Experimental and Behavioral Finance

Lecture 2: finance.

Learning objectives
1. ‘behavioral’ is a deviation from a ‘rational’ benchmark. What is considered ‘rational’
behavior in economics/finance?
2. Assumptions and theories about individual behavior.
a. Decision making (EUT: Expected Utility Theory)
3. Consequences on aggregated level
a. Asset prices (CAPM)
b. Market efficiency (EMH)

Model Homo Economicus

If economic agents were as rational as defined in theory, markets could be left to their own
devices without any serious imbalances emerging or bubbles forming.
The homo economicus acts out of:
1. Self interest
2. Rational behavior
3. Maximizing personal utility
4. Reaction to constraints
5. Fixed preferences: it means that if you like beer better than wine, it will always be
this way.  HOWEVER, preferences change
6. Complete information

Self interest
- Own well-being; no fairness concerns
- Only interested in non-social material goods

Rational
- Consistent beliefs (perception/ processing/ updating information)
- Consistent preferences
- Consistent action

Informed
Agents do not know what the future holds.
- Agents are fully informed of their alternative courses of action
- Can access the repercussions and consequences of those actions, weighted by
probabilities of occurrence.

Criticism
Humans do not behave like this, other factors play a role. (no underlying, unifying theory of
behavioral econ/finance). Why do we see this homo economicus so often then? Because it
was conceptualized to come up with economic models to predict macroeconomics! The
criticism is based on the misconception that the homo economicus model seeks to explain
the behavior of individuals.
 It is rather a model of aggregate behavior; deduces from the sum of people’s individual
decision statements on macroeconomic aggregates such as consumer demand. It is often
used because it is easy to calculate.
Experimental and Behavioral Finance

Financial decision making

Knowing or learning about your buying price, it shouldn’t matter at all because one should
focus on the future. However, more than 50% of the humans still consider their buying
price.
 Disposition effect: don’t want to sell against a loss, do want to sell at a gain.

Diminishing increase of utility per extra product. 30 diamonds still give you more utility than
2 diamonds. However, the utility increase of 1 to 2 diamonds was way bigger than the one
of 29 to 30 diamonds.

Dealing with the probabilities

Bayes’ rule deals with updating probabilities after observing a signal. You take the signal into
account to update your prior belief about the probability. (However, information isn’t that
available to really apply this to real life + people make mistakes).

How to combine probabilities and outcomes?

It depends on who’s behavior you model. For individuals, probably not since individuals
behave risk averse. However, firms etc. care about the expected value (they think rationally)
because they can back it up with numbers. They have enough capital to not be too risk
averse.

Saint Petersburg Paradox

Peter tosses a coin and continues to do so until it shows heads. He agrees to give Paul one
ducat if he gets heads on the very first throw, two if he gets it on the second etc. so that
with each additional throw the number of ducats he must pay is doubled.

For the first throw, there is a 50% chance of getting one euro, a ¼ of getting it on the second
etc. So, it can go on till infinity.

If you were a casino, you should be willing to participate playing this game if people have
money to back it up. So, in general, people dislike it. Even if you know they could pay out
you wouldn’t pay too much since people are risk averse.
Experimental and Behavioral Finance

What are alternative rules we could choose?

For decision theory, expected utility comes into play. It has an axiomatic foundation
(completeness, transitivity, continuity, independence)

Risk aversion
Frequent observation: people are mostly not willing to accept a fair gamble.
Risk seeking would be problematic (systematically lose money, so rejecting a risk gamble is
sensible). Because you could accept unfair gambles and systematically lose money.

Expected utility of a prospect

You would only accept it when the utility of the expected value is higher than the expected
utility.

Certainty equivalent and risk premium

Certainty equivalent is defined as a wealth level which leads decision-maker to be
indifferent between a particular prospect and a certain wealth level.

how costly is that risk of participating?  risk premium

Experimental and Behavioral Finance

Allais paradox
 Allais paradox is a choice problem to show an inconsistency of actually observed
choices with the predictions of expected utility theory.
 The paradox shows that individuals prefer certainty over a risky outcome even if this
defies the expected utility axiom.

E.g.
Lottery A: $1 million 11% of the time and $0 89% of the time.
Lottery B: $5 million 10% of the time and $0 90% of the time.

Think for a moment about which you prefer. Write your answer down.

