Lecture 2 Behavioral Finance | October 9th, 2023

Behavioral Economics

  • A number of economic frameworks assume that humans evaluate financial decisions consistently and rationally
  • Heuristics
    • Humans make a vast majority of their decisions using mental shortcuts
  • Framing
    • Humans use anecdotes & stereotypes to understand & respond to events
  • Market Inefficiencies
    • Mispricing or non-rational decision making

Anchoring

  • People estimate answers to new & novel problems with a bias towards reference points
  • Common examples
    • Price you bought a stock at
    • High point for a stock

      Mental Accounting

  • Money is fungible, but people put it into separate “mental accounts”
  • Also known as “bucketing”
  • Example:
    • Lost Movie Tickets
      • Lose 40 dollars or two tickets in advance (no one wants to buy movie tickets twice)
    • “Found Money” → parents’ money
  • Real world problems: Vacation Fund & Credit Card Debt

Confirmation & Hindsight Bias

  • Very different biases, but often conflated with each other.
  • Confirmation Bias
    • We selectively seek information that supports pre-existing theories, and we ignore/dispute information that challenges or disproves them
  • Hindsight Bias
    • We overestimate our ability to predict the future based on the “obviousness” of the past
  • Confirmation of the two is particularly bad

Gambler’s Fallacy

  • We see patterns in independent, random chains of events
  • We believe that, based on a series of previous events, an outcome is more likely than odds actually suggest
  • Example: Dinner Party & Coin Flips
  • Real odds might be 51/49, but we tend to jump to 80/20
  • Likely cause: the rarity of “independent events” in day-to-day experience

Herd Behavior

  • Tendency to mimic the actions of the larger group
    • Building Psych Experiment
    • Empty Supermarket
  • Crowd psychology may be a contributor to bubbles
  • Bucking the crowd creates stress & fatigue, it gets harder, not easier.
  • Easier to be “wrong with everyone” than “right and alone”

Overconfidence

  • Dunning-Kruger Effect. The more poorly you perform, the more you over-estimate your performance
  • Capability in one domain can lead to overconfidence in others
  • Humility is a virtue

Recency & Availability Bias

  • Recency Bias
    • We overweight recent events in our decision making
    • Example: 2008 Financial Crisis & Celebrity Illness
  • Availability Bias
    • We assume that the data we have been provided is representation of the entire data set
    • Studies show checking stock prices daily leads to more training & worse results on average aversion
  • We hate losses more than we love winning
  • We even hate being responsible for losses → it’s OKAY to not be rational