Chapter 22
Behavioral Finance:
Implications for
Financial Management
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills
•
Identify behavioral biases and understand
how they impact decision-making
•
Understand how framing effects can
result in inconsistent and/or incorrect
decisions
•
Understand how the use of heuristics can
lead to suboptimal financial decisions
•
Recognize the shortcomings and
limitations to market efficiency from the
behavioral finance viewpoint
22-2

Chapter Outline
•
Introduction to Behavioral Finance
•
Biases
•

of an unknown future
•
Overconfidence results in assuming
forecasts are more precise than they
actually are
22-5

Overoptimism
•
Example: overstating projected cash
flows from a project, resulting in a
high NPV
•
Overestimate the likelihood of a
good outcome
•
Not the same as overconfidence, as
someone could be overconfident of
a negative outcome (i.e.,
“overpessimistic”)
22-6

Confirmation Bias
•
More weight is given to information
that agrees with a preexisting
opinion
•
Contradictory information is deemed
less reliable

–
Reliance on stereotypes or limited
samples to form opinions of an entire
group
•
Representativeness and
Randomness
–
Perceiving patterns where none exist
22-9

The Gambler’s Fallacy
•
Heuristic that assumes a departure from
the average will be corrected in the short-
term
•
Related biases
–
Law of small numbers
–
Recency bias
–
Anchoring and adjustment
–
Aversion to ambiguity
–
False consensus
–
Availability bias

Implementation costs
–
Transaction costs may outweigh potential
arbitrage profit
22-12

Bubbles and Crashes
•
Bubble – market prices exceed the level
that normal, rational analysis would
suggest
•
Crash – significant, sudden drop in
market-wide values; generally associated
with the end of a bubble
•
Some examples of crashes:
–
October 29, 1929
–
October 19, 1987
–
Asian crash
–
“Dot-com” bubble and crash
22-13

Money Manager
Performance
•

•
Consider a political election with two
competing candidates, one who is pro-life
and the other who is pro-choice.
–
How might a pollster representing one side
frame a survey question differently than
someone from the competing political camp?
–
What does this say for the potential accuracy of
reported survey results?
–
How might this situation apply to a company?
22-16

Comprehensive Problem
•
Warren Buffett, CEO of Berkshire Hathaway,
is often viewed as one of the greatest
investors of all time. His strategy is to take
large positions in companies that he views as
having a good, understandable product but
whose value has been unfairly lowered by
the market.
–
What behavioral biases is Buffett attempting
to identify?
–
If he successfully identifies these, will he be
able to outperform the market?