SPS Introduction
Marta Serra-Garcia, PhD E-mail: marta.serragarcia@lmu.de
Behavioral Finance
Why is behavioral finance important?
"Success in investing doesn't correlate with I.Q. once you're above the level of 25…
Once you have ordinary intelligence, what you need is the
temperament to control the urges…
that get other people into trouble in investing.”
Warren Buffett
HOW DO INDIVIDUALS BEHAVE?
Moving from the standard assumptions to the behavioral reality
Standard assumptions
Homo “economicus”
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max δt
t=0
∞
∑ p(st ) U ( x
it | s
t )
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Individuals care about their OWN
payoff KNOW and take into
account the actual probabilities of each
state Discount all future
periods at the same rate
Standard assumptions
Homo “economicus”
Aren’t we sometimes time inconsistent?
Do we always have correct judgment?
Don’t we care about others’ well-being?
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t=0
∞
∑ p(st ) U ( x
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SOME EXAMPLES
Kiva.org
Social Finance
• UK initiative: Social impact bonds
• What are they?
– Investors from around the world
– Provide $
– For socially important projects, e.g. released prisoners
Stickk
THIS COURSE
What will we look into?
Topics
A. Introduction (1)
– How does behavior differ from the “homo economicus”?
– What are the most important insights for behavioral finance?
B. Traders’ behavior (2, 3)
C. Individual financial behavior (4, 5, 6 and 7)
B. Traders’ behavior
1. Risk
– How do we make decisions under risk?
– Does it help explain the equity premium puzzle?
2. Trading
– Do traders display biases?
– How can they be explained?
C. Individual financial behavior
1. Intertemporal Decision Making
– How do individuals make decisions over time?
– What are the implications for saving and borrowing?
2. Financial knowledge
– How much do individuals know about finance?
– Can it also explain their behavior in financial markets?
3. Complexity
– How does complexity affect the choice of investments?
4. Field experiments
– How can we increase individual saving?
– Decrease over-borrowing?
INTRODUCTION
Behavioral economics
Standard assump,ons Behavioral “approach”
Time-‐consistency… …Self-‐control problems Individual self-‐interest… …Social preferences
Consistent beliefs (e.g. Bayes’ rule)… …Overconfidence and other biases
Expected uElity… …Loss aversion
A problem
• Individuals often suffer from “self-control” problems
• Examples:
– Quitting smoking – Starting a diet
– Studying for an exam – …may be tomorrow?
• Ex-post there seems to be a lack of will-power in human beings…
• …this is at odds with the perfectly rational “homo
economicus”
A problem (II)
• How do we understand the lack of willpower?
• Ex-ante (t=0, day 1 of the course)
– make plan for week 1 and week 2
– Example: “I will study for 4 hours each week”
• When week 1 comes…
– The choice is between
• Now (week 1)
• Next week (week 2)
… it is more tempting to postpone studying for week 2
Example: credit card borrowing
• How may lack of self-control affect credit card borrowing?
• Ausubel (1999) studied a large-scale field experiment – Credit card company randomly
– offered 3 different contracts:
1. Control treatment
– 1st 6 months: 6.9% interest – thereafter: 16% interest 2. Pre treatment
– 1st 6 months: 4.9% interest (low now) – thereafter: 16% interest
3. Post treatment
– 1st 6 months: 6.9% interest
– thereafter: 14% interest (low tomorrow)
• How do you think the response rates were?
DellaVigna (2009)
• Provides an overview of different behavioral biases
– Time-inconsistency
– Reference-dependent preferences – Social preferences
– Non-standard beliefs
• Gives examples of field experiments or empirical studies that document such biases
• Attention: we will focus on Sections 1 to 3 only
Do biases disappear in the market?
• Standard assumptions in finance:
– Absence of frictions – Rational traders
• …Efficient Market Hypothesis:
– Assets will be priced at their “fundamental” value – i.e., expected future cash flows
• Why?
– If they were not arbitrageurs would take up the opportunity to earn $$$$...
Efficient Market Hypothesis
• Example:
– Share of BMW
• Fundamental value: 100 euro
• Currently trading at 80 euro…
…because of pessimistic traders (who are wrong…)
– What can the arbitrageur do?
