“The investor’s chief problem, and even his worst enemy, is

likely to be himself.”
— Benjamin Graham

“There are three factors that influence the market: Fear,

Greed, and Greed.”

— Market folklore

8-1
 FIN3399—
Special Topics in
Finance
Behavioral Finance
Behavioral Finance

Winter Intersession
2023
Chapter 3 –
Dr. Hind Lebdaoui Emotional Shortcuts
and Errors
EMOTIONAL VS COGNITIVE SHORTCUTS

Hard to mitigate
 EMOTIONAL SHORTCUTS AND ERRORS

▪Like cognitive shortcuts, they are part of

the intuitive “blink” System 1 in our
minds, leading to good choices in most of
life
▪Shortcuts turn into errors when they
mislead us into poor choices
▪System 2, the reflective “think” system in
our minds leads to better choices when
System 1 misleads
 EMOTIONAL SHORTCUTS AND ERRORS

▪People with knowledge of human

behavior and financial facts use
emotional shortcuts correctly,

▪Whereas people lacking such

knowledge commit emotional errors as
they use them incorrectly
 EMOTIONAL SHORTCUTS AND ERRORS— FEAR
▪Fear acts as an emotional shortcut that
turns into an error when fear is absent or
when it is exaggerated
▪Fear guides us rightly when it prompts us to
retreat from a knife-wielding stranger
bearing an angry face, and when it prevents
us from buying houses likely to be
repossessed in foreclosures
▪But fear guides us, when it compels us to sell
all our stocks in a financial crisis
 EMOTIONAL SHORTCUTS AND ERRORS

•The interaction between cognition and

emotion makes it difficult to attribute shortcuts,
errors, and choices to one or the other
•Traveling RAK-TNG: drive or fly?
•Reason tells us that flying is safer than
driving long distances, yet some choose to
drive
•The choice can be attributed to cognition,
where images of crashed airplanes are more
readily available to mind than images of
crashed cars, or to emotion, where airplane
crashes evoke greater fear, or to a
combination of both
 EMOTIONAL SHORTCUTS AND ERRORS

The “ultimatum game”

EMOTIONAL SHORTCUTS AND ERRORS

The “Prisoner dilemma”

 EMOTIONAL BIASES
Emotional biases are:
▪Influenced by feelings and emotion
▪Usually related with human behavior to
avoid pain and produce pleasure;
▪Arise spontaneously as a result of attitudes
and feelings;
▪Less easy to correct and can only be
“adapted to”.
Examples: loss-aversion, overconfidence, self-
control, endowment, regret aversion, and
status quo.
 How would an investor with
loss aversion behave with:
Winning stocks vs Losing ones?
Quick vs slow
LOSS AVERSION?
A further indication of loss-aversion is an
unbalanced and overly-risky portfolio that is
the net result of
1. selling winning investments
and
1. holding on to losing investments.
LOSS AVERSION?
Mrs. Maradona is given two diagnostic questions to test for
loss-aversion bias.
Question 1, she is asked to choose between:
A. An assured gain of $400
B. A 25% chance of gaining $2,000 and a 75% chance of gaining
nothing
Mrs. Maradona chooses the assured gain of $400, despite the
fact that option B has an expected value of $500. This is
A or
consistent with selling winning B? too soon in order to
investment
lock in a gain.
Question 2, she is asked to choose between:
A. An assured loss of $400
B. A 50% chance of losing $1,000 and a 50% chance of losing
nothing
Mrs. Maradona chooses option B, despite the fact that its
expected value (-$500) is less than the outcome choosing
A or B?
option A (-$400). This is consistent with refusing to sell a
losing investment in order to avoid recognizing a loss.
OVERCONFIDENCE- EXAMPLES
Investors demonstrate overconfidence
bias by holding an irrational belief in
the superiority of their knowledge and
abilities. It is also known as the illusion
of knowledge bias.

