These are the slides from the 2nd session of the Stanford University class, CS 007 "Personal Finance for Engineers," given on September 28, 2021. This seminar covers the topic of Behavioral Finance.
4. YOU ARE NOT
RATIONAL
ANCHORING MENTAL ACCOUNTING CONFIRMATION &
โจ
HINDSIGHT BIAS
GAMBLERโS FALLACY
HERD BEHAVIOR OVERCONFIDENCE OVERREACTION &
โจ
AVAILABILITY BIAS
LOSS AVERSION
5. WHY BEHAVIORAL ECONOMICS?
โข A number of economic frameworks
assume that humans evaluate
financial decisions consistently &
rationally
โข Daniel Kahneman & Amos Tversky
(1960s)
โข 2002 Nobel Memorial Prize in
Economic Sciences
โข Prospect Theory
6. THREE THEMES IN BEHAVIORAL ECONOMICS
โข Heuristics
โจ
Humans make a vast majority of
their decisions using mental
shortcuts or rules of thumb.
โข Framing
โจ
Humans use anecdotes &
stereotypes to understand &
respond to events
โข Market Inefficiencies
โจ
Mis-pricing or non-rational decision
making
7. ANCHORING
โข People estimate answers to new &
novel problems with a bias towards
reference points
โข Tversky & Kahneman (1974)
โจ
(quick multiplication)
โข Dan Ariely
โจ
(social security numbers & prices)
โข Common examples:
โข Price you bought a stock at
โข High point for a stock
8. MENTAL ACCOUNTING
โข Money is fungible, but people put it
into separate โmental accountsโ
โข Also known as โbucketingโ
โข Example: Lost Movie Tickets
โข Example: โFound Moneyโ
โข Real world problems:
โจ
Vacation Fund & Credit Card Debt
9. CONFIRMATION & HINDSIGHT BIAS
โข Very different biases, but often conflated
with each other.
โข Confirmation Bias
โจ
We selectively seek information that
supports pre-existing theories, and we
ignore / dispute information that
challenges or disproves them.
โข Hindsight Bias
โจ
We overestimate our ability to predict the
future based on the โobviousnessโ of the
past.
โข Combination of the two is particularly bad.
10. GAMBLERโS FALLACY
โข We see patterns in independent,
random chains of events.
โข We believe that, based on a series of
previous events, an outcome is more
likely than odds actually suggest.
โข Example: Dinner Party & Coin Flips
โข Real odds might be 51/49, but we tend
to jump to 80/20.
โข Likely cause: the rarity of โindependent
eventsโ in day-to-day experience.
11. HERD BEHAVIOR
โข We have a tendency to mimic the actions of
the larger group
โข Example: Building Psych Experiment
โข Example: Empty Supermarket
โข Crowd psychology may be a contributor to
bubbles.
โข Bucking the crowd creates stress & fatigue.
It gets harder, not easier.
โข Easier to be โwrong with everyoneโ than
โright and aloneโ
โข No gets fired for buying IBM?
12. OVERCONFIDENCE
โข In โBehaving Badlyโ (2016), 74% of
investment managers believed that
they deliver above-average
performance.
โข Dunning-Kruger Effect. The more
poorly you perform, the more you
over-estimate your performance.
โข Capability in one domain can lead to
overconfidence in others.
โข Humility is a virtue.
13. RECENCY & AVAILABILITY BIAS
โข Recency Bias
โจ
We overreact to recent events
โข Example: Celebrity Illness
โข Availability Bias
โจ
We assume that the data we have been
provided is representative of the entire data
set.
โข The combination is particularly bad.
โข Studies show checking stock prices daily leads
to more trading & worse results on average.
โข Worse for engineers, because we are immersed
in โgame changersโ & โit is different this timeโ
14. YOU HAVE $1,000 AND YOU MUST PICK
ONE OF THE FOLLOWING GAMES
You have a 100% chance of gaining $500.
B
You have a 50% chance of gaining $1,000, and
a 50% chance of gaining $0.
A
OR
15. NOW, YOU HAVE $2,000 AND YOU MUST
PICK ONE OF THE FOLLOWING GAMES
B
A
OR
You have a 50% chance of losing $1,000, and
a 50% chance of losing $0.
You have a 100% chance of losing $500.
16. LOSS AVERSION (PROSPECT THEORY)
โข We hate losses more than we love winning
โข Average loss aversion across multiple
studies is between 2:1 and 3:1
โข Affects our views on a wide range of
situations, including career decisions,
dating, purchasing, investing and taxes.
โข We even hate being responsible for
decisions that could result in a loss
โข Example: โSunk Costโ mistakes with
investments
โข Currently under debate!*
* https://blogs.scientificamerican.com/observations/why-the-most-important-idea-in-behavioral-decision-making-is-a-fallacy/?amp
18. ITโS OK TO NOT BE RATIONAL
โข As Dan Ariely beautifully put it, the
key is that humans are predictably
irrational
โข Know your own flaws, and you can set
up systems to help account for them
โข Self awareness is key
โจ
(yes, my Mom is a psychologist)