FINA  3010:  FINANCIAL  MARKETS  
 
   
 
 
 
Wenxi  JIANG  
 
 
(Fall  2015)  
 
   
 
 
 
Lecture  Note  5:  
 
 
Individual  Investors  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
© Wenxi Jiang

  1  
Outline    
 
1.  Classic  framework  of  decision-­‐making  
• Expected  utility  function  
• Risk  aversion  
 
2.  Psychological  bias  
• Prospect  theory  
• Preference  to  the  familiar  
• Representativeness  
• Overconfidence  
 
3.  Stylized  facts  of  individual  investors’  behavior  
• Over  trading  and  underperformance  
• Under-­‐diversification  
• Trend  chasing  
 
   

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Overview  
 
Course  content    
Part  I:  Financial  Assets  and  Instruments  
- Debt  
- Stock  
- Insurance,  futures,  and  options  
Part  II:  Investor  in  Financial  Markets  
- Individual  investors  
- Institutional  investors  
Part  III:  Prices  of  Financial  Assets  
 
Investors  are  the  key  players  in  financial  markets  
• Understanding  investors’  behavioral  is  essential  to  understand  the  
dynamic  of  financial  markets  
• The  research  in  the  area  has  been  helped  by  psychology  study  in  
human  judgment  and  decision-­‐making  
- Pioneered  by  Denial  Kahneman  and  Amos  Tversky,  starting  in  
1970s  
 
Roadmap  
• Psychological  bias  based  on  experimental  evidence  
• Stylized  facts  regarding  individuals’  trading  and  investing  behavior  

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The  classic  framework  of  decision-­‐making  
 
How  should  people  evaluate  the  potential  future  outcomes  that  
would  follow  from  taking  some  course  of  action?    
 
Economists  agree  on  the  right  answer:  use  the  “expected  utility”  (EU)  
framework  
• Start  with  a  utility  function  𝑈(𝑊)  that  stipulates  how  happy  you  are  
at  each  level  of  wealth  
• 𝑈(𝑊)  is  typically  taken  to  be  increasing  and  concave  
 
 
 
Then,  for  each  course  of  action  
• List  the  possible  wealth  outcomes  that  could  result  
• Compute  the  utility  of  each  outcome    
• Weight  the  utility  of  each  outcome  by  the  probability  of  the  outcome  
• Sum  up  across  outcomes  to  get  the  expected  utility  of  the  course  of  
action  
• Do  this  for  each  course  of  action,  and  choose  the  course  of  action  
with  the  highest  expected  utility  
 

  4  
Example  
 
 
 
 
 
• In  its  typical  implementation,  i.e.  with  𝑈(𝑊)  increasing  and  concave,  
EU  predicts  that  people  are  risk  averse  
- That  is,  they  would  prefer  a  gamble’s  expected  value  to  the  
gamble  itself  
 
• The  process  described  above  can  be  justified  as  rational  decision-­‐
making  
- And  most  models  of  financial  markets  assume  that  individuals  
make  decisions  in  the  way  
• Unfortunately,  a  large  body  of  experimental  evidence  shows  that  EU  
is  not  a  good  description  of  how  people  actually  make  decisions  
 
 
 
 

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Psychological  bias  
 
1.  Prospect  theory  
Example  A:    
a)  In  addition  to  what  you  own,  you  have  been  given  $1000.  Now  choose  
between  $500  and  ($1000,  0.5)  
b)  In  addition  to  what  you  own,  you  have  been  given  $2000.  Now  choose  
between  -­‐$500  and  (-­‐$1000,  0.5)  
 
Example  B:    
Would  you  accept  or  turn  down  a  bet  that  you  have  a  50%  chance  to  win  
$110  and  another  50%  chance  to  lose  $100?  
 
Example  C:    
Choose  between  $3000  and  ($4000,  0.8)  
Choose  between  ($3000,  0.25)  and  ($4000,  0.2)  
 
• These  and  many  other  examples  triggered  a  search  for  better  
descriptions  of  decision-­‐making  than  EU  
- The  best-­‐known  is  “prospect  theory”  (Kahneman  and  Tversky,  
1979)  

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 - Widely  considered  the  best  available  description  of  decision-­‐
making  in  experimental  settings  
 
Four  key  ideas  in  prospect  theory  
(1)  Reference  dependence  
• People  think  in  terms  of  potential  gains  and  losses  relative  to  some  
reference  point,  not  in  terms  of  absolute  wealth  level  
- See  Example  A  above  
 
(2)  Loss  aversion  
• People  are  much  more  sensitive  to  potential  losses  than  to  potential  
gains  
- See  Example  B  above  
 
