Overview

Fundamentally, behavioral finance is about

understanding how people make decisions,
both individually and collectively. By
understanding how investors and markets
behave, it may be possible to modify or
adapt to these behaviors in order to
improve economic outcomes.

Why is B.F. necessary?

Financial Calculation is based on some logical
theory like CAPM and EMH, while these theory
could explain certain "idealized" events,the real
world is MESSY .
People behave unpredictably and irrationally
when it comes to investment, theories dont help
to get the result.
A person can make profit in both up and down
market, by combining conventional and modern
theory of Behavior Finance

Investment Decision Cycle

Anchoring :
The assumptions of rationality says that
our thoughts and opinion should always be
based on relevant and fact. In reality,
however, this is not always so rather.
People have a tendency to attach or
anchor their thoughts to a reference
point even though that may hardly have
any logical association with the decision at
hand.
It actually doesnt mean that investor will
not change his mind.

Continue..

Over-confidence:
People are generally overconfident
regarding their ability and knowledge. They
tend to underestimate the imprecision of
their beliefs or forecasts, and they tend to
overestimate their ability.
overconfident investors generally conduct
more trade as they believe they are better
than others at choosing the best stocks and
best times to enter or exist a position.
Thus, overconfidence can cause investors
to under-react to new information and that
leads to earn significantly lower yields than

Continue..

Herd Behavior:
Herd behavior is the tendency of individual to
follow the actions (rational or irrational) of a
larger group. This herd mentality is the result of
two reasons. Firstly, there may be a social
pressure of conformity. Most people do not want
to be outcast from the group they belong.
Secondly, there is a common rational that a
large group is unlikely to be wrong.
Purchasing stocks based on price momentum
while ignoring basic economic principles of
supply and demand is known in the behavioral
finance arena as herd behavior and that leads to
faulty decision.

Continue..

Over and under-reaction :

Disproportionate reaction to news, both
good and bad has been often seem in the
financial market. They tend to become
more optimistic when the market goes up
and more pessimistic when the market
goes down. Irrational optimism and
unjustified pessimism are shown in over
and under-reaction of investors.

Continue..

Loss Aversion:
It means that investor is risk seeker when
faced with respect of loss, but becomes risk
averse when faced with the prospects of
enjoying gains. Khaneman has said that
investors are Loss aversion. This Loss
Aversion means that people are willing to
take more risks to avoid loss than to realize
gain.

Continue

Financial Cognitive Dissonance : (the state of having inconsistent

thoughts, beliefs, or attitudes, especially as relating to behavioral decisions and
attitude change.)

Decision making is the most complex and challenging activity

of investors.
Every investor differs from the others in all aspects due to
various factors like demographic factor, socioeconomic
background, educational level, gender, age and race.
Cognitive dissonance is the perception of incompatibility
between two cognitions, which can be defined as any element
of knowledge including attitude, emotion, belief or behavior.
Festinger theory of cognitive dissonance states that individual
attempts to reduce inner conflict in one of the two ways: (i) he
changes his past values, feelings or options; and (ii) he
attempts to justify or rationalize his choice.

Strategies for Overcoming Behavioral Finance

Understanding behavioral finance will help the
investor to select a better investment
instrument and they can avoid repeating the
expensive error in future.
Stock Investments
Investors should keep detailed records of the
specific stock which was purchased for their
portfolio. Investors should also decide specific
criteria for making an instant decision to buy,
sale or hold.
Investor should keep in mind certain
questions and its answers e.g.

Continue..

(i) Why investors purchase the stock?

(ii) What is the time horizon of the investment?
(iii) What is the expected rate of return?
(iv) After one year the stock has under-performed
or over-performed.
(v) Do you plan on buying, selling or holding your
position?
(vi) How risky is this stock within your overall
portfolio?

Mutual Fund Investment

Mutual Fund Investors selects M.F. on following
steps,
(i) Invest in only no-load mutual fund with low
operating expense;
(ii) Look for funds with a strong historical track
record over 5-10 years;
(iii) Invest with tenured Portfolio Manager with a
strong investment philosophy; and
(iv) Understand the specific risk associated with
each mutual fund.

