Behavioral Finance

Behavioral Biases in Finance Decisions

In traditional finance there are three basic models are
1. Behaviors are assumed rational,
2.Capital asset pricing model shows the way how the price is set, and
3. Capital market is efficient.
Price is the sign which reflects all the information needed in the market. This is also
known as efficient market hypothesis (EMH). Market anomalies and volatility of market
price take the traditional finance into the dilemma. The main reason of these “Gordian
knots” can be imputed to that behavioral biases are not taken into consideration in the
traditional finance.

Behavioral Finance, a new paradigm in finance filed, explains financial problems from
psychology perspective. In psychology, human behavior has some deviation in judgment
under a particular situation, especially when the condition is uncertain. The patterns of
deviation are known as behavioral biases. Behavioral biases can be expressed in
various forms: overconfidence, loss aversion, familiarity,etc. Every behavioral bias has a
different effect on corporate financial decision making. In psychology, behavioral biases
are the pattern of deviation in judgment which occurs in a particular situation, especially
when the condition is uncertain. In other words, behavioral biases are a tendency that a
human would make some systematic error in a certain circumstance based on cognitive
factor rather than evidence. Biases can result from many perspectives and can be
divided into two main categories:
 cognitive biases
 and emotional biases.
Both of them have the similar effect, but emotional biases cause the distortion in
decision making due to emotional factors, such as fear, worried, etc. behavioral biases
takes many patterns, each form has their own representative and effect on financial
decision making.

Heuristics
Heuristic, as known as a rule of thumb, is a way refers to problem solving, learning and

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discovery. Heuristics used by most managers because they speed up the process to find
a solution when situation is extremely complicated. Heuristics are shortcuts that simplify
the complex methods of assessing the probabilities and values ordinarily required to
make judgments, and eliminate the need for extensive calculation. Heuristics can make
the decision-making much easier. There are many situations that investors would like
using heuristic to solve problems. For example:
 firstly, when an investor is unawareof the optional method for the problem, even
though the ideal solution does exist. Moreover, the investor does not have a
resource to get help from others or it is too costly to get help from others.
 Secondly, it is hard for investors to obtain sufficient information for solving the
problem, or maybe the time is limited for investors to make a decision.
 Thirdly, an investor may be not familiar with programs to process the data.
Moreover, the emotional features of the decision might be overwhelming.
Heuristic sometimes can be a powerful tool to find the solution. However, when it was
used inthe wrong situation, it may cause investors to make systematic mental mistakes

Overconfidence
Overconfidence is the tendency that people overestimate their ability. Overconfidence
pertains to how well people understand their own abilities and limits of their knowledge.
In general, people always place too much weight on their efforts, knowledge and skills,
especially when the confidence level is very high.

Familiarity bias
Familiarity is the tendency that people believe in and prefer things that they are familiar
with. Familiarity bias suggests that people’s ability to see events as likely to happen
depend on how they recall specific past information associated with that event. Imagine
that you are asked to buy stocks of a company you know well, and you worked there or
you are a long-term customer, or choose to purchase a company’s stock you never you
heard off or located in another country. Most investors would like to invest their money in
the familiar company, because they think of the companies they are not familiar are
riskier. Simply speaking, investors like to invest something they know. However, the
market does not reward investors with risk premium for “loyalty” or “familiarity”.

Loss aversion
Loss aversion, which is also known as prospect theory, is the tendency that an individual
has stronger desire to avoid losses than experience comparable gains. Loss aversion

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implies how investors make their choices between two alternatives involving risk.
Decision making is sensitive to the way how these alternatives are expressed. Usually,
investors could try to avoid negative choice. For example, if an investor has to make a
decision between a sure loss of 7500 and a 75 percent change of losing l0, 000 and 25
percent chance of losing anything. Most investors will choose the latter one because
investors hate to lose, the uncertain choice holds out the hope that they will not have to
lose.

