10. Heuristics And Financial Decision Making Flashcards
How does traditional economic theory presume we process information?
We take decisions involving uncertainty. Our answers implicitly involved judgement about likelihoods or uncertain values.
Traditional economic theory presumes we process information correctly, according to statistical rules.
What does the psychological and economic experimental evidence say?
Judgements often based on heuristic principles:
1) Representativeness
2) Anchoring
3) Availability
Rules of thumb: can be applied to complex situations: they reduce complexity but might lead to biases in judgements.
What is representativeness?
Whether an object belongs to a group A or B is judged by how close the object resembles the stereotype of A or B, how representative the object is of either A or B.
Eg. People naturally feel that probability that they will win the lottery and be overjoyed the next day is higher than the probability that they will just win the lottery.
The picture of smiling winners seems more representative of the class of lottery winners than somebody that just wins the lottery.
Gambler’s and hot-hand fallacy.
What is anchoring?
People start their reasining from some initial value.
This initial value is given by the context in which prediction is made, result of a partical computation.
How did we test the anchoring effect?
55 students were shown six roducts with brief descriptions mentioning market price. After that subjects asked whether they would buy each good for a dollar value equal to the last two digits of their social security number.
After this, Accept/Reject response, they stated their dollar maximum willingsness-to-pay (WTP) for the product.
A random device determined whether the product would in fact be sold.
Which conclusions can we draw from anchoring?
Choices are sensititve to irrelevant influences such as anchoring. Initial valuations seem arbitrary.
Because earlier decisions are used as inputss for future decisions –> initial choice will exert an inapporpriate influence over subsequent choices and values.
Looking at a series of choices by a single individual –> orderly pattern (coherence) with respect to numerical parameters like price, quentity, quality and so on.
Adjustments typically insufficient such that: different initial values lead to different final valuations.
What is selective accessibility?
People compare target object to anchor by testing hypothesis that the value of the target is equal to the anchor value.
People engage in a ‘positive test strategy’ and selectively retrieve knowledge from memory that is consistent with the anchor.
Eg. You get the assessment that the demand for a particular treatment will raise by 20% next year. To assess how critical you are towards this assessment, relevant information must be obtained or retrieved from memore.
Unconscious/intuitive information search distorted = info is searched and generated suggesting the demand will indeed raise by 20%.
What is anchoring and adjusting?
Environmental cues function as starting points for our judgement tasks.
Judgements involve adjustments from these starting points.
Adjustments usually insufficient implying that environmental cues have an excessive influence on our judgements.
Consequence: different initial values lead to different final valuations.
Eg. 1x2x3x4x5x6x7 vs 7x6x5x4x3x2x1
What is availability?
Estimates of uncertain values or probability judgements are also affected by availability.
Availability heuristics –> mental shortcut that occurs when people judge the importance and (relative) likelihood of a given event as a function of the ease with which it comes to mind.
The more easily available, the mire likely an event appears to be.
Eg. Assessing divorce rates by recalling divorces among one’s acquantances.
Evaluating the likelihood of failure of a business venture by considering the various ways in which it might fail.
People rely on their mental sampling affected by ease of retrieval.
Mental sampling = intuitive statistical method.
Not random and certainty not always unbiased. Important factors influecing judgements by availability:
1) Recency: how long ago did september 11 take place?
2) Salience: the news’ ability to get our attention, eg. Terrorism
3) Imaginiability: how easy to visualize
What is the judgement of word frequency?
This is a result from availability: consider a random word from an English text. Is it more likely that the word starts with a K or that K is its third letter?
2/3 of the subject judged first position more likely compared to third position. Median estimated ratio 2/1
Conclusion: easier to retrieve words with letter in first position = higher availability = easier construction –> relative frequency/likelihood evaluated higher
What with representativeness for companies & investments?
Investors might think that if a company has a high quality management, a strong image and consistent growth in earnings = good investment.
Financial theory disagrees: in firm valuetion, future cash flows are forecasted and discounted back to present using an appriopriate risk-adjusted discount rate.
All previously mentioned attributes should be reflected in these cash flow estimates and the risk-adjusted discount rate. They should already be part of the price so that good companies sell at high prices and bad companies at low prices.
Given this: no reason to favor a good over a bad company. Future excess returns are unpredictable.
It is a mistake to think a company with past above average earnings growth is representative of good investment, but representativeness migh imply that we associate past sucess with likely future return.
What did Shefrin & Statman 1995 investige?
“Making sense of beta, size and book-to-market”
They use survey data from the Fortune magazin: fortune asked executives to evaluate firms on different attributes: 0 (poor) - 10 (excellent).
Dimensions: quality of management, quality of products and services, innovativeness, long term investment value, financial soundness, ability to keep, attract and develop talent, etc.
Management quality highly correlated with value as long term investment.
In particular, big companies and companies with low book to market value are perceived to have good quality management.
What can we conclude on the research with representativeness on companies & investments?
Perceived management quality extremely important for value as long term investment.
Executives believe that good companies are good investment opportunities.
Important: no company attribute should be associated with investment value. Everything should be in the price so that all comapnies are equally good investment opportunities.
Size and book/market ratio highly correlated with perceived management quality: big companies and companies with low book/market ratios are seen as well managed companies.
Big companies often become big because they are good.
Big high-growth comapnies are representative of good ivnestments - evidence points into the opposite direction.
What is “chasing the winner”?
Investors choose investment funds based on past performance.
It seems they take past performance as representative for future investment performance.
Such ‘trend following’ or ‘momentum chasing’ has long been a popular strategy among technical analysts.
What did Canada in 2005 examine?
A survey among workers managing their own retirement money.
Asked to start their pension from scratch and allocate money between 2 stocks: (1) an average return of 5% over past 5 years and (2) an average return of 15% over past 5 years.
Additional information: analysts forecast that both stocks earn on average 10% annually over the next years.
Neutral investors: to maximize diversificaiton 50/50 in both stocks
Momentum chasers put more than 50% in stock (2)
Contrarians: put more than 50% in stock (1)
Result: 63,8% were momentum chasers and 11,6% contrarians.
