Behavioural Finance and Framing Bias - Research Paper Example

4TH March Behavioral finance The current competitive business arena has forced many local and international companies to undertake extensive research with an aim of expanding their investment portfolio as well as face off their competitors. In their efforts to determine the occurrence of a certain event, statisticians rely on heuristic principles. Tversky and Kahneman 1125, argue that heuristic principles are significant especially in simplifying the wide range of tasks that are associated with prediction of occurrence of events. However, these principles sometimes lead to errors that effect the final decision of statisticians thus affecting the overall decision making process in an organization. It is imperative to note that the mistakes made by portfolio managers, brokers and other market participants are driven by behavioral biases. This paper seeks to analyze major behavioral biases that cause the investment mistakes and the reasons as to the participants fall in the trap. Framing bias During the decision making process, investors should fame the questions that will guide them in the process. According to Tversky and Kahneman 1124, the framing of a problem highly influences the decisions made by the investors. Framing bias entails the failure to reframe the choices given. As a result, investors suffer losses that can be avoided if the questions are reframed by the participants during a research. In order to ensure appropriate choices are made Lim 2540 depicts that managers should consider various factors. First, they should ask themselves whether or not they are addressing the actual problem. Secondly, they should integrate gains and losses in the choices available. Thirdly, they need to reverse the questions. For example, if there are sellers they should evaluate their behaviors assuming they are buyers. Fourthly, managers must frame the questions to cover the entre aspects of an investment for instance the total costs. In addition, managers must emulate an intensive perspective during framing. The section below analyses some of the major statistical errors that are associated with framing bias. Representativeness Representativeness heuristic is adopted by people to evaluate the probability based on the fact that an event A resembles and event B. For example, if an event B is highly representative to an event A, then it means that the probability that A originated from B is high (Tversky and Kahneman 1124). One of the major courses of errors that are related to representativeness is the use of similarity to determine the relationship between events. This is based on the fact that representative or similarity of event is not determined by several factors that are vital in determining probability. For example, representativeness is insensitive to prior probability of outcomes. In addition, representativeness is insensitive to sample size. It is worth to note that during evaluation of the probability of obtaining specific result for a sample that is derived from a particular population, most statisticians emulate representativeness heuristic. This means that they assess the possibility of the result obtained from a sample. For instance, the average height of 5 women will be 4 feet. This result is obtained from the similarity of the sample size to the corresponding parameter which in this case it is the average height in the population of women. Nevertheless, Tversky and Kahneman 1126 notes that the similarity of the statistics obtained from a sample is independent of population parameter. In this regard, if representativeness is applied in assessing the probability, the sample size and the sample statistics are absolutely independent. Misconception of chances Misconception of chances is another major aspect that causes framing bias. According to this bias, individuals undertaking research expects that events generated by a random process will depict the key characteristics of the entire process even if the sequence is short. For instance, in coin tosses, individuals a sequence such as H-T-T-H-T to be more possible as compared to T-T-T-H-H-H sequence. According to Health and Tversky 25, individuals believe that vital characteristics of process will be exhibited by the local parts of the sequence as well as at the global level. However, it is fundamental to note that a locally representative sequence at the local level is characterized by large number of alterations that makes it to deviate from the expectations that are chance based. Insensitivity to predictability Odean 1778 stipulate that insensitivity to predictability is a major aspect that leads to framing biases. Individuals make numerical predictions that are related to the demand of services and products, football outcomes as well as value of stocks in future. For example, when a local firm aims at going global, managers may make description of the products and services that they would introduce in the market. The most favorable products would attract a description of high profits thus becoming the key representative of that description (Tversky and Kahneman 1127). On the other hand, if the description is average, average performance of the products will be depicted as the most representative. It is important to note that a favorable description is not affected by the way it depicts accurate prediction or reliability of the particular description. It is therefore clear that if policy makers solely rely on the favorableness of the description made by various people, the prediction made are not sensitive to evidence reliability. This results to a major bias that affects the normality of theories that govern statistics. Misconception of regression Regression is a major statistical tool that used by statisticians to explain phenomenon such as the height of mothers and their children or the performance of managers on various tasks (Tversky and Kahneman 1128). However, some individuals have poor conception of regression leading to unfavorable representation of the data. For