...All of economics is meant to be about people’s behavior. Behavioral Economics is a field of economics that studies how the actual decision-making process influences the decisions that are reached. The standard economic theory is known as neoclassical economics. Neoclassical economics stops short of trying to explain where people’s preferences come from, but it does not take account of the direct influence of other people’s behavior and social standards on our behavior. The theory imagines we independently know what we want and that our preferences are permanent. This standard theory is very good at explaining short-term decision-making (I want green vegetables and choose beans as they are on special offer) but cannot explain longer-term changes in preferences (I now only choose organic food). Along the same lines the importance of institutions – both formal institutions such as regulations, and informal ones, for example, how people organise markets – and the evolution of the whole economic system are not subjects of neoclassical analysis. This has significant implications Behavioral economics has evolved to be a separate branch of economic analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources. Behavioral economics is that branch of one, which deals with the study and application...
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...Journal of Economic Behavior & Organization 72 (2009) 147–152 Contents lists available at ScienceDirect Journal of Economic Behavior & Organization journal homepage: www.elsevier.com/locate/jebo Cognitive abilities and behavioral biases Jörg Oechssler a,∗ , Andreas Roider a , Patrick W. Schmitz b a b Department of Economics, University of Heidelberg, Bergheimer Str. 58, 69115 Heidelberg, Germany Department of Economics, University of Cologne, Germany a r t i c l e i n f o a b s t r a c t We use a simple, three-item test for cognitive abilities to investigate whether established behavioral biases that play a prominent role in behavioral economics and finance are related to cognitive abilities. We find that higher test scores on the cognitive reflection test of Frederick [Frederick, S., 2005. Cognitive reflection and decision-making. Journal of Economic Perspectives 19, 25–42] indeed are correlated with lower incidences of the conjunction fallacy and conservatism in updating probabilities. Test scores are also significantly related to subjects’ time and risk preferences. Test scores have no influence on the amount of anchoring, although there is evidence of anchoring among all subjects. Even if incidences of most biases are lower for people with higher cognitive abilities, they still remain substantial. © 2009 Elsevier B.V. All rights reserved. Article history: Received 19 May 2008 Received in revised form 15 April 2009 Accepted 15 April 2009 Available online...
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...Chapter 18 A SURVEY OF BEHAVIORAL FINANCE ° NICHOLAS BARBERIS University of Chicago RICHARD THALER University of Chicago Contents Abstract Keywords 1. Introduction 2. Limits to arbitrage 2.1. Market efficiency 2.2. Theory 2.3. Evidence 2.3.1. Twin shares 2.3.2. Index inclusions 2.3.3. Internet carve-outs 3. Psychology 3.1. Beliefs 3.2. Preferences 3.2.1. Prospect theory 3.2.2. Ambiguity aversion 4. Application: The aggregate stock market 4.1. The equity premium puzzle 4.1.1. Prospect theory 4.1.2. Ambiguity aversion 4.2. The volatility puzzle 4.2.1. Beliefs 4.2.2. Preferences 5. Application: The cross-section of average returns 5.1. Belief-based models 1054 1054 1055 1056 1056 1058 1061 1061 1063 1064 1065 1065 1069 1069 1074 1075 1078 1079 1082 1083 1084 1086 1087 1092 ° We are very grateful to Markus Brunnermeier, George Constantinides, Kent Daniel, Milt Harris, Ming Huang, Owen Lamont, Jay Ritter, Andrei Shleifer, Jeremy Stein and Tuomo Vuolteenaho for extensive comments. Handbook of the Economics of Finance, Edited by G.M. Constantinides, M. Harris and R. Stulz © 2003 Elsevier Science B.V All rights reserved . 1054 5.2. Belief-based models with institutional frictions 5.3. Preferences N. Barberis and R. Thaler 6. Application: Closed-end funds and comovement 6.1. Closed-end funds 6.2. Comovement 7. Application: Investor behavior 7.1. 7.2. 7.3. 7.4. 7.5. Insufficient diversification Naive diversification Excessive trading The selling decision...
