Studied in behavioural economics, hindsight bias, also known as a knew-it-all-along phenomenon or creeping determinism, is a psychological phenomenon in which individuals show a tendency of perceiving incidents that have already taken place as having been more predictable than they were before the incident happened.
Behavioural Economics According to the school of classical economics, people are intrinsically rational, looking to maximise their utility, and make decisions that are best for oneself. A behaviourist is likely to challenge this school of thought, opining that people often times work irrationally, whether on purpose or not. How should the best parts of psychology and economics interrelate in an enlightened economist's mind? One of the greatest minds of the 20th century, Mr Charlie Munger stated that- “I don't think it's going to be that hard to bend economics a little to accommodate what's right in psychology.” Humans are emotional and easily distracted beings. Consequently, decision making may or may not be made in their self-interest always. Every day, humans make decisions as basic as what amount should one pay for lunch, whether one should pursue a course, invest in gym equipment or how much should be kept aside as monthly savings to making personal finance decisions. There is a dedicated branch of economics that seeks to explain why people decide, what they decide. This branch is called behavioral economics. Your brain effects your thinking- Making Wrong Investment Decision? Blame Your Amygdala! Let us deep dive- What Is Behavioural Economics? Behavioral economics combines understandings from psychology, judgment, decision making and economics with an intent to produce an accurate understanding of human behaviour. It relates to the economic decision-making processes of individuals and institutions. The concept explores reasons as to why people sometimes tend to make irrational decisions, why and how their behaviour does not follow predictions of economic models. It should be noted that behavioural economics focuses on the observable behaviour of humans and does not have strong theoretical or normative assumptions about how an economic system/ business sector or stock market works or should work. Read: Understanding Behavioural Finance & Investment Decisions Let us further break this down with an example: Unlike the field of classical economics, in which decision-making is entirely based on logic, behavioural economics gives room to irrational behaviour and further attempts to understand reasons behind the same. Brexit, for instance is a classic example of how behavioural economics can be useful because behavioural economics can help illuminate how the narrow vote to leave the European Union (EU referendum) was influenced majorly by gut choices, as some experts suggest, as opposed to rational decision-making. The Origin Of Behavioural Economics A keen observer of human behaviour, American economist Richard H. Thaler is broadly believed to be the founder of behavioural economics. He was awarded the 2017 Nobel Memorial Prize in Economic Sciences for his significant contributions to behavioural economics. Thaler’s opinions on the branch is believed to have been inspired by notable works of Israeli psychologist and economist Daniel Kahneman and cognitive and mathematical psychologist Amos Nathan Tversky. Daniel Kahneman also won a Nobel Memorial Prize in Economic Sciences in 2002 for his brilliant work on prospect theory, which he developed along with Tversky. Thaler is best known for incorporating psychological assumptions into analyses of economic decision-making. One of Thaler’s popular ideas – Nudge: Why Move the Earth When A Nudge Can Do! Simple Solutions to Complicated Problems What Are Various Themes Of Behavioural Economics? Three prevalent themes in behavioural economics comprise heuristics, framing and market efficiencies. Why Is Behavioural Economics Important? Behavioural economics provides new ways to think about barriers and drivers to a range of behaviours. This makes it significant, as traditional economic theory does not use insights from psychology, sociology and neuroscience to explain people’s decisions. So much so, behavioural economics seems to have the power to change the way economists and policymakers think about real world problems. Must read: How To Use Psychology To Aptly React To The Coronavirus Pandemic The field also builds a bridge between economic theory and reality- a bridge based on scientific evidence coming from disciplines in behavioural science. Some experts even regard behavioural economics as a counter-revolution, which takes economics closer to its roots, based on psychological intuition and introspection wherein psychology enacts a scientific discipline that can offer much more than merely intuitions and introspection. Besides, understanding basic concepts from behavioural economics can be very useful. It can help people be better negotiators. How Does Behavioural Economics Influence Market Participants? Clearly, people don’t behave as rational, as traditional economists have assumed. They are affected by cognitive biases, are extremely influenced by other people and often practice herd mentality, have different perceptions about attitudes and behaviours. In context to the stock market, erroneous, irrational financial decisions are the result of different unpredictable reactions by market participants subject to losses and high market risks. Therefore, for decision-making, it is essential to consider all the factors in the market-which creates a place for behavioural economics besides accounting fundamentals, macro and micro-economic factors, economic projections, etc. Consider this- a sudden drop in the value of a few stocks followed by an equally rapid recovery, demonstrates that market participants did not cause such movements by rational choices but rather emotional reactions. Read: What does Fear Do to your Portfolio? Stocks that Scared Investors in 2019 No wonder Benjamin Graham, the father of value investing, and mentor of Warren Buffett the world’s best investor coined the term ‘Mr. Market.” Clearly, he understood there is more to market than numbers. Read: Are you a Growth Investor? Then You Must Wear the Hat of a Psychologist! Why Has Behavioural Economics Concept Risen Over The Years? Let us take cues from dramatic global events over the years- for instance the Great Financial Crisis of 2008 or the novel coronavirus crisis of 2020 (Global Virus Crisis, as some call it). Read: Things to Learn from Past Crises: Role of Financial Planners During Times of Crisis These could not be explained by traditional neoclassic economic models though the impact of