This paper was prepared for John B. Taylor and Michael Woodford, Editors

8

There appears to be much more to money illusion than just anchoring; people associate nominal

quantities with opinions about the economy, anticipated behavior of the government, fairness, and

prestige, opinions that are not generally shared by economists, see Shiller (1997a,b).

11

stressed real quantities.  The quantities that were shown in the question (whether nominal

or real) may have functioned as anchors.

8

Mental Compartments

Related to the anchoring and framing phenomena is a human tendency to place particular

events into mental compartments based on superficial attributes.  Instead of looking at the

big picture, as would be implied by expected utility theory, they look at individual small

decisions separately.

People may tend to place their investments into arbitrarily separate mental com-

partments, and react separately to the investments based on which compartment they are in.

Shefrin and Statman (1994) have argued that individual investors think naturally in terms

of having a “safe” part of their portfolio that is protected from downside risk and a risky part

that is designed for a chance of getting rich.  Shefrin and Thaler (1988) have argued that

people put their sources of income into three categories, current wage and salary income,

asset income, and future income, and spend differently out of the present values of these

different incomes.  For example, people are reluctant to spend out of future income even if

it is certain to arrive.  

The tendency for people to allow themselves to be influenced by their own mental

compartments might explain the observed tendency for stock prices to jump up when the

stock is added to the Standard and Poor Stock Index (see Shleifer, 1986).  It might also help

explain the widely noted “January effect” anomaly.  This anomaly, that stock prices tend to

go up in January, has been observed in as many as 15 different countries (Gultekin and

Gultekin, 1983).  The anomaly cannot be explained in terms of effects related to the tax

year, since it persists also in Great Britain (whose tax year begins in April) and Australia

(whose tax year begins in July), see Thaler (1987).  If people view the year end as a time of

reckoning and a new year as a new beginning, they may be inclined them to behave

differently at the turn of the year, and this may explain the January effect.

A tendency to separate out decisions into separate mental compartments may also be

behind the observed tendency for hedgers to tend to hedge specific trades, rather than their

overall profit situation.  René Stulz (1996, p. 8), in summarizing the results of his research

and that of others on the practice of risk management by firms, concludes that:

It immediately follows from the modern theory of risk management that one

should be concerned about factors that affect the present value of future

cash flows.  This is quite different from much of the current practice of risk

management where one is concerned about hedging transaction risk or the

risk of transactions expected to occur in the short run.

---

9

Recent surveys of hedging behavior of firms indicates that despite extensive development of

derivative products, actual use of these products for hedging is far from optimal.  Of the firms cited

in the Wharton/study, only 40.5% reported using derivatives at all. On the other hand, Dolde (1993)

surveyed 244 Fortune 500 companies and concluded that over 85% used swaps, forwards, futures or

options in managing financial risk. Nance, Smith and Smithson (1993) in a survey of 194 firms

reported that 62% used hedging instruments in 1986. These studies concentrated on rather larger

companies than did the Wharton study.  Overall, these studies may be interpreted as revealing a

surprisingly low fraction of respondents who do any hedging, given that firms are composed of many

people, any one of whom might be expected to initiate the use of derivatives.

12

The Wharton/CIBC Wood Gundy 1995 Survey of Derivatives Usage by U.S. Non-

Financial Firms (Bodnar and Marston, 1996) studied 350 firms:  176 firms in the

manufacturing sector, 77 firms in the primary products sector, and 97 firms in the service

sector.  When asked by the Wharton surveyors what was the most important objective of

hedging strategy, 49% answered managing “volatility in cashflows,” 42% answered

managing “volatility in accounting earnings,” and only 8% answered managing “the market

value of the firm” (1% answered “managing balance sheet accounts and ratios”).  Fifty

percent of the respondents in the survey reported frequently hedging contractual

commitments, but only 8% reported frequently hedging competitive/economic exposure.

It is striking that only 8% reported that their most important objective is the market

value of the firm, since maximizing the market value of the firm is, by much financial

theory, the ultimate objective of the management of the firm.  It is of course hard to know

just what people meant by their choices of answers, but there is indeed evidence that firms

are driven in their hedging by the objective of hedging specific near-term transactions, and

neglect consideration of future transactions or other potential factors that might also pose

longer run risks to the firm.  In the Wharton study, among respondents hedging foreign

currency risks, 50% reported hedging anticipated transactions less than one year off, but

only 11% report frequently hedging transactions more than one year off.  This discrepancy

is striking, since most of the value of the firm (and most of the concerns it has about its

market value) must come in future years, not the present year.

9

Overconfidence, Over- and Under-Reaction and

the Representativeness Heuristic

People often tend to show, in experimental settings, excessive confidence about their own

judgments.  Lichtenstein, Fischhoff and Philips (1977) asked subjects to answer simple

factual questions (e.g., “Is Quito the capital of Ecuador?”) and then asked them to give the

probability that their answer was right:  subjects tended to overestimate the probability that

they were right, in response to a wide variety of questions.

Such studies have been criticized (see Gigerenzer, 1991) as merely reflecting nothing

more than a difference between subjective and frequentist definitions of probability, i.e.,

critics claimed that individuals were simply reporting a subjective degree of certainty, not

the fraction times they are right in such circumstances.  However, in reaction to such

criticism, Fischhoff, Slovic and Lichtenstein (1977) repeated the experiments asking the

---