Investor Behavior and the

Financial Market
Values, Preferences, and Choices:
Deviations from the Standard Model

Prof. Seungho Choi

Department of Finance
Hanyang University Business School
Course Schedule

Topic
Week 1 수업 소개/전통적 경제학적 모형에 대한 소개
Week 2 가치, 선호와 선택에서의 편향
Week 3 기대심리, 휴리스틱 측면에서의 편향
Week 4 불확실성 하에서의 합리적 선택과 그 한계 1
Week 5 공휴일 (개천절)
Week 6 불확실성 하에서의 합리적 선택과 그 한계 2
Week 7 인지편향에 대한 수업 내 토론 및 케이스 발굴
Week 8 중간고사
Week 9 행동재무론에 대한 소개: 효율적 시장 가설
Week 10 현재가치 모형이 의미하는 바는 무엇인가?
Week 11 정보, 정보에 대한 반응과 시장유동성
Week 12 금융시장에서의 행동적 편향에 대한 수업 내 토론 및 케이스 발굴
Week 13 행동 기업 재무 1
Week 14 행동 기업 재무 2
Week 15 행동 가계 재무
Week 16 기말고사
Assessment Outline

Total 100%

Attendance 10%

Discussion 10%

Assignment 20%

Mid-Term Exam 20%

Final Exam 40%

Assessment Outline

▪ Attendance (10%)
▪ Discussion (10%):
✓ Two discussion sessions planned (Week 7 and 12)
✓ Topic 1: What are the examples of behavioral anomalies
that you encounter personally in your daily life?
✓ Topic 2: What are the examples of market anomalies that
people observe in the financial markets?
✓ Each student submits one-page summary by Week 6
and 11
✓ Active participation rewarded
Assessment Outline

▪ Assignment (20%):
✓ Related to topic 2 of in-class discussion, you are required to submit
a written report of no more than five pages in text.
✓ Guideline: Try and answer the following questions.
1. Try and find a not-so-well-known example!
2. Is it really an anomaly? Can you explain the phenomenon
rationally?
3. What is causing such an anomaly? Can you link to the lecture
material during the first part of the course?
4. If it is an anomaly, what are the factors that prevent the market
from correcting itself?
Assessment Outline

▪ Mid-Term Exam (20%): 90 mins, short answers

▪ Final Exam (40%): 90 mins, longer essays

Deviations (1): Reference Point and Loss Aversion

▪ Reference point (준거점)

▪ The concept of a reference point is a crucial feature of the
prospect theory.
▪ When people have alternatives, they assess the utility of each
possible outcome, relative to a reference point.

▪ Loss aversion (손실 회피): the observation that human beings

experience losses asymmetrically more severely than equivalent gains.
Deviations (1): Reference Point and Loss Aversion

▪ Suppose that you and your best friend are both studying finance at a
reputable university in your home country. After graduation, you find a
job at Bank of America for $72,000. However, your best friend
manages to find a similar job at Citigroup for $80,000.
However, Bank of America’s entry-level salary is $68,000, while
Citigroup’s entry-level salary is $85,000.
Q. Who do you think will feel happier?

▪ Where you set your reference point matters!

Deviations (1): Reference Point and Loss Aversion

▪ Next year, all the colleagues at Bank of America and Citigroup have a
salary freeze. However, you and your best friend manage to secure a
pay rise in the contract. Your salary rises to $82,000, while your
friend’s salary rises to $87,000.
Q. Who do you think will feel happier?

▪ Finally, suppose now that you have to undertake a difficult internal

qualification assessment, which usually has a 50% pass rate. If you
pass, your salary rises to $102,000, but your salary falls to $62,000 if
you fail. Do you think the impact of gains and losses have an
equivalent impact on your welfare?
Deviations (1): Reference Point and Loss Aversion

▪ People’s preferences depend on reference points, both against others

in the peer group and also against their previous wellbeing

▪ People exhibit loss aversion:

“I hate to lose more than I like to win” – Jimmy Connors

Why is this a problem? Think about Pareto efficiency

Deviations (1): Reference Point and Loss Aversion

Why is this a problem? Think about Pareto efficiency

▪ Pareto efficiency: an economic state where resources cannot be

reallocated to make one individual better off without making at least
one individual worse off, implying that resources are allocated in the
most economically efficient manner.

▪ Traditional argument: “If you can make one person better off without
making another worse off, why not do it?”
It can sow resentment! (think about “donation-linked admission”)
Deviations (2): Peak-End Rule

Peak-End Rule (Frederickson, 2000):

▪ A psychological heuristic that changes the way we recall past events.
➔ We remember a memory or judge an experience based on how they
felt at the peak moments, as well as how they felt at the end.
Deviations (2): Peak-End Rule

Peak-End Rule (Frederickson, 2000):

▪ Patients who suffer pain for longer (and more in total quantity) do not
necessarily report more displeasure
▪ Key determinants are (1) peak pain and (2) pain in the last 3 minutes
10
9
A (total pain: 49) Patients often
8
7 report A is a worse
6
experience than B
5
4
3 B (total pain: 50)
2
1
0
1 2 3 4 5 6 7 8 9 10
Deviations (3): Anticipatory Utility

Anticipatory utility (예상효용) (Schooler, Ariely and Loewenstein, 2003)

▪ Anticipation of pleasure can itself be pleasurable, so people may
defer the experience itself to prolong the anticipation

▪ Anticipatory utility highlights the importance of considering not only

the immediate consequences of choices but also the emotional
and psychological benefits associated with looking forward to
future events and experiences.
Deviations (3): Anticipatory Utility

”If, for example, you come at four o'clock in the afternoon,

then at three o'clock I shall begin to be happy.
I shall feel happier and happier as the hour advances. At
four o'clock, I shall already be worrying and jumping about.
I shall show you how happy I am!”
- The Little Prince, Antoine de Saint-Exupery
Deviations (4): Other Expectations Effects

“The mind gets what it expects” (Ariely, 2008)

1. Bargh, Chen and Burrows (1996): a group of subjects shown words

like “Florida”, “retirement”, “ancient” and “bingo” (words usually
associated with the elderly) actually walked substantially slower than
the control group

2. Waber et al. (2007): two groups of patients are dosed with the same
placebo painkiller, but one group is told it costs $2.50 and the other
group 10 cents.
Those believing it to be more expensive report better pain relief
Deviations (5): Addiction and Abstention

Addiction and abstention

▪ Some goods are known to be

notoriously addictive
e.g., tobacco
▪ People may fear they might
become addictive, so they
abstain from consumption
altogether, even though an
occasional cigarette or two may
be pleasurable to them
Deviations (6): Framing Effects

You are a policymaker choosing between two possible medical research:

Situation A
Research 1 will save 200 lives
Research 2 will save 1/3 probability of saving 600 lives but 2/3
probability of saving no one
Deviations (6): Framing Effects

You are a policymaker choosing between two possible medical research:

Situation A
Research 1 will save 200 lives
Research 2 will save 1/3 probability of saving 600 lives but 2/3
probability of saving no one

Situation B
Research 1 will kill 400 lives
Research 2 has 1/3 probability that no one will be killed but 2/3
probability that 600 lives will be killed
Deviations (6): Framing Effects

▪ This is the incredibly famous framing effect (Tversky and Kahneman,

1981) that violates the invariance assumption of the standard model
▪ It is the phenomenon where the way information is presented (or
framed) can significantly influence people's decisions and choices,
even though the underlying information remains the same
▪ Positive Framing: When information is presented in a positive or gain-
oriented manner, people tend to be more risk-averse and make safer
choices.
▪ Negative Framing: When information is presented in a negative or
loss-oriented manner, people tend to be more risk-seeking and make
riskier choices.
Deviations (6): Framing Effects

Other examples:
1. At a university, 93% of Ph.D. students registered early when a
“penalty for late registration” was advertised, but only 67% did so
when the same deal was presented as a “discount for early birds”
2. “Mindless eating” (Wansink, Just and Payne, 2009)
Even the MBA students with prior health education still consume
more when food is given in a gallon-size bowl rather than the same
amount in two half-gallon-size bowls
3. If a medication is described as having a 90% success rate, people
may be more inclined to take it. On the other hand, if the same
medication is described as having a 10% failure rate, people may be
less inclined to take it.
Deviations (7): Anchoring Effects (고정효과)

Anchoring effects: the cognitive bias where individuals rely too heavily on
the first piece of information they encounter when making decisions,
even if that information is arbitrary or irrelevant. The initial information
serves as an "anchor" that affects subsequent judgments and choices.

