Behavioural Finance and personal investing summary
Week 1: Introduction
Semi open book, the 12 papers you can bring to the exam.
1/3 is knowledge, 2/3 about the papers. Exam is 85% and the perusal is 15%, every week before 10
Wednesday 5 comments for the papers.
Appetizer: get to now the field
What is Behavioral Finance [BF]?
Describe, understand and analyze financial behavior using insights from other [social] sciences like:
psychology, sociology, neuroscience.
-> both market behavior and behavior of market participants
“Study of finance based on credible assumptions about how people behave” [William Forbes, 2010] .
if you think about yourself the assumptions about fullt rational economic agents aren’t always true.
Positive science [as opposed to normative] (means a science that looks at how people actually
behave rather than normative, how you should behave. When looking at core theories in behavioral
finance they assume how you should behave. In this course this is a far cry from the real world, why is
there a discrepancy (between finance and what people really do). Its about the mind, psychology.
-> Please note that BF does not intend to replace the [normative] neoclassical finance [NF];
BF even crucially depends on it: NF supplies tools to optimize decision making, and provides
a useful benchmark to contrast actual decision making and market outcomes.
Some key psychological concepts › Framing effects (how frame) › Mental accounting (boxes in mind)
› Loss aversion (people hate to loose) › Probability Weighting (people don’t take probability as
probability) › Heuristics (mental shortcuts to facilitate decision making) › Emotions (feelings) › Self-
Deception (sometimes not good at many things) › Social forces (others influence us) & Herding
(follow others rational but sometimes not) › Bounded Self-Control (discipline)
Behavioral Finance vs Modern Finance
Started with perfect markets and people. Ideally,
handy. Nowadays, markets are not perfect.
Information not symmetric, etc. still we assume
people behave as if they are rationale and
optimize. Then the next step is BF: we are dealing
with humans in fifnancial amrkets also.
The two levels of analysis in Behavioural Finance
I. Micro Judgment & Choice: • Corporate Managers [Behavioral Corporate Finance]
Investor behavior [both retail and professionals] -> Focus of this course
II. Market Observations: • Some classic examples of Anomalies [or “Puzzles”] today • Keep
in mind the “Sentiment” papers of week 6
,Categorization of Investor Behaviour. The fields within investor behavior.
Portfolio composition behavior - Influenced by Framing, Heuristics & Emotions
Trading behavior - Influenced by Self-deception & Inertia
Buying Behavior - Influenced by Heuristics & Emotions
Selling Behavior - Influenced by Framing, Emotions & Limited Self-control (here the loss aversion is
important)
Why is this study of investor behavior relevant?
Micro argument: - It affects the investor’s wealth & well being (if affects us and people around us)
Macro argument - It may affect the market, and thus relates to market efficiency
Some history:
Allais Paradox [1953] :
The paradox thus refers to a
contradiction of expected utility
theory.
Sometimes people don’t act on the
expected utility theory. Has to do
with framing, probability weighting
etc.
Anecdotes [based on Thaler, 2018]
Your friends thank you for removing a bowl of cashew nuts before having a fancy dinner.
• But , Econs always prefer more choices to fewer
You own a free ticket to a concert. You decide not to go because of the bad weather, but remark that
if you would have paid the full price, you probably would have gone.
• But, Econs should ignore sunk costs. We are taught to ignore sunk cost, but don’t do this actually.
Human behavior contradicting theory.
You are shopping for a mobile. The price is €25 [€350]. Someone tells you that a 10 minute drive
away the price is only €15 [€340]. You decide to go there [not to go there].
• But, Econs should value time consistently
,Some examples:
Two different option for the payment. People don’t like
option 1. Better give the discount.
Same situation, but framing. Reference point is
different.
Second example: How happy and how many dates did
you have.
No correlation here. Assessment happiness and dates
doesn’t influence.
Reverse the question, first ask for dates and then the
happiness. Then 66% correlation. Experiment how we
can manipulate and how out mind works. First giving a clue, putting in the mind. 0 dates is quite bad
think by yourself and then correlate. That’s happening in your mind.
Third: WTP for insurance when dying. First one covers
more. But, humans pay more for B. 20% more for B, for
lower coverage. Not consistent with expectance of
economist. Its fear, terror accidents, triggers in minds.
Then pay more.
Market Anomalies (challenge the efficient market hypothesis, one of the most important things in
finance. = prices are right).