Hindsight bias
In looking backward at the market loss, investors can exhibit what would be called
selective recall. With the benefit of the selective recall, past event seems obvious.
Investors generally forgot all of thoughts and feelings at that time, and only focused on
the few things that eventually matter. In this way, investors feel that past events seem
extremely easy to predict than it were. This is what we called hindsight bias. Hindsight
bias may damage people’s foresight, because it makes people wrongly expect that the
future can be predict easily too.
Hindsight bias is consisted by three components:
 impressions of inevitability
happens when people are able to identify apparent causes of the event’s
occurrence. If the causes are easily explained, the likelihood of hindsight bias will
increase.,
 impression of foresee ability
engages that the future is foreseeable if there is no surprise associated with the
event that occurred. Otherwise, the hindsight bias will be avoided if the event is
surprising and forecaster finds no apparent clauses for it.
 memory distortion.
People forget what their original forecast was and assumed their forecast was
almost right than inactuality.

Confirmation bias
Confirmation bias is the tendency that investor prefer to interpret the information in the
way that confirms their preconceptions and try to avoid the interpretation that contradict
their beliefs. As a result, investor recalls the information selectively from their memory
and use information to interpret evidences in a biased way.

Confirmation biases can be specified to three types:

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  biased search for information,
 biased interpretation
 and biased memory.
All three types of biases have a similar effect: trying to find the evidence to confirm
their original beliefs.

Anchoring
“In many situations, people make their estimates by starting from an initial value that is
adjusted to yield the final answer. The initial value may be suggested by the formulation
of the problem or the result of a partial computation. That is, different starting points yield
different estimates, which are biases toward the initial value. We call this the
phenomenon anchoring”

Many studies show that anchoring has an extensive impact on people’s decision making
process, and the domain it affects is so broad, such as probability estimates, legal
judgment, valuations, purchasing decision and etc. The types of anchors can be
diversified. Different context can generate different anchoring effect. The research
finding of Epley and Gilovich (2001, 2005) demonstrates that the adjustment process
plays a role when the anchor values are self-generated. Where participants adjust from
the value they know to the right answer. Some other empirical findings show
informational relevance can also play a role in affecting people’s susceptibility to the
anchoring effect. For example, in the legal domain, higher damage awards are obtained
when higher compensations are questions are required in court (Hastie et al., 1999;
Marti and Wissler, 2000). However, some research has found out anchor values also
yield an effect in judgmental decision. For example, the anchoring-and- judgment was
first introduced by Tversky and Kahneman (1974). Mussweiler and Strack demonstrate
that difference between high and low anchors occurred only with anchor values within
the range of plausible answer but not for the implausible or extreme ones. Wegner et al
(2001) propose a new perspective on anchoring based on the process of attitude
change. We can see from the above that when the mechanism or context changed, the
anchoring can be changed as well. (Furnham and Boo, 2011)

Mental accounting
Some literatures demonstrate that “people use “mental account” in multi-attribute
decision situations, wherein individuals form separate, psychological accounts and use

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them to evaluate events or options” (Moon, et al, 1997, p.145). This is what we called
mental accounting bias.
Many researchers try to prove the impact of mental accounting on decision making.
Tversky and Kahneman (1981)’s experimental evidence, which is about purchase of a
jacket and a calculator at the same store, with discount on calculate at alternative store,
exhibits that people make their purchasing decision not only focus how much absolute
money they can save, but also the saving money related to the original price of the
specific item. Later, the result from experiments of Mowen and Mowen (1986), Ranyard
and Abde-Nabi (1993) all show that people’s decision can be affected strongly by mental
accounting. There is no exemption for people to make a decision in finance filed. Mental
accounting can be the explanation of some “anomalies” in the capital market.

Regret avoidance
We can hear investors always say they have learnt from their mistakes all the time. By
making decisions based on speculation, investors are setting themselves up from regret
and biases are trying to avoid whatever causes those regrets. Regret avoidance is
based on the idea counterfactual thoughts that lead to regret. For example, “If only I had
not made the decision to buy that stock or fund when it went down” this is a
counterfactual, because literately it counter the fact.

