2017 Investment Symposium
Session 6: General Luncheon: Behavioral Finance
Moderator:
Suhrid Swaminarayan, FSA, FIA
Presenter:
Werner DeBondt, Ph.D
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Werner De Bondt
[email protected]
SOA Investment Symposium
Chicago, March 2017
Overview
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Decision fiascoes in history.
Overconfidence.
The Dunning-Kruger effect.
Extrapolation. Confirmation bias. Unrealistic
perceptions of control. Groupthink.
Managing overconfidence.
“The financial services sector has been dramatically transformed .. Technology has enabled
creditors to achieve significant efficiencies ..
Where once more-marginal applicants would
simply have been denied credit, lenders are now
able to quite efficiently judge the risk posed by
individual applicants and to price that risk
appropriately. These improvements have led to
rapid growth in subprime mortgage lending.”
Alan Greenspan
April 8, 2005
“Those of us who look to the self-interest of
lending institutions to protect shareholder
equity have to be in a state of shocked disbelief.”
Alan Greenspan
“We will never have a perfect model of risk.”
Financial Times
March 16, 2008.
Experimental evidence
• Probability is a degree of belief in a
proposition. Sometimes, it is possible to verify
the truth or falsity of the proposition.
• Example 1: “Absinthe is a precious stone.”
Please give the probability that this statement
is true.
• Example 2: For each of ten items, provide a
low and high guess so that you are 90 percent
sure that the correct answer falls between the
two. Item 1: “Diameter of the moon in miles”
10 questions
Provide a low and high guess so that you are 90%
sure that the correct answer falls between the
two.
The challenge is to be neither too narrow nor
too wide. If you are successful, you should have
10% misses, i.e., one miss.
1. Martin Luther King’s age at death
2. Length of the Nile River (in miles)
3. # of countries that are members of OPEC
4. # of books in the Old Testament
5. Diameter of the moon (in miles)
6. Weight of an empty Boeing 747 (in pounds)
7. Year in which W.A. Mozart was born
8. Gestation period of an Asian elephant (in days)
9. Air distance from London to Tokyo (in miles)
10. Deepest known point in the oceans (in feet)
“Overconfidence is built so deeply into
the structure of the mind that you couldn’t
change it without changing many other
things.”
Daniel Kahneman
Interview with The Guardian
July 18, 2015
What determines confidence?
• The strength of the evidence (Extremeness of
impression. How warm is a recommendation
letter? Sample proportion of heads.)
• The weight of the evidence (Reliability of
source. Credibility of the writer. Size of
sample.)
• High strength+low weight=overconfidence.
• Low strength+high weight=underconfidence.
Analysis
Intuitive judgments are overly influenced by
the degree to which the available evidence is
representative of the hypothesis at hand.
(What are the features of similarity?)
People focus on the strength of the evidence
as they perceive it and then make an
(insufficient) adjustment in response to its
weight.
… HEURISTICS AND BIASES …
Overconfidence, accuracy and information
Hypothesis
Beyond some early point in the informationgathering process, accuracy reaches a ceiling.
Yet, confidence continues to climb.
Thus, most judges are overconfident.
CONFIDENCE
ACCURACY
INFORMATION
“To know that you know what you know, and
that you do not know what you do not know,
that is true knowledge.”
Confucius
The Analects
So what?
• A major psychological force. The phenomenon
controls action. Overconfidence moves people
to do things that they may not have done
otherwise.
• The negative consequences are not easily
eliminated.
• Cognitive vs. motivational explanations.
Overconfidence makes people feel good.
“We live in a fantasy world, a world of illusion.
The great task in life is to find reality.”
Iris Murdoch
1919-1999