Continue..

THE DISPOSITION EFFECT:

Investors tend to retain losing securities for too long

a period. On the contrary, they tend to sell off
profitable securities too soon.
MENTAL ACCOUNTING:

Investors often ignore the fungibility of money. They

irrationally and illogically assign different values to
money obtained from different sources and also on
the basis of intended use. Investors often save
money in low-interest bearing accounts for a
purpose they perceive to be more important while
they are still having loan to repay and thus reduce
their wealth. Money received from gift, windfall gains
or bonus is considered to be cheaper than earned
money. Thus such unearned money is spent more
than earned money.

Continue.

CONFIRMATION BIAS:
Investors willfully look for such information which
supports his / her idea about any security. They shun or
do not look for any information to the contrary. Thus
decisions are often taken on incomplete information
leading to erosion of wealth.
HINDSIGHT BIAS:
The investor believes that some past event was
predictable though in fact it was not. Such faulty belief or
bias may lead to establishing false casual relationships
which may end up in incorrect oversimplifications .

GAMBLERS FALLACY:
The investors believe that if something has
happened recently, the probability of an opposite
phenomenon increases and the probability of a
similar phenomenon increases.

Continue

AVAILABILITY BIAS:
Investors tend to allot more importance to recent information
than on relatively past information. Thus they focus on the
short-term perspective and miss out on the longterm picture.
Thus they are willing to assume more risks after a gain. On the
contrary they are willing to assume les risks after a loss.
INNUMERACY:
Investors may have a phobia about numbers. They usually
want to avoid numerical processing of data. This robs them off
the quantitative analytical tools which are so essential for
successful investing.
HEURISTICS:
Investors often resort to rules of thumb which makes their
decision making process easier. Benartzi & Thaler (2001)
detected that many investors follow the 1/N rule which
encompasses the simple rule of thumb that when there are N
alternatives for investment, 1/N amount of money should be
invested in each of the alternatives.

Continue..

REGRET THEORY:
Regret theory of choice under uncertainty
was put forward by Graham Loomes &
Robert Sugden (1982). When applied to
investor behavior, this theory postulates
that in case of losses due to erroneous
decisions, investors regret more if the loss
was due to an unconventional decision
rather than a conventional decision.

Asymmetric Perception of Gains and losses

Losses loom larger than equivalent Gains,

Gains loom larger than equivalent nonlosses
The gain vs non-loss asymmetry in
perceived satisfaction is stronger in
promotion focus, while the loss vs non-gain
asymmetry in perceived dissatisfaction is
stronger in prevention focus

Discounting Factors

Hyperbolic discounting :
It refers to the tendency for people to
increasingly choose a smaller-sooner
reward over a larger-later reward as the
delay occurs sooner rather than later in
time. When offered a larger reward in
exchange for waiting a set amount of time,
people act less impulsively (i.e., choose to
wait) as the rewards happen further in the
future. Put another way, people avoid
waiting more as the wait nears the present
time. Hyperbolic discounting has been
applied to a wide range of phenomena.

continue

Continue.

Exponential discounting :
It implies that the marginal rate of
substitutionbetween consumption at any pair of
points in time depends only on how far apart those
two points are. Exponential discounting is
notdynamically inconsistent.
Hyperbolic discounting is a particular
mathematical model devised as an improvement
over exponential discounting, in the sense that it
better fits the experimental data about actual
behavior. But note, the time inconsistency of this
behavior has some quite perverse consequences.
Hyperbolic discounting has been observed in both
human and non-human animals.

Continue.

