Behavioral Finance

Corporate Finance Institute®

 Course Objectives

Understand what behavioral Learn the most common self- Understand cognitive biases and
finance is, how it differs from deception biases, their causes, explore their root causes with
modern finance, and how it and potential measures you can real life examples
impacts on financial markets take to prevent them

Learn about the most common Understand loss aversion and Study the herding bias and other
emotional biases and discuss other biases that contribute to its social factors that distort
their causes with examples effect decision-making

Corporate Finance Institute®

 What is Behavioral Finance

Behavioral finance studies the influence of psychological, cognitive, emotional, and social factors on
financial and investment decisions.

VS
Modern Finance Behavioral Finance
• Rational decision makers • Normal decision makers

• Perfect self-control • Limited self-control

• Not influenced by biases • Influenced by biases and

and cognitive errors cognitive errors

• Risk-average, never averse • Varying risk preferences

to regret and can regret losses

Corporate Finance Institute®

 Decision Making Biases and Errors

Types of Biases Examples

Self Maintaining false beliefs and often denying logical evidence, Overconfidence
Deception which limits the ability to learn Bias

Cognitive errors associated with how the brain processes Confirmation

Cognitive
information that can impact decision-making Bias

Allowing emotions or one’s mood to impact decision Loss Aversion

Emotional
making

Arise from the influence of others on an individual’s Herding Bias

Social
decision-making process

Corporate Finance Institute®

 Reflective vs. Reflexive Reasoning

Reflective Reflexive
Reasoning Reasoning

Logical approach to decision-making,

where individuals reflect on
information to come to a conclusion.
VS Emotional approach to decision-
making that doesn’t follow a
structured process.

• Requires effort to engage • Easier to engage

• Slow • Fast

Corporate Finance Institute®

 Two Reasoning Exercise

Take a look at the diagram below. Which line is longer?

Corporate Finance Institute®

 Two Reasoning Exercise

Both lines are the same length!

Muller-Lyer illusion

Your reflective mind knows that the lines are the same length but your reflexive mind sees them as being different.

Corporate Finance Institute®

 Cognitive Reflection Task (CRT) Exercise

Cognitive reflection test (CRT) is a task designed to measure a person's tendency to override an incorrect
"gut" or reflexive response and engage in further reflection to find a correct answer.

1. A bat and ball together cost $1.10 in total. The bat costs a dollar more than the
ball. How much does the ball cost?

Reflexive Reasoning Reflective Reasoning

• $0.10 • $0.05, making the bat $1.05
and the total $1.10

Corporate Finance Institute®

 Cognitive Reflection Task (CRT) Exercise

2. If it takes five minutes for five machines to make five widgets, how long would it
take 100 machines to make 100 widgets?

Reflexive Reasoning Reflective Reasoning

• 100 minutes • 5 minutes, since 1 widget
takes 5 minutes to make

Corporate Finance Institute®

 Cognitive Reflection Task (CRT) Exercise

3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes
48 days for the patch to cover the entire lake, how long will it take to cover half of
the lake?

Reflexive Reasoning Reflective Reasoning

• 24 days • 47 days, patch doubles so it
will be half covered on the
day before

Corporate Finance Institute®

 Self-Control is Limited

A vast amount of psychological research suggests that our ability to use self-control to override our
emotional reaction is limited. It becomes even more limited:

In high stress situations When there is When decisions rely on

information asymmetry interactions with others

So how do we prevent ourselves from falling victim to emotional reactions?

We can prevent this by developing a better understanding of the biases and errors can
prevent us from falling victim to them.

Corporate Finance Institute®

 Self Deception Biases

Corporate Finance Institute®

 Overview of Behavioral Finance Biases

We have grouped behavioral finance biases into three main categories, each of which has its own set of
biases that interact with and influence each other. None of these biases act in isolation.

Self-Deception Cognitive Biases Social Biases

Biases

• Optimism Bias • Herding Bias

• Overconfidence Bias • Gender Bias

• Illusion of Knowledge • Social Factors

Information Emotional
• Illusion of Control Processing Biases
Biases

Corporate Finance Institute®

 How Self Deception Biases Impact Decision Making in Finance

Mergers & Acquisitions Corporate Financing Capital Investing

Decisions Decisions
• Biased managers might • Biased managers tend to • Biases can lead to
make bidding mistakes. choose higher debt managerial
levels. overconfidence.
• Self-deception biases
can lead to over • Self-deception biases • Managers with a record
optimism about deal can impact capital of successful decisions
synergies and structure decisions. can be affected by biases
overvaluation. and cognitive errors.

Corporate Finance Institute®

 Types of Self-Deception Bias: Optimism Bias

Optimism bias causes decision makers to overestimate the likelihood of positive outcomes and
underestimate the likelihood of negative outcomes.

Positive Outcomes Negative Outcomes

We overestimate our We underestimate our

longevity (how long we are likelihood of getting cancer.
going to live).

Corporate Finance Institute®

 Case Study: Management Team Optimism

The study examined the influence of optimism amongst top management team
members on corporate investment decisions.

Introduction
Three Scenarios:

01 02 03
If optimism lead to a If optimism lead to an If optimism lead to an
preference for debt increase in M&A increase in
financing over equity activity investment-cash flow
financing sensitivity

Source: Tobias Heizer and Laura R. Rettig, “Top Management Team Optimism and Its Influence on Firms' Financing and Investment Decisions”
(Review of Financial Economics, February 17, 2020).
Corporate Finance Institute®
 Case Study: Management Team Optimism

Analyzed over 539,000 insider Constructed an optimism

stock trades indicator

Data & Method where managers buy and sell shares in their
own firms using Thomson Reuters Insider
Filings starting in 1986

Optimism led to Optimism had a

Optimism led to significant impact
a preference for
an increase in
Results debt financing on the amount of
investment-cash
over equity M&A activity
flow sensitivity.
financing.
undertaken.

Source: Tobias Heizer and Laura R. Rettig, “Top Management Team Optimism and Its Influence on Firms' Financing and Investment Decisions”
(Review of Financial Economics, February 17, 2020).
Corporate Finance Institute®
 Case Study: Optimism and Markets

The study examined the influence of stock and bond market optimism and
merger waves and wanted to test:

Introduction

01 02
Whether or not financial Whether or not financial
market optimism explained market optimism explained
the volume of M&A activity the choice of M&A financing

Source: Klaus Gugler et al., “Market Optimism and Merger Waves” (Managerial and Decision Economics, February 28, 2012).

Corporate Finance Institute®

 Case Study: Optimism and Markets

Two measures of general Constructed measures Data source:

optimism in financial for valuation and
Global M&A from Thompson
markets: assets acquired by a
Financial Securities Data
Data & Method company
• Aggregate P/E multiple for (1985 – 2008)
the stock market
to examine the choice of
• Interest rate spreads in the financing
bond market

Mergers undertaken
More M&A when optimism in
Optimism in
activity when markets was high led
financial markets
Results optimism in both
influenced how to lower returns for
the bond and
M&A deals were shareholders of the
stock markets
financed.
was high. acquiring
companies.

Source: Klaus Gugler et al., “Market Optimism and Merger Waves” (Managerial and Decision Economics, February 28, 2012).