• Buy BMW shares
• Short-sell, e.g. Mercedes-Benz, shares – What will happen?
• BMW prices will start to go up…
Barberis and Thaler (2003)
• Provide an overview of the EMH
• Explain several reasons why it may not hold:
– Implementation costs – Agency problems
– …etc
• Attention: we will focus on section 2
TRADERS’ BEHAVIOR
How do we take risks?
Consider Steven faces the following problems:
1. He has been given 1000, and asked to choose:
– (1000,0.5) – (500, 1)
2. He has been given 2000, and asked to choose:
– (-1000,0.5) – (-500, 1)
• Conclusion: … there’s something about losses
How do we take risks? (II)
1. Suppose you are given the choice between:
a) 4000 euro with an 80% chance, or zero else b) 3000 euro with a 100% chance
Which one do you choose?
2. Now consider you are given the choice between:
a) 4000 euro with 20% probability b) 3000 euro with 25% probability
Which one do you choose?
Conclusion: …there’s something about certainty
A new theory of decision making
Kahneman and Tversky (1979)
Prospect Theory
• Makes different assumptions
1. Individuals compare outcomes to a reference point
• Is this a gain or a loss?
2. Individuals dislike losses more than gains
• Losing 100 euro in a bet feels worse than gaining 100
3. Individuals underweight high probabilities that are < 1
• Certainty has a “special” value
Prospect Theory “at work”
• Let us take “puzzles” in financial behavior
• …does prospect theory explain them?
• We will consider two:
1. The equity premium puzzle 2. The disposition effect
1. The equity premium puzzle
• Benartzi and Thaler (1995)
• Equity returns vs bond returns
• If equity returns so much more than bonds, why do people buy bonds?
Period 1802-1870 1871-1925 1926-1990
Equity 5.7 6.6 6.4
Bond 5.1 3.1 0.5
2. The Disposition Effect
• Suppose Ann bought a share of Nokia on Jan 1
st, 2012
– She paid 20 euro
• Now, May 21
st, 2012
– Value of share is 10 euro
• Imagine the future prospects are:
– 50% chance of recovering back to 20 euro – 50% chance of dropping to 0 euro
• What would Ann do (in most cases)?
2. The Disposition Effect (II)
• Now consider the opposite case
• The share’s value is 30 euro today
• In the future the prospects are:
– 50% chance of falling back to 20 euro – 50% chance of having a value of 40 euro
• What would Ann do?
2. The Disposition Effect (III)
• Definition: “a tendency to ride losses and sell gains”
• Shefrin and Statman (1985)
– Describe the disposition effect
– How it is in line with prospect theory
• Odean (1998a)
– Considers 10,000 accounts from a retail brokerage house – Documents the disposition effect
– Investors realize large losses…
3. Overconfidence
Do investors trade TOO much?
• How could that ever occur?
Overconfident investors!!
• Why?
– Rational investors do not trade if costs > expected returns – Overconfident investors THINK
– …their expected returns are higher than they actually are
Odean (1998b)
• Odean (1998b)
• Takes again 10,000 accounts from brokerage house
• And shows that:
…Not only do investors lose with their stock purchases
• Due to trading costs
• But they also pick “bad” stocks…
INDIVIDUAL FINANCIAL
BEHAVIOR
The Golden Eggs
• Commitment is common in many financial products
• Pension plan…can’t take it out til retirement
• Mortgage…store $ in a house
• Christmas clubs…save $ until x-mas
• Its similar to the goose which laid golden eggs…
…it generated large returns in the FUTURE
…trying to speed up the process could destroy everything
Laibson (1997)
• Why do we use such commitment devices?
• We are time-inconsistent
– The planner in us…
• …would like us to save in the future
• …but is also aware of our self-control problems – A solution: commit today!
Meier and Sprenger (2010)
• Is there any truth to this?
• Let’s test it
– Take individuals’ credit card statements
– Examine, using experiments,
• Are they impatient?
• Are they time-inconsistent?
If hyperbolic discounting is at work…
….a relationship between time-inconsitency and credit card borrowing is expected
Thaler and Benartzi (2004)
• Save More Tomorrow™
• How can we help employees save more for retirement?
• Employees typically participate in a savings plan
• Their idea?
– Have employees commit to
• Higher savings?