With regret avoidance, people tend to focus on the poor outcome and blame the
decision that guides them there. A bad decision is driving too fast. Bad outcome for
investor sometime means the loss in their stock portfolio, but that does not mean the
decision drive the stock itself is necessarily bad, because sometime investor can avoid
bad decisions but they may realize they cannot avoid bad outcome. If investors can
analyze the market situation careful, adjust their portfolio and never make decisions
based on speculation, they may eliminate the effect of regret.

Besides the biases we talked above, there are still many behavioral biases affect
investors’ decision making. Only when investors know well what kind of mistake they
may make during the decision making process, they can make a better decision for the
result

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The effect of behavioral biases in financial decision making
Many researches of behavioral finance show that behavioral biases affect investors
when they make financial decisions. These effects affect not only small investors, but
also for those experts who study finance for a long time. Market “anomalies”, which
cannot be explained by traditional finance, seem find their reasonable explanations from
the perspective of behavioral finance.

In this chapter, we are going to look at the effect of behavioral biases from several
categories: Investors, corporation and market.

Investors
Most finance economists think there are two types of investors in the market:
arbitrageurs and noise trader. Arbitrageurs are assumed to be fully rational, but noise
traders are defined investors who are subjected to systematical biases. De Long (1989)
talks that noise trader usually do not take economics’ suggestion to buy or hold the
market portfolio. Instead, they would like to pick stock through their own research.
However, they fail to diversify their portfolio finally, because irrational act or biases can
have an impact on their decision making procedure.

The following is going to show some examples that how the behavioral biases affect
investors:
Overconfidence is a main factor that affects investors’ financial decision making. The
main performance of overconfidence is that investors are overconfident about their
ability, knowledge and under estimate risks. In the research of Kyle and Wang (1997),
they find out that “overconfident traders might earn higher expected profits or have
higher expected utility than rational traders as overconfidence words like a commitment
device to aggressive trading.” However, the advantage of high profit of overconfidence
investor can be attributed to the first mover. The trading volume in the market is
predicted to be high when there are many overconfident investors.

Base on the rational portfolio theory, investor should pay more attention to the expected
utility of a portfolio rather than a specific component in the portfolio. However, there is a
tendency that investor split up their investment into safe account, which is used to
guarantee their lowest wealth level. Investors who make a decision in this way mostly
are affected by mental accounting. This can also explain why there are some mutual

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fund companies recommend constructing portfolio that contains “cash in the bottom
layer, bonds in the middle layer, and stock in the top layer”
Some researches show that investor pay attention to a specific price. Benartizi and
Thaler (1995) argue that this specific price is the price that investors compare to the
current stock price. Most investors prefer to take the purchase price of security as their
specific price, which is known as a reference point. Investors usually wait until the price
of stock arrives at the reference point, then they can start to trade. This kind of investors
is affected by the anchoring bias.

Investor is not the only one that suffers the impact of behavioral bias since they are the
main component of the market. The whole capital market will be affected by the
behavioral bias when most investors in the capital market cannot make rational financial
decision.

Corporation
Behavioral biases affect not only investors’ decisions, but also the decision of a
corporation. Corporation is a type of organization, which is defined by March and Simon
(1993) as a “system of coordinated action among individuals and groups whose
preferences, information, interests or knowledge differ” (p.2). In corporations, firstly,
managers play an important role. They organize the business run into the right track. So
how managers make their financial decision can affect the development of the
corporation directly. Secondly, shareholder’s profit is important, how a corporation set
their financial decision can always affect shareholders’ welfare. On the contrast,
shareholder, bondholders, management, suppliers, customers, etc are a part of
corporation, how they behave can also affect company’s decision making.

Managers
As a manager in a corporation, the financial decision they made must be best for the firm
to grow. However, even for those managers who are experts in the decision making and
afford the responsibility for the development of a corporation, the effect of behavioral
biases still is inevitable. Managers’ decision making procedure still can be influenced by
their behavioural biases. We called it managerial biases when this situation happens. In
the study of Malmendier and Tate (2002), They use the data form Forbes 500
companies to test the overconfidence CEO hypothesis and they find out that most CEOs
are suffered from overconfidence, and this is strongly affected the decision of corporate

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investment. The paper explains the relationship between “investment level and cash flow
levels is the tension between the overconfidence of the CEO and market valuation”
(p.2). After three main steps test, they concluded that “overconfidence has high
explanatory power for the sensitivity of investment to cash flow” (p. 35). The following
two examples also demonstrate that managers’ decisions are affected by the behavioral
biases.

