Notes to Lecture II

Sahin, C

I Prospect theory: an analysis of decision under risk (Kahneman & Tversky1979)

Reference points, loss aversion, anchoring and adjustment
1. Prospect theory identifies a departure from preference specifications that
emphasize levels of goods and wealth as the sole drivers of value or utility.
2. Loss aversion refers to a kink in prospect theorys value function at its
origin, specifically that losses are disliked more than equal-size gains are
liked.
3. Belief formation process (not a utility perception) under which one begins
at a specific initial value, salient but perhaps entirely irrelevant, and then
adjusts toward a final estimate based on other considerations.
Largely irrelevant reference point stock prices of the target play roles in
merger and acquisition activity through both the prices and the types and quantities of rms traded.
This psychological motivation has well-established roots in the anchoring-and-conservativeadjustment estimation method, the salience of initial anchor positions in negotiations, and the prospect
theory tenet that the utility of an outcome is a function of the outcomes distance from a reference
point.
1. Prior stock price peaks of targets affect several aspects of merger and acquisition activity.
2. Offer prices are biased toward recent peak prices although they are economic- ally
unremarkable.
3. An offers probability of acceptance jumps discontinuously when it exceeds a peak price.
4. Conversely, bidder shareholders react more negatively as the offer price is influenced upward
toward a peak.
5. Merger waves occur when high returns on the market and likely targets make it easier for
bidders to offer a peak price:
a. It is well known that merger waves coincide with higher recent returns and stock
market valuations. The potential link to reference price peaks is that higher market
valuations mean that more targets are trading closer to their peak prices. Therefore,
these reference points may become easier to satisfy (from the perspective of targets)
and to justify (from the perspective of bidders) when valuations are high than when
they have fallen
6. Parties thus appear to use recent peaks as reference points or anchors to simplify the complex
tasks of valuation and negotiation.
7. A 10% increase in the 52-week high is associated with a 3.3% increase in the offer premium,
controlling for a variety of bidder, target, and deal characteristics.
8. higher offer prices are associated with higher probabilities of deal success
9. The probability of deal success increases discontinuously by 4.46.4% when the bidder
makes an offer price even slightly above the targets 52-week high.
10. The bidders announcement effect becomes more negative with the targets distance from its
52-week high.
11. The bidder announcement effect is 2.45% worse for each 10% increase in the component of
offer premium that is explained by the 52-week high; this is quite large relative to the
unconditional bidder announcement effects. Given the strong connection between 52-week
highs and offer prices, an interpretation is that shareholders of the bidder may view the bidder
as more likely to be overpaying when the target has fallen far below this reference price.
12. Once a target valuation is established by any means, the bidder must estimate the minimum
price that the target will accept. Boards may predict that the targets 52-week high will be
used both as a strategic anchor.
1.

Notes to Lecture II
Sahin, C

II Disposition effect
1. Disposition effect, the tendency of investors to hold losing investments too long and sell
winning investments too soon.
2. Investors demonstrate a strong preference for realizing winners rather than losers.
3. They does not appear to be motivated by a desire to rebalance portfolios, or to avoid the
higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio
performance.
4. For taxable investments, it is suboptimal and leads to lower after-tax returns. For taxable
investments the disposition effect predicts that people will behave quite differently than they
would if they paid attention to tax consequences.
5. Investors might choose to hold their losers and sell their winners not because they are
reluctant to realize losses but because they believe that todays losers will soon outperform
todays winners.
6. Investors choose to sell their losers in December as a self-control measure. They reason
that investors are reluctant to sell for a loss but recognize the tax benefits of doing so. The
end of the year is the deadline for realizing these losses. So each year, investors postpone
realizing losses until December when they require themselves to sell losers before the
deadline passes.
7. There are also rational reasons why investors may choose to hold their losers and sell their
winners:
a. Investors who do not hold the market portfolio may respond to large price
increases by selling some of the appreciated stock to restore diversification to
their portfolios;
b. Investors who purchase stocks on favorable information may sell if the price
goes up, rationally believing that price now ref lects this information, and may
continue to hold if the price goes down, rationally believing that their
information is not yet incorporated into price; and
c. Because trading costs tend to be higher for lower priced stocks, and because
losing investments are more likely to be lower priced than winning investments,
investors may refrain from selling losers simply to avoid the higher trading costs
of low-priced stock.
8. Their behavior is consistent with prospect theory; it is also consistent with a belief that their
winners and losers will mean revert.