Self-attribution bias, a subset of

overconfidence bias, is the tendency to
take credit for successes and attribute
the blame for failures to others (or
chance).
OVERCONFIDENCE- EXAMPLES
o“Suppose you make a winning investment.
How do you generally attribute the
success of your decision?”
oXYZ is described as having “a tendency
to be quick to blame, and rarely gives
credit to team members for success.” : a
clear example of self-attribution bias.
o“I know the industry, and I think that I am
an expert on the industry”.
How would an investor with
SCB behave with risk?
SELF CONTROL- EXAMPLES
o“I have always followed a budget and
have been a disciplined saver for
decades. Even in hard times when I had to
reduce my usual discretionary spending, I
always managed to save.” : This is an
example of an individual acting rationally
according to expected utility and
demonstrating no effect of self-control bias.
oRenABCaldo mentions his preference for
luxury cars and his inability to save for
retirement.
 EMOTIONAL SHORTCUTS AND ERRORS
Self-Control

Self-control is described as a conflict between

emotion and cognition, or as a conflict
between:
❑ The utilitarian, expressive and emotional
benefits of having something now and
❑ The utilitarian, expressive and emotional
benefits of having it later, or
between judgments derived from System 1 and
judgments derived from System 2.
 EMOTIONAL SHORTCUTS AND ERRORS
1. Please make the following choices:
Which would you prefer if both were free, a or b?
a. Dinner at a fancy French restaurant
b. Dinner at a local Greek restaurant
If you prefer the French restaurant, which would you prefer, c or d?
c. Dinner at the French restaurant on Friday in 1 month
d. Dinner at the French restaurant on Friday in 2 months
What are the reasons for your preference?
If you prefer the French restaurant, which would you prefer, e or f?
e. Dinner at the French restaurant on Friday in 1 month and dinner at the Greek restaurant on
Friday in 2 months
f. Dinner at the Greek restaurant on Friday in 1 month and dinner at the French restaurant on
Friday in 2 months
What are the reasons for your preference?
If you prefer the Greek restaurant, which would you prefer, g or h?
g. Dinner at the Greek restaurant on Friday in 1 month
h. Dinner at the Greek restaurant on Friday in 2 months
What are the reasons for your preference?
If you prefer the Greek restaurant, which would you prefer, i or j?
i. Dinner at the Greek restaurant on Friday in 1 month and dinner at the French restaurant on
Friday in 2 months
j. Dinner at the French restaurant on Friday in 1 month and dinner at the Greek restaurant on
Friday in 2 months
What are the reasons for your preference?
ENDOWMENT BIAS
An individual sets a higher asking price when selling an
asset than she would be willing to pay for an asset with
the same characteristics.

Individuals may demonstrate an irrationally strong

attachment to assets that were inherited from a
relative. Alternatively, an employee may be unwilling to
sell her employer’s shares out of a sense of loyalty.
How quick would an investor
with Endowment bias behave
with stocks trading?
ENDOWMENT BIAS- DIAGNOSTIC TEST
“How would you describe your emotional
attachment to possessions or investment
holdings?”
• Failing to sell (and replace) certain assets
• Holding an inappropriate asset allocation
• Failing to explore opportunities
How would an investor manage his
Portfolio while having a regret
aversion bias? Active? Passive?
 REGRET AVERSION- INVESTMENT TEST
Question 1 Suppose you make an investment in Stock ABC, and
over the next six months, ABC appreciates by your target of 15
percent. You contemplate selling but then come across an item in
the Financial Times that rehashes the company’s recent successes
and also sparks new optimism. You wonder whether ABC could
climb even higher. Which answer describes your likeliest response
given ABC’s recent performance and the FT article?
A. I think I’ll hold off and wait to see what happens. I’d really

“kick” myself if I sold now and ABC continued to go up.

B. I’ll probably sell because ABC has hit the target I set, and I try t

stick to the targets I set.