example, one way that depicts incorrect intuition about regression is that some people do not expect a regression where the possibility of its occurrence is high. Similarly, Tversky and Kahneman 1129 specify that if people realize the existence of a regression, they apply various explanations on the phenomena. One of the major results of misconception of regression in the social sector is that it underestimates the applicability of rewards and overestimates the implications of punishment. During the activities of an organization, rewards are given to the employees who depict remarkable performance while punishment is administered to poor performers. The concept of regression argues that employees’ behavior is likely to improve after the punishment while a reward will lead to deterioration of their characters. Lack of adequate know how on such a key aspect of regression has resulted to poor making of important decision in various organizations. Regret Aversion Bias Regret aversion bias entails the avoidance of making investment decision due to the fear of making decision that is not optimal. DeBondt and Thaler 802 argue that due to the emerging investment opportunities in the developing countries, it is fundamental for local organizations to diversify their operations in these countries. One of the key aspects that enhance the profitability of international firms is that emerging markets provides opportunities for diversification of investments thus leading to high returns on the investment. However, the regret aversion bias hinders the investors. Another impact of regret aversion bias is that it makes some investors to be hesitant in their investment decisions due to the loss that they underwent in the past operations. In the same way, some investors who view investing as a probabilistic endeavor are not highly affected by regret aversion. Self-control bias Self-control is also a major bias that causes errors in the statistics thus affecting the reliability of the final data. In their efforts to increase the investment of the companies investing in the emerging market, investors face the challenges of self-control. According to DeBondt and Thaler 55 investors are hesitant to behave patiently in the current business atmosphere but they aim at acting patiently in the future. For example, if investors are offered between 100 shares today and 110 shares tomorrow most of the investors would choose the first option. However, if the same investors are given a chance to be offered 110 shares in one year and two days or 100 shares in a year, the large number of the investors would choose the option of 110 shares in one year. Disregarding of the future challenges that may affect the individuals who are focused at investing in the emerging markets is one of the aspects that characterize self-control bias. In this regard, it is important for investors to make predictions that they need to attain in future. To address the challenges caused by self-control bias, it is significant to include shareholders in making vital decisions that are necessary in diversifying in the emerging market. In this way, managers would be in a position to get various predictions from the interested parties. Through evaluation of the market predictions and performance of shares in future, managers are able to differentiate between good and wrong predictions. Optimism bias Optimism bias entails being excessively optimistic about the results of an activity (Rothman 135). Some of the aspects that depicts optimism bias include under-estimating the possibility of occurrence of negative situations and overestimating the likelihood of positive events. In addition to the illusory superiority and illusion of control, investors and basically managers who are focused at investing in the emerging market are faced with optimism bias. Being one of the positive illusions, to which investors are susceptible, optimism bias negatively affects the operations of firms investing in emerging market. For example, it may lead implementation of plans as well as reduction of benefits and increment of costs of the plan. Mental accounting bias According to Brown and George 582, mental accounting bias entails framing of transaction based on the utility that is derived from the transactions. Some of the major aspects that are covered by mental accounting bias include transaction value and acquisition value. While transaction value entails the value that an investor attaches on the investments, acquisition value is amount of money that an investor is willing to allocate to the acquisition of various products or services. One of the major challenges faced by individual who are willing to invest in the emerging market is inadequate financial resources to diversify in the stocks of the emerging markets. However, due to tendency of individuals to put their money in separate accounts, and allocation of tasks to different accounts the investment behavior and their consumption decisions are negatively affected (Brown and George 585). Confirmation bias Confirmation bias is another major challenge that causes errors in the field of statistics. This bias entails the favoring of the information that confirms the hypothesis that has been depicted by the individuals undertaking a research. One of the major aspects of confirmation bias is that statisticians interpret the information gathered in a biased way. As a result of the biased interpretation and inappropriate analysis of the data collected, attitude polarization is attained (Budescu and Maciejovsky1830). Attitude polarization is an implication that is experienced when various parties undertaking a research are exposed to same evidence but they give a differentiated opinion (Budescu and Maciejovsky1829). Key implications of the confirmation bias in the filed of finance is that it leads to overconfidence of the investors thus ignoring the fact that their future investment may result to loss of money. To overcome the negativities of confirmation bias, investors who are aimed at investing in emerging markets