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...Behavioural Finance Martin Sewell University of Cambridge February 2007 (revised April 2010) Abstract An introduction to behavioural finance, including a review of the major works and a summary of important heuristics. 1 Introduction Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient. For more information on behavioural finance, see Sewell (2001). 2 History Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and most influential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the Stock Market. He based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’. In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets...
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...Behavioural Finance Martin Sewell University of Cambridge February 2007 (revised April 2010) Abstract An introduction to behavioural finance, including a review of the major works and a summary of important heuristics. 1 Introduction Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient. For more information on behavioural finance, see Sewell (2001). 2 History Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and most influential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the Stock Market. He based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’. In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets. Tversky and Kahneman...
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...The book that I chose for this book review is Thinking Fast and Slow by Daniel Kahneman. He is an Israeli-American psychologist and winner of the 2002 Nobel Prize in Economic Sciences. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology. The main thesis of the book is quite simple. When judging the world around us, we use two mental systems: Fast and Slow. The Fast system (System 1) is mostly unconscious and makes snap judgments based on our past experiences and emotions. When we use this system we are as likely to be wrong as we are to be right. The Slow system (System 2) is more rational, conscious and slow. They work together to provide us with a view of the world around us. Together, they shape our impressions of the world around us and help us make choices. System 1 is largely unconscious and it makes snap judgments based upon our memory of similar events and our emotions. System 2 is painfully slow, and is the process by which we consciously check the facts and think carefully and rationally. Problem is, System 2 is easily distracted and hard to engage, and System 1 is wrong as often as it is right. System 1 is easily swayed by our emotions. Some examples he cites include the fact that pro golfers are more accurate when putting for par than they are for birdie, regardless of distance, and people buy more cans of soup when there's a sign on the display that says "Limit 12 per customer." An easier way...
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...This paper will consider why people value gains and losses differently in different circumstances by addressing what mental accounting is and how it impacts consumer decision making; and how a company can take advantage of their consumers’ mental accounting (Tvorik, 2014). This writer will also consider different scenarios from differing points of view; as a marketer and as a consumer. As a marketer, this writer will analyze how I would frame certain decisions to benefit from the disparities in my own cognitive accounting. As a consumer, I will address how to avoid the pitfalls posed by the inequalities of again, my own cognitive accounting (Tvorik, 2014). Mental accounting is a term that describes how people categorize and quantify economic outcomes (Thaler, 1980). This is similar to financial accounting in the way of using a system of debits and credits and affects how people spend and save their money, thus consumer decision-making. Mental accounting determines “when an individual chooses to act or postpone a purchase, how he or she perceives gains and losses, and how timing bears on the individual’s choices” in relation to the three mental buckets: current income, current wealth and future income (Tvorik, 2014). It is a figurative, or mental, balance sheet that compartmentalizes income and spending (Vedantam, 2007). People will spend and save differently depending on how the money was received, earned income or “free,” unexpected money such as a tax return or lottery...
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...BEHAVIORAL FIANCNE AND WEALTH MANAGEMENT AUTHOR : MICHAEL M. POMPiaN BEHAVIORAL FIANCNE AND WEALTH MANAGEMENT AUTHOR : MICHAEL M. POMPiaN BOOK REVIEW OF : BOOK REVIEW OF : PREPARED BY : ASHISH SHARMA PREPARED BY : ASHISH SHARMA 2014 2014 Behavioral Finance and Wealth Management Author Information “Michael M. Pompian, CFA, CFP, is a partner at Mercer Investment Consulting, a firm serving institutional and private wealth clients. Prior to joining Mercer, he was a wealth management advisor with Merrill Lynch and PNC Private Bank, and served on the investment staff of a family office. Pompian is a Chartered Financial Analyst (CFA), a Certified Financial Planner (CFP), and a Certified Trust Financial Advisor (CTFA). He is also a member of the CFA Institute (formerly AIMR) and the New York Society of Security Analysts (NYSSA). He holds a BS in management from the University of New Hampshire and an MBA in finance from Tulane University. Pompian is a regular speaker on the subject of behavioral finance and has published several articles on the subject. He is married with three sons and can be reached at michael.pompian@mercer.com. “ Michael M. Pompian describes various biases which we can see in human beings , also tells about various experiments on human beings in his book “ BEHAVIOURAL FINANCE AND WEALTH MANAGEMENT “ and tells “HOW TO BUILD OPTIMAL PORTFOLIOS THAT ACCOUNTS FOR INVESTOR BIASES “ The book is published...