In March 1961, Masaru Ibuka and Akil Morita, the founders of Sony, attended a trade
show in New York. While there, they saw a television screen with the special sharp and
brightest image that they had never seen. The color tube was called the Chromatron.
This screen was belonged to Autometric Laboratory, small subsidiary of Paramount
Pictures. Sony Company wanted to introduce this technology into its product. Morita
negotiated a technical license to make this product, color tube. Ibuka lead to develop a
prototype. By September 1964 Ibuka’s team had a satisfactory result in the prototype but
not in the commercially viable manufacture process. Ibuka had both the optimistic and
confidence. At that time, he had the product announced and invested in a new facility to
house the Chromatron assembly. He thought Chromatron could be their top priority, so
he place 150 people on the product line.

The cost of the Chromatron color television was more than double the retail price of the
product. The sharp difference makes Morita wanted to terminate the product project.
However, Ibuka refused. In November 1966, finance manager of Sony announced that
Sony was “close to ruin”. Then Ibuka agreed to stop the project. There are at least two-
overconfidence and loss aversion behavioral biases that affect Ibuka such expert when
he made his decision. Overconfidence made him stick to his belief that Chromatron color
television would be a success at the end. So he started to invest many labor and finance
resource. Loss aversion bias drove him to keep the project even if the cost was much
higher than the price.

Another case is about Syntex Corporation, a pharmaceutical corporation registered in

Panama in 1944. In 1977, Gabriel Garay, a senior Syntex researcher, created a team to
make new drug, Enprostil. The drug was used to turn off stomach acid and thereby heal
stomach ulcers. In 1978, Syntex won a patent on the compound. The potential market
for enprostil was large. The products help company to yield billions in sales. In the
1980s, it took the company eight years to bring the new drug from a chemist’s bench to

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a pharmacist’s shelf. After the company had invested in the research of enprostil,
evidence began to show the side-effect of the enprostil. An internal Syntex memo
warned that the enprostil may provoke fatal. The former executives of Syntex stated, the
result was that the company “failed to pull the plug early enough on weak products, for
example, it poured more than 100 dollar million into the anti-ulcer drug enprostil in the
late 1980s before shelving it ”.

From this case, it is reasonable to speculate that loss aversion is the reason why Gabriel
Garary did not want to terminate the project. However, this is not the truth. The person
who should be responsible to terminate the project was John Fried, who was the vice
chairman of the corporation and the president of Syntex research division. The initial
memo from the laboratory had ordered to be rewritten by him.

In 1985, Syntex had a new drug application for enprostil pending with the food and drug
administration. The company had invested a lot in enprostil and it continued to do so. In
1987, the enprostil was reported that the mechanism was discovered in the drug. This
mechanism can cause some serious problems in veins and arteries, so it may cause
heart attack to patients. In court, Fried admitted that the project did not make any
progress; instead, the project was going around in the circle.

Fried repeatedly dismissed unfavorable study report on enprostil is a performance of

confirmation bias. He looked for the information that can confirm his belief that their
project would be success finally, and was trying to avoid the information opposite.
Overconfidence and loss aversion also play a role in his decision making process. He
over believe that the project would be a success and scared to loss what they had, these
biases lead him go to the failure.

Dividend policy
In the Modigiani-Miller (MM) theory, the starting point in the traditional finance, states
that corporation structure and dividend policy are not affected by the corporation’s
operation or its market value under the condition that no transaction cost, tax or other
frictions. However, the assumption of MM theory is not realistic. In practice, taxes,
transaction cost and other friction do exist, so they can affect the financial decision of the
corporation. Besides, shareholders have different preference of the dividend distribution;

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their preference can influence the policy. From the behavioral biases perspective, it may
explain the “dividend puzzle”.

