Monday, July 25, 2011

Principles of Behavioral Finance

Tonight I want to explain a few terms that were quoted from Nudge in last nights blog.  I am finding that these terms are used by many that are teaching, prompting or explaining behavioral economics, behavioral finance, and applied social psychology.  Also, I find that my textbook, Nudge, and Dr. Robert Shiller (professor of economics at Yale, specializes in behavioral economics) all use basically the same examples to explain the concepts, as well.  First, a word on Dr. Robert Shiller.  He is the author of two books which (I believe) may explain the new movement mentioned by Thaler and Sunstein: libertarian paternalism regarding economics.  His latest books are Irrational Exuberance and The New Financial Order.  I mention Dr. Shiller because I will use his definitions of terms from his Open University course on Economics offered free of charge to anyone online (check it out...many full courses available). 

Dr. Shiller states the principles of behavior finance are:
Wishful thinking: "people tend to make the error of believing what they want to believe, leading to biased probablility."  An example of this kind of erronous thinking is believing your team will win or the candidate you voted for will win just because you want them to.
Attention Anomalies: "human attention tend to be sporadic, we make errors in attention."  We give too much attention to some things while we pay too little attention to other things. Shiller argues that people tend to pay attention to what other people are paying attention to.  Thus, we give excess attention to the media lead agenda setters (nudge).  Consequently, we forget the details and specifics but remember generalities. My textbook calls this online judgement: judgement that is made at the moment that is processed and then is stored and determines our attitude formation and behavior.
Anchoring: "people make quanative judgements by subconsciously using some arbitrary stimulus. Then we tend to have over confidence in our anchored judgements...we think we know."  Besure to look back at last nights blog to see how useful Sunstein and Thaler thinks anchors are.  Remember anchors are placed and well-chosen nudges.
Representativeness Heuristics: "This refers to a human tendency to judge events on basis of similarity to other events that are prominent in our mind without regard to the actual probability of the event."
These key terms should help to inform you more closely of the mistakes we make in our assumptions that the choice architects, influence and change agents are counting on us making. 

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