Behavioral Finance

Behavioral Finance Economics 437

Biases • Representativeness • Availability • Adjustment and Anchoring

Representativeness • Ignores Base Rates in favor something that seems causal

Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of a reality • Is Steve? • Farmer • Salesman • Airline Pilot • Librarian • Physician

Hmmm? • We are in a room of 70 engineers and 30 lawyers • Bill is a 30 year old man. He is married with no children. A man of high ability and high motivation, he promises to be quite successful in his field. He is well liked by his colleagues • Is Bill more likely to be a lawyer or an engineer?

Representativeness • Less is more • RGRRR • GRGRRR • GRRRRR

Availability (Saliency) • If you have been recently exposed to something or reminded of something, you are more likely to choose that which is more “salient” or “available” to you

Availability • Saliency • Buying airport insurance • Related to overconfidence and over reaction

Biases • Small Sample Bias: “The strong bias toward believing that small samples closely resemble the population from which they are drawn…” page 114. (e.g. cancer in rural counties) • Anchoring including “anchoring and adjusting” • Was Ghandi more or less than 144 when he died? • Limit of 12 per person (average taken was seven, much higher than when there was no limit)

Causes vs Statistics • 85% of cabs in the city are green • Witness says “blue” • 20% false witness • ???

Regression to the mean • Highly intelligent females tend to marry men who are less intelligent than they are • The correlation between the intelligence scores of spouses is less than perfect (and men and women do not differ in intelligence on average)

Vagueness -- Game 1 Consider an Urn Containing: ½ red balls ½ green balls If you can pick a red ball you win $ 100, otherwise zero

Vagueness -- Game 2 Consider an Urn Containing red and green balls, But we have no idea how many of each If you can pick a red ball you win $ 100, otherwise zero

Insurance Distortions • Flight Insurance …. $ 100,000 coverage in case of • Terrorism • Anything but terrorism • Anything

Insurance Distortions • Flight Insurance …. $ 100,000 coverage in case of • Terrorism $ 7.42 • Anything but terrorism $9.00 • Anything $ 7.44

Buy me a beer! • From a resort • From a small country town store

Fairness and “Reference Points” • Shortage of cars develops • Dealer raises prices $ 200 above list • 71 % unfair • Dealer has been selling these cars at a discount of $ 200 below list price. He now eliminates the discount • Only 42 % unfair

Cutting wages • A small co employs several people. Workers’ incomes have been about average for the community. Business is slow. Owners reduce the workers’ wages by 10 percent for the year • 61 % unfair • A small co employs several people. The workers have been receiving a 10% bonus each year. Business is slow. Owners eliminate the bonus for the year. • 20 % unfair

Tipping • Survey • A restaurant you visit frequently, bill is $ 10, what is the tip? • $ 1.28 on average • A restaurant in another city that you do not intend to return to • $ 1.27 on average

Another Example • Can of insecticide costs $ 10 • Current risk level 15 out of 10,000 (injured) • What would you pay to eliminate the risk • Result of survey $ 3.78 • Same can but has no risk • What price reduction would be okay to have a 1 in 10,000 risk? • 77 % said they would refuse to buy the product at any price if the risk were increased

Anchoring (the bag of marbles) • 50 red; 50 white • Probability of drawing a red marble • 90 red; 10 white • Probability of drawing (with replacement) 7 red marbles in a row

Anchoring (the bag of marbles) • 50 red; 50 white 50% • Probability of drawing a red marble • 90 red; 10 white 48% • Probability of drawing (with replacement) 7 red marbles in a row • 90 red; 10 white 52% • Probability of drawing (with replacement) at least one white marble in 7 tries

Going to the UVA Basketball Game • Paid $ 200 for a courtside ticket • As you try to enter, you realize you have lost the ticket • Someone offers to sell you another ticket for $ 200….would you buy it? • You are on the way to the basketball game and have decided to pay $ 200 for a courtside ticket • As you try to enter, you realize that you have lost two hundred dollar bills, but still have several left and can buy the ticket • Would you still buy the ticket?

Sunk Costs • A man joins a tennis club and pays a $ 3000 yearly membership fee. After two weeks of playing, he develops a tennis elbow • He continues to play (in pain) saying: “I don’t want to waste the $ 300”

Decoupling • Club Med Pricing • Prix Fixe • Buying a car vs cab and car rentals • Telephone service by the call or flat rate • Credit card decoupling • Waiting in line (depends upon what you are waiting for • Dividends vs Capital Gains

Naïve Diversification • Four Choices: • Three Bond Funds • One Stock Fund • Put ¼ in each • Four Other Choices • Three Stock Funds • One Bond Fund • Put ¼ in each

Perceptions of “Randomness”- an example of “representativeness” • In a population of families with exactly six children, which sequence of births is more likely: • B B B G G G • G B B G B G • School A has 65 % boys, School B has 45 % boys • You enter a class at random with 55 % boys • Is this class more likely from School A or School B?

20 marbles, randomly divided among five children I II Alan 4 4 Ben 4 4 Carl 5 4 Dan 4 4 Ed 3 4 In many rounds of random assignment, which of these results is more likely?

Here’s an easy one • Two hospitals, large one, small one • 45 babies born each day in large hospital • 15 babies born each day in small hospital • On average, 50 % of babies are male • Over the course of a year, which has hospital has more days when 60% or more babies born are male? The large one or the small one?

The End

Behavioral Finance