ISM Lecture Topic essay

Given this information, which of the following three cases is most probable? Linda is a librarian Linda is a librarian and active in environmental movement Linda works in the banking industry – Peter is a streetwise extrovert who talks quickly and wears smart clothes.

Young bright and dynamic, he has a slight East London accent. He works for a large investment bank. What is the probability Peter is a derivatives trader? 01 0 4 Concept – Judgments based on stereotypes – How representative of, or similar to, the underlying category or process is the predicted event? Other factors that affect such judgments are frequently ignored 5 Illustrations – Stock market reaction to dot. Com firm name changes During the mania After the mania – Fund style name changes and impact on fund inflows “Good firm good stock” syndrome The use of the PEG in stock valuation – The trustee fund manager selection interview – Evaluating fund manager performance 6 Biases – Insensitivity to sample size in drawing conclusions, e. G.

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Evaluating fund reference on the basis of five or fewer years – Ignoring base-rate frequencies, I. . Insensitivity to prior information CLC – Gamblers’ fallacy or law of small numbers, I. E. Expecting chance to be cloistering or reading patterns into random events 0 Technical analysis – Ignoring regression towards the mean, e.

G. Expecting extreme performance to be followed by similar extremes Value and glamour stocks – Insensitivity to predictability, I. E. Ignoring the lack of reliability of the evidence 7 Base rate fallacy example – Information 2 cap companies: the Green and the Blue 85% of the caps are Green and 15% are BlueA witness identified the cap as a Blue cap The witness made correct identification in 80% of the cases and erred in 20% What is the probability that the cap involved was actually Blue? – Solving: Assume 100 caps CLC 85 Green and 15 Blue Out of 85 Green, the witness would identify Out of 15 Blue, the witness would identify Therefore, when the witness identifies BLUE, 85 x (Blue) 15 x 68 correctly = 17 incorrectly ? 12 correctly 17 out of 29 times it is wrong 15 x 20% = 3 incorrectly 12 out of 29 times it is right The probability that the cap was actually BLUE is 12/29 = 41 % 8Gamblers’ fallacy example – A brokerage house analyst is looking at the daily price change relative to the market of a stock he is following over the past 6 days. – Which of the following sequences is most likely to have occurred? Days Sequence + denotes stock price change > market index – denotes stock price change < market index 9 Anchoring and adjustment heuristic Question - In 1896, the Dow Jones Industrial Average (DJIA) was 40. At the end of 2006, the DJIA was 12,463.

The DEJA is a price weighted average. Dividends are omitted from the index. What would the DEJA average have been at the end of 006 if the dividends were reinvested each year? 10 – An initial value is adjusted to arrive at the final assessment E.

G. Budget process Analyst earnings forecast PIE adjustment for risk, using previous share price high / low, industry average PIE benchmark Experiments demonstrate people will even anchor on a random number generated by, e. . A wheel of fortune, despite being told its lack of relevance to the experimental task. – Implausibly extreme anchors had a proportionally smaller effect than anchors close to the expected value – Use of anchoring in negotiation strategies 11 Insufficient adjustment: people are typically conservative, they undercoat to new information Compare to the representative heuristic We are poor Bayesian statisticians! Overly narrow confidence bands (this is also an aspect of overoptimistic bias) Most marked when people lack expertise or knowledge People anchor on an initial value, then adjust for upper and lower limits E. G. Surprise of market forecasters after outcome 12 part 2: Other judgmental biases 13 The framing judgmental bias – Traditional finance assumes frame independence, I.

E. Framing is transparent; & Decision makers can see through the different ways cash flows might be described Behavioral finance reflects frame dependence, I. E. Framing is opaque in practice – we cannot see through it; Perceptions are highly influenced by how decision problems are framed; Actual behavior f (how the decision problem is posed); Change the form C] change in substance – Example: framing dependency in reported earnings Pro-formal earnings vs.. GAP earnings 14 Loss aversion – Suppose you are offered a bet on the toss of a fair coin. If the coin comes up tails you have to pay OHIO If heads comes up you would win EX How large would EX have to be to make you want to play? 5 – The ability to tolerate loss is a key determinant of all financial decision making – Prospect theory (Keenan and Adverts, 1979) says “losses loom larger than gains” A loss has about two and a half times the impact of a gain of the same magnitude People hate to lose, particularly in the investment environment “Many clients, however, will not sell anything at a loss.

They don’t want to give up the hope of making money on a particular investment, or perhaps they want to get even before they get out.

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