Behavioral finance: Contributions of cognitive psychology and neuroscience to decision making

Behavioral Finance is a field of study that attempts to explain how and why individuals and groups actually make financial decisions, as opposed to how “rational” theory dictates they should make such decisions. Findings from Cognitive Psychology & Neuroscience relevant to both financial decision making AND general management decision making.Behavioral Finance: Contributions of Cognitive Psychology and Neuroscience to Decision Making 2012 National Business and Economics Society Conference Maui, Hawaii March 7-10, 2012 James A. Howard, Ph.D. Agenda 1.Overview – Five Paradigms 2.Background: Rules of Thumb/Heuristics Paradigm 3.Background: Rational Being/Theory Paradigm 4.Cognitive Psychology/Behavioral Finance Paradigm 5.Neuroscience Paradigm 6.The Future: The Unconscious Paradigm 7.Conclusion 2 Overview – Five Paradigms Behavioral Finance (Def): A field of study that attempts to explain how and why individuals and groups actually make financial decisions, as opposed to how “rational” theory dictates they should make such decisions. Findings from Cognitive Psychology & Neuroscience relevant to both financial decision making AND general management decision making 3 Knowledge Accumulation/Evolution – Financial/General Decision Making 4 Background: Rules of Thumb/Heuristics Paradigm 5 •Finance considered a proto science, based on experience, heuristics, simple analytics from 1800s through 1940s •Mental shortcuts-Bounded rationality (Simon) •Predominant influence on financial decision making through mid 1940s •Especially relevant when uncertainty, lots of information, urgency Some Useful Heuristics •Pareto Principle •Use the Best (copy/benchmark) •Take the First Recognized •Fast & Frugal Trees (Checklists) •Finance-Related oPayback Criterion o1/N (allocate an average amount) oFull Cost Pricing oGraham & Dodd Investment Rules oLivermore Trading Rules 6 Background: Rational Being/Theory Paradigm 7 •Borrow Von Neuman & Morgenstern (1944) theory of expected utility (EU) •Assumes individuals make decisions according to EU (rational) •“Rational” decision maker makes decisions that represent Completeness (can rank order all alternatives), Transitivity (B>A, C>B, then C>A), Continuity (if A>B & B>C, then there will be a combination of A & C where individual is indifferent to B •Golden age of Financial Theory (1950-1972): Modern Portfolio Theory, Theory of Capital Structure and Dividends, Capital Asset Pricing Model, Efficient Markets Hypothesis, Black-Scholes Option Pricing Model Expected Utility - Example 8 Risk Averse Decision Maker: U(EP=3000) > U(P) or U(3000) > U (.50*1000 + .50*50000) The utility of the expected prospect/gamble [U(EP=3000)] is greater than the utility of the gamble [U(P)]. The point on the curve where expected utility (EU) intersects the curve is the point where the individual is indifferent between that amount for certain and a gamble that pays either $1,000 or $5,000, each with a probability of .50. Note that this amount is less than the expected value of $3,000 because the individual is risk averse. Cognitive Psychology/Behavioral Finance Paradigm 9 •Slovic JF (1972) paper on the importance of emotions in decision making and the fact that theory ignores influences of emotions •Psychologists Kahneman & Tversky development of Prospect Theory (1973, 1974, 1981), based on experiments that decision behavior violates rational assumptions of EU Violations of Rational Assumptions Cognitive Psychology •Biases - Excessive Optimism - Overconfidence - Confirmation - Illusion of Control - Hindsight - Conservatism •Heuristics - Representativeness - Availability - Anchoring - Affect •Framing Effects - Glass Half Empty/ Half Full - Loss Aversion - Aversion to a Sure Loss 10 Biases and Heuristics Framework- (As Counterpart to Traditional Finance’s Asset Pricing Framework) Biases are the predispositions to commit specific types of errors Think of heuristics as information processing shortcuts (rules of thumb) that mainly result from one’s experiences in a field of work. Of course, such simplifying shortcuts are great- until we consider that heuristics, by nature, are imperfect; and consequently, will result in biases and errors. Behavioralists argue that both heuristics and biases are in fact systematic and can last for long periods of time and can affect the prices of investments for long periods of time. 11 Biases Excessive Optimism When people overestimate how frequently they will experience favorable outcomes, and underestimate how frequently they will experience unfavorable outcomes Overconfidence When people make mistakes more frequently than they believe and view themselves as better than average Confirmation When people attach too much importance to information that supports their views relative to information that runs counter to their view Illusion of Control When people overestimate the extent to which they can control outcomes. Hindsight When subjects, after learning the eventual outcome, give a much higher estimate for the predictability of that outcome than subjects who predict the outcome without advance knowledge Conservatism Shows as an attachment to past analyses, practices, beliefs, and commitments even when they start to prove erroneous, counterproductive, even unsustainable 12 Heuristics Representativeness When people try to determine the probability that a data set A was generated by a model B, or that an object A belongs to class B, they often use the representativeness heuristic. This means they evaluate the probability by the degree to which A reflects the essential characteristics of B. Availability When people rely on information that is readily available and intuitive relative to information that is less salient and more abstract Anchoring When people form an estimate by beginning with an initial number and adjusting to reflect new information or circumstances. However, they tend to make insufficient adjustments relative to that number, thereby leading to anchoring bias Affect When people base their decisions primarily on intuition, instinct, and gut feeling 13 Framing Framing effects in decision situations arise when different imagery and descriptions of the same problem highlight different aspects of the outcomes. People generally evaluate acts based on the direct consequences of the act, such as the money lost or gained. That is, people generally evaluate acts in terms of a mental account, which includes only the direct consequences of the act. In other words, choices (decisions) more often than not depend on the manner in which alternatives are framed (described) and presented to us; a no-no proposition in expected utility theory. The frame that a decision maker adopts is controlled partly by the formulation of the problem and partly by the norms, habits, and personal characteristics of the decision maker. 