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Risk and Emotions

Version 01 for behavioural finance
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on 11 February 2013

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Transcript of Risk and Emotions

Emotional and Cognitive Perceptions
of Risk. By Nicholas Barberis Finance puzzles. Behavioral Finance Alternatives
and their application. Emotional and Cognitive Perceptions of Risk. Efficient Market Hypothesis Traditional Finance Paradigm Asset-Pricing Puzzles. Prospect Theory.

Narrow Framing. Presented by Gerardo Ruglio Caruso. Behavioural Finance. The efficient market hypothesis assumes that all participants in an economy are rational but...

Are they rational? What is the meaning of rational agents? Rational agents update their beliefs correctly based on new information. (using Bayes' theorem). Do rational agents evaluate risk according to expected utility? Gerardo Ruglio Caruso Do rational agents update their beliefs correctly? Why do people deviate from Bayes' theorem? Representativeness is an heuristic bias that may lead to biased decision making. In fact, When people rely on representativeness to make judgements, they are likely to judge wrongly because the fact that something is more representative does not make it more likely. Why do people deviate from Bayes' theorem? The overconfidence effect is a well-established bias in which someone's subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high. Kahneman and Tversky:

Prospect theory
Narrow framing
Ambiguity aversion. Week 2 Week 3 "I'd be a bum on the street with a tin cup if the markets were always efficient." Warren Buffett. Rational Agents: Rational Agents: Expected Utility: The traditional finance paradigm is an elegant theory, but it may not represent the real world very well, and many finance puzzles relative to the theory remain unexplained. The utility curve says that all investors are risk averse but is it true? IPO Puzzle Momentum Puzzle Equity Premium Puzzle The underdiversification puzzle Portfolio Puzzles. The disposition effect puzzle Questions? Equity Premium Puzzle. Refers to the fact that the average return on the stock market relative to U.S. T-bills has been higher than the expected utility model predicts. The puzzle says that individuals must have implausibly high risk aversion according to standard economics models. What does the expected utility theory say? The expected utility model says that the stock market is not very risky because it has a low correlation with other major household risks. What does the theory say? The puzzle arises because this unexpectedly large percentage implies a suspiciously high level of risk aversion among investors. Does the equity market pay more than the government due to the highest risk aversion? Momentum Puzzle. Winning stocks in prior periods continue to win.

Losing stocks in prior periods continue to lose. The puzzle is trying to understand why prior winners continue to produce higher returns without being riskier. IPO Puzzle. The average return of IPO stocks in the five years after issue is abnormally low compared with a control group of stocks. Asset-Pricing Puzzles. Asset-Pricing Puzzles. Asset-Pricing Puzzles. The underdiversification and no participation Puzzles. Portfolio Puzzles. A majority of agents held no position in equity. In 1984, only 28 percent of investors held any position in equity. Among the households with more than $100,000 in liquid wealth, only 48% had any position in equity. The stock market has a low correlation with other household risks. The underdiversification and no participation Puzzles. Portfolio Puzzles. Facts: A significant fraction of investors put large amounts of money in just a few stocks. Where is diversification?

Why some individuals do not participate? Portfolio Puzzles. The disposition effect puzzle. Investors prefer to:


Sell stocks that have produced a gain.


Keep stocks that have recorded a loss. Does this strategy maximize the wealth of the investor? Portfolio Puzzles. The disposition effect puzzle. It does not work with slaves.


Why investors do with stocks? Tversky and Kahneman (1979 & 1981) Investors often evaluate a gamble in isolation, separate from their other risks. Tversky and Kahneman (1979 & 1981) Narrow Framing Prospect Theory Individuals focus on the gains and losses.

Investors are much more sensitive to losses.. Alternatives Prospect Theory without Narrow Framing. Prospect Theory with Narrow Framing. Thank you for your attention! Prospect Theory without Narrow Framing. Expected Utility theory and Prospect theory lead to CAPM. Prospect Theory without Narrow Framing. What happens when the returns are not normally distributed? Assets that are more positively skewed get overpriced and earn lower average returns Prospect Theory without Narrow Framing. To see why, notice that by taking a significant position in a positively skewed stock, an investor is giving herself a chance to become rich. Lottery-type possibilities Prospect Theory without Narrow Framing. Lottery-type possibilities Therefore, the investor is willing to overpay for the security and, as a consequence, accept a low average return.

The investor is gambling. He or she is changing a higher return by the possibility to become rich! IPOs
Low average returns
The distribution of IPO returns is highly positively skewed.
Most IPOs are not very successful, but some do incredibly well. As a result..... The investor is willing to pay up for IPOs and accept their low average return.
Prospect theory predicts that they will earn low average returns.
The investor is giving himself or herself a chance, albeit a small chance, of becoming very wealthy. According to prospect theory Prospect Theory without Narrow Framing. Prospect Theory without Narrow Framing. Lottery-type possibilities Lottery-type possibilities Now, we can understand the underdiversification puzzle and the IPO pricing puzzle.

It is desirable to be underdiversified in a few positively skewed stocks. Prospect Theory without Narrow Framing. Further study showed that high daily volatility has some ability to predict future positive skewness. As a result, individual investors may see volatile stocks as lottery-type investments. Once again, the investor is willing to overpay for these stocks and accept their low average returns. Prospect Theory without Narrow Framing. Prospect Theory with Narrow Framing. According to prospect theory, investors are more sensitive to losses than to gains, so if the stock market goes up, the investor feels good, but if it goes down, the investor feels very bad. This way of thinking helps explain some investor behaviours. Prospect Theory with Narrow Framing. The theory leads to a high equity premium:

Investors will stay in the market only if they expect a very high average return relative to other investment products.

The theory explains the stock market non participation because of the investor's sensitivity to potential losses. These patterns can be explained using
narrow framing. Investors analyze the stock market in isolation. Regardless other risks they face. The disposition effect. Prospect Theory with Narrow Framing. Investors are risk averse regarding moderate probability gains. Specifically, an investor prefers $50 for certain rather than a 50 percent chance of $100 and a 50 % chance of nothing. He will sell the winner to realize the gain. The disposition effect. Prospect Theory with Narrow Framing. The investor will wait in case it recovers. Analyzing a negative return stock: They prefer a 50 percent chance of losing $100 and a 50 percent chance of losing nothing as opposed to losing $50 for sure. If a stock goes up, investors will want to sell the stock to take the gain.

The resulting selling pressure may push the price down temporarily.

From that lower price base, subsequent returns have to be higher, mechanically. This leads to a momentum effect in which high return is followed by more high return. The same argument operates on the down side as well. The disposition effect and the momentum puzzle. Prospect Theory with Narrow Framing. Conclusion. The traditional models of expected utility have produced six major puzzles

Prospect theory and narrow framing capture investors' attitudes toward risk and help explain these puzzles. The no participation puzzle References: Barberis, Nicholas 2008, 'Emotional and Cognitive Perceptions of Risk', CFA Institute, pg 22-27. Just when returns are normally distributed
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