(3)  Diminishing  sensitivity  
• People  are  less  sensitive  to  an  additional  dollar  of  gain,  the  further  it  
is  from  the  status  quo  
- And  also,  less  sensitive  to  an  additional  dollar  of  loss,  the  
further  it  is  from  the  status  quo  
• Observation:  
- People  are  risk  averse  over  moderate-­‐probability  gains,  i.e.,  
they  prefer  $500  to  ($1000,  0.5)    

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 - But  risk-­‐seeking  over  moderate-­‐probability  losses,  i.e.,  they  
prefer  (-­‐$1000,  0.5)  to  -­‐$500  
 
(4)  Probability  weighting  
• People  weight  outcomes  not  by  their  actual  probabilities  but  by  
transformed  probability  that  put  more  weight  on  low-­‐probability  
outcomes  
• Observation:  the  preference  for  both  lotteries  and  insurance    
- People  prefer  -­‐$5  to  (-­‐$5000,  0.001),  but  also  prefer  ($5000,  
0.001)  to  $5  
- Hard  to  explain  under  EU  
- But  follows  naturally  from  the  overweighting  of  low-­‐
probability  outcomes  
 
2.  Preference  for  the  familiar  
• People  have  an  excessive  preference  for  things  that  feel  familiar  
• Special  version:  mere  exposure  effect    
- Mere  exposure  to  something  makes  us  like  it  more  than  
justified  based  on  informational  considerations  alone  
 
 
 
 

  8  
 3.  Representativeness:  Belief  in  the  “law  of  small  numbers”  
• The  “law  of  large  numbers”  is  a  true  mathematical  fact  
- A  large  data  sample  will  reflect  the  properties  of  the  mode  that  
generated  it  
• However,  people  appear  to  incorrectly  believe  in  a  “law  of  small  
numbers”  
 
A  belief  in  the  law  of  small  numbers  has  an  important  consequence:    
• An  individual  will  draw  overly  strong  inference  from  short  sample  
• In  particular,  he  will  be  too  quick  to  “detect”  a  trend  in  the  data,  and  
to  extrapolate  it  into  the  future  
– “over-extrapolation”
• “Over-­‐extrapolation”  
• e.g.• the hot-hand
E.g.,  the   phenomenon
hot-­‐hand  phenomenon   in basketball
in  basketball  
 

 
 

Note:   9  

• more generally, someone who believes in the law of

4.  Overconfidence  
Three  types:  
(1)  Overplacement  
• People  have  overly  rosy  views  of  their  ability  and  prospects  relative  
to  other  people  
(2)  Overprescision  
• People  are  too  confident  in  the  accuracy  of  their  beliefs  
(3)  Overestiamtion  
• People  overestimated  the  absolute  level  of  their  ability    
 
 
Stylized  facts  of  individual  investors’  behavior  
 
We  want  to  understand  investor  behavior  
• The  decisions  investors  make  about  their  assets  and  liabilities  
• The  portfolio  they  hold  and  how  they  trade  
 
Structure  of  the  lecture:    
• Document  the  fact  (applied  to  most  financial  markets)  
• Discuss  the  possible  explanations  
 
 

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1.  Over-­‐trading  and  underperformance  
 
Most  studies  find  that  individuals  do  a  poor  job  trading  stocks  
• They  underperform  a  range  of  benchmarks,  such  as  their  beginning-­‐
of-­‐the-­‐year  portfolio,  and  the  return  of  the  overall  market  
• E.g.,  one  study  looked  at  the  trading  of  70,000  households  through  a  
large  discount  brokerage  from  1991  to  1996  (Barber  and  Odean,  
2000)   Trading Is Hazardous to Your Wealth 775

25 .
OGross Return
ENet Return
0Turnover
u 20

o 15

0~ 5

0
I (Low 2 3 4 5 (High Average S&P 500
Turnover) Turnover) Individual Index
Fund
Individual Investors Quintiles based on Monthly Turnover  
 Figure 1. Monthly turnover and annual performance of individual investors. The white
bar (black bar) represents the gross (net) annualized geometric mean return for February 1991
through January 1997 for individual investor quintiles based on monthly turnover, the average
Explanation:   Overconfidence  
individual investor, and the S&P 500. The net return on the S&P 500 Index Fund is that earned
by the Vanguard Index 500. The gray bar represents the monthly turnover.