Continu

Time

Value of Money:
Future Value : Present Value X
Present Value: Future Value
F.V. Annuity: P[-1/r]
F.V. Growing Annuity : P[-/r-g]
P.V. Annuity: P

[/r]

P.V. Growing Annuity: C/r-g []

Traditional Finance and Behavioral Finance

Behavioral Finance challenges the

simplistic view of investors and markets
held by traditional finance.
A typical conclusion is that behavioral
finance is used when one tries to describe
the actual behavior of an average investor,
however rational advice should be based
on traditional finance.

Continue.

Traditional
Finance
focuses
onhowindividuals should behave. Individuals
are considered as being Rational Economic
Men. This leads to markets where prices reflect
all available relevant information.
Behavioral Finance recognizes that the way
the information
is presented to investors
can affect how they make decisions and it can
lead to emotional and cognitive biases.
Behavioral Finance focuses onwhy investors
behave the way they do. Since investors
decisions are not always optimal, this results in
markets that are temporary or persistently
inefficient.

Continue

Traditional Finance requires integrating all

assets into one huge account so that a clever
investor can always benefit from the diverging
movements of the various components .
Behavioral finance is mental accounting
,according to
which the great asset
allocations problem is split up into a couple of
smaller problems across which diversification is
not optimally adjusted.

Deciding Mental Accounting rationality

depends on whether the advantage of
diversification is worth risk taking , due to
complexity of the great asset allocation
problem . Its better keeping separate mental
account for the risk free asset.

Micro Behavioral Financedeals with

individuals. It attempts to explain why
individuals deviate from the Traditional Finance
theory.
Macro Behavioral Financedeals with
markets. It attempts to explain why markets
deviate from efficient markets.
Traditional Finance is based on neoclassical
economics. It assumes individuals are riskaverse, have perfect utility function and focus
on maximizing the personal utility function.
Hence, Rational Economic Men create
efficient markets.

Traditional Finance is based on utility theory

with the assumption of diminishing marginal
returns. This means that risk-averse utility
functions are concave. The indifference curves
are convex due to diminishing rates of
substitution.
Behavioral Finance observes that individuals
sometimes can have both risk-averse and riskseeking behaviors.

Traditional Finance assumes:

Unlimited prefect knowledge
Utility maximization
Full rational decision making
Risk aversion
Behavior Finance assumes:
Bounded Rationality and Prospect Theory
Capacity limitations of knowledge
Cognitive limitations on decision making
Satisfice instead of Optimize
Prospect Theory: views of gains & losses
versus returns and risk.

Weber Law
Weber found that thejust noticeable differencebetween two
weights was approximately proportional to the weights. Thus,
if the weight of 105 g can be distinguished from that of 100 g,
the differential threshold is 5 g. If the mass is doubled, the
differential threshold also doubles to 10 g, so that 210 g can
be distinguished from 200 g.
In this example, a weight seems to have to increase by 5% for
someone to be able to reliably detect the increase, and this
minimum required fractional increase (of 5/100 of the original
weight) is referred to as the "Weber fraction" for detecting
changes in weight.
Other discrimination tasks, such as detecting changes in
brightness, or in tone height (pure tone frequency), or in the
length of a line shown on a screen, may have different Weber
fractions, but they all obey Weber's law in that observed
values need to change by at least some small but constant
proportion of the current value to ensure human observers will
reliably be able to detect that change.

Utility / Preference Function

To understand Utility Theory , firstly we need to understand
Prospect Theory.
Definition;
Decision making under risk can be viewed as a choice
between prospects or gambles."
Prospect theory has probably done more to bring psychology
into the heart of economic analysis than any other approach.
Prospect theory has gained much ground in recent years, and
now certainly occupies second place on the research agenda
for even some mainstream economists. Unlike much
psychology, prospect theory has a solid mathematical basis
making it comfortable for economists to play with.
However, unlike expected utility theory which concerns itself
with how decisions under uncertaintyshouldbe made (a
prescriptive approach), prospect theory concerns itself with
how decisions areactuallymade (a descriptive approach).

