15.

481x Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Unit 3: Psychology and Behavioral Biases
Lecture: Psychology and Finance
Roadmap
Efficient Markets Behavioral Finance
Rational Expectations Psychology

Artificial Intelligence Cognitive Neurosciences

Bounded Rationality

EvoluAonary Biology Adaptive Markets

Ecology Hypothesis
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Today’s Readings

© 2020 by Andrew W. Lo
Lecture 3 Slide 3
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 15.481
Behavioral Critique of Efficient Markets
§ Rationality is not supported by the data
§ Cognitive and behavioral biases
– Loss aversion, anchoring, framing
– Probability matching
– Randomization
– Overconfidence
– Overreaction
– Herding
– Mental accounting
© 2020 by Andrew W. Lo
Lecture 3 Slide 4
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 15.481
Behavioral Critique of Efficient Markets
Even Samuelson (1947) Had Reservations:
…[O]nly the smallest fraction of economic writings, theoretical and applied, has been
concerned with the derivation of operationally meaningful theorems. In part at least
this has been the result of the bad methodological preconceptions that economic laws
deduced from a priori assumptions possessed rigor and validity independently of any
empirical human behavior. But only a very few economists have gone so far as this. The
majority would have been glad to enunciate meaningful theorems if any had occurred to
them. In fact, the literature abounds with false generalization.
We do not have to dig deep to find examples. Literally hundreds of learned papers have
been written on the subject of utility. Take a little bad psychology, add a dash of bad
philosophy and ethics, and liberal quantities of bad logic, and any economist can prove
that the demand curve for a commodity is negatively inclined.

© 2020 by Andrew W. Lo
Lecture 3 Slide 5
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Behavioral Biases
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Perception and Cognitive Load

www.viscog.com
© 2020 by Andrew W. Lo
Lecture 3 Slide 7
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Wason Selection Task
§ “If a card has an even number on one side, the
other side is red”
§ Which card(s) should you turn over to test the
truth of this claim?

3 8
© 2020 by Andrew W. Lo
Lecture 3 Slide 8
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 15.481
Wason Selection Task
§ Suppose cards have age / type of drink
§ “If you are drinking alcohol, you must be over 21”
§ Which card(s) should you turn over to see if a
violation has occurred?

Age Age
16 42
© 2020 by Andrew W. Lo
Lecture 3 Slide 9
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Mental Accounting
Consider Scenario A:
§ You have two $250 tickets to a Broadway show
§ On your way to the theater, you lose the tickets
§ Would you:
1. Buy another two tickets at the theater?
2. Go home without seeing the show?
© 2020 by Andrew W. Lo
Lecture 3 Slide 10
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 15.481
Mental Accounting
Consider Scenario B:
§ You decide to go see a Broadway show
§ On your way to the theater, you learn that you
lost $500 in the stock market
§ Would you:
1. Buy two $250 tickets at the theater?
2. Go home without seeing the show?
© 2020 by Andrew W. Lo
Lecture 3 Slide 11
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Probability Sense
Linda is 31 years old, single, outspoken, and very bright.
She majored in philosophy. As a student, she was deeply
concerned with issues of discrimination and social justice,
and also participated in antinuclear demonstrations.
Please check off the most likely alternative:
§ Linda is a bank teller
§ Linda is a bank teller and is active in the feminist
movement
© 2020 by Andrew W. Lo
Lecture 3 Slide 12
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Probability Matching
Consider Repeated Coin-Toss Guessing Game:
§ If you’re correct, you get $1, otherwise -$1
§ Suppose coin is biased (75% H, 25% T)
§ Profit-maximizing strategy: HHHHHHHHHHHH
§ Actual behavior: HHHTHHHHTTHHHTHHHHTH
§ Common to ants, fish, pigeons, primates, etc.
§ Why? Is it irrational or adaptive?
© 2020 by Andrew W. Lo
Lecture 3 Slide 13
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 15.481
The Ellsberg Paradox
Urn A contains 100 balls:
§ 50 red, 50 black
§ Pick a color, then draw a ball
§ If you draw your color, $10,000 prize
§ Which color would you prefer?
§ How much would you pay to play?
© 2020 by Andrew W. Lo
Lecture 3 Slide 14
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 15.481
The Ellsberg Paradox
Urn B contains 100 balls:
§ Unknown proportion of black and/or red balls
§ Pick a color, then draw a ball
§ If you draw your color, $10,000 prize
Irrational
§ Which color would you prefer? or
§ How much would you pay to play? Adaptive??
© 2020 by Andrew W. Lo
Lecture 3 Slide 15
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Loss Aversion
§ A: $240,000
§ B: $1,000,000 With 25% Probability
$0 With 75% Probability

Which Would You Prefer?

