This report explores on a white paper that explores the different aspects of prospect theory. The report is based on a case study of a major consulting firm (Shefrain Consulting). The first aspect that the report discusses is the difference between prospect theory and expected utility theory. Several differences are indicated and one of the difference is that in the prospect theory an individual makes the decision whether to invest or not based on the reference point before ranking it as a loss or gain while in expected utility theory, an investor makes a decision based on the final outcome. Value function which is linear is explained to put a higher value on the final state of welfare than in the assets.
The report explores the varying biases found on Jojo’s case which include: confirmation bias, hindsight bias and illusion control bias. The aspect of confirmation biases was identified as the investor tended to believe that the 14% increase on commercial property in the city will remain and did not think about losses. Hindsight bias follows that onset of a previous incident was not only obvious but predictable too which in the case study is when the investor buys more stocks in Omega Corporation to increase their financial position.
Behavioral finance and investments were explored following Violet’s case scenario where she portrays a convex utility function as she is a risk taker. The investor makes several irrational behaviors where she spends more on a luxurious way of living. Some of the recommendations are that Violet mental accounting and self-control on her salary income and annual benefits. The other concept discussed in the report s the application of behavioral finance in corporate governance. The report provides that federal laws govern the fiduciary duties. The last section was on the four learned lessons in Behavioral Finance. The most important lessons that I think are of significance in the future are overconfidence, extrapolation, mental accounting effect and disposition effect
Behavioral Finance and the Psychology of Financial Decisions
White Paper on Prospect Theory
Prospect theory is defined as a behavioral economic theory where an individual value both loses and gains, and based on the perceived gains instead of loss they make decisions. Prospect theory has been used to solve strategy issues of litigation, social dilemmas, negotiation, and international conflict (Kahneman and Tversky, 2013). The theory is founded on the traditional expected theory, as it is used to form a decision on two alternatives with possible risks. However, the prospect theory is different, as it applies the aspect of psychology in the consideration process. The first aspect to explore is the difference between prospect theory and the traditional expected utility theory.
The traditional expected utility theory bases its argument on that, while making an investment, an individual tends to maximize the expected utility of their wealth while faced with uncertainty. Levy and Levy (2013) explain that the traditional expected utility theory is disadvantageous, as it fails to describe fully the behavior of a person while making a choice on risky alternatives. Due to this, the traditional expected utility theory provides a feeble correlation between the real decisions and utility theory model. Kahneman and Tversky (2013) explain that prospect theory, which calculates value is uneven with expected utility theory. This is because the expected utility value is a vital linear in the probability an aspect absent in value
Expected Utility Theory
Rabin (2013) explains that expected theory is where decisions are made under conditions where each option that is taken causes a known outcome. It is important to note that expected theory is different from certainty as in that, the probability is known and equivalent to zero, while in uncertainty the probability is completely unknown. The theory applies a principle, which asserts that each person try to maximize expected utility by choosing between risky options where one weighs the utility of each outcome to the probability, and the choice is made if it has the highest weighted sum (Hirshleifer, 2015).
Rabin (2013) explains that expected utility theory dominates the aspects of decision making under risk – both as a descriptive model of the behavior and normative model of rational choice. In comparison, prospect theory involves analyzing and evaluating prospects, as they relate to the reference point (Hirshleifer, 2015). In this form of a theory, an individual makes decisions in regard to how they define loss and gain, which is identified based on the reference point. Based on this, the value function of prospect theory puts a higher value on the welfare’s final state than in assets.
In contrast to the prospect theory, Quiggin (2012) explains that expected utility theory does not have a reference point. Hirshleifer (2015) explains that in expected utility, an individual makes decisions on losses and gains based on observations of the final outcomes. Practically, when an individual plan to make an investment of 15% return, it will be categorized as a gain following the expected utility theory, which is appealing for investors to invest. However, if such investments incur a 20% cost on capital, the expected utility theory will result in a loss, which ranks it as not appealing to invest. Generally, in the prospect theory an individual makes a decision whether to invest or not based on the reference point before ranking it as a loss or gain while in expected utility theory, an investor makes a decision based on the final outcome.
Alalis and Hagen (2013) explain that the prospect theory provides the aspect of loss aversion. In this case, it means that the prospect theory provides the investor with the amount of utility they attain from investing. Quiggin (2012) explains this concept by stating that an increase in return on investment reduces the marginal utility of wealth while a reduction (loss) in return on investment, investors feel a lower satisfaction in comparison to the satisfaction felt. This interpretation results in the belief that gains are less than the losses incurred because to investors, a downside is more felt than an upside. Mathematically, if an investor earns a utility of $400, he/she will be less dissatisfied than an investor losing $400.