continue,

We have an irrational tendency to be less

willing to gamble with profits than with
losses..
This means selling quickly when we earn
profits but not selling if we are running
losses
individuals do not assess risky gambles
following the precepts of von NeumannMorgenstern rationality. Rather, in
assessing such gambles, people look not
at the levels of final wealth they can
attain but at gains and losses relative to
some reference point, which may vary

Continue.

prospect theory deals with the way we frame

decisions, the different ways we labelor code
outcomes, and how they affect our attitude toward risk
Prospect theory helps explain how loss aversion, and
an inability to ignore sunk costs, leads people to take
actions that are not in their best interest. The sting of
losing money, for example, often leads investors to pull
money out of the stock market unwisely when prices
dip.
In a nutshell, prospect theory assumes that investors'
utility functions depend onchangesin the value of
their portfolios rather than the value of the portfolio.
Put another way, utility comes from returns, not from
the value of assets.

Continue

Prospect theory was developed by Daniel Kahneman and

Amos Tversky (1979), and it differs from expected utility
theory in a number of important respects. First, it replaces
the notion of utility with value.
Whereas utility is usually defined only in terms of net
wealth, value is defined in terms of gains and losses
(deviations from a reference point).
Unlike expected utility theory, prospect theory predicts
that preferences will depend on how a problem is framed. If
the reference point is defined such that an outcome is
viewed as a gain, then the resulting value function will be
concave and decision makers will tend to be risk averse. On
the other hand, if the reference point is defined such that
an outcome is viewed as a loss, then the value function will
be convex and decision makers will be risk seeking.

Continue

Prospect theory also differs from

expected utility theory in the way it
handles the probabilities attached to
particular outcomes. Classical utility
theory assumes that decision makers
value a 50 percent chance of winning as
exactly that: a 50 percent chance of
loosing. In contrast, prospect theory
treats preferences as a function of
decision weights, and it assumes that
these weights do not always correspond
to probabilities. Specifically, prospect
theory postulates that decision weights

Continue

As per Daniel Kahneman and Amos Tversky

Case 1 : a. 25% chances of winning 3,000
b. 20% chances of winning 4,000
65% will choose later
Case 2 : a. 100% chances of winning 3,000
b. 80% chances of winning 4,000
80% chances chose the former .

Expected Utility Theory

Expected Utility Theory (EUT) states that the decision
maker (DM) chooses between risky or uncertain
prospects by comparing their expected utility values.
Expected utility is an economic term summarizing
theutilitythat an entity or aggregate economy is
expected to reach under any number of circumstances.
The expected utility is calculated by taking
theweighted averageof all possible outcomes under
certain circumstances, with the weights.
It involves explicit use of a utility function, an expected
utility hypothesis and the presumptions of diminishing
marginal utility of money.

Continue

According to Gabriel Cramer(1728),

mathematician evaluate money in
proportion to its quantity , while , in
practice, people with commonsense
evaluate money in proportion to the utility
they can obtain from it.
Daniel Bernoulli(1738) in his landmark
article wrote;
The determination of the value of an item
must not be based on the price, but rather
on utility it yields. There is no doubt that a
gain of one thousand ducats is more
significant to the pauper(poor) than to a

Continue..

A common utility model, suggested by

Bernoulli , is the logarithmic function
U(W)=In(W) , known as log utility

It is a function of the gamblers total

wealth W, and the concept of diminishing
marginal utility of money is built on it.
Under EUT function will be,
In(wealth after the event)- In(wealth before
the event)

Decision making under RISK and

UNCERTAINTY
For example, suppose there is a gamble in
which the probability of getting a $100 payment
is 1 in 80 and the alternative, and far more
likely, outcome, is getting nothing. Then the
expected value of this gamble is $1.25. Given
the choice between this gamble and a
guaranteed payment of $1, by this simple
expected value theory people would choose the
$100-or-nothing gamble. However, under
expected utility theory, some people would be
risk averse enough to prefer the sure thing,
even though it has a lower expected value,
while other less risk averse people would still
choose the riskier, higher-mean gamble

Continue..