Now consider these two other lotteries:

Lottery C: $1 million guaranteed

Lottery D: $5 million 10% of the time, $1 million 89% of the time, and $0 1% of the time.

if you said that you preferred the $1 million, you also said that you preferred Lottery A and
must therefore prefer Lottery C. Alternatively, if you said you prefer $5 million with
probability 10/11 and $0 with probability 1/11, you also said that you preferred Lottery B
and must therefore prefer Lottery D.

Modern portfolio theory (MPT by Markowitz)

Goal: construct optimal individual portfolio (CAPM)
Key assumptions:
- Risk-averse investors
- Returns are normally distributed
- Investors care about mean return and variance ONLY
- Future return distributions are known – decision under risk
- Assets are tradable (sufficient liquidity)
- No transaction costs

CAPM capital asset pricing model

Equilibrium model:
- Brings together all investors
- Specifying a relation between expected rates if return and covariance of all assets

If everyone in the economy holds an efficient portfolio, then how should securities be priced
such that all securities are bought?
Experimental and Behavioral Finance

Any beta smaller than one would reduce the risk  Return would be lower.

Critique
The use of the CAPM is favored for its simplicity: it is an effective tool for introducing
concepts of portfolio theory and asset pricing. However:
- It’s not very predictive of the market. The prediction of the CAPM that the market
risk premium is a significant explanatory variable in the determination of the asset
risk premium is rejected.

Market efficiency
Capital markets allocate resources to their best use.
- Markets transfer funds from lenders (have money) to borrowers (good investment
opportunities, no money).
Efficient capital market
- Lenders earn higher risk adjusted returns
- Borrowers do not have to forgo profitable opportunities
The prices are right.

Market efficiency and information

Seminal paper: Fama (1970): a market in which prices always fully reflect all available
information is called efficient.
Malkiel (1992):
- A capital market is said to be efficient if it fully and correctly reflects all relevant
information in determining security prices.
- Formally the market is said to be efficient with respect to some information set if
security prices would be unaffected by revealing that information to all participants
- Moreover, efficiency with respect to an information set implies that it is impossible
to make economic profits by trading based on that information set.

Weak form efficiency – prices reflect all information contained in historical returns.
Semi-strong efficiency – prices reflect all relevant information publicly available.
Strong form efficiency – prices reflect even insider information.
Experimental and Behavioral Finance

What if markets are efficient?

- If markets are efficient, no one should be able to predict the market. That is because
if a piece of information about future markets existed, it would already be in the
price so no prediction would be possible.
- No investor can consistently make excess returns!
- Security prices should respond quickly and accurately to new information
- Professional investors should not outperform net of all fees (active money
management is useless!)
- Ex post simulated trading strategies should fail
- Stock market is unpredictable: history plays no role, the current price is the best
predictor
- No systematic evidence of profitability of technical trading strategies

Joint hypothesis problem

All tests of market efficiency have two maintained hypotheses:
1. Markets are efficient
2. A fair return on a security or portfolio is from a particular model; e.g. CAPM

In case you reject, what does it mean? There are some possibilities:
- Markets are not efficient?
- Pricing model is wrong?
- Or both? But which? Joint hypothesis problem!

Information paradox:“If all available information would be immediately and fully

reflected in prices, nobody had an interest in producing information (because
making money by use of the information would not be possible). But then prices
could not reflect this information.”

Efficient market hypothesis

Experimental and Behavioral Finance

Joint hypothesis problem

If it is true that markets are efficient, we come to the joint hypothesis problem. The only
way to test whether the market is efficient, is to test whether the prices are right. If you find
that the price is at the correct level, you can assume the market is efficient. If it is deviating,
it is inefficient.

The issue is: we need a model to make this statement. We need to have a benchmark. But
as soon as we know that, we have two maintained hypotheses:
1. Markets are efficient
2. A fair return on a security or portfolio is from a particular model e.g. CAPM

Is the market efficient, or is the model, right? It could be that the market is efficient, and we
are not rational enough to see that the price should be this extreme because our model is
wrong. In case you reject, what does it mean??
- Markets are not efficient
- Pricing model is wrong
- Both? But which?  Joint hypothesis problem!

Do inefficient markets exist?

Deviations from efficiency e.g. New Economy Bubble
 Prices were too high relative to fundamental values
 Money was invested in over-valuated securities (i.e. wrong investment opportunities
chosen)

Fama Welch
Repeated unsubstantiated use of the term The internet bubble was a bubble, even if I
internet bubble have no scientific proof (joint hypothesis)
(If we look at the data and accumulate all I lost a lot of money and couldn’t afford to
IPOs) Is it unreasonable that the equivalent hold on. In time, that too, was a bubble.
of two Microsofts would eventually emerge This is not just ex-post for me.
from the tech and internet related IPOs?
(These actually did emerge: FaceBook,
Google)
Some traditional financial theories are just difficult to prove: inefficient or efficient market.

