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Gulnur Muradoglu1 Behavioural Finance Biases in Financial Decision Making Session 2 Read Kahneman and Reipe, 1998 DeBondt and Thaler, 1985.

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Presentation on theme: "Gulnur Muradoglu1 Behavioural Finance Biases in Financial Decision Making Session 2 Read Kahneman and Reipe, 1998 DeBondt and Thaler, 1985."— Presentation transcript:

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2 Gulnur Muradoglu1 Behavioural Finance Biases in Financial Decision Making Session 2 Read Kahneman and Reipe, 1998 DeBondt and Thaler, 1985

3 Gulnur Muradoglu2 Review zBiases? zHeuristics? zOverconfidence zOptimism zHindsight bias zOverreaction

4 Gulnur Muradoglu3 Which Circle is larger?

5 Gulnur Muradoglu4 Biases zIntuition can not be trusted! xMust be supplemented by analytical thinking xUse a ruler to dispel the illusion! zSystematic errors of judgement:bias yNormative analysis xrational solution to a decision problem yDescriptive analysis xhow real people actually make decisons yPrescriptive analysis xpractical advice that you can use for rational decisions

6 Gulnur Muradoglu5 Decision Making Process zDecision: a choice between gambles youtcomes of possible options are not known in advance! xYou make judgements about probabilities xYou assign values to outcomes You combine these beliefs and values to form preferences yJudgements can be systematically wrong! xSystematic errors of judgement are called biases!

7 Gulnur Muradoglu6 Which is? zThe more frequent cause of death? yHomicide? yStroke?

8 Gulnur Muradoglu7 Heuristics zThe process by which people find things out for themselves yUsually by trial and error! yTrial and error leads to rules of thumb yThis process leads to errors xsometimes systematic errors! yThese rules of thumbs themselves xcame to be called heuristics! yAvailability heuristic xavailability bias!

9 Gulnur Muradoglu8 What is your best estimate? zDow Jones 1998 yClosed at 9181 xDJIA does not include reinvested dividends yWhat would be the closing value of DJIA be? xIf DJIA were redefined to reflect the reinvestment of all dividends? xSince May 1896 when its value was 40 xGive your Best Guess, Low guess, High Guess so that you feel 90% confident that true value lies between your low guess and high guess

10 Gulnur Muradoglu9 Overconfidence zHighly systematic bias forecasts of stock prices forecasts of earnings per share trades of investors (trading too much) zPeople set narrow confidence bands high guess is too low low guess is too high! zWell calibrated professionals xmeteorologists face similar problems every day make explicit probabilistic predictions obtain precise and immediate feedback on outcome

11 Gulnur Muradoglu10 How good are you? zHow good a driver are you? yCompared to drivers you encounter on the road are you xAbove-average? xAverage? xBelow average?

12 Gulnur Muradoglu11 Optimism zOptimists xexaggerate their talents xunderestimate the likelihood of bad outcomes xare prone to an illusion of control underestimate the role of chance in human affairs misperceive games of chance as games of skill zOverconfidence and Optimism combined overestimate knowledge underestimate risks exaggerate their ability to control events xVulnerable to statistical surprises? DeBondt, 1998

13 Gulnur Muradoglu12 Did you know? zOn the day before the Bank of England announcement, what was your estimate of the probability that interest rates would remain constant? zDo you think you have estimated the direction of change in FTSE100 correctly last week? zNow, have a look at the forecasts you made last week, have you estimated the direction of change for FTSE100 correctly?

14 Gulnur Muradoglu13 Hindsight Bias zReality looks much more obvious in hindsight than in foresight! zPeople with hindsight bias yperceive events that occurred to have been more predictable

15 Gulnur Muradoglu14 Hindsight Bias zPeople can rarely reconstruct, xafter the fact, what they thought about the probability of an event before it occurred Earlier estimate of probability is exaggerated after the event occurs zEvents that were not anticipated often appear almost inevitable after they appear zHindsight xpromotes overconfidence creates the illusion that the world is more predictable than it really is xturns reasonable gambles into foolish mistakes

16 Gulnur Muradoglu15 Which one is more likely? zYou are tossing a coin six times. Which of the following sequences is more likely to occur? HHHTTTHTHTTH

17 Gulnur Muradoglu16 Which one is more likely? zYou have tossed five coins and observed the following sequence HHHHH zNow, you are tossing the sixth coin. yHeads or Tails?

18 Gulnur Muradoglu17 Overreaction zHuman mind is pattern-seeking xbiased to think that a casual factor is at work! perceive patterns where non exists have too much confidence in their judgements of uncertain events zFund managers that were successful for a few years in a row? zOdean, 1998 xIndividual Investors who sold a stock and bought an other one immediately the stock they sold outperformed the one they bought by 3.5% in a year!

19 Gulnur Muradoglu18 Overreaction zDeBondt and Thaler, 1984 yQuestion: xDoes overreaction affect stock prices? yAnswer: xYes! Loser portfolios experience exceptionally larger returns than winner portfolios (25%!) yImplication xWeak form market inefficiency Explanation to the January Phenomenon

20 Gulnur Muradoglu19 Research Design yMonthly stock price data xexcess returns calculated using 3 different benchmarks yresearch period yPortfolio formation xStart in December 1932 (t=0) compute excess returns for the previous 3 years repeat this for all non-overlapping 3 year periods for each portfolio formation date rank cumulative abnormal returns from high to low –firms in top decile constitute winner portfolio –firms in bottom decile constitute loser portfolio

21 Gulnur Muradoglu20 Analysis zCompute ycumulative abnormal returns xfor all portfolios for the next 36 months zCompare ywinner versus loser portfolios xCumulative abnormal returns at t=36 yeach portfolios’ returns xat t=0 and t=36

22 Gulnur Muradoglu21 Results Cumulative Abnormal Returns Months after portfolio formation Loser portfolio Winner portfolio

23 Gulnur Muradoglu22 Summary zBiases? zHeuristics? zOverconfidence zOptimism zHindsight bias zOverreaction


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