Behavioral Biases

Professor Massimo Massa

 Managerial Decision Making

Decision making: the process by which managers respond

to opportunities and threats by analyzing options, and
making decisions about goals and courses of action.

Decisions in response to opportunities: managers

respond to ways to improve organizational performance.

Decisions in response to threats: occurs when managers

are impacted by adverse events to the organization.
Managerial Decision Making
 Classification

Behavioral Biases

Attitude Attention-
Towards Risk Self-Concept Grabbing
Prospect Theory Anchoring
Overconfidence
Mental Accounting Attention
Self-Attribution
Narrow Framing Social Norms
Regret Aversion

Conservatism

Representativeness
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 Classification

Behavioral Biases

Attitude Attention-
Towards Risk Self-Concept Grabbing
Prospect Theory Anchoring
Overconfidence
Mental Accounting Attention
Self-Attribution
Narrow Framing Social Norms
Regret Aversion

Conservatism

Representativeness
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 Certainty, Probability and Possibility
 Problem 1:
 Alternative A: p=80% gain $4000, p=20% gain $0
 Alternative B: p=100% gain $3000 80% prefer B

 Problem 2:
 Alternative A: p=20% gain $4000, p=80% gain $0 65% prefer A
 Alternative B: p=25% gain 3000, p=75% gain 0

People like CERTAINTY!

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Certainty, Probability and Possibility
 Problem 1:
 Alternative A: 45% chance to win $6000 86% prefer B
 Alternative B: 90% chance to win $3000

 Problem 2:
 Alternative A: 0.1% chance to win $6000 73% prefer A
 Alternative B: 0.2% chance to win $3000

People like to bet

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Certainty, Probability and Possibility
 Problem 1:
 Alternative A: p=80% loss of -$4000, p=20% gain $0
 Alternative B: p=100% loss -$3000 92% prefer A

 Problem 2:
 Alternative A: p=20% loss of -$4000, p=80% gain $0
 Alternative B: p=25% loss of -$3000, p=75% gain $0
58% prefer B

People are risk averse -- in area of gains

People are risk-loving -- when it comes to losses

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 Prospect Theory – Value Function

VALUE

PLEASURE

LOSSES GAINS

PAIN REFERENCE POINT

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 Loss Aversion

 Losses loom larger than gains

 The pain of a loss is twice as great as the pleasure of a

gain

 We simply hate to lose – even small amounts

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 Question:
 Example: the U.S. is preparing for the outbreak of an unusual
disease, expected to kill 600 people.There are 2 programs:

Program A: 200 people will be saved 72

Program B: 1/3 likelihood of 600 saved, 2/3 that none saved 28

Program A: 400 people will die 22

Program B: 1/3 likelihood of nobody dying, 2/3 that 600 die 78

Sensitivity of decision making to framing of the problems

➢ Different choices as a result of a different presentation of the

same problem

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 Mental Accounting

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. The “Mad Money” host reiterated his
paid to wait” concept, which involves
investing in dividend-paying stocks.
Despite economic events or how the
overall stock market is faring, high
yielding stocks pay investors to wait
until things getting better. These stocks
could go up or down, but the investor
gets the dividend payment
nonetheless.

“You need dividend payers like this in case Europe falls apart all over again,
something nobody seems to be expecting at the moment even as the likelihood that
things go wrong over there is still pretty high,” Cramer explained. “Even if the stocks
have done nothing or next to nothing, your wallet’s fatter just for owning them.
That’s the main reason I keep stressing dividends and the need to reinvest those
dividends back into the stocks to get ever larger amounts of cash from the companies.”.
16 Behavioral Finance 11/1/2022
 A Game

Case – “Frank”, Netherlands, 1/1/05

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 Deal or no deal

Yellow box is the one you set aside, blue ones are on stage
The boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$

You can
accept the deal and go home
or
no deal and eliminate one of the blue boxes

I offer you 410 000 $

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 Deal or no deal

Yellow box is the one you set aside, blue ones are on stage
The boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$

You can
accept the deal and go home
or
no deal and eliminate one of the blue boxes

I offer you 603 000 $

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 Deal or no deal

Yellow box is the one you set aside, blue ones are on stage
The boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$

You can
accept the deal and go home
or
no deal and eliminate the remaining blue box

I offer you 416 000 $

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 Deal or no deal

Yellow box is the one you set aside, blue ones are on stage
The boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$

You are walking home with a yellow box

Yes, you are correct, there’s 1 dollar inside

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 What would YOU do?
Mean = 383,427
Source: Post, et. al (2008)
22
 What would YOU do?
Mean = 64,502
Source:23Post, et. al (2008)
 What would YOU do?
Mean = 85,230
Source:24Post, et. al (2008)
 What would YOU do?
Mean = 95,004
Source:25Post, et. al (2008)
 What would YOU do?
Mean = 85,005
Source:26Post, et. al (2008)
 What would YOU do?
Mean = 102,006
Source:27Post, et. al (2008)
 What would YOU do?
Mean = 2,508
Source:28Post, et. al (2008)
 What would YOU do?
Mean = 3,343
Source:29Post, et. al (2008)
 What would YOU do?
Mean = 5,005
Source: Post, et. al (2008)
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 Deal or No Deal?