Corporate Finance Institute®

 How Can We Guard Against Optimism Bias

Follow a logical decision-making process, evaluating all possible scenarios

Recognize that negative events can happen to anyone at random

Prepare for all outcomes, not just for positive ones

Corporate Finance Institute®

 Rate Your Driving Skills Exercise

How would you rate your driving abilities?

Below Average Average Above Average

1 2 3 4 5
I don’t think I could
I’m okay if I avoid Those accidents Very good - I’m fast Excellent - I’m better
pass a driver’s test
tricky parking spots weren’t my fault but I avoid trouble than most drivers
today

Corporate Finance Institute®

 Rate Your Driving Skills Exercise

How would you rate your driving abilities?

Below Average Average Above Average

1 2 3 4 5
I don’t think I could
I’m okay if I avoid Those accidents Very good - I’m fast Excellent - I’m better
pass a driver’s test
tricky parking spots weren’t my fault but I avoid trouble than most drivers
today

Allstate survey of 1,000 US adults (July 2011):

36 percent 64 percent

Corporate Finance Institute®

 Types of Self-Deception Bias: Overconfidence Bias

Overconfidence bias occurs when an individual believes their judgements, skills, or intellect are superior
than they actually are.

It can be broken down into:

Over Estimation Over Placement Over Precision

Belief that our actual Belief that our skills/actions Belief that our information is
skills/actions are better than are better compared to other more accurate than it is.
they really are. people.

Source: Don A. Moore and Derek Schatz, “The Three Faces of Overconfidence” (Social and Personality Psychology Compass, August 3, 2017).

Corporate Finance Institute®

 Types of Self-Deception Bias: Overconfidence Bias

Overconfidence can lead to investment mistakes, such as:

An investor can An investor can Over-confident investors

overestimate their ability underestimate a tend to hold under-
to correctly value a financial risk, blinded by diversified portfolios and
potential investment. confidence. are more exposed to risk.

Corporate Finance Institute®

 Case Study: Options Traders and Overconfidence

The study examined whether investor overconfidence could be linked to higher

trading activity in the options market.

Introduction

Earlier research had already identified investor

overconfidence bias associated with higher trading
volumes in the equity markets.

Source: Han-Sheng Chen and Sanjiv Sabherwal, “Overconfidence among Option Traders” (Review of Financial Economics, February 2019).

Corporate Finance Institute®

 Case Study: Options Traders and Overconfidence

Constructed measures of Data source:

option trading volume
Ivy DB's OptionMetrics, Center for Research
dependent on past returns in Security Prices, Capital IQ Compustat
Data & Method (overconfidence measure) (1996-2015)
and controls

It took 3 months on
Option trading average for changes in
volumes were Overconfident stock market returns to
positively option traders
Results impact options trading
correlated with tended to choose
past stock call options. volumes. It takes time
market returns. for traders to gain
confidence.

Source: Han-Sheng Chen and Sanjiv Sabherwal, “Overconfidence among Option Traders” (Review of Financial Economics, June 19, 2018).

Corporate Finance Institute®

 Case Study: Overconfidence and Financing Decisions

The study examined the relationship between managerial overconfidence and

corporate finance decisions.

Introduction

The study analyzed whether Past research showed the effect

overconfident managers were of overconfidence and
less likely to issue public equity in overestimation of profitability on
favor of debt or private equity. the decision to issue debt or
equity.

Source: Masaya Ishikawa and Hidetomo Takahashi, “Overconfident Managers and External Financing Choice” (Wiley InterScience, February 11,
2010).
Corporate Finance Institute®
 Case Study: Overconfidence and Financing Decisions

Constructed proxies for The standardized difference between

managerial overconfidence forecast vs. actual earnings
from a database on (managerial forecast bias) was used
Data & Method managerial forecasts of EPS as the measure of overconfidence.

Firms that chose

to publicly issue Overconfident Overconfident
equity had a managers managers
Results lower preferred private preferred debt to
managerial placement. equity.
forecast bias.

Source: Masaya Ishikawa and Hidetomo Takahashi, “Overconfident Managers and External Financing Choice” (Wiley InterScience, February 11,
2010).
Corporate Finance Institute®
 How Can We Guard Against Overconfidence Bias

Watch for signs of How would your decision Stick to the facts and
overconfidence in our own change if you were less follow an objective
behaviour confident? approach

Corporate Finance Institute®

 Compare Financial Models Exercise

Lisa and Susan, FP&A professionals at a large multinational company with 10 years of forecasting
experience in the industry, were asked to come up with independent forecast for the company’s
next quarter.

Lisa Susan

Spent 245 hours Spent 45 hours

Analyzed 75,000 data points Analyzed 10,000 data points

Reviewed 20 years of historic data Reviewed 18 years of historic data

Whose forecast model is more accurate?

Corporate Finance Institute®

 Illusion of Knowledge and Control

Overconfidence stems from two illusions:

Illusion of
Illusion of Control
Knowledge

Tendency to believe that decisions Tendency to overestimate our

become more accurate with more influence on the outcome of
information uncontrollable events

Corporate Finance Institute®

 Case Study: Illusion of Control

The study examines the impact and influence of organizational characteristics on a firm’s
forecasting competency.

Introduction
The study addresses two research questions:

01
What are a firm’s characteristics that influence its forecasting ability?

02
How do these characteristics impact forecasting biases?

Source: Rodolphe Durand, “Predicting A Firm’s Forecasting Ability: The Roles Of Organizational Illusion Of Control And Organizational Attention”
(Strategic Management Journal, June 16, 2003).
Corporate Finance Institute®
 Case Study: Illusion of Control

Two organizational characteristics were identified to influence forecasting estimation

biases:

Data & Method • Organizational illusion of control

• Organizational attention

The more an
Study found high organization believed
organizational they could influence
Results illusion of control the outcome of
increased positive uncontrollable events,
forecast bias. the positive their
forecasts.

Source: Rodolphe Durand, “Predicting A Firm’s Forecasting Ability: The Roles Of Organizational Illusion Of Control And Organizational Attention”
(Strategic Management Journal, June 16, 2003).
Corporate Finance Institute®
 How Can We Guard Against These Illusions

How information is analyzed It is better to stay focused on

matters more than how much a few key points and analyze
information has been gathered. these in detail rather than
try and analyze everything.

Corporate Finance Institute®

 Cognitive Biases

Corporate Finance InstituteⓇ

 Overview of Behavioral Finance Biases

As we dive into the next few lessons, here is how we have structured our discussions:

Self-Deception Cognitive Biases Social Biases

Biases

• Optimism Bias • Herding Bias

• Overconfidence Bias • Gender Bias

• Illusion of Knowledge • Social Factors

Information Emotional
• Illusion of Control Processing Biases
Biases

Corporate Finance Institute®

 Cognitive Bias: Information Processing vs. Emotional

Cognitive biases are mental shortcuts. They help us navigate our world daily because we cannot
possibly process all the information around us, all the time. Therefore, these cognitive biases help us make
decisions quickly, and hopefully, effectively.

Information Processing Emotional

• Quantitative • Attitude

• Statistical • Feelings

• Less effort to correct • More difficult to change

Corporate Finance Institute®

 2008 Global Financial Crisis Exercise

On a scale of 1 to 5, how predictable do you believe the 2008 global financial crisis was?

