FINS3655 Exam Summary PDF

[COURSE0000] XXXX Table of Contents The Default Decoy Effect Expected Value and Utility Prospect theory Limitations Disposition Effect Framing effect Equity risk premium puzzle Endowment Effect Disjunction Effect Neurofinance Social Preferences Moral Reasoning In...

[COURSE0000] XXXX Table of Contents The Default Decoy Effect Expected Value and Utility Prospect theory Limitations Disposition Effect Framing effect Equity risk premium puzzle Endowment Effect Disjunction Effect Neurofinance Social Preferences Moral Reasoning Intertemporal choice Risk Taking Ambiguity aversion Information Processing Belief perseverance Overconfidence Confirmation bias Herding behaviour Disposition effect Household finance Investor behaviour Corporate Finance  The Default The Default: the status quo (default) option influences choices when the alternative is complex (ie, having to make multiple decisions) ○ The complexity of the alternative action makes the default more attractive When people don’t know what to do, they pick what has been chosen for them (the default) People are susceptible to external influences when there is a lack of preference or the decision is complex The influence of defaults: ○ Decision-makers might believe that defaults are suggestions by the policy-maker (ie, a recommended action) ○ Making a decision often involves effort, whereas accepting the default is effortless ○ Defaults often represent the existing state or status quo, and change usually involves a trade-off Considerations for policy-holders in choosing defaults – ○ A no-action default for each policy ○ Defaults can lead to misclassification must be balanced between ethical and psychological questions – tradeoff between errors may be physical, cognitive and emotional costs Experiment 1. Your patient is about to have a hip replacement but you realized that you forgot to try 1 with medication – Do you pull the patient back and try the medication or let the patient have hip physicians replacement 2. Your patient is about to have a hip replacement but you realized that you forgot to try 2 medications – Do you pull the patient back and try the medication or let the patient have hip replacement AND if you pull the patient back, which medication do you try Results In the first scenario, majority of physicians decided to try the medication In the second scenario, majority of physicians decided to let the patient have the surgery Organ Donor experiment Respondents were asked about organ donation with different defaults – opt-in, opt-out, and neutral (no default)  Countries on the left were told to check the box to participate, countries on the right were told to check the box if they do not wish to participate Results Opt-out had higher consent rates than opt-in – When people don’t know what to do, they pick whatever has been chosen for them (the default) Decoy Effect Decoy Effect: the options presented will influence decision-making, particularly where an inferior third option changes decisions between two options that are similar in value Economist Presenting between 2 options and 3 options experiment 2 options: ○ Internet-only subscription for $59 - 68 students ○ Print-and-Internet subscription for $125 - 32 students 3 options: ○ Internet-only subscription for $59 - 16 students ○ Print-only subscription for $125 - Zero students ○ Print-and-Internet subscription for $125 - 84 students RESULT Rome or Presenting between: Paris Option 1 – trip to Rome expenses paid, trip to Paris expenses paid experiment Option 2 – trip to Rome expenses paid, trip to Rome breakfast included, trip to Paris expenses paid Result In option 1, neither dominates – 50/50 split In option 2, Rome expenses paid becomes more popular Expected Value and Utility Expected value: a rational calculation of the value derived directly from the outcome, without sentimental attachment and valuing gains and losses equally ○ Calculation – The value of each possible outcomes * the probability of that outcome ○ Assumes people always choose the option with the highest expected value, even if it involves risk Expected utility: accounts for the subjective value (utlity) offered by each outcome ○ Calculation – Find the utility of an outcome * the associated probability ○ Incorporates risk preferences of investors  St-Petersburg A fair coin is tossed repeatedly until a tail appears, ending the game. The pot starts at $1 and is Paradox doubled every time a head appears. You win whatever is in the pot after the game ends. Thus you win $1 if a tail appears on the first toss, $2 if a head appears on the first toss and a tail on the second, $4 if a head appears on the first two tosses and a tail on the third etc – What is the expected value of the St-Petersburg game? Result St-Ptersburg Paradox: the expected value of the game is infinite. However, few people are willing to pay more than a little amount to play it ○ Daniel Benoulli – the value of a gamble is not its monetary value. Instead, people attach some subjective value or utility to monetary outcomes Shows that EU describes how people decide under certainty better than EV does ○ People do not seek to maximise EV, but EU Risk preferences: 1. Risk neutrality (linear): each extra dollar of wealth raises utility exactly as much as the previous dollar 2. Risk aversion (concave): the additional pleasure from an additional dollar is smaller than the pleasure from the previous dollar