Why did Frank play they way he did?

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 A Dynamic Bias
How does it work

0. Start at the reference point

1. Now comes 20 dollars

2. 20 dollars are taken back –

where are you now?

- It depends …

If updated reference point /

segregation

If did not update reference point /

integration
Remember: length of evaluation window has profound effect on your utility
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 Classification

Behavioral Biases

Attitude Attention-
Towards Risk Self-Concept Grabbing
Prospect Theory Anchoring
Overconfidence
Mental Accounting Attention
Self-Attribution
Narrow Framing Social Norms
Regret Aversion

Conservatism

Representativeness
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 Question

 Steve, a thirty-year-old American, has been described

by a former neighbor as follows: “Steve is very shy
and withdrawn, invariably helpful, but with little real
interest in people or social world. A meek and tidy
soul, he has order and structure and a passion for
details.”

 Which occupation is Steve currently more likely to

have:
 A: A salesman
 B:A librarian
 Base Rate Neglect

 Probably a salesman.
 There are 15 millions sales people in the US but
only 180,000 librarians.

 People tend to ignore the base rate (i.e., P(A)) in

their calculations.
 For example, people often put too much
weight on recent short term successes when
picking stocks.
 Question:

Which is the more likely cause of death?

Falling Plane Part Shark Attack

Death by falling plane parts is 30x MORE likely
Source:
36 http://www.learner.org/discoveringpsychology/11/e11expand.html
 Gambler’s Fallacy

Roulette is a casino game where a wheel and a ball are

spun in opposite directions and eventually, the ball falls
into a space. Bets can be placed on whether the ball will
fall into a red, black, or green space.

There are 18 red spaces,

18 black, and 1 green

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 Gambler’s Fallacy

You’re in Vegas and walk up to roulette tables with the 5

previous spins posted as:

Table 1 Table 2
2 9
27 36
31 7
26 5
12 9

Which table would you feel more comfortable placing a

bet on “black”?

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 Question: What Will Google’s Price Be
In The Future?

Google Stock Price

$800 Dec-04 to Dec-07

$600

$400

$200

$0
Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07

Source:
39 www.morningstar.com
Representativeness
 Illusion of Control

 Craps players throw

harder when they want
higher numbers and
softer for lower
numbers
 People choose their own
lottery numbers,
thinking they can pick
the winners

Source: Henslin, (1967)

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 Let’s Play A Game…

Hit or Stand?
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 Blackjack

 Experts say you should take another card (hit)

 Most players do not take a card (stand)

 Why?

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 Regret Aversion

 Taking action and losing feels worse than “doing nothing”

and losing

 Although the outcome is the same, regret plays a larger

role post-action

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 Classification

Behavioral Biases

Attitude Attention-
Towards Risk Self-Concept Grabbing
Prospect Theory Anchoring
Overconfidence
Mental Accounting Attention
Self-Attribution
Narrow Framing Social Norms
Regret Aversion

Conservatism

Representativeness
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 Extremeness Aversion

When two options with similar

attributes are presented …

$250 $300

… people pick the less expensive option

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 Extremeness Aversion -2
When a more expensive third
option is available …

$250 $300 $400

… people tend to go for the middle of the road

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 Anchoring:
Wine Connoisseurs

 Participants in experiment are shown an average bottle of wine,

then asked if they would pay an amount equal to the last two
digits of their Social Security Number

 Results: Those with the highest SSN would pay three times
more than those with lowest SSN

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 Willingness To Pay For A Bottle Of Wine
$27.91

$15.45
$14.45
$12.55

$8.64

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 WTP for a “Rare” Bottle of Wine

$37.55
Average Wine

Rare Wine $27.91

$24.55
$22.45
$18.09
$14.45 $15.45
$11.73 $12.55
$8.64

Lowest Quintile 2 3 4 Highest Quintile

- SSN - SSN

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 Attention as a scarce resource
 The set of available opportunities if often very large
 In making decisions we first select which options to consider
 then decide which of those options to choose.
 When there are many alternatives, options that attract attention are more likely
to be considered, hence more likely to be chosen, while the options which do
not attract attention are often ignored.
Alternatives selected

All alternatives

Subset of alternatives
considered

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 The Role of the Default Option and
Nudges

Opt-In
Opt-Out

Source: Johnson, et. al (2003)

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