Examples:
▪ Pricing: if the first price a customer sees for a product is very high,
they may perceive subsequent prices as more reasonable and be
more likely to make a purchase.
▪ Discounts: Stores often use the "original price" of a product as an
anchor when advertising discounts. Customers are more likely to
perceive a 20% discount as a better deal if the original price is higher.
Deviations (7): Anchoring Effects (고정효과)

“Anchor matters”: Ariely, Loewenstein and Prelec (2003):

Students are divided into two groups.

Situation 1: Group A is asked whether they are willing to pay $2 to listen
to a poetry recital (only 3% said yes)
Group B is asked whether they would accept $2 to listen
to a poetry recital (59% said yes)

Situation 2: Both groups are then asked whether they would attend a
poetry recital for free
35% of Group A now say yes, only 8% of Group B say yes
Deviations (8): Menu Effects

Lots of examples, particularly in marketing, but I only present two here:

1. Attraction Effect (or “decoy effect”) (미끼 효과): it occurs when the
introduction of a third option, often less desirable, influences
individuals to change their preference between two other options.

The Economist magazine has the following two options

(1) 1-year online only subscription for $59
(2) 1-year print only subscription for $125
Deviations (8): Menu Effects

Lots of examples, particularly in marketing, but I only present two here:

1. Attraction Effect (or “decoy effect”)

The Economist magazine has the following three options
(1) 1-year online only subscription for $59
(2) 1-year print only subscription for $125
(3) 1-year print and online all-inclusive subscription for $125
Deviations (8): Menu Effects

Lots of examples, particularly in marketing, but I only present two here:

1. Attraction Effect (or “decoy effect”)

The Economist magazine has the following three options
(1) 1-year online only subscription for $59
(2) 1-year print only subscription for $125
(3) 1-year print and online all-inclusive subscription for $125

Q. No one would choose (2) instead of (3), so why put it there?

A. It’s a decoy to make people choose (3) instead of (1)
(Because (3) now appears a “bargain”!)
Deviations (8): Menu Effects

2. Paradox of Choice: having too many choices can lead to negative

outcomes, such as increased anxiety, decreased satisfaction with the
chosen option, and even a reduced likelihood of making a choice at
all.

Example: Iyengar and Lepper (2008)

Consumers are given an opportunity to sample

(1) six different jams (simple-choice)
(2) twenty-four different jams incl. six ones in (1) (difficult-choice)
Deviations (8): Menu Effects

Results:
1. More people prefer to sample 24 jams, but substantially more people
end up purchasing a jam when they only sample 6 jams
2. When faced with a vast array of choices, people often felt
overwhelmed and struggled to make a decision. This choice overload
leads to decision paralysis, where individuals either made suboptimal
choices or decided not to choose anything at all.
3. Those who made choices from the smaller sample reported higher
satisfaction with their selections compared to those who chose from
the larger sample.
➔ “Too much choice is no longer a choice!”
Deviations (9): Visceral Factors (감정적 요소)

Human emotions also affect and drive our behavior

Deviations (9): Visceral Factors

Some known results:

▪ Individuals experiencing severe levels of stress are more likely to

behave in a selfish manner
▪ Even moderate levels of anxiety can lead us to narrow our frame and
obsess on unlikely events (e.g., North Korean nuclear issue)
▪ Sensory contact (sight, sound, touch etc.) can have significant impact
on impulsive behavior
▪ People tend to overestimate how long the current emotional state will
last, then underestimate the strength of emotion once it is resolved
Real-Life Implications of These Deviations

1. Placebo effect
In many countries including Korea, false or exaggerated advertising is
a criminal offense.
But if people actually gain more satisfaction just from believing the
hype, is it still an unethical thing that needs penalizing?

Think about your last trip to jjimjilbang:

for each “themed” bath, there is always
a huge panel of its supposed “good
effects” on your physical health.
Should this be encouraged or
discouraged?
Real-Life Implications of These Deviations

2. Dealing with menu effect

In Korea, Superintendents of Education (교육감) at the provincial
level are elected every four years.
Those at #1 or #2 on the ballot gain unfair advantage, because
people perceive them to be associated with the two main parties.

Solution:

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