From 1980 Behavioral Finance gained momentum with
studies on so called market anomalies that posed a
serious challenge to the Efficient Market Hypothesis, e.g.:
• 1985: Winner-Loser Effect • 1987: Stock market crash
In week 6 we’ll also take a look at: • Post Earnings
Announcement Drift, Closed end funds puzzle, Twin stock
anomaly, Stale news and Name Change effects, Equity
Carve-out mispricing, and Mood effects. • Sentiment
induced mispricing
Does the stock market overreact? 2 portfolios here. They
had rule: stock part of portfolio on performance of last 5
years. Best put in the winner portfolio and worse in loser
portfolio. Average return of these portfolios: huge return for the losers. This isn’t consistent with the
efficient market hypothesis. Past prices cant predict the future? One used past prices, huge effect.
Black Monday: Thaler 1987 “It is hard to argue that the price at the close of trading on Thursday, and
the price at close of trading the following Monday - which was more than 25% lower - can both be
rational measures of intrinsic value, given the absence of news. Nothing happened, expect the price
decline. When believe in rational markets then this can only happen with news event. Not then its
something different, emotions/panic etc.
,Week 2: Prospect theory, Framing and Mental Accounting
Framing • Examples of how and when Framing matters
Prospect Theory • Standard risk preferences • Intuitions behind Prospect Theory (the maths behind it
see the separate video on Brightspace)
Mental Accounting
Investor behavior: The Dispostion Effect • Drivers • Why suboptimal? • Empirics
Framing:
Quite some papers like Tversky and Kaneman. Its part of the prospect theory. We have visual illusions.
The context fools out brain with the tables (Shepard tabletop illusion). Also the Muller-Lyer illusion,
which line is longer. Or Bruner and Minturn illusion, with 12,13,14 and ABC, context tells its B or 13.
As humans we need techniques to assist us in these visual illusions. In this course cognitive illusions.
Cognitive is about information and how the memory functions. Brain is making these mistakes,
illusions. Knowing about them helps, but doesn’t solve.
Defining Framing
The way in which a question is asked to or a problem is mentally viewed by a decision maker has a
strong impact on the answer given or the decision made. › The context and positive or negative
framing of the same problem can have a substantial influence on judgement and choice. › Form thus
may override substance. › Driven by reliance on intuition and emotions.
Example from the 2003 Johnston and Goldstein
paper: comparing countries if the citizens want to
become organ donors. What’s going on here?
Opt out is the thing here. Defaults. Do defaults
save lives. The right countries is opt out, optional
out. Opt in is less people consent, optional in. left
side, people lazy, don’t fill in the form (90%
probably wants to be donor).
Another important driver is the endorsement effect. The government gives implicit advice. Its also
emotions.
Amsterdam: need to print the yes and then the folders. Is the same, but people again are lazy etc.
Many people get it now and don’t like it. Its an effort to put the sticker, most don’t do it. Even tiny
effort is difficult. 60% didn’t get it anymore, enormous paper waste saving.
,Rational choice required well defined preferences: know what we want
When people tank it, most people like B. then same situation in different frame, then same people
chooses C over B. How possible when you
have well defined risk preferences?
People have something else they have in
their mind and take into account?
Heuristics (nextweek). Makes sense, but
when you rely on these you make a
mistake from rational choice theory.
Famous framing experiment (from the book)
Tversky & Kahneman,
Science, 1981
This is just reframing from
dying to people that live
People who for us decide to
combat diseases they asked.
People that matter here, can
also be manipulated.
For us students: 77 of us exposed to
live save frame, 72% going for the risk
averse option. Going for the knowing
certain how many people survive.
Almost same, 80 students in other
group, risk seeking majority there. Not
as extreme as original, but almost the
same, 40 years later. Also shows we
are in same situation. When making
decision, w can be manipulated to
make risk seeking or averse option.
Another example: allocate
money over 5 funds. One equity
fund and 4 bund funds. And
other way around. The equity
stake is one of the key
components, driver of volatility.
Allocation to equity we look at,
we see huge difference. Make
sure the option you put in the
plan greatly affect the choices
of the participants. Choice architecture also, how frame the context, knowing it influences them.
,Prospect Theory: Intuitions (Amos Tversky & Daniel Kahneman designed it)
A typical assumption in economic analysis is that
people have stable risk preferences [commonly:
risk aversion], people apply probabilities linearly
to uncertain outcomes, and utility is derived from
final wealth states.
We assume people are risk averse. Do take them
but want compensation. Also the utility function
assumes this on the slide.
wWe like the sure rather than the
gamble, risk averse. In line with risk
preference story.
Small change, add minuses to the
numbers. It becomes 50/50. Risk averse
to risk seeking.
Now the area of smaller probabilities.
Same again with loss, than more people
back to risk averse.
Interesting, hypothetical and not real life. But tells a lot. You can be, the preferences, key thing. Lets
see this:
There is a groups that’s always risk
averse, small this is the usual
assumption in finance). Small risk
seeking always, even smaller. Both risk
averse and seeking is 88% of us.
