Behavioral finance

1. Behavioral Finance

Utevskaya Marina Valerievna
PhD
Saint-Petersburg State University of Economics
Associate Professor, Corporate Finance and Business Evaluation Department
Director of International Master Program “Corporate Finance, Control and Risks”

2. PART III

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3. Role of Investor Behavior

• Bounded Rationality: “satisficing” behavior. Information
processing limitations. Example: memory limitations.
• Investor Sentiment: beliefs based on heuristics rather than
Bayesian rationality.
• Investors may react to “irrelevant information” and hence
may trade on “noise” rather than information.

4. “Irrational” Behavior of Professional Money Managers

• May choose a portfolio very close to the benchmark
against which they are evaluated (for example: S&P500
index).
• Herding: may select stocks that other managers select to
avoid “falling behind” and “looking bad”.
• Window-dressing: add to the portfolio stocks that have
done well in the recent past and sell stocks that have
recently done poorly.

5. An Example

• Initial endowment: $300. Consider a choice
between:
• a sure gain of $100
• a 50% chance to gain $200, a 50% chance to gain $0.
• Initial endowment: $500. Consider a choice
between:
• a sure loss of $100
• a 50% chance to lose $200, a 50% chance to lose $0.

6. Reversal in Choice

• Case 1: 72% chose option 1, 28% chose option 2.
• Case 2: 36% chose option 1, 64% chose option 2.
=> A reversal in Choice
• Problem framed as a gain: decision maker is risk averse.
• Problem framed as a loss: decision maker is risk seeking.

7. Allais Paradox

The Allais paradox is a choice problem designed
by Maurice Allais (1953) to show an inconsistency of
actual observed choices with the predictions of expected
utility theory.
The Allais paradox arises when comparing participants'
choices in two different experiments, each of which
consists of a choice between two gambles, A and B.

8. Kahneman Framework of “two minds”

• to describe the way people make decisions
• an “intuitive” mind: rapid judgments with great ease and
with no conscious input
• “reflective” mind: slow, analytical and requires conscious
effort
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9. Kahneman Framework of “two minds”

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10. Kahneman Framework of “two minds”

Illustration of what
is meant by intuitive
mind, and how it
sometimes leads
one astray
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11. Kahneman Framework of “two minds”

• One of the insights that earned Kahneman the Nobel
Prize1 is that we humans are sometimes as susceptible to
“cognitive illusions” as we are to optical illusions.
• These illusions, also known as biases, result from the use of
heuristics, or, more simply, mental shortcuts.
• Kahneman’s discovery that under certain circumstances
intuition can systematically lead to incorrect decisions
and judgments changed psychologists’ understanding of
decision making, and, ultimately, economists’, too.
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12. Kahneman Framework of “two minds”

• Behavioral economics showed instead that we are not as
logical as we might think, we do care about others, and
we are not as disciplined as we would like to be.
• It is not that people are irrational in the colloquial sense,
but that by the nature of how our intuitive mind works we
are susceptible to mental shortcuts that lead to erroneous
decisions.
• Our intuitive mind delivers the products of these mental
shortcuts to us, and we accept them. It’s hard to help
ourselves.
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13. Kahneman Framework of “two minds”

• Loss aversion:
• described by Prospect Theory (Kahneman and Tversky, 1979)
• losses loom larger than equal-sized gains
• loss aversion affects many of our decisions, including
financial ones
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14. Kahneman Framework of “two minds”

• EXAMPLE
• Selling a losing stock is extremely unpalatable because it
brings the reality of loss very much to mind.
• People often sell winning stocks too soon because the act
of selling a winning stock realizes a gain, and that gives
us pleasure.
• The mistake people are making here is one of mental
accounting: instead of looking at their portfolio “as a
whole” they look at each stock separately, and make
decisions based on these separately perceived realities.
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15. Kahneman Framework of “two minds”

• Loss aversion also makes people reluctant to make
decisions for change because they focus on what they
could lose more than on what they might gain. This is
called “inertia,” or the status quo bias (Samuelson and
Zeckhauser, 1988).
• Inertia is at play when people know they should be doing
certain things that are in their best interests (saving for
retirement, dieting to lose weight, or exercising), but find
it hard to do today.
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16. Kahneman Framework of “two minds”

• “We make intuitive judgments all the time, but it’s very
hard for us to tell which ones are right and which ones are
wrong” says Nicholas Barberis, a behavioral finance
researcher at the Yale School of Management
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17. SMarT

• Richard Thaler
• Save More TomorrowTM program (SMarT)
• An alarmingly large proportion of employees fail to
participate in their company’s defined contribution
retirement plan, often forgoing matching funds (free
money) from employers
• SMarT effectively removes psychological obstacles to
saving in the short and longer term, and helps people
overcome them with very little effort on their part
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18. SMarT

There are four ingredients to the program:
1. Employees are invited to pre-commit to increase their
saving rate in the future. Because of procrastination,
most people find it easier to imagine doing the right
things in the future, similar to our New Year resolutions
to start exercising and dieting next year.
2. For those employees who do enroll, their first increase
in savings coincides with a pay raise so that their takehome pay does not go down. This avoids triggering the
mind’s hypersensitivity to loss, or loss aversion.
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19. SMarT

3. The contribution rate continues to increase automatically with each successive pay raise until a previously
agreed upon ceiling is reached. Here, inertia is working in
people’s best interest, ensuring that people stay in the plan
and the contribution rate increases.
4. Employees may opt out of the plan at any time they
choose, though experience shows that people rarely do. This
provision makes them more comfortable about joining in
the first place.
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20. SMarT

• In the first case study of SMarT, employees at a midsize
manufacturing company increased their contribution to
their retirement fund from 3.5 percent to 13.6 percent of
salary over a three-and-a-half-year period (Thaler and
Benartzi, 2004). This is a remarkable improvement in
saving behavior. As a result, the program is now offered
by more than half of the large employers in the United
States, and a variant of the program was incorporated in
the Pension Protection Act of 2006 (Hewitt, 2010).
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21. SMarT

• “The lesson of the experience with the SMarT program,
therefore, is general and powerful: the strategic
application of a few key psychological principles can
dramatically improve people’s financial decisions.”
• Financial advisors can take advantage of such insights in
their own practices to help their clients make better
decisions which, ultimately, should lead to better
financial outcomes.
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