2 Behavioral Finance

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Classical Decision-Making

Process

• Asset Integrat ion – People choose between risky prospects by comparing

the distributions resulting from integrating theseprospects with the rest of their assets

• Risk avers ion – If expected return is held constant, people prefer the

prospect with the smaller spread or variance – People always prefer a sure outcome over a risky

prospect with the same expected value

• Rational expectat ion – Their predictions are assumed to properly reflect all

the relevant information available to them – In the absence of inside information, all investors

agree about the future value of any security



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The Three Themes of

Behavioral Finance

• Heuristic-driven Bias – Behavioral finance recognizes that practitioners use rules of

thumb called heuristics to process data. How about traditionalfinance?

– E.g. “Past performance is the best predictor of future

performance, so invest in a mutual fund having the best five-yearrecord.”

• Frame Dependence – Behavioral finance postulates that in addition to objective

considerations, practitioners’ perceptions of risk and return arehighly influenced by how decision problems are framed.

• Inefficient Market – Behavioral finance assumes that heuristic-driven bias and

framing effects cause market prices to deviate from fundamentalvalues.



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Heuristic

• Heuristic refers to the process by which people findthings out for themselves, usually by trial and error. Trialand error often leads people to develop rules of thumb,but this process often leads to other errors.

A broader perspective

• people develop general principles as they find things outfor themselves.

• they rely on heuristics, rules of thumb, to draw

inferences from the information at their disposal.• people are susceptible to particular errors because the

heuristics they use are imperfect; and

• people actually commit errors in particular situations.



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ehavioral Decision

Research

• Loss aversion

• Reference dependence

• Asset segregation• Mental Accounting

• Biased expectations

• Decision Framing• Agency Friction



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Loss AversionExample

Choose between two opportunities to gain: • A su re gain of $8,500 or• 85% chance of receiving $10,000 and 15% chance of receiving

nothingMost people prefer the sure option, even though the same expected

return in both cases

=> a sure outcome is preferred over a gamb le w ith the sameexpected value

• Choose between two opportunities to lose:• A sure loss of $8,500 or• 85% chance o f los ing $10,000 and 15% chance of losin g

noth ing • Most people prefer the gamble than the sure loss. A SURE LOSS IS

WORSE THAN THE RISK OF LOSING A LITTLE BIT MORE WITHTHE GAMBLE, COMBINED WITH A CHANCE THAT THEY WILLNOT LOSE AT ALL



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Value-Expressive

• When probability of loss is large, people exhibitrisk-seeking rather than risk-averse behavior

• Risk aversion holds for gains and risk seeking

holds for losses => Value function

Losses Gains

Value



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Value-Expressive

1. Differences in wealth

– People tend to isolate their investment decisions and comparethem to the status quo rather than integrate them witheverything else they own.

– Very sensitive to changes and relatively insensitive to absolutevalues

– Think in terms of gains and losses, not terminal wealth values

2. S-shaped – Concave above the reference point and convex below it – Consistent with risk aversion in the domain of gains and risk

seeking in the domain of losses – Most sensitive to change the nearer they are to the reference

point.

=>The first $100 you win is what gives you the mostpleasure per $100, and the first $100 you lose is themost painful per $100



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Value-Expressive

3. Asymmetric

– The loss curve is much steeper than thegain curve

– People are more sensitive to negative thanto positive stimuli

– The unhappiness one feels upon losing a

certain sum of money, is generally greaterthan the pleasure one feels after winning thesame amount



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Asset Segregation

• Evaluate risky projects in terms of theiranticipated gains or losses rather than in termsof final asset positions, defined by combining theprospects at hand with all other holdings

Decis ion I. Choose between:

• A. A sure gain of $240• B. A 25% chance of gaining $1,000 Decis ion II. Choose between: • C. A sure loss of $750• D. A 75% chance of losing $1,000



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Asset Segregation

• Decision I produced risk aversion: 84% chose option Aand 16% chose B.

• Decision II produced risk seeking: 87% chose option Dand 13% chose C

• A & D - A su re gain of $240 and 75% chance oflos ing $1,000

• B & C - A 25% chance of g aining $1,000 and a sureloss of $750

• Overall 73% chose A&D, which is more inferior thanB&C (only 3%). The combination of risk seeking inthe domain of losses and risk aversion in thedomain of gains can lead to the choice of an inferior

portfolio



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Reference Dependence

• The choice individuals make between twoassets depends on where they are now:their reference point, i.e. their current

wealth level

Choose between

• having $60,000 for sure and• an even chance of having $75,000 or

$50,000



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Reference Dependence

• Standard Finance: the choice depends only onthe utility function, which reflects risk attitude

• Behavioral Finance : depends on current wealth

level – – if currently having $60,000, most people prefer the

$60,000 option (risk averse)

– if currently having $75,000, most people prefer an

even chance of either having $75,000 or $50,000over $60,000 for sure (risk seeking – choose thegamble)



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Mental Accounting

• People’s preferences depend on the wayin which decisions are framed, not just onthe objective outcomes.

• Standard finance assumes that peoplecombined all the relevant outcomes andmake choices accordingly.

• Behavioral research indicates that peopletend to maintain sets of separate mentalaccounts and do not combine outcomes



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Biased Expectations/

Overconfidence• Overconfidence leads to misapprehensions about

oneself and to the illusion of control – Managers need tobe aware of this tendency when forecasting earnings

Example

• A game is played with two decks of cards, red and blue.Players pay $1 and receive one card from one of thedecks. The card is then returned to the deck, the dealershuffles and draws one card. If the player’s card isdrawn, the player wins $100.

• When the game is played with the blue deck, the dealer

only shows the card to the player.• When the game is played with the red deck, the player

gets to touch the card and return it to the dealer.• Players were asked to sell their cards prior to revealing

the card chosen by the dealer.



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Biased Expectations/

Overconfidence

• RESULTS:

– Blue deck (no touching of cards): 19% wereunwilling to sell their cards. Average asking

price was $2 – Red deck (players were able to touch cards):

37% were unwilling to sell their cards.

Average asking price was $9



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Decision Framing• How we view a situation depends on what we decide.• Given a set of circumstances, one can put a spin on the

outcome merely by framing the situation to create asense of impending loss or gain, pain or pleasure.

• Posi t ive prospect . When given the choice between an

80% chance of $4,000 gain versus a certain (100%)$3,200 payoff, only 20% of subjects choose theuncertain payoff, even though it has a higher expectedvalue (0.80 x $4,000 = $3,200)

• Negative pro spect . When given the choice between an80% chance of a $4,000 loss versus a sure loss of$3,200, 92% of subjects prefer the uncertain loss; only8% choose the certain loss, even though it has the lowerexpected loss.

• Asset allocation decisions become a dilemma whenimmediate risk of loss overpowers long-term potential



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Agency Friction• The tendency for investment managers (i.e., agents) to select

portfolios consisting of good companies rather than goodstocks in an effort to make the portfolio attractive to investors

(i.e., principals)

• Some investors become very critical during down periods inthe market and closely scrutinize the holdings in theirportfolios

– May be challenging to defend certain assets if they are outof favor or have underperformed recently – Managers tend to hold stocks that are currently in favor so

that if these stocks underperformed during down market,investors may be more forgiving as they are holding stocksof great com panies

– If a portfolio of out of favors stocks did not perform well, itwill be viewed negatively by the investors as containingstocks of bad companies

– This behavior will preclude the participation in value stocksthat have been beaten down and do not l ook attractive



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Agency Friction

• Most studies show that stocks of badcompanies outperform stocks of goodcompanies in the long run

– Investors have overreacted to posi t ive

news o f the good companies and the

negat ive news of the bad companies



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CAPITAL ASSET PRICING

MODEL (CAPM)

– The presence of Markowitz-based information traders(with specific mean-variance preferences and do notcommit cognitive errors)

– Expected returns are determined by standard betas,measures of systematic risk determined with respectto the market portfolio

– Determining standard betas is problematic due todifficulty in selecting an appropriate proxy for the

market portfolio – Demand and supply for a stock is determined by its

standard beta, which is utilitarian in nature



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BEHAVIORAL ASSET PRICING

MODEL (BAPM)

– Market interaction between information traders andnoise traders (do not have specific mean-variancepreferences and do commit cognitive errors)

– Expected returns are determined by behavioral betas,measures of risk determined with respect to themean-variances-efficient portfolio. This portfoliodiffers from the market portfolio depending on thepreferences of noise traders (i.e., whether growthstock or value stocks are currently favored)

– Determining behavioral betas is problematic in the

preferences of noise traders can change over time – Demand and supply for a stock is determined by its

behavioral beta, which is both utilitarian and valueexpressive



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Dividend Vs Capital Gain

• Standard investors (“rational”):

– Indifferent between dividends and capital becausethey do not rely on companies to create dividends;they create homemade dividends by selling shares

– In the world where dividends are taxed more heavily,they are better off when companies refrain frompaying dividends

– Immune to problems of self-control. Stick to savingplans and never engage in impulse buying

– Know that the returns of the average manager arerelevant in the evaluation of a particular manager



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• Behavioral investors (“normal” ): – A dividend dollar is different from a capital dollar because they

frame the dollars into two distinct mental accounts, i.e. thedecline in the share price is a loss in the capital mental account,whereas the elimination of the dividend is a loss in the dividend

mental account – Dividend dollars are framed into i ncome mental accounts,

distinct from capital mental accounts

– Vary in their attitudes toward risk among their various mentalaccounts – highly risk averse in downside-protection and much

less risk averse or even risk-seeking in upside-potentialaccounts (buy both insurance polices and lottery tickets)

– Draw backs: covariance between accounts are ignored andportfolios lie below the efficient frontier



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– Subject to temptation and look for tools toimprove control

• Framing is beneficial to investors with imperfect

self-control• “Consume from dividends but don’t dip into capital”

is a good rule for investors whose self-controlproblems center on spending

• Homemade dividends are dips into capital, andinvestors with imperfect self-control are afraid thatone dip might lead to another (like the recoveringalcoholics are)



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– Homemade dividends have anotherdisadvantage – regret • Regret is tied to responsibility for choice

• The investors who sold the share to gain $1,000will feel regret if the share prices soar, while thereceipt of $1,000 from dividends involves littlechoice and little regret

– Susceptibility to a broad set of cognitive errors

• ‘The law of small numbers’. Behavioral investorsoften conclude that even a one-year record isplenty of evidence about skill – flock to the mutualfunds with the best recent performance



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VALUE OF INVESTMENT

PROFESSIONALS

• Market efficiency carries two meanings: – Investors cannot systematically beat the market

– Securities prices are rational

• Both standard finance and behaviorists would agree on

the first meaning• Behaviorists would argue against the second meaning,

which ignores the many value-expressive characteristicsthat seem to affect market pricing

• Accepting the first meaning and rejecting it in therational-prices sense, investment professionals mustcombine traditional investment management practiceswith investment counseling

2 Behavioral Finance

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