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Review

Biases?Heuristics?OverconfidenceOptimismHindsight biasOverreaction

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Which Circle is larger?

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Biases Intuition can not be trusted!

Must be supplemented by analytical thinkingUse a ruler to dispel the illusion!

Systematic errors of judgement:bias Normative analysis

rational solution to a decision problem

Descriptive analysishow real people actually make decisons

Prescriptive analysispractical advice that you can use for rational decisions

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Decision Making Process

Decision: a choice between gambles outcomes of possible options are not

known in advance!You make judgements about probabilitiesYou assign values to outcomes

• You combine these beliefs and values to form preferences

Judgements can be systematically wrong!Systematic errors of judgement are called

biases!

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Which is?

The more frequent cause of death? Homicide? Stroke?

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HeuristicsThe process by which people find things out

for themselves Usually by trial and error! Trial and error leads to rules of thumb This process leads to errors

sometimes systematic errors!

These rules of thumbs themselvescame to be called heuristics!

Availability heuristicavailability bias!

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What is your best estimate?Dow Jones 1998

Closed at 9181DJIA does not include reinvested dividends

What would be the closing value of DJIA be?If DJIA were redefined

• to reflect the reinvestment of all dividends?

Since May 1896 • when its value was 40

Give your Best Guess, Low guess, High Guess• so that you feel 90% confident that true value lies between

your low guess and high guess

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OverconfidenceHighly systematic bias

• forecasts of stock prices• forecasts of earnings per share• trades of investors (trading too much)

People set narrow confidence bands• high guess is too low• low guess is too high!

Well calibrated professionalsmeteorologists

• face similar problems every day• make explicit probabilistic predictions• obtain precise and immediate feedback on outcome

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How good are you?

How good a driver are you? Compared to drivers you encounter on

the road are youAbove-average?Average?Below average?

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OptimismOptimists

exaggerate their talentsunderestimate the likelihood of bad outcomesare prone to an illusion of control

• underestimate the role of chance in human affairs• misperceive games of chance as games of skill

Overconfidence and Optimism combined• overestimate knowledge• underestimate risks• exaggerate their ability to control events

Vulnerable to statistical surprises?• DeBondt, 1998

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Did you know?

On the day before the Bank of England announcement, what was your estimate of the probability that interest rates would remain constant?

Do you think you have estimated the direction of change in FTSE100 correctly last week?

Now, have a look at the forecasts you made last week, have you estimated the direction of change for FTSE100 correctly?

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Hindsight Bias

Reality looks much more obvious in hindsight than in foresight!

People with hindsight bias perceive events that occurred to have

been more predictable

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Hindsight BiasPeople can rarely reconstruct,

after the fact, what they thought about the probability of an event before it occurred

• Earlier estimate of probability is exaggerated after the event occurs

Events that were not anticipated• often appear almost inevitable after they appear

Hindsightpromotes overconfidence

• creates the illusion that the world is more predictable than it really is

turns reasonable gambles into foolish mistakes

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Which one is more likely?

You are tossing a coin six times. Which of the following sequences is more likely to occur?

HHHTTT HTHTTH

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Which one is more likely?

You have tossed five coins and observed the following sequence

HHHHH

Now, you are tossing the sixth coin. Heads or Tails?

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OverreactionHuman mind is pattern-seeking

biased to think that a casual factor is at work!• perceive patterns where non exists• have too much confidence in their judgements of uncertain

events

Fund managers that were successful• for a few years in a row?

Odean, 1998Individual 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!

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Overreaction

DeBondt and Thaler, 1984 Question:

Does overreaction affect stock prices?

Answer:Yes!

• Loser portfolios experience exceptionally larger returns than winner portfolios (25%!)

ImplicationWeak form market inefficiency

• Explanation to the January Phenomenon

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Research Design

Monthly stock price dataexcess returns calculated using 3 different

benchmarks

research period 1926-1982 Portfolio formation

Start 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

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Analysis

Compute cumulative abnormal returns

for all portfolios for the next 36 months

Compare winner versus loser portfolios

Cumulative abnormal returns at t=36

each portfolios’ returnsat t=0 and t=36

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Results

CumulativeAbnormal Returns

Months after portfolio formation

Loser portfolio

Winner portfolio

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Summary

Biases?Heuristics?OverconfidenceOptimismHindsight biasOverreaction