• Totally unpredictable (1)

• Totally predictable (5)

1 2 3 4 5

Somewhat Somewhat
Totally unpredictable Very predictable Totally predictable
unpredictable predictable

Corporate Finance Institute®

 2008 Global Financial Crisis Exercise

On a scale of 1 to 5, how predictable do you believe the 2008 global financial crisis was?

• Totally unpredictable (1)

• Totally predictable (5)

1 2 3 4 5

Somewhat Somewhat
Totally unpredictable Very predictable Totally predictable
unpredictable predictable

Possibility of
Hindsight Bias

Corporate Finance Institute®

 Types of Cognitive Bias: Hindsight Bias

Hindsight bias is the tendency to believe that after an event has occurred, it could have been foreseen.

“I knew it all along”

Bias
It is a very common bias amongst investors.
Hindsight bias is everywhere in the financial
business!
“Hindsight is 20/20”
Bias

Corporate Finance Institute®

 Types of Cognitive Bias: Hindsight Bias

Hindsight bias is the tendency to believe that after an event has occurred, it could have been foreseen.

Memory When individuals recall their judgments as being closer to the

Distortion outcome than they were.

Inevitability When individuals claim that results were more probable than they
were.

Foreseeability When individuals claim that they would have predicted the known
results more accurately than they did.

Source: Dustin P. Calvillo and Abraham M. Rutchick, “Domain Knowledge and Hindsight Bias among Poker Players” (Journal of Behavioral
Decision Making, September 5, 2013).
Corporate Finance Institute®
 Case Study: Hindsight Bias and Investment Performance

A 2007 paper tested the hypothesis that hindsight bias impacts the earnings of bankers.

Through empirical data collection and analysis of the performance of 41 bankers in Frankfurt and 29 in
bankers in London, the researchers found:

High earning bankers were significantly less hindsight

biased than low-earning and mid-earning bankers.

The difference between low- and mid-earning bankers

was not statistically significant.

Splitting the bankers into groups with 10+ and less

than 10 years of experience did not impact results.

Source: Biais, Bruno, and Martin Weber. “Hindsight Bias and Investment Performance,” January 2007.

Corporate Finance Institute®

 Types of Cognitive Bias: Self-Attribution Bias

Have you ever caught yourself taking credit for something that really you
didn’t deserve?

Corporate Finance Institute®

 Types of Cognitive Bias: Self-Attribution Bias

Prevents investors from recognizing and learning from mistakes!

Self-attribution bias is the tendency to attribute positive results (successes) to the individual’s skills and
abilities, while negative results (failures) are credited to uncontrollable factors or ”bad luck”.

You may ace one exam and think You got a great bonus this year
it’s due to your skills, while if you and attribute it to your skills,
do poorly on another, you may when in fact the firm had a great
attribute it to ”bad luck”. year overall.

Corporate Finance Institute®

 Types of Cognitive Bias: Self-Attribution Bias

Prevents investors from recognizing and learning from mistakes!

Self-attribution bias is the tendency to attribute positive results (successes) to the individual’s skills and
abilities, while negative results (failures) are credited to uncontrollable factors or ”bad luck”.

Self-attribution Overconfidence
Bias Bias

Leads investors to become Leads investors to often take

overconfident and more on unnecessary financial risk
prone to biases. or trade too aggressively.

Corporate Finance Institute®

 Types of Cognitive Bias: Self-Attribution Bias

Good Outcome Bad Outcome

Right Self-Attribution
Skill Bad luck
Analysis Bias

Wrong Good luck Mistake

Analysis

Corporate Finance Institute®

 Case Study: Self-Attribution Bias and M&A

Study examines the world of UK Mergers & Acquisitions.

• When M&A deals create good outcomes for the acquiring company, is there a self-
attribution bias and does it lead to an increasingly overconfident CEO?

• Does the CEO’s self-attribution overconfidence bias increase the higher the deal
Introduction volumes?

Source: John A. Doukas and Dimitris Petmezas, “Acquisitions, Overconfident Managers and Self-Attribution Bias” (European Financial
Management, 2007).
Corporate Finance Institute®
 Case Study: Self-Attribution Bias and M&A

• The study used M&A data from the UK between 1980-2004.

• 91% of acquisitions during the period were associated with private targets.

Data & Method

• Study found that the self-attribution bias associated with successful M&A deals,
propelled managers to do even more M&A deals with greater overconfidence.

• However, higher volumes of M&A deals did not lead to greater and greater
Results valuation creation.

Source: John A. Doukas and Dimitris Petmezas, “Acquisitions, Overconfident Managers and Self-Attribution Bias” (European Financial
Management, 2007).
Corporate Finance Institute®
 How Can We Guard Against Self-Attribution and Hindsight Bias

01 Keep a record of past decisions that will allow you to go back and reflect.

One of the best ways to measure your own performance.

Promotes accountability.

Corporate Finance Institute®

 How Can We Guard Against Self-Attribution and Hindsight Bias

02 Re-evaluate your reasoning from an objective perspective.

Evaluating situations from different perspectives is critical in being

objective.

This is an integral part of the investment process before executing any

trade.

Corporate Finance Institute®

 How Can We Guard Against Self-Attribution and Hindsight Bias

03 Seek out alternative scenarios.

Examine alternative cases.

Corporate Finance Institute®

 International News Exercise

Consider the following English language news sources. Please select your preferred source for
international news (not domestic). You can select more than one.

Other

Corporate Finance Institute®

 Types of Cognitive Bias: Confirmation Bias

Confirmation bias is the tendency to search for and favor information that strengthens our own actions,
judgements, and reasoning.

Overconfidence

Under-diversified
Portfolios

Unnecessary
Financial Risks

Corporate Finance Institute®

 Types of Cognitive Bias: Confirmation Bias Examples

Tech company with a new cloud-based software is about to announce a partnership with one of the
country’s largest bricks and mortar retailers.

You are considering adding this stock to your

portfolio.

Look for articles and other data that confirms

this information.

Miss the fact that the tech company is facing

potential legal challenges.

Corporate Finance Institute®

 Types of Cognitive Bias: Confirmation Bias Examples

Confirmation bias can be seen in technical analysis. Imagine you are a trader who has recently invested in
a stock.

You are very bullish about the stock.

Look for bullish technical analysis signals that

support your view.

Bearish technical warning signals may be

downplayed/ignored.

Corporate Finance Institute®

 Case Study: Strategic Implications of Confirmation Bias Inducing Advertising

This research examines the effects of consumers’ confirmation bias on the advertising and pricing
strategies of companies, and the impact on company profits.

Consumer Product Firm

Source: Rajesh Bagchi, Sung H. Ham, and Chuan He, “Strategic Implications of Confirmation Bias-Inducing Advertising†” (Production and
Operations Management, June 2020).
Corporate Finance Institute®
 Case Study: Strategic Implications of Confirmation Bias Inducing Advertising

This research examines the effects of consumers’ confirmation bias on the advertising and pricing
strategies of companies, and the impact on company profits.

“We will typically give more weight to brands we’ve had a positive experience with.”

Study results suggest that confirmation bias did not improve firms’ profits in the short run but did benefit
frequently purchased products over a longer time horizon.

When confirmation bias induces higher willingness-to-pay

• Competitors increase ad efforts – (↓) lower short-run prices

and (↑) higher long-run prices.

