Text of Gulnur Muradoglu1 Behavioural Finance Prospect Theory and Loss Aversion Session 3: Read Shefrin and...
Gulnur Muradoglu1 Behavioural Finance Prospect Theory and Loss Aversion Session 3: Read Shefrin and Statman, 1984 Kahneman and Tversky, 1979
Gulnur Muradoglu2 Overview zProspect theory yas an alternative to utility theory yattitudes towards risk might be different under different circumstances zLoss aversion in financial behaviour yriding losers for too long yselling stocks with gains
Gulnur Muradoglu3 What would you do? zA real estate investment example: yBill and his wife are in their early thirties and just had their first child. A good friend James is an expert in real estate. James can find underdeveloped property that looks like mess but has great potential. After purchasing James cleans it up, divides into parcels and resells at substantial profit. During the past three years he sold most of his properties to one to two times what he has paid for them.Since he makes the purchases with borrowed funds, James has been earning a very high rate of return!
Gulnur Muradoglu4 What would you do? zA real estate example (contd) ySome years ago James has gone through some personal problems and Bill was very helpful and supportive during those times. James wants to repay Bill for his kindness. So last year James recommended Bill join him by investing in a small rural tract and Bill did. This year James sold the tract for a 75% profit. Bill and wife are very happy! They bumped into James one evening and James is very enthusiastic about another deal. Bill and his wife want to set aside money for their baby doughters future, particularly her university education
Gulnur Muradoglu5 What would you do? zA real estate example (Contd) yJames tells them the details: Clear Lake is worth $205,000. James will invest $102,500 and will be equal partners will Bill and his wife and follow the usual formula. Within a year he will sell all the lots for $459,000. Bill and his wife have $17,500 in savings and James assures them they can borrow the remaining $85,000 at an attractive interest rate. James is a great believer in leverage as it can offset inflation and taxes.
Gulnur Muradoglu6 What would you do? zOn a scale of 1 to 10, how would you rank Clear Lake as an investment whose purpose is to fund university education in 15 years? 10.9.8.7.18.104.22.168.2.1 10 extremely suitable,1 entirely unsuitable
Gulnur Muradoglu7 What would you do? zA real estate example (Contd) Bill is making the payments on the $85,000 loan and not earning anything on the $17,000 savings. Three months later Bill sees James and asks him how Clear Lake is doing. James says there is a small problem. Apparently the property has not been surveyed properly and lots can not be sold until the survey is complete and the survey is taking more time than anticipated. Moreover the original loan $85,000 has come due. Renewal is no problem but the bank renews only $75,000. Bill has to come up with the additional $10,000 himself. James is embarrassed but remains upbeat about the success of the project. Bill and his wife have saved exactly $10,000 in recent months.
Gulnur Muradoglu8 What would you do? zIf you were in Bills or his wifes position, how would you react emotionally? xWorried or anxious? xPatient and believing? zIf you were in Bills or his wifes position xwould you begin feeling regret? xWould you feel anyone should be blamed?
Gulnur Muradoglu9 What would you do? zIf you answered yes yWho would you blame most? xJames? Yourself? The situation? zHow obvious does it seem to you that yit would have gone that way? xAnswer on a scale of 1 to 10 1.2.3..22.214.171.124.8.9.10 1 very obvious, 10 impossible to predict
Gulnur Muradoglu10 What would you do? zA real estate example (Contd) yTime passesA year later James apologizes that it has taken so long to get things moving. James says he will work things out so that Bill and his wife will not have to make any more payments on the loan. James will handle the financial details. To move up sales he will put up a model home on one of the lots. yNext time Bill sees James there is good news and there is bad news. Good news is the model home has been built and sold, the bad news is this has not stimulated additional demand. James says he feels terrible and proposes Bill to take over his interest in Clear Lake. Bill thinks OK, if I accept the offer I will avoid extra losses but if investment turns profitable I lose the chance to lower my loss and make a positive return.