Stiglitz
Information paradox: if all available information would be immediately and fully reflected in
prices, nobody had an interest in producing information, because making money using it
would be impossible. But then prices could not reflect this information.
But why would it work (efficient market hypothesis):
 Rational behavior: If everyone behaves rationally, prices would be right.
 Uncorrelated errors: even if there are people in the market who trade against too
high or too low prices, they would cancel each other out.
Unlimited arbitrage: any correlated error or irrational behavior will be driven out by those
who do behave rational by trading at the right price.
Experimental and Behavioral Finance

Lecture 3: From normative to descriptive empirical anomalies

Data
There is a lot of available data. Every second there is hundreds of trades going on. You can’t
possibly test all the data at once. Selections have to be made.

Common types of financial analysis

Financial market data is usually panel data, which consists of
 Time-series: years, months, weeks (
 Cross-sectional: companies, currencies, funds
Proprietary data to study certain aspects of the financial decision process:
- Individual trading data from stock brokerage firms
- Self-administered questionnaires
- Company-specific information

Equity carve-outs
Are basically an IPO from within a publicly traded company. Some part of that company is
growing so fast that a separate IPO is made for it.
Usually, with an IPO you have a private company that goes public, with an equity carve-out,
you don’t really know how much value it holds; however, you do know that the company
should be at least as much as the carved-out part.

However, in reality, the palm shares (carve-out) were higher than the one of the original
companies.

The market didn’t set the right prices!

Twin-shares
Prior to its 2005 unification, the Royal Dutch Shell group was jointly held by two holding
companies (aggregate dividends were divided according to ownership 60:40):
- Royal Dutch Petroleum
- Shell transport
Two companies that are publicly traded with a joint venture.
Experimental and Behavioral Finance

Equity premium puzzle

Return on equity is too high relative to returns on risk-free assets like bonds.
What does too high actually mean?
 If investors have EUT preferences and market is in equilibrium, they would have to
be extremely risk averse
 In fact, they would have to prefer P(52.000)>P(50%, 50.000, 100.000)
Potential explanations
 Loss aversion instead of risk aversion: people want to avoid losing money
 Transaction costs: this lowers the EPP, it doesn’t solve it
 Tail risks (non-normally distributed risks): maybe not assessing risk correctly

Long term reversal

De Bondt and Thaler (1985)
It seems like past winners (stocks that perform well), would become future losers (stocks
that perform bad). And past losers, would become future winners.  long term reversal
According to EMH the past doesn’t matter for the future expectations, however, De Bondt
and Thaler show different (violation to weak EMH):

The formation period is 36 months

before buying the stock and the
evaluation period is 60 months after
buying the stock.

Comparing the stocks: significantly the loser portfolio is higher than the former winner
portfolio.  long term reversal.
Experimental and Behavioral Finance

The market isn’t efficient, otherwise this phenomenon wouldn’t come up time to time
again. IF the market was perfect, everyone would do this. Therefore, there is a violation of
the weak market efficiency.

Reactions to events

Overreacting: acting upon a piece of

information more extremely than you
would have to.

Underreaction: acting upon a piece of

information less extremely than you would
have to.

Psychology also plays a role: emotions etc.

Medium term momentum

Momentum is based on underreaction

The winner portfolio outperforms the loser portfolio in the short run.

Proposed explanations
Reactions to recent earnings announcements (last 6 months/last year)
 Market underreacts to information about the short-term prospects of firms
Positive feedback trades
 Traders look at what happened in the very short term, and they expect this to
happen in the future too.
 Does technical analysis suggest SR momentum?
Remember the initial example:
 Disposition effect: sell winners, hold losers
o If people sell the winners too early, they are sold at a lower price than
potential. Vice versa with losers. This means that the momentum strategy
might work.
 Momentum strategy: sell losers, buy winners
Experimental and Behavioral Finance

Brief digression – disposition effect

A lot more gains were realized.

Rules to earn money?

