Behavioral Finance Lecture 4 by vsn10047

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									                             Behavioral Finance
                                 Lecture 4
Theme 2 continuation:

Hedonic Editing

                         -   the preference of some frames over others

                             o Investors are particularly susceptible to this


From a Stockbroker Manual (See slides for Write up)

When you suggest that the client close at a loss a transaction that you originally
recommended and invest the proceeds in another position you are currently
recommending, a real act of faith has to take place. That act of faith can more easily
be effected if you make use of some transitional words that I call “magic selling
words.”

The words that I consider to have magical power in the sense that they make for a
more easy acceptance of the loss are these: “Transfer your assets.”


Why “Transfer you Assets?”

        Because they induce the client to use a frame in which he or she reallocates
assets from one mental account to another, rather than closing a mental account at a
loss.

A Theory of Hedonic Editing for Mental Accounts (Thaler and Johnson, 1991)

Read and record you answer for the following questions and then move on to the
next.

   1. Imagine that you face the following choice. You can accept a guaranteed
      $1,500 or play a stylized lottery. The outcome of the stylized lottery is
      determined by the toss of a fair coin. If heads comes up, you win $1,950. If
      tails comes up, you win $1,050. Would you choose to participate in the
      lottery? Yes or no? Yes means you take your chances with the coin toss. No
      means you accept the guaranteed $1,500.

   2. Imagine that you face the following choice. You can accept a guaranteed loss
      of $750 or play a stylized lottery. The outcome of the stylized lottery is
       determined by the toss of a fair coin. If heads comes up, you lose $525. If tails
       comes up, you lose $975. Would you accept the guaranteed loss? Yes or no?
       Yes means you accept a $750 loss. No means you take your chance with a
       coin toss.


Most common responses are to take $1,500 and run in 1)

       The risk averse response, as we talked about earlier

              Why is this a risk averse response?

                     Because, the average payoff to the lottery ticket is $1,500, the
                     same amount involved in the riskless option.

                             Recall: a risk averse person will not take part in a fair
                             bet.


In 2) many people choose the lottery over a guaranteed loss.

       This is risk seeking behavior

              The expected payoff to the coin toss is $750 loss, the same amount
involved in the riskless option.


       the Moral of the Story?
           o People are not uniform in their tolerance for risk!

                     It depends on the situation

NOTE: It is quite common for financial planners and investment advisors to
administer risk tolerance quizzes in order to determine a degree of risk that is
suitable for their clients.

                         -   BUT behavioral finances stresses that risk is not
                             uniform in terms of tolerance levels

                             o That is risk is not uni-dimensional

Consider these further examples, which should help to bring out the complexity of
the issues more

   3. Imagine that you have just won $1,500 in one stylized lottery, and have the
      opportunity to participate in a second stylized lottery. The outcome of the
       second lottery is determined by the toss of a fair coin. It is comes up heads,
       you win $450 in the second lottery. It tails comes up, you lose $450. Would
       you participate in the second lottery after having won the first? Yes or no?

   4. Imagine that you have just lost $750 in one stylized lottery, but have the
      opportunity to participate in a second stylized lottery. The outcome of the
      second lottery is determined by the toss of a fair coin. If heads comes up, you
      win $225 in the second lottery. If tails comes up, you lose $225. Would you
      choose to participate in the second lottery after having lost in the first? Yes or
      no?


Time to compare your answers

                          -   From a dollar perspective note that 1) and 3) are
                              equivalent

                          -   Traditional finance would say that you should respond
                              the same way in either case

                              o In practice, though, many people switch (upwards of
                                25%, typically)

Thaler and Johnson suggest that the answer for this switch lies with hedonic editing,
the way people organize their mental accounts.

       Thought processes of lottery participants may go something like, “If I lose
$450 in the second lottery, after having won $1500, I’m down to $1050, which is the
same amount I would have had in the first lottery had I participated and lost. So, I’m
no further behind.”

       Of course, if people win, the will often NOT net their two gains, but rather savor
them separately.

       Thaler and Johnson hypothesize that the added attraction of experiencing
gains separately inclines people to be more willing to gamble.

When we look at choices 2) and 4) where losses are concerned, most people seem
incapable of netting out moderately sized losses of similar magnitudes.

        In other words, people nearly have a nervous breakdown when considering a
loss of $225 coming on top of a prior loss of $750.

                          -   of course, most people choose to partake of the lottery
                              in choice 2), while not in 4) even thought the choices
                              are dollar equivalent.
                                 o Most people who chose to take the gamble in 2) no
                                   longer take it in 4).

Cognitive and Emotional Aspects

         Recall:
                   Cognitive aspects concern the way people organize their information

                   Emotional aspects deal with the way people Feel as they register the
                   information

         NOTE: this distinction is an important one!

Consider the previous example

       The main cognitive issue in 3) is whether or not people ignore having just
won $1,500 when deciding whether or not to take an even chance on winning or
losing $450.

                   Some ignore it and others do not.

                          Cognitive and emotional aspects are acting together

                                 If you ignore the amount of money you just won, you in
                                 essence feel the loss of the $450, as just that, a loss of
                                 $450.

                                 Those who choose to consider the $1,500 are, in
                                 essence, only experiencing a smaller gain ($1,050), if
                                 they lose $450.


