Case studies

1. A study by Justine Hastings and Jesse Shapiro (2013) provides

the clearest evidence of a very important concept of
behavioral finance. In their work, they studied consumers’
choice between regular and premium gasoline (petrol) when
the price of gasoline fell by about 50% in 2008 from a high of
about 90 cents a litre to just below 45 cents using customer
data from a grocery store that also sold gasoline. Consider the
following scenario: Suppose a household is currently spending
$80 a week on regular gasoline and the price drops from 90
cents to 45 cents a liter, so the household’s gasoline
expenditure would then drop to $40 a week. If a typical
economically rational individual were confronted with such a
drop, in gasoline prices, what would you expect him or her to
do? Firstly, since gasoline is cheaper, the household could be
expected to make more road trips. That sounds reasonable.
Secondly, since gaining the equivalent of $40 a week in extra
take-home pay, he or she could foreseeably spend that on
anything that enhances utility, from more entertainment to
more luxuries as long as the extra $40 is spent in ways that
maximize overall utility. Some of that extra money might even
be spent on a higher grade of gasoline (despite this not having
any established tangible benefits), but “rational” economic
theory would only predict a minuscule amount would be
spent in this way. But what actually happened? The study
found that the shift to premium gasoline was 14 times greater
than predicted by a standard demand model. Further they
also found that in contrast, there was no tendency for families
to upgrade the quality of two other regular grocery store
purchases, namely milk and orange juice during this same
period.
Answer the following questions based on the details of the above
study and using your knowledge of behavioral finance.
a. Identify and explain briefly the behavioral finance concept
that caused the irrational behavior as revealed by the study.
b. How does this behavioral aspect affect the way we take
decisions relating to use of money?
c. What is the underlying anomaly that causes this bias? How do
we avoid this bias?

2. Respondents were told that they could allocate money that

they had just inherited among four investment choices: a.
shares in XYZ that had moderate risk; b. shares in ABC that
had high risk; c. T-bills; and d. Government Bonds. The
average allocation was: a. 32%; b. 18%; c. 18%; and d. 32%. In
addition to this base case, four additional portfolio options
were offered, where participants were told that one of the
four portfolios (instead of money) had been left to them. They
could leave their money where it was, or without cost shift it
to one of the other three choices. No matter which
investment option was chosen as the original portfolio, it was
always the most popular choice even though it was not
something that they had any part in choosing.

Identify and explain the behavioral bias in the above experiment.

Also, explain the two principal behavioral finance concepts signified
by the behavior of the respondents.

3.Analyze the following situations and identify and describe one or

more
behavioral characteristics/biases/concepts.
3.
i) Imagine that you have decided to see a play where
admission is $10
per ticket. As you enter the theater, you discover that you
have lost a $10 bill. Would you still pay $10 for a ticket to
the play?
ii) Imagine that you have decided to see a play and have
paid
the admission price of $10 per ticket. As you enter the
theater,
you discover that you have lost the ticket. The seat was
not
marked and the ticket cannot be recovered. Would you
pay $10
for another ticket?

Of the respondents given the first question, 88% said they

would buy a ticket. Yet, of the respondents given the second
version of the question, the
majority (54%) said they would not buy a ticket.
4.

i) You have a Complimentary Premium Seat ticket for the

Filmfare Awards Nite ! On the day of the event there is
heavy
rain and flooding and major disruptions in traffic! Would
you
brave the weather condition and attend the event?
ii) You have Bought a Premium Seat ticket for the
Filmfare Awards Nite ! On the day of the event there is
heavy
 rain and flooding and major disruptions in traffic! Would
you
brave the weather condition and attend the event?

A substantially higher number of respondents chose to

brave the
weather and attend the event in Situation (ii) vis-à-vis
Situation(i).

5. Imagine that Country A is preparing for the outbreak of an

unusual

disease, which is expected to kill 600 people. Two

alternative programs to combat the disease have been
proposed
Situation I
i) If Program A is adopted, 200 people will be saved.
ii) If Program B is adopted, there is a ⅓ probability that 600
people
will be saved, and a ⅔ probability that no people will be
saved.
Which of the two programs would you favor?
72% of the respondents chose Program A.
Situation II
Imagine that the Country A is preparing for the outbreak
of
an unusual disease, which is expected to kill 600 people.
Two alternative programs to combat the disease have
been proposed.
iii) If Program C is adopted, 400 people will die.
 iv) If program D is adopted, there is a ⅓ probability that
nobody will die, and a ⅔ probability that 600 people will
die.
Which of the two programs do you favor?
78% of the respondents chose Program D.

6. Assume a roulette wheel has a 50% chance of stopping on red

and a 50% chance of stopping on black. The wheel stops on red 8
times in a row. Which statement is true? Give Reasons by giving
reference to the likely behavioral bias.

a) Red is a better than even bet now as the trend is red

b) Odds of the next spin being black are now increasing due
to mean reversion
c) Neither A nor B

7. Consider Laura Smith. She is 31, single, outspoken and very

bright. She majored in economics at university and, as a student,
she was passionate about the issues of equality and
discrimination.

Question:
Is it more likely that Laura works at a bank? or
Is it more likely that she works at a bank AND is active in the
feminist movement?
Identify likely behavioral bias and Give Reasons!
iii) would you say that there are more words in the English
language that begin with the letter t or with the letter k? You
might try to answer this question by thinking of as many words
as you can that begin with each letter.
 Since you can think of more words that begin with t, you might
then believe that more words begin with this letter than with k.
What Heuristic is seen in this exercise?
Explain the relevant heuristic bias and indicate its limitations

8. would you say that there are more words in the English language
that begin with the letter t or with the letter k? You might try to
answer this question by thinking of as many words as you can that
begin with each letter.

Since you can think of more words that begin with t, you might then
believe that more words begin with this letter than with k. What
Heuristic is seen in this exercise?

Explain the relevant heuristic bias and indicate its limitations.

9. XYZ stock had very strong revenue in the last year, causing its
share price to shoot up from Rs 25 to Rs 80. Unfortunately, one of
the company's major customers, which contributed to 50% of XYZ's
revenue, had decided not to renew its purchasing agreement with
XYZ. This change of events causes a drop in XYZ's share price from Rs
80 to Rs 40. The investor now believes that XYZ is undervalued. Is the
investor right in his assessment? Give reasons for your answer with
detailed reference to behavioral bias if any.

10. As Warren Buffett famously put it, “What the human being is
best at doing is interpreting all new information so that their prior
conclusions remain intact.”

Consider for example, an investor that hears about a hot stock from
an unverified source and is excited by the potential returns. That
investor might choose to research the stock in order to "prove" its
touted potential is real. What ends up happening is that the investor
finds all sorts of green flags about the investment (such as growing
cash flow or a low debt/equity ratio), while glossing over financially
disastrous red flags, such as loss of critical customers or dwindling
markets. What is the behavioral bias seen in the above investor
approach? Explain how the bias affects investment decisions.