In the early paper of Black (1976), he uses the term “dividend puzzle” to show the poor
understanding of dividend policy. Theoretically, shareholders are supposed to have no
cash dividends when dividends are taxed at a higher rate than capital gain. Instead, in
reality, shareholders complained a lot when dividends are cut. Concerned about this
puzzle, there are some economists try to give a rational explanation. In the book of
Baker and Nofsinger (2010), it mentions “dividend may be an optimal way to reduce
transaction costs to shareholders in managing their funds” and “distributing dividends
might be an appropriate way to encourage investment” (p.437). It is still under discussion
that whether rational theories can explain this puzzle.

Shefrin and Stateman (1984) offer a new explanation from behavioral biases
perspective. They believe that mental accounting and self –control is the reasonable
explanation for this puzzle. Mental accounting can be explained that “dividends can be
saved as a separated gain when the stock price rises and used as a silver lining if the
price drops”. Self-control can be explained that investors want the dividends. They would
like to control their own money and resist dipping into capital. By adding the human
psychology into consideration, dividend puzzle seems find its reasonable reason. It
demonstrated that a corporation should pay careful attention on human behavior.

Mergers & Acquisitions

Theoretically, a merger between an acquiring firm and a target firm is to achieve the
synergies. So when the synergy is positive, acquiring firm could go for it. Moreover, in
the tradition principles of Mergers and acquisitions, prices in the market are efficient.
There is no difference for a corporation to use cash or stock for acquisition.

However, some evidences in fact show that managers in corporation do suffer the effect
of biases. Most of them are overconfidence or optimistic about the decision they make.
Shefrin (2007) also mentions that “firms whose executives qualify as excessively
optimistic and overconfident are 65% more likely to have completed and acquisition than
firm whose executives do not so qualify. Overconfidence executives press on with an
acquisition, even when the reaction in the market is negative” (p.162).

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McKinsey and Co (2005) find that there is 70% of the cases that managers intend to
acquire corporation operating in different industry since they are overconfident about the
synergy from the diversifying mergers. The poor assumptions that managers could make
and too optimism about the opportunity on cross-selling are also the reason that
managers overestimate the synergy,

Shefrin (2007) claims that the heuristic influence managers when they are making a
decision of M&A. “Some managers base their acquisition decision on intuitive judgment;
try to do some particular deals no matter what. These managers either fail to undertake
formal valuations or else weak the numbers to support the decision that they wish to
make” (p.164) Paying by cash or stock could be matter when managers are excessive
optimism and overconfident. Shefrin (2007) analyzes this case in the situation when the
manager of the acquiring firm is overconfident, but the manager of the target firm is
rational. He finds out that the value of the acquiring firm and the amount of synergy will
be overestimated since the manager is overconfident. As a result of that, they will
overpay for an acquisition. During this process, there might be a dilution cost appear.

What the overconfident manager has to concern is the synergy is excess the dilution
cost. Otherwise, the acquisition may not occur. Meanwhile, if the payment is by cash,
overconfident managers perceive no dilution cost, they do if the payment is stock.

Capital budgeting
Capital budgeting can be an important step in the success of a project of a corporation
since it helps the corporation to decide a new investment is worth. During the capital
budgeting process, the set and size of a corporation’s real asset is relevant, the cash
flow it generated can determine the profit and value of the project.

There are several methods for a manager to use in capital budgeting. Such as
profitability index, accounting rate of rate. However, the most common method is Net
Present Value (NPV). No matter which methods corporations take, their investments
decision should get benefit for their shareholders.

In Net Present Value method, manager can assess the expected value they get from the
project. Generally, managers would accept the positive result and reject the negative
result. However, this process greatly affected by the expectation of future cash flow, so

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having a correct future cash flow expectation is critical to making the right decision.
Expectation of future cash flow is very subjective process since it comes from manager’s
prediction. The behavioral biases effect is inevitable.
Overconfidence can be the main effect in this process. Studies find that individuals are
overconfidence that they tend to overestimate the precision of their ability and
information. In fact, research of Russo and Schoemaker (1992) shows that manager
tends to have deeply rooted overconfidence in their beliefs and practices. In their paper,
they also explore the cognitive factors that cause overconfidence. The main reason is
that it is difficult for people to image all the ways that events can unfold. This is called
availability bias. “Because we fail to envision important pathways in the complex net of
future events, we become unduly confident about predictions bases on the fewer
pathways we actually do consider”(p.11). Second factor is anchoring bias, which can be
explained that we give our best guess before we give a ballpark range or confidence
interval.

