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Essay 8
1. What is anchoring? Explain the social security number experiments. Explain the number of
countries from Africa in UN experiments.
Anchoring is when people relying too much on the first piece of information available. Once
exposed to an estimate people make their estimates close to that number. The social security number
experiment consisted of 55 students who were asked to write down the last two digits of their social
security numbers. After this was done, they then were all asked how much they were willing to pay for
a certain bottle of wine, and computer items and what would they pay for these items. The results were
astonishing, the students with the highest social security numbers bid the highest, while those with the
lowest numbers bid the lowest. The people in the experiment anchored their social security number to
the numbers they bid. The 20% of social security numbers bid 56 dollars and the bottom 20% bid 16
dollars. Another example can be seen when Subjects were then asked What is the percentage of
countries coming from Africa in the U.N. after a wheel with numbers 1-100 was spun in front of
participants. The results found that the median answer was 25% for these seeing 10 on the wheel.
However, those who saw 65 from wheel their median answer was 45. This just proves anchoring can
occur with meaningless numbers.
2. Why do we do anchoring?
People anchor to a number and don’t adjust enough for it. People anchor because once they are
exposed to a number they make decisions based on that first number because that number is stuck in
their head. People put too much value in the first number because they think it is of importance and
stick to it. It shows how impressionable we really are to outside information.
3. How can anchoring impact finance? How can anchoring impact real estate? Use examples from
the slides in your answers.
Anchoring can impact finance in many ways. One way this can be done is through IPO’s. IPO
stands for the initial public offering which is where starting prices come from. Anchoring could be seen
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through this because if an IPO of one stock is higher than its competitors it might believe they are better
and superior when this isn’t 100% true. People think just because they have a higher number they are
better; however, this is just an initial price, tomorrow the stock could drop. Another example of
anchoring is seen is in valuation exercises. When evaluating one must look at the starting values, the
growth rates, the other companies that you use to base your numbers on. The problem that arises is who
is to say what these numbers actually are and where do they come from.
4. What is mental accounting? Explain the lawnmower experiment. Explain the Boston Celtics
example.
Mental accounting is when people categorize their economic and financial decisions. We assign
money to different categories and spend money in accordance with the categories. Mental accounting is
shown in the lawnmower experiment and the Boston Celtics example. The lawnmower example
portrays 2 scenarios one with an extra 500 dollars cash and the 500 dollars check. The question asked
would you buy a standard lawnmower for 2,000 dollars or pay extra for the fancier model that costs 250
dollars more. The results showed the 1st scenario that they would buy the fancier model because they
had just won 500 dollars from playing bingo the previous night. However, the 2nd scenario shows that
people would stick to the regular model even though they discovered they have a check from Mom for a
rainy day worth 500 dollars. People said yes with the extra cash opposed to the check because most
people engage in mental accounting. Humans tend to value dollars differently as opposed to a check
even though money is fungible. Mental accounting is also seen when there was a sealed bid auction for
tickets to the Boston Celtics during the Larry Bird era. Half the participants were told that whoever won
the auction would have to pay cash for the tickets within 24 hours. The person who bid the most would
win and have to pay with cash. The other half of the participants were told they would have to pay for
the tickets within 24 hours with a credit card. The person who bid the most would win and have to pay
with a credit card. The results show that the average credit card bid was twice the average of the cash
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that was bid. This experiment shows how people are guilty of mental accounting. The participants put
money into separate accounts when presented with a financial decision. People consider their cash
account as a current asset and their credit card account as future income, which is why people with the
credit card bids were twice as high. Humans do not value future income as much as they do their current
assets. People value cash more than credit card remittances, even though they equal the same amount of
money.
5. Why do you think we do mental accounting?
I think people are guilty of mental accounting because as we assign money to different categories
it controls how we feel about the money, but if money is unassigned to a category we feel differently
with it. Once we have a set purpose for money it allows us to control our funds, without mental
accounting I don’t think there would be structure to our choices. If people didn’t have different
categories for their money people wouldn’t be able to save, spend, invest, and enjoy their money
properly.
6. Explain the House Money effect that comes from mental accounting. How does this impact
financial decision making in the stock market?