Momentum rules: positive autocorrelation in returns
Create zero-cost arbitrage portfolios by
- Buying past 3-12 months winners
- Short selling past 3-12 months losers (hold for next 3-12 months)
Contrarian rules (negative autocorrelation in returns)
- Buying past 3-5 years losers
- Selling past 3-5 years winners (hold for next 3-5 years)

Reactions to earnings announcements

How to test over-/underreaction more directly?
Make use of new information entering the market
 earnings announcements (most economists agree that earnings are a good estimate of
the value of a company)
Experimental and Behavioral Finance

Calendar effects
Returns at specific time intervals during the year differ from reference returns:
 January effect: buy in December, sell in January  persistent (because of taxes)
 Halloween effect: sell in May, buy at Halloween
 Weekend/Monday: sell in the weekend and buy again on Monday

Overreaction/ underreaction!!!
Experimental and Behavioral Finance

Lecture 4: Limits to arbitrage (EMH)

Unlimited arbitrage
As long as there are a few people who are rational and have some form of rational
expectations of the price, they can leverage their knowledge, get funding, use all the money
to drive the price to the correct one (at the same time make more money). This drives the
nonrational beings out of the market since they will be losing money.

Herding
Herding: include any behavior similarity brought about by the interaction of individuals.
People want to do similar things to others who they look up to or their peers etc.

Rational arguments:
- Payoff externalities: if you are in a network, it makes sense to behave similar to the
people in your network too because you will get judged for your payoff.
- Sanctions: punished by peers if you buy war stocks
- Preference interactions: en vogue to buy green stocks
- Direct communication: trust judgment of peers
- Observational influence: imitation because you honestly think it is a good strategy.

Investor sentiment
Sentiment = noise that is correlated among investors
- Attention-grabbing stocks (e.g. Tesla, Coca-Cola), mood including events
If sentiment is driving prices, prices move farther and farther from fundamental value.
- Sentiment index based on trading activity predicts future stock returns.
o E.g. researching the type of music traders listen to (Spotify)
- Attention measure of sentiment: google search volume index.

Errors ARE correlated  rules out the second pillar of EMH

 Evidence for correlated errors by Barber, Odean and Zhu (2009)
 Divide investors arbitrarily into two groups
 If trading decisions were independent across investors, they would be uncorrelated
across groups
 Mean correlations of stock purchases: 73% (75%) for discount (retail) investors
 If you know what one group of investors is doing, you know a great deal about what
another group is doing
 Stocks heavily bought by individual investors one week earn strong returns
contemporaneously and in the subsequent week.  some sort of spread
Experimental and Behavioral Finance

Three pillars: unlimited arbitrage

Rational agents will take advantage of irrational traders and irrational agents will lose
money. Irrational agents will exit the market and not affect market outcomes in the long
run. Only works with unlimited arbitrage! However, arbitrage IS limited.

Limits to arbitrage – the general idea

Arbitrage: one of the central tenets of financial economics
- Enforcing the law of one price, keeping markets efficient
- Purest form: no capital required/risk-free
- But can be both risky and costly in reality!

Fewer incentives/ possibilities to exploit mispricing

- Pronounced mispricing might persist (even worse). Once we accept that;
- Prices are not necessarily right!

Arbitrageurs have limited risk capacity!

1) Clients’ money: manage other people’s money, others may redraw their funds
2) borrowing constraints: cannot leverage infinitely
3) illiquid markets: no one who wants to buy your stock
4) access to markets: it can be costly to trade in different markets.

What are the limits to arbitrage?

Arbitrage is risky
1. Noise trader risk: noise traders drive the price away.
2. Model risk: the model you are using is wrong.
3. Fundamental risk: fundamentals might change in between times.
4. Synchronization risk: you may not be strong enough by yourself as an arbitrageur.
Arbitrage is costly: cost to implement arbitrage strategy

Noise Trader Risk

Refers to the risk that mispricing worsens in the short run. That is because there is a
possibility that pessimistic traders become even more pessimistic about the future.
Mispricing can remain for a long time in the market.
- Do arbitrageurs have a long horizon? No: they trade other people’s money
- Markets can stay irrational longer than you can stay solvent – Keynes

Schleifer and Vishny: Why does Noise Trader Risk matter?

Because it can force arbitrageurs to liquidate their positions since the money isn’t theirs.
This is relevant because most real-world arbitrageurs manage other people’s money. In the
model:
 Investors lack the specialized knowledge to evaluate the arbitrageur’s strategy 
investors simply evaluate arbitrageurs based on current returns.
 If mispricing worsens in the SR:
o Negative returns  Investors withdraw funds  Arbitrageurs are forced to
liquidate positions
 Consequence: fear of such liquidation dampens incentives to engage in arbitrage
strategies in the first place
Experimental and Behavioral Finance

Different trader types

Arbitrage traders
 Smart guys
 Use fundamentals – earnings, balance sheets, etc.
 Discounted cash flow or other methods

Noise traders
 Dumb guys
 Follow price trends, charts, hunches
 Follow herd, Feedback traders
 Random buyers and sellers
 noise traders are good for the economy; provide liquidity to the market. Not good for
market efficiency; mispricing.

