Behavioral Corporate Finance

Table of Contents
Lecture 1....................................................................................................................................4
The economist: No Hard Feelings (2016).......................................................................................4
TED talk: Human nature and the blank slate:..............................................................................4
Buss 2009: The great Struggles of Life..........................................................................................8
TED talk: The psychology of your future self.............................................................................11
Smith 1759: The theory of moral sentiments...............................................................................12
New York Times article: the difference between rationality and intelligence..........................16
Lecture 2..................................................................................................................................16
Chapter 1: Background to the study of Psychology....................................................................16
Chapter 2: Methods of Psychology..............................................................................................20
Chapter 3: Genetics and Evolutionary Foundations of Behavior..............................................22
Economist: Evolutionary psychology: The idea that woman are cyclical cuckolders bites the
dust.................................................................................................................................................28
TED talk: How to make stress your friend..................................................................................28
Chapter 4: The Neutral Control of Behavior..............................................................................28
Chapter 5: Mechanisms of Motivation and Emotion..................................................................29
Chapter 8: Basic Processes of Learning......................................................................................31
Lecture 3..................................................................................................................................39
Chapter 9: Memory, Attention, and Consciousness....................................................................39
Chapter 10: Solving problems: reasoning and intelligence........................................................45
Lynn & Kanazawa 2011: A longitudinal study of sex differences in intelligence at ages 7, 11
and 16 years...................................................................................................................................50
Chapter 12: Social Development..................................................................................................52
AlShawaf & Conroy-Beam (2015)................................................................................................53
Lecture 4..................................................................................................................................55
Chapter 13: Social Psychology.....................................................................................................55
Casciaro (2005):.............................................................................................................................66
Hirshleifer (2020): Presidential address: social transmission bias in economics and finance. 67
Lins, Servaes and Tamayo (2019): Social Capital, Trust, and Corporate Performance: How
CSR Helped Companies During the Financial Crisis (and Why It Can Keep Helping Them)68
Cialdini (2009): The psychology of persuasion............................................................................69
Lecture 5..................................................................................................................................70
Chapter 14: Personality................................................................................................................70
Judge 2002 - Personality and leadership qualitative/quantitative review.................................89
 Judge 2009 - The bright and dark sides of leader traits.............................................................90
Buss 2009 - How Can Evolutionary Psychology Successfully Explain Personality and
Individual Differences?.................................................................................................................91
TED TALK, Brian Little: “Who are you really?”......................................................................93
Lecture 6 - Online...................................................................................................................94
Thinking fast and slow by Kahneman.........................................................................................94
Behavioral economics: Past, present, and future by Richard Thaler......................................100
Chicago Booth review, “Are markets efficient” by Richard Thaler and Eugene Fama........101
Behavioral biases during the corona crisis by Hersh Shefrin..................................................102
Corona crisis and financial crisis by Avanidhar Subrahmanyam...........................................102
Lecture 7:..............................................................................................................................103
Aabo (2020): Firm dynamics and CEO personality traits........................................................103
Omar (2019): Psychopathic traits of corporate leadership as predictors of future stock
returns..........................................................................................................................................107
Campbell (2019): Born to take risk?..........................................................................................111
Schulz (2019): The Church, intensive kinship, and global psychological variation................114
Lecture 8................................................................................................................................117
Barberis (2018): Richard Thaler and the Rise of Behavioral Economics...............................118
Thaler (2015): Misbehaving - the making of behavioral economics........................................120
Shiller (2017): Narrative Economics..........................................................................................123
Kahneman and Tversky (1979): Prospect Theory: An Analysis of Decision Under Risk......127
Hill and Buss (2010): Risk and relative social rank: positional concerns and risky shifts in
probabilistic decision-making.....................................................................................................129
Economist: Risk off: Why come people are more cautious with their finances than other. . .130
Johnson et al (2006): Overconfidence in wargames: experimental evidence on expectations,
aggression, gender and testosterone...........................................................................................131
TED talk: Tari Sharot - The Optimism bias.............................................................................132
Puri and Robinson (2007): Optimism and economic choice.....................................................132
Heaton (2019): Managerial optimism: New observations on the unifying theory..................136
Malmendier & Tate (2015): Behavioral CEOs: The role of managerial overconfidence.......137
Hilary, Segal & Wang (2016): The bright side of managerial over-optimism........................143
Lecture 9................................................................................................................................144
Baker & Wurgler (2013): Behavioral corporate finance: An updated survey (Part 1)..........144
Kumar (2009): Who gambles in the stock market....................................................................150
Economist: Is the equity-risk premium too tight for safety?...................................................151
Statman (2011): What investors really want.............................................................................151
Schumpeter: The look of a leader..............................................................................................154
TED Talk: Frans de Waal - The surprising science of alpha males........................................155
 Baker & Wurgler: Behavioral corporate finance: An updated survey (Part 2).....................155
Graham, Havey & Puri (2013): Managerial Attitudes and corporate actions........................163
Lecture 10..............................................................................................................................166
New York times: Narcissism is increasing. So you're not so special........................................166
W. Keith Campbell: The psychology of narcissism (Video).....................................................166
Aabo, et al., (2020 WP): Corporate acquisitions and the CEO’s traits and biases.................166
Lecture 11: Emotional, Social and Cultural Finance.........................................................172
Overview of behavioural finance................................................................................................172
Emotions in finance:....................................................................................................................179
Social effects in finance...............................................................................................................192
Culture in finance........................................................................................................................195
Lecture 12:............................................................................................................................200
Nicklas Bang Eriksen Thesis......................................................................................................200
Aabo and Eriksen (2017): Corporate risk and the humpback of CEO narcissism................202
Political strength - economist......................................................................................................205
TED talk about how training transform your brain.................................................................206
McGonigal (2020): Why does running give you a high? A look at the evidence.....................206
Dong (2019): Athletes in boardrooms: evidence from the world.............................................207
Nofsinger (2019): Deep sleep: The impact of sleep on financial risk taking............................213
3 articles on nutrition..................................................................................................................213
Harvey (2017): Presidental address - the scientific outlook in financial economics...............216
Lecture 13..............................................................................................................................219
Gigerenzer (2011): Heuristic Decision Making.........................................................................219
Kahneman (2009): Conditions for intuitive expertise...............................................................224
Hertwig (2016): Homo ignorans - deliberately choosing not to know.....................................227
Thaler (book): Nudge....................................................................................................................230
Cialdini (2003): Crafting Normative Messages to Protect the Environment................................231
Baer, et al., (2017): The business logic in debiasing.....................................................................231
Koller (2012): Overcoming a bias against risk..............................................................................233
Campbell (2011): CEO optimism and forced turnover.................................................................234
Solnick (1998): Is more always better? A survey on positional concerns....................................234
Guest lecture: Frederik and Jesper: do narcissistic CEOs rock the boat?....................................236

EXAM:
 Articles and videos in italics less likely to be asked about
 Questionclass at 17/12 at 8-10 pm
Lecture 1
Leaders are being compensated with stock options.
This is to align their objectives with the objective of the share holders.
Option have an asymmetric profile as well  they have a limited downside.

CEOs tend to be:

Undiversified
Risk adverse
Overconfident

The overconfidence is in opposite to risk adverseness and to be undiversified.

Corporate Finance:
Mangers are not that rational  we need to take this into account.

We will split the course in biases traits and personalities.

The economist: No Hard Feelings (2016)

Men are more deposited shaking hands and so on after a match.
We have brain from the stone age.
 It is an evolutionary thing.

TED talk: Human nature and the blank slate:

The brain is not blank slate - we have some fundamentally different brians e.g. men and
women.
“Man has no nature”  former believe

If we are blank slate, we should be equal.  there should be no unequalness from a political
perspective.

Siblings are not shaped by parenting by only by there genes. E.g. adopting siblings, who have
lived all their life together are not similar at all.

Men/women are better at what they evolutionary were supposed to do.

We don’t know much about how the brain works.

Correlation is not the same as causation. Dental floss example: People who uses floss lives
longer  there is a correlation, but could there be something else explaining e.g. education,
smoke habits, doctor visits.

Cosmides and Tooby 2013: Evolutionary psychology: New perspectives on cognition

and motivation
Evolutionary Psychology: New Perspectives on Cognition and Motivation BY Leda
Cosmides and John Tooby (ARP, 2013)

Evolutionary psychology … is the second wave of the cognitive revolution.

The first wave

… focused on computational processes that generate knowledge about the world: perception,
attention, categorization, reasoning, learning, and memory.

The second wave

… views the brain as composed of evolved computational systems, engineered by natural
selection to use information to adaptively regulate physiology and behavior.

From ancestral hunter-gather

This shift in focus — from knowledge acquisition to the adaptive regulation of behavior —
suggests a mind populated by a large number of adaptive specializations, each equipped
with content-rich representations, concepts, inference systems, and regulatory variables,
which are functionally organized to solve the complex problems of
1) survival and
2) reproduction
encountered by the ancestral hunter-gatherers from whom we descend.

We are products of many years of natural selection.

The blank slate - revisited

Both before and after Darwin, a common view among philosophers and scientists has been
that the human mind resembles a blank slate, virtually free of content until written on
by the hand of experience. This perspective grants that evolution may have equipped the
mind with a few primary reinforcers that have hedonic value (food, water, pain avoidance,
sex).

A very different picture of the human mind is emerging from evolutionary psychology.
In this view, human nature — the species-typical information-processing architecture of the
human brain — is packed with content-rich adaptive problem-solving systems. Like
expert systems (in artificial intelligence), each is designed to deploy different concepts,
principles, inference procedures, regulatory variables, and decision rules when activated by
cues of its proper domain.

The blank slate is dead  the mind is not a hard disc zero. This picture of the mind stems
from evolutionary psychology.

The brain and natural selection

The brain is an organ, and its evolved function is to extract information from the
environment and use that information to generate behavior and regulate physiology.
From this perspective, the brain is a computer, that is, a physical system that was designed to
process information.

Its programs were designed not by an engineer, but by natural selection, a causal process
that retains and discards design features on the basis of how well they solved problems that
affect reproduction.

Natural selection produces computational systems that solve adaptive problems reliably,
quickly, and efficiently.

The brain is design by natural selection, not by engineer

we are equipped with a stone age brain.
We look at different things according to which state we are in, e.g. when we are hungry 
that is we are primitive as human beings.

Example: visual attention

Visual attention is an umbrella term for a suite of operations that select some portions of a
scene, rather than others, for more extensive processing.
Focusing too exclusively on a single task can be very costly. An evolutionary perspective
suggests there should be systems that incidentally scan the environment for opportunities
and dangers; when there are sufficient cues that a more pressing adaptive problem is at hand
—an angry antagonist, a stalking predator, a mating opportunity—this should trigger an
interrupt circuit on volitional attention and activate programs specialized for processing
information about the new problem in an adaptive manner.

Change blindness is limited largely to inanimate objects. Changes to nonhuman animals

(and to people) are detected faster and more accurately than changes to plants, buildings,
tools, and even vehicles. Speed and accuracy at noticing changes were far greater for
nonhuman animals than for vehicles. This is what one would expect if animal monitoring
arises from an animal-specific evolved system rather than content-free learning.

We are more aware of living things moving that “dead” things.

Stone age  we had to move from animals
Today we should we afraid of e.g. cars  still there is empirical evidence that we are more
aware of living things such as animals moving.

Ingroup / outgroup attention

Our ancestors evolved as a group-living species, in small,
face-to-face bands consisting of 25–200 men, women, and children.
Because most of one’s interactions will be with ingroup members in this social ecology, a
default setting that allocates more attention to ingroup than outgroup members would be
functional. Not surprisingly, people find it easier to visually distinguish and recall
individuating information about ingroup members than outgroup members. This
phenomenon—ingroup heterogeneity paired with outgroup homogeneity—is well
established in social psychology.

It may be safe to ignore outgroup members in most circumstances, but not when there
are cues that they might intend to harm you. The anger of an ingroup member is less
likely to erupt into aggression because ingroup members participate in a network of
cooperative relationships that afford other opportunities for resolving disagreements. Because
outgroup members are outside this network, aggression may be the only bargaining tool
open to them, making their anger more dangerous.

Evolutionary game theory

In evolutionary game theory, a decision rule or strategy that garners higher payoffs leaves
more copies of itself in the next generation than alternatives that garner lower payoffs.
Over generations, conditional cooperators outreproduce defectors because they harvest
gains in trade from interacting repeatedly with one another.
Adaptations for participating in collective action can be selected for only if they cause
contributors to cooperate conditionally. In social exchange, a cooperator can avoid cheaters
by switching partners when alternatives are available. This is more difficult in collective
actions, because withdrawing from free riders means withdrawing from the group.
A better solution is to keep the group, and either exclude free riders from it or else punish
them to incentivize higher contributions in the future.
Behavioral economists and social psychologists have repeatedly shown that people are
willing to punish free riders, even when they incur a personal cost to do so.

As a person you are willing to sacrifice some of your wealth.

And one are willing to punish the ones who cheat or are free riders  next time your will be
willing to sacrifice somethings for the greater good.

Welfare tradeoffs (1)

Actions undertaken by one individual sometimes impact the welfare of others. Although
biologists had previously assumed that selection favored choices that were completely selfish,
over the past five decades, evolutionary biologists have identified a series of selection
pressures that favor taking the welfare of others into account.

The most fitness promoting choice may not simply be to maximize one’s own welfare.
Instead, under various conditions selection favors placing weight on the welfare of
another.

Gratitude, guilt, and anger may be social emotions that evolved to recalibrate welfare
tradeoffs. The gratitude emotion program is activated when someone puts an unexpectedly
high weight on your welfare. The gratitude program then recalibrates your welfare tradeoffs
toward the generous person upward—serving the function of consolidating cooperative
relationships. Guilt is activated when a person discovers they have placed too low a weight
on someone else’s welfare triggering an upward recalibration of the transgressor’s welfare
tradeoff toward the victim, so that future treatment is less exploitive.

We are able to take someone else welfare into account.

We show anger to make put more emphasis on our welfare.

Welfare tradeoffs (2)

Acts or signals of anger communicate that, unless the target starts to place more weight
on the angry individual’s welfare, the angry individual will inflict costs on the target (in
noncooperative relationships) or withdraw benefits from the target (in cooperative
relationships).
This suggests that there should be two regulatory variables that summarize these
dimensions of social power and feed into the anger system:
1) a formidability index that encodes the individual’s self-assessment of his ability to
inflict costs (fighting ability)
2) a conferral index that encodes the individual’s self-assessment of his ability to
confer/withhold benefits.

Welfare tradeoffs (3)

Formidability index
For our male ancestors, upper-body strength was a major component of the ability to inflict
costs on others (by injuring or killing them). Hence, greater strength should set a man’s
formidability index higher. Even now, people can accurately assess men’s strength from
sparse visual or vocal cues, and they spontaneously base their assessment of others’ fighting
ability on it.
Conferral index
The ability to confer/withhold benefits has many sources, but one factor that is easy to
operationalize is sexual attractiveness in women.
Men with greater upper-body strength were more prone to anger, felt more entitled to
better treatment, and prevailed more in conflicts of interest than men with less upper-
body strength.
In women, attractiveness produced these same effects.

Gone too far?

Buss 2009: The great Struggles of Life

The great struggles of Life - Darwin

and the Emergence of Evolutionary
Psychology
by David m. Buss (American
Psychologist, 2009)

Charles Darwin
Darwin envisioned a scientific revolution for psychology.
His theories of natural and sexual selection identified
two classes of struggles:
1) The struggle for existence
2) The struggle for mates
Evolutionary psychology synthesizes modern evolutionary biology and psychology.

3 classes of survival struggles:

Darwin identified three classes of survival struggles:
1) Struggles with the natural conditions of life
2) Struggles with other species
3) Struggles with members of one’s own species:
“Successful warriors in traditional tribal cultures attain higher social status, attract more
wives, and have more children than do less successful warriors.”
“ … humans have evolved adaptations for killing other humans, along with evolved
defenses for preventing getting killed”

“… geneticists discovered that 8% of men bore a chromosomal signature characteristic of

the Mongol rulers … An astonishing 16 million men in that region alive today are likely
descendants of the ruthless conqueror Genghis Kahn”

The struggle for mates (1):

At least two problems if we only have the survival struggle:
1) The peacock’s plumage, metabolically costly and a lure to predators, appeared to
contradict the theory of natural selection.
2) Why would the sexes differ given that both have faced the same struggles for
existence?
To address these puzzles, Darwin developed a second evolutionary theory, the theory of
sexual selection.
Sexual selection “depends on the advantage which certain individuals have over others of the
same sex and species, in exclusive relation to reproduction”.

The struggle for mates (2):

Sexual selection encompasses two component processes:
1) Same-sex competition. If males compete, and the victors gain preferential sexual access
to females, then evolution occurs because the victorious males reproduce more successfully
and consequently pass on genes that contributed to the development of qualities that led to
their successes.
2) Mate preferences. The female “exerts some choice and accepts one male in preference to
others. Or she may accept . . . not the male which is the most attractive to her, but the one
which is the least distasteful” …. Female mate choice also produces a struggle among males
who “display their charms before the female”.

Darwin focused on female choice and male competition.

We now know that male choice and female competition also are prevalent,
especially among humans.

Competition among males (1):

The logic of male intrasexual competition, of course, is more general than physical contests.
If position in status hierarchies influences preferential access to mates, for example, then men
can compete with each other for rank and status without a physical contest, and
sometimes without interacting with each other at all. Men devote more effort to status
striving than do women, for example, which is almost certainly a product of adaptations that
evolved over deep time as a result of recurrent male intrasexual struggles.
Evolutionary psychological research has identified dozens of tactics of attraction men use
to compete for mates …These include displaying a good sense of humor, showing good
manners, being wellgroomed, offering help, keeping physically fit to create a healthy
appearance, wearing stylish outfits, giving gifts, cooking a woman a gourmet meal, taking
her out to a restaurant, showing signs of commitment, declaring their undying love, and
expressing self-confidence.

Men tend to focus more on status than females.

Competition among males (2):

Wilson and Daly (2004) provided evidence that men possess a specialized adaptation for
“discounting the future,” valuing immediate goods over future goods.
When given a choice between a smaller sum of money tomorrow versus a larger sum of
money at a later date, men more than women tend to choose the immediate resource.
The discounting function became especially steep after men viewed images of physically
attractive women. This shift in the steepness of future discounting did not occur after men
viewed images of unattractive women, nor did it occur for women viewing either attractive or
unattractive male faces.
The male-specific shift in future discounting, rather than reflecting maladaptive impulsivity,
reflects an adaptation designed to obtain immediate reproductive benefits when future
opportunities are uncertain.

Men are the primitive gender

When men look at pictures of attractive women, they tend to discount the future more. This is
not the same case when they look at ugly women.
Men thinks more short term, where women think more long term (they know it is for 9
months+). Women think about that they need a man that can provide them recources.

Female mate choice:

Women universally prefer men with economic resources, as well as the qualities that lead
to economic resources, such as ambition, industriousness, social status, self-confidence, and
slightly older age.
Women also have well-articulated desires for masculine faces, scents of symmetrical men,
and other health cues.
They also prize bravery, athletic prowess, and a high shoulder-to-hip ratio—indicators
of the physical ability to protect them and their children.
Should not matter (that much) today but our preferences today are shaped by our ancestors!

Male mate choice:

“Man is largely, but by no means exclusively, influenced in the choice of his wife by
external appearance”.
Universal standards of female beauty, we now know, correspond to two classes of variables:
1) Cues to youth
2) Cues to health … both of which are ultimately cues to fertility!
A low waist-to-hip ratio (WHR) has been documented
across cultures as a key criterion for female body beauty.
A low WHR signals youth, health, and nonpregnancy status.

Low WHR has also something to do with low level of complications given birth

Competition among females:

Women, more than men, denigrate their sexual rivals on appearance.
Because men value sexual fidelity as a paternity confidence cue,
for example, women’s derogation tactics focus on impugning their rival’s sexual conduct—
calling the rival promiscuous, loose, easy to get into bed, and wanton.
These tactics backfire if the man is seeking a short-term mate,
since they indicate to the man a higher probability of gaining sexual access.
Thus, women adjust their derogation tactics according to mating context.
“Mama’s baby – Papa’s maybe”

Missed by Darwin (1):

Conflicts Within Families
Genetic relatedness often produces abundant acts of helping toward kin.
Nonetheless, the 50% difference in genetic relatedness between parents and their children
predicts that they will sometimes conflict … The optimal allocation of parental resources
from a parent’s perspective differs from the optimal allocation of resources from the child’s
perspective. Selection favors adaptations in children to extract more resources from
parents than is optimal from the parent’s perspective.
An especially poignant example of within-family conflict occurs within stepfamilies. Having
a stepparent in the home is the most powerful predictor of child abuse and homicide of
children. Rates of these crimes are between 40 and 100 times greater within stepfamilies
than among nonstepfamilies. Lack of genetic relatedness, in short, portends family conflict.

Missed by Darwin (2):

Sexual conflict
Antagonistic co-evolution can occur whenever the fitness optimum for each sex differs.
Example …consenting to sexual intercourse. If the optimum emotional involvement is
higher for women than for men, sexual conflict can ensue. A woman cannot attain her
(higher) optimum investment prior to sex without simultaneously preventing the man from
attaining his (lower) optimum investment.
Men deceive women about the depths of their feelings, commitment, and love in order to
secure sexual access to women. One study found that 71% admitted to deceiving a woman in
these ways, compared to only 39% of women when asked a parallel question. Women, in
turn, have evolved defenses against these forms of deception, such as prolonging
courtship before consent.
Women deceive men about the likelihood of sexual access to secure material benefits, to
evoke jealousy in existing mates, or to increase their perceived mate value.

Insights:
Darwin’s insight provided the groundwork for a cogent meta-theory of psychological sex
differences:
1) Women and men are expected to differ psychologically primarily in those
domains in which they have recurrently faced different adaptive problems over
deep time.
2) Men and women are predicted to be psychologically similar in all domains in which
they have recurrently faced similar adaptive problems.
=> Try to be aware of that when we are looking into biases and personality traits in the
behavioral finance literature

TED talk: The psychology of your future self

We are not always satisfied with the decisions we have made.
Why do we make decisions that our future self will regret?

We are walking around with an illusion that we just now have become the person that we
want to be.

The question they asked: How much have out value changed in the last 10 years and how
much do we expect our values to change in the next 10 year.
 people in general underestimate how much they are going to change in the future.
People do not see themselves changing, but are aware of that they have changed in the last 10
years.

We overestimate stability of who we are and underestimate the likelihood of whether we are
going to change.
People are work in progress who fail to see that they actually are changing.

The younger your are the more your preferences change.

Smith 1759: The theory of moral sentiments

The theory of moral sentiments By adam smith (1759)

Adam Smith (1723-1790) … a Scottish moral philosopher, pioneer of political economy, and
key Scottish Enlightenment figure.
Smith is best known for two classic works:
1) The Theory of Moral Sentiments (1759)
2) An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

Sympathy (1):
“There is, however, this difference between grief and joy, that we are generally most
disposed to sympathize with small joys and great sorrows.
The man who, by some sudden revolution of fortune, is lifted up all at once into a condition
of life, greatly above what he had formerly lived in, may be assured that the congratulations
of his best friends are not all of them perfectly sincere.
An upstart, though of the greatest merit, is generally disagreeable, and a sentiment of envy
commonly prevents us from heartily sympathizing with his joy.”

Sympathy (2):
“It is quite otherwise with grief. Small vexations excite no sympathy, but deep affliction calls
forth the greatest. The man who is made uneasy by every little disagreeable incident, who is hurt if either the cook or the butler have failed in the least article
of their duty, who feels every defect in the highest ceremonial of politeness, whether it be shewn to himself or to any other person, who takes it amiss that his intimate friend
did not bid him good-morrow when they met in the forenoon, and that his brother hummed a tune all the time he himself was telling a story; who is put out of humour by the
badness of the weather when in the country, by the badness of the roads when upon a journey, and by the want of company, and dulness of all public diversions when in
Joy is a pleasant emotion, and we
town; such a person, I say, though he should have some reason, will seldom meet with much sympathy.

gladly abandon ourselves to it upon the slightest occasion. We readily, therefore, sympathize
with it in others, whenever we are not prejudiced by envy. …Our sympathy, on the contrary,
with deep distress, is very strong and very sincere. … Nature, it seems, when she loaded us
with our own sorrows, thought that they were enough, and therefore did not command us to
take any further share in those of others, than what was necessary to prompt us to relieve
them.”

Sympathy (3):
“It is because mankind are disposed
to sympathize more entirely
with our joy than with our sorrow,
that we make parade of our riches,
and conceal our poverty.”

Pursuing riches … why?:

“… it is chiefly from this regard to the sentiments of mankind, that we pursue riches and
avoid poverty. For to what purpose is all the toil and bustle of this world? what is the end of avarice and
ambition, of the pursuit of wealth, of power, and preheminence? Is it to supply the necessities of
nature? …
Do they imagine that their stomach is better, or their sleep sounder in a palace than in a
cottage? …
The rich man glories in his riches, because he feels that they naturally draw upon him the
attention of the world, and that mankind are disposed to go along with him in all those
agreeable emotions with which the advantages of his situation so readily inspire him… The
poor man, on the contrary, is ashamed of his poverty. He feels that it either places him out of the
sight of mankind, or, that if they take any notice of him, they have, however, scarce any fellow-feeling
with the misery and distress which he suffers.”

Why do we pursue to be rich? Are things better when we are rich?

Loss/risk aversion:
“Pain,
I have already had occasion to observe, is, in almost all cases,
a more pungent sensation
than the opposite and correspondent pleasure.
The one, almost always, depresses us much more below the ordinary,
or what may be called the natural state of our happiness,
than the other ever raises us above it.”

Praise (-worthiness):
“When he is perfectly satisfied with every part of his own conduct, the judgment of other
people is often of less importance to him…
Very few men can be satisfied with their own private consciousness that they have attained
those qualities, or performed those actions, which they admire and think praise-worthy in
other people; unless it is, at the same time, generally acknowledged that they possess the one, or have
performed the other; or, in other words, unless they have actually obtained that praise which they think due both
to the one and to the other. In this respect, however, men differ considerably from one another. Some
seem indifferent about the praise, when, in their own minds, they are perfectly satisfied that
they have attained the praise-worthiness. Others appear much less anxious about the praise-
worthiness than about the praise.”

Happiness (1):
“Happiness consists in tranquility and enjoyment …
In prosperity, after a certain time, it falls back to that state; in adversity, after a certain time, it
rises up to it …
The great source of both the misery and disorders of human life, seems to arise from over-
rating the difference between one permanent situation and another.”

Happiness (2):
“What the favourite of the king of Epirus said to his master, may be applied to men in
all the ordinary situations of human life.
When the King had recounted to him, in their proper order, all the conquests which he
proposed to make, and had come to the last of them;
And what does your Majesty propose to do then? said the Favourite. –
I propose then, said the King, to enjoy myself with my friends, and endeavour to be good
company over a bottle. –
And what hinders your Majesty from doing so now? replied the Favourite.”

Adversary - recommendation:
“Are you in adversity?
Do not mourn in the darkness of solitude, do not regulate your sorrow according to the
indulgent sympathy of your intimate friends;
return, as soon as possible, to the day-light of the world and of society.
Live with strangers, with those who know nothing, or care nothing about your misfortune;
do not even shun the company of enemies; but give yourself the pleasure of mortifying their
malignant joy, by making them feel how little you are affected by your calamity, and how
much you are above it.”

PROSPERITY - recommendation:
“Are you in prosperity?
Do not confine the enjoyment of your good fortune to your own house, to the company of
your own friends, perhaps of your flatterers, of those who build upon your fortune the hopes
of mending their own;
frequent those who are independent of you, who can value you only for your character
and conduct, and not for your fortune.
Neither seek nor shun, neither intrude yourself into nor run away from the society of those
who were once your superiors, and who may be hurt at finding you their equal, or, perhaps,
even their superior.”

Useful qualities:
“The qualities most useful to ourselves are,
first of all, superior reason and understanding, by which we are capable of discerning the
remote consequences of all our actions, and of foreseeing the advantage or detriment which is
likely to result from them:
and secondly, self-command, by which we are enabled to abstain from present pleasure or to
endure present pain, in order to obtain a greater pleasure or to avoid a greater pain in some
future time.
In the union of those two qualities consists the virtue of prudence, of all the virtues that which
is most useful to the individual.”

Status Quo Bias:

“We suffer more, it has already been observed, when we fall from a better to a worse
situation, than we ever enjoy when we rise from a worse to a better.
Security, therefore, is the first and the principal object of prudence. It is averse to expose
our health, our fortune, our rank, or reputation, to any sort of hazard. It is rather cautious than
enterprising, and more anxious to preserve the advantages which we already possess, than
forward to prompt us to the acquisition of still greater advantages.”

Estimating our merit (1):

“In estimating our own merit, in judging of our own character and conduct, there are
two different standards to which we naturally compare them.
The one is the idea of exact propriety and perfection, so far as we are each of us capable
of comprehending that idea.
The other is that degree of approximation to this idea which is commonly attained in the
world, and which the greater part of our friends and companions, of our rivals and
competitors, may have actually arrived at.
We very seldom (I am disposed to think, we never) attempt to judge of ourselves without
giving more or less attention to both these different standards.”

Estimating our merit (2):

“So far as our attention is directed towards the first standard,
the wisest and best of us all, can, in his own character and conduct,
see nothing but weakness and imperfection; can discover no ground for arrogance and
presumption, but a great deal for humility, regret and repentance.
So far as our attention is directed towards the second, we may be affected either in the one
way or in the other, and feel ourselves, either really above, or really below, the standard to
which we compare ourselves.”

Optimal virtue (1):

“Though in prosperity, however,
the man of excessive self-estimation may sometimes appear
to have some advantage over the man of correct and modest virtue;
though the applause of the multitude, and of those who see them both only at a distance, is
often much louder in favour of the one than it ever is in favour of the other;
yet, all things fairly computed, the real balance of advantage is,
perhaps in all cases, greatly in favour of the latter and against the former.“

Optimal virtue (2):

“The man who neither ascribes to himself, nor wishes that other people should ascribe to him,
any other merit besides that which really belongs to him, fears no humiliation, dreads no
detection; but rests contented and secure upon the genuine truth and solidity of his own
character.
His admirers may neither be very numerous nor very loud in their applauses;
but the wisest man who sees him the nearest and who knows him the best, admires him the
most.
To a real wise man the judicious and well-weighed approbation of a single wise man, gives
more heartfelt satisfaction than all the noisy applauses of ten thousand ignorant though
enthusiastic admirers.”

Optimal virtue (3):

“But the philosophers of all the different sects very justly represented virtue; that is, wise,
just, firm, and temperate conduct; not only as the most probable, but as the certain and
infallible road to happiness even in this life …
Wise, prudent, and good conduct was, in the first place, the conduct most likely to ensure
success in every species of undertaking; and secondly, though it should fail of success, yet
the mind was not left without consolation.
The virtuous man might still enjoy the complete approbation of his own breast; and might
still feel that, how untoward soever things might be without, all was calm and peace and
concord within. He might generally comfort himself, too, with the assurance that he
possessed the love and esteem of every intelligent and impartial spectator, who could not fail
both to admire his conduct, and to regret his misfortune.”

And in his 1776 book:

Adam Smith (“The Wealth of Nations, 1776):
“The overweening conceit which the greater part of men have of their own abilities is an
ancient evil remarked by the philosophers and moralists of all ages.
Their absurd presumption in their own good fortune has been less taken notice of. It is
however, if possible, still more universal.”
In 1776: We tend to be overconfident and believe in good luck!
200+ years after: Still the same?

New York Times article: the difference between rationality and intelligence
Don’t equal sign between rational and intelligent

Lecture 2
Science is always in a context  we want it to be objective.

Chapter 1: Background to the study of Psychology

What Is Psychology?
  Psychology is the science of behavior and the mind
 Behavior: the observable actions of a person or an animal
 Mind: an individual’s sensations, perceptions, memories, thoughts, dreams,
motives, emotions, and other subjective experiences

Three Fundamental Ideas for Psychology

1: Behavior and mental experiences have physical causes that can be studied scientifically
2: The way people behave, think, and feel is modified over time by their experiences in their
environment
3: The body’s machinery, which produces behavior and mental experiences, is a product of
evolution by natural selection

1: Behavior and mental experiences have physical causes that can be studied
scientifically

Physical Causation of Behavior

 Dualism (17th Century)  mind and body
 Materialism (17th Century)
 Physiological Research (19th Century)

Descartes’ Version of Dualism: Focus on the Body

 René Descartes (1596-1650)
 Believed that even quite complex behaviors can occur through purely
mechanical means, without involvement of the soul
 His theory is popular among nonscientists even today because it acknowledges
the roles of sense organs, nerves, and muscles in behavior without violating
people’s religious beliefs or intuitive feelings

Thomas Hobbes and the Philosophy of Materialism

 Thomas Hobbes (1588-1679)
 All human behavior, including the seemingly voluntary choices we make, can
in theory be understood in terms of physical processes in the body, especially
the brain
 His work helped inspire a school of thought about the mind known as
empiricism

Nineteenth-Century Physiology: Learning About the Machine

 Increased understanding of the reflexes
 Reflexology
 Physiologists began to suggest that all human behavior occurs through
reflexes
 Localization of Function in the Brain
 Specific parts of the brain serve specific functions in the production of mental
experience and behavior
 Johannes Müller (1838-1965)
 Different qualities of sensory experience come about because the
nerves from different sense organs excite different parts of the brain

Phrenology
  Work by Broca and others showed that particular cognitive functions are controlled
by specific areas of the brain
 This led to the popular belief that all aspects of thought, emotion, and personality can
be located in the brain, culminating in the pseudoscience known as phrenology

2: The way people behave, think, and feel is modified over time by their experiences in
their environment

Mind and Behavior are Shaped by Experience

 Empiricism (17th Century)
 John Locke, tabula rasa (blank slate)
 Human knowledge and thought derive ultimately from sensory experience
 Our senses provide the input that allows us to acquire knowledge of the world
around us, and this knowledge allows us to think about that world and behave
adaptively within it

The Empiricist Concept of Association by Contiguity

 If a person experiences two environmental events (stimuli, or sensations) at the same
time or one right after the other (contiguously), those two events will become
associated (bound together) in the person’s mind such that the thought of one event
will, in the future, tend to elicit the thought of the other

The Nativist Response to Empiricism

 Nativism
 Most basic forms of human knowledge and operating characteristics of the
mind are native to the human mind and do not have to be acquired from
experience
 Immanuel Kant (1724-1804)
 a priori knowledge: built into the human brain and does not have to be
learned
 a posteriori knowledge: gained from experience in the environment

This is more close to Darwin

The above challenge the perception of the mind as a blank slate.

3: The body’s machinery, which produces behavior and mental experiences, is a

product of evolution by natural selection

The Idea that the Machinery of Mind and Behavior Evolved through Natural Selection
 Natural selection and the analysis of the functions of behavior
 Charles Darwin (1809-1882)
 Proposed that natural selection underlies the evolution of behavioral
tendencies (along with anatomical characteristics) that promote
survival and reproduction
 Natural selection also offered a scientific foundation for nativist views of the mind

The Scope of Psychology

 Psychology is a vast and diverse field
 Every question about behavior and mental experience that is potentially answerable
by scientific means is within its scope
  Psychologists strive to explain mental experiences and behavior

Level of analysis: in psychology, a person’s behavior or mental experience can be examined

at these levels: (biological processes / environmental experiences, knowledge and
development

Explanations That Focus on Biological Processes

§ Neural explanations
§ Behavioral neuroscience
§ Study of how the nervous system produces the specific type of
experience or behavior being studied

Viewing the Active Brain

In recent years, the field of behavioral neuroscience has advanced greatly, due in part to new
techniques for assessing the amount of activity that occurs in specific brain locations as a
person performs mental tasks. These neuroimaging techniques are discussed in Chapter 5.

Explanations That Focus on Biological Processes

§ Physiological explanations
§ Physiological psychology or biopsychology
§ The study of the ways hormones and drugs act on the brain to alter
behavior and experience, either in humans or in nonhuman animals
§ Genetic explanations
§ Behavioral genetics
§ Attempts to explain psychological differences among individuals in
terms of differences in their genes
§ Evolutionary explanations
§ Evolutionary psychology
§ Explaining universal human characteristics by attempting to discover
how or why they came about in the course of evolution
Explanations That Focus on Environmental Experiences, Knowledge, and Development
§ Learning explanations
§ Learning psychology
§ Explaining behavior in terms of learning
§ Cognitive explanations
§ Cognitive psychology
§ Study of cognition by inferring from the behaviors we can observe
§ Social explanations
§ Social psychology
§ Explaining people’s mental experiences and behavior by identifying
how they are influenced by other people or by one’s beliefs about other
people

§ Cultural explanations
§ Cultural psychology
§ Explaining mental experiences and behavior in terms of the culture in
which the person developed
§ Developmental explanations
§ Developmental psychology
§ Documenting and describing the typical age differences that occur in
the ways that people feel, think, and act

Psychological Specialties / Complementarities

§ Good researchers often use several different levels of analysis in their research and
may study a variety of topics that in some way relate to one another

Psychology as a Hub Science

Chapter 2: Methods of Psychology

Research Design: Correlational Studies

§ Observes/measures the relationship between two variables
 § Does NOT show cause and effect
§ Example: Diana Baumrind’s study on parental discipline and child behavior
Correlation ≠ Causation

This is also why twin studies are so popular

Causation is often much more difficult to prove than correlation.

Minimizing Bias in Psychological Research

§ Error
§ Random variability in results (next slide)
§ Bias
§ Nonrandom variability in results (next slide)
§ Three types of bias
§ Sampling biases
§ Measurement biases
§ Expectancy biases

Examples of Variation and Bias

FIGURE 2.4 Random variation, bias, and both. The difference between random variation in
behavior and bias in research is like the difference between the sets of target holes produced
by a novice archer (target A) and by a skilled archer whose bow sights are misaligned (target
B). Target C shows the results from a novice archer using misaligned bow sights.

Avoiding Biased Samples

§ Biased sample
§ When members of a particular group are initially different from those of
another group in some systematic way, or are different from the larger
population that the researcher is interested in
§ Example: Literary Digest’s poll of U.S. voters in 1936

Reliability and Validity of Measurements (part 1)

§ Reliability (next slide)
§ Yields similar results each time it is used
§ Validity (next slide)
§ Measures or predicts what it is said to measure or predict

Reliability and Validity of Measurements (part 2)

A: low reliability, high validity B: high reliability, low validity C: high reliability and high
validity
The pattern in target A reflects an unreliable measure: The different measurements (arrows)
are distributed randomly. The pattern in target B reflects a reliable measure: All the shots are
clustered in one area, but it is not valid (assuming the bull’s-eye reflects the “real concept”).
Finally, target C reflects both reliability (consistency) and validity (all shots in the “right”
place).

Validity  is it actually measuring what I want to measure?

The Facilitated-Communication Debacle

§ Who is typing the message?
§ In the technique of facilitated communication, a facilitator holds the hand of
the disabled person in order to “help” that person type a message on a
keyboard. Experiments have shown that when this technique is used with
autistic individuals, it is the facilitator, not the autistic person, who composes
the message and controls the typing, even though the facilitator is not
conscious of doing so.

Avoiding Observer-Expectancy and Subject-Expectancy Effects

§ Blind experiment
§ Observer is “blind”
§ Double-blind experiment
§ Observer and subject are “blind”
§ May use a placebo

Replicating Earlier Studies

§ Scientific ideas are tested by reproducing, or replicating, the results of prior studies.
§ Recent research has shown that many findings published in prominent psychology
journals do not replicate, although most replication studies produced the same pattern
as the original studies.
§ Science is a conservative institution, and textbook writers in particular are likely to
include only well-established findings.

Chapter 3: Genetics and Evolutionary Foundations of Behavior

Darwin’s Theory
§ 150 years ago, Charles Darwin proposed a theory of evolution that explains both the
differences and the similarities between species
§ Today, evolutionary scientists discuss the application of evolutionary theory to
explain behavior
Genes Work Only through Interaction with the Environment
§ Environment is every aspect of an individual and his/her surroundings except the
genes themselves
§ There is continuous complex interplay between genes and the environment

Route Through Which Genes Affect Behavior

Genes build proteins, which form or alter the body’s physiological systems (including brain
systems), which, in turn, produce behavior. Each step in this process involves interaction with
the environment. Aspects of the internal environment control gene activation, and aspects of
both the internal and the external environments act on physiological systems to control
behavior. Behavior, in turn, can affect gene activation through direct and indirect effects on
the internal environment.

Genotype vs. Phenotype

§ Genotype
§ The set of genes that an individual inherits
§ Phenotype
§ Observable properties of the body and behavioral traits

Identical twins: These 13-year-old girls have the same genotype, but they obviously differ in
at least one aspect of their phenotype. It is uncertain what caused this difference. It may have
derived from their occupying different positions in the womb such that one received more
early nutrition than the other, which activated genes promoting more growth.

How Genes Are Passed Along through Reproduction

§ DNA exists in chromosomes
§ The normal human cell has 23 chromosome pairs
§ All humans have 22 of these pairs; the last pair is sex chromosomes (XX for females,
XY for males)
§ One member of each of these pairs comes from one parent, the other member of the
pair comes from the other parent

Chromosomes of a Normal Human Male

Chromosomes of a normal human male cell. The 22 numbered pairs of chromosomes are the
same in a normal female cell as they are in a normal male cell. The remaining two, labeled X
and Y, are the sex chromosomes. The normal human female cell (not shown) has a second X
chromosome instead of a Y.

Genetic Diversity of Offspring

§ Genes have a better chance of survival if they are rearranged at each generation
§ Twins are the only offspring that are not diverse
§ Identical twins
§ Fraternal twins
§ Why do you think it would be advantageous to have genes rearrange each generation?

Mendelian Pattern of Heredity

§ Mendel came up with the idea that genes come in pairs and that one can be dominant
over the other
§ He discovered that some behaviors are affected by a single gene
§ Fearfulness in dogs
§ KE family language disorder
Explanation of Mendel’s 3:1 ratio. When a pea plant that is heterozygous for round versus
wrinkled seeds is pollinated by another pea plant that is similarly heterozygous, four possible
gene combinations occur in the offspring. Here R stands for the dominant, round-producing
allele, and r for the recessive, wrinkle-producing allele. The phenotype of three of the
offspring will be round and that of one, wrinkled. This 3:1 ratio was Mendel’s famous
finding.

Polygenic Characteristics and Selective Breeding

§ Selective breeding: Modifying a specific behavior or characteristic by mating
individuals with or without the specific characteristics
… as opposed to 0-1 …

Selective Breeding for Maze Learning

FIGURE 3.9 Selective breeding for “maze brightness” and “maze dullness” in rats. The top
graph shows, for the original parent stock, the distribution of rats according to the number of
errors they made in the maze. Subsequent graphs show this distribution separately for the rats
bred to be “bright” or “dull.” With successive generations of selective breeding, an increasing
percentage in the “bright” strain made few errors and an increasing percentage in the “dull”
strain made many errors. (Based on data from Tryon, 1942.)

Epigenetics
§ Epigenetics examines gene-regulating activity that doesn’t involve changes to the
DNA code and that can persist through one or more generations. Turn off / on.
§ Example: During WWII, part of the Netherlands experienced extreme famine.
Children who suffered malnutrition during their first 3 months as fetuses => high risk
for obesity as adults + their offspring were heavier than average. =
Grandchildren affected.

Evolution by Natural Selection

§ Darwin: On the Origin of Species
§ Artificial selection
§ Human-controlled selective breeding
 § Natural selection
§ Selective breeding in nature
§ Darwin’s essential point: Individuals of a species vary in the number of offspring they
produce
§ Traits that increase # of offspring will be selected “for”
§ Traits that decrease # of offspring will be selected “against”

Darwin’s Core Concepts of Natural Selection

§ There is overproduction of offspring in each generation.
§ There is variation in features or traits within members of a generation.
§ Individual differences are inherited from one generation to the next.
§ Individuals with collections of traits that fit well with the local environment are more
apt to survive and have more offspring than individuals whose traits do not fit as well
with the local environment.

Genetic Diversity Provides the Material for Natural Selection

§ There are two sources of the genetic variability on which natural selection acts
§ Reshuffling of genes during reproduction
§ Mutations
§ Errors that occasionally and unpredictably occur during DNA
replication

In the X-MEN movies, a mutation causes certain people to develop extraordinary powers. Do
you think anything like that could happen in real life? Why or why not?

Evolution Has No Foresight

§ Evolutionary paths are not working toward some predetermined end
§ Humans are not the “most evolved” species
§ Natural selection is not a moral force
§ Naturalistic fallacy

Genes and experience combine to produce an animal’s current structure and its behavior.
That behavior is then the target for natural selection, continuing the cycle.

Natural Selection as a Foundation for Functionalism

 § Functionalism: The attempt to explain behavior in terms of what it accomplishes for
the behaving individual
§ Tries to answer how a trait helped ancestral members of the species survive and
reproduce

Distal and Proximate Explanations

§ Distal explanations
§ Functional explanations at the evolutionary level
§ Distal causation is sometimes referred to as ultimate causation
§ Proximate explanations
§ Explanations that deal with the mechanism in the immediate conditions

Limitations on Functionalist Thinking

§ Some traits are vestigial
§ Some traits are side effects of natural selection for other traits
§ Some traits result from chance
§ Evolved mechanisms cannot deal effectively with every situation

Studying Behavior
§ What are the environmental conditions needed for the full development of this
behavior?
§ What internal mechanisms are involved in producing this behavior?
§ What consequences does this behavior have in the individual’s daily life?
§ In the course of evolution, why would the genes that make this behavior possible have
been favored by natural selection?