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...therefore if we are not very careful we can fall into a never ending train of irrational decisions. Dan Ariely makes it quite apparent that this behavior takes place in everyday life even though we may not know it and hopes that his research can open our eyes to this fact and help us to avoid making irrational choices. He challenges the traditional assumption that the economic man uses rational thought to make decisions and challenges his readers to rethink the way they view the simple, everyday choices made on a daily basis. After reading the book, he makes it obvious that we all unknowingly act predictably irrational, however he gives us the tools to overcome this and think and behave in a rational manner. Some of the major points discussed in the book include the truth about making decisions based on comparisons, the fallacy of supply and demand, the endowment effect, anchoring effects, social versus market norms, and placebo effect among a number of other important areas embedded in our decisions making processes. By studying and understanding Ariely's research, we can change the way we approach behavioral economics and possibly change the way it is taught by including the unnoticed factors that...
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...THE JOURNAL OF FINANCE • VOL. LVI, NO. 4 • AUGUST 2001 Investor Psychology and Asset Pricing DAVID HIRSHLEIFER* ABSTRACT The basic paradigm of asset pricing is in vibrant f lux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models. The best plan is . . . to profit by the folly of others. — Pliny the Elder, from John Bartlett, comp. Familiar Quotations, 9th ed. 1901. IN THE MUDDLED DAYS BEFORE THE RISE of modern finance, some otherwisereputable economists, such as Adam Smith, Irving Fisher, John Maynard Keynes, and Harry Markowitz, thought that individual psychology affects prices.1 What if the creators of asset-pricing theory had followed this thread? Picture a school of sociologists at the University of Chicago proposing the Deficient Markets Hypothesis: that prices inaccurately ref lect all available information. A brilliant Stanford psychologist, call him Bill Blunte, invents the Deranged Anticipation and Perception Model ~or DAPM!, in which proxies for market misvaluation are used to predict security returns. Imagine the euphoria when researchers discovered that these mispricing proxies...
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...Behavioral Economics Matters for HIV Research: The Impact of Behavioral Biases on Adherence to Antiretrovirals (ARVs) Abstract Behavioral economics (BE) has been used to study a number of health behaviors such as smoking and drug use, but there is little knowledge of how these insights relate to HIV prevention and care. We present novel evidence on the prevalence of the common behavioral decision-making errors of present-bias, overoptimism, and information salience among 155 Ugandan HIV patients, and analyze their association with subsequent medication adherence. 36 % of study participants are classified as present-biased, 21 % as overoptimistic, and 34 % as having salient HIV information. Patients displaying present-bias were 13 % points (p = 0.006) less likely to have adherence rates above 90 %, overoptimistic clients were 9 % points (p = 0.04) less likely, and those not having salient HIV information were 17 % points (p\0.001) less likely. These findings indicate that BE may be used to screen for future adherence problems and to better design and target interventions addressing these behavioral biases and the associated suboptimal adherence The Importance of BE Biases for Chronic Health Behaviors We focus on three key behavioral biases that have been found to influence health behaviors for other chronic conditions [9] and that we hypothesize may also be important to components of ARV adherence: Present-Bias A key behavioral bias is present-bias, which is the tendency...
