FIN 335 Harvard University Explain the Social Security Number Discussion

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FIN 335

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1 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 2 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 3 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 4 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. 5 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. 6 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? 7 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. 8 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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1. What is anchoring? Explain the social security number experiments. Explain the number
of countries from Africa in UN experiments.

Anchoring is a situation where people tend to develop complete reliance on the easily available data or
information on the issues at hand. In most cases people make their estimation around the number availed
to them. During the social security number experiments, a group of 55 students were requested to write
the last two digits of their social security. Later the same group was asked the amount they would pay
for a give wine bottle, as well as computer items. Surprisingly, the student’s social security numbers
were directly proportional to their bid numbers. Averagely, 20% of the social security numbers bid $56
whereas the 20% at the bottom bid was $16. A similar explanation comes up when answering a question
about the African countries’ representation in the United Nations. Which also proved that the concept of
anchoring does not need any substantial ground or meaning to make any sense.
2. Why do we do anchoring?

The main reason why people anchor is because decisions are made in the brain based on the first
number that was stored or introduced to the same brain. Reliance on the first number is due to the belief
that the number is or great importance. This gives an explanation of the level of trust and reliance on
outside information.
3. How can anchoring impact finance? How can anchoring impact real estate? Use examples
from the slides in your answers.
One of the major impacts of anchoring in finance is in the case of Initial Public Offering (IPOs), where a
higher stock is presumed to be indicating better performance which may not be the case or absolutely
true. The public tend to believe a higher stock indicates a better position ignoring the fact that it may
change due to a fall in stock prices. The same concept can be used in the real estate when evaluating the
value of an asset or a house. The main limitation is the origin of the numbers that are normally used.

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4. What is mental accounting? Explain the lawnmower experiment. Explain the Boston
Celtics example.
Mental accounting is basically the economic and financial decisions explaining how money is allocated
and spent on the same. The lawnmower experiment and the Boston Celtics examples. In the lawnmower
experiment, there are two cases an extra $500 cash and similar value of check. A question is presented
of whether to take the standard lawnmower of $2000 or go for a better quality at an extra $250. The
outcome is one buying a fancier model since they have extra $500. In the second scenario the people are
more rigid as they would stand by the normal model despite the $500 extra since they embrace the
mental accounting concept and value check differently from dollar. The case of Boston Celtics is
similar as there were half of the participants who were told they would pay with cash while the other
half with credit cards. According to the result from the same time limit bids, the average credit card bids
were double the cash bids meaning people consider their cash accounts to be current assets and the
credit card to be future. They also have little trust with the future income as they are with the current
income.
5. Why do you think we do mental accounting?

I think the we embrace mental accounting since it gives us different opinion on the money. So, whether
it is assigned to a category, we have different thoughts about the money and the possession of it. Having
a plan for money gives us the opportunity to have control without necessarily considering the mental
accounting. The lack of categories for money would not allow people to use their money accordingly.
6. Explain the House Money effect that comes from mental accounting. How does this impact
financial decision making in the stock market?

House money effect explains the concept behind people who make so much money also ends up taking
the most risk since the same winnings are reused to make further investments. Experience with gains
make people to become more willing to risk since the have gained enough. The house money effect

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concept also makes some investors make higher risk due to the mental accounting concepts. Getting
money that did not exist they are motivated to keep up with the trend. One of the perfect examples is
those who bet in the casinos as they are encouraged to bet if they just won. This concept has substantial
impact on the stock behaviors. Most of the investors do not consider the concept of rebalancing which
affects them significantly when th...


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