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    Oct Netherlands 101209

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    Prashanth Annamreddi
    - Behavioral finance aims to improve understanding of financial market participants by incorporating insights from psychology, as people do not always act rationally as traditional finance models assume. - Studies using the game show "Deal or No Deal" show that people take more risks after experiencing losses compared to their reference point, contrary to rational models. This suggests people are loss averse. - As a result, incentive schemes and risk management models need to account for how risk taking behaviors change with gains and losses, as greater risk taking after losses can increase market volatility, especially following downturns.

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    Oct Netherlands 101209

    Uploaded by

    Prashanth Annamreddi
    23 views25 pages
    - Behavioral finance aims to improve understanding of financial market participants by incorporating insights from psychology, as people do not always act rationally as traditional finance models assume. - Studies using the game show "Deal or No Deal" show that people take more risks after experiencing losses compared to their reference point, contrary to rational models. This suggests people are loss averse. - As a result, incentive schemes and risk management models need to account for how risk taking behaviors change with gains and losses, as greater risk taking after losses can increase market volatility, especially following downturns.

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    - Behavioral finance aims to improve understanding of financial market participants by incorporating insights from psychology, as people do not always act rationally as traditional finance models assume. - Studies using the game show "Deal or No Deal" show that people take more risks after experiencing losses compared to their reference point, contrary to rational models. This suggests people are loss averse. - As a result, incentive schemes and risk management models need to account for how risk taking behaviors change with gains and losses, as greater risk taking after losses can increase market volatility, especially following downturns.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
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    23 views25 pages

    Oct Netherlands 101209

    Uploaded by

    Prashanth Annamreddi
    - Behavioral finance aims to improve understanding of financial market participants by incorporating insights from psychology, as people do not always act rationally as traditional finance models assume. - Studies using the game show "Deal or No Deal" show that people take more risks after experiencing losses compared to their reference point, contrary to rational models. This suggests people are loss averse. - As a result, incentive schemes and risk management models need to account for how risk taking behaviors change with gains and losses, as greater risk taking after losses can increase market volatility, especially following downturns.

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    of 25

    Behavioral Finance and Risk Management

    Guido Baltussen,
    October 12th 2009

    13 October 2009

    What QS can learn from Behavioral Finance

    Behavioral Finance
    The traditional finance paradigm studies finance by
    (irrationally) assuming all agents are rational
    optimizers.
    By contrast, behavioral finance aims at improving
    our understanding of the behavior of financial
    markets and its participants, by applying insights
    from psychology and other behavioral sciences
    BF started in 1750s, and it grew rapidly during the
    last 10 years.
    I will discuss one of the latest insight and its relation
    with incentive schemes and risk management
    13 October 2009

    What QS can learn from Behavioral Finance

    Summary: irrational risk preferences


    Question: How do people respond to losses relative
    to a benchmark, or reference point?

    To study this data I use date from the television


    game show Deal or No Deal, which is a perfect
    natural laboratory for analyzing decisions that
    involve risk
    I find that people take more risk after losing
    substantial amounts of money

    This is inconsistent with the rational (utility-based)


    models, which form the basis of many incentive
    schemes and risk management models.
    13 October 2009

