NON-STANDARD BELIEFS

NONSTANDARD BELIEFS

• STANDARD MODEL: IN AVERAGE, WE ARE CORRECT ABOUT DISTRIBUTION OF THE STATES

• IN OTHER WORDS, WE ARE ABLE TO UNDERSTAND REALITY AS IT IS BY CORRECTLY ESTIMATING POSSIBLE OUTCOMES

• MISTAKES, IF HAPPEN, ARE NOT SYSTEMATIC/BIASED

• BEHAVIORAL ECONOMICS FINDS THREE (MAIN) INCORRECT BELIEFS:

1. OVERCONFIDENCE

2. LAW OF SMALL NUMBERS

3. PROJECTION BIAS

OVERCONFIDENCE

1. OVERESTIMATION OF ONE’S KNOWLEDGE/ABILITY (I THINK I KNOW A LOT)

2. OVERPLACEMENT OF ONE’S PERFORMANCE COMPARED TO OTHERS (I AM BETTER THAN)

3. CALIBRATION OF SUBJECTIVE PROBABILITIES (I AM SURE I GOT THIS RIGHT)

YOUR EXAMPLES?

OVERCONFIDENCE: OVERESTIMATION OF

KNOWLEDGE/SKILL/ABILITY

• HOW LONG DOES IT TAKE TO FINISH A PROJECT

• HEALTH CLUB CONTRACT (OVERCONFIDENCE ABOUT SELF-CONTROL OR SOPHISTICATED CONSUMER?)

• RISKS OF HOSPITALIZATION

MANAGERIAL OVERCONFIDENCE: OVERESTIMATION OF KNOWLEDGE/SKILL/ABILITY

• CEOS: INVEST IN “TOO” MANY PROJECTS AND HOLD “TOO” MUCH COMPANY STOCK OPTIONS (MAYBE IT IS INSIDE INFORMATION TOO?)

• EXCESS SENSITIVITY OF CORPORATE INVESTMENT TO THE AVAILABILITY OF CASH FLOWS:

• HOW FIRMS DECIDE TO INVEST IN A NEW OPPORTUNITY?

• SHOULD AVAILABLE CASH FLOW MATTERS?

MANAGERIAL OVERCONFIDENCE: OVERESTIMATION OF KNOWLEDGE/SKILL/ABILITY (CONT.)

• OVERCONFIDENCE ABOUT OWN-COMPANY PERFORMANCE CAN MAKE STOCK OPTIONS AN ATTRACTIVE COMPENSATION FORMAT FOR EMPLOYERS. THIS FORM OF OVERCONFIDENCE IS PARTICULARLY PLAUSIBLE SINCE THE WORKERS THAT ARE OVERCONFIDENT ABOUT A PARTICULAR COMPANY ARE MORE LIKELY TO SORT INTO IT.

• ANOTHER EXPLANATION FOR THIS FORM OF OVERCONFIDENCE?

OVERCONFIDENCE: RELATIVE PERFORMANCE

• BETTER DRIVER THAN THE AVERAGE

• MOST PEOPLE PREFER TO SOLVE A PUZZLE THAN TO BE PART OF A RANDOM DRAW EVEN THOUGH ONLY THE TOP SOLVERS GET TO WIN

• THIS COULD BE ANOTHER TRAIT IN PLACE TOO…

• WHAT ABOUT STARTING A NEW BUSINESS?

OVERCONFIDENCE: CALIBRATION OF SUBJECTIVE

PROBABILITIES/PRECISION OF INFORMATION• MBA STUDENTS AND CONFIDENCE INTERVALS

• TRADING STOCKS – MEN TRADE MORE… ARE MEN ALWAYS MORE OVERCONFIDENT THAN WOMEN?

• SOMETIMES, THIS TYPE OF OVERCONFIDENCE IS COUPLED WITH SELF-ATTRIBUTION BIAS: WE ARE OVERCONFIDENT IN OUR PRIVATE INFORMATION ABOUT A STOCK AND DISCOUNT ANY NEGATIVE PUBLIC INFORMATION

• EXAMPLE: FINANCIAL MARKET ANOMALY, MOMENTUM AND LONG-TERM REVERSAL OF RETURNS

OVERCONFIDENCE IS MORE COMMON WHEN…

• FEEDBACK IS NOISY

• DECISION MAKER HAS AN ILLUSION OF CONTROL

• WHICH LEADS TO AN ILLUSION OF KNOWLEDGE/SKILL/ABILITY/…

• PEOPLE REMAIN OVERCONFIDENT DESPITE FAILURES BECAUSE THEY TEND TO ASCRIBE THEIR SUCCESS TO THEIR SKILL AND THEIR FAILURE TO BAD LUCK

LAW OF SMALL NUMBERS

• TO MAKE INFERENCES/GENERALIZATIONS FROM SMALL SAMPLES/SMALL AMOUNT OF DATA

• SUBJECTS MISCONSTRUE THE FACT THAT THE DATA IS I.I.D. (INDEPENDENT AND IDENTICALLY DISTRIBUTED)

• GAMBLER’S FALLACY (DISTRIBUTION IS KNOWN):

• WINNING STREAKS, HOT HAND

• OVERINFERENCE/EXTRAPOLATION (DISTRIBUTION IS UNKNOWN):

• USE OF (LIMITED) PAST PERFORMANCE TO PREDICT FUTURE

REPRESENTATIVENESS HEURISTICS

• TENDENCY TO FORM JUDGEMENT BASED ON STEREOTYPES

• “UP, UP, DOWN” MORE LIKELY THAN “UP, UP, UP”

• WE ARE TOO QUICK TO DETECT PATTERNS IN DATA THAT ARE IN FACT RANDOM

• AND WE ARE OVERLY OPTIMISTIC ABOUT PAST WINNERS AND OVERLY PESSIMISTIC ABOUT PAST LOSERS

GAMBLER’S FALLACY

• NEW JERSEY LOTTERY PARI-MUTUAL BETTING SYSTEM: THE FEWER SAME NUMBER WINNERS, THE HIGHER THE PAYOFF

• PAYOUT FOR A NUMBER THAT WON ONE OR TWO WEEKS BEFORE IS 33% HIGHER THAN FOR AN AVERAGE NUMBER

• WHAT IS GOING ON HERE?

OVERINFERENCE/EXTRAPOLATION

• EMPLOYER STOCK INVESTMENT:

• BOTTOM PERFORMANCE COMPANIES: 10.4% OF EMPLOYEE SAVINGS

• TOP PERFORMANCE COMPANIES: 39.7% OF EMPLOYEE SAVINGS

• PURCHASE STOCK WITH HIGH PAST RETURNS

• STOCK “WINNERS” ARE OVERPRICED AND UNDERPERFORM “LOSERS” BY 25 PERCENTAGE POINTS NEXT THREE YEARS

ALTERNATIVE MODEL OF THE LAW OF SMALL NUMBERS FOR ACTUAL INVESTOR

BEHAVIORS

GAMBLER’S FALLACY• AFTER A SEQUENCE OF IDENTICAL

SIGNALS, EXPECT A MEAN REVERTING REGIME AFTER SHORT RUN

• WIN – WIN – WIN – WIN – LOSS IS EXPECTED

OVERINFERENCE• AFTER A LONGER TREND,

INVESTORS EXPECT A TRENDING REGIME

• 5 WINS – 1LOSS – 6 WINS – 2 LOSS – 3 WINS – 1 LOSS – EXPECT A WINNING TREND OVERALL

PROJECTION BIAS

• EXPECT FUTURE PREFERENCES TO BE TOO CLOSE TO THE PRESENT ONES

• WHERE IS CONSUMPTION AND REPRESENTS CURRENT STATE

FUTURE UTILITY:

• PARAMETER CAPTURES THE EXTEND OF PROJECTION BIAS

• PREDICTS FUTURE HUNGER AND HOW WELL WE ADAPT

• WHY PEOPLE ARE MORE LIKELY TO RETURN AN ITEM IF PURCHASED IN A COLD WEATHER DAY?

NONSTANDARD DECISION MAKING

DECISION MAKING BIASES

• FRAMING

• LIMITED ATTENTION

• SUBOPTIMAL HEURISTICS

• SOCIAL PRESSURE

• EMOTIONS

FRAMING

• CONTEXT MATTERS (DUH!)

• HOW CHOICES ARE FRAMED MATTERS

• WE CAN PICK THE BEST LOTTERY OPTION UNDER NARROW FRAMING (PRESENTED INDIVIDUALLY) BUT PICK THE WORST CHOICE UNDER BROAD FRAMING (ALL OPTIONS PRESENTED AT THE SAME TIME)

• IRA MATCH VS. SAVER’S CREDIT: PEOPLE MORE LIKELY TO CONTRIBUTE TO THE SIMPLER OPTION (IRA MATCH) DUE TO FRAMING

LIMITED ATTENTION

• PROCESSING ONLY A LIMITED AMOUNT OF INFORMATION

• ATTENTION IS AN SCARCE RESOURCE: WE CAN ONLY PAY ATTENTION TO ONE PIECE OF INFORMATION AT TIME OR THINK ONLY ONE STEP AHEAD

• WHERE IS THE VALUE OF A GOOD, IS ITS VISIBLE COMPONENT AND ITS OPAQUE COMPONENT

• WHERE DENOTES THE DEGREE OF INATTENTION

QUESTION 4

• INATTENTION IS A FUNCTION OF SALIENCE AND COMPETING STIMULI.

• EXPLAIN THIS CONCEPT IN LAYMAN’S TERMS.

• IS INATTENTION RATIONAL OR IRRATIONAL?