It depends on the sign (reflection effect
from Tversky and Kaneman) and
probabilities of outcomes.
People also care about final wealth?
They said:
Is it true? 300 euros given, and then
choice, gives certain amount with
change.
Same outcome, framed in terms of
losses. Higher amount in beginning.
Same outcome. How do we choose?
The same pattern, most of us are preferring the risk free option. If we change it, slight majority for
risky option. Risk seeking in loss, we focus maybe more on changes. Quite big group, half almost
focusses on changes in health rather than health itself.
,Preferences in mixed gambles:
What’s the lowest amount of money you require
before taking this gamble.
Median needs 775 gain to compensate for this
loss.
When we can loose something we want the
double size gamble. Requires a lot of risk aversion = loss aversion. People hate to loose 500 and
require huge premium to get them in the loss possibility.
----
Loss aversion is driving risk preferences, and these can be in all directions.
Impact 1: the impact of the sign of outcomes: Giving child a marshmallow, then happy. Another kid
give her two. Before she can eat, take one away. The happiness will be worse, but same situation. In
rational world the same situation. This is loss aversion, losing has consequences.
Impact 2: focus on changes fit our sensory system: imagine you put hand in 25 degree bowl. Should
feel the same. Now teel that the right
hand comes from bowl of 0 and left
from 50. Then in bowl, exact situation,
but feeling is different. Humans don’t
care about the absolute wealth, but the
change in it. The key focus in it.
Intuition 3: focus on change needs a
reference point: comparing to what.
This is a mental process here the three options. How we frame it influences the willingness of sell.
This is the essence of the disposition effect we will talk about.
The profit frame will lead to higher sell propensity than the loss frame.
This reference point can be manipulated.
Research example from the Rio 2016 Olympic games: Olympic tennis champions. Research facial
expressions. When they win/immediate and when they get the medal. The silver one outperformed
the bronze, but not that happy. Bronze happier than silver. This has to do with reference point. For
silver this is gold, they lost gold. For the bronze this is 4th, they were better than this.
Intuition 4: diminishing sensitivity: holds for both losses and gains. We see that happening both
domains. Makes sense. When in dark environment small change is big. When in light the change is
smaller. Diminishing sensitivity.
Intuition: linear probabilities: Imagine these
three starting point, chances 1% extra probability.
In utility it doesn’t matter, all up by 1. As human,
not the same. First from impossible to possible, C
is quite possible to possible. Same for the others
down below. Psychological are different. They
question linear probability for this. Probabilities
, are transformed in the mind. 1% has much bigger impact as other ones. Especially B has huge impact,
the loosing impact is gone. The emotional effect when realizing this. Willingness to pay for getting rid
of this 1% outweighs the value of it.
➔ As a consequence people transform objective probabilities
If we want to depict human behavior/risk preferences we have to take all into account: marginal
utility, loss aversion, changes rather than wealth levels and transformations of probabilities. That’s
the essence of prospect theory.
These insights led to Prospect Theory
Two fases: • Framing/Editing: e.g. choosing a reference point • Evaluation: embedded in two
mathematical functions
Major “Ingredients”: A. Reference dependence [→ People focus on Gains vs Losses, thus changes
compared to a reference point] B. Impact of Loss Aversion [→ People hate to lose] C. Diminishing
sensitivity [both for losses and gains] [→ Leading to asymmetric risk preferences] D. Application of
Probability Weighting [→ People transform probabilities]
Fundamental difference from utility theory and prospect theory is that prospect theory is a positive
theory, descriptive, it tells how people behave, expected utility theory tells how people should
behave. Look at wealth, not what people do. Prospect theory a nice addition. Why people behave the
way they do.
➔ In this week’s extra video the PT-equations are explained
Mathematics behind it. it’s the value.utility of it
* probability. These reflected in the two
equation.
Value equation, concave and convex, risk averse
and risk seeking.
Objective probabilities and how we perceive.
Wee see on low side people overweight (1% is 5
times important).
Mental accounting: kind of a framing issue, more specific. It’s from Thaler.
Normal accounting in companies gets grip in finance in organizations. Labeling the money, for
salaries, investments etc. Same in human mind, people label money. Kids, retirement etc.
Traditional people have money and total is total. But people label it into groups to get grip on finance
like normal accounting. Sometimes real account (for kids) but most are just mental constructs.
Overview of Mental Accounting: Set of cognitive operations used by individuals and households to
organize, evaluate, and keep track of financial activities.
The key idea is that people categorize money and mentally allocate it to a certain ‘bucket’.
Money placed in one bucket is not interchangeable with money in another. Money is thus treated as
non-fungible, in sharp contrast to the economic principle of perfect fungibility of money. (in
traditional its perfectly fungible, label different this changes).
