Lecture 7: Behavioral Finance

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Lecture 7 Behavioral Finance

• The Role of Psychology

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Questionnaire, Part IGive 90 Confidence
Interval

1. How much does the Statue of Liberty weigh, in
   tons? (entire steel-reinforced copper figure)
2. What is the 2000 population of Turkey?
3. How many square miles in Sahara Desert?
4. Endowment of Yale University as reported in
   1998-9 Support of Education Survey?
5. How much, in dollars, does one receive if one
   wins the Pulitzer Prize (2001)?

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Questionnaire, Part IIGive 90 Confidence
Interval

• 6. US Population in first census (1790)
• 7. US Traffic fatalities New Years Day 1/1/98
• 8. Connecticut land area, square miles
• 9. Height of Mount Everest
• 10. 100-meter dash winner, time in seconds, 1896
  Olympics

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Overconfidence

• From my October, 1987 Investor Survey
• Did you think at any point on October 19, 1987
  that you had a pretty good idea when the market
  would rebound?
• Institutional 29 yes, Individual 28 yes
• Among buyers 47, 48
• If yes, what made you think you knew when a
  rebound would occur?
• Answers intuition, gut feeling, common
  sense

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Prospect Theory

• Kahneman and Tversky, Econometrica 1979
• Two elements, value function and weighting
  function
• Elements replace utility function and
  probabilities in expected utility theory

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Samuelsons Lunch Colleague

• Paul Samuelson offered two-to-one odds to his
  colleague colleague wins 200 if heads, loses
  100 if tails. Colleague refused bet.
• Samuelson asked him if he would take 100 such
  bets. Colleague said yes.
• Samuelson proved mathematically that his
  colleague was not rational (from expected utility
  theory). Scientia 98108-13, 1963

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Allais Paradox

• Which do you prefer 25 chance of winning 3000
  and a 20 chance of winning 4000? 35,65
• Which do you prefer 100 chance of winning 3000
  or an 80 chance of winning 4000? 80,20

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Regret Theory

• Prospect of regret pain generates avoidance
  behavior
• People avoid selling stocks that have gone down
  in value, rush to sell those that have gone up
  (disposition effect).

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Cognitive Dissonance

• Mental conflict that occurs when one learns ones
  beliefs are wrong, avoidance behavior
• Ads for recently purchased cars
• Disposition effect

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Wishful Thinking Bias

• People exaggerate probability that their team
  will win.
• People exaggerate probability that the candidate
  they favor will win.

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Attention Anomalies

• Attention is fundamental aspect of human
  intelligence and its limits
• Social basis for attention
• Inability to account for ones attention
• No arbitrage assumption of financial theory No
  ten-dollar bills lying around. Does not require
  everyone is paying attention.

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Anchoring

• Kahneman Tversky wheel of fortune experiment
• Subjects unaware of their own anchoring behavior
• Examples stock prices anchored to past values,
  or to other stock prices in same country.

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Mental Compartments

• Shefrin Thaler Compartments current wage,
  asset, and future.
• Shefrin Statman Investors have a safe part
  of their portfolio that they will not risk, and a
  risky part of their portfolio that they can
  have fun with

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Representativeness Heuristic

• People judge by similarity to familiar types,
  without regard to base rate probabilities
  (sensitive, artistic woman, sculptress or bank
  teller)
• Tendency to see patterns in what is really random
  walk

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Disjunction Effect

• Inability to make a decision that is contingent
  on future information
• Shafir Tversky People who took one of
  Samuelsons lunch colleague bet were asked if
  they would take another. Most took the second bet
  whether or not they won the first. But most would
  not take second bet before outcome of first was
  known.
• Reaction of stock market to news

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Gambling Behavior

• 61 of US adults gambled in 1974.
• 1.1 of men and 0.5 of women are compulsive
  gamblers
• Gamblers Anonymous
• Gambling associated with self esteem and
  competence
• Generates an aroused state that chases away cares

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Magical Thinking

• B. F. Skinner 1948, fed hungry pigeons
  mechanically at 15-second intervals. Pigeons
  developed superstitions
• Stock market responses to events may have similar
  origins

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Quasi-Magical Thinking

• Newcombs Paradox (named after William Newcomb of
  Livermore Labs by Robert Nozick, 1969,
  reformulated by Shafir Tversky) Subject plays
  a game with a computer, and is told that the
  consumer can predict from his behavior what he
  will do. Two boxes appear on computer screen.
  Subject is told that computer knows pretty well
  whether subject will choose box A or both box A
  and B. Computer puts 1000 in box A, and
  1000,000 in box B if it thinks subject will
  choose box B alone, otherwise puts nothing in box
  B.

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Quasi Magical Thinking II

• Langer People bet more on coin not yet tossed.
• People pay more for lottery ticket in which they
  choose the number

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Culture and Social Contagion

• Social cognition, collective memory
• Durkheim, 1897, suicide rates differ across
  countries for no more reason than different
  cultural themes
• A global culture in todays world