INATTENTION STUDIES

• SHIPPING COSTS ON EBAY

• SALES TAXES IN GROCERIES

• BEER SALES: DIFFERENCES IN EXCISE AND SALES TAXES

• HOSPITAL DISCHARGES: DIFFERENCE IN RANKS MORE SALIENT THAN ACTUAL SCORES

• CANCER DRUG ARTICLE: FRONT PAGE OR PAGE A28

• POSTEARNINGS ANNOUNCEMENT DRIFT

• STOCK RETURNS DUE TO DEMOGRAPHIC CHANGES

MENU EFFECTS: HOW INFORMATION IS PRESENTED

• EXCESS DIVERSIFICATION: WEAK EVIDENCE IN FINANCE, STRONG IN OTHER LIFE CHOICES

• PREFERENCE FOR THE FAMILIAR: INVESTING IN DOMESTIC EQUITIES & OWN COMPANY STOCK

• PREFERENCE FOR THE SALIENT: PICK COMPANIES THAT STAND OUT THE DAY BEFORE

• CONFUSING ON IMPLEMENTING CHOICES: MCI AND MCIC

• AND CHOICE AVOIDANCE

CHOICE AVOIDANCE

• INFORMATION OVERLOAD

• SHOPPERS IN UPSCALE GROCERY STORE ENCOUNTER TASTING BOOTHS FOR JAMS:

6 JAMS: (40% STOPPED); 30% BOUGHT VS.

24 JAMS: (60% STOPPED); 3% BOUGHT

(IYENGER & LEPPER, 2000; B. SCHWARZ, 2000)

Also people more likely to invest if a default is easily available

PERSUASION

• EXCESS IMPACT OF THE BELIEFS OF THE INFORMATION PROVIDER

• ADVISOR BEING PAID BY HOW HIGH PEOPLE GUESS # OF COINS IN A JAR – CONFLICT OF INTEREST

• ANALYST FORECAST ARE BIASED UPWARD: LARGE INVESTORS DISCOUNT INFORMATION BUT SMALL INVESTORS DO NOT

SOCIAL PRESSURE

• FOLLOW THE LEADER / CONFORM TO THE NORMS

• EXTRA TIME IN SOCCER GAMES: LOCAL TEAM GETS MORE

• SIMILAR TO PEER EFFECT, RATIONAL DIFFUSION OF INFORMATION, SOCIAL LEARNING, ETC…NOT A VERY CLEAN IDENTIFICATION

• CASHIER WORKING FASTER WHEN OBSERVING A HIGH PERFORMER

EMOTIONS

• SOMETIMES THE MAIN “BIAS”, SOMETIMES A MEDIATOR

• TIPS ON SUNNY DAYS, STOCK RETURNS AFTER LOSS IN INTERNATIONAL SOCCER MATCH, CLOUD COVER AND STOCK RETURN

• SOME OF THEM MIGHT BE JUST SPURIOUS

• AROUSAL IS PARTICULARLY IMPORTANT IN THE SHORT RUN

• VIOLENT MOVIES AND CRIME – DO WE KNOW THE RELATIONSHIP?

MARKET RESPONSE

TWO CONSUMERS:

SOPHISTICATED• I KNOW I HAVE A PROBLEM (SELF-

CONTROL, TIME INCONSISTENCY, ETC) AND DEMAND A COMMITMENT DEVICE

NAIVE• I AM NOT AWARE OF ANY PROBLEMS

AND MIGHT PAY MORE FOR GOODS AND SERVICES

FIRMS DESIGN CONTRACTS FOR EACH GROUP

QUESTION 5

• WORKERS DISPLAY LOSS AVERSION WITH RESPECT TO NOMINAL WAGES LOSSES BUT NOT WITH RESPECT TO REAL WAGES LOSSES. HOW DO FIRMS REACT TO THIS BIAS? ARE FIRMS TAKING “ADVANTAGE” OF THEIR WORKERS?

OTHER MARKET RESPONSES

• MARKET TIMING CONCEPT: INVESTOR EVALUATION IS IRRATIONAL

• MAY HELP EXPLAIN THE UNDERPERFORMANCE OF IPOS – GO PUBLIC WHEN OVERPRICED?

• DISASTER RELIEF BEING POSTPONED UNTIL THE NEWS COOL OFF BECAUSE OF VOTER INATTENTION

• SOMETIMES MARKET RESPONSE IS POSITIVE:

• SMART PLANS: DEMAND FOR COMMITMENT

• OPT OUT DEFAULTS ON 401(K) PLANS: INERTIA AND CHOICE AVOIDANCE

QUESTION 6

• THE AUTHOR MAKES A POINT THAT FIRMS ARE MORE LIKELY TO BE RATIONAL ACTORS THAN INDIVIDUALS. WHAT IS HIS ASSESSMENT BASED ON? HOW DO YOU FEEL (AS A BUSINESS GRAD STUDENTS) ABOUT HIS ASSUMPTION THAT FIRMS DO NOT (OR RARELY) DISPLAY DEVIATIONS FROM THE STANDARD MODEL?

SUMMARY

• CAN/SHOULD MARKET ELIMINATE NONSTANDARD BEHAVIOR?

• BAYESIAN LEARNERS

• NO AGGREGATE MARKET EFFECT

• DO FIRMS WANT TO DE-BIAS CONSUMERS?

• GOVERNMENT INTERFERENCE VERSUS FREE MARKET: WHAT IS THE BALANCE?