Behavorial finance
Few simple questions to test your financial literacy
• Suppose that your financial portfolio has an initial value of 100$ and that over the year, this
value increased to 110$. How much did you make?
o The simple 1-period return is the relative increase in value over that period:
• Suppose that you need to decide to invest in a product for which the return depends on
three possible scenarios for the state of the economy: good, neutral and bad. Each one with
a certain probability and outcome. Is this an attractive investment when the risk-free rate of
return is 0%?
o To answer this question, we need to evaluate the expected return and risk of the
investment. The expected return of discrete outcomes is the sum of these outcomes,
weighted by their probability of occurrence:
=> Risk averse investors will thus prefer the risk free rate of return, because it has a
higher expected return and no risk.
o Note the asymmetry between neutral/good
and bad. The market takes the stairs up and
the elevator down. The market doesn’t move down the same way it moves up.
Downward moves are generally much larger, faster and shorter in duration. Upwards
moves are slower and more sustained.
• Suppose you have 100$ in a savings account earning 2% interest a year. After five years, how
much would you have?
o Compounding! During the five years, you earn interest on your interest. 100*(1+i)n
• Do you prefer to receive annual over semi-annual interest payments?
o NO! The higher the frequency of interest payments, the larger is the amount
received in terms of ‘interest on interest’.
• Suppose the market drops by 50%, how much do you need to make to reach the same level
again?
, o 100%!
• Imagine that the interest rate on your savings account is 1% a year and inflation is 2% a year.
After one year, would the money in the account buy more than it does today, exactly the
same or less than today?
o You have less. The reason is inflation. Inflation is the rate at which the price of goods
and services rises. If the annual inflation rate is 2%, but the savings account only
earns 1%, the cost of goods and services has outpaced the buying power of the
money in the savings account that year. Put another way, your buying power has not
kept up with inflation. You need to look at the real rate of return.
• If interest rates rise, what will happen to bond prices?
o When interest rates rise, bond prices fall. This is because as interest rates go up,
there is a decrease in the present value of the future cash flows the investor will
receive (the discount rate is higher, thus the discounted cash flows are lower than
before).
o **People are very afraid today, because interest rates are starting to raise again.
• True or False? Buying a single company’s stock usually provides a safer return than a stock
mutual fund.
o In general, investing in a stock mutual fund is less risky than investing in a single
stock. Mutual funds are a way to diversify. Diversification means spreading your risk
by spreading your investments. With a single stock, all your eggs are in one basket. If
the price falls when you sell, you lose money. With a mutual fund that invests in the
stocks of dozens of companies, you lower the chances that a price decline for any
single stock will have a large impact on your return.
Rational financial decision making.
, • How do people make financial decisions? In traditional economic textbooks they talk about
‘the economic man’ and make the assumption of rationality.
o The assumption of rationality is a simplification to build models.
• How do normal people make financial decisions? In real life, it depends on the type of
decision, the person, the situation, etc. This is what behavorial finance is about. Sometimes,
you make a decision like a monkey and thus very randomly.
o If you look at people their behavior, they don’t think ‘you win some, you lose some’.
People hate losing more than they love winning.
o People also don’t do what they should do. Very often, we know what we need to do
to be successful, the rational planner. However, what we do is often something very
different. Emotions and cognitive bias are in the way and limit our self-control.
o Also, people behave like sheep that follow the crowd. If everybody makes a mistake,
no problem. If you are the only one making a mistake, you feel very bad.
o Some people act as a shark and profit from other people. Other people act based on
their values.
o People also have limited computation skills, they make mistakes. Perception is very
important. The way you present decisions to people, affect their decisions. First
example: This is all about perception.
Second example: the economic man would immediately know the answer, we have
to think about it.
• We are the decision architect. By knowing about these biases, we can set rules to avoid them
and to avoid the mistakes of others. Also, successful investing is anticipating the anticipation
of others, also when the others are irrational. Warren Buffet: Price is what you pay, value is
what you get. Irrational behavior can have a huge impact on the financial markets. It
depends on whether the rational agents can outcompete the less rational agents. This is
important to know if the real price reflects the true value or not.
Explaining financial decisions under uncertainty.
, 1. Outline
a. Modeling financial decision making using the prospect theory instead of expected utility
b. Use of prospect theory to explain financial decisions
c. Exploiting the predictable mistakes of others and avoiding yours (behavorial portfolio
allocation, behavorial corporate finance).
2. Sensitivity to the objective function of the decision maker
a. Optimal financial decision making
Optimal means best according to a criterion: the objective function. Uncertainty about future
payoffs, heterogeneity across individuals and the interaction between individuals, the
economic system and technology make this criterion complex. That’s why we need to make
simplifying assumptions. (3)
i. Assumption about the decision problem
We need to decide between two contracts (prospects). Depending on the prospect chosen,
the wealth we will have at the end of the period will be different. The actual value of the
wealth will depend on the state of the world.
ii. Assumptions about the word
Consider a world with n possible states. In each state the wealth received from the
prospect can be different. Each state has a probability pi, with i = 1,…,n and p1 + p2 + … + pn
= 1.
iii. Assumptions about the individual optimality criterion
Three possibilities. Maximize expected wealth. Maximize expected utility. Maximize
weighted value ( = prospect theory).
1. Maximum expected wealth
You will chose prospect 1 if:
You will be indifferent when: =