14 Framing Glass Half Empty/Half Full Preference for an option depends upon whether choices are couched in terms of probabilities of success or failure Aversion to a Sure Loss When subjected to a loss from a starting endowment, there is a tendency to hold the investment/project until break even, irrespective of whether the outlook is positive or negative for future performance. Risk Aversion When there is a gain, the tendency is to take the small gains (too soon) with the idea one is now playing with house money. 15 The Effect of Emotion Herding/Bubbles - Research conducted to explain the formation and bursting of bubbles provides strong support for the position that humans are motivated to follow the path that the herd is on in circumstances where emotions run high or where there are perceived risks/costs with deviating from the path being taken by most. Example: Parker & Prechter (2007) analyze a number of stock market bubbles and crashes and conclude that cycles of optimism and pessimism feed on each other, resulting in extreme levels of optimism and eventual reverses in asset prices. When the optimism has run its course and asset prices decline, it appears virtually everyone resets their expectations becoming pessimistic and asset prices crash as extreme price declines are realized. More on the impact of emotion in the discussion of neuroscience contributions. 16 Hyperbolic Discounting Contrary to theory, individuals do not apply a constant discount rate over time to anticipated future rewards. The further an event lies in the future, the less people care about it and the less it is affected by hyperbolic discounting. Example: Propensity people have for short term rewards largely accounts for saving less and consuming more in the short term. Accounts for under saving for retirement and destructive short termism driving many decisions in the corporate world. 17 Cognitive Psychology Contributions - Summary •The initial publications by Slovic, Kahneman, & Tversky attracted a great deal of interest and evolved into the related field of study, behavioral finance. •The lack of a standard taxonomy in financial decision/behavioral errors has detracted from overall coherence •Best Strategy for avoiding decision errors is to know yourself, develop emotional intelligence 18 Neuroscience Paradigm 19 •Since the mid-1990s, the fMRI (functional magnetic resonance imaging) device has been employed to observe changes in brain blood flows in response to various experimental situations. •The fMRI scanner applies a strong magnetic field to the subject and records the variations of the magnetic field caused by an increase in blood flowing to the brain. •This provides indirect evidence of the interaction of different parts of the brain in reacting to rewards/pleasure, fear/pain/anger. The Brain – Reward and Loss Circuits 20 •Brain has three major regions: most ancient part Brain stem: midbrain (reptilian), next oldest, the center of emotions or the limbic system (dogs), and the cerebrum/prefontal cortex where rational thought and decision making occurs •Reward circuit – dopamine released to nucleus accumbens, increased blood flow and message to prefrontal cortex to act •Loss circuit – amygdala stimulated and release message to prefrontal cortex to act Findings from Neuroscience….More •In a study by Knutson et al. (2001) they found that NAcc activation represents gain prediction, while amygdala/ anterior insula activation represents loss prediction (Paulus et al., 2003). •Importance of dopamine in stimulating gain circuit (diminishing returns): -Unanticipated gain - Strong reaction and feeling of pleasure in the gain circuit transmitted to the prefrontal cortex -Gain equal to anticipated gain – Small or no reaction in the gain circuit -Gain less than anticipated – Activity in the loss circuit of the limbic system, particularly the anterior insula •Some supporting explanation for evidence of momentum in stock prices and the forming and bursting of bubbles 21 Findings from Neuroscience….More •Neuroscience has helped to clarify and provide a physiological basis for the hypotheses and cognitive psychology findings (poor decisions driven by biases, heuristics, framing effects) published for the past three decades. Observed outcomes in the form of financial decision making represent how the limbic system is working with the prefrontal lobes •Risk-seeking choices (such as gambling at a casino) and risk-averse choices (such as buying insurance) may be driven by two distinct neural mechanisms involving the nucleus accumbens (NAcc) and the amygdala. •Financial decision making is the result of the interactions of the limbic system (demanding action) with the frontal lobes (evaluating and deciding) of the cerebrum. 22 The Next Frontier: The Unconscious Paradigm 23 •Appears current state of neuroscience cannot tell us much more about the brain and decision making •Mercier & Sperber (2011) argue that what researchers have labeled as biases and heuristics may be more accurately captured as a general unconscious confirmation bias •Experimental evidence implies up to 90% of human behavior originates at the unconscious level: genetic/instincts, culture, repressed experiences, internalized experience/knowledge Approaches for Unlocking the Unconscious •Next generation of neuroscience tools •Advances in knowledge about the effects of brain “chemicals”: oxytocin, vasopressin, dopamine, serotonin on decision making •More comprehensive, multidisciplinary teams in research efforts •Include stakeholders from sociology, psychology, medicine, anthropology when interpreting results 24 Conclusions/Summary •In the past 100 years, we have accumulated much knowledge about how we make financial decisions •Many findings from research are equally applicable to general management decision making •This knowledge accumulation may be described as a combination of 5 paradigms, with different paradigms being dominant at different points in time •In spite of all the research, experimentation, observation, and application, at critical times, financial decision making is poor at all levels of society is poor •Recent research in neuroscience implies that up to 90% of our behavior originates at the unconscious level 25 Conclusions/Summary….Continued •Research going forward should focus on unlocking how decision making behaviors originate in the unconscious •Research design and execution should involve multidisciplinary teams: neuroscientists, psychologists, medical experts in brain chemicals, sociologists, anthropologists, and perhaps more •Organizations should focus more on debiasing training as a means promote “emotional intelligence” and help its managers make better decisions in general 2