Third factor is confirmation bias. Manager always look for the information to support their
idea, unfortunately, when the condition is uncertain and decision is more complex, it is
easier to find one side support. From the perspective of capital budgeting, there are
some ways to explain why the manager to be overconfidence in general. In the study of
Gervais (2009), he claimed first, capital budgeting is complex process and condition in
the process is uncertain. Second, “capital budgeting decisions are not well suited for
learning” (p. 2). Third, “unsuccessful managers are less likely to retain their jobs and be
promoted; those who succeeded may become overconfident because of a selfattribution
bias” (p. 2).

There are still some corporation situation that cannot be explained by traditional finance,
for instance, dividend smoothing, stock dividend, and so on. However, if taking human
behavioural biases into consideration, it can help economist to find a reasonable
explanation.

Market
The appearance of market anomalies starts to shake the position of Efficient Market
Hypothesis. The market is not efficient as economists used to think in the traditional
finance. Investors’ irrational financial decision can change situation of the whole capital

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market that it is supposed to have in EMH. In this section, the paper is going to talk
about some applications of behavioural finance on the capital market.

Capital structure
Capital structure has been a controversial problem in finance recently. There are many
approaches that comprised the theory of capital structure. Nevertheless, in practice,
some phenomenon cannot be explained by theories. Those theories mostly are based
on the traditional classical theory, which is rational assumption. Anomaly leads some
researchers start to find other solution, and they found that the human factor maybe the
way to solve those issues.

Baker, Ruback and Wurgler (2004) claim their research on behavioral finance can be
divided into two approaches: the irrational investors and irrational managers. The first
state of approach is irrational investors and rational manager. Irrational investors make
the wrong decisions which can affect the securities' price. However, rational manager
can recognize the mispricing and take advantage of irrational investors. Since manager
gets more information than investors does, it is easy for managers to identify the
mispricing. We can attribute this to asymmetry information.

The determinant of capital structure (market timing) can be the application of this state.
Since the rational managers have sufficient information, when the price much higher
than it is true value, manger can take the opportunity to issues new stocks. (Vasiliou and
Daskalakis)

The second approach is irrational manager and rational investors. Within this stage,
managers are assumed to be overconfidence. They are over optimism about the firm’s
asset and investment opportunity. Baker, Ruback and Wurgler (2004) assert that
overconfidence manager would never issue new stock since the investors are rational
and the capital market is efficient. The capital structure decision will focus on the internal
fund and debt. (Vasiliou and Daskalakis)

Baker and Wurgler (2002) state that market timing can be the determinant of capital
structure. In the finance, market timing “refers to the practice of issuing shares at high
prices and repurchasing at low price” (p. 5). In other word, market timing is to buy or sell
the financial asset at a favorable time. Barberis and Thaler (2002) also study market

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timing in their behavioural finance research. They conclude that the success framework
on market timing may be the basis of a successful theory of capital structure. Their
paper also shows that irrational investors do affect financing decision.
The useful of market timing does support that the market is not efficient. It also threatens
to the traditional finance theory. When investors make irrational decisions, it can lead the
anomalies appeared in the capital market. Capital structure could be a good example.

Accumulate anomalies which caused by many irrational investors, lead the researches
start to looking for the solution from human factors.

Initial Public Offering

Initial public offering is a crucial step for a company especially for those small young
companies. It is when companies start to offer stocks or bond to the public to expand
their capital finance. However, there are some evidences show that the share price of
IPO firms is under priced at the first day, which means there is a significant difference
between the offer price and price sold at the closing-end market. Under-pricing of IPO
has been seen as an anomaly and studied by a large of economists for many years.