should emulate a divergent view point. For example, the investors can assume that their investments have collapsed and should therefore seek for reasons of the collapse. Hindsight bias Hindsight bias refers to the propensity of individuals to view situations as more predictable. This means that before an event occurs, individual, have a strong belief and awareness of the occurrence of the event. Also referred to as I-knew-it-all-along phenomenon, hindsight bias is demonstrated in various situations for example during sports and in the political arena (Lim.2540). One of the major aspects of this bias is that when individuals or investors are faced with choices that are almost similar but only one is correct they realize that they did not know the situation as they thought they did. In this regard, it is appropriate for individuals who are aiming at investing in emerging markets to evaluate all the possible outcomes and eliminate the tendency of assuming that they know everything. Recency bias Budescu and Maciejovsky1830, argues that recency bias is a major challenge that affects the suitability of the information obtained through statistical methods. According to this bias, individuals judge situations based on what happened in the recent. For example, during the evaluation of the employees some managers check the performance of the employees in the last few weeks. This may result to deceiving results to an organization as far as the productivity of their employees is concerned. One of the key merits of this bias is that by indicating a recent improvement in the performance of an employee it is an indication of road to achievement of his or her goals and an organization can enhance their productivity by motivating them. On the other hand investors who make investment decision based on recent performance of the stock in the emerging markets may overly positive thus affecting their profitability. In addition, unintended implications of recency bias are experienced after relying on the current market prices rather than historical performance of share prices in the financial market. The table below act as an example of how recent bias can manifest itself during making of investment decision. Investors decision Possible outcomes Keeping money at home instead of depositing in a bank and earn a 5% interest on the deposit. The bank performance better and the investor misses the 5% interest Investing in other form of investments such as gold and bonds Gold and bond markets decline while the stock market improves. An investor is forced to chase the performance of the stock market due to the loss incurred in gold and bond market Cash out the money invested in gold or bonds due to a drop of 35% An investor is fined due to the withdrawal of the money before the specified time. Source- Budescu and Maciejovsky1843 Loss aversion bias Loss aversion bias maintains that individuals have strong fear of the negative implications of a loss as compared to the enjoyment they receive if they incur a gain. One of the major aspects that make loss aversion bias to hinder the diversification of companies in the stock of the emerging is that managers have strong fear of investing in new markets. As a result, their investment decision is affected thus resulting to the reduction of the company’s profit. According to Odean.1782, consequences of losses on the investment decision of companies are twice as strong as the gains derived from investments. In this regard, individuals prefer to face the risks that would reduce the implication of the losses. Conclusion Based on the above discussion, it is clear that even though the emerging markets offer vital investment opportunities for local and international firms, the occurrence of biases has hindered the expansion of companies. One of the key biases that hinder the diversification of organizations in emerging markets is the framing bias. Being the fear to reframe the choices, framing bias is caused by representativeness, misconception of chances, insensitivity to prediction and misconception of regression. As noted by Divecha 4 the correlation between FT Emerging Markets Index and FT Developed Multinational Index was high in the last 10 years. However, few investors were willing to expose their emerging markets by buying multinationals in developed markets (Divecha 6). This is due to the correlation that only depicted the duration that the two indexes were moving in the same fashion and no information about the size of their relative moves. Thus the correlation results to an error that demotivated the investors. Works Cited Tversky, A and Khneman, D. Judgement under Uncertainity:Heuristics and biases. Journal of Science 185 (4175) 1124-1131,1974. Brown and George W. On Small-Sample Estimation. The Annals of Mathematical Statistics. 18, (4) 582–585. Budescu and Maciejovsky. The effect of payroll feedback and information pooling on reasoning Errors. Evidence from experimental markets. Management Science, 51, 1829-1843, 2005. DeBondt and Thaler. Does the Stock Market Overeact? Journal of Finance 40 (3), 793-805, 1985. DeBondt and Thaler..Does Security Analysts Overeact? Journal of Finance 40 (3), 793-805. American Economic Review, 80 (2), 52-57, 1990. Divecha,A. Are Developed Multinational Companies a Good Proxy for Emerging Markets? pp 4-15 2011.GMO LLC. Available from http://s3.amazonaws.com/files.posterous.com/sethkaufman/x9mGY7FPMxfVkDM6gEN1HjwBnTSQ26oS4FJS99kWxQWs4b7L5FORZKFpaSkx/QL-w9zS5xGW.pdf?AWSAccessKeyId=AKIAJFZAE65UYRT34AOQ&Expires=1330926409&Signature=6Tegv9%2FlONQ2TsSip0ou41tZOCY%3D Health and Tversky. Preference and Belief: Ambiguity and Competence under Uncertainty. Journal of risk and Uncertainty 4: 5-28, 1991. Lim. Do Investors Intergarte Losses and Segregate Gains? Mental Accounting and investor Trading Decisions. The Journal of Business, 79 5 2539-2574, 2006. Odean. Are Investors Reluctant to Realize Their Losses. Journal of Finance 53(5), 1775- 1798, 1998. Rothman, K.J. et al. Modern epidemiology. Lippincott Williams & Wilkins pp.134-137, 2008. Read More