Four Mating Systems

FIGURE 3.19 Four mating systems. In a polygynous system (common in mammals), the
unmated males are a threat to the mated male, and in a polyandrous system (present in some
birds and fishes), the unmated females are a threat to the mated female. Threat is reduced by
monogamy and promiscuity because, with those systems, most individuals find mates.

Mating Patterns and Parental Investment

§ Parental investment:
§ Time, energy, and risk to survival involved in producing, feeding, and caring
for offspring
 § Trivers (1972): In general, for species in which parental investment is unequal,
the more parentally invested sex will be more vigorously competed for and
more discriminating when choosing mates
§ Polygyny (one male, more females)
§ Related to high female and low male parental investment
§ Polyandry (one female, more males)
§ Related to high male and low female parental investment
§ Monogamy (one male, one female)
§ Related to equivalent male and female parental investment
§ Promiscuity (many males, many females)
§ Related to investment in the group

Emotions and Human Mating

§ Human mating is mostly monogamous (one male, one female) and partly polygamous
(one male, more females)
§ Romantic love and mating
§ Jealousy and mating

Sex Differences in Aggression

§ Male primates, including men, are generally more violent than are females of their
species
§ Most aggression and violence in male primates relate directly or indirectly to sex.
Genes that promote violence are passed to offspring to the degree that they increase
reproduction.

Evolutionary Analyses of Helping and Hurting: Cooperation

§ Helping (promoting another’s survival or reproduction) takes two forms: cooperation
and altruism.
§ Cooperation (helping others while also helping oneself, as in the case of wolves
hunting together) is easy to understand evolutionarily
§ Apparent acts of altruism (helping others at a net cost to oneself) make evolutionary
sense if explained by the kin selection or reciprocity theories.

The kin selection theory holds that behavior that seems to be altruistic came about through
natural selection because it preferentially helps close relatives, who are genetically most
similar to the helper (Hamilton, 1964).

The reciprocity theory provides an account of how acts of apparent altruism can arise even
among nonkin. According to this theory, behaviors that seem to be altruistic are actually
forms of long-term cooperation (Trivers, 1971).

Economist: Evolutionary psychology: The idea that woman are cyclical cuckolders
bites the dust
Ovulating women are more strongly attracted to men with faces that have pronounced
masculine characteristics.

TED talk: How to make stress your friend

Stress makes you sick  stress is the ememy.  this perception is wrong.
Stress is nor harmly for your health.
It is about how your perceive stress.

Stress response can change as a results of the way you think about it.
You can view your stress as helpful.

Chapter 4: The Neutral Control of Behavior

Hormonal Influences on Sex Drive
§ Hormonal Influences on Male Sex Drive
§ Crucial hormone for the maintenance of the sexual drive is testosterone
§ Many experiments have shown that the amount of testosterone that men
secrete into their blood is affected by psychological conditions
§ Hormonal Influences on Female Sex Drive
§ Estrogen and progesterone
§ In most mammals, female sexual drive and behavior are tightly controlled by
the estrous cycle

Changes in the Brain Over Time

§ If you use it, it will grow
§ Research of rats and mice saw in increase in brain structure after time in an
enriched environment
§ Restructuring of the cortex during skill development
§ As an animal or person develops skill at a task, ever more neurons in the brain
are recruited into the performance of that skill

The Evolution of the Human Brain

§ Human brains are substantially larger than expected for their body weight
§ This difference is greatest in the association (“thinking” cortex)
§ Gradual changes in relative brain size can be seen in the line that led to
modern humans
§ Genes associated with brain size have arisen relatively recently in human
evolution
§ Encephalization: formula for evaluating the expected ratio between brain weight and
body weight

Brain Comparisons

Comparison of the brains of four mammals. All the brains contain the same structures, but in
the chimpanzee and human, proportionately much more cortical space is devoted to
association areas than in the rat and cat. (Adapted from Rose, 1973.)

Estimated Encephalization Quotients (EQ) for Chimpanzees (Pan Troglodytes) and

Four Other Hominid Species
Chapter 5: Mechanisms of Motivation and Emotion

Principles of Motivation (part 1)

§ Motivation: factors (internal and external) that cause an individual to behave in a
particular way at a particular time
§ Motivational state (drive)
§ Incentives
§ Homeostasis: the constancy of internal conditions that the body must actively
maintain

Principles of Motivation (part 2)

§ Regulatory drive: a drive that helps preserve homeostasis (e.g., hunger)
§ Nonregulatory drive: a drive that serves some other purpose (e.g., sex)
§ Human drives that seem not to promote survival or reproduction
§ Art, music, and literature?

Types of Drives
§ Regulatory drives
§ Safety drives
§ Reproductive drives
§ Social drives
§ Educational drives

Understanding Emotions
§ Emotion: a subjective feeling that is mentally directed toward some object
§ Affect: feeling associated with emotion
§ Mood: emotion undirected at an object that lasts for a period of time

How Many Emotions Are There?

A model of primary emotions. Robert Plutchik has proposed that the spectrum of all emotions
can be represented by a cone with eight sectors. The vertical dimension of the cone represents
emotional intensity. The eight sectors represent eight primary emotions, arranged such that
similar emotions are next to one another and opposite emotions are on opposite sides of the
cone. In the exploded view of the cone, with the sectors laid out flat, the emotion labels in the
spaces between sectors represent mixtures of the adjacent two primary emotions. (This model
of emotions may appear similar to the model of affects shown in Figure 6.14, but it was
developed from a different set of observations and premises; the two models are not directly
comparable.)

Effects of Bodily Responses on Emotional Feelings

§ James’s peripheral feedback theory of emotion
§ Argued that peripheral bodily reactions precede and cause emotions (next
slide)
§ Schachter’s cognition-plus-feedback theory
§ Peripheral feedback affects emotional intensity, but perceptions and thoughts
determine the type of emotion
§ Influence of facial feedback on emotional experience
§ Feedback from facial muscles can induce feelings and bodily reactions
indicative of emotion

Three Theories of Emotion

§ Common sense theory

§ James’s theory
§ Schachter’s theory

Each theory proposes a different set of causal relationships among perception of the stimulus,
bodily arousal, and emotional feeling. According to the commonsense theory (so labeled by
James), the emotional feeling precedes and causes the bodily arousal. James’s theory reverses
that relationship, and Schachter’s theory holds that the intensity of the emotional feeling
depends on the bodily response, but the type of emotion experienced (such as fear, anger, or
love) depends on the person’s cognitive assessment of the external stimulus or situation.

Brain Mechanisms of Emotion

§ The amygdala assesses the emotional significance of stimuli
§ Rapidly evaluates sensory information for its significance to survival or well-
being and triggers bodily responses
§ The prefrontal cortex
§ Crucial for conscious emotional experience and deliberate action based on it

Chapter 8: Basic Processes of Learning

What Is Learning?
§ Learning: any process through which experience at one time can alter an individual’s
behavior at a future time
§ Experience: any effects of the environment that are mediated by the individual’s
sensory systems
§ Behavior at a future time: any subsequent behavior that is not part of the
individual’s immediate response to the sensory stimulation during the learning
experience

Agenda
§ Classical conditioning
§ Operant conditioning
§ Play, exploration, and observation

Classical Conditioning
§ Classical conditioning: a learning process that creates new reflexes
§ Reflex: A simple, relatively automatic, stimulus–response sequence mediated
by the nervous system
§ Stimulus: a particular event in the environment
§ Response: a behavior resulting from the stimulus
§ Habituation: a decline in the magnitude of a reflexive response when the
stimulus is repeated several times in succession

Classical Conditioning Procedure

Classical conditioning procedure. A neutral stimulus initially does not elicit a response. After
it is paired for several trials with an unconditioned stimulus, however, it becomes a
conditioned stimulus and does elicit a response.

Extinction of Conditioned Responses and Recovery from Extinction (part 1)

§ Extinction — without the UCS (food), eventually the CS (bell) will no longer produce
the CR (salivation)
§ Spontaneous recovery — after time, the conditioned response (salivation) might recur

Extinction of Conditioned Responses and Recovery from Extinction (part 2)

Extinction and spontaneous recovery of conditioned salivation. The conditioned stimulus in

this case was the sight of meat powder, presented repeatedly out of the animal’s reach at 3-
minute intervals. Extinction was complete by the fifth and sixth presentations, but when 2
hours were allowed to elapse before the seventh presentation, the response was partially
renewed.

Generalization and Discrimination in Classical Conditioning

§ Generalization — the CR (salivation) occurs in response to similar conditioned
stimuli (sounds similar to a bell)
§ Discrimination — the CR (salivation occurs only in response to one specific CS (bell
- requires discrimination training)

Pavlov and the Emergence of Behaviorism

§ Early behaviorists were inspired by Pavlov’s work on conditioning
§ Developed objective stimulus–response descriptions of behavior
§ Established learning as their main explanatory concept

Theories of Classical Conditioning

Comparison of S-R and S-S theories of classical conditioning. According to the S-R theory,
conditioning produces a direct bond between the conditioned stimulus and the response.
According to the S-S theory, conditioning produces a bond between the conditioned stimulus
and a mental representation of the unconditioned stimulus, which, in turn, produces the
response. Support for the S-S theory comes from experiments showing that weakening the
unconditioned response (through habituation), after conditioning, also weakens the
conditioned response.

What Is Learned in Classical Conditioning?

§ Classical conditioning interpreted as learned expectancy
§ Expectancy theory helps make sense of the observation that a conditioned response
is often quite different from the unconditioned response
§ Conditioning depends on the predictive value of the conditioned stimulus
§ The conditioned stimulus must precede the unconditioned stimulus
§ The conditioned stimulus must signal heightened probability of occurrence of
the unconditioned stimulus.
§ Conditioning is ineffective when the animal already has a good predictor

Patterns of Stimulus Presentation

Patterns of stimulus presentation in which conditioning does or does not occur. The top time
line illustrates a pattern of stimulus presentation in which conditioning occurs. The three
lower time lines illustrate patterns in which poor or no conditioning occurs even though the
potential conditioned stimulus (blue) and unconditioned stimulus (red) are often paired.
Strong conditioning occurs when the potential conditioned stimulus is a reliable and
nonredundant predictor of the unconditioned stimulus.

Conditioned Fear, “Liking,” Hunger, and Sexual Arousal (part 1)

§ Fear conditioning – John B. Watson
FIGURE 4.6 Little Albert with Watson, Rayner, and furry animals. Prior to the conditioning
experience, 11-month-old Albert played happily with a live laboratory rat (left). After he was
conditioned to respond fearfully to the rat, he also cried at the sight of other furry objects,
including a rabbit, thereby exhibiting generalization (right).

Conditioned Fear, “Liking,” Hunger, and Sexual Arousal (part 2)

§ Liking
§ Evaluative conditioning: changes in the strength of liking or disliking of a
stimulus as a result of being paired with another positive or negative stimulus.
§ Conditioned hunger
§ Appetizer effect
§ Conditioned sexual arousal

Conditioned Drug Reactions

§ Conditioned compensatory reactions to drugs
§ Two effects: a direct effect followed by a compensatory reaction that
counteracts the direct effect and tends to restore the normal bodily state
§ Conditioned reactions as causes of drug tolerance
§ Depends at least in part on conditioning
§ Conditioned reactions as causes of drug relapse after withdrawal
§ Effects of environment on relapse

Operant Conditioning
§ Operant conditioning
§ Reflects the impact of an action’s consequences on its recurrence
§ Entails learning about conditions and consequences
Thorndike’s Puzzle Box:

Thorndike’s Law of Effect

FIGURE 4.9 Thorndike’s law of effect. According to Thorndike, the stimulus situation
(being inside the puzzle box) initially elicits many responses, some more strongly than others,
but the satisfying consequence of the successful response (pressing the lever) causes that
response to be more strongly elicited on successive trials.
Skinner’s Method of Studying and Describing Operant Conditioning
§ B.F. Skinner
§ Behaviorist
§ Defined reinforcer as a stimulus change that follows an operant response and
increases the frequency of that response

B. F. Skinner and his operant-conditioning chamber. To study operant behavior in rats and
other animals, Skinner invented an apparatus widely known as the Skinner box. When the rat
shown here presses the lever, it activates an electrical relay system that causes the delivery of
a food pellet into a cup next to the lever. Each lever press can be automatically recorded to
produce a cumulative record.

Cumulative Response Curve

Typical cumulative response curve for a rat learning to press a lever in a Skinner box. This
graph is called a cumulative response curve because the height of the curve at any point
indicates the total (cumulative) number of responses that the rat has made up to that time. The
graph is automatically produced, while the rat is responding, by a recording machine outside
the Skinner box. A pen moves horizontally across a roll of paper at a constant rate, and each
lever press made by the rat produces a slight vertical movement of the pen. Thus, the degree
to which the curve slopes upward is a measure of the animal’s response rate. Note that early
in learning, the response rate was very low and then gradually increased to a fast, steady rate.

Skinner’s Work
§ Operant conditioning without awareness
§ Skinner argued that most of our actions can be understood as operant
responses that occur because of their past reinforcement
§ Reinforcement can occur with or without awareness

Principles of Reinforcement
§ Shaping of New Operant Responses
§ Shaping: successively closer approximations to the desired response are
reinforced until the desired response finally occurs and can be reinforced
§ Extinction of Operantly Conditioned Responses
§ An operantly conditioned response declines in rate and eventually disappears
if it no longer results in a reinforcer
§ Extinction is not true “unlearning”
 § Passage of time following extinction can lead to spontaneous recovery of the
response

Distinction Between Positive and Negative Reinforcement

§ Reinforcement: any process that increases the likelihood that a particular response
will occur
§ Positive reinforcement: occurs when the arrival of some stimulus following a
response makes the response more likely to recur
§ Negative reinforcement: occurs when the removal of some stimulus following a
response makes the response more likely to recur

Distinction Between Reinforcement and Punishment

§ Punishment: process through which the consequence of a response decreases the
likelihood that the response will recur
§ Positive punishment: the arrival of a stimulus decreases the likelihood that the
response will recur
§ Negative punishment: the removal of a stimulus decreases the likelihood that the
response will recur

Reinforcement and Punishment

Two types of reinforcement and two types of punishment. Reinforcement (whether positive
or negative) increases the response rate, and punishment (whether positive or negative)
decreases the response rate. The terms “positive” and “negative” refer to whether the
reinforcing stimulus arrives or is removed when the response is made.

Discrimination Training in Operant Conditioning

§ Learners generalize to stimuli that they perceive as similar to the discriminative
stimulus but can be trained to discriminate
§ Discrimination and generalization of an operantly conditioned behavior can be used to
identify concepts a subject has learned
- baby sucks / story
- pigeon / tree

When Rewards Backfire: The Overjustification Effect in Humans

§ In humans, rewards can have a positive or negative effect, depending on the
conditions in which they are used and the meanings that they engender in those who
receive them
 § Overjustification effect: previously reinforced behavior declines because the reward
presumably provides an unneeded extra justification for engaging in the behavior
- soccer kids / medals

Play, Exploration, and Observation

§ In the natural environment, learning is promoted by
1) Play
2) Exploration
3) Observation

Play: How the Young Learn How

§ Groos’s theory: play is practice of species-typical skills
§ Young animals play more than do adults of their species
§ Species of animals that have the most to learn play the most
§ Young animals play most at those skills that they most need to learn
§ Play involves much repetition
§ Play is challenging
§ Applying the Theory to Humans
§ Symbolic play

Exploration: How Animals Learn What and Where

§ The nature of mammalian exploration
§ Often includes an element of fear
§ Evidence that animals acquire useful information through exploration
§ Tolman and Honzik’s rats
§ Latent learning (next slide)

Latent Learning

Latent learning of a maze. Each rat received one trial per day in the maze, with or without a
food reward in the goal box. The group that received its first reward on day 11 performed as
well on day 12 (and thereafter) as the group that had received a reward every day. From this,
Tolman and Honzik concluded that the rats had learned the spatial layout of the maze even
without a reward, but the rats did not use that knowledge until the changed conditions made it
worthwhile for them to do so.

This can be an evolutionary advantage.

Social Learning (= Observation): Learning by Watching and Interacting with Others
§ Social learning: occurs in a situation “in which one individual comes to behave
similarly to another”
§ Observational learning: occurs by watching others
§ Vicarious reinforcement: the ability to learn from the consequences of others’
actions
Learning how by watching skilled performers
§ Neuroscientists have discovered that the brains of human beings and of at least
some nonhuman primates contain organized systems of neurons (nerve cells)
called mirror neurons that seem to be well designed to make imitation easy
and natural
§ Cultural Transmission in Chimpanzees

The infant sitting beside her mother is too young to work seriously at nut cracking but may be
learning something about it through watching the older master.

Lecture 3
Chapter 9: Memory, Attention, and Consciousness

An Information-Processing Model

We have limited capacity in our “brain”. Most of the information we throw out again. Some
of it we keep short term. Some of it we keep in the long term, because it is so important to us.

The most important thing to remember in relation to this course, is that when we are
retrieving, it is not a copy paste. In the process of retrieving, we want this to make sense. If
we don’t remember all of it as a “copy paste”, we want it to make sense. When we retreat it,
we don’t exactly remember it 100% identic.

Control Processes: The Mind’s Information. Transportation Systems (part 1)

 Attention: process that controls the flow of information from the sensory store into
the short-term store
 Encoding: process that controls movement from the short-term store into the long-
term store
 Retrieval: process that controls the flow of information from the long-term store into
the short-term store

We pay attention, a lot of this is lost.

Encoding - we notice a red building and some other things - some of it we remember, and
some is lost.
Retrieval - not a copy/paste.

Control Processes: The Mind’s Information. Transportation Systems (part 2)

 Effortful processes: require the use of mental resources for their successful
completion
 Automatic processes: require little or none of the short-term store’s limited capacity

“Fast” and “Slow” Thinking: Dual-Processing Theories of Cognition

 Dual-processing theories: when solving problems, people have two general ways of
proceeding
 Fast thinking: intuitive, with little or no sense of voluntary control
 Slow thinking: involves the conscious self-deciding which aspects of a problem to
attend to, deciding which cognitive operations to execute, and then deliberately
solving the problem

Kahneman wrote this book. We only have two ways of thinking: fast and slow. First, fast
thinking - may be okay, but it also might be very biased. If you are not aware of this, you
don’t know the effect of fast thinking.

Attention: The Portal to Consciousness

 Preattentive processing: analysis, at an unconscious level, in which the mind
determines which stimuli are worth passing into working memory

A generalized model of attention. All sensory input enters the sensory memory store, where
it is processed pre-attentively. Then some of it is selected to pass through the gate into
conscious, working memory. The arrow going from working memory to the gate indicates
top-down control of the selection criteria.

Ability to Focus Attention and Ignore the Irrelevant

 Selective listening: ability to listen to and understand one person’s voice while
disregarding others nearby
 Selective viewing: attending selectively to different, nearby parts of a visual scene
without moving the eyes

When looking out the window, you must focus on something.

The Ability to Shift Attention to Significant Stimuli

 Shifting attention to meaningful information in auditory sensory memory
 Echoic memory: auditory sensory memory
 Shifting attention to meaningful information in visual sensory memory
 Iconic memory: visual sensory memory
  Effect of practice on attentional capacity
 Practice can enhance the capacity to attend to several items of information at
once

Executive Functions
 Executive functions: relatively basic and general-purpose information-processing
mechanisms that, together, are important in planning, regulating behavior, and
performing complex cognitive tasks

Multi-tasking. Where are we actually focusing? Texting/talking in phone while driving not
okay but talking to passengers while driving is okay. It is the attention you’re giving that
makes it bad. So, how can it generally be okay to talk to passengers instead? As they are
present, they have a clue about what’s happening, which the ones over phone doesn’t.

Types of Long-Term Memory

What kind of things do we remember?

1. Explicit memory  I can tell you I was born in 1963, what degree I have, the world is
flat (semantic), etc.
2. Implicit memory  driving, bicycling (you are not aware of everything you do, you
just bike - you must learn it, can’t be explained). Priming is the things we know we do
not really know we know.

A Network Model of Memory Organization

This diagram depicts schematically some of the links,

or associations, among a tiny fraction of the thousands
of different concepts that are stored in a typical
person’s long-term semantic memory. (From Collins,
A., & Loftus, E. [1975]. A spreading-activation theory
of semantic processing. Psychological Review, 82,
407–428. Figure 1, p. 412. Copyright © American
Psychological Association.)
If you want to remember something, it is nice to know it in association with something.
What’s his name? It’s his wife, then you maybe remember his name. Once you understand
something, it helps you make sense of it. This is typically here we have limited knowledge
about what actually happens.

Encoding Information Into Long-Term Memory

 Maintenance rehearsal: process by which a person holds information in working
memory for a period. Meaning we go from the short-term memory to actually store it
in the long term.
 Encoding rehearsal: process by which a person encodes information into the long-
term store

How can we secure that we will actually remember it in the long term memory? That we can
retrieve it? One of them is chunking: that we combine something together with something
else to remember it.

Next 3 slides: 1) Elaboration

2) Chunking
3) Visualization

 Elaboration: The process of thinking about an item of information in such a way as

to tie the item mentally to other information in memory, which helps to encode the
item into long-term memory. Putting it into a context. We can’t replicate what
someone says identically, even though we remember it. But we get an understanding
of it, without explicitly remembering what it says in the book.

Superior memory resulting from meaningful elaboration.

Subjects were shown a long sequence of words and, for each, were
asked questions that required them to focus on the way the word
was printed, how it sounded, or what it meant. The type of question
dramatically affected the subjects' later ability to recognize words
as ones that had appeared in the sequence. (Based on data from
Craik & Tulving, 1975.)

 Chunking: grouping adjacent items that are at first perceived as separate, thus
making them a single item.

FIGURE 9.17 Chess memory. The top drawings exemplify the

types of chess layouts used in chess memory research. On the
left is a board taken from a master’s game, and on the right is
one with randomly arranged pieces. The graph shows the
memory performance (averaged over 13 experiments) of chess
players of various skill levels who studied either a game board or
a random board for 10 seconds or less. The average number of
pieces per board was 25. Skill level is measured in ELO points:
1,600 is Class B, 2,000 is Expert, and 2,200 is Master. (With
permission from Gobet, F., Lane, P. C. R., Croker, S., Cheng, P. C-H., Jones, G., Oliver, I., &
Pine, J. M. [2001]. Chunking mechanisms in human learning. Trends in Cognitive Sciences,
5, 236–243. Copyright © 2001, with permission from Elsevier.)

§ Visualization Promotes Encoding: Visualizing verbally presented information may

improve memory by creating an additional memory trace, by chunking separate items
together into one image, and by forming links to information already in long-term
memory

Depending on what kind of information it is, can we visualize it? We may chunk it together,
then visualize the associations trying to understand it.

Memory Consolidation (part 1)

 Consolidation: process by which the labile memory form is converted into the stable
form. Long-term memories exist first in a labile form, becoming gradually more
stable through consolidation
 Role of retrieval
 Frequent recall of memories can promote both their modification and their
consolidation
 Active retrieval of information can consolidate memory and facilitate learning

I know it without explicitly knowing it - know it when I see its there.

Memory Consolidation (part 2)

 Role of sleep
 Sleep shortly after learning helps to consolidate memories and, in some cases,
may reorganize memories in ways that promote new insights.

If we want to learn something, if we sleep afterwards, it seems to be a benefit.

Retrieving Information From Long-Term Memory

 Long-term memories are stored not in isolation but in networks in which each item is
linked to many others through associations

Mental Associations
 Association by contiguity: some concepts are associated because they have occurred
together (contiguously) in the person’s previous experience
 Association by similarity: items that share one or more properties in common are
linked in memory whether or not they were ever experienced together

Two non-exclusive ways to look at it. They might happen at the same time, or they might
have some similarities.

Why Elaborative Rehearsal Creates Easily

Retrievable Memories
 The more mental associations you create in
learning a new item of information, the more
ways will be available for you to retrieve it later
 Value of self-generated retrieval cues. Subjects generated either one or three single-word
properties related to each of 500 nouns. Later they were tested for their ability to recall each
noun, using either their own self-generated properties or another subject’s self-generated
properties as retrieval cues. (Based on data from Mäntylä, 1986.)

Memory Construction as a Source of Distortion (part 1)

 Effects of preexisting beliefs
 Schemas: one’s generalized mental representation, or concept, of any given
class of objects, scenes, or events
 Scripts: schemas that involve the organization of events in time rather than of
objects in space

Memory Construction as a Source of Distortion (part 2)

 False eyewitness memories: effects of suggestion
 Memories can also be affected by events that occur after the event being
remembered was encoded
 False memories of childhood experiences: effects of suggestion and imagination
 Research strongly suggests that childhood memories are even more subject to
distortion by suggestion and imagination than are memories acquired later in
life

The eyewitness might deliberately lie, or worse: she thinks she tells the truth, but it was not
exactly what happened. If you ten years later are going to tell what you saw, you will
probably give a different description than ten years ago - not because you lie deliberately, but
because you fill in the blanks.

Adults might remember something that actually did not happen. E.g. regarding child abuse, if
you try filling in the blanks, you might end up lying (not on purpose).

Source Confusion and Social Pressure as Causes of False-Memory Construction

 According to some theorists, a basic cause of most cases of false-memory
construction is source confusion (Lindsay, 2008)
 Social pressure also figures into many cases of false memory (Loftus, 1997).

How much you remember from your birthday? To what degree are you just filling in the
blanks? You are biased, because you know what birthday parties are supposed to be like, but
you maybe do not remember all your old birthdays. But you know typically in a birthday you
will have a cake, why you fill in the blanks and assume you had a cake.

Prospective Memory and Mental Time Travel

 Failures of prospective memory are common complaints for people of all ages and
have serious consequences in some workplaces
 Remembering to do things in the future requires good executive functions, as well as
a well-developed sense of self
  Subjects that are given a prospective memory task perform more poorly on ongoing
problem-solving tasks (the tasks compete for a limited set of resources)

Another thing is this prospective memory. It’s not about looking back, but in five minutes
you will have to start the recording of zoom lecture. While walking around talking to the
students… the more things you have to remember the harder it is. If you’re reading and you
get a SMS. Either you open it or you wait. If answering it now helps you focus later on, as its
out of your way, maybe you should.

Rita is shopping at a noisy store and talking to a sales associate when she hears her name
being called and looks around. What term describes Rita’s ability of talking to the sales
associate and responding to her name?
a. selective attention
b. discriminatory selection
c. preattentive processing
d. cocktail-party phenomenon

Shelly was talking on her cell phone while driving and she missed a road sign. What term do
psychologists use to explain this?
a. discriminatory selection
b. attentional mishap
c. attentional blindness
d. inattentional blindness

What memory system is Dana using as she recalls her vacation to her friend?
a. semantic memory
b. procedural memory
c. priming
d. episodic memory

If you had to memorize the series of letters FBINSACIA and did so by noting that FBI, NSA,
and CIA are all names of governmental agencies, what technique of encoding information
into long-term memory would you be using?
a. rehearsal
b. concentration
c. elaboration
d. chunking

Chapter 10: Solving problems: reasoning and intelligence

Four different ways of looking at reasoning: analogy, induction, decution, insight.

How People Reason

 Analogy: refers to a similarity in behavior, function, or relationship between entities
or situations that are in other respects, such as in their physical makeup, quite
different from each other
 Use of analogies in scientific reasoning
 Scientists often attempt to understand and explain natural phenomena by
thinking of analogies to other phenomena that are better understood
 Use of analogies in judicial and political reasoning and persuasion
  People frequently use analogies to convince others of some claim or course of
action they support

Very often we look at similar situations and firm on this situation. This is quite a similar
situation, so should not we do this? In science this is also done - can we draw some
conclusions from kind of similar scientific problems.

Inductive Reasoning
 Inductive reasoning: attempt to infer some new principle or proposition from
observations or facts that serve as clues
 Hypothesis construction
 Scientific reasoning: generating hypotheses about how something in the world works
and then systematically testing those hypotheses

Inductive Reasoning and Some of Its Biases

 Availability bias
 Tendency, in reasoning, to rely too much on information that is readily
available to us and to ignore information that is less available
 Confirmation bias
 Tendency is to try to confirm rather than disconfirm their current hypotheses
 Predictable-world bias
 Tendency to believe that events are more predictable than they actually are

Deduction
 Deductive Reasoning: attempt to derive logically the consequences that must be true
if certain premises are accepted as true

Answers: Series problem: no. Syllogism: yes.

(Alternative forms: indeterminate, indeterminate, no.)

The Concrete Nature of Deductive Reasoning

 Deductive Problems: Logic or Content?

Consider the following two syllogisms. In each, you are instructed to use logic alone, not
your knowledge of the real world. In each, you are to assume that the first two propositions
are valid, and you are to judge whether or not the conclusion follows logically from those
propositions.
Elements of Insight
 Insight problems: Problems that are specially designed to be unsolvable until one
looks at them in a way that is different from the usual way

 Breaking out of a mental set: broadening perception and thought

 Mental set: a well-established habit of perception or thought
 Functional fixedness: the failure to see an object as having a function other
than its usual one
 Discovering a solution
 Deliberate attention to aspects of the problem and materials that were not
noticed before can lead to the sudden perception of a solution

 Functional fixedness and tools: A special case?

 Our tendency to see tools as designed for a specific purpose leads to functional
fixedness but may also result in more efficient use of tools
 Unconscious mental processes may lead to insight
 Insight often derives from abandoning a mental set (a habitual way of
perceiving or thinking) and paying attention to aspects of the problem and
materials that might otherwise be overlooked.
 The value of a happy, playful frame of mind
 Insight may also be facilitated by an incubation period or by a happy or
playful frame of mind.

Cross-Cultural Differences
 Responses of Unschooled Non-Westerners to Western-Style Logic Questions
 Most studies of reasoning have been conducted in Western cultures, usually
with university students as subjects
 Non-Westerners, who haven’t attended Western-style schools, often find it
absurd or presumptuous to respond to questions outside their realm of concrete
experiences

An East–West Difference: Focus on Wholes Versus Parts (part 1)

 In perceptual tests, East Asians tend to focus on and remember the whole scene and
the interrelationships among its objects, whereas Westerners tend to focus on and
remember the more prominent individual objects of the scene as separate entities,
abstracted from their background.

The Frame-Line Test

The Frame-line test. Children are asked to draw the line in the boxes at the bottom that is
either the same absolute length as the line in the top box (absolute task) or the same relative
length (relative task). Beginning at age 6, Americans perform better on the absolute task, and
Japanese perform better on the relative task. However, 4- and 5-year-old children in both
America and Japan make more errors on the absolute task.

The Practice and Theory of Intelligence Testing

 Binet-Simon intelligence scale
 Binet regarded intelligence as a loose set of higher-order mental abilities that can be
increased by schooling. His tests used school-related questions and problems
 Most modern intelligence tests are rooted in Binet’s approach and use a variety of
verbal and nonverbal subtests

History of Intelligence Testing

 Stanford-Binet scale
 First test used widely in North America
 Wechsler Adult Intelligence Scale, Fourth Edition (WAIS-IV)
 Wechsler Intelligence Scale for Children, Fourth Edition (WISC-IV)
 For children ages 7–16
 Wechsler Preschool and Primary Scale of Intelligence, Fourth Edition (WPPSI-IV)
 For children ages 2–7

The Validity of Intelligence Tests as Predictors of Achievement

 IQ scores correlate moderately well with school grades and job performance. Such
correlations are commonly used as indices of IQ validity
FIGURE 10.8 Standardized scoring of Wechsler IQ tests. The scoring system for Wechsler
IQ tests is based on the assumption that intelligence is distributed in the population according
to a normal distribution (represented by the bell-shaped curve). Thus, raw scores on the test
are converted into IQ scores in such a way as to produce a normal distribution. Notice that
with this system about 68% of IQ scores are between 85 and 115 and about 95 percent are
between 70 and 130.

The Concept of General Intelligence

 General intelligence (g)
 The underlying mental ability that affects performance on a wide variety of
mental tests and accounts for the statistical correlation among scores on such
tests
 Fluid intelligence
 Ability to perceive relationships among stimuli independently of previous
specific practice or instruction concerning those relationships.
 Crystallized intelligence
 Mental ability derived directly from previous experience
 Mental speed and executive functions
 Modern measures of mental quickness and executive functions correlate
significantly with IQ.
 General intelligence as an evolutionary adaptation for novelty
 General intelligence may have been selected for in human evolution because it
helps us deal with novel problems.

Genetic and Environmental Contributions to Intelligence

 Nature, Nurture, and IQ Differences
 The reasonable version of the nature–nurture question asks whether genetic or
environmental variation contributes more to observed IQ variation within a
population

FIGURE 10.10 A geometric analogy to heritability. It is senseless to say that a given

rectangle’s area results more from its length than from its width, or vice versa. However,
differences among rectangles in area can result primarily or entirely from differences in
length (as shown in group A) or in width (as shown in group B). Similarly, one can imagine
one group of people in which IQ variation results mostly from their differing genes and
another group in which it results mostly from their differing environments.

Genetic and Environmental Contributions to Intelligence (part 2)

 Heritability: the degree to which variation in a particular trait, within a particular
population of individuals, stems from genetic differences as opposed to environmental
differences
 Heritability coefficient
 Family studies of the heritability of intelligence
 Comparing identical and fraternal twins to study the heritability of traits
 These studies have shown that, within a population, genetic variation
accounts for about half of IQ variance in children and for more than
that in adults

Genetic and Environmental Contributions to Intelligence (part 3)

 Influence of family environment
 Effects of the shared family environment (aspects of the environment shared
by children growing up in the same home) on IQ are temporary; they
disappear in adulthood
 Effects of personality and life experiences on intelligence
 There is evidence that a person’s job or leisure activities can alter his or her
fluid intelligence

Origins of IQ Differences Between Cultural Groups

 Why within-group heritability coefficients cannot be applied to between-group
differences
 Heritability coefficients for IQ within groups cannot be legitimately used to
explain the source of average IQ differences between groups

What Do You See?

Why high within-group heritability tells us nothing about group differences. In this
example, the same genetically diverse mix of wheat seeds was planted in two fields. Within
each field, the environment is quite uniform (same thickness of topsoil), so the differences in
plant size are mostly the result of differences in genes (high heritability). However, the
difference between the two fields in average plant size in this case cannot result from genes
because genetic differences would cancel out in the averages; it must result from differences
in the environment.
Origins of IQ Differences Between Cultural Groups (part 2)
 Evidence that black–white IQ differences are cultural in origin
 The average black–white IQ difference found in the United States (12 points)
is related to the social designation of black or white rather than to the degree
of African or European ancestry
 Different types of minority status can have different effects on IQ
 Involuntary minority status is particularly likely to reduce a group’s IQ
(Buraku outcasts of Japan – a cultural class not racially distinct)

The Historical Increase in IQ

 The large historical gains in IQ—perhaps resulting from changes in technology—also
demonstrate the influence of cultural factors
 Improvements in education
 Greater use of technology
 We are constantly being presented with new ideas, new information, and new
problems to solve

Lynn & Kanazawa 2011: A longitudinal study of sex differences in intelligence at

ages 7, 11 and 16 years
Intelligence:
This paper presents the results of a longitudinal study* of sex differences in intelligence …
at the ages of 7 and 11 years girls have an IQ advantage of approximately 1 IQ point, but at
the age of 16 years this changes in the same boys and girls to an IQ advantage of 1.8 IQ
points for boys.
= Minimal difference in average intelligence!
(British respondents, 98% Caucasian)

* Cross-sectional data are problematic because among older adolescents, more males are in
prison and other custodial institutions and these are not included in the samples on which
norms are based. These excluded males have lower average IQs, so their omission from
normative samples inflates the IQs of males that are tested. Longitudinal data overcome this
problem by assessing IQs of the same males and females at different ages. The principal
interest of the results is that these longitudinal data show that the same girls, who obtained a
higher average IQ than boys at the ages of 7 and 11 years, obtained a lower average IQ than
boys at the age of 16 years.

Stupid boys – bright boys:

Boys had larger standard deviations than girls at all three ages, confirming the frequent
contention advanced by Havelock Ellis (1904) and many others that the variance of
intelligence is greater in males than in females.

Lawrence Summers (1)

(Then) Harvard President Lawrence H. Summers (2005):
"It does appear that on many, many different human attributes -- height, weight, propensity
for criminality, overall IQ, mathematical ability, scientific ability -- there is relatively clear
evidence that whatever the difference in means -- which can be debated -- there is a
difference in the standard deviation, and variability of a male and a female population.
And that is true with respect to attributes that are and are not plausibly, culturally
determined. If one supposes, as I think is reasonable, that if one is talking about physicists
at a top 25 research university, one is not talking about people who are two standard
deviations above the mean. And perhaps it's not even talking about somebody who is three
standard deviations above the mean. But it's talking about people who are three and a half,
four standard deviations above the mean in the one in 5,000, one in 10,000 class. Even small
differences in the standard deviation will translate into very large differences in the
available pool substantially out."

Lawrence Summers (2)

Lawrence Summer was forced to resign.
The Globe quoted Steven Pinker, a psychology professor, as saying that the Summers talk
was "masterly" and that "All his claims were well supported in the scientific literature."
The Globe quoted Elizabeth Spelke, another psychology professor, as saying: "I disagree
point for point. There is not a shred of evidence for the biological factor, based both on my
own research and my reading of other people's research.“

Remember: One does NOT exclude the other (coexistence)

- discrimination and differences in intelligence dispersions

Evolutionary speculations
1) …human evolutionary history of mild polygyny. Under polygyny, girls who reach
puberty earlier gain a reproductive advantage over their age mates by being able
to marry polygynous men. The reason for this is that females are in competition with
other females for reproductive success. Females who mature earlier than other
females can start reproducing earlier and have access to polygynous men, while their
age mates who have not yet reached puberty cannot. At the same time, there is no
reproductive incentive for men in a polygynous breeding system to mature earlier.
2) Decline in gamete quality with age is a more serious constraint for women than for
men. Decline in sperm quality is buffered by the large number of sperm
produced. In contrast, ova production is much more limited. Women are
therefore under stronger selection pressure to begin mating as soon as possible.

Chapter 12: Social Development

The Development of Prosocial Behavior
§ Prosocial behavior: voluntary behavior intended to benefit other people
§ Empathy
§ Develops during the second year
§ Giving and helping
§ Around 12 months of age, infants routinely begin to give objects to their
caregivers and to delight in games of give and take
§ Sharing
§ Learning to share can be difficult for younger children

Developmental Functions of Play

§ Play is a vehicle for acquiring skills
§ Chasing games
§ Play fighting
§ Play may enable children to acquire more advanced understandings of rules and social
roles and greater self-control
§ Age-mixed play
 § Age-mixed play appears to be less competitive and more conducive to
teaching, learning, and development of nurturing skills than is play among age
mates

Gender Differences in Social Development

§ Gender differences are evident in every culture studied
§ Gender differences in interactions with caregivers
§ Adults treat girls and boys differently beginning at birth, at least partly on the
basis of socially grounded beliefs about gender. This may help to create or
widen some gender differences

Several Frequently Reported Sex Differences

Gender Identity
§ Gender identity: a person’s subjective sense of being male or female
§ Self-imposed gender segregation
§ In all cultures that have been studied, boys and girls play primarily with others
of their own sex
§ Gender differences in styles of play
§ Boys’ and girls’ groups are in some ways different subcultures. Boys tend to
play competitively, in relatively large, hierarchical groups. Girls play more
cooperatively, in smaller, more intimate groups. These differences may be
muted in age-mixed play.

AlShawaf & Conroy-Beam (2015)

Human Emotions: An Evolutionary Psychological Perspective
By Laith Al-Shawaf & Daniel Conroy-Beam & Kelly Asao & David M. Buss
(emotion review, 2015)
Emotions:
Emotions are superordinate mechanisms that evolved to coordinate the activity of other
programs in the solution of adaptive problems.
Emotions must have evolved to solve adaptive problems in a broad range of domains
tributary to reproductive success.
Emotions have evolved as superordinate mechanisms responsible for coordinating suites of
other information-processing programs, including those of attention, perception, memory,
categorization, learning, and energy allocation, as well as the more typically considered
elements of physiology and manifest behavior.

Adaptive problem
Adaptive problems can be structurally complex. An example of predator avoidance:
1) focus attention on the predator (we have to be able to focus on that predator)
2) down-regulate attention to distracting stimuli
3) suppress motivations relevant to other adaptive problems (e.g., approaching mates)
4) determine whether one has been spotted
5) identify whether there are other predators in the environment (if there’s a lion in front
of you, you won’t think about you’re tired/hungry etc.)
6) accurately recall the spatial layout of the environment if it is already familiar select a
propitious escape route
7) move in the determined route
8) shunt energy away from nonessential physiological processes (e.g., immune
function) and toward those necessary for escape (e.g., catabolism in the muscles)

The coordination problem

Two problems:
1) Conflicting outputs. One reason that adaptations require coordination is that they
often have opposing outputs. The problem of conflicting outputs can be solved by
mechanisms that control the activation and deactivation of programs so as to
minimize interference with effective problem solving. For example, a first glance at
an attractive potential mate might motivate approach, but up close, infected sores
might become unmistakably apparent. Conflicting motivations must therefore be
coordinated to result in a successful solution to the adaptive problem at hand.
2) Concatenation (sequence). Many adaptive problems require that subtasks be
completed in a specific order.

An effective solution
To produce an effective solution, an emotion must
(a) activate the right programs,
(b) deactivate conflicting programs,
(c) adjust program thresholds to meet task demands, and
(d) manage the sequence duration of program activation as well as the point of program
termination.
Emotions can be thought of as organismic “modes of operation”.

If I am hungry, I look at the landscape differently than if I’m not hungry. In terms of
corporate decisions, we know that the weather actually matters. If it shines or rains, whether
compared to what you’re used to (In Bergen you’re used to rain, in Florida sun).
Various emotions
Fear, anger, and disgust evolved to solve survival problems and are widely regarded as
“basic”. These three emotions help us primarily survive; they are all related to surviving. I
fear if there’s a predator, a cliff I can fall out of. I care whether I see a fresh apple or rotten
apple.
Romantic love, sexual arousal and parental love are however, just as basic. Sexual arousal
motivates the pursuit of intercourse, sexual jealousy protects a mate ship from interlopers,
and parental love motivates behaviors that contribute to the health and success of offspring.
They are not necessary in order to survive.
A modern evolutionary perspective emphasizes that the bottom line of evolution by selection
is differential reproductive success. Evolutionary biologists recognize that survival is
critical, but only to the extent that it is tributary to reproductive success.

Sex thresholds and memory

The minimum obligatory parental investment is greater for women than for men.
The higher investing sex suffers more severe costs as a consequence of injudicious mating
decisions. Consequently, easy-to-cross thresholds of sexual arousal are more costly for
women than for men. Thus, the theoretical optimum for sexual arousal thresholds is higher
for women than it is for men. Selection therefore favors higher thresholds in women,
making men more sexually excitable in response to more minimal stimulation.
Memory effects should show sex-differentiated design features:
1) Men recalled and regretted more acts of sexual omission.
2) Women recalled and regretted acts of sexual commission with inappropriate
partners (e.g., men who were unattractive or uninterested in commitment).

Two Sex biases

Sexual arousal activates the sexual overperception bias, the adaptive male tendency to
overestimate the sexual interest of women displaying ambiguous cues such as a smile. By
activating the overperception bias, sexual arousal presumably motivates approach,
minimizes missed opportunities, and may even transform an initially uninterested woman
into an interested one.
The commitment skepticism bias refers to women’s tendency to underestimate the
commitment intent of potential mates. Commitment skepticism evolved because of a large
cost asymmetry in the types of error a woman could make when inferring a man’s
commitment intent: underestimating commitment may result in wasted time, but
overestimating commitment can lead to deception and exploitation (ultimately pregnancy
and left to rear offspring without the provisioning of a committed mate).

Over perception bias: the man would go for a chance, as he would hate missing a chance
where he could do something. However, women have more commitment skepticism bias.

Lecture 4
Chapter 13: Social Psychology

Social Psychology
§ Social psychology: the subfield of psychology that deals most explicitly with how we
view one another and are influenced by one another. It’s not only about oneself, but
about others around you as well.
§ Forming impressions of other people
 § People “naturally” come to understand the psychological world, and from an
evolutionary perspective, this drive to understand others has clear adaptive
functions

Making Attributions From Observed Behavior

(part 1)
§ Attribution: a claim about the cause of someone’s behavior
§ Actions are directly observable, and thoughts are not, making our judgments about
others based largely on what we observe of their actions

We judge a lot, not by what’s going on in your mind, but what people do. If I scream “I’m
god” we assume “oh he’s like that and that”. This is why we look so much into behavior in
psychology, as it tells us something about what’s going on in one’s mind. In CFO’s we can’t
see in their mind whether they’re narcissistic. Their signature might tell something about
whether they are narcissistic. Another thing is how they word themselves, if using singular (I,
instead of we) then typically more narcissistic.

Making Attributions From Observed Behavior

(part 2)
§ The person bias is the tendency to give undue weight to personality and not enough
to the situation in making attributions
§ Fundamental attribution error
§ The person bias is less often observed in East Asian cultures

In our culture where we are fairly individualistic (compared to Asia) we tend to sign these
attributes to the person. We don’t look at the fact that you are together with e.g. two gang
members. Your personality isn’t what you do, but it’s affected by it. We have person-bias in
the individualistic cultures.

Effects of Facial Features on Person Perceptions

The attractiveness bias
§ A common bias is that we tend to see physically attractive people as more
intelligent*, social, competent, and moral than less attractive people
(* can actually explain 4% of difference in intelligence – why?)
The baby-face bias
§ We tend to see baby-faced individuals as more honest, naïve, helpless, and
warm—but less competent—than otherwise comparable people with mature
 faces. This bias may have evolved to promote caregiving of infants and young
children by adults

A glimpse of a picture of an unknown can give an imagination of that person. After 10

minutes with the person you will find out whether you were fairly wrong/right.