Another concept to learn from diminishing marginal concept is that an increase in wealth (investor) results in a lower increase in marginal utility. The probability of an outcome is unknown in prospect theory because an investor makes a decision based on uncertainty. However, the expected theory follows a known outcome to calculate the probability while maximizing utility, which results in attaining the highest expected outcome (Hirshleifer, 2015). In conclusion, while prospect theory evaluates the aspects of utility attained from investments, expected utility ensures either gains or losses.
The last aspect of prospect theory and expected utility is that prospect theory involves the weighting functions. Allais and Hagen (2013) define a weighting function as one which is attained by multiplying each outcome’s value with a decision weight. However, it is important to note that weights on decisions fail to measure the probability of events but rather measures how an event influences the desirability of an event. Bocquého, Jacquet, and Reynaud (2013) explain that in every product, there is a weight and a function attached to the objective probability.
In addition, both the probability weighting function and value function are not linear where although they have significant features they lack a closed mathematical form. The most significant feature of probability function is that large probabilities are underweighted while small probabilities are over-weighted. However, at end-point, the weighting function is not well behaved and an extremely low probability is likely to be ignored or exaggerated.
In Jojo’s case scenario, we identify three behavioral concepts – confirmation bias, hindsight bias, and illusion control bias. Below we explain how each bias affected decision making on investment.
One behavioral finance concept I identified in the scenario is confirmation bias. Maxwell, Jeffrey, and Lévesque (2011) explain that confirmation bias is when an investor searches for information that is in line with their idea on investments more than searching for information that contradicts the investment. However, following a one-sided aspect poses an investor at risk of faulty decisions as it skews their form of reference. Maxwell et al. (2011) explain that confirmation bias makes an investor to have an incomplete image of the investment situation. In the scenario, after reading the investor article, the investor finds that there has been a 14% increase on commercial property in the city every year since 2,000. On closer analysis, the investor notes that the commercial property in the City was purchased at $1.5 million last year. The investor is happy as he believes the trend will continue but he fails to evaluate the likelihood of losses in future or tremendous change on investment in the company.
The second identified bias is hindsight biases, which Roese and Vohs (2012) explain that it occurs after a belief that the onset of a previous incident was not only obvious but predictable too. This bias is based on perception and occurs when the needs of an investor to find order in the world makes them form an explanation that allows them to understand that, past events were predictable and obvious. Through this, an investor can form an erroneous link between the cause of an incident and its effect causing them to make poor decisions due to oversimplification of the situation.
In our case study, hindsight bias is evidenced when the investor explains that they are holding a large position in Omega Corporation, “unrealized loss – Omega’s stock price declined last year when reported sales and earnings failed to meet analyst expectations. I took advantage of the decline to increase my position.” One aspect to note from this case scenario is that irrespective of the stock price reducing in the previous year, the investor took the advantage to buy more stock to increase their position in the business. This investor applies overconfidence while following a dangerous path and maintains a belief that he will possess a superior investing ability or stock picking.
The last behavioral finance concept is illusion control bias. Yarritu, Matute, and Vadillo (2014) define illusion control as the tendency of an individual to believe they can either influence or control an outcome of uncontrolled events. This mostly results in over-optimism and overconfidence, which may make an investor desire to make more investments resulting in improper portfolio diversification. yARRI explains that illusion control bias is based at the heart of pseudoscientific and superstitious beliefs. In this case, an individual believes they are controlling incidents, which are independent of their behaviors. In our case, although the investor understands the technology industry, he believes he can control the outcome of the technology stocks. This belief is just but an illusion.
Behavioral Finance and Investments
Violet portrays a convex utility function as she is a risk taker. This behavior is evident from her expensive vacation each year and the purchase of a new luxury car after two years using her annual bonus contributions and salary income. Another form of risk is averse where Violet inhibits concave utility function on losses as she has certainty prospects on expected value rather than following uncertain risks. Violet thus follows Friedman-Savage utility function as she has both concave utility function and convex utility function. Chaudhary (2013) defines Friedman-Savage utility function as the curvature value of an investor’s utility function, which varies to the amount of money one has.
Generally, classical investment theories assume that an investor always acts towards maximizing their returns. However, several studies suggest that not all investors are rational while making investment decisions. The uncertainty is likely due to inefficient markets and rational investors (Chaudhary, 2013). Thus, behavioral finance is a field that explores why an investor fails to make the expected decision, as well as the reason the market behaves in contradiction to the expectations. According to Chaudhary (2013), the majority of average investors make investment decisions based on sale low on panic mood, most investors buy high on speculations, and on emotion rather than logic.