Source: Rajesh Bagchi, Sung H. Ham, and Chuan He, “Strategic Implications of Confirmation Bias-Inducing Advertising” (Production and
Operations Management, June 2020).
Corporate Finance Institute®
 Confirmation Bias Exercise

If the card has a vowel on one side, then it must have an even number on the other side.

A Q 4 7
Which 2 cards would you turn over to test the rule?

A) A, 4 B) A, 7 C) Q, 4 D) Q, 7

Corporate Finance Institute®

 How Can We Guard Against Confirmation Bias

Benefits on your career in the long-run, leading to sounder

Seek disconfirming evidence decisions.
and pay attention to
resources that disagree with
your ideas.

Corporate Finance Institute®

 How Can We Guard Against Confirmation Bias

Seek disconfirming evidence Keep an open mind about Ask yourself why you are
and pay attention to possible alternatives to wrong rather than why
resources that disagree with your method. you are right.
your ideas.

Corporate Finance Institute®

 Finding Patterns Exercise

Review the two sequences and see if you can determine any sort of logical pattern behind them.

Sequence 1

0, 1, 1, 2, 3, 5, 8, 13
Sequence 2

Corporate Finance Institute®

 Finding Patterns Exercise: Sequence 1

Leonardo Fibonacci number series – 1170AD.

0, 1, 1, 2, 3, 5, 8, 13, 21, 34

Corporate Finance Institute®

 Finding Patterns Exercise: Sequence 1

Leonardo Fibonacci number series – 1170AD

In the Fibonacci sequence, each number is the sum of the previous two numbers.

0 1 1 (0+1) 2 (1+1) 3 (1+2) 5 (2+3) 8 (3+5) 13 (5+8) 21 (8+13) 34 (13+21)

Consecutive terms: 0 1 0.500 0.667 0.600 0.625 0.615 0.619 0.618

0 1 1 2 3 5 8 13 21
1 1 2 3 5 8 13 21 34

Every other term: 0.382

13
34

• The ratio between consecutive terms trends to 0.618.

0.618 + 0.382 = 1
• The ratio between every other term trends to 0.382.

Corporate Finance Institute®

 Finding Patterns Exercise: Sequence 2

Sequence 2 is purely random!

Sequence 2

• Over 62% of study subjects believed that the sequence represented the
shooting streak.

• In truth, the sequence was completely random!

Source: Gilovich, Thomas, Robert Vallone, and Amos Tversky. “The Hot Hand in Basketball: On the Misperception of Random Sequences.”
Cognitive Psychology, 1985.
Corporate Finance Institute®
 Types of Cognitive Bias: Clustering Illusion

Clustering illusion refers to a cognitive bias in where an investor observes patterns and trends in what
are truly random events.

Investors observe patterns and trends

in data when in fact the data is random.

Common in technical analysis

Corporate Finance Institute®

 How Can We Guard Against Clustering Illusion

“Past performance is not indicative of future performance.”

Focus on long-term Recognize that events can Make sure the evidence is
periods to identify be unrelated and not robust and err on the side
potential trends. necessarily fit a pattern. of caution.

Corporate Finance Institute®

 Guess the Likelihood of an Event

• She is 31, single, outspoken & very bright.

• She majored in philosophy at university.

• As a student she was deeply concerned with issues surround equality and
Laura Smith discrimination.

Which is more likely?

A. Laura works at a bank. 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦% < 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦&

B. Laura works at a bank AND is active in the feminist movement.

Representative Bias

Corporate Finance Institute®

 Types of Cognitive Bias: Representative Bias

Representative bias occurs when the similarity of events/objects confuses an individual’s thinking
regarding the probability of an outcome.

Mental Shortcut Real probability of event happening

Replacing a question of How closely it corresponds to a similar event

probability/logic with a question
of similarity.

Corporate Finance Institute®

 Types of Cognitive Bias: Representative Bias

Representative bias occurs when the similarity of events/objects confuses an individual’s thinking
regarding the probability of an outcome.

Some investors tend to rely on stereotypes when making investment

decisions.

Ex. ‘Good’ companies make good investments.

Base-rate
Neglect

When judging the likelihood of an outcome, investors often fail to

accurately consider the sample size of the data.

Ex. Research Analysts forecasting results based on only recent-past

Sample-size
performance and growth.
Neglect

Source: Michael Pompian, ed., “Representativeness Bias,” in Behavioral Finance and Wealth Management: How to Build Investment Strategies
That Account for Investor Biases, 2012, pp. 85-97.
Corporate Finance Institute®
 Case Study: Representative Bias in Intuitive Judgement

Pretend you’re one of the participants in the study.

Source: Daniel Kahneman and Shane Frederick, “A Model of Heuristic Judgment,” Heuristics of Intuitive Judgment (Cambridge University Press,
2002).
Corporate Finance Institute®
 Case Study: Representative Bias in Intuitive Judgement

Researchers conducted an experiment by asking a group of participants a series of questions.

Tom W. is a student picked at random from the body of graduate students at a university. Below is
Tom’s personality sketch written during his final year in high school by a psychologist:

Tom W. is of high intelligence, although lacking in true creativity.

He has a need for order and clarity, and for neat and tidy systems in which every detail finds its
appropriate place.

His writing is rather dull and mechanical, occasionally enlivened by somewhat corny puns and by
flashes of imagination of the sci-fi type.

He has a strong drive for competence.

He seems to feel little sympathy for other people and does not enjoy interacting with others. Self-
centered, he nonetheless has a deep moral sense.

Source: Daniel Kahneman and Shane Frederick, “A Model of Heuristic Judgment,” Heuristics of Intuitive Judgment (Cambridge University Press,
2002).
Corporate Finance Institute®
 Case Study: Representative Bias in Intuitive Judgement

The researchers then asked the following questions:

01 In which of these fields is Tom W more likely to be a student?

Method 02 How would you rank order these fields in terms of the likelihood that Tom W is a
student in that field?

Business Administration Medicine

1. Most likely
Computer Science Library Science
2.
Engineering Physical and Life Sciences

Humanities and Education Social Science & Social Work

9. Least likely Law

Source: Daniel Kahneman and Shane Frederick, “A Model of Heuristic Judgment,” Heuristics of Intuitive Judgment (Cambridge University Press,
2002).
Corporate Finance Institute®
 Case Study: Representative Bias in Intuitive Judgement

Business Administration 1. Computer Science Small number of students

in these fields in the school
Computer Science 2. Engineering

Engineering 3. Business Administration

Humanities and Education 4. Physical and Life Sciences

Law 5. Library Science

Medicine 6. Law Representative

Bias
Library Science 7. Medicine

Physical and Life Sciences 8. Humanities and Education

Social Science & Social Work 9. Social Science & Social Work

Source: Daniel Kahneman and Shane Frederick, “A Model of Heuristic Judgment,” Heuristics of Intuitive Judgment (Cambridge University Press,
2002).
Corporate Finance Institute®
 How Can We Guard Against Representative Bias

“Be aware of your natural tendencies for biases.”

Have I based my analysis on How representative is the

probability rather than sample of the whole?
similarity?

If your decision was the very first thought that popped into your mind, slow down
and think more critically.