The expected utility theory takes into

account that individuals may be
risk-averse, meaning that the individual
would refuse a fair gamble (a fair gamble
has an expected value of zero). Risk
aversion implies that their utility
functions areconcave(sink)and show
diminishing marginal wealth utility. The
risk attitudeis directly related to the
curvature(turned curvy) of the utility
function: Risk Neutral individuals have
linear utility functions, while risk seeking
individuals have convex utility functions

Continue

A decision that maximizes expected

utility also maximizes the probability of
the decision's consequences being
preferable to some uncertain threshold.
In the absence of uncertainty about the
threshold, expected utility maximization
simplifies to maximizing the probability
of achieving some fixed target. If the
uncertainty is uniformly distributed, then
expected utility maximization becomes
expected value maximization.

Allias Paradoxes

The Allias paradox is a choice problem designed by

Maurice Allais to show an inconsistency of actual
observed choices with the predictions of EUT.
It can be explained by this table:
Experiment 1
Gamble 1A

Experiment 2

Gamble 1B

Gamble 2A

Gamble 2B

Winnin
Winnin
Winnin
Winnin
Chance
Chance
Chance
Chance
gs
gs
gs
gs

$1
million

100%

$1
million

89%

Nothing

1%

$5
million

10%

Nothing

$1
million

89%

11%

Nothing

90%

$5
million

10%

Continue

Several studies involving hypothetical and small monetary

payoffs, and recently involving health outcomes, have
supported the assertion that when presented with a choice
between 1A and 1B, most people would choose 1A.
Likewise, when presented with a choice between 2A and 2B,
most people would choose 2B. Allais further asserted that it
was reasonable to choose 1A alone or 2B alone.
However, that the same person would choose both 1A and
2B together is inconsistent with expected utility theory.
The inconsistency stems from the fact that in expected
utility theory, equal outcomes added to each of the two
choices should have no effect on the relative desirability of
one gamble over the other; equal outcomes should "cancel
out". Each experiment gives the same outcome 89% of the
time. If this 89% common consequence is disregarded,
then the gambles will be left offering the same choice.

continue

Experiment 1

Gamble 1A

Experiment 2

Gamble 1B

Gamble 2A

Gamble 2B

Winnin
Winnin
Winnin
Winnin
Chance
Chance
Chance
Chance
gs
gs
gs
gs
$1
million

$1
million

89%

$1
million

89%

Nothing

1%
$1
million

11%
$5
million

Nothing

10%

89%

Nothing

89%

Nothing

1%

$5
million

10%

11%

Continue

The independence axiom states that two identical

outcomes within a gamble should be treated as
irrelevant to the analysis of the gamble as a whole.
However, this overlooks the notion of complementarities,
the fact your choice in one part of a gamble may depend
on the possible outcome in the other part of the gamble.
In the above choice, 1B, there is a 1% chance of getting
nothing. However, this 1% chance of getting nothing also
carries with it a great sense of disappointment if you
were to pick that gamble and lose, knowing you could
have won with 100% certainty if you had chosen 1A. This
feeling of disappointment, however, is contingent on the
outcome in the other portion of the gamble (i.e. the
feeling of certainty). Hence, Allais argues that it is not
possible to evaluate portions of gambles or choices
independently of the other choices presented, as the
independence axiom requires, and thus is a poor judge
of our rational action.

Mathematical proof of inconsistency

Experiment 1
1.00U($1M)>0.89U($1M)+0.01U($0M)
+0.1U($5M)
Experiment 2
0.89U($0M)+0.11U($1M)<0.9U($0M)
+0.1U($5M)

Elsbergs Paradoxes
The Ellsberg Paradox explains why we aim low
and settle for the mediocre.
For example:
Youre in a room with two large vase. The vase are
covered so you cant see inside them. But you
know the vase on the left contains 50 white
marbles and 50 black marbles. The vase on the
right also contains 100 marbles, but the ratio of
white to black marbles is unknown, with every
ratio as likely as any other.
Heres the game:If you can draw a black
marble in one pick, without looking, you win
$100.
Which vase will you choose?

