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Behavior Finance

Behavior Finance. Mental Accounting. Experiment 1. You face the following pair of concurrent decisions. First examine both decisions, then indicate your choice, by circling the corresponding letter. Both choices will be payoff relevant, i.e., the gains and losses

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Behavior Finance

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  1. Behavior Finance Mental Accounting

  2. Experiment 1 • You face the following pair of concurrent decisions. • First examine both decisions, then indicate your choice, by circling the corresponding letter. • Both choices will be payoff relevant, i.e., the gains and losses • will be added to your overall payment. • Decision (i): Choose between • Asure gain of $2.4 • B25% chance to gain $10 and a 75% chance to gain $0. • Decision (ii): Choose between • Csure loss of $7.5 • D75% chance to loss $10, and a 25% chance to lose $0.

  3. It is often observed people often choose A and D. In Tversky and Kahneman (1981), 60% of participants chose this combination with small real stakes, and 73% did so for large hypothetical stakes. But A and D is first order stochastically dominated: the joint distribution resulting from combination of B and C is a ¼ chance of gaining $2.5 and a ¾ chance of losing $7.5. the joint distribution of A and D is a ¼ chance of gaining $2.4 and a ¾ chance of losing $7.6. These violations are a demonstration of narrow bracketing.

  4. Redelmeier, Donald A., and Amos Tversky. "On the framing of multiple prospects." Psychological Science 3.3 (1992): 191-193. The investment choice in a risky asset can depend on whether the asset is framed as part of a Portfolio of other assets or as a standalone investment. Abstract. We investigated decisions involving multiple independent uncertain prospects. At the extremes, a decision maker may either consider each prospect as a separate event (segregation) or evaluate the overall distribution of outcomes (aggregation). Contrary to choice by segregation, people sometimes reject a single gamble but accept a repeated play. On the other hand, people tend to choose by segregation when a particular gamble is singled out from a larger ensemble. Similarly, physicians make different choices when they evaluate problems on a case-by-case basis than when they consider the broader picture. Peoples' tendency to segregate multiple prospects represents a significant violation of the standard theory of rational choice.

  5. Mental Accounting • Mental accounting describes how people code, categorize and evaluate economic outcomes. A concept named by Richard Thaler (1980).

  6. Examples of Mental Accounting

  7. Integration vs. Segregation • Integration occurs when current and past decisions are viewed together, while segregation occurs when situations are viewed one at a time.

  8. Applications of Mental Accounting in Finance

  9. Benartzi, Shlomo, and Richard H. Thaler. "Myopic loss aversion and the equity premium puzzle." The quarterly journal of Economics 110.1 (1995): 73-92. Myopic loss aversion = mental accounting + loss aversion The authors gave an alternative explanation for the equity premium puzzle: Stock look much less attractive to investor if repeatedly evaluated in short intervals than if considered within the overall investment horizon. In other words: A portfolio or sequence of gambles is less attractive compared to the overall portfolio distribution if each gamble in the set is evaluated separately.

  10. Experiment 2 Q1. Would you accept to participate in two independent draws of a simple lottery: ($200, 0.5; -$100, 0.5)

  11. Experiment 2 Q2. Would you accept to participate the following lottery: ($400, 0.25; $100, 0.5; -$200, 0.25)

  12. The example is due to Samuelson (1963). Consider a decision maker with the value function: v(x)=x, if x>=0 v(x)=2.5x if x<0 This decision maker will accept the aggregate gamble in Q2 as the overall evaluation is positive (+25). However, he assigns the negative value -25 to each of the two lotteries in Q1. Thus, for segregated evaluation the gamble is rejected.

  13. Result of our inclass experiment • Q1. Would you accept to participate in two independent draws of a simple lottery: ($200, 0.5; -$100, 0.5) Yes: Q2. Would you accept to participate the following lottery: ($400, 0.25; $100, 0.5; -$200, 0.25) Yes:

  14. Experiment 3 • In each round, you are given $200 • Lottery: 1/3 probability to win $2.5x, 2/3 probability to lose $1x.

  15. Gneezy, Uri, and Jan Potters. "An experiment on risk taking and evaluation periods." The Quarterly Journal of Economics 112.2 (1997): 631-645. Experimental Design: In our setup, two groups of participants are subjected to the same sequence of choices. Subjects in the first (high frequency) group are supplied with feedback information after each round of the sequence, and can change their choice after each round. The subjects in the second (low frequency) group, however, get feedback information only after three rounds, and can only adapt their choices after three rounds. If our design is successful in manipulating subjects’ evaluation period, MLA would predict that the low-frequency subjects make more risky choices. If subjects use a longer horizon to evaluate outcomes, the trade-off between losses and gains becomes more favorable for the risky option. At the same time, subjective expected utility (SEU) theory does not predict a systematic difference in risk taking between the two treatments in our setup.

  16. Result of our inclass experiment • Average total amount bet Group 1: 1099 cents Group 2 (3 periods decision): 1271 cents The difference was not significant.

  17. Choi J J, Laibson D, Madrian B C. Mental Accounting in Portfolio Choice: Evidence from a Flypaper Effect. The American Economic Review, 2009, 99(5): 2085-2095. Abstract. Consistent with mental accounting, we document that investors sometimes choose the asset allocation for one account without considering the asset allocation of their other accounts. The setting is a firm that changed its 401(k) matching rules. Initially, 401(k) enrollees chose the allocation of their own contributions, but the firm chose the match allocation. These enrollees ignored the match allocation when choosing their own-contribution allocation. In the second regime, enrollees selected both accounts' allocations, leading them to integrate the two. Own-contribution allocations before the rule change equal the combined own- and match-contribution allocations afterward, whereas combined allocations differ sharply across regimes. (JEL G11, J32)

  18. Barberis N, Huang M. Mental accounting, loss aversion, and individual stock returns. The Journal of Finance, 2001, 56(4): 1247-1292. A non-technical summary by the authors: Suppose that you own a portfolio of three stocks – A, B, and C -- and that, over the course of a year, your holdings of stock A go up in value by $1000, your holdings of stock B go down by $1000, and your holdings of stock C go up by $500. If you do Portfolio accounting, you look at the performance of the overall portfolio, and, since its value went up by $500, you feel good. If you do stock-level accounting, however, you look at the performance of each stock separately: you feel good about the performance of stocks A and C, but bad about the performance of stock B.

  19. In this paper, we study two kinds of mental accounting and compare their predictions for financial markets. Under the first kind of accounting, investors derive pleasure and pain from gains and losses in the value of their overall stock market holdings, and are more sensitive to losses than to gains. We call this “portfolio accounting” because people are paying attention to the performance of their portfolio. Under the second kind of accounting, investors derive pleasure and pain from gains and losses in the value of individual stocks that they own, and are again more sensitive to losses than to gains. We call this “stock-level accounting”.

  20. Barberis and Huang argued that when investors are loss averse and do portfolio accounting, then the average return of stock market has to be quite high. Yet, when investors are loss aversion and do stock accounting, then the average return on the stock market will be even higher. The reason is that people who do stock- level accounting focus on the fluctuations of individual stocks – and since individual stocks are more much more volatile than a portfolio of stocks, these fluctuations will appear very alarming. As a result, these investors perceive the stock market to be Very risky. The stock market therefore needs to earn a very high average return to compensate.

  21. The authors then apply the framework to interpret the US stock market behavior over the 20th century. In the firsthalf of the 20thcentury, mutual funds were not common – to get exposure to the stock market, people invested directlyin individual stocks. This suggests that, at the time, stock-level accounting was quite common: many people probably tracked their performance stock by stock. Towards the endof the 20thcentury, however, mutual funds became very popular. This probably shifted investors towards portfolioaccounting: after all, mutual funds group stocks into portfolios and report the performance of those portfolios. Above, we argued that, under stock-level accounting, people perceive the stock market to be more risky than under portfolio accounting. Therefore, if, over the course of the 20thcentury, there was a shift from stock-level accounting to portfolio accounting, there would also, concurrently, have been a shift in perceptions about the stock market – in particular, a shift towards viewing it as less risky. This, in turn, would have led to people to push the value of the stock market up. Perhaps this is one reason why the stock market didrise dramatically in the final two decades of the 20th century.

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