Corporate Finance Institute®

 How Can We Guard Against Representative Bias

“Be aware of your natural tendencies for biases.”

Have I based my analysis on How representative is the

probability rather than sample of the whole?
similarity?

“If you’ve had 10,000 hours of training in a predictable, rapid-feedback

environment — chess, firefighting, anesthesiology — then blink. In all other cases,
think.”

Corporate Finance Institute®

 Investment Strategy Exercise

Congratulations! You are US-based, in your mid 30s, and you’ve inherited $1 million which has already
been invested by reputable financial advisors as follows:

60% Equities 40% Fixed Income

40% - US Equities 10% - US Govt. Bonds

20% - Global Equities 20% - US Corporate

10% - International Bonds

Corporate Finance Institute®

 Investment Strategy Exercise

Congratulations! You are US-based, in your mid 30s, and you’ve inherited $1 million which has already
been invested by reputable financial advisors as follows:

60% Equities 40% Fixed Income

40% - US Equities 10% - US Govt. Bonds

20% - Global Equities 20% - US Corporate

10% - International Bonds

Corporate Finance Institute®

 Investment Strategy Exercise

You have the choice to keep the existing investment strategy or change it for one of three other options.
Which option do you prefer?

A 60% Equities 40% Fixed Income B 50% Equities 50% Fixed Income

40% - US Equities 10% - US Govt. Bonds 30% - US Equities 15% - US Govt. Bonds

20% - Global Equities 20% - US Corporate 20% - Global Equities 20% - US Corporate

10% - International Bonds 15% - International Bonds

C 40% Equities 60% Fixed Income D 80% Equities 20% Fixed

Income
30% - US Equities 15% - US Govt. Bonds 30% - US Equities
33.3% of
30% - US Corporate each
30% - Global Equities 30% - Global Equities
category
15% - International Bonds

Corporate Finance Institute®

 Investment Strategy Exercise

You have the choice to keep the existing investment strategy or change it for one of three other options.
Which option do you prefer?

A 60% Equities 40% Fixed Income B 50% Equities 50% Fixed Income

40% - US Equities 10% - US Govt. Bonds 30% - US Equities 15% - US Govt. Bonds

20% - Global Equities 20% - US Corporate 20% - Global Equities 20% - US Corporate

10% - International Bonds 15% - International Bonds

C 40% Equities 60% Fixed Income D 80% Equities 20% Fixed

Income
30% - US Equities 15% - US Govt. Bonds 30% - US Equities
33.3% of
30% - US Corporate each
30% - Global Equities 30% - Global Equities
category
15% - International Bonds

Corporate Finance Institute®

 Types of Cognitive Bias: Status-quo Bias

Status-quo bias occurs when an individual prefers the current state, “status quo”, to an alternative,
resisting change.

Familiarity “Better the devil you

know than the devil
you don’t.”

Unknown Reality

Corporate Finance Institute®

 Types of Cognitive Bias: Status-quo Bias

Status-quo bias occurs when an individual prefers the current state, “status quo”, to an alternative,
resisting change.

One of the biggest

instigators of status-
quo bias is loss
aversion.

An investor might be reluctant to reallocate

their investment position and maintain the
current portfolio to minimize the risk of loss.

Corporate Finance Institute®

 Case Study: Status-quo Bias and Attitude Towards Risk

An experiment was conducted between 195 PhD students at the University of Economics and Management of Sousse,
Tunisia (May 2016) to detect risk preferences and examine the bias.

Goal was to conduct a rigorous examination of the link between status quo bias and risk preferences of individuals.

Individual risk preferences were strongly correlated to status-quo bias:

71.70% of risk-averse participants made status quo

choices.

89.55% of risk loving participants and 82.67% of the

risk-neutral participants didn’t show any status quo
bias.

Source: Insaf Bekir and Faten Doss, “Status Quo Bias and Attitude towards Risk: An Experimental Investigation,” Wiley, April 1, 2019.

Corporate Finance Institute®

 How Can We Guard Against Status-quo Bias

Take an objective stance to decision-making, analyzing possible outcomes by

sticking to only the facts.

Repeating past choices is often safe and easier than implementing a change,
but a change can be for the better.

Put pen-to-paper and try quantifying risks in your decision-making. Relate

them to lifestyle changes, and daily impacts.

Corporate Finance Institute®

 Shoe Shopping Exercise

Imagine you are out shopping for new shoes and two pairs of shoes catch your eye. You like each pair
equally (i.e. you don’t have a preference). Which pair do you choose?

1st Pair of Shoes 2nd Pair of Shoes

Regular price $75 Regular price $150
No sale/discount Sale 50% off
available
Reduced price $75

Corporate Finance Institute®

 Shoe Shopping Exercise

Imagine you are out shopping for new shoes and two pairs of shoes catch your eye. You like each pair
equally (i.e. you don’t have a preference). Which pair do you choose?

1st Pair of Shoes 2nd Pair of Shoes

Regular price $75 Regular price $150
No sale/discount Sale 50% off
Anchoring Bias
available
Reduced price $75

Corporate Finance Institute®

 Shoe Shopping Exercise

Imagine you are out shopping for new shoes and two pairs of shoes catch your eye. You like each pair
equally (i.e. you don’t have a preference). Which pair do you choose?

1st Pair of Shoes 2nd Pair of Shoes

Regular price $75 Regular price $150
No sale/discount Sale 50% off
Anchoring Bias
available
Reduced price $75

Corporate Finance Institute®

 Types of Cognitive Bias: Anchoring Bias

Anchoring bias occurs when people rely too much on pre-existing information, or the first piece of
information that they see when making decisions.

You are shopping for a new suit at the store.

Suit #1 costs $250 Suit #1 costs $950

Corporate Finance Institute®

 Types of Cognitive Bias: Anchoring Bias

Anchoring bias occurs when people rely too much on pre-existing information, or the first piece of
information that they see when making decisions.

You are shopping for a new suit at the store.

Suit #1 costs $250 Suit #1 costs $950

Corporate Finance Institute®

 Case Study: An Examination of Anchoring-Induced Bias and Search Costs

Study looked into whether out-of-state home buyers paid a premium on transactions in Phoenix, Arizona
vs. their in-state counterparts, and whether this could be explained by the anchoring bias.

01 The typical out-of-state buyer overpaid by 5.52% relative to an in-state counterpart,

leaving an average of $194,480 on the negotiating table.

02 They also found evidence consistent with this premium being

driven by:

Anchoring High Search Time

Bias Costs Constraints

Source: Val E. Lambson, Grant R. McQueen, and Barrett A. Slade, “Do Out-of-State Buyers Pay More for Real Estate? An Examination of
Anchoring-Induced Bias and Search Costs” (Real Estate Economics, 2004).
Corporate Finance Institute®
 Case Study: Judgement Under Uncertainty and Anchoring Bias

Another study asked a similar question: What percentage of United Nations

membership is made up of African countries?

Anchor 10% 65%

25% of UN 45% of UN
Answer
membership memberships

Source: Amos Tversky and Daniel Kahneman, “Judgment Under Uncertainty: Heuristics and Biases,” Science (American Association for the
Advancement of Science, 1974).
Corporate Finance Institute®
 How Can We Guard Against Anchoring Bias

Acknowledge the bias! Delay decision making Create your own anchors
Awareness is the first and follow a step-by-step that can be beneficial in
step. approach. setting financial goals.

Corporate Finance Institute®

 Choose Your Treatment Exercise

01 There is a disease affecting 600 people. Which treatment do you choose?

Treatment A Treatment B

200 lives will be saved. There is 33.3% chance of saving all 600
people, and a 66.7% chance of saving
no one.

Corporate Finance Institute®

 Choose Your Treatment Exercise

02 There is a disease affecting 600 people. Which treatment do you choose?

Treatment A Treatment B

400 people will die. There is 33.3% chance that no one will
die, and a 66.7% chance that all 600
people will die.

Corporate Finance Institute®

 Choose Your Treatment Exercise

01 Treatments A&B are framed as a gain.

02 Treatments A&B are framed as a loss.

A
Treatment A Treatment A

200 lives will be saved. 400 people will die.

A

Treatment B B Treatment B

There is 33.3% chance of saving all 600 There is 33.3% chance that no one will
B people, and a 66.7% chance of saving die, and a 66.7% chance that all 600
no one. people will die.

Corporate Finance Institute®

 Types of Cognitive Bias: Framing Bias

Framing biases occurs when people make decisions based on the way the information is presented, as
opposed to just on the facts themselves.

The same facts presented in two different ways can lead to people making different judgments or
decisions.

99%
1%
FAT
FAT
FREE

Corporate Finance Institute®

 Case Study: Framing Bias and Retirement Savings Decisions

Study looks at the relationship between framing and retirement savings decisions.

Narrow Framers Broad Framers

Individuals who tend to make More likely to consider both

decisions based primarily on their immediate consumption needs
immediate consumption needs. and future retirement needs.

Source: Serah Shin, Hyungsoo Kim, and Claudia J. Heath, “Narrow Framing and Retirement Savings Decisions” (The Journal of Consumer Affairs,
Fall 2019).
Corporate Finance Institute®
 Case Study: Framing Bias and Retirement Savings Decisions

This study tested whether individuals with narrow framing were less willing to
increase their retirement savings contributions.

Results provided empirical evidence that narrow framing bias affects retirement savings
decisions.

Of the participating population, 18.6% of respondents were identified as being ‘Narrow

Framers’.

Amongst Narrow Framers, 62.6% indicate a willingness to increase their retirement savings
contributions whereas that percentage is 71.9% for Broad Framers, confirming the hypothesis.

Susceptibility to Narrow Framing Bias

Contribute more to retirement savings for tomorrow, today

Source: Serah Shin, Hyungsoo Kim, and Claudia J. Heath, “Narrow Framing and Retirement Savings Decisions” (The Journal of Consumer Affairs,
Fall 2019).
Corporate Finance Institute®
 Now You Have a Go…

Imagine your work for a large public listed company, and these are the earnings per share (EPS) figures for
2018 and 2019. How would you frame the Q4 results as a positive and then as a negative?

Framing as a Positive

EPS FY2019 FY2018 In Q4 of 2019, we generated an EPS of $3.10,

Actual Forecast Actual which was _____________________.
Q1 $2.23 $2.20 $2.17
Q2 $2.32 $2.25 $2.17
Q3 $2.28 $2.30 $2.19
Framing as a Negative
Q4 $3.10 $3.50 $2.20
In Q4 of 2019, we generated an EPS of $3.10,
which was _____________________.

Corporate Finance Institute®

 Now You Have a Go…

Imagine your work for a large public listed company, and these are the earnings per share (EPS) figures for
2018 and 2019. How would you frame the Q4 results as a positive and then as a negative?

Framing as a Positive

EPS FY2019 FY2018 In Q4 of 2019, we generated an EPS of $3.10,

Actual Forecast Actual which was 90 cents higher the Q4 of 2018, an
Q1 $2.23 $2.20 $2.17 increase of 41%.

Q2 $2.32 $2.25 $2.17

Q3 $2.28 $2.30 $2.19
Framing as a Negative
Q4 $3.10 $3.50 $2.20
In Q4 of 2019, we generated an EPS of $3.10,
which was 11 percent or 40 cents below
forecast.

Corporate Finance Institute®

 Even Word Order Can Impact Framing

Consider the following two sentences. Both sentences have the exact same words but ordered differently.
Do you notice any difference in how you interpret the two sentences?

A The company’s brand image remained relatively strong despite a year in which the Consumers’ Association
voiced heavy criticism.

B Despite a year in which the Consumers’ Association voiced heavy criticism, the company's brand image
remained relatively strong.

Put the words you want to de-emphasize in the middle of the sentence, and the words you want
to emphasize at the start and end of the sentence.

Corporate Finance Institute®

 How Can We Guard Against Framing Bias

Conduct thorough (and Rephrase the problem at

objective) research before hand and see what impact
making investment decisions. this has on your conclusion
can help.

Corporate Finance Institute®

 Emotional Biases

Corporate Finance InstituteⓇ

 Overview of Behavioral Finance Biases

Self-Deception Cognitive Biases Social Biases

Biases

• Optimism Bias • Herding Bias

• Overconfidence Bias • Gender Bias

• Illusion of Knowledge • Social Factors

Information Emotional
• Illusion of Control Processing Biases
Biases

Emotional biases are based on impulse, intuition, and feelings and are often the most difficult to keep in-
check.

Corporate Finance Institute®

 Three Founders Exercise

Apart from the obvious – what unique personal quality do these three founders have in-common?

Steve Jobs Jeff Bezos Larry Ellison

Corporate Finance Institute®

 Three Founders Exercise

All three founders were adopted! The news media once popularized the theory that the
secret to the success of the three technology icons was the fact that they were all adopted.

From this, people extrapolated the following arguments:

They were highly They were comfortable They were unafraid to

motivated to prove being an ‘outsider’ and challenge the status-quo
themselves different from other

Corporate Finance Institute®

 Three Founders Exercise

They were highly Not

They based
were on facts!
comfortable They were unafraid to
motivated to prove being an ‘outsider’ and challenge the status-quo
themselves different from other

There’s some notion that because I was abandoned, I worked very

hard so I could do well and make my parents wish they had me back,
or some such nonsense, but that’s ridiculous […]

Corporate Finance Institute®

 Types of Emotional Bias: The Narrative Fallacy

The Narrative Fallacy

Stories often help us to make sense of the world.

Easier to remember than facts.

VS
Which is easier to recall?

Corporate Finance Institute®

 Types of Emotional Bias: The Narrative Fallacy

“The narrative fallacy addresses our limited ability to look at sequences

of facts without weaving an explanation into them, or, equivalently, forcing
a logical link, an arrow of relationship upon them.

Explanations bind facts together. They make them all the more easily
remembered; they help them make more sense. Where this propensity
can go wrong is when it increases our impression of understanding.”

— Nassim Nicholas Taleb, The Black Swan

Corporate Finance Institute®

 Case Study: Narrative Decision-making in Investment Choices

Do people use narratives to make sense of, and to act on, financial information?

Study conducted 3 discrete experiments that demonstrated narrative thinking’s effect on people’s
investment choices:

01 Participants learned and made judgements about stock prices of fictious companies.

For each company, participants received an announcement from analysts about company’s performance.

Participants then predicted future stock prices for these companies.

