Behavioral Finance/Economics

1. Behavioral Finance/Economics • Much of finance/economic models assume utility maximizing behavior or profit maximizing behavior on the part of economic agents. • Economic agents make mistakes. Do we learn from those mistakes? Mistakes do not necessarily violate the assumption of utility or profit maximization. • However, if we continue to make the same mistakes, or, if people make mistakes in the same way, then the assumptions of utility maximization or profit maximization may be suspect. • Behavioral economics is an attempt by some researchers to redefine economic decision-making with a psychological foundation. • Behavioral economics accounts for behavior like procrastination, self control, envy, revenge, love, the madness of crowds, bandwagon effects, snob effects, etc. • Efficient Markets Hypothesis-Prices are right • John Maynard Keynes- “ Markets can stay irrational longer than investors can stay solvent.”

2. Some researchers in behavioral economics and behavioral finance • Daniel Kahneman (economist/psychologist) and Amos Tversky (psychologist) – Econometrica (1979) “Prospect Theory: An Analysis of Decision under Risk” in Kent Library • Richard Thaler (economist)- The Winner`s Curse: Paradoxes and Anomalies of Economic Life , Advances in Behavioral Finance- in Kent Library • Robert Shiller (financial economist)-Irrational Exuberance -in Kent Library • Matthew Rabin-(economist) “Incorporating Fairness into Game Theory and Economics” The American Economic Review, 1993. In Kent Library

3. Daniel Kahneman- Thinking Fast and Slow • People’s brains have a System 1 (the slow, rational part) and a System 2 (the fast, emotional part). • How many animals of each type did Moses take with him on the ark?

4. A bat and a ball cost a total of $1.05. The bat costs $1 more than the ball. How much does the bat cost?

5. How many animals of each type did Moses take with him on the ark? • How many animals of each type did George bush take with him on the ark? • x+y=1.10, x-y=1, x=?

6. Some perceived regularities in decision-making that seem to be inconsistent with utility maximization. • Framing Effects-frame is the combination of beliefs, values, attitudes, mental models, and so on which we use to perceive a situation. • Kahneman and Tversky defined a decision frame as ‘the decision-maker’s conception of the act, outcomes and contingencies associated with a particular choice.’ • When would a person be more likely to get an operation? • Doctor tells them “90% of patients who undergo this procedure are alive after 5 years.” • “10% of patients who undergo this procedure are dead within 5 years.”

7. Tversky and Kahneman told people to assume there was disease affecting 600 people and they had two choices:  • Program A, where 200 of the 600 people will be saved . • Program B, where there is 33% chance that all 600 people will be saved, and 66% chance that nobody will be saved. Expected value of program B is 200 lives saved (and 400 people will die). • The majority of people selected A, showing a preference for certainty or risk aversion. • They then offered them another two choices: • Program C, where 400 people will die, 200 people live. • Program D, where there is a 33% chance that nobody will die, and 66% chance that all 600 people will die. Expected value of D is 200 people live and 400 people die. Same as program B. • Most people now selected D, seeking to avoid the loss of 400 people. • Notice how the framing makes the difference. Prospects A and C are the same, and B and D are the same. • Framing the prospect as a gain makes people risk averse. Framing the prospect as a loss makes people risk takers.

8. An Example: The manager`s dilemma • You are the manager of a call center. The call center takes calls from customers who are having problems with your product. For the call center to be successful you have to charge a price for the service. There are two types of people who answer the call: those who are native English speakers and those who are non-native English speakers.

9. You want to satisfy the customer and not make them frustrated with the person taking their call. • There are too many incoming calls for everyone to get a native English speaking answerer. • How should you charge for the service? • Charge a high regular price and give a discount for those choosing a non-native speaker? Say $2 is regular price, $1 discount for choosing a non-native speaker? • Or, charge a $1 regular price for non-native speaker and a $1 premium for talking to a native English speaker?

10. Anchoring effects-Initial impressions become reference points that anchor subsequent thoughts and judgments. 1. Investors who are considering selling shares of a corporation look at the stock price. Is it higher or lower than it was when they bought it? 2. Dramatic or easy-to-recall events often become strong anchors. For example, the vividness of the horrible events of September 11 caused many to view airline travel as too risky, but travel has never been safer. • Overconfidence-causes people to trade stocks more often.