The house money effect is when people who make a lot of money in the stock market, take more
risk because they are risking the gains that they already won (betting house money). Once people
experience gain they become more open to assuming risk because they feel like they already have
gained enough that if they were to lose a little it wouldn’t hurt. The house money effect states that some
investors will increase their risk in the market because of mental accounting. Once Investors notice they
are risking money they didn't have previously, but have gained through their interaction with the market
it makes them want to continue this streak. One example is seen through casino gamblers. If they
recently won they are more willing to risk the extra gain. However, gamblers who have recently lost
either are desperate to win back their losses they take more risk while others take less risk after losing. If
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one is guilty of the house money effect the most important thing to do in their portfolio is to rebalance it.
After large increases in stocks, investors should rebalance some of the gains to lower-risk investments.
However, this is easier said than done and is the reason why the financial decision made from the house
money effect impacts the stock market. Once someone has gains and the house money effect kicks in,
then many investors do not do the rebalancing. Markets eventually fall, and they lose out due to this
imbalance. Investors choose to take more risk the gains rather than rebalance.
7. Explain the results of the experiment shown on slides 202-204. Why is this an interesting results
for finance and economics?
The results of the experiment done with the male undergraduate students at Berkeley show how
the current state of mind can impact our decisions. These men were asked to answer a set of questions in
two different states, how would they act when aroused sexually but not in an aroused state of mind and
how would they act when they actually were sexually aroused. The results showed when the males were
in a cold, normal state of mind they respected women, we not attracted to the odd sexual activities, and
said they would always use a condom. The results of the aroused men showed the exact opposite.
Prevention, protection, conservatism, and morality disappeared from the conversation and 25% said they
were more likely to not use a condom. Once emotions get involved it often blurs the line of what is right
and wrong. When we try to predict behavior in another state, we tend to get it wrong. This happens
because we believe we are always rational, but the reality is that we have these two states. Humans act
completely differently in “hot” states of anger, sexual arousal, hunger, frightened and the influence of
arousal shows how our state of mind can affect our financial and economic decisions. In finance, many
people trade on emotion. They trade badly as a result of feeling frightened. People being to feel greed
when they don’t make as much as they should and that’s why they start to trade badly.
8. Explain how hormones like testosterone and cortisol can prolong bubbles and crashes.
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Coates and Herbert did a study where they measured the steroid levels of traders in the City of
London. The study showed successful traders were heavily influenced during market booms by a
positive feedback loop which was fueled by their increased levels of testosterone. Coates writes the
results are similar to the “winner’s effect” in sports amongst male athletes. The winner effect is when
successive victories push testosterone levels higher and higher and gives the winner an advantage. This
doesn’t last long until the athlete begins to misjudge risk and take stupid chances. He adds, “testosterone
doesn’t create bubbles, but it exaggerates them. It’s possible that bubbles are a male phenomenon.”
When markets fall, traders become stressed by uncertainty and volatility which produces a lot of
cortisol. This makes them fall into a negative feedback loop that turns them into emotional fearmongers, rather than analytical thinkers. This negativity prolonging and deepening the market plunge,
and dragging down the economy. Testosterone and cortisol can prolong bubbles and crashes because it
ends up influencing their financial decisions. When there are high levels of testosterone it can prolong a
bubble because of increased confidence. Cortisol can prolong crashes because the amount of stress from
the level of uncertainty makes them thing negatively and continues to drag the economy down.
9. Can emotions move the market? Some research suggests that it can. Explain the slides 210-211.
Shiller argues an investor's emotional state when they pick their investments is one of the most
important factors that cause the bull market. Some research suggests that a trader's emotional states
translate into a market mood, that moves the market. Data from a study that involved 26 different
countries argued morning sunshine resulted in good moods that lead to higher stock returns. The theory
is sunny day might make a person feel optimistic and hence more likely to buy stocks. Another study
found that the amount of pollution in the air that day impacts the stock market. The higher the pollution,
the worse the returns were. Another way emotions move the market is when daylight savings occur.
Stock markets are have shown to fall when sleep patterns are disrupted by daylight savings changes.
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10. What is present bias? In your answer use the military example on slides on 219-221 to explain.
Present bias is how much weight we give when we make decisions about the values from what
we can gain and lose in the present versus the future. We choose to give most of our attention to the
future and make decisions that affect our present more than our future. Back in the 1990s, the U.S.
military had to cut back on its forces. In this time, the government offered over 65,000 individuals who
were going to lose their jobs a choice between a one-time lump sum or a series of annual payments.