Survival of noise traders

Long history argument: rational traders kick noise traders out of the market, by taking their
money when they trade at incorrect prices. (Friedman, 1953)
Problem: ability of arbitrageurs to correct mispricing
 Short term horizon (Shleifer & Vishny, 1997)
 Risk aversion (face noise trader risk)
Consequence: noise traders survive in the long run. They are not driven out of the market.
 price behaves according to what the noise traders do.

Model risk
The risk that arbitrageurs are using an incorrect model. They always use a simplified version
of reality, which leads to the risk that something will fail to be accounted for.
 How to evaluate returns? CAPM?
o But is the model calibrated correctly? Does it map the relevant parts of
reality, in the right way?
 Arbitrage is possible if prices deviate from fundamental value
o What if you have a bad model and the market value is correct?
o Risk for arbitrageur: having wrong predictions about prices

What might be mis-calibrated?

Believe that an asset is over/undervalued
 Model wrong? Price right?
Believe that future dividends follow a certain path or have the right discount factor
 Model wrong? Is discounted cash flow wrong?
Believe that assets are close substitutes for hedging purposes
 Model wrong? Close substitutes are not close?
Experimental and Behavioral Finance

Fundamental risk
the risk that fundamentals change as soon as time passes.

Barberis and Thales (2003)

The most obvious risk an arbitrageur faces. If he buys Ford’s stock at (the undervalued price
of) $15, if there is a piece of information about Ford’s fundamental value causes the stock to
fall further, this leads to future to losses.

Examples
 Hedging part of the risk using substitutes (industry risk)
 Investor is exposed to different sources of risk (market risk, industry risk, firm-
specific risk)
Example: buy Meta at bargain price (Long), short sell substitutes (Yahoo, Google, Amazon)
- Industry goes up (long meta gains, short position loses)
- Industry goes down (long meta loses, short positions win)
- Firm specific: meta price moves towards fundamentals, no impact on short position
 arbitrage pays off.

Synchronization Risk
Many sophisticated traders in the market cause bubbles to burst before they really get
under way. (Friedman, 1953; Fama, 1965)

Speculative attack against the upward trend:

Go short to exploit overpricing profits for prices going down to fundamental
 competition brings prices down to fundamental value: who starts the speculative attack?

What happens if you start, and no one joins? Competitors able/ willing to sell short? Not
willing to synchronize on short selling?

Timing game
When will behavioral traders be overwhelmed by rational arbitrageurs?
Collective selling pressure of arbitrageurs more than suffices to burst the bubble.

Rational arbitrageurs understand that an eventual collapse is inevitable. But when? Delicate,
difficult, dangerous TIMING GAME!
 Price increases with exponential growth rate (bubble is forming)
 Arbitrageurs subsequently become aware of price bubble, creating selling pressure
 action: short selling?
o Short sell too early:
 Other arbitrageurs still do not realize there is a bubble
 Price continues to increase
 Risk of a margin call
o Short sell too late:
 Bubble burst
 No extra gain
 Potential losses from holding shares
Consequence: sequential awareness leads to delayed arbitrage  persistence of bubble
Experimental and Behavioral Finance

Implementation costs
 Commissions
 Execution risk: simultaneous buying and selling generally impossible
o Risk of price movement between selling and buying
 Counterparty risk
o Fails to meet her obligation in the future
 Market liquidity risk
o Liquid security: low bid-ask spread, small price impact, high resilience  easy
to trade
o Associated risk: liquidity worsens when you need to unwind
 Funding liquidity risk: available funding; own capital, clients capital, collateralized
loans
o Associated risk: trader cannot fund current position anymore and is forced to
unwind
 Short sale constraints
o Borrowing the underlying security from someone at an additional cost
o Right of lenders to close out positions at any time
o Risk of short squeeze
o Collateral – risk of margin call

Summary
Experimental and Behavioral Finance

Lecture 5: prospect theory

Normative baseline Expected Utility Theory

How individuals should act when confronted with decision-making under risk. However, the
results are not in line with EUT. How to deal with observed phenomena that go against
rational assumptions in EUR?  prospect theory
 Completeness (A>B)
 Transitivity (A>B, B>C  A>C)
 Continuity (A>B>C)  pA + (1-p)C = B
 Independency (A>B)  pA + (1-p)C >> pB + (1-p)C

Risk premium – the difference between the expected value and certainty equivalent. The
positive outcome means risk adversity. The risk premium tells us the amount at which an
individual is indifferent between prospect and expected prospect.