 What Ellsbergfound is that

Peopleoverwhelminglychoose to draw the
ball from the vase with a known set of
probabilities, rather than take a chance on the
vase with an unknown ratio.
This is despite the fact that the second vase
could have better odds of drawing black
marbles, like 99 to 1 or even 100 to no white
marbles. Of course, the ratio in the unknown
urn could also be tilted in the other direction.
Theres no way of knowing.
The fact is, the probability of drawing a black
marble from either vase isidentical.

4 Ways the Ellsberg Paradox Inhibits

YourDecision-Making

1.You Stick With a Known Situation,

Even if Its Bad for You
Wonder why so many of us are stuck in the9
to 5 grind, sinking inruinousdebt, while our
dreams keep getting put on the backburner?
The Ellsberg Paradox suggests a
reason:Human beings are so risk averse
that we choose to stick with bad
situations rather than face
uncertainty.Uncertainty is scary.
But is fear of the unknown going to keep you
stuck in a situation you know is making you
miserable?

2. You Cant Embrace Change

When change is outside of your control,
thepsychological barriers are even worse.
Part of the reason volunteers dont pick the
second urn in the Ellsberg Paradox is that the
ratio of white to black marbles is outside your
control. Picking a black marble out of either urn
is still up to chance, but at least the ratio cant
change on you like in the second urn.
Embracing change is one of the key strategies
tolive an agile lifestyle. Becausethe world is
changing so quickly, only the agile among us will
thrive. But being agile means getting
comfortable with the vast amount of stuff thats
outside your control . And thats hard.

 3. You Aim Low and Settle for

Mediocre Results
The second vase in the Ellsberg Paradox
could contain 100 black marbles and youd
always win the $100. But youll never know
since you always stick with the 50/50 urn.
Thats how many of us treat our lives. We
stay in mindless corporate jobs for the
security andclimb the laddersothers set
out for us, never thinking what heights we
could reach if we were just a bit more
comfortable with uncertainty.

 4. You Let Other PeopleTalk You Out

of Everything
While youre struggling with all this
ambiguity, theother people in your
lifedefinitely wont get it.
From the outside looking in, theyll never
understand why you want to give up your
high-prestige Fortune 500 job for the
chaotic uncertainty of being an
entrepreneur or an artist.
Because they dont know the toll its taking
on you mentally, physically, or emotionally,
they compare the things they can measure

Rationality from an economics and evolutionary prospective

What is a rational decision? Economists traditionally viewed
rationality as maximizing expected satisfaction.
This view has been useful in modeling basic micro economic
concepts, but falls short in accounting for many everyday human
decisions. It leaves unanswered why some things reliably make
people more satisfied than others, and why people frequently act
to make others happy at a cost to themselves.
Traditional psychological functions governing risk aversion,
discounting of future benefits, and budget allocations to multiple
goods, for example, vary in predictable ways as a function of the
underlying motive of the decision-maker and individual differences
linked to evolved life-history strategies. A deep rationality
framework not only helps explain why people make the decisions
they do, but also inspires multiple directions for future research.

 Decisions depend on the current

environment, plus the decision makers
gender, and stage in the life cycle
As a result, many decisions that are
called inconsistent or irrational in
behavioral economics are actually
deeply rational to the domain in which
the decision is being made.
Men are more likely to take risky financial
decision than women

Herbert Simon and Bounded Rationality

Simon developed a model , which consists of 3 steps,

The Intelligence Phase - The intelligence phase consists
of finding, identifying, and formulating the problem or
situation that calls for a decision. This has been
calleddeciding what to decide. The intelligence stage may
involve, for example, comparing the current status of a
project or process with its plan. The end result of the
intelligence phase is a decision statement.
The Design Phase - The design phase is where we develop
alternatives, involves a great deal of research into the
available options. During the design phase we should also
state our objectives for the decision we are to make.
The Choice Phase - In the choice phase, we evaluate the
alternatives that we developed in the design phase and
choose one of them. The end product of this phase is a
decision that we can carry out.