They either offered $22,283 upfront or $3,714 annually for 18 years. There was no risk of default as
they were getting paid directly by the U.S. Government. With interest rates, the series of annual
payments ended up being around $43,415.The government went out of its way to explain the choices
with pamphlets, counseling, and media and said that the lump sum also would have been taxed at a
higher rate than the annual payments. However, more than half of the officers and more than 90 percent
of the enlisted personnel were guilty of the present bias and chose the lump sum. Individuals cared more
about the present than the future. They didn’t care about the future grater amount and went with their gut
impulse because they valued the present much more.
11. Why are we guilty of the present bias? That is, why do we give up so much in the future for
something now?
We are guilty of the present bias because we are impatient and want to receive immediate
gratification from their decision-making. We give up so much in the future for something now because
we want to see the reward now rather than wait. People don’t know what tomorrow brings, so they
might as well make decisions that affect the present then make a decision that affects the future.
Choosing to do something, such as saving money for the future can feel like a loss right now. In
addition, people lack self-control and make decisions that give them instant results/answers as opposed
to waiting for something they might not even be alive for.
12. Are companies guilty of present bias? What did Graham, Harvey and Rajgopal find?
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In 2006 Chartered Financial Analysts conducted a survey that concluded, “the obsession with
short-term results by investors, asset management firms, and corporate managers collectively leads to
the unintended consequences of destroying long-term value, decreasing market efficiency, reducing
investment returns, and impeding efforts to strengthen corporate governance.” In essence, companies are
guilty of present bias because they also make decisions for the short run. In 2005 Graham, Harvey and
Rajgopal surveyed with 401 executives that said that managers would reject a positive net present value
project if it lowered earnings below quarterly consensus expectations. In addition, they found that over
75% of the sample would choose to give up economic value to smooth earnings. In general, companies
run for the short-term and not for the long-run, which is the reason companies do not do as well as they
could. Many companies do not invest in the long-run if it will be painful to their profits in the short-run.
13. What is a nudge? In your answer use the example of 401k’s to show that nudging can be really
beneficial for people.
Nudging is a technique used when we are guilty of present bias. Nudging is a push to help us
make better decisions. Nudging can be seen through 401k retirement funds. Pensions no longer exist and
401K’s took their place, people need to sign up for them. However, many people do not sign up despite
its benefits. In 2001 Madrian and Shea had an opt-in provision where individuals had to sign-up. They
found in the first three months of employment only 20% of employees signed up, and by three years,
only 65% signed up. Then in 2004, the company began to automatically enroll people in the plan but had
the option to opt-out if they choose to. The switch from opt-in to opt-out is a nudge, a push in the right
direction. The results showed in the first three months 90% of employees were enrolled and 98% after
three years. Nudging can be beneficial for people when we realize people are making mistakes because
it nudges/pushes us to behave and make choices in a more rational way.
14. Which personality type (Meyers-briggs) is most guilty of being overconfident. Which is least
likely to be overconfident.
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According to the Meyers-Briggs personality type test, ESTP people are the most prone to be
overconfident. ESTP are those who fall into the category of extrovert, sensing, thinking, and perceiving.
In addition, those who are classified as ENTP, ESTJ, ISTP, and ESFP are next most likely to be
overconfident. On the other hand, INFJ is the least likely to be overconfident and more risk-averse. INFJ
falls under the categories of introvert, intuitive, feeling, and judging. The other personality types that are
least likely to be overconfident are also ENFJ, INFP, INTJ, and ISFJ. Extroverts tend to be more prone
to overconfidence, as opposed to introverts who take too little risk.
15. See slide 240. Why would having a client answer this question help the investment advisors?
Kahneman and Riepe conducted a list of questions to ask clients to figure out if they are subject
to behavioral biases that will make them bad investors. One of the questions they ask is, “which of the
following sequences is more likely to occur when a coin is tossed: HHHTTT or HTHTTH?” Both
sequences are equally just as likely to occur however most people choose the second option. People
overreact and the law of small numbers will cause them to say the first is less likely to happen because it
seems artificial. This question tells advisors if their clients believe in randomness or in order and logic.
One of the follow-up questions they ask the people who are prone to overreact is, “ask yourself whether
you have real reasons to believe you know more than the market.” The other question is, “before making
an active decision, consider that the trade is based on random factors. List the reasons why it is NOT due
to random factors.” These questions work well to help advisors know how their clients think and what
types of investments best fits them.
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