Lesson 3: Decision-making errors and biases in behavioral Finance

Behavioral economists

Assume that individuals or organizations adopting non-conventional approaches to decision making, rooted in real world decision making parameters, make rational or smart decision

Bounded rationality

Rational choice that takes into account the cognitive limitations of the decision-maker—limitations of both knowledge and computational capacity.

Bounded rationality

Is deeply concerned with the ways in which the actual decision-making process influences the decision that are reached

Fast and Frugal Heuristic

Refer to decision-making shortcuts that are satisficing by nature as

Fast and Frugal Heuristic

It represents a decision-making shortcuts that is quick and relatively easy and is typically predicated on intuition and influenced by emotional consideration.

Irrational behavior

Biases and persistent errors often called

Error and biases approach

Even if no limitations exist to an individual’s information gathering and processing capacity, the average individual will not behave in the fashion prescribed and predicted by the conventional wisdom because of the introduction of emotional considerations

Random walk hypothesis

Traditional finance’s EMH maintains that not only should asset prices reflect the underlying fundamental values of the assets, incorporating all pertinent information, but also that no individual can predict future movements in asset prices because these prices follow walk. This is known as

1/N rule

A mathematical formulation to determine the structure of a rate of return maximizing asset portfolio, given an individual's risk preference

Passive investment

This satisficing approach outperforms, net of investment fees, investment portfolios constructed using the optimal algorithms derived from economic theory, except over very long spans of time

Trust Heuristic

A non-conventional tool used by decision makers who might engage in irrational or error prone and biased behavior

Trust

High probability expectation that the other party to a transaction will deliver on promises made

Price Cascades

Herding can result in market inefficiencies called

Knightian uncertainty

Uncertainty that cannot be measured with any precision

Risk

Can be measured in terms of probabilistic outcomes, based on past parameters and outcomes

Irrational exuberance

Animal spirits, also called

Animal spirits

They are highly intuitive and involve trusting one’s gut instincts, which are often experientially based, as well as the gut instincts of others

Beauty contest

Refers to rational individuals estimating what future prices might be by anticipating what other people believe future prices will be, as opposed to what the fundamental values of the assets actually is

Herding

Occurs when decision makers follow the leader in terms of investment decision

Disposition Effect

Results in individuals selling stocks too quickly that have appreciated in price but holding on to stocks that have depreciated in price for too long

Illusion of control

Occurs when decision makers believe they have some control over outcomes although they do not

Overconfidence bias

Not confined to point estimates of prospective outcomes. It also refers to the subjective evaluation of confidence intervals around these point estimate

Overoptimism

Occurs when individual believes that he/she is less at risk or more likely to achieve a certain rate of return or outcome than is objectively true

Ambiguity Aversion

Occurs when an individual avoids prospects where the outcome is more ambiguous and favors more certain outcomes

Behavioral biases

Defined, essentially, the same way as systematic errors in judgement