Behavioral Finance (2/2)

In this lesson, you’re expected to learn about:
– identifying irrational behavior in corporate finance
– realizing that emotions and personal judgments play a role in financial decisions
– how to measure irrational behavior

Letting Relationships Influence Finances 

The idea that the people you know are more important than what you know carries weight all over the world. In Chinese it’s called guanxi, in Arabic it’s called wasta and in Russian it’s blat, but it all means the same thing: showing favoritism based on personal relationships rather than merit or qualifications. This form of favoritism is called cronyism (or nepotism when you’re dealing with relatives).

Here’s how cronyism works. You’re in charge of something at your company, and you make decisions to spend money on goods and services based on the personal relationships you have with people instead of their merit compared to those competing with them.

Maybe you’re in charge of recruiting staff or you know someone who is, and you push for a particular person to get the job based on the fact that you know her and you want to maintain good relations with her. As a result, wages are paid to an employee who has lower productivity and less potential to contribute to the company in the long run compared to other candidates.

Or maybe you purchase supplies from the company where one of your family members works, because you trust that person over someone you don’t know. In this case, you end up paying more for the company’s supplies by simply accepting the higher price or by not performing a full evaluation of market prices and quality.

Cronyism isn’t the same as networking though. In cronyism, you’re looking to use professional opportunities to benefit your social connections.

Satisficing Can Optimize Your Time and Energy  

Remember that old saying ‘time is money’? Well, you’re about to find out that people naturally apply a value to their time. This value isn’t so much about money as it is about using your limited amount of time doing things you need or want to do.

As a simple example, imagine that you’re spending your day off lounging around the house playing computer games, and you decide that you can’t be bothered to cook dinner. So you decide to order a pizza. You could probably make something healthier, cheaper and more delicious, but you settle for something that’s ‘good enough’ and doesn’t require any additional time or effort on your part.

In corporate finance, the application and measurement of what’s ‘good enough’ is called satisficing. In a more practical sense, the term refers to humans’ inability to know what’s truly rational.

Suppose that you own a veterinary surgery. When you’re shopping for flea powder for your patients’ dogs, you probably don’t know what price every shop in the city charges and so you just go to whatever shop you’ve visited before, believing them to have prices reasonably below retail or with whom you have a working rapport. Even if that shop doesn’t have enough flea powder, you probably end up buying whatever they do have available with the mindset that you can always go back when you run out.

In fact, a shop a couple of miles away has plenty and the powder is $1 cheaper per box, but you don’t know that and you don’t intend to run around the entire city, because the measure of time needed to collect fully all the information and the resources required to make a rational decision aren’t available.

In the time it took you to go back out and pick up more flea powder, you would’ve been better off going to the other shop, but being unaware that the other shop even has flea powder you determined that this option was good enough for your immediate needs.

Thus, satisficing behavior causes people to make less-than-optimal decisions, but they do so based on the decision that their time’s worth more than the potential benefits.

As with all financial decisions, satisficing comes with a degree of uncertainty and risk, and so the results can be good or bad. Therefore, we aren’t saying that satisficing itself is good or bad, just that you need to recognize that it happens and in certain cases it may need addressing.

Prospect Theory

According to the prospect theory, when making financial decisions that aren’t certain (meaning that the outcomes aren’t certain, but the probability of success can be estimated), people look at the potential for gain or loss instead of relying on rational thinking using the probable outcomes.

Consider medical insurance as an example of this theory in action. Insurance companies have so much data available to them that they can determine with extreme accuracy the probability of a person getting sick or hurt based on ancestry, geographical location, job, lifestyle habits and a number of other variables that they research when people apply for cover.

Prospect theory has two extremes:

1) Highly cautious people who fear potential loss significantly more than they desire potential gain. 
These people have a difficult time investing at all for the fear that they may lose their money. They purchase the maximum amount of insurance they can buy and are definitely not investing in the stock market.

2) Risk-takers who desire the potential gains far more than they fear the potential losses. 
These people take extreme risks in the hope of receiving a huge financial return. They’re often traders, bank executives or gambling addicts.

The people who make the most rational decisions attempt to measure potential gains and losses objectively, weighted by probability. Many of them end up working as value investors or finance underwriters.

[Optional] Prospect Theory
Accepting that People Are Subject to Behavioral Biases  

When you’re dealing with corporate finance, you rely on the collection and analysis of data to help you answer questions and make decisions.