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...Predictably Irrational provides an exciting perspective on the field of behavioural economics. Ariely presents his own theories and research on various aspects of human behaviour. He explains the fundamental differences between traditional economics and behavioural economics in a way that is easy to understand. Traditional economics assumes that people are rational, whereas behavioural economics stresses that they are irrational. Ariely’s primary focus in the work is this debate between rationality and irrationality. The entire book is written in the first person using an informal tone. The casual tone can be justified as the book is aimed at the general public, as opposed to other researchers and academics. However, given the scientific nature of the information he is presenting, the informal tone also causes his findings to lack assertiveness. Keeping in theme with the informal tone, Ariely uses many anecdotes to convey his findings in a way that is relevant to, and can be understood by, the reader. The anecdotes help the reader grasp the concepts with greater ease, but the addition of personal stories further detracts from the assertiveness of his research. At the risk of losing some readers, it would have been preferred for Ariely to use a more formal approach to match the serious content of his work. Clearly, Ariely aimed to reach a broader range of readers who would not normally study behavioural economics. The book is geared mainly at an American audience. The research is conducted...
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...Behavioural Finance Literature Review Name Institution Professor Date ABSTRACT INTRODUCTION It is tough today to avoid the concept of behavioural finance in the day to day operations of the modern day’s business. All over the world Governments are in a process of experimenting the application of the psychology of decision making to tune their citizens towards better behaviours. Companies and institutions are paying attention to this concept as a new opportunity of realizing profits. Traditionally, the finance paradigms relied heavily on understanding finance markets using the models that had agents who were rational. In the Scenario, rationality implied that when the companies received new information, they updated their agents believes as described by the Bayes law. Besides, with their beliefs, managers and agents made decisions that are acceptable because they are consistent with the Savage idea of Subjective Expected Utility. This traditional approach was viewed as successful if it received data backing. However, as markets became complicated, it became clear that basic acts involving the stock market, the average returns and peoples trading behaviours could not be comprehended in the traditional model. The behavioural finance is the new approach to the emerging financial markets as it addressed the challenges faced by the traditional paradigms. The basic argument of this paradigm is that some financial phenomena can be best can be best comprehended by the...
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...Libre des Sciences Commerciales Appliquées Review of Literature Behavioral Finance Presented to Dr. Mohamed EL-Hennawy Group Assignment Prepared By Albert Naguib Noha Samir Wael Shams EL-Din Moshira Gamil Marie Zarif January 2012 | TABLE OF CONTENTS | | | |List of Table………………………………………………………………………….. | |List of Figure ………………………………………………………………………… | |List of Abbreviations/Acronyms ……………………………………………………. | |Introduction……………………………………………………………………….. | |2. Appearance of Behavioral Finance…………………………………………………… | |2.1. Important Contributors…………………………………………………. ………. | |3. Behavioral Biases…………………………………………………………………… ...
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...Chapter 9 Behavioral Finance and Technical Analysis The effiecient market hypothesis makes two important predictions. First, it implies that security prices properly reflect whatever information is available to investors. Second, active traders will find it difficult to outperform passive strategies such as holding market indexes. A relatively new school of thought dubbed behavioral finance argues that sprawling literature on trading strategies has missed a larger and more important point by overlooking the first implication of efficient markets-the correctness of security prices. Behavioral finance are models that emphasize potential implications of psychological factors affecting investor behavior. Its premise is that conventional financial theory ignores how real people make decisions and that people make a difference. A growing number of economists have come to interpret the anomalies literature as consistent with several “irrationalities” that seem to characterize individuals making complicated decisions. 2 Broad Categories: 1. Investors do not always process information correctly and therefore infer incorrect probability distributions about furture rates of return. 2. Even given a probability distribution of returns, they often make inconsistent or systematically suboptimal decisions. Information Processing Errors in information processing can lead investors to misestimate the true probabilities of possible events or associated rates of return. Forecasting errors...
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