a. Concavity of the utility function measures how risk averse an individual is 3. Risk loving (convex): suppose an individual has increasing marginal utility of wealth, such that each dollar provides greater additional happiness than the dollar before it Risk seeking over losses – when looking at a decision in a loss frame, we almost always become risk seekers Losses loom larger than gains – negative response to losses is greater than positive feelings about gains Prospect theory Prospect theory: amends EU by showing individuals do not rationally maximise utility, but are instead influenced by psychological biases and framing effects (Kahneman and Tversky 1979, 1992) ○ People evaluate outcomes relative to a reference point, not final wealth values (like in EU) ○ Two aspects – (1) the value function, (2) probability weighting 1. Value People are risk averse for gains, risk seekers for losses function Diminishing marginal sensitivity to gains and losses – ie, difference between $100 and $200 is stronger than $1000 and $1100 Loss aversion: losses loom large than gains  Concave for gains (risk averse in gains), convex fo losses (risk seeking in losses) Kink at reference point (showing loss aversion) – slope is steeper for losses than gains (ie, losses felt more) Diminishing slope in both directions = diminishing sensitivity to gains/losses as magnitude increases 2. Probability Tendency to overweight low probability events and underweight high probability events weighting ○ Ie, fear of flying following 911 vs fear of driving from car accidents Sensitive to changes in probability in the middle of the range (30% to 40%) than changes moving us from probability to certainty (10% to 0%, or 90% to 100%) Four-fold pattern of risk aversion Describes how attitudes vary depending on whether they are dealing with gains or losses, and whether proabilities are low or high  Catastrophic potential Catastrophic potential: overestimating risk of activities that may injure or kill a large number of people immediately and violently ○ As opposed to chronic but less heavily reported risks Fear of flying after 9/11 cf automobile accidents Familiarity/controllability Familiarity/controllability: willingness to undertake risk when we believe that we are in control or are familiar with the situation Limitations May not fully address temporal effects, extreme risk behaviours, social influences, and biases like hyperbolic discounting or overconfidence Disposition Effect Disposition effect: tendency for individuals to be risk averse over gains, risk seeking over losses ○ Ie, prematurely sell assets that have made financial gains, while holding on to assets that are losing money Relation to prospect theory and loss aversion – people prefer to lock in gains but reluctant to realise losses as it feels more painful Framing effect Framing effect: manner in which information is presented affects people’s decision making (vaia wordings, settings, situations etc.) Focus on gains and losses, not final wealth levels ○ Illustrates risk seeking for losses, and risk averse for gains Asian US is preparing for the outbreak of an unusual Asian disease expected to kill 600 people. Two disease alternative programs to combat the diases have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows: Framing 1: ○ Program A – 200 people saved ○ Program B – ⅓ probability that 600 people saved, ⅔ probability that no people saved Framing 2: ○ Program A (alternative wording) – 400 people die  ○ Program B (alternative wording) – ⅓ probability nobody dies, ⅔ probability 600 people die Results In scenario 1, risk avoidance – A preferred to B (76% for A) In scenario 2, risk taking – C less acceptable than D (67% prefer D) Frequency of Subjects asked to imagine they are portfolio managers, allocating portfolio between two funds, A evaluations (bond) and B (stock) (Thaler, Group 1 – sees monthly observations on returns of B. After each observation, allocate portfolio Tversky, between A and B over the next month. Sees realised return over that month, and allocate once Kahneman, again Schwartz, Group 2 – shown exactly the same series of returns, except that it is aggregated at the annual 1997) level, ie, does not see the monthly fluctuations, only the cumulative annual returns. After each observation, allocate portfolio between A and B over the next year Group 3 – same series, this time aggregated at the 5-year level Results Average final allocation chosen by subjects in Group 1 was much less titled towards the stock Subjects in Group 1 adopted the monthly return distribution as a frame – saw more frequent losses, more wary of the stock Risk Consider a speculative portfolio expected to yield a return of 15% in excess of treasury bills, perception with a 10% error rate per annum (10% volatility) at different ○ It means that 93% probability of a positive return in any given year time scales Use a simulator and assess the probability of a positive return at narrow time scales – (Taleb, 2001) probability of positive return is 50% over any given second, 50.1% over any minute, 51% over any hour, 54% in any given day, 67% in any given month ○ Noise is higher in higher frequency zones Minute by minute observation of the returns – each day (8 hours) will have 241 pleasurable minutes against 239 unpleasure ones ○ 60688 and 60271 pleasurable and unpleasurable experiences per year Monthly observation – since 67% of monthly returns are positive, 8 gains