Topics:
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Prospect Theory
Disposition Effect
Overconfidence
Herding
Overreaction and Underreaction
The Equity Premium Puzzle and Myopic Loss Aversion
The Home Bias
Limits to Arbitrage
Market Sentiment
Lecture 05 – Prospect Theory
 The Reflection Principle sates that decision makers are risk averse in the positive domain (profits)
and are risk seekers in the negative domain (losses) – also an instance of framing
o Example of plague (death and save lives) 2 scenarios
 2 Stages of Prospect Theory
o Stage 1 Editing: In this stage, the decision maker reduces the decision problem into
numerical profits, losses and their probabilities. The editing process takes into account
the effects of mental accounting, framing, reference points and other heuristics of
decision making.
o Stage 2 Evaluation: Evaluation is based on the difference of each alternative outcome
from a reference point. It is not based on the final (absolute) wealth as in utility theory.
 Prospect theory was introduced as an alternative to utility theory. We emphasized that in
prospect theory:
 Decision makers edit prospects taking into consideration people’s biases before proceeding
to the evaluation stage.
 Prospects are valuated according to the extent to which they deviate from a reference point.
 Risk aversion exists in the gains domain while risk seeking exists in the domain of losses.
 Decision makers exhibit loss aversion: Losses hurt more than the satisfaction generated by
gains.
Lecture 06 – Disposition Effect
 The disposition effect is investors’ reluctance to realize losses and their eagerness to realize gains
— the disposition to “ride losers” too long and to sell winners too early
 Importance:
o conflict with optimal tax planning and hence hints at irrationality
o implies that decision makers base their decision on sunk costs
o implications for investment strategies
o effects on prices (supply and demand mechanism)
o one of the first behavioral bias explored with large-scale data from real investors
o one of the first phenomena explained by prospect theory.
 Causes: Mental accounting, Reference points, Regret
 Odean Study: compares the propensity to sell winners to that of losers.
o Alternatives that needs to be ruled out: Taxes, Rebalancing of portfolio, Personal
information, Trading costs, Belief in negative correlation in stock returns
 Shapira Vanezia Study: Contributions
 It generalized the DE across country borders.
 It employed a different method for calculating the DE.
 Its analysis of the DE was made at a time when profits from the stock market
were essentially tax free in Israel.
 All investors — amateurs and professionals alike — exhibit the disposition effect.
 The investment decisions of professionals are less affected by the disposition effect.
 Former findings are generalized to countries other than the US, other tax systems and other
methods for calculating the disposition effect.
Lecture 07 – Overconfidence
 Two major schools of thought concerning overconfidence: (i) Overestimating the precision of our
own estimates (miscalibration): The mean estimate is correct, but its dispersion is too narrow. (ii)
Overconfidence in the sense of optimism, or a belief that we are better than the average.
 Self-attribution and confirmation bias
 Overconfident investors take more risks and, in the long run, earn higher returns.
 Overconfident investors have an advantage over rational rivals in trading competitions.
 Effects of Overconfidence on M&A
o The hubris hypothesis.
o Exaggerated self-confidence.
o Empirical tests of the effect of overconfidence on mergers and acquisitions.
 Overall Effects of Overconfidence
o Overconfidence affects usage of debt, dividends, and investments.
o Overconfidence and short term vs. long term debt.
Lecture 08 – Herding
 Herding occurs when the decision maker (investor) undertakes or refrains from undertaking an
action just because other decision makers (investors) have undertaken it or refrained from
undertaking it. It is not merely the act of behaving like others! Genuine herding occurs when
investors base their decision only on observed behaviors of others and disregard their own
information.
 Causes: Informational motives: Investors think that others know something they do not. Due to
people’s inherent need of conformity and social validation, they try not to deviate from the
norms.
 Types: Intentional and Spurious
 Who Herds? Almost everyone. Herding has been found in all fields of business and finance,
among investors (in all types of assets: stocks, options, real estate, etc.), traders, analysts,
institutional investors, bankers, bank depositors (e.g., bank runs). Evidence for herding comes
from all countries
 Effects:
o Herding reduces market efficiency by restricting information dissemination.
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Herding can increase market volatility and therefore may have a destabilizing effect.
Herding can cause contagion of crises from one country to the next.
But, the effects of herding are not necessarily all negative; herding saves information
costs and some investment mutual funds may benefit from it.
 Factors that Affect Herding: Type of traders, Market characteristics, Type of assets, Period,
Volume.
 Cascade Theory of Rational Herding:
o Strengths: presumably rational investors behave in a certain way, experimentally texted
and supported
o Critiques: (i) Strong Assumptions, (ii) Investors know others investors’ decisions, (iii)
Investors do not communicate; they merