Review

1. Review • Biases? • Heuristics? • Overconfidence • Optimism • Hindsight bias • Overreaction

2. Which Circle is larger?

3. Biases • Intuition can not be trusted! • Must be supplemented by analytical thinking • Use a ruler to dispel the illusion! • Systematic errors of judgement:bias • Normative analysis • rational solution to a decision problem • Descriptive analysis • how real people actually make decisons • Prescriptive analysis • practical advice that you can use for rational decisions

4. Decision Making Process • Decision: a choice between gambles • outcomes of possible options are not known in advance! • You make judgements about probabilities • You assign values to outcomes • You combine these beliefs and values to form preferences • Judgements can be systematically wrong! • Systematic errors of judgement are called biases!

5. Which is? • The more frequent cause of death? • Homicide? • Stroke?

6. Heuristics • The process by which people find things out for themselves • Usually by trial and error! • Trial and error leads to rules of thumb • This process leads to errors • sometimes systematic errors! • These rules of thumbs themselves • came to be called heuristics! • Availability heuristic • availability bias!

7. What is your best estimate? • Dow Jones 1998 • Closed at 9181 • DJIA does not include reinvested dividends • What would be the closing value of DJIA be? • If DJIA were redefined • to reflect the reinvestment of all dividends? • Since May 1896 • when its value was 40 • Give your Best Guess, Low guess, High Guess • so that you feel 90% confident that true value lies between your low guess and high guess

8. Overconfidence • Highly systematic bias • forecasts of stock prices • forecasts of earnings per share • trades of investors (trading too much) • People set narrow confidence bands • high guess is too low • low guess is too high! • Well calibrated professionals • meteorologists • face similar problems every day • make explicit probabilistic predictions • obtain precise and immediate feedback on outcome

9. How good are you? • How good a driver are you? • Compared to drivers you encounter on the road are you • Above-average? • Average? • Below average?

10. Optimism • Optimists • exaggerate their talents • underestimate the likelihood of bad outcomes • are prone to an illusion of control • underestimate the role of chance in human affairs • misperceive games of chance as games of skill • Overconfidence and Optimism combined • overestimate knowledge • underestimate risks • exaggerate their ability to control events • Vulnerable to statistical surprises? • DeBondt, 1998

11. Did you know? • On the day before the Bank of England announcement, what was your estimate of the probability that interest rates would remain constant? • Do you think you have estimated the direction of change in FTSE100 correctly last week? • Now, have a look at the forecasts you made last week, have you estimated the direction of change for FTSE100 correctly?

12. Hindsight Bias • Reality looks much more obvious in hindsight than in foresight! • People with hindsight bias • perceive events that occurred to have been more predictable

13. Hindsight Bias • People can rarely reconstruct, • after the fact, what they thought about the probability of an event before it occurred • Earlier estimate of probability is exaggerated after the event occurs • Events that were not anticipated • often appear almost inevitable after they appear • Hindsight • promotes overconfidence • creates the illusion that the world is more predictable than it really is • turns reasonable gambles into foolish mistakes

14. Which one is more likely? • You are tossing a coin six times. Which of the following sequences is more likely to occur? HHHTTT HTHTTH

15. Which one is more likely? • You have tossed five coins and observed the following sequence HHHHH • Now, you are tossing the sixth coin. • Heads or Tails?

16. Overreaction • Human mind is pattern-seeking • biased to think that a casual factor is at work! • perceive patterns where non exists • have too much confidence in their judgements of uncertain events • Fund managers that were successful • for a few years in a row? • Odean, 1998 • Individual Investors • who sold a stock and bought an other one immediately • the stock they sold outperformed the one they bought by 3.5% in a year!

17. Overreaction • DeBondt and Thaler, 1984 • Question: • Does overreaction affect stock prices? • Answer: • Yes! • Loser portfolios experience exceptionally larger returns than winner portfolios (25%!) • Implication • Weak form market inefficiency • Explanation to the January Phenomenon

18. Research Design • Monthly stock price data • excess returns calculated using 3 different benchmarks • research period 1926-1982 • Portfolio formation • Start in December 1932 (t=0) • compute excess returns for the previous 3 years • repeat this for all non-overlapping 3 year periods • for each portfolio formation date rank cumulative abnormal returns from high to low • firms in top decile constitute winner portfolio • firms in bottom decile constitute loser portfolio

19. Analysis • Compute • cumulative abnormal returns • for all portfolios for the next 36 months • Compare • winner versus loser portfolios • Cumulative abnormal returns at t=36 • each portfolios’ returns • at t=0 and t=36

20. Results Loser portfolio Cumulative Abnormal Returns Winner portfolio Months after portfolio formation

21. Summary • Biases? • Heuristics? • Overconfidence • Optimism • Hindsight bias • Overreaction