Investment failures cause three times more pain than the joy attained from attaining gains. In our case study, we see Violet Siosan making irrational behavior where she makes a short-term, out-of-the-money call and put options on investment with the knowledge that they have a low probability of paying off. At her age, 42 years, Violent should identify an investment plan that creates value to preserve capital. In this case, it is advisable that Violet weighs the advantages of long-term investment over short-term investments. Nofsinger (2011) explains that while short-term investments yearn to preserve capital, long-term investment is more on wealth creation. With this, Violet will have income for her later year in life. However, for this to happen, Violet requires to make several adjustments on some of her investments, as well as her expenses.
To reduce her expenses, Violet should stop paying low pay-off earthquake insurance, as her home is located in a low-probability earthquake zone. Instead, the amount paid for the earthquake insurance could be put in a long-term investment that will have a high return in the near future. Some individuals prefer high payoff risks due to insufficient funds, which make them insure against low probability and low pay off risks such as earthquake insurance. This can be explained following the concave utility function where purchasing a low payoff like earthquake insurance contains low probability losses. Violet requires adjusting her luxurious lifestyle to save more money for her investments. For example, she purchases a new luxurious car every two years and expensive annual vacations. Her desire to invest more should be attained through the sacrifice of her luxurious way of spending.
The form of bias evident from Siosan behavior includes mental accounting and self-control. On the aspect of self-control, it is evident that Violet spends half of her annual bonuses and her salary income on her current consumptions, in short-term satisfaction, an upscale bill, and buying luxurious cars; a behavior that is disadvantageous to long-term investments. In the aspect of mental accounting, Violet categorizes her wealth by current owned assets, future goals, and current income. Her decisions on the amount to spend and save are based on the total income and benefits she has. For example, Violet saves on short-term investment rather than in long-term investments like a retirement account.
The aspect of sacrificing her way of life follows the anchoring aspect of behavioral finance. According to Chaudhary (2013), anchoring in behavioral finance assumes that the opinion and the thoughts of an investor are based on fact and relevance. However, in Violet’s case, this is not so because of her tendency to anchor or attach her thoughts to reference point irrespective of the illogical association with decision-making. Based on this concept, although the company in which Violet has invested makes more money, she is likely to maintain her previous opinion that the change attained is temporary. This is due to an under-reaction to positive information.
Following mental accounting, it is true that the retirement portfolio of Violet is consistent with the Behavioral Portfolio Theory and inconsistent with a mean-variance framework. This is because Violet cares about the expected return and expected risk, which can be determined by measuring the probability of failure to attain the mental accounting goal (Shefrin and Statman, 2000). The inconsistency may result if Violet fails to follow a secure retirement by failure to select the assets, which are appealing to her goals like dividends and bonds.
Behavioral Corporate Finance
Morck (2004) explains that there is a likelihood of disaster eruptions if there is mismanagement between directors while blowing whistles, demanding answers, and asking questions. The legal duties of the board of directors in behavioral finance are decisions to allocate capital such as stock acquisitions, dividend distributions, and equity offerings. The board of directors is required to engage in merger negotiations where under Federal securities they are at the risk of disclosure duty. This is inconsistency with fiduciary duties, which under the state law they owe the stakeholders. Baker and Wurgler (2013) explain that the board of directors discharges their state law fiduciary duties using an over-priced offering where the corporation makes money and in turn, the shareholders enjoy the gains.
Baker and Wurgler (2013) explain that the Federal securities laws that in situations that the board of directors does not owe the shareholders any fiduciary duties, a violation may result if the corporation exploits the market’s inefficiencies without disclosing. In behavioral finance, directors are at risk of conflicts between duties owned to buyers and duties owned to existing shareholders. This follows a business judgment rule, which states that the fiduciary duties do not legally require the board of directors to effect an offering. However, the board may be required to occasionally find it desirable or necessary to effect an offering. Baker and Wurgler (2013) explain that after affecting a price, the state’s fiduciary law subjects it to judicial scrutiny.
Based on this theoretical argument, a decision to affect the secondary offerings of the securities is by selling the company to the buyers. Such a decision necessitates a board of directors to attain the highest shareholder’s value, which also requires judicial scrutiny. Through this, the director is at stake while the company is at stake following the enhanced scrutiny of the director’s action. The reason why the fiduciary law regulates the market and the board of directors is due to the probability of the board of directors putting high priced offerings (Morck, 2004), which increases the likelihood of market inefficiencies in the economy.
Your Future and Behavioral Finance Post 2008
The financial crisis in 2008 greatly affected the investment not only in the U.S. but global investments in general. Erkens, Hung, and Matos (2012) explain that the financial crises in 2008 caused the banking sector to lose money on mortgage defaults, credit to businesses and consumers to dry up, and interbank lending to freeze. In addition, Helleiner (2011) notes that the financial crisis resulted in losses in the financial market, as well as the major economic aggregates like investments, growth, and GDP. This section will explore the four most important behavioral finance lessons from the financial crisis.
