Behavioral Finance Economics 437

Readings Richard Thaler, “Misbehaving” -- the main reading, along with Kahneman, for the April 14 mid term examination There may be other readings as well, but these are the main readings Expected to know Dan Kahneman’s “Thinking: Fast and Slow” for April 14 mid term examination

Anomalies There are many, many strange things discovered in psychology experiments and in experimental economics Are they just random and unconnected? Are do they have important “predictable” consequences If they don’t have “predictable” consequences, then the may just cancel each other out, leaving the EMH in the driver’s seat

Unexplained (by EMH) anomalies The Equity Premium Puzzle The Endowment Effect The Status Quo Effect (selling winners, not losers) Framing problems (where one presentation frames as “saving” lives and another presentation frames as “killing” people Could these lead to a common prediction?

Two Ways of Valuing Lotteries (uncertain chances) Expected Value of the lottery (think, average if repeated over time) Expected Utility of the lottery And then, assume risk aversion (diminishing marginal utility

Expected Value Utility Utility is linear in expected value of wealth

Expected Utility Utility Expected Utility (note assumption of risk aversion Wealth

Loss Aversion The idea here is that an individual suffers more from a loss than he would enjoy and equal amount of a gain Losing $ 100 is more painful than Gaining $ 100 One doesn’t balance the other The loss is much more severe than the gain Thus, individuals try desperately to avert losses, even if it is irrational to do so (emotion outweighing rationality)

Two persons whose wealth is $ 5 million today Loss Aversion Implies That Your Utility is mainly about changes in wealth, not actual level of wealth Two persons whose wealth is $ 5 million today Person A was worth $ 1 million yesterday Person B was worth $ 10 million yesterday Isn’t one of these persons really, really happy and the other person really, really sad, even though there wealth is identical? So, is the “level” of wealth really the determinant of utility (happiness)

Consider Civil Litigation Mr. Jones sues Mr. Smith for $ 1 million All agree that Mr Jones has a 90% chance of winning And 10% chance of getting nothing at all Jones is offered $ 800,000 to settle

Jones Utility Function (shows risk aversion) Exp Value of Suit 0.8 1.0 Wealth (in $ millions)

Consider Civil Litigation Mr. Jones sues Mr. Smith for $ 1 million All agree that Mr Jones has a 90% chance of winning And 10% chance of getting nothing at all Smith is offered the opportunity to pay $ 800,000 and the suit will be dropped

Smith Utility Function (shows risk preference) Exp Value of Suit 0.8 1.0 Wealth (in $ millions)

Could Jones and Smith Be the Same Person? Would someone take $ 800,000 to settle, but refused to pay $ 800,000 to settle Evidence shows that people are eager to take money, but reluctant to pay to settle (rather take their chances) Why?

Answer: Loss Aversion Risk averse when contemplating gains Risk preferring when contemplating losses

Utility Function Utility Gains A reference point Losses

The End