Behavioral Finance

1. Behavioral Finance Economics 437

2. Two stage game: First stage—you have a 75% chance of winning nothing and the game is over; 25 % chance to move to second stage of the game, which presents you with the following options. You must first decide which of the two choices below you would pick. A. A certain win of $ 30 B. 80 % chance of winning $ 45 and 20% chance of winning zero

3. 25 % chance to win $ 30 and 75 % chance to win zero • 20% chance to win $ 45 and 80% chance to win zero

4. 25 % chance to win $ 30 and 75 % chance to win zero • 20% chance to win $ 45 and 80% chance to win zero Must choose A or B before stage one • [A certain win of $ 30] • [80 % chance of winning $ 45 and 20% chance of winning zero] 25% Game ends, you win zero 75%

5. A. 80 % chance of imminent death and 20% chance of normal life with an expected longevity of 30 years B. 75 % chance of imminent death and 25% chance of normal life with an expected longevity of 18 years

6. Consider new case where there is a 25% chance that the tumor is treatable and a 75 % chance that it is not. If not, death is imminent. Otherwise, the potential outcomes are as follows C. 20 % chance of imminent death and 80% chance of normal life with an expected longevity of 30 years D. Certainty of a normal life with an expected longevity of 18 years February 11, 2009

7. Mental Accounting • Sale of two items • $ 150 Jacket • $ 5 calculator • Will you go to the store two blocks away to buy $ 145 jacket? • To get the calculator for free • Get a free ticket to go to the play. Lose the ticket that morning, will you go? • Find $ 1,000 on the street. Get a $ 1,000 unexpected dividend on your stock.

8. Vagueness -- Game 1 Consider an Urn Containing: ½ red balls ½ green balls If you can pick a red ball you win $ 100, otherwise zero

9. Vagueness -- Game 2 Consider an Urn Containing red and green balls, But we have no idea how many of each If you can pick a red ball you win $ 100, otherwise zero

10. Insurance Distortions • Flight Insurance …. $ 100,000 coverage in case of • Terrorism • Anything but terrorism • Anything

11. Insurance Distortions • Flight Insurance …. $ 100,000 coverage in case of • Terrorism $ 7.42 • Anything but terrorism $9.00 • Anything $ 7.44

12. Buy me a beer! • From a resort • From a small country town store

13. Fairness and “Reference Points” • Shortage of cars develops • Dealer raises prices $ 200 above list • 71 % unfair • Dealer has been selling these cars at a discount of $ 200 below list price. He now eliminates the discount • Only 42 % unfair

14. Cutting wages • A small co employs several people. Workers’ incomes have been about average for the community. Business is slow. Owners reduce the workers’ wages by 10 percent for the year • 61 % unfair • A small co employs several people. The workers have been receiving a 10% bonus each year. Business is slow. Owners eliminate the bonus for the year. • 20 % unfair

15. Tipping • Survey • A restaurant you visit frequently, bill is $ 10, what is the tip? • $ 1.28 on average • A restaurant in another city that you do not intend to return to • $ 1.27 on average

16. Another Example • Can of insecticide costs $ 10 • Current risk level 15 out of 10,000 (injured) • What would you pay to eliminate the risk • Result of survey $ 3.78 • Same can but has no risk • What price reduction would be okay to have a 1 in 10,000 risk? • 77 % said they would refuse to buy the product at any price if the risk were increased

17. Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of a reality • Is Steve? • Farmer • Salesman • Airline Pilot • Librarian • Physician

18. Hmmm? • We are in a room of 70 engineers and 30 lawyers • Bill is a 30 year old man. He is married with no children. A man of high ability and high motivation, he promises to be quite successful in his field. He is well liked by his colleagues • Is Bill more likely to be a lawyer or an engineer?

19. Going to the UVA Basketball Game • Paid $ 200 for a courtside ticket • As you try to enter, you realize you have lost the ticket • Someone offers to sell you another ticket for $ 200….would you buy it? • You are on the way to the basketball game and have decided to pay $ 200 for a courtside ticket • As you try to enter, you realize that you have lost two hundred dollar bills, but still have several left and can buy the ticket • Would you still buy the ticket?

20. Sunk Costs • A man joins a tennis club and pays a $ 3000 yearly membership fee. After two weeks of playing, he develops a tennis elbow • He continues to play (in pain) saying: “I don’t want to waste the $ 300”

21. Naïve Diversification • Four Choices: • Three Bond Funds • One Stock Fund • Put ¼ in each • Four Other Choices • Three Stock Funds • One Bond Fund • Put ¼ in each

22. Perceptions of “Randomness”- an example of “representativeness” • In a population of families with exactly six children, which sequence of births is more likely: • B B B G G G • G B B G B G • School A has 65 % boys, School B has 45 % boys • You enter a class at random with 55 % boys • Is this class more likely from School A or School B?

23. The Big Enchilada – “Loss Aversion” • Explains • Equity Premium Puzzle • Endowment and Status Quo Biases • Extreme Risk Aversion • Means “path determined” utility

24. The Big Enchilada – “Loss Aversion” • Explains • Equity Premium Puzzle • Endowment and Status Quo Biases • Extreme Risk Aversion • Means “path determined” utility

25. The Problem of Consistency • Scylla and Charybdis • Which Ulysses’ preferences do you honor? • Example of precommitment

26. Biases • Small Sample Bias: “The strong bias toward believing that small samples closely resemble the population from which they are drawn…” page 114. (e.g. cancer in rural counties) • Anchoring including “anchoring and adjusting” • Was Ghandi more or less than 144 when he died? • Limit of 12 per person (average taken was seven, much higher than when there was no limit)

27. Availability • Saliency • Buying airport insurance • Related to overconfidence and over reaction

28. Causes vs Statistics • 85% of cabs in the city are green • Witness says “blue” • 20% false witness • ???

29. Causes vs Statistics • 85% of cabs in the city are green • Witness says “blue” • 20% false witness • ???

30. Regression to the mean • Highly intelligent females tend to marry men who are less intelligent than they are • The correlation between the intelligence scores of spouses is less than perfect (and men and women do not differ in intelligence on average)

31. Predictions • Paul Meehl • High school grades; one aptitude test • Outperformed complex batteries of test • “Clinical vs Statistical” Prediction • Dr. Apgar • Five variables: (heart rate, respiration, reflex, muscle tone, color)…give it a 0,1,2 • Score of 8 or above – great! • Score of 4 or less – trouble!

32. Analyzing Past Success • Books about great business leaders • Ignore “right place, right time” phenomenon • Chance may be more important • “Outliers” by Malcolm Gladwell • “I was smart” versus “I was lucky”

33. Optimism and Overconfidence • Business start ups • Four in five fail • But, no one ever assumes they are in the “four”

34. Regret • Mr. Brown almost never picks up hitchhikers. Yesterday he gave a man a ride and was robbed • Mr. Smith frequently picks up hitchhikers. Yesterday, he gave a man a ride and was robbed • Which of the two will experience greater regret? • Who will be criticized most severely by others?

35. Another Framing Example • The one-month survival rate is 90 % • There is a 10 % mortality rate in the first month • Do these sound different to you?

36. Mathematical Illusions • Adam switches from a gas-guzzler of 12 mpg to a slightly less voracious guzzler that runs at 14 mpg • The environmentally virtuous Beth switches from a 30 mpg car to one that runs at 40 mpg • Who saves more gas?

37. The End