Recap:
                             -   Frame Dependence means that the way people behave
                                 depends on the way that their decision problems are
                                 framed

                             -   Hedonic Editing means that people prefer some frames
                                 to others

Consider the financial implications

         Consider investor preferences for cash dividends
                         -   as stocks go up, dividends can be savored separately
                             from capital gains
                         -   when stocks go down, dividends act as a “silver lining”
                             to buffer capital loss

                             o In essence, people want to keep dividends in their
                               right pocket, to borrow from Miller’s description

Excerpt from Forbes Magazine (1998)

“Then in 1986 we did a closed-end fund….I always worried about discounts on
closed-end funds….The first nine months out of the gate, we were at a 17%
discount. I was mortified. I sat down and did a lot of thinking. Bonds funds at
the time were selling at about parity. Stock funds were all at discounts. It
didn’t make sense, because stocks do better than bonds in the long rung. And I
realized bond funds pay interest. People like the certainty of an income
stream. So I said, “Well, we’re going to pay the dividend, whether we earn it or
not.” And we went to this 10% dividend policy….The discount narrowed
immediately.” (closed-end fund manager Martin Zweig)

       The deep discount is relative to the net asset value (NVA), the value the
       shares would trade for if the fund were open-ended instead of being
       closed.
       This is what started Zweig thinking about dividends…


Closed End fund = A closed-end fund is a publicly traded investment
company that raises a fixed amount of capital through an initial public
offering (IPO); limited number of shares traded. The fund is
then structured, listed and traded like a stock on a stock exchange.

Open end fund = mutual funds we typically talk about; that is, they can issue and
redeem shares, essentially, whenever they (those who run it) like; this is in contrast
to the closed-end funds which require shares to be purchased from shareholders of
that fund. Prices directly related to funds performance; where the closed end fund is
determined by the performance and the premium placed by the market.
Self Control

      Controlling one’s emotions

                       -   The certainty of an income stream is important to a vast
                           majority of people

                       -   Economists refer to this an income smoothing

                       -   This is why, people like the certainty that comes with
                           dividends!

                           o In essence, dividends are a “certain” income stream

                                     What does this have to do with self-control?

                                         •   The “don’t-dip-into-capital” heuristic

                               o Older investors, especially retirees who finance
                                 their living expenditures form their portfolios,
                                 worry about spending their wealth too quickly,
                                 thereby outliving their assets

                                       o They fear a loss of self-control, where
                                         the urge for immediate gratification
                                         leads them to go on a spending spree

                                                o How do they get around this?
                                                       Dividends are one way
                                                       Dividends are labeled as
                                                       income, not capital
                                                           • AND people tend
                                                               to frame them as
                                                               such.

                                         o So they spend their dividends freely!
Regret

Is the emotion experienced for not having done the right thing. Not making the right
decision

        It is more than the pain of loss.

               It is the pain associated with feeling responsible for the loss.

Example:

      You travel a particular route to school everyday, but one day you decide for
whatever reason to travel another route. In doing so, you wind up in an accident.

        Even if the odds of an accident were the same on either route, how will you
feel?

        “If only I had done what I always do, none of this would have happened.”

- This can have profound effects on how you view the future.

        - If you feel regret strongly, you may have a strong dislike of variety.


Financial Example:
      Equity-fixed income allocation in a defined contribution retirement plan.

         “My intention was to minimize my future regret. So I split my contributions
fifty-fifty between bonds and equity.” (Harry Markowitz, Nobel Laureate - -
responsible for modern portfolio theory!!)

Regret minimization often leads people to choose dividends, as well, over stocks,
when financing consumer expenditures.

        Why?

               If the stock price soars after you sell, you feel a deep sense of regret!
Money Illusion

- Dealing with inflation

Consider the following example:

Two individuals, Ann and Barbara, who graduated from the same college a year
apart. Upon graduation, both took similar jobs with publishing firms. Ann started
with a yearly salary of $30,000. During her first year on the job, there was no
inflation, an in her second year, Ann received a 2% ($600) raise in salary. Barbara
also started with a yearly salary of $30,000. During her first year on the job, there
was 4% inflation, and in her second year, Barbara received a 5% ($1,500) raise in
salary.

       a) As they entered their second year on the job, who was doing better in
          economic terms?

       b) As they entered their second year on the job, who do you think was
          happier, Ann or Barbara?

       c) As they entered their second year on the job, each received a job offer
          from another firm. Who do you think was more likely to leave her present
          position for another job, Ann or Barbara?

Most common answers:
      a) Ann is better off
      b) Barbara is happier
      c) Ann is more likely to look for another job

Question: if Ann is better off, why is she less happy and more likely to look for
another job?

Suggestion some authors have made is that people like to think in Nominal terms,
even though they are quite apt at calculating the impact of inflation.
Theme 3: Inefficient Markets

                      -   Representativeness, and the market’s treatment of past
                          winners and losers

                      -   Anchoring-and-adjustment, and the market’s reaction to
                          earnings announcements

                      -   Loss aversion, and the risk premium on stocks

                      -   Sentiment, and market volatility

                      -   Overconfidence, and the attempt to exploit mispricing

								
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