Behavioral economics and financial decision making
1. Behavioral Economics and Financial Decision-making
Deborah Kozdras
dkozdras@usf.edu
Http://stavros.coedu.usf.edu
Generously funded by State Farm
and the Coca Cola Foundation
2. Cass Sunstein: Nudge
What do people notice and what do they miss?
https://www.youtube.com/watch?v=vJG698U2Mvo
3. And did you see the gorilla?
http://theinvisiblegorilla.com/gorilla_experiment.htm
https://newrepublic.com/article/108153/show-me-the-money
http://www.economist.com/node/21551032
4. Nudge
Contrary to the prediction of
standard economic theory
(that people act rationally)
behavioral economists have
found that outcomes are
much affected by whether
people are automatically
enrolled in a program (for
savings,) and asked if they
want to opt out, or instead,
not automatically enrolled
and asked whether they want
to opt in.
If people are automatically
enrolled in a program, many
of them tend to stay in; if they
are not automatically
enrolled, many of them tend
to stay out.
9. Informational Issues and Teaching
About Financial Literacy
• Jump Start Survey: no correlation between
financial education and test performance.
• Math is a key: science and engineering
students score better than business and
economics students.
• Knowledge-based programs are not effective
in changing behavior.
• Financial literacy may correlate with problem
solving ability.
https://www.newamerica.org/asset-building/policy-papers/the-effectiveness-of-youth-financial-education/
16. Over confidence +
Heuristics and Biases
• From home/background
knowledge: My dad said that . . .
• From limited reading of evidence:
But it says that natural gas is the
cleanest . . .
• From evidence outside of the text:
We use the most X so that is the
one we should choose.
• More information-based, but
when emotion gets involved . . .
Contrary to the prediction of standard economic theory, behavioral economists have found that outcomes are much affected by whether people are automatically enrolled in a program (say, for savings, or to protect their privacy online) and asked whether they want to opt out, or instead not automatically enrolled and asked whether they want to opt in. If people are automatically enrolled in a program, many of them tend to stay in; if they are not automatically enrolled, many of them tend to stay out. For this reason, default rules, specifying what happens if people do nothing, have a big impact. Inertia is a powerful force.
We also know that people often use heuristics, or mental shortcuts, in thinking about risks.
Herd behavior is the tendency of individual to follow the actions (rational or irrational) of a larger group. This herd mentality is the result of two reasons. Firstly, there may be a social pressure of
conformity. Most people do not want to be outcast from the group they belong. Secondly, there is a common rational that a large group is unlikely to be wrong. Purchasing stocks based on price momentum while ignoring basic economic principles of supply and demand is known in the behavioral finance arena as herd behavior and that leads to faulty decision. In the late 1990s, Venture capitalist and private investors were frantically investing huge amount of money into internet related companies, even though most of them did not have financially sound business models.
A recent study supported by PWC and conducted by the Global Financial Literacy Excellence Center at George Washington University found that millennial are better educated, more ethnically diverse, and more economically active than their predecessors. However, experience does not make up for education; the millennials also confront bigger difficulties interns of economic uncertainty and student debt.. Despite the fact that financial literacy programs abound, and some school districts require financial literacy as a part of the curriculum, students still struggle with financial literacy, according to a recent report on youth financial literacy. In fact, some studies found no correlation between financial education and test performance. But does test performance on financial concepts the answer? Researchers note that while knowledge of financial concepts is a start, knowledge-based programs are not effective in changing behavior. In fact, research suggests financial literacy seems to align with problem solving and decision-making.
People are generally overconfident regarding their ability and knowledge. They tend to underestimate the imprecision of their beliefs or forecasts, and they tend to overestimate their ability. Terrence Odean I his research found that overconfident investors generally conduct more trade as they believe they are better than others at choosing the best stocks and best times to enter or exist a position. Thus, overconfidence can cause investors to under-react to new information and that leads to earn significantly lower yields than the market.
Anchoring
The assumption of rationality says that our thoughts and opinion should always based on relevant and fact. In reality, however, this is not always so rather. People have a tendency to attach or “anchor” their thoughts to a reference point even though that may hardly have any logical association with the decision at hand. Although the company is making more money, its stock price does not rise because investor assume that the change is earning is only temporary. Thus, the investor remain anchored to their previous view of the companies potential profitability because they have under-reacted to the new, positive information. This does not mean that investors will never move away from their initial reference point or anchor. They will realize that the company is likely to continue to be more profitable in the future and that its stock is probably an attractive potential investment.
Confirmation bias is the tendency to seek evidence consistent with a prior belief. In the above strip, Dilbert's boss demonstrates this bias to a tee when he assumes his astute managerial skills are what caused a minuscule (and clearly unrelated) improvement in the company's stock price.
Framing decisions are made based on the way things are said. Framing shows up again in the above strip when Dilbert's boss frames Dilbert's lack of a salary raise relative to the alternative of being attacked by bears, which Dilbert finds compelling.
Loss Aversion Finally, in prospect theory (which is a key concept in behavioral economics), the pain associated with a possible loss is much greater than the pleasure associated with a gain of the same magnitude. In the above strip, Dilbert's garbage man clearly understands this concept much better than Dilbert.
It means that investor is risk seeker when faced with respect of loss, but becomes risk averse when faced with the prospects of enjoying gains. Khaneman has said that investors are “Loss aversion”. This ‘Loss Aversion’ means that people are willing to take more risks to avoid loss than to realize gain.