In response to Question 1, Mr. Renaldo avoids selling at his
previously-established target because he’d regret doing so and
watching ABC appreciate further. Note that the 15% growth target
was (presumably) based on rational expectations, whereas the
Financial Times article offers no new information to justify
deviating from this strategy.
 REGRET AVERSION
Question 2: Suppose you have decided to invest £10,000 in one individual company
stock, and you have narrowed your choice down to two companies: Blue, Inc., and
Red, Inc. Blue is a well-followed, eminently established company whose
shareholders include many large pension funds. Red is newer but has performed
well; it has not garnered the same kind of public profile as Blue, and it has few well-
known investors. According to your calculations, both stocks are expected to have
equal risk and return payoffs. Which answer most closely matches your thought
process in this situation?
A. I would probably feel indifferent between the two investments, because both
generated the same expected parameters with respect to risk and return.
B. I will most likely invest in Blue because if I invested in Red and my investment
failed, I would feel foolish. Few well-known investors backed Red, and I would really
regret going against their informed consensus only to discover that I was wrong.
C. I will most likely invest in Blue because I feel safe taking the same course as so
many respected institutional investors. If Blue does decline in value, I know I
won’t be the only one caught by surprise. With so many savvy professionals
sharing my predicament, I could hardly blame myselffor poor judgment.

Answer C indicates the presence of regret-aversion bias, as the investor is absolving himself
of any blame in the event that the investment in Blue underperforms because with “so many
savvy professionals sharing my predicament, I could hardly blame myself for poor
judgement.” Note that this expressed desire to avoid the pain of taking responsibility for a
bad investment puts regret-aversion clearly in the category of emotional biases.
 How would an investor manage
Manifestation:
hiswhen
Portfolio while
employees fail having
to allocate pensiona regret
contributions from their employer outside of the
aversion
default option.bias? Active?
Testing for status quo Passive?
bias is a
simple matter of asking an investor how frequently
he trades or reviews his portfolio’s performance.
 STATUS QUO
Investors who are aging and not taking actions to adjust their
portfolios
Investors who avoid making any changes to one’s portfolio.
A manifestation of this bias is when employees fail to allocate
pension contributions from their employer outside of the default
option.
Testing for status quo bias is a simple matter of asking an investor
how frequently he trades or reviews his portfolio’s performance.
The consequences of status quo bias are:
• Holding an inappropriate asset allocation

• Failing to explore certain investment opportunities

Summarizing Emotional Errors
 Behavioral Bias Diagnostic Question
Imagine you make an investment that drops 25 percent in the first six months. You
Loss Aversion are unsure if it will come back. What would you normally do (NOT what you think
•Hindsight you should do; what you would do)?
Endowment How would you describe your emotional attachment to possessions or investment
•Framing holdings?
•Endowment
Status Quo How would you describe the frequency of your trading?
You purchase a stock at $50 per share. It goes up to $60 in a few months, and then
•Anchoring
Anchoring it drops to $40 a few months later. You are uncertain what will happen next.
How would you respond to this scenario?
•Status-quo
Mental Accounting Generally, do you categorize your money by different financial goals, or do you
•Loss Aversion
Regret Aversion
look at the bigger financial picture?
Have you ever made an investment that you have regretted making? How did that
•Regret affect your future investing decisions?
Hindsight Do you believe investment outcomes are generally predictable or unpredictable?
Aversion Assume you have agreed to a financial plan created by your adviser that has a
•Representati projected return of 9 percent and an annual standard deviation of +/–15% (a
Framing typical plan). Would it surprise you to know that statistically in the worst case, the
veness plan’s return could be negative 36 percent or more in one year out of 100? Would
•Availability this information cause you to rethink your risk tolerance?
Assume you make an investment based on your own research. An adviser presents
•Mental
Conservatism you with information that contradicts your belief about this investment. How would
you respond?
Accounting
Availability Do you ever make investment decisions (such as selecting a mutual fund or
•Conservatism online broker) based on word-of-mouth or name recognition?
Have you ever made a new investment because of its apparent similarity to a past
successful investment (e.g., a tech stock or value stock) without doing research to
Representativeness validate the new investment's merits?
Behavioral Bias Diagnostic Question
Imagine you make an investment that drops 25 percent in the first six months. You
Loss Aversion are unsure if it will come back. What would you normally do (NOT what you think
you should do; what you would do)?
Endowment How would you describe your emotional attachment to possessions or investment
holdings?
Status Quo How would you describe the frequency of your trading?
You purchase a stock at $50 per share. It goes up to $60 in a few months, and then
Anchoring it drops to $40 a few months later. You are uncertain what will happen next.
How would you respond to this scenario?
Mental Accounting Generally, do you categorize your money by different financial goals, or do you
look at the bigger financial picture?
Regret Aversion Have you ever made an investment that you have regretted making? How did that
affect your future investing decisions?
Hindsight Do you believe investment outcomes are generally predictable or unpredictable?
Assume you have agreed to a financial plan created by your adviser that has a
projected return of 9 percent and an annual standard deviation of +/–15% (a
Framing typical plan). Would it surprise you to know that statistically in the worst case, the
plan’s return could be negative 36 percent or more in one year out of 100? Would
this information cause you to rethink your risk tolerance?
Assume you make an investment based on your own research. An adviser presents
Conservatism you with information that contradicts your belief about this investment. How would
you respond?
Availability Do you ever make investment decisions (such as selecting a mutual fund or
online broker) based on word-of-mouth or name recognition?
Have you ever made a new investment because of its apparent similarity to a past
successful investment (e.g., a tech stock or value stock) without doing research to
Representativeness validate the new investment's merits?
 DIAGNOSTIC QUESTIONS