Gulnur Muradoglu11 What would you do? zPut yourself in Bills shoes. yIf you sign over your interest to him you will have to come to terms with your $27,500 loss. If you keep your interest you risk losing more money, but you might also recover your investment! xWould you tell James you understand that he is trying to help and come to terms with your loss and sign your interest over to him? xWould you remind James that he said this would pay for your childs university education and you still expect to do that (keep your interest)?
Gulnur Muradoglu12 What would you do? zSix years have passed.James proposes that you sign your interest to him. James also tells you that one of the estate agents offers $35,000 for the unsold lots and together with the sale of the lot with model home ($8,900) total amount received would be $43,900. James says he has decided to accept the estate agents offer. xWould you tell James you understand that he is trying to help and come to terms with your loss and sign your interest over to him? xWould you remind James that he said this would pay for your childs university education and you still expect to do that (keep your interest)?
Gulnur Muradoglu13 Prospect theory zKahneman and Tversky,1979 yUtility theory is a normative model of choice under uncertainty xsystematic violations of axioms yProspect theory as a descriptive model of decision under uncertainty xrisk aversion in gains xrisk seeking in losses xinconsistent preferences when the same choice is presented in different forms xover-weighting of low probabilities
Gulnur Muradoglu14 What would you do? zYou toss a coin. If you lose you lose 100 yWhat is the minimal gain that would make this gamble acceptable? zWhat sure gain is as attractive as y50% chance to gain 1,000 y50% chance to gain nothing
Gulnur Muradoglu15 Value Function Value Losses Gains
Gulnur Muradoglu16 What would you do? zYou are facing the chance to win 20,000 yConsider the following. xAre the differences significant to you? xCan you order them by their impact on your preferences? A. The probability is either 0 or 1? B. The probability is either 41% or 42% c. The probability is either 99% or 100%
Gulnur Muradoglu17 Non linear weighing of probabilities zRational choice ymultiply utility by probability! yProbabilities have equal weighting! zPeople deviate yoverweight low probabilities yunderweight high probabilities
Gulnur Muradoglu18 Who is more upset? zAndy owns stocks he bought for 100. The value of the stock was 160 yesterday and today it dropped to 150. zBecky owns stocks she bought for 200. The value of the stock was 160 yesterday and today it dropped to 150.
Gulnur Muradoglu19 Purchase price as a reference point zDisposition effect yreluctance to realize losses! xA will perceive as a reduction in gain xB will perceive as increased loss! zOdean, 1998 yInvestors are more likely to sell when price increases
Gulnur Muradoglu20 What would you do? zChose between A sure gain of 240025% chance to win 10,000 75% chance to gain nothing zChose between A sure loss of 240075% chance to lose 10,000 75% chance to lose nothing zChose between 25% chance to win 2,400 25% chance to win 2,000 75% chance to lose 7,60075% chance to lose 7,500
Gulnur Muradoglu21 Narrow framing zInvestors consider decision problems yone at a time ydo not adopt a broader frame zNarrow framing yis mainly due to multiple mental accounts (details next week!)
Gulnur Muradoglu22 Prospect theory zAccounts for observed attitudes towards risk yrisk aversion in gains risk seeking in losses yOver-weighting of small probabilities xlottery tickets, insurance policies yGains and losses defined with a reference point xFraming (details next week!)
Gulnur Muradoglu23 Riding losers too long zShefrin and Statman, 1985 yAversion to loss realization in financial markets xtax considerations can not explain patterns in loss and gain realization xa wider theoretical framework mental accounting regret aversion self control
Gulnur Muradoglu24 Riding losers too long zResearch Design yQuestion: Do investors time the realization of their losses differently from the realization of their gains? yData: xIndividual Investors roundtrip duration of trades 1964-1970 xMutual Funds purchases and redemption of mutual fund shares 1961-1973
Gulnur Muradoglu25 Riding losers too long zAnalysis yFor all values of roundtrip duration (1 month to 12 months) 40% of trades realize losses! yThe ratio of redemptions to purchases in gains is higher than that