© 2020 by Andrew W. Lo
Lecture 3 Slide 16
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 15.481
Loss Aversion
§ C: – $ 750,000
§ D: – $1,000,000 With 75% Probability
$0 With 25% Probability

Which Would You Prefer?

© 2020 by Andrew W. Lo
Lecture 3 Slide 17
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 15.481
Loss Aversion
§ A+D: $240,000 With 25% Probability
– $760,000 With 75% Probability

§ B+C: $250,000 With 25% Probability

–$750,000 With 75% Probability

Now Which Would You Prefer?

© 2020 by Andrew W. Lo
Lecture 3 Slide 18
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 15.481
Framing
If Program A is adopted, 200 people will be saved. If Program B is
adopted, there is 1/3 probability that 600 people will be saved, and
2/3 probability that no people will be saved. Which of the two
programs would you favor?
vs.
If Program A is adopted, 400 people will die. If Program B is
adopted, there is 1/3 probability that nobody will die, and 2/3
probability that 600 people will die. Which of the two programs
would you favor?
© 2020 by Andrew W. Lo
Lecture 3 Slide 19
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Modeling Risk Preferences 15.481

Preferences Under Uncertainty:

§ Utility of a Random Variable
§ Difficult To Evaluate
§ Requires Strong Assumptions
§ Von Neumann and Morganstern
§ Expected Utility Theory (EUT)

Modern Finance Theory Built On EUT

© 2020 by Andrew W. Lo
Lecture 3 Slide 20
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Modeling Risk Preferences 15.481

Denote By U(x) Your Utility Function

§ U($50,000) = 1, U(–$10,000) = 0
§ Consider three gambles, G1, G2, G3:
G1: $50,000 With 50% Probability
– $10,000 With 50% Probability
§ What is the most you would pay for G1?
§ Call this value $C1 (certainty equivalent)
© 2020 by Andrew W. Lo
Lecture 3 Slide 21
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Modeling Risk Preferences 15.481

Denote By U(x) Your Utility Function

§ Now consider G2, G3:
G2: $50,000 With 50% Probability
$C2
$C1 With 50% Probability

G3: $C1 With 50% Probability

$C3
– $10,000 With 50% Probability
© 2020 by Andrew W. Lo
Lecture 3 Slide 22
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Modeling Risk Preferences 15.481

Estimated Utility Function (<Your Name Here>)

1.2

1.0

0.8 Probability G1 G2 G3
50% $50,000 $50,000 #N/A
50% ($10,000) #N/A ($10,000)
0.6
Certainty C1 C2 C3
0.4 Equivalent: #N/A #N/A #N/A

0.2

0.0
-$20,000 -$10,000 $0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000

© 2020 by Andrew W. Lo
Lecture 3 Slide 23
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Modeling Risk Preferences 15.481

Spring 2020 15.481 Risk Aversion Profile

0.00 0.20 0.40 0.60 0.80 1.00 1.20
ENTIRE CLASS 0.23

MALE 0.18
FEMALE 0.36
<26Y 0.24
>=26Y 0.21
MBA (INCLUDING LGO) 0.28
MFIN 0.33
UNDERGRADUATE STUDENT 0.30

USA 0.25
AMERICAN COUNTRY (NON-USA) 0.24
CHINA 0.22
INDIA 0.21
ASIAN COUNTRY (NON-CHINA, NON-INDIA) 0.48
AFRICAN COUNTRY 0.71
EUROPEAN COUNTRY 0.17

GENERAL INVESTORS 1.07

FINANCIAL ADVISORS 0.78
INSTITUTIONAL INVESTORS 0.36

© 2020 by Andrew W. Lo
Lecture 3 Slide 24
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