Underpricing of IPO happened “when companies is going to public the shares they tend
to sell is underpriced, in that the share price jumps substantially on the first day of
trading”. As a result, it is quite costly to the owners of IPO Company since “shares sold
for personal accounts are sold at too low a price, while the value of shares retained after
the IPO is diluted” (Ljungqvist, 2006, p. 1). It causes a situation that “money left on the
table” for IPO company.

Many economists try to explain the situation in a reasonable way. Some researchers
doubt about the information asymmetry, some researchers studied from the perspective
of risk of lawsuits, some stand at the ownership and control’s point to observe the whole
case. As a consequence, some researchers suggest that behavioral biases might be the
better explanation for the IPO under-pricing. From the behavioral explanations’
perspective, many economists assume that “either the appearance of irrational investors
who bid up the price of IPO shares beyond true value, or that issuers are subject to
behavioral biases and fail to put pressure on the underwriting banks have under-pricing
reduced”.

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Ljungqvist, Nanda, and Sing (2004) think that investors are not rational. They assume
that some investors overoptimistic about the future prospects of the IPO companies.
However, from the issuers’ perspective, why do those issuers never mind putting their
money on the table? Loughran and Ritter study the puzzle in 2000. They propose the
prospect theory (Loss aversion) to explain the situation. In their paper, why issuers do
not get upset about leaving money on the table in IPO, it remarks: “the theory assumes
that issuers care about the change of their wealth, rather than the level of wealth” (p.2).

So in the case of under pricing of IPO, the theory can help to predict that “issuers will
sum the wealth loss from leaving money on the table with the large wealth gain from a
price jump, producing a net increase in wealth for pre-issued
shareholders”(Lijungqvist,2006, p. 2). According to the paper of Loughran and Ritter
(2000), underwriters would like to choose a lower offer price because the investment
bankers can get some benefits: they can find buyer for IPO easier, and it reduces the
marketing cost; investors can improve their priority for being allocated in hot IPO by
engaging in rent-seeking behavior.

Most “Gordian Knot” that cannot be explained by traditional finance, as we can see from
the examples above, have their reasonable explanation in the view of behavioral
finance. They also show that the effect of behavioral biases exist not only on the
individual investor but also on the whole capital market. As Baker and Nofsinger (2010)
mention in their textbook, it is always hard to prove that people are entirely rational no
matter from theoretical or empirical perspective, especially when the condition is
uncertain. However, does it mean that there is no way to deal with or reduce the effect of
behavioral biases?

The solution of behavioral biases

People all have their own behavior and that can affect how they trade. From the
previous chapter we can see that the effect of behavioral biases in financial decision
making can have some consequences: first, it is very costly for an investor or a
corporation if they make an irrational decision. Second, anomies disturb the
development of the capital market, market is inefficient. Third, theoretically, it repudiates
the traditional finance. Maybe you are wondering is there any solution to overcome

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these behavioral biases. That is the main question we are going to explore in this
chapter.

Generally speaking, there is no one specific solution to cure all the behavioral biases at
the same time, since each behavioral bias has its own characteristic and representative.
However, we can learn the method from some specific bias, in order to deal with the
biases when the similar situation occurs in the future. Following are some
recommendation that researchers gave on behavioral biases.

In the procedure of trying to reduce the effect of hindsight biases, Goodwill (2010) cites
that “there are some evidences shows that the hindsight biases can be reduced if an
individual can explain how events, which did not actually occur, could have occurred” (p.
7). Wallace, Change, and Carroll (2009) also find out that hindsight bias can be reduced
if people work hard to gain the new knowledge, and it can cause them to reduce their
perception of the level of past knowledge. Through learning the new knowledge, people
will not think that they “know it all along”.

In the reality, people like to use “‘reference point’ view of mergers which holds salient but
largely irrelevant reference point stock price of the target help to explain mergers and
acquisitions” (Baker, Pan and Wurgler, 2009, p.2). This way is always affected by the
individual’s psychology. Baker and Xuan (2009) also find out that mangers prefer to use
the price when they entered the company as a fundamental reference point. They claim
“mangers see the firm through the lens of their experience. In the case of raising capital,
the share price at the arrival of the manager serves as an important referent point” (p.1).

