the quality of prices, less likely to accurately estimates the value
4) Overconfident traders have lower expected utility than do those who are properly calibrated

CHAPTER 9: IMPLICATIONS OF OVERCONFIDENCE FOR FINANCIAL DECISION-MAKING

In this chapter, we address the extent to which this behavioral tendency impacts financial decisionmaking.
Our focus will be on investors and other market practitioners. We will relate the various manifestations of
overconfidence and excessive trading. We turn to the demographics and dynamics of overconfidence in a
financial setting. We investigate whether overconfidence can be “learned” by past experience in markets.
Evidence that relates overconfidence to underdiversification and excessive risk taking is explored.

OVERCONFIDENCE AND EXCESSIVE TRADING

There is evidence that the overconfidence of investors leads to excessive trading. We begin with a simple
illustrative model that relates overconfidence and trading activity.

OVERCONFIDENT TRADERS: A SIMPLE MODEL

i = investor

V = Posterior estimate

a = weight

p = market price
  The higher ai is, the higher is the weight an investor puts on his own opinion. Since there is a
very large number of investor views determining p, any value of ai more than slightly above
zero suggests some overconfidence, with higher values suggesting more overconfidence than
lower values. Here, by overconfident we primarily mean miscalibrated, which implies an
inflated view of the precision of one’s information (or opinion).

EVIDENCE FROM THE FIELD

Brad Barber and Terrance Odean

- Examined the trading histories of more than 60,000 U.S. discount brokerage investors between 1991
and 1996 to see if the trades of these investors led to improvements in portfolio performance.
- Barber and Odeanfound that, on average, investors turn over 75% of their portfolio annually.
- divided their sample of individual investors into five equal groups (quantiles), where the groups
were formed on the basis of portfolio return.
- Those trading the least only turned over 0.19% of the portfolio per month, less than 3% per year.
- Those trading the most turned over 21.49% of their portfolio per month, more than 300% per year.
- An inspection of the figures reveals that there was a slight improvement in gross performance, but
not so much in the net performance. Meaning, most of the excessive trading was not helpful. The
evidence reported suggests that the trades were not based on superior information, but were borne
from misinformation.

EVIDENCE FROM SURVEYS AND THE LAB

Markus Glaser and Martin Weber

- Combined naturally occurring data with information elicited from a survey.

Mark Grinblatt and MattiKeloharju

- Investigated whether trading activity, based on a dataset of equity trading data in Finland, is related
to overconfidence and sensation seeking.
- Those who have higher degree of sensation seeking to be prone to excessive trading derived from the
experience of trading.
- Trading activity is positively related to both overconfidence and sensation seeking.

Sensation seeking – a personality trait whose four dimensions are thrill and adventure seeking; experience
seeking; disinhibition; and boredom susceptibility.

Adventure seeking – a desire to engage in thrilling and even dangerous activities.

Experience seeking – the desire to have a new and exciting experiences, even if illegal.

Disinhibition – behaviors associated with a loss of social inhibition.

Boredom susceptibility – dislike of repetition of experience.

Bruno Biais, Denis Hilton, KarineMazurier and Sebastien Pouget

- Considered the impact of two psychological traits, overconfidence, based on calibration tests, and
self-monitoring, namely the disposition to attend to social cues and appropriately adjust behavior.
- Found that while overconfidence did not lead to a significant increase in trading intensity, it did serve
to significantly reduce profits.
- High self-monitors earned relatively greater trading profits.

DEMOGRAPHICS AND DYNAMICS

Gender and Overconfidence in the Financial Realm

- Men traded 45% more than women did, incurring higher trading costs.
- Men reduce their net returns by 0.94% more than women.
- Finance and business professions, being often viewed as male activities attract women who are
relatively more overconfident.

Dynamics of Overconfidence Among Market Practitioners

- An advantage to looking at professionals is that they often make public forecasts.

- It seems logical to think that if people recall their successes and failures equally clearly, they should
move toward an accurate view over time.

Cognitive dissonance – induces us not to forget what is unpleasant or did not go our way.

Self-attribution bias – leads us to remember our successes with great clarity, if not embellishment.

Hindsight bias – induces us to idealize our memory of what we believe or forecasted in the past.

Confirmation bias – the tendency to search out evidence consistent with one’s prior beliefs and to ignore
conflicting data, also contribute.

Simon Gervais and Odean

- Inferencing those who are successful in their fields might be more overconfident than those who
have just entered the market.

The evidence on whether professionals are overconfident is mixed.

- One study examined a dataset of futures market traders and was unable to find any costs associated
with their trading activity.
- Another study found that less-disciplined traders are less successful, arguing that lack of discipline
can stem from overconfidently ignoring new public information.
UNDERDIVERSIFICATION AND EXCESSIVE RISK TRADING

Underdiversified people are too quick to overweight/underweight securities when they receive a
positive/negative signal, and insufficient diversification results.

- As long as they believe they have identified a few winners in this group, they are content. After all,
they are so sure that certain stocks are good buys, why dilute their portfolios with stocks that they
have not studied?

William Goetzmann and Alok Kumar

- Found out that underdiversification was less severe among people who were financially
sophisticated.
- Diversification increased with income, wealth, and age.
- Overconfidence is the driving force behind both excessive trading and underdiversification.

EXECESSIVE OPTIMISM AND ANALYSTS

- Abundant research has established that analysts tend to be excessively optimistic about the
prospects of the companies that they are following.

