Availability and overconfidence biases: a study over Brazilian small companies.

Author:Fernandes, Jose Luiz Barros
Position:Report
 
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  1. INTRODUCTION

    Companies have decision-making processes typically involving individual judgments to solve problems, and this process is influenced by cognitive biases which are intrinsic to the decision-maker.

    Traditional financial theories are based on the assumption of investor's rationality; however, they are not able to explain every phenomenon in the financial field. Behavioral finance seeks to explain the behavior of financial investors not based on reason alone, since some deviations from rational behavior cannot be dissociated from the human nature and they must be considered in the economic context.

    This work verifies the deviations from strictly rational behavior of small and micro entrepreneurs in the automotive sector evaluating the foundation of their decisions, taking into account the behavioral theory. We specifically verify the existence of two biases: availability and overconfidence. We evaluate if they can generate a direct impact on the entrepreneurs' decisions. We also provide a comparison of the previous results with the ones obtained from a sample of undergraduate students.

    Our results provide a clear support to the existence of the availability and overconfidence biases. Moreover, an interesting negative correlation among those biases was also found.

  2. THEORETICAL BACKGROUND

    Behavioral finance is the literature stream that incorporates psychology and sociology in economics to study the behavior of financial investors, trying to explain the anomalies that cannot be explained by the traditional financial models. In this study, we focus on two biases quoted in the literature: overconfidence and availability.

    Overconfidence is the individual belief of considering ourselves with skills above-average. This bias can override the rational aspect of human being; however, it does not always generate negative outcomes. Kyle and Wang (1997) found that the trader who has this bias can generate increased profitability compared to the competitor merely rational. Barber and Odean, (2001) found that men are more overconfident than women. Burnside et al (2010) offer an explanation for the forward premium puzzle in foreign exchange markets based upon investor overconfidence and availability.

    Overconfidence is not just among financial investors. Polls report that 80% of people believe to have above average skills when they refer to driving skills, sense of humor, relationships with other people and leadership. Hirshleifer (2007) posits that availability cascades and ideological replicators have powerful effects on regulatory outcomes.

    Overconfidence is also present in the corporate world as shown in Malmendier and Tate (2005), Scheinkman and Xiong (2003). Typically this bias influences trades and prices as investors believe that their proposals are better and more reliable, avoiding the achievement of an analysis with greater precision. This fact generates a great number of trades thus increasing their risk and may lead to some high prices which are not due to the actual value, but to the over enthusiasm of investors.

    On the other hand, availability bias posits that decisions are based on the degree of ease or difficulty that related information arises in the decision maker's mind. People tend to base their decisions on...

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