Head or Heart?

Manila Bulletin, February 17, 2010 | Go to article overview

Head or Heart?


Valentine just a few days away, it bears reflecting whether we decide on the basis of head or heart. In love, the conflict is well acknowledged but when it comes to finance and business, we tend to believe the head should always win.As we explore the choices we confront in finance, whether it is a savings, financing, or investment decision, the traditional thinking is we will identify the factors affecting the decision at hand, prioritize these factors according to a scale, measure the potential impact of decisions, review the costs and benefits, assess the risk, and choose the option that will lead to the best results in terms of desired outcome. We would like to believe we apply a system in cool and calculated fashion to the choices we confront. In fact, we tend to believe we are above average in handling our choices, that we are competent, and that we know what we are doing.But how valid are these assumptions? Many of the issues we confront are happening under complex, undefined and even confusing conditions. Do we really think before we act? And even if we attempt to think out our decisions, is the process we follow rational, logical and systematic?Finance today is spawning new ways of looking at how people make decisions. Several irrationalities are now cited on how individuals handle complicated decisions. Emotions often affect the self-control that is essential to rational-decision-making. Often, people are unable to understand fully what they are dealing with.Modern textbooks on Investments like that of Bodie, Kane and Marcus are incomplete if they do not cover extensively new material on behavioral finance, models of financial markets that emphasize potential implications of psychological factors affecting investor behavior. According to this view, investors do not always process information correctly and therefore infer incorrect probability distributions about future rates of return. Also even after a probability of distribution of returns has been correctly identified, they often make inconsistent or systematically sub-optimal returns.Among the various examples of so-called anomalies identified by psychologists are the following. Forecasting errors happen when people give too much weight to prior beliefs when making forecasts, a memory bias, and tend to make extreme forecasts given the uncertainty in their information.Overconfidence happens when people tend to overestimate the precision of their beliefs or forecasts, and tend to overestimate their abilities. At the other extreme, conservatism bias occurs when investors are too slow or conservative in updating their beliefs in response to new evidence.There is a failure of the principle of regression to the mean when people infer a pattern too quickly based on a small sample and extrapolate apparent trends too far into the future.Even when information processing were done correctly, people will tend to make less than fully rational decisions. …

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