Extensions to Simon's Model

Implementation
The decision that is ultimately carried out.
Review
In this phase, decision implemented is evaluated. Was the course
of action taken a good choice?
Occam's Razor is a principle attributed to the 14th century
English logician and Franciscan friar, William of Ockham that
forms the basis of methodological reductionism, also called
the principle ofparsimony. In science,parsimonyis the trait
of being the least complicated explanation for an observation.
This is widely held as a value for judging hypotheses.
In its simplest form, Occam's Razor states that one should not
make more assumptions than needed. When multiple
explanations are available for a phenomenon, the simplest
version is preferred. Simon's model also is based on the facts of
the fewest assumptions.

Simons Bounded Rationality Model

1.

To present a more realistic alternative to the

economic rationality model, Herbert A Simon
proposed an alternative model. He felt that
management decision-making behavior could
best be described as follows

In choosing between alternatives, managers

attempt to satisfice, or look for the one which is
satisfactory or good enough. Examples of
satisficing criteria would be adequate profit or
share of the market and fair price.
2. They recognize that the world they perceive is a
drastically simplified model of the real world.
They are content with this simplification
because they believe the real world is empty
9/27/16
56
anyway.

Simons Bounded Rationality Model (contd)

3.

4.

Because they satisfice rather than maximize, they

can make their choices without first determining
all possible behavior alternatives and without
ascertaining that these are in fact all the
alternatives.
Because they treat the world rather empty, they
are able to make decision with relatively simple
rules of thumb or tricks of the trade or force of
habits. These techniques do not make impossible
demands upon their capacity for thought.

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57

New Rational Techniques: ABC and

EVA
Traditionally, accounting identified costs according to the
category of expenses (for example, salaries, supplies and fixed
costs). Activity-based Costing (ABC), on the other hand,
determines costs according to what is paid for the different
tasks employees perform. Under ABC, costs associated with
activities such as processing sales orders, expediting supplies
and/or customer orders, resolving supplier quality and/or
problem, and retooling of machines are calculated. Both the
traditional and ABC methods reach the same bottom line costs,
but ABC provides decision makers a much more accurate
breakdown of the cost data. For instance, at Hewlett-Packard
when ABC showed that testing new designs and parts was
extremely expensive, engineer changed their plans on the spot
to favour components that required less testing, thus greatly
lowering costs.
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58

New Rational Techniques: ABC and EVA

Another example of rethinking the traditional economic rationality

used by management decision makers is the finance technique of
Economic Value Added (EVA). A long standing tenet of the
economic model has been that a rational decision is one which
resulted in the earning higher than the cost of capital.
Traditionally, the cost of capital has simply been equated with the
interest paid on borrowed capital. Under EVA, however, the true
cost of all capital is determined. For example, the true cost of
equity capital is the opportunity cost (what shareholders could
earn in price appreciation and dividends if they invested in similar
company). Also, what a firm spends on research and development
or employee training has been traditionally treated as expenses,
but under EVA, it is treated as capital investment and is added
into the cost of capital. The EVA is determined by subtracting this
total cost of capital from the after-tax operating profit.
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The Social Model

At the opposite extreme from the economic rationality model is the
Social Model. Sigmund Freud presented humans as bundles of
feelings, emotions, and instincts with their behaviour guided by
their unconscious desires.
Although most contemporary psychologists would take issue with
the Freudian description of humans, almost all would agree that
social influences have significant impact on decision-making
behaviour. Furthermore, social pressures and influences may cause
managers to make irrational decisions.
There seems to be a tendency on the part of many decision makers
to stick with a bad decision alternative, even when it is unlikely that
things can be turned around. Staw and Ross have identified four
major reasons why this phenomenon of escalation of commitment
might happen.
1) Project Characteristics
2) Psychological Determinants
3) Social Forces
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4) Organizational Determinants

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Investor Rationality and Market Efficiency