Trying to reduce the biases in mergers and acquisitions, Dessint claims that the fairness
opinion might be helpful to reduce the behavioral bias in Mergers and Acquisitions.
According to his paper, fairness opinions are “third-party assessments, usually
performed by an investment bank, on the fairness of the financial terms of a mergers or
acquisitions, especially with regard to price” (p. 5). In his research, the author thinks
since the fairness opinion is expressed by the finance experts, it should help companies
to reduce “the psychological influence of the target 1-year high price as a salient
reference point on the financial terms of M&A transaction”(p. 4). The result showed that
the fairness opinion is reliable and can reduce behavioral biases when “there are at least
two opinions, one used by the target company and the other one used by the acquiring

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firm, respectively issued by an external expert who does not act as financial advisor on
the transaction”(p. 4)
Besides the methods mentioned above in the specific situation, Kahneman, Tversky,
and Flyvbjerg develop a method, which is called Reference class forecasting, to
eliminate or reduce the behavioral bias on decision making.

Reference class forecasting method can help the decision to be more precise in
projections by “basing on the actual performance in a reference class of comparable
actions” (Flyvbjerg, 2008, p. 1). Reference class forecasting is based on the Daniel
Kahneman and Amos Tvesky’s (1979a, 1979b; Kahneman, 1994) theories of planning
and decision-making under uncertainty. In Kahneman and Tvesky’s theory work, they
find a systematic fallacy in the procedure of decision making, which is that people in
general is too optimistic about their judgment due to overconfidence and take insufficient
information into the consideration about the outcome. “They underestimate the costs,
completion times, and the risk of planned actions, whereas they overestimate the benefit
of the same action” (Flyvbjerg, 2008, p. 2). Kahneman argues that this fallacy caused
from “actors focus on the constituents of the specific planned action rather than on the
outcomes of similar actions already complete” (Flyvbjerg, 2008, p. 2). He recommends a
cure for the fallacy by using the distributed information from previous, similar ventures.

They suggest that forecasters “should therefore make every effort to the forecasting
problem so as to facilitate utilizing all the distributional information that is available”
(Kahneman and Tversky 1979b, p. 316). Based on the theory of Kahneman and
Tversky, Flyvbjerg develops the method of reference class forecasting to use in the
practice. When it comes to a specific project, the following three steps are involved:
1. Identify the relevant reference class of past, similar project. The class
must be broad enough to be statistically meaningful but narrow enough
to be truly comparable with the specific project.
2. Establishing a probability distribution for the selected reference class.
This requires access to credible, empirical data for a sufficient number
of projects within the reference class to make statistically meaningful
conclusions
3. Comparing the specific project with the reference class distribution, in
order to establish the most likely outcome for the specific project.
(Flyvbjerg, 2008, p. 8)

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Let us apply the method into a simple case. A manager at a chemical company is
considering a new investment to introduce the new technology to their plant. According
to the reference class forecasting, the first step the manager should do is to identify the
relevant factors of past, similar project. In this case, the investment will be made
depends on whether the general outcome of the company can be increased or not. The
manager should look at other chemical plants build with the new technologies, because
technology has a strong influence on the outcome of an industry (Lovallo and
Kahneman, 2003).

After they have identified their relevant reference class, they should focus on the
distribution for the elected reference class. The chemical manager should study the
income distribution of plants with new technology. For those plants with new
technologies, how much they gain on average, the extreme and the median income
(Lovallo and Kahneman, 2003).

Based on the study the manager has, the third step is to compare the project with the
reference class distribution. The manager should understand the data they have,
analyze their specific situation, and predict where they could fall on the distribution. In
order to make sure the result ismore accurate, the manager can estimate the correlation
between forecast and actual result based on the historical precedent, and improve their
forecast (Lovallo and Kahneman, 2003).

Preference class forecasting has also been recommended by American Planning

Association (APA) in order to improve the quality of forecast and accuracy. Trying to
overcome the effect of behavioral bias in financial decision making is a not easy. The
wise way is to keep learning and to know you better. Collect information sufficiently and
analyze the market objectively, it may help you to reduce the effect of biases.

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