Prospect theory (Kahneman & Tversky) – this paper presents a critique of EUT as a
descriptive model of decision making under risk, and develops an alternative model, called
prospect theory.

Allais Paradox (Kahneman & Tversky, 1979): choice problem to show an inconsistency of
actually observed choices with the predictions of expected utility. Explained by experiment.
The individual chooses between:
Gamble A: 100% chance 100mio
Gamble B: 10% chance 500mio
89% chance 100mio

And amongst:
Gamble C: 11% chance 100mio
89% chance of nothing
Gamble D: 10% chance 500mio
90% chance of nothing

EUT means that A>B should also mean C>D. Study shows that individuals would choose A>B
but C<D. in the first gamble, security is chosen over utility. In the second vice versa.

Common consequence effect/ common ration effect: defines a class of choice problems in
which choices shift as the probability is moved from one common consequence to another.

Reflection effect: reflection at zero reverses the preference order. Risk-averse in gain and
risk-seeking in the loss domain.

Certainty effect: when the winning probability is substantial, most people choose a lower
outcome. When the winning probability is negligible, most people choose a higher outcome.
Experimental and Behavioral Finance

Isolation effect:

Reference points: the situation where you start out with, to see gains and losses. At this
particular point, you decide whether something is good or bad: the cross line.
 Relevant aspect: people react different to gains than to losses!
 People are loss averse  losses are felt stronger than gains
 People are risk averse for gains and risk seeking for losses

Losses loom larger than gains

Prospect theory
 Decide between lottery or sure gain
o Pick lottery if sure gains < 2.00
o Pick sure gains if > 2.00
 Certainty equivalent  1.75
o Pick lottery at 6.50  risk seeking
o Pick sure at 0.50  risk averse
 Risk premium = EV – CE

Gain  risk-averse at high probability but risk-seeking at low probability

Loss  risk-averse at low probability but risk-seeking at high probability

Key aspect of observed behavior

1. People exhibit risk aversion and risk seekingness, depending on the nature of the
prospect.
2. Peoples’ valuations of prospects depend on gains and losses relative to a reference
point. This reference point is often the status quo.
3. People are averse to losses because losses loom larger than gains.
Experimental and Behavioral Finance

PT theoretical framework
How to make sense of all these phenomena that go against rationality assumptions of EUT?
 KT presented a theoretical framefork to incorporate the phenomena
 ‘’.. an alternative account of individual decision making under risk, called prospect
theory.’’ (Kahneman & Tversky, 1979)

Two phases in the choice process

 Editing phase
o Coding: Reference point correspondents to the current asset position  but
what does current mean?
o Combination: Prospects can be combined.
 P(25%, 3000; 25%, 3000; 50%, 6000)  P(50%, 3000; 50%, 6000)
o Segregation
 P(25%, 1000; 800)  800 + P(25%, 200)
 P(25%, -80;-30)  -30 + P(25%, -50)
o Cancellation: discards common constituents, choose between probabilities.
o Simplification: simplify complex situations
 P(49%, 101)  P(50%, 100)
o Detection of dominance: Detect and discard dominated prospects


Editing operations may permit or prevent the application of others.  order may play a
role.
Anomalies found can be due to different editing procedures on the same prospect. E.g.
neglecting common consequences may lead to the Allais paradox.

 Evaluating phase  where is the reference point?

o Value function: v(z)
 Z is a deviation from a reference point
 Gain zomain z>0 vs loss domain z<0
o weighting function
 Pi associates decision weight pi with probability p.

Risk-taking after gains and losses

 Break-even effect
o When risk increases after losses; when you lack behind people often take
more risk
o Horse racing: more bets are made at the end of the day
 House money effect
o When risk increases after gains
o The more money you made, the higher the distance to the loss domain
Experimental and Behavioral Finance

Lecture 6: Experiments in economics and finance

Science (financial) economics?

Social science vs natural science
 Social science is concerned with society and the relationships among individuals
within a society
 Natural science is concerned with the description, prediction, and understanding of
natural phenomena, based on empirical evidence from observation and
experimentation.

Normative: what is ought to be (EUT)

Positive: what IS (Prospect theory?)

Methods
Qualitative: refers to the meanings, concepts definitions, characteristics, metaphors,
symbols, and description of things ‘’and not to their’’ counts or measures.  room for
interpretation
Quantitative: systematic empirical investigation of observable phenomena via statistical,
mathematical or computational techniques.

What is experimental finance?

‘’ Finance does not need experiments, because we have a lot of data ‘’
However, in the experiments, we control the variables. We know exactly what people do
and we know the fundamental value. In the real world, this is not the case.

Experimental finance is:

- The design, implementation, and analysis of synthetic settings,
- In which human subjects make decisions,
- For the purpose of answering one or more Research Questions

Simple two-treatments example

Starting point:

H 0 : X G ≥ X T vs H A : X G < X T
X G =$ other

X T =$ other X =α + β × DT +ϵ

Take less money for the decision maker.

Experimental and Behavioral Finance

Key parameters
 Players: number and type
 Experimental rules: allowable actions by players that govern interactions and actions
players can take
 Information and information availability: who knows what when
 Payoff functions: transform choices into monetary payoffs

Vernon Smith’s induced value theory

Key methodological innovation of experimental economics: rewards in experiments are not
correlated with confounding personal characteristics. What type of incentive/reward works?
1. Monotonicity: more is better than less (assumes people react on rewards, utility)
2. Salience: subjects are aware of and care for changes in rewards received (2$ vs 10$)
3. Dominance: variations in rewards valued higher than variations in other
experimental outcomes (monetary consequences have a stronger effect than other
consequences)

Typical laboratory experiment

 Students (are not that expensive)
 Anonymous interaction player A (VS role playing)
 Context free
 Repetition
 Performance based payoffs

Integration into mainstream economics

 Test theoretical models (and support?)
o Nobel prize economic sciences 1994: Harsanyi, Nash, Selten
 (Lab in the) Field Experiments: more realistic? We change circumstances. People
behave in the field, and they don’t know they are in the experiment.
 Institutions and political economy
 Preferences: too broad area of preferences (they form the utility functions, so
essence of economics). How to measure such preferences and how do they affect
behavior?
 Norms
 Discussion of results: comment, reply

Test theoretical models (and support)

Experimental and Behavioral Finance

Not that established yet.

(Lab in the) field experiments: more realistic?

Study extreme situations (emotions, stress, ..) or trader characteristics

Anecdotal and indirect empirical evidence suggest that excitement and market bubbles are
intertwined, such that excitement not only arises during bubbles but may also help fuel
them. We directly test the impact of excitement on bubbles in a bubble-prone experimental
asset-pricing market ( Capinalp, Porter, and Smith, 2001 ). Prior to trading, participants are
assigned to emotion inductions through video clips The results of fifty-five markets show
larger asset pricing bubbles in magnitude and amplitude in the excitement treatment
relative to a treatment of same valence and lower intensity (calm) and a treatment of
similar intensity and opposite valence (fear).

Using laboratory experiments, we provide evidence on three factors influencing trader

performance: fluid intelligence, cognitive reflection, and theory of mind (ToM). Fluid
intelligence provides traders with computational skills necessary to draw a statistical
inference. Cognitive reflection helps traders avoid behavioral biases and thereby extract
signals from market orders and update their prior beliefs accordingly. ToM describes the
degree to which traders correctly assess the informational content of orders. We show that
cognitive reflection and ToM are complementary because traders benefit from
understanding signals’ quality only if they are capable of processing these signals.
Experimental and Behavioral Finance

Wind tunnel experiments

 Collaborate with industry: test beds for market design
 1) theory
 2) tested in laboratory
 3) implemented in a big hall (300 people)
Example:
 Theory, design, laboratory experimental testing, field implementation and results of
a large, multiple market and policy constrained auction
 The auction involved the sale of 18788 ten-year entitlements for the use of
electronic gaming machines in Victoria  176 interconnected markets for 363
potential buyers with more than $600M in revenue

Community
 ESA: Economic Science Association
 SEF: Society for experimental finance

What is an experiment?
 Decision making situation
 Compare conditions (treatments)
 Change one variable at the time (treatment variable)

 Market level: manipulate institution and compare price performance

o Permitting margin purchases increased prices
o Permitting short selling decreased prices
 Individual level: manipulate incentives and compare investments
o Convex incentives increased risk taking for others
 Relevant: ceteris paribus (all other things being equal)
o Randomized controlled trials (RCT)
o Change in one variable, not more! Or control (joint hypothesis)

Again: relevant to distinguish!

