1.1 Behavioral Finance and Cognitive Bias
The term “behavioral finance” refers to an area of business which sets aside the financial aspects and embraces the cognitive psychology aspects. Together with Vernon Smith and Hersh Shefrin, Daniel Kahneman, the Israelian psychologist who won the 2002 Economics Nobel prize, explained why the branch of behavioral finance shapes business decisions. The findings of Kahneman informed the scientific community in the area of management decision-making by implementing notions of cognitive psychology to economical decisions.
The main areas of cognitive finance are the following:
- 1.The framing: The way a problem or a decision to take is presented and how different ways of presenting it have an impact on the subsequent actions of the decision maker;
- 2.Market Inefficiency: Contrary to rational (myopic investment evaluation, distorted decisional processes, biased returns, etc.);
- 3.Heuristics: Simple proposed rules which explain the process of how people make judgment, take decisions, and face complex problems or incomplete information. Through heuristics processes a problem is decomposed in its constituent elements so that decisions that are not completely rational might be considered fully satisfying.
Continuing the last point, we can say that if heuristics goes well in the daily life and in financial ambit through simplification and intuition, they can bring to mistakes and cognitive prejudices. This may even lead to the much costly, so-called bias. By the term bias it is indicated, in fact, a predisposition to a sort of cognitive mistake. Three examples are as follows:
- Excessive optimism: People start to overestimate the frequency of pro-results and to underestimate that one of against-results;
- Illusion of control: People begin to overvalue the grade of control they have about the results, forgetting that the outcome of a decision is a mix of fortune and personal abilities;
- Overconfidence: People excessively trust in their resources and overestimate them.
And it is about this last concept, overconfidence, that this work will be based. First of all, it is important to emphasize that overconfidence is a cognitive bias ’s definition, as can be considered a distortion in the perception reality. In fact, people show a certain tendency to overestimate the trustworthiness and the precision of acquired information and they strain to overestimate their ability to elaborate them.
Overconfidence can be decomposed in different cognitive biases, such as:
- Self-serving bias: People ascribe their success to interior or personal factors, but they ascribe their failures to external or situational factors. For example, if target sales have been reached, the seller has developed his mission in a good way. Instead, if they are not reached, the fault is the bad course of the economy. There is the tendency to emphasize own success and to minimize own failures. Having bias self-serving primes the overconfidence.
- Valence effect: The tendency to overestimate the probability to gain positive results instead of negative ones. Differently from bias self-serving, the manager sensitive to the valence effect simply believes in the high probability of the success compared to the failures, without connecting necessarily the positive results to his own management.
- Wishful thinking: People tend to attribute importance to desirable aspects rather than realistic aspects. In this way, then, there is a risk of giving preference to decisions that probably won’t produce any benefit with, on the contrary, the possibility to produce a contradictory result compared to the expectations .
- Anchoring: People tend to rely on irrelevant or not completely known information. Since all the available information has not been considered, it is possible to reach wrong decisions. This is especially dire when very important information is omitted. Under some points of view, anchoring and overconfidence tend to prevail once over the other. In fact, some managers omit part of information.
1.2 The Approach of Big Five Model
In psychology, there are five factors that are used to describe the human personality. The theory at the base of these factors is called Big Five Model. There are two starting points for this theory. The first point identifies the dimensions which characterize the individual differences through statistical factorial analyses (factorial approach). The second point considers the vocabulary of the common language similar to a storage of elements which are able to describe the individual differences (theory of linguistic settling). Using factorial analysis, examination of relationships between the different personality descriptors has repeatedly highlighted the emergence of five great factors:
- Extroversion : The trait which reflects the wish to have power and influence on the others. An outgoing person expresses sympathy, stimulating feelings such as the enthusiasm and the euphoria. But when, in the same group there are two people with the same extroversion levels, there is the risk of a conflict;
- Friendliness : The trait that reflects the strong desire to be accepted to the others. Friendly people focus on getting along rather than being in the lead. Therefore, this factor is not suitable for managers who must reorganize the proper holding, but it is appropriate for positions in service enterprises;
- Conscientiousness: The trait that more influences the work’s performance because of its effects on the motivation and on the stress. In fact, conscientious people tend to give priority to the effort for the results, which is reflected in the desire to reach the work’s targets as a mean to express own personality;
- Emotional stability : Emotionally people think they do determine the events with their behavior;
- Open-mindedness : The trait which is more suitable for work which require high levels of creativity and is definable as capacities to create new and useful ideas and solutions.
Various researchers have demonstrated the significance of Big Five Model for its ability to identify personality’s features in the organizational environment context and finding a connection between these features and overconfidence.
Pallier et al. (2002) had highlighted how the lack of an association between overconfidence and extroversion would reflect a lack of power.
Schaefer et al. (2004) defined overconfidence as the difference between confidence and accuracy by pointing out that the extroversion of a subject is positively associated to the overconfidence. Since extroversion is connected to an optimistic attitude, it is reasonable to assume that the latter increases even more overconfidence. In addition, friendliness is negatively associated to overconfidence, given that it is more linked more to accuracy.
- Extroversion and conscientiousness are significantly connected with the open-mindedness and the confidence.
- Open-mindedness is positively connected to the confidence, but even with accuracy and not always to overconfidence.
The intrinsic variance to the Big Five’s factors should lead to a wrong connection between overconfidence and the five elements of the model. To solve this problem, Schaefer et al. (2004) utilized a series of partial correlations, have reached a similar result, examining the connection between every Big Five’ s factor and verifying at the same time the influence of the other elements. They conclude that just the extroversion , but no accuracy, has a significant positive correlation with the overconfidence.
1.3 The Behavioral Business Finance
Relatively to business implications, behavioral finance plays a very important role. Business finance has the primary target to improve the company’s value ensuring that the return on capital is higher than the cost of capital, without exposing to undue risks. A complete explanation about decisional models requires, however, a knowledge of the managers’ convictions and preferences, because they are on the head of the company.
The study of business finance assumes that the company’s managers have a full rationality, which is that, after analyzing and valuing information at their disposal, they act in such a way to maximize the business usefulness. Not always, though, this hypothesis is consistent with the reality: it is more plausible that people act with a limited rationality, because they often are not able to solve the function of maximization.
Behavioral business finance , based on the assumption that company managers are not fully rational, studies the effects that some psychological phenomenon can lead to any levels of prejudices and distortions in the business decision judgement.
According to the traditional theory, based on the essential assumption that all the actors of market act in a rational way, the investments undertaken by managers which have been revealed damaging for the company, are linked to the so-called conflict of interests. This is the situation that happens when a high decisional responsibility is handed by a subject who has personal or professional interests in conflict with the impartiality required by that responsibility. We can consider, for example, the establishment of corporate empires through numerous acquisitions of other corporates or the use of business assets for personal purposes. As claimed by Jensen and Meckling (1976), the higher the percentage of risk capital held by a corporate manager is, the lesser their noise behaviors for the company will be. So, a solution might be the utilization of incentives based on a variable remuneration based on the results gained or the utilization of actions assigned free of charge, with the intention of involving mostly the manager.
In 1986, if the company’s management once sustained the necessary costs to complete the projects tends to dissipate the remaining cash flow through unproductive acquisitions, Jensen supports further his thesis. Less cautious behavior in companies with high available cash flows are expected. The debt, then, represents a benefit, since it limits the top management to dissipate their resources, forcing them to make fixed payments for the interests, that reduce the cash flow and limit their own interests. It is evident that, increasing the exposure of managers to the company’s capital can limit the e...