Source: Samuel G. B. Johnson and David Tuckett, “Narrative Decision-Making in Investment Choices: How Investors Use News about Company
Performance” (Working paper, September 2017).
Corporate Finance Institute®
 Case Study: Narrative Decision-making in Investment Choices

Do people use narratives to make sense of, and to act on, financial information?

Study conducted 3 discrete experiments that demonstrated narrative thinking’s effect on people’s
investment choices:

01

Traditional financial theory: stock prices should Stock will rise in the future (still consistent with other
take a random walk after the initial adjustment. securities), adjusted for the riskiness of the asset.

Source: Samuel G. B. Johnson and David Tuckett, “Narrative Decision-Making in Investment Choices: How Investors Use News about Company
Performance” (Working paper, September 2017).
Corporate Finance Institute®
 Case Study: Narrative Decision-making in Investment Choices

Do people use narratives to make sense of, and to act on, financial information?

Study conducted 3 discrete experiments that demonstrated narrative thinking’s effect on people’s
investment choices:

01 Participants learned and made judgements about stock prices of fictious companies.

For each company, participants received an announcement from analysts about company’s performance.

Participants then predicted future stock prices for these companies.

Instead, participants exhibited actions that indicate narrative fallacy. They forecasted stock prices that
were positively correlated with the announcement.

Source: Samuel G. B. Johnson and David Tuckett, “Narrative Decision-Making in Investment Choices: How Investors Use News about Company
Performance” (Working paper, September 2017).
Corporate Finance Institute®
 Case Study: Narrative Decision-making in Investment Choices

Do people use narratives to make sense of, and to act on, financial information?

Study conducted 3 discrete experiments that demonstrated narrative thinking’s effect on people’s
investment choices:

02 These biased predictions had downstream consequences for asset allocation choices.

03 These choices were driven in part by emotional reactions to the company performance news.

Source: Samuel G. B. Johnson and David Tuckett, “Narrative Decision-Making in Investment Choices: How Investors Use News about Company
Performance” (Working paper, September 2017).
Corporate Finance Institute®
 How Can We Guard Against the Narrative Fallacy

Engaging with and understanding the Narrative Fallacy is a crucial first step!

Analyze your thoughts Learn from experience,

critically by seeking fail, and overcome.
opposing theories

“What the human being is best at doing is interpreting all new

information so that their prior conclusions remain intact.”

- Warren Buffet

Corporate Finance Institute®

 Find the Common Denominator

Playing with Testing vegetable

Test-driving a car electronics at an ripeness at the
Apple Store supermarket

What do they have in common?

Corporate Finance Institute®

 Find the Common Denominator

All three scenarios are designed to give you the experience of “ownership”. This is taking
advantage of something called the endowment effect.

Ownership Experience Apple Stores encourage you Same reason why the
test the products with no time dealership lets you test drive.
Retailers try and create limit.
psychological ownership in order
to get you to buy their products.
Interacting with a product helps activate feelings of
ownership and the endowment effect.

Corporate Finance Institute®

 Types of Emotional Bias: Endowment Effect

The endowment effect occurs when individuals overvalue something they own, regardless of the item’s
objective value.

My House Your House

Asking Price: $3,000,000 Asking Price: $2,000,000

Bias Properties Bias Properties

6,500 sq ft 6,200 sq ft

5 bedrooms 5 bedrooms

5 full + 2 half bathrooms 5 full + 2 half bathrooms

Corporate Finance Institute®

 Case Study: Anomalies and the Endowment Effect

1984

“No I will not sell you my lottery ticket. This experiment has been replicated will
all sorts of objects.
I don’t care if you pay me double.

It’s my ticket and I am feeling lucky

today!”

Source: Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias,”
Journal Of Economic Perspectives, 1984.
Corporate Finance Institute®
 How Can We Guard Against the Endowment Effect

Know your Relying on instinct can feel right but relying on actual data will always pay
facts! off in the long-run.

Keep the If we are looking at stocks, ask yourself, would I buy it today? Do the
decisions in the reasons still hold?
“here and now”.

Crowd source Where appropriate, seek the opinions of your peers.

opinions.

Corporate Finance Institute®

 Portfolio Management Exercise

You’re a portfolio manager at a pension fund and you’ve got a few active positions in
equities that are volatile.

Your group has agreed on hard stops if things go awry, but also has set targets where you
would be willing to realize your gains and unwind your positions.

Technology Apparel Mining

Entry Px $349 $91 $72 Which positions

would you sell?
Current Px $375 $90 $67

Stop Px $345 $85 $65

Target Px $380 $95 $77

Corporate Finance Institute®

 Portfolio Management Exercise

Which positions would you sell?

Unrealized gain Technology Apparel Mining

Entry Px $349 $91 $72

Unrealized losses
Current Px $375 $90 $67

Stop Px $345 $85 $65

Target Px $380 $95 $77

Corporate Finance Institute®

 Types of Emotional Bias: Disposition Effect

Disposition effect is the tendency for investors to hold onto losing trades for too long, and exit profitable
trades too quickly, where people avoid realizing paper losses but seek to realize paper gains.

Holding onto losers too long Exiting profitable trades too quickly

Corporate Finance Institute®

 Types of Emotional Bias: Disposition Effect

Investors exhibit risk-seeking behaviour with losing investments, holding

onto them to see if they will eventually rise.

Investors exhibit risk-averse behaviour with profitable investments by

selling off the “winners”.

Corporate Finance Institute®

 Types of Emotional Bias: Disposition Effect

Winning
trades

Losing
trades

Corporate Finance Institute®

 Case Study: Are Investors Reluctant to Realize Their Losses

Study tested disposition effect by analyzing trading records for 10,000 accounts at a large
discount brokerage house.

Individual investors are

more prone to the
disposition effect.

Investors might exhibit the Investors’ reluctance to realize

effect since they believe that loses is at odds with optimal
today’s losers will soon tax-loss selling for taxable
outperform today's winners. investments.

Source: Terrance Odean, “Are Investors Reluctant to Realize Their Losses?” (The Journal of Finance, December 1998).

Corporate Finance Institute®

 How Can We Guard Against the Disposition Effect

The key to minimizing the disposition effect is having a logic-oriented mindset rather than emotional
mindset.

Create a plan that governs your risk profile before putting on trades and stick to it!

Lock in a Lock in a
profit target stop-loss

Purchase Px: $2,500 Purchase Px: $2,500

Target Px: $3,000 Market drops.

Don’t be tempted to
Exit the trade.
sell at $2,700.

Corporate Finance Institute®

 Lottery Exercise

01 Which option do you choose?

Option A Option B

Win $1,000. Play a lottery where there is a 70%

chance of winning $14,285.71, and
30% chance of winning nothing.

Corporate Finance Institute®

 Lottery Exercise

02 Which option do you choose?

Option A Option B

Lose $1,000. Play a lottery where there is a 70%

chance of losing $14,285.71, and 30%
chance of losing nothing.

Corporate Finance Institute®

 Lottery Exercise

01 Options are framed as a gain.

02 Options are framed as a loss.

Option A Option A

Win $1,000. Lose $1,000.

Option B Option B

Play a lottery where there is a 70% Play a lottery where there is a 70%
chance of winning $14,285.71, and chance of losing $14,285.71, and 30%
30% chance of winning nothing. chance of losing nothing.