Behavioral Bias Diagnostic Question

Overconfidence Suppose you make a winning investment. How
do you generally attribute the success of your
decision?
Suppose you make an investment based on
Confirmation your own research. The investment doesn’t
move up as much as you thought it might. How
are you likely to respond?
Illusion of Control You are offered two free lottery tickets. You
may either select your own numbers or have a
machine do it. What would you do?
Self-Control Do you tend to save or spend disposable
income?
 Bias
BELIEF PERSEVERANCE BIAS
Description Examples/Implications
Maintain prior views by • Hold winners or losers too long
Conservatism inadequately incorporating • Under-react to new information
new information • exhibit discomfort or difficulty in processing new
information
Look for and notice what • Focus on confirmatory/positive information about
confirms prior beliefs existing investments
Confirmation
• Over-react to confirmatory/positive information
• Hold under-diversified portfolio
Hindsight See past events as having • Overestimate the degree to which a prior event was
been predictable predictable
False belief that we can • Feeling of control over company where one works
Illusion of Control influence or control • Hold under-diversified portfolio
outcomes
Classify new information • Look for patterns in new information
based on past • Over-optimism about a past winner
experiences • Treat small sample as “representative” of entire
population
Representativeness • Invest in companies that remind one of successful
clients
• Over-react to new information and neglect base
rate
• Excessive trading and high manager turnover
(owing to focus on short-term performance)
 INFORMATION PROCESSING BIASES
Biases Description Examples/Implications

Framing Answer question • Exhibit risk-averse (risk-seeking or loss-aversion) attitude

differently based on how when outcomes are framed in terms of gains (losses)
it is asked/framed
developing estimates • Place high weight on anchor
Anchoring based on “anchor” value • Under-react to new information
and (e.g. target price) and • Influenced by purchase price or arbitrary price levels
Adjustment adjusting
decisions up or down
based on that value
Mental Accounting • Investing some money very conservatively and the rest in
Treat one sum of money speculative stocks.
different from other • Ignore correlations among various assets and total return
depending on source or • Hold suboptimal portfolio due to inefficient asset
use allocation
• Place high weight on easily available information,
Availability influenced by advertising
Influenced by how
• Select alternatives with which one has greater
easily outcome comes
to mind resonance; select alternatives that are easily
retrievable
• Focus on a limited set of investments
(“categorization”)
• Make investment decisions based on their
familiarity with the industry or country (“narrow range of
experience”)
 INFORMATION PROCESSING BIASES
Emotional Bias Description Examples/Implications
Loss Aversion Prefer avoiding losses over • Hold on to losing stocks too long and sell
achieving gains winning stocks too early (also called
“disposition effect”), Home money effect
(high risk after successful investment)
Overconfidence Unwarranted faith in ones • Excessive trading, Narrow confidence
abilities (Illusion of intervals, Assign high probability of success
knowledge; self attribution)

