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Behavioral Finance

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Heather Lui

on 11 August 2011

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Transcript of Behavioral Finance

Behavioral Finance Loss
Aversion The tendency for people to strongly prefer avoiding losses over acquiring gains Loss Aversion Frame of
Dependence Question... Would you rather: A. Avoid paying $100 in a fine for illegal parking
B. Win $100 in a random lucky draw

Would you rather…
A. Avoid a $5 surcharge
B. Get a $5 discount Behavioral finance helps explain certain anomalies in the field that can only be attributed to human behavior that defy traditional tenets of straightforward, clear-cut economics and finance According to the theories of loss aversion, people will have the tendency to choose A over B; some studies show that losses are psychologically twice and a half as powerful as gains… Like many theories of behavioral finance... Loss aversion goes against certain concepts of traditional economics... e.g. Coase Theorem Coase Theorem:
The concept that free trade and full allocation of property rights produces a most efficient economy; and that it doesn’t matterwho owns what as long as it is owned by somebody Loss Aversion Theory-
Closely related to the Endowment Effect Endowment Effect:
People place a higher value on things they own over things they don’t Students who had won prized basketball tickets said they would sell at an average of

Students who had no won said they would sell at an average of $2400 $170 Real Life example: case Study In a Duke University study… Kahneman et al., 1990 Case Study 2: 3 groups; sellers, buyers, choosers

Sellers willing to sell the mug at an average of around
Buyers willing to buy at around

Independent valuation of mugs: Asked whether they would rather have cash or the mug at a set of prices ranging between $0.25 and $9.25.

 Median price was - much closer to that of the buyers, supporting the idea that the sellers were overpricing the mug they had just been given $7.12 $2.78 $3.12 Thus... People treat “out-of-pocket” and opportunity costs differently and process them differently in the mind

‘...People often demand much more to give up an object than they would be willing to pay to acquire it" (Thaler, 1980) Another Question: Taiwan stocks fall 466.21 points. You bought a new stock a few days ago for $43 and now it's $33. Do you sell or do nothing?

Taiwan stocks increase by 466.21 points. You bought a new stock a few days ago for $43 and now it's $53. Do you sell or do nothing? Former Apple CEO John Sculley launched a new sophisticated handheld organizer called Newton. Sales were disappointing when the product was launched due to many technical errors in the program but Sculley was committed to the project. A year later they launched Newton again with enhanced featuers but it still did not sell well. Apple did not terminate. A few monthes later it came with new features but still did not do well. Apple did not terminate. A bit later, they gave Newton its own division in Apple but to no avail. Apple did not terminate. Finally, when Steve Jobs became CEO, he called an end to the project. Real Life Example And therefore in investing Many investors do not want to sell at a loss even though doing so may create further loss Frame of Dependence The way people behave depends on the way that the problem/decisional situation is formed and presented Most people are unable to see through the "opaque frame" Question Imagine that our conntry has been hit with a huge disease epidemic and we're expecting 600 people to die. Now there are two plans, the results are as following according to the analysis of our top scientists...
We have two experiments and two plans for each. You can only choose one of the two plans for each scenario: Various Other Theories and Phenomena Question A stock you just bought gained a lot. Do you think....: a) I am good at choosing the right stocks to invest in

b) The economy is good right now A stock you just bought the other day just fell a lot. Do you think....: a) I am so bad at choosing the right stocks to invest in

b) The economy is SO bad right now Attribution Theory people accredit successes to themselves but blame failures on other or the environment

However when explaining others' behavior, people tend to other persons fault attribute failures as that person's personal faults Question If you had bought a $1000 ticket for a concert and discovered that you lost the ticket the day of, would you buy another ticket at the door?

If you lost $1000 on the day of the concert, and had not purchased any tickets yet would you still go to the concert and buy a ticket at the door? People are more likely to purchase the ticket in the second scenario

Perceptions of sunk cost and opportunities affect people's spending decisions Question In a betting game you have already won $30. If you flip a coin and it's heads you will win an additional $9 but if you flip a coin and it's tails then you will lose $9. Do you flip?

You are playing a betting game and haven't won any money yet. If you flip a coin and it's heads you win $39. If you flip and it's tails you win $21. If you don't flip it at all you get $30. Do you flip? For the first scenario, 70% of people will flip
For the second one, only 43% people flip



If you already have money or have won "extra money", it will affect your decision-making on spending and risking. Past gains affect present investments. Even though probabilities and outcomes are the same... Heather, Joyce, and Anne Plan A : 200 people will be rescued
Plan B : 1/3 probability all 600 people will be rescued, 2/3 probability that no one will be rescued Experiment 1 Experiment 2 Plan C : 400 people will die
Plan D : 1/3 probability that no one will die, 2/3 probability that all 600 people will die Experiment (1) :

Experiment (2) : Results 72% choose A 78% choose D Plan A is Plan C, and Plan B is Plan D; these two are same question, just worded using different descriptions, and thus resulting in different choices → Frame dependence

Facing gain : risk aversion
Facing loss : willing to bear
risk Actually... SCenario 2 Assume a risk free rate 6%
Someone has lost $60,000, and has been invited to invest in stock, costing $300,000. There is a 70% that they will gain $60,000 and 30% chance that they will lose $60,000 Their investing decision...? 70% gain $60,000, 30% lose $60,000
70% breakeven, 30% total loss of $120,000 (including the loss before) Frame of Acts People tend to feel losses much more acutely than they feel gains of comparable magnitude.

Therefore, they prefer frames that obscure losses, if possible – and engage in hedonic editing. Which shows us that... Q&A- Thank you listening!! --2011 Summer Internship--
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