Behavioral finance
Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions.I attended a session by Denby Bloch (of Taxbriefs) at the recent Investment-Net-Work meeting in Tring. Denby spoke about:
Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses.
Framing: The way a problem or decision is presented to the decision maker will affect his action.
Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies.
The theme of the session was all about The overwhelming advice of successful investors from Keynes to Soros is to run the winners and cut the losers. Yet most investors still fail to do this.
posted by Chris Read @ 19:00
1 Comments:
The Availability Heuristic states that an easily recalled and vivid event seems more probable.We attach
higher probability to that which we can envisage most clearly. Often the recent past is more vivid than
the future, so our probability judgements are biased by 'anchoring' on the current situation. An aspect of
this is demonstrated by the 'gambler's fallacy'. This commonly held misconception says, for example, that
when we have tossed a coin four times and have got four heads in a row, we are then due to toss a tail -
by the law of averages.We can recall more easily seeing four heads and a tail come up in five tosses than
we can recall seeing five heads in a row. Hence a tail now seems more likely. However, of course, the
chance of another head is still 50:50.
The Representativeness Heuristic works simply on the basis of weighing up how much this example looks
like previous ones. This is demonstrated by 'the conjunction fallacy'. Suppose we know Linda enjoys
playing saxophone, which of the following is more likely: (A) Linda is an insurance clerk or (B) Linda is an
insurance clerk who plays jazz in the evenings. Most people say (B) because it "sounds more like Linda".
However (B) is a subset of (A). It must be more
probable/likely that she is an insurance clerk with any kind of hobby (including jazz), than an insurance
clerk only into jazz.
Both these heuristics are further strengthened by overconfidence. Experiments show that typically people
are more confident than correct in their judgement. When their answers were only 60% correct, people
were 75% confident. When they were 100% confident, they were still just 85% correct .
It seems we overestimate the correctness of our (heuristic) decisions when we make them.
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