these events has been beyond massive. Therefore, other schools of economic thought gained traction and behavioural economics was one such concept. Businesspersons seemed to make decisions based on their emotional state of mind while investors demonstrated nervousness that caused a massive sell off to an extent that circuit breakers had to be launched while. Acts of spontaneity, irrationality, impatience, and herd mentality amid incidents of recent years have paved the way for economists to believe that the human mind is a crucial key to understand economic patterns, financial decisions and eventually- market and economic stances. Do You Know Few Top Behavioural Economists? Besides the foundation setters Kahneman, Tversky and Thaler, a number of economists, and psychologists have emerged as prominent figures within the field of behavioural economics over the years- Behavioural economics enhances the explanatory power of economics as it provides it with a firm and more rational psychological basis. It surely is a way to make economics more accurate by incorporating more realistic assumptions about how humans behave. Besides, good understanding of human decision-making, its rational and irrational aspects, offers opportunities of influencing choices that take better account of how people actually respond to the context within which their decisions are made. There are various to help one not fall prey to behavioural traps, mind you, knowledge alone does not help, but an ability to look at bigger picture and through the eyes of various mental models would help one reduce the errors. Eliminating behavioural errors would not be possible or rather would one be flawless and loose the human touch? Read: All I want to know is where I am going to die so that I’ll never go there- Inversion a Power Tool
What is Regression Analysis? Regression Analysis explains the relationship between the dependent & the independent variables. It also helps to predict the mean value of the dependent variable when we specify the value for independent variables. Through regression analysis, we make a regression equation where the coefficient in the equation represents the relationship between each independent and dependent variable. Mathematical interpretation of Regression Analysis: Mathematically, regression analysis can be represented using the below formula. Y = mX + C Y - dependent variable/response variable X - independent variable/predicator variable m - coefficient C - constant or intercept In this equation, the sign of the co-efficient shows the relationship between the dependent and the independent variable. If the sign of the coefficient is positive, it means that there is a positive relationship between the dependent and the independent variable. In other words, if the value of ‘m’ is positive, then X increases and thus, response variable or dependent variable also increased. Similarly, if the sign of the coefficient is negative, it means that there is a negative relationship between the dependent and the independent variable. A negative value of ‘m’ implies that if predicator or the independent variable increases then response variable decreases. Types of Regression In machine learning, linear and logistic regression analysis are the two most common types of regression analysis techniques used. However, there are other types of regression analysis as well, and their application depends on the nature of data into consideration. Let us look at these types of regression analysis one by one. Linear Regression: Linear Regression is a basic form of regression used in machine learning. Linear regression comprises of predictor variable and dependent variable, which are linearly related to each other. Linear regression is mathematically represented as: where ‘e’ is the error in the model. The error is defined as the difference between the observed & the predicted value. In linear regression, the value of m and c is selected in a way that there is less scope of predictor error. It is important to note that the linear regression model is prone to outliers, and one should be careful not to use linear regression in case the size of the data is enormous. Logistic Regression: Logistic regression is used when data is discrete. By discrete, we mean that the data is either 0, 1, true or false. Logistic regression is applied in such cases where we have only two values. It represents a sigmoid curve which tells the relationship between the dependent and independent variable. In the case of logistic regression, it is essential to note that data, in this case, should be extensive, which almost equal chances of values to come in target variable. Also, there should be no multicollinearity between the dependent and the independent variables. Ridge Regression: Ridge Regression is used when the correlation between independent variables is high. The reason is that for multi-collinear data, we get unbiased values from least square estimates. But in the case of multi co-linearity, there could be some bias value. Thus, in case of ridge regression, we introduce a bias matrix. It is a powerful regression method where the model is less prone to overfitting. Mathematically, it is represented as: Lasso Regression: Lasso Regression is amongst the type of regression in machine learning that performs regularization and feature selection. It does not allow the absolute size of the regression coefficient. Thus, it results in the coefficient value to get nearer to zero, which does not possible using Ridge Regression. In Lasso regression, the features that are required is used and remaining are made zero. Thus, the chances of overfitting get eliminated. In case, the independent variables are highly co-linear, the n lasso regression picks one variable, and the other variable shrinks to zero. Polynomial Regression: Polynomial regression is a type of regression analysis technique which is similar to multiple linear regression with little changes. In this technique, the relationship between the dependent and independent variable is denoted by an n-th degree. In polynomial regression, one fits a polynomial equation on the data using a curvilinear relationship between the independent and dependent variables. θ0 is the bias or constant θ1, θ2, θ3… θn are the weights in the equation N is the degree of polynomial Bayesian Linear Regression: Bayesian Linear Regression uses the Bayes theorem to find the value of regression coefficient. In this technique, the posterior distribution of the features is determined instead of finding the least squares. Bayesian Linear Regression is similar to linear regression and ridge regression, however, it is much simpler than Simple linear regression.
Business Ethics Business ethics or corporate ethics dictates the policies and best practices that address ethical morals and hardships faced while operating a business. The best practices or code of conduct are applicable to all stakeholders associated with the corporate including individuals and the entire organization and how the stakeholders should conduct themselves to maintain an ethical decorum and legality while running a business. A clearly defined business ethics basic guideline helps taking decisions when the company or an individual stakeholder faces an ethical predicament. Need for Business Ethics “Ethics is knowing the difference between what you have a right to do and what is right to do” said by Potter Steward (former American lawyer and judge) The concept developed in 1960s-70s as globalization started taking world business to the next level. With rising interaction and an increasing focus on customer satisfaction, respecting cultural norms, social causes started to become an integral part of the process to connect a chord with the customers. For adding maximum value, corporates started following practices that showcase honesty, transparency, equality, integrity, loyalty, respect, compassion, and fairness. It also assisted in building brand value or goodwill in the market, along with creating a trust level with customers or clients. As a company expands, its communication within existing stakeholders and new stakeholders increases. For the business to operate smoothly, rules and regulations set by the company help the stakeholders to follow ethical guidelines and conduct themselves virtuously with each other. Business ethics also supports fair practices being conducted in the business and adhering business commitments. The best practices assist in deciding the right path and not to take a wrong path for immediate business gains. It ensures that when two entities or individuals carry out a business deal, there is fairness maintained in the agreement. For example, suppose a TV manufacturing company expects quality spare parts from its suppliers in a given time, the suppliers are liable to remain committed to the business deal i.e. to provide spare parts that have all gone through quality checks, and not a single defective part should reach the manufacturer which may lead to production hassle or customer loss for the manufacturer. If a supplier fails to comply with quality issues or time commitment, the manufacturer can experience considerable criticism from its end-users. Another example would be that of insider trading. Insider trading is the purchasing or selling of a public company's stock or other securities because of access a piece of nonpublic information regarding the company. For example, a director or a stakeholder of a publicly traded company gets to know that the company is set to announce a development that may trigger the share price of the company comparatively higher. On the basis of the information, the said stakeholder buys a share of a certain amount at lower prices and once the price goes up, sells them making a huge profit. The practice is illegal as all stakeholders who possess shares of a publicly traded company, were not aware of this development and only a few sitting inside the company could access this data and earn profit whereas a fair practice calls for information to be used only when it’s available for all shareholders associated with the company. How to ethically frame a code of conduct? While framing a code of conduct, an organization must take into consideration that the guidelines should take into considerations societal responsibilities and causes and should be virtuous. Four schools of thoughts have been in use to frame business ethics, including deontological, utilitarian, virtuous, and communitarian approaches. Deontological: The theory focuses on framing code of conduct on the basis of “duty” or obligations irrespective of the consequences that will stem out from following the code of conduct. The theory had been promoted by Immanuel Kant, who believed that morality arising from respect for one another, and the proper behavior should be the underlying factor for ethical reasoning. Utilitarian: The Utilitarian approach calls for actions that will lead to the ideal outcome for a given business scenario or problem. The actions will be based on a greater good with less impact on any stakeholder involved. However, there has to be clarity in the ethical line of reasoning on what is considered best and why, as the term “best” can be relative for each stakeholder involved. Virtue Ethics: This point of view focuses on the virtue that will be obtained from the actions taken. The actions will focus on the fact that the result obtained is desirable without being connected with any certain behavior or decisions. Hence, the behavior has to be rational and virtuous to ensure it is valid, beneficial, and valuable. Communitarian: In this perspective, the individual decision-maker ask about the duties owed to the communities in which they participate. This is a relatively simple frame of reference, where the individual decision maker will recognize the expectations and consequences of a given decision relative to the needs, demands and impacts of a certain preferred community. Here are more examples Conflict between company stakeholders: In case of conflict between two stakeholders in an organization, it is always advisable to treat the matter with utmost impartiality. Giving preference or being partial to any one party is considered to be unfair to the other party. This demonstrates unethical conduct. Management team or supervisor should provide solutions to the problem, which is fair and ethical to both the parties. An unfair final decision will ultimately hold the organization, and the supervisor jointly responsible for the adverse effect. Transparency while dealing with shareholders or customers: The Company should always be transparent regarding its dealings. Whether with shareholders or customers, the information provided on any development or about the company and its products should always be accurate and real. The disclosures should not be wrong or partial for attaining capital gains. If a company engages in providing incorrect material or partially disclosed information, it is considered to be unethical as the customers or shareholders may experience loss based on the wrong information. For example, a food and beverage company are expected to declare the name of its ingredients while labeling the product. If any discrepancy is found in labeling, the entire lot of that product is recalled from the market, as intake of that product may lead to health hazards for the consumer. Such incidences lead to business loss and goodwill of the company. Equality in the wage system: An organization should follow an unbiased wage system where discrimination regarding gender, race, or LGBTQ should not take place.
Jury refers to a body of able persons who have sworn to deliver a verdict on a matter submitted to them. They take the evidence into check and make sound judgements pertaining to a case. A jury is expected to be a fair and unbiased body.