If taking the most good-looking candidate for a job e.g. then there is attractiveness bias.

Perceiving and Evaluating the Self

§ Effects of Others’ Appraisals on
Self-Understanding and Behavior
§ Self-fulfilling prophecies
§ Pygmalion in the Classroom
§ Adults’ expectations about children’s behavior created the expected behavior
§ Such effects occur at least partly by altering the children’s self-concepts

What you expect of people is to some degree self-fulfilled. If something is changing, its fairly
easy to change it in one or the other direction. If you’re set, like an adult, it’s harder to
change. I am still able to change direction, but somewhere in the middle, as I am a little old.

Seeing Ourselves Through the Eyes of Others

§ Self-esteem: one’s feeling of approval, acceptance, and liking of oneself
§ The sociometer theory
§ Self-esteem reflects the level of acceptance or rejection we believe we can
expect from others

People who are able to distinguish good and bad behavior is what matters. If we have two
good friends and your volleyball team, it probably matters more what the first thinks rather
than the latter.

Actively Constructing Our Self-Perceptions

(part 1)
§ Social comparison: process of comparing ourselves with others in order to identify
our unique characteristics and evaluate our abilities. Yes, we compare ourselves.
§ Reference group: the group against whom the comparison is made
(big fish in a small pond / small fish in a big pond)

One of the choices we have to make, do we want to be a large fish in a small pond or a
small fish in a large pond?

Actively Constructing Our Self-Perceptions

(part 2)
§ Enhancing our views of ourselves
§ Self-serving attributional bias
§ a tendency to attribute our successes to our own inner qualities and our
failures to external circumstances
§ Accepting praise at face value
§ Remembering successes, forgetting failures
(= reconstructive memory)
§ Overinflated sense of self
 § when one’s self-concept is far in excess of one’s accomplishments, the
outcome may be maladaptive

How much is actually your memory and how much is a photo you’ve been told about? If we
were perfect copy/paste it would be difficult to manipulate your choice - for example
convince you that he’s good instead of bad.

Attitudes: Their Origins and Their Effects on Behavior

§ Explicit attitudes: conscious, verbally stated evaluations
§ Implicit attitudes: attitudes that are manifested in automatic mental associations

If explicitly saying “I don’t care whether you’re black or white” either out loud or to myself,
we do it consistently. However, if we say it, but if we see a black person and we have trouble
looking at them as equal individuals, it’s an implicit attitude.

The implicit is more dangerous as its uncautioness we can’t be aware of.

Attitudes as Rationalizations to Attain Cognitive Consistency (part 1)

§ Cognitive dissonance theory
§ We have a mechanism built into the workings of our mind that creates an
uncomfortable feeling of dissonance, or lack of harmony, when we sense some
inconsistency among the various explicit attitudes, beliefs, and items of
knowledge that constitute our mental store

Cognitive is how we perceive thing, if there’s dissonance there is a conflict, we don’t like it.
We like being in confirm of our beliefs. We are more comfortable when being supported, we
seek that information and try to avoid the other information.

E.g. a racist might seek articles stating the difference between people with different skin
color.

In corporate project, we find that China is a great country to enter. We find information that
confirms this belief.

Attitudes as Rationalizations to Attain Cognitive Consistency (part 2)

§ Avoiding dissonant information
§ We are motivated to reduce cognitive dissonance—a discomforting lack of
accord among our explicit beliefs, knowledge, attitudes, and actions
§ Firming up an attitude to be consistent with an action
§ The desire to prevent or reduce cognitive dissonance often leads people to
avoid dissonant information and to set aside doubts about a decision once it
has been made

FOX news doesn’t never take in liberal news, but it’s different how FOX and CNN represent
their news. New York times have a lot of negative one-sided articles about Trump, they front
the liberal.

Perceiving Ourselves and Others as Members of Groups

§ Personal identity: self-descriptions that pertain to the person as a separate individual
 § Social identity: self-descriptions that pertain to the social categories or groups to
which the person belongs

In-Groups and Out-Groups and Their Effects on Perception and Behavior

§ We tend to have more positive associations with in-groups (groups we belong to)
than with out-groups (groups we don’t belong to)
§ Stereotypes: the schemas that we have about groups of people

Distinction Between Explicit and Implicit Stereotypes (part 1)

§ Implicit stereotypes: sets of mental associations that operate more or less
automatically to guide our judgments and actions toward members of the group in
question, even if those associations run counter to our conscious beliefs
§ Both public and private stereotypes are referred to as explicit stereotypes because the
person consciously uses them in judging other people

Distinction Between Explicit and Implicit Stereotypes (part 2)

§ Implicit association tests take advantage of the fact that people can classify two
concepts together more quickly if they are already strongly associated in their minds
than if they are not strongly associated
§ Try it yourself on www.implicit.harvard.edu/implicit
Gay, race, weight, etc.

Distinction Between Explicit and Implicit Stereotypes (part 3)

§ Implicit stereotypes can be deadly
§ Implicit stereotypes can lead people who are not consciously prejudiced to
behave in prejudicial ways, despite their best intentions

Race of suspect affects decision to shoot in computer simulations. During the first 80
trials of a computer simulation game, police officers who had to make split-second decisions
“shot” more often at unarmed black suspects than at unarmed white suspects. With practice,
however, this bias disappeared.

Defeating Explicit and Implicit Negative Stereotypes

§ Studies reveal that negative implicit stereotypes can promote prejudiced behavior
even without conscious prejudice
§ Implicit prejudices are based on primitive emotional processes, modifiable by
classical conditioning. Positive associations with members of the stereotyped group
can help to reduce implicit prejudice
Effects of Being Observed and Evaluated
§ Social pressure: a set of psychological forces that are exerted on us by others’
judgments, examples, expectations, and demands, whether real or imagined

Dominant response: Picture of Serena William

Drive / arousal =>
§ Social facilitation: enhancing
effect of an audience on
task performance
§ Social interference: a decline in performance when observers are present (non-
dominant response / too much pressure on working memory)

Facilitation of “Easy” Tasks, Interference With “Hard” Ones

§ The presence of others facilitates performance of dominant actions and interferes with
performance of nondominant actions

Zajonc’s theory of social facilitation and interference. This theory relates social
facilitation and interference to a more general effect of high arousal or drive on dominant
(habitual, cognitively easy) and nondominant (nonhabitual, cognitively difficult) responses

Choking Under Pressure

§ Academic tests
§ With sufficient pressure, such choking can occur even in students who
normally do not suffer from test anxiety, and researchers have found that it
occurs specifically with test items that make the highest demands on working
memory
§ Stereotype threat
§ A threat that test takers experience when they are reminded of the
stereotypical belief that the group to which they belong is not expected to do
well on the test

If you’re parents explicitly tells you to go to nursery instead of finance, its expectations and
stereotypic. We live up to expectations because it is so easy. Sometimes ask a question, if we
are uncomfortable with a social role you have come into.

Stereotype Threat in a Working Memory Task

Older (average age = 69) and younger (average age = 21) adults were given working memory
tests and told that these tests were “fully validated and diagnostic of memory capacity.” In the
Threat condition, subjects were told that both younger and older adults would be performing
these tasks, which is usually enough to remind older adults that memory is typically worse in
older than younger adults. In the Reduced Threat condition, subjects were also told that these
were “age-fair” tests in which performance does not vary with age. As you can see, the
younger and older adults varied minimally in the Reduced Threat condition. In contrast, the
older adults performed significantly worse in the Threat condition. (Based on data from
Mazerolle et al., 2012.)

Impression Management
§ Impression Management: the set of ways by which people consciously and
unconsciously modify their behavior to influence others’ impressions of them
§ Shakespeare: “All the world’s a stage, and all the men and women merely players.”
§ Intuitive politicians
§ We perform in front of others not just to tell a good story or portray a
character but also to achieve real-life ends that may be selfish or noble, or to
some degree both.

To be true to yourself you can’t deviate too much, but just to some degree.

Effects of Others’ Examples and Opinions

Two kinds of influences …
§ Informational influence: social influence that works through providing clues about
the objective nature of an event or situation
§ Normative influence: social influence which works through the person’s desire to be
part of a group or to be approved by others

Asch’s Classic Conformity Experiments (part 1)

§ Basic Procedure
§ A college-student volunteer was brought into the lab and seated with six to
eight other students, and the group was told that their task was to judge the
 lengths of lines. On each trial they were shown one standard line and three
comparison lines and were asked to judge which comparison line was identical
in length to the standard

You may think that they know something you don’t, so information exploits by following
that group.

Asch’s Classic Conformity Experiments (part 2)

§ The task on each trial was to select the comparison line that was identical in length to
the standard. On critical trials, the confederates unanimously made a specific wrong
choice (either 1 or 3, in this example)

Norms as Forces for Helpful and Harmful Actions (part 1)

§ Effects of implicit norms in public-service messages
§ Public-service messages can be made more effective if they portray the
undesirable behavior as nonnormative
NO! Many people steal – don’t steal! NO!
YES! Most people don’t steal – don’t do it! YES!

The first example is counterintuitive. It’s much better to make the people you address outside,
the second example.

Norms as Forces for Helpful and Harmful Actions (part 2)

§ Conformity and the passive bystander effect
§ The more bystanders present at an emergency, the less likely any of them are
to help. This may result from both informational and normative influences
§ Emotional contagion
§ Acts to unite the members of a group, coordinating their actions and
promoting bonds of attachment. Successful leaders are often particularly good
at expressing emotions

The passive bystander effect: Two possibilities if you see people walk by an accident. If they
don’t act, either they know something you don’t know, or it might be a social norm: accepted
to not do anything.
Social Pressure in Group Discussions
§ Group discussion can make attitudes more extreme
§ Group members influence one another through normative social pressure
§ Group polarization:
if all or a large majority of the members argue on the same side of the issue—discussion
typically pushes that majority toward a more extreme view in the same direction as their
initial view

Through social media you can find groups that thinks like you, and you can be radicalized.

Groupthink
Occurs when group members are more concerned with group cohesion and unanimity than
with genuine appraisal of various approaches to a problem.
The ability of groups to perform well increases if
a) leaders refrain from advocating a view themselves
b) leaders encourage group members to present their views and challenge each
other
c) the group focuses on problem-solving (and not group cohesion)
Pre-mortem?
not post-mortem

Groupthink very important in corporate decisions. If you actually want some real impact,
you can maybe make them write it down, then talk about it. So, the people don’t get affected
by the first person starting the discussion e.g. Groupthink might suppress some valuable
information otherwise.

Pre-mortem: what you can do. When you’re in a discussion about a project.
If you’re at a fairly late stage, you have given your opinion, then you can try a different
method. If in two years this project turned out a disaster, tell me why it would be a disaster.
Force the colleagues to come up with reasons why it could go wrong.

Simple methods to improve groupthink. First, just need to be aware, then you can manage.

Requests and Sales Pressure: Some Principles of Compliance

§ The low-ball technique: increasing the price after commitment to buy
§ Foot-in-the-door technique: making a small request to prepare the ground for a large
one

Low-ball technique: if it is not so formal, the technique should be, because of conflict of
distance, you have already persuaded you want the car, and you would now need to tell
yourself why you don’t need it anyway - might be hard.

Conditions That Promote Obedience: Milgram’s Experiments (part 1)

§ Obedience: those cases of compliance in which the requester is perceived as an
authority figure or leader and the request is perceived as an order
§ Basic procedure
§ Experiment involves “Teacher” and “Learner” roles. Teacher is instructed to
give Learner increasingly powerful “shocks”
Conditions That Promote Obedience: Milgram’s Experiments (part 2)
§ Explaining the Finding
§ The norm of obedience to legitimate authorities
§ The experimenter’s self-assurance and acceptance of responsibility
§ The proximity of the experimenter and the distance of the learner
§ The absence of an alternative model of how to behave
§ The incremental nature of the requests

Conditions That Promote Obedience: Milgram’s Experiments (part 3)

In the first four conditions of the experiment, the greatest degree of obedience occurred when
the experimenter and the subject were in the same room and the learner was out of sight in
another room. Obedience dropped with decreased proximity of the experimenter and
increased proximity of the learner. In conditions 5 and 6, the presence of a disobedient or
obedient confederate, masquerading as another subject, dramatically altered the tendency to
obey. In each condition, obedience is defined as continuing to give shocks, up through the
highest shock level.

To Cooperate or Not: Prosocial Behavior and the Dilemma of Social Life

§ Social dilemma: a situation in which a particular action will (a) benefit the individual
who takes it, (b) harm the individuals who don’t, and (c) cause more harm than
benefit to everyone if everyone takes it

If Denmark polluted much, it would not matter because they are such a small country, but if
all countries thought like that, the world would be destroyed. Why the optimal would be for
all countries to cooperate.

The Tragedy of the Commons: A Social-Dilemma Allegory

§ Hardin compared our whole planet with the common grazing land that used to lie at
the center of New England towns
§ “Should I add another cow to my herd?”

Conditions That Promote Cooperation (part 1)

§ Accountability, Reputation, and Reciprocity
§ In laboratory games, these factors are neatly confined to the specific actions
allowed by the game, but in real life they are not confined
§ Fairness
§ People would rather gain nothing than enter into an unfair agreement by which
they gain a little and another person gains a lot
 § Punishment of Cheaters
§ Experiments show that in public-goods games with more than two players,
people are willing to give up some of their own earnings in order to punish a
player who has contributed substantially less than his or her share to the public
good

We are willing to punish an anonymous person that was not willing to give us a fair share of
the amount. Unless we are socially handicapped, we have a good sense of fairness. We would
like to sacrifice our own wealth, to those who are not treating us fairly. If we do not have the
ability to punish, cooperation would suck, so we need the ability to punish to cooperate
better. See graph below.

Altruistic Punishment

In each trial of this social-dilemma game, each player was given 20 money units and could
contribute any amount of that to a common pool. The money contributed was then multiplied
by 1.4 and redistributed evenly among the four players. In one condition, players could
punish low contributors by giving up one of their own money units to have three units taken
away from the punished player. With the punishment option, cooperation increased from trial
to trial. Without that option, it decreased from trial to trial. At the end of all trials, the players
could exchange the money units they had accumulated for real money. (Based on data from
Fehr & Gächter, 2002.)

Conditions That Promote Cooperation (part 2)

§ Personal identity: thought of oneself as an independent person with self-interests
distinct from those of other people
§ Social identity: thought of oneself as a more or less interchangeable member of a
larger entity, the group, whose interests are shared by all members
§ Shared social identity among group members increases cooperation within the group
but decreases cooperation with other groups.

Group Against Group: Lessons from Robbers Cave (part 1)

§ A study conducted in the 1950s with 11- and 12-year-old boys at a 3-week camping
program in Oklahoma’s Robbers Cave Park
§ Researchers were interested in understanding how hostility between groups develops
and how it can be resolved

Group Against Group: Lessons from Robbers Cave (part 2)

§ The Escalation of Conflict
§ Within-group solidarity
§ Negative stereotyping of the other group
§ Hostile between-group interactions
Promoted hostility.
This project shows how quickly we could make a homogenous sample.

Group Against Group: Lessons from Robbers Cave (part 3)

§ Resolving the conflict by creating common goals
§ Hostility was greatly reduced by superordinate goals that required the two
groups to cooperate
§ Superordinate goals: goals that were desired by both groups and could be achieved
best through cooperation between the groups

Superordinate goals: in this case we by purpose make them cooperate. E.g. you need to fix
this to be able to get bla bla bla, then they must cooperate.

Casciaro (2005):
Competent jerks, Lovable fools and the Formation of Social Networks
BY Tiziana Casciaro and Miguel Sousa Lobo (hbr, 2005)

Would YOU choose the lovable fool or the competent jerk?

“Love affair” or mission accomplished

Social psychologists have long known that we like people who are similar to us; people we
are familiar with; people who have reciprocal positive feelings about us; and people who
are inherently attractive, either in their appearance or their personality - that is, they are
considerate, cheerful, generous, and so on.

For Better
1) Their similar values, ways of thinking, and communication styles help projects flow
smoothly and quickly.
2) You don't waste a lot of time figuring out what to expect from them or explaining
what you mean every time you say something. And less emotional stress.
For Worse
1) Limited range of perspectives.
 2) The required expertise or knowledge may lie elsewhere.

“solutions”
Three basic approaches / solutions.
1) Where possible, manufacture liking in critical relationships. (familiarity, similarity,
bonding)
2) Carefully position universally likable people so they can bridge organizational
divides. (identify, protect, position)
3) Work on the jerks. (reassess contribution, reward (punish) good (bad) behavior,
socialize and coach, reposition)

Hirshleifer (2020): Presidential address: social transmission bias in economics and

finance
Social transmission bias in economics and finance BY David hirshleifer (JF, 2020)

Missing chapter:
Missing chapter in our understanding of finance:
The social processes that shape economic thinking and behavior.
Social transmission bias:
The systematic directional modification of ideas or signals as they pass from person to
person.
In standard analyses of economic behavior, people interact only impersonally via trading
orders and observation of market prices. However, people also observe each other and talk to
each other, where talking includes written text and social media.

Transmission bias:
Social transmission bias derives from combinations of bias in the messages that senders
convey to others (or what is visible to others about “senders” as targets of observation) and
bias on the part of receivers in what is absorbed and understood.
Transmission bias related to senders can take at least two forms.
1) Signal distortion (a shift in the sign or intensity of what is transmitted)
2) Selection (a sender’s full information is not always conveyed to a potential receiver)

Attraction without preference

There can be attraction to a behavior without any preference for it. An example:
(Retail) investors are attracted to high variance or skewness, but they do not have a
preference for strategies based on variance or skewness. Nor do they have a belief that high
variance or skewness is indicative of a superior investing opportunity. Indeed, they may be
unaware of the variances and skewnesses of the available strategies. The attraction to these
strategy characteristics is socially emergent.

How?
Owing to self-enhancing transmission, there is an upward selection bias in the return reports
seen by receivers. This has a larger effect for the high variance strategy, which generates a
larger upper tail of high returns that are heavily reported and highly persuasive. Receivers are
subject to two standard behavioral biases: they fail to adjust for self-enhancing transmission,
and they think that reported past performance is strongly indicative of future performance.

Folk models
A folk model:
An understanding of how the world works—an internal representation of external reality.
1) Folk models are key drivers of human behavior.
2) As lenses for seeing the world, different folk models induce different biases in the
social transmission of information signals.
3) Since thinking is costly and requires effort, folk models are often oversimplified
representations of reality.
Folk models may compete:
1) Past returns tend to continue (“the trend is your friend”)
2) Past returns tend to reverse (“buy on the dips”).

Social emergence:
The attraction to certain kinds of investment strategies is socially emergent.
An implication of social emergence is that it is unwarranted to slip from an empirically
observed behavior to the conclusion that there is a direct psychological bias “for” that
behavior. Thus, social emergence can easily create the illusion of a direct individual
propensity “for” a behavior when no such propensity exists. So the inferences drawn from
empirical tests of behavioral hypotheses are often overstated.
In behavioral finance the path from assumptions to conclusions is often very direct.
1) When we observe that investors trade too aggressively, we conclude that they must be
overconfident.
2) When we observe that expectations become more optimistic after price run-ups than
after run-downs, we conclude that they must overextrapolate.
3) When we see individual investors tilted toward buying lottery stocks, selling winners
more than losers, or saving too little, we conclude that investors have preferences for
skewness, for realizing gains not losses, and for immediate consumption.

Lins, Servaes and Tamayo (2019): Social Capital, Trust, and Corporate Performance:
How CSR Helped Companies During the Financial Crisis (and Why It Can Keep
Helping Them)

Does CSR lead to better performance?

Many studies have documented a positive relation CSR (corporate social responsibility) and
corporate performance.

However, correlation does not equal causation!

Do CSR investments actually lead to an increase in stock returns and operating performance?
OR can firms that perform well financially simply afford more CSR investments, thereby
sharing some of the shareholder spoils with other stakeholders?

Social capital:
The propensity of people in a society to cooperate to produce socially efficient outcomes
Important here are the norms of reciprocity and trustworthiness that arise from connections
among individuals.

Proxy for social capital:

A firm’s CSR activities
CSR and the financial crisis:
High-CSR firms (non-financial, US firms) had
• higher profitability
• higher gross margins
• higher sales growth
• higher stock returns
than low-CSR firms during the financial crisis (August 2008-March 2009).
They also had higher sales per employee and were able to raise more debt.
Results are consistent with a stakeholder and investor commitment to help companies
deemed to be more trustworthy during the crisis.

CSR in other crises and beyond:

Crisis of trust 2001-2002 with the bankruptcies of Enron, Worldcom, etc.:
The same!
Credit supply shock (July 2007-July 2008) preceding the financial crisis:
No difference between high-CSR and low-CSR firms!
Non-crisis periods:
No difference between high-CSR and low-CSR firms!

What kind of CSR?:

Two components:
1) Internal stakeholders (Employees and Diversity)
2) External stakeholders (Community, Human Rights, and Environment).
Both components of CSR matter!
Both were significant in explaining crisis period raw and abnormal stock returns.
However, CSR matters more in high-trust areas than in low-trust areas (defined after the
firms’ headquarters in the US)

Social capital = insurance policy:

The building of social capital can be thought of as an insurance policy that pays off when
investors and the economy at large face a severe crisis of confidence and when the reward
for being identifiably trustworthy markedly increases.

Thus, CSR protects against some kind of downside risk!

Cialdini (2009): The psychology of persuasion

Book: Influence: The Psychology of persuasion

Introduction
Although there are thousands of different tactics that compliance practitioners employ to
produce yes, the majority fall within six basic categories. Each of these categories is
governed by a fundamental psychological principle that directs human behavior and, in so
doing, gives the tactics their power.
The book is organized around these six principles, one to a chapter.
The principles —reciprocation, consistency, social proof, liking, authority, and scarcity
— are each discussed in terms of their function in the society and in terms of how their
enormous force can be commissioned by a compliance professional who deftly incorporates
them into requests for purchases, donations, concessions, votes, assent, etc.

Chapter 2:
COMMITMENT AND
CONSISTENCY
Hobgoblins of the Mind
It is easier to resist at the beginning than at the end.
—LEONARDO DA VINCI

Chapter 4:
SOCIAL PROOF
Truths Are Us
Where all think alike, no one thinks very much.
—WALTER LIPPMANN

Chapter 5:
LIKING
The Friendly Thief
The main work of a trial attorney is to make a jury like his client.
—CLARENCE DARROW

Chapter 6:
AUTHORITY
Directed Deference
Follow an expert.
—VIRGIL

Chapter 7:
The Rule of the Few
The way to love anything is to realize that it might be lost.
—G. K. CHESTERTON

EPILOGUE:
With the sophisticated mental apparatus, we have used to build world eminence as a species,
we have created an environment so complex, fast-paced, and information-laden that we
must increasingly deal with it in the fashion of the animals we long ago transcended.
Unlike the animals, whose cognitive powers have always been relatively deficient, we have
created our own deficiency by constructing a radically more complex world.

Lecture 5
Chapter 14: Personality
Personality
 Personality: a person’s general style of interacting with the world, especially with
other people
There are so many different traits, and we will primarily talk about the big five + narcissism.
(Being optimistic some might see as a trait; confidence is more a skill).
 Trait: a relatively stable predisposition to behave in a certain way
 Trait theories
o Specifying a manageable set of distinct personality dimensions that can be
used to summarize the fundamental psychological differences among
individuals
Traits seemed not to be influenced by nurturing or at least in a very small degree (growing up
doesn’t affect your traits).

Personality as Behavioral Dispositions, or Traits

 Factor analysis
o Statistical procedure for analyzing the correlations among various
measurements (such as test scores) taken from a given set of individuals; it
identifies hypothetical, underlying variables called factors that could account
for the observed pattern of correlations and assesses the degree to which each
factor is adequately measured by each of the measurements that was used in
the analysis 

Whats the most relevant traits? Using factore analysis. Some traits are so correlated
empirically that we treat it as one trait.

The Five-Factor Model of Personality (part 1)

 A person’s personality is most efficiently described in terms of his or her score on
each of five relatively independent global trait dimensions (OCEAN):
o Openness to experience
o Conscientiousness
o Extraversion do you love being in groups or do you prefer solitude?
o Agreeableness are you very friendly or more “don’t care what people think”?
o Neuroticism ‘what will happen’ or you have both feet on ground and stay
calm?
Some argue that we can’t describe a person with five traits, or that it to detailed. However,
this is an established way of describing and according to researches it makes sense.
• Neuroticism–stability (N): High end: Experience many forms of emotional
distress, have unrealistic ideas and troublesome urges.
Low end: Emotionally stable, do not get upset easily, and are not prone to depression.
Facets: Anxious–calm; Angry–placid; Depressed–not depressed; Self-conscious–not self-
conscious; Impulsive–controlled; Vulnerable–secure.
• Extraversion–introversion (E): High end: Prefer intense and frequent
interpersonal interactions; are energized and optimistic.
Low end: Reserved and tend to prefer a few close friends to large groups of people.
Facets: Warm–detached; Gregarious–withdrawn; Assertive–unassertive; Active–
contemplative; Excitement-seeking–tranquility-seeking; Positive emotions–modulated
emotions.
 • Openness to experience–non-openness (O): High end: Seek out new experiences
and have a fluid style of thought.
Low end: Traditional, conservative, and prefer familiarity to novelty.
Facets: The six facets refer to openness versus non-openness to experience in each of six
realms: Fantasy, Aesthetics, Feelings, Actions, Ideas, and Values.
• Agreeableness–antagonism (A): High end: Regard others with sympathy and act
unselfishly.
Low end: Not concerned with other people and tend to be antagonistic and hostile.
Facets: Trusting–suspicious; Straightforward–conniving; Altruistic–selfish; Compliant–
noncompliant; Modest–self-aggrandizing; Tender-minded–hard-headed.
• Conscientiousness–undirectedness (C): High end: Control one’s own behavior in
the service of one’s goals.
Low end: Have a hard time keeping to a schedule, are disorganized, and are unreliable.
Facets: Competent–incompetent; Ordered–disordered; Dutiful–neglectful; Achievement–
striving–not achievement–striving; Self-disciplined–not self-disciplined; Deliberative–
careless.

Note: In this table, the five major traits and the six facets of each trait are indicated as
dimensions, using antonyms to indicate the two ends of each dimension. Usually the traits
and facets are referred to using just the first term of each of the antonym pairs shown here.
Source: McCrae, R.R., & Sutin, A.R. (2007). New frontiers for the five-factor model: A
preview of the literature. Social and Personality Psychology Compass, 1(1), 423–440.
Republished with permission of John Wiley & Sons Inc. Permission conveyed through
Copyright Clearance Center, Inc.

In terms of evolution you can question-mark: if it is so optimal to be open, why aren’t we all
open? The introvert would be averted out.

OCEAN:
“O” = “open to experience,” versus those who are more closed.
“C” = “conscientiousness,” in contrast to those with a more lackadaisical approach to life.
“E” = “extraversion,” in contrast to more introverted people.
“A” = “agreeable individuals,” in contrast to those decidedly not agreeable.
“N” = “neurotic individuals,” in contrast to those who are more stable.

The Five-Factor Model of Personality (part 2)

 Measurement of the Big Five traits and their facets
o NEO personality inventory
 Questionnaires designed to measure individuals on the Big Five traits or other traits
all require honesty and insight from the respondent to yield accurate results

 Go to: https://www.personal.psu.edu/~j5j/IPIP/ 
o (choose short version = 120 Q) or google “ipip-neo personality test” (120 Q) 
The Five-Factor Model of Personality (CEOs)
 CEOs of non-financial S&P1500 firms 2007-2018:
4 ,7 5 ,1 4 ,7 4 ,1 3 ,3

O PE CO N EXT AG R NEU

If you need to take though decisions it might be good being non-agreeable, but in other
settings it might be positive.

Grit and the Dark Triad (part 1)

 Duckworth and colleagues proposed a higher-order personality trait independent of IQ
that is predictive of success in a wide range of domains
 Grit: perseverance and passion for long-term goals
o Perseverance of effort
o Consistency of interest you’re focused and you stay focused because you’re
interested in that. You do it and you do it with effort.

This leads to success (at least from the outside, not necessarily happiness).

Grit and the Dark Triad (part 2)

 Researchers have identified people with socially aversive personalities as scoring high
on the dark triad of personality traits, which consists of narcissism,
Machiavellianism, and psychopathy (Book et al., 2016; Jonason et al., 2009)
o Narcissism: extreme selfishness with a grandiose view of one’s own abilities
and a need for admiration. Trump - an obvious narcissist. Likes exposure,
likes to pinpoint himself, hates criticism, loves being praised.
o Machiavellianism: a personality type in which the person is predisposed to
manipulate other people, often through deception. Someone who doesn’t have
any moral problem with manipulating. See them as tools justifying the aim.
o Psychopathy: amoral or antisocial behavior, coupled with a lack of empathy
and an inability to form meaningful personal relationships. Difference in terms
of narcissism, is that they have a total lack of empathy. A narcissist may have
lack of caring, but at least have some empathy.

Dark triad is characterized by three elements.

In politics this may somewhat be a good thing.

Continuity and Change in Personality Over Time

 General stability of personality
o Studies show that adult personality is relatively stable and becomes more
stable with age. Correlation coefficients for repeated tests, even many years
apart, range from .50 to .70 
 Patterns of change in personality with age
o Some of the changes in personality that occur with age are relatively
consistent across samplings of individuals and constitute what is commonly
thought of as increased maturity

Big Five Scores and Age

Average Big Five scores vary somewhat with age and sex. This graph depicts the mean
scores for men and women on each of the Big Five traits as a function of age. The results are
derived from a sample of 132,515 adults, aged 21–60, who completed a version of the Big
Five Personality Inventory that was posted on the Internet. Other studies, using more
systematically chosen samples, have shown similar results. (Based on data from Srivastava et
al., 2003.)

Genetic Foundations of Personality Traits

 The heritability of traits
o Heritability: the degree to which individual differences derive from
differences in genes rather than from differences in environmental
experiences 
o Studies have shown that the traits identified by trait theories are rather strongly
heritable
 Relative lack of shared effects of the family environment
o Personalities of biological relatives raised in the same family are generally no
more similar than those of equally related people raised apart 

Personality as Adaptation to Life Conditions

 Why are people different from one another in personality?
 Proximate explanation: focuses on causal mechanisms that operate in the lifetime of
the individual to produce the phenomenon in question 
 Distal explanation: focuses on function, or evolutionary survival value, rather than
mechanisms 

In terms of extraversion - large majority towards the introvert side and minor majority
towards extrovert in this class. The proximate explanation … Distal explanation - in terms of
evolution, how does it make sense? The environment has been different in different
geographical locations. In groupwork it might be nice to work with someone like you, but
ideally you should have people with different competences so you can complement
eachother.

Advantages of Being Different From One Another (part 1)

 Diversifying one’s investment in offspring
 o Just as diversified investments help protect one’s financial future in a world of
unpredictable change, diverse personalities may protect one’s genetic
investment 
 Studies of the bold–cautious dimension in fish
o Fish (including pumpkin seeds and perch) can be bold or cautious; each
tendency has benefits and risks. Such variation is affected by the environment
(including the number of other bold or cautious fish present) as well as by
heredity

Fish - being different is not something unique to humans. Why? They pick up different
positions that they hear in the society, they don’t need to be cloned. If we were clones, we
would have a worse society and also less economic output.

Advantages of Being Different From One Another (part 2)

 The Big Five traits as alternative problem-solving strategies
o Human variations in the Big Five traits can, likewise, be viewed as alternative
strategies for survival and reproduction
 Differential susceptibility to environmental influence
o Some individuals are more susceptible to environmental influences than
others, often faring the best in highly supportive environments and the worst
in nonsupportive environments 

We have to be aware of us being different. We have to be aware of who we are? Are there
something we should be aware of or measure or manage?

Adapting to the Family Environment

 Siblings raised together may experience quite different environments, for reasons that
include chance events, consequences of their own choices, and differences in how
they interpret the same occurrences
 The tendency to exaggerate differences between siblings (sibling contrast) and the
tendency for siblings to identify with different parents (split-parent identification)
may reduce sibling rivalry and diversify parental investment
o Sibling contrast: differences between siblings
o Split-parent identification: a tendency for each of two siblings to identify
with a different one of their two parents

How can two siblings be so different even though they are raised in same family etc.? Same
people, same environment, but there is a difference in being the firstborn, second born and
thirdborn. A different in expectation of whether you are a girl or a boy.

Sibling Contrast
Mothers were asked to compare pairs of their children by stating whether the two were
similar or different on various personality dimensions and by stating which parent each child
identified with more strongly. Sibling contrast (orange bars) refers to the percentage of times
that the mothers said “different” rather than “alike” in response to personality questions.
Split-parent identification (blue bars) refers to the percentage of times two siblings were said
to identify with different parents rather than with the same parent. (Based on data from
Schacter, 1983.)

We and society have different expectations.

Adapting to One’s Gender (part 1)

 Gender differences in personality
o On average, women score slightly to moderately higher than men on
agreeableness, neuroticism, and conscientiousness 
 Evolutionary foundations of gender differences
o Personality theorists who favor evolutionary explanations of gender
differences point to the universality of certain gender differences and to the
long history of evolution in which males and females were subject to different
reproductive challenges generation after generation 

Adapting to One’s Gender (part 2)

 Cultural Foundations of Gender Differences
o Cultural theorists point to the different experiences, expectations, role models,
and opportunities provided by the culture for girls and boys 
o Apparently because of cultural pressures, some personality characteristics that
run counter to gender stereotypes correlate with unhappiness 

Personality: Psychodynamic and Humanistic Views (part 1)

 Sigmund Freud
o Founder of psychoanalysis
o Viewed himself as a detective whose task was to use cues in people’s behavior
to uncover the secrets of their unconscious minds
 Psychodynamic theories
o Personality theories that emphasize the interplay of mental forces

Personality: Psychodynamic and Humanistic Views (part 2)

  Unconscious motivation
o Freud proposed that the main causes of behavior lie deeply buried in the
unconscious mind
 Sex and aggression as motivating forces in Freud’s theory
o Freud considered drives to be analogous to physical forms of energy that build
up over time and must somehow be released
 Considered the sex drive to be the main pleasure-seeking and life-
seeking drive and the aggressive drive to be the force that lies behind
all sorts of destructive actions 

Personality: Psychodynamic and Humanistic Views (part 3)

 Social drives as motives in other psychodynamic theories
o Alfred Adler developed a psychodynamic theory that centers on people’s drive
to feel competent 
 Inferiority complex
 Superiority complex
o Erik Erikson emphasized the role of society in shaping personality
Developed the psychosocial stages of development

Erikson’s Psychosocial Stages of Development

 Stage 1: Basic trust versus mistrust (birth to 1 year)
 Stage 2: Autonomy versus shame and doubt (1 to 3 years)
 Stage 3: Initiative versus guilt (3 to 6 years)
 Stage 4: Industry versus inferiority (6 years to puberty)
 Stage 5: Identity versus identity confusion (12 to 18 years)
 Stage 6: Intimacy versus isolation (young adulthood)
 Stage 7: Generativity versus stagnation (middle adulthood)
 Stage 8: Integrity versus despair (late adulthood)

We all employ defense mechanism in order to cope with our life as socials.

The Mind’s Defense Against Anxiety

 Defense mechanisms
o Mental processes of self-deception that operate to reduce one’s consciousness
of wishes, memories, and other thoughts that would threaten one’s self-esteem
or in other ways provoke a strong sense of insecurity or anxiety 
o Repression
o Displacement
 sublimation
o Reaction formation
o Projection
o Rationalization

How can we defend our castle? With these defense mechanisms.

Examples of defense mechanisms: Unconsciously how do you survive not getting the
person you love as they are out of your league? Repression, we have to unconsciously
suppress the feelings of loving her, as you can’t get her and for you to survive you need to
suppress them. Sublimation, start doing something else. Reaction formation, I love her so
much so you turn that into hate. Projection, if we have some thoughts that are not allowed in
society, sexual desire for small children (not allowed) but you have the desire, so you try to
push it on other “you love it”.

Defensive Styles as Dimensions of Personality (part 1)

 Repressive coping
o There is ample evidence that many people regularly repress the emotional
feelings that accompany disturbing events in their lives 
o Repressive style may often originate, and be most helpful, at a time when the
person is coping with a seriously disturbing life event 
o There is also evidence that repressors may develop more health problems than
nonrepressors

The most used defense mechanism. If there’s something we don’t like, we try to reduce it. It
might be perfectly rational. In our social lives, we need to put a lid on our own feelings in
order to cope intact with other people.

Defensive Styles as Dimensions of Personality (part 2)

 Distinction Between Mature and Immature Defensive Styles
o Some defenses are more conducive to a person’s long-term well-being than
are others 
 Immature ……………...Intermediate………………Mature
Projection…Repression/reaction formation…Suppression

«I hate homosexuals” might be a defense mechanism - reaction formation - because you are
gay and want to “hide it”.

Mature and Immature Defensive Styles

Love, work, and happiness in men with mature and immature defensive styles. Harvard
alumni classified as using primarily mature defenses were more frequently rated as having
rich friendships, good marriages, satisfaction with their work, active involvement in public
service, and a high degree of happiness than were those classified as using primarily
immature defenses. (Based on data from Vaillant, 1977.)

The Humanistic Perspective: The Self and Life’s Meanings (part 1)

 Humanistic theories: emphasize people’s conscious understanding of themselves and
their capacity to choose their own paths to fulfillment 
 Being oneself; making one’s own decisions
 o Self-concept
o Self theory

The Humanistic Perspective: The Self and Life’s Meanings (part 2)

 Self-actualization and Maslow’s hierarchy of human needs
o Self-actualization: the process of becoming one’s full self or realizing one’s
dreams and capabilities
o Only addressed when more basic needs are adequately met

Personality: Social-Cognitive Views (part 1)

 Social-cognitive theories: draw both from clinical psychologists’ experiences with
their clients and from academic psychologists’ research on learning, cognition, and
social influence 
 Beliefs viewed as personality traits
o Social-cognitive personality theorists frequently study beliefs that have to do
with the value or futility of action

Related to the personality traits (extrovert, introvert etc.).

Personality: Social-Cognitive Views (part 2)

 Beliefs about the locus of control over desired effects
o Locus of control: a person’s perception of the typical source of control over
rewards. Internal locus of control refers to the perception that people control
their own rewards through their own behavior, and external locus of control
refers to the perception that rewards are controlled by external circumstances
or fate 
 People have an internal or external locus of control, depending on whether they do or
do not believe that rewards are controlled by their own efforts 

There are some things that have shown to be extremely important for success. Important for
success, not only business-success but in life (happiness), is locus of control. Do we have an
internal or external lotus of control? Do you think that you can do things, so you change your
life, or do you think it come from something outside?

Internal control - you think you’re the master of your destiny, then you will try to take
control. The more you take control, the more likely you are to succeed in what you try to
achieve.

Personality: Social-Cognitive Views (part 3)

 Beliefs about one’s own ability to perform specific tasks
 o People have high or low self-efficacy, depending on whether they do or do not
believe they can accomplish the relevant tasks

Personality: Social-Cognitive Views (part 4)

 Beliefs about the possibility of personal improvement
o People vary in the degree to which they see themselves as fixed entities or
malleable
 The power of positive thinking
o People with an internal locus of control, high self-efficacy, and malleable self-
view tend to apply themselves more and to be more successful 

Personality: Social-Cognitive Views (part 5)

 The optimistic child
o Young children tend to be overly optimistic about their own abilities, which
enhances their self-efficacy and results in improved performance in some
situations
 Adaptive and maladaptive optimism and pessimism
o In general, people with optimistic styles of thought cope better than others
with life’s demands. However, defensive optimism can cause harm, and some
people use pessimism adaptively 

Cross-Cultural Differences in Personality

 Because the social environment differs from one culture to another, social-cognitive
theorists expect beliefs and habitual ways of thinking to differ cross-culturally
 Collectivism–individualism
o In collectivist cultures, most people have collectivist personality styles, which
focus on interdependence
o In individualist cultures, most have individualist personality styles, which
focus more on individuality and independence
 Cultural differences in conceptions of personality
o In non-Western cultures, the traits that are most useful in characterizing
personality may not fully match the five-factor model 
HARMONY – FACE – REN QING

_____ is defined as the relatively consistent patterns of thought, feeling, and behavior that
characterize each person as a unique individual.
a. Personality
b. A trait
c. Disposition
d. Individuality

_____ is a higher-order personality trait independent of IQ that is predictive of success in a

wide range of domains; it is also defined as “perseverance and passion for long-term goals.”
a. Motivation
b. Dark triad
c. Achievement
d. Grit
Angela and Enrico are siblings. Angela is extremely neat, is an introvert, and is always
willing to help with the chores, all behaviors exhibited by her mother. Enrico, on the other
hand, is messy, an extrovert, and avoids doing his chores, behaviors that reflect his father’s
irresponsible, sociable behavior. A plausible explanation for this split-parent identification
offered by Frances Schachter is that it _____.
a. reflects the evolutionary role of men and women
b. actually reflects their birth order
c. reinforces inherited traits
d. reduces sibling rivalry

Of the defense mechanisms proposed by Freud, which is exemplified by homophobia

a. displacement
b. repression
c. reaction formation
d. projection

Humanistic theorists refer to the process of becoming one’s full self—that is, of realizing
one’s dreams and capabilities—as _____.
a. self-concept
b. personal myth
c. phenomenological reality
d. self-actualization

____ is an individual’s beliefs about his/her own abilities to perform specific tasks.
a. Self-esteem
b. Self-concept
c. Self-efficacy
d. Self-actualization

Of the Big Five personality factors, the largest and most consistent gender differences occur
on the ________ dimension
a. agreeableness–antagonism
b. extroversion–introversion
c. neuroticism–stability
d. conscientiousness-undirectedness

Young children tend to be overly ____ about their own abilities, which enhances their self-
efficacy and results in improved performance in some situations.
a. enthusiastic
b. optimistic
c. pessimistic
d. hopeful

Which of the following does not apply to individuals from a collectivist culture?
a. They emphasize the interdependence of people.
b. They are dutiful to other members of their family.
c. They are highly concerned with personal relationships.
d. They emphasize their own uniqueness.

The personality theories presented in the text are culturally limited because ____.
 a. they emphasize Western values of individuality and autonomy
b. they were developed primarily by Eastern psychologists
c. they were all developed by English-speaking psychologists
d. they were developed decades ago before multiculturalism was widespread

What is a trait, and how do traits differ from states? What does it mean to say that a
trait is a dimension rather than an all-or-none characteristic?
Trait can be defined as a relatively stable predisposition to behave in a certain way; states are
temporary and unstable.
Traits are not characteristics that people have or lack in all-or-none fashion but, rather, are
dimensions (continuous, measurable characteristics) along which people differ by degree

What is grit, what does it predict, and how is it similar to or different from the
personality trait of conscientiousness?
Grit is defined as “perseverance and passion for long-term goals” (Duckworth et al., 2007, p.
1087) and consists of two lower-order factors: perseverance of effort and consistency of
interest.
Although Duckworth et al. reported that grit was associated with the personality trait of
conscientiousness as measured in the Big Five model, grit accounted for additional
individuals’ differences in outcomes beyond conscientiousness and IQ.
The benefits of grit on performance may be due to its association with practice, which has
been shown to be important for developing expertise in many domains.

How do researchers assess the validity of personality tests?

A personality test is valid to the degree that scores on each of the traits it measures correlate
with aspects of the person’s real-world behavior that are relevant to that trait.
The validity of personality tests such as the NEO-PI has been supported by countless studies.

Why might personality traits be most apparent in novel situations or life transitions?
Personality differences may be most clearly revealed when people are in novel, ambiguous,
stressful situations and in life transitions, where cues as to what actions are appropriate are
absent or weak (Caspi & Moffitt, 1993).
As one pair of researchers put it, in the absence of cues as to how to behave, “the reticent
become withdrawn, the irritable become aggressive, and the capable take charge” (Caspi &
Moffitt, 1993, p. 250).

What is the evidence that personality is relatively stable throughout adulthood?

The results of several studies indicate a rather high stability of personality throughout
adulthood.
Correlation coefficients on repeated measures of major traits (such as the Big Five) during
adulthood typically range from .50 to .70, even with intervals of 30 or 40 years between the
first and second tests (Briley & Trucker-Drob, 2014; Terracciano et al., 2006).

How have researchers assessed the heritability of personality traits? What are the
general results of such studies?
Heritability refers to the degree to which individual differences derive from differences in
genes rather than from differences in environmental experiences. Numerous research studies
have shown that the traits identified by trait theories are rather strongly heritable.
The most common approach in these studies has been to administer standard personality
questionnaires to pairs of identical twins and fraternal twins (who are no more similar
genetically than are ordinary siblings). The usual finding is that identical twins are much
more similar than are fraternal twins on every personality dimension measured, similar
enough to lead to an average heritability estimate of roughly .50 for most traits, including all
of the Big Five (Bouchard, 2004; Bouchard & Loehlin, 2001).

What evidence suggests that being raised in the same family does not promote similarity
in personality?
Being raised in the same family has an almost negligible effect on measures of personality
(Bouchard, 2004; Turkheimer & Waldron, 2000).
Twin pairs who had been raised in different families were, on average, as similar to—and as
different from—each other as were twin pairs who had been raised in the same family (the
Minnesota study).

How does a distal explanation of personality variability differ from a proximate one?
A proximate explanation, focuses on causal mechanisms that operate in the lifetime of the
individual to produce the phenomenon in question. Proximate explanations of personality
differences focus on ways by which differing genes and experiences work to make us
different.
The other type of answer, referred to as distal explanation, focuses on function, or
evolutionary survival value, rather than mechanisms.

