Behavioral Finance More on Biases March Behavioral Finance Economics 437

Behavioral Finance More on Biases March All Readings Covered on MidTerm Including Fischer Black’s article on Noise

Behavioral Finance More on Biases March Representativeness Ignores Base Rates in favor something that seems causal

Behavioral Finance More on Biases March Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of a reality Is Steve?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

Behavioral Finance More on Biases March 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?

Behavioral Finance More on Biases March Representativeness Less is more RGRRR GRGRRR GRRRRR

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March Availability Saliency Buying airport insurance Related to overconfidence and over reaction

Behavioral Finance More on Biases March 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)

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March Insurance Distortions Flight Insurance …. $ 100,000 coverage in case of Terrorism Anything but terrorism Anything

Behavioral Finance More on Biases March Insurance Distortions Flight Insurance …. $ 100,000 coverage in case of Terrorism $ 7.42 Anything but terrorism $9.00 Anything $ 7.44

Behavioral Finance More on Biases March Buy me a beer! From a resort From a small country town store

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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?

Behavioral Finance More on Biases March 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”

Behavioral Finance More on Biases March 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

Behavioral Finance More on Biases March 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?

Behavioral Finance More on Biases March 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?

Behavioral Finance More on Biases March 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?

Behavioral Finance More on Biases March The End