Self-Control Fail to act in pursuit of long • Focus on short-term satisfaction

term goals • Fail to save enough for the future
Endowment Exhibit an emotional • Shares in father’s company a source of
attached to the asset owned family pride
• People value asset more when they hold
rights to it
• Hold inherited/purchased securities
Regret Aversion Avoid pain of regret • Hold losing positions for too long
associated with bad • Prefer low risk assets, Engage in “herding
decisions behavior”, Prefer maintaining positions in
familiar investments
Status Quo Do nothing rather than • Hold on to securities even if they are
make a change inconsistent with risk/return objectives;
trade very infrequently
PRACTICE WITH EXCEL- FILES ON PORTAL
Group 1- “Country returns” file group— Please indicate your
perception of the expected return of a broad index of stocks of
each country in the following 12 months, from 1 for low
expected return to 10 for high expected return.
Group 2-“Country risk” file group— Please indicate your
perception of the risk of a broad index of stocks of each
country in the following 12 months, from 1 for low risk to 10
for high risk.
Group 3-“Country returns and risk” — Please indicate your
perception of the expected return and risk of a broad index of
stocks of each country in the following 12 months, from 1 for
low expected return to 10 for high expected return, and from
1 for low risk to 10 for high risk.
Calculate the mean returns and risk of each country according to groups 1 and 2.
Calculate a regression of returns on risk and display as a scatter diagram.
Calculate the mean returns and risk of each country according to group 3.
Calculate a regression of returns on risk and display as a scatter diagram.
 EMOTIONAL SHORTCUTS AND ERRORS

Mood
Mood is muted emotion, less intense than emotion,
but longer lasting
Fear of unemployment is less intense than fear of
an impending automobile accident but the former
can last for months and years, qualifying as mood
Fear of unemployment damages workers’ mental
health, especially those whose mental health is
already precarious
 EMOTIONAL SHORTCUTS AND ERRORS

Optimism and pessimism can be described as

moods
Optimism is associated with the emotions of
hope and happiness, and pessimism with the
emotions of fear and sadness, but optimism
and pessimism are not as intense as hope,
happiness, fear, or sadness. Sentiment in the
context of investments often corresponds to
mood
Bearish sentiment corresponds to pessimistic
mood and bullish sentiment to optimistic one.
 EMOTIONAL SHORTCUTS AND ERRORS
Mood (Optimism and pessimism)
Assume you are the vice president of product development in a company. You are
evaluating 3 new product proposals. For each proposal you have an estimate of 41
a. Research and development costs.
b. Average annual sales in first five years after product introduction.
You have made it a practice to ask two persons in research and development, A and B, in
whom you have equal confidence, to give you independent estimates of research and
development costs. You also ask two persons in marketing, X and Y, in whom you have
equal confidence, to give you independent estimates of sales. These estimates are given
below for the three proposals. In order to make a financial analysis of each proposed
product, you must make your own estimate of research and development cost and sales,
in the case of each proposal. Your estimate may be based on the estimates provided to
you, but your estimate does not have to be the average of the estimates given to you.
MOOD (OPTIMISM AND PESSIMISM)

Based on the information on the previous slide:

To what extent do you agree or disagree with the following statements:
Strongly Disagree (1) Disagree (2) Somewhat Disagree (3)
Neither Agree Nor Disagree (4) Somewhat Agree (5) Agree (6) Strongly Agree (7)

❑Research and development people typically overestimate R&D

costs
❑Research and development people typically underestimate R&D
costs
❑Marketing people typically overestimate sales
❑Marketing people typically underestimate sales
CH03,…….