FIN 468 Intermediate Corporate Finance Topic 11 Behavioral Corporate Finance Larry Schrenk Instructor 1 of 22 Topics Foundations of Behavioral Finance Anomalies and Applications to Corporate Finance A Cautionary Note In my Opinion but Not Necessarily in the Opinion of my Colleagues in Finance 1 2 There is good evidence for the empirical examples I will present The theoretical explanations are more speculative and almost every claim in these areas is controversial 3 of 70 Foundations of Behavioral Finance Three Areas of Study Anomalies Evolutionary Psychology Neuroeconomics 5 of 70 1 Anomalies Deviations from Classical Economic Behavior Irrationalities Only Relevant if Systematic 6 of 70 Anomaly Example Framing Asian Disease Experiment Given an outbreak of the Asian disease and 600 people who are going to die which plan should be implemented Plan A or Plan B Same Choice but Two Alternate Frames 7 of 70 Frame 1 Life Language Plan A 200 people are saved Plan B 33 chance that all will be saved 67 chance that none of them will be saved 8 of 70 Frame 2 Death Language Plan A 400 people die Plan B 33 chance that all will be saved 67 chance that all will die 9 of 70 Results Frame 1 Life Language A B 72 28 Certain Choice Risky Choice Frame 2 Death Language A B 22 78 Certain Choice Risky Choice 10 of 70 2 Evolutionary Psychology Reasoning Human Organs Evolve in Response to Environment Brain is a Human Organ Our Brian has Evolved in Response to Environment encountered during Human Evolution 11 of 70 Evolutionary Psychology Traditional Brain View Tabula Rasa Blank Slate Flexible Open to Any Programming Evolutionary Psychology one version Modular Brain Neural circuits designed for problems faced during our evolutionary history Question of Universality Domain Specificity vs Domain Generality 12 of 70 Evolutionary Psychology When Did the Brain Evolve Pleistocene Period Human Evolution 1 8M to 10 000 years ago Homo erectus 1 6M years ago Homo sapiens 200 000 years ago Permanent Human Settlements 10 000 years ago Hunter Gatherer Societies for 99 of Human Development 13 of 70 Evolutionary Psychology Possible Evolution 10 000 to present Lactose Intolerance Example Future Evolution Time Scale 14 of 70 Evolutionary Psychology Roughly phrased We are using hunter gatherer modules to confront 21st century problems or Our modern skulls house a stone age mind 15 of 70 Evolutionary Psychology Examples Evolved Fear Learning Psychology Data While spiders and snakes kill far less than guns people nonetheless learn to fear spiders and snakes about as easily as they do a pointed gun and more easily than an unpointed gun rabbits or flowers Explanation Spiders and snakes were a threat to human ancestors throughout the Pleistocene whereas guns and rabbits and flowers were not 16 of 70 Evolutionary Psychology Examples Hunting Hypothesis and Human Coalitions Mating Behavior 17 of 70 3 Neuroeconomics Study of how the brain functions when making decisions Neuroimaging e g fMRI PET Scans Imaging brain activity to infer how the brain works Issues Automatic versus Controlled Processes Emotions 18 of 70 Neuroeconomics fMRI 19 of 70 Neuroeconomics 20 of 70 Neuroeconomics and Framing Activity in the frontal and parietal cortices suggests that working memory and imagery mechanisms are involved differentially in choosing risky versus sure options fMRI results indicate that the certain choice is considerably less costly in terms of cognitive effort than the risky one when individuals choose among options framed as gains Since in negatively framed questions participants chose the risky option more often than the certain option in response to such problems our results suggest that people are more willing to accept a computational rather than an emotional cost Gonzalez et al The Framing Effect and Risky Decisions Examining Cognitive Functions with fMRI 2005 21 of 70 Neuroeconomics and Framing 22 of 70 Automatic versus Controlled Processes 23 of 70 Anomalies 24 of 36 The Anomalies 1 2 3 4 5 6 7 8 Excessive Optimism Overconfidence Confirmation Bias Illusion of Control Representativeness Availability Anchoring Framing 25 of 70 Excessive Optimism People overestimate favorable and underestimate unfavorable outcomes 26 of 70 Excessive Optimism Examples Most people display unrealistically rosy views of their abilities and prospects Typically over 90 of those surveyed think they are above average in such domains as driving skill ability to get along with people and sense of humor They predict that tasks such as writing survey papers will be completed much sooner than they actually are 27 of 70 Excessive Optimism and Corporate Finance Managerial overconfidence and optimism lead to overinvestment Foreign exchange companies are more optimistic about how exchange rate moves will affect their firm than how they will affect others Delayed cost cutting Stock bubbles 28 of 70 Overconfidence People are overconfident in their abilities and knowledge 29 of 70 Overconfidence Examples Confidence intervals people assign to their estimates of quantities the level of the Dow in a year say are far too narrow Their 98 confidence intervals for example include the true quant People poorly estimate probabilities Events they think are certain to occur actually occur only around 80 of the time and Events they deem impossible occur approximately 20 of the time 30 of 70 Overconfidence Examples Expertise too is often a hindrance rather than a help Experts armed with their sophisticated models have been found to exhibit more overconfidence than laymen particularly when they receive only limited feedback about their predictions 31 of 70 Overconfidence and Corporate Finance Research shows that professionals from many fields exhibit overconfidence in their judgments including investment bankers engineers entrepreneurs lawyers negotiators and managers Overconfidence can lead to investment distortions predominantly overinvestment Economic overconfidence e g forecasting business cycles 32 of 70 Confirmation Bias People put too much confidence in information that supports their own view 33 of 70 Confirmation Bias Examples People are reluctant to search for evidence that contradicts their beliefs Even if they find such evidence they treat it with excessive skepticism Some studies have found an effect whereby people misinterpret evidence that goes against their hypothesis as actually being in their favor 34 of 70 Confirmation Bias and Corporate Finance Investors tend to