    What QS can learn from Behavioral Finance

    13 October 2009

    What QS can learn from Behavioral Finance

    Round 1
    Mean = 453,326
    13 October 2009

    What QS can learn from Behavioral Finance

    Round 2
    Mean = 537,602
    13 October 2009

    What QS can learn from Behavioral Finance

    Round 3
    Mean = 689,911
    13 October 2009

    What QS can learn from Behavioral Finance

    Round 4
    Mean = 947,690
    13 October 2009

    What QS can learn from Behavioral Finance

    Round 5
    Mean = 1,263,583
    13 October 2009

    What QS can learn from Behavioral Finance

    Round 6: No Deal
    Mean = 1,515,300
    13 October 2009

    What QS can learn from Behavioral Finance

    10

    Round 7
    Mean = 1,894,000
    13 October 2009

    What QS can learn from Behavioral Finance

    11

    Anecdotic evidence?
    Unlucky Frank

    Dutch contestant,
    aired January 1, 2005
    13 October 2009

    What QS can learn from Behavioral Finance

    12

    Round 1: No Deal
    Mean = 383,427

    13 October 2009

    What QS can learn from Behavioral Finance

    13

    Round 6: No Deal
    Mean = 102,006

    13 October 2009

    What QS can learn from Behavioral Finance

    14

    Round 9: No Deal
    Mean = 5,005

    13 October 2009

    What QS can learn from Behavioral Finance

    15

    Contestant Frank, NL, Jan 1, 2005

    13 October 2009

    What QS can learn from Behavioral Finance

    16

    Main findings
    Choices are influenced by previous, but irrelevant,
    outcomes, even with these very large amounts at stake:
    People take more risk if they are in a very unfavorable
    (loser) situation.
    This tendency to take more risk after losses holds while
    no real losses are at stake, but expected winnings fall
    short of (personal) benchmark.

    13 October 2009

    What QS can learn from Behavioral Finance

    17

    Implications(1)
    What does this mean for investments?
    People take more risk if they are losing money in an
    absolute sense (f.e. day traders)

    People take more risk if they are losing money in a


    relative sense (f.e. fund managers )
    More risk taking in markets tend to increase volatility

    13 October 2009

    What QS can learn from Behavioral Finance

    18

    Implications(2)
    Incentive schemes:

    Incentive schemes tend to increase risk taking behavior


    Since outcomes below benchmark feel as losses, repay
    schemes may only provide a partial solution
    Risk management:
    More risk taking after losses increases volatility (risk) of
    investments, especially after down markets.
    Risk management managers should take this dynamic
    aspect of behavior into account to not misjudge risk.

    13 October 2009

    What QS can learn from Behavioral Finance

    19

    Summary
    People do not behave in accordance with the standard finance
    models
    Instead, the psyche of investors has substantial
    consequences for the behavior and risks of financial markets

    Hence, as risk managers be aware of this!

    13 October 2009

    What QS can learn from Behavioral Finance

    20

    Questions ?

    13 October 2009

    What QS can learn from Behavioral Finance

    21

    Appendices

    13 October 2009

    What QS can learn from Behavioral Finance

    22

    Two Theories of Risky Choice

    Expected Utility Theory (John von Neumann and Oskar


    Morgenstern, 1944)

    Describes how people should make decisions by means of


    rational computations based on objective outcomes and
    probabilities, without cognitive limitations and emotions

    13 October 2009

    What QS can learn from Behavioral Finance

    23

    Two Theories of Risky Choice

    Prospect Theory (Amos Tversky and Daniel Kahneman, 1979)

    Describes how people actually make decisions, based on several


    anomalies that have been observed in experiments, including
    - framing in terms of gains of losses
    - loss aversion
    - convex value function for losses

    13 October 2009

    What QS can learn from Behavioral Finance

    24

    Decisions of Losers and Winners


    Loser
    Round

    No.

    %D

    %BO

    Winner

    No.

    %D

    %BO

    No.

    %D

    6%

    17

    0%

    6%

    17

    0%

    6%

    17

    0%

    15%

    17

    0%

    12%

    17

    0%

    15%

    17

    0%

    40%

    17

    12%

    29%

    17

    41%

    31%

    17

    6%

    69%

    14

    14%

    58%

    13

    46%

    54%

    14

    21%

    82%

    10

    10%

    71%

    10

    20%

    78%

    10

    40%

    94%

    50%

    85%

    43%

    86%

    63%

    99%

    25%

    97%

    67%

    99%

    75%

    105%

    0%

    91%

    67%

    100%

    100%

    120%

    0%

    91%

    100%

    72

    14%

    70

    31%

    72

    25%

    2 - 9

    13 October 2009

    %BO

    Neutral

    What QS can learn from Behavioral Finance

    25

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