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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