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investment style and from time-series regressions that employ either the
Capital Asset Pricing Model (CAPM) or the three-factor model developed by
 • Most  investors  believe  that  they  are  “above  average”  traders,  and  
therefore  trade  stocks  actively  
- Many  are  over-­‐estimating  their  ability,  however,  and  end  up  
under-­‐performance  
 
Evidence:  
• This  view  predicts  that  more  overconfident  people  will  trade  more  
- The  psychology  literature  suggests  that  men  are  more  
overconfident  than  women  
- This  predicts  that  men  will  trade  more,  and  perform  worse  
- The  evidence  is  consistent  with  this  (Barber  and  Odean,  2002)  
 
Note:  
• Overconfidence  has  also  been  applied  to  understanding  the  puzzling  
high  leverage  of  trading  volume  in  many  financial  markets  
• In  an  economy  where  all  investors  are  fully  rational,  there  will  be  
relatively  little  trading  
- Each  investor  will  infer  a  negative  signal  from  others’  
willingness  to  trade  with  them  
• Trading  volume  will  be  much  higher,  however,  when  investors  are  
overconfident  
- They  disregard  the  signal  in  others’  willingness  to  trade  

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2.  Under-­‐diversification  
Traditional  advice  tells  people  to  diversify  their  holdings  of  financial  
assets  
• Many  households  appear  to  ignore  this  advice,  however  
• Three  types  of  under-­‐diversification  
- Home  bias  and  local  bias  
- Concentrated  stock  holdings  
- Large  holdings  of  own-­‐company  stock  
 
Home  bias  
Individual  often  invest  heavily  in  domestic  stocks,  apparently  ignoring  the  
benefits  of  international  diversification  
 
Local  bias  
Within  individuals’  domestic  equity  holdings,  individuals  tilt  toward  
locally  headquartered  stocks  
• The  average  distance  to  a  stock  in  a  typical  investor’s  portfolio  is  
917  miles  
• But  the  average  distance  to  a  stock,  across  all  stocks,  is  1225  miles  
 
Explanation:  Preference  for  the  familiar/Mere  exposure  effect  

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 • Mere  exposure  to  something  makes  us  like  it  more  than  justified  
based  on  information  alone  
• We  are  exposed,  every  day,  to  our  home  country  and  to  our  local  
region  
 
Concentrated  stock  holdings  
Some  investors  hold  concentrated  positions  in  relatively  few  stocks,  but  
these  investors  do  not  outperform  
 
Explanation  1:  Overconfidence  
• Investors  may  be  overconfident  about  the  validity  of  their  analysis  
 
Explanation  2:  Prospect  theory  (probability  weighting)  
• People  may  want  to  have  large  positions  in  “lottery-­‐type”  stocks  so  
as  to  give  themselves  a  chance  of  becoming  wealthy  
 
Large  holdings  of  own-­‐company  stock  
People  invest  a  surprisingly  large  fraction  of  their  retirement  savings  in  
the  stock  of  their  own  company  (Benartzi,  2001)  
• 23%  of  their  discretionary  contributions  
• Mini-­‐case:  Mr.  McClendon  and  Chesapeake  Energy  Corporation  
 

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Explanations:    
•  
•  
•  
 
3.    Trade  chasing  
Many  investors  appear  to  have  poor  market  timing  
• They  increase  their  exposure  to  the  stock  market  when  it  is  highly  
valued,  in  advance  of  poor  returns  
• And  reduce  their  exposure  when  its  valuation  is  low,  in  advance  of  
high  returns  
Key  evidence:  the  dollar-­‐weighted  average  return  on  mutual  funds  is  
lower  than  the  time-­‐weighted  average  return  
• By  1.5%  per  year  
 
Explanation:  over-­‐extrapolation  
• Some  investors  overweight  past  returns  when  forming  beliefs  about  
future  returns  
 
   

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Suggested  readings  
 
Sections  3  and  7,  Barberis,  Nicholas,  and  Richard  Thaler.  "A  survey  of  behavioral  finance."  Handbook  of  
the  Economics  of  Finance  1  (2003):  1053-­‐1128.  

 
Reference  
 
Barber,  Brad  M.,  and  Terrance  Odean.  "Boys  will  be  boys:  Gender,  overconfidence,  and  common  stock  
investment."  Quarterly  journal  of  Economics  (2001):  261-­‐292.  
 
Barber,  Brad  M.,  and  Terrance  Odean.  "Trading  is  hazardous  to  your  wealth:  The  common    
stock  investment  performance  of  individual  investors."  Journal  of  Finance  (2000):  773-­‐806.  
   
Kahneman,  Daniel,  and  Amos  Tversky  (1979),  “Prospect  Theory:  An  Analysis  of  Decision  Under  Risk,”  
Econometrica  47,  263-­‐291.    
 

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