FINANCE QUIZ 4 (10-12), Finance Quiz 5

In 2020 a judge in Chicago convicted Navinder Sarao who was implicated in playing a role in the "flash crash" of 2010. What was his illegal behavior?

Spoofing or placing orders to create demand then canceling them before execution

Lessons from experimental bubble markets cont. ii.

•Although standard and lottery assets have identical expected values, traders were willing to pay more for lottery asset. •Suggests that traders may be subject to probability judgment error (overweighting small probabilities). •Another possible explanation is that speculation or gambling plays into how people determine what they will pay to acquire an asset. -Willing to pay more for lottery asset because they become more risk taking as trading heats up. -Researchers found that bubbles increase when more cash in a market.

Lack of understanding cont.

•As is well known, there is a low probability (especially using U.S. data) that bonds will outperform stocks over a long horizon. •Probability however rises as the horizon shortens, and once we are down to one year it's not far from a coin flip. •Experimental evidence: average allocation going to stock fund was higher when people were shown 30-year return distributions vs. one-year return distributions . •Argued to be because of loss aversion.

Explanations: Procrastination and limited self-control

•Consider a choice between 2 amounts of money: a small amount at t and a bigger one at t+1. •When t is far off people often prefer bigger reward. •When t hits zero (now vs. future), people often prefer smaller more immediate reward. •This is inconsistent with a constant discount rate - but consistent with hyperbolic discounting.

Trust

•Contrary to the predictions of non-cooperative game theory, trust and reciprocity are reported in simple games. •Results of ultimatum and dictator games commonly indicate that people are not purely selfish.

Homo economicus

•Decision-makers in finance theory are rational and self-interested. •Real people care about others (other-regarding preferences). •Experiments have been used to provide insights into these issues.

Where were the directors?

•Directors of Enron seemed to rubber-stamp anything management brought before them. •They were very highly paid with average compensation of $380,000 in 2000. •Did Enron board monitor or strive to please management? •It was a large board with a majority of skilled outsiders.

Status quo bias and saving

•Insufficient saving can also be driven by status quo bias: -For example, if you are not enrolled in an automatic savings plan (e.g., a 401(k)), status quo bias says don't bother (do nothing) -But, if you are enrolled, status quo bias says stay in -Later we will see how this can be used to improve outcomes

Who is more fair?

•More variability is shown across cultures in the field than with student populations. •Cross-cultural experiments suggest that the economic organization of a culture may be an important factor. •More generosity is reported in cultures with more active exchange.

Significant amounts are sent

•Most often, the proposer sends more than zero. -Typically, offers are around $4 •Rejections by responders are not as common as might be expected, except for low offers. •Was this because of altruism or fairness? •Was generosity strategic? •But what about perception of self? -"I am a good person so I send money."

A growing trend in industry

"Fidelity Institutional Retirement Services, Citistreet, JP Morgan/America Century Retirement Plan Services, Putnam Investments and Vanguard Group are planning to roll out a feature that would allow participants to commit to automatic contribution increases, which would occur either periodically or in concert with salary increases, when signing up for 401(k) plans."

Solomon Asch

Conducted famous conformity experiment that required subjects to match lines.

In this game subjects are anonymously paired. The decision-maker is given some money and decides how much to send the other player. The second player makes no decision. What is this game called?

Dictator game

Which of the following statements is false?

Emotions include physiological elements. Moods are about something, like a person or situation. (ANSWER) An emotion is not the same as a mood. Emotion and cognition cannot be separated.

Regret even gets Nobel prize winners!

Harry Markowitz

After the 2008 financial crisis regulators attempted to fix some of the problems that came to light, such as flaws in the rating process for new issues. Which of the following is currently true about bond ratings?

Issuers pay for ratings so they shop around to find the most favorable one.

Stock M has a beta of 1.0 and the standard deviation of its returns is 14%. Stock N has a beta of 1.4 and the standard deviation of its returns is 12%. Which stock has more total risk?

Stock M.

Which of the following sequences is more likely to occur when a fair coin is tossed? (i) HHHHHH (ii) HTHTTH

They are equally likely.

Which of the following statements regarding the small firm effect is true?

This effect predicts that small capitalization portfolios beat large cap.

A rational explanation for home equity bias is an information advantage.

True

Growth stocks have high price-to-earnings ratios.

True

For a person who is _________, the expected utility of the prospect is greater than the utility of expected wealth. This person would accept a fair gamble.

a risk seeker

True _____ involves no risk.

arbitrage

"Economic man" or homo economicus is rational and self-interested. But, most people have other-regarding preferences. This means that most people

are concerned about the welfare of others.

A behavioral explanation for the equity premium puzzle is called myopic loss aversion. With myopic loss aversion investors

are loss averse and evaluate their wealth position about once a year.

Which of the following is a benefit of a defined benefit plan?

avoidance of market risk

Many companies including Apple, ExxonMobil and Ford shut down or suspended their operations in Russia in response to its invasion of Ukraine. Investors have strongly voiced support for such decisions. This is an example of

conscience investing.

The primary provider of internal discipline to managers is the

corporate board.

One market puzzle is the finding that stock prices move too much to be predicted by the present value of future dividends. This is called

excess volatility.

After the 2003 settlement between Wall Street securities firms and regulators, securities firms struggled to make research profitable. True or false: As a result, analysts have become less bullish on the firms they follow.

false

Herding cannot be rational.

false

I am offered a bet in which I pay $100 to predict whether a coin toss gives heads or tails. If I predict correctly, I get $250 and, if I don't, I get nothing. If am risk averse, I definitely will not take this bet.

false

Psychology studies find that preschool children from wealthy families are more charitable than children from less wealthy families.

false

Recent research reports on financial misconduct rates across major U.S. cities. Atlanta is at the bottom of the list and is one of the worst cities when it comes to financial misconduct.

false

According to the __________ people buy assets at prices they know are too high because they believe someone else will pay even more.

greater fool theory

According to Jason Zweig, a Wall Street Journal writer, wild trading ideas sometimes just feel right. Even when we think we are making decisions based on data and logic, often we are actually making decisions based on

gut feelings

ill has the following utility function: u(w) = w^0.5 or the square root function. Using expected utility, which prospect is preferred? P1(0.40, 100, 10,000) P2(0.50, 64, 14,400)

ill has the following utility function: u(w) = w^0.5 or the square root function. Using expected utility, which prospect is preferred? P1(0.40, 100, 10,000) P2(0.50, 64, 14,400)

Overconfidence can take different forms. Which of the below is NOT a form of overconfidence?

illusion of control miscalibration better than average effect All of the above are forms of overconfidence. (ANSWER)

Emotion is not all bad because

it can make it easier to make a good decision by improving problem solving.

For a person who is _________, a gain adds less to utility than an equal size loss subtracts from it.

loss averse

Sometimes people have the tendency to think that their knowledge is more accurate than it really is. This is called

miscalibration.

Stanley Milgram

obedience to authority; had participants administer what they believed were dangerous electrical shocks to other participants; wanted to see if Germans were an aberration or if all people were capable of committing evil actions

Many people suffer from present bias. What can be a result?

procrastination insufficient saving poor health choices all of the above. (ANSWER)

When a firm first offers its stock to the public through an IPO, we often observe a first day pop in market prices. Who loses?

retail investors who pay too much in the aftermarket.

With __________ we observe negative correlation in returns.

reversal

_____________ is when you know what the outcomes could be and can assign probabilities to the possible outcomes.

risk

Correlated opinion on value that is not related to fundamental information and can move markets is called ______________.

sentiment

Disposition effect

tendency to sell winners too early and hold on to losers too long. •If anything, because of tax reasons, you should be quicker to take losses. •This may be driven by regret: if you cash in a loser you have to face the fact that you made a mistake.

Studies of employees who manage their own money find that

the majority are momentum chasers.

Which of the following is not an example of social conformity?

trading on House Money

In "Dishonesty: The Truth about Lies" Dan Ariely reported that the majority of people were not honest about the number of math problems they answered correctly in a math game called the Matrix Experiment.

true

The stock market cares about climate change even if some people do not believe it is real. When a firm reports negative climate change there is evidence of an impact on its stock price.

true

To be assured of reaching retirement savings targets, one article by Jason Zweig of the WSJ recommended that you should save a total of ____ times the annual income you want when you retire.

twenty-two

Freddie completes a survey that uses a confidence interval approach. He is asked to construct 80% confidence intervals. Of the 100 questions on the survey, Freddie's intervals include the true answer 86 times. We conclude that Freddie is

underconfident.

Mood and risk attitude

•But it is not clear there is a simple way to characterize relationship between mood and risk attitude. •When someone is in a poor mood does he take more risks or fewer? -Answer probably depends on context and individual's personality

SDIP programs cont.

•Goal of such programs is to not only convince people to save.. -But also to convince them to save a sufficient amount for a properly funded retirement •Firms can employ financial counselors who try to persuade workers to sign up for a program of deferral increases... -Which only begin to kick in at a future date

Internet revolution

•In 90s stock prices for some corporations soared. •Valuations seemed to be disconnected from underlying fundamentals, but many argued they were warranted because it was a "new economy." - Long periods of growth were to be expected. •Focus will be on Enron to illustrate some particular pitfalls. - Did this corporation's board and financial analysts have investor welfare in mind?

Ultimatum game

•In an ultimatum game subjects are paired but cannot see each other and never learn other's identity. •First mover (proposer) will be given some money and decides how much to send to other (responder). •Responder can accept or reject offer. •If offer is rejected, neither gets anything.

Lessons from experimental bubble markets cont.

•In some experiments, two assets are traded in order to investigate whether pricing differs across the assets. •One study allowed trading of two assets: a standard asset and a "lottery" asset. •Second asset is referred to as lottery asset because its payoffs are similar to a lottery. -Payoff usually zero, but 4% of the time asset earns large dividend payment of $18.00

Historical P/E ratios

•Market levels out of line with earnings levels. -Seen by looking at P/E ratio •Market run-up during this bull market was unprecedented. •Three other major peaks in stock market history: 1901; 1929; and 1966. -From these peaks subsequent performance turned out to be sub-par.

Path Dependence

•Recall that Prospect theory was developed to describe one-shot gambles. •But, many decisions are sequential. •Evidence suggests that decisions are affected by prior gains and losses so that they are path dependent.

Anchoring vs. representativeness iii.

-Even more dark clouds. -Now you coarsely transition - thinking that "it's going to rain for sure!" -What is reality? Never 0% or 100%. New information should alter probabilities but a flip-flop doesn't make sense. •Coarse calibration has been used to explain tendency for prices to trend and eventually reverse.

Form of a value function

-Function used often is: v(z) = zα for z≥0, 0<α<1 v(z) = -λ(-z)β for z<0, l>1, 0<β<1 -Kink at origin is from λ. -Value function (not utility) so v is used. -Ask people about 50/50 coin toss where loss is $50 and gain is unknown. -What gain would make people indifferent between gamble or no gamble? •Many say about $125, which implies value of 2.5 for λ. •Value above one reflects loss aversion.

Predictability and grades

-High school average GPAs: 3.44 (sd = 0.36); GPA achieved at college was 3.08 (sd = 0.40). -One student was chosen: high school GPA of 2.2. -People underestimated mean regression for this low-achiever. -Average prediction was 2.03 but average GPA was 2.7. -For high achiever in high school with GPA of 3.8, the prediction was 3.46 and the actual was 3.30.

Development of prospect theory

-These and other results led to prospect theory as an alternative to expected utility theory. -Key precepts: •Value function is in terms of gains or losses •Risk aversion in positive domain •Risk seeking in negative domain •Loss aversion

Substance of emotion

1.Cognitive antecedents - belief trigger 2.Intentional objects - about something 3.Physiological arousal - hormonal & nervous system changes 4.Physiological expressions - observable expressions 5.Valence - can rate on a scale 6.Action tendencies - urge to act

What hampers arbitrage exploitation?

1.Fundamental risk 2.Noise-trader risk 3.Implementation costs

Neoclassical economics

1.People have rational preferences across possible outcomes or states of nature . 2.People maximize utility and firms maximize profits. 3.People make independent decisions based on all relevant information.

Stock X has a beta of 1.4 and stock Y has a beta of 0.8. The market risk premium is 5.0% and the risk-free rate is 4.0%. What is the expected return for a portfolio equally invested in stock X and the risk-free asset?

7.5%

Which of the following statements is false?

A heuristic will perform best in a new or different decision environment. (ANSWER) A heuristic can be a useful decision short-cut. A heuristic uses a subset of available information. People have used heuristics for many centuries. An example is moving away from a loud sound.

You watched "Mind over money," a NOVA documentary. What was illustrated in the production?

A sad movie impacts the decision a person makes after watching it. Emotions play a role in explaining the choices people make. People will sometimes pay more than $20 for a $20 bill. All of the above were illustrated in the documentary. (answer)

Amari started with her firm 40 years ago when she was 23 years old. At that time, she opened a retirement savings plan and allocated 80% of the contributions to a stock fund and 20% to a bond fund. Since then, her allocations have not changed. What is(are) the potential problem(s)?

As she got older, she probably should have tilted away from stocks and increased his allocation to the bond fund. If she really wanted to keep the same risk exposure, she needed to rebalance as the value of his investments changed over time.

People often make decisions based on emotions relating to possible future emotions. Which of the following is a likely example of this?

Asia keeps holding onto a stock even though it has performed very badly.

Bernie Ebbers

CEO of WorldCom

A key trading rule relates to earnings announcements. The reaction to high or low earnings announcements is slow. True or false: To profit from this I would buy when a firm releases negative earnings news, and sell with positive news.

False

A person who understands the benefits of diversification will overweight local companies.

False

A positive theory tells us how people should act. Expected Utility Theory is a positive theory.

False

After Enron, WorldCom, and other debacles many employees lost their wealth because they invested heavily in the firms they worked for. Today the benefits of diversification are well-recognized and employees very rarely over-invest in their employer's stock.

False

Lusardi and Mitchell have used their "big three" financial literacy questions to evaluate the literacy of people all around the world. True or false: Americans are financially literate and over 3/4 of people answer all three questions correctly.

False

People may not save enough due to how our brains are "wired." For our ancestors, there was not much point to saving. True or False: Even with conscious effort, there is little hope that we can override our impulses because this is how we are wired.

False

Segregation of decisions means that a decision maker would separate the past from decisions to be made now. When it comes to segregation and integration of decisions we know that it does not really matter which people do because the theory is unaffected.

False

The Allais paradox is a well-known contradiction of Prospect Theory.

False

The Securities and Exchange Commission put in place limit up-limit down mechanism on individual stocks in an effort to curb market volatility. True or false: The mechanism is rarely triggered in recent years.

False

The equity premium is the extra return demanded by investors to compensate for the risk of investing in bonds.

False

Trayvon lives in Arkansas where he owns a building construction company. He invests heavily in the local favorite, Walmart. He closely follows the social media relating to Walmart. Trayvon often shops at Walmart and he feels knowledgeable about this company. From what we have learned in Behavioral Finance, this investment strategy is probably a good one.

False

We can reasonably expect that when given more choice with an increase in the number of funds offered in a retirement savings plan, most employees will save more.

False

We watched the film Dot Con. True or False: The film illustrated how the most important goal of a professional financial analyst is to provide accurate forecasts.

False

In 1984, AT&T was forced into a divesture creating seven regional bell companies. Suppose that at that time, your aunt lived here in Atlanta, was a manager at the firm, and was very optimistic about the future of the company. She chose to move all of her investment from AT&T stock into BellSouth. If you had been able to advise her at that time, based on what you have learned in Behavioral Finance what would you have told her?

I would have advised her against putting all in BellSouth.

Bernie Madoff was a highly respected and trusted investment advisor who committed the largest financial fraud in U.S. history. Which is FALSE?

Many of Bernie's clients were with him for decades. Bernie was once chair on the NASDAQ exchange. Bernie's fraud was first uncovered by an SEC investigation. (ANSWER) His firm's period of growth resulted from a Ponzi scheme.

Maria is a student at KSU. Which is more likely to be true?

Maria is a finance major. (answer) Maria is a finance major and good at picking winning stocks.

Theoretical Foundations of Efficient Markets

Market efficiency requires that only one of the following three conditions need hold: 1.Universal rationality 2.Uncorrelated errors 3.Unlimited arbitrage

Stanley Milgram's experiments are famous around the world because the results were shocking. Which of the following is a true statement regarding Milgram's results?

Most subjects conformed to the teacher's requests.

Consider a person with the following value function under prospect theory: v(w) = w1/2 if w ≥ 0 v(w) = -(-w)1/2 if w < 0 where w = wealth. Is this individual loss averse?

No.

Bernie Madoff

Operated largest ponzi scheme in American history., famous for the Ponzi Scheme in which he took billions from his investors ; responsible for largest criminal conspiracy in history; Sentenced to a life sentence.

Terrance Odean provided evidence of the disposition effect using a database of discount brokerage trading accounts. He computed the proportion of gains realized (PGR) and the proportion of losses realized (PLR) and found that

PLR < PGR.

Laurie Santos studies problems in human psychology with primates. We watched a TED film in which Laurie Santos described her research on monkeynomics. Which statement best reflects her findings?

Primates have many of the same predictable irrationalities humans do.

What is true about an investor's risk tolerance?

Risk tolerance increases with increases in wealth.

A researcher named Solomon Asch put students in groups and asked them to pick a line (from a set of three) that was the same length as a line given initially. Which is correct?

The correct answer was obvious, but students often conformed to an incorrect majority.

The trading histories for 60,000 investors during the 1990s are examined by Barber and Odean. Which of the following is true?

The greatest over-trading was by men.

In an experimental bubbles market, participants trade assets with a fixed life. We typically see prices rise well above fundamental value but crash near the end of trading. Which of the following is true?

Traders seem to prefer an asset with a small probability of a large payout.

A goal of a scheduled deferral increase program (SDIP) is to convince employees to commit to future contribution increases at regular intervals. True or False: Research indicates that they have been successful in increasing savings rates.

True

Ahmaud often holds stocks that have been losers and sells stocks that have been winners. His behavior is consistent with the disposition effect.

True

I prefer Coke to Pepsi, Sprite to Coke, and Sprite to Pepsi. My preferences satisfy transitivity.

True

In a futureless language like Chinese, the present and future are spoken about identically. As we saw in a TED talk, economist Keith Chen argues that language significantly affects the propensity to save. He argued that a futureless language has a grammatical structure that encourages positive future-oriented behavior, like saving more.

True

In the 1960s psychologists reported the results of the "marshmallow test." Small children who waited for a second marshmallow were found to have more willpower or patience. The results did not hold up over time and today this test is not believed to be a consistent indicator of life outcomes.

True

Recent research finds that people of color and women are viewed as riskier investments and are expected to underperform their peers in the mutual fund industry.

True

Researchers report long-term reversal in returns so that winners become losers and losers become winners.

True

Two fund separation occurs when investors maximize utility by combining the risk-free asset with a fund of risky assets.

True

The optimal board size will depend on the characteristics of the individual firm. However, in general, it is a good idea to include outsiders.

True.

In the trust game the responder (or trustee) can choose to send some money back to the proposer (also called the investor). Which of the following is true?

Trust always does not always pay off.

Some mistakes surrounding retirement and pensions

a.Procrastination and lack of self-control -Insufficient saving b.Information overload and inertia c.Misunderstanding asset allocation d.Diversification and 1/n heuristics -Inappropriate asset mixes

Six observable features that allow us to define an emotion are described by John Elster. Which of the following is NOT a feature he included in the list of those important in understanding the substance of emotion?

affect

The weighting function in Prospect Theory is the same as the probability in Expected Utility Theory.

false

I just tossed a coin three times and got heads every time. I think it is very likely that tails will appear next. This is an example of

gambler's fallacy.

Tran is a financial analyst who works for a Fitch Ratings. Fitch Ratings is one of the big three rating agencies, along with Moody's and Standard and Poor's. These firms generate earnings through subscriptions and fees.Tran is a(n)

independent analyst.

Brokers sometimes direct orders to particular market markets who provide compensation to the broker. As we saw with Robinhood, payment for order flow can result in

inferior execution of orders.

Potential explanations for home equity bias include

institutional restrictions. familiarity. excessive optimism. all of the above. (ANSWER)

Many people do not save enough for retirement. This could be due to

limited self-control. status quo bias. hyperbolic discounting. All of the above. (ANSWER)

The Palm IPO in 2000 seemed to suggest mispricing in the stock market. We concluded there were probably two factors. What were they?

limits to arbitrage and irrationality

The joint hypothesis problem refers to the fact that tests of market efficiency have two theories tested at the same time. The two theories are

markets are efficient and a model of returns such as CAPM.

Often people bid too much for assets in common value auctions with incomplete information. An example is corporate takeovers. Which of the following is a possible factor in explaining winner's curse?

overconfidence

In a Fortune survey, senior executives were asked to assign values between 0 (poor) and 10 (excellent) to companies in their industry. The majority of executives indicated that the most important company attribute of a company's quality was

quality of management.

Advisors ofter use questionnaires to assess a client's risk tolerance. A problem is that they don't always measure what we want to measure. This is a problem with

questionnaire validity.

Alex just lost $100,000 in Las Vegas. Now he is taking big bets because he does not want to leave the casino at a loss. This is an example of

the break-even effect.

People often value what they have more than they would if they had to go out and buy the item. This is called

the endowment effect.

A market can be efficient if

the errors investors make are uncorrelated. all traders are rational. arbitrage is unlimited. any of the above conditions is satisfied. (ANSWER)

Which of the following is a key precept of Prospect Theory?

value function in terms of gains and losses

With ___________ form market efficiency prices reflect information revealed in past prices, but not all other public information.

weak

Interpretation

§See first row (upper panel). §Management quality (i.e., good company) and value as a long-term investment (i.e., good stock) are very highly correlated. §Note high R-squared. §Executives believe that good companies are good stocks. §But no company attribute should be associated with investment value. •

Interpretation cont. ii.

§See last regression in upper panel. §Value as a long-term investment is regressed on size, book-to-market and management quality. §As before, latter strongly impacts perceived investment value. §Additionally, size and book-to-market, even accounting for their impact on management quality, independently influence perceived investment value. §In other words, big high-growth firms are representative of good investments §But opposite is true! §Is this behind fact big high-growth firms are inferior investments? •

Interpretation cont.

§See third row of lower panel. §Two firm characteristics, size and book (value) to market (price), are strongly associated with perceived management quality. §Big companies and those that have low book-to-market ratios (growth companies) are viewed as good companies §Not surprising: §Big companies have often become big because they are good (i.e., well-managed) §And growth can only come from quality

Excessive emotional turbulence

•A study looked at 80 day traders. -Tracked their daily emotional state. -And their trading profits and losses. •Those whose emotional reaction to gains and losses was most intense had the worst trading performance. •Suggests need for balanced emotions.

Trust games

•A trust game is similar to an ultimatum game in that 2 subjects are paired. •It is designed to measure trust and reciprocity. •Difference is that responder can choose to send some money back to proposer. •Amount received by responder is usually increased by some multiple (such as 3 times).

Does chasing past returns make sense?

•Academic evidence is somewhat subtle here: •There is evidence of (a little) intermediate-term momentum (3-month to 1-year returns) •But there is also evidence of reversals for longer-term returns (3-5-year returns) •So best answer to survey question is to be a slight contrarian - but one has to be careful not to surrender diversification •Absolutely fine to maximize diversification.

Agency costs

•Agency costs are incurred because managers' incentives are not consistent with maximizing value of firm. •Direct costs: -Example: need to monitor managers, including cost of hiring outside auditors •Indirect costs: -Example: managers of a firm that is an acquisition target may resist the takeover attempt because of concern about keeping their jobs, even if the shareholders would benefit from merger

Agency relationship and agency problem

•Agency relationship exists whenever someone (the principal) contracts with someone else (the agent) to take actions on behalf of the principal and represent the principal's interests. •In an agency relationship, agent has authority to make decisions for the principal. •An agency problem arises when the agent's and principal's incentives are not aligned.

Financial analysts

•Analysts are information intermediaries. •They are valuable to investors because they assimilate and disseminate information. •But research has found that analysts are too optimistic. •Shouldn't their goal be to provide the most accurate forecasts possible? We need to understand their incentives

Analysts and social forces

•Analysts avoid standing out in a crowd. •When uncertainty is low, analysts tend not to be too optimistic but when uncertainty is high, analysts are less concerned about harming their reputations. •Does this mean they follow the crowd? •Analysts are important information providers so if they irrationally follow, that would be a problem.

Conflicts of interest

•Analysts in research units may want to assist corporate finance arms by providing optimistic forecasts. •This optimism helps to sell stock that bank is currently offering, but also attracts firms who might need investment banking services in the future. •Even analysts employed by independent research firms have conflicts of interest. •Management is an important source of information about a covered firm so analysts may want to keep them happy.

Disposition effect, prospect theory and mental accounting

•Another view: some explain disposition effect by prospect theory and mental accounting. •If a security has made money from the original date of purchase it moves up along the prospect theory value function (stocks C and D) •While, if a security has lost money, it moves down along the same function (stocks A and B).

Enron

•Bankruptcy of Enron was largest U.S. bankruptcy at the time, now surpassed by the failures of CIT Group, GM, Worldcom, Wash Mutual and Lehman Brothers. •Its leaders were known for their hubris and perhaps unparalleled arrogance. •What about the other players? •Social forces may have influenced the behavior of the board of directors and financial analysts.

Some use 1/n heuristic

•Because people don't understand asset allocation (and how to diversify over asset classes), they use faulty heuristics. •Diversification heuristic: choose bit of everything. •Special case is 1/n heuristic: exactly split your choices among all n alternatives. • In present context, 1/n says if people are offered n funds in a 401(k) they will put 1/nth of their money in each fund. - True regardless of fund mix.

A success story?

•Before 2001 Enron was phenomenally successful. •In 2000, the stock peaked at $90.75. •At bankruptcy filing at the end of 2001, the stock was worth $0.25. •Shareholders and employees, many of whom had invested heavily in Enron stock in their retirement accounts, were devastated. •Could they have known that something was out of the ordinary?

Transitivity of preferences over prospects

•Consider two more prospects P3 and P4: -P3(.7, 300, 2,100) -P4(.5, 600, 2,000) •An ordering of P4 vs. P3 and P3 vs. P1 could be: •P4 > P3 and P3 > P1 •Transitivity says: P4 P1

Evidence from mutual fund manager behavior

•Consistent with familiarity bias, managers tend to favor local firms. •Average manager invests in companies that are 160-84 kilometers, or 9-11%, closer to her than the average firm she could have held. •Local preference is related to firm size: tendency to invest locally stronger for smaller firms (where informational advantage is likely to be greater).

Damasio and emotion

•Damasio provides evidence that decision-making suffers without emotion. •The neural systems for reason and emotion cannot be separated so that decision-making and emotion are intertwined. •He studies the behavior of brain-damaged patients who were emotionally flat because of frontal lobe brain damage. •The patients had average or better cognitive abilities but their emotional responses were abnormal. •They had no problems with abstract problem solving, attention, knowledge, language, or memory. •But, they couldn't make a decision or plan for the future.

Examples of emotions

•Despite lack of a unified theory of emotion, there is some agreement on what emotions exist. •Some mental states are clearly emotions: anger, hatred, guilt, pride, regret, elation, fear, joy, and love. •Emotion is worth considering because it can cause one to make bad (or good) financial decisions.

Preview of financial errors from heuristics and biases

•Diversification heuristic -Stock-bond menu influences risk taking in DC plans •Information overload -Lower participation rates for DC plans with more investment choices

What about after losses?

•Do you become more risk averse after losses? -This is snake-bit effect: "I have lost a lot from risky investments so now I am moving towards a much less risky portfolio" -And some do seem to act this way. •But some evidence (e.g., "Deal or No Deal" research) suggests greater risk taking after losses. -Consistent with prospect theory and still being distant from loss aversion kink. -Suggests you want to "break even." -After a prior loss people seem to value breaking even (break even effect) so they take risky gambles in order to try to break even.

Preview of emotion and financial decision-making cont.

•Does emotion lead people to take on more or less risk because of such non-market items as weather and World Cup success? •Can such phenomena be mapped on to the level of market?

Home bias

•Domestic investors hold mostly domestic securities. -American investors hold mostly U.S. securities -Japanese investors hold mostly Japanese securities. -British investors hold mostly U.K. securities. •In so doing they forego gains from international diversification.

What were they thinking?

•Each participant was assigned the role of the "teacher" and the "learner" was an actor. •Wires connected the electric box to the learner, but the learner only acted as if an electric shock was transmitted. •How many administered shock? •Every subject in original study administered some shock to learner.

SDIP programs cont. ii.

•Essential ingredient is pre-commitment mechanism... -Like joining a health club -Here twist would be to sign a contract to join a health club that is only opening in (say) three months •Once people get used to process of saving (seeing its wisdom), they become familiar and comfortable with the system.

Status quo bias and wandering asset allocation

•Even if people have it right and are not prone to panic... -Status quo bias can lead to insufficient changes in asset allocation over time and wandering risk exposure •Say you begin a 401(k) and you specify that you want 60% of your money to go into a stock fund and 40% into a bond fund. -If you do nothing else, over time, your risk taking will on average increase -This is exact opposite of what should be happening -You must rebalance

Experimental bubbles

•Experimental asset markets have provided new insights into how markets work. •One of most perplexing findings from this research is tendency of prices to rise far above fundamental value and then later crash. •First study to report bubbles in experimental asset markets was published in 1988. •Since then many studies have investigated factors that both mitigate and promote bubble formation.

Experimental evidence

•Experimental evidence favors emotions over prospect theory in explaining disposition effect •Experimental design was predicated on whether or not individuals have chosen their investments. -When no choice you will experience disappointment -When choice you will experience regret (which is stronger than disappointment) •So disposition effect should be stronger with choice - which turned out to be true.

Obedience to authority

•Experiments that were conducted in the 1960s have become famous around world. •A box was constructed with levers that purportedly delivered electric shocks from 0 to 450 volts. •Voltages were labeled from "slight shock" to a final designation of "XXX." •Final, ominous designation was two switches after "danger: severe shock."

Operational definition of market efficiency

•Financial markets are efficient if no one can consistently earn excess returns. Excess means... -After risk is factored in -And after costs are factored in •What sort of costs? -Transaction costs -Analysis costs

Dividends and value

•Focus on standard asset, leaving lottery asset for later. •Asset trades for twelve five-minute periods so if you buy one unit in period 1 and hold it until the end of the experiment, you would earn twelve dividends. •Expected value of dividend each period is sum of probability-weighted possible dividends: 0.48*0.50 + 0.48*0.90 + 0.04*1.20 = $0.72 •What is asset worth? -If you are risk neutral: 0.72 * 12 = $8.64 -Fundamental values in all subsequent periods can be computed just as easily by multiplying number of periods remaining times expected value of $0.72

Prospects 8 & 9 again

•Following probabilities are mapped on to this weighting function: -pr = .20; p = .26 -pr = .25; p = .29 -pr = .80; p = .64 -pr = 1; p = 1 •Say we use v(z) = z1/2. •Prospect 8: -A: .26*40001/2 + 0 = 16.44 -B: .29*30001/2 + 0 = 15.88 -A is preferred.

Myers-Briggs Types

•Four key attribute scales: -E vs. I (Extrovert vs. Introvert): How do you interact with the world? -S vs. N (Sensing vs. Intuitive): What kind of information do you notice? -T vs. F (Thinking vs. Feeling): How do you make decisions? -J vs. P (Judging vs. Perceiving): Do you act in a structured fashion or spontaneously? •Where people fall is a useful predictor of behavioral flaws like overconfidence and optimism. •The ESTP (extroverted-sensing-thinking-perceiving) personality type tends to be the least risk averse and most overconfident. •The INFJ (introverted-intuitive-feeling-judging) personality type tends to be the most risk averse and least overconfident.

Groupthink

•Groupthink is an extreme form of conformity. •Often a small group has insulated itself from the outside world. •Loyalty and common thinking is stressed in the group. •NASA was warned by a panel of experts that the Columbia had safety problems. •If you are in a group that seems to believe it is invulnerable, question it!! -Enron

Historical (realized) equity premium in U.S.

•Historically, a well-diversified portfolio of stocks has substantially outperformed fixed income securities. •Important to look at real returns which control for inflation effects. •Difference between expected equity return and fixed-income return is known as equity premium. -This is return for bearing additional risk of stocks relative to bonds or bills.

Fundamental risk

•If you think a stock is underpriced you can buy it, but you might be sideswiped by the market, industry, or idiosyncratic risk. •New information arrives all the time. •Fundamental risk arises because prices can rationally change as info arrives. •Pure arbitrage seeks to eliminate the risks. Problem: you need to find perfect substitutes

Phineas Gage

•In 1848, a 25-year-old construction foreman named Phineas Gage had an accident. •Before the accident, Phineas was a successful railroad construction manager, known to show good character and be able-bodied. •A distracted Phineas discharged an explosion that sent an iron bar through his left cheek, exiting the top of his head. •The iron bar used to explode rock was three-feet, seven-inches long and 1.25 inches in diameter, weighing 13.25 pounds.

A change in regulation

•In 1974 the Employment Retirement Security Act (ERISA) was passed. •Before then, many pension plans were underfunded (e.g., Studebaker). •ERISA does not require pensions be offered or stipulate a benefit level but it regulates pensions after they are established. •Plans must provide for vesting of pension benefits after a minimum number of years and that employers who sponsor plans satisfy certain minimum funding requirements.

Experimental bubbles cont.

•In a typical bubbles design, subjects trade an asset over a fixed number of periods. •Asset has a common dividend that is earned on all units and determined at the end of a trading period using a known probability distribution. •If risk neutrality is assumed, we can easily compute fundamental value of asset by multiplying number of trading periods by expected dividend each period. -Given risk aversion, correct value would be lower.

People do not understand asset allocation (and risk in general)

•In one experimental study, employees at a firm offering a DC pension were asked to allocate their money between two funds, labeled 'A' and 'B.' •Information presented for these funds was based on historical data for a broad U.S. stock market index and 5-year Treasury bonds. •One group saw return distributions in terms of one-year returns, and second group in terms of 30-year returns. -That is, same information was "framed" in two different ways

What do people send?

•In one study, on average subjects sent $6.36 of $10.00. •Two multipliers (3X and 6X) were used. •Reciprocity is amount returned to investors divided by amount available to responders (i.e., multiplier times amount received). •Reciprocity ratio is less than 50% most of the time so that responders kept more than they returned.

Employees become investors

•In the U.S. we have seen a huge shift to DC plans from DB. •In a defined benefit plan the employer commits to payments after retirement where the payments are determined by a formula. •In a defined contribution plan the employee and employer contribute to an account whose growth depends on contributions and investment returns. •There is no guarantee of a level of support with DC.

Behavioral explanation

•Investors think (wrongly) that dividend growth changes for a stock are permanent rather than transitory. -For this reason they overreact. -When they figure things out mean reversion sets in. -High returns are followed by low returns -- and vice versa. -Recency plays a role: recent high earnings growth makes people think that future growth is going to be higher than it actually turns out to be. •A similar story can be told for overall market.

What explains real-world bubbles

•Irrational Exuberance by Robert Shiller first came out in 2000 when Dow was approaching 12,000. •Main argument of book was that market at end of 1999 was in grip of a major bubble! •Events proved to be on Shiller's side. •Did the "greater fool theory" explain pricing? For the tulip mania, some argued preferences were the source - is a tulip like a Picasso

Herding

•It can be rational to ignore your information and follow the behavior of others. •It can be costly to determine what is best. •People are social learners.

But who's an outsider?

•It has been found that two randomly chosen people can be connected by surprisingly short chains. -Any two Americans are likely tied by chains of 5 or 6. •Many boards are interlocked, so that there are overlapping board memberships. •How would you vote on another CEO's compensation package when he is voting on yours next week?

Excess volatility puzzle

•It seems that often market movements are not obviously explained by new information. •One study examined largest stock price movements and important news events to try to ascertain connections. •First looked at major events and whether they induced major market movements. •Example 1: Japanese bomb Pearl Harbor (Dec. 7, 1941). -Market rises dramatically (up by 4.37%). •Example 2: Johnson defeats Goldwater in presidential election (Nov. 4, 1964). -Market hardly moves (down by 0.05%).

Misplaced loyalty

•Loyalty is valued by people and may be particularly valuable in business relationships. •A director might go along with a CEO because of a predisposition to obedience. •Recall electric shock experiments. -Subjects were asked to deliver electric shocks to others when they answered a question incorrectly. -Amazingly, every participant gave some shock. -Authority is quite powerful!

Industry solutions

•Many such people would be better off being directed into a special portfolio... -That is dynamically adjusted (and whose risk is altered) over time •Examples: -OneStep of Vanguard -20xx funds of Fidelity

Is equity premium too high?

•Many theorists believe equity premium is too large for actual risk. •Especially clear when we look at longer horizons: -At longer horizons stocks almost always outperform. -Plus risk of stocks declines more quickly than would be expected. -Latter is due to mean reversion of stock returns. -Many say high premium since WW2 is probably not sustainable. -Though 2008 had a large negative impact on overall postwar average!

Interpretation

•Mode is at zero - which is a good answer. •Most are momentum-chasers (64%). •A very high spike indicates many chase momentum to the point of losing all diversification. •There are some contrarians (12%) but many go too far and lose diversification. •Mean loser vs. winner percentage: -33%. •Conclusion: many people forego scope for diversification by leaning toward the momentum-chasing stock. • •

Conflicting effects

•Mood maintenance: "I am feeling good. I should walk away and enjoy this feeling." •House money: "This is the house's money. Let's have some fun and really make some money." •Likely many people are influenced by both impulses. •Though evidence is that house money dominates. •After a prior gain, people are more willing to take risk.

Opening and closing accounts

•Once an "account" is closed, you go back to zero. •Evidence that people avoid closing accounts at a loss: -Selling a stock at a loss is painful: disposition effect (to be discussed). -Companies rarely have low negative earnings but often have low positive earnings: •They manage earnings either pushing things to low positive... •Or they "take a bath" and move to high negative

Market efficiency and arbitrage

•One of main foundations of EMH is no-arbitrage condition. •If there are pricing errors (e.g., caused by irrational investors), smart-money traders arbitrage them away. •Important to remember that true arbitrage involves no risk. •No free lunches are left on the table!

People are paralyzed by too much choice

•One reason for lack of saving in context of 401(k)s is information overload. •Researchers, using data from 800,000 employees, found participation in 401(k)s went down when there was too much choice. -Participation peaked at 2 funds offered -For every 10 additional funds offered, drop in participation of 1.5-2% •For perspective, median number of options in U.S. as of 2002 was 18.

Does mood move markets?

•One study using data from 26 international stock exchanges shows good moods resulting from morning sunshine lead to higher stock returns. •Other researchers report that stock markets fall when traders' sleep patterns are disrupted due to clock changes due to daylight savings time. •A third study suggests that World Cup outcomes are strongly correlated with the mood of investors. -After a loss in an elimination game, significant market declines were reported in the losing country's market

Summary of survey results

•Only 27% were (roughly) consistent in their asset allocation (16% perfectly consistent). •Gap in equity allocations was 26% (strongly statistically significant). •Therefore many members were not consistent in their asset allocation. many members did not understand asset allocation. •They were likely to be overly influenced by the menu of funds offered.

Calibration-based overconfidence cont.

•Or use confidence interval approach. •Suppose individuals are asked to construct 90% confidence intervals (e.g., height of Mount Everest). •Usually, a percentage of individuals less than 90% comes up with intervals that bracket true answer. •This also suggests miscalibration-based overconfidence.

Conclusions

•Overconfident traders traded the most. •And performed the worst. •Miscalibration was predominant. •And better-than-average effect mattered as well. •Overconfidence mattered both at individual and market levels. •Other effects mattered too: -Higher education - less trading -Experience investing - more trading

Why corporations?

•Ownership shares are more easily transferred with a publicly-traded corporation. •A corporation is a legal entity with unlimited life, but owners have limited liability. •Though there are external regulators (SEC), who provides internal discipline to managers?

Anchoring

•People are initially anchored on their prior belief. •Quickly multiply these eight numbers: 1 * 2 * 3 * 4 * 5 * 6 * 7 * 8 -Most people will come up with a low estimate: anchored on product of first 4 or 5. -A bit better (but still too low) with: 8 * 7 * 6 * 5 * 4 * 3 * 2 * 1

Representativeness

•People judge probabilities "by the degree to which A is representative of B, that is, by the degree to which A resembles B." -A can be sample and B a population OR A can be a person and B a group OR A can be an event/effect and B a process/cause •Behaviors associated with representativeness: -Conjunction fallacy -Base rate neglect/underweighting -Hot hand -Gambler's fallacy -Overestimating probability

Getting people to save: Automatic enrolment

•People often do not join retirement plan - even leaving money "on table." •Because of inertia and procrastination, automatic enrolment can be a powerful force. •A clinical study of a company switching to auto-enrolment provided strong evidence of this. -New auto-enrolled workers on par with workers with many years of experience in participation.

Survey evidence and 1/n

•People were told to imagine that they have $100,000 in their pension. All of their old investment choices have been eliminated. •Allocate the entire amount among a "government bond fund," a "corporate bond fund" and a "stock fund." •A second question was identical, except that the three choices were a "bond fund," a "growth stock fund," and a "value stock fund."

The frontal lobe

•Phineas regained physical strength and had no speech or language problems. •He had a severe change in personality. •His former employers would not allow him to return to his construction job. •Phineas was never able to land a stable position. •He no longer seemed to have concern for his future. •Damasio connects Phineas's change of character to frontal lobe damage.

Affect and financial decision-making

•Positive affect is a "warm and fuzzy feeling." •One study looked at relationship between image of a market and behavior of investors. -Emotion induced by the stimulus of considering a given industry is highly correlated with probability a participant would choose to invest in that industry

Momentum and Reversal

•Predictable serial correlation: -Medium (3-6 month)-term momentum or positive correlation in returns. -Winners keep on winning and losers losing. •Winners and losers: -Short (1 month) and long (5 year)-term reversals or negative correlation in returns. -Losers become winners and winners become losers.

Excessive optimism

•Present when people's predictions about the future are unrealistically optimistic. •In essence, people assign probabilities to favourable/unfavorable outcomes that are just too high/low given historical experience or reasoned analysis. •Excessive optimism and miscalibration can go hand in hand. -Suppose you purchase a stock -True distribution for the return on this stock over the next year entails an expected return of 10%, with a 90% confidence range of -10% to 30% -Your (optimistic) distribution, has expectation of 20%, with a 90% confidence range of 10% to 30%

Prospect theory, mental accounting, and prior outcomes

•Problem with prospect theory is that it was set up to deal with one-shot gambles - but what if there have been prior gains or losses? •Do we go back to zero (segregation), or move along curve (integration)?

Offers in ultimatum and dictator games

•Proposers' endowment in game was $5. •Horizontal axis indicates amount sent to responder/receiver in dollars. •Vertical axis shows percentage of offers at each dollar amount.

Risk aversion vs. risk seeking

•Prospect pair 1 -- choose between: -A: (.8, 4,000) -B: (1.0, 3,000) or B:(3,000) -Note: with certainty no need to show a probability •Prospect pair 2 - choose between: -A: (.8, -4,000) -B: (-3,000) •Results for 1: most prefer sure $3000 which is consistent with risk aversion. •Results for 2: most prefer the lottery- this is inconsistent with risk aversion. •Implies people are risk seeking in negative domain (reflection effect)!

Some more prospects

•Prospect pair 10 - you are given $1000 - then choose between: -A: (.5, another $1000) and B: ($500) •Prospect pair 11 - you are given $2000 - then choose between: -A: (.5, -$1000) and B: (-$500) •Results for 10: most prefer B. •Results for 11: most prefer A. •Problems are identical! A is a 50-50 chance of 1,000 and 2,000 and B is a sure 1,500. •People have chosen differently because of different frames.

Loss aversion

•Prospect pair 3 -- choose between: -A: (1.0, 0) or no bet -B: (.5, $50, -$50) •Most choose A. •Despite risk aversion in positive domain and risk seeking in negative domain, losses loom larger than gains. •This is called loss aversion (a gain adds less to utility than an equal-sized loss subtracts from it).

But what are weights?

•Prospect pair 4 -- choose between: -A: (.9, $2000) and B: (.45, $4000) •Prospect pair 5 - choose between: -A: (.002, $2000) and B: (.001, $4000) •If risk neutral indifferent between 4A and 4B (and 5A and 5B). •Most choose 4A (risk averse) and 5B (risk seeking), but this contradicts expected utility (no consistency). •

Lottery tickets

•Prospect pair 6 -- choose between: -A: (.001, $5,000) -B: ($5) •Most prefer A which is inconsistent with risk aversion. -Lottery effect -People seem to overweight low-probability events (which is why people buy lottery tickets)

Insurance

•Prospect pair 7 -- choose between: -A: (.001, -$5,000) -B: (-$5) •Most prefer B which is inconsistent with risk seeking. -Insurance need -Once again, people seem to overweight low-probability events (which is why people buy insurance)

Psychological profiling

•Psychographic profiling, a common marketing technique, is process of assigning individuals to groups based on personality, attitudes, values and beliefs. •Probably best-known psychographic profiling technique is the Myers-Briggs Type Indicator personality assessment. •According to Myers-Briggs, people can be slotted into one of 16 personality types.

More on myopic loss aversion

•QUESTION: Given prospect theory approach, what evaluation period is consistent with historically observed market risk premium? •ANSWER: About a year - which is logically how often a typical investor gives his portfolio a careful look. •Reasons: -Tax is paid annually. -Portfolio assessment and adjustments are often annual. . Less frequent evaluation leads to: - higher demand for stock - higher price of stock -lower equity premium

Pride and regret

•Regret is obviously a negative emotion. -You might regret a bad investment decision and wish you had made a different choice -Your negative feelings are only amplified if you have to report a loss to someone •Pride is the flip side of regret. -You probably would not mind too much if it just slipped out in conversation that you made a good profit on a trade

Responders' rejections of offers in ultimatum games

•Rejections of offers are rare in some groups but common in others. •Low offers, defined as less than 20% of endowment, were not rejected at all in some populations.

Myopic loss aversion and equity premium puzzle

•Researchers have linked prospect theory to equity premium puzzle. -Key is to remember loss aversion (investors hate losing money) and to consider how often investors evaluate their portfolios. -Intuitively, if you evaluate your position every day, there is a very good chance that by day's end you will have lost money, so you find stocks very risky. -But if you evaluate stocks once per decade there is a much smaller chance that you will lose money, so you will find stocks not so risky.

Pure self-interest?

•Results of ultimatum game seem inconsistent with self-interest. -On average, proposers send positive amounts and responders reject offers that are <20% of endowment about ½ the time. -Self-interested senders would not send more than the minimum offer. -Self-interested responders would never reject an offer (even a very low one). •But, what if senders are strategic and afraid responders will reject?

Risk measurement

•Risk tolerance has two aspects. -Risk capacity is the risk appropriate for an average person of the same age, income, retirement plans, etc. -Risk attitude depends on specific personal characteristics and preferences. •Remember that questionnaires can give poor results. -Validity is the extent to which we are measuring what we want to measure (ask right questions) -Reliability refers to consistency (ask same question slightly differently and see if response is the same)

Special purpose entities

•SPEs can be used to hide foreign income from U.S. taxes or to hide huge amounts of debt. •An SPE is a shell created by a sponsor (Enron) and financed by independent third parties. •Enron was not required to consolidate financial statements as long as an independent party had an equity stake of 3% of the SPE's assets. •Large amounts of debt financed the SPEs, and their principal asset was Enron stock.

Getting people to save more: SDIPs

•Scheduled deferral increase programs (SDIPs) take advantage of various behavioral biases: -Limited self-control -Procrastination -Hyperbolic discounting -Inertia (status quo bias) •Trick: get employees to sign up for future contribution increases at regular intervals. •This uses fact that people are better at being tough on themselves if this starts in the future.

Types of analysts

•Sell-side analysts work for brokers, dealers, and investment banks. -Their reports can be used to attract investment banking business. •Buy-side analysts work for large money management firms, such as mutual and hedge funds and insurance companies. -Their reports are usually generated for internal purposes. •Independent analysts do not work with a large investment or money management firm. -They provide independent research, and their firms generate earnings through subscriptions or fees.

Big market puzzles

•Several big puzzles relate to aggregate stock market - behavioral finance has partial explanations for some of these puzzles: -Equity premium puzzle: stock returns are higher than they should be given risk borne by investors in stock markets -Bubbles: why do markets get so far out of line with fundamentals? -Excess volatility: stock returns are more volatile than they should be given that stock prices are present values of future expected cash flows.

Shiller and theory

•Shiller tackles excess volatility taking a theoretical approach. •He showed that it is difficult to explain the historical volatility of stock returns... -Assuming investors are rational and discount rates are constant •Existing volatility implies a great deal of variation in dividend growth rates - which is fine if these expectations are realized. •Using constant growth model, he considered growth rate forecast changes needed to justify realized changes in stock prices. •Given a constant discount rate these would be unreasonably high.

Small Firm Effect

•Small cap portfolios vs. large cap portfolios -Small cap wins out. -Firms with low market cap earned excess returns even after taking risk into account. •Small cap effect seems to have disappeared in the last 20 years. •Perhaps this is because small cap investing became a recognized strategy after the research results were publicized.

Many people do not save enough

•Some people have difficulty even getting started with any saving at all. -Some leave money "on the table" and don't take advantage of company matches •And even those who save often do not save enough. -Many find they are ill-prepared for retirement, and regret it when it is too late to catch up

Mood and risk attitude cont.

•Some research suggests happier people are more optimistic and assign higher probabilities to positive events. •But at same time, other decision-making research indicates that even though people may be more optimistic about their likelihood of winning a gamble when they are happy, same people are much less willing to actually take the gamble. -In other words, they are more risk averse when they are happy

What's the best board?

•Some say smaller is better because with more members some will free ride. •Most boards include insiders and outsiders. •An insider may have better information and expertise. •An outsider may have a broader background and may be truly independent. •Outsider-dominated boards may be better at aligning the incentives of owners and managers.

Behavioral finance and client management

•Some suggest that behavioral finance can be utilized by financial advisors: -to enhance relationship between client and advisor -and improve process of portfolio selection •Useful to know something about the appropriate amount of risk for the particular client. -Use a questionnaire to assess risk tolerance What is risk tolerance?

Process of debiasing

•Steps that must be followed to eliminate bias: 1.Awareness of bias 2.Motivation 3.Direction and magnitude awareness 4.Ability •Helpful intervention strategies: 1.Warn of problem 2.Describe problem 3.Provide personalized feedback 4.Train extensively

House money effect

•Successful investment can cause elation (great happiness). •And bad investments can cause distress. •Result is that prior gains and losses can cause changes in risk taking. •Say you are at a casino. You do really well at blackjack and you are up $200. -Do you play more or less aggressively?

Evidence on disposition effect cont.

•Test of disposition effect: proportion of gains realized should exceed proportion of losses realized. • This turned out to be true.

Efficient Set

•The efficient frontier represents the set of portfolios that maximize expected return for a given risk level. •The risk that is eliminated is called diversifiable or nonsystematic risk. •The risk that can not be diversified is called nondiversifiable or systematic risk. •If we add a risk-free asset, investors max. utility by combining the risk-free asset with the market portfolio (two fund separation).

Prospect theory and mental accounting explanation cont.

•The farther you are away from risk-seeking domain, the less likely it is that a particular gamble will be partly influenced by risk seeking. •So risk aversion is higher for gambles beginning at D vs. C, or C vs. B, or B vs. A. •Since you are less risk averse for losers you are more likely to hold onto them.

The frontal lobe

•The frontal lobe is the largest lobe in our brain and regulates judgment, decision-making, and the ability to plan for the future. •In the last few million years, the human brain has experienced remarkable changes. •The human brain grew quickly and doubled in mass. •This gives humans a decided advantage over other animals—the ability to plan. •Damasio's research suggests that emotion and rational decision-making are complementary.

Equity premium seems too high

•Theorists have shown that realized equity premium implies an improbably large degree of risk aversion. •In an economy with reasonable parameters, average return on stock market would be just 0.1% higher than risk-free rate, not 3.9% (or higher) observed in most studies.

Risk aversion assumption

•This comes from frequent observation that most people most of the time are not willing to accept a fair gamble: •Would you be willing to bet me $100 that you can predict a coin flip? -P(.5, -100, 100) -Most would say no. •Risk aversion implies concavity.

Overconfidence and excessive trading?

•This evidence only indirectly relates trading and overconfidence. -How do we know that it is overconfidence that is driving excessive trading? •Studies from surveys and the lab try to establish direct relationship between overconfidence and trading activity. •

SMarT or Save More Tomorrow Program

•This is a prescriptive savings program proposed by Benartzi and Thaler. •People commit in advance to allocating some of their future salary increases toward retirement savings. •They find -(1) 78% of those offered the plan joined -(2) the vast majority of those enrolled in the SMarT plan (80 percent) remained in it through the fourth pay raise -(3) the average saving rates for participants increased from 3.5% to 13.6% •The results suggest that behavioral findings can be useful in the design of savings programs.

Lessons from experimental bubble markets

•Though experimental bubbles markets are simple and do not include all important features of a complex market (like NYSE), they teach us how real bubbles might be generated. •Price bubbles are more moderate and disappear faster when traders are experienced. •Potential for short-selling leads to bubble dissipation.

Fixing 401(k)s

•Three thrusts: -1. Getting people to save •POSSIBLE SOLUTION: Automatic enrolment -2. Getting people to save more •POSSIBLE SOLUTION: SDIP-type programs (Scheduled Deferral Increase Program) -3. Getting people to save more appropriately POSSIBLE SOLUTION: Tailored investment vehicles

Evidence on disposition effect

•To distinguish between winners and losers a reference point is needed. -Purchase price of a security is a natural reference point •More precisely, appropriate to focus on frequency of winner/loser sales relative to opportunities for winner/loser sales. •Specifically, proportion of gains realized (PGR) is: realized gains / relaized gains + paper gains

interpretation

•Typical price pattern in bubbles markets is different from what one would expect. •Solid line indicates fundamental value each period, beginning at $8.64 in period 1 and falling by $0.72 each period. - Dashed lines show median transactions prices per period for four different bubbles markets

Where were the analysts?

•Up to bankruptcy, analysts were optimistic. •They either accepted managerial projections, or they did not question them. •Even after the SEC began inquiring about conflicts of interest at Enron, the average analyst recommendation was buy or 1.9, where 1 = strong buy and 5 = strong sell. •They may have been optimistic because of the large investment banking fees generated by Enron. •Analysts also would have wanted to keep open the channels of information with management.

Value versus Growth

•Value vs. growth (glamour) portfolios are constructed. •Usually value firm has a high book/market or low prices to accounting measures like earnings or cash flows. •Growth firm is the converse. •Go with value.

Overconfidence and demographics

•We are not all equally overconfident. •The greatest offenders are men: -On a survey men and women were asked what they expected the market return and their own portfolio return to be in the following 12 months. •Both men and women expected their portfolios to outperform the market - but gap greater for men Also evidence that highly educated, high-income people are more overconfident

Simulated trading strategies

•We can look at possible strategies using historical data and see if they would have earned excess returns. •These strategies must be based on information that was available. •If a strategy succeeds in generating excess returns, this is preliminary evidence against market efficiency •But we need: -Statistical significance. -Consistency. -Beware of data mining!

Fama, market efficiency, and available information

•Weak form: historical prices and returns •Semi-strong form: all public information •Strong form: all information, including private information

Interpretation cont.

•What happened? -Usually price in period 1 is below fundamental value but quickly rises high above this point •Price in first period may be low due to subjects' initial risk aversion because they are trading in an environment in which they are inexperienced •Some of bubbles in this figure are quite persistent -- but all eventually crash back to fundamental value as remaining trading periods become small

Example: Status quo bias or endowment effect

•What you currently have seems better than what you do not have. Experimental subjects valued something that they possessed (after it was given to them) more than they would have if they had to consciously go out and buy the item

Anchoring bias: Example of anchoring to irrelevant info

•Wheel with numbers 1-100 was spun. -Subjects were asked: •1. Is the number of African nations in the UN more or less than wheel number? •2. How many African nations are there in the UN? -Answers were highly influenced by wheel: •Median answer was 25 for those seeing 10 from wheel. •Median answer was 45 for those seeing 65 from wheel. -Grasping at straws!

Conformity

•When people conform they give in to real or imagined social pressure. •Students were given a figure and asked which lines were the same in length. •Though the answer seemed obvious, it was found that students conformed to an incorrect majority about one-third of the time. •Three-fourths of the students conformed at least one time.

Two important lessons

•While many lessons can be learned from the Enron debacle, from this chapter two stand out. •The next time you hear that extreme valuations are warranted by a new economy, be sure to question the basis. •Loyalty can be misplaced in an organization and people are cautioned to keep a separate identity.

What are the benefits?

•With DB the employee avoids -market risk -longevity risk •With DC the account -is portable (important for mobile Americans) -allows control over investment choices •But are employees good investors? •One study found that DB plans outperformed DC by 2% per year, net of all fees.

Here's the game (enron was doing this)

•Your spouse wants you to get rid of your sports car which is a money pit. •You sell it to your friend for $60,000, twice what you paid for it. •Does this mean the car is worth $60,000? •What if you lent your friend the $60,000 and he is in financial ruins? •At some point you will be forced to cover a big loss.

Dan Ariely is a highly-regarded behavioral economist. In his TED presentation he talked about differences in organ donation rates across countries. In related recent news, it is reported that many Georgians do not register to vote. More are now registered because the system automatically opts Georgians in when they get a driver's license. True or False: From what Dan Ariely said, we can conclude that people do not register to vote because they just do not care about who is elected.

False

Employers who promise retirement benefits though defined benefit plans are committing to support retirees at a particular level. True or false: History shows that Americans can count on receiving promised future benefits as they entered into agreed upon contracts.

False

According to Dr. John Coates: "We don't think biochemistry explains what starts a bubble or a crash. We do think, however, that steroids can exaggerate a bull market and turn it into a bubble. A bull market can almost be seen as a market with roid rage." As we saw in an Australian television production (Catalyst, "Risky Business"), some behavioralists like Dr. Coates believe that higher levels of testosterone elevate confidence leading traders to

take more risk

Sarah just won $100,000 in Las Vegas. Now she is increasing her bets and making even bigger wagers than previously. This is an example of

the house money effect.

But do executives know better?

§Fortune magazine has been surveying senior executives on company attributes for a number of years. §Executives are asked to assign values between '0' (poor) and '10' (excellent) to each company in their industry for the following items: §quality of management §quality of products/services §innovativeness §long-term investment value §financial soundness §ability to attract, develop, and keep talented people §responsibility to the community and environment §wise use of corporate assets 82% of respondents consider quality of management as most important attribute of a company's quality.

Representativeness: "Good companies are good investments"

§Seems obvious that if a company has high-quality management, a strong image and has enjoyed consistent growth in earnings, it must be a good investment. §Students of finance of course know better. §Positive qualities should already be embedded in price Loosely speaking, good companies will already sell at high prices, and bad companies will already sell at low prices •

Theater ticket problems

•1. Imagine you have decided to see a play where admission is $10. As you enter theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket to the play? •2. Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?

Problems with expected utility theory

•A number of violations of expected utility have been discovered. •Most famous is Allais paradox (#5, p. 15). •Alternative theories have been developed which seek to account for these violations. •Best-known is prospect theory of Daniel Kahneman and Amos Tversky.

Prospects

•A prospect is defined as a series of wealth or income levels and associated probabilities. •Example: -$500 with probability .8 -$2,000 with probability .2 -P1(.8, 500, 2,000) •When 2nd option is zero, let's write: -P2(.8, 500) •Expected utility theory comes from a series of assumptions (axioms) on these prospects.

Home bias and informational advantage

•A rational explanation for local preference is informational advantage. -You know more about what is close. -Gains from being local to a company may appear in improved monitoring capability and access to private information.

Emotions about emotions

•Agents may make decisions because they have emotions about possible future emotions. •Specifically, fear of a negative emotion, or hope for a positive emotion, may influence behavior. •Fear of regret is argued to drive certain financial decisions. An investor might regret having made a bad investment.

Joint hypothesis problem

•All tests of market efficiency have two maintained hypotheses: -Markets are efficient. -A fair return on a security or portfolio is from a particular model (in early tests this model was usually CAPM). •Rejection means: -Markets are not efficient. -Method for calculating fair returns is faulty. -Or both. •But which? Joint hypothesis problem!

Mood and affect

•An emotion is about something, whereas a mood is a general feeling that does not focus on anything in particular. •Affect is how a person experiences a feeling. •Somebody's affective assessment is experience she has in response to a stimulus. -Affect is evaluative in that a person can say whether a stimulus is good or bad, positive or negative

Anchoring vs. representativeness

•Anchoring says new information is discounted. •Representativeness (base rate neglect variety) says people are too influenced by latest information. •Potential conflict between anchoring and representativeness in how people deal with new evidence. • Which is right? -Perhaps both depending on situation...

Survey evidence

•Another study combined naturally-occurring data with information obtained from a survey. •Used trading data from online brokerage accounts and psychometric data obtained from same group of investors who responded to an online questionnaire. •Various measures of trading activity were correlated with a number of metrics of overconfidence. •Solid evidence that those who were most subject to better-than-average effect traded the most.

Anchoring: Real estate appraisal study cont.

•Average appraisal price of the first group came in at $67,811 - second group was at $75,190. •If we take the mid-point of these values ($71,500.50) as our best estimate of the true appraisal value, the gaps between the two appraisal averages was a full 10%. Agents were anchored on list prices that they were exposed to - despite the fact that only 25% mentioned list price as one of the factors that they considered.

Preview of impact of OC on financial decision-making

•Because of overconfidence it is argued that investors trade securities too much. -Resulting in excessive volume at level of market •And they are underdiversified.

Preview of impact of OC on financial decision-making cont.

•Because of overconfidence managers: -Are too ready to enter markets -Overinvest -Allow cash flows to dictate investment -Acquire other companies too quickly -Take on too much debt •

Better-than-average effect

•Better-than-average effect says that many of us feel we are smarter or more skilled than average. •But only 50% of us can really be better than average. •Evidence suggests that people pick definition of task that suits their purpose.

Capital asset pricing model (CAPM)

•CAPM is an equilibrium model: it brings all investors together. •According to CAPM only risk related to market movements is priced by market. •This is because all other risk can be diversified away. •Beta is measure of nondiversifiable risk for a security.

Properties of utility functions

•Certain properties of utility functions can be demonstrated: -Upward-sloping -Unique up to a positive linear transformation •Latter allows one to set u(lowest outcome)=0 and u(highest outcome)=1, which can be useful for proving certain things Other properties such as differentiability (implying continuity) are often assumed

Certainty equivalents

•Certainty equivalent is defined as that wealth level which leads decision-maker to be indifferent between a particular prospect and a certain wealth level. •We need to solve for w below: U(P7) = 3.4069 = u(w) = ln(w) •Solution is w = 30.17 or $301,700

Confidence vs. overconfidence

•Confidence is all about having a positive feeling about your skills, knowledge, etc. •But overconfidence is when you have an inflated sense of your abilities. •Various manifestations: -Miscalibration -Better-than-average effect -Illusion of control Excessive optimism

Expected utility of a prospect

•Consider prospect P7: •P7(.4, 50,000, 1,000,000) •Assume u(w) = ln(w) (in 10,000s) •Use expected utility formula: U(P7) = 0.40u(50,000) + 0.60u(1,000,000) •Using logarithmic utility function, we have: U(P7) = 0.40(1.6094) + 0.60(4.6052) = 3.4069 •Graph also shows utility of exp. value of prospect: u(E(w)) = ln(62) = 4.1271

Four Key Trading Rules

•Earnings announcement momentum •Small firm effect •Value versus growth •Momentum and reversal

Earnings Announcements

•Earnings announcement momentum is reported. -Reaction to extreme announcements is slow. •Common approach is to use an event study. -Compute returns before an event (earnings announcement) and compare to returns after to see if they are "abnormal." -Abnormal returns are computed based on a model of risk and return (CAPM). •Researchers report that the market reacts positively (negatively) to good (bad) news. •But, there seems to be continued drift in prices. •

Frames

•Essential condition for a theory of choice is principle of invariance: different representations of same problem should yield same preference. •Unfortunately this sometimes does not work out in practice: -People have different perspectives and come up with different decisions depending on how a problem is framed.

Excessive optimism cont.

•Evidence on excessive optimism: -Students expect to receive higher marks than they actually do receive -And they overestimate the number of job offers that they will receive -People often think that they can accomplish more than they actually end of accomplishing •Cost of excessive optimism: -Inability to meet one's goals can lead to disappointment, loss of self-esteem and reduced social regard -And time and money can be wasted pursuing goals that are unrealistic

Can retail investors profit from local information?

•Evidence that retail investors also have some ability in this regard. •Reminiscent of money manager finding, based on a dataset of retail investors, local investments outperformed remote investments by 3.2%/year.

Potential home bias explanations

•Excessive optimism about prospects of domestic market. •Comfort-seeking and familiarity. -What is familiar is good (i.e., a good investment) •Institutional restrictions: -Capital movement restrictions -Differential trading costs -Differential tax rates •Latter likely plays a very minor role.

Perception and processing constraints

•Expectations influence perceptions. •People see what they want to see. •People experience cognitive dissonance when they simultaneously hold two thoughts which are psychologically inconsistent.

Preview of financial errors from heuristics and biases

•Expectations influence perceptions: -If most people are saying good/bad things about company, you will "find" good/bad things •It has been argued that cognitive dissonance can: -Explain why people don't exit poorly-performing mutual funds

Example: Information overload

•Experiment involving tasting jams and jellies in a supermarket. •Treatment 1: Small selection. •Treatment 2: Large selection. •Which attracted more interest? -Treatment 2. •Which lead to more buying? -Treatment 1.

Risk Aversion

•For a person who is risk averse, the expected utility of the prospect is less than the utility of expected wealth. •U(P7) = 3.4069 < u(E(w)) = 4.1271 •This person would rather have 620,000 with certainty than a prospect with a chance to get 50,000 or 1,000,000. •For a risk seeker the situation is flipped (and the utility function is convex).

Poor diversification is implied

•From diversification standpoint, if anything you are wise to underweight (not overweight) local companies. •If you work and invest locally, technically speaking, your two income sources are highly correlated. •Diversification theory says you should look for income streams that are weakly correlated. •Better for investors to buy stock in Baby Bells outside their region.

Culture

•From the same study, culture matters as well. •It was noted whether CEOs were Finnish or Swedish. •Controlling for language of the company, Finnish speakers prefer Finnish CEOs. •And Swedish speakers prefer Swedish CEOs.

Gambler's fallacy

•Gambler's fallacy may apply if people are fairly sure about nature of population. -They think even small samples should always look like population. •So if you flip coin 9 times getting 6 heads and 3 tails, these people would say that a tail is more likely to come next... •"We are due for tails." -Winning lottery numbers are avoided based on mistaken view that they are not likely to come up again for a while.

Self-preservation heuristics

•Hear a noise with an unknown source? -Move away till you know more •Food tasting off? -Stop eating it •These make good sense. •Other heuristics, which are more cognitive, are related to comfort with the familiar... •

Heuristics

•Heuristics -rules-of-thumb or decision-making shortcuts •Necessary because the world, being a complicated place, must be simplified in order to allow decisions to be made. •Heuristics often make sense but falter when used outside of their natural domain.

Home bias within a country

•Home bias seems to be driven by a comfort-level with the familiar. •In 1984, AT&T was forced by the court into a divestiture whereby seven "Baby Bells" were created. •Created along regional lines - example: Bellsouth serving southeastern United States. •

Familiarity and home bias

•If people like familiarity, then we would expect that a disproportionate number of a Baby Bell's customers to hold a disproportionate number of shares in the same Baby Bell. •This is exactly what happened after the divestiture.

Language

•In Finland, there are two official languages, Finnish and Swedish. •Annual reports are normally published in Finnish or in both official languages, but in a few cases reports are only published in Swedish. •Controlling for other relevant factors, Finnish investors prefer companies whose language of publication is Finnish. •And Swedish investors prefer companies whose language is Swedish - with bilingual companies being mid-ranked.

Experimental evidence

•In an experimental study correlation between various forms of overconfidence and trading activity was also investigated. •Participants first filled out questionnaires eliciting their level of overconfidence. •Then trading sessions were conducted: -Subjects were endowed with cash plus stocks (with random dividends) that they could trade -Private signals of true dividend -Most accurate people were given least noisy signals •Point was to see if overconfidence and trading activity were correlated. •Other variables were also investigated.

Example: Ambiguity aversion

•In experiments, people are more willing to bet that a ball drawn at random is blue if they know the bag contains 50 red and 50 blue. -Than if they know a bag contains blue and red balls in unknown proportions •Lesson: people are more comfortable with risk vs. uncertainty (ambiguity). -

Underdiversification and excessive risk taking

•In one study underdiversification was less severe among people who were financially sophisticated. •Diversification increased with income, wealth, and age, and those who traded the most also tended to be the least diversified. -Perhaps because it is argued that overconfidence is driving force behind both excessive trading and underdiversification.

Implementation costs

•In some cases, horizon is short but short-selling is: -Expensive (commissions, spreads, price impact & fees for shorting stock) -Difficult or even impossible (lack of availability regardless of fees; legal factors: many institutions cannot short) •Plus there is cost of finding these arbitrage opportunities.

Digression: Momentum-chasing and company stock

•In studying plan member new allocations into company stock, one researcher has established that much of it was from chasing winners. •Forming portfolios based on 1-yr/10-yr own-company stock returns: -Low-return portfolios had 21%/10% put into company stock -High-return portfolios had 24%/40% put into company stock -Those who allocated most to company stock earned 6.8% less than those who allocated the least.

Valuing prospects under prospect theory

•Instead of expected utility we have: V(P) = p(pr A) * v(zA) + p(1 - prA) * v(zB) •Steps: -Convert probabilities to decision weights -Calculate values of wealth differences -Use above formula

Weights continued

•Invoke linear transformation rule to see contradiction. -Set u(0) = 0 and u(4,000) = 1 -4A choice implies u(2,000) > .5 •.9u(2,000) + .1u(0) > .45u(4,000) + .55u(0) •.9u(2,000) + 0 > .45(1) + 0 -5B choice implies u(2,000) < .5 •Prospect theory reconciles observed choices. -Nonlinear weighting function can explain these choices (as we will see in a few minutes).

Behavioral finance and client management

•Is its also useful to know client's biases. -Researchers have come up with a series of questions that can be assembled as a kind of behavioral test -- to be given to clients in order to tease out particular biases that client in question is most prone to •One example from test is as follows. •Which of the following sequences is more likely to occur when a coin is tossed - HHHTTT or HTHTTH? -Actually both are equally likely •But to those who might be prone to overreact to chance events (such as recent performance), first will seem less likely.

Emotion is not all bad

•It can improve decision-making in two respects: -1. Emotion pushes individuals to make some decision when making a decision is paramount. •Often a decision has to be made -2. Emotion can assist in making optimal decisions. •Positive feelings can make it easier to access information in the brain, promote creativity, improve problem solving, enhance negotiation, and build efficient and thorough decision-making •It really comes down to emotional balance: emotional intelligence.

Anchoring vs. representativeness ii.

•It is argued that people are "coarsely calibrated." •Suppose morning forecast is for sun. Day starts sunny. You go on a picnic. -Some dark clouds start to move in -You are anchored to prior view and discount clouds -More dark clouds: the same thing

Psychological profiling in financial context

•Main approach is to attitudinally segment respondents based on measurable attributes according to their money attitude. •Value added is available to extent that money attitude can explain investor behavior over and above pure demographics. •EXAMPLE: One study came up with 5 groups (using questions on interest in retirement and financial planning, saving behavior, optimism and risk taking): -1. Successful planners (21%) -2. Up-and-coming planners (26%) -3. Secure doers (20%) -4. Stressed avoiders (19%) -5. Live-for-today avoiders (14%)

Preview of impact of emotion on financial decision-making

•May be behind disposition effect: tendency to sell winners too early and hold on to losers too long. -Fear of regret may be driver •May favor investment in some firms or industries but not others. -Emotion induced by the stimulus of considering a given industry is highly correlated with the probability a participant would choose to invest in that industry

Memory tricks

•Memory is not a simple matter of information retrieval: -It is reconstructive -It is variable in intensity •With emotion playing a role -It is prone to self-serving distortion •hindsight bias - "I knew it all along."

Calibration-based overconfidence

•Miscalibration normally implies thinking that your knowledge is more accurate than it really is. •Measured through calibration tests. •Ask people 50 multiple choice questions. -Then ask how many right? And compare the two numbers -If you think you got 25 right...but you only got 15 right -You appear to be overconfident

Problems measuring overconfidence

•Most people most of the time appear to be overconfident. •But overconfidence does not seem to be universal. -When outside their expertise people are underconfident. •Also, depending on the metric, it is possible for people to be judged overconfident using one metric but not using another. -And there is no universally accepted way to measure overconfidence

Noise and sentiment

•Noise is opinion on value unrelated to fundamental information (i.e., based on misinformation) •Sentiment is correlated noise, and has the potential power to move markets. •This implies that price movements can be driven by misinformation rather than information.

Noise-trader risk

•Noise trader risk arises because mispricing might worsen in the short run. •It has been shown that noise-trader risk is systematic, which means that it cannot be diversified away. •Real world arbitrageurs cannot wait it out because as professional money managers they do not have long horizons - they are usually evaluated at least at once per year. •

Theater ticket problems cont

•Nothing is really different about the problems. •Is the ticket worth $10? •Of respondents given first question, 88% said they would buy a ticket. •Of respondents given second question, 54% said they would not buy a ticket. •In 2nd question, integration is more likely because both lost ticket and new ticket would be from same "account." -Integration might suggest that $20 is too much for the ticket.

Example: Diversification heuristic

•Observe people at a buffet... -Many people try a bit of everything -Do not want to miss out on something good •Diversification sometimes comes naturally.

Financial decision-making is inherently emotional

•Often financial decisions involve big stakes. •So emotion will inevitably appear. •One study looked at physiological characteristics of professional securities traders while engaged in live trading... -Reporting significant correlation between market events and physiological characteristics such as cardiovascular data

Behavioral finance and client management cont. ii.

•People prone to this blind spot are advised to: -Ask yourself whether you have real reasons to believe that you know more than market -Before making an active decision, consider the possibility that the trade is based on random factors -List reasons why it isn't based on random factors before making a particular trade

Base rate neglect

•People sometimes ignore base rates, also called priors or given relative frequencies of outcomes . •K&T example: Subjects told 70% of a sample of data from lawyers and 30% engineers. Is Dick a lawyer or an engineer? Dick is a 30-year-old man. He is married with no children. A man of high ability and high motivation, he promises to be quite successful in his field. He is well liked by colleagues.

Perception and the frame

•Perception is not just seeing what's there - but it is influenced by the frame: -How tall is that sports announcer? -Halo effects: Someone who likes one outstanding attribute of an individual likes everything about the individual -Primacy vs. recency effects •Primacy dominates if list •Recency dominates if over time

Prospects 8 & 9 again cont.

•Prospect 9: -A: .64*40001/2 + 0 = 40.48 -B: 1*30001/2 = 54.78 -B is preferred. -A vs. B flip-flop comes from weighting function.

Certainty effect

•Prospect pair 8 -- choose between: -A: (.2, $4000) -B: (.25, $3000) •Prospect pair 9 - choose between: -A: (.8, $4,000) -B: ($3000) •Most choose 8A and 9B, but they shouldn't. -8A is risk seeking and 9B is risk aversion. •Why? -Certainty is accorded high weight relative to near-certainty •

Prospect theory

•Prospect theory was developed by Kahneman and Tversky based on observing actual behavior. •Experimental evidence says that people often behave contrary to expected utility theory. •Expected utility theory is normative. -What people should do •While prospect theory is positive. -What people actually do

Biases related to representativeness

•Recency: -Recent evidence is more compelling. •Salience: -Dramatic evidence is more compelling. •Availability: -Freely available, easily processed information is more compelling.

Mental accounting

•Related to prospect theory and frames. •Accounting is process of categorizing money, spending and financial events. •Mental accounting is a description of way people intuitively do these things, and how it impacts financial decision-making. •Often tendency to use mental accounting leads to odd and suboptimal decisions. •A few highlights of mental accounting follow...

Preview of financial errors from heuristics and biases iii.

•Representativeness (and halo effects) -"Good companies are good stocks" thinking may lead to value advantage •Recency -May explain chasing winners •Anchoring and slow adjustment coupled with representativeness -May explain momentum and price reversal

Analysts and excessive optimism

•Research has established that analysts tend to be excessively optimistic about prospects of companies that they are following. •True both in U.S. and internationally. •In U.S., where tendency was most pronounced, buys/sells were observed 52%/3% of the time. •In Germany, where this tendency was least pronounced, buy/sell ratio was still 39%/20%. •Another motivation: conflict of interest and desire to keep prospective issuers happy.

Overconfidence may not be all bad

•Research has shown that predictions about the future tend to be more optimistic when: -Goals are far off -A course of action has been committed to •When these conditions are met, excessive optimism may be useful in enhancing performance.

Portfolio risk and return

•Return is a weighted average of returns of individual securities. •Risk is less than a weighted average of risks of individual securities - provided correlations are less than one. •The lower are correlations the lower is the risk of a portfolio.

Illusion of control

•Reveals itself when people think that they have more control over events than objectively can be true. -For example, gamblers may think that they can control the dice or the cards

But where are these substitutes?

•Say Ford is underpriced in the market. •You buy Ford. -But market may drop. -Or auto industry may drop. •So you buy Ford and short GM. -But Ford itself may falter without industry or market dropping (idiosyncratic risk) . •Even if you totally manage fundamental risk, there is still noise-trader risk: spread may widen as investors get it even more wrong.

Expected utility

•Say one has to choose between two prospects. •Based on assumptions such as completeness and transitivity (and others), it can be shown that when such choices over risky prospects are to be made, people should act as if they are maximizing expected utility: U(P) = pr A * u(wA) + (1-pr A) * u(wB) •Can generalize to more than two outcomes: U(P) = pr A * u(wA) + pr B * u(wB) + pr C * u(wC)

Expected utility theory

•Says that individuals should act when confronted with decision-making under uncertainty in a certain way. •Theory is really set up to deal with risk, not uncertainty: -Risk is when you know what the outcomes could be, and can assign probabilities -Uncertainty is when you can't assign probabilities; or you can't come up with a list of possible outcomes

What should be true if markets are efficient

•Security prices should respond quickly and accurately to new information. •Professional investors should not outperform net of all fees. •Simulated trading strategies should fail.

Why don't we learn?

•Self-attribution bias retards the learning process by allowing us to embellish our triumphs while forgetting our defeats. •Hindsight bias says we knew what was going to happen when we really didn't. •Confirmation bias may contribute too - this is tendency to search out evidence consistent with one's prior beliefs and to ignore conflicting data. •These effects suggest that overconfidence can evolve over time.

Do people trade because of knowledge or knowledge perception

•Several related studies documented trading losses that were perhaps attributable to overconfidence. -60,000 households during 1991-96 studied -Looked at their performance (returns) -Found that those trading the most frequently earned an average annual return of 11.4% vs. the market's 17.9% -Even net of transactions costs and adjusted for risk those who traded the most underperformed the market by 10% per year -Greatest offenders were men •

Does local preference boost performance?

•Significant payoff to local preference. •Fund managers on average earn 2.67%/year more on local investments. •While local stocks avoided by managers underperform by 3%/year. •And those better able to select local stocks tend to concentrate their holdings more locally.

Hot hand phenomenon

•Sometimes people feel that distribution/population should look like sample, but sometimes they feel sample should look like distribution/population. -Former is especially true if people aren't sure about nature of distribution/population. -As in hot hand phenomenon in sport: •In basketball, it is erroneously thought that you should give ball to hot player •Research finds that prob. of making the next shot no different than overall prob. of making it.

Psychological profiling in financial context cont.

•Supporting this attitudinal segmentation work is recent evidence that planners behave differently from avoiders in their saving and investment behavior. •If planners actively consider their financial future and adequacy of state of preparedness, likely to take steps when any deficiency is detected. •Research has shown that those with a planner mindset tend to be much better at wealth accumulation.

Momentum-chasing: Survey evidence

•Survey of workers managing their own retirement money. •Respondents were to asked to start their pensions from scratch and allocate money between two stocks: -One with an "average return over the last 5 years of 5%" -And a second with an "average return over the last 5 years of 15%." -Further told that "analysts forecast that both stocks should earn about 10% per year over the next 5 years."

Momentum Evidence

•Take a long-short portfolio based on prior returns. •So, short poor performers and buy good performers. •Jegadeesh and Titman (1993) found that you could make average excess return of 0.95% per month (over 12% annually) with a portfolio based on prior 6 month returns.

Overestimating predictability

•Tendency to underestimate regression to mean - amounts to exaggerating predictability. •GPA example: subjects were asked to predict GPA in college from high school GPA of entrants to the college. •

The brain

•Tools for mapping brain: •PET (positron emission tomography) •fMRI (functional magnetic resonance imaging) •Main parts of brain: •Brain stem structures •Limbic system (seat of emotion) •Forebrain (seat of cognition) •All parts of the brain continuously "communicate" with each other. •And efficient communicating (as brain injury evidence suggests) is essential

Evolutionary theory

•Traits that contribute to the survival of a species become characteristics of the species in the long run. •Evolutionary theorists argue that our basic emotions have evolved to promote the survival of the species. •Emotions have adaptive value because they lead to action and also communicate to others. •Example: danger leads to fear, which leads to flight and communication: "get away."

Preferences and utility functions

•Two key assumptions about preferences: -Completeness (can order choices by preference) -Transitivity (we'll see this in a minute) •Utility over goods: u(2 bread, 1 water) > u(1 bread, 2 water) •Utility over money: u(w2) > u(w1) if w2 > w1

Anchoring: Real estate appraisal study

•Two randomly selected groups of real estate agents were taken to a house and asked to appraise it. •Same information set, including house's (purported) list price. Only difference between the two groups was that the first group was given a list price of $65,900, while the second group was given a list price of $83,900 -- $18,000 more.

Type 1 & 2 heuristics

•Type 1: Autonomic and non-cognitive, conserving on effort. -Used when very quick choice called for -Or when it's "no big deal" •Type 2: Cognitive & requiring effort. -Used when you have more time to ponde •Type 2 can overrule Type 1.

Market efficiency

•Value is what a security should be worth based on careful analysis. •Price is what the market says it is worth. •What is relationship between value and price if markets are efficient? -Older version of market efficiency says value and price are always identical. -More subtle and realistic version says they can sometimes differ a little.

Conjunction fallacy

•Which seems more likely? -a. Jane is a lottery winner. -b. Jane is happy lottery winner. •Many pick b, but a must have a higher probability, as a Venn diagram clearly shows. •Problem: conjunction fallacy. •Don't assume that specific conditions are more likely than general ones.

An odder example

•You must make two lottery choices. One draw will be in morning; other in afternoon. •Prospect pair 12: -A: ($2400) -B: (.25, $10,000) •Prospect pair 13: -A: (-$7500) -B: (.75, -$10,000) •People prefer 12A (risk-averse) and 13B (risk seeking).

Expected utility example

•u(w) = w.5 •Prospects: -P5(.5, 1000, 500) -P6(.6, 1200, 300) •For P5: U(P5) = .5 * 1000.5 + .5 * 500.5 = 26.99 •For P6: U(P6) = .6 * 1200.5 + .4 * 300.5 = 27.71 •So P6 P5.

Corporate board

•A corporate board is one method to minimize conflicts of interest between owners and managers. •Most shareholders simply do not have the time to monitor managers so they shirk and rely on others (the free rider problem). •Is there an optimal board size or composition?

Dictator game

•A dictator game is similar, except that the first mover's decision can't be rejected. •It is designed to separate strategic behavior and fairness. •A self-interested proposer will know this so he will send the smallest possible amount. •Subjects in dictator games are less generous but typically about 2/3 will send a positive amount.

Market moves vs. news?

•50 biggest market moves of last 50 years matched against explanation in New York Times. •On several days Times actually reported there was no apparent cause (e.g., Sept. 3, 1946). •Many other times "cause" doesn't seem important enough - doesn't seem that there is really any new meaningful information. •Suggests excess volatility... -Driven by changes in market sentiment?

What should and did people say?

•60% desired equity exposure might mean 20/20/60 on 1st question; 40/30/30 on 2nd. •Equity share will be a function of (among other things): -Risk attitude: comfort with risk taking -Risk capacity: age / proximity to retirement; labor income risk •Since people are different with respect to such factors, actual equity share was not so interesting. •Consistency was of greatest interest since it implies understanding, but result was: -33% equity on first; 67% equity on second •