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Some Well Established
Behavioural Biases
After studying this topic you should:!
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•Be able to describe and critically evaluate at least
three significant decision making biases and how
they impact upon financial investment.!
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• Be able to use these behavioural biases as
alternative perspectives on financial behaviour
compared to orthodox financial theory (e.g. Life cycle
analysis)!
!
•Be capable of giving advice to savers and
investments that might combat these decision
making biases.
Learning Outcomes
What Is Behavioural Finance: A Reminder?
• Heuristics: shortcuts we take to arrive at
decisions in a complex and uncertain world.!
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• Decision biases: Biases such as over optimism
when making investment decisions.!
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• Recognising the behavioural/psychological
basis of decision making. This compared with
the rational all knowing individual of orthodox
finance.
The Key Behavioural Biases for This Topic
Biases Regarding Losses and Gains
Hyperbolic Discounting
Issues in Self Control
Overconfidence, Optimism and Pessimism
Biases Regarding Losses and Gains
Orthodox finance treats losses and gains equally
The Impact of Optimism Bias !
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• Over confidence !
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• Reluctance of investors to incorporate adverse events into
planning!
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• ‘Inside’ and ‘Outside’ Thinking (Kahenmen and Lovallo)
Implications of Optimism Bias!
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• Over loading on company stock!
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• Ignore effects of inflation and taxes!
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• accept optimistic analyst reports!
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• investors over rate their skills!
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• investors (and fund managers) over invest in their home region
Discounting the Future
Remember that money has a different value !
according to when it arrives (it has time value)!
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The standard formulae for adding up money over
time !
to arrive at the value of an asset is as follows:
Where I is income per period, r is the discount rate, n is the!
number of periods and V is the value of the asset.
Standard problems with discounting:!
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• choosing an appropriate discount
rate!
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• choice of time horizon!
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• forecasting the future etc
Behavioural Finance adds another level of criticism
Samuelson: Life Time Utility MaximisationLife Cycle Utility Maximisation
Continued Behavioural Finance argues that individuals have a
contradictory stance towards the future
Two sources of bias that reflect upon
life cycle theory:!
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• Hyperbolic discounting!
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• self control bias
Also myopic (or short sighted) decision making
Discounting in the Context of Life Cycle Theory
Hyperbolic Discounting
Time inconsistency
Changing our minds about a decision when the time arrives
Reversing preferences
“.....choose the one apple now rather than
two apples one day later offer them two
apples in one year and a day and one apple
in one year they will prefer the two apples.
Same apples, same gap in time, only
difference is that the choice is displaced into
the future.”
A More Formal Graphic Analysis of Hyperbolic Discounting
Time
Value
Hyperbolic
Time
Value
ExponentialHyperbolic Discounting: The Spike of Temptation
Time
Value
Diagram ThreeCommitment Mechanisms
Commitment Mechanisms are : actions and
agreements that prevent people from falling foul
of time inconsistency!
!
An example: The UK Endowment mortgage, or
any binding savings agreement.
Myopic behaviour is where an inter temporal
investment decision is considered one period at a time
with no reference to subsequent periods.!
!
Example: choosing a mortgage because it has a low
starting rate of interest when this might rise
significantly in later periods (Miles report, 2004).
Interesting question: Is the individual decision maker aware !
of these inconsistencies? !
!
Can they do anything to counter this problem?
13The Need For Self Control
The bias arises from the emphasis upon the !
present rather than the future. !
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It is therefore a similar idea to myopic behaviour
[“YOU DONT THINK THAT i am going down
there for a quarter do You” Self Control is
influenced by the stake]
An Example
Think of examples from everyday life.
The Various Effects of Control Bias
• Spending more today at the expense of saving
tomorrow!
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• Failure to plan for retirement!
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• Asset allocation imbalances (e.g. Too much
emphasis upon income for spending or equities for
risk).!
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• Forgetting the principles of compound interest or
pound cost averaging (basically-taking a short term
view).
Countering the Lack of Self Control
From the Financial Advisors Perspective:!
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• Control spending. Advise client to pay themselves first.!
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• Encourage Planning. Need written plans.!
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• Portfolio Allocation. Look for balanced asset allocation!
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• Encourage discipline. For example show !
the client the power and benefits of compound interest.
Over Confidence Bias
“In its most basic form, overconfidence can be
summarised as unwarranted faith in one’s intuitive
reasoning, judgements, and cognitive
abilities” (Pompian, p. 51)
The key characteristics of overconfidence bias are:!
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• People think that some things are certain to happen which
are not.!
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• Overconfident in their abilities to predict and how precise
information that they receive is.!
!
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• There is a tendency to equate quantity of information with
quality of information.
17Financial Advice and Overconfidence Bias
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• Demonstrate how a past trading record has not produced!
good results.!
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• If clients are over trading then show them the errors of their
ways!
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• If investors underestimate downside risk then demonstrate the!
volatility of markets.
You Should Now Be Able
To:
• Explain optimism bias and its implications for
investor behaviour.!
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• Explain hyperbolic discounting.!
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• Outline the behavioural life cycle theory!
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• Explain overconfidence bias.!
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• With respect to each of the above consider the
implications for financial planning and financial
advice.
1920
Reading For Next Weeks Tutorial
Quang Nguyen and PingSun Leung, 2009, Do Fishermen
Have Different Attitudes Toward Risk? An Application of
Prospect Theory to the Study of Vietnamese Fishermen,
Journal of Agricultural and Resource Economics 34(3):518–
538!
This is an interesting application of Prospect theory that
indicates its wide ranging applications. There is inevitably
some jargon but try to read around that and get the general
idea of what this paper was testing, how it relates to the
literature, its actual application of prospect theory, generally
how the research was conducted and what it found.
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