How does an analogy to financial investment explain the value of producing offspring
who differ from one another in personality?
One way to think about the value of genetic diversity and personality differences is through
an analogy between producing offspring and investing money (Miller, 1997). Investors who
put all their money into one company risk going broke if that company collapses suddenly.
Smart investors diversify: diversified investment greatly reduces the potential for dramatic
loss while maintaining the potential for substantial gains over the long run.
From the perspective of evolution by natural selection, producing offspring is an investment,
the goal of which is to send multiple copies of one’s genes into future generations. Over the
course of evolution, natural selection would favor mechanisms that ensure diversity of
personality in offspring—even the random diversity that results from genetic mixing in
sexual reproduction.

How might sibling contrast and split-parent identification be useful in reducing sibling
rivalry and diversifying parental investment?
Within-family emphasis on the differences between siblings is referred to as sibling contrast.
Split-parent identification is defined as a tendency for each of two siblings to identify with
a different one of their two parents. If the first child identifies more strongly with the mother,
the second typically identifies more strongly with the father, and vice versa.
Sibling contrast and split-parent identification are devices by which parents and children
consciously or unconsciously strive to reduce sibling rivalry, which can be highly disruptive
to family functioning. If siblings are seen by themselves and their parents as having very
different abilities, needs, and dispositions, then the siblings are less likely to compete with
one another and more likely to be valued and rewarded separately for their unique
characteristics.

What differences have researchers found between women and men in personality
traits?
On average, women score slightly to moderately higher than men on agreeableness,
neuroticism, and conscientiousness.
Apparently because of cultural pressures, some personality characteristics that run counter to
gender stereotypes correlate with unhappiness. For example, shy young men are generally
less happy than shy young women.

How might gender differences in personality be understood in terms of natural

selection? What evidence suggests that hormones may provide a basis for such
differences?
Females’ greater role in child care, and perhaps a need for cooperative relationships with
other adults in relation to child care, may have led to selection for personality qualities
promoting nurturance, cooperation, and caution; whereas males’ greater need to compete in
order to reproduce may have led to selection for competitiveness, aggressiveness, and risk
taking.
Oxytocin, which is at higher levels in females than in males, tends to promote affiliation; and
testosterone, which is at higher levels in males, tends to promote aggression.

What evidence supports the view that gender differences in personality are at least
partly shaped by cultural expectations?
Some gender differences in personality have changed, over historical time, in keeping with
changing social roles and expectations.
In particular, a systematic analysis of scores on various tests of assertiveness, given to men
and women in the United States between 1931 and 1993, revealed that gender differences in
this trait changed over time in keeping with changes in the culture (Twenge, 2001).
Beginning in the mid-1960s, however, women entered the workforce in ever-increasing
numbers and took on roles previously considered to be masculine, and their assertiveness
scores subsequently increased.

What characteristics of the mind underlie personality differences, according to the

psychodynamic perspective?
According to psychodynamic theories, personality differences lie in variations in people’s
unconscious motives, in how those motives are manifested, and in the ways that people
defend themselves from anxiety. These are: (a) people are often unconscious of their motives
and (b) processes called defense mechanisms work within the mind to keep unacceptable or
anxiety-producing motives and thoughts out of consciousness.½

How is the concept of unconscious motivation illustrated by posthypnotic suggestion?

In a demonstration of posthypnotic suggestion, a person is hypnotized and given an
instruction such as “When you awake, you will not remember what happened during
hypnosis. However, when the clock chimes, you will walk across the room, pick up the
umbrella lying there, and open it.” When awakened, the subject appears to behave in a
perfectly normal, self-directed way until the clock chimes. At this signal, the subject
consciously senses an irresistible impulse to perform the commanded action and consciously
performs it, but has no conscious memory of the origin of the impulse (the hypnotist’s
command). If asked why he or she is opening the umbrella, the subject may come up with a
plausible though clearly false reason, such as “I thought I should test it because it may rain
later.”
According to Freud, the real reasons behind our everyday actions are likewise hidden in our
unconscious minds, and our conscious reasons are cover-ups, plausible but false
rationalizations that we believe to be true.
How did Freud draw inferences about the content of his clients’ unconscious minds?
Freud concluded from his observations that much of human behavior consists of disguised
manifestations of sex and aggression and that personality differences lie in the different ways
that people disguise and channel these drives.

How do repression, displacement, reaction formation, projection, and rationalization

each serve to defend against anxiety?
Repression is the process by which anxiety-producing thoughts are pushed out or kept out of
the conscious mind.
Displacement occurs when an unconscious wish or drive that would be unacceptable to the
conscious mind is redirected toward a more acceptable alternative. In some cases,
displacement may direct one’s energies toward activities that are particularly valued by
society, such as artistic, scientific, or humanitarian endeavors; in these cases, displacement is
referred to as sublimation.
Reaction formation is the conversion of a frightening wish into its safer opposite.
Projection occurs when a person consciously experiences an unconscious drive or wish as
though it were someone else’s.
Rationalization is the use of conscious reasoning to explain away anxiety-provoking
thoughts or feelings.

What benefit and harm might accrue from the repressive style of coping?
The repressive style may often originate, and be most helpful, at a time when the person is
coping with a seriously disturbing life event.
Other research indicates that the repressive style helps people who have had heart attacks or
who have lost loved ones to suicide to cope psychologically.

What relationships did Vaillant find between defensive styles and measures of life
satisfaction?
Vaillant divided the various defense mechanisms into categories according to his judgment of
the degree to which they would seem to promote either ineffective or effective behavior.
Immature defenses were those presumed to distort reality the most and to lead to the most
ineffective actions. Projection was included in this category.
Intermediate defenses (referred to by Vaillant as “neurotic defenses”), including repression
and reaction formation, were presumed to involve less distortion of reality and to lead to
somewhat more effective coping.
Mature defenses were presumed to involve the least distortion of reality and to lead to the
most adaptive behaviors. One of the most common of the mature defenses was suppression,
which involves the conscious avoidance of negative thinking. Suppression differs from
repression in that the person has more conscious control over the decision to think about or
not think about the distressing experience.
Another defense in the mature category was humor, which, according to Freud and other
psychodynamic theorists, reduces fear by making fun of feared ideas.

How, in general, do humanistic theories differ from psychodynamic theories?

While psychodynamic theories emphasize unconscious motivation and defenses, humanistic
theories emphasize people’s conscious understanding of themselves and their capacity to
choose their own paths to fulfillment.

What is Maslow’s theory about the relationship among various human needs?
How might the theory be reconciled with an evolutionary perspective?
Abraham Maslow (1970), suggested that to self-actualize, one must satisfy five sets of needs
that can be arranged in a hierarchy (see Figure 14.9). From bottom to top, they are
(1) physiological needs (the minimal essentials for life, such as food and water);
(2) safety needs (protection from dangers in the environment);
(3) attachment needs (acceptance and love);
(4) esteem needs (competence, respect from others and the self); and
(5) self-actualization needs.
In Maslow’s view, the self-actualization needs encompass the needs for self-expression,
creativity, and “a sense of connectedness with the broader universe.” Maslow argued that a
person can focus on higher needs only if lower ones, which are more immediately linked to
survival, are sufficiently satisfied so that they do not claim the person’s full attention and
energy.
Maslow’s needs hierarchy makes some sense from an evolutionary perspective. The
physiological and safety needs are most basic in that they are most immediately linked to
survival. The social needs for acceptance, love, and esteem are also linked to survival, though
not in quite as direct and immediate a fashion. The self-actualization needs are best construed
evolutionarily as self-educative needs. Playing, exploring, and creating can lead to the
acquisition of skills and knowledge that help one later in such endeavors as obtaining food,
fending off predators, attracting mates, and securing the goodwill and protection of the
community.

How, in general, do social-cognitive theories differ from psychodynamic theories?

In place of the instinctive, unconscious motives posited by psychodynamic theories as the
prime shapers of personality, social-cognitive theories emphasize the roles of general beliefs
about the nature of the world, which are acquired through one’s experiences in the social
environment.

What sorts of behaviors correlate with an internal locus of control?

Hundreds of studies have shown consistent, though usually not very high, correlations
between scores on Rotter’s locus-of-control scale and actual behavior in various situations.
People who score toward the internal end of the scale are, on average, more likely than others
to try to control their own fate. They are more likely to take preventive health care measures
(Reich et al., 1997), to succeed in weight-loss programs (Adolfsson et al., 2005), to seek
information on how to protect themselves during a tornado warning (Sims & Baumann,
1972), to resist group pressure in laboratory tests of conformity (Crowne & Liverant, 1963),
and to prefer games of skill over games of chance (Schneider, 1972).
Business leaders who have an internal locus of control implement more innovative, high-risk
strategies for growing the business than do those who have an external locus of control,
which can be good or bad depending on the economic climate (Wijbenga & van
Witteloostuijn, 2007).

What evidence supports the theory that high self-efficacy (a) predicts high performance
and (b) may help cause high performance?
(a) Bandura and his colleagues have repeatedly demonstrated that improved self-efficacy for
a task predicts improvement in actual performance of the task. In one study, for example,
various treatments were used to help people overcome their fear of snakes. Those who
claimed after treatment that they now expected to be able to pick up and handle a large snake
were indeed most likely to succeed at the task, regardless of which treatment they had
received (Bandura et al., 1977).
(b) Self-efficacy is not simply a correlate of good performance but is also a cause of it
(Bandura & Locke, 2003). Evidence includes experiments in which false feedback designed
to raise or lower a person’s self-efficacy improved or worsened performance. Those who
were led to believe they were good problem solvers worked more persistently, used better
strategies, and were more successful at solving problems than were those who were led to
believe they were not so good (Bouffard-Bouchard, 1990).

What is the benefit of the belief that the self is malleable?

How can people’s belief in their own malleability be enhanced, and what effects have
been observed of such enhancement?
People who have a malleable view of themselves see themselves at any given point, even late
in life, as changing, developing, improving. Their intelligence is not fixed but is something
that can grow or atrophy depending on their own efforts or lack of efforts. Dweck (2006,
2008) and her colleagues have found that people who view themselves as malleable are more
likely to strive for self-improvement in all realms of life than are those who see themselves as
fixed. They embrace education. They rebound from setbacks, which they interpret as growth
experiences rather than failures. They seek out difficult problems to solve so they can learn
from them. They strive to improve their personal relationships with others rather than accept
them for what they are. Because of such efforts, they tend to succeed in life. Global praise
about attributes, such as “you are intelligent,” tend to create a fixed, stagnant view of the self,
while praise about effort or choice of strategy for specific tasks—such as “you worked hard
and did a great job on that report”—tend to create a malleable, dynamic view of the self.

What evidence supports the value of optimism?

Through what mechanisms might optimism produce its beneficial effects?
Correlational studies using several “optimism” questionnaires have shown that, in general,
people with an optimistic style of thought are happier and tend to cope more effectively with
life’s stressors than do people who have a pessimistic style.
The most likely explanation for positive correlations with optimism is that optimistic thinking
leads people to devote attention and energy to solving their problems or recovering from their
disabilities, which in turn leads to positive results. Pessimists are relatively more likely to
say, “It won’t work out anyway, so why try?”

What seems to differentiate adaptive from maladaptive optimism and adaptive from
maladaptive pessimism?
The difference between those who use either optimism or pessimism constructively and those
who do not has to do with beliefs about locus of control and personal malleability.
People who believe that rewards are controllable (internal locus of control) and that they
themselves can improve through effort (malleable self-belief) are likely to work hard and do
well regardless of whether their focus is on achieving anticipated success (the goal of
optimists) or preventing anticipated failure (the goal of pessimists). Consistent with this view,
Norem (2008) reports that the defensive pessimists she has studied believe more strongly
than do other anxious people that they can improve themselves through effort.

What evidence supports Mischel’s concept of situation-specific dispositions?

In one study, Mischel and Phillip Peake (1982) assessed repeatedly, by direct observation, 19
different forms of behavior presumed to be related to the trait of conscientiousness in a group
of college students. Included were measures of regularity of class attendance, promptness in
completing assignments, bed neatness, and neatness of class notes. They found high
consistency within any one of these measures but relatively low consistency across measures.
For instance, students who kept neat notes for one class were very likely to keep neat notes
for another class but only slightly more likely than average to keep their beds neat.

In general, how do personalities in collectivist cultures differ from those in individualist

cultures?
Collectivist cultures are those that emphasize the interdependence of people and the duties
people have to other members of their family and community.
Individualist cultures, in contrast, place relatively more emphasis on personal freedom and
rights and relatively less emphasis on responsibilities to others.
The cultures of North America, Australia, and Western Europe generally fall on the
individualist side of this dimension, and the cultures of East Asia, Africa, and South America
generally fall on the collectivist side.

What sorts of trait dimensions are emphasized in China more than in Western cultures?
In China, much emphasis is placed on such traits as

1) harmony (inner peace of mind and a harmonious way of interacting with others),
2) face (a concern with maintaining one’s dignity or reputation in relationships with
others), and
3) ren qing (a relationship orientation that emphasizes the mutual exchange of favors)
(Lin & Church, 2004).
None of these traits quite matches any of the facets of Western psychologists’ five-factor
model.

Judge 2002 - Personality and leadership qualitative/quantitative review

Meta-analysis
Correlations with leadership:
Openness to Experience .24
Conscientiousness .28
Extraversion .31
Agreeableness .08
Neuroticism -.24
The letters O, C, E tend to correlate with leadership
Neuroticism tend to uncorrelate with leadership

EMERGENCE VERSUS EFFECTIVENESS

Correlations with leadership criteria:
Leader Leader
emergence effectiveness
Openness to Experience .24 .24
Conscientiousness .33 .16
Extraversion .33 .24
Agreeableness .05 .21
Neuroticism -.24 -.22

Study setting
Correlations with leadership:
Business
Openness to Experience .23
Conscientiousness .05
 Extraversion .25
Agreeableness -.04
Neuroticism -.15

CEOs – what kind of personality?

Judge 2009 - The bright and dark sides of leader traits

A review and theoretical extension of the leader trait paradigm

Looking at traits like OCEAN, narcissism and so on…

Unidimensional?
If this was for all human beings and not only leaders, natural selection would have made us
extremely open, conscientious, extravert and so on.

It’s good that a leader is open to experience, new ideas and creative. But is might also be
that the leader is so open and creative that it’s not interesting to get the main business
working, just going from one project to another. In different industries it might not be good to
be open. Conscientiousness you feel a duty for the goals you put, and you stick to them. If
you’re on top of the organization you might be too restrictive on those goals, maybe you
should be an CEO instead, where you need to think strategically? Too conscientious might be
a hinder to develop. It most senses it’s good to be outgoing as a leader, but you might also be
too outgoing. Agreeableness is good in social terms, but if a leader is so agreeable, so much
seeking comfort in getting acknowledgement, it might not be good. In general, you do not
want a neurotic CEO. If you are too confident, too sure that nothing bad happens, not
anxious in any sense, you might take some things for granted in terms of risk. But generally,
we do not want neurotic CEOs.

Buss 2009 - How Can Evolutionary Psychology Successfully Explain Personality and
Individual Differences?

If being extrovert is so positive, why come not all people are extrovert? The concept of
reproduction would indicate that. We are all different, we have different personalities. If there
is a good and a bad trait, we would all have the same personalities.

How can evolutionary psychology successfully explain personality and individual

differences?
Doesn’t it come naturally that selection has reduced or eliminated heritable individual
differences because traits that are advantageous tend to spread over time to fixation.
=> Heritable individual differences are best viewed as ‘‘noise’’.

One view is to say that it’s noise. Ideally, it’s one ideal human, but it’s just variation/noise.

Differences do exist
Empirically
1) Profound and consequential individual differences have been well documented.
2) Researchers have shown that most of these individual differences have a heritable
component and show stability over time.
3) These stable individual differences have been shown to have important
consequences for evolutionarily relevant outcomes, such as survival, mating
success, offspring production, and parenting.
Theoretically
Individual differences are pivotal to the vast majority of social adaptive problems.
Consider selecting a mate. Constants simply do not count. No woman ever thought
‘‘Wow, this guy is really attractive — he has an opposable thumb and speaks a
language.’’ Species-typical characteristics become invisible when solving the adaptive
problem of mate selection.

We know there are differences. We know that personality is primarily inherited. More nature.
The stability over time question marks the noise-explanation, so we know that noise can’t be
the whole explanation.
These personality traits matter in terms of our ability to reproduce. We are social animals, so
different from tigers/solitary animals, we thrive in a group.

Explanations (1)
Life-History Theory
Each individual has finite time and energy budgets. Effort allocated to solving one adaptive
problem precludes effort allocated to other adaptive problems and provide sustenance for his
children and extended kin.
The optimal trade-off between different allocations will undoubtedly differ depending on
variables such as one’s own qualities, life expectancy, and the total energy an individual has
to expend.
Testosterone is one hormone that facilitates success in intrasexual competition, status
striving, and mating effort. It is interesting to note that there is evidence that men’s
testosterone levels drop following entry into a committed mateship and drop further
after they have children.

Explanations (2)
Costly Signaling Theory
Individuals compete with one another in sending signals to others about their quality as a
mate, friend, and coalition member. Those perceived as having the highest quality have an
advantage in being chosen by the highest quality mates, friends, and coalitions. These social
competitions provide incentives for deception.

Balancing Selection
Balancing selection occurs when genetic variation is maintained by selection, such that
different levels on a trait dimension are favored, or are adaptive, in different environmental
conditions to the same degree.

What is the ideal CEO? Of course, there is noise, he/she might be ideal but have this little
disadvantage. How do you find the ideal CEO? How many signals are there? Too many
signals, hard to find the ideal CEO.

Explanations (3)
Mutation Load
Each human carries mutations. Although selection eventually weeds out harmful
mutations, those that are only mildly harmful may not be purged by selection for many
generations. Although a few new mutations are introduced within each individual, most
genetic variation caused by mutation-selection balance reflects older mutations, inherited
from ancestors, that have yet to be purged.

Not regarding CEO’s. Most mistakes would be reeded out in terms of reproduction.

Explanations (TAA)
Summing up (subjectively):
1) Noise in my generation (I am different – my own “fault”)
2) Noise – not devastating – in earlier generations (I am different – my parents’
“fault”)
3) Scope for different strategies in the same environment (I am different – in order to
attract a mate)
 4) Scope for different strategies in different environments (I am different – because I
adapt)

First, there is noise in each generation. That noise is not necessarily reeded out unless it
freighted us. If being born with red hair is not a big disadvantage, it will continue - even
though it might be new noise.

Does it matter?
Evolution provides a common platform but from that platform differences exist
=> Important to take into account personality and individual differences in the context of
corporate decisions!

It seems to matter a lot. Correlation is not the same as causation, these different traits, in a
CEO, have profound complication for a corporate decision. Personality traits have
profound meaning for corporate decisions.

E.g., it is important to note that we all tend to be too optimistic (the common platform) but it
is also important to note that we deviate in the magnitude of this over-optimism (individual
differences).

TED TALK, Brian Little: “Who are you really?”

Trait psychology.

OCEAN. All of these dimensions have influence on how our life goes.

Extraversion/agreeableness say something about how well do you work with people?

Traditionally, scientists have emphasized what they call the first and second natures of
personality—genes and culture, respectively. But today the field of personality science has
moved well beyond the nature vs. nurture debate. In Who Are You, Really? Dr. Brian Little
presents a distinctive view of how personality shapes our lives—and why this matters. Little
makes the case for a third nature to the human condition—the pursuit of personal projects,
idealistic dreams, and creative ventures that shape both people’s lives and their personalities.
Little uncovers what personality science has been discovering about the role of personal
projects, revealing how this new concept can help people better understand themselves and
shape their lives.

All these questions boil down to the notion of personality. Psychologists concerned with
the (perhaps unsolvable) task to define personality use individual differences in the way
people tend to think, feel and behave to do so. In his TED Talk “Who are you, really? The
puzzle of personality”, Cambridge research professor Brian Little also starts out with the
science of trait psychology. This area of psychology uses the OCEAN mnemonic, developed
in the 1970s, to describe the universally held aspects of difference between people:

But are these categories sufficient to really capture the complexity that is the human
personality? Of course not! That is why Little’s research is concentrating on the moments
when we transcend those traits and is convinced that our personalities comprise so much
more and are even more formable that expected.
Lecture 6 - Online
Thinking fast and slow by Kahneman
https://www.youtube.com/watch?v=CjVQJdIrDJ0

Kahneman proposes that the human brain has two different ways of thinking. System 1 is the
system that operates automatically, fast and intuitive. It can be seen as some kind of human
autopilot that handles the simple and routine-based tasks one already knows. On the contrary,
if the brain experiences something it cannot put into a familiar context, system 2 will kick in.
Then a more rational and attentive form of thinking is required, where more time is spent
solving a given problem.

Intuitive thinking - it just happens, it comes from somewhere, we are not the author of it. For
example, seeing a picture of a girl with brown hair, its intuition that the hair is brown.

17*24=408 is not intuitive thinking, it is hard work. You need a method learned in school to
solve it.

System 1 is the intuitive - automatic activities. We are prepared basically by this spreading
activation prepares things for what might come next. We will be able to recognize and
respond to things more easily than before.
System 2 is the effortful one. The deliberate one. Self-control and deliberate exertion of
effort are impaired.

The basic innate operations, functions that we have such as having emotional reactions to
things, all this is System 1. We don’t choose to do it, it just happens. But also, system 1 is
where skill is. That is when we get to be skilled at something it becomes automatic and it
demands your resources and we get to be very good at it. Now, the issue of intuition. Herbert
Simon’s definition of intuition is recognition. There is no difference. The little kid knows it’s
a dog, without knowing. When can you trust intuition and when can’t you? So, all of us have
expert intuition.

If you get feedback at work, it’s easier to develop an intuition. Intuitive expertise is likely to
develop in these situations. It won’t develop in a chaotic universe. Picking stocks to invest in
can develop intuition, but it isn’t enough regularity in prices for intuition to develop.

False intuitions - they are system 1 in the sense that they are effortless and automatic.

Memory can remember routes and not lists. Creating a mental route instead of lists.

Poster with eyes/flowers, the people have no idea that the posters influence their behavior.
System 1 can do those things. A lot in our mind is happening which we are not aware of.

Example: ABC and 13,14,15. The B looks identical in both examples. This tells us
something important about the associative machinery in system 1. Everything is made
coherent. So, in the context of letters you see it as a B and in the context of numbers you see
it as 14. Important: One is the coherence and the other is that you’re not aware of the
ambiguity. The ambiguity is suppressed. That is the way the system works; it generates
associatively coherent representations of reaction to situation.
Associative memory or system 1 is also very pository about world knowledge. So, it is
informed by a lot of things that we know. It takes very little time to create a “norm” - met
somebody familiar on a vacation, second time you meet him its less of a surprise.

Mechanism of substitution: when we are asked a question we cannot answer, system 1 will
substitute an easier question for a hard one. Intuition not coming from expertise. Several
mechanisms come from this substitution. Mechanism of substitution leads to intuitive
errors.

The author:
Daniel Kahneman (1934-)
An Israeli-American psychologist notable for his work on the psychology of judgment and
decision-making, as well as behavioral economics (2002 Nobel Prize in Economics). With
especially Amos Tversky (1937-1996) Kahneman established a cognitive basis for common
human errors that arise from heuristics and biases, and developed prospect theory.

Thinking, fast and slow (pp 13+28):

System 1: Fast thinking (intuitive thought - automatic)
System 2: Slow thinking (deliberate thought)
Constantly questioning our own thinking would be impossibly tedious.
System 2 is much too slow and inefficient to serve as a substitute for System 1 in making
routine decisions. The emotional tail wags the rational dog.
Advice: Learn to recognize situations in which mistakes are likely and try harder to
avoid significant mistakes when the stakes are high.

Brainstorming on … (pp. 23-24)

Biases (= a predisposition toward error):
Excessive optimism – overconfidence – confirmation bias – illusion of control
Heuristics (= a rule of thumb used to make a decision)
Representativeness – availability – anchoring – affect

Prospect theory (1) (pp. 283+)

Prospect theory rests on two observations:
1) People attach values to gains and losses rather than to wealth
2) The decision weights that people assign to outcomes are different from probabilities.

Prospect theory (2) (pp. 283+)

The traditional
utility function:
Note:
Wealth (x)
Utility (y)
Prospect theory (3) (p 283+)
Prospect theory
value function:
Note:
Changes in wealth (x)
Value (y)
= 1) Loss aversion + 2) risk aversion in positive domain + 3) risk seeking in negative domain!

Prospect theory (4) (p 283+)

Weighting
function:
Note:
Probability (x)
Weight (y)
= 1) small probabilities are over-weighted + 2) certainty effect!
THE FOURFOLD PATTERN (p. 317)

THE INVISIBLE GORILLA (pp. 23-24):

A short film of two teams passing basketballs, one team wearing white shirts, the other
wearing black.
Task: Count the number of passes made by the white team
(ignoring the black players) = a absorbing task
A woman wearing a gorilla suit appears in the film, crossing the court, thumps her chest, and
moves on.

Half of viewers do not notice the gorilla. And are surprised afterwards.
=> We can be blind to the obvious, and we are also blind to our blindness!

We know from evolution that there is a tradeoff. Focus is good, but too much focus might
disturb other observations.

SELF-CONTROL AND COGNITIVE EFFORT (pp. 23-24):

Both self-control and cognitive effort are forms of mental work.
Challenged by cognitive work, we are more likely to yield to a temptation.

People who are cognitively busy are more likely to make selfish choices, use sexist language,
and make superficial judgments in social situations.

Exception
“Flow” – people sometimes expend considerable effort for long periods of time without
having to exert willpower (riding a motorcycle, writing a book, painting).
By not having to exert self-control, resources are freed and directed to the task at hand.

MOOD AND INTUITION (pp. 68-69):

Mood affects the operation of System 1.

A good mood is a signal that things are generally going well, the environment is safe, and it is
all right to let one’s guard down.
A bad mood indicates that things are not going very well, there may be a threat, and vigilance
is required.

Good mood advantage: A sense of cognitive ease is generated (better performance in some
tests). Life performance improved, but strategic decisions might be something else.
Good mood disadvantage: More prone to logical errors (biases).
Critical point is that the mood affects you.

HALO EFFECT (pp. 82):

“If you like the president’s politics, you probably like his voice and his appearance as
well.”
Black and white – nothing in between.

The tendency to like (or dislike) everything about a person (or a firm) – including things
you have not observed – is known as the halo effect.

The representation of the world that System 1 generates is simpler and more coherent than
the real thing => leading to mistakes / biases.

Hitler loved dogs and kids – does not fit into our black and white system. It disturbs us and
uses our mental energy.

System 2 should help us not have a bias. System 2 should justify system 1’s behavior: “I
don’t like her” (first impression, system 1). Kat writes that system 2 should NOT
justify, which one is correct?

BASKETBALL AND RANDOMNESS (pp. 116-117):

“Hot hand” – an accepted “fact” among players, coaches, and fans.
However, analysis of thousands of sequences of shots => no support for a “hot hand”.

We are far too willing to reject the belief that much of what we see in life is random. We are
looking for patterns.
If we follow our intuition, we will more often than not err by misclassifying a random
event as systematic.
We tend to take from our own experience.

Successful acquisitions of a CEO?

Investments by an investment manager?

ANCHORING AND HOUSE PRICE (pp. 124+126):

Real estate agents were given an opportunity to access the value of a house that was
actually on the market.
Half the agents saw an asking price that was substantially higher than the listed price.
Half the agents saw an asking price that was substantially lower than the listed price.

The first half stated a much higher price than the second half!

Research says that we get affected by something that doesn’t have anything to do with the
question.

Spin of a wheel of fortune – guess of % of African nations in the UN affected by spin of

wheel.
Negotiating a bazaar: The seller makes an outrageous proposal.
Do not come back with an equally outrageous counteroffer.
Make a scene, storm out or threaten to do so – eliminate the anchor!

INDUCTION VERSUS DEDUCTION (pp. 174):

“Subjects’ unwillingness to deduce the particular from the general was matched only by
their willingness to infer the general from the particular.” (Nisbett and Borgida)

We love stories!

If its representative of what we see we might come up with a story, it might be biased.

Knowing more statistical facts about human behavior does not necessarily change the
understanding of the world.
The test of learning psychology is whether your understanding of situations you
encounter has changed, not whether you have learned a new fact.

IMPORTANT for this study!

How should investors react?

Evolutionary we tend to have gone from the particular to the general, as humans. How could
we do anything else? We have experiences, we listened to these anecdotes/stories. If this and
this happens, then it must be because of this. So, its rational for us to have this brain.

PREMORTEM (pp. 264-265):

Can overconfident optimism be overcome by training? Kahneman is not optimistic!
Suggestion: Premortem (Gary Klein)

When the organization has almost come to an important decision, but has not formally
committed yet …
“Imagine that we are a year into the future. We implemented the plan as it now exists. The
outcome was a disaster. Please take 5-10 minutes to write a brief history of that disaster.”

Two advantages: 1) overcomes groupthink (often a problem in teams)

2) unleashes imagination of knowledgeable individuals

WEALTH = HAPPINESS? (p. 397):

The satiation level beyond which experienced well-being does not increase?
(450,000 responses / Gallup-Healthways Well-Being Index, a daily survey of 1,000
Americans)

Answer: Household income of $75,000

Correlation between happiness and wealth above this level = approximately 0.

Potential reason: Reduced ability to enjoy the small pleasures of life

NICE CLIMATE = HAPPINESS?:

Permanent life circumstances seem to have little effect on well-being!

Are students in California happier than students in Ohio and Michigan?

Answer: No
This is in spite of the fact that the students in California enjoyed their climate
while the students in Ohio and Michigan despised theirs.

= Focusing Illusion
PS: Scandinavian countries are among the happiest in the world.

You may think you will be constantly happy if you lived in Florida where the sun is always
shining, but you will get used to.

We tend to overestimate the value/benefit it actually gives us. To for example change the
wealth level of ours or the climate. We may think that we will be much happier if that or that.

Behavioral economics: Past, present, and future by Richard Thaler

https://www.aeaweb.org/webcasts/2016/Behavioral.php

ADAM SMITH
Overconfidence: the over-weening conceit which the greater part of men has of their own
abilities
Loss aversion: pain is in almost all cases, a more pungent sensation than the opposite and
correspondent pleasure
Self control: the pleasure which we are to enjoy ten years, hence, interests us so little in
comparison with what which we may enjoy today.

KEYNES (founder of behavioral finance)

Listened the first 15 minutes - is it really relevant??

Thaler (2016, presidential AEA address)
Some take-aways:
1) One theory to accomplish two rather different goals, namely, to characterize optimal
behavior and to predict actual behavior. We should not abandon the first type of
theories as they are essential building blocks for any kind of economic analysis, but
we must augment them with additional descriptive theories that are derived from data
rather than axioms.
2) “Explainawaytions”: (1) “as if” and (2) errors are randomly distributed with mean
zero.
For example, prospect theory is based upon experiments. Based upon experiments with low
budgets, small experiments. We cannot argue that because students that get paid act that way,
that people in the real world act the same.
3) “If you raise stakes” and “people will learn” – however, inconsistent!
If you have high stakes, then you learn from them - it’s too late (save up for retirement, didn’t
do it, “oh will just do it next time” - not possible). Always be aware that those experiments
are controlled environments, so it might be different in the real world.
4) As a rule, it is easier to cater to biases than to eradicate them.
5) Efficient market hypothesis (EMH) has two distinct components. (1) “no free lunch”
(= impossible to beat the market on a risk-adjusted basis) and (2) “price is right” (the
inference that unpredictability implies rational prices is what Shiller (1984, p. 459)
once called “one of the most remarkable errors in the history of economic thought”).
6) Behavioral economic theory must be evidence-based theory. However, we should not
expect some new grand behavioral theory to emerge to replace the neoclassical
paradigm.
7) The fact that there is a long list of biases is both a blessing and a curse. The blessing is
that there are a multitude of interesting ways in which human judgment diverges from
rational expectations, each of which offers the possibility of providing useful insights
into economic behavior. The curse is that the length of the list seems to offer theorists
a dangerously large number of degrees of freedom.
8) It is time to stop thinking about behavioral economics as some kind of revolution.
Rather, behavioral economics should be considered simply a return to the kind of
open-minded, intuitively motivated discipline that was invented by Adam Smith and
augmented by increasingly powerful statistical tools and datasets.

On one hand we know that markets are not efficient - not to an extent where we can say that
markets always are efficient. What’s interesting is that if its inefficient to an extent so we can
earn money.

Chicago Booth review, “Are markets efficient” by Richard Thaler and Eugene
Fama
http://review.chicagobooth.edu/economics/2016/video/are-markets-efficient

Efficient - prices incorporating all available information about future values. Thaler means
financial markets are inefficient, Fama means they are efficient (at least the model).

Can you beat the market and are prices correct (reflecting all information)?
Black Monday 1987 - markets were not efficient. The markets fell 25% and Thaler says that
he doesn’t believe the value of the economy fell 25% as well,

Risk changes a lot very quickly, especially when times are good/bad.

Gene Fama says bubbles doesn’t exist. Thaler talks about Cochrane’s graph of housing
prices, indicating a bubble around financial crisis. A mutual fund called CUBA, no relation to
CUBA, but when Obama announced relaxed relationship with CUBA the price of it rallied.
This Thaler would call a bubble. What do Eugene Fama call this anomaly?

Fama means no-one has identified bubbles.

Are the price and instrinsic value the same? It shouldn’t be true that shares of CUBA are
selling at a 70% premium.

Bubbles are when prices exceed a rational valuation of the securities being traded.

Fama: Value stocks are riskier than growth stocks according to Fama. People thought there
was an arbitrage opportunity, long value short growth, get a low variance portfolio. However,
this wasn’t true you got a high variance.
Thaler: Value firms look scary.

Behavioral biases during the corona crisis by Hersh Shefrin

https://www.youtube.com/watch?v=N2E2zexRnd8

Suspects are successive optimism, overconfidence group think, motivated reasoning, status
quo bias.

Groupthink a dynamic about wanting to please the group leader, the case here (as well with
the other characteristics), they didn’t want to tell the leader in the Chinese province as they
wanted to please him, but eventually he understood. Status quo bias - failing to act when
acting is needed - a case here as well.

All of these phenomenon’s were playing out in Huhang. All of these features were features
that characterized the way the US is lead.

Trump makes clear that he will fire you if you go against him, why groupthink is strong in
the US. As people need to be careful when presenting information to him, people didn’t
really inform him about COVID either, before it was too late. Clear excessive optimism. He
refused to act, status quo bias.

Overreaction in the stock market? The market itself had been overpriced dramatically relative
to fundamentals, so he didn’t know whether the prior overpricing + a reaction in concern of a
pandemic, distinctly would leave you with a market being undervalued (overreaction).

Corona crisis and financial crisis by Avanidhar Subrahmanyam

https://www.youtube.com/watch?v=mp3zyWwoXes

Financial crisis mainly affected financial firms.

Financial crisis 2008:
Many affected financial firms.

Corona:
Affects a broader section of population.

Consumer demand:
Paying the citizen 100/100 dollars can be very useful
Consumer incentive has to recover  matter of psychology when they are ready to spend

99% of affected people by corona virus will recover.

Newspapers are dramatical
This is a difficult I terms of getting people to consume more.

The financial consequences get underestimated.

Lecture 7:
Aabo (2020): Firm dynamics and CEO personality traits
Firm dynamics and CEO personality traits By Aabo & Pantzalis & Park & Wulff 
(wp, 2020)

Heraclitus
“The only constant in life is change”
Heraclitus, a Greek philosopher (around 500 BC)

Duffee (1995):
Duffee (1995) finds that stock returns and volatility are positively correlated at the firm
level (as opposed to the negative correlation at the aggregate level)

Grullon et al. (2012)

Grullon et al. (2012) show that the positive relation between firm-level stock returns and
firm-level return volatility is due to firms’ real options.

Grullon et al. focus on firm characteristics and show that firms with abundant investment
opportunities (i.e., small, young, research-intensive, and fast-growing firms) and high
operational flexibility (i.e., firms in non-unionized industries, firms with high earnings
convexity, and firms with high sales convexity) prosper in times of uncertainty because they
are able to exploit the inherent asymmetry in their large real option holdings.

Meaning that the more the stock fluctuates the higher the return
Volatility at an aggregate level, when volatility increases return declines. This is opposite for
the firm level.

When something happens with the stock price, something has happen with the firm,
competitors etc.
Volatility for a company is good because a company has real options. Firms with a lot of real
options have a more positive return.
On a firm-specific level, volatility is positively correlated with returns (real options).

CEO personality traits

Our question:
Who makes the decisions (to exercise the real options)?
Our answer:
The CEO in particular!
=> How do CEO personality traits affect the ability to exercise real options when
volatility increases?

How does the peersonality of the ceo affect the ability to exploit?

CEO personality traits

How do CEO personality traits affect the ability to exercise real options when volatility
increases?
O Openness to experience + or - ?
C Conscientiousness + or - ?
E Extraversion + or - ?
A Agreeableness + or - ?
N Neuroticism + or - ?

Who are actually better? Is it good to be open to experience? We would think so, as if you’re
not open to experience you’re not open to new things. Conscientiousness - too focused on
budget and deadlines etc., you might not be aware of what actually happening, why we would
say they should be conscientiousness. Too neurotic not good, an inappropriate question.

Setting
• Nonfinancial S&P 1500 firms
• 2007 to 2018
• Dependent variable: Excess stock returns

• Independent variables
1) Change in volatility (standard deviation of the firm’s daily returns during the month)
2) Big Five personality traits
3) Interaction terms
4) Control variables

We are interested in the change in volatility. Instead of having proxies for how many real
options we have, whether our company is young/old etc., we say that the CEO must matter,
why we put in his personality traits. We are particularly interested in the interaction term.

COMMENTS TO TABLE 3:
Openness to experience is positive for a CEO. Then you are more likely to be able to exploit
these changes in volatility and go for something new.

We find that conscientiousness is negative. Too conscientious you are too fixed in the old
world reading those budgets.

Can’t find any significant about extraversion. We would have thought it was positive but
can’t find any empirical support on this.

Neurotism is negative. We thought so. If you are towards the anxious side, you are not having
a proactive approach to the CEO role.

These are as expected, except for extraversion, that was a surprise.

But we cannot think that it would be best to have a CEO being open to experience, less
conscientiouss, less neurotic. On the other side of the coin, if you’re in a more stable
environment it might not be good to have a CEO being very open, then maybe it would be
better with a CEO more conscientous.

Table 3:
Table 3. Firm dynamics and CEO personality traits
This table reports the estimated coefficients from the regression of excess monthly return. T-statistics are reporte
parentheses. Refer to Appendix for detailed variable descriptions. ***, **, and * indicate significance at the 1%,
and 10%, respectively.

Dependent variable = Excess monthly return

(1) (2)
Market factor loading -0.002 -0.002
(-0.93) (-0.69)
Book-to-market ratio -0.004 -0.001
(-1.01) (-0.23)
Size -0.002*** -0.001**
(-2.66) (-2.57)
Previous return -0.003 -0.006
(-0.64) (-1.18)
Volume -0.008 -0.009
(-1.55) (-1.63)
∆Volatility -0.143* -0.130
(-1.71) (-1.61)
CEO openness 0.000
(0.20)
CEO conscientiousness -0.002
(-1.29)
CEO extraversion 0.000
(0.03)
CEO agreeableness 0.001
(0.96)
CEO neuroticism -0.002
(-1.38)
CEO narcissism -0.002
(-0.44)
CEO overconfidence 0.004***
(6.89)
∆Volatility * CEO openness

∆Volatility * CEO conscientiousness

∆Volatility * CEO extraversion

∆Volatility * CEO agreeableness

∆Volatility * CEO neuroticism

∆Volatility * CEO narcissism

∆Volatility * CEO overconfidence

 Table 3. Firm dynamics and CEO personality traits
This table reports the estimated coefficients from the regression of excess monthly return. T-statistics are reporte
parentheses. Refer to Appendix for detailed variable descriptions. ***, **, and * indicate significance at the 1%,
and 10%, respectively.

Dependent variable = Excess monthly return

(1) (2)
∆Volatility * CEO openness

∆Volatility * CEO conscientiousness

∆Volatility * CEO extraversion

∆Volatility * CEO agreeableness

∆Volatility * CEO neuroticism

Findings:
We find that the ability to exploit volatility is positively associated with CEO openness to
experience and negatively associated with CEO conscientiousness and neuroticism.
1) CEOs who are open to experience are well positioned to exploit increased uncertainty
because they are curious and inventive. As such, they see opportunities where other
CEOs see threats.
2) Conscientious CEOs tend to be efficient and organized. Such qualities are, however,
at a disadvantage when uncertainty increases and detailed planning becomes obsolete.
3) Neurotic CEOs have a hard time coping with increased uncertainty in bad times.
We do not claim and we do not empirically find that open, non-conscientious, and non-
neurotic CEOs are better managers in general. In fact, we find that none of the Big Five
personality traits by themselves are associated with better corporate performance. Rather, we
posit and empirically find that CEOs with the abovementioned personalities are better at
exploiting increases in uncertainty (and are worse at status quo situations).

Omar (2019): Psychopathic traits of corporate leadership as predictors of future stock

returns
Psychopathic traits of corporate leadership as predictors of future stock returns
By Omar & Wisniewski & Yekini (efm, 2019)

Psychopathy:
Psychopathy involves amoral or antisocial behavior, coupled with a lack of empathy and an
inability to form meaningful personal relationships (Grey and Bjorklund, 2018).

Psychopathic traits are primarily associated with genetic factors (Taylor et al., 2003).

Psychopaths’ insincere charm is sometimes mistaken for charisma, their ruthlessness

sometimes viewed as the ability to make calculated business decisions, and their mastery of
deception helps them to cover up their counterproductive and fraudulent activities.
Psychopaths are potentially devastating for the companies involved. (Omar et al., 2019)

The proportion of psychopaths in managerial positions is higher than that in the general
population (Babiak et al., 2010; Boddy, 2011).

There must be a characteristic with psychopaths that make them emerge as leaders. Not
necessarily good leaders, but at least they emerge as a leader.

The fact that they don’t have empathy ties into that they may cut the size of decisions (“you
are fired”), normal people would be more emphatic. They know what they want. They tend to
be overrepresenaed amongst CEO compared to the normal population.

Psychopathy and stock returns:

Findings (209 non-financial FTSE 350 Index firms):
Negative association between the presence of managerial psychopathic traits and future
return on common equity (and other performance measures such as ROA and Tobin’s Q).

They find a negative association between psychopaths at CEO-level and returns. They do
tend to emerge as leaders, but they also tend to be ineffective leaders.

Why?
1) Direct effect on profitability (bullying and exploitation, inability to retain key staff
members, fraudulent activities, deliberate chaos, extreme risk taking)
I am a psychopath, I am the CEO, you don’t like me, I’m harsh, I deceive you. You don’t feel
much obligation to live up to your best to make this company work.
2) Reputational damage (media controversies, audit problems, lack of involvement in
charitable giving and CSR activities)

Proxies for psychopathy (1):

1) Presence of psychopathic language in corporate communications (annual reports
excluding financial statements and notes)
• Diction’s Self-Reference dictionary (I, myself, my, mine) +
• Diction’s Human Interest dictionary (them, he, she, mother, uncle, parent,
gentlemen, friends, ladies) –
• Diction’s Aggression dictionary (demolish, conquer, attacking) +
• Diction’s Blame dictionary (undependable, terrible, stupid) +

How do we measure the big five, a narcissist etc.? A proxy to use is this. They use four
machine learning dictionaries. For example, human interest. You are a psychopath if you
couldn’t care less, unless they e.g. give you something etc. Aggression dictionary, a
psychopath tends to be aggressive.

Proxies for psychopathy (2):

2) Questionable integrity
• Auditors express their reservations in the “Emphasis of Matter” section
• Interventions from the Financial Reporting Council
3) Excessive risk taking (idiosyncratic risk from CAPM)
4) Lack of empathy (charitable donations)
Another proxy is to question the integrity. Excessive risk taking. Lack of empathy - typically
can be seen on charitable donations - a psychopath: why should I give anything to a charity,
as it doesn’t benefit me?

Table 4: it shows that whether we measure it one way or another, we see consistently,
language, audit problems, FRC, idiosyncratic risk, lack of empathy - all are minus. However
not all of them are significant, but no matter if you measure it on how they speak, how many
audit problems they have, the risk taking, the lack of empathy, they find that its detrimental to
stock returns.
Table 6: it’s not that robust, but its more or less consistent.

Main conclusion:
Psychopaths are ineffective corporate leaders!
… also ties into the distinction between leader emergence and leader effectiveness!

Campbell (2019): Born to take risk?

BORN TO TAKE RISK? THE EFFECT OF CEO BIRTH ORDER ON STRATEGIC
RISK TAKING
By CAMPBELL & JEONG & GRAFFIN (amj, 2019)

BIRTH ORDER:
Nature or nurture?

Evolution:
Evolutionary theory suggests that humans adapt to their environment over time to
survive.
One birth order–related adaptation is sibling rivalry (Buss, 2007; Sulloway, 1996).

Humans developed the tendency to engage in sibling rivalry since historically many children
did not survive to adulthood (Buss, 2007).

By engaging in sibling rivalry siblings compete for parental investment, which may lead
to resource allocation differences that historically increased the likelihood of survival (Buss,
2007; Sulloway, 1996).

… evolutionary theory logic suggests that early-life family experiences, which birth order
captures, shape an individual’s tendency to engage in behaviors in childhood that persist
throughout life and, as we theorize, into the executive suite (Suitor & Pillemer, 2007;
Sulloway, 1996).
Sibling rivalry exists because in general too many children were born. The one surviving
were the ones that were best at getting the attention from their parents. So, sibling rivalry is a
fact. From evolution we were equipped with this, not whether we were first- or second born,
but we were equipped with the willingness to rival with our siblings to survive.