Following the bankruptcy of major banks in the financial crisis, the central banks and the governments went to their rescue. The bailout of the central banks and the government protected the financial sector for a time but it did not fully solve the fundamental cause of the crisis. Some lawmakers blamed the structured finance for the financial crisis. Other proposed causes include poor risk management and overconfidence in investors. It also opens the eyes to the likelihood of overinflating prices as was seen with the dramatic decline in stock and housing prices.
Through the case scenario of the 2008 economic recession, I have learned several lessons from Behavioral Finance that will not only benefit me but also my organization in the future. The financial meltdown greatly affected the country, as well as the world in general. Helleiner (2011) explains that the financial crisis in 2008 rendered many employees jobless, some lost their homes, or go bankrupt. Nonetheless, a repeat of the same can be avoided through the four lessons I learned in Behavioral Finance.
The first important lesson that I learned in Behavioral Finance is to do with overconfidence. Hirshleifer (2015) defines overconfidence in Behavioral Finance as the tendency of an individual to exaggerate or overestimate their ability to successfully perform a certain task. I think overconfidence is an important aspect of behavioral finance due to its potential harm to the ability of an investor to pick stock over a long time. One trait of overconfident investors is that they believe that they are better than other individuals in selecting the best stocks and when to invest or exit the position.
As an individual, the aspect of overconfidence helped me understand that although I may have access to computational models and best reports, I still require achieving the market-beating returns. As an organization, the aspect of overconfidence is essential, as it will help managers to maintain and attain realistic estimations by understanding what every investment day has something to offer to the market. Though this, we can evaluate the risk part of any investment to ensure issues like the ones that occurred during the financial crisis are avoided.
Hirshleifer (2015) explains that overconfidence is the most observed psychological bias among investors and can make an individual or an organization to overlook risks, overrate their knowledge, and overestimate the impact of uncontrollable events. For the business, this is important particularly while assessing our performance to that of our competitors without confirming our past successes. Generally, overconfidence is of great importance because it will be of benefit during decision making, as an individual and the business now and in the future.
This is a belief based model that I believe will be significant in my personal financial life and the organization in general. Lu and Tang (2015) explain that the concept of over-exploration is due to the representativeness heuristic where an individual or a business over-extrapolates the past while forecasting on the future. For example, if an individual plans to buy a house, and in future forecasts a growth in the price of housing, it is an over-extrapolation of the past growths in the pricing. This is the reason many of the victims of financial crisis overpaid for their homes including taking loans with an excessively high loan-to-value ratio.
It formed a real estate bubble during the era due to an oversupply of credit to home buyers following the subprime loans. The aspect of subprime loan is also evident following securitization where it manufactures securities that have AAA ratings. Having AAA rating means that an individual is likely to face an extrapolation rather than the current financial situation. The lesson learned from this bias is that it is avoidable through investment planning by the periodical rebalancing of investments every year. As an individual, as well as the organization, this can be attained by selling some well-performing assets and buying the poorly performing assets. Generally, this bias teaches us the need of having a financial plan, as well as an investment strategy before rebalancing.
Mental accounting can be defined as the tendency of an individual or business to separate their monetary investments into varying accounts following a subjective criterion. This may include the intent and the source of money for every account. An individual applies the varying compartments of the brain to make varying decisions on investments either on gains or losses. Antonides et al. (2011) explain that in mental accounting, a gain does not compensate for losses in the brain even if the amounts are the same. The concept helps in explaining the fear and the greed of emotions that is widely experienced by traders and investors following the behavioral portfolio theory. Such fears are what marked the financial crisis in 2008. The mental effect will be of great both to the business and individually as it will help in keeping portfolios improperly diversified with separate accounts, which is safer in future risky investments and incidental needs to attain maximum gains that will rapidly increase the consumption expenditure.
The fourth lesson learned from behavioral finance is disposition effect, which according to Henderson (2012) is a behavioral finance concept where an investor is able to sell winners easily and quickly and holds the losers for more time. This theory is explored through loss aversion and prospect theory where an investor may sell the winners easily due to fear of a decline in value. Similarly, an investor with a loser stock holds it for longer periods hoping the value will increase. Henderson (2012) explains that the disposition effect was evident in the financial crisis in 2008 in the Chinese market. As an individual, I noted that the indisposition effect, smaller investors are highly affected by the disposition effect in comparison to larger investors. Following the reversion of stock prices, we can borrow the irrational belief that relies on a rebound in case of poorer performing stocks. I would follow this because it depends on preference where one can choose on investment to avoid regret while choosing it.
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