• Increase savings with salary increases?
Financial literacy
• How much do “regular” households know about finance?
Basic concepts:
² Calculating a %
² Inflation
² Compound interest
² Time value of money
• Is this something households know?
• Does it matter?
van Rooij, Lusardi and Alessie
How much financial knowledge do people have?
• Devise a survey to measure knowledge
• Ask a representative sample of the population in NL
Does it relate to household wealth?
&
Stock market participation?
Lusardi and Tufano (2009)
Debt literacy
How does knowing about debt related to indebtedness?
Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you
didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
i. 2 years;
ii. Less than 5 years;
iii. 5 to 10 years;
iv. More than 10 years;
v. Do not know.
vi. Prefer not to answer
Complexity in financial products
• Many financial products are complex
– Several pages of footnotes
– Several fees and charges for different cases…
• Is this complexity irrelevant?
– A “standard” rational agent is a “supercomputer”
– However, normal humans are not…
– What does it imply?
Choi et al. (2010)
• Consider mutual index fund decisions
• An index fund is simply a collective investment scheme that tracks a specific index, e.g. the S&P 500 Index
Why does the law of one price fail?
Why do individuals invest in high-fee index funds?
• Experiment with MBAs, white-collar workers and students
• How does simplified information affect individuals?
A short recap
• Until now we have considered…
• Traders’ behavior
– Considering lab experiments – Trading data
• Individuals’ financial behavior – Lab experiments
– Case studies – Survey data
• Now, we focus on two field experiments – Large-scale experiment (randomization!)
– Individuals do not know they are in an experiment…
Simplifying financial products
• Pay-day borrowing
– Common in the US
– Pay $15-17 fee for every $100 borrowed – When next monthly income is received Ø Implied APR of 400% !
• Bertrand and Morse (2011)
- Is pay-day borrowing a mistake?
- Or is it done with “complete knowledge” of its costs?
Incentives vs. knowledge
• In many developing countries, poor households are
“unbanked”
• How do we increase their access to banking?
Cole et al (2011)
• Two strategies:
1. Provide knowledge about financial matters 2. Provide $$ for opening an account
THE PLAN
Aims & Evaluation
• Get to know what behavioral finance is
– How it applies to traders’ behavior – …and also to individual behavior
• How to achieve this?
– Writing a short paper (Seminar Arbeit) – Presenting your paper in class
– Discussing the ideas presented in class
Writing a short paper
• Goal
– Write a 6 to 10 page paper
– Font size: 11pt; spacing: double
• It should NOT be a only summary of the paper
• It is VERY IMPORTANT:
– That you are critical with the paper!!
– Every paper has limitations – Try to ask yourself:
• This is what the authors do or argue…
• But could it be done differently?
– E.g. More or different data? And why?
• Or, could there be a different explanation?
Writing a short paper
• Questions to cover in the paper:
1. What is the research question?
2. How has it been answered?
Model, Experimental Design, Data?
3. Results: What have we learned?
4. Conclusion
5. Policy implication (Important: At least one)
6. Experimental Design related to main idea in the paper (voluntary: gives you the chance to earn a higher grade)
Writing a short paper
• Steps (voluntary)
1. Read through the paper 2. Prepare an outline
3. Write up the paper 4. Revise it
• At each step you can come an meet me
Writing a short paper
• Meeting schedule
1. Meeting 1: to discuss questions about the paper
– May 30th from 6 to 8pm
2. Meeting 2: to discuss your outline
– June 6th from 6 to 8pm
3. Meeting 3: to discuss any questions when writing it up
– June 13th from 6 to 8pm
• Deadline:
– June 25th, 6pm (Munich time)
– Deliver paper by e-mail and print at office
Presentation in class
• We will get together to learn about each others’ papers
• If presentations are clear and easy to follow, it will be more fun
• Even better, with a lively discussion…
– We will learn more
– We will be able to interact and discover others’ opinions
Presentation in class
• Each presentation
– Should be 20 minutes long – + 10 minutes discussion
– Aim:
• Present a summary of the paper
• Provide your critical opinion
• Ask questions to audience
– Evaluation:
• Based on content of presentation
• Ability to engage others in the discussion (NB: there may be positive reciprocity here…)