Being the first one, no competition in the beginning. Being the second, another situation. It
maybe doesn’t matter for your personality in terms of OCEAN, but it matters for your
actions, for when you are out there.

Family:
... the family has been described as the “most important and enduring of all human
social groupings” (Smith, 2009: 5) …

Birth order, which captures early-life experiences within the family domain, has been
described as one of, if not the most, fundamental, engrained, and generalizable
determinants of individual behavior (Jaskiewicz, Combs, Shanine, & Kacmar, 2017;
Sulloway, 1996).

Parents invest more in earlier-born children and these individuals have a greater tendency
to “not take unnecessary chances [or risks]” (Grable & Joo, 2004: 81). In contrast, laterborn
children tend to receive less parental investment and resources (Hertwig, Davis, &Sulloway,
2002). Evolutionary theory thus suggests that younger siblings are more likely to engage in
risky behaviors to try to “recalibrate parental investment in their favor” (Sulloway &
Zweigenhaft, 2010: 414).

Our only salvation is mom (and maybe dad) the first year.
First born - don’t need to take so many risks, in order to get my parents attention.
Second born - rivalry to get attention, need to fight for the ability to survive (at least in
ancient times, not today literally). Has a sibling larger and bigger than you, threat.

The birth order matters, and how many years apart matters.

Hypothesis:
The later a CEO’s birth order, the more strategic risk they will take.

Moderated by
1) Age gap between a CEO and the closest sibling -
2) CEO age -
3) Sibling CEO +

Sibling 3 and 4 take more risk than 1.

1. Will fight more with the siblings with age closest too you.
CEO age, younger better remember the rivalry between siblings.
Sibling CEO

Setting:
Family-controlled business groups in South Korea (Chaebols)
Dependent variable: Strategic Risk Taking

… proxied by aggregating three major outlays:

 1) Capital expenditures
2) Research and development (R&D) spending
3) Acquisitions
Thus, risk-taking index = the log of the sum of the three different types of risky spending

Birth order:
CEO birth order variable:
1 for a first-born
2 for a second-born
3 for a third-born
and so on …

Findings:

Hypothesis – confirmation?
Hypothesis: The later a CEO’s birth order, the more strategic risk they will take. Confirmed

Moderated by
1) Age gap between a CEO and the closest sibling - (confirmed)
2) CEO age - (not confirmed)
You remember it wether you are 30 or 60.
3) Sibling CEO + (confirmed)
If you have a sibling being CEO you will compare to them and take more risk to outcompete
them. As we can see its positive, it leads to more risk.

Schulz (2019): The Church, intensive kinship, and global psychological variation
The Church, intensive kinship, and global psychological variation
By Schulz & Bahrami-Rad & Beauchamp & Henrich (Science, 2019)

How does the church, especially the western church, how does that affect how we behave
today? And differences between different countries/cultures.

Most studies are US studies or weird countries, so it might not be representative. Especially
as we are now in a different generation than couple years ago. We will be more diversified
than just the western culture alone.

Three foundations:
1) Anthropological research Diverse kin-based institutions have been the primary
structure for organizing social life in most societies around the world and back into
history. With the origins of agriculture, cultural evolution increasingly favored
intensive kinship norms related to cousin marriage, clans, and co-residence that
fostered social tightness, interdependence, and in-group cooperation.
Kin-based institutions means a lot. Institution of kinship refers to a set of relationships and
relatives formed thereof, based on blood relationships (consanguineal), or marriage (affinal).
2) Psychological research People’s motivations, emotions, and perceptions are shaped
by the social norms they encounter while growing up.
3) Historical research The Western Church systematically undermined Europe’s
intensive kin-based institutions during the Middle Ages (for example, by banning
cousin marriage).
How does it matter what happened 1500 years ago in terms of the western church
dominance? In relation to these kin-based institutions.

Base:
Result:
Western, Educated, Industrialized, Rich, and Democratic = WEIRD
persons are outliers!

People from these societies tend to be

1) more individualistic
2) more independent
3) more impersonally prosocial (e.g., trusting of strangers)
4) less conform
5) less loyal to in-group

Ind.:
Main results:
Countries with longer historical exposure to the medieval Western Church or less intensive
kinship (e.g., lower rates of cousin marriage) are more individualistic and independent, less
conforming and obedient, and more inclined toward trust and cooperation with strangers.
+
Comparing only the adult children of immigrants in European countries, those whose parents
come from countries or ethnic groups that historically experienced more centuries under the
Western Church or had less intensive kinship tended to be more individualistic, less
conforming, and more inclined toward fairness and trust with strangers.

Lecture 8
Barberis (2018): Richard Thaler and the Rise of Behavioral Economics
Richard Thaler and the Rise of Behavioral Economics By Nicholas Barberis
(2018)

Richard Thaler was awarded the 2017 Sveriges Riksbank Prize in Economic Sciences in
Memory of Alfred Nobel for his contributions to behavioral economics.

Endowment effect:
“... but it was an experiment that Thaler described in a 1990 paper with Kahneman and Jack
Knetsch that has become the focus of attention (Kahneman et al., 1990). In this experiment,
half of the participants are given a mug and are asked, for each price on a list of prices,
whether they would be willing to give up the mug in exchange for that amount of money. The
remaining participants are not given a mug; instead, they are asked, for each price on a list of
prices, whether they would be willing to pay that amount to receive a mug. The key finding is
that the average amount that participants require in order to give up their mug is roughly
double the average amount that participants without mugs are willing to pay to obtain a
mug.”

Sunk cost effect:

“This is illustrated by the memorable example of a family who, having previously paid $40
for tickets to a basketball game, decide to drive through a snowstorm to attend the game, even
though, had they received the tickets for free, they would have stayed home.”

Absolute versus relative:

“Another anomaly is a violation of traditional models of search; for example, a shopper is
willing to drive across town to save $5 on a $25 item, but not on a $500 item.”

Limited self-control:
“Another anomaly is limited self-control, exemplified by the guests who, unable to stop
eating the cashews brought out as a pre-dinner snack, feel relieved when the host removes the
nuts and hides them in the pantry.”

The first finance paper:

“… Thaler’s first finance paper (De Bondt and Thaler, 1985) caused a stir. The paper
showed that, on average, stocks with big losses over the previous three years subsequently
outperform stocks with big gains over the previous three years in a way that is not captured
by beta. Moreover, De Bondt and Thaler gave this finding an unabashedly behavioral
interpretation: that is, stocks with big losses over the previous three years are stocks that
investors have become irrationally pessimistic about, and the high subsequent returns of these
stocks represent a correction back up to fair value.”

Closed-end funds:
“… closed-end funds, which are funds that, at inception, raise capital from investors and then
allocate this money to stocks or other assets. After inception, the shares of a closed-end fund
are traded on an exchange; investors wanting to buy or sell fund shares do so there at the
prevailing market price. …. on average, the price of a fund is lower than the value of the
assets it holds. …. Individual investors constitute a larger fraction of the ownership base of
closed-end funds than of the assets held by these funds. As a result, if these investors become
excessively exuberant (pessimistic) about the future prospects of the assets they own, they
will push the prices of closed-end funds up (down) relative to the prices of the assets held by
the funds. …

Parent versus daughter:

“… parent companies were sometimes worth less than the implied market value of their
subsidiary holdings, a sign of severe mispricing. … In the examples the authors study, the
relatively overvalued subsidiary is typically a technology firm. Their findings therefore add
credence to the view that technology stocks as a whole were overvalued in the late 1990s, and
that their dramatic rise and fall in price constituted a major financial bubble.”

The equity premium puzzle (1):

“Benartzi and Thaler (1995), the first paper to use prospect theory to think about asset prices,
captures Thaler’s vision of how behavioral models of risky choice might look. The authors
address a long-standing puzzle in financial economics, the “equity premium puzzle”. Over
the past two centuries, the average return of the US stock market has greatly exceeded the
average return of Treasury Bills. Of course, because the stock market is riskier than Treasury
Bills, it is not surprising that its average return is higher. However, traditional models of asset
prices have had trouble explaining the sheer size of the difference in the average returns of
the two asset classes.”

The equity premium puzzle (2):

“Benartzi and Thaler (1995) argue that we can make sense of the high historical average
return of the stock market by incorporating elements of prospect theory – specifically,
reference dependence and loss aversion – into our description of investors’ decision-making.
Suppose that, in line with reference dependence, investors derive utility from annual changes
in the value of their financial wealth – annual because, in this framework, investors are
assumed to track their financial wealth on an annual basis, perhaps because they receive their
most comprehensive brokerage statements once a year or because they file their taxes once a
year. Suppose also that investors are loss averse; in other words, they are much more
sensitive to a potential drop in financial wealth than to a potential increase. Benartzi and
Thaler (1995) perform some calculations to show that if investors take this source of utility
into account when allocating their wealth, then this can explain the stock market’s high
historical average return. To these investors, the stock market is unappealing: if they allocate
a large fraction of wealth to it, they face the possibility of a painful loss over the next year.
As a result, they require a high average return to hold the available supply of stocks.

Libertarian paternalism:
“… this is an approach that nudges people toward a sensible action (the paternalistic part),
but without taking any options away from them (the libertarian part)”

Increasing saving rates:

“Thaler was supportive of auto-enrollment …he was concerned that its effectiveness might
be limited by the relatively low default saving rate that it often uses…. Benartzi and Thaler
reasoned that, to increase saving rates, they had to find a way to overcome two
psychological impediments to saving. The first is loss aversion: because saving more
means a reduction, or loss, in take-home pay, it is unappealing. The second is present bias, a
type of time discounting in which extra weight is given to current payoffs: because an
increase in saving means a reduction in take-home pay today, it is all the more aversive.
Benartzi and Thaler came up with a plan called Save More Tomorrow, which neutralizes
these biases. When an employee enrolls in the plan, he agrees to increase his saving rate in
the future by a fixed amount every time he receives a pay increase. Notice two things.
First, at the time of enrollment, the saving increase is in the future; present bias therefore
does not stop the employee from enrolling. Second, as the saving increases are tied to pay
increases, the employee never experiences a drop in (nominal) take-home pay; loss
aversion therefore has no bite.

Thaler (2015): Misbehaving - the making of behavioral economics

Misbehaving - the making of behavioral economics By Richard H. Thaler (2015)

The book (1):

The creative genius who invented the field of behavioral economics is also a master
storyteller and a very funny man.
All these talents are on display in this wonderful book.
Daniel Kahneman
(winner of the Nobel Prize in Economics, 2002)

The book (2):

Richard Thaler has been at the center of the most important revolution to happen in
economics in the last thirty years.
In this captivating book, he lays out the evidence for behavioral economics and explains
why there was so much resistance to it.”
Robert J. Shiller
(winner of the Nobel Prize in Economics, 2013)

Excerpt … on acquisition and transaction utility (1) (page 59):

“Eventually I settled on a formulation that involves two kinds of utility: acquisition utility
and transaction utility. Acquisition utility is based on standard economic theory and is
equivalent to what economists call “consumer surplus”… For an Econ, acquisition utility is
the end of the story…
Humans on the other hand, also weigh another aspect of the purchase: the perceived quality
of the deal. That is what transaction utility captures. It is defined as the difference between
the price actually paid for the object and the price one would normally expect to pay, the
reference price.”

Excerpt … on acquisition and transaction utility (2) (page 60):

Survey question:
“You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour
you have been thinking about how much you would enjoy a nice cold bottle of your favorite
brand of beer. A companion gets up to go make a phone call and offers to bring back a beer
from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown
grocery store]. He says that the beer might be expensive so asks how much your are willing
to pay for the beer. He says he will buy the beer if it costs as much or less than what you
state. But if it costs more than the price you state, he will not buy it. You trust your friend,
and there is no possibility of bargaining with the (bartender)[store owner].
What price will you tell him?
Median answers: ($7.25) [$4.10]

Excerpt … on the poker table (1) (page 83)

Survey question:
“Problem 1. You have just won $30. Now choose between:
a) A 50% chance to gain $9 and a 50% chance to lose $9. [70%]
b) No further gain or loss. [30%]
Problem 2. You have just lost $30. Now choose between:
a) A 50% chance to gain $9 and a 50% chance to lose $9. [40%]
b) No further gain or loss. [60%]
Problem 3. You have just lost $30. Now choose between:
a) A 33% chance to gain $30 and a 67% chance to gain nothing. [60%]
b) A sure $10. [40%]”

Excerpt … on the poker table (2) (page 83)

“Problem 1 illustrates the “house money effect”. Although subjects tend to be risk averse
for gains, meaning that most of them would normally turn down a coin flip gamble to win or
lose $9. When we told them they had just won $30, they were eager to take that gamble.
Problems 2 and 3 illustrate the complex preferences in play when people consider
themselves behind in some mental account. Instead of the simple prediction from prospect
theory that people will be risk-seeking for losses, in problem 2 a loss of $30 does not generate
risk-taking preferences when there is no chance to break even.* But when given that chance,
in problem 3, a majority of the subjects opt to gamble.
* This means that the prediction from prospect theory that people will be risk-seeking in the
domain of losses may not hold if the risk-taking opportunity does not offer a chance to break
even.”

Excerpt … on economics students (page 94)

“The economics training the students receive
provides enormous insights into the behavior of Econs,
but at the expense of losing common-sense intuition
about human nature and social interactions.
Graduates no longer realize
that they live in a world populated by Humans.”

Excerpt … on self control (page 103):

”… I came across a quote from social scientist Donald McIntosh that profoundly influenced
my thinking:
“The idea of self-control is paradoxical unless it is assumed
that the psyche contains more than one energy system, and
that these energy systems have some degree of independence from each other”.
… it seemed to me to be obviously true. Self-control is centrally, about conflict. And, like
tango, it takes (at least) two to have a conflict. Maybe I needed a model with two selves.”

Excerpt … on fairness games (1) (pages 144-146):

”Economists, psychologists, and sociologists have all studied this problem using variations
on the following simple game. Suppose we invite ten strangers to the lab and give each of
them five one-dollar bills. Each subject can decide how many (if any) dollar bills he wishes
to contribute to the “public good” by privately putting that money into a blank envelope. The
rules of the game are that the total contributions to the public good envelope are doubled, and
then the money is divided equally among all players …
… When the game was played by economics graduate students, the contribution rate was
only 20% ... “
Economist and philosopher Amartya Sen:
“The purely economic man is indeed close to being a social moron.
Economic theory has been much preoccupied with this rational fool”

Excerpt … on fairness games (3) (pages 144-146):

” … a large proportion of people can be categorized as conditional cooperators, meaning that
they are willing to cooperate if enough others do. People start out these games willing to give
their fellow players the benefit of the doubt, but if cooperation rates are low, these
conditional cooperators turn into free riders.
However, cooperation can be maintained even in repeated games if players are given the
opportunity to punish those who do not cooperate … people are willing to spend some of
their own money to teach a lesson to those who behave unfairly, and this willingness to
punish disciplines potential free riders and keeps robust cooperation rates stable.”

Excerpt … on the endowment effect (page 154):

“The endowment effect experiments show that people have a tendency to stick with what
they have, at least in part because of loss aversion. Once I have that mug, I think of it as
mine. Giving it up would be a loss. And the endowment effect can kick in very fast. In our
experiments, the subjects had “owned” that mug for a few minutes before the trading started.
Danny liked to call this the “instant endowment effect”.
And while loss aversion is certainly part of the explanation for our findings, there is a related
phenomenon: inertia. In physics, an object in a state of rest stays that way, unless something
happens. People act the same way: they stick with what they have unless there is good reason
to switch, or perhaps despite there being a good reason to switch. Economists William
Samuelson and Richard Zeckhauser have dubbed this behavior “status quo bias”.”

Excerpt … on employment contracts as gift exchanges (page 182):

“… in a laboratory setting, “firms” that elected to pay more than the minimum wage were
rewarded with higher effort levels by their “workers”. This result supported the idea, initially
proposed by George Akerlof, that employment contracts could be viewed partially as a gift
exchange.
The theory is that if the employer treats the worker well, in terms of pay and working
conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus
making the payment of above-market wages economically profitable.”

Excerpt … on keynes and behavioral finance (1) (pages 209-211):

“…Keynes … was a true forerunner of behavioral finance.
… Keynes … thought that emotion, or what he called “animal spirits,” played an important
role in individual decision-making, including investment decisions.
Keynes was also skeptical that professional money managers would serve the role of the
“smart money” that EMH defenders rely upon to keep markets efficient. Rather, he thought
that the pros were more likely to ride a wave of irrational exuberance than to fight it. One
reason is that it is risky to be contrarian. “Worldly wisdom teaches that it is better for
reputation to fail conventionally than to succeed unconventionally.” Instead, Keynes thought
that professional money managers were playing an intricate guessing game*.”
* Professional investment may be likened to those newspaper competitions in which the
competitors have to pick out the six prettiest faces from hundred photographs, the prize being
awarded to the competitor whose choice most nearly corresponds to the average preferences
of the competitors as a whole.
Excerpt … on keynes and behavioral finance (2) (pages 209-211):
Your turn:
“Guess a number from 0 to 100
with the goal of making your guess as close as possible
to two-thirds of the average guess of all those participating in the contest.”
All participants get the same task.
NB: First-level thinkers, second-level thinkers, and people with too much economics training.
Winning guess of Financial Times readers: “accident”.

Excerpt … on high trading volume (page 217):

“In a rational world there would not be very much trading – in fact, hardly any … no
rational agent will want to buy a stock that some other rational agent is willing to sell.
Imagine two financial analysts, Tom and Jerry, are playing a round of golf. Tom mentions
that he is thinking of buying 100 shares of Apple. Jerry says, that’s convenient, I was
thinking of selling 100 shares. I could sell my shares to you and avoid the commission to my
broker. Before they can agree on a deal, both think better of it. Tom realizes that Jerry is a
smart guy, so asks himself, why is he selling? Jerry is thinking the same about Tom, so they
call off the trade.
… However, if you assume that some investors are overconfident, high trading volume
emerges naturally. Jerry has no trouble doing the trade with Tom, because he thinks that he is
smarter than Tom, and Tom thinks he’s smarter than Jerry. They happily trade, each feeling
a twinge of guilt for taking advantage of his friend’s poor judgement.”

Excerpt … on market efficiency and risk (page 217):

“… it is not a violation of the efficient market hypothesis if you beat the market by taking on
more risk. The difficulty comes in knowing how to measure risk.
… Eugene Fama … pointed out that all tests of the no-free-lunch component of market
efficiency were actually “joint tests” of two hypotheses: market efficiency and some model
of risk and return.
… This joint hypothesis argument applies to any apparent violation of the EMH.
… The central question became whether to accept our interpretation of our findings as
evidence of mispricing, which goes against the EMH, or to say that they were attributable to
risk.”

Excerpt … on the three bounds (page 258):

“… I had adopted the pedagogical device of calling these essential elements “the three
bounds”:
1) Bounded rationality
2) Bounded willpower
3) Bounded self-interest
In law and economics these properties of Humans had heretofore been assumed to be
thoroughly unbounded.

What difference does it make that we are humans.

Shiller (2017): Narrative Economics

Narrative Economics BY Robert J. shiller (AER, 2017)

We are more proven to stories e.g. we read stories with amazing/interesting headlines
Narrative economics:
… the study of the spread and dynamics
of popular narratives, the stories,
particularly those of human interest and emotion,
and how these change through time,
to understand economic fluctuations.

Narrative … … a simple story or easily expressed explanation of events that many people
want to bring up in conversation or on news or social media because it can be used to
stimulate the concerns or emotions of others, and/ or because it appears to advance self-
interest.

We have a problem in that sense ups and down in economics are difficult to explain, ot at
least the magnitude is difficult to explain and estimate.
Is that change in stories?
Often we can’t really explain what have happened
A small ting can lead to a different story, a different mode of operation….

An example:
A recession is a time when many people have decided to spend less, to make do for now
with that old furniture instead of buying new, or to postpone starting a new business, to
postpone hiring new help in an existing business, or to express support for fiscally
conservative government.
People might make any of these decisions in reaction to the recession itself (that’s
feedback), but to understand why a recession even started, we need more than a theory
of feedback.
We have to consider the possibility that sometimes the dominant reason why a recession is
severe is related to the prevalence and vividness of certain stories, not the purely economic
feedback or multipliers that economists love to model.

Sartre:
The existentialist philosopher Jean-Paul Sartre (1938):
“A man is always a teller of tales,
he sees everything that happens to him through them;
and he tries to live his own life
as if he were telling a story.
But you have to choose:
live or tell.”

We are all story tellers about ourself.

We tell stories to other people that might deviate from the story about ourselves
The story might change gears
Emotionally you tell different stories about yourself, you do not change the story you tell to
other that much (you might want to keep a certain image).

Scripts:
Narratives may not generally be acted upon reflectively, since,
in the words of psychologists Schank and Abelson (1977),
they may be taken as scripts.
When in doubt as to how to behave
in an ambiguous situation,
people may think back to narratives
and adopt a role as if acting in a play
they have seen before.
The narratives have the ability to produce social norms
that partially govern our activities, including our economic actions.

Those story we tell about our self and other they might create social norms.

Affect heuristic:
Affect heuristic … people who are experiencing strong emotions, such as fear, tend to
extend their feelings to unrelated happenings (Slovic et al. 2007).
Shiller:
…using data from a questionnaire survey with institutional investors and high-income
Americans, we found that these people generally have exaggerated assessments of the risk
of a stock market crash, and that these assessments are influenced by the news stories,
especially front page stories, that they read.
One intriguing finding was that an event such as an earthquake could influence estimations
of the likelihood of a stock market crash. The respondents in our survey gave statistically
significantly higher probabilities to a stock market crash if there had been an earthquake
within 30 miles of their zip code within 30 days, triggering the affect heuristic.

When we are afraid in one aspect, it then to reflect in other aspects that is not even related.
Mode of operations of feelings.
In evolutionary sense, this might makes sense to we in a mode where you are afraid (many
dangers and threats from animals, lack of food and other tribes).

Great depression (2007-2009):

Examples of narratives:
 1) In 2001, the UK television show Property Ladder was launched. This reality TV show
which depicted individuals buying homes, fixing and prettifying them a little, and
then reselling them at a large profit, was a big success.
2) The Northern Rock bank run in 2007, the first UK bank run since 1866, brought
back the old narratives of panicked depositors forming angry crowds outside closed
banks.
3) Widespread fears of long-term job insecurity because of advancing technology.
Facebook and Gmail appeared in 2004, YouTube in 2005, Twitter in 2006, and the
iPhone in 2007.
Kahneman and Tversky’s representativeness heuristic is the principle that people judge
current events by their similarity to memories of representative events.

What kind of stories do we have when it comes to economics?

The story might be that buying a house is good, you can get a profit when you sell.
Bank run - stories that suddenly became much more present, since it happened in the western
world
Long term job insecurity - things are suddenly changing, new technology…we might not
need that many employees.

We heat things and think of them as representative of everything that is going on.

Relevant Question:
Can research on narratives help us explain (and potentially mitigate) future economic
crises?

Kahneman and Tversky (1979): Prospect Theory: An Analysis of Decision Under

Risk

Prospect Theory: An Analysis of Decision Under Risk By David Kahneman and Amos
Tversky (1979)

The authors:
Daniel Kahneman (1934-) An Israeli-American psychologist
Notable for his work on the psychology of judgment and decision-making, as well as
behavioral economics (2002 Nobel Prize in Economics).

With especially Amos Tversky (1937-1996), Kahneman established a cognitive basis for
common human errors that arise from heuristics and biases, and developed prospect theory.

Decision making under risk:

u Prospect theory
u People identify a reference point generally representing their current state
u People are much more sensitive to potential losses than to potential gains (i.e.,
loss aversion)
u People tend to overweight rare events (Hertwig et al., 2004)
u Often, high-probability events also receive less weight than they
deserve

Most of us have loss aversion.

We fell losses more.
Loss at the same magnitude as a gain is felt much more.

On the gain side we prefer safety  we have a concave function on the gain side. We are risk
averse in the gain setting.
In the loss setting are risk seeking.
We have loss aversion - want to be compensated  this gives I kink at the orego

Insurance situation  we would rather pay a little sum now evenso we know that there is
only low probability that the house catches fire.
Lottery situation  we would like a very small probability to win big.
 That is with small probability we are risk averse in the negative domain and risk seeking
in the positive domain (that is the opposite in what one would normally do)

Prospect theory:
Prospect theory rests on two observations:
1) People attach values to gains and losses rather than to wealth
2) The decision weights that people assign to outcomes are different from probabilities.

Prospect theory:
The traditional
utility function:
Note:
Wealth (x)
Utility (y)

Prospect theory:
value function:
Note:
Changes in wealth (x)
Value (y)
= 1) Loss aversion + 2) risk aversion in positive domain + 3) risk seeking in negative domain!
Lines are more steep in the negative domain - this is the loss aversion.

Lotteries are often more popular in bad times. When things are going good, they are more
optimistic about life.

Prospect theory:
Weighting function:
Note:
Probability (x)
Weight (y)
= 1) small probabilities are over-weighted
+ 2) certainty effect!

The fourfold pattern:

Gains Losses
High probability 98% chance to win $10,000 98% chance to lose $10,000
Certainty effect Fear of disappointment Hope to avoid loss
RISK AVERSE RISK SEEKING
Accept unfavorable settlement Reject favorable settlement
Low probability 2% chance to win $10,000 2% chance to lose $10,000
Possibility effectHope of large gain Fear of large loss
RISK SEEKING RISK AVERSE
Reject favorable settlement Accept unfavorable settlement
Hill and Buss (2010): Risk and relative social rank: positional concerns and risky
shifts in probabilistic decision-making
Risk and relative social rank: positional concerns and risky shifts in probabilistic decision-
making by Sarah E. Hill and David M. Buss (Evolution and Human Behavior 2010)

Main findings:
The evolutionary-based hypothesis predicts that concern with relative position will lead to
increased risk when
(1) the higher variance outcome offers the potential to render one better off than
social competitors, but the lower variance outcome would not,
(2) the choice is in a decision domain affecting one's ability to solve adaptive problems
reliably present in human social life, and
(3) the decision is being made about a gain rather than a loss.
The study found support for these predictions, demonstrating that positional concerns may
reverse the certainty effect from prospect theory. Our findings highlight the important role
played by social comparisons in individual decision-making and preferences for risk.

When do you actually seek competition?

We are social animals  we compare our self to others?

Evolutionary background (1):

Survival …
Theory—originally developed to predict animal's foraging behaviors—predicts that an
organism's decision-making will be modulated in favor of pursuing riskier (i.e., more
variable) food patches when their physiological needs exceed the outcomes available from
choosing less variable patches.
Reproduction …
In domains where the fitness benefits associated with personal outcomes are contingent on
those available to others, need depends on one's ability to outperform relevant social
competitors in addition to meeting baseline levels required for survival.

Financial distress situation - management wants to take very risky choices to benefit the share
holders.

Evolutionary background (2):

However …
Being motivated by relative rather than absolute outcomes comes at a real cost to the
individual. Exhibiting a preference for an absolutely lesser income, for example, in favor of
having an income higher than one's competitors would render one better able to acquire
scarce resources that play a critical role in fitness (e.g., mates, status) but this
preference comes at the cost of the individual having access to an absolutely smaller
amount of monetary resources with which to purchase items one may desire. When
reasoning about resources whose impact on fitness is less direct and less dependent on the
outcomes available to others (e.g., days off from work, happiness) it is unlikely that the
benefits associated with being positionally better off would outweigh the costs.

Evolutionary background (3):

No change for losses …
For our hunter-gatherer ancestors for whom resource scarcity was a significant
concern, incurring a loss in one of these critical domains may have caused death or made
them more susceptible to death.
Given the asymmetrical influence that gains and losses have had on fitness over evolutionary
time, individuals are predicted to favor the high variance outcome when choosing
between two losses, as this outcome offers the possibility of the individual meeting their
need level in this domain.

Economist: Risk off: Why come people are more cautious with their finances than
other

We are born with a fundament (genes) that play a role in terms of risk.
Upbringing, environment and experiences also matter.

Watching a horror moving can affect how you think about risk. It should not have an effect,
but it has since we are humans. Things that are not tied together becomes ties together.

Johnson et al (2006): Overconfidence in wargames: experimental evidence on

expectations, aggression, gender and testosterone
By Johnson & McDermott & Barrett & Cowden & Wrangham & McIntyre & Rosen
(prs, 2006)

Abstract:
“Overconfidence has long been noted by historians and political scientists as a major cause
of war …
Mounting empirical studies now show that mentally healthy people tend to exhibit
psychological biases that encourage optimism, collectively known as ‘positive illusions’.
Positive illusions are thought to have been adaptive in our evolutionary past because they
served to cope with adversity, harden resolve, or bluff opponents …
… in experimental wargames:
(i) people are overconfident about their expectations of success;
(ii) those who are more overconfident are more likely to attack;
(iii) overconfidence and attacks are more pronounced among males than females;

War puzzle:
… a central problem in international relations dubbed the ‘war puzzle’:
Rational states — whether expectant winners or expectant losers — should not fight
because if they assess each other accurately, they could avoid the costs and risks of war
(blood, treasure and uncertainty) by negotiating a pre-war bargain reflecting their relative
power.
Because wars do occur,
states appear to overestimate their relative power.

Positive illusions – the advantages:

Positive illusions confer numerous advantages in many life tasks as a kind of self-fulfilling
prophecy — promoting health, creativity, physical and mental performance in the face of
otherwise debilitating obstacles.
Such adaptive advantages led to a selection pressure for positive illusions through our
evolutionary history.
One proposed adaptive advantage is specifically linked to conflict: positive illusions may
have improved combat performance in the past by bolstering resolve and/or deceiving
opponents via bluffing.
This would predict that positive illusions are greater under threat, and are stronger in
males (who have been the predominant warriors and fighters throughout evolutionary
history).

Giving the stone age brain and the men’s evolutionary fighting instinct men should be more
overconfident than women.

War games – various findings:

Wars occurred in 47.8% of the games.
Players’ expectations of their performance were significantly above the middle value of
100.4
Those who carried out unprovoked attacks on their opponents gave significantly higher
pre-game self-rankings.
In the process of the wargame, males learned that they were not as good as they initially
forecast, and females learned that they were better than they forecast.
Males also made significantly more unprovoked attacks than females.

War games - conclusions:

1) Subjects in a war game were overconfident about their expectations of success in
conflict.
2) Those who were more overconfident were more likely to make unprovoked
attacks.
3) Overconfidence and unprovoked attacks were more pronounced among males than
females.
4) Overconfidence or unprovoked attacks were not correlated with testosterone.
Narcissism scores predicted both overconfidence and unprovoked attacks among males.

TED talk: Tari Sharot - The Optimism bias

People are optimistic about themselves, but not the person setting next to them are other
people in general.

Most people put themselves in top of abilities - this is statistically not possible  this is the
optimism bias.

People with expectations feel better. When people with high expectations succeed, they
attribute it to themselves.
Anticipation makes us happy - student would rather pay for a kiss from a celebrity in 3 days.
People prefer Friday, because it is anticipation about the weekend.

Optimism makes you try harder

How do we maintain optimism in the face of reality?

Effect of “smoking kills”  it will hit the other guy, not me.

Puri and Robinson (2007): Optimism and economic choice

Optimism and economic choice BY Manju puri & david t. robinson (jfe, 2007)
Abstract:
“We create a novel measure of optimism using the Survey of Consumer Finance by
comparing self-reported life expectancy to that implied by statistical tables.
This measure of optimism correlates with positive beliefs about future economic conditions
and with psychometric tests of optimism.
Optimism is related to numerous work/life choices: more optimistic people work harder,
expect to retire later, are more likely to remarry, invest more in individual stocks, and save
more.
Interestingly, however, moderate optimists display reasonable financial behavior, whereas
extreme optimists display financial habits and behavior that are generally not considered
prudent.”

MEASUREMENT OF OPTIMISM:
The authors develop a measure of optimism using data from the Survey of Consumer
Finances (SCF). Question asked in the survey:
”About how long do you think you will live?”

The authors then compare a person’s subjective life expectancy to their actuarial life
expectancy based on that person’s demographic characteristics.

People on average are quite accurate at forecasting their life expectancy: the average forecast
error is less than two years. Yet there is considerable variation in the accuracy of
respondent’s life expectancy forecasts.
This life expectancy miscalibration is the measure of optimism.
Note: The vast majority of optimism is idiosyncratic to the individual respondents and cannot
be explained by demographics.

Dispositional optimism:
Dispositional optimism is defined as a global expectation that more good (desirable) things
than bad (undesirable) will happen in the future (Scheier and Carver, 1985).
While optimistic bias may vary from one setting to the next (Weinstein, 1980), dispositional
optimism is a psychological trait that lies at the heart of an individual’s outlook on life in
general.

There is a large body of evidence in psychology and medicine that illustrates the power of
dispositional optimism. For example, optimistic cancer patients face lower mortality risk and
they experience faster recovery after coronary artery bypass surgery than pessimists do. They
also adjust more smoothly to major life transitions like going to college or failure to achieve a
desired pregnancy.

The evidence in psychology suggests that one main channel through which dispositional
optimism works is through developing coping habits or behavior that is more likely to lead to
desired outcomes (e.g. use sunscreen, take vitamins, eat low-fat foods).

Bias is something you can learn and de-learn

However …:
The literature on optimistic bias—overestimates of the probability that a favorable outcome
will occur, or underestimates that a negative outcome will occur—argues that overoptimism
can be foolish, dangerous, and unhealthy.
This line of thinking illustrates the dangers of extreme optimism, which may lead individuals
to neglect taking basic precautionary measures.
This negative view of optimism squares with the economics literature’s focus on related
psychological concepts such as overconfidence (especially with regard to the likelihood of
future events). The prevailing wisdom in economics is that optimism must lead to suboptimal
decisions, and hence to lower utility. E.g. Odean (1998) provides evidence on individual
equity ownership, while Arabsheibani, de Meza, Maloney, and Pearson (2000), Bernardo and
Welch (2001), and Coelho, de Meza, and Reyniers (2004) provide evidence on
entrepreneurship.
Is optimism good or bad, then?

Good or bad?:
How can someone be better off by holding systematically mistaken beliefs about the future?
Economic theory only admits a narrow range of possibilities (3).
1) Utility has an anticipatory component. An individual may get greater overall utility
if the anticipation of good things on the horizon outweighs the ex post mistaken
actions to which these beliefs sometimes lead.
2) Optimism is a form of commitment in a game against a future version of oneself.
The optimist overweighs this future state of the world, which raises the benefit of the
small actions (=good habits), but does not overweigh it by so much that the future
state appears inevitable, in which case no preparation is necessary.
3) The observable data upon which people make everyday decisions underidentifies the
decisions of interest, and therefore rationally admits multiple points of view. In such a
world, individuals are free to choose from a set of possible distributions that are
consistent with observables. An optimist would be someone who has a prior
distribution that places the greatest weight on desirable outcomes and the least weight
on unfavorable outcomes, conditional on the data. Such a person may be led by these
beliefs to make decisions that are ex post utility enhancing.

Empirical findings:
Optimistic respondents …
1) … work longer hours.
2) … are more likely to report that they will work forever.
3) … are more likely to remarry (”the triumph of hope over experience”).
4) … are more likely to be stock-pickers but are not more likely to tilt their equity/debt
dimension towards equity.
5) ... save more.
=> A complicated picture of optimism and its relation to financial decision-making:
1) Stock-pickers NOT OKAY
2) Save more OKAY => more focus on optimism and economic behavior (next
slide)

Optimism and economic behavior (1):

The schism
Optimistic bias versus dispositional optimism or …
Prevailing wisdom in financial economics (optimism is bad)
versus
Prevailing wisdom in psychology (optimism is good)
Is the relation between optimism and economic choice (1) further evidence of the benefits of
optimism (=save more) or (2) evidence of imprudence (= stock picking)?

Optimism and economic behavior (2):

Hypothesis:
Modest amounts of optimism may be more likely to correlate with positive behaviors
identified in the psychology literature, whereas extreme optimism may be more likely to
correlate with the negative behavior identified in the economics literature.
The distinction:
Extreme optimists are the right-most 5% of optimists. These are people who are
approaching two standard deviations away from the mean and thus on average are nearly 20
years overoptimistic.

Empirical findings:
Moderate optimists seem to have prudent financial habits,
while extreme optimists do not.
Moderate optimists are more likely …
1) … to pay off their credit card balances
2) … to have long planning horizons
3) … to work harder
4) … not to be day traders.
Extreme optimists are less likely to save, they work less, they have short planning horizons,
and they have more individual stocks in their portfolios.

So, Is optimism good or bad?:

The results on extreme optimists are consistent with evidence in finance and economics that
suggest overoptimism (or relatedly, overconfidence) can lead to behavior that might not be
rationally justified.
However, the distinction between mild and extreme optimists points to an important new
dimension to optimism:
Optimism in small doses can be a good thing.
= non-linearity (bell shape) in the relation between optimism and prudent financial decision
making

Optimism and self-control:

Thaler and Shefrin (1981):
Self-control is a battle between a Doer self, who enjoys utility in the present, and a
Planner self, responsible for making decisions that provide utility for all future Doer selves.
Two observations:
1) Moderate (extreme) optimists are less (more) likely to be smokers.
2) Moderate (extreme) optimists hold a greater (smaller) fraction of their wealth in liquid
assets.
Interpretation:
Optimists, because they feel that the future is likely to be favorable, tilt the balance of
power more towards the Planner self, thereby setting aside more resources for future
enjoyment. These people suffer from fewer self-control problems, since each periods’ Doer
self has diminished ability to take actions that detract from future Doer selves.

Conclusion:
Optimism is a bit like red wine:
Too much is clearly bad, but a little each day can be good for one’s health.
Thus, too much optimism may be detrimental to one’s economic well-being,
a moderate amount of optimism is associated with better decision-making.

Related research:
Campbell et al. (2011, JFE):
”We show theoretically that optimism can lead a risk-averse Chief Executive Officer (CEO)
to choose the first-best investment level that maximizes shareholder value. Optimism below
(above) the interior optimum leads the CEO to underinvest (over-invest). Hence, if boards
of directors act in the interests of shareholders, CEOs with relatively low or high optimism
face a higher probability of forced turnover than moderately optimistic CEOs face. Using a
large sample of turnovers, we find strong empirical support for this prediction. The results
are consistent with the view that there is an interior optimum level of managerial optimism
that maximizes firm value.”

Moderate optimism might be a good thing.

Heaton (2019): Managerial optimism: New observations on the unifying theory

Managerial optimism: New observations on the unifying theory By Heaton (2019)

Heaton:
Financial Management article in 2002 – controversial!
Followed by Malmendier & Tate (JF, 2005)
Two essential building blocks of the implications of managerial optimism / overconfidence!

Why controversial?
Previously …
Pecking-order theory of capital structure
… explained by asymmetric information
Empire building / excessive investments
… explained by agency theory
 CEO’s tend to investor more than what is good. The CEO’s is agent for himself and not
only the share holders. The CEO himself want to have a big empire. The CEO is loyal to
himself.

Why necessary?
Because the two explanations conflict!
(loyal managers versus disloyal managers)
Pecking-order theory of capital structure
… explained by asymmetric information
Empire building / excessive investments
… explained by agency theory
Would be nice to have one explanation that do not contract -- the above say that the CEO is
loyal but at the same time disloyal.

Solution
One unifying theory for two empirical observations: Managerial optimism!

Richard roll (1986)

“Psychologists are constantly bombarding economists with empirical evidence that
individuals do not always make rational decisions under uncertainty.
For example see Oskamp (1965), Tversky and Kahneman (1981), and Kahneman, Slovic, and
Tversky (1982).
Among psychologists, economists have a reputation for arrogance mainly because this
evidence is ignored; but psychologists seem not to appreciate that economists disregard the
evidence on individual decision making because it usually has little predictive content for
market behavior.
Corporate takeovers are, I believe, one area of research in which this usually valid reaction
of economists should be abandoned; takeovers reflect individual decisions.”
Roll, R. (1986). The hubris hypothesis of corporate takeovers. Journal of Business, 59(2),
page 199.

Behavioral corporate finance

Behavioral asset pricing = LESS successful
Behavioral corporate finance = MORE successful

Why?
Irrational managerial behavior is not to the same degree subject to the “arbitrage objection”
(i.e., that rational actors would eliminate irrationality).
Roll’s insight implied that the arbitrage objection could not be raised as easily regarding the
behavior of corporate managers.

In corporate finance you can identity one particular person who can influence things.

Malmendier & Tate (2015): Behavioral CEOs: The role of managerial overconfidence
Behavioral CEOs: The role of managerial overconfidence BY Ulrike malmendier & Geoffrey
tate (JEP, 2015)

Issues...
1) How to measure overconfidence?
2) Implications of overconfident CEOs?
Note: CEO overconfidence implies overinvestment only when the firm is flush in internal
funds, and it implies a heightened sensitivity of investment to the availability of cash and
other forms of capital that the CEO perceives to be relatively cheap.
3) Biased managers or biased investors?
NB: Many of the existing empirical studies are based on correlations between overconfidence
measures and corporate policies. They are subject to the standard
Measuring CEO Overconfidence (1):
The most common approach to measuring CEO overconfidence:
Use decisions that the executive makes on his or her personal portfolio of company stock
options.
Logic: Since the 1980s (and particularly during the 1990s), top US executives have received
increasingly large stock and option grants as part of their compensation. They commonly find
themselves in a position where they are under-diversified with respect to company-
specific risk. Moreover, the value of a CEO’s human capital is tied to the success of the firm,
heightening the under-diversification problem. Stock options are not tradeable and typically
take years to vest before they can be exercised to purchase (and then sell) the underlying
stock. Moreover, executives are contractually prohibited from taking short positions in the
company’s stock. Under these conditions, a rational, risk-averse executive should seek to
exercise stock options, once they are vested, before expiration in order to diversify.

CEO’s tend to be risk adverse

They are per definition under diversified both in monetary terms and human capital term
(especially in human capital terms).
By given CEO’s options should counter the risk aversion and make them have the same risk
assessment as the shareholders want - this is in the rational world.

Most CEO’s get options every year. Very seldom that we see the option market go down
every year.

Measuring CEO Overconfidence (2):

Details:
The exact timing of optimal option exercise will vary depending on the “moneyness” of the
options (that is, on how far the current price of the underlying stock exceeds the strike price
at which the executive has an option to purchase the stock), the risk aversion of the
executive, and the extent to which the executive is under-diversified.
Overconfident executives, however, overestimate the future performance of their firms
and are therefore more willing to hold options, expecting to profit from future stock price
appreciation.
Building on this logic, Malmendier and Tate (2005) proposed the systematic tendency to
hold options longer before exercise as a measure of overconfidence.

Measuring CEO Overconfidence (3):

In concrete terms:
Executive options typically have a ten-year lifespan at grant. While exact vesting schedules
vary from one option package to the next, they are almost always fully vested after four
years. Thus, CEOs who hold options all the way to expiration have taken a long-term bet
on the future performance of their company’s stock, despite their under-diversification.
Classifying such CEOs as overconfident is the basic idea of the “Longholder” measure.
We classify a CEO as overconfident if that executive ever held vested options until the year
of expiration, provided that the options were at least 40 percent “in the money” at the start
of the final year. Imposing the 40 percent threshold ensures that we do not classify CEOs as
overconfident who hold “underwater” options to expiration: when an option is “underwater”
the current market price of the underlying stock is lower than the strike price, so, of course, a
rational executive in any model will decide against exercising such an option.
Measuring CEO Overconfidence (4):
The use of executive options was relatively limited in the 1980s and early 1990s compared
to the later sample years. Both the absolute level of option compensation and its relative level
(percent of compensation paid via options) increase dramatically from about 1995 to 2000.
In more recent years, option compensation has been declining, while the use of restricted
stock grants has started to rise. Shareholder demands, tax-law changes, and the experience
of worthless options in the wake of the financial crisis are typically cited as reasons. If the
recent decline of option-based compensation continues, it may become impractical to use
option exercise to measure beliefs in the future

The company now need to expense the options.

They could say that they are not given away something that is worth something, because the
options are “at the money” when they are given - this they can’t do anymore.

Measuring CEO Overconfidence (5):

Several promising recent approaches not tied to option exercise decisions:
1) Managerial forecasts of earnings. Specifically, using the fraction of a firm’s
voluntary earnings forecasts that later turned out to exceed the realized earnings.
2) Portrayal in the business press. Count past articles in prominent business
publications that refer to CEOs using words that suggest overconfidence
(“confident”/“confidence,” optimistic” /“optimism”) relative to the number of articles
that refer to CEOs with words that are unlikely to suggest overconfidence (“cautious,”
“conservative,” “practical,” “reliable,” and “steady”).
3) Survey instruments. (1) Using 10 years of a quarterly survey, which contains
projections by US chief financial officers. They use the 80 percent confidence interval
of the CFOs’ predictions of one- and ten-year market-wide stock returns to illustrate
the miscalibration of senior executives’ beliefs. (2) Directly measure the
psychological traits and attitudes of senior executives through psychometric
personality test of risk-aversion, optimism, time preferences, loss aversion, and
other personality traits.
Optimism can also be measured by forecasting.

Implications of Ceo overconfidence (1):

The seemingly straightforward argument that an overconfident CEO will tend to
overinvest is incomplete in a way that could be misleading.
Thus, hubris does not necessarily imply “too much investment” or “too many mergers”.
Instead, it induces
a tradeoff between
misperceived gains from investment
and
the costs of external financing!
We define overconfidence as the
overestimation of the value a manager believes he or she can create.

Implications of Ceo overconfidence (2):

CEO overconfidence manifests itself in two forms:
1) An overconfident manager believes that the company’s current assets are
undervalued by the market.
2) An overconfident manager overestimates the value of future potential investments
he or she might pick.
The CEO makes two decisions:
1) the level of investment, including both internal investment (capital expenditure) and
external investment (mergers);
2) Whether financing of the investment will rely on internal cash flow (or,
equivalently, on riskless debt) versus external equity capital.

Implications of Ceo overconfidence (3):

Two main testable predictions about the difference in behavior between a rational and an
overconfident CEO:
Prediction 1
The investment of overconfident CEOs is more sensitive to the availability of internal
cash flow than the investment of CEOs who are not overconfident. In other words,
overconfident CEOs may only overinvest if their company is flush with internal funds.
Prediction 2
The investment–cash flow sensitivity of overconfident CEOs is more pronounced in
equity-dependent firms than in firms with untapped debt capacity.
Generally, investment for overconfident CEOs is sensitive to the availability of cash or
other forms of capital that the CEO perceives to be relatively cheap.

Implications of Ceo overconfidence (4):

Empirical results (I) – the DARK side:
1) The relation between investment and the interaction of various overconfidence
measures with cash flow is estimated to be significantly positive, implying a
significantly higher sensitivity of investment to internal resources among
overconfident CEOs than among rational peers.
2) The cash flow sensitivity appears most prominently among equity-dependent
firms.
3) Overconfident CEOs tend to have a higher tendency to undertake mergers and,
particularly, diversifying deals, especially if they have access to internal financing.
 4) The market reaction to merger announcements of overconfident CEOs is
significantly more negative than that of non-overconfident CEOs, pointing to the
suboptimality of overconfident CEOs’ chosen level of (external) investment.

Dark side - they for acquisitions they should not have gone for
The stock market may not realize whether the CEO s overconfident or not. In general, the
acquisitions that are made by overconfident CEO they were counted as inferior to
acquisitions that were made by rational CEO’s

Overconfident CEO’s use less debt.

Implications of Ceo overconfidence (5):

Empirical results (II) – the DARK side :
1) Firms with overconfident CEOs pay out smaller dividends, which is consistent with
overconfident CEOs viewing external financing as costly and wishing to build
financial slack for future investment needs.
2) Overconfident CEOs use less external finance and, conditional on accessing
external capital, issue less equity (more debt) than their peers, consistent with
overconfident managers’ aversion to equity financing.

Implications of Ceo overconfidence (6):

Empirical results (III) – the BRIGHT side :
1) Overconfidence is generally beneficial for a firm’s innovation performance, and
especially so in competitive and innovative industries. Firms choose overconfident
CEOs at times when the predictable consequences of overconfidence on policies—
like high levels of investment given abundant internal funds—are likely to benefit the
firm.
2) Moderate biases can increase value by mitigating the effects of risk aversion.
CEOs with relatively low or relatively high optimism face a higher probability of
forced turnover than moderately optimistic CEOs, which is consistent with the view
that there is an interior optimum level of managerial optimism that maximizes firm
value.
3) Firms are able to profit from the overconfidence of CEOs when providing equity-
linked or bonus compensation. Sophisticated principals can take advantage of biased
agents.
The bright side (partly) explains why we consistently observe overconfident CEOs over
time.

Biased managers or biased investors (1):

Managers exploit irrational investors:
Firms tend to issue relatively more equity than debt just before periods of low market returns
and shun equity, in favor of debt, before periods of high returns. Thus, managers exploit the
inefficiency of the stock market. Market timing has large and persistent effects on capital
structure.
But what if both managers and investors are irrational? SEE NEXT SLIDE
The figure shows a stylized, hypothetical example of the discrepancies between a firm’s true
value over time, as it would be assessed by a rational CEO (solid line); an overconfident
CEO’s assessment (dotted line), which persistently lies above the rational assessment; and
investors’ assessment (dashed line), which lies sometimes above the rational assessment
(positive investor sentiment) and sometimes below the rational assessment (negative investor
sentiment).

Of the red line is the true value of the company and you are always optimistic (green line)
one would always think that they are selling their shares at a bargain.
Tough, stock process diverge from the fundamental value and might sometime be above the
optimistic value, and at that time one want to issue equity.

Biased managers or biased investors (3):

The figure
1) Both types of biases—persistent managerial overconfidence and time-varying
investor sentiment—can be combined to capture a broader range of facts.
2) Overconfidence induces the CEO to overestimate the value of the firm relative to
the market much of the time, and relative to its true value all the time.
3) During periods of very positive investor sentiment, investors’ assessment of the firm
might be even more optimistic than that of the CEO. Such peak periods of investor
sentiment produce distorted access to equity financing and allow for periods of market
overvaluation (narrowly shaded areas) albeit shorter ones than in a world with (only)
rational managers (narrowly shaded plus widely shaded areas).
4) There is no inherent inconsistency between these two strands of behavioral
corporate finance.

The perspective:
The key agency problem of the firm involves the separation of ownership and control. The
classic statement of this problem is that managers of firms have an incentive to pursue their
own private benefits, while shareholders and other claimholders of the firm would like the
manager to act as an agent for their interests.
1) Even when managers intend to maximize claimholder value, they can fail to do
so because they hold overconfident beliefs.
2) Providing equity-linked compensation may mitigate traditional misalignment of
CEO incentives but is unlikely to affect the choices of biased managers, who
already believe they are maximizing value.
3) Measures to improve active monitoring of the firm—to the extent that the monitors
themselves are rational—may address both concerns.
How do we cope with a overconfident manager?
Overconfidence alone can make the manager take very risky decisions.
 how do the board of directors control such manager.

Hilary, Segal & Wang (2016): The bright side of managerial over-optimism
The bright side of managerial over-optimism By hilary & hsu & segal & wang (JAE,
2016)

Abstract:
“Human estimation and inference are subject to systematic biases such as overconfidence
and over-optimism.
In contrast to prior research that has identified multiple negative consequences of these
biases, we focus on positive effects.
We empirically examine a setting in which over-optimism
a) is a related but different bias from overconfidence,
b) emerges dynamically in a rational economic framework, and
c) generates higher managerial effort.
Importantly, this additional effort improves firm profitability and market value.”

A CEO that experiences success will tend to become confident.

This will also makes them strive for it and this is a good thing  it generates effort.

Static versus dynamic overoptimism:

“We first note that individuals are over-optimistic in general, and particularly so regarding
the effect of their own actions (we call this phenomenon “static over-optimism”).
In addition, managers may suffer from a biased attribution of causality after a series of
good performances that leads them to under-estimate the role of random noise and over-
attribute successes to their own actions (we call this phenomenon “dynamic
overconfidence”).
1) Our first hypothesis posits that the degree of managerial overoptimism should
increase after a series of successes.
2) Our second hypothesis conjectures that firm performance should increase following a
series of successes …

Even if you as a CEO start out by being realistic and succeed you will strive to have success
again.

Empirical findings (1):

1. Managers who experienced more frequent successes in the recent past, subsequently
issue more optimistic forecasts. Further analysis reveals that they also exercise stock
options later (Malmendier and Tate, 2005; Campbell et al., 2011) and issue earnings releases
with a more optimistic tone (based on textual analysis). Importantly, these results hold in
specifications with manager fixed effects. By showing that over-optimism has an endogenous
and dynamic component, our results suggest that, at least to a certain extent, some managers
are made (rather than just born) overoptimistic.
2. The over-optimism we document can improve firm performance. Managers appear to
exert greater effort to meet their own over-optimistic forecasts. Specifically, firm
accounting performance and quarterly market return increase as the degree of managerial
over-optimism increases.
Empirical findings (2):
3. Over-optimism increases with flexibility in decision-making and with the diffusion of
priors, and decreases with managerial experience.
4. We perform a path analysis. Results demonstrate a series of structural links that go from
past performance to overconfidence, from overconfidence to over-optimism, from over-
optimism to effort, and from effort to performance.
Past performance (= recent successes)
=> Overconfidence (= more optimistic forecasts) and Over-optimism
=> Effort (= trying to reach optimistic forecasts)
=> Better performance

Lecture 9
Baker & Wurgler (2013): Behavioral corporate finance: An updated survey (Part 1)
Behavioral corporate finance:An updated survey (Part 1) by Malcolm baker & Jeffrey
wurgler (2013)

Two worlds:
World 1 Focus in part 1!
Irrational investors / rational managers
(“market timing and catering” approach)

World 2 Focus in part 2!

Irrational managers / rational investors
(“managerial biases” approach)
…in reality, a number of different “worlds”!

Two building blocks:

First building block
Irrational investor must influence market prices
This rests on …
1) Rational investors are limited in their ability to compete and arbitrage away
mispricings.
2) Irrational investors’ biases are systematic (“herding”)
Second building block
Managers must be “smart” in the sense of being able to distinguish market prices and
fundamental value (so as to recognize the mispricings that irrational investors have created)
Are managers smart?
Reasons why managers could be smart:
1) Corporate managers have superior information about their own firm.
2) Corporate managers can manufacture their own information advantage by managing
earnings.They may also be able to shape investor demand through investor
relations.
3) Corporate managers have fewer constraints than equally “smart” money managers.
CFOs tend to be judged on longer horizon results than are money managers, allowing
them to take a view on market valuations in a way that most money managers cannot.
Short sales constraints also prevent money managers from mimicking CFOs.

Three (conflicting) goals:

The manager balances three (conflicting) goals:
1) Maximize fundamental value traditional goal
2) Maximize current share price “cater” to short-term investor demands
3) Exploit mispricing for the benefit of
existing long-run investors “market timing” financing policy = sell (buy)
overvalued (undervalued) securities

Empirical challenges:
- How to measure mispricing?
- Market-to-book ratio
Thus, a high market-to-book ratio indicates that the firm is overvalued.
However, market-to-book ratios are also used as proxies for growth options.
- Joint hypothesis problem (market inefficiency or “bad” model)
To identify an abnormal return, we need a model for “normal” returns that is correct
(e.g. CAPM is highly criticized but we probably have no better alternative)

So what … ?:
But even if we have market inefficiency and smart managers, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A, diversification and focus)
2) Financial policy (equity issues, repurchases, debt issues, cross-border issues, financial
intermediation, capital structure)
3) Other corporate decisions (dividends, earnings management, firm names, nominal
share prices)

Real investment:
Two ways real investment can be affected:
1) The investment itself may be subject to mispricing. E.g. investors may
overestimate the value of investment in particular technologies. What is “fashionable”
investments (e.g. internet stocks in the late 1990s)?
2) A financially constrained firm may be forced to pass up fundamentally valuable
investment opportunities if the firm is undervalued.*
* Problem: If we find an empirical link between overpricing and real investment is it then
due to:
1) managers who rationally exploit mispricing (world 1) or
2) managers who are as overoptimistic as the investors (+world 2, be elaborated
later)

M&A (1):
Market timing model of acquisitions:
Acquirers are overvalued, and the motive for acquisitions is not to gain synergies, but to
preserve some of their temporary overvaluation for long-run shareholders.
Specifically, by acquiring less-overvalued targets with overpriced stock, overvalued acquirers
can cushion the fall for their shareholders by leaving them with more hard assets per share.
… helps to explain the time-series link between merger volume and stock prices.
1) Market mispricing proxies and merger volume are positively correlated
2) Acquirers tend to be more overpriced than targets
3) Offers for undervalued targets are more likely to be hostile
4) Overpriced acquirers pay higher takeover premia.
M&A (2):
Market timing model of acquisitions:
Acquirers are overvalued, and the motive for acquisitions is not to gain synergies, but to
preserve some of their temporary overvaluation for long-run shareholders.
BUT why do managers prefer a stock-for-stock merger to an equity issue if the market
timing gains are similar?
One explanation is that a merger more effectively hides the underlying market timing
motive from investors, because the equity issue and investment decision are bundled.

Diversification and focus:

Are the drivers of the diversification wave in the 1960s and subsequent re-focus wave
related to catering?
Standard explanations for entering unrelated lines of business include agency problems or
synergies, e.g. internal capital markets and tax shields. Likewise, moves toward greater focus
are often interpreted as triumphs of governance.
An alternative explanation is that the 1960s conglomerate wave was at least in part driven
by efforts to cater to a temporary investor appetite for conglomerates.
Some estimates:
Diversification premium = +36% 1966-1968 -> -1% 1969-1971 -> -7% 1972-1974

Investors can easily diversify by themselves.

So what … ?:
But even if we have market inefficiency and smart managers, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A, diversification and focus)
2) Financial policy (equity issues, repurchases, debt issues, cross-border issues,
financial intermediation, capital structure)
3) Other corporate decisions (dividends, earnings management, firm names, nominal
share prices)

Equity issues (1):

Graham and Harvey (2001) anonymous survey of CFOs of public firms:
“the amount by which our stock is undervalued or overvalued was an important or very
important consideration” in issuing equity.
Furthermore:
• Studies find a strong empirical relationship between stock prices and seasoned
equity issuance.
• 1970-1990: The average IPO earns lower returns than a size-matched control firm
by 30%, and the average SEO underperforms that benchmark by 29%.
• Equity issuance, relative to total equity and debt issuance, predicts aggregate
market returns between 1927 and 1999. When the equity share was in its top
historical quartile, the average value-weighted market return over the next year was
negative.

Whether or not they consider the stock as over- or undervalued decides whether or not they
issue more equity.
When it is considered overvalued, they consider more equity.

Equity issues (2):

Viewed as a whole, the evidence indicates that market timing and attempted market
timing play a considerable role in equity issuance decisions.
However:
1) seasoned equity issuance that is not associated with mergers is an infrequent event
2) IPO and SEO subsequent underperformance is in line with firms going from
growth options firms to assets-in-place firms

Repurchases:
Brav, Graham, Harvey, and Michaely (2005) survey of 384 CFOs:
“the most popular response for all the repurchase questions on the entire survey is that firms
repurchase when their stock is a good value, relative to its true value”
Furthermore:
• Repurchases cluster after unusual market crashes
• Firms that repurchase earn positive abnormal returns on average, suggesting that
managers are on average successful in timing them.

Equity issues + repurchases:

The evidence is that managers tend to issue equity before low returns, on average, and
repurchase before higher returns.
Does it matter in terms of magnitude?
Suppose that rationally required returns are constant. By following aggregate capital inflows
and outflows into corporate equities, and tracking the returns that follow these flows, Dichev
(2007) reports that the average “dollar-weighted” return is lower than the average buy-and-
hold return by 1.3% per year for the NYSE/Amex, 5.3% for Nasdaq, and 1.5% (on average)
for 19 stock markets around the world. Put differently, if NYSE/Amex firms had issued and
repurchased randomly across time, then, holding the time series of realized returns fixed,
they would have paid 1.3% per year more for the equity capital they employed.

Debt issues:
Graham and Harvey (2001) anonymous survey of CFOs of public firms:
Interest rates are the most cited factor in debt policy decisions. CFOs issue debt when they
feel “rates are particularly low”. Expectations about the yield curve also appear to
influence the maturity of new debt. Short-term debt is preferred “when short-term rates
are low compared to long-term rates” and when “waiting for long-term market interest rates
to decline”.
At the same time, CFOs do not confess to exploiting their private information about
credit quality, instead highlighting general debt market conditions.
Empirical studies confirm the behavior. But is this debt market timing successful?
The aggregate share of long-term debt issues in total long- and short-term debt issues is
negatively related to the term spread + the term spread is positively related to future excess
bond returns => indication of success!

Equity + Debt issues:

Debt issues, much like equity issues, are followed by low equity returns.
Why?
1) Equity overvaluation lowers the cost of debt directly, because credit risk models
routinely include stock market capitalization as an input.
2) Perhaps managerial and investor sentiment is correlated; managers tend to be most
optimistic precisely when capital is cheap, and thus raise and invest as much as
they can from any source. This story combines investor and managerial irrationality
 and so does not fit neatly within the market timing framework, but may have some
truth.

Cross-border issues:
Graham and Harvey (2001) anonymous survey of CFOs of public firms:
Among US CFOs who have considered raising debt abroad, 44% implicitly dismissed
covered interest parity in replying that lower foreign interest rates were an important
consideration in their decision.
Furthermore:
Foreign firms tend to issue more debt in the US and the UK when rates there are low relative
to domestic rates.
No reference to empirical studies on the successfulness of such policies.

Financial intermediation (1):

Charles Prince, the CEO of Citigroup, said famously in July 2007:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the
music is playing, you’ve got to get up and dance. We’re still dancing.”
A behavioral view of the crisis starts with the observation that less than fully rational demand
was the underpinning of twin bubbles in real estate and the debt contracts underlying real
estate and other similar assets.
One simply explanation:
Investors extrapolated short histories of high real estate returns and low default
probabilities.

Financial intermediation (2):

A defining feature of the financial crisis was that systemically important banks retained a
significant exposure to all types of mortgage securities.
Potential explanations:
1) they simply carried inventory of mortgages and were left with these securities on
their balance sheets at the start of the financial crisis
2) they intentionally took risks. This moral hazard view has shaped the debate in
financial reform. A challenge to this view is that the leadership of Bear Stearns and
Lehman Brothers, who were in a position to change leverage, had a lot at stake, and
indeed lost much of their wealth in 2008.
3) there were agency problems within the firm, and the structured finance groups with
the most information about these markets did not share this with management
4) they were convinced by their own marketing or, relatedly, they were focused on
short-term performance and the high prices of mortgage securities

CAPITAL STRUCTURE:
As an accounting identity, a firm’s capital structure is the cumulative outcome of a long
series of incremental financing decisions, each driven by the need to fund some investment
project, consummate a merger, refinance or rebalance, or achieve some other purpose.
To the extent that market timing is a determinant of any of these incremental financing
decisions, then, it may help to explain the cross-section of capital structure. In particular,
if market timing-motivated financing decisions are not quickly rebalanced away, low-
leverage firms will tend to be those that raised external finance when their stock prices were
high, and hence those that tended to choose equity to finance past investments and mergers,
and vice-versa for high leverage firms.
Empirical evidence: A high “external finance weighted-average” of a firm’s past market-to-
book ratios would mean that the firm raised the bulk of its external finance, equity or debt,
when its market-to-book was high. If market timing has a persistent impact on capital
structure, this variable will have a negative cross-sectional relationship to the debt-to-assets
…. In a broad Compustat sample from 1968 to 1999, a strong negative relationship is
apparent. => support

So what … ?:
But even if we have market inefficiency and smart managers, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A, diversification and focus)
2) Financial policy (equity issues, repurchases, debt issues, cross-border issues, financial
intermediation, capital structure)
3) Other corporate decisions (dividends, earnings management, firm names,
nominal share prices)

Dividends:
Investors may view cash dividends per se as a salient characteristic
=> this raises the possibility of a catering motive for paying them.
US data between 1963 and 2000: Firms initiate dividends when the shares of existing
payers are trading at a premium to those of nonpayers, and dividends are omitted when
payers are at a discount. To measure the relative price of payers and nonpayers, they use an
ex ante measure of mispricing they call the “dividend premium”, which is just the difference
between the average market-to-book ratios of payers and nonpayers. They also use ex post
returns, and find that when the rate of dividend initiation increases, the future stock returns of
payers (as a portfolio) are lower than those of nonpayers. This is consistent with the idea that
firms initiate dividends when existing payers are relatively overpriced.
However, probably only a small part of the explanation for dividends.

Prior technology stock did not pay out dividends - they were on a growth journey.
Back in time dividends were a sign of a stable company.

Earnings management:
Survey by Graham, Harvey, and Rajgopal (2005):
• CFOs believe that investors care more about earnings per share than cash flows.
• 41% of CFOs would be willing to pass up a positive-NPV project just to meet the
analyst consensus EPS estimate.
Earnings are managed to exceed three salient thresholds (in order of priority):
1) positive earnings
2) past reported earnings
3) analysts’ expectations

Firm names:
Through a name change a firm may be able to
create a salient association with a temporarily overpriced category of stocks.
Systematic evidence has been assembled for the Internet bubble.
Catering to Internet sentiment did seem to deliver a short-term price boost during the
bubble
+
Names were later used to dissociate companies from the Internet sector when prices crashed.
(= also a positive announcement effect when firms later dropped their dotcom names)

Nominal share prices:

The average share price has centered around $25 since the Depression despite a dramatic
deflation in the value of a dollar over the last century.
Standard explanations based on signaling or optimal trading ranges, which are most
naturally thought of in real not nominal terms, are unable to explain the constancy of
nominal prices.
It seems that managers are simply following norms, adhering to an arbitrary historical
convention from which there is no particular reason to deviate given investor expectations.
Maybe share prices are used as another tool to cater to time-varying shareholder
sentiment. In analogy to the dividend premium, managers may try to exploit a “low-price
premium” => some supporting evidence.

So what … ? => Potentially a lot:

But even if we have market inefficiency and smart managers, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A, diversification and focus)
2) Financial policy (equity issues, repurchases, debt issues, cross-border issues,
financial intermediation, capital structure)
3) Other corporate decisions (dividends, earnings management, firm names,
nominal share prices)
There is supporting evidence that the combination of
market inefficiency and smart managers do have real consequences!

Kumar (2009): Who gambles in the stock market

Who gambles in the stock market By Alok Kumar (jf, 2009)

Basic idea:
Setup:
1) Recent research in behavioral economics demonstrates that people’s risk-taking
propensity in one setting predicts risky behavior in other settings.
2) People’s gambling propensity, as reflected by their socioeconomic characteristics,
predicts gambling behavior in other settings, including the stock market.
3) Evidence from lottery studies indicates that the heaviest lottery players are poor,
young, and relatively less educated, single men, who live in urban areas and
belong to specific minority (African-American and Hispanic) and religious
(Catholic) groups.
Q: Do investors with these specific characteristics
invest disproportionately more in stocks with lottery features?

Lottery tickets = stocks?

Lottery tickets have
1) very low prices relative to the highest potential payoff (i.e., the size of the jackpot)
2) low negative expected returns
3) payoffs that are very risky (i.e., the prize distribution has extremely high variance)
4) an extremely small probability of a huge reward (i.e., they have positively skewed
payoffs).
Q: Which kind of stock resemble lottery tickets the most?
A: Low-priced stocks with high idiosyncratic volatility and high idiosyncratic
skewness.

Main findings:
1) Individual investors prefer stocks with lottery features, and like lottery demand, the
demand for lottery-type stocks increases during economic downturns.
2) Socioeconomic factors that induce greater expenditure in lotteries are associated with
greater investment in lottery-type stocks. State lotteries and lottery-type stocks
attract very similar socioeconomic clienteles.
3) Because lottery-type stocks underperform, gambling-related underperformance is
greater among low-income investors who excessively overweight lottery-type
stocks.
In short …
Poor, young, (catholic), less educated single men who live in urban areas, undertake
nonprofessional jobs, and belong to specific minority groups (African-American &
Hispanic) invest more in lottery-type stocks.

They may be perfectly rational in terms of happiness. They pay an amount for having a
dream come true.

Economist: Is the equity-risk premium too tight for safety?

Guesstimate of equity risk premium

What is the equity risk premium looking forward.

This fluctuates a lot.

Statman (2011): What investors really want

What investors really want By Meir statman (2011)

The book:
The book is extremely valuable for theory, as a survey of how the human animal makes
financial decisions, and for the practice of making smarter financial decisions”
Harry M. Markowitz
(winner of the Nobel Prize in Economics, 1990)

Main message:
u Three kind of benefits:
1) Utilitarian
2) Expressive
3) Emotional

When you buy stuff you might not just want it for utilization, but also for expressive purpose.
You might want an high profiled car to give an certain expression.

CSR and green investment - not just focus on utilitarian, but maybe also expressive an
emotional.

Customers may not only look for utilitarian purposes.

Three kind of benefits (p. 237):
The utilitarian benefits of investments center on what they do for your pocketbooks. Profits
are utilitarian benefits.
The expressive benefits of investments are in what they convey to us and to others about our
values, tastes, and status. Some express their values by investing in companies that treat their
employees well. Others express their status by investing in hedge funds.
And the emotional benefits of investments are in how they make us feel. Bonds make us feel
safe and stocks give us hope.”
Utilitarian (car: from one place to another / Expressive (Prius hybrid versus Mercedes /
tobacco companies) / Emotional (Prius hybrid versus Mercedes / tobacco companies)

Examples:
1) Lottery players pay a dollar for lottery tickets that pay on average only 50 cents. And
they may buy insurance at the same time.
2) Stock of gun manufacturers and tobacco firms (“sin” companies) earn higher returns.
3) Low-cost index funds yield greater wealth. However, even clever investors may
choose to invest in hedge funds because of status conveyed by membership in an
“exclusive” club (expressive and emotional benefits).

The best risk return you can get for e.g. pension is to go for low cost index funds.
But you want to be diversified.
Why then low cost  the only thing you can count on is the fees, you can’t count on the risk
measures.
Studies say that active management funds do not outperform the market when you deduct the
fees.

In general we use a lot of money to feel good  this means that we think of much more tan
utilization

Maximizing benefits (p. 238):

“Yet while I empathize with investors’ wants for expressive and emotional benefits,
I see no benefit in cognitive errors that mislead us into sacrificing utilitarian benefits for
no benefits at all.
No benefit comes from foregoing the utilitarian benefits of diversification because we do not
understand them.
And no benefit comes from failing to make wise choices among utilitarian, expressive, and
emotional benefits.
We can increase the sum of our benefits if we understand our investment wants,
overcome our cognitive errors, weight the trade-offs between benefits, and choose
wisely.”

Illusion of control (1) (pp. 49-51):

“Optimism, whether realistic or not, is associated with control, whether real or illusory. A
sense of control is largely beneficial, and its absence is accompanied by pessimism,
depression, and the reluctance to face challenges.”
“A sense of control gained through lucky charms or rituals can be useful.”
IF we are considering tasks that can be improved by concentration and effort.
“A sense of control … can help improve performance if a sense of control brings real
control.” Example 1.
“But no concentration or effort can improve performance when outcomes are random, not
susceptible to control, as is often true in much of investing and trading.” Example 2.

One can have the illusion that one can control events.
Sometimes this can be beneficial  if you feel that you can control sometime and you
actually can, this can calm you and make you trust your abilities.
But if you are into something like tossing coin you cannot control the outcome, then it does
not help to tell yourself that it is lucky coin.

Internal locus of control - contributes also to happiness.

 it can be beneficial to think you can control a lot of thing this can help you to be motivated
to execute these things.

Illusion of control (2) (pp. 49-51):

Example 1
“In a golfing experiment,
some people were told they were receiving a lucky ball;
others received the same ball and were told nothing.
Everyone was instructed to take ten putts.
Players who were told that their ball was lucky made 6.42 putts on average
while those with the ordinary ball made only 4.75.”
Damisch, Stoberock, and Mussweiler, “Keep Your Fingers Crossed! How Superstition
Improves Performance”, Psychological Science 21/7 (2007): 1014-1020.

Illusion of control (3) (pp. 49-51):

Example 2
“One experiment in the world of trading involved 107 traders from the City of London
investment banks. The traders were told that they would see a chart of an index whose value
would change up or down. They were also told that even though changes in the index are
partly random, three keys, Z, X, and C, have special effect. The task was to raise the index as
much as possible at the end of each of four rounds of the game. Traders rated their success at
raising the index at the end of each round and were compensated by the total value of the
index at the end of the four rounds. In truth, movements in the index were random and the
three keys had no effect on outcomes. Any sense of control was illusory. Still, some traders
believed that they had much control while others believed that they had little. It turned
out that traders with the highest sense of control displayed the lowest level of
performance.”
Fenton-O’Creevy, Nicholson, Sloane, and Willman, “Trading on Illusions: Unrealistic
Perceptions of Control and Trading Performance”,
Journal of Occupational and Organizational Psychology 76 (2003): 53-68.

Maximizers versus satisficers (p. 122):

“Investors with high desire for maximization set high goals for themselves, motivating
them to take greater risks for a chance to reach their goals…
On average, men have a higher desire for maximization than women, and the relatively
young have a higher desire for maximization than the relatively old….
… “maximizers” are always wondering if they could have made better choices, whereas easy
going “satisficers” are satisfied with their choices even if they are not the best.
Indeed, the survey revealed that maximizers have a higher tendency for regret than
satisficers.”
Statman, ”The Cultures of Risk Tolerance”, SSRN 2010.

Maximizers and satisficers  there is a tendency that satisficers are more happy.
Maximizers will always think they could have done more - you never known when you have
maximized.
Satidficers will feel they have achieved they goal and then they can strive for higher
objectives.

Status displays (p. 166):

“While wealth is absolute, status is relative…
Many prefer to be relatively wealthy in a poor society than relatively poor in a rich
society…
Our happiness depends on how our socioeconomic group is doing relative to the average in
our geographic area.
We gain status by pulling ourselves up or pushing others down.”
Solnick and Hemenway, “Is more always better?: A survey on positional concerns”, Journal
of Economic Behavior & Organization (1998) 37/3: 373-383

The relationsship/curve for earning money is the linear.

It seems as there is a max to the happiness to can achieve by earning more money.

Status competition (pp. 170-1071):

Sometimes the rich subvert the emblems of status. Henry Paulson, then a Goldman Sachs
partner and more recently the U.S. secretary of the Treasury, wore an inexpensive Casio
watch.
But opting out of status competitions is not always easy. We can hardly opt out of status
competitions within our families, illustrated by H.L. Mencken who defined a wealthy man
as one who earns $100 more than his wife’s sister’s husband.
… 33-year-old James Hong … co-founder of Hotornot.com …. found himself envious of
Max Levchin, his best friend and a founder of PayPal, whose net worth is probably in the tens
of millions. Hong opted out of the status competition by replacing his Porsche Boxster
with a Toyota Prius… “The only way I’ve dealt with it over time is to consciously decide
not to care. Still, every now and then, when I hear they’re getting a certain valuation, I think,
“I need that, too”. There’s a little devil inside all of us that says, “Why not you?””.
Hafner, “In Web World, Rich Now Envy the Superrich”, NY Times (2006, November 21).

Wearing an inexpensive watch when you have the money to buy an expensive watch say that
you don’t care  top you money do not matter.

Schumpeter: The look of a leader

Boss stereotype:
Deep voice, good posture, a touch of grey in this thick, lustrous hair, and for his age a fit
body.
30% of future 500 companies are 6 feet and 2 inches or higher (for the average population
this is just around 4%).

Maybe the stone age brain that e.g. say that we want a leader with a deep voice.
Overweight people, especially women, are judge to be unable to control themselves.  this
oculd be because that men are obsessed to sex/hip to waist ratio and so on (this is
evolutionary). Tough is does not make sense in relation to women tasks in the stone age -
they were supposed to be at home doing nothing is they had a proper man who could supply
for them.

“Power pose” - the way you stand can have an effect.

TED Talk: Frans de Waal - The surprising science of alpha males

https://www.medpagetoday.com/tedmed/tedmed/84206

Alfa males was loved and respected after he “retried” (gorilla).

Tough it does not go this way for all males.

Body language - show power.

Hair is up
Body is up standing.

The smallest male in the group can be alfa with the right support.

Demonstrating unity: Standing together, walking together synchronically

How to you become an alfa:

Have to generous e.g. share food
Show interest in the infants (we e.g. see this under presidential elections where the candidates
hold babies)

Stressful to be alfa
In general, they hold up for the underdogs and have to stop fights and so on
Show empathy for others  provide comfort for the group (great leaders also have to do e.g.
come to troubles areas after nature disasters and provide comfort).

The group are usually supportive of good leaders, but not the bad ones (the ones who bullies).

Alfa females can also be a very important figure.

The alfa in the group does not have to be a male.

Baker & Wurgler: Behavioral corporate finance: An updated survey (Part 2)

Behavioral corporate finance: An updated survey (Part 2) By Malcolm baker & Jeffrey
wurgler (2013)

Two worlds:
World 1 Focus in part 1!
Irrational investors / rational managers
(“market timing and catering” approach)

World 2 Focus in part 2!

Irrational managers / rational investors
(“managerial biases” approach)
…in reality, a number of different “worlds”!
Irrational managerial behavior:
Behavior that departs from rational expectations and expected utility maximization.
We are not interested in rational moral hazard behavior, such as empire building, stealing, or
plain slacking off.
We are concerned with situations where the manager believes that he is actually close to
maximizing firm value—and, in the process, some compensation scheme—but is in fact
deviating from this ideal.

Deviations from rational behavior:

Main deviations:
1) Bounded rationality (this relies on some type of cognitive or information-gathering
cost that prevents agents from making fully optimal decisions and instead use rules of
thumb)
2) Optimism (an overestimate of a mean ability or outcome)
3) Overconfidence (an underestimate of a variance)
4) Reference points (e.g. a stock’s 52-week high)
5) Anchoring (the agent forms beliefs by adjusting from a potentially arbitrary starting
point, and the bias is that the final belief is biased toward this anchor)

Building block (1):

When do irrational corporate managers have an impact?
For less than fully rational managers to have an impact,
corporate governance must be limited
in its ability to constrain them into making rational decisions.
This is analogous to the requirement of limited arbitrage for the market timing approach.
Unlike in a traditional agency problem, which arises out of a conflict of interest between
managers and outside investors, standard incentive contracts have little effect, because an
irrational manager may well think that he is maximizing value.

Building block (2):

Casual observation indicates that top managers “matter”.
This is supported by systematic evidence!
Managers have the power to make decisions
that affect investment and financing policy and firm value.

It may not matter that much that the manager is irrational if the firm had properly corporate
governance.

Optimism and overconfidence:

Most research in the managerial biases literature focus on optimism and overconfidence.
Why?
1) They are strong and robust, having been documented in many samples
2) Managerial decisions tend to be highly complex, a setting where overconfidence is
most pronounced, and idiosyncratic, which reduces the potential for debiasing
through learning.
3) These biases are also often fairly easy to integrate into existing models. Optimism is
usually modeled as an overestimate of a mean ability or outcome and overconfidence
as an underestimate of a variance.
4) Optimism/overconfidence naturally leads to more risk-taking. See next slide!
Survival of the “risk seeker”
… or why top managers tend to be optimistic/overconfident.
Even if there is no optimism/overconfidence on average in the population of potential
managers, those that are overconfident are more likely to perform extremely well (and
extremely badly), placing them disproportionately in the ranks of upper (and former)
management.

And even if an individual manager is born without bias, an attribution bias—the tendency to
take greater responsibility for success than failure - may lead successful managers to
become optimistic/overconfident.

Two goals:
The manager balances two goals:
1) Maximize perceived fundamental value Excluding “perceived” this is also a
prime target for the rational manager.
2) Minimize perceived cost of capital The manager acts on behalf of
existing shareholders.
An optimistic manager never believes
there is a good chance to issue equity
(as opposed to a rational manager who
exploits irrational investors
by selling (buying) overvalued
(undervalued) shares).
Note that two “biases” may cancel out the effect on e.g. investments.
Optimism => too many investments
but risk aversion => moves back the investment level to its first best! Next slide for another
example!

Optimism versus overconfidence:

Does optimism and overconfidence lead in the same direction?
Not always!
E.g. an optimistic manager never sells equity unless he has to. Optimism predicts a pecking
order of financing decisions: The manager relies on internal capital and debt and uses
outside equity only as a last resort.
However …
If overconfidence leads to an underestimation of the risk of earnings, managers may view
their debt as undervalued and too expensive as a source of capital. The convexity of equity,
on the other hand, leads managers to view their equity as overvalued. This reverses the
pecking order that obtains under optimism.

Empirical challenge:
The challenge is to identify optimism, overconfidence, or the behavioral bias of interest.
(corresponding to the main challenge to find a proxy for misvaluation in the irrational
investors approach)

Without an empirical measure, the irrational managers approach is typically difficult to

distinguish from standard agency theory (or asymmetric information models).
E.g. we observe a firm that invests excessively.
Is this because of an over-optimistic manager that thinks he is maximizing fundamental
value but instead makes overly optimistic cash flow forecasts or
is this because of a rational manager that builds an empire (leading potentially to more
prestige, higher pay, and better future jobs)?

So what … ?:
But even if we have powerful managers that may be bounded, optimistic, overconfident,
reference point dependent, and/or anchored, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A)
2) Financial policy (equity issues, IPO prices, raising debt, contracting and executive
compensation)

Real investment (1):

Entrepreneurial startups are often made under a halo of overconfidence and optimism.
Empirical studies …
1) 68% of entrepreneurs think that their startup is more likely to succeed than
comparable enterprises, while only 5% believe that their odds are worse, and a third
of entrepreneurs view their success as all but guaranteed.
2) Only half of all startups survive more than three years.
3) More generally, the return on private equity in the US between 1952 and 1999 is
lower than seems justified given the undiversified nature of entrepreneurial
investment.

Real investment (2):

Optimism and overconfidence also may influence investment in more mature firms …
Empirical studies …
1) A comparison of forecast and actual construction costs for pioneer process plants in
the energy industry shows a strong optimism bias in project cost forecasts, with
actual costs typically more than double the initial estimates.
2) Based on a manager-level proxy for optimism based on the propensity for a manager
to voluntarily hold in-the-money stock options in his own firm (intuition: since the
CEO’s human capital is already so exposed to firm-specific risk, voluntarily holding
in-the-money options is a strong vote of optimism) the sensitivity of investment to
cash flow is higher for the more optimistic CEOs. It is especially high for
optimistic CEOs in equity-dependent firms, that is, in situations where perceived
financial constraints are most binding.

Real investment (3):

Optimism and overconfidence also may influence investment in more mature firms …
CONT.
Empirical studies …
3) Survey asked financial executives to estimate the mean (optimism) and variance
(overconfidence) of their firm’s stock return. Financial executives are extremely
overconfident: their subjective 80% confidence intervals about the firm’s one-year stock
return contains the realized return only 33% of the time. Both optimism and overconfidence
are associated with higher investment.
4) R&D is particularly inviting to overconfident managers (the payoff is inherently quite
uncertain). Overconfident managers - measured using options-based proxies and the
character of descriptions of the CEO in the press - invest more in R&D and translate this to
higher patent and patent citation count.

Real investment (4):

Bounded rationality appears to be a plausible explanation for some common capital
budgeting criteria.
Empirical studies …
1) The net present value criterion is the optimal capital budgeting rule (in efficient
markets), but real managers tend to employ simpler rules. Over 50% use the IRR
rule, which avoids a cost of capital calculation. The IRR rule is more widely used
than NPV. Over 50% of CFOs actually use the payback period rule, an even less
sophisticated rule that requires neither a cost of capital input nor cash flow forecasts
beyond a cutoff date.
2) Those managers who do use a discounting procedure tend to apply a firm-wide
discount rate rather than a project-specific rate => multidivision firms that simply
apply a weighted, average discount rate to all projects overinvest in high beta
divisions and underinvest in low beta divisions.

Real investment (5):

Loss aversion also appears as an explanation for certain investment patterns.
Empirical studies …
The managerial propensity to “throw good money after bad”.
Two potential explanations:
1) Rational career concerns, e.g. a situation where the manager tries to distort the
updating process to maintain high compensation.
2) Irrational loss aversion.
The market reaction to the termination of historically unprofitable investment projects
is positive, suggesting that investors recognize that executives have a tendency to continue
poor projects.

M&A (1):
A hubris-based theory of acquisitions:
Successful acquirers may be optimistic and overconfident in their own valuation of deal
synergies, and fail to properly account for the winner’s curse.
Empirical studies …
1) Optimistic CEOs complete more mergers, especially diversifying mergers
2) Optimism has its biggest effect among the least equity dependent firms - when
managers do not have to weigh the merger against an equity issue that they, as
optimists, would perceive as undervalued.
3) Investors are more skeptical about bid announcements when they are made by
optimistic CEOs.

M&A (2):
CEO narcissism is a trait related to but distinct from overconfidence.
Narcissism - measured as the ratio of first person singular pronouns to total first person
pronouns used in CEOs’ transcribed speeches – is related to M&A patterns:
1) Narcissist CEOs are more likely to be acquirers, and more likely to have initiated
their transactions. This is interpreted as consistent with the high-stakes activity
required to maintain the narcissistic ego.
 2) Targets run by narcissists secure higher bid premia. This may arise because
narcissistic CEOs demand extra compensation for the loss of ego associated with
losing control.

M&A (3):
Reference point thinking (anchoring), in particular involving the offer price, also plays a
role in merger activity. The target may use peak prices as a starting point for negotiations
and/or may resist selling at a “loss” to a recent peak, akin to a disposition effect.
Empirical findings …
1) There is a spike in the distribution of offer prices at the target’s 52-week high and
other historical peaks.
2) Bidding-firm shareholders react negatively to the component of the offer price that
is driven by the 52-week high, which suggests that they rationally view this portion as
overpayment.
3) The probability that an offer goes through increases discontinuously when the offer
exceeds the 52-week high.
Continued…
4) Mergers and stock market valuations are positively correlated. The offer
premium required to exceed a recent price peak is smaller when valuations have
increased. Conversely, when valuations have plummeted, targets may fail to adjust
from prior peak anchors and, as a result, ask for valuations that are simply implausible
to bidders.

So what … ?:
But even if we have powerful managers that may be bounded, optimistic, overconfident,
reference point dependent, and/or anchored, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A)
2) Financial policy (equity issues, IPO prices, raising debt, contracting and
executive compensation)

Equity issues:
Reference point / anchoring …
Does the CEO drive a firm’s stock returns? If so, then a CEO would rightly be proud, and
shareholders should take notice, when she has created value and raised the share price above
the level that prevailed when she took the helm. If not, for example if share prices are
dominated by aggregate moves, then that historical price does not serve as a particularly
meaningful reference point for CEO-specific value creation.
Empirical studies …
1) Equity issuance is responsive to recent stock returns, but considerably more so when they
occur during the current CEO’s tenure. In particular, the probability of equity issuance in a
follow-on offering increases discontinuously when the share price exceeds the inherited
price.

IPO prices (1):

Reference-point managerial preferences (and mental accounting) …
Investment bankers underwriting the offering form an initial file price range, as they shop the
deal to institutional investors. Two outcomes:
1) If demand for the new shares is high, the bankers will price the offering at the high
end of this range.
 2) If it is low, they will price the offering at the midpoint, or sometimes lower. On the
first day, prices are a market outcome of the new supply and demand.
Issuing managers mentally account for two quantities in judging an offering’s success:
1) the (perceived) gain from the gap between the first-day closing price and a natural
reference point, the midpoint of the file price range
2) the (real) loss from the dilutive effect of the underpricing.

IPO prices (2):

Reference-point managerial preferences (and mental accounting) …
CONTINUED
If the gain is judged to outweigh the loss, where each is evaluated separately with the
prospect theory value function, the executives are satisfied. Intuitively, they may be too
overwhelmed by the “windfall gain” to complain much about underpricing.
Empirical studies …
1) Underpricing is greater when the offer price is above the initial file price range.
2) Specifically, in issues where the offer price is below the minimum of the file price
range, first-day returns are a relatively small 4%, on average,
3) while those priced above the maximum have average first-day returns of 32%.

Raising debt:
Reference points / anchoring …
Borrowers and lenders use past terms as anchors or reference points for current terms.
Empirical findings …
1) the nominal level of historical borrowing costs exerts a strong influence on the
cost of debt. E.g. firms that took out credit from a banking syndicate between 2005
and 2007 saw the influence of the 2008 financial crisis have a muted impact on their
2008 borrowing costs from the same source. For firms whose credit rating remained
constant over this period, one-third received exactly the same borrowing rates as in
the pre-crisis period. Comparable firms that had not established such anchor terms
saw higher borrowing costs.
2) Specific managers and bankers appear to form relationships that are most affected by
the bias; when a firm changes lead banks, the effect of past terms deteriorates;
and, when a firm changes CEO or CFO, the effect of past terms deteriorates.

Capital structure (1):

The most basic optimism model predicts a pecking order financing policy.
But is the pecking order financing policy due to optimism or adverse selection?
A natural test would use cross-sectional variation in measured optimism to see whether such
behavior is more prevalent in firms run by optimists.
Empirical studies (related to the investment slides before) …
1) Firms run by optimists (as identified by their options-based proxies for optimism)
display a higher sensitivity of investment to internal cash flow.
2) Managers classified as optimistic show a differentially higher propensity to make
acquisitions when they are not dependent on external equity.

Capital structure (2):

Bounded rationality …
Managers tend to use simple targets for capital structures.
Empirical findings …
 1) 10% of the CFOs use a “very strict” target debt-equity ratio
2) 34% use a “somewhat tight” target or range.
Such leverage targets are typically defined in terms of book values of equity and debt. Is this
just
1) a rule of thumb
2) a boundedly rational focus on slower moving book values, or
3) a rational recognition that book values are a better proxy for liquidation value than
market value?

Contracting & executive comp. (1):

Contracting with optimistic entrepreneurs …
1) Because optimists tend to inefficiently persist in their initial business plan, the optimal
contract transfers control when changes are necessary. Contingent transfers of
control are common features of venture capital contracts.
2) Because optimists believe good states to be more likely, they are willing to trade some
control and ownership rights in bad states for greater claims in good ones; in this
sense, the optimal contract “pays the entrepreneur with dreams”.
3) Optimists self-select into short-term debt, as it transfers payments and control to the
investor in states that they think are unlikely, while realistic entrepreneurs prefer less
risky long-term debt. The use of short-term debt is positively related to an ex post
measure of optimistic expectations, the difference between realized growth and initial
growth expectations.

Contracting & executive comp. (2):

Contracting with optimistic managers …
Standard contracting models seem unable to explain basic aspects of CEO compensation.
Convex incentives are commonly induced through stock options.
Yet these turn out to be hard to calibrate to standard models with risk-neutral shareholders
and risk-averse, undiversified executives.
=> CEOs tend to be optimistic
(“paying with dreams”)

So what … ? => Potentially a lot:

But even if we have powerful managers that may be bounded, optimistic, overconfident,
reference point dependent, and/or anchored, so what?
Does it have any real consequences in terms of …
1) Investment policy (real investment, M&A)
2) Financial policy (equity issues, IPO prices, raising debt, contracting and
executive compensation)
There is supporting evidence that the combination of
powerful managers and managerial biases do have real consequences!

Graham, Havey & Puri (2013): Managerial Attitudes and corporate actions
Managerial Attitudes and corporate actions By Graham & Harvey & Puri (Jfe, 2013)

Abstract:
“We administer psychometric tests to senior executives to obtain evidence on their
underlying psychological traits and attitudes.
We find US CEOs differ significantly from non-US CEOs in terms of their underlying
attitudes.
In addition, we find that CEOs are significantly more optimistic and risk-tolerant than the
lay population.
We provide evidence that CEOs’ behavioral traits such as optimism and managerial risk-
aversion are related to corporate financial policies.
Further, we provide new empirical evidence that CEO traits such as risk-aversion and time
preference are related to their compensation.”

The survey approach (1):

While the survey approach allows us to ask many unique questions, it is not without
potential problems:
1) Surveys measure beliefs, not necessarily actions.
2) Perhaps some of the survey questions are misunderstood or otherwise produce noisy
measures of the desired trait or characteristic.
3) Moreover, at least for some questions, executives can potentially parrot explanations
that they think researchers want to hear, rather than state their true beliefs.
4) In addition, field studies may face the objection that market participants do not
necessarily have to understand the reason they do what they do in order to make
(close to) optimal decisions.
It is possible that the respondents are not representative of the underlying population.

The survey approach (2):

Given that we conduct our survey at one point in time, it is not possible to determine
causation for the most part.
1) For example, we cannot say for sure whether risk-tolerant CEOs use less short-
term debt or whether firms that have a policy of using short-term debt attract
less risk-tolerant employees.
2) Likewise, in most cases, it is not possible for us to distinguish whether the
personality trait causes the corporate policy from whether an executive ‘‘learns’
’a trait on the job,
3) nor can we separate a managerial fixed effect from a company fixed effect. In the
latter case, a company might optimally seek out an executive with certain traits due to
the needs of the business. Indeed, our results are consistent with such an
interpretation.

Q Personal Risk aversion (1):

Suppose you are the only income earner in your family.
Your doctor recommends you move because of allergies.
You have to choose between two possible jobs (choose one):
(a) 100% chance that the job pays your current income for life.
(b) 50% chance that the job pays twice your current income for life and 50% chance that
the job pays 2/3 of your current income for life.

Q Personal Risk aversion (2):

IF (a) 100% chance that the job pays your current income for life.
Which job would you choose if the choices were instead:
(c) 100% chance that the job pays your current income for life.
(d) 50% chance that the job pays twice your current incomes for life and 50% chance that
the job pays 4/ 5 of your current income for life.

Q Personal Risk aversion (3):

IF (b) 50% chance that the job pays twice your current income for life and 50% chance
that the job pays 2/3 of your current income for life.
Which job would you choose if the choices were instead:
(e) 100% chance that the job pays your current income for life.
(f) 50% chance that the job pays twice your current income for life and 50% chance that
the job pays 1/2 of your current income for life.

Personal Risk aversion - results:

US CEOs:
Highly risk-averse = 9.8% (= C)
US CFOs:
Highly risk-averse = 8.4% (= C)
Similar-aged lay population:
Highly risk-averse = 64%
Where are you?

Q Optimism (1):
1. In uncertain times, I usually expect the best. “I agree a lot’’=4, ‘‘I agree a
little’’=3, ‘‘I neither agree nor disagree”=2, ‘‘I disagree a little”=1,‘‘I disagree a
lot’’=0
2. If something can go wrong for me, it will. “I agree a lot’’=0, ‘‘I agree a little’’=1,
‘‘I neither agree nor disagree”=2, ‘‘I disagree a little”=3,‘‘I disagree a lot’’=4
3. I’m always optimistic about my future. “I agree a lot’’=4, ‘‘I agree a little’’=3, ‘‘I
neither agree nor disagree”=2, ‘‘I disagree a little”=1,‘‘I disagree a lot’’=0
4. I hardly ever expect things to go my way. “I agree a lot’’=0, ‘‘I agree a little’’=1,
‘‘I neither agree nor disagree”=2, ‘‘I disagree a little”=3,‘‘I disagree a lot’’=4
5. I rarely count on good things happening to me. “I agree a lot’’=0, ‘‘I agree a
little’’=1, ‘‘I neither agree nor disagree”=2, ‘‘I disagree a little”=3,‘‘I disagree a
lot’’=4
6. Overall, I expect more good things to happen to me than bad. “I agree a lot’’=4,
‘‘I agree a little’’=3, ‘‘I neither agree nor disagree”=2, ‘‘I disagree a little”=1,‘‘I
disagree a lot’’=0

Q Optimism (2):
Take the sum of your points and divide them by six:
Sum of points / 6 = optimism score
Higher than 3 = Very optimistic

Optimism - results:
US CEOs:
Very optimistic = 80.2%
US CFO:
Very optimistic = 65.3%
CEOs and CFOs are more optimistic than the lay population.
Where are you?

Q time preference (1):

Question:
Would you rather win US$10,000 now or win US$13,000 a year from now?
Q time preference (2):
If you answer that you would rather win US$ 10,000 today,
you are categorized as being impatient
because you have an implicit discount rate of more than 30%.

Time preference - results:

US CEOs:
Impatient = 32.8%
US CFO:
Impatient = 26.4%
Where are you?

Aversion to sure losses (1):

Question:
Last year your company invested $5 million US in a project that was expected to generate
cash flows of $10 million US after one year. A year has passed and the project yielded
nothing. Now you have the opportunity to invest an additional sum in this same project.
There is a 20% chance that the project will generate a $10 million US cash flow in a year’s
time and nothing thereafter. There is an 80%chance that the new investment will generate
nothing at all.
How much would you be willing to invest today?
$__________million dollars US.

Aversion to sure losses (2):

If you reply $2 million or more,
you are classified as averse to sure losses,
because this action indicates a willingness to overpay to continue the project in order to avoid
the ‘‘sure loss’’ of terminating the project today.

Aversion to sure losses - results:

US CEOs:
Averse to losses = 8.5%
US CFO:
Averse to losses = 13.2%
Where are you?

Empirical findings:
1) Companies initiate more mergers and acquisitions when their chief executive is
more risk-tolerant.
2) Optimistic CEOs use more short-term debt than do firms led by less optimistic
CEOs.
3) Male CEOs are more likely to have higher debt ratios, and in particular, higher
short-term debt ratios than their female counterparts.
4) Firms with high historical or future rates of growth are more likely to be run by
risk-tolerant CEOs. These chief executives are likely to be younger. They are also
more likely to be taller than average.

The survey was conducted in early 2006.

If asked today – after the financial crisis and Covid-19 –
CEOs and CFOs may be less optimistic and more risk-averse!

Lecture 10
New York times: Narcissism is increasing. So you're not so special.

What about social media

On social media we always post the best about ourselves.

W. Keith Campbell: The psychology of narcissism (Video)

Two types of narcissist:

- Grandinose:
Exterverison, attention seeking
Could seek a career at celebrities or politics
- Vulnuable:
quiet and reserved. Easily threaten

Twin studies who strong genetic component.

Higher in countries that are more individualistic

Aabo, et al., (2020 WP): Corporate acquisitions and the CEO’s traits and biases
Corporate acquisitions and the CEO’s traits and biases by Aabo & Hanousek Jr. &
Pantzalis & Park

Nobel prizes in economics:

Adam smith (1723-1790)

… a Scottish moral philosopher, pioneer of political economy, and key Scottish
Enlightenment figure.
The Theory of Moral Sentiments (1759)
An Inquiry into the Nature and Causes
of the Wealth of Nations (1776)
“Pain, I have already had occasion to observe, is, in almost all cases, a more pungent
sensation
than the opposite and correspondent pleasure.” = loss aversion
“The overweening conceit which the greater part of men have of their own abilities is an
ancient evil
remarked by the philosophers and moralists of all ages.” = overconfidence
“Their absurd presumption in their own good fortune has been less taken notice of. It is
however, if possible, still more universal.” = optimism

“Animal spirits”:
NOT coined by Robert Shiller but by …
… John Maynard Keynes
The General Theory
of Employment, Interest
and Money (1936)

Discovery:
Behavioral economics is not a new discovery
but a rediscovery!

Richard Thaler: 1) Smith said it all

2) Econs versus Humans

Richard roll (jb-1986):

“Psychologists are constantly bombarding economists with empirical evidence that
individuals do not always make rational decisions under uncertainty.
For example see Oskamp (1965), Tversky and Kahneman (1981), and Kahneman, Slovic, and
Tversky (1982).
Among psychologists, economists have a reputation for arrogance mainly because this
evidence is ignored; but psychologists seem not to appreciate that economists disregard the
evidence on individual decision making because it usually has little predictive content for
market behavior.
Corporate takeovers are, I believe, one area of research in which this usually valid reaction
of economists should be abandoned; takeovers reflect individual decisions.”
Roll, R. (1986). The hubris hypothesis of corporate takeovers. Journal of Business, 59(2),
page 199.

Our research question:

Main research Q:
Which CEO trait or bias fosters corporate acquisitions?
Subsequent research Q:
What are the value-implications of such acquisitions?

Motivation:
Contribution to literature:
A comprehensive approach to the two questions:
Which CEO trait or bias fosters corporate acquisitions?
What are the value-implications of such acquisitions?

Sample:
All non-financial S&P 1500 firms
per mid-2019
for fiscal years 2007-2012
893 firms
1675 CEOs

Dependent variable:
Acquisition
= dummy variable equal to 1 if in a given year the firm announces at least one acquisition
which is eventually successful

Acquisitions included:
1) the acquiring firm obtains at least 51% of the target shares
2) the acquiring firm did not hold 51% or more of the target before the deal
3) the acquisition is worth at least 5% of the value of the acquiring firm

traits and bias:

Openness to experience
Conscientiousness 1-7 based on CEO speech
Extraversion in conference calls (only Q&A session)
Agreeableness following Harrison et al. (SMJ-2019)
Neuroticism
Narcissism Usage of first-person singular pronouns
in conference calls (only Q&A session)
Overconfidence Option-based measure

Hypotheses:
Correlations:

(1) (2) (3) (4) (5) (6) (7)

-
1 0.016 0.012 0.027*** -0.013 0.001
(1) Acquisition 0.034***
0.016 1 0.021** -0.021** 0.046*** 0.014 0.025**
(2) Overconfidence
- - -
0.012 0.021** 1 -0.007
(3) Narcissism 0.034*** 0.083*** 0.058***
0.027*** -0.021** -0.007 1 0.640*** 0.419*** 0.620***
(4) Extraversion
-
-0.013 0.046*** 0.640*** 1 0.753*** 0.840***
(5) Openness 0.034***
(6) - -
0.014 0.419*** 0.753*** 1 0.612***
The Big Five personality traits are highly correlated.
Narcissism and overconfidence seem more to have lives of their own.

Table 4:
Extraversion +
Overconfidence +
 Dependent variable: Acquisition
(1) (2) (3) (4) (5) (6) marg.eff.
0.2003*
Overconfidence 0.1959** * 0.0186**
(0.0833) (0.0840) (0.0078)
Narcissism 0.2063 0.1691 0.0157
(0.5563) (0.5662) (0.0525)
0.2126*
Extraversion 0.1320* * 0.0197***
(0.0689) (0.0826) (0.0076)
Openness -0.2001 -0.0185
(0.2090) (0.0194)
Conscientiousness -0.1072 -0.0099
(0.1678) (0.0155)
Agreeableness -0.0159 -0.0015
(0.1144) (0.0106)
Neuroticism -0.0446 -0.0041

Robustness:
Results are mostly robust …
1) Acquisition measures
2) CEO overconfidence measures
3) Traits measures
4) Excluding financial crisis
5) Duality / non-duality
6) Over-performing versus under-performing years
… with one major exception
Firm fixed effects! => Not causation – only association
(supported by high correlation between Big Five personality traits of outgoing and incoming
CEOs)

Table 6:
Overconfidence +
Extraversion +
Conscientiousness +
Agreeableness -
 Dependent variable: CAR(-1,+1)
(1) (2) (3) (4) (5)
Overconfidence 0.0143*** 0.0132** 0.0145**
(0.0054) (0.0054) (0.0064)
Narcissism -0.0089 -0.0187 -0.0248
(0.0325
) (0.0322) (0.0383)
Extraversion 0.0013 0.0126*** 0.0120**
(0.0034) (0.0048) (0.0058)
Openness -0.0222* -0.0169
(0.0116) (0.0143)
Conscientiousness 0.0311*** 0.0340***
(0.0089) (0.0111)
Agreeableness -0.0161** -0.0145*
(0.0067) (0.0081)
Neuroticism 0.0007 0.0042
(0.0086) (0.0109)

Robustness:
Overconfidence + but only after a good performance stretch*
Extraversion +but only after a good performance stretch
Conscientiousness + fairly robust
Agreeableness - fairly robust

Endogeneity (1):
Heckman two-stage test
If CEOs with certain traits self-select in certain industries and/or firms select CEOs with
certain familiar (industry-wide) traits in mind, selection bias can potentially affect the M&A
outcomes. Thus, we want to account for the possibility that the factors affecting the
propensity of CEO traits matching those of their firm’s industry are also affecting their
acquisition decisions. In other words, the proposed approach seeks to address the endogeneity
concern wherein it is not the CEO trait/bias per se that drives corporate acquisitions but rather
objective firm characteristics, which also are associated with CEOs with certain traits/biases.
Instrumental variable (IV): average distance from other firms within the same industry.

We use a binary indicator of whether or not the number of CEO traits and biases that are
similar in the same industry are at least 4 (i.e., more than half). The average distance from
other firms in the same industry is likely to be related to the “conformity” of CEO traits and
biases through network and social proximity effects but not likely to be related to the firm’s
acquisition. decisions.

Endogeneity (2):
Table 8:
1) Firms located near their industry peers tend to choose a CEO whose majority (4 out of
7) traits/biases are in line with the industry "norm".
 2) The inverse of Mills ratio coefficient in the second stage regressions is generally
insignificant. Thus, it appears that the firm characteristics that drive the choice of
CEO selection do not significantly affect the acquisition decision and corresponding
market reaction.
Main deviation from previous results:
1) CEO narcissism + for acquisitions after a good performance stretch
2) CEO overconfidence + less robust for stock market reaction

Hypotheses vs findings:

Compared to previous literature:

Deviations:
1) CEO narcissism less associated with the acquisition decision compared to Ham et
al., 2018 – signature size does not seem to explain the difference.
2) CEO overconfidence does not cause acquisitions and are positively – if anything
– associated with the stock market reaction contrary to Malmendier & Tate (2008)
– potential explanation is different time periods (2007-2018 versus 1980-1994).
New:
1) Conscientiousness is positively associated with the stock market reaction.
2) Agreeableness is negatively associated with the stock market reaction.

Lecture 11: Emotional, Social and Cultural Finance

Guest Lecture in Aarhus BSS Prof. Arman Eshraghi

Main objective:
Providing a high-level summary of the role of emotions, social effects and culture in
Behavioural Finance

Overview of behavioural finance

Adam Smith: Individuals weigh out-of-pocket costs more than opportunity costs, have self-
control problems and are overconfident...

Daniel Kahneman (Nobel 2002): “Our comforting conviction that the world makes sense
rests on a secure foundation: our almost unlimited ability to ignore our ignorance.”
(Thinking Fast and Slow, 2011)
System 1 and 2:

Cognitive Reflection Test (CRT):

Answer the following three questions as quickly as you can:
• A baseball bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How
much does the ball cost?
• If it takes 5 machines 5 minutes to make 5 tools, how long would it take 100 machines to
make 100 tools?
• In a lake, there is a patch of lily flowers. Every day, the patch doubles in size. If it takes 48
days for the patch to cover the entire lake, how long would it take for the patch to cover half
of the lake?

More than 2 of these Q’s korrekt you are more a system 2 thinker than system 1 thinker.
People with high CRT go for the more ricky gamble

Neurofinance: key lessons

Reflexive Brain vs Reflective Brain
Prefrontal Cortex associated with utility judgements
o Gender variation (Sapra & Zak, 2010)
o Age variation (Mohr & Heekeren, 2012)

Reflexive Brain vs Reflective Brain

Prefrontal Cortex associated with utility judgements o Gender variation (Sapra & Zak, 2010)
o Age variation (Mohr & Heekeren, 2012)
o Pathological variation?

Cognitive load
In a study by Shiv and Fedorikhin (1999), cognitive burden is manipulated by having subjects
keep a 2-digit or 7-digit number in mind as they walk from one room to another.
On the way, subjects are given a choice between a piece of cake or a fruit salad.

Cognitive burden can bias you towards short term choices vs. more rational long term
choices.

Reflexive Brain vs Reflective Brain

Prefrontal Cortex associated with utility judgements o Gender variation (Sapra & Zak, 2010)
o Age variation (Mohr & Heekeren, 2012)
o Pathological variation?
Preference for bigger/delayed reward or smaller/immediate reward o Cognitive load can
distort this (Shiv & Fedorikhin, 1999)

 Time discounting results from the combined influence of two neural systems:
o Emotional brain is impatient
o Analytic brain is patient
 Emotional brain responds little to delayed rewards
 Emotional brain creates taste for instant gratification

Question:
You are on a TV game show and can choose one of the following. Which would you take?
a. $1,000 in cash
b. A 50% chance at winning $5,000 c. A 25% chance at winning $10,000 d. A 5% chance at
winning $100,000

Loss aversion:
We toss a coin. If it’s heads, you lose £10. If it’s tails, you win £X.
How large should X be for you to take this gamble?
A. £10 B. £20 C. £30 D. £40

We toss a coin. If it’s heads, you lose £1,000. If it’s tails, you win £X.
How large should X be for you to take this gamble?
A. £1,000 B. £2,000 C. £3,000 D. £4,000

Loss aversion is particularly acute in the investment environment “Losses loom larger than
gains” by about 2-3 times
Investors like to get even before they get out...

Losses are involved with a lot of psyhic resistance

Lossses are often felt more than gains
Prospect theory value function

Loss aversion is a function of the chance of loss

Perception og gain an dlosses depends on reference point  it is aabout whether or preceive
it to be a gain or aloss.
Loss aversion does not go away.
Loss aversion a difficult to mitigate.

Disposition effect:
Selling a winning position: changing a paper gain to a realized gain Selling a losing position:
changing a paper loss to a realized loss
Investors sell winners too soon and hold on to losers too long

Robert Shiller (Nobel 2013):

Market efficiency
In traditional finance, markets are assumed to be efficient and even if not all investors are
rational, the market itself will be rational through:
1. random errors cancelling out
2. the process of arbitrage
Behavioural finance argues that cognitive limitations of investors cause market prices to
deviate from fundamental values.

We also talk about systematic bias. In fact the randam errros are not random, they are
systematic.

We can look at the graph in regard to when we buy and sell

Based on this graph long term investors are not going to loose money.
Short term investing are more risky. We see that in the red spot  you can be caught up in
these spot, that are financial crisis.
The point is that it is difficult to time the market even for professtional investors.

History of financial bubbles:

1. The Dutch Tulip Bulb Bubble 1636: tulips bulbs became very overpriced. Investors
became very emotional about it and wanted a piece of it.
2. The South Sea Bubble 1720
3. The Mississippi Bubble 1720
4. The US bubble 1927–1929
5. The Mexican bank loan bubble 1970s
6. The Japanese bubble 1985–1989
7. The bubble in in Finland, Norway and Sweden 1985–1989
8. The bubble in Thailand, Malaysia, Indonesia, etc. 1992–1997
9. The Dot-Com bubble 2000–2001
10. TheGlobalFinancialCrisis2007–2009

Emotional roller coaster

Keynes: The market can stay irrational longer than you can stay solvent

Richard Thaler (Nobel 2017)

Nudge
Misbehavior

Emotions in finance:
Case 1:
1. On Thursday 27 Nov 1997, a cover article in the Nature prominently features a cancer
“cure” drug.
2. Share price of EntreMed, the small biotechnology company developing the drug, rises
__40_ % the same day but then drops

3. The same story as in November appears on the cover of the Sunday 3 May 1998 issue of
the New York Times
4. Share price rises ___300__% on the day!

5. Six months later the price is still double that before the 3 May 1998. Price rise was even
contagious to other members of the NASDAQ Biotechnology Index!

Why did this happen?!

Efficent market: the information was not new second time, so the share price should not have
reacted.
There was also a spill over effect to other biotech firms.

The first time the new hit the market is was a Thursday the next time it is a Sunday.
There some has to wait to Monday to react to the new - the buying pressure was therefore
compressed from Friday to Monday, therefore there were aday of the week effect.
Also November vs. may  studies of sentiment shows that optimism tends to go up in the
beginning of spring and go down during winter. This is called the Halloween effect. If you
buy the stock market index at the end of October and then sell at the beginning of May, if you
keep doing that every year, you return is on average positive.
More noise investors read the new york time than nature and might react more dramatically.
Under reaction and ove rreaction.

Possible reasons:
How did lack of any new news generate such a delayed and contagious permanent rise in
share price five months later?
1.------------------- 2.------------------- 3.------------------- 4.-------------------

Under-reactions and over-reaction:

Behavioural finance can be seen as the science of studying under- reaction and over-reaction.
The bulk of research evidence shows that investors have a tendency to:
Under-react to new information &
Over-react to old/existing information

The first time you hear something you are might late to react and do not believe the news.
The second or third time you hear the news, then you believe it is true and to that extent that
you might overreact to the same piece of information.

Red is positive news, blue is bad news.

In real life there is a delayed reaction to both good and bad news (dottet line)
eventually we will convert to what would be the appropriate reaction.

Post-earning announcement drift:

As companies announcement their financial performance.
better or worse than expectations we will have a positive or negative drift  this is the post
earnings announcement drift.

News shocks:

Causes of under-reaction:
1. Anchoring: Investors are often tied (‘anchored’) to existing prices and levels, in other
words the ‘status quo’.
2. Overconfidence: Investors place too much confidence on the accuracy of their
existing information and/or knowledge
3. Loss aversion: When bad news hits the market, individuals dislike ‘losing’ more than
they enjoy ‘gaining’ the same, so decide to keep their positions

Causes of over-reaction:
1. Representativeness: Based on a few characteristics, people tend to infer that a single
observation is representative of the entire population
2. Availability: People tend to over-estimate probability of a low frequency event if they
have recently heard such an event has occurred
3. Herding: Individuals tend to mimic the actions of a larger group

Measuring sentiment:
Sentiment research:

Sports sentiment:

BW index:
Baker and Wurgler (2006) construct a sentiment index out of proxies such as:
1. Share turnover
2. Number of IPOs
3. First-day returns of IPOs
4. Dividend premium
Can explain stock returns in cross section (but not time series)

Textual analysis:

o Study measures the interactions between the media and the stock market using daily content
from Wall Street Journal
o Key finding: High media pessimism predicts downward pressure on market prices followed
by a reversion to fundamentals
FEARS index:

FEARS index predict short--term reversals

In “love” with the stocks we hold?:

Case 2:
TV shows which have an impact on the stock market
Overdramatic and existing tv show  because of that many people follow and watch the
show.
In the show the host come up with recommendation on which stock to buy  this leads to
abnormal return.

Engelberg et. Al (2009):

Average 3% abnormal overnight returns following his recommendations
o Immediate market response to the recommendations even though the show airs after the
NYSE trading hours
o These price spikes followed by partial reversals
o Short-selling significantly higher than normal on the day following the recommendations
People bought shares in PSY’s father company. Just because this familt relation, complete
superficial. Nothing to do with company fundamentals.

Case 3:
- Using the count of flash mob videos on YouTube from each country and region as a
proxy for the investor enthusiasm
- Individual investors became net buyers of the stock when the attention level increased
in their neighbourhood
- Attention drove the stock price up by 800% without information
And one of the largest institutional investors was Dimensional Fund Advisors
advised by Eugene Fama

Follow up song “Gentlemen” releases in April 2013!

Company name changes:

Cooper et al (2001) study name changes during the dot-com era: Dot-com produced
cumulative abnormal return of 74% for the 10 days surrounding the announcement day
A mere association with the internet was a sufficient trigger

A more recent example:

Companies started to change their name to something with dot-com, even tough they did not
have any relation to the internet, web-based etc. The same goes for the blockchain
technology.
It was so hot and in fashion that companies wanted to be associated with this new hot trend.
Cosmetic name changes.

Even stock tickers matter:

Another example:
Managerial attributes:
 - Men with high levels of testosterone have different facial characteristics including a
higher facial Width-to-Height Ratio (fWHR)
- fWHR compares the distance between cheekbones to the distance between the upper
lip and midbrow
- Doesn’t change with age and is correlated with voice masculinity

Prior evidence showing that high testosterone CEOs deliver better firm performance (Wong
et al., 2011)
Findings based on 1400 CEOs show that high-testosterone CEOs:
1. increase firm risk
2. maintain high leverage ratio
3. are more acquisitive
4. receive high risk-adjusted compensation

Alpha and fund managers:

Barber and Odean (2001):

o Men expect their portfolios to outperform the market in the next 12 months by 2.8% and
Women by 2.1%
o Men trade 43% more than Women and single men 67% more than women
o Men underperform Women by 1% per annum and single men underperform single women
by 1.4% per annum

Women on corporate bonds:

Mixed evidence:

Slide 81
Theory:
o Psychic reality (the subjective reality of the inner world) v. external reality (the actual facts)
o The struggle between the pleasure principle and the reality principle
o We defend against such conflicting feelings “easily” by making the painful ones
unconscious
o What is made unconscious becomes more influential (powerful) as a consequence

Phantastic objects:
Any investment can have an exceptionally exciting and transforming meaning in unconscious
psychic reality
Such as dot.com stocks, CDOs, hedge funds, etc.
A mental representation of something (or someone, or an idea) which fulfils an individual’s
deepest (unconscious) desires to have exactly what they want exactly when they want it

Bernie Madoff the “miracle worker”:

The “perfect” phantastic object!
o Very satisfying wish fulfilment phantasy
o Questioning the Madoff phantasy was futile
o Whistleblowers such as Harry Markopolos were dismissed and vilified
o Investment banks such as J P Morgan “knew” but didn’t want the party to stop

Some insight of emotional finance:

✓ The emotional understanding of risk
✓ The key role of trust in investing
✓ Emotional finance and momentum
✓ Market inability to deal with bad news
✓ Problems in making satisfactory pension provision
✓ Stock market anomalies and gambling
✓ Asset pricing bubbles and the Global Financial Crisis
Emotional bubbles:

Ambiguity aversion:
Generally, individuals prefer risk to uncertainty and thus avoid uncertain situations
Risk: The probability distribution is precisely known
Uncertainty: The probability distribution is unknown
The “known unknown” vs the “unknown unknown”
Ambiguity aversion is also closely associated with the diversification heuristic, i.e. that
people like to try a little bit of everything when choices are not mutually exclusive

Social effects in finance

- Most of what we have discussed so far has focused on the cognitive psychology of
individuals...
- But we are also social animals
- And are subject to social effects
Herding:
o Investors tend to select investments that other investors select to avoid “falling behind”
o Difference between intentional and spurious herding
o Spurious herding is when individuals reach the same conclusions independently of each
other

We as socail anamals are not that different from cattel.

We want to buy the same stocks as others.

Why does herding occur:

1. Social pressure of conformity
2. Most people are very sociable and have a natural desire to be accepted by a group
3. Common rationale that it’s unlikely that such a large group could be wrong (“safety in
numbers”)
4. Even the large group is proved wrong later, the feeling of regret on making a wrong
decision is lower when you know that many others made the same mistake

We are all social animals and ww do not want to be singled out.

No one want to make a wrong decision that they ar egoing to regeret.

Herding channels:
How do you make financial decisions?
Mostly by...
o Downloading large amount of data and analyse?
o Applying asset pricing model or equity evaluation tools? o Screening stocks?
Or...
o Talking to people?
o Watching TV programmes featuring investment advice? o Reading financial newspapers?

Most people are in the second category.

Role of conversations:
Conversation allows for the rapid exchange of information, opinions, and emotions. This is
important for the stock market and investing given the roles of:
o Brokers
o Institutional investors
o Individual investors
o Financial gurus

Social interactions in investing:

Hong et al (2004) show that interaction makes people more comfortable in investing. Their
survey of 7500 households demonstrates that:
Social households are more likely to invest in the stock market
This is magnified if the household is in a high stock-market participation community which is
consistent with peer-effects

Information about investing can diffuse through neighbourhoods.

- When a neighbour increases purchases in an industry by 10%, the household increases
ownership by 2%.
- When a neighbour increases ownership in local company, household also increases by
the same amount

In investment circles, rumours abound...

Rumour and gossip websites Twitter feeds
Other social media
Word of mouth

Groupthink:
A situation in which the desire for harmony or conformity in the group results in an irrational
or dysfunctional decision-making outcome

Groupthink is particularly strong when:

o Group dynamics feature friendliness
o There is a powerful opinionated leader
o Group members operate under stress
o There is strong desire for social conformity
o There is no explicit decision making procedure

Associated effect called groupfeel

Both will result in dysfunctional decision making.

Other challenges in group decision making:

- Poor information sharing
o Members tend to use information for confirmation bias purposes rather than to
provide disconfirming evidence
- Poor conflict management
o Divergent opinions may be suppressed
- Social loafing
o Also known as the “free rider” problem

“Gentlemen, I take it we are all in complete agreement on the decision here... Then I propose
we postpone further discussion of this matter until our next meeting to give ourselves time to
develop disagreement and perhaps gain some understanding of what the decision is all
about.”
Alfred Sloan, former CEO of General Motors

When there are no opposing views it could be a sign of groupthink.

Investment Clubs:
A group of family members, friends, or co-workers who come together to pool their money
and invest in the market.

Despite their best intentions, they commonly underperform the market index...

The club underperform on average. Could be because of groupthink and herding.

Clubs serious about socialization

o Potential stocks are proposed with little data.
o Arguments for purchasing are more “story-telling.” o Very little analysis.
o Little debate.
Clubs serious about investing
o Formal procedures for proposing stocks. o Have investment criteria.
o Procedures help mitigate emotional and psychological biases.

Culture in finance

Definitions of culture:
‘The derivatives of experience, more or less organized, learned or created by the individuals
of a population... transmitted from past generations, from contemporaries, or formed by
individuals themselves.’
Schwartz (1992)
‘The collective programming of the mind which distinguishes the members of one group or
category of people from another.’
Hofstede (1994)
Hofstede Scale:

Early life experience:

American CEOs who grew up during the Great Depression are:
▪ Averse to debt leading to suboptimal capital structure
▪ Lean excessively on internal finance

CEOs growing up under the great depression were very exposed to debt and bankruptrupcy.
Therefore they relied for on internal finance.
Career background:
- CEOs with military culture are less likely to be involved in corporate fraud
(Benmelech and Frydman, 2015)
- They are also less tax avoidant, and leave on average $1-2m more tax on the table
(Law and Mills, 2017)

Culture and gender:

Men are generally seen to be more overconfident and risk-taking than women, however, this
is highly culture-dependent (Gneezy et al., 2009)

Culture and perceptions of luck:

- In Chinese culture, the numbers 8, (and to some extent 6 and 9) are considered lucky
because they sound similar to words meanings ‘prosperity’ and ‘longevity’
- While 4 is unlucky: sounds similar to ‘death’
- Hirshleifer et al. (2016, MS) find that Chinese investors significantly overreact to
IPOs with a registration code containing lucky numbers, e.g., 601988 (Bank of China)
- These IPOs underperform by more than 10% after three years.

Culture and loss aversion:

Culture and investor patience:

Culture heritage:
‘Does a CEO’s Cultural Heritage Affect Performance under Competitive Pressure?’, Review
of Financial Studies, 2018 (with Nguyen and Hagendorff)

Motivation:
Plenty of evidence that cultural heritage affects personal choice
This study showed that:
▪ Cultural heritage can influences broader organizational- and society-level outcomes
▪ Cultural values and beliefs decay with time

Cultural heritage:

Main finding:
“Descendants-of-immigrant” CEOs behave differently from other CEOs
They do so in ways that is consistent with the culture prevailing in their country of origin
Cultural heritage matters for:
o Firm performance,
o Through its effect on CEO policy choices

Challenge: measuring culture:

- Single-country studies: Many countries are culturally homogenous
- Cross-country studies cannot isolate cultural differences from institutional and
economic differences
- Our approach: “Descendants-of-immigrant” CEOs in the US
o Holds constant institutional and economic environment
o Exploits variations in the cultural origin of the CEO
- We hand-collect a dataset that tracks the entire family tree of US CEOs

CEO’s family tree:

Voila!
Thomas Theobald is a fourth-gen immigrant from Germany.

Results vary with immigration generations:

And country of origin

Channels: Impact of firm policies:
CEOs with German, Italian, Polish and Russian ancestors associated with
Lower credit losses
→Uncertainty-avoidance Better acquisition performance
→Uncertainty-avoidance/Collectivism
More economical use of expenses
→ Restraint

Lecture 12:
Nicklas Bang Eriksen Thesis

1. A few words about myself

2. Ørsted and my current position
3. Thesis
4. Paper: “Corporate risk and the humpback of CEO narcissism”
5. Reflections on thesis process
6. Reflections on BCF and my own professional experience

Thesis: CEO narcissism, corporate risk-taking and performance

Evidence based on a sample of US manufacturing firms and the use of data from
LinkedIn profiles as unobtrusive measures of CEO narcissism

Motivation:
From corporate finance to behavioral corporate finance
– The necessary fundamental assumptions of corporate finance and the
interesting aspect of relaxing these assumptions with regard to rationality and
psychology

The concept of narcissism

– An interesting concept stemming from the psychology literature
– A concept which is arguably more relevant than ever

Use of unobtrusive measures and more specifically the LinkedIn profile as data source
of such measures
– Inherent problems of having CEOs take personality tests
– Unobtrusive measures have been used previously within the literature on
narcissism in a BCF context - but not with use of social media platforms
– Recent research have found a relationship between narcissism and the use of
social media platforms
Research question:

Is there a relationship between CEO narcissism and corporate risk-taking and is there a
relationship between CEO narcissism and corporate performance?
No previous study has had the particular purpose of examining the potential relationship
between CEO narcissism and corporate risk-taking, although a positive relationship between
narcissism and risk-taking has been found in a study of undergraduates.

Methodology:
• Construction of a LinkedIn index as measure of CEO narcissism, based on profile
characteristics observed for 494 CEOs and LinkedIn profiles
• Use of a previously used measure of CEO narcissism; CEO prominence in company
press releases, based on press releases observed for 491 CEOs
• Using different accounting-based and market-based measures of both corporate risk-
taking and performance
• EGLS panel regression analysis testing for linear and non-linear relationships
• A set of robustness tests

Findings:
CEO narcissism and corporate performance
– The results remain inconclusive
CEO narcissism and corporate risk-taking
– An non-linear relationship in the form of an inverted u-shaped curve is found
between CEO narcissism and corporate risk-taking
– This means that moderate levels of narcissism are associated with high
corporate risk-taking, while higher and lower levels of narcissism are
associated with lower corporate risk-taking.

Contribution:
• Evidence on the relationship between CEO narcissism and corporate risk-taking
• The introduction of a new approach of using unobtrusive measures from social media
platforms in studying personality traits in BCF, as the LinkedIn profile of the CEO is
used in the study as a source of indicators of CEO narcissism
Aabo and Eriksen (2017): Corporate risk and the humpback of CEO narcissism

Results indicates increase u-shape

Main finding (2):

There is an inverse U-shape relationship between
CEO narcissism and corporate risk-taking
We find that the specific form of the inverse U-shape relationship implies that
1) a very low degree of CEO narcissism and a very high degree of CEO narcissism are
associated with the same (low) level of corporate risk taking,
2) the majority of firms are situated on the left-hand side of the inverse U-shape curve so
that an increase in CEO narcissism is associated with an increase in corporate risk
taking, and
3) a moderate degree of CEO narcissism – as compared to a very low or a very high
level of CEO narcissism - is associated with an increase in corporate risk taking of
12% (as measured by the change in stock return volatility).
The inverse U-shape relationship (the “humpback”) is potentially a reflection of the
paradoxical nature of the narcissistic personality in which the self-esteem is high but at the
same time fragile with a combination of self-admiration and a constant need of having this
positive self-view confirmed.

Narcissism in the context of the paper:

Narcissism …
… a coherent but multifaceted personality dimension that can be defined, again, as the degree
to which an individual has an inflated sense of self and is preoccupied with having that
self-view continually reinforced” (Chatterjee and Hambrick, 2007)
… characterized by a high, but very fragile sense of self-esteem (Kernis, 2005)
Þ Potentially, these two aspects of narcissism may affect
corporate risk taking differently

The concept was in its modern usage predominantly recognized as a personality disorder until
Raskin and Hall (1979) developed their Narcissistic Personality Inventory that allowed
researchers to study narcissism as a personality dimension as opposed to the more extreme
case of a clinical disorder
Related literature (1):
Chatterjee and Hambrick (2007) investigate 111 CEOs from the computer hardware and
software industries in the period 1992-2004 and find that CEO narcissism is positively related
to 1) strategic dynamism and grandiosity, 2) the number and size of acquisitions, and 3)
extreme and fluctuating performance.

They construct an index of five different indicators of CEO narcissism:

1) the prominence of the CEO’s photograph in the company’s annual reports, 2) the CEO’s
prominence in the company’s press releases, 3) the use by the CEO of first-person singular
pronouns in interviews, 4) the cash compensation of the CEO scaled by that of the second-
highest paid executive, and 5) the non-cash compensation of the CEO scaled by that of the
second-highest paid executive.

Chatterjee and Hambrick (2011) investigate listed firms from the US computer hardware
and software industries in the period 1992-2008 to study the determinants of risk taking by
CEOs. They measure risk taking by three major forms of spending: research and development
(R&D), capital expenditures, and acquisitions. They find no effect for narcissism and
conclude that there is little evidence that narcissists are “pervasively extreme risk takers”.
They construct an index of four different indicators of CEO narcissism:
1) the prominence of the CEO’s photograph in the company’s annual reports, 2) the CEO’s
prominence in the company’s press releases, 3) the cash compensation of the CEO scaled
by that of the second-highest paid executive, and 4) the non-cash compensation of the CEO
scaled by that of the second-highest paid executive.

Aktas et al. (2016) investigate 187 US deals in the period 2002-2006 and find that 1)
acquirer shareholders react less favorably to a takeover announcement when the target CEO
is more narcissistic, 2) narcissistic acquiring CEOs negotiate faster and are marginally more
likely to initiate deals, 3) acquirer CEO narcissism and target CEO narcissism are associated
with a lower probability of deal completion and reduce the likelihood that the target CEO will
be employed by the merged firm.
They use the CEO’s first-person singular pronoun usage in interviews* as an indicator
of CEO narcissism.
* This is the proxy that Chatterjee and Hambrick (2011) avoid because they fear that self-
referencing by CEOs has tended to decline. However, Aktas et al (2016) find no significant
change in CEO speech format in their sample firms.

Methodology:
Sample:
1) 475 US listed manufacturing firms
2) 2010-2014
3) CEO LinkedIn profile 2015

Linkedin Measures as a proxy for narcissism:

An example:

Main regression model:

Stock return volatility (log)it =
β0 + β1LinkedIni + β2LinkedIni^2
+ β3CEO age (log)i + β4CEO genderi
+ β5Total assets (log)it + β6Leverage ratioit + β7Current ratio (log)it
+ β8NAICS 32 dummyi + β9NAICS 33 dummyi + tαtYeart + it

Robustness:
Our results are robust to:
Other measures of corporate risk such as idiosyncratic volatility (CAPM), idiosyncratic
volatility (FF3F) and to some extent ROA volatility (as opposed to stock return volatility).
An alternative proxy for CEO narcissism, Press release (the number of times the CEO is
mentioned by name in the firm’s ten most recent press releases scaled by the total amount of
words (in thousands) in these press releases).
Single year regression analysis (as opposed to panel data for 2010-20).
Reflections:
Existing literature
– What is interesting?
– What is left undone?
Use of scientific articles in general for inspiration
– Independent variables
– Dependent variables
– Control variables
– Method
– Structure
– Layout
– Theory
Use the guidance from Tom
– Find out what can be answered through a look at scientific articles, books or
the internet and find out what cannot or what seems to be more unclear when
looking through the various available sources of information
– In the latter case make use of the expertise that Tom has
Planning
– It is hard to know how much time will be needed for the different stages of the
work on the thesis
– For my thesis I highly underestimated the time I would need to do the actual
analysis
– Therefore, put in extra time as buffer

The approach I applied: waiting until the end with checking the results
– Not necessarily a good idea
Data retrieval and analysis
– Consider early on how you want to retrieve data and how you want to analyze
it
Collection and use of primary data
– Not recommended unless you are willing to spend a lot of time doing it
– Difficult to estimate the time needed

Political strength - economist

https://www.economist.com/science-and-technology/2012/10/20/political-strength
Being strong or not only matters when we acknowledge that it matters our stoneage-brain -
what our ancestors did. Physical appearance might matter, but the strength mattered a lot for
men during the stone-age, but not that much for females.

The brain we are born with is not that different from our ancestors’ brain.

TED talk about how training transform your brain

Why is exercise the most transformative thing you can do for your brain today?

Brain-changing effects of exercises:

1. it has immediate effect on your brain (a single workout will increase levels of
dopamine etc. which will increase your mood right after).
 2. A single workout can improve your ability to shift and focus your attention.
3. A single workout will improve your reaction time.

Hippocampus produces new brain cells that improve your long-term memory.

McGonigal (2020): Why does running give you a high? A look at the evidence
Why does running give you a high?
Because of your ANCESTORS (If it didn’t have any advantages, it wouldn’t be established
in the first place or have survived).

Survival:
Runner’s high = a reward to our ancestors for hunting and gathering!
Without it, we would just try to conserve energy.
 Natural selection!

In terms of survival, and with our stone age brain, we should be very laze. Why would you go
over there or run if you lose energy?

Running like a hunter

Walking slowly for 30 minutes = no effect
Running at maximum effort = no effect

Jogging = effect!

Corresponding to the needs of our ancestral hunter.

It is likely that we have an evolutionary explanation for runners high.

Chemicals:
Endorphins + Endocannabinoids => relieve pain and induce pleasure
(“don’t worry, be happy” chemical)

It hurts, but it doesn’t hurt as much as if we didn’t have the runners high.

Bonding:
A runner’s high helps us bond! Why?

Groups who were better at sharing were more likely to survive. Natural selection favored
traits that encouraged within-group cooperation. Runner’s high made sharing the spoils with
your tribe more rewarding.

Experiment
Participants played an economic game that required contributing money to a communal pool.
The more they contributed, the more all parties would benefit.
Participants who exercised for 30 minutes before playing the game shared more!

Conclusion:
Keep on running…
… both as an employee, as a CEO, and simply as YOU!
Dong (2019): Athletes in boardrooms: evidence from the world
Abstract:
This study examines the relation between the athletic experience of board directors and
corporate outcomes. We predict that athletes’ attributes, such as physical fitness, mental
resilience, leadership, and team-working skills, enhance their monitoring role. Using a
large sample from 71 countries, we find that athletic experience is associated with better
firm performance. The benefits are more pronounced when the experience is of team
sports and confrontational sports, and for firms experiencing financial crisis. The results
remain consistent when we instrument the athletic experience of directors with the number
of Olympic medals won and Olympic sports participated in by the country in question
at the previous Olympic Games.”

Why beneficial?
- Fitness
- (Top) Athlete

The fitness-level of the person might be of importance. It increases the capacity in terms of
mind.

Top athlete  competitive mind and experience that might do so that you are a better
manager.

People that have been exposed to natural disaster in their upbringing are more risk-taking in
their life afterwards. People who experience nature disasters later on are less risk-taking.

Why beneficial - fitness

• Physical fitness brings various psychological benefits, including a reduction of
anxiety, stress, and tension.
• … aerobic fitness improves neurocognitive functions and therefore benefits the
executive control process in several ways (e.g. scheduling, planning and working
memory).
• … physical training improves self-concept, mood, and work performance, but … per
se does not affect most personality traits.

Why beneficial – (top) athlete

• … athletes are found to exhibit physical fitness, mental resilience, a strong ability to
manage pressure, and good team-working skills.
• … athletes tend to be more emotionally stable and confident than others.
• … athletes have a high level of resilience as they regularly receive formal training on
management techniques that help them cope with stress and difficult situations such
as injuries during their sporting career.
• … sports participation could facilitate the development of maturity concepts including
discipline, teamwork, organization, fair play, and tough-mindness …

A team-sport or a very individualistic sport. One is not necessarily better than the other, but
in terms of teamwork, the team-sports might give some qualities that the individualistic sport
don’t give.

Two main functions of a board

 • Advisory – act as sparring partner to the CEO.
• Monitoring – to be agent for the shareholders.

How can athletes improve the board?

Potential channels:
• Independence
• Commitment
• Leadership
• Professional experience

Through these four channels athletes can improve the board.

Are you acting independent?
Through athlete, you have shown you are committed. You keep on going. Commitment is
what an athlete typically can do.
Conclusion:
Personal characteristics (i.e. physical fitness and personality/psychological traits)
associated with athletes benefit boards and enhance firm value.

Thus, such non-expertise-related personal experience has real economic consequences for
corporate governance and firm performance.
Nofsinger (2019): Deep sleep: The impact of sleep on financial risk taking

Sleep - important?
• … sleep is an essential factor for health and circadian rhythms.
• … one of the most important ways to cope with high stress and working long hours is
sleep.
• … individuals who report poor sleep quality have a higher number of illnesses and
worse overall health.
• … sleep loss can cause the brain to start eating itself as portions of the synapses in the
brain are consumed by astrocytes.
• … sleep loss leads to deficits in fundamental cognitive processes such as
concentration, attention, and memory.
• … sleep problems are a risk factor for developing depression.

