Morning Knowledge /3. BehaviorNICOLA GENNAIOLI SAYS THAT COGNITIVE AND BEHAVIORAL BIASES CAN EXPLAIN THE BUMPY TRENDS OF FINANCIAL MARKETS AND OTHER PARADOXES. BUT CAN THEY ALSO EXPLAIN TODAY'S REACTIONS TO THE CORONAVIRUS OUTBREAK?
Decision makers, according to the concept of representativeness, tend to overemphasize the representative features of a group or a phenomenon. These are defined as the features that occur more frequently in that group than in a baseline reference group.
After observing strong earnings growth – for example - analysts think that a firm may be the next Google. “Googles” are in fact more frequent among firms experiencing strong growth, which makes them representative. The problem is that “Googles” are very rare in absolute terms. As a result, expectations become too optimistic, and future performance disappoints. That’s the reason, according to Bocconi Professor of Finance Nicola Gennaioli, why investors would be better off not following analysts’ advice!
Representativeness helps describe expectations and behavior in different domains, not only in financial markets. “In a classical example, we tend to think of Irishmen as redheads because red hair is much more frequent among the Irish than among the rest of the world”, Prof. Gennaioli says. “Nevertheless, only 10% of Irish people are redheads. In our work, we develop models of belief formation that embody this logic and study the implication of this important psychological force in different domains”.
And in today’s bear market, do you think that some of these behavioral biases are at play?
by Fabio Todesco