Even though all the data you need to make the best decision may be available, how you perceive and use that data can be an erroneous process thanks to the following two types of bias:

1) Statistical Bias

This type of bias occurs when people collect data from a sample rather than from an entire set of data and then assume that the data they collect represents the entire set of data. Say that a financial analyst wants to assess the returns on capital investment that a company is able to generate. If he takes data only from the marketing department of the company rather than from every department, his analysis is going to be biased.
2) Cognitive Bias

This bias occurs during the processing of information, when people choose to use their own personal judgment rather than the data results. Cognitive biases come in a variety of forms:

• Status quo bias refers to the tendency of people to avoid changing established methods, such as when a team of employees refuses to implement a more efficient management accounts system just because they don’t want to learn the new system.
• Self-serving bias refers to the tendency of people to give themselves credit for successes but blame outside factors for failure. This type of bias contributes to wrong self-assessments of investing performance.
• Confirmation bias refers to the tendency of people to acknowledge only data that confirms their preconceived beliefs, resulting in the rejection of factual information that challenges their beliefs. This bias can devastate a company when it leads to management ignoring their analysts or professional advisers.

Corporate finance relies heavily on the accuracy of data and the precision of analysis. Although individuals are constantly subject to multiple types of bias, companies can reduce the rate of error due to bias by maintaining proper data collection methods and using full analyses.

The key is to interpret only what actually occurs instead of letting personal judgment influence decisions.

Analyzing and Presenting Information Is Fraught with Problems 

How people process the data available to them is subject to behavioral errors based on the context in which the information is presented. For instance, when some expression of judgment makes its way into the presentation of data, that judgment influences how others analyze and understand the information.

The process of introducing your own interpretation of a subjective measure or event is called framing. Everything you witness is processed through a filter, called a frame, which is composed of everything you’ve come to assume about the world around you, including the behavior of people. These frames cause you to understand and interpret things in a different manner from the people around you and, as a result, alter how you each respond.

Ethnocentrism

Ethnocentrism is another form of framing, in which you judge the occurrences of one nation by the standards of another.

For example, when an analyst from a nation of people who are culturally more comfortable taking risk analyses the shares of a company from a nation of people who are culturally averse to risk, the analyst is likely to see the company’s price to earnings ratio as being extremely low for the value of the company. As a result, the analyst may think that the company is undervalued.

The problem is that the analyst is judging another nation’s company based on the frame of his/her own ethnocentrism.

Unless those shares cross-lists (which is where a company trades its shares on one or more foreign stock markets in addition to its own domestic stock market), the price isn’t likely to increase as the analyst predicts, simply because the people of the nation where the shares are from aren’t willing to take the additional risk compared to the company’s future potential earnings.

Framing can influence all sorts of financial decisions. Keep in mind that data is the term used for raw results and information is used when those raw results have been processed in some way.

You have to be very careful to apply relevant contextual information along with any analysis you give and ensure that the manner in which you present information remains objective, neutral and free of judgments that contribute to framing.

Measuring Irrationality in Finance Is Rational Behavioral Finance 

Understanding how irrational financial behavior works is only half the job. You also have to determine the value of irrationality. That is to say, you need to work out how much your own inherent irrationality costs you (and your company) financially.

To see what we mean, consider how you’d measure the cost of satisficing behavior:   

Assume that a person goes shopping, intending to purchase ten loaves of bread:
• Shop A has only five loaves at $2 per loaf.
• Store B has ten loaves at $1 per loaf.

1. The person spends $1 in fuel each direction getting to and from Shop A, not knowing that Shop B has more loaves of bread at a cheaper price. So she goes to Shop A twice, buying five loaves of bread each time.

2. The person spends $24 on bread and travel. If she’d checked out Shop B’s stocks, she would’ve spent only $10 for the bread, $2 for fuel plus an additional $1 for going between stores. The cost of being lazy (satisficing) in this example is $11.

Satisficing isn’t the only behavior that has a measurable influence on finance. Although some are easier to quantify than others, all behaviors are measurable, but not all necessarily have a negative influence.

For instance, people who were too worried about their finances to invest in an Internet company may have saved themselves from the crash in the late 1990s, giving that behavior a positive value. That doesn’t mean that it was good behavior, however, because it was still based on irrationality.

The decisions to refrain from investing were based on an emotional response rather than a calculated determination of the level of risk, and so the decisions were just lucky and could just as easily have resulted in missing out on important investment opportunities.

After identifying the role that an individual plays in the financial world and recognizing what behavioral anomalies each individual is subject to, you can make estimates on the cost of behavioral anomalies and take steps to minimize the risk that such behaviors occur.

Formalizing and quantifying the role of human behavior in causing deviations from rational financial decisions is an important step not only to understanding but also improving upon the current financial infrastructure of organizations.

Jim Rohn