Jimmy Martínez-Correa

Behavioral Finance - Lecture 3

Theory of Beliefs and Expectation
Biases

EAFIT, Summer Course

Medellín/Copenhagen, Summer, 2020.
 Plan for the day

> Why are Beliefs Important for Long-run Survival in the Stock
Market? (50 min)
o Trading in complete and incomplete markets
o Some evidence
-------------------------Break (10 min)-------------------------
> Rational biases (50 min)
o Optimistic behavior and financial markets
-------------------------Break (10 min)-------------------------
> More on Time Inconsistency (60 min)
o Kahoot
o Feedback on course project
 Learning objectives for today

1. Why are beliefs so important

2. Belief formation and financial choices

 Overview and Learning Objectives

> Motivation: Why are beliefs important?

▪ Blume, L. and Easly, B. (2006). “If You're so Smart, Why Aren't You Rich? Belief
Selection in Complete and Incomplete Markets,” Econometrica, 74(4), 929-966.
> Rational biases
▪ Brunnermeier, M.K., and Parker, J.A., “Optimal Expectations,” American Economic
Review, 95(4), 2005, 1092 – 1118.
▪ Brunnermeier, M.K., Gollier, C., and Parker, J.A., “Optimal Beliefs, Asset Prices and the
Preference for Skewed Returns,” AEA Papers and Proceedings, 97(2), 2007, 159 - 165.

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 Long-run Survival in Markets

> Market selection hypothesis

o Market selects for survival traders with more accurate beliefs

> Blume and Easley study theoretically the market

selection hypothesis both in complete and incomplete
markets

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 Long-run Survival in Markets: Classical
vs Behavioral Approach.
> Classical economics predicts that prices of assets in the
long run only depend on traders with rational
expectations
> Behavioral theories predict that irrational traders (noise
traders) can drive rational traders out of the market.
> Can we reconcile the two views?

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 What is a complete market?

> Imagine there are three states of the world:

o Shiny
o Rainy
o Cloudy
> A market is complete if there is at least one asset per
states.
o Loosely speaking, a market is complete if all bets that people
would like to make are actually possible to make.
> Markets are incomplete when there is at least one state
in the world where people cannot bet on.

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 Main Results

> In complete markets

o In complete markets all that matters for long-run survival is the discount
rate and beliefs about the future.
o A trader survives because of accurate beliefs (rational expectations).
o Individuals with bayesian learning survives in the long run.

> In incomplete markets

o People with less accurate beliefs can drive out of the market agents with
more accurate beliefs
o So behavioral theories have more to say in this environment
 The theoretical problem

> Economy with many individuals indexed by i and that

maximizes expected utility

> A social planner maximizes social welfare function

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 Some definitions

> Defining survival:

> Defining accurate beliefs (relative entropy)

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Some scenarios to study under complete
markets

Scenarios Beliefs Discount Factors

Scenario 1 i.i.d Heterogeneity
Scenario 2 Heterogeneity Identical
Scenario 3 Heterogeneity Identical
but with learning
Scenario 4 Heterogeneity Heterogeneity

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 Scenario 1: i.i.d. beliefs and different
discount factors across traders
> What trader survives? i? j?
o Compare marginal utilities

> Then in the long-run the ratio of marginal utilities is given by

is a survival index

> Necessary condition to survive: maximal survival index

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 Scenario 2: Identical discount factor but
different beliefs

> A trader survives because of accurate beliefs (rational

expectations.
> A trader survives if beliefs are close enough to the truth.

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 Scenario 3: Identical discount factor but with
different beliefs and possibilities of learning

> These results imply that individuals with bayesian

learning survives in the long run.

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 Why is bayesian learning ”rational”?

> 1% of women have breast cancer (and therefore 99% do

not).
> 80% of mammograms detect breast cancer when it is
there (and therefore 20% miss it). These are the false
negatives.
> 9.6% of mammograms detect breast cancer when it’s not
there (and therefore 90.4% correctly return a negative
result). These are the false positives.

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 Why is bayesian learning ”rational”?

Cancer (1%) No Cancer (99%)

Test Positive 80% 9.6%
Test Negative 20% 90.4%

> If you get tested and get a positive result what are the
chances that you have cancer?

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 Why is bayesian learning ”rational”?

Cancer (1%) No Cancer (99%)

Test Positive 80% 9.6%
Test Negative 20% 90.4%

> If you get tested and get a positive result what are the
chances that you have cancer?
o Chance of having cancer and getting a positive test = 80%*1% =
0.8%
o Chance of not having cancer and getting a positive test =
99%*9.6% = 9.5%
o Chance of having cancer conditional on getting a positive test=
0.8%/(0.8%+9.5%)=7.8%

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 Why is bayesian learning ”rational”?

> Bayesian updating takes into account potential noise in

the information you have
> For example, is good to deal with false positives and
false negatives.
> Bayesian updating is a filter of noise information.

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 Scenario 3: Identical discount factor but with
different beliefs and possibilities of learning

> Intuitively it means that if there is much to learn then

people that start with beliefs close to the truth can be
driven out of the market by people with less accurate
beliefs but with less to learn.
> If there is a lot to learn then the market selection
hypothesis may not hold.

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 Scenario 4: Different beliefs and discount
factors

> Basic intuition:

o If you have high enough discount rate (patient enough) you may
be able to compensate for not so accurate beliefs. So this
individual may consume more than another trader with more
accurate beliefs.
> Why?
o Low discount rate (patience) induce people to save a lot and this
compensate for the wrong beliefs.

> So the market selection hypothesis may not hold here

either.

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 Incomplete Markets

> In this case, the market selection hypothesis can fail.

> Why?
o Example 1: Suppose that you have good accurate beliefs about
the future. But there are other people that may have not so good
accurate beliefs on average. However the latter have really good
forecasts, even better than you, for the states of the world in
which people can trade in. Even though you have better beliefs
about the future in general, you are driven out of the market
because other people have more accurate beliefs for the states
that matter for trading.

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 Incomplete Markets

o Example #2: Suppose that you have somewhat good beliefs

about the future and act according to those. Now assume that
there are other traders that are optimistic about the future of the
asset and this leads them to over-save a lot in this asset. You
might be unlucky and get a chain of events that you could not
fully hedge because of incomplete markets and you blow up.
The irrationally overoptimismtc guys that over-saved survived
because over-saving is the ex-post optimal strategy.
o Similar situations can arise if the over-saving is coming from high
risk aversion or high discount factor.

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 Main Results

> In complete markets

o In complete markets all that matters for long-run survival is the discount
rate and beliefs about the future.
o A trader survives because of accurate beliefs (rational expectations.
o Individuals with bayesian learning survives in the long run.
▪ But a person with a lot to learn can be driven out of the market by a trader
with less accurate beliefs
o If a person is patient enough that person may be able to compensate for
not so accurate beliefs.
> In incomplete markets
o People with less accurate beliefs can drive out of the market agents with
more accurate beliefs
o So behavioral theories have more to say in this environment
 Investor Sentiment (Baker & Wurgler 2007)

> If we have both:

o Investors who are subject to sentiment
▪ Optimism or pessimism about stocks in general
▪ Herding
▪ Bubbles
o Betting against sentiment is costly and risky

> Sentiment will mainly affects difficult-to-value (and

arbitrage) stocks
o Smaller, younger, unprofitable, non-dividend paying, high growth
potential, etc

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Predictions
 Index of Investor Sentiment
(Baker & Wurgler 2007)

> Construct an index from series that proxy for investor

sentiment
o Trading volume, number of IPOs, IPO first-day returns, closed-
end fund discount, dividend premium, etc

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Portfolios Based on Sensitivity to Sentiment
Index

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 In-class discussion

> The results from Blume and Easly imply that under
certain conditions only beliefs and discount factors
(patience) matter for survival in a complete market. Is
this intuitive?
> Why is risk aversion not showing up here as a
determinant?
> Can you explain why risk aversion might matter for long-
run survival?

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Rational Biases

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 Is optimism a good or a bad thing?

> Optimism can be good because it can help you cope

psychologically with the prospect of bad outcomes in the
future.
o Leaders of teams normally frame situations in a postive
optimistic way to motivate employees.

> But it can be bad…

o Too much optimism can induce you to make wrong choices.
o E.g., buying a really expensive house with a big loan under the
optimistic assumption that your income or housing prices are
going to be really high in the future.

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 What do we know about optimism?

> Psychological research shows that people are wired for

optimism
o E.g., people tend to forget bad memories and remember good
ones.
o So optimism is a natural tendency for humans.
> Many choices we make are not based on cognition but
on automatic emotional processes.
> So optimism is a natural response and heuristic to solve
problems.

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 What is the main intuition in this study?

> Classical economics and finance predicts that the most rational thing
to do is to have ”rational expectations”
o i.e. subjective probabilities = actual objective probabilities
o People have incentives to have rational expectations because it induces
optimal behavior.

> Behavioral theories predict that people will display optimistic beliefs
o People have incentives to be optimistic because they help them feel
good.
o But deviating from rational expectations is costly: optimism induces
suboptimal behavior.
▪ E.g.: Taking a loan to bet on a long-shot stock.

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 What is the main intuition in this study?

> Can we combine the classical and the behavioral

approach?
> Here we study a theory of ”rational biases”
> Beliefs are chosen optimally:
o Psychological benefits of optimism are taken into account
o Costs of optimism are taken into account
o At the optimum people trade-off optimism with realism and end
up biasing beliefs but not so much.

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 Why people find optimism beneficial?

> Classical theories care about final utility of wealth while

behavioral theories care about interim valuations of
utility:

o So people care about their final utility of wealth but also about
how the are going to feel about final utility of wealth in interim
periods.
o People anticipate that they can feel anxiety before final wealth is
realized.

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 How a rational individual would make
portfolio choices given beliefs

> If probabilities
are given people choose a portfolio
allocation on the risky asset that maximizes expected
utility.

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 How are optimal beliefs chosen?

> People choose beliefs that maximize weighted average

of final expected utility (using realism, i.e., actual
probabilities) and anticipated utility using the biased
probabilities.

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 Assumptions

> Assumption 1 means that people have biased beliefs are

reasonable:
o follow the rules of probabilities and
o never believe something that is not possible at all

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 Assumptions

> Assumption 1 means that people have biased beliefs

are reasonable:
o follow the rules of probabilities and
o never believe something that is not possible at all
> Assumption 2 means that one can find an optimal
biased belief that maximizes wellbeing of individuals
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 So why would people rationally bias
beliefs?

> Optimism make people feel better

o They know bias beliefs have a cost and optimally trade benefits
of optimism against its cost

> Optimism is a wired automatic heuristic, but people may

conciously tame it and allow some optimism to help them
psychologically but this bias is not that big so it is not
very distortive.
o People might use this way of making choices when there is a lot
at stake.

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 Discussion: What can we explain with
this model

> Result 1: People take too much risk due to optimism

o People take more risk than he would like if the person was a
realist.

> Result 2: People display a preference for skewness

o Optimism make more salient the long-shot type of assets.

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 Endogenous Heterogenous Beliefs

> If we allow agents to hold different beliefs in the market,

they end up betting against each other.
> There are several interesting predictions:
o Optimism → Preference for skewness→ increases the price of
positively skewed assets→ reduces expected return
▪ Low beta anomaly
o Optimism → Preference for skewness→decreases the price of
negatively skewed assets → increases expected returns
▪ Equity premium puzzle
o Optimism → overinvestment
▪ Local stocks (home biased puzzle)
▪ Investment in companies they work for

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 Three Stylized Facts

> Households are not optimally diversified but

underdiversification is modest
o People hold portfolios invested in mutual funds and a few
additional stocks
> Households tend to have a preference for stocks that
have positive skewness
> Assets with positive skewness tend to have a lower
return.

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 Portfolio Choices

> People invest more in states where subjective

probabilities are more optimistic than the actual
probabilities for that state.

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Optimal Portfolio Choices: Preference for
Skewness

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Optimal Portfolio Choices: Portfolios are suboptimally
diversified and people hold a few skewed assets

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Optimal Portfolio Choices: Preference for Skewness increases
demand for skewed assets and this increases price and therefore
returns.

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A THEORY OF MOTIVATED BELIEFS

Benabou, R. (2015). “The Economics of Motivated Beliefs,”

Working Paper, Princeton University.
 Motivated Beliefs: Example

> Huntington’s disease (Oster et al., 2013):

o A person with a parent with the disease has a 50% of inhereting
the gene
o People fail to update update bad news
▪ Worse motor score tests → objective probability of 99% of having
the disease
▪ But people report a probability of 40%
▪ People act upon this beliefs:
– Many people decide not to get tested
– Those who get tested and have the gene change behavior: get pregnant,
retire early, divorce, etc…
– Those that do not get tested behave as if they did not have the disease.

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 Why people distort beliefs?

> Two potential explanations:

o Self-efficacy model: holding optimistic beliefs in anticipation that
the future-self will not have enough ”will of power” to go through
with the plans.
o Affect-driven model: holding optmistic beliefs to compensate for
anticipated utility of a bad state of the world.

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Self-efficacy Model

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Affect-driven Model

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 The two models in one

> At t = 1 the individual maximize

> At t = 0 beliefs are manipulated to maximize

o where mi are the direct costs of information decisions (avoiding

information or people, repressing unwanted thoughts)

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 Discussion

> Do you think is rational to hold optimistic beliefs in the

stock market?
> When can optimistic beliefs help?
> When can they hurt?

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 Conclusions

> People bias beliefs. Is it always a bad thing to do?

> If you bias beliefs because you know you will need a
morale boost in the future to get things done, maybe it is
not a bad idea.
> If you bias beliefs to compensate the disutyility of
contemplating bad outcomes in the future, maybe you
end up making bad choices (e.g., not taking the
Huntington’s test)

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