Corporate Finance Institute®

 Types of Emotional Bias: Loss Aversion

Loss aversion is the tendency to prefer avoiding losses to acquiring gains.

People detest loses significantly more than they enjoy gains.

Logic suggests that you should be indifferent between

equal gains and losses.

PAIN
FROM LOSS PLEASURE
FROM GAIN

Corporate Finance Institute®

 Types of Emotional Bias: Loss Aversion

Prospect Theory describes how people choose between different options (i.e. Prospects) and how they
estimate – often in a biased or incorrect way – the perceived likelihood of each of these options.

Prospect Theory

Loss Aversion

Corporate Finance Institute®

 Case Study: The Collapse of Barings Bank

Barings Bank was a United Kingdom institution with worldwide reach.

1989 1992 After…

Nick Leeson was hired as a A new Barings employee Leeson tried to make back
trader and he quickly rose suffered a small loss on the loss through speculative
through the ranks and Leeson’s watch. trading, which led to even
prospered. bigger losses hidden in the
Leeson did not wish to
same account.
lose his reputation for
infallibility, so he hid the
loss in an error account.

Source: Robert Prentice, “Loss Aversion - Ethics Unwrapped - UT Austin,” Ethics Unwrapped, March 29, 2019.

Corporate Finance Institute®

 Case Study: The Collapse of Barings Bank

“I wanted to shout from the rooftops…this is what the situation is, there are massive losses, I want to stop.
But for some reason you’re unable to do it. […]”

— Nick Leeson

Leeson, in a last-effort, took a A severe earthquake hit Kobe, Then 233-year-old Baring,
short-term highly leveraged Japan, which sent the index collapsed overnight and was
bet on the Nikkei index. plummeting. purchased by ING for £1.00.

Source: Robert Prentice, “Loss Aversion - Ethics Unwrapped - UT Austin,” Ethics Unwrapped, March 29, 2019.

Corporate Finance Institute®

 How Can We Guard Against Loss Aversion

There is no easy solution. Loss aversion is a strong emotional bias.

Reframe your Try to lower the Primary goal of

thoughts! cost of losses. investing…

Reframe your loss as a gain and Set conservative stop-losses so is increasing gains, not
see if this changes your decision. to mitigate realized losses. mitigating losses!

Corporate Finance Institute®

 Social Biases

Corporate Finance InstituteⓇ

 Behavioral Biases Poll

Which of the following behavioral biases affects investment decision making the most?

Herding Bias Confirmation Bias

Overconfidence Loss Aversion

Source: Shreenivas Kunte, “The Herding Mentality: Behavioral Finance and Investor Biases,” CFA Institute Enterprising Investor (CFA Institute,
June 13, 2017).
Corporate Finance Institute®
 Behavioral Biases Poll

Which of the following behavioral biases affects investment decision making the most?

Herding Bias 34%

Confirmation Bias 20%

Overconfidence 17%

Loss Aversion 13%

Source: Shreenivas Kunte, “The Herding Mentality: Behavioral Finance and Investor Biases,” CFA Institute Enterprising Investor (CFA Institute,
June 13, 2017).
Corporate Finance Institute®
 Types of Social Biases: Herding Bias

Herding bias, also known as the bandwagon effect, it is the tendency for people to rationalize that a
course of action is the right one because “everyone else is doing it.”

Examples:

Dotcom bubble where most companies did not

have sound business models.

The herding bias is often cited as a core driver of investment

bubbles.

Technical analysis works because of the herding

bias.

Looks at what the herd is doing to predict where the herd will
go next, and trade accordingly.

Corporate Finance Institute®

 Case Study: Herd Behavior and Investment

Classical Economic Theory: markets are efficient, and market players have perfect information.

Investment decisions reflect players’ rationally formed expectations.

Herding bias increases when…

Managers want to enhance or keep intact their reputations.

Market volatility is high and “sharing-the-blame” is seen as a

safeguard.

Compensation depends on absolute, rather than relative

performance.

Source: David S. Scharfstein and Jeremy C. Stein, “Herd Behavior and Investment ,” June 1990.

Corporate Finance Institute®

 Case Study: Herding in the German Mutual Fund Industry

Study analyzed the trading activity of German mutual funds from 1998–2002.

Tested if mutual fund managers engaged in herding behavior, and if this impacted stock prices.

Herding measure: avg. tendency of managers to accumulate on the same side of the market in a
particular stock at a certain time.

01 Overall level of herding was slightly higher in the German market compared to other mature capital
markets.

02 Significant portion of herding in the market was associated with spurious herding because of changes
in benchmark index composition.

Source: Andreas Walter and Friedrich Moritz Weber, “Herding in the German Mutual Fund Industry,” European Financial Management, 2006.

Corporate Finance Institute®

 How Can We Guard Against Herding Bias

Turn off autopilot. Ask yourself ‘why’?

People get used to repetitive activity. Make a conscious effort to ensure

that you form your own opinion.
Be aware of the reasons why
you’re taking action.

Corporate Finance Institute®

 How Can We Guard Against Herding Bias

Slow down. Have your opinion.

Give yourself enough time to process Make sure you have your own
your reason and take the time you opinion that is not influenced by
need to make decisions. external factors.

Corporate Finance Institute®

 Types of Social Biases: Gender Biases

Gender bias is a preference or prejudice toward one gender over the other.

Gender Bias has been and continues to be pervasive in many societies globally.

01 Which gender makes for more successful investors?

02 Is one gender more prone to be influenced by cognitive biases?

Corporate Finance Institute®

 Case Study: Women and Investing

Research suggests men and women may be significantly closer in their investing views than
many people assume.

Differences are shaped more by social and demographic factors—such as education,

employment status, financial circumstances etc.

Question 1 Question 2

Are there any innate Does either gender want to be

differences between men and more actively engaged in the
women? investment process?

Source: Michael Liersch, “Women and Investing: A Behavioral Finance Perspective” (Merrill Lynch Wealth Management Institute, 2015).

Corporate Finance Institute®

 Case Study: Women and Investing

Research suggests men and women may be significantly closer in their investing views than
many people assume.

Differences are shaped more by social and demographic factors—such as education,

employment status, financial circumstances etc.

Women tend to be more risk averse than men

when it comes to investment decisions.

However, most significant impact on investor

Question 1
behavior is the level of financial knowledge.
Are there any innate
differences between men and Both men and women are equally subject to
women?
strong emotional influences.

Source: Michael Liersch, “Women and Investing: A Behavioral Finance Perspective” (Merrill Lynch Wealth Management Institute, 2015).

Corporate Finance Institute®

 Case Study: Women and Investing

Research suggests men and women may be significantly closer in their investing views than
many people assume.

Differences are shaped more by social and demographic factors—such as education,

employment status, financial circumstances etc.

No, it was much more education level, wealth

Question 2 and other factors.
Does either gender want to be
more actively engaged in the
investment process?

Source: Michael Liersch, “Women and Investing: A Behavioral Finance Perspective” (Merrill Lynch Wealth Management Institute, 2015).

Corporate Finance Institute®

 How Can We Guard Against Gender Biases

Call out implicit Don’t forget to Standardize

bias when it strikes listen processes

Corporate Finance Institute®