experienced per year, and 4 losses Annual observation – since 93% of annual returns are positive, over the next 20 years, will experience 1 pain for 19 positive experiences per year Myopic loss aversion: tendency to focus on short-term losses rather than long-term gains ○ Pleasure of a gain is inferior to the pain of a loss of an equivalent amount (losses hurt more) ○ Losses are experienced more frequently at narrow time scales ○ More frequent evaluations lead to increased risk aversion  Equity risk premium puzzle Equity risk premium puzzle: phenomenon where observed returns on a risky security significantly exceed those on risk-free bonds ○ Puzzle because it is an order of magnitude greate than can be rationalised by standard economic models Reasonable that stocks return a higher amount than t-bills or bonds since risk averse investors should require higher compensation for holding the risky asset investors would need absurdly high coefficients of risk aversion (α=-30) to explain higher premiums for stocks over riskless assets ○ Ie, people would have to be implausibly risk-averse to justify the returns on equities over the returns for t-bills Potential answer to the puzzle, based on prospect theory (Benartzi and Thaler, 1993) ○ Investors are loss averse (ie, more sensitive to losses than gains) Loss aversion makes stocks less attractive than the sure return from T-bills – hence, investors choose portfolios as if operating within a 1-year time horizon ○ Investors evaluate their portfolios frequently Endowment Effect Endowment effect: phenomenon where people assign more value to things they own, even if object was recently acquired or if market value is significantly lower ○ Ie, once something is in our possession, we irrationally consider it more valuable than pre-ownership Willingness to pay (WTP) vs Willingness to accept (WTA) – theoretically, WTP = WTA Avian Situation 1 – neighbour has a chicken coop in his backyard. There is a 0.001 change (1 in 1000) Bird Flue that you get Avian Bird Flu and die from it. How much would you be willing to pay for him to eliminate this risk? Situation 2 – neightbour is moving in and wants to install a chicken coop in his backyard. There is a 0.001 chance you will get Avian Bird Flue and die because of this. How much would you be willing to accept for this risk? Result WTA (in first situation) is significantly higher than WTP (in second situation) Students ½ of students in class were randomly given an inexpensive desirable object. Students who did not receive and anything were asked how much they would pay for the item, their maximum buying price (WTP). objects Students who received the good were aksed their minimum selling price (WTA). Professors would carry out any trades between students that overlapped. in a follow up, there was a 3rd group known as choosers. They were not endowed with a mug but instead  given a choice between receiving the amount of money or mug for each price point considered by the buyers and sellers. Result Since the goods were randomly assigned, ½ of the items should change hands ○ In reality, virtually no one traded. The WTA values were much higher than WTP values – ie, sellers require much more to part with item than buyers are willing to pay The chooser behaved much closer to buyers than sellers – suggesting that endowment effect does not stem from buyers but from sellers overvalueing the good once owned Relation to Prospect theory ○ Loss aversion makes us feel like giving up something we own is a loss – even though economically, it may not be significant ○ According to reference dependence, once an object becomes part of your endowment, you view it as a reference point. Any decision to sell or give it up is framed as a loss, rather than a neutral transaction Disjunction Effect Disjunction effect: occurs when one will do X given A occurs and will do X given A does not occur, yet will not do X when the outcome of A is unknown Tversky Imagine you played the gamble ($200, 0.5; -$100, 0.5). You don’t know the result of the gamble. Do you & want to play it a second time? Alternatively, how would you feel about playing the second gamble if you Shafit, knew you had lost 100 on the first gamble. Finally, would you accept to play the second gamble if you 1992 knew you had won 200 on the first gamble? Most frequent choice pattern is accept when win, accept when lost, but reject when do not know After a gain, they are up no matter what and can’t lose. After a loss, they are down and it is their chance to get out of the red But when outcome is unknown, no clear reason for accepting the second gamble Sure-thing principle: taking action X if event A occurs, X if A does not occur, and taking the same X if they know nothing about A Tversky Imagine that you have just taken a tough exam. It is the end of the semester, you feel tired and run down, & and you find out that you (passed OR failed OR will find out the result the day after tomorow) the exam. Shafir, You now have an opportunity to buy a very attractive 5-day vacation package to Hawaii at an exceptionally 1992 low price. The special offer expires tomorrow. Would you: 1. Buy the vacation package 2. Not buy the vacation package 3. Pay a $5 fee to retain the right to buy the vacation package at the same price the day after tomorrow Results Pass version – 54% chose the package, 30% chose to wait  Fail version – same thing Delayed result (version with uncertainty) –