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Behavioral Finance/Economics

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Behavioral Finance/Economics Much of finance/economic models assume utility maximizing behavior or profit maximizing behavior on the part of economic agents. – PowerPoint PPT presentation

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Title: 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 Winners 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
  • Peoples 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?
  • xy1.10, x-y1, 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-makers 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 managers 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
    wont 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 dont 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 dont
    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.
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