CHAPTER 10: INDIVIDUAL INVESTORS AND THE FORCE OF EMOTION

 Market movements are commonly attributed to the emotions of the investors.

 It is argued that when emotions are in balance, it can facilitate decision-making.

10.1 IS THE MOOD OF THE INVESTOR THE MOOD OF THE MARKET?

 Robert Shiller, Irrational Exuberance: “The emotional state of investors when they decide on their
investments is no doubt one of the most important factors causing the bull market.”

Some recent research concludes that what appears to be anomalous financial behavior can be explained
in emotion:

1. Sunny day vs. Gloomy day

- People tend to express good moods and optimism on a sunny day resulting from morning
sunshine that lead to higher stock returns as they are more likely to buy stocks.
- On the other hand, due to a gloomy day, people tend not to buy stocks given the mood of the
environment.
2. Trader’s sleep patterns
- Stock markets fall when traders’ sleep patterns are disrupted.
3. Soccer Games
- Soccer games are correlated with the mood of the investors
- After a loss in a World Cup elimination game, significant market declines are reported in the
losing country’s market.
  Even if people were irrationally optimistic on a sunny day, it does not necessarily mean that they
run out to buy stocks on sunny days. Market behavior can still be consistent with rational
pricing.

RISK ATTITUDE AND INVESTOR BEHAVIOR

 Risk attitude is important because it affects how a person values an asset.

 If risk aversion changes in response to changes in mood, how much a person is willing to pay for a
stock will change.
 The relationship of a person’s mood and risk attitude depends on the context and the individual’s
personality.
 It is unclear how positive and negative emotional states translate into changes in risk attitude and
market pricing

Example:

 One person who is in a very sour mood may engage in risky behavior like driving recklessly or
drinking too much alcohol.
 Another person who is not having a good day may shy away from risk more than usual and simply
withdraw from others.
 Happier people are more optimistic and assign higher probabilities to positive events.
 People may be more optimistic about their likelihood of winning a gamble when they are happy, the
same people are much less willing to actually take the gamble.

10.2 PRIDE AND REGRET

Pride – a feeling or deep pleasure or satisfaction derived from one’s own achievements; confidence and
self-respect

Regret – feel sad, repentant, disappointed over something that has happened or been done, especially a
loss or missed opportunity

 One might regret a bad investment decision and wish they had made a different choice.
 One would feel prideful that they made a good profit on a trade.
 Researchers believe that people strongly motivated to avoid the feeling of regret.
 Importantly, the effects of pride and regret are asymmetric. It seems that the negative emotion,
regret, is felt more strongly by people.

10.3 THE DISPOSITION EFFECT

 Researchers have recognized the tendency of investors to sell superior-performing stocks too
early while holding on to losing stocks too long.

Disposition effect: the tendency to sell winners and hold losers

 1. EMPIRICAL EVIDENCE
- Based on observations of behavior
- Proportion of Gains Realized (PGR) vs. Proportion of Losses Realized (PLR)

Proportion of Gains Realized (PGR)

𝑅𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝐺𝑎𝑖𝑛𝑠
𝑃𝐺𝑅 =
𝑅𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝐺𝑎𝑖𝑛𝑠 + 𝑃𝑎𝑝𝑒𝑟 𝐺𝑎𝑖𝑛𝑠

Proportion of Losses Realized (PLR)

𝑅𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝐿𝑜𝑠𝑠𝑒𝑠
𝑃𝐿𝑅 =
𝑅𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝐿𝑜𝑠𝑠𝑒𝑠 + 𝑃𝑎𝑝𝑒𝑟 𝐿𝑜𝑠𝑠𝑒𝑠𝑠

- PGR > PLR = sell winners over losers

- PGR < PLR = sell losers over winners
- For tax reasons, investors should prefer to sell losers, not winners.
- An investor with a positive tax rate should put off realizing gains on winners because of tax
liability generated, but should recognize losses sooner in order to reduce current tax liability.

Possibilities related to Rationality by Terrance Odean

 Portfolio rebalancing suggests that losers, whose aggregate value is now lower than winners,
need to have their positions increased relative to winners in order restore desired portfolio
allocation.
 Investors anticipate that losers will outperform winners looking forward.

2. EXPERIMENTAL EVIDENCE
- Manipulating an independent variable and observing the effects on a dependent variable
- Summers and Duxbury manipulated choice and responsibility regarding participants’ current
stock positions
- Responsibility for an outcome is a prerequisite for the disposition effect,

10.4 HOUSE MONEY

Path-dependent behavior: People’s decisions are influenced by what has previously transpired

House Money effect: After a prior gain, people become more open to assuming risk

Break-even effect: After a prior loss, people may take a risky gamble in order to try to break even

Snake-bit effect: An initial loss can cause an increase in risk aversion

10.5 AFFECT

 Emotions, particularly regret, can impact financial decision-making.

 Affect: refers to the quality of a stimulus and reflects a person’s impression or assessment.
 Cognitively, a person’s perception includes affective reactions and thus, judgement and decision-
making are tied to the particular reactions the person has.
 Affective reactions are cognitive representations of distinct body states, and the brain uses an
emotion to interpret situation.

Robinson Simbajon Mojica |Oct. 28, 1998 | 20 y/o

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Justin Clarence S. Go | Aug. 8, 1998 | 20 y/o

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