 Subjects randomly assigned to treatments
 Two or more conditions (control, treatments)
 Manipulate only one treatment variable

What is NOT an experiment?

 Why is a quasi-experiment different to an experiment?
o Non-random assignment to groups
o However, standard in econometrics: dummy variable is always a quasi-
experiment
 Demonstration: examines the behavior within a single setting. The lack of controlled
manipulation leaves a demonstration suspectable to criticism that any feature of the
setting (such as the wording of instructions, labeling of strategies or even the color of
the laboratory), is driving observed behavior.
 Do we really see the disposition effect in Weber and Camerer (1997) or is it the
experimental design which is designed to show the effect?
Experimental and Behavioral Finance

Degree of freedom
 Econometrician: Model, variables, proxies
 Experimenter: Model, variables, design

To sum up
Experiment: does behavior in treatment 1 differ to behavior in treatment 2?
- Subjects randomly assigned to subjects
Quasi-experiments: does behavior of type 1 subjects differ to behavior of type 2 subjects
- Comparison between two (or more) types of subjects
Demonstration: compare to theoretical benchmark

Econometrics and experiments

Financial economics is grounded in analytical modelling, which uses mathematical methods
to derive the implications of some fundamental assumptions about individual or aggregate
behavior. Many of these models provide testable predictions about the behavior of markets,
firms, and investors.
 Archival data analysis
 Key problems:
o Omitted variable biases: model incorrectly omits relevant variables
o Selection biases: selection of data, subjects, environments
o Unobservable variables: relevant variables missing/ insufficient proxy

How can experiments prevent those problems?

1. Treatment variation: one variable at the time
2. Randomized controlled trials
3. Elicitation from subjects (risk preferences, emotions), design (fundamental value)

Reasons to conduct experiments

Test theory by implementing assumptions of theory as faithful as possible (convenience
assumptions as well?)
 Test behavioral assumptions (myopic loss aversion)
 Test multiple equilibria models (minimum effort game)
 Test convergence to equilibrium (asset markets + limits to arbitrage)
 Testing environments that cannot be solved theoretically (market environments)
 Testing models that cannot be tested with secondary data (theory of mind,
speculation, uncertainty VS risk)
Experimental and Behavioral Finance

How do individual biases aggregate to market behavior?

Traditional finance:
- Efficient markets eliminate biases! Rational traders, uncorrelated errors, unlimited
arbitrage

Experiments show:
- Markets do barely reduce biases
- Biases can be reduced by experience and incentives
- Market structure plays a role

Improve financial decision making:

- Test design information provision
- Learn about actual risk attitudes of clients
- Learn about perception of risk/ambiguity
- Learn about biases and test bias mitigation techniques
- Test client relationships to foster payback speed of loans

Education:
- Teach financial decision making using experiments (providing awareness from
eureka effects)

Overview
1. Experiments test predictions
2. Experiments provide behavioral models
3. Experiments refine theories
4. Experiments suggest / construct new theories
5. Experiments serve as measurement tools
6. Experiments test market design
7. Experiments allow for learning

What do we do?
“The really bad thing about Aristotelianism was that it was based on the notion that the
truth about the world could be determined by pure though – philosophy – without actually
carrying out tests […] to see if the theories and hypotheses were right”
- Natural philosophy–using formal arguments to rationalize historical data–is not
convincing!
 We want to make use of the scientific method  Which means inevitably: the use of
Experiments
 Describe and understand correlation vs causality
Experimental and Behavioral Finance

Some open questions

 Why is policy and regulation in finance not based on controlled experimentation
(wind tunnels, clinical trials, field experiments)?
 What do you learn about theory when trying to design an experiment?
o Feynman: “What I cannot create I do not understand”
 How to aggregate individual irrationality to market outcomes?
o Main problem in Behavioural finance
 How can institutions discipline behavioural weaknesses

The Stanford prison experiment (SPE) was a social psychology experiment that attempted

to investigate the psychological effects of perceived power, focusing on the struggle
between prisoners and prison officers.
Early reports on experimental results claimed that students quickly embraced their assigned
roles, with some guards enforcing authoritarian measures and ultimately subjecting some
prisoners to psychological torture, while many prisoners passively accepted psychological
abuse and, by the officers' request, actively harassed other prisoners who tried to stop it
Experimental and Behavioral Finance