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Behavioural Biases in ENRON

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15 views

Behavioural Biases in ENRON

Uploaded by

aiman.elahi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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NUST Business School

Fin 329 – Behavioral Finance

Assignment 1 – ENRON and Behavioral Biases

Submitted to:

Dr. Nabeel Safdar

Submitted by:

Aiman Elahi (344158)


BS ACF 21, B
Answer:

Following is an analysis of how behavioral biases – both cognitive and emotional – of key
stakeholders contributed to the demise of Enron.

Analysts’ Biases

1. Herding

Analysts, especially those of lower ability, often suppress their insights to align with peers to reduce
risk or enhance their perceived competence. In the case of Enron, it resulted in biased forecasts as
analysts tended to “groupthink”.

2. Anchoring (and Adjustment) and Primacy Effect

Best-in-class analysts continued to believe the stock was a “value” and poised to bounce back, thus
holding onto losing positions (anchoring), fueled by the first impression of growth (primacy effect).
When stocks plummeted from $97.5, analysts hoped there would be a turnaround to the reference.
Furthermore, they tended to rely too heavily on the initial information, such as when assessing
financial figures based on previously reported numbers (which were impressive) or industry
benchmarks (signaling growth) rather than on recent reports (which were fraudulent).

Investors’ Biases

1. Self-control Bias

In the mania of the dot-com run-up in stock prices, investors seemed to focus entirely on short-term
gains, overtrading and hoping to benefit from the surge in stock price, ignoring prudent long-run
financial strategies.

2. Hot hand Fallacy

Because of Enron's recent surge in stock prices and the growth frenzy surrounding it, investors
believed that their hands were hot and the company would continue an upward trend.

3. Availability Bias

When employees loaded up on company stock en masse and bullish commentary on Enron stock
prices pervaded conversation and gained popularity, negative details were easily overlooked and
easily ‘retrievable’ information was given more weight.
Employees’ (as investors) Biases

1. Confirmation and Overconfidence Bias

Enron employees, driven by confirmation bias, overinvested in company stock, rationalizing


disproportionate holdings with confidence in the firm's "big things" (i.e. confirming the existing
belief that growth was inevitable). This selective processing and a lack of diversification exposed
their savings to high downside risks.

2. Ambiguity Aversion

This bias caused employees and investors alike to believe that their employers’ stocks were less
ambiguous investments than others (due to familiarity). But this unveiled the perils of investing too
heavily in a single company’s stock. While some argue that the Enron stock was in fact more
‘ambiguous’, actors still did not scrutinize suspicious accounting practices due to ambiguity
aversion.

3. Optimism Bias and Illusion of Control

Optimism bias led Enron employees to overinvest in company stock, with 62% of their 401(k) plan
assets in Enron shares by 2000, far above average. This overconfidence, driven by a belief in the
company’s invincibility, mirrored a broader trend where employees believed that they could control
their company’s stock performance by performing well and were, thus, optimistic about it.

4. Endowment Effect

This emotional bias resulted in employees valuing what they owned i.e. company stock, higher than
actual, due to emotional attachment.

Directors’ Biases

1. Overconfidence

The deregulation of the industry fueled the directors’ overconfidence in their ability to evade
accountability and continue fraudulent reporting. This overconfidence also resulted in
underestimating default risk on debt financing the hundreds of SPEs they had created. Directors also
showed a ‘self-attribution’ bias by attributing growth to artificial growth techniques like SPEs
backed by company stock.

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