11. The endowment effect-Once people possess an item they frequently will not accept a money amount greater than the amount the individual originally paid for the item. An example: Some people won’t throw away junk, but store it in storage units etc. • An implication of the endowment effect is that people treat opportunity costs differently than out-of-pocket expenses. • Foregone gains are less painful than perceived losses (A perception manifested in people's judgments about fairness)

12. Loss Aversion: The disutility of giving up an object is greater than the utility associated with acquiring it. Examples: 1. People are often reluctant to sell a stock that has performed poorly until it is back to the price it was originally bought losing out on the opportunity to earn returns in another investment. 2. Battered women often return to jerks who beat them. 3. You want to sell your house which you bought for $105,000. However, given current market conditions, your house is only worth $100,000. You receive an offer for $100,000. Interest rates are 7%. You turn down the offer. You correctly assume you will receive an offer for $106,000 one year from today.

13. Implication of loss aversion: Status quo bias-individuals have a strong tendency to remain at the status quo, because the disadvantages of leaving it loom larger than advantages. • Need to be careful in selecting the default option. Should it be “opt in” or “opt out.” • People save too little- • Default option 1-employers always enroll employees in a retirement 401k plan. • Default option 2-employers always increase your contribution in line with your pay increase. .

14. Prospect theory vs. Expected utility theory • Expected utility theory suggests that individuals can determine expected values of risky prospects and make choices consistent with utility maximization. • Prospect theory-people are not good intuitive statisticians. Likely outcomes are estimated to be less probable than they really are; and outcomes that are quite unlikely are typically estimated to be more probable than they are. Furthermore, people often behave as if extremely unlikely, but still possible, outcomes have no chance whatsoever of occurring.

15. Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and she participated in anti-nuclear demonstrations. Which of the following statements are more probable? • A. Linda is active in the feminist movement. • B. Linda is a bank teller. • C. Linda is a bank teller and is active in the feminist movement.

16. Perceptual Contrasting Effects-When we make decisions, we tend to do it by contrasting between the decision item and reference items. When two things appear close to one another, we will tend to evaluate them against one another more than against a fixed standard. • When you meet two other people, you are likely to compare each against the other on several dimensions to decide whom you prefer. This may include physical beauty, similarity of interests, and various personality factors.  • A simple physical way of illustrating perceptual contrast is to put one hand into hot water and the other into cold water, then move both hands to lukewarm water. The cold hand will feel hot and the hot hand will feel cold. • To make something look good, first show something of inferior quality. Or, to get someone to buy something expensive, first show them something even more expensive.

17. Self-control problems • If we expand the choice set (the budget set) that individuals face are they better or worse off? • Is it appropriate to give gifts of food to a person who is trying to diet and lose weight? • Should we offer an alcoholic a drink? • Should we take a compulsive gamble to a casino to see a show?

18. Public Policy and Self-Control • Programs such as food stamps and other welfare programs expand the choice set of individuals who receive those benefits. • Does it make them better off? • Many poor individuals have the worst problems with self-control. • They have very high discount rates and care about the present more than the future.

19. Time inconsistency Hyperbolic discounting-people generally prefer smaller, sooner payoffs to larger, later payoffs when the smaller payoffs would be imminent; but when the same payoffs are distant in time, people tend to prefer the larger, even though the time lag from the smaller to the larger would be the same as before. When given a choice, some people would prefer $50 today to $100 one year from now, but would choose $100 six years from now versus $50 five years from now. ”Eat, drink, and be merry, for tomorrow you may die.”

20. Lots of people want the IRS to withhold more than they owe in taxes so they get a big refund check. This behavior amounts to giving the IRS an interest free loan. School teachers who work 9 months are given the option of receiving their salary over 9 months or over 12 months. Many choose the 12 monthly checks because they don’t “trust” themselves. They lose interest income. Before you choose a college think of the reputation the college has: is it a diploma mill or does it require hard work? Most people prefer the college to have a good reputation, but once they arrive, they often prefer easy classes.

21. Availability bias-Kahneman and Tversky-People seem to judge the odds of a given event occurring based on how readily an example comes to mind. • Acquiring information is costly and people look for shortcuts. • Imagine a situation in which gifts are being distributed in red and blue boxes. You don't know what the boxes contain, but everyone is asking for a red box. Therefore, you ask for a red box too, assuming they must know something you don't and because you want to appear "in the know" too. • This case is rational herding or kind of like the band-wagon effect. Now, consider that everyone was thinking just like you, and that the chain began only because a prominent individual was seen picking a red box.

22. When asked to rate the probability of a variety of causes of death people tend to rate "newsworthy" events as more likely. • People often rate the chance of death by plane crash higher after plane crashes, and death by natural disaster as too likely only because these events are reported more often than common causes of death.

23. Confirmation bias-People look for examples and anecdotes that confirm their prior beliefs. • Example: I think that my dreams and nightmares foretell the future. I have a dream and the next day it comes true confirming my prior belief. However, I ignore all the times my dreams don’t come true. • After people buy a new car they eagerly read the advertisements for that car  - the ads, of course, confirm that their purchase was a good one.