2
PERSPECTIVE
Understand and Explain the observed behavior of
Investors and Market
As apposed to Traditional finance, which is based
on hypotheses about How Investors and Markets
SHOULD behave.
In TF(SF): People are Rational
In BF: People are Normal
How much we can rely on scientific,
mathematical or economic models?
Predicting economy is more difficult than
predicting Weather! Why?
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HEURISTIC DRIVEN BIAS
Heuristic refers to the process by which people
find things out for themselves and develop rules
of thumb.
Generally these rules of thumb have themselves
come to be called HEURISTICS
Availability Heuristic
Canadian Capital?
What do you know about Greenland?
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PORTFOLIO APPROACH
Portfolio approach
provides the benefit of
diversification.
Diversification is logical
If you drop the basket,
all eggs break
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REPRESENTATIVENESS
Judgments based on stereotypes
1. Low Grades in A/O Levels lead to ______ GPA in College
2. Past three years loosing stocks will be the _____ stocks for
the next three years
3. Mean Reversion and Regression towards mean
4. August 18, 1997 issue of Fortune magazine
1. Barton Biggs of Morgan Stanley
2. Robert Farrell of Merrill Lynch
5. For the next 5 to 10 Years Equity returns range
between 5-10%
6. CR for the next 21 months was more than 41%
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OVERCONFIDENCE
DJIA Average closed 1998 at 9181.
As a price index, it does not include reinvested
dividends from its inception in 1896 when the
starting value was 40.
What's your best, low and high guess about the
value at the end of 1998 if dividends had been
reinvested?
652230
Result of overconfidence: Overly narrow
confidence band
More prone to SURPRISES
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ANCHORING AND ADJUSTMENT
CONSERVATISM
We tend to underestimate and incorporate the
impact of new information
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AVERSION TO AMBIGUITY
Sure 1000 and an even gamble of 0 or 2000?
50 Black and 50 red chips (2000 or 0)
What if you don’t know how many black or red
chips are there in the container?
“It wasn’t worth a jump into the abyss to find out
how deep it was”
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FRAME DEPENDENCE
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10
FRAME DEPENDENCE
TF assumes that Frames are transparent thus there is a
frame independence
There are several ways of looking at Cash flows and they
should provide the same results.
If you transfer a dollar from your right pocket to left, you
are no wealthier (Dividend Irrelevance)
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LOSS AVERSION
First Decision
A: A sure gain of $2400
B: a 25 percent chance to gain $10000; and 75
percent chance to gain nothing
Second Decision
C: A sure loss of $7500
D: a 75 percent chance to lose $10000; and 25 percent
chance to lose nothing
Choice D is a classic example of get evenities
(Nicholas Leeson of Baring PLC)
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HEDONIC EDITING
Investors prefer some frames to others
Magic Selling Words: instead of telling them
about losses and cutting your original position,
you should say “Transfer your assets”
1: Guaranteed Gain of $1500 or H=1950, T=1050
2: Guaranteed Loss of $750 or H=525, T =975
3: You have just won $1500 and have an
opportunity to participate in second lottery with
H= win 450, T= lose 450
4: You have just lost $750 and have an option to
participate in second lottery with H= win 225, T=
lose 225
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EXTRA TOPICS
Self Control
Regret
Money Illusion
Ann: $30000, no inflation, raise 2% (600)
Barbara: $30000, 4% inflation, raise 5%(1500=
Who was doing better in economic terms?
Who do you think was happier?
Who is more likely to switch job?
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COGNITIVE ERRORS
Belief Perseverance Biases (cognitive dissonance)
Conservatism Bias
Confirmation Bias
Representativeness Bias (overweight the small
sample information)
Illusion of Control Bias (More trade, less
diversification)
Hindsight Bias (Reconstructive memory, past is
easier to predict!, poor decision with +outcome?)
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INFORMATION PROCESSING BIASES
Anchoring and Adjustment Bias
Mental Accounting Bias (Mental Buckets of Assets)
Framing Bias
25% of the people with disease X given medicine Z will
survive
75% of the people with disease X will die even if given
medicine Z)