Sleep and risk taking:

… sleep deprivation is associated with self‐reported socially risky activities, such as
1) alcohol, cigarette, and drug use
2) as well as suicidal behavior.
… losing 1 hour of sleep due to daylight savings causes an increase in
1) pedestrian injuries
2) traffic accidents
3) fatal vehicle crashes
4) workplace injuries
and a decrease in an individual's general life satisfaction and mood.

You are a better version of yourself if you sleep.

Sleep and financial risk taking:

… sleep has a significant impact on both financial risk taking and time preferences.
… individuals who have poor sleep
1) display more distortion of probability,
2) are more susceptible to the present bias,
3) and have a higher discounting rate.
If managers have poor sleep and more sleep disturbances, they could
1) distort the probability of their investments
2) take more risk than is optimal
3) and the present bias could lead to less profitable investments.

3 articles on nutrition
1: Extraneous factors in judicial decisions
Legal formalism holds that judges apply legal reasons to the facts of a case in a rational,
mechanical, and deliberative manner.
In contrast, legal realists argue that psychological, political, and social factors influence
judicial rulings.
This paper tests the common caricature of realism that
justice is “what the judge ate for breakfast”
in sequential parole decisions made by experienced judges.

A judge will rule by the law. Early in the morning, before or after break, etc.
Setting
1,112 judicial rulings (collected over 50 days in a 10-month period)
8 Jewish-Israeli judges
2 different parole boards (that serve four major prisons in Israel)
78.2% of rulings relate to parole requests (the remainder consist of parolee requests to change
the terms of their parole or requests by parole candidates to change the terms of their
incarceration)
2 daily food breaks — a late morning snack and lunch

Findings
The likelihood of a favorable ruling is greater at the very beginning of the work day or after a
food break than later in the sequence of cases.
The percentage of favorable rulings drops gradually from ≈65% to nearly zero within each
decision session and returns abruptly to ≈65% after a break.
Every judge in our sample was more likely to rule in favor of a prisoner at the beginning of a
session than at the end of a session.

Why?
Making repeated judgments or decisions depletes individuals’ executive function and mental
resources, which can, in turn, influence their subsequent decisions.

The apparent depletion exhibited by the judges is due to the act of making decisions rather
than simply elapsed time. In an analysis that included both the cumulative minutes variable
and the ordinal position counter, only the latter was significant.

Rejecting requests is an easier decision. Thus, favorable rulings took significantly than
unfavorable rulings and written verdicts of favorable rulings were significantly longer than
written verdicts of unfavorable rulings.

Status quo bias.

It seems not to be so much the time as such, but more related to number of cases. The effort
of actually making the decision.

2: Impact of nutrition on social decision making

Food intake is essential for maintaining homeostasis, which is necessary for survival in all
species.

Food intake also impacts multiple biochemical processes that influence our behavior.

“We are what we eat” - our decisions depend upon our physiological state that impacts our
brain and the decisions we make.

Findings:
Breakfasts with different macronutrient compositions modulated human social behavior.

There are three macronutrients: protein, fats and carbohydrates.

Breakfasts with a high-carbohydrate/protein ratio increased social punishment behavior in
response to norm violations compared with that in response to a low carbohydrate/ protein
meal.

Why?
Next paper - an evolutionary explanation!

3: An evolutionary perspective on nutrition and social decision making

The balance of carbohydrate to protein in a breakfast preparation influenced subsequent
human social decision making.

The deeper question is: Why?

“Nothing in biology makes sense except in the light of evolution”

Do the findings reflect an evolved mechanism that conferred a survival advantage across
evolution?

Suggestive answer
Observation:
The need to share protein while minimizing conflict was likely more pressing across hominin
evolution than any need to share more carbohydrate-rich foodstuffs, because protein
frequently came in the form of kills that both allowed for—and mandated—food sharing.
When sharing large prey, this type of social tolerance may have been less metabolically
costly (and hence less costly to the survival and reproduction of involved individuals) than
would have been the case when sharing carbohydrate food stuffs, which typically came in
smaller amounts on a more regular basis.

Thus, it is possible that either protein-mediated social tolerance or carbohydrate-mediated

social punishment is adaptive.

Summing up:
The body and mind are integrated.
The body reacts to exercise and nutrition.
Thus, exercise and nutrition affect our mind and thus our (corporate ) decisions!

TED TALK: Your body language may shape who you are
Body language related to gender. Woman feel less powerful than men - alpha men tend to
take up more space and feel more powerful.

Our minds change our bodies, and our bodies change our minds.

High power men, alpha males have high testosterone and low cortisol.

NYT article: when revolution came for Amy Cuddy

More vulnerable to chance as it was a small study.
(In finance it’s the opposite - we typically have a lot of data and can easily find something
significant)
Harvey (2017): Presidental address - the scientific outlook in financial economics

”Significant” results
Journals contribute to data mining through their focus on publishing papers with the most
“significant” results.
This leads to publication bias, whereby readers see only a select sample of the actual
research conducted.
Publication bias may also be induced by authors cherry-picking the most significant results
(p-hacking) to submit to a journal.

Harking: Hypothesizing After the Results are Known

Essentially, you have a theory that Y should be correlated with X1.
You test that theory and include controls X2 to X20.
You find no correlation between Y and X1, but you find a correlation between Y and X7.
You then change the theory and throw X1 in with the control variables.

HARKing is most likely to occur when it is relatively easy to run an experiment, for example,
a regression that uses Compustat data …

P-value (1):
… the most basic mistake in using p-values is to assume that a test with a p-value of 5%
implies that there is only a 5% chance that the null hypothesis is true. This is a mistake
because a p-value is calculated under the assumption that the null hypothesis is correct.
Over time, Fisher’s (1925) p-value has been embedded in the Neyman and Pearson (1933)
framework in a way that often obscures its original meaning. NP introduced the idea of the
Type I error rate (false positive rate, or rejecting the null when the null is true, which is the
false positive rate in repetitive experiments). The p-value for a test statistic is compared to the
Type I error threshold to determine the test outcome, creating a subtle link between the p-
value and the Type I error rate. As a result, people often mistakenly describe the p-value as
the Type I error rate.

P-value (2)
… the NP approach is deductive and can best be thought of as a decision rule that is useful if
the decision is made many times …. In contrast, the Fisher approach is inductive. We
examine the evidence, and this evidence leads to an increased probability of a conclusion.

With years of confusion, the difference between p-values, error rates, and significance levels
has become blurred. Indeed, the very definition of p-value is now subject to confusion. For
example, many incorrectly believe that p-values give the probability that the result could
have occurred by chance alone.

P-value (3)
A p-value tells us p(D|H). The p-value indicates the probability of observing an effect, D,
(or greater) given the null hypothesis H0 is true, that is, p(D|H0). It does not tell us p(H0|
D). However, it is often interpreted incorrectly as indicating p(H0|D).
“What is the probability of obtaining a dead person (label this part D) given that the person
was hanged (label this part H); this is, in symbol form, what is p(D|H)? Obviously, it will be
very high, perhaps 0.97 or higher. Now, let us reverse the question. What is the probability
that a person has been hanged (H), given that the person is dead (D); that is, what is p(H|D)?
No one would be likely to make the mistake of substituting the first estimate (0.97) for the
second (0.01); that is, to accept 0.97 as the probability that a person has been hanged given
that the person is dead. Even though this seems to be an unlikely mistake, it is exactly the
kind of mistake that is made with interpretations of statistical significance testing — by
analogy, calculated estimates of p(H|D) are interpreted as if they were estimates of p(D|H),
when they are clearly not the same.
P-values do not tell us the probability of the null hypothesis being true given the data,
p(H0|D). Rather, they simply indicate the probability with which the particular evidence
will arise if the null hypothesis is true, p(D|H0).

P-value (4)
Further Issues
• A low p-value, while rejecting the null hypothesis, tells us little about the ability of
the hypothesis to explain the data. For example, you might observe a low p-value
but the model has a low R2.
• Low p-values could result from failing to control for multiple testing.
• Low p-values could result from selection and/or p-hacking.
• Low p-values could result from a misspecified test.
• P-values crucially depend on the amount of data. It has been well-known that, with
enough data, you can reject almost any null hypothesis.

P-value (5)
Scientific conclusions and business or policy decisions should not be based only on
whether a p-value passes a specific threshold.
It is rare that there is a clean dividing line between “true” and “false”, and a p-value
should not be used as such a dividing line.
Rather, it is crucial to account for other factors such as the plausibility of the theory and
its assumptions, the quality of the data, and any other evidence that might be relevant for
the study.
P-values do not tell us about the size of the economic effect. Economic significance is
often described as the impact of moving from the first quartile to the third quartile of the
distribution of the variable in question (it should not be the impact of moving from the 1st to
the 99th percentile).

P-hacking
… running thousands of correlations and reporting only the most significant one constitutes
academic fraud. A more subtle version of this type of p-hacking is studying correlations
among, say, 11 variables and choosing to report only 10 of the correlations. Unfortunately,
not reporting all variables examined in empirical work is commonplace in financial
economics.
P-hacking also occurs when the researcher tries a number of statistical approaches (e.g.,
linear probability vs. Logit or Probit, panel regression vs. Fama-MacBeth (1973), Newey-
West (1987) lag 1 vs. lag 4, different clustering choices, different choices of instrumental
variables) and reports the one with the most impressive “significance.”
Data manipulation and exclusion can also lead to p-hacking. Researchers make many
choices in terms of standardization, log or other transformations, winsorization, and outlier
exclusion. If these choices lead to the most significant results being presented, this is p-
hacking. Similarly, the choice of data set can lead to p-hacking. For example, if the
researcher reports a significant result using the 1970 to 2017 period and does not reveal that
the same result is weaker in the 1960 to 2017 period, this is p-hacking.

P-hacking – AN EXAMPLE
Here are the instructions that I gave my research assistant: (1) form portfolios based on
the first, second, and third letters of the ticker symbol; (2) show results for 1926 to present
and 1963 to present; (3) use a monthly, not daily, frequency; (4) rebalance portfolios monthly
and once a year; (5) value weight and equally weight portfolios; (6) make a choice on
delisting returns; and (7) find me the best long-short portfolio based on the maximum t-
statistic. There are 3,160 possible long-short portfolios based on the first three letters of the
tickers. With two sample periods, there are 6,320 possible portfolio choices, equal and value
weights bring this number to 12,640, and two choices for reconstituting the portfolio doubles
this number again. In short, there are a huge number of choices.
… dozens of strategies have “significant” t-statistics. This is an egregious example of what is
known as p-hacking. One might think this is a silly example. But it is not.
A paper referenced in the HLZ (2016) factor list shows that a group of companies with
meaningful ticker symbols, like Southwest’s LUV, outperform (Head, Smith, and Watson
(2009)). Another study, this time in psychology, argues that tickers that are easy to
pronounce, like BAL as opposed to BDL, outperform in IPOs (Alter and Oppenheimer
(2006)). Yet another study, in marketing, suggests that tickers that are congruent with the
company’s name outperform …

Prior beliefs (1)

Let me motivate the use of prior beliefs with an example from a famous letter written by
Leonard Savage in 1962. Consider three experiments.
1) A musicologist claims to be able to distinguish between pages of music written by
Mozart or Haydn. Using 10 pairs of score pages, Mozart versus Haydn, the
musicologist identifies each one correctly.
2) An elderly woman claims that she can tell if milk was put in a tea cup before or after
the hot tea was poured in. Again using 10 different trials, the woman identifies each
one correctly.
3) A patron at a bar claims that alcohol helps him predict the future. You conduct an
experiment using 10 coin flips and the patron correctly guesses heads or tails for each
flip.

Prior beliefs (2)

In each of these experiments, the p-value is less than 0.001 (=1/210). However, what you
take away from each test should be different.
1) You know that the test subject is a musicologist. This is her area of expertise and
there is little reason for her to make a false claim. Indeed, it is not even obvious that
 you need to run the experiment to verify her claim, but in doing so the experiment
confirms what you already believe.
2) Maybe you are initially skeptical of the claim, but the evidence convinces you.
Personally, I remember my grandfather sending his tea back at a restaurant because he
always asked for the tea bag to be put in the pot before the water was added; he knew
when the server got it wrong. So in the second experiment, there is a shift in your
beliefs given the outcome of the experiment.
3) The claim that alcohol causes clairvoyance is preposterous. Thus, while the p-value is
less than 0.001, you chalk this up to luck—such an occurrence should happen
naturally once in every 1,024 trials—and your beliefs are largely unaffected.

Prior beliefs (3) = Is it a plausible story?

These simple examples illustrate two points. First, as I discuss earlier, if the effect is
improbable (a drunk foretelling the future), there will be a lot of false positives. Second, and
more importantly, what really counts is the ability of the test to change beliefs. In the first and
third tests, beliefs do not change as a result of the evidence. In the second test, beliefs are
updated.

Prior beliefs (4)

What insight does the above discussion have for research in financial economics?
The key takeaway is that the more improbable the effect, the more careful we have to be
because there will be many false positives.

This aggregate view of false discoveries in finance research, which is distinct from the usual
concern for single-hypothesis tests, casts doubt on the credibility of many empirical
findings.

There is a simple message here: we cannot simply report the usual p-values.
Given the rare effects problem, we somehow need to take prior beliefs into account.
For more on a full-blown Bayesian approach please see the paper (not relevant for the exam).

Lecture 13
Gigerenzer (2011): Heuristic Decision Making
Abstract
“… Heuristics are efficient cognitive processes, conscious or unconscious, that ignore part
of the information.
Because using heuristics saves effort, the classical view has been that heuristic decisions
imply greater errors than do “rational” decisions as defined by logic or statistical models.
However, for many decisions, the assumptions of rational models are not met, and it is an
empirical rather than an a priori issue how well cognitive heuristics function in an uncertain
world …

An example
Commercial retailers need to distinguish those customers who are likely to purchase again
in a given time frame (active customers) from those who are not (inactive customers). These
companies have a large database containing the amount, kind, and date of every customer’s
previous purchases. How can an executive predict which customers will be active in the
future?
1) Statistically sophisticated academics might opt for a Bayesian analysis, regression
analysis, or some other optimizing strategy to predict the probability that a customer with a
given purchase history is active at some future time.
2) Experienced managers use a simple recency-of-last-purchase rule. Thus, if a customer
has not purchased within a certain number of months the customer is classified as inactive;
otherwise, the customer is classified as active.
The simple model won!

What is it?
We adopt the following definition:
A heuristic is a strategy that ignores part of the information, with the goal of making
decisions more quickly, frugally, and/or accurately than more complex methods.

You want a model that is able to predict the future.

How are decisions made?

Three major answers have been proposed.
The mind applies
1) logic (using mental capacity, frameworks, prior experience to conclude)
2) statistics, or (“this pattern has been there historically, might repeat in the future)
3) heuristics.
Rules of logic and statistics have been linked to rational reasoning and heuristics linked to
error-prone intuitions or even irrationality.
Deviations from logical or statistical principles became routinely interpreted as judgmental
biases and attributed to cognitive heuristics such as “representativeness” or to an intuitive
“System 1.”

However …
The “father” of bounded rationality, Simon (1989), however, asked a fundamentally different
question, leading to a different research program.

Simon’s question:
“How do human beings reason when the conditions for rationality postulated by the
model of neoclassical economics are not met?”
As Simon stressed in his Nobel Memorial Lecture, the classical model of rationality requires
knowledge of all the relevant alternatives, their consequences and probabilities, and a
predictable world without surprises. We have all information, we can see all potential
scenarios and we are able to compute it mentally and digest that information.

Less Is more
When heuristics were formalized, a surprising discovery was made.
In a number of large worlds, simple heuristics were more accurate than standard statistical
methods that have the same or more information. These results became known as
less-is-more effects!
There is an inverse-U-shaped relation between level of accuracy and amount of
information, computation, or time.
In other words, there is a point where more is not better, but harmful.
How much information should you gather? How efficient is your decision making? You will
have to gather some information, but the relationship is inverse. Collect information,
improve, collect information, improve - but at a certain point it’s not improving anymore.

Building blocks
Three building blocks have been proposed:
1) Search rules specify in what direction the search extends in the search space.
2) Stopping rules specify when the search is stopped.
3) Decision rules specify how the final decision is reached.
In the previous example, the hiatus heuristic (1) searches for recency-of-last-purchase
information; (2) stops when it is found, ignoring further information; and (3) uses a nine-
month threshold to make the decision.

If its 10 months ago we do not think this customer would repeat.

The adaptive toolbox

The collection of heuristics and building blocks
an individual or a species has at its disposal for constructing heuristics,
together with the core mental capacities that building blocks exploit.

Where do heuristics and their underlying core capacities come from?

1) hardwired by evolution
2) individual learning
3) selected and learned by social processes (as in imitation and explicit teaching of
heuristics)
4) the content of individual memory

Why heuristics?
Two answers have been proposed to the question of why heuristics are useful
1) The accuracy effort trade-off (see next slide)
2) The ecological rationality of heuristics (see next slides)

Accuracy effort trade-off

The classical explanation is that people save effort with heuristics, but at the cost of accuracy.
Two interpretations of this tradeoff:
(a) Rational trade-offs. Not every decision is important enough to warrant spending the time
to find the best course of action; thus, people choose shortcuts that save effort.
(b) Cognitive limitations. Capacity limitations prevent us from acting rationally and force us
to rely on heuristics, which are considered a source of judgmental errors.

Ecological rationality of heusristics

A heuristic is ecologically rational to the degree that it is adapted to the structure of the
environment
Heuristics that rely on only one reason, such as the hiatus heuristic and take-the-best
heuristic, tend to succeed (relative to strategies that rely on more reasons) in environments
with
(a) moderate to high uncertainty and (uncertainty is different than being risky. Here
you often arent able to look at history and say “it definitely will repeat”, can’t put it in
a framework where you just use history.)
 (b) moderate to high redundancy. (redundancy meaning if you get more information,
how much wiser will you get? It tells you about the same factors)

We are not used to see that it has the inversed relationship. Where is it most likely that these
rules of thumb /heuristics are ok?

In these environments (where a and b applies) it might actually be optimal.

Dealing with error

Error depends – except for the unsystematic noise term – on
1) Bias
2) Variance
where bias is the difference between the mean prediction and the true state of nature and
variance is the expected squared deviation around this mean.
Variance decreases with increasing sample size, but also with simpler strategies that have
fewer free parameters. Thus, a cognitive system needs to draw a balance between being
biased and flexible (variance) rather than simply trying to eliminate bias. In the extreme, the
total elimination of variance at the price of higher bias can lead to better inferences.
This “bias-variance dilemma” helps to explicate the rationality of simple heuristics and how
less can be more.

Prediction Versus Fitting

Prediction takes place when the data have not yet been observed and a model with fixed
parameter values is used to predict them.
Fitting takes place when the data have already been observed and the parameters of a model
are chosen so that they maximize the fit (such as R2).
In general, the more free parameters a model has, the better the fit, but this does not
hold for predictions. In a large world where parameters need to be estimated from small or
unreliable samples, the function between predictive accuracy and the flexibility of a model
(e.g., number of free parameters) is typically inversely U-shaped.
Both too few and too many parameters can hurt performance. Competing models of
strategies should be tested for their predictive ability, not their ability to fit already
known data.

Fit a model to the data. However, is the model valid? Does it tell you something about the
future? Should go with a less complicated model.

Four classes of heuristics (1)

1) Recognition-based decision making
Recognition heuristic: If one of two alternatives is recognized and the other is not, then infer
that the recognized alternative has the higher value with respect to the criterion.
E.g. name recognition of Swiss cities is a valid predictor of their population. If I mention 10
cities and you recognize two of them, it’s likely that those two are the largest (a heuristic)
E.g. in predicting federal and state elections in Germany forecasts based on name recognition
were almost as accurate as interviewing voters about their voting intentions.

Fluency heuristic: If both alternatives are recognized but one is recognized faster, then infer
that this alternative has the higher value with respect to the criterion.
Take-the-first heuristic: Choose the first alternative that comes to mind.
 2) One-reason decision making (looks for only one “clever” cue and bases decision on
that cue alone)
Example: Geographic profiling. The task of geographic profiling is to predict where a serial
criminal is most likely to live given the sites of the crimes. profiling. They tested the circle
heuristic, which predicts the criminal’s most likely location in the center of a circle drawn
through the two most distant sites of crime. It relies on one cue only, the largest distance. In a
comparison with 10 other profiling strategies, the heuristic predicted the locations best.
Complex profiling strategies appear to become more accurate if the number of crime
locations known is nine or higher.

Example: Sequential heuristics predict consumer choices well. Heuristics are important
early in the decision process to form a consideration set, which consists of eliminating most
products from further consideration. Once the consideration set is formed, consumers
evaluate the remaining options more carefully.
End of an example: …the tree was more accurate in predicting actual heart attacks than the
HDPI: It sent fewer patients who suffered from a heart attack wrongly into a regular bed and
also nearly halved physicians’ high false-alarm rate. Last but not least, the tree was
transparent, easy to memorize, and easy to modify, and was accepted by physicians who
disliked relying on a logistic regression they barely understood.

The value added is that if people that are using it can see what happens, it’s not a blackbox.
They can see the reasoning in it - it makes sense to do this and this.

If you don’t see the logic in the rules, then you’re less likely to believe them.

3) Trade-off heuristics
Tallying: Whereas take-the-best ignores cues (but includes a simple form of weighting cues
by ordering them), tallying ignores weights, weighting all cues equally. It entails simply
counting the number of cues favoring one alternative in comparison to others.
1/N rule: Allocate resources equally to each of N alternatives. Non-intended results in
relation to one’s own kids (the first and the last are favored by this rule, as they are the only
having a period “alone”. If this heuristic is used, the kid in the middle suffers).

4) Social intelligence
Less-is-more effects are larger in group decisions than in individual decisions.

Social heuristics. Example of the default heuristic: Although most citizens profess that they
approve of organ donation, relatively few sign a donor card: only about 28% and 12% in the
United States and Germany, respectively. In contrast, 99.9% of the French and Austrians are
potential donors. These striking differences can be explained by the default heuristic. In
explicit-consent societies such as Germany, the law prescribes that nobody is a donor unless
one opts in. In presumed- consent societies such as France, the default is that everyone is a
donor unless one opts out. Social heuristics are about following the norm. Why do we behave
so differently here than in Vietnam/Brazil/etc.? Because of norms (also culture etc. but
mostly social heuristics saying how we should behave).

Moral behavior. Although moral behavior has long been attributed to conscious reflection,
reasons are typically used to justify behavior after the fact and that the causes are mostly
unconscious or intuitive. These unconscious causes are often social heuristics, such as
imitating the behavior of peers in order to gain acceptance by the group. This perspective on
moral behavior is different from assuming that people have internalized specific moral rules
such as don’t steal and don’t kill. We are not supposed to murder/steal/lie. We may not have
a moral compass, however, we follow the norm of moral behavior.

End remark
“The more unpredictable a situation is, the more information needs to be ignored
to predict the future”
Main points:
Heuristics can be more accurate than more complex strategies even though they process
less information (less-is-more effects).
A heuristic is not good or bad, rational or irrational; its accuracy depends on the structure
of the environment (ecological rationality).

Using heuristics might be better because we either can’t get the information, or we won’t
improve knowing the information. If uncertain/redundancy, then heuristics are optimal.

Kahneman (2009): Conditions for intuitive expertise

Intuitive expertise: when is gut feeling okay? And when would it leave you to the wrong
decision.

A definition of skilled intuition:

Simon (1992):
“The situation has provided a cue: This cue has given the expert access to information stored
in memory, and the information provides the answer. Intuition is nothing more and nothing
less than recognition”

Skilled intuition - the expert gets a cue that says, “ok with that cue, I know that this will
happen”. The expert has seen this before, given that cue, this will happen - skilled intuition.

Two approaches (1)

1. Naturalistic decision making (NDM):
… focuses on the successes of expert intuition
… grew out of early research on master chess players
… intuition is the recognition of patterns stored in memory
... members of the NDM community are typically practitioners who operate in “real-world”
organizations.
... a central goal of NDM is to demystify intuition by identifying the cues that experts use to
make their judgments, even if those cues involve tacit knowledge and are difficult for the
expert to articulate.

Example: Firefighting commanders can make good decisions without comparing options.
Recognition-primed decision (RPD) strategy is effective because it takes advantage of the
commanders’ tacit knowledge.

People in the field talk about NDM. When something burns, a firefighter extinguishes the fire
automatically. Heuristics are good.

2. Heuristics and biases (HB)

… has a skeptical attitude toward expertise and expert judgment
… Inconsistency is a major weakness of informal judgment (When presented with the same
case information on separate occasions, human judges often reach different conclusions.)
… human judgments are noisy to an extent that substantially impairs their validity
… members of the HB community are mostly based in academic departments, and they tend
to favor well-controlled experiments in the laboratory

One more born out in academic. Heuristics and biases are bad. You cannot rely on it. Ignore
some important information or you have a bias. How can that be good?

Kahneman’s skepticism is borne:

Kahneman served in the Psychological Research Unit of the Israel Defense Forces. One of
Kahneman’s duties was to assess candidates for officer training, using field tests and other
observations as well as a personal interview.

Kahneman (2003) described the powerful sense of getting to know each candidate and the
accompanying conviction that he could foretell how well the candidate would do in further
training and eventually in combat. The subjective conviction of understanding each case in
isolation was not diminished by the statistical feedback from officer training school, which
indicated that the validity of the assessments was negligible.

Kahneman coined the term illusion of validity for the unjustified sense of confidence that
often comes with clinical judgment.
On the contrary, Klein’s formative encounter was with the successful decision making of
fireground commanders.

When he looked into candidates, he thought he had a good sense - but it was just guessing, he
was wrong. Heuristics and biases = bad.

System 1 and system 2:

Intuitive judgments and preferences have the characteristics of System 1 activity:
1) They are automatic,
2) arise effortlessly,
3) and often come to mind without immediate justification.
In contrast, the deliberate activities of System 2 are controlled, voluntary, and effortful —
they impose demands on limited attentional resources.

Intuition is tied to system 1.

Which class of intuition

The two approaches (NDM and HB) focus on different classes of intuition:
1) Intuitive judgments that arise from experience and manifest skill are the province of
NDM, which explores the cues that guided such judgments and the conditions for the
acquisition of skill.
2) HB researchers have been mainly concerned with intuitive judgments that arise from
simplifying heuristics, not from specific experience. These intuitive judgments are
less likely to be accurate and are prone to systematic biases.

Kahneman focuses on simplified heuristics. He talks to a lot of candidates, thinks he know a

lot about their personality/skills etc., however, what he found didn’t make any sense - not any
improvements.
Conditions for good intuition
Two requirements:
1) Skilled intuitions will only develop in an environment of sufficient regularity.
2) There has to be an adequate opportunity to learn the relevant cues.
Thus, two conditions must be satisfied for skilled intuition to develop:
1) An environment of sufficiently high validity.
2) Adequate opportunity to practice the skill.

When is it likely that you can recognize something from your brain? When you have
experienced it several times before, remember it and have learned from it - when you’re an
expert in the field. Using it for future decisions.

Luck or valuable gut feeling

A common genre of business literature celebrates successful leaders who made strategic
decisions on the basis of gut feelings and intuitions that they did not adequately check, but
many of these successes owe more to luck than to genius.

How to distinguish?

The safe way to evaluate the probable accuracy of a judgment (our own or someone else’s) is
by considering the validity of the environment in which the judgment was made as well as the
judge’s history of learning the rules of that environment.

For one successful entrepreneur there probably has been hundred not successful. We only
hear about the top of the iceberg. It’s not representative what we see.

Algorithms or humans?
Algorithms outperform humans under two quite different conditions, so we should not
believe in experts:
1) When validity is so low that human difficulties in detecting weak regularities and in
maintaining consistency of judgment are critical. When the cues you get are very
uncertain, when the patterns are not strict. Then human intuition might not do it.

2) When validity is very high, in highly predictable environments, where ceiling effects
are encountered, and occasional lapses of attention can cause humans to fail.
Automatic transportation systems in airports are an example in that class. You
encounter it again and again, nothing to do with humans not making the right
decisions, but they get exhausted - can’t stay concentrated. E.g. traffic signals,
humans could have done that. So simple and repetative that a machine can do it as
good.

Experts versus non-experts

True experts know when they don’t know.

Non-experts (whether or not they think they are) do not know when they don’t know.

Thus, subjective confidence is therefore an unreliable indication of the validity of intuitive

judgments and decisions.
Conclusion:
When is it likely that gut feeling may be valuable?
When the task environment is “high-validity” (i.e., there are stable relationships between
objectively identifiable cues and subsequent events or between cues and the outcomes of
possible actions). Medicine and firefighting are practiced in environments of fairly high
validity. In contrast, outcomes are effectively unpredictable in zero-validity environments. To
a good approximation, predictions of the future value of individual stocks and long-term
forecasts of political events are made in a zero-validity environment.
+
Adequate opportunities for learning the environment (prolonged practice and feedback that is
both rapid and unequivocal).

Hertwig (2016): Homo ignorans - deliberately choosing not to know

Abstract:
“Western history of thought abounds with claims that knowledge is valued and sought. Yet
people often choose not to know. We call the conscious choice not to seek or use knowledge
(or information) deliberate ignorance. Using examples from a wide range of domains, we
demonstrate that deliberate ignorance has important functions. We systematize types of
deliberate ignorance, describe their functions, discuss their normative desirability, and
consider how they can be modeled. To date, psychologists have paid relatively little attention
to the study of ignorance, let alone the deliberate kind. Yet the desire not to know is no
anomaly. It is a choice to seek rather than reduce uncertainty whose reasons require
nuanced cognitive and economic theories and whose consequences—for the individual and
for society—require analyses of both actor and environment.”

Want to know?
Modern psychology has … portrayed humans as possessing an emotion-like urge to know
(Silvia, 2008) or an instinct-like “burning curiosity” (Maslow, 1963, p. 114).”
“… and economists have contended that utility maximizers always prefer more
information to less (Blackwell, 1953).
“Although humans are often portrayed as informavores, the circumstances under which
they refrain from acquiring or consulting information are many and varied.”
Focus of paper:
Our concern is deliberate ignorance, defined as
the conscious individual or collective choice not to seek or use information.

More information cannot be worse - but it actually can. Deliberate ignorance - we choose not
to know.

Types of deliberate ignorance:

Deliberate ignorance:
1) Emotion-regulation and regret avoidance device
2) Suspense- and surprise maximization device
3) Performance enhancing device
4) Strategic device
5) Impartiality and fairness device
6) Cognitive sustainability and information management device
The next slides take one at a time …
1: Emotion-regulation and regret avoidance device
Examples:
1) People may avoid potentially threatening health information because it
compromises cherished beliefs. If you could, would you like to know which date and
year you would die? It’s not obvious that everybody wants to know / not know.
2) The regulatory function of deliberate ignorance may extend to a wider range of
domains (e.g., to investors who ignore their portfolios in downturns).
3) Pay secrecy can be a firm’s strategy to hide pay inequality. Among employees,
choosing not to discuss one’s pay with one’s colleagues can be a conscious
strategy to avoid envy and its potentially detrimental effects on job satisfaction.

2: Suspense- and surprise maximization device

Example: Suppose someone is planning to spend the weekend bingeing on the new season of
her favorite TV drama. Will she appreciate a friend giving her a preview? Hardly.
People attend soccer games and read mystery novels for the drama.
Revealing the ending would spoil their fun.

3: Performance enhancing device

Examples:
1) … feedback has also been shown to reduce performance under some circumstances
(Kluger & DeNisi, 1996), such as when it causes attention to be directed away from
the task to the self, depleting cognitive resources needed for the task.
2) It has also been suggested that feedback revealing large discrepancies between
aspired-for and actual performance triggers arousal that, in turn, impairs performance.

Sometimes it might be good to get constant feedback. But if you can see that you are way
behind, it might be devastating and discourage. Or maybe it would help you get yourself
together, but it’s not obvious.

4: Strategic device
1) Gaining bargaining advantage
… bargaining situation puts negotiators in a “battle of the sexes.” If one party opts not to
know what a reasonable solution is, the burden of avoiding a stalemate rests with the
informed bargainer, who is forced to make concessions from which the ignorant party stands
to gain.
2) Self-disciplining
… nonsmokers who believe the risk of lung cancer to be high may fear that seeing lower
estimates would encourage them to smoke—and thus change their behavior in a way they
will later regret. Don’t want to see information telling consequences of smoking. Don’t want
to see information on the other car you considered buying.
3) Eschewing responsibility
Studies using the dictator game have shown that the opportunity to avoid responsibility (by
choosing to be ignorant of the recipient’s payoffs) increases the proportion of selfish choices.
If you not know, you’re not responsible.
4) Avoiding liability
… scientific communities, funding institutions, and lawmakers decide to leave some areas of
inquiry unfunded because exploring them involves profound risks to the public (e.g., research
on highly pathogenic avian influenza H5N1 viruses).
Under most rules of criminal law, it must be shown to the requisite standard that a defendant
was aware of the facts that constitute the crime in question.

5: Impartiality and fairness device

Theoretically speaking, everyone thus shielded by a thick veil of ignorance from the
temptation of pursuing their own special interests would agree on universal standards
of fairness and justice.

One example is blind auditioning in classical music. This fairly recent change in major
orchestras’ audition policies—the identity of candidates is now hidden by asking them to play
behind a screen—has increased the probability of female musicians being hired, thus,
substantially boosting the proportion of women in symphony orchestras.

Its arbitrary that 9/10 employees are men. You might believe it yourself, but it might be
unconsciously bias. Its coincidence that all employees are white. You may not know you
have a bias.

6: Cognitive sustainability and information management device

People drown in intractable amounts of information.
In an informationally fattening environment, citizens risk losing control over how they
allocate their attention.

The choice to know one fact invariably implies not knowing other facts.
Indeed, the ability to select a few valuable pieces of information and deliberately ignore
others may become a core cultural competence to be taught in school like reading and
writing.

With all the information we get, we simply need to choose and select. I deliberately choose to
read NYT. What is best? You cannot read everything.

End remark:
Would use of a heuristic process rather than expected utility maximization render the
choice of deliberate ignorance irrational?
1) Indeed, some researchers have conceptualized the heuristics that people use as error-
prone (Kahneman, 2011).
2) Another view says that even if people could implement a complex utility-
maximization calculus, they would often prefer to use heuristics to save mental
effort, at the price of sacrificing some accuracy (utility; Payne, Bettman, &
Johnson, 1993).
3) A third view suggests that heuristic processing of reasons, concerns, and motives can
result in choices that are adaptive and ecologically rational (Gigerenzer, Hertwig,
& Pachur, 2011).

TAA: Deliberate ignorance is here to stay and is in contradiction to our normal assumptions!

Thaler (book): Nudge

The authors make two claims:
1) … seemingly small features of social situations can have massive effects on
people’s behavior; nudges are everywhere, even if we do not see them. Choice
 architecture, both good and bad, is pervasive and unavoidable, and it greatly affects
our decisions.
2) … libertarian paternalism is not an oxymoron. Choice architects can preserve
freedom of choice while also nudging people in directions that will improve their
lives.

Paternalism: I know better. “You have to blabla”. Giving direction.

Libertarian: It might be better to study, but you could chose whether you want to study or go
to the bar. Try to direct what I think is the best direction.

False assumption:
The false assumption is …
… that almost all people, almost all of the time, make choices that are in their best interest or
at the very least are better than the choices that would be made by someone else.
People do less well in contexts
in which they are inexperienced and poorly informed,
and in which feedback is slow or infrequent.

Two misconceptions:
1) The first misconception is that it is possible to avoid influencing people’ choices.
Not possible: E.g. the sequence in which you get offers will make you favor the first
more than the latter.
2) The second misconception is that paternalism always involves coercion.

Examples of nudges:
1) Display of food in a school cafeteria
2) Tax compliance
3) Saving plans
4) Organ donations

Cialdini (2003): Crafting Normative Messages to Protect the Environment

Injunctive norms:
Involving perceptions of which behaviors are typically approved or disapproved
We are social animals!

Descriptive norms:
Involving perceptions of which behaviors are typically performed
A lot of people steal – don’t steal!

Highlighting descriptive norms is likely to be a counterproductive tactic in

environmental information campaigns when environmentally harmful behavior is
prevalent, but effective when the prevalent behavior is environmentally beneficial.
We appreciate cleanliness – don’t litter

Baer, et al., (2017): The business logic in debiasing

What is debiasing?
Debiasing is to take as much as possible bias out of risk decisions
in organizations by using insights from the fields of psychology.
 … as much as possible … = it is difficult to get rid of biases
… risk decisions … = being in business is risky
… insights from the fields of psychology … = forget about rational utility-maximizing
decision-making under full information

Bias:
What is a bias?
Biases are predispositions of a psychological, sociological, or even physiological nature that
can influence our decision making. They often operate subconsciously and by definition are
outside the logical process on which decisions are purportedly based.

… predispositions … = we are predisposed

… influence our decision making … = they matter!
… often operate subconsciously … = first step: awareness

Various biases (1):

Action-oriented biases
• Excessive optimism
• Overconfidence
• Competitor neglect
Interest biases
• Misaligned individual incentives
• Emotional attachments
• Differing perceptions of corporate goals

Various biases (2):

Pattern-recognition biases
• Confirmation bias
• Subjective experience
• False analogies
Stability biases
• Anchoring without sufficient adjustment
• Loss aversion
• Sunk-cost fallacy
• Status-quo bias

Various biases (3):

Social biases
• “Groupthink”
• “Sunflower management”

When you are in a group it feels nice to be consensus. Once you’re in a group, you tend to
have more extreme thoughts, as its okay to have those (you’re a group).

Sunflower management - the boss should not share his view first, then the answer will just
be: “yes sounds good boss”.

How to manage biases?:

Training is helpful to create demand for de biasing, but by itself cannot solve the problem.
The biases are often too strong to be overcome through training exercises alone.
The solution lies in designing an alternate decision process
and selecting an effective de-biasing strategy.
1) Analytical tools can be very efficient in debiasing high-frequency decisions.
2) Infrequent decisions (e.g. M&A) lack sufficient data for analytical tools to be applied.
Here, debiasing can be conducted by imposing specific, structured elements in group
discussions and group-based decisions to detect and counter emerging biases

We have to deliberately choose some forms that can kind of debias the decisions. You are
still overconfident, but you’re forced to think about things you wouldn’t think about.

Change in culture:
A systematic approach requires a cultural change.
The cultural change involves
bringing informal decision-making processes into the open
by appropriately formalizing them,
so that they may be subject to debiasing
through explicit procedural changes.

Low-frequency decisions:
Data selection is prone to confirmation bias - the selection of information that would tend to
confirm our own expectations and business goals. Data that contradict our intentions is prone
to rejection as faulty.

The use of a neutral fact base, for example, can anchor decisions in objective reference
points.
initial anonymous voting reveals concerns without the impediment of groupthink effects.
Another powerful approach is the premortem analysis.

Another debiasing technique is the formal challenger role, i.e. a devil's advocate.
Confidential voting is a way to empower every participant to challenge the group free of any
social pressure.

If a boss wants your qualified opinions, then you would say “lets meet in half an hour and
present to me why this project would be a disaster”. Forced to oppose the boss.

Debiasing in action:
1) Diagnose
2) Design
3) Implement

Be aware of risk, identify risk. Are they overconfident? Narcisistic? Etc. Be aware!
How to manage it, what to do about it?

Koller (2012): Overcoming a bias against risk

A matter of size:
The right level of risk aversion depends on the size of the investment.
CEOs making decisions about large, unique investments are typically more risk averse than
overconfident — and they should be, since failure would cause financial distress for the
company.
Repeated decisions about the many smaller investments that a company might make during
the course of a year should be risk neutral. Decisions about projects of this size don’t carry
the risk of causing financial distress. Risk aversion is also unnecessary because statistically, a
large number of projects are extremely unlikely all to fail (unless they are highly correlated to
the same risks).

There is some risk we would want to take as an organization, that we are reluctant to take. Is
the risk that you might go bankrupt or a rounding error? First, we care about, second, we
don’t.

Soures of risk aversion:

Much of the typical risk aversion related to smaller investments can be attributed to a
combination of two well-documented behavioral biases:
1) Loss aversion, a phenomenon in which people fear losses more than they value
equivalent gains.
2) Narrow framing, in which people weigh potential risks as if there were only a single
potential outcome — akin to flipping a coin only once — instead of viewing them as
part of a larger portfolio of outcomes — akin to flipping, say, 50 coins.

Many companies wind up with risk aversion at the corporate level that resembles that at the
individual level — squandering the risk-bearing advantages of size and risk pooling.

From an organization point of view, a lot of risks are small. If they are too small, you are kind
of diversified and risk neutral.

What to do?
1) Consider both the upside and the downside. We want a sub-manager to look equally
at gains and losses.
2) Avoid overcompensating for risk (too high a discount rate). We don’t want to put a
high discount rate, that is the same as risk aversion.
3) Evaluate performance on a portfolio of outcomes (not single projects). They look at
his or her decision, so you need to put incentives in, so that the mistake is okay (if you
could see the risk, it’s okay).
4) Reward skill, not luck

Campbell (2011): CEO optimism and forced turnover

”We show theoretically that optimism can lead a risk-averse Chief Executive Officer (CEO)
to choose the first-best investment level that maximizes shareholder value. Optimism below
(above) the interior optimum leads the CEO to underinvest (over-invest). Hence, if boards
of directors act in the interests of shareholders, CEOs with relatively low or high optimism
face a higher probability of forced turnover than moderately optimistic CEOs face. Using a
large sample of turnovers, we find strong empirical support for this prediction. The results
are consistent with the view that there is an interior optimum level of managerial optimism
that maximizes firm value.”

Solnick (1998): Is more always better? A survey on positional concerns

A survey on positional concerns

Survey: Can we rely on the answers? Ultimately, we are interested in what people are doing
(= actual behavior), not what they claim that they are doing.
Positional: A frontal attack on the assumption that people measure their wealth, gains, and
losses etc. in absolute terms.

Main findings:
Concerns about position were strongest for attractiveness and supervisor's praise and weakest
for vacation time.

“People care about their relative position in society for many reasons. For example, a high
standing in society can yield respect, admiration and power.

How well an individual feels that he is doing in society is typically affected more by his
relative position than by his absolute wealth.”

Significant majority went for relative positions. It depends on your position in relation or
compared to your competitors/peers/etc.

Why?
1) Envy in the form of jealousy
2) Rational - A high relative standing is crucial to achieving many desirable objectives
(Rationally it makes sense. Once we acknowledge that we are in some kind of
competition.)

Positional treadmill:
Positional externalities are said to occur when one person's action
alters an important frame of reference for others.

Positional treadmill …

… is the process by which each person strives to gain advantage, but since all are trying to
get ahead, all remain in the same relative position.

Fits nicely into this …

At any point in time, the rich tend to be happier than the poor. But over time, the proportion
of people reporting that they are happy does not increase with increases in the average
income of society.

I work out, but since everyone else also is working out, the threshold “increases”. It makes
sense to be in a treadmill, but at the same time, we have to appreciate the absolute level we
have - or else we might find ourselves in a treadmill and not going anywhere.

Why do we work so much?

It is particularly important to ask whether leisure is a positional good.

Positional concerns about income can cause people to work too many hours, giving them
higher absolute income but little change in relative income.

This dynamic is based on the assumption that positional concerns for income loom larger
than positional concerns for leisure.
This assumption seems to be correct according to the survey: “… in their pursuit of high
relative income people are unlikely to be restrained by a desire for greater relative leisure”.

Are YOU going to work many hours?

Yes, I do not want to be a loser.
No, I care about my absolute position.

Results of survey:
In their informal comments after completing the survey, respondents volunteered that their
positional choices were not motivated primarily by envy.

Many seemed to see life as an ongoing competition, in which not being ahead means falling
behind.

In their view, consistent with theorists who emphasize the instrumental nature of positional
concerns, a higher relative, standing leads to such desirable outcomes as
1) access to better jobs and education,
2) improved marital prospects
3) opportunity to pass these advantages to one's children.
Respondents' interest in their relative standing may be a rational reaction to the way the
world works.

Appreciate the absolute position you have as well.

Q for positional reflection (1)

Game theory?
How does it change when you go from absolute to relative position?
Or at least also take relative position into account …

E.g., if you gain marginally and your main competitor gain tremendously
would you then go for the small absolute gain or avoid the relatively huge loss …?
Generally, in a survival of the fittest setting with few or only one opponent – what to do?

Q for positional reflection (2)

Do you want to be a big fish in a little pond
(CEO of a small company)
(the top player for a low-ranked team)

or a small fish in a large pond?

(vice president of a large company)
(the bread-and-butter for a high-ranked team)

TED-talk with Emily: We are social animals; we need to feel we belong to something. We
need to: belonging + purpose + transcendence + story telling.

Guest lecture: Frederik and Jesper: do narcissistic CEOs rock the boat?
Why relevant / interesting?
§ Personal traits and biases influence our decisions, whether we know them or not
§ Psychology and human irrationality can explain many financial outcomes
§ CEO decisions influence many stakeholders
 § Knowing about the strengths and pitfalls of human personalities can help
organizations optimize their risk-profile and perhaps performance

Definition of the narcissism concept:

Narcissism is the degree to which an individual has an inflated sense of self and is
preoccupied with having that self-view continuously reinforced.

Definition of narcissistic supply:

Narcissistic supply is the drug to which narcissists are addicted and comes in the form of
adulation, fame, social status, power and celebrity and therefore occupational prestige is a
driver of this supply.

Definition of overconfidence:
Overconfidence is the tendency of individuals to think that they are better than they really are
in terms of characteristics such as ability, judgment, or prospects for successful life outcomes.
Sample and methodology:

Definitions of variables and estimation model:

Main findings:

Empirical findings:
Economics significance:

Robustness test: