Behavioral Finance ’18-‘19

Table of Contents

Chapter 1: Normal People.................................................................................................................................................... 2

Chapter 2: Wants for Utilitarian, Expressive, and Emotional Benefits...................................................................................3
Chapter 3: Cognitive Shortcuts and Errors............................................................................................................................ 5
Chapter 4: Emotional Shortcuts and Errors........................................................................................................................... 8
Chapter 6: Experienced Happiness, Life Evaluation, and Choices.....................................................................................11
Kahneman & Tversky (1979): Prospect Theory: An Analysis of Decision Under Risk........................................................13
Chapter 7: Behavioral Finance Puzzles.............................................................................................................................. 18
Barber & Odean (2000): Trading is Hazardous to Your Wealth: Common Stock Investment Performance of Individual
Investors............................................................................................................................................................................. 21
Don & Sengmueller (2009): Trading as Entertainment?...................................................................................................... 24
Kumar & Lim (2008): How do Decision Framer Influence the Stock Investment Choices of Individual Investors?.............26
Chapter 5: Correcting Cognitive and Emotional Errors....................................................................................................... 30
Hershfield et al., 2011: Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self...................32
Bhattacharya et al. (2012): Is Unbiased Financial Advice to Retail Investors Sufficient?....................................................35
Looney & Hardin (2009): Decision Support for Retirement Portfolio Management: Overcoming Myopic Loss Aversion via
Technology Design............................................................................................................................................................. 40
Goldstein, Johnson, & Sharpe (2008): Choosing Outcomes vs Choosing Products: Consumer-Focused Retirement Advice
............................................................................................................................................................................................ 41
Chapter 8: Behavioral Portfolios......................................................................................................................................... 41
Das et al., 2010: Portfolio Optimization with Mental Accounts............................................................................................ 47
Chapter 9: Behavioral Life Cycle of Saving and Spending.................................................................................................. 50
Chapter 10: Behavioral Asset Pricing Models..................................................................................................................... 55
Benartzi & Thaler (1995): Myopic Loss Aversion and the Equity Premium Puzzle.............................................................61
Chapter 11: Behavioral Efficient Markets............................................................................................................................ 64
Malmendier & Tate (2005): CEO Overconfidence and Corporate Investment....................................................................69
Khaneman (2011): Thinking, Fast and Slow: Chapter 24.................................................................................................... 72

Focus on wants / needs / benefits per chapter  short list?

Focus on core topics
Chapter 1: Normal People
Rational people Normal people
Always prefer more wealth to less Care about emotional and expressive benefits
Indifferent how wealth is realized Care about how wealth is accumulated
Never commit framing errors Frame wealth into distinct mental accounts
Immune to cognitive and emotional errors Susceptible to cognitive + emotional errors; difficult to
overcome
Cognitive and Emotional Shortcuts and Errors
Rational people’s brains are never full  able to rank variables according to sets of benefits and costs and make the best decision
Normal people’s brains cope by creating a cognitive shortcut simplifying the problem
 decrease the number of variables or levels within variables (e.g. only restaurants within 1 mile, only restaurants with 4 stars or
more), can include emotional shortcut (e.g. preferring Italian over Japanese)

Good shortcuts = close to best choices, solutions, and answers

BUT: can turn into errors, e.g. buying a house based on cookie smell and disregarding a leaky roof (emotional shortcut), or buying 100
shares when offered 100 or 200 shares when no shares were actually preferred (cognitive shortcut)

System 1 and System 2

System 1 = intuitive “blink” system, automatic, fast, effortless
System 2 = reflective “think” system, controlled, slow, effortful
Using System 2 is easier when there is time for engagement, beneficial when poor choices by System 1 result in substantial
consequences e.g. when buying a house, diversifying our portfolio, etc.
Rational people use System 2 whenever System 1 misleads
Normal people disregard System 2 outcomes whenever System 1 provides the answer
HOWEVER, normal people differ from ignorant to knowledgeable, reflected in the use of System 2.

Three Kinds of Knowledge

1. Financial-facts knowledge: includes facts about financial markets; stocks, bonds, other investments; benefits of diversification,
drawbacks of investment fees, difficulty of beating the market
2. Human-behaviour knowledge: includes knowledge about
a. wants e.g. riches, social status, adherence to values
b. cognitive shortcuts, e.g. framing, hindsight, confirmation
c. emotional shortcuts and errors e.g. hope, fear, pride, regret
3. Information knowledge
a. Exclusively available information (private / inside information)
i. Available to 1 person e.g. the CEO
b. Narrowly available information
i. Available to 2,3, a dozen executives of a company, analysts, readers of publications geared to industry or
technology experts

Both exclusively and narrowly available information includes:

- Corporate earnings before announcement
- Planned but unannounced future actions of a bank
- Information possessed by skilled financial analysts, money managers, people able to combine widely available information
with narrowly available information into clear “mosaics” of information
Widely available information
- Available to everyone, but not necessarily KNOWN to everyone
- Includes e.g. information published in major newspapers, widely read news sites, widely watched television programs on
finance
No hard line separating narrowly available information from widely available information BUT can make finer gradations distinguishing
very narrowly available information (e.g. only known to company insiders) from information not SO narrowly available (e.g. to some
analysts)
Can distinguish widely available information e.g. business section of NY Times from very widely available information, e.g. the front
page of NY Times

From Ignorant to Knowledgeable

“Sunk” costs: costs that have already incurred and cannot be salvaged even when probed otherwise by cognitive and emotional errors

Ignorant people have not learned to move beyond intuitive System 1, even when it misleads AND often mistrust financial-facts
knowledge.
e.g. it is a financial fact that it is difficult to forecast stock prices, but the average person thinks it is not so difficult.

System 2 often leads to better answers than System 1, BUT not always the sure and correct answers.
Transforming from ignorant to knowledgeable costs money, time, and physical and mental exertion
 pay money, time, and exertion when substituting reflective System 2 for intuitive System 1
Transformation worthwhile when benefits exceed costs, can also happen when learning from refinancing errors by committing smaller
errors on second refinancing than on first
Chapter 2: Wants for Utilitarian, Expressive, and Emotional Benefits
People want three kinds of benefits: utilitarian, expressive, and emotional
Utilitarian benefits of two investments are identical when they yield identical return
BUT: satisfaction they yield, reflecting expressive and emotional benefits, varies by paths of that identical return
e.g. investors are most satisfied when value of investments fall first and then recover
 least satisfied when value first climbs, then falls
Preference is true whether identical return is positive or negative
Satisfaction influences risk preferences, return beliefs, trading decisions
Our wants:
- Riches and protection from poverty;
- Nurture our children and families;
- Demonstrate competence;
- Playing games and winning;
- Staying true to our values;
- Enjoy the comfort of familiarity and passion of patriotism;
- Gain high social status;
- Promote fairness;
- Paying no taxes;
- Etc.

Trade-offs between wants, e.g. between utilitarian benefits of great wealth and expressive and emotional benefits of adherence to
values
Conflicts between our wants and wants of others, e.g. conflicts between benefits received by corporate managers and shareholders,
money managers and investors, financial advisors and clients

Wants for Riches and Protection from Poverty

Hope for riches encourages people to invest entire portfolio in stocks and lottery tickets
Fear of poverty encourages us to invest entire portfolio in government bonds and hold tightly to Social Security.
Solution  balance two wants by dividing money into layers of portfolio pyramids (upside potential and downside protection)
Bottom: bonds and annuities paying guaranteed income, designed to be free from fear of poverty
Top: stocks and lottery tickets, designed to give hope of riches
Wants for Nurturing our Children and Families
Parents are concerned about investments in children’s education, help to start household, be financially independent when turning into
adults

Wants to Play Games and Win

Trading can have great utilitarian benefit of wealth BUT many an investor is drawn by the expressive and emotional benefits of playing
and winning
Traders prefer lottery-like stocks whose return distributions are skewed toward high returns
 satisfies wants for utilitarian, expressive, and emotional benefits of playing and winning
Stocks of over-the-counter companies are lottery-like stocks, traders overpay for them as gamblers overpay for lottery tickets yield a
negative 40% average return

Emotional benefits of playing and winning are observable in the brain

Stronger reaction when people consider asymmetric gambles than when considering symmetric gambles with equal expected value
and variance
Stronger reaction when people considered positively skewed gambles (skewed towards high returns) than considering negatively
skewed gambles (skewed toward low returns)
Positively skewed gambles elicit more positive arousal and negatively skewed gambles elicit more negative arousal than symmetric
gambles with equal expected value and variance

Wants to Demonstrate Competence

Related to ambiguity aversion: preference from known risks over unknown risks
 rather choose alternative where probability distribution of outcome is known over one where distributions are unknown
- May arise from expressive and emotional benefits gained by demonstrating competence to others and ourselves
- Consequences of bets include psychic payoffs of satisfaction or embarrassment, either from self-evaluation or from an
evaluation by others
People prefer to guess before the event
- more satisfactory when right and less uncomfortable when wrong
- influences trading frequency

Males and investors with larger portfolios or more education perceive themselves as competent
Female investors and investors with smaller portfolios or less education perceive themselves as less competent
 perception more competent demonstrated by trading more frequently

Wants to Stay True to Our Values

Values vary and direct our wants for particular utilitarian, expressive, and emotional benefits
e.g. mutual funds can follow precepts of religions, and exclude companies that conflict with religious beliefs; exclude weapon
manufacturers / companies polluting the environment
Changes in circumstances affect trade-offs between utilitarian, expressive, and emotional benefits
e.g. 2008 financial crisis, sinking the market values of houses below mortgage balances
Homeowners chose to cease paying in “strategic default”
Carry utilitarian benefits i.e. no more financial burden of mortgages
Impose expressive and emotional costs on homeowners wanting to conform to values and social norms frowning on such defaults

Wants for High Social Status

Status seeking can underlie ethical consumption, beyond adherence to values
Can be status investments in movies  delivers expressive and emotional benefits + hope for utilitarian
 investors share in utilitarian benefits of profits, enjoy expressive and emotional benefits in patron trips to Oscar parties, visits to film
sets, etc.
Equal benefits for paintings and other collectibles  described as “emotional assets”, delivering “emotional dividends”
Provide low utilitarian price appreciation on average BUT some people accept great expressive and emotional benefits as
compensation for meager utilitarian benefits
Also true for investment in start-ups, combining high risk with high social status  wanting to be part of the process and feel pleasure of
creating sth new

Wants for Fairness

Fairness can be considered differently among people
Can be regarded as claim to rights, including right to freedom from coercion, right to equal power
Freedom from coercion is violated when people are coerced to refrain from trading with willing traders, when they possess inside
information or not
Freedom to equal power s violated when income inequality is high; when one trader has access to inside information but another one
does not

Disagreement about rankings of fairness rights by ideology and self-interest

Insider trading is unfair because inside information is misappropriated (stolen), violating right to freedom from coercion
Insider trading is unfair because insiders have power in form of informational advantage (that cannot be overcome with research or
skill), violating right to equal power
Notions of fairness vary by culture e.g. behavior is deemed acceptable / fair in Thailand, can be deemed unfair / unacceptable in the
Netherlands

Wants to Pay no Taxes

Low taxes deliver utilitarian benefits  tax-saving strategies deliver expressive and emotional benefits in addition to utilitarian ones
People express themselves as high-income investors; social status is as high as tax bracket
 wanting to be smart while pretending to be stupid
Tax avoidance increases utilitarian benefits (people keep more of their earnings), but can also reduce utilitarian benefits  engaging in
tax avoidance results in paying higher interest in bank loans
Our Wants Vary
By personality traits e.g. conscientiousness, values (e.g. protecting the environment), religion, circumstances (e.g. wealth), classby
social class, by identities (e.g. professional identities), by culture, political leanings (Democratic companies are less likely to be subject
of environmental, labor, civil rights-related litigation), by religion (default rates on Islamic loans are less than half the rates on
conventional loans
All people want benefits of high social status BUT status symbols vary by culture across countries

Our Wants as Investors and Consumers

Rational investors differ from normal investors in willingness to separate roles as investors from roles as consumers
Investors only care about wealth production – consumers care about all benefits of wealth consumption (utilitarian, expressive,
emotional)

Occasionally possible to separate production of wealth from its consumption, as well as separation of utilitarian costs and benefits from
expressive and emotional ones
e.g. trading utilitarian benefits of wealth for expressive and emotional benefits of attaching name to a college
Usually impossible to separate production and consumption of wealth, impossible to separate utilitarian costs and benefits from
expressive and emotional ones
e.g. trading expressive and emotional benefits of morality for utilitarian benefits of profits by large holdings
Houses combine investment and consumption
When gain value they are highlighted as investments; accepted as consumption when losing value
Combine utilitarian benefits (providing shelter), expressive benefits (displays of social states and taste), and emotional benefits (pride of
ownership)
Combination in art and gambles (when winning we congratulate ourselves for making wise investments (utilitarian benefits), when
losing we say “we had fun” i.e. expressive and emotional benefits

Our Wants and Errors

Goal is to satisfy wants for utilitarian, expressive, and emotional benefits while avoiding cognitive and emotional errors
Distinction between wants and errors
E.g. in buying lottery tickets. People can be enticed into buying tickets by cognitive errors, exaggerating the odds of winning.
- people continue to buy lottery tickets bc they want expressive and emotional benefits of prize money
Thrills and sensations
Sensations seekers can be divided in knowledgeable and ignorant seekers
Ignorant seekers:
- Blind to errors caused by overconfidence in their abilities as drivers or traders
- Want thrills and sensations but are ignorant of price
Knowledgeable sensation seekers
- acknowledge their overconfidence
- want thrills and sensations and are willing to pay the price
 frequent trader more likely to sacrifice returns rather than increase them by their trading, willing to bc of expressive and emotional
benefits derived from trading

Small-victories strategy:
Provides expressive and emotional benefits, and can result in utilitarian benefits when task is completed faster by breaking it down in
smaller pieces

Our Wants and Shoulds

Rational people are free of conflicts between wants and “shoulds”, normal investors are not
Wants Shoulds
Visceral Reasoned
Benefits in present Benefits usually in future
Focus attention on expressive and emotional benefits Focus attention on utilitarian benefits
Prompted by instinctive System 1 Prompted by reflective System 2
Investment advice filled with should: save more, spend less, diversify, buy and hold
Information influences use of System 2; nudging people away from wants to should

Conflicts and Tradeoffs of Utilitarian, Expressive, and Emotional Benefits Within a Person
Utilitarian benefits often dominated by expressive and emotional benefits
Trade-offs associated with social responsibility evident in workers learning about employer’s high social responsibility
 workers value expressive and emotional benefits of purpose and meaning, willing to trade utilitarian benefits of higher wage for
benefits of working for socially responsible employer

Conflicts and Trade-Offs of Utilitarian, Expressive, and Emotional Benefits Among People
Wants of agent can conflict with wants of principal
(principal = investor, agents = corporate managers, money managers, analysts, etc.)
Agents may attempt to satisfy own wants rather than wants of clients  principal-agent conflicts
e.g. CEO forced to retire during takeover  CEOs wants of utilitarian, expressive, and emotional benefits of keeping posts against
wants of shareholders who want utilitarian benefits of high share prices

Chapter 3: Cognitive Shortcuts and Errors

Cognitive shortcuts are part of intuitive “blink” System 1, leading to good choices BUT can become errors when misleading us into poor
choices. System 2 leads to better choices when System 1 misleads
 knowledgeable people employ cognitive shortcuts correctly, ignorant people commit cognitive errors when employing shortcuts
incorrectly
Cognitive shortcuts  cognitive rules of thumb and cognitive heuristics
No complete list of cognitive shortcuts and associated errors; most relevant in context of finance are “framing, hindsight, confirmation,
anchoring and adjustment, representativeness, availability, and confidence”

Framing
Traders commit framing errors when framing trading race between them and the market, e.g. where is the economy going, and what
are the prospects of this company
Traders possessing human-behavior and financial-facts knowledge frame trading correctly as against traders on the other side of the
trade – likely buyers of what they sell and likely sellers of what they buy e.g. do I know more about the prospects of this company than
company outsiders who have exclusively / narrowly available information, whereas I have widely available information

Frames in Mental Accounting

People frame money into distinctly labeled mental accounts and treat them accordingly
Helps people keep track of money and direct it to where we want it to go
Failures occur when failing to account for exceptional expenses
 people underestimate spending on exceptional purchases overall, resulting in overspending on each individual exceptional purchase
People keep money in specific mental account, generally unable to transfer money from one account to another
People generally distinguish income earned with much effort and unearned income obtained with little effort  spend unearned income
more easily than earned income
Source of money affects willingness to take risk
Mental accounting behavior equal for people across cultures, social-classes, income levels, geographic locations

Frames in the Winner’s Curse

Framing errors underlie winner’s curse: winners of auctions pay too much for what they buy
BUT: choice to submit high bid not always error, can also be due to a want tradeoff between utilitarian, expressive and emotional
benefits of particular bid
Frames in Money Illusion
Usage of nominal units of money in place of “real” – inflation-adjusted – units of money
e.g. 2% nominal pay raise when inflation is at 3% = 1% real pay cut; 1% nominal pay raise when inflation is at 0% = 1% real pay raise
 people observe first situation as better due to framing pay cuts and raises in nominal money units (2% is more than 1%) rather than
real money units (1% cut is worse than 1% raise)
Makes cuts in real pay by currency devaluations easier to bear than cuts in nominal pay
Knowledgeable people less affected  will pause after finding answers with System 1 and engage System 2 before reaching their
conclusions

Hindsight
Good hindsight shortcuts lead people to repeat actions that brought good outcomes and avoid actions that brought bad outcomes
Turn into errors when randomness and luck are prominent  loosening associations between past and future eves, and between
actions and outcomes
Can mislead lucky traders to think that fast trading always gets them to profit destinations and unlucky traders into thinking that fast
trading always inflicts losses
People exaggerate what could have been anticipated in foresight; misremember own predictions about what they knew in foresight
Hindsight errors in underestimating the volatility of stock prices

Confirmation
Confirmation errors mislead investors to choices that degrade returns while expecting choices to bolster returns
Investor believe they can pick winning stocks oblivious to losing records; recording wins as confirming evidence; neglecting to record
losses as disconfirming evidence
Investors committing greater confirmation errors expect higher returns, trade more frequently, realize lower returns
Underlie managers’ decisions to acquire other companies when evidence indicates that most acquisitions add no value to acquiring
companies
Managers review fewer pages of information + are less likely to change their mind after seeing new information

People are driven to confirmation errors by motivated reasoning that alleviates cognitive dissonance
(= the discomfort experienced when confronted with beliefs or fast that disconfirm our own views)

Anchoring and Adjustment

Occurs relying too heavily on an initial (occ.irrelevant) piece of information in the decision-making process
Expert consensus economic forecasts are anchored to data from previous months
 results in substantial errors; stock traders use 52-week high as anchor and reference point against which they evaluate the potential
impact of news
Predictions of long-term returns anchored by recent returns
Professionals often not conscious of susceptibility to anchoring and adjustment errors
Anchoring and adjustment errors underlie surprises at encountering rare “black swan” events (e.g. 1990s anchor to US as invulnerable
superpower)

Representativeness
Representativeness information makes us conclude that if sth looks like a duck, swims like a duck, and quacks like a duck, then it is
probably a duck
BUT base-rate information can indicate that this conclusion is unwarranted bc there a many kind of fowl looking, swimming, and
quacking like a duck, but aren’t ducks

Visible in assessing financial risk, e.g. risk of financial fraud associated with data breaches
Base-rate information reflects prevalence of breaches in population; representativeness information reflects whether a consumer was
personally affected by a breach
Reflected in misperceptions of chance that mislead us into seeing patterns in random sequences
“hot hand” bias: expecting continuations of sequences (lottery players tending towards numbers that have been drawn several weeks in
a row)
“gambler’s fallacy” bias: expecting reversal of sequences (lottery players shying away from numbers that have recently been drawn)
Amateur investors extrapolate recent investment returns; expecting high returns following high past returns, expect low future returns
following low past returns

Errors evident among traders who estimate variation of series of stock prices observed in graphs
Mislead traders to infer variation from representativeness information, assigning little weight to other prices serving as base-rate
information
Infer higher variation in a series where maximum and minimum prices are more extreme even when the distributions of series are
identical in mean, variance, and their distribution parameters
Errors more pronounced amongst traders that are more educated, employed full time, trading frequently, have longer trading
experience, and trade a wider range of securities
Technical analysis of stocks and other investments involves search for patterns in series of past prices that predict future prices 
subject to representativeness errors as patterns are found in random data

Promotes increased trading when traders perceive trading as a game of skill

Investors can change their expectations abruptly bc stock returns are volatile, supplying reasons for traders that hamper returns
Availability
Making judgements of likelihood of event based on how readily certain information comes to mind
Rooted in attention being a scarce resource; attention is conserved by gravitating toward easily available, especially vivid, information
Fail to ask whether this is all the available information, and search for additional information
e.g. influence of local news

Amateur investors frequently buy attention-grabbing stocks, e.g. stocks with extreme trading volume, or extreme one-day returns
Attention-driven buying stems from difficulty of searching among the thousand available stocks
Often observed in workplaces  worker’s stock purchases similar to those of coworkers; stocks do not yield higher returns; social
interactions limit diversification, increase in risk with no increase in expected returns
e.g. preference for round numbers; advantage to companies whose name are at beginning of alphabet

Confidence
Classified in three types of confidence shortcuts and errors
 Overestimation/ underestimation errors
o Overestimation occurs when expecting 12% return when objective assessment indicates it should be 8%
o Underestimation occurs when expecting 6% return
 Overplacement/ underplacement errors
o Overplacement occurs when expecting our portfolio to place us in top 10%, when objective assessment places us
among bottom 40%
o Underplacement occurs when expecting to be among bottom 30%
 Overprecision / underprecision errors
o Overprecision when believing there is a 90% probability that portfolio return will fall between 10-14% when objective
assessment indicates that there is a 90% probability that it will fall between -10% to -26%
o Underprecision occurs when believing there is a 90% probability that return will fall between -20% to -36%

People committing overplacement errors enjoy higher status than people underplacing or objectively placing themselves  maintain
high status even when overplacement is revealed

Overestimating error likely when contemplating difficult tasks; underestimating when contemplating easy tasks
These errors occur because any estimate includes an error component (e.g. cannot overestimate A grade on easy test but can
overestimate C grade on difficult test, estimating it as a B)
Investors perceiving investing as difficult task are likely to overestimate future returns

Overplacement error likely when contemplating easy tasks; underplacement when contemplating difficult tasks
Investors perceiving investing as difficult task tend to underplace themselves relative to other investors
Commit overplacement when contemplating common events; commit underplacement when contemplating rare events, regardless if
events are positive or negative
Investors who perceive above-average future returns as common event are likely to overplace themselves relative to other investors

Overprecision errors evident in forecasts of stock-market returns by financial executives

Realized returns only within 80% confidence intervals 33% of the time
Greater overprecision errors in forecasts of stock-market returns are associated with greater overprecision errors in forecasts of
companies’ projects with higher corporate investment
Managers issuing accurate forecasts in the past tend to become overconfident in precision of their future forecasts

Managers overestimation of future performance increases propensity to engage in reporting fraud

Overestimating managers are more likely to engage in earnings management where they “borrow” from future earnings to boost current
ones
Overestimate future earnings to cover up borrowed earnings

Research has shown that

 Three kinds of overconfidence are distinct
 Substantial propensity for overprecision in estimates of stock-market returns + estimates of own portfolio returns
 No general propensity for making overplacement errors
 No general propensity for overestimation, aside for minority that greatly overestimated their returns
 Propensity for overestimation and overplacement errors is concentrated among particular groups, such as active traders

People often overestimate their control  leads to “illusion of control”

Overestimation of control can enhance performance in settings where people have some control
 students allowed to keep luck charm do better on memory test than students whose lucky charms are kept in another room
Overestimation can increase savings rates and wealth accumulation
Internal locus of control has people saving more and accumulate more pension wealth than people with external locus of control
Conclusion + summary of chapter p.67
Chapter 4: Emotional Shortcuts and Errors
Emotional shortcuts part of intuitive System 1, leading to good choices
 turn into error when misleading us into poor choices
Reflective system 2 leads to better choices when System 1 misleads
People with knowledge of human behavior and financial facts use emotional shortcuts correctly; people without knowledge commit
emotional error
Interaction between cognition and emotion make it difficult to attribute shortcuts, errors, and choices to one or the other

Emotion, Mood, and Affect

Emotion: very intense, short duration, clear focus
Mood: muted emotion, less intense than emotion, but longer duration
Affect: faint whisper of emotion or mood, stripped down to valence, positive or negative
Appraisal-tendency framework (AF) distinguishes cognitive appraisals from appraisal tendencies
 Each emotion defined by specific pattern of cognitive appraisals
o E.g. anger when appraise car accident caused by other people; sadness when appraised as controlled by factors
beyond human control, e.g. weather
 6 cognitive dimensions of appraisals underlying emotions
o Pleasantness, anticipated effort, certainty, attentional activity, responsibility, control
 Appraisal tendencies shape future perceptions and behavior

Hope and Fear

Fear: negative emotion arising in response to danger, hope: positive emotion in anticipation of reward
Cognitive appraisal states: fear is unpleasant, hope is pleasant  similar in external control
Exuberance is extreme hope  irrational exuberance refers to investor enthusiasm that drives asset prices up to levels that aren't
supported by fundamentals. 

Stock market declines induce fear  days of substantial stock market declines are also days of substantial increases in hospital
admissions
High stock returns associated with better mental health, high volatility of returns is associated with poorer mental health
Fear induced by earthquakes increases probability that people assign to stock-market crashes
Fear increases risk aversion, leading to high risk aversion in financial busts and low risk aversion in financial booms
Fearful investors fly to safety by switching from risky investments to safe investments  VIX (volatility index) measures expectations of
future risk by expectations of future volatility of stock returns
Flight-to-safety episodes coincide with increases in VIX, bearish consumer sentiments + bond returns exceeding stock returns

Fearful investors expect low returns with high risk – hopeful investors expect high returns with low risk
High past returns associated with increased return expectations combined with decreased risk perceptions and risk aversion
Months where large proportions of investors believed that stock market is overvalued were also months when investors believed that it
is a good time to invest
 consistent with System 1, but not with System 2; reflection shows that believing the market is overvalued is accompanied by belief
that now is not a good time to invest
Fear leads to early sell-off of stock and is contagious: fearful people sell especially early when believing their fear is shared by others

Greed, Ambition, and Status Seeking

Greed = reflection of ambition
Status seeking = heightened by fear and hope
Fear of being outpaced by social status of competitors, hope to outpace them instead
 status order in society is never stable
 describe ourselves as ambitious when striving to add to wealth and increase social status, describe our neighbors who do the same
as greedy
People vary in status seeking
- People strongly disposed toward status seeking focus on achieving gains, weakly disposed people focus on avoiding losses
- Status order especially unstable in periods of exuberance e.g. during dot.com boom

Happiness, sadness, and disgust

Happiness: associated with gains + enjoyment; encourages toward actions bringing further gains and enjoyment
Sadness: associated with losses and helplessness; makes people pause + contemplate actions resulting in losses and helplessness
Disgust : associated with proximity to distasteful objects / ideas; makes us expel repellent objects + keep distance from repugnant ideas
Happiness + sadness affect appraisal tendencies
 sadness promotes desire for immediate gratification and increased spending, myopic misery (tendency to seek immediate gains
even if that means suffering long-term losses)
 induces greater impatience, higher risk aversion, increased sensitivity to losses
 happiness promotes delayed gratification and increased savings
 people induced to feel disgust are willing to sell assets at lower prices than people who do not feel disgust
Anger
Arises in response to threats or danger (like fear and anxiety)  BUT internal locus of control
 stimulates risk taking + acting as optimists
- people disposed to anger more willing to invest in stocks, prefer medium- and long-term investments, believe that they can
forecast stock-market trends
- people disposed to anxiety prefer interest-bearing accounts, do not believe they can forecast stock-market trends

Anger can counter cognitive errors, reducing tendency to commit confirmation errors
Can mislead into poor choices  induces underestimation of likelihood of losses and other bad outcomes
can be beneficial in negotiations  expressing anger conveys toughness, can evoke fear in counterparts  lead to greater
concessions
BUT can backfire leading to escalations, acts in retaliation, walking away from negotiation table bc it can be inferred that angry
negotiators are especially selfish

Advantage of walking away from negotiation

 imposes costs now but yields possible benefits later in the form of fairness
Deprived from utilitarian benefits but enjoyment of emotional benefits of self-righteousness
Turning down unfair offers teaches other to be fair

Regret and Pride

Regret is cognitive emotion  negative + unpleasant, experienced imagining that different choice brings better outcomes (painful)
Pride on opposite emotional spectrum of regret (pleasurable)
Both emotions come when exercising control and carry responsibility
Useful parts of System 1, warning against behavior likely to inflict regret, encourages behavior likely to generate pride
Engagement System 2 necessary when System 1 misleads into overlooking randomness and luck in relation between choice and
outcome

Regret aversion + pride seeking affect financial choices e.g. choice of buying or selling a stock
Investors prefer to repurchase stocks previously sold at a gain rather than stocks previously sold at a loss
Prefer to repurchase stocks whose prices declined subsequent to an earlier sale rather than stocks whose prices increased
Preferences do not add to returns tho

Regret associated with responsibility for choices

Can escalate commitment to choices in effort to minimize regret e.g. endlessly waiting on a bus
Attempts to alleviate regret by maintaining ignorance to outcomes of choices that were considered but not made and by shifting
responsibility
Certain people shift blame when choices turn out badly, take responsibility when choice turns out positive  underlies broker’s lament
(when stock goes up investors say they bought the stock, when stock goes down they say their brokers sold them the stock)
Anticipation of future regret affects today’s choices
 contemplating the regret that will be felt in future when choices made today turn out poorly

Self-control
Centers on interaction between hot emotion of System 1 and cool cognition of System 2
- Can be insufficient, excessive, or just right
- Insufficient when hot emotion urging immediate gratification overcomes cool cognition delaying gratification
- Excessive when ho emotion urging delayed gratification overcomes cool cognition urging immediate gratification
Insufficient and excessive self-control are equally often observed
Too much self-control evident in tendency to spend less today than ideal level of spending
Prospect of spending money inflicts emotional pain even as cognition encourages spending
People use cognitive strategies to encourage self-control  children exhibiting more self-control mature into adults more successful at
relationships, work, and handling stress (marshmallow experiment)

Genes affect mastery of self-control

People born with certain capacity of self-control, accompanied by personalities that facilitate self-control
Saving requires self-control  genetics account for approx. one-third of differences in saving behavior
Parents have no long-term effects on children’s saving behavior beyond genetic endowment provided  effect is strongest when
children are in twenties, but disappears by middle age

Conscientiousness (closely related to self-control): one of Big Five personality traits, others are: extraversion, openness,
agreeableness, neuroticism
- Most closely related personality trait to academic achievement, job performance, marital stability, and longevity
- Accumulate more wealth than less conscientious people, after accounting for differences in income, education, and cognitive
ability

Mood
Muted emotion, less intense than emotion, but longer lasting: influenced by weather, seasons, and sunshine; good weather associated
with high stock returns
People generally happier on sunny days than on cloudy days; sunshine induces good moods, focusing on good news; clouds induce
bad moods, focusing investors on bad news
Cloudy days associated with low stock returns, increase perceived overpricing in both individual stocks and an index of stocks, increase
selling propensities of institutions

Mood associated with Seasonal Affective Disorder (SAD) is similar in emotions of sadness and depression, but less intense
- Increases risk aversion in financial decisions
- Stronger preference for safe choices during winter than those without SAD, preferences do not differ during summer
- Seasonal variations in stock returns among countries consistent with variations in risk aversion associated with SAD
- SAD phenomenon + associated increase in risk aversion evident in seasonal variation in flows into and out of mutual funds
- Flows out of risky mutual funds categories into safe categories increase in fall; flows out of safe categories into risky ones
increase when daylight increases
- Other influences are local weather, length of day, daylight savings, lunar phase
Mood and outcomes can be influenced by e.g. divorce, affecting investment decisions

Optimism + pessimism are moods

Optimism associated with emotions of hope and happiness
Pessimism associated with emotions of fear and sadness
Neither moods as intense as hope, happiness, fear, or sadness
Sentiment in context of investments often corresponds to mood; bearish sentiment = pessimistic mood; bullish sentiment = optimistic
mood
Propensity rooted in genetics
Optimists work harder, anticipate longer age-adjusted work careers, are more likely to remarry after divorce
Economic recessions are weaker, expansions are stronger, economic recovery is faster in states where people are optimistic
People advice optimism selectively when it can affect performance; optimism improves persistence rather than performance 
overestimation of association
Downside: can lead to excessive debt, less attention to forecast errors than pessimists
Estimates of costs and profits are on average optimistic; overestimation of profits, underestimation of costs
Prevalence attributed to organizational pressures; optimism reflected in planning fallacy
(= phenomenon where predictions about how much time is needed for a future task display optimism bias and result in an
underestimation of time needed)
Connected to anchoring errors  managers anchored original cost estimates; fail to adjust sufficiently for likelihood of problems delays
+ expansions of projects
Connected to framing errors  managers frame project as dependent entirely on own company’s abilities and plans, exclude potential
abilities and actions of competitors

Optimism in corporate context good and bad

Good: motivation of project champions and teams to work hard on completing projects at promised low costs and high profits
Bad: selection of losing projects
Overcome by complementing “inside view” (tends to focus on company’s own capabilities, experiences, and expectations) with “outside
view”, consisting of statistical analysis of similar projects completed earlier in their or other companies
Inside view corresponds to analysis of representativeness information about features of particular project
Outside view corresponds to analysis of base-rate information about rate of success of similar projects

Good consequences can be obtained without bad consequences

Project committee selects projects promised to be profitable on basis of own estimates of costs and profits, properly adjusting upward
cost estimates provided by project champions and adjusting downward profit estimates
Don’t share estimates with project champions  sets champions up for ambitious target that they are committed to, makes them and
their teams work on making projects profitable even if short of target
 back up plans can be harmful as it reduces drive toward goals, efforts devoted to reaching them

Affect
Whisper of emotion / mood, in valence (refers to intrinsic attractiveness (positive valence) or aversiveness (negative valence) of an
event, object, or situation)
People assume to make rational choices + weigh pros and cons of various alternatives
 often choice made on pure basis of liking X more than Z, choice justified by various reasons
Affect in choices is evident in numbness to statistics and sensitivity to emotional images
 people donate more to picture of African girl than statistics about hunger in Africa

Investments exude affect

- Can distort information and influence beliefs; positive affect of risky investments increases people’s confidence in ability to
evaluate them
- People update beliefs in a way that is consistent with self-preservation motive of maintain a positive emotional state and
avoiding cognitive dissonance
- Self-preservation induces confirmation errors detering incorporating news contradicting past choices, contributes to formation
of incorrect beliefs

Emotional benefits affect

Illustrates blurry line between wants and errors  emotional error when paying more and having no additional utilitarian benefits; no
emotional error because of emotional benefits or costs of conforming or deviating to and from culture
BUT preference for e.g. Class A shares is error, since Class B shares are superior (have all benefits in addition to greater voting rights)
Stocks of admired companies have positive affect (like beautiful loan applicants); stocks of spurned companies have negative affect
(like unattractive loan applicants)
Companies with negative affect are expected to have low returns with high risk
Errors; stocks of admired companies deliver lower returns than stocks of disdained companies

Chapter 6: Experienced Happiness, Life Evaluation, and Choices

Expected-Utility Theory and Prospect Theory
Two concepts of happiness:
1. Experienced happiness: emotional well-being, hedonic well-being
a. Does not rise beyond an annual income of approximately $75,000
b. Can be assessed as fleeting happiness
2. Life-evaluation
a. Allows people to place themselves on ladder from bottom “worst possible life” to top “best possible life”
b. Can be assessed as sustained happiness

People with incomes much below $75,000 experience much less happiness, much more worries and sadness experienced yesterday
than people with income close to $75,000
People with incomes much above $75,000 experience no greater happiness than people whose income exceeds $75,000 with only a
little, do not report more enjoyment or less worries
Both have means to rent car if theirs breaks down, no calls from debt collector
Both groups can be deprived of experienced happiness during some days by circumstances

People with annual incomes exceeding $100,000 report substantially higher life evaluation than people earning $75,000; people with
incomes exceeding $200,000 report substantially higher life evaluation than people with incomes exceeding $100,000

Life evaluation reflects all benefits of wealth  utilitarian benefits of consumption of goods and services, expressive and emotional
benefits of high social status and pride
 Explains why people owning great wealth continue to strive for greater wealth

Levels of Wealth and Gains and Losses of Wealth

Theories that assess happiness and predict choices
1. Expected-utility theory: standard finance
a. Utility is wealth utility, life evaluation or sustained happiness derived from wealth
b. Predicts that sustained happiness from wealth is high when wealth is high, placing the wealthy higher on the life
evaluation ladder

Wealth utility increases more slowly than wealth

 first million dollars adds more units of wealth utility to zero units of wealth utility of 0; second million adds much less units, and third
million even less
Association between wealth and wealth utility varies among people
 units of wealth utility is different per individual

2. Prospect theory
a. Utility is gain-loss utility, experienced happiness or fleeting happiness derived
from gains and losses of wealth relative to a reference point
Experienced happiness today influenced by gains or losses from yesterday
 scale of gain-loss utility = arbitrary, only ratios of gain-loss utility relative to one another matter
Association between gains and losses and gain-loss utility varies among people
Predicts people are regularly confused by the frame of wealth  can set reference point at different point in time to highlight gains and
obscure losses

Predictions
Expected-utility: people’s choices reflect a preference for high wealth over low wealth
Prospect theory: people’s choices reflect a preference for high gains over low gains or losses
Both theories: choices reflect risk aversion
Expected-Utility Theory and Prospect Theory
Expected-Utility Theory (EUT) Prospect Theory (PT)
Utility is wealth utility Utility is gain-loss utility
Wealth utility is sustained happiness, or life evaluation Gain-loss utility is fleeting happiness, or experienced
Wealth utility is determined by total wealth happiness
Choices are made by considering the effects of Gain-loss utility is determined by gains and losses
outcomes on total wealth relative to reference point
Perceptions of total wealth are not affected by framing Choices are made by considering the effects of
People’s choices always conform to risk aversion, outcomes on gains and losses
where risk aversion is variance aversion Perceptions of gains and losses are affected by framing
 People’s choices always conform to variance aversion,
never to variance seeking
People estimate objective probabilities of outcomes
Emotions play no role in choices
People’s choices always conform to risk aversion,
where risk aversion is variance aversion, loss aversion,
sometimes shortfall aversion
People estimate subjectively probabilities of outcomes,
replacing objective probabilities by “probability weights”
Emotions play roles in choices, especially hope, fear,
pride, and regret

Variance Aversion and Loss Aversion

Expected-utility theory: choices correspond to risk aversion, never risk seeking, when risk is measured by variance of returns
Prospect theory: choices correspond to risk aversion, when risk is variance aversion, loss aversion, or shortfall aversion
 some prospect theory choices conform to variance aversion, consistent with expected-utility theory, whereas other choices conform
to variance seeking, consistent with shortfall aversion in prospect theory, but inconsistent with expected-utility theory

Choices When All Outcomes are in the Domain of Gains

People choose certain income over 50-50 gamble involving greater numbers 
variance aversion
e.g. current wealth is 20,000, yielding 220 units of wealth utility
Sure 10,000 brings total wealth to 30,000, yielding 258 units of wealth utility
Gamble offers 50-50 chance to leave total wealth at current 20,000, yielding 220
units of wealth utility, or bring it to 40,000, yielding 270 units of wealth utility
Mean of 220 and 270 units associated with gamble = 245 units, lower than the 258
units associated with sure income  expected-utility predicts people choose sure
10,000

Same is true for prospect theory

Where does the future wealth fall on the frontier  divide gamble by possible
outcomes  choice resulting highest utility wins
BUT, difference between wealth utility derived may be so great that variance aversion
is overcome, and the gamble is chosen

Loss Aversion
Expected-utility theory: choice of gamble depends on the wealth-utility to be derived
 divide outcomes and look at choice yielding highest utility
Reference point is current wealth

Prospect theory can come to different solution  possible outcome spans domains
of gains and losses, pain of losses is greater than pleasure of gains in equal
magnitude
Loss aversion reflected in prospect theory function that declines by more in the
domain of losses than it increases in domain of gains in range close to reference
point
Variations in loss aversion affect choices
low-loss aversion person may accept gamble while high-loss aversion person
rejects gamble
On average, investors are willing to accept a 50-50 chance for a potential loss or a
gain only if potential gain is at least 4 times as large as potential loss
Loss aversion varies by gender, age, and culture  men are on average less loss
averse than women, young are less loss averse than old, Chinese people less loss
averse than people in US

Shortfall Aversion
Reference point is aspiration level higher than our current position
Gamblers will prefer a bold bet that offers a (small) chance to eliminate shortfall from their aspiration than with timid bets that offer even
smaller chances to eliminate it
Risk is accepted in the form of variance and in form of potential loss to reduce risk in form of shortfall from aspiration
E.g. people will prefer a gamble of 50-50 chance of 0$ and 15,000$ over a sure 5,000$ loss, as the gamble has a less high loss-utility
and therefore provides less shortfall from the aspiration level

Aspirations and Shortfall Aversion

People are not risk seekers, but risk is payment for a chance to reach aspirations
 variance acceptance is price of shortfall aversion
People of all social classes aspire the utilitarian, expressive, and emotional benefits of even high social classes e.g. people risking their
hundred-million-holding class for a chance to enter the billion-holding class  setting wealth and incomes of others as reference point
for aspirations
Life satisfaction diminishes when income is low relative to perceived incomes of others
Income inequality causes financial distress among low-income people  keeping up with the Joneses
Prospect theory utility determined by gains and losses of wealth relative to reference wealth
 might be current wealth but also aspired wealth

Probability Weights, Aspirations, and Expressive and Emotional Costs and Benefits
Expected-utility theory: people use objective probabilities of possible outcomes as they consider choices
Prospect theory: people use subjective probabilities that can depart from objective probabilities
Probability weights: ratios of subjective probabilities to objective probabilities
e.g. objective probability indicates 1 in 1,000,000 chance to win the lottery; 100,000 probability weight overweighs this to subjective
probability to 1 in 10 chance

Probability weights equal 1, subjective probabilities equal objective probabilities when free of making errors and consider only utilitarian
costs and benefits
Probability weights depart from 1 even when free of making errors when also considering aspirations, expressive and emotional costs
and benefits e.g. hope and fear

Aversion to shortfall from aspiration+ hope for reaching it prompts assigning much higher subjective probability than objective
probability indicates
Probability weights can overcome objective probabilities in terms of aspiration to avoid shortfall, heightened by e.g. the anticipated
emotional cost of regret, emotional benefit of hope, cost of fear

Conclusion p.133

Kahneman & Tversky (1979): Prospect Theory: An Analysis of Decision Under Risk
Introduction
Critique of expected utility theory as descriptive model of decision making under risk
Proposition of alternative account of choice under risk  prospect theory

Critique
Decision making under risk viewed as choice between prospects or gambles
Prospect (x1, p1; …; xn, pn) is contract yielding outcome xi with probability pi, where p1 + p2 + .. + pn = 1
Application of expected utility theory to choices between prospects is based on
Expectations: U (x1, p1; …; xn, pn) = p1u (x1) + … + (pnu (xn)
Overall utility of prospect, denoted by U, is expected utility of its outcomes
Asset Integration: (x1 p1; … ; xn, pn) is acceptable at asset position w if
U (w + x1, p1; … ; w + xn, pn) > u (w)
Prospect is acceptable if utility resulting from integrating the prospect with one’s assets exceeds utility of those assets alone

 domain of utility function is final states including one’s assets position rather than gains or losses
Risk Aversion: u is concave (u’’ < 0)
Person is risk averse if she prefers the certain prospect (x) to any risk prospect with expected value x
In expected utility theory, risk aversion is equivalent to concavity of the utility function

Certainty, Probability, and Possibility

In expected utility theory, utilities of outcomes are weighted by their probabilities
Issue: people overweigh outcomes that are considered certain, relative to outcomes which are merely probable  certainty effect

Allais Paradox:
- Pattern of preferences violates expected utility theory
- 82% of subjects chose B in problem 1; 83% chose C in problem 2; majority made modal choice in both problems
- First preference implies

- Second preference implies reverse inequality  problem 2 obtained from problem 1 by eliminating .66 chance of winning
2,400
- Change produces greater reduction in desirability when altering character of prospect from sure gain to probable one, than
when both original and reduced prospects are uncertain
Assume:
Expected utility theory violated bc choice of B implies u(3,000) / u(4,000) > 4/5,
whereas choice of C implies reverse inequality (prospect C can be expressed as
(A, .25) and prospect D can be rewritten as (B, .25))
Substitution axiom of utility theory asserts that if B is preferred to A, any probability
mixture (B,p) must be preferred to mixture (A,p)
Reducing probability of winning from 1.0 to .25 has greater effect than reduction from .8
to .2
In situation where winning is possible but not probable, most people choose prospect
that offers the larger gain
Results suggest generalization:
if (y, pq) is equivalent to (x,p) then (y,pqr) is preffered to (x,pr), 0 < p, q, r < 1

Reflection Effect
- x denote loss of x, > denotes prevalent preference, i.e. the choice made by the majority of subjects

In each of four problems, preference between negative prospects is mirror image of preference between positive prospects  reflection
of prospects around 0 reverses the preference order (reflection effect)
Implications:
1. Effect implies that risk aversion in positive domain is accompanied by risk seeking in negative domain
2. Preference between corresponding negative prospects also violate expectation principle in same manner  outcomes
obtained with certainty are overweighed relative to uncertain outcomes (certainty is not generally desirable)
a. Overweighting of certainty favors risk aversion in the domain of gains and risk seeking in the domain of losses
3. Reflection effect eliminates aversion for uncertainty or variability as an explanation of the certainty effect
a. Assumption that people prefer prospects that have high expected value and small variance BUT data indicates that
certainty increases the aversiveness of losses as well as desirability of gains

Probabilistic Insurance
Examination of relative attractiveness of various forms of insurance does not support notion that utility function for money is concave
everywhere
- People prefer insurance programs offering limited coverage with low or zero deductible over comparable policies that offer
higher maximal coverage with higher deductibles (contrary to risk aversion)
- Other issue inconsistent with concavity hypothesis can be referred to as probabilistic insurance

Assume: insurance program where client pays half of regular premium, in case of damage 50% change of having to pay other half of
premium and insurance company covering all losses, 50% chance get back insurance payment and suffering all the losses
- Majority will not purchase probabilistic insurance; reducing probability of loss from p to p/2 is less valuable than reducing
probability from p/2 to 0
- Expected utility theory (with concave u) implies that probabilistic insurance is superior to regular insurance, if at asset position
w one is just willing to pay a premium y to insure against a probability p of losing x, then one should definitely be willing to pay
smaller premium ry to reduce probability of losing x from p to (1-r)p, 0<r<1
- If one is indifferent between (w-x,p ; w, 1-p) and (w-y), probabilistic insurance should be preferred (w-x, (1-r)p; w-y, rp; w – ry,
1-p) over regular insurance (w-y)
- Prove proposition by showing that: pu (w – x) + (1 – p) = u (w – y), which implies
(1 – r) pu (w – x) + rpu (w – y) + (1 – p) u (w – ry) > u (w – y)
- Without loss of generality we can set u(w – x) = 0 and u(w) = 1. Thus, u (w – y) = 1 – p, and we want to show that
rp (1- p) + (1 – p)u (w – ry) > 1 – p or u (w -ry) > 1 – rp, which only holds if u is concave

 puzzling consequence of risk aversion hypothesis of utility theory bc probabilistic insurance appears intuitively riskier than regular
insurance
THUS, intuitive notion of risk not adequately captured by assume concavity of utility function for wealth
- All insurance is probabilistic  insurance consumer still vulnerable to many financial and other risk not covered by policies
- Difference between probabilistic insurance and “contingent insurance”  provides certainty of coverage for specified type of
risk
- Contingent insurance will be generally more attractive than probabilistic insurance when probabilities of unprotected loss are
equated
Isolation Effect
People simplify choice between alternatives by disregarding components that alternatives share, focus on components that distinguish
 can produce inconsistent preferences because pair of prospects can be decomposed into common + distinctive components in more
than one way, different decompositions can lead to different preferences
 isolation effect
Two-stage game:
- Stage 1: probability of .75 to end game without winning anything; probability of .25 to move into second stage
- Stage 2: choice between (4,000, .8) and (3,000)  must make choice before start of game
- Main difference between two figures is location of decision node (square)
- In standard form decision maker faces choice between two risky prospects; in sequential form, faces choice between risky and
riskless prospect

- Reversal of preferences due to dependency among events is particularly significant  violates the basic supposition of
decision-theoretical analysis (choices between prospects determined solely by probabilities of final states)
- Isolation effect implies that contingent certainty of fixed return enhances the attractiveness of this option, relative to a risky
venture with same probabilities and outcomes

Utility theory states that same utility is assigned to wealth of $100,000, regardless of whether it was reach from prior wealth of $95,000
or $105,000
 choice between total wealth of $100,000 and even chances to won $95,000 or $105,000 should be independent of whether one
currently owns smaller or larger of these two amounts
- Added assumption of risk aversion; theory entail certainty of owning $100,000 always preferred to gamble
- HOWEVER, pattern only obtained if individual owns smaller amount, not greater amount
 implies that carrier of value or utility are changes of wealth, rather than final asset positions that include current wealth (cornerstone
of prospect theory)

Theory  MATH
Prospect theory distinguishes two phases in choice process:
1. Editing phase: preliminary analysis of offered prospects, often yields simpler representation of these prospects
2. Evaluation phase: edited prospects are evaluated, and prospect of highest value is chosen

Editing phase
- Function is to organize and reformulate options: simplify subsequent evaluation + choice
- Apply several operations that transform outcomes + probabilities associated with offered prospects
- Major operations: (first three applied to each prospect separately)
o Coding: outcomes perceived as gains and losses  defined relative to neutral reference point
 Reference point corresponds to current asset position, gains and losses coincide with actual amounts
received or paid
 Location of reference point and coding out outcomes as gains or losses affected by formulation of offered
prospects, expectations of decision maker
o Combination: prospects simplified by combining probabilities associated with identical outcomes (prospect (200, .25;
200,.25) reduced to (200, .5) and is evaluated as such)
o Segregation: prospects containing riskless component segregated from risky component in editing phase (prospect
(300, .8; 200, .2) decomposed in sure gain of 200 and risky prospect (100, .8)
o Cancellation: applied to set of two or more prospects
 Essence of isolation effects described earlier is discarding of components shared by offered prospects
 Other type of cancellation: discarding common constituents i.e. outcome probability pairs
 Choice between (200, .20; 100, .50; -50, .30) and (200, . 20; 150, .50; -100, .30) reduced by cancellation to
choice between (100, .50; -50, .30) and (150, .50; -100, .30)
- Additional operations:
o Simplification: rounding probabilities or outcomes; discarding extremely unlikely outcomes
o Detection of dominance: dominant alternatives are rejected without further evaluation
- Anomalies of preference result from editing of prospects e.g. inconsistencies associated with isolation effect result from
cancellation of common components
o Preference order between prospects does not need to be invariant across context, because same offered prospect
could be edited in different ways depending on context in which it appears

Evaluation phase
 - Decision maker assumed to evaluate each edited prospect, choose prospect of highest value; overall value of edited prospect
(V) is expressed in terms of two sales, π and υ
- First scale ( π ¿ associates with each probability p a decision weight π (p), reflects impact of p on overall value of prospect
o π is not a probability measure
- Second scale (υ ) assigns each outcome x a number υ (x), reflecting subjective value of that outcome
o Outcomes defined relative to reference point  υ measures value of deviation from reference point, i.e. gains and
losses

Present formulation concerned with simple prospects of form (x, p; y, q), which have at most two non-zero outcomes
 one receives x with probability p, y with probability q, and nothing with probability 1 – p – q, where p + q ≤ 1
Offered prospect strictly positive if its outcomes are all positive, i.e. if x, y >0 and p + q = 1; strictly negative if outcomes all negative;
regular if neither strictly positive nor strictly negative

Basic equation of theory describes manner in which π and υ are combined to determine overall value of regular prospects
If (x, p; y, q) is regular prospect (i.e. either p + q <1, or x ≥ 0 ≥ y, or x ≤ 0 ≤ y) then

where υ (0) = 0, π (1) =1

V defined on prospects,υ defined on outcomes; two scales coincide for sure prospects, where V(x, 1.0) = V (x) = υ (x)
- Equation generalizes expected utility theory by relaxing expectation principle

Evaluation strictly positive + strictly negative prospects follows different rule

- Editing phase: prospects segregated into two components (i) riskless component, i.e. minimum gain or loss which is certain to
be obtained or paid; (ii) risky component, i.e. additional gain or loss actually at stake
- Described as, if p + q = 1 and either x > y > 0 or x < y < 0, then

Meaning, value of strictly positive or strictly negative prospect equals value of riskless component plus value difference between
outcomes, multiplied by weight associated with more extreme outcome
- Essential feature = decision weight applied to value-difference υ (x) - υ (y), representing risky component of prospect, but to
not to υ (y), representing riskless component

Equations of prospect theory retain general bilinear form that underlies expected utility theory, but must be assumed that values are
attached to changes rather than to final states, and that decision weights do not coincide with stated probabilities
 lead to normatively unacceptable consequences, e.g. inconsistencies, intransitivity, violations of dominance
 if decision maker has no opportunity to discover that preferences can violate decision rules, anomalies implied by prospect theory
expected to occur

Value Function
Carriers of value are changes in wealth / welfare, rather than final states
 prospect theory assumes evaluation of changes / differences rather than evaluation of absolute magnitudes e.g. object at given
temperature may be experienced as hot or cold depending on temperature to which one has adapted

BUT, should not be taken to imply that value of particular change is independent of initial position
 should be treated as function in two arguments: asset position serving as reference point, magnitude of change (positive / negative)
from that reference point
Psychological response is concave function of magnitude of physical change:
Difference in value between gain of 100 and gain of 200 appears to be greater than difference between gain of 1,100 and gain of
1,2000
- Value function is concave for gains and convex for losses
- Derived value (utility) function of an individual does not always reflect “pure” attitudes to money, since it could be affected by
additional consequences associated with specific amounts
- Losses loom larger than gains; aversiveness of symmetric fair bets generally increases with size of the stake
 if x > y ≥ 0, then (y, .50 – y, .50) is preferred to (x, 50 – x, .50), therefore

Value function is (i) defined on deviations from reference point; (ii) generally concave for gains
and convex for losses; (iii) steeper for losses than for gains

Weighting Function
Prospect theory multiplies each outcome by a decision weight
Weights are inferred from choices between prospects like subjective probabilities are inferred from preferences in Ramsey-Savage
approach

 decision weights are not probabilities, do not obey probability axioms, should not be interpreted as measures of degree / belief

Measure impact of events on desirability of prospects, not only perceived likelihood of events
Can be influenced by e.g. ambiguity
π is increasing function of p, with π (0)=0 and π (1)=1; outcomes contingent on impossible event are ignored, scale is normalized so
that π (p) is ratio of weight associated with probability p to weight associated with certain event

Preferences suggest that for small values of p, π is subadditive function of p,

i.e., π (rp) > r π (p) for 0 < r < 1. Say, (6,000, .001) is preferred to (3,000., .002). Thus:

Very low probabilities are generally overweight, as π (p) > p for small p
Preference for lottery of 5000 over certain 5 implies π (.001)υ (5,000)>υ (5), thus π (.001)>υ (5) / υ (5,000) > .002, assuming value
function for losses is convex

Although π (p) > p for low probabilities, there is evidence to suggest that 0 < p < 1, π (p) + π (1 – p) < 1
 called subcertainty
 typical preferences in any version of Allais paradox imply subcertainty for relevant value of p
Allais Paradox: inconsistency of actual observed choices with the predictions of expected utility theory

Slope of π in interval (0,1) viewed as measure of sensitivity of preferences to changes of probability

Subcertainty entails that π is regressive with respect to p, i.e. that preferences are generally less sensitive to variations of probability
than the expectation principle would dictate
 subcertainty captures sum of weights associated with complementary events is typically less than weight associated with certain
event

Substitution axiom conform to: if (x,p) is equivalent to (y, pq) then (x,pr) is not preferred to (y,pqr),
0< p,q,r≤ 1.
Axiom: a statement or proposition which is regarded as being established, accepted, or self-evidently true
Thus,

For fixed ratio of probabilities, ratio of corresponding decision weights is closer to unity when probabilities are low than when they are
high
This property of π imposed constraints on shape of π : it holds only if lo π is convext function of log p

Simplification of prospects in editing phase can lead to an individual to discard events of extremely
low probability and treat events of extremely high probability as if they were certain
 people limit in ability to comprehend and evaluate extreme probabilities, so π is not well-behaved
near end-points

Hypothesized non-linearity of π
- Would people pay as much to reduce no. bullets from 4 to 3 as from 1 to zero (Russian
Roulette)
- People would pay more in second situation, value of money reduced by probability that
someone will die
- Potential violations of dominance  prevented by assumption that dominated alternatives are detected + eliminated prior to
evaluation of prospects; but theory permits indirect violations of dominance
- Decision task where decision maker generates alternative equal in value to given prospect  asymmetry introducing
systematic biases

Discussion
Risk attitudes
Dominant pattern of preferences observed in Allais’ example follows from present theory if:

 violation of independence axiom attributed to subcertainty and inequality π (.34) < 1 - π (.66)
- Indicates that Allais type violation will occur whenever the υ -ratio of two non-zero outcomes is bounded by corresponding π
ratios
Shift of references
Change of reference point alters preference order for prospects
e.g  person who has not made peace with losses is likely to accept gambles that would be unacceptable to him otherwise
 tendency to bet on long shots increases in course of betting day
e.g. person formulates decision problem in terms of final assets rather than gains and losses  eliminates risk seeking

People expected to exhibit more risk seeking in deciding whether to accept a fair gamble than deciding whether to purchase a gamble
for a fair price

Chapter 7: Behavioral Finance Puzzles

The Dividend Puzzle
Why preference for spending dividends while refraining from selling stocks and spending their proceeds?

Solution: combination of wants for saving and spending; cognitive and emotional shortcuts and errors, including framing, mental
accounting, hindsight, regret, and self-control; and tools for correcting them, including distinctions between capital and dividends, rules
regulating saving and spending, and insights from expected utility and prospect theories.

Wants for utilitarian, expressive, and emotional benefits

Conundrum of wanting to save for tomorrow and wanting to spend today
 both have utilitarian, expressive + emotional benefits
Today spending benefits: Food, shelter, cars, movies, vacations
Today saving benefits: Security, pride, high social status; observed in people regardless of amount of holdings

Framing and mental accounting

Normal-ignorant investors vs normal-knowledgeable investors
Normal-ignorant investors: framing of capital of stock as fruit tree, dividends as fruit  collecting and spending dividends does not
diminish capital of stock
Confuse form of homemade dividends and cashed dividend check for difference in substance

Rational investors
Framing selling fruit and buying other fruit trees to grown capital
Realize homemade dividends identical in substance to cashed dividend check, only different in form
Price shares of company declines when dividends are paid, but wealth of shareholders does not decline  decline in price of shares
when dividend is paid equals cash added to shareholder’s bank accounts when dividend checks are deposited
Capital declines when dividends are spent, not when dividends are reinvested

Difference in substance homemade dividends from company-paid dividends

Deepens dividend puzzle  taxes have advantage with homemade dividends
Tax rebate vs tax rate on dividends
- tax rebate when realizing losses e.g. selling shares at lower than purchasing rate, increasing wealth on average more than
contrasting tax on company-paid dividend, reducing wealth
- tax rate when realizing gains e.g. selling shares at higher than purchasing rate, reducing wealth – however, wealth loss is
smaller than with tax on company-paid dividend

Self-control
Company-paid dividends have advantage over homemade dividends bc facilitation of exercise in self-control  controlled by setting
separate mental accounts for income (e.g. salary – dividends) and capital (e.g. stocks)
“spend income but don’t dip into capital” spending from salary + dividends from income mental account, but no creation and spending
of homemade dividends by selling stocks from capital mental account
 technique diminishes likelihood of turning 3 percent homemade dividend into 30 percent homemade dividend depleting portfolios +
retirement portfolios

Self-control tools: stocks paying no dividends + mutual funds with automatic reinvestment of dividends, interest + capital gains
No automatic reinvestment = mutual funds depositing “distributions” – dividends, interest, realized capital gains – into market funds,
mingling them with regular income so they’re ready for spending
Automatic reinvestment = reduces availability of dividends, interest, realized capital gains = easier resistance to spending temptations
also during self-control lapses

Stock dividends illustrate power of mental accounts + their use for self-control
 company paying stock dividends pays no cash, but sends shareholders additional shares in proportion to the number they already
own
 makes NO sense to rational investors
HOWEVER, reduces expressive + emotional costs even when not increasing utilitarian benefits bc placed in income mental account,
can be sold and proceedings can be spent without violation of THE rule

Hindsight, regret, and pride

Company-paid dividends have advantage of less likely to inflict regret
Buying of 1.400-euro laptop with cash dividends from shares vs buying laptop with homemade dividends from selling shares of same
stock
Share price increase the next day, regret of early selling stock, no regret from company dividends bc timing of dividends was out of
control
Responsibility of homemade dividends, no responsibility of company-paid dividends
In case of share price decrease next day, pride from homemade dividends bc of foresight
BUT: decline in gain-loss utility exceeds increase in gain-loss utility, therefore feeling of pride less severe than feeling of regret (LOSS
AVERSION)

Framing in prospect and expected-utility theories

Company-paid dividends advantage in context of prospect theory
Investor frames dividends into one mental account and capital into another 
both show gains, both are savored separately
Total gain-loss utility greater for two separate gains than for one, lumped together gain
In case of dividend gain but capital loss, higher gain-loss utility when using two different mental accounts
 investor able to integrate mental accounts = integration of dividend and capital loss in 1$ total gain to eliminate the consideration of a
loss. Otherwise, non-dividend paying stock would be preferred.

The Disposition Puzzle

Normal investors quick to realize gains, slow to realize losses
 disposition to sell winners too early ride losers too long
Solution:
- Combination of wants for emotional benefits of pride avoidance of emotional costs of regret;
- Roles of expected utility and prospect theory
- Use of cognitive and emotional shortcuts + pitfalls of errors e.g. framing, mental accounting, hindsight, regret, self-control,
AND tools for correcting errors including rules + systems that induce realization of losses

Wants, shortcuts, and errors

Realizing losses imposes emotional cost of regret; realizing gains yields emotional benefits of pride
- Unwillingness to repurchase stocks whose prices increased subsequent to sales, even though repurchases are optimal
- Strength of reluctance to repurchase greater when measures of regret are higher
-  great reluctance to repurchase = large disposition effect

Reluctance can increase cheating – people suffering from “getevenitis” attempt to get even
Taxes confer utilitarian benefits on realizing losses  rational investors realize losses quickly
Taxes impose utilitarian costs on realizing gains  rational investors postpone realizing gains

Hindsight errors: mislead normal investors into think what is clear in hindsight was equally clear in foresight
Responsibility for choices CRUCIAL in emotional costs of regret
e.g. disappointment when someone else responsible for choosing loss generating stocks
 regret when bear own responsibility
Reluctance to close mental account containing losing stock = giving up hope that account could be closed at a gain = admitting
judgement was wrong

Disposition effect only discovered in people bearing responsibility for stock choosing
Magic words to counter disposition effect (reluctance to realize losses)
1. Transfer your assets
a. Sell shares, realize losses, buy other shares with proceeds
b. Diverts attention from closing of one account to opening of new account
c. Find different attractive uses of money made available from realizing losses e.g. reaching savings goal  facilitates
realizing losses by highlighting hopeful opening of new account
d. Found in December effect  investors become more willing to realize losses when sanitized to tax benefits of loss
realization
2. Harvest your losses
a. Replaces frame of realizing rotten losses with plucking ripe peaches
b. Stop-loss-orders: precommitment and automatic action; takes away choice of manually closing mental account at
loss
3. Framing
a. Blurs purchase price as reference point for gains and losses  mutes disposition effect
b. Can also highlight purchase price  bolsters disposition effect
Realization utility:
- Emotional benefit of pride when realizing gains = positive realization utility
- Emotional cost of regret when realizing losses = negative realization utility

Framing in Expected-Utility and Prospect Theories

Expected utility theory predicts investor would realize losses to increase wealth beyond current wealth by tax rebate
Prospect theory predicts investor would hold share for another day if chances are good enough price share will go up again (depends
on difference gain-loss utility of chance compared to certain)
 reluctance to realize losses and eagerness to realize gains
Countering the Disposition Effect
Self-control: interaction between reason and emotion, trade-offs between utilitarian and expressive and emotional benefits
Utilitarian benefit e.g. lower taxes = quick realization of losses
Expressive + emotional cost e.g. regret = delay loss realization

Self-control necessary to admit wrongful judgement and realize losses

 can be facilitated by rules e.g. realizing losses at ten percent
Control system that mandates traders settle trading positions at end of each day
 only works as well as ability to prevent rogue traders from ruining them

Reluctance can lead to larger bets in attempt to get even; can lead to larger losses
Evidence that beliefs about future prices underlie reluctance to realize small losses, but not large losses
Fear pushes against reluctance to realize losses as it highlights the possibility that loss may increase beyond ability to sustain it

Disposition Effect among Corporate Managers

Errors in judgement
- Pessimism vs optimism
o Pessimism = underestimates of NPV by cost overestimates / price underestimates
 Projects can be rejected by committees offering positive NPV, blocking company value increases +
increased wealth of shareholders
o Optimism = overestimates of NPV by cost underestimates or profit overestimates
 Projects offering negative NPV can be selected, decreasing value of company + decreasing wealth of
shareholders

Reluctance to Terminate
- Conflicts of interest between managers, their corporate bosses or shareholders
 can lead to termination of managers leading them
- Detracts from utilitarian benefits of shareholders
- Reluctance increases with responsibility
o Regret felt by terminating projects chosen themselves greater than regret felt by terminating projects chosen by
others  desire to get even, link between responsibility and regret

Failure to Terminate
- Utilitarian costs of loss of job / bonus; expressive costs of loss of status; emotional costs of regret about choosing project that
turned out to be a mistake

Difference between utilitarian benefits shareholders – utilitarian, expressive, emotional benefits pf mangers evident in stock prices
- Increases in stock prices + shareholder wealth after termination of negative NPV projects = shareholders relief

Puzzles of Dollar-Cost Averaging and Time Diversification

Dollar-cost averaging: dividing cash in segments + committing to convert each segment into stocks according to predetermined
schedule
e.g. $120,000 in cash  commit to invest $10,000 in stocks on 10th of each of coming 12 months
Lump-sum investing: investing every bit of cash at once  more likely to increase wealth

Time diversification: belief that risk of stocks declines as investment horizon increases  not true

Both puzzles popular but difficult to justify within framework of standard finance
Solutions: combine wants for utilitarian, expressive, and emotional benefits; application of expected utility + prospect theories; roles of
cognitive and emotional shortcuts + errors; tools for correcting errors

Framing and Expected-Utility and Prospect Theories in Dollar-Cost Averaging

Loss aversion might deter investor from buying stocks
Dollar-cost averaging overcomes loss aversion in frame highlighting gains + obscuring losses

Implies $11.25 per-share gain

 normally framed, investor sees gains in all circumstances except when stock prices don’t change
Average cost per share paid lower has no economic significance
 caused by high volatility, does not change uncertainty
Pride, Regret, and Fear in Dollar-Cost Averaging
Investors mitigate anticipated emotional costs of regret accompanied by losses relative to cash reference point by converting only a part
of cash into shares today, vice versa for shares into cash
- Consolation when share prices plummet
- Pride at thought that shares can be bought at lower prices

Dollar-cost averaging = non-contingent plan

- Manifested in strict rule set at initiation of plan to invest particular amount in each subsequent period
- Is inferior in eyes of rational investors  ignores new information about shares and market
Advantages: rules bolster self-control, counter fear, mitigate regret

Self-control in Dollar-Cost Averaging

Stock-buying plan attractive by old probabilities may become unattractive, inclination to abandon plan
- Unable to do so by strict rules  combat self-control lapses
- 401(k) also automatically buys stocks, different in that there is not choice in investing lump sum or in installments
- Investors frame as winners bc buying shares at lower than average price

Reverse Dollar-Cost Averaging

Dollar-cost averaging recommended to investors with cash considering converting in stocks and vice versa  therefore benefits not in
risk reduction

- Gain-loss utility of converting all $2000 into stocks / cash less than utility of holding
o -124 + 80 / 2 = -22 as opposed to 0
o -160 + 47 / 2 = - 56.5 as opposed to 0
- Dollar-cost averaging overcomes inclination  results in conversion of wealth

Framing and Expected-Utility and Prospect Theories in Time Diversification

Related to equity premium puzzle
 solution in could be in myopic loss aversion
- Frequency of losses varies by length of periods over which returns are observed
- More frequent over short periods than over long periods
- Observing returns over short periods can mislead into belief that losses are more likely over long periods than they truly are
BUT:
- Can also be that people invest less when seeing no historical return distributions lack of knowledge makes investors
excessively pessimistic about future stock returns

Framing Errors in Time Diversification

Can mislead investors in illusory happy ending
- If risk is framed as probability of losing money, risk declines as
horizon increases
- Risk is framed as total amount of money that can be lost, risk
increases as horizon increases

- Effect of time on probability of losses can be perfectly balanced by

effect of time on total amount of money that can be lost  risk neither
increases nor decreases as investment horizon increases
- Error of framing small probabilities as zero probabilities: illusory-
happy-ending-error
 contrasting myopic loss aversion error

Regret and Self-Control in Time Diversification

Time horizon can be flexible “the long run” rather than fixed “30 years”
Conclusion p.170
Barber & Odean (2000): Trading is Hazardous to Your Wealth: Common Stock Investment Performance of Individual Investors
Introduction
- Paper supports view that overconfidence leads to excessive trading
- Very little difference in gross performance of households trading frequently (monthly turnover in excess of 8.8 percent) and
trading infrequently
- Households trading frequently earn net annualized geometric mean return of 11.4 percent, those trading infrequently earn 18.5
percent
- Consistent with models where trading originates from overconfidence, inconsistent with models where trading results from
rational expectations
Descriptive analysis concludes
 Households trade common stocks frequently
 Trading costs are high
 Households tilt investments toward small, high-beta stocks
Poor investment performance of households can be explained by cost of trading + frequency of trading, not portfolio selections
- Tilt of households to small stock and value stocks helps performance during sample period
Results may differ from earlier research by:
- Analyzing household holding investment at discount brokerage firm rather than retail brokerage firm
o Wide variety of investment advice available to both retail + discount investors
o Retail brokerage firms provide stock selection advice  if valuable and attended advice, possible investors at firms
earn both better gross and better net returns
- Considering tendency of individual investors to tilt to small stock  likely extremely important bc small stocks outperform large
stocks by 67 basis points per month during sample period

Results
gr
Gross return earned by individual investors in aggregate ( RAGt ) and gross return earned by average household ¿ ) very close to
return earned by investment in a value-weighted index of NYSE/AMEX/Nasdaq stocks.

Fama-French model includes two factors to CAPM to reflect portfolio exposure to two classes: small caps, and stocks with high book-
to-market ratio
 SMB = Small (market capitalization) Minus Big, HML = High (book-to-market-ratio) Minus Low
 measuring historic excess returns of small caps over big caps and value stocks over growth stocks
 explains over 90% of portfolio diversification returns compared with average 70% given by CAMP

Panel 1 + panel 2:
 look at excess return: three out of four performance measures indicate that gross performance is unremarkable
 own-benchmark abnormal return reliably negative; meaning that investors would have earned higher returns following a buy-and-
hold strategy; gross-performance is hurt by trading
Coefficient estimate (Rmt – Rft) = market excess return
Individual investors tilt toward small stocks with high market risk
Average household slight tilt toward value stocks (high book-to-market ratios), more pronounced tilt to
small stocks

Panels C + D:
- Net of transaction costs, individual investors performance  own-benchmark abnormal return + Fama-French indicate
significant underperformance of 15 to 31 basis points per month (1.8 percent to 3.7 percent per year)
o Performance measures appropriate bc controlling for style preference of individual investors: small stocks with above-
average market risk
o Own benchmark indicate individual investors would have increased annual return by 2% if held to beginning of-year
portfolio
Net return performance of individual investors is reliably negative

Portfolio size influence:

- Small portfolios:
o Slightly higher monthly turnover
o Tilt more heavily toward high-beta, small, value stocks than large portfolios
- Both small and large portfolios underperform

Overconfidence and Performance

Investors suffering from overconfidence trade too much (i.e. trading reduces expected utility)
Grossman Stiglitz: investors will trade when marginal benefit of doing so is equal to / exceeds marginal cost of trade including cost of
acquiring information  rational expectation framework)
Models:
1. Rational expectations model: predicts that investors who trade more (i.e. whose expected trading is great) have same
expected utility as those who trade less
a. Predicts that gross risk-adjusted return of households with high turnover will be higher than of households with low
turnover  little difference in net-adjusted returns
2. Overconfidence model: predicts that investors who trade more will have lower expected utility
a. No prediction about differences in gross returns

Models tested against sample:

- Prediction of Grossman Stiglitz model not supported: those trading more do not earn higher gross returns
- High turnover households (quintile 5) underperform low turnover households (quintile 1)
-  look at difference high- low; own-benchmark abnormal return, Fama-French intercept
- Differences in gross returns across turnover quintiles are small
- Dramatic differences in net returns across turnover quintiles
Price Momentum
Stocks that have performed well recently tend to earn higher returns than those that haven’t
Sampled investors are anti-momentum investors: on average they tend to hold stocks that have recently underperformed the market
 consistent with evidence that individual investors tend to hold losing and sell winning investments
- Individuals tend to tilt investments toward stocks that have performance poorly recently
- Principal of investors trading most actively realizing on average lowest net returns not affected by inclusion of momentum
characteristic
- Active investors continue to underperform compared to less active investors

Liquidity, Rebalancing, Tax-Motivated Trading

Other motivations (besides information-motivated + overconfidence-motivated) for trading
Liquidity
- Investors trade as rational response to liquidity shocks  implausible explanation for 75% annual turnover of individual
investors
- Trading resulting from liquidity shocks can be accomplished at much lower cost by investing in mutual fund than by investing in
individual common stocks
Rebalancing
Investors desiring portfolio with certain risk characteristics will rationally rebalance their portfolio to maintain their risk profile
 can be achieved at much lower cost by selecting portfolio of mutual funds
Taxes
Investors holding stock that have lost value since purchase can realize losses, used to shelter gains, reduce tax liability
Reasons why this is cannot explain results:
- Implausible explanation once again
- High turnover + significant underperformance in both taxable and tax-deferred accounts
 if overconfidence is main motivation for trading, active trading + significant underperformance should be found in taxable and
tax-deferred accounts
o Tax-deferred accounts outperform taxable accounts by six basis points per month
- Odean documents that most investor trading activity is inconsistent with tax-motivated trading  observed that investors at
discount brokerage sell profitable investments twice as often as unprofitable investments

Gambling
Many people appear to enjoy gambling.
We consider two distinct types of gambling:
1. Risk-seeking
a. One demonstrates a preference for outcomes with greater variance but equal or lower expected return
b. Excessive trading has a related but decidedly different effect, it decreases expected returns without decreasing
variance.
 c. Thus risk-seeking may account for underdiversification, but it does not explain excessive trading
2. Entertainment  gaining emotional benefits from gambling, fuels greater trading

Conclusion
- Gross returns earned average; poor net results
- Average household underperforms a value-weighted market index by about 9 basis points per month (=1.1% annually)
- After accounting for tilt common stock investments towards small value stocks with high market risk, underperformance
averages 31 basis points per month (3.7%)
- Average household turns over approximately 75% of common stock portfolio annually
- Poor performance of the average household traced to costs associated with high level of trading
- Most dramatic empirical evidence is provided by the 20% of households that trade most often
- Net returns lag a value-weighted market index by 46 basis points per month (5.5%)
- Accounting for high-turnover household tilt common stock investments towards small value stocks with high market risk,
underperformance averages 86 basis points per month (10.3%)
- Investment experience of individual investors similar to experience of mutual funds
- Trading by individual investors more deleterious to performance bc execution small trades + facing higher proportional
commission costs than mutual funds

Main point: trading is hazardous to wealth. Why then do investors trade so often?
- High levels of trading partly explained by overconfidence = too much trading
- Behavioral finance models that incorporate investor overconfidence provide an even stronger prediction: Active investment
strategies will underperform passive investment strategies
- Overconfident investors overestimate value of private info = trade too actively; below-average returns
- Those who trade the most are hurt the most.

Don & Sengmueller (2009): Trading as Entertainment?

Introduction
- Leading answer to question why people trade is overconfidence
- Little empirical evidence for claim
- Paper examines hypothesis that trading is driven by entertainment motives
- Entertainment driven investors turn over portfolio of stocks, bonds, funds, and options at roughly twice the rate than peers
- Fraction of total portfolio turnover than can be explained by objective investor attributes doubles by including entertainment
attributes as additional explanatory variable
- Turnover possible to be rationalized by savings, dissavings, or liquidity motives varies little across investors as a function of
their entertainment attributes
- Cross-sectional variation in proxies for overconfidence largely fails to explain variation in trading activity
- Self-professed gambles tend to be younger, less educated, less wealthy  hold more concentrated portfolios that exhibit more
positively skewed returns, are more likely to hold and trade options

Motivation and Data

Motivation
- Three distinct motives for entertainment trading: 1) recreation; 2) sensation seeking, and; 3) aspiration for riches
- Recreational trading motivated by feeling of accomplishment or camaraderie or can emerge as by-product of following
financial markets as a hobby
o Hobby investors have to overcome less psychological hurdle when executing changes to portfolio  directly lowering
marginal cost of trading
o Actively following financial markets = more exposed to trading signals = more trading
o Rise in self-esteem; ability to boast to family and friends
o Barberis & Xiong 2008 – realization utility  investors derive extra utility from realized gains and losses, trading
necessary to reap utility offered by realizing gains from investment that has appreciated sufficiently
- Sensation seeking motivated by subconscious quest for arousal
o Sensation seekers look for intensity + novelty in experience
o Underdiversified portfolio of volatile stocks = intense stimuli in form of extreme returns
o  can trigger trading
o Sensations seekers in finance may value act of trading in and of itself because a trade affords desired novelty of
experience
- Trading motivated by aspiration of richer  trade = bet that carries a “dream value” i.e. joy of imagining what a handsome
payoff will buy
o Aspiration-driven investors should hold portfolios with volatile and positively skewed returns to increase chance of
reaching an aspiration level far above current wealth
o Exposure to trading stimuli in form of extreme returns + inherent impatience to reach desired wealth level =
aspiration-driven investors can pick up + abandon trading ideas more quickly than their peers
Data
- Typical respondent is male, young, has held account for three years
- Male investors + wealthier investors appear to enjoy dealing with investments more than female + less wealthy counterparts
- Participants enjoying games only when money is involved tend to be younger, less well educated, and less wealthy
 - Self-professed gamblers hold more concentrated equity portfolios; consisting of individually riskier securities
- People classified as gambler hold portfolios of stocks + exhibit mutual funds that exhibit more positively skewed returns 
enjoying more risky propositions = trade more options
- Evidence suggests two types of investors potentially deriving entertainment benefits from trading: 1) hobby investors (reported
to enjoy investing); 2) gamblers (reported to enjoy risky propositions in general and gambling in particular)
o Gamblers motivated by quest for arousal / aspiration for riches
o Tend to be younger, less wealthy, hold more concentrated portfolios of more volatile securities to provide necessary
stimuli / increase chance of reaching desired wealth level

Baseline Results
Main hypothesis: some investors derive nonpecuniary benefits from researching, executing, talking about, anticipating, experiencing
outcome of a trade  offset cost of trading
 ceteris paribus, entertainment-driven investors trade more than peers
- Investors reporting to enjoy investing trade more aggressively than peers  higher average monthly turnover
- Investors with affinity to gambling (“games are only fun when money is involved”) turn over portfolio at twice rate than investors
who strongly disagree
- Virtually entire difference in total turnover between those who enjoy investing or gambling and their peers = higher excess
turnover of entertainment-driven investors

Average monthly turnover on demographic / socioeconomic attributes

- Male and younger investors trade significantly more than their peers
- Self-employed investors trade more than employed peers
- Those who thoroughly enjoy investing trade more than twice than those who not
- Investors who enjoy risky propositions in general and gambling in particular trade more aggressively than peers – controlling
for objective investor attributes
- Both investors who enjoy dealing with personal finances and investors who enjoy risky propositions trade more aggressively
than peers

Results suggest that:

- Investors appear to derive pleasure from trading both as pastime and as form of gambling
- Respondents who enjoy investing but not gambling and those who enjoy gambling but not investing trade more than their
peers who enjoy neither investing nor gambling; those who enjoy both investing and gambling trade the most
- Entertainment-driven investors exhibit similar normal turnover when compared with their peers: BUT: substantially higher
excess turnover

Alternative explanations
Unimportant accounts
- Investors classified as entertainment driven may be more likely to hold financial assets outside observed account e.g. in a full-
service brokerage account
- Lower trading costs = likely to concentrate trading activity in observed account BUT trading activity need not be higher than
that of nonentertainment investors
- Proxies for importance of observed accounts are significantly negatively related to excess turnover  explanatory power of
entertainment attributes = unchanged

Past performance
- Survey responses can be artifact of past performance e.g. investors reported to enjoy investing / gambling may feel good
about investing bc investments have done well
- Trading motivated by past returns rather than entertainment motives
- Investors reporting to enjoy investing / gambling underperform peers during sample period  if alternative was true, should
have outperformed

Overconfidence
- None of overconfidence proxies significantly related to excess turnover
- Controlling for proxies of overconfidence in addition to other investors attributes, hobby investors + gamblers continue to trade
significantly more than counterparts
- Relationship between turnover at end of sample + overconfidence proxies does not depend on whether proxies are modeled
as set of dummy variables / cardinal
- Does not depend on definition of turnover (total vs excess) except: agreeing with ”I’m much better informed than the average
investor” is significantly positive related to turnover if turnover is defined as average excess turnover across entire sample
period
- Variation in overconfidence generally unrelated to excess turnover except: respondents who dislike gambling and appear
overconfident (consider themselves much more informed than average investor) trade more than those who dislike gambling
and do not appear overconfident

Conclusion
- Paper suggests some investors derive nonpecuniary benefits from trading that offset costs of churning  entertainment-driven
investors trade even though trading diminishes expected monetary payoff of portfolio
- Variation in self-reported enjoyment of investing and gambling explains variation in trading intensity after controlling for
competing explanations e.g. overconfidence
 - Most entertainment-driven investors trade about twice as much as those who do not take pleasure in gambling and investing,
controlling for wide range of investor attributes
- Estimated that more than half of observed portfolio turnover is excess turnover
 turnover in excess of what can be justified by standard trading motives e.g. savings, liquidity, rebalancing
- BUT difficult to assess relative importance of leisure vs gambling-motivated trading with data at hand
- Aggressive trading may be hazardous to investor’s wealth
 would not directly jump to conclusion that active trading reduces investor wealth

Kumar & Lim (2008): How do Decision Framer Influence the Stock Investment Choices of Individual Investors?
Introduction
- Traditional portfolio choice models = investors formulate trading decisions by maximizing expected utility defined over total
wealth  each investment choice evaluated according to impact on aggregate wealth
- BUT: people tend to consider each decision as unique  isolating current choice from other choices i.e. narrow framing,
interactions among multiple decisions are often ignored
- Tversky & Kahneman define decision frame as “decision-marker’s conception of acts, outcomes, and contingencies
associated with particular choice”  many different decision frames can be potentially induced
- Finally chosen frame influenced by formulation of problem + personal characteristics and habits of person making the decision

Narrow Framing
- People can adopt most readily available frame, often narrow + suboptimal, also due to limited cognitive capabilities +
integration requires significant cognitive costs
- Choosing frame that increases perceived utility, makes outcome appear more favorable
 hedonic optimizers pick narrow decision frame that segregates gains instead of using broad decision frame combining all
gains
- Preference of narrow framing bc non-consumption utility e.g. regret influences decisions

Narrow Framing and Disposition Effect

- Investors can exhibit stronger disposition effect bc narrowly framing stock-level gains and losses instead of adopting broader
frame considering overall portfolio performance
- Prospect theory and disposition effect: tendency to frame decision narrowly at individual stock level instead of framing them
broadly influences investors’ propensity to sell portfolio winners + losers
- Narrow framing investors sensitive to performance of individual stock exhibit greater propensity to sell winners relative to
losers  broader framing investors less likely to exhibit asymmetry, even if evaluating portfolio gains + losses using prospect-
theoretic value function

Narrow Framing and Diversification

- Investors may underdiversify bc narrowly examining risks of individual stocks  do not use broader decision frame to evaluate
aggregate portfolio risk taking into account correlation structure of portfolio
- Stocks may appear unattractive when considered in isolation, can bring considerable diversification benefits to aggregate
portfolio

Main hypothesis: investors framing decision narrowly exhibit stronger disposition effects and weaker diversification skills
- Decision frames adopted by people influenced by manner in which different alternatives are presented to them in particular
time interval
- Study uses degree of clustering in trades as proxy for level of narrow framing in stock investment decisions
- Investors who execute less-clustered traders are more likely to use narrower decision frames in investment decisions than
investors who execute more clustered trades

Clustered Trades and Framing Decisions

Potential Narrow Framing Proxies
Degree of narrow framing measured by using degree of clustering  does an investor executes trades separately or multiple trades
simultaneously

Measure degree of trade clustering (TC)

NTDAYSi = total number of das on which investor i trades stocks
NTRADESi = total number of stock trades executed by investor i during sample period
- Low TC indicates trades are temporally separated, degree of narrow framing likely to be higher
- Mean TC is .226, typical investor executes 10 trades over 7.74 trading days
- 16% of all investors execute each trade on different trading day  have zero TC measure

Trade Clustering and Investor Characteristics

 PSize and Age are important bc circled in original article used during tutorial
- Investors in highest TC decile hold larger portfolios than those in bottom decile
- Execute more trades per year but with smaller size compared to lowest decile
- High TC = higher turnover rates BUT relation not monotonic
- TC increases with income, age, portfolio size, trades per year, number of stocks in portfolio
o Higher for investors trading foreign securities + mutual funds
o TC might be associated with stronger preference for diversification

Trade Clustering and the Disposition Effect

Disposition Effect Measure
Considering actual trades + potential trades of investor i during sample period,
proportions of gains realized (PGR) and proportion of losses realized (PLR) are
computed as:

Peer Group Adjusted Trade Clustering and Disposition Effect Measures

PLR and PGR sensitive to portfolio size and trading frequency
 proportions likely to be smaller for investors holding lager portfolios + more frequent trades bc portfolio contains larger number of
stocks with capital gains and capital losses
 dependencies likely to induce mechanical associations between DE and variables correlated with portfolio size + trading frequency

Prevention against possibility of mechanical relation by minimizing potential influences of portfolio size, number of stocks and trading
frequency on TC and DE, defining peer group adjusted measures of trade clustering and disposition effect
- Obtain peer group adjusted TC measure for each investor as:

- Positive (negative) ATC measure indicates that trades are more (less) clustered then other investors exhibiting similar trading
frequency, hold portfolios with similar number of stocks + similar size (i.e. peers)
- Magnitude of measure indicates number of SDs investor is away from mean of respective peer group

Trade Clustering and the Disposition Effect: Sorting Results

 High-low difference; portfolio size
- Examine relation between adjusted trade clustering (ATC) and adjusted disposition effect (ADE)
- Mean ADE decreases with ATC
- Highest ATC quintile, mean ADE is negative (-0.156), indicating that investors exhibit lower disposition effect than peer group
means
- Difference in mean ADE of top and bottom ATC quintiles is large (=-0.258) and statistically significant at 1% level
- Mean ADE decreases with ATC across all portfolio size + trading frequency quintiles
- Additional regression; ATC measure can explain considerable portion of cross-sectional variation in disposition effect,
significant

Interpretation of Disposition Effect Results

- Investors who execute more clustered trades exhibit weaker disposition effect  consistent with first part of main hypothesis
Investors that adopt narrower decision frames exhibit a stronger disposition effect bc they are likely to focus on gains and losses of
individual stock rather than examining overall portfolio performance

Two interpretations:
1. Decision frames influence disposition effect, even though the narrow frame is not actively chosen
Making intuitive choices = separate decisions induced o adopt narrow decision frame
2. Certain investors intentionally choose broader decision frames  hedonic optimizers choose decision frame and level of
mental accounting that maximizes perceived utility
a. Loss aversion, diminishing sensitivity of value function  impact of loss is larger than impact of gain of same
magnitude, sensitivity to gains and losses declines as magnitudes increase
b. Hedonic editing hypothesis predicts that people would prefer to combine loss with larger gain or with another loss
because combined outcome generates higher utility than total utility generated by segregated outcomes
 degree of trade clustering would reflect level of framing in trading decisions; hedonic optimizers attempt to overcome reluctance to
realize losses by executing clustered trades
Integration of outcomes through simultaneous trades reflects desire to engage in “portfolio-level thinking”

Trade Clustering and Portfolio Underdiversification

Diversification measure
Normalized version (NV) of portfolio variance is used as diversification measure
NV for portfolio p is defined as

- Average variance of each investor portfolio is estimated using monthly returns data; portfolio variance measure is estimated
using realized portfolio returns
- Peer group adjusted diversification (ADIV) measure defined using negative of normalized variance measure and peer group
adjustment methodology, so ADIV increases as level of diversification increases

Trade Clustering and Diversification: Sorting Results

 - Level of portfolio diversification increases with ATC
- Degree of trade clustering positively related to level of portfolio diversification
- Mean adjusted diversification of investor portfolios in highest and lowest ATC quintiles are 0.154 and -0.074, differential of
0.228 statistically significant at 1%
- Diversification level increases with ATC across all portfolio quintiles and across all trades per year quintiles

Diversification Regression Estimates

Strongest determinants of portfolio diversification
- Local bias: difference between weighted distance of actual investor portfolio from her location and weighted distance of market
portfolio from her location
- Trade clustering
Investors executing more clustered trades + tend to make simultaneous trading decisions hold better-diversified portfolios than
investors who execute separate trades + tend to make separate decisions
 investors who adopt narrower decision frames hold relatively less-diversified stock portfolios

Trade Clustering, Style Preferences, and Portfolio Performance

Relation between adjusted trade clustering and portfolio performance
- Investors executing more clustered trades exhibit weaker disposition effects and hold relatively better diversified portfolios
o Adopt broader decision frames, be better positioned to examine interactions among multiple portfolio decisions
o Might be better able to assess total risk of portfolios  trade clustering can be positively correlated with risk-adjusted
portfolio performance
- Investors executing less clustered trades + adopt narrower decision frames can earn higher raw returns bc preference to hold
riskier stocks
o Riskier stocks earn higher returns = trade clustering negatively related to raw portfolio performance

- Sample underperforms common performance benchmarks

- Investors executing more clustered trades holdless risk portfolios, earn lower raw returns
 no considerable variation of Sharpe ratio across ATC quintiles
o Lowest ATC quintile earns mean monthly return of 1.251% + have mean portfolio SD of 9.029%  Sharpe ratio
0.101
o Highest ATC quintile earns lower mean monthly return 1.122% but also has lower mean SD 7.594  Sharpe ratio
0.104
- Consistent with diversification regression  investors executing more clustered trades hold less risky, better-diversified
portfolios
Low ATC investors continue to outperform high ATC when measuring portfolio performance using Jensen’s alpha
 underperform when applying other asset-pricing models to define performance benchmarks

Mixed evidence on relation between trade clustering and portfolio performance

- Relation depends on choice of performance measure
- Negative when considering raw performance measure / Jensen’s alpha; positive when measuring risk-adjusted performance
using three-factor alpha or four-factor alpha

Summary and Conclusions

- Investors executing more clustered trades exhibit weaker disposition effects and hold better-diversified portfolios
- Investors who execute less-clustered trades exhibit preference for small-cap and value stocks, earn higher raw returns, lower
risk-adjusted returns
- Framing model is important determinant of investors’ stock investment decisions
- Narrow framing would have broader influence on investors’ portfolio choices and trading decisions beyond its effect on risk
attitudes
- Study does not examine relation between narrow framing and stock returns BUT results suggest that investors’ framing
choices likely to have implications for stock returns
o Stock preferences vary systematically with degree of trade clustering
o Concentration of investors more likely to frame decisions narrowly vary with stock characteristics in predictable
manner
o Stock may exhibit greater volatility and lower correlations with other stocks within same category
MAYBE

Chapter 5: Correcting Cognitive and Emotional Errors

- Financial experts gain expertise over time by acquiring human-behavior + financial facts knowledge, and using reflective
System 2 to process it
 expertise = eventual reliance on System 1, bypassing System 2, in predictable environments
- Less predictable environments = EXPLICIT use of System 2, feedback long-term outcomes for financial professionals =
delayed, sparse, ambiguous  promoting confidence in choices without promoting quality of choices

Financial advisors can lead investors by providing human-behavior + financial facts information AND correcting cognitive + emotional
errors
- Can point out availability + hindsight errors caused by advertisements
- Emotional errors of fear causing investors to sell all stocks after crash
- Financial advisers improve financial behavior + well-being of both working and retired people
o More diversified portfolios
o Reduced trading activity
o Increased risk-adjusted stock returns
o Avoiding of taxable distributions
o Difference larger in December; only when investors face large capital losses  advisers guide investors to realize
losses
- Most effect when educating with “just in time” human-behavior + financial-facts knowledge
o Just in time information not always have lasting effects:
 Study where offering large discount from high interest rate charged for overdrafts reduced overdraft usage
 probs bc highlighting high interest rate
 Messages mentioning overdraft availability without mentioning interest rates increased usage
 Neither change persisted after stopping messages

Correcting by Prompting Use of System 2

Genetics factors explain up to 50% of variation in susceptibility to investment errors e.g. disposition effect, propensity to select
investments with high recent returns, familiarity effect
- Influence non-investment choices  persistent preference of familiarity
- Susceptibility to errors diminished by high intelligence
o Prompts use System 2  BUT usage more closely related to disposition for reflection
o Better able to correct overconfidence + hindsight errors; not better able to correct anchoring errors / overcome
resistance to realizing losses
- Blind spots hamper corrections + usage
o Exacerbated by tendency to trust own introspections more than perceptions by others

Correction of errors by using System 2

- Use proper framing by correcting anchoring errors
o Anchors: affect estimates of targets by highlighting features shared by anchor and target, obscuring features of target
that differ from anchor
 Highlights differences between features of anchor + target
 Can make us consider many anchors rather than one  people evaluate plausibility of each anchor relative
to others
 - Framing + mental accounting can increase self-control
o People with insufficient self-control succumb to excessive indulgence e.g. by co-holding credit card with savings
accounts
- Prospective hindsight to correct hindsight errors
o E.g. considering why certain industry will perform worse than other industry 10 years from now elicits potential
causes for failure not generated by using System 1
- Correct overprecision errors by
o 1) split question of confidence interval in parts (10%, 50% intervals)
o 2) estimate for 1 month in future, 2 months, 3 months
 Becomes time explicit, highlighting uncertainty of estimates  better calibrated confidence intervals
 3 month intervals are wider than 2 month interval, which are wider than 1 month interval
o General “wisdom of crowds”  average of one guess by two people more accurate than two guesses by one person
- Representativeness errors could be corrected by considering base-rate information AND representativeness information
o e.g. knowing that someone beat the S&P 500 index in 11 of 13 years; base-rate information includes knowing that if
500 coin flippers flip 13 coins each, winner on average will flip 11.63 heads
- Correcting confirmation errors by proper framing
o People tend to search for confirming evidence, reluctant to search for disconfirming evidence
o Framing by using concrete and familiar information
o BUT: confirmation errors can prompt “cheater detector” module in brains  proficient at detection of cheaters on
social contracts
o Also corrected by using double-blind experiments
- Correction of endowment effect by encouraging “thinking like a trader”  ready to bear emotional costs of regret
o Use system 2 to counter emotional errors, specifically error of regret
o Rationales underlying endowment effect are
 Loss aversion: Willing to give an item we own only at price that compensates for the item AND for its loss
 Emotional benefits of pride; emotional costs of regret
 Pushed by uncertainty of market value  regret when sold item for less than market value; pride
when sold for more
o Can be trained; used by strategies
- Corrections by quantitative models and algorithms
o Outperform human judgment; e.g. availability and representativeness errors
o Improve investment selection process; helps avoid cognitive errors degrading process
o BUT people prefer human judgment  lose confidence in models faster than in human forecasters making same
mistake

Correcting by Incentives
Reducing cost of good choices, increasing cost of poor choices
Insufficient self-control incentives:
- Emotions, e.g. love of children can increase self-control, counter pull of immediate gratification
o Also fund in love of projected older selves increases insufficient self-control
- Mental accounts; people save more when receiving savings-labeled wages in two envelopes
- Commitment devices
o E.g. preventing premature withdrawals
- Temptation bundling: bundles wants with shoulds (wants to win lottery; should save)
Excessive self-control incentives
- Reluctant to indulge  benefit from commitment devices countering excessive self-control
Incentives not always effective in correcting errors
- Backfire in sports + test taking: reduces performance by increasing anxiety + heightening tendencies to replace reliable
formulas with idiosyncratic ones in attempts to improve performance
- Accountability improves performance where effort improves performance, not effective alone in correcting errors
- Can distort assessment of credit risk  e.g. incentives encouraging poor advce can induce poor advice even when incentives
are removed
o Behavior consistent among advisors; more likely to choose poor investment for themselves
o Consistent with wants for expressive + emotional benefits of being incorruptible
 Maintaining image induces advisers to offer consistent advice; even when reducing own utilitarian benefits

Readiness for Correction

Correction requires readiness for correction
Activation of System 2 hampered by:
- Fatigue + distraction: fatigue = difficult to perform tasks requiring self-control; distracted = succumbing to temptation
- Poverty
o Scarcity distracts attention from important future needs  directing it to today’s pressing needs
o Can result in over-borrowing  cycle of poverty
- Hunger; anger; arousal
 not always aware of lack of readiness, resistance of correction when conflicting with wants
- Can be caused by differences in equally valid studies differing in conclusion
- Can also be bc of challenging autonomy of people, their incomes + status
Exploiting can Trump Correcting
Firms can choose to exploit errors e.g. by hiding / shrouding information
- Mostly done in markets where not all people are knowledgeable (knowledge = free from cognitive and emotional errors)
o E.g. hotels where customers can purchase add-ons at much higher price than costs
o Sellers of lottery tickets exploit representativeness errors reflected in beliefs in hot-hand and gambler’s fallacies
o Mutual funds exploit availability errors by directing attention to easily available e.g. only advertising best performing
funds
- Conflicts of interest induces advisers to misguide investors
o E.g. by churning portfolio thus generates more fees; client profits from better diversified portfolio
o Advisors often fail to correct errors, reinforce errors conformed to interests
o Especially likely to offer inferior products to consumers with little financial knowledge
o Directing clients into portfolios independent of investors’ risk preference + life-cycle stages
- Managers of credit card companies exploit unrealistic optimism, insufficient self-control
o Target less-educated customers with low introductory interest rates but high late and over-limit fees
o Mileage programs offered mainly to most-educated customers rely less on these fees
o Practices have been prohibited by CARD Act of 2009
 Requires credit card companies to present dual payoff information in account statements in addition to
specific amount that pays balance in full
 BUT: customers then choose lower monthly payments than those given specific amount that pays balance in
full, and were less likely to pay full balance
 people can be motivated by saving 15% like their colleagues instead of current 5% but can also
demotivate to save even 5%

Correcting, Nudging, and Mandating

Correcting (debias) cognitive and emotional errors when pointing people to their wants
 wants are different from shoulds
Nudge when pressing people towards shoulds
Mandate when shoving people towards shoulds

Mandates are paternalistic: no option to resist by opting out

Nudges are libertarian-paternalistic: allows resistance by opting out
Correction = libertarian when asked for; libertarian-/paternalistic when people don’t

e.g. helpful to help people save enough for retirement

- Anchoring errors in system 1 misleads people in underestimating exponential growth of savings
o Inadequate savings when young = inadequate spending when old
- Cognitive shortcut “rule of 72”  used to estimate number of years it would take an amount to double when growing
exponentially

Conclusion
Can correct errors by human behavior + financial facts knowledge
Transforms us from normal-ignorant to normal-knowledgeable  transforms choices from normal-foolish to normal-smart
Transformation initiated by awareness of errors, then use System 2 when being misled by System 1

Hershfield et al., 2011: Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self
Introduction
- 51% of households fall at least 10% short of reaching target replacement rates
- Fully two-thirds of early baby boomers do not have resources to maintain preretirement standard of living in retirement 
inability to forecast consequences of financial decisions
- Extreme discounting believed to occur in situations in which immediate gains are traded off against long-term gains
o Leads to decisions believed to be rejected with enough planning
o Failure to save for retirement considered prototypical example of discounting to excess

Two remedies to increase saving + reign in excessive discounting

1. Reduce lure to immediacy + amount that can be consumed in present through precommitment to starting to save at later date
a. Precommitment involves any devices used to enact constraints in present to limit undesirable / promote desirable
behaviors in the future
2. Increase appeal of waiting to spend + expected enjoyment of future spending by directing people’s imagination to future uses
for money
a. Insensitive consumers fail to understand positive future consequences of waiting
b. Interventions encouraging people to elaborate on future outcomes/ consider future uses for money to increase
patience

Article explores 3rd option  connection between present + future selves

- People fail to identify with future self bc lack of belief / imagination
- Leaving people to interact with future versions of themselves will cause more resources allocated to future
Future Self-Continuity
Theoretical Foundations and Empirical Evidence
Psychological connectedness believed to vary with respect to age difference between different selves
i.e. person can feel more connection to future self in one year than in 40 years
- less connectedness with distant self  might seem like different person altogether
- Estranged from future self = saving is choice between spending money today / giving it to stranger years from now
- Hypothesized that people who feel as though future self is different person fail to acknowledge connection aka fail to identify
with themselves in the future
- People make attributions about future self in same manner as done for others  attributing future self’s behavior to
dispositional factors rather than situational factors; make decisions for future self, using same process when making decisions
for other people
- Degree to which people report feeling connected with future selves related to intertemporal decision making
o Higher levels of future self-continuity positively associated with financial assets
o Perceived connectedness with future self = predictive of choices on several different temporal discounting tasks +
distinct from other construct related to temporal preference, e.g. present bias
- Participants showing grease neural activation differences between thoughts about current self and future self also showed
steepest discount rates

Increasing Connectedness with Future Self

Neglecting future self can be caused by some failure of imagination / false belief
- When imagining pains in further future people imagine them less vividly, believe they will somehow be less real / less painful
- Empathy gaps: misunderstanding how will feel in future about decision made in present

Age-Progressed Embodiments of Future Self

Examination of association between seeing embodiment of one’s future self + propensity to save for retirement / accept later monetary
rewards over immediate ones
Reasons why people might behave differently after seeing future self
1. People may ordinarily not be able to imagine their future selves
2. Even if people often imagine future selves, maybe not at distant retirement age
3. Imagination of future may be propositional (I will have enough money to leave to children) rather than visual; vivid visual
imagery believed to exert strong influences on preferences + memory
4. Imagined self may be uncertain; vague; probabilistic  computer rendering is definite + specific
5. Renderings created by computer may be viewed as more authorative then imagined selves
6. Neglect of future self may be due to failure of imagination  easier to imagine future self when seeded with image based on
present appearance
 article part of effective interventions for increasing saving behavior

Overview
4 studies:
Study 1: use of immersive virtual reality to put participants inside visual representation of body + face as they will approximately look
Study 2: extends results of study 1; includes more implicit dependent variables + rules out demand effects
Study 3a: tests whether interventions work in field conditions e.g. over Internet
Study 3b: assesses generalizability of results using community sample, examines extent to which manipulations enhance future self-
continuity

Study 1: Immersive Virtual Reality and the Future Self

Hypothesis: participants who see age-morphed version of future selves ae more likely to allocate money to retirement savings account
after exposure than those who see current version of themselves
Results and Discussion
- Participants exposed to future selves in virtual reality allocated more than twice as much money to retirement account than
those who were exposed to current selves
- BUT possibility outcome seeing aged face depressed participants’ mood  appeal of short-term options diminished not bc
enhanced connectedness future self but BC amusing options less appealing when experiencing negative moods
- Results future self-condition did not indicate participants had significantly stronger negative emotions than participants in
current self-emotion
- Controlling for average of all negative emotions  condition still predictor of amount of money allocated to retirement
- Results suggest that interaction with vivid version of future self, causes people to give modestly greater weight to long-term
saving

Study 2: Ruling Out Demand Characteristics

Study 2 rules out two alternative explanations for findings from study 1:
1. Monetary allocation task occurred directly after virtual reality paradigm  participants felt pressure to allocate more to long-
term account
a. Solved by separating virtual reality portion from decision-making portion, provided cover story to hide research
purposes
 2. Possible participants in experimental condition were primed with concept of aging  prime prompted more savings for
retirement
a. Solved by exposing participants to either own aged avatar or another participant’s aged avatar

Attempt to extend findings to three different dependent variables

- Short-term temporal discounting task
- Lon-term temporal discounting task
- Retirement spending questionnaire
 enables testing degree to which manipulations increase focus on future self for all types of intertemporal choices rather than just
long-term ones
- Short-and long-term discounting may have different processes; opting for larger rewards in both cases might be linked to
better saving behavior  money not spend on pleasurable experiences in present can be used for other purposes in the future
Hypothesis:
- Participants who interacted with avatars depicting future selves, as opposed to future others, would demonstrate greater
willingness to choose larger, future rewards on all three tasks

Results and Discussion

Results indicate that participants in future-self condition exhibited more saving behavior across three tasks than participants in future
other condition
 vivid exposure to one’s future self in immersive virtual reality environment, compared with exposure to another person’s older avatar,
leads to increased saving in both short-and long-term decision-making tasks

Study 3A: Generalization to Field Conditions

Study takes applied perspective
1. Gives virtual renderings emotional qualities to intentionally exert a demand or “nudge” in context of online decision aid
 Aid provides users with accurate estimates of present + future spending levels that will be attainable given various saving rates

Information SO USEFUL it alone could serve as basis for prudent savings decisions, providing participants with this information should
greatly reduce uncertainty about how saving will affect material wealth in short + long run
 present design enables mitigation effect of income uncertainty when estimating persuasive effect of virtual renderings

2. Tests whether kind of intervention proposed can be practically adapted for widespread Internet participation from home, office,
elsewhere
- Virtual reality research has demonstrated that exposure to virtual cause-and-effect actions can change actual behavior

Materials:
Retirement allocation slider bar  interface indicates how much current + future income will be affected by allocation decision
- Present face becomes happier when slides moves left, sadder when slider moves
right
- Future-self face becomes sadder as slider moves left, happier as slider moves right
- Percentages of incomes always indicated for both conditions  provide detailed
information about trade-offs of saving + should reduce uncertainty about material
consequences of saving
- TWO DIFFERENT CONDITIONS

Two scales had to be completed by participants:

1. MacArthur Scale of Subjective Social Status
a. Captures socioeconomic status (SES)
b. Indicate where people believe they stand compared to others in terms of
employment grade, education, household and personal income, household
wealth, satisfaction with standard of living, feelings of financial security
c. Ten-ranged social ladder M=7.08, SD=1.7
2. Perceived income stability
a. How stable to participants believe income would be in future careers on five-point scale M=3.83 SD = .9

Results and Discussion

Retirement allocation:
- Participants in future-self condition allocated significantly higher percentage of pay to retirement than participants in current-
self condition  MEDIUM effect size
Potential moderators:
- SES and income stability affect retirement allocation decisions
- BUT: neither are significant moderator  condition remains significant, positive predictor of retirement allocation when
controlling for SES and perceived income stability

Study 3B: Stronger Test of Generalization to Field Conditions

Attempts to rule out alternative explanation for findings from study 3a
 results could be found due respondents reacting to valence of different faces instead of due to exposure to future self
 - Rather than being motivated to save more by presence of future self, participants could have been moving retirement slider
bar toward whichever face was smiling
- Perform identical study to Study 3a, except participants be exposed to neutral version of current / future selves

Purposes:
1. Ensure results from first three studies are generalizable by fishing participants in study 3b from national online pool as
opposed to undergraduate students from uni
2. Examining potential mechanism that could underlie relationship between exposure to future self + enhanced saving behavior
1) Does present manipulation boost continuity with future self?

Hypothesis:
Participants exposed to images of future selves would allocate more current income to retirement and report greater sense of
continuity with their future selves
Also, future self-continuity acts as mediator between experimental condition and retirement allocation

Method
Future Self-Continuity Scale
- Measures degree to which participants feel similar to future selves
- Participants pick pair of Euler circles (out of possible seven pairs) that best represent how similar they feel to future selves in
ten years’ time  higher score = more continuity with future self

Procedure
Difference with study 3a:
- Participants uploaded photos instead of being photographed in person  ensures wide range of photos can be used for this
type of treatment in field
- Participants are exposed to fixed image of current / neutral-self maintaining neutral expression
- Participants completed Future Self-Continuity Scale
- National sample of participants

Results
Participants in future-self condition allocated significantly higher percentage of pay to retirement than participants in current-self
condition
Exposure to age-progressed rendering of future self = increase in saving behavior
Participants in future-self condition have higher continuity with future selves than participants in current-self condition

Mediation:
- When regressing allocation percentage on condition and future-self continuity, direct effect from condition to retirement
became nonsignificant
- Future-self continuity remained significant predictor of retirement allocation
- Significant mediation

General Discussion
New kind of intervention in which people can be encouraged to make more future-oriented choices by having them interact with age-
progressed renderings of themselves
- Manipulating exposure to visual representations of future selves leads to lower discounting of future rewards, higher
contributions to saving accounts
- Study 2 indicates that effects are not due to thinking about aging per se or demand effects BUT can arise from direct exposure
to renderings of future self
- Study 3a and 3b showed that this type can translate to field at low expense
When people make important long-term decisions, vivid representations of future selves should increase their future orientation of
saving decisions
BUT MUCH research to be done on psychological processes affected by manipulations
- Exposure to future self may causes more parity in emotional experiences between current self and future self
-  hold-cold empathy gap
Success of study can be due to fun and engaging self-control manipulations

Bhattacharya et al. (2012): Is Unbiased Financial Advice to Retail Investors Sufficient?

Introduction
- Financial advice offered by third parties may be biased  information asymmetry between investor + advisor may provide
camouflage to advisors who act in own interest and detriment of their clients
- 64% of EU members by CFA institute believe that prevailing fee structure is intended to steer sales instead of serving
customers
- Retail investors would benefit if they could instead receive unbiased + theoretically sound advice
Hypothesis: will investors really benefit from only supply-side remedies?  can unbiased financial advice steer retail investors toward
efficient portfolios

Findings:
1. Those who accept the offer (5%) more likely to be male, older, richer, more financially sophisticated, have longer relationship
with brokerage
 2. These who accept offer, hardly follow it
3. Though portfolio efficiency hardly improves for average advisee, improves for average advisee who follows advice
4. Investors who most need financial advice are least likely to obtain it
Results imply that mere availability of unbiased + theoretically sound financial advice is necessary but not sufficient condition for
benefiting retail customers

Why is advice not sought?

- Lack of financial sophistication as measured poor past portfolio performance
- Desire to not increase tax payments
- Lack of familiarity and/or trust measured by length of relationship with brokerage

Wealthier investors + those with lower-risk portfolio values tend to follow advice more often
Contribution of article is to highlight centrality of demand-side problem – unbiased financial advice is useless unless it is followed - +
recognize the limitations of regulations in dealing with demand-side problem

Field Study
Overview
Brokerage
- Financial advice offered would not be conflicted i.e. recommendations would be independent of product issuers
- Financial advice would not be discretionary advice from individual investor, but recommendations produced by optimizer that
improves portfolio efficiency
o would use primarily exchange-traded funds (EFTs) + mutual funds to increase diversification within + across asset
classes, both domestic and foreign
- In order to ensure + signal objectivity of its financial advice, bank would avoid any incentive problems by not charging
commission on trades that were based on recommendations offered
- During test phase, advice was free of charge

Details of Advice
- Risk preferences were solicited by asking to select between six categories ranged from “safe” to “opportunity” as investment
philosophy
 calculation of risk capacity score that determine maximum possible level of risk a client should be exposed to in
recommended portfolio
o Main input for forming customer-specific recommendations enhancing portfolio efficiency

Recommendations
Generated by mean-variance optimizer that focuses on portfolio efficiency  based on Markowitz 1952
Finance literature indicates retail investors make errors by holding Underdiversified portfolios
 typically, not linked to investment skill
Goal of optimization = increasing diversification
- Precautionary measures to ensure expected return estimates are not biased by any past extreme return realizations
1) Optimizer uses shrinkage factor  implemented by using security’s deviation from long-run average return of
securities with comparable level of risk
2) Optimizer set up in way it selects from set of only 80 securities with comparable level of risk (predominantly ETFs
and/or mutual funds)
- Highly diversified portfolio = potential effect past idiosyncratic realizations minimized  volatilities estimated using past
volatilities
- Risk capacity score of customers is final input into optimizer
- Optimization subject to constraints + side conditions e.g. maximum weight on asset class according to client’s wishes / risk
capacity; maximum number of securities; minimum weight on single security; short-sale constraints; number of securities
retained from existing portfolio
o 25% of value original portfolio retained on average bc 1) retain some securities in which customers have tax
advantage; 2) increase chance that investors will act on recommendations
o Implies that recommended portfolios differ across investors bc investors differ in capacity score, prior portfolio
allocations, side constraints, point in time at which they receive their recommendations
Table 1 indicates optimizer improves diversification of portfolios along 3 dimensions
1. Investments in single stocks reduced from 53% to 27%; clients advised to invest 67% in well-diversified ETFs and mutual
funds (panel A)
2. Average recommended portfolio more diversified in different asset classes; share of equity reduced from 73% to 59%’ share of
fixed income + real estate securities increased from 1% to 23% (panel B)
3. International diversification strongly enhanced by recommendations (panel C)

- Median recommended portfolio has exactly same size as original portfolio (panel D)
o Clients advised not to increase / decrease investments in risky assets
o Mean recommended portfolio 19% larger than advised portfolio  optimizer matched size of recommended portfolio
with size original portfolio by default, could request larger (smaller) size if wanting to invest (divest)
- Clients may not follow advice because asked to increase investments in risky securities  use ratio of recommended and
original portfolio as another independent variable to discover why clients do or do not choose to follow advice they opted for
- Median recommended portfolio 90% financial wealth held with brokerage?  not play money

 optimizer aligns each client’s risk capacity with riskiness of recommended portfolio

Data and Methods

Data Collected
Portfolio characteristics for customers who chose to receive advice:
- Data when customer received advised; what customer was recommended to buy + sell
 four different daily return series for each customer in treatment group:
1. Actual investment returns in pre-advice period
2. Actual investment returns in post-advice period
3. Buy and hold investment returns in post-advice period if portfolio hadn’t changed from day before advice was given
4. Investment returns on recommended portfolio of post-advice period if advice had been followed exactly

We use two measures of diversification—HHI and the share of idiosyncratic risk (the part of the risk that is uncompensated)—and two
measures of portfolio performance—the Sharpe ratio and MPPM—as our four measures of portfolio efficiency.

Degree of following
Measure extent to which investors opted into advisory model actually follow recommendations

- Where j denotes investors, i indicates specific security, d indexes trading day, Euro is value in euros that investor j holds in
security i on trading day d.
- Numerator = sum in euros of all overlapping securities (i.e. of those securities that occur in both (actual and recommended
portfolio)
- Denominator = value of actual portfolio plus value of recommended portfolio, less overlap
- Degree of following = ratio between intersection of two sets + union of the two sets, where the two sets are the actual portfolio
and the recommended portfolio
 only values between zero and one; ratio = 1 when consumer fully follows advice; ratio = 0 if actual and recommended
portfolio do not share a single security

Degree of following variable = measure how closely advice is implemented at particular point in time
- Calculate change in degree of following from day advice is given to each day in period from t = 5 to t = 11
- Change in degree of following is exact measure of client’s efforts to implement advice
o Measure increases = advisee acting according to recommendations
- Measure considers buy and sell sides of advice  advisee can sell security for other reasons that following advice e.g.
liquidity, tax motives; check for robustness
 only considers buy side + share of recommended portfolio that investor holds at any time

Descriptive Statistics
Table 5
- 91% of customers accepting offer are male (control group 81%)
- Mean age 52.9 vs. 49.0; wealth level measured by micro geographic level 6.6 vs 6.3; have longer relationship with the bank
(9.1 vs 7.4 years)
 customers accepting offer are more likely to be male, older in age, and richer
 - Portfolio characteristics are significantly different for two subgroups
o Customer accepting offer ha higher-risk portfolio value, higher share of risky assets, more trades per month, lower
portfolio turnover
o Differences between advisees and non-advisees exist but are non-significant

Pre-advice period: calculation of average daily returns of investment portfolios, standard deviations of returns, four-factor alphas
- Raw returns not significantly higher for customers who accept offer
- Alphas significantly higher for customers who accept offer than for those who do not accept offer BUT both alphas are
significantly negative
- Share ratios + betas are similar
- MPPM significantly higher for customers who accept offer than who do not; BUT MPPM negative for both
 conclusion: customers who accept offer are more likely to be financially sophisticated

Diversification (measured by lower HHI, lower idiosyncratic risk share, lower home bias) significantly higher for customers accepting
offer than for customer do not accept offer  confirms conclusion

BUT, largely negative alpha estimates in pre-advice period tell that all customer, regardless of whether accepted offer, significantly
underperform benchmark index
- Also high idiosyncratic risk shares, high HHIs, high home bias = significant potential improvement of diversification
THUS: investors could benefit from unbiased + theoretically sound advice

Improvement in actual raw returns from pre-advice period to post-advice period for customers who accept offer (-5.3% to 21.2%) us not
much different than those who do not accept offer (-7% to 17.0%
Drop in standard deviations samesies
 later confirmation that obtaining advice does not improve diversification
- No significant decrease in HHI or idiosyncratic risk of advisees’ portfolios compared with non-advisees portfolios
 average advisee does not benefit much from advice

Reasons why there is not much benefit

 Advice is not sound / average advisee does not follow advice
 follow-up tests show that (table 5)
- Recommended portfolios perform much better than actual portfolios in post-advice period
- Recommended portfolio perform much better than buy and hold portfolios of advisees in post-advice period
- Results suggest that financial advice was sound BUT average advisee does not follow advice; investment performance had
been improved

Statistics on Degree of Following Advice

- Panel A: recommended portfolio very different from average advisee’s existing portfolio
o 1/5 investors essentially no overlap; half of investors overlap <20%
o No one’s existing portfolio coincides with recommended portfolio
- Panel B: distribution mass shifted = some investors follow advice + increase degree of following
o Distributions shown do not differ greatly  only few investors follow advice
- Panel C: Most investors do not follow advice; some mass in negative zone
o Some investors disregard advice i.e. sell securities recommended to keep and buy securities not recommended
- Mean degree of following is 15.6% on day of recommendation
 on average, majority of positions in original portfolio have to
be changed
- mean degree of following is lower (16.4%) at end of post-advice
period  although investors may initially act in accordance with
advice, no sticking to it
Conclusions from figure + table:
- recommended portfolios are very different from average
advisee’s actual portfolios; average advisee does not follow
advice fully

Who Chooses to Obtain Advice

Less than 5% of customers contacted accepted offer to obtain free and unbiased financial advice
- sample is predominantly male, older, rich AND clients accepting offer are more likely to be male, older, richer, and have a
higher risky share in portfolio
o effect comes from low-wealth customers who choose not to obtain advice
- more active traders but have less portfolio turnover
More financially sophisticated  why need advice?
1) Became financially sophisticated because of financial literacy training – have positive view of advice
2) Elderly + financially more sophisticated men are more likely to be defrauded or older investors are more likely to make
erroneous financial investment decisions
a. Financial advice by these groups can be interpreted as attempt to address disadvantages
3) Regret  investors that performed badly have regret; reluctant to obtain advice, acknowledge past mistakes
 a. Prefer inaction (ignore advice and be wrong = lower psychic cost) to action (obtain advice, change portfolio, risk
being wrong = higher psychic cost)
b. Weakened by finding that investors with lower short-term returns opt for advice more often
4) Once bitten, twice shy hypothesis: investor followed past advice and had done well want to receive more advice and vice
versa  Cannot come from same brokerage
5) Clients are optimistic: invest more in individual stock, extreme optimists exhibit imprudent financial behavior e.g. not wanting
advice  Cannot test it bc we don’t have psychological metrics
6) Investors receive advice from other sources
a. Even if received from outside, must be bad – not followed bc portfolios are largely inefficient before and after advice
is offered
7) Offer of free and unbiased financial advice is regarded as spam email was official message sent to inbox of banking
account; follow up by phone call
Summary why advice not sought:
- Lack of financial sophistication, measured by poor pas portfolio performance
- Desire to not increase tax payments
- Lack of experience, familiarity, and/or trust, as measured by length of relationship with brokerage
 those most in need of advice are least likely to obtain it

Who Chooses to Follow Advice if they Obtain It?

Wealthier investors + investors with lower risky portfolio values tend to follow advice more
- Investors with higher portfolio value opt for advice; investors with lower portfolio value follow it more
o Can be bc people with lower portfolio value have relatively less experience with risky assets and may follow advice
more
Non-results
1) Investors do not pay attention to advice because they consider accounts in brokerage as “play money” BUT data indicates that
financial wealth predominantly held by this brokerage
2) Not followed because investors asked to increase investments in risky assets BUT design only recommended increase if
investor asked for increase
3) Advice short-lived thus ignored
a. But clients trade often; average holding period only little over a year; no utility loss from investing in efficient portfolio
Conclusion: Cannot pinpoint why financial advice is ignored after it is sought
 lack of results with respect to other variables is due to lack of power; little variation in dependent variable

Does the Advice Benefit the Advisee

Is financial advice sound
Portfolio efficiency would have been improved by the decreased HHI and share of idiosyncratic risk in their portfolios, increased Sharpe
ratios and MPPM of their portfolios

Does advice benefit average advisee

Evidence implies that average advisee does not improve portfolio diversification from advice but does improve portfolio performance,
albeit very modestly
 advice was sound so there was little benefit because average advisee did not follow advice
- Even partially following advice would have improved portfolio efficiency

Who Would Most Benefit from Advice

Evidence indicates that more (less) financially sophisticated investors are, the more (less) likely they are to obtain advice

Conclusion
1) Those who accept offer (5%) more likely to be male, older, wealthier, more financially sophisticated, have longer relationship
with brokerage
2) Those who accept offer hardly follow it
3) Though average advisee’s portfolio efficiency hardly improves, average advisee who follows advice does see an increase in
portfolio efficiency
4) Investors most needing the financial advice are least likely to obtain it
 mere availability of unbiased financial advice is necessary but not sufficient condition for benefiting retail customers  Can lead a
horse to water, but can’t make it drink
Need additional research why people do or do not follow financial advice

Looney & Hardin (2009): Decision Support for Retirement Portfolio

Management: Overcoming Myopic Loss Aversion via Technology Design
Myopic loss aversion:
view on investments short time focused
 reactions too negative to recent losses
 narrow framing
Equity premium puzzle:
Difference = real stock return over government bonds
Premium reflect relative risk - in contrast to „risk-free“ government bond
 large premium implies high level of risk aversion
H1: DM will choose higher risk, when presented with long-term information horizon.
H2: DM will choose significantly more risk, when decision frequency highly restricted.
H3: DM will choose significantly more risk, when suggestive guidance provided that recommends a relatively aggressive asset
allocation.
H4a: DM will choose significantly more risk, when decision frequency
highly restrictive and short-term information horizon presented.
H4b: DM will not choose sign. more risk, when decision frequency
highly restrictive and long-term information horizon presented.
H5a: DM will choose portfolio with sign. more risk, when suggestive
guidance recommends rel. aggressive asset allocation and short-
term information horizon.
H5b: DM will not choose portfolio with sign. more risk, when
suggestive guidance recommends rel. aggressive asset allocation
and long-term information horizon.
H6a: DM will choose portfolio with sign. more risk, when suggestive
guidance recommends rel. aggressive asset allocation and system
minimally restricts decision frequency.
H6b: DM will not choose portfolio with sign. more risk, when
suggestive guidance recommends rel. aggressive asset allocation
and system highly restricts decision frequency.

Goldstein,
Johnson, &
Sharpe
(2008):
Choosing Outcomes vs Choosing Products: Consumer-Focused
Retirement Advice

Product (fund) attributes: performance history, composition, brand image, etc

Risks in fund investing:
1. Risk between portfolios
2. Risk within portfolios
3. Risk of a portfolio:
- interfund correlations
- interest rate
- inflation rate
- currency risk etc.

Uncertainty: beliefs of customer about product attributes

Recommendation: distribution between risky and risk-free asset; perodic rebalance
long-term: roughly log-normal distribution of long-term returns
BUT: not considered risk
Distribution Builder: -
participant arranges markers
-
distribution is costconstrained

Behavioral portfolio theory: Shefrin & Statman, 1987 & 2000, portfolio theory of behavioral finance
Mean-variance portfolio theory (MVPT)
Described on mean-variance frontiers
Portfolio satisfies wants for utilitarian benefits (high
expected returns + low risk)
Investors consider portfolios as a whole
Investors measure risk by variance of returns
Investors have single risk aversion in portfolio as a
whole
Investors are always risk averse, risk is measured by
variance of returns
Textbook MVPT starts with estimation of parameters of investments
 the expected return + SD of returns of each investment, and correlation between returns of every pair of investments
THEN, place parameters in mean-variance optimizer yielding a mean-variance frontier (frontier = portfolios with highest expected return
of each level of SD)
LAST, investor choose among portfolios on mean-variance frontier corresponding to trade-off between wants for high expected returns
and wants for low standard deviations
Actual MVPT has elements of BPT
 can become “unpalatable” i.e. prescribing allocations much different from current allocations
- No relationship between gender and risk aversion
Summary:
- investors can
only obtain upside
gain, if accept
downside risk
 equity premium
- not
clear how investors
choose
products

preferences for
outcomes, not
for products
needed
(Das/Markowitz)
 well defined preferences necessary for reasoned
selection of investments
Chapter 8: Behavioral Portfolios
Mean-variance portfolio theory: Markowitz, 1952, portfolio
theory of standard finance
Behavioral portfolio theory (BPT)
Described on behavioral-wants frontier
Portfolio satisfies wants for utilitarian benefits AND
expressive + emotional benefits (e.g. sincere social
responsibility, high social status)
Investors consider portfolio as layered pyramids (each
layer is mental account associated with want / goal)
Investors measure risk by probability of shortfall from
goal, amount of shortfall, or wild combination
Investors have risk aversion for each mental account
Investors are always risk averse, risk is measured by
probability of shortfall from goal, amount of shortfall, or
wild combination  risk aversion as measured in BPT
can correspond to risk seeking as measured in MVPT
(current = 33% US stocks, 20% international vs. mean-variance
optimized portfolio = 0% US stocks, 54% international)
 make more palatable by placing constraints on mean-variance
optimization process, minimum allocation to US stocks + maximum
allocation to international
Why are people so difficult? --- “food portfolio analogy”
Textbook mean-variance diners perceive foods as bundle of nutrients
i.e. benefits / costs other than utilitarian costs and benefits of nutrition
do not matter
Textbook mean-variance investors perceive investments as bundle of
expected returns, their SDs, their correlations  all investments mix in
portfolio so other features do not matter
Diet on nutrition-cost frontier of food provides necessary nutrition at
lowest cost
Portfolio on mean-variance frontier of investments provides necessary expected return at lowest standard deviation of returns

BUT normal investors want more than what’s on mean-variance frontier

 dieticians consider expressive + emotional benefits of palatability, variety, prestige, culture
 accounting for full-range of benefits (utilitarian, expressive, emotional)
Recommendation then is optimal even when BELOW nutrition-cost frontier; same for investment portfolios on behavioral-wants frontier
Investors’ wants and the behavioral-wants frontier
Portfolios on behavioral-wants frontier when satisfying investors’ wants for utilitarian, expressive, and emotional benefits, free of
cognitive + emotional errors
Are often below mean-variance frontiers
Examples include portfolios providing expressive + emotional benefits of social responsibility, patriotism and familiarity, pride and
avoidance of regret, and convention

Wants for social responsibility

e.g. exclusion of stocks of nuclear companies
Mean-variance theory:
separate portfolio production from portfolio spending  construction of
portfolio including stocks from nuclear companies yielding greatest wealth at
desired level of risk, then spend extra wealth in contribution to antinuclear
campaign
Separation of production of wealth from its spending goals makes no sense
to socially responsible investors ; also, no sense in separation of utilitarian
benefits from expressive + emotional ones

Expected annual returns of constrained socially responsible portfolios fall

below unconstrainted mean-variance frontier by more than 3 percentage
points
BUT wants for utilitarian, expressive + emotional benefits of social
responsibility can place constrained socially responsible portfolios on
behavioral-wants frontier

Wants for patriotism and familiarity

Patriotic investments yield expressive + emotional benefits, wants for patriotism promotes home bias: preference for investments of
home countries
Implies cognitive + emotional errors misleading investors into bearing extra risk with no extra expected returns
 forgoing risk-reducing benefits of global diversification
Investors in countries with high proportions of patriotic citizens invest larger proportions of portfolios in stock of home countries than
investors in less patriotic countries

Home bias places portfolios below mean-variance frontier, and below behavioral-wants frontier if stemming from errors. Placed on
behavioral-wants frontier when stemming from wants for expressive + emotional benefits of patriotism

Wants for familiarity also prefers home investments

 evident in aversion to mutual fund managers with foreign-sounding names

Investors in late 1990s misled to abandon global diversification by cognitive errors of representativeness + hindsight + emotional cost of
regret
Representativeness errors made investors to extrapolate from past returns and conclude that future returns of international stock would
continue to trail returns US stocks
Hindsight errors misled them into thinking relatively poor performance of international stock was as clear in foresight as in hindsight
Regret compounded hindsight, inflicting frustration for not having switched from international to US stocks years before
Behavioral-wants frontiers vary from investor to investor by wants + trade-offs between utilitarian, expressive, and emotional benefits

Wants for pride and avoidance of regret

Gains: emotional benefit of pride, expressive benefit of image of a winner
Losses: emotional cost of regret, expressive cost of image of a loser

Tracking-errors optimization: application of mean-variance analysis

Returns replaced by tracking errors; gains and losses relative to returns of benchmark portfolios
Variance of returns replaced by variance of tracking errors
Mean-variance frontier of returns and their SDs replaced by mean-variance frontier of tracking errors + SDs
Optimal tracking-errors portfolio chosen on mean-variance frontier of tracking errors; portfolio with expected returns higher than those of
benchmark portfolio, implying high positive tracking errors, relatively low SD of tracking errors
Portfolios on mean-variance frontier of tracking-errors and their SDs fall below mean-variance frontier of returns and their SDs
BUT tracking-error optimization can lead to portfolios on behavioral-wants frontier since it satisfied wants for avoiding expressive costs
of image of a loser coming with returns lower than their benchmark, emotional cost of regret, maybe utilitarian costs of losing clients
Wants for adherence to convention
Portfolio allocation constraints can assure adherence to convention  portfolios are palatable
Extreme allocations are inherent in mean-variance efficient portfolios constructed with precise estimates
Constraints can be used as useful judgment tools in construction of good portfolios rather than diversion from them

Estimates of mean-variance parameters involve judgment e.g. choice of estimation period (most recent decade, last four decades)
Investor wants (including wants for expressive + emotional benefits of adherence to convention) extend beyond utilitarian benefits of
high expected returns + low variance of returns
 constraints on allocations are sensible way to incorporate judgment + wants into portfolios
Replacing ignorance with knowledge and correcting cognitive and emotional errors
Improved investor behavior and portfolio performance needed for good portfolio practice  replace ignorance with knowledge, correct
cognitive + emotional errors

Quite difficult  investors are resistant to knowledge

Socioeconomic status might influence process by which people learn  low status = more pessimistic beliefs about stock returns than
higher status

Other difficulties: misperceptions about benefits of portfolio diversification

Diversification reduces volatility of portfolios, measured by SD of returns, leaving expected returns unchanged
People with low financial literacy believe that diversification increases volatility of portfolios
Caused by apparent greater predictability of returns familiar securities (e.g. Apple stocks) than returns e.g. S&P 500 portfolio, being
diversified over 500 stocks
Can also believe that diversification adds risk rather than reduces it
People with high financial literacy believe diversification increases expected returns of portfolios, when it actually leaves expected
returns unchanged
Might choose risky diversified portfolios because misperceive them as offering high returns

MORE DIFFICULTIES
Errors related to correlations
Not considering correlations and misperceiving their role in the benefits of diversification are errors increasing the risk of portfolios 
imposing utilitarian costs without compensating with utilitarian, expressive, and emotional benefits

Expected return portfolio composed of two investments in equal proportions:

Investment Expected return Standard deviation
Investment 1 6 percent 20 percent
Investment 2 10 percent 40 percent
Correlation between returns of two investments: 0.3

1 1
E ( R p ) = ∗6 %+ ∗10 %=8 %
2 2
BUT: standard deviation is less than the 30 percent mean of the standard deviations of the returns of the two investments (unless the
correlation between their returns is a perfect 1.0)
σ (R ) =√ ¿ ¿
p

People tend to overlook correlations when constructing their portfolios  is not taking into account when choosing portfolios
Benefits disappear when returns of investments correlate at 1.0 BUT even 0.99 correlations provide substantial diversification benefits
Benefits diversification also depend on standard deviations of return on investments
Benefits diversification are low when correlations are high, but benefits diversification are high when standard deviations are high
Benefits of diversification tend to be higher in bear than in bull markets
Correlations tend to be higher in bear than bull markets, but also SDs  higher SDs in bear markets add to benefits of diversification
more than the higher correlations subtracted from these benefits

Return gaps: gaps between returns of pairs of investments e.g. US stocks + international stocks
 better measure of benefits of diversification than correlations alone bc they account for effects of both correlations AND SDs
Gaps provide intuitive yet accurate measure of benefits diversification
Return gaps and associated benefits of diversification are low when correlations are high; return gaps and associated benefits
diversification are high when standard deviations are high

Estimated ReturnGap=2σ
σ = average of standard deviations of returns of two investments
√ (1− ρ)
2

ρ = correlation between returns of two investments

Return gap answers question: by how much will I lag or lead a diversified portfolio if I fail to diversify
Benefits of diversification are all about falling into the gap
Diversified investors give up hope of having their entire portfolio at the top of the gap BUT gain freedom from fear of having their entire
portfolio at the bottom
Entire gap can be in region of losses
Diversification only mitigates possibility of losses

Assessing wants and correcting errors with investor questionnaires

Questionnaires asses conflicting wants for high expected returns and low risk
Risk aversion takes form of variance aversion, variance being represented by “fluctuations in value”
Investors preferring investments with little or no fluctuations in value, and willingly accept lower return associated with these
investments
 high variance aversion, tilt recommendations toward low-variance portfolios containing high allocations to low-variance bonds and
cash, high allocations to high-variance stocks

Risk aversion can also take form of loss aversion

Loss aversion increases as stakes increase i.e. people become less willing to wager 50-50 chances when stakes increase
Risk aversion best measured by posing question involving gambles over lifetime income
Other questions regarding loss capacity
Older investors are deemed to have lower loss capacity in investment portfolios, as older people are likely to have most of their wealth
in form of investment portfolios rather than human capital
Prefer higher allocations to bonds and cash that impose smaller losses over short horizons than stocks

Questionnaires often assess wants beyond high expected returns and low risk (whether measured as variance aversion or loss
aversion)
 wants for maximization are wants for winning
Men have greater wants for maximization than women, young have greater wants than the old
Greater wants for maximization are associated with high declared loss tolerance
 need to examine whether high declared loss tolerance is anything more than an artifact of great wants for maximization

Questions about confidence

High correlations between overconfidence and loss tolerance can indicate than overconfident investors are more loss tolerant
People who are overconfident also state they have high loss tolerance
 need to examine whether high declared loss tolerance is anything more than an artifact of overconfidence

Questions about skill and luck

Men tend to believe that success in picking stocks earning higher-than-average returns is mostly due to skill, whereas women tend to
believe it is mostly due to luck
Men are more likely to commit overconfidence errors, in form of overplacement
BUT no general propensity for overplacement (below 50% of males and below 40% of females)

(high) Maximization seeking is associated with (high) regret aversion, but regret aversion is not associated with loss aversion
 disparity indicates that regret aversion is distinct from loss aversion, even though two are often conflated

Regret aversion: investors are reluctant to buy stocks they have previously sold at a loss, because they wanted to avoid regret
Social values: how inclined are you to seek out or avoid companies with a history of the following practices and companies

Investment companies design investor questionnaires to educate investors about global diversification, guide them to overcome
cognitive and emotional errors, and elicit their wants  allows company to tailor investment recommendations to specific client

Portfolio choices
Variance aversion: risk aversion measured by standard deviation (variance) of expected return
Shortfall aversion: risk aversion measured by probability of shortfall from aspired or target wealth
Shortfall aversion can correspond to variance seeking  not perceived as risk seeking

Affinity between BPT and liability directed investing

Affinity between measures of risk in BPT and measures of downside risk e.g.
VaR
Risk in VaR = losses relative to current wealth
Risk in BPT = losses relative to target wealth
Variations in behavioral-wants frontier corresponds to variations in target wealth
relative to current wealth
e.g. investor has 100,000 current wealth and 130,000 target wealth by terminal
date (one year from today)
portfolio can be formed composed of one of two stocks (L)ottery, M(oderate), or
combination

Expected return Standard deviation

Lottery -10% 80%
Moderate 20% 12%
 Correlation: 0.0

Expected wealth
Minimum (SD) Expected Maximum (SD)
Lottery 18,000 90,000 162,000
Moderate 105,600 120,000 134,400

Mean-variance investors that are extremely risk averse (SD averse) choose
portfolio with lowest standard deviation
Investors that are indifferent to S of wealth choose portfolio with highest expected
wealth, disregarding the SD
Investors that are somewhat adverse sacrifice some expected wealth for a lower
SD
NO investor is willing to sacrifice expected wealth for higher SD of wealth

Extremely adverse investors choose to invest in LST

Indifferent investors invest 100% in moderate
Somewhat adverse investors divide wealth between M and L along the frontier
NO investor chooses to invest 100% in L because it is dominated by other
portfolios (there is at least one portfolio with a higher expected return and a lower
SD)  100% moderate has
expected wealth of 120,000,
higher than L’s 90,000, and an
SD of 14,400, compared to 72,000.
Portfolio 100% L does not fall on mean-variance frontier
Portfolio consisting only of L falls on behavioral-wants frontier  provides lowest
probability of shortfall from terminal wealth

BUT investors with low target wealth relative to current may NOT find portfolio 100% L
on behavioral-wants frontier, bc it is dominated by other portfolios

Behavioral-wants portfolios as pyramids of wants and associated

goals
Investors view portfolios as set of distinct mental-account layers in
portfolio pyramid
Each account corresponds to particular want, associated goal, and
their utilitarian, expressive, and emotional benefits
Optimal behavioral-wants portfolio effectively balances wants while
avoiding cognitive and emotional errors

Target wealth in downside protection is relatively low

Target wealth in upside potential is relatively high
Variance aversion in downside mental accounts
Variance seeking in upside mental accounts
Investors are RISK AVERSE in both mental accounts, when risk
aversion as measured as shortfall aversion (from target wealth in
each mental account)

How to construct behavioral portfolio?

Divide portfolio as a whole in mental accounts of wants and associated goals
Upside mental account USUALLY consists of undiversified stocks and similar investments
Downside mental account consists of diversified stocks, bonds, similar investments
Pyramid structure is reflected in “core and satellite” and “risk budget’’ portfolios  well-diversified core layer geared to downside
protection and less diversified satellite layer geared to upside potential
Investors in mean-variance portfolio have single attitude towards risk, measured as variance of returns of portfolio as a whole  NOT
many attitudes for each mental account
Investors in behavioral portfolio theory have many attitudes towards risk, measured by shortfall from target wealth in each mental
account
 may be willing to accept high shortfall risk in upside potential account, little short-fall risk in downside protection mental account

Mental-accounting pyramid structure offers solution to diversification puzzle

Investors placing great importance on upside-potential mental account do not neglect downside-protection ones
 often construct portfolio as if first filling up downside-protection mental account before moving to fill upside potential mental account

Pyramid structure differs between younger and older investors

Younger investors: income from job provides protection (during
working years);
investment portfolio offer upside potential
 investment portfolio consists primarily of stocks, reflecting
relatively low loss aversion
Older investors: income from jobs decreases importance;
investment portfolio becomes downside protection
 investment portfolio consists of higher proportions of bonds,
reflecting high loss aversion
Younger people have higher loss aversion in jobs than in
investment portfolios, and vice versa for older people

Mean-variance portfolios with mental accounts

Das et al., mental accounting portfolio framework
 combines mental-accounting structure of behavioral portfolio theory
with mean-variance optimization
e.g.

Not necessary to have three “real” accounts when allocating same bond to
different mental accounts
 one “real” bond account, and three “virtual” bond accounts listing
allocation in bond fund of each mental account
Investors can observe portfolios as 1) an actual account format for the
portfolio as a whole, and 2) a virtual account format for each of the mental
accounts
All mental accounts and portfolio as a whole are on behavioral-wants
frontier; are on mean-variance frontier WHEN there are no constraints on
allocation  otherwise, might fall somewhat below mean-variance frontier

Advantages of mental-accounting framework and behavioral-wants portfolios?

Mental-accounts representation depicts normal investors 
investors want to reach goals
Wants-based mental accounts allows articulation of each want, associated gal, target wealth at target date, and attitude toward risk
(measured by SD) in mental account of each want and associated goal

Strategic and tactical asset allocation

Strategic asset allocation: allocations to asset classes that fit investors best (e.g. 60% stocks, 30% bonds, 10% cash). Can change over
time as people’s circumstances change (e.g. marriage, children, etc.)

Tactical asset allocation: temporary shifts of asset allocations away from strategic allocations (e.g. increasing to 70% stocks,
decreasing to 20% bonds)  attempt to increase portfolio returns beyond returns of strategic asset allocation by identifying and
exploiting temporary divergence of asset-class prices from their values

Security selection: selection of particular securities in an asset class  attempt to increase portfolio returns beyond returns of strategic
asset allocation by identifying and selecting securities promising higher returns than other in their asset class

93.6% average of variation in total returns of portfolios is explained by strategic asset allocation
Remainder of variation explained by variation in tactical asset allocation and security selection
 would assume that strategic allocation is more important than tactical asset allocation / security selection
NOT TRUE: explaining variation of returns different from explaining magnitude of returns and their signs (positive / negative)

Strategic asset allocation is part of management of investors, focusing on

examination of wants, associated goals, financials resources  followed by
diagnosis of deficiencies, completed by guidance to avoid cognitive and
emotional errors on way to wants and associated goals

Tactical asset allocation and security selection are part of management of

investments, focusing on increasing returns without increasing risk

Strategic asset allocation involves movements on frontier e.g. from portfolio A

to portfolio B
Tactical asset allocation and security selection involve movements of frontier
e.g. from portfolio A to portfolio C

Investors engaging in tactical asset allocation and security selection aim to

move frontier higher, but often move it lower instead

Das et al., 2010: Portfolio Optimization with Mental Accounts

Introduction
Mean-variance portfolio theory: each investor has a consumption utility function that depends on the expected return of her overall
portfolio and its standard deviation (measure of risk)
Production function: each MVT faces it in form of the mean-variance efficient frontier, each chooses to consume among the available
ones the one that maximizes his utility based on expected risk and return
Behavioural portfolio theory: investors consider portfolios as collection of mental accounting subportfolios
- Each subportfolio has a goal and each goal has a threshold
- Each mental account has an efficient frontier
- A subportfolio is dominated, if there is another portfolio that has the same expected return and a lower probability of failing to
reach the threshold level
- Trade-off between expected return and probability of failing the threshold level
- Investors are always risk averse in contrast of MVT investors
MA framework: risk as the probability of failing to reach the threshold level in each mental account and attitudes toward risk that vary
by account
MVT optimization:
- Minimizing the variance of a portfolio
- Subject to
- Achieving a specified level of expected return
- Being fully invested
MA optimization:
- Maximizing expected return
- Subject to a specified maximum probability of failing to reach the threshold
- Purpose of the paper is to combine features of MVT and MA into a unified framework

Methodology

- Solution for MVT optimization:

- Gamma is the risk aversion coefficient and needs to be specified
- Mean-variance efficient frontier is specified by choosing different values of gamma
- The smaller the gamma coefficient, the more is invested into stocks
- Each VaR constraint in the MA framework corresponds to a particular implied risk-aversion coefficient in the MVT framework
- Different subportfolios have different risk aversion coefficients
 - If , then the threshold
- Assumption of normality imposed
- To optimize, inequality is replace by equality and the optimal weights function is plugged into the equation:

- Substitute the optimal weight function into the equation above to get the risk
aversion coefficient gamma out of it
- When an investor specifies her MA preferences for each subportfolio through the parameter pair (H, alpha), she is implicitly
stating what her risk preferences gamma are over the given portfolio set (mean, variance)
- The aggregate portfolio of MA subportfolios is also mean-variance efficient, because the combinations of portfolios are on the
efficient frontier
- Since the portfolio weights are not linearly proportional to the risk-aversion coefficient gamma, gamma implied in the
aggregate portfolio is different from the weighted average of the gammas of the three subportfolios
- Expected return is convex in the probability of failing to reach the threshold

H=0 or negative: An increase in risk aversion leads to a lowering of the probability of failing to reach a threshold but also to a lower
expected return
H>0: probability of failing to reach a threshold is increasing in risk aversion, while the expected return is decreasing
Efficient portfolios lie in the range where the probability of failing to reach the threshold is declining and all portfolios in the range
beyond this point are dominated
For each H there is a different MA frontier; as H is increasing, we shift from lower to higher frontiers

No feasible solution, when , to solve include either other assets or reduce H

Kind of the threshold return is higher than the return the assets involved could provide
 - When gamma is misspecified, the loss can be substantial
- In table, left column shows real gamma, top row shows % how much the real gamma is misspecified
- Values in the middle show the loss in return measured in basis points
- MA portfolios do better if they better specify the investor goals
- If short selling is prohibited, there is a loss in the efficiency of MA portfolios; the
aggregate portfolio is not necessarily on the constrained portfolio frontier
- In practice, the short selling constraint must only be applied on the aggregate portfolio
level
- To mitigate it at least a little:
- Optimize all individual portfolios, which are not subject to short selling constraints
- Check if the aggregate portfolio has short selling
- If so, accept first all holdings in the subportfolios without short selling
- Because of that, limits on positions for the rest of the subportfolios are imposed
- The rest is then optimized subject to residual position limits
- The loss in efficiency is very small
- Investors with low risk aversion will suffer more due to that than the ones with risk
aversion, when they use the MA framework
- Worst case reduction in Sharpe ratio is under 6%
- Mean reduction is much less than 1%

Results
Problem equivalence:
- The MA problem is mathematically equivalent to the MVT optimization
- There are three consequences of the equivalence:
- MA optimal portfolios always lie on the MVT efficient frontier
- MA problem’s constraint specifies a mapping into an implied risk-aversion coefficient in the MVT problem
- Many MA portfolios may map into a single mean-variance efficient portfolio
Value-at-risk type constraint: trade-off between risk and return in MA
Mental account subportfolios:
- Assumptions:
- Investors are better at stating their goal thresholds and probabilities of reaching them than their risk-aversion coefficients
(consumption vs. production view)
- Investors are better able to state thresholds and probabilities for subportfolios than for aggregate portfolios
- No loss in MVT efficiency when short selling is permitted
- If no short sales allowed, loss is small compared to the loss that occurs from investors inaccurately specifying their risk
aversion

Chapter 9: Behavioral Life Cycle of Saving and Spending

Portfolio theory: production of portfolios by coming investment such as stocks and bonds
Life-cycle theory: complements portfolio theory
- accumulation of assets into portfolios (converting cash into investments)
- decumulation from them from portfolios into assets (converting investments into cash)
- Aqcumulate by saving during working years; decumulate by spending during nonworking years

Standard life cycle theory: only reason for saving is spending

- Ideal outcome: simultaneous last breath of life and last dollar of spending
- People want smoothed marginal utility of consumption and leisure during life cycle
- Starts by estimating life-cycle wealth  present value of current income, current capital, and future income
- Follow value by choosing saving and spending path
- Theory predicts that people spend “permanent income” each year  an amount that exhausts life-cycle wealth during our life-
cycle, even when values fluctuate from year to year

Behavioral life-cycle theory: saving bc consists of wants for full range of utilitarian, expressive, and emotional benefits of wealth
- Wealth generated by spending on necessities e.g. food, shelter; spending on discretionary items e.g. recreation and travel;
spending on luxury items, e.g. expensive cars and jewelry
- Mere wealth owning rather than spending also yields expressive and emotional benefits
- Some spending might incudes expressive and emotional costs e.g. blowing money on restaurant when you can cook better at
home
Consumption gap: gap between available spending and actual spending
e.g. retirees continuing the growth of pre-retirement portfolios
 Solution: emotional and expressive benefits of security, being able to aid family members, and pride of watching wealth accumulate
Related to Personal Saving Orientation (PSO): indicator of people’s consistent and sustainable saving activities, reflecting personal
habits that are incorporated into their lifestyle

Not all people accumulate median wealth

- Difficulty in matching spending to permanent income, bc difficulty in estimating life-cycle wealth, longevity, and future spending
needs  involve chances of running out of money before running out of life, or vice versa
- Need to exhibit self-control to accumulate sufficient savings and refrain from spending too fast during workings years and
retirement
Standard and Behavioral Life-Cycle Theories
Standard life-cycle theory Behavioral life-cycle theory
1. People want to “smooth” spending during 1. People want more than to “smooth” spending during entire life-
entire life cycle – resolve easily conflict cycle – want full range of utilitarian, expressive, and emotional
between wants for spending and wants for benefits of wealth, including expressive and emotional benefits of
saving owning wealth but not spending it
2. People need no tools and no help in resolving 2. Difficulty in resolving conflicts between wants for spending and
conflicts between wants wants for saving
3. Predicts people regard current income, current 3. People reconcile conflict between wants by devices such as
capital, and future income as mere framing, mental accounting, and self-control rules that restrict dips
components of life-cycle wealth into other than designated mental accounts
4. Public policy helps reconcile conflicts between wants with program
e.g. Social Security, helps overcome cognitive and emotional
errors by law and regulations e.g. fiduciary regulations
5. Predicts people regard current income, current capital, and future
income as distinct mental accounts  framing including restrictions
of dipping into education account for holiday spending
Current income: current wages, current interest, dividends from bonds, stocks, other investments
Current capital: current value of portfolio of bonds, stocks, other investments
Future income: future wages, future interest and dividends, future income from other investments

The Spending-Sources and Spending Uses Pyramids

Spending-sources: layers arranged from first tapped into to last tapped

into
Spending-uses: layers arranged from those with higher spending priority to those with lower priority

Other income: social security benefits, payments from defined-benefit payment plan
Other regular capital: 401(k), individual retirement account (IRA)m other defined-contribution retirement saving accounts
Other bequest capital: houses
Other necessities: support of minor children, support of needy adults, elderly parents, disabled siblings  for some people, these
spendings belong in discretionary items layer
Sometimes savings belong in necessities, sometimes in discretionary
Overall reluctance to dip into bequest capital and into regular capital  people barely touch defined-contribution retirement accounts in
early retirement years

Sandwich generation: parents supporting both their children and their elderly parents
- Having elderly dependents decreases the probability of college savings and stockholdings by twice as much as poor personal
health
- Average transfer from older family members to the younger generation are large enough to be considered major spending
items
Poor families and wealth families crave social identity reflecting financial responsibility and self-sufficiency
- Reluctance to ask for assistance because of it
- Poor families prioritize payments of particular debts that affirm self-sufficient or upwardly mobile identities; ignore / reject debts
that are viewed unfair / unjust
 - Result: poor families are trapped in costly cycles of indebtness and hindered social mobility
Some spending motivated by wants for social status  less affluent families attempt to “keep up with the Joneses”
- Middle- and upper middle-income families take on more housing-related debt and have higher debt-to-income in places where
top incomes are high
- Motivated and dampened by friends and neighbors

Self-control
Wants for spending it all today overwhelm wants for saving for tomorrow when self-control is weak
 weak self-control and associated lack of planning skills = financial distress
- Differences in self-control affect incidence of financial distress more than differences in education / financial literacy
Better at identifying deficient self-control in others than in ourselves
Poverty undermines self-control, breeding scarcity and narrowing slack
-  overload people’s cognitive and emotional resources and hamper savings, job performance, and decision-making
- Poverty regularly exploited (e.g. most profitable American credit card consumers are those on the verge of bankruptcy)
- Advertisements expensive mortgages most effective when targeted at uninformed (tend to be less educated, minorities, poor)

Complex financial products confuses investors  misled into products that benefit providers at their expense
Genes influence saving behavior  people can have high PSO and are more likely to reach financial security and wealth than people
who have low PSO
- Usually strong savers score high on conscientiousness, while low on neocriticism
- Spending and wealth increase with conscientiousness, wealth increases faster  conscientious people save more
Self-control can be encouraged by commitment
- Conscientiousness and self-control can be excessive when they direct people to borrow at high interest rates while
maintaining saving accounts earning low interest
- Usually happens in emergencies rather than dipping into savings when people believe that spending savings is what
irresponsible people do
Conflicts between wants for spending and saving in romantic relations
- Marriages of opposites in terms of spending and saving habits usually more unstable than couples with similar habit
- Spenders are preferred to savers in romantic settings if they are perceived as possessing ample financial resources
- Savers are preferred if spending is perceived as depleting resources
- Savers perceived as possessing greater self-control, which is sexy  sexiness further enhanced by perception of hot body
because savers are expected to take better care of their bodies
- BUT, spenders are hot too, because self-control can stand in the way of fun (savers are boring)

Evidence about Standard and Behavioral Life-Cycle Theories

Most compelling evidence in favor of behavior life-cycle theory might be vast financial advertising industry helping people plan and
implement spending and saving throughout their life cycles
- No need for such industry and plans in world of standard life-cycle theory where people do the planning and implementation
easily on their own
- Other evidence: distinction between capital and income, manifestations of cognitive and emotional shortcuts and errors,
differences between financial liquidity and mental liquidity

Capital and Income

- Standard life-cycle theory: no distinction capital from income bc dollars of capital indistinguishable from dollars of income in
total of life-cycle wealth
- Behavioral life-cycle theory: distinction, ready to spend income but reluctant to dip into capital and spend its proceeds
 favored by evidence
o More likely to spend dividends than sell shares and their proceeds
o Some investors distinguish their capital contributions, e.g. prices paid for stock, from capital gains amassed to those
shares over time  easier to spend capital gains than capital contributions

Behavioral life-cycle theory predicts that older people prefer stocks with high dividend yields more than younger people and that people
with lower labor income prefer stocks with higher dividend yields more than people with higher labor income
- Trend exists because older people, lower labor income people more likely to rely on portfolio for spending
- Older investors with lower labor income dip into capital non-transparently to collect dividends for mental income accounts (e.g.
by buying stocks before ex-dividend days)

Some investors dip into capital by buying high-yield bonds – low-credit-rated bonds (junk bonds)
- Defaults more common among such bonds than among high-credit rated bonds  defaults are dips into capital
- Investors seeking greater yields in speculative investments leads to greater, often disastrous, dips into capital

Hindsight, Regret, Financial Liquidity, and Mental Liquidity

Standard life-cycle theory consistent with investors who convert capital into cash just in time for spending, and with considerations of
financial liquidity, where financially liquid investments are cashed before illiquid ones
- Investment financially liquid when they can be cashed quickly at prices equal to current market values
Theory is INCONSISTENT with holdings of substantial amounts of cash for spending needs when considerations of utilitarian benefits
direct people to hold stock and bonds, but not cash
 behavioral life-cycle theory IS consistent with this
Mental liquidity: investors can cash funds without exposing themselves to the cognitive errors of hindsight and emotional costs of regret
- Choosing to cash shares of stock fund today bears responsibility for a choice that might inflict losses if stock prices increase
tomorrow
- Utilitarian cost of lost money accompanied by emotional costs of regret
- Strict schedule of conversion stocks and bonds to cash reduces responsibility and alleviates potential for regret
- Investors likely to be aware of prices of stocks sold yesterday  clear perceiving of losses if stock prices increase today, NOT
likely to be aware of price of stocks sold three to five years ago (losses are obscured)
Perceptions of Standard and Behavioral Life-Cycle Theories
Both theories are descriptive: BLCT offers prescriptions, not SLCT
 SLCT built on premise that people do not need prescriptions or other help in arranging spending and saving during life cycle
Some prescriptions of behavioral life-cycle theory conform to standard life-cycle theory
e.g. Social Security system
- Eliminates need to estimate life-cycle wealth + calculate smoothed spending for people relying solely on it
 contributions from wages are mandatory, made automatically during working years, and smoothed inflation-adjusted
monthly payments are made automatically during retirement
- Eliminates need to estimate longevity among people relying solely on it
 Social Security payments continue for as long as people and their eligible dependents live; system makes it unnecessary to
exercise self-control
 reconciles conflicting wants for spending and saving not only during working years but also in retirement
- System does not allow substitution of lumpsum payments for monthly payments or borrowing from future payments

e.g. Defined-benefit pension plans

- Employers and employees contribute into pension funds during working years
- Employees and eligible dependents receive monthly pension payments in retirement
- Some plans do allow substitution of lump-sum payments for monthly payments and borrowing from future payments 
tempting for people with insufficient self-control

e.g. Defined-contribution retirement saving plans

- Primary tools in bridging gap between Social Security payments and adequate retirement income
- People with these plans must. Manage spending and saving during working years
- Mitigate uncertain longevity in retirement while facing uncertain inflation + investment returns
- Challenge for financial experts and ordinary people not being aware of tasks and challenges

Annuities and the Annuity Puzzle

Consistent with SLCT
- Facilitate smoothing of spending and eliminate longevity risk by converting life-cycle wealth into permanent income
- Mitigate longevity risk even if only portions of savings are annuitized at retirement
- Probability of running out of money is 18.7% (against 67.4%) when half portfolio is annuitized  people are reluctant to
annuitize (annuity puzzle)
 Aversion to transparent dips into capital  must dip into capital account when buying annuity  converting capital into income
 Money illusion  lump sum of 100,000 seems larger than equivalent as 500 monthly annuity payment
 Availability errors  images of outliving life expectancy not as readily available as images of many kinds of deaths
o Interact with regret aversion  people contemplate possibility that heirs only receive pennies of annuity dollars when
they die soon after buying annuity
 Annuities emit a ‘smell of death”  reminding people that they relinquish hope for riches
o Contrary to prediction of SLCT, people’s wants not only include downside protection but also upside potential to see
portfolio mushroom into portfolio they can spend, bequeath, hoard  enjoying social status + pride that accompany
riches

Saving and Sustainable Spending

Prescription consistent with both theories facilitates estimation of future income from savings balances, even if not converting them into
annuities
Proposed regulations requiring providers of defined-contribution retirement saving accounts to send participants periodic estimates of
lifetime monthly income corresponding to their account balances
- Statement can specify the current account balance and projected account balances at retirement

No need to fully replace full income during working years with income in retirement
 80% ratio sufficient to maintain standard of living
 retired people don’t need to save for retirement, pay work expenses, likely to pay lower taxes, be free of mortgage debts

How much does have to be saved before retirement? Varies by gender, marital status, education, and who you ask
Issues with 80% ratio
1. One-third of full-time workers follow sharp transition between full-time employment – no employment at all; others continue full-
time or part-time employment
 not obvious when to stop measuring income ass pre-retirement and start measuring as post-retirement
2. Retirement income commonly measured as Social Security payments plus defined-benefit pension payments, sometimes also
annuity payments
 people can finance consumption out of savings, recorded as drawdown of capital rather than financing from income
 3. Resources do not have to last indefinitely; people often reduce spending substantially as they get older due to physical
limitations and less inclination to spend for personal reasons

Solution  Hurd and Rohwedder’s consumption-based measure of economic readiness, incorporates complexities of modern post-
retirement income streams + consequences
- Measure includes whether household has high probability to have resources to finance trajectory of spending from shortly
following retirement until death

Other definition of adequate retirement is 95-100% chance of dying with positive wealth after reducing consumption by 10%
Good prescriptions for sustainable withdrawal rates from saving balances in retirement
- Initial 2.1 percent annual withdrawal rate if retirement span extends to 30 years and 1.49 percent if it extends to 40 years

RMDs (required minimum distributions): government-mandated withdrawal rates from defined-contribution retirement savings
accounts, starting at age 70.5
- Based on actuarial estimates of life expectancy
- RMD rules have not been enacted as prescriptions for sustainable withdrawal rates  enacted so tax-deferred retirement
savings do not turn into tax shelters of infinite duration
- RMD withdrawal rates can be seen as prescriptions to be applied also to savings not subject to RMD rules
 can be supplemented by prescribed tax-efficient sequencing of withdrawals
RMD rules issues
- Savings likely to grow at rate exceeding inflation
- Many people choose to spend less than RMD rates

People can choose to spend more or less than is sustainable by their objective circumstances
 Younger people underestimate life expectancy, old people overestimate
 Subjective probabilities differ according to age  can incline young to save too little and old to spend too little
 Disaster can decrease estimates of life expectancy, increase spending

Financial Literacy, Comprehension, and Behavior

Financial literacy can be key prescription of BLCT if it yields financial comprehension + promotes behavior demonstrating financial
comprehension
- Answers indicate that financial literacy is widely lacking, especially among women, minorities, the poor, and those without
college years across countries
Gaps between financial literacy, financial comprehension, and behavior demonstrating financial comprehension
- Men across countries are on average more financially literate than women
- Men more overconfident than women and trade investment more frequently  some frequent traders aware of utilitarian costs
of trading but trade bc of expressive and emotional benefits
- Frequent trading amongst other indicates lack of financial comprehension and financial behavior demonstrating
comprehension
Financial behavior of employees can be improved without improving financial literacy
- Employees in defined-benefit pension plans do not choose amounts of savings and do not decide how to invest them 
choices are left to employers
- Menus of investments offered in defined-contribution retirement saving plans vary greatly from company to company  act as
implicit advisors, but “choice overload”

Standard and Behavioral Life-Cycle Theories in Public Policy

Differences between different theories have important implications for public policy prescriptions
- No role for public policy in standard life-cycle theory  people are free of errors to estimate life-cycle wealth
- Role in behavioral-life-cycle theory, protection against cognitive + emotional errors and wants e.g. spending it all now

Prescriptions of public policy range from libertarianism to libertarian paternalism, and paternalism
Libertarians
Advocate hands-off policies,
freedom to save and spend how
people wish
Conforms to standard-life cycle
theory
People arrange spending and
saving to enjoy smoothed
permanent income throughout
life-cycle
Libertarian paternalists Paternalists
Advocate policies that nudge people Advocate mandates that shove
toward saving while young, cautious people into saving when young,
spending when old cautious spending while old
Conforms to behavioral life-cycle Conforms to behavioral life-cycle
theory theory
People are hampered in spending + saving by conflicts between wants for
spending + saving, cognitive + emotional errors

Role of government + public policy prescriptions evident in all of investing, saving, and spending
direct government provisions e.g. Social Security, indirect government provisions, e.g. law and regulations deferring taxes
Social security = paternalistic; overcomes insufficient self-control by shoving people into saving  prohibits lump-sum payments in lieu
of monthly payments
Defined-benefit pension plans = paternalistic; mandatory for employees in organizations that provide them  permit lump-sum
payments; tempting for people with insufficient self-control

Margin regulations = paternalistic; limits leverage by not allowing stock buyers to borrow more than 50 percent value of stock purchases
Suitability regulations = paternalistic; requires brokers to recommend securities to customers only if brokers have reasonable ground for
believing their recommendations are suitable to customers situation + needs
 BUT set low paternalism bar  broker can recommend high-cost mutual funds paying high commissions over identical low-cost fund
paying low commissions

Fiduciary standards = higher paternalism bar: do not allow brokers to recommend high-cost mutual fund over identical low-cost mutual
fund
Libertarian-paternalistic nudge prominent in context of savings  automatic enrollment into defined-contribution retirement saving plans
e.g. 401(k)
- Counters tendency to procrastinate in saving + place wants for spending over wants for saving
- Increases proportion of employees that enroll; become anchored to default contribution level
- Especially effective among millennials
 choice defaults fail when default options don’t match people’s preferences; when reduce perceived choice autonomy

Tax subsidies less effective than automatic contributions in promoting retirement savings
- No difference in total 401(k) contribution rates between employees hire before Roth introduction and afterwards
- Implies that take-home pay declines and future retirement spending increases among those who choose Roth introduction
 can be outcome of employee confusion about and neglect of tax properties of Roth accounts
 can be outcome of “partition dependence”: shortcut whereby fixed amount is allocated to 401(k), regardless whether
traditional or Roth

People still can resist nudges by opting out of voluntary defined-contribution retirement saving plans ---
by extracting liquidity from accounts by borrowing or withdrawing money long before retirement, even when discouraged by taxes and
penalties
 all countries but USA have made systems illiquid before contributors reach 55, therefore USA generates pre-retirement leakage

Mandatory defined-contribution retirement saving plans = paternalistic = shoves into shaving

- Complement shoves of social security; substitute shoves of increasingly rare defined-benefit pension plans
- Form of these plans: employers make contributions without imposing requirements that employees make contributions, but
also without granting employees the right to substitute higher salary for these contributions

Observed shift from paternalistic defined-benefit pension plan to libertarian defined-contribution savings plan  happenstance; offers
an out to corporations whose defined-benefit pension assets are short of liabilities

Retirement Income for the Wealthy, Middle Income, and Poor

Discussions public policies best at promoting adequate life-cycle spending and saving need to make distinctions between four income
groups:
1. Wealthy: earn more than adequate income; savings large enough to ensure only retirement worries are estate taxes + status
competitions
2. Steady middle
o Earns adequate incomes; save enough for adequate retirement spending
o Savings-to-spending ratio high, mutes fears of longevity risk
3. Precarious middle, two segments:
o Low earners: strive to save from low earnings; meager savings = close to poverty, inadequate retirement spending
o High spenders, e.g. NFL players; spend adequate incomes during working ears; fail to save enough for adequate
retirement spending
 Savings-to-spending ratio low  lack of self-control and patience, propensity to spend highly related to
impatience
4. Poor: earn inadequate income; unable to save much for adequate retirement spending

Lines separating wealthy, middle income, and poor not precise

 people’s subjective assessments of financial security can be at odds with objective assessments
e.g. objective assessment places people into wealth group, but subjective assessment places them into precarious middle group
 wealth group bc having sufficient income, allowing additional saving rather than needing to spend
 lower spending to save for insecure future

Financial fragility prominent among precarious middle + poor

- Especially those with low educational attainment, families with children, suffered wealth losses, unemployed
- Nudging poor into saving more likely to fail bc of lack of resources available
o Poverty rather than insufficient self-control or other cognitive + emotional errors are primary barrier
 - Mandatory defined-contribution savings plan would aid precarious middle by replacing weak self-control with strong outside
control  insufficient for poor, because there is nothing to save

Chapter 10: Behavioral Asset Pricing Models

Useful asset pricing models associated expected returns of investment assets (e.g. stocks and bonds) with factors / characteristics (e.g.
risk and liquidity)
- Allow estimation of expected returns once knowing factors / characteristics + associations with expected returns

Function of wants for utilitarian benefits, expressive and emotional benefits, and cognitive and emotional errors
- Utilitarian benefits in investment pricing models: low risk high-liquidity
- Expressive and emotional benefits: virtue of acquiring and holding socially responsible funds; belief that stocks of admired
companies yield higher return; prestige of hedge funds; thrill of trading
- Likely to be associated with high prices + low expected returns

Tradeoff between wants for expressive and emotional benefits and utilitarian benefits
 investors must be willing to trade e.g. lower returns for expressive benefits of shunning stocks of tobacco companies

Cognitive errors:
- Underestimation of intangible capital e.g. high employee moral (enhances future profits more than employee costs)
Emotional costs:
- Affect that misleads investors into favoring stocks of admired companies exuding positive affect over stock, even when
expected returns are lower than of spurned companies’ stocks
- Frequent trading is likely to yield higher returns than rarer trading

Arbitrage in Meal Markets and Investment Markets

Rational + knowledgeable investors can eliminate by arbitrage the effects of ignorant investors
 most arbitrage opportunities are risky rather than risk free e.g. buy asset and simultaneously sell it at a higher price
- Investors increase proportion of portfolio allocated to certain stock, diversification reduces, portfolio risk increases
- Limits willingness of rational and knowledgeable investors to allocate high proportions of portfolios to certain stocks  limits
effect on prices + expected returns 
- Prices+ expected returns in markets with hampered arbitrage likely to reflect wants for expressive + emotional wants for
utilitarian benefits, prices + expected returns likely to reflect cognitive and emotional errors

Effects of hampered arbitrage

- Prices of closed-end funds + exchange-traded funds
o Closed-end funds = portfolios of securities e.g. stocks + bonds
o Investors wanting to redeem shares of closed-end funds do not submit redemption requests – receive payments 
sell shares of closed-end funds in stock market at any time during trading day
o Prices of closed-end fund shares would be identical to net asset values of shares contain in markets with no arbitrage
costs
o Rational + knowledgeable investors buy shares of closed-end funds, simulteneaously sell shares of companies with
shares in these funds (IF prices shares of funds were lower than net asset value)
o Buying + selling exerts pressure on prices, presses up prices of shares of funds, presses down prices of shares of
companies in funds
o Deviations of prices from net asset values indicate presence of arbitrage costs

Theoretical and Empirical Asset Pricing Models

Construction theoretical pricing models
1) Theoretical rationales for investor wants for utilitarian, expressive, emotional benefits + investor cognitive and emotional errors
2) Examination of empirical evidence about associations between investment asset returns and factors / characteristics reflecting
want and cognitive and emotional errors

Construction empirical pricing models

1) Empirical evidence about associations between asset returns and factors / characteristics e.g. low-risk investments yield lower
/ higher returns on average than high-risk investments
2) Examination of possible theoretical rationales for association

Central difference standard + behavioral asset pricing model = theoretical rationales for associations (in either theoretical or empirical
models)
- Behavioral asset pricing theory includes wants for expressive + emotional benefits + occurrence of cognitive + emotional
errors

Theoretical Capital Asset Pricing Models

First investment asset pricing model of standard finance is theoretical capital asset pricing model (CAPM) (developed by Sharpe) 
risk of investment asset determines expected return
- Built on Markowitz’s mean-variance portfolio theory
o Assumption that investors choose portfolios by expected returns + risk alone
 o Assumption that investors seek high expected returns but are averse to risk, measured by SD of returns
o Return seeking + risk aversion leads investors to portfolios on mean-variance frontier, offering highest expected
return for each level of standard deviation

CAPM adds two assumptions

1) Assumption of agreement: all investors agree on joint distribution of returns of all investment assets
a. Identical estimates of expected return shares, SD of returns, correlation between returns + returns of every other
investment asset
2) Assumption of borrowing and lending: investors can borrow and lend unlimited amounts at common risk-free rate + are not
averse to do so

CML tanged to mean-variance frontier at market portfolio M 

investors choose from CML
Market portfolio = portfolio of all investment assets in the world; weight
of each asset in market portfolio = total market value relative to total
market value of all assets

CAPM equation
E ( Ri ) =Rf + Bi ¿
Where,
E ( R )= expected return of investment I
i
E ( Rm ) = expected return of market portfolio
R f = risk-free rate
Bi= market-factor beta
¿ = expected market-factor return / market-risk premium / equity premium
Market-factor beta of investment is market-factor coefficient
Measure of risk of that investment according to CAPM
 depends on correlation between returns + those of market portfolio as well as on ratio of SD of its returns to that of market portfolio
σi
Bi=ρGM
σM
Where
Bi = investment market-factor beta
ρGM = correlation between returns of investment + returns of market portfolio
σ i = SD of returns of investment
σ M = SD of returns of market portfolio
True market portfolio difficult to calculate = use of proxies of market portfolio (e.g. broad index of US stock market) + proxies of risk-free
investment asset (e.g. US Treasury bills / bonds)
Estimates of expected market-factor return = “equity premium”  usually based on realized return over long periods
Realized equity premium in US = 6.6  difference between mean annualized returns of S&P 500 Index and Treasury bills during more
than eight decades
More reliable estimate for worldwide use = annualized equity of 3 to 3.5 percent

Excess return (alpha) = returns exceeding those expected according to an asset pricing model
Measured by regression equation (usually with monthly realized returns) by specific asset pricing model, e.g. CAPM

Theoretical rationale for role of beta of market factor in CAPM = role of risk in determining expected returns, especially risk of doing bad
in bad times
e.g. estimate 0.96 beta implies that in bad times, when market portfolio loses 1 percent of value, the investment is expected to lose 0.96
percent of value; makes it less risky than market portfolio; 1.5 beta = loses 1.5 percent of value when market portfolio loses 1 percent of
value

Empirical Three-Factor Asset Pricing Model

Predicts that differences between expected returns of any two investments assets come only from differences between market-factor
betas
- Evidence not consistent  excess returns when measured by CAPM
- Deviations of realized returns from returns expected by asset pricing model = anomalies

 realized returns of group of stock e.g. group of small-cap stocks during periods extending into many decades; anomaly bc higher
than expected by the CAPM

Fama French Three-Factor Model

 - Empirical model; begins with known empirical associations between returns of stocks and the small-large and value-growth
factors
- Proceeds to argue that theoretical rationale for association is role of
small-large and vale-growth-factor betas in measuring risk better
than market-factor beta
- Market factor commonly measured as difference between return of
index of all stocks, return of Treasury bills
- Small-large factor measured as difference between returns of
indexes of small-cap and large-cap stocks
- Value-growth factor measured as difference between returns of
indexes of value and growth stocks
o Value stocks = high ratios of book value per share to price
per share (high book-to-market ratios)  sell cheap (stock
undervalued)
o Growth stocks = low ratios of book value per share to price
per share (low book-to-market ratios)  sell expensive (stock overvalued)

Expected return of asset is function of:

1. Risk related to market factor
2. Risk related to small-large factor
3. Risk related to value-growth factor
SMB = small minus big; HML = high minus low

Empirical Evidence and Theoretical Rationales

Fabrication of asset pricing models to cover what is observed is current norm in asset pricing models
 researchers are factor mining
- Recommended stricter criteria for establishing statistically significant associations between factors + returns
o Accounts for possibility that associations reflect nothing more than factor mining
o Strong empirical associations between factors + returns cannot substitute for theoretical rationales
- Theoretical models pleasing to offer testable hypotheses followed by empirical evidence that supports them BUT not superior
to empirical ones (once theoretical rationales for empirical associations have been identified)

Perverse empirical association between returns, market-factor beta, variance of returns

- Stocks with high variance of returns + high market-factor beta have yielded substantially lower returns than stocks with low
variance of returns + low market-factor betas
o Theoretical rationale: combination of individual investors’ preference for risk + common institutional investors’
mandates that discourage arbitrage activity that press lower returns of stocks with low market-factor betas; push
higher returns of stocks with high market-factor betas

Profitability (quality) premium

- Stocks of highly profitable companies yield above-average returns
- Theoretical rationale: profitable companies are riskier, higher returns of stocks are compensation for higher risk
- Behavioral rationale: cognitive errors mislead investors into underestimating true value of profitable companies, high trading
costs limit arbitrage that could have eliminated profitability premium

Fleeting and Sustained Factors in Asset Pricing Models

Associations between factors + returns in standard + behavioral asset pricing models range in duration from fleeting to sustained
- Factor has place in sustained asset pricing model if rationale reflects sustained wants for utilitarian, expressive, emotional
benefits / incurring of sustained cognitive + emotional errors
- e.g. expected return of risky stock likely to exceed that of less risky bonds even if knowledge of differential in expected return
is widely available

Fleeting association eliminated by arbitrage in period as short as a day

- but arbitrage process slower + less effective when costly, e.g. among small-cap and illiquid stocks

Standard and Behavioral Rationales

Standard rationales
1. Data-mining hypothesis
2. Risk hypothesis

Data-mining hypothesis (1)  no evidence

Empirical associations between stock returns and small-large and vale-growth factors are due to “data mining” (among infinite number
of company and stock characteristics )
- Positive excess returns of stocks of small and value companies
- Negative excess returns of stocks of large and growth companies
 - The data-mining bias creeps in slowly when anomalies or happenings in the market are given more weight or importance than
they deserve

- Escape by examining investors’ expectations of returns in addition to realized returns

- E.g. association between expectations of returns + book-to-market ratios = weak  reason to suspect association between
book-to-market ratios and realized returns = bc of data mining
- Suspicions bc weak association between expectations of returns and book-to-market ratios means investors do not
incorporate book-to-market ratios into expectations of returns

Weak association = support of data-mining hypothesis

Strong association = reject data-mining hypothesis

BUT: evidence indicates statistically significant association between expectations of stock returns and book-to-market ratios and market
capitalization
No statistically significant association between expectation of returns and market-factor betas
 inconsistent with data-mining hypothesis predicting weak associations

Risk hypothesis (2)  no evidence

CAPM Hypothesis:
- An association between expectations of returns and market-factor betas
- No association between expectations of returns and book-to-market ratios and market capitalization
CAPM Evidence:
- They find no association between expectations of returns and market-factor betas
- They find an association between expectations of returns and book-to-market ratios and market capitalization
 If difference in expectations of returns due to differences in risk, risk not indicated by market-factor beta

Fama & French state high book-to-market ratios + low market capitalizations in three-factor model indicate high risk
If true, then:
- Expectations of returns high for value stocks with high book-to-market ratios, low for stocks with large market capitalizations
BUT:
- Expectations of returns low for stocks with high book-to-market ratios and high for stocks with large market capitalizations
SO:
- Differences in expectations of returns are due to differences in risk, risk not indicated by high book-to-market ratios or small
market capitalizations (as in three-factor model)

Risk indicated by small market-cap and high book-to-market ratios in three-factor model might be risk of financial distress
 financial soundness can be measure of financial distress; low financial soundness = high financial distress

Investors expect high returns from stocks with low financial soundness (financial distress hypothesis)
 long-term investment value is high among stock of companies with low financial soundness
BUT: long-term investment value is low among stocks of companies with low financial soundness
INCONSISTENT with financial distress hypothesis
- ALSO: stocks of financially distressed companies provide lower returns, even having much higher SDs and market-factor
betas than stocks of companies not as distressed

Behavioral rationales
1. Cognitive-errors hypothesis
2. Emotional-errors hypothesis
3. Wants for expressive and emotional benefits hypothesis

Cognitive-errors hypothesis (3)  no evidence

Empirical association between returns and book-to-market ratios and market capitalizations is due to cognitive errors
- Stock with low book-to-market ratios and large market capitalizations yield higher expected returns than stocks with high book-
to-market ratios and small capitalizations
Evidence: stocks of value companies yield higher returns than stocks of growth company
- Investors make a mistake by extrapolating high past returns and rates of growth of sales in sales in earnings
 misleads to believe that stocks of growth (glamour) companies will yield higher subsequent returns that stocks of value
companies
 empirical evidence indicates that stocks of value companies yield subsequent higher returns

Tobin’s Q resembles market-to-book ratio but is broader = ratio of total market value of all securities of a company to the replacement
value of its assets (price having to pay to acquire Entire Company)

- Cognitive errors may mislead investors to identify stocks with high Tobin’s Q, large market capitalizations, high price-to-
earnings ratios as stock likely to yield higher future returns
BUT: evidence shows these stocks yield low returns, so these investors are WRONG
AGAIN BUT: no actual evidence offered that investors actually extrapolate or actually consider Tobin’s Q, market capitalizations, price-
to-earnings ratios SO
 characteristics hypothesis: claims investors consider but misinterpret characteristics
- If considering characteristics as estimating future returns, high characteristic scores should correspond to high Fortune ratings
on long-term investment value
BUT: not true, no statistical significance hypothesis

Emotional-Errors hypothesis (4)  evidence

Empirical association between stock returns, book-to-market ratios, and market capitalizations are due to emotional errors, specifically
caused by misleading affect
- Halo effect of companies and stocks: misleads investors into thinking that stocks of companies with positive affect yield higher
returns and impose lower risk than stocks of with negative affect

Predictions:
1. Positive affect is associated in eyes of investors with high long-term investment value
a. Tested by associated between affect elicited by company names + Fortune ratings on long-term investment value
b. Evidence: names eliciting positive affect tend to elicit expectations of high stock returns

BUT: Names of companies and images bringing to investors’ minds are what elicit misleading affect (rather than company
characteristics)
c. Tested by names of companies, industries, three characteristics
d. Evidence: difference of 0.01 in R squared when including characteristics
 emotional-errors hypothesis more supported than characteristics version of cognitive-errors hypothesis

2. Halo of affect leads investors to expect that stocks of companies with positive affect will yield higher return AND impose low
risk
a. Risk hypothesis predicts that expectations of high future returns are accompanied by assessments of high risk BUT:
b. They are in fact accompanied by assessment of LOW risk

Also, link between return scores, risk scores, Fortune ratings on long-term investment value
o High Fortune ratings on long-term investment value associated with high future return scores  coefficient future
return scores positive + statistically significant
o High Fortune ratings on long-term investment value associated with low risk scores  coefficient risk scores negative
+ statistically significant
- Additional support for emotional errors hypothesis by other studies  Stocks rated A-, A, A+ have high appeal to investors
BUT inferior to Class B shares
o Investors losing money on high quality issues direct anger more toward market than broker who recommended the
stock, losing on low quality issues = direct anger toward broker, lawsuit?

Wants for Expressive and Emotional Benefits hypothesis (5)  evidence

Empirical association between stock returns, book-to-market ratios, market capitalizations due to investors’ wants for expressive and
emotional benefits of stocks of large-growth companies (large market-cap, low book-to-market ratios)

Distinguishing wants from errors:

- Wants can be implicit rather than explicit
- Implicit when reluctant to admit to others or ourselves e.g. want for high social status
Investors can be enticed in preferring large-growth stocks over small-value stocks (ERROR)
- because believe former offers higher expected returns
- because want implicitly or explicitly, expressive + emotional benefits of stocks of admired companies e.g. large-growth stocks

CONCLUDING:
EVIDENCE favors emotional-errors and wants hypotheses over data-mining, risk, cognitive-error hypotheses in explaining empirical
association between stock returns, book-to-market ratios, market capitalizations

Standard and Behavioral Asset Pricing rationales

Empirical findings often consistent with more than one theoretical interpretation, more
than one possible rationale
e.g. rationales underlying momentum factor  Included in Cahart 4-factor Model
where UMD = long previous 12-month return winners minus short previous 12-month
return losers

 stocks that yielded higher returns than peers’ during 6-month to 12-month periods tend to continue to yield higher returns than peers
in following months, and vice versa

Rationales underlying momentum

Standard rationales:
- Company assets + growth opportunities change in predictable ways as consequence of optimal investment choices
o Trend imparts predictability to changes in companies’ systematic risk  prevalence of momentum
- Company-specific risks e.g. business risks at market and company-specific levels affect investment decisions  companies
have some ability to forecast company-specific risks
o Companies adjust operations by forecast company risk = impose company-specific risk in addition to market risk on
investors
o Creates nonlinear risk premium  explains momentum and three factors of market, small-large, and value-growth
- Information availability: lower-momentum profits in markets with smaller differences in information availability among investors
- Institutional structures predicts lower-momentum profits in markets with lower conflicts of interest between money managers +
investors delegating investment management

Behavioral rationales
Disposition effect: underreaction of prices to new information = momentum
- Gradual increase for price to get even with intrinsic value
- Some investors rush to close mental account  presses prices down, slows down process
Frog in the pan observation: investors are less attentive to information when it arrives gradually in small bits than same information fed
as lump
- Continuous information induces momentum as stock prices change gradually
Overconfidence: lower-momentum profits in markets with more sophisticated investors

Behavioral Asset Pricing Models

Challenges
- Noise drivers: susceptible to cognitive errors; steer prices in directions corresponding to errors
- Extrapolation investors: good news increases intrinsic values = increase stock price  expect further increases, buying stocks
+ pushing prices higher than intrinsic values should let
o Representativeness error
- Emotions, mood, affect: significant influence on stock price returns  uplifted mood = bullish sentiment, elevating stock prices
- Must account for investors’ wants for expressive and emotional benefits

Standard asset pricing model rationales:

- Limited to wants for utilitarian benefits among investors free of cognitive and emotional errors
Behavioral asset pricing model rationales:
- Includes wants for utilitarian, expressive, emotional benefits and presence of cognitive and emotional errors

Behavioral model includes two social-responsibility factors to four-factor asset pricing model of market, small-large, value-growth,
momentum
1. Top-bottom factor (reflects cognitive errors)
a. Difference between returns of stocks of companies ranked high and low on five social responsibility criteria
i. Community (e.g. generous giving)
ii. Diversity (e.g. promotion of women + minorities)
iii. Employee relations (e.g. strong union relations)
iv. Environment (e.g. pollution prevention)
v. Products (e.g. product quality + safety)
2. Accepted-shunned factor (reflects wants for expressive + emotional benefits)
a. Difference between returns of stocks of companies commonly accepted by socially responsible investors + returns of
company stock shunned by these investors
i. Shunned = stock of companies in alcohol, tobacco, gambling, firearms, military, nuclear industries

Underestimation of value of intangible capital e.g. good employee, company relations = cognitive error likely to be committed bc cost of
intangible capital immediately evident in lower current earnings  benefits less evident and lie in future
 stocks of companies ranking high overall on SR criteria yielded higher returns
 stocks of shunned companies yield higher returns than those of accepted companies
Some investors willing to trade utilitarian expected returns for expressive and emotional benefits of avoiding stocks of shunned
companies BUT ALL DEPENDS ON INDIVIDUAL

- Negative shunned 0.40 = tilts away from stocks of accepted companies

 - Negative 0.05 top-bottom factor = tilts away from stocks of top companies
- Market-factor beta lower = return moves up or down less than return of other
- Small-large factor negative = tilts toward small stocks
- Negative momentum factor = tils away from momentum stocks
 near-zero beta = no tilt!!
- Positive excess returns – alpha - = realized return exceeds return that could be expected by six-factor model

Factors and Characteristics in Asset Pricing Models

Betas of factors in factor models (Fama French; four-factor model, etc.) can be biased measures of characteristics
Characteristic pricing models: alternative, replacing factors such as accepted-shunned with company + stock characteristics e.g. is the
company shunned or accepted
 useful when factors of companies in proximity of ones with negative factors are drawn down with them e.g. supermarket near casino

Characteristic models more difficult to estimate than factor models

- Need to “open” a fund / company to measure characteristic of each of its stocks
- Would need to calculate average of all grades (e.g. positive 1 if top third, negative 1 if bottom third, 0 if in middle) by combining
grades of each stock

“Smart Beta” and Asset Pricing Models

RECAP:
Portfolio in market factor of CAPM is market portfolio  market-capitalization weighted portfolio (MCWMP) of all assets in which weight
of each asset equals proportion of its market capitalization relative to total market capitalization of all assets
- MCWMP lies on mean-variance frontier AND provides best combinations of expected returns + SDs when combined with
borrowing + lending
- Same market portfolio is portfolio in market factor of all factor models

BUT: what if it doesn’t lie on mean-variance frontier?

Smart beta portfolios: portfolios in which proportions of assets depart from their proportions in market portfolio, aiming at higher ratios of
expected returns to standard deviations than provided by portfolio
 e.g. portfolio tilting toward small-value stocks = smart-beta portfolio
- Assigns greater proportions to small and value stocks than proportions in market portfolio
- Portfolios can be reflections of behavioral asset pricing models
o Differences between expected returns of portfolios depend not only on differences in market-factor beta but also
difference in betas of other factors
o E.g. small-large, value-growth, momentum, top-bottom, accepted-shunned, etc.
- Investment companies can settle on relevant factors in its smart-beta portfolios

Conclusion p.285  CHECK PPT

Benartzi & Thaler (1995): Myopic Loss Aversion and the Equity Premium Puzzle
Introduction
Equity premium puzzle: stocks have outperformed bods by surprisingly large margin
Annual real return stocks = 7%; real return fixed income securities 1%  Answer equity premium puzzle:
1. Loss aversion: tendency for individuals to be more sensitive to reductions in their levels of well-being than to increases
a. Prospect theory
2. Mental accounting: implicit methods individuals use to code + evaluate financial outcomes
a. Important aspect: dynamic aggregation rules  not neutral in presence of loss aversion
b. Can cause people to turn do one bet but accept two or more under certain circumstances
i. Decision-makers loss-averse = willing to take risks if evaluating their performance infrequently
Equity premium puzzle?
- Attractiveness of risky asset depends on time horizon of investor
o The longer the investor intends to hold the asset, to more attractive the risky asset will appear, investment not
evaluated frequently
- Two contributing factors to investor being unwilling to bear risks associated with holding equities
o Loss aversion
o Short evaluation period
o = myopic loss aversion

Equity premium puzzle

Stocks have had significant edge for last 120 years
- Investing in stocks only = 7 times more return than only bonds
- People must be confused about relative safety of different investment over long horizons
Possible explanations
- Risk aversion not satisfactory explanation  would need coefficient of 30; logarithmic function has relative coefficient of 1.0
- Puzzle might be rational response to time-varying risk of economic catastrophe
- Non-expected utility preferences  inverses link between coefficient relative risk aversion + elasticity of intertemporal
substitution
 o Why are t-bill rates so low?
- Habit-formation model: utility consumption assumed to depend on past levels of consumption
o Customers averse to reductions in consumption levels
o Model improves ability to explain intertemporal dynamics of returns; does not help explain differences in average
returns across assets

Prospect Theory and Loss Aversion

Value function  utility is defined over gains and losses i.e. returns

λ = coefficient of loss aversion; 2.25

β = 0.88
Indicates that reductions are painful
Prospective utility of gamble, G, paying off xi, with probability p,

,
π i= decision weight associated assigned to outcome i; depends on cumulative distribution of gamble, not only p
Use of prospect theory must be accompanied by specification of frequency that returns are evaluated
 evaluation period (length of time over which an investor aggregates returns)  e.g. evaluations every 3 months
NOT PLANNING HORIZON  e.g. saving for retirement in 30 years (horizon)
BUT: the more often an investor evaluates his portfolio, the shorter the horizon, the less attractive he will find high mean, high risk
investments
Merton & Samuelson: as long as returns on stocks and bonds are random walk, a risk averse investor with utility function that displays
constant relative in aversion should choose the same allocation for any time horizon
 counterintuitive

How Often are Portfolios Evaluated

Questions: if investors have prospect theory preferences, how often would they have to evaluate their portfolios to explain the equity
premium?
1. What evaluation period would make investors indifferent between holding all their assets in stocks or bonds
2. For an investor with this evaluation period, what combination of stocks and bonds would maximize prospective utility?

Method
Simulation done to accommodate the cumulative or rank-dependent formulation of prospect theory
 returns ranked from best to worst, return is computed at twenty intervals along cumulative distribution
Four simulations: compare CRSP stock index with both treasure bills returns, and five-year bonds returns
 comparisons done in both real and nominal returns
Prefer bonds to T-bills bc think that for long-term investors these are closest substitutes
Prefer nominal to real bc
1. Returns usually reported in nominal returns  even when inflation adjusted returns are calculated
2. Simulations reveal that if investors were thinking in real dollars  would not be willing to hold treasury bills over any evaluation
period  ALWAYS yield negative prospective utility

Results

Lines = prospective value of portfolio at different evaluation periods

- Curves cross = equally attractive
- Nominal returns equilibrium = 13 months; real returns equilibrium = 10 / 11 months
Main aspect of prospect theory driving results = loss aversion
- Specific functional forms of value function + weighting functions are not critical
 ISSUE: investors do not choose between all bonds or all stocks

 simulation where prospective utility of each portfolio mix between 100%

bonds and 100% stocks in 10% increments

- results for real returns similar

- Portfolios between 30 – 55 percent stocks yield approximately same
prospective value
- Roughly consistent with observed behavior

Myopia and Magnitude of Equity Premium Puzzle

Theory suggests that equity premium is produced by combination of loss aversion +
frequent evaluations
Loss aversion = risk aversion in standard models, factual
Frequency of evaluations = policy choice
Stocks become more attractive as evaluation period increases

 by how much would equilibrium equity premium fall if evaluation period increased
- Analysis real returns stocks – real returns five-year bonds
- Actual equity premium of evaluation period of 1 year = 6.5%

Person with twenty-year investment horizon has psychic costs of evaluating portfolio
annually of 5.1% per year
 would be indifferent between stocks + bonds if equity premium were only 1.4%
Remaining 5.1% is potential rents payable when able to resist temptation to count money often

Do Organizations Display Myopic Loss Aversion

Objections to explanation = model based on individual decision-making
 more concerned with pensions funds + endowments
Pension Funds
Assets in plan earn higher return = firm can make smaller contributions to fund in future years
Assets do not earn high enough return – firm’s contribution rate will have to increase to satisfy funding regulations

Common allocation: .6 stocks, .4 bonds + treasury bills

- Pension funds have infinite time horizon + historical equity premium  why no higher proportion to stocks?
 myopic loss aversion produced by agency problem
Pension fund is likely to exist as company remains in business, pension fund manager will not be in job forever
- Must make regular reports on funding level + returns of funds’ assets = short horizon = conflict between pension fund manager
+ stockholders
- Leibowitz & Langetieg 1989: investors + investment managers set personal investment goals that must be achieved in time
frames of 3 to 5 years; investors having to account for near term losses, long-run results have little significance
- THUS: agency costs produce myopic loss aversion

Foundation & University Endowments

Two causes for myopic loss aversion
1. Agency problems similar for pension plans
2. Spending rules: specifies that organizations can spend x percent of an n-year moving average of value of endowment, where
n is typically five or less
a. Purpose is smoothing out impact of stock market fluctuations BUT sudden drop, long bear market has pronounced
effect on spending
b. Choice between competing goals of maximizing present value of spending over infinite horizon; maintaining steady
operating budget

Difference between universities + operating foundations and individuals saving for retirement
Individual only important thing is terminal wealth  transitory fluctuations only impose psychic costs
Universities + operating foundations  psychic cost of seeing endowment fall, very real costs of cutting back programs in case of cash
flow reduction
- Strengthens argument of myopic loss aversion as explanation for equity premium  existence of economic factors
contributing to loss aversion

Conclusions
 Equity premium puzzle: why investors extremely unwilling to accept variations in returns yet be willing to delay consumption to
earn 1 percent a year?
 Solution: combination of high sensitivity to losses with tendency to frequently monitor wealth
  Tendency shifts domain of utility function from consumption to returns, returns makes people demand a large premium to
accept return variability
 Investors unwilling to accept return variability even if short-run returns have no effect on consumption

Chapter 11: Behavioral Efficient Markets

Two different versions of efficient markets + corresponding efficient market hypotheses
- Price-equals-value market hypothesis: markets in which investments prices always equal their intrinsic values
o Impossible to beat bc excess returns come from exploiting gaps between prices + intrinsic values (absent in price-
equals value market)
- Hard-to-beat market hypothesis: markets where some investors are able to beat the market, most unable to do so
o Prices may deviate greatly, far from price-equals-value efficiency  deviations hard to identify in time / difficult to
exploit for excess returns
 why do investors believe markets are easy to beat?

Behavioral finance provides evidence contradicting price-equals market hypothesis; evidence consistent with hard-to-beat market
hypothesis  also explains why investors believe markets are easy to beat

Rational investors: know markets hard to beat

Normal investors: markets easy to beat  get beat by it
Cognitive + emotional errors; willing to sacrifice returns + utilitarian benefits for expressive benefits of image of being “active”
investors, emotional benefits of hope of beating the market

 ignorance: unawareness that returns of active investors are on average lower than those of passive investors
 exploitation of cognitive + emotional errors by financial companies + financial press e.g. via promoting active funds (market is easy to
beat)
 exploitation of overconfidence errors  leads to excessive trading; unlikely to be discouraged by knowledge of lower returns
frequent traders
 wants for expressive + emotional benefits: as mentioned earlier + sacrifice utilitarian benefits of low cost + diversification of passive
mutual funds for expressive + emotional benefits of having own separate accounts

Intrinsic Values
Intrinsic value of stock = present value of expected dividends during life
 only thing rational investors care about

Price-equals-value stock market states price of stock always equal intrinsic value
Determined by expected dividends during company life, including expected dividend received at end of life (can be zero or billions)

Time value of money: money received in future is less valuable than money received today  discounting of future expected dividends
to account for stocks’ required return, determined by correct pricing model
 model accounts for utilitarian benefits + costs (e.g. risk) + expressive, emotional costs and benefits
Required return = expected return, cost of equity
Intrinsic value of stock is sum of expected dividends during company’s expected life, discounted to account for stock’s required return
 rational investors refuse to buy stocks at prices exceeding intrinsic value

Price-Equals-Value Markets and Hard-to-Beat Markets

Market is hard to beat if most investors find it hard to earn consistent excess returns
Important to considered whether markets are price-equals-value markets bc such markets are crucial for proper allocation of economy’s
resources, either labor or capital
 proper allocation provides benefits for all

e.g. stock market in which $100 price per share of software company exceeds $60 intrinsic value. Managers sell 10,000 shares at $10
each for total of $1 million  use proceeds to expand operations. Would have forgone expanding if sale of 10,000 shares had fetched
only $600,000
biotechnology company whose $60 price per share is short of $100 intrinsic value. Managers chose to forego expanding operations bc
only yield $600,000; would have expanded operations if price per share had been $100, fetching $1 million
Resources not allocated properly  will be allocated to software company whereas would have done more good if had been allocated
to biotech company

Price-Equals-Value Market Hypothesis

Testing hypothesis difficult bc difficult to estimate intrinsic value of investments
 replacement of price-equals-value hypothesis with hard-to-beat market hypothesis in discussions of efficient market hypothesis,
assuming both hypotheses are equal

Price-equals-value market hypothesis implies as a result the change-price-equals-change-value market hypothesis, whereby changes
in price equal changes in intrinsic values easier to test

- Economist Ray Fair found instances in which large changes in level of S&P 500 Index occurred with no events likely
associated with changes in intrinsic value  “stock price determination is complicated”
 - Economist Richard Roll found R-squared, proportion of variation of returns of stocks accounted for by news about changes in
intrinsic values, of .35 when using monthly returns, .20 when using daily returns.
- Robert Shiller found greater changes in prices than should be expected according to hypothesis  difference can be
explained by investor psychology; changing perceptions + tastes affect selection of stocks + bonds as thy affect selection of
food, clothing, health, politics

Forms of Hard-to-Beat Market Hypothesis

1. Exclusively available information form is claim that not even investors with exclusive available information can beat the market
2. Narrowly available information form accepts that investors with exclusively available information can beat market; claims
investors with no more than narrowly available information cannot bear it
3. Widely available information form accepts that investors with exclusively / narrowly available information can beat market;
claims investors with no more than widely available information cannot

Eugene Fama divided efficient market hypothesis into three forms:

1. Strong: even investors with private information cannot beat market
2. Semi-strong: investors with private information can beat market, investors with no more than public information cannot
3. Weak: investors with no more than subset of public information – past stock prices and volume of trading – cannot beat market
BUT: issues with ambiguity terms “available / public information” e.g. publication front page Times = widely available information; inside
page of Times = narrowly available

Similarities + differences three forms of hard-to-beat market hypothesis and three form of Fama
- Semi-strong efficient market proven to be inconsistent
 price of shares change following front page report of Times in 1988, when same information was available on page inside
Times in 1997
 inside page is narrowly available information; front page publication = widely available information
- BUT: stock price did not increase in months following front page publication, consistent with widely available information form
of hard-to-beat market  investors buying stocks after front-page publication are unable to sell at higher price
- Inconsistent with narrowly available information form  readers of inside page who bought shares in 1997 beat the market

Who Beats a Hard-To-Beat Market

Investors with exclusively available information can beat market easily, narrowly available information find it hard, widely available
information = impossible
 investors with exclusive and narrow information gain market beating returns by emptying pockets of investors who attempt to beat
market with widely available information alone
 inconsistent with exclusively available information form of hard-to-beat hypothesis and strong form of efficient market hypothesis
- Executives with access to exclusively or very narrow information beat market by wider margins than executives with
information not as narrowly available

Use of exclusive + narrow information illegal; prohibited by insider trading regulations

- Insiders beat outsiders in trading race
- Opportunistic trades by insiders motivated by exclusive + narrow available information  most opportunistic traders are local,
nonexecutive insiders in geographically concentrated, poorly governed companies
- Earn 10% of annual excess returns

How to reduce opportunistic trading?

- Insiders file trades with Securities and Exchange Commission (SEC)  narrowly available information becomes more widely
available
- Still narrowly available bc digging out trading information from Sec files requires grater effort than getting it from newspaper

Money managers beat market by digging out exclusively / narrowly available information during e.g. meetings with corporate executives
- Facilitated by connections
- By culture e.g. more common in China
- Lobbyists (e.g. hedge funds do this)

People and funds hide competitive information that gives beat-the-market advantage
e.g. via trading through accounts of children
Divide large batches of shares into smaller batches that are traded gradually over time
Short selling likely motivated by exclusively / narrowly available information  short selling generally followed by low stock returns

Many beat-the-market failures by amateur investors aka widely available information

Bull markets inflates investor confidence, bear markets deflate confidence
 bull = more frequent trading but lower returns; bear = less trade
People mimic peers’ behavior bc wanting to maintain status; learning from peers by observation
Social interactions can potentially improve investment performance by reducing risk by diversification BUT can also have opposite
effect with investment clubs (consensus decisions)

Wants and Errors – Trying to Beat the Market with Widely Available Information
Information traders: those with exclusively / narrowly available information willing to trade and those with only widely available
information who refrain from trading
Noise traders: traders who are willing to trade despite having nothing more than widely available information

Fisher Black says “noise trading is key to solving trading puzzle”

 motivation to trade by ignorance about cognitive and emotional errors e.g. thinking noise = information, or motivated by wants e.g.
just liking to trade
- Sometimes hiring fund managers that charge fees equal to or exceeding excess return generated
 delivering investors their funds returns equal to match-the-market index fund returns

WHY DO THEY TRY 

- Beat-the-market investors: buy an undiversified handful of stocks, trading them frequently 
- Amateurs: only widely available information 
- Professionals: exclusively or narrowly available information 
- Knowledgeable investors with only widely available information refuse to trade 
- Trading puzzle: there is still a lot of trading 
- If someone has information, he wants to trade; on the other side should be someone that has knowledge; therefore, either
party has to make a mistake; the knowledgeable investor declines to trade then 
- Information traders: those with exclusively or narrowly available information that want to trade, and those with only widely
available information that do not want to trade 
- Noise traders: willing to trade even though they only have widely available information 
- Another motivation than ignorance might be that noise traders just like to trade 
- Match-the-market investors: buy and hold passive low-cost diversified index funds 
- Beat-the-market managers charge higher fees than index fund managers 
- Investors holding btm funds fail to beat it even when their managers are able to beat, because these charge fees equal to the
excess return 
- Mtm and btm investors have average market returns, do-it yourself btm investors underperform the market 
- By now, hedge funds underperform the markets as well, even before accounting for fees 
- Most finance professors are mtm investors 
- Errors of btm investors: 
- Framing errors: knowledgeable investors know they are not the only ones watching news, and most likely the slower ones;
ignorant traders still trade 
- Spamers: post wrong information; trade faster than their victims against the exaggerated target-price projections 
- Deficient financial-facts knowledge and human-behavior knowledge: these disadvantages are especially large in opaque
markets; brokerage firms overcharge unsophisticated investors on the mark-up 
- Trading disadvantage: some brokerages route their clients’ trading orders to exchanges paying them larger rebates even
when this is to the disadv. of the clients 
- Index funds do not differ in return, but in fee, which is often not considered 
- Overconfidence errors: 62% of the people expect to beat the market 
- Availability errors: undiversified investors who trade frequently are likely to earn extreme returns in comparison to the
diversified investor; in times of positive returns, this is shared, but not in negative times 
- Representativeness errors: neglecting to examine base rate information; change expectations abruptly; also when using
technical analysis (-7% return) due to feeling of seeing patters and attribution of random success to skill; leads to herding 
- Emotional errors: positive mood and positive affect end up in increased return expectations combined with decreased 
risk perception and risk aversion; market declines result in fear and negative mood and higher expectation of risk 
- Group polarization: group tends to decide for more extreme decisions than individuals would have chosen 
- Confirmation errors: committee members seek confirming evidence for the committee’s views 
- Disposition effect: realize gains, but not losses, also professionals being a target 
- Wants: affect behavior even in the absence of errors; satisfaction of expressive and emotional benefits 
- Professionals are not immune to cognitive and emotional errors and wants, but generally more aware and better at
overcoming 
- Consultants do not improve the performance 
- EXPLOITING COGNITIVE AND EMOTIONAL ERRORS 
- HOW MANAGERS TRY TO EXPLOIT PEOPLE 
- Behavioral funds: Managers of behavioral funds identify common wants and cognitive and emotional errors and attempt to
exploit them for the benefit of their own investors; on average fail to gain excess return 
- Holding period returns: dropping the negative oldest returns, timing, promoting of false impressions, … 
- Names frame funds: change their fund’s name to take advantage of hot investment styles; investors are indeed fooled 
- Advertising: makes mutual funds more available to memory, slows redemption from poorly performing funds; companies
advertise the returns of their best performing funds 
- Window dressing: changing the composition of the portfolio to increase the appeal; buy stocks that increase during the
quarter and sell the ones that decreased; following quarter will have bad performance; these firms charger higher fees;
misreporting of stock positions 
- Positive affected stocks: fund managers invest in stocks that yield lower returns, but are more attractive to investors; greater
amounts of money flowing into funds with attractive stocks more than offset lesser amounts of money withdrawn from funds
based on lower returns 
- Ratings of funds: penalties for being at the bottom are larger than rewards from being at the top; asymmetry between
rewards and penalties leads managers to take more risk in the middle year 
- Career concerns: motivation to herd into stocks that analysts upgrade; more pronounced for downgrades 
 - Closet index funds: managers move their portfolios closer to benchmark portfolios in down markets, because net inflows in
portfolios that outperform their benchmark in down markets are lower than funds that outperform in up markets; investors base
their investment decisions on the sign and magnitude of fund returns, rather than on relative returns to the benchmark 
- Funds-of-mutual funds: sell stocks that managers of stand-alone funds want to buy, degrades their returns 
- Bunched trades: trades of the same stock on the same day in the same direction for more than one client; favored clients
receive higher prices when selling 
- The btm money management is reinforced by a competitive environment and supported by a mix of behavioral, agency,
organizational and cultural factors 
- BUT THERE IS HOPE 
- Adaptive market hypothesis: amateurs make mistakes but they learn and adjust, and competition between money
managers fosters adaptation and innovation 
- Btm funds charge lower fees and generate higher excess returns when they face competitive pressure from low-cost index
funds 
- Other investors push against btm funds by investing in index funds 
-
Making the Market Hard to Beat by Beating It
Investors believing that hard-to-beat market hypothesis is false can me hard-to-beat market hypothesis come true
Markets can be neither hard-to-beat nor price-equals value if all investors believe markets are already hard to beat and price equals
value
- Moved closer to this status by investors who believe that markets are in price-equals value category AND can be beat
- Absence of attempts to beat market can increase gaps between prices and values; absence reduces incentives to acquire
information about gaps + trade to exploit gaps for higher returns

Market as assumed by price-equals-value market hypothesis has ability to aggregate investors’ information tiles and partial mosaics
into complete mosaics  in the end prices equal intrinsic values
 Intrinsic values of security assessed as pieces of mosaics
 Investors dig out tiles of exclusively + narrowly available information, fit them into empty spaces in mosaic including tiles of
widely available information
 Infer that overall mosaic, even if incomplete, shows intrinsic values higher or lower than prices, proceed to buy investments
whose prices are lower than inferred intrinsic values, sell investments whose prices are higher than inferred intrinsic ones

Gaps between prices + intrinsic values indicate that markets are not in price-equals value category  gaps are oil that lubricates
process by which traders narrow gaps while striving to beat market

Traders motivated by potential excess returns buy stocks whose prices are lower than intrinsic value  buying pushes prices higher,
closer to intrinsic value
Similarly motivated to sell stocks whose prices are higher than intrinsic value  selling presses price lower, closer to intrinsic value
Process central in Andrew Lo’s adaptive market hypothesis  dynamics of adaptation determine not only efficiency of markets but also
waxing + waning of financial institutions, investment products, and institutional + individual fortunes
e.g. John Paulson hedge fund gaining $15 billion against subprime mortgage securities
 dug out exclusively + narrowly available information tiles, combining them with widely information tiles = mosaic of subprime
mortgage securities

Markets are poor at aggregating information tiles into mosaics whose clarity corresponds to aggregate of information tiles of all
investors
- Poor at aggregating information tiles that are geographically dispersed
- Future earnings and cash flows of companies can be predicted from past earnings + cash flows of other companies in related
geographical regions  implies not all available information is aggregated in current prices

Trading motivated by exclusively and narrowly available information can move prices closer to intrinsic values
- Increased ownership of stocks by hedge funds likely to possess such information leads to narrowing gaps between prices +
intrinsic values
- But extreme gaps can still occur, most pronounced among hedge funds using leverage

- Horizontal axis = measure of aggregate effort by digging exclusively + narrowly available

information, assembling mosaics of intrinsic values
- Vertical axis = index of price-equals-value market efficiency, measured by average width of
gaps between prices + intrinsic values  100-index number corresponds to market with no
gaps

NOBODY digs out information tiles when all prices are already equal to intrinsic values
 no incentive to dig out information tiles
- Cost of digging out information tiles + trading impedes price-equals-value markets
o Traders’ expected profits from efforts at beating markets at 100-index price-equals-value do not cover costs including
forgone income in alternative occupations
- Market where most traders are skilled at digging out exclusively + narrowly available information beat market, earning returns
equal to / exceeding cost
 - Traders less skilled quit when failing to earn returns  market converge to less than 100-index price-equals value status, e.g.
90-index where gaps are wide enough to let skilled traders beat market by magnitudes at least equal to costs

BUT UNCERTAINTY: uncertainty about estimates of intrinsic values + timing of convergence of prices to intrinsic values limits amounts
that rational and normal-knowledgeable traders are willing to bet on estimates of gaps between prices + intrinsic values

Gaps larger in some market than other  discrepancy due to costs of digging out information tiles + trading are higher in some markets
than others, including uncertainties

Costs are higher in markets of small-capitalization stocks and markets of

developing-countries stocks than in large capitalization + developed countries

Lower price-equals-value market efficiency = lower hard-to-beat market efficiency =

markets of small capitalization + developing-countries stock easier to beat? NO
- Costs of digging out information + trading can be higher in markets with
lower price-equals-value efficiency, opposing benefits of exploiting larger
gaps
 larger gaps likely a consequence of greater costs
- Market-sum rule holds equally in all markets  index investors in small-
capitalization + developing-countries’ stock markets earn market returns;
some investors beat market + higher returns, others are beaten + lower
returns

Fisher Black: “Solution to trading puzzle = trading by noise traders (normal-ignorant

traders)”
- But introduce noise into prices; cognitive + emotional errors, wants for
expressive + emotional benefits
- Noise drivers markets away from price-equals-value by increasing gaps
- Prices of investments where noise traders operate reflects information
trader on by information traders + noise that noise traders trade on

Increase in gaps between prices + intrinsic values as noise traders join information
traders
- High trading volume may indicate trading by noise traders impeding price-
equals-value markets, rather than trading by information traders promoting
price-equals-value markets
- Price investment with high trading volumes move more slowly toward
intrinsic values than prices of investments with low volumes

Noise traders can move stock + bonds prices powerfully e.g. by switching entire pension account balances between funds holding
mostly stocks + holding mostly bonds in attempts to “time the market”
 leads to increases and decreases of almost 2.5 percent in stock prices, more than .3 percent of bond prices
- Also evident in price movements following resurfaced old news, e.g. 2008 resurfacing of 2002 bankruptcy of United Airlines’
parent company  stock price dropped 76% within minutes

Traders can deliberately push prices away from intrinsic values which hampers price-equals-value efficiency
e.g. hedge funds manipulating stock prices at critical reporting dates
Pattern of movements clearly evident among funds with stronger incentives to improve ranking relative to peers

Bubbles in Rational and Hard-to-Beat Markets

- Positive bubbles: prices exceed intrinsic values 
- Negative bubbles: prices short of intrinsic values 
- There are no bubbles in pev markets 
- Can exist in htb markets, if investor do not recognize them in time and exploit them 
- Investors can suffer great losses, even if they recognize the bubbles, but when the timing is bad 
- Reasons for bubbles: 
- Quest for utilitarian, expressive and emotional benefits 
- Herding money managers; professionals often inflate bubbles more than amateurs 
- Cognitive errors of representativeness and confirmation: excessive extrapolation of prices and neglection of disconfirming
data, news amplified representativeness 
- Sentiment (bullish or bearish) has highest effect on small-cap because of difficulties in estimating the intrinsic value, and
also costly arbitrage 
- Market structures: e.g. restrictions on short selling 
- Castles in the air: investors buy at inflated prices with the expectation to sell at even more inflated prices 
- Emotional errors: positive affect leading to excessive hope; negative affect leading to excessive fear 
FORESEEING BUBBLES 
- Robert Shiller: it is possible, if bubbles are extreme 
- Eugene Fama: it is not possible 
- Crashes do not always follow booms, there are more often booms following crashes 
- Hindsight and confirmation errors obscure disconfirming evidence 
- CAPE ratio: cyclically adjusted P/E ratio, might indicate the inflation and deflation of bubbles 
- One should not try to exploit bubbles, because 
- In hindsight is the identification easier 
- Expected return of exploiting bubbles is rather small 
- Investors might not have enough patience and switch from Treasury bills to stocks in the wrong moments 

- Smart beta: center on portfolios whose allocations do not correspond to market capitalization; generate excess returns, which
is evidence that markets are not efficient 

Malmendier & Tate (2005): CEO Overconfidence and Corporate Investment

- Study investment decisions of CEOs who overestimate the future returns of their companies, measured by a failure to divest
company-specific risk on their personal accounts
- Findings: overconfident CEOs have a heightened sensitivity of corporate investment to cash flow; particularly among equity-
dependent firms
- 2 traditional explanations for investment distortions are the misalignment of managerial and shareholders interests +
asymmetric info between corporate insiders and the capital market
- Both cause investment to be sensitive to the amount of cash in the firm
- Under the agency view, managers overinvest to reap private benefits
- Under asymmetric info, the managers themselves restrict external financing in order to avoid diluting the undervalued shares
of their company

Imperfections in the capital market

- Proposition of an alternative explanation for investment–cash flow sensitivity and suboptimal investment behavior.
- Rather than focusing on firm-level characteristics, we relate corporate investment decisions to personal characteristics of the
top decision maker inside the firm.
- We argue that one important link between investment levels and cash flow is the tension between the beliefs of the CEO and
the market about the value of the firm.
- Overconfident CEOs systematically overestimate the return to their investment projects.
- If they have sufficient internal funds for investment, they overinvest
- If they do not have sufficient internal funds, however, they are reluctant to issue new equity because they perceive the stock of
their company to be undervalued by the market. As a result, they curb their investment.

Our overconfidence story builds on a prominent stylized fact from the social psychology literature, the better-than-average effect:
- Individuals attribute good outcomes to their actions, but bad outcomes to bad luck
- 3 main factors triggering overconfidence:
- The illusion of control
- A high degree of commitment to good outcomes
- Abstract reference points that make it hard to compare performance across individuals
- A CEO who hand-picks an investment project is likely to believe he can control its outcome and to underestimate the likelihood
of failure
- The typical CEO is also highly committed to good company performance since his personal wealth and the value of his human
capital fluctuate with the company’s stock price.
- Finally, assessing the ability to pick profitable investment projects is difficult

To construct measures of overconfidence, we exploit the overexposure of typical CEOs to the idiosyncratic risk of their firms.
- CEOs receive large grants of stock and options as compensation.
- Because of under-diversification, risk-averse CEOs should exercise their options early given a sufficiently high stock price
- First, we identify a benchmark for the minimum % in-the-money at which CEOs should exercise their options
 - If a CEO persistently exercises options later than suggested by the benchmark, we infer that he is overconfident in his ability to
keep the company’s stock price rising and Second, we look at the end of the option’s duration. If a CEO is optimistic enough
about his firm’s future performance that he holds options all the way to expiration, we classify him as overconfident.
- Finally, since underdiversified CEOs should also avoid acquiring additional equity, we classify CEOs who habitually increase
their holdings of company stock as overconfident

We find that CEOs who excessively hold company stock options do not earn significant abnormal returns over the S&P 500 on
average
- We show that investment–cash flow sensitivity is significantly higher for “late exercisers” or “stock purchasers” than for their
peers.
- Overconfident CEOs invest more when they have more cash at hand. Further, the sensitivity of investment to cash flow is
strongest for CEOs of equity-dependent firms,
- We provide evidence that CEO characteristics other than overconfidence have explanatory power for corporate decision
making.
- CEOs with an engineering education or employment background display higher investment–cash flow sensitivity, while CEOs
with a financial education exhibit lower sensitivity
- The sensitivity is higher for CEOs who assume multiple positions in their companies
- Caveat to results: Issue of endogeneity
- The overconfidence based explanation for investment distortions has a number of novel policy implications.
- Traditional theories, which link investment–cash flow sensitivity to capital market imperfections or misaligned incentives,
propose timely disclosure of corporate accounts or high-powered incentives as potential remedies.
- Our findings suggest that these provisions may not suffice to address managerial discretion.
- A manager whose incentives are perfectly aligned and who does not face any informational asymmetries may still invest
suboptimally if he is overconfident.
- Thus, refined corporate governance structures, involving a more active board of directors or constraints on the use of internal
funds, may be necessary to achieve first–best investment levels.

Model
- Assume that the manager maximizes current shareholder value
- The only friction in the model comes form the manager’s inflated perception of the firm’s investment opportunities
- Prediction 1: The investment of overconfident CEOs is more sensitive to CF than the investment of CEOs who are not
overconfident
- Prediction 2: The investment-CF sensitivity of overconfident CEOs is more pronounced in equity-dependent firms
- The empirical analysis consists of 2 steps:
- Construction of an empirical overconfidence measure
- Analysis of the relation between overconfidence and sensitivity of investment to CF (P1) + the change in this relation as equity
dependence increases (P2)
-
Overconfidence measures
Definitions
- We construct 3 measures of overconfidence: Holder 67, Longholder, Net Buyer
- CEOs are highly exposed to idiosyncratic risk of their company
- Unlike perfectly hedged outside investors, then, CEOs must trade off the option value of holding stock options against the
costs of underdiversification
- Risk aversion and underdiversification predict early exercise of executive options.
- Similarly, underdiversified CEOs, in order to divest themselves of idiosyncratic risk, should minimize their holdings of company
stock.
- Overconfidence, however, may lead CEOs to overestimate the future returns of their investment projects.
- Therefore, they believe that the stock prices of their companies will continue to rise under their leadership
- As a result, overconfidence induces them to postpone option exercise or even to buy additional company stock
- If an option is more than 67% in-the-money at some point in year 5, the CEO should have exercised at least some potion of
the package during or before the 5th year
- Longholder:
- We focus on the expiration date of option packages rather than the end of the vesting period.
- We classify a CEO as overconfident if he ever holds an option until the last year of its duration. As the typical option in the
sample has 10 years’ duration and is fully vested (at the latest) by year 5, the CEO chooses to hold, rather than exercise, the
option for at least 5 years.
- Net buyer:
- CEOs to purchase additional company stock despite their already high exposure

Discussion
- Traditional agency theory suggests that the incentive effect of stock and options will reduce investment-CF sensitivity – the
opposite prediction of our overconfidence model
- Alternative explanations of the measures:
- Inside information.
- A CEO may decide not to decrease exposure to company risk because of private information about future stock prices that
makes holding options or buying stock attractive.
- Inside information also predicts investment–cash flow sensitivity.
 - Since the information has not been incorporated into the market price, the firm’s stock is undervalued and investment may be
sensitive to cash flow for the usual reasons.
- One of the key distinctions between overconfidence and information is persistence.
- Positive information = transitory
- We would expect a CEO to sometimes hold his options (when he has positive inside info) + to sometimes exercise them early
(when he has negative info)
- The second key distinction between overconfidence and info is performance
- If positive info is the true reason for not diversifying the personal portfolio then CEOs who exhibit this behavior should earn
positive abnormal returns over a strategy of diversification
- On average, CEOs do not beat the market by holding options beyond the threshold
- Similarly, the average CEO does not consistently beat the market by holding options
- Thus, there is no evidence that positive info motivates CEOs who hold options beyond the theoretically motivated threshold
- Signaling
- = Another reason why CEOs may want to hold company risk is to convey a (potentially) costly signal to the capital market that
their firm’s prospects are better than the prospects of similar firms
- Signaling should alleviate informational asymmetries and thus eliminate investment-CF sensitivity among the firms in which
CEOs hold their options
- Moreover, the usefulness of option exercises as a signaling device is doubtful
- Risk tolerance
- A CEO may hold his options beyond the threshold because he is less risk averse and, therefore, less affected by
underdiversification
- If anything, however, lower risk aversion should predict lower investment-CF sensitivity since less risk averse managers
should be more willing to lever up the firm
- Tax reasons:
- An option holder may postpone exercise to delay the payment of taxes on his profits.
- Personal income tax deferral, however, would not predict higher sensitivity of investment to cash flow among holders, nor does
it apply to additional stock purchases.
- Procrastination.
- Finally, CEOs might hold options until expiration if they are “inertial” in the sense that Inertia on their personal account may
carry over to the corporate account of the firm in a reluctance to conduct equity issues
- We find, however, that more than 8% of the CEOs classified as overconfident under the Longholder measure conduct other
transactions on their personal portfolios in the two years prior to the year their “longheld” option expires.
- CEOs are significantly more likely to conduct acquisitions than their peers and, thus, do not appear to procrastinate on the
corporate account. Finally, an inertial CEO should not habitually purchase company equity

Test 1: Overconfidence and investment

Holder 67
- CEOs who own a higher percentage of their company— both in company stock and in options—display a smaller investment-
to-cash flow sensitivity.
- Thus, high ownership may indeed mitigate agency problems,
- We also find that Q has more impact on investment for higher levels of
- cash flow
- If current cash flow measures the success of past investment decisions, this result suggests that more successful companies
are more responsive to investment opportunities in determining the level of their investment.
- Corporate governance slightly increases investment–cash flow sensitivity.
- This effect, however, appears to be linked to the subsample of relatively
- successful firms in these regressions.
- Finally, larger firms have significantly less sensitivity of investment to cash flow than smaller firms.
- One interpretation of this result is that size captures the effects traditionally attributed to financing constraints in the
investment–cash flow sensitivity literature.
- As predicted by our model, CEOs who demonstrate a higher level of overconfidence than their peers in their personal portfolio
decisions also exhibit a higher sensitivity of corporate investment to cash flow.
- We also examine the effect of holding options that are between zero and 50% in-the-money and find an insignificant negative
effect on investment–cash flow sensitivity.
- Thus, as predicted, increased investment–cash flow sensitivity comes only from holding highly in-the-money options.
- Our overconfidence measures are most associated with the CEOs who appear to be overconfident rather than well informed
- Overall, then, inside info does not appear to drive our results

Longholder
- Q appears to positively impact the sensitivity of investment to cash flow.
- Also, as before, equity ownership and firm size are negatively associated with investment–cash flow sensitivity.
- Vested options now positively impact investment–cash flow sensitivity.
- This positive correlation may indicate that CEOs with high ownership in vested options are more reluctant to dilute existing
shares
- Longholder CEOs have higher sensitivity of investment to cash flow
- We conclude that an overconfident CEO will increase investment more when CF increases than his less confident peers
Net buyer
- CEOs are classified as overconfident based on their stock purchase decisions during their first five years in the sample
- The effect of Q interacted with CF is now negative + marginally significant
- Though this result is difficult to interpret, it is not relevant for our results
- The most important finding is that being a Net Buyer increases the sensitivity of investment to CF
- Overall, overconfidence increases the sensitivity of investment to CF under any measure

Test 2: Overconfidence and financial constraints

- We show that overconfidence should matter most for firms that are equity dependent
- If a firm has a sufficient amount of cash or untapped debt capacity to finance all of the CEOs desired investment projects, then
CF may not affect the level of investment
- If a firm must, instead, access the equity market for additional finance, overconfidence should have an impact on the sensitivity
of investment to CF
- Overconfident CEOs are more likely than other CEOs to raise debt (rather than equity) to cover financing needs
- Thus, both predictions of our simple model of overconfidence are confirmed in the data

Other personal characteristics

- Relation between overconfidence and other observable executive characteristics: educational + employment background, birth
cohort, accumulation of titles within the company
- CEOs with technical education have more investment-CF sensitivity than CEOs with general education while CEOs with
financial education have less
- CEOs who belong to the Great Depression birth cohort have more investment-CF sensitivity
- In addition, CEOs who have accumulated additional titles display heightened sensitivity of investment to CF
- We conclude that more conventional “style” effects, rooted in the CEO’s background, may be important for determining
investment policy.
- However, overconfidence is distinct from these observable CEO characteristics.

Conclusion
- The main goal of this paper is to establish the relation between managerial overconfidence and corporate investment
decisions.
- Our analysis consists of three main steps:
- First, we derive the prediction that the sensitivity of investment to cash flow is strongest in the presence of overconfidence.
- We then construct three measures of overconfidence:
- Does the CEO hold his options beyond a theoretically calibrated benchmark for exercise?
- Does the CEO hold his options even until the last year before expiration?
- Does the CEO habitually buy stock of his company during the first five sample years?
- Whenever the answer to one of these questions is yes, we classify a CEO as overconfident.
- We then regress investment on cash flow, the overconfidence measure
- We find a strong positive relation between the sensitivity of investment to cash flow and executive overconfidence.
- We also find that overconfidence matters more in firms that are equity dependent
- These results have important implications for contracting practices and organizational design.
- Specifically, standard incentives such as stock- and option-based compensation are unlikely to mitigate the detrimental effects
of managerial overconfidence.
- As a result, the board of directors may need to employ alternative disciplinary measures, such as debt overhang, which can
suffice to constrain overconfident CEOs.
- In addition, the results confirm the need for independent and vigilant directors

Khaneman (2011): Thinking, Fast and Slow: Chapter 24

Heuristic #25: THE OPTIMISTIC BIAS.
 We are prone to neglect facts, others’ failures, and what we don’t know in favor of what we know and how skilled we are
 We believe the outcome of our achievements lies entirely in our own hands while neglecting the luck factor
 We don’t appreciate the uncertainty of our environment
 We suffer from the illusion of control and neglect to look at the competition (in business start-ups for example). “Experts who
acknowledge the full extent of their ignorance may expect to be replaced by more confident competitors, who are better able to
gain the trust of clients,”
 Being unsure is a sign of weakness so we turn to confident experts who may be wrong
 Potential for error: unwarranted optimism which doesn’t calculate the odds and therefore could be risky