Chapter Twelve

Behavioral Finance

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 Behavioral Finance

Conventional Finance Behavioral Finance

• Prices are correct and • What if investors don’t
equal to intrinsic value behave rationally?
• Resources are
allocated efficiently
• Consistent with EMH

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 The Behavioral Critique

Two categories of irrationalities:

1. Investors do not always process information
correctly
• Result: Incorrect probability distributions of
future returns
2. Even when given a probability distribution of
returns, investors may make inconsistent or
suboptimal decisions
• Result: They have behavioral biases
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 Errors in Information Processing:
Misestimating True Probabilities

1. Forecasting Errors: Too much weight is placed

on recent experiences

2. Overconfidence: Investors overestimate their

abilities and the precision of their forecasts

3. Conservatism: Investors are slow to update their

beliefs and under react to new information

4. Sample Size Neglect and Representativeness:

Investors are too quick to infer a pattern or trend
from a small sample
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 Behavioral Biases: Examples

1. Framing
• How the risk is described, “risky losses” vs.
“risky gains,” can affect investor decisions

2. Mental Accounting
• Investors may segregate accounts and take
risks with their gains that they would not take
with their principal

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 Behavioral Biases: Examples

3. Regret Avoidance
• Investors blame themselves more when an
unconventional or risky bet turns out badly
4. Prospect Theory
• Conventional view: Utility depends on level of wealth
• Behavioral view: Utility depends on changes in
current wealth
• Incremental value of a loss is larger than that of a
loss.
“the hurt of a $1000 loss is more painful than the benefit of a $1000 gain”.
•

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 Examples of Prospect Theory

Have $300 (“Initial endowment”).

Consider a choice between:
a sure gain of $100
a 50% chance to gain $200, a 50% chance to gain $0.

Consider a choice between:

a sure loss of $100
a 50% chance to lose $200, a 50% chance to lose $0.

Case 1: 72% chose option 1, 28% chose option 2.

Framed as a gain: decision maker is risk averse.

Case 2: 36% chose option 1, 64% chose option 2.

Framed as a loss: decision maker is risk seeking.
•
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 Figure 12.1 Prospect Theory

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 Limits to Arbitrage

• Behavioral biases would not matter if

rational arbitrageurs could fully exploit the
mistakes of behavioral investors
• Fundamental Risk:
• “Markets can remain irrational longer than you
can remain solvent”
• Intrinsic value and market value may take too
long to converge

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 Limits to Arbitrage

• Implementation Costs:
• Transactions costs and restrictions on short
selling can limit arbitrage activity
• Model Risk:
• What if you have a bad model and the market
value is actually correct?

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 Bubbles and Behavioral Economics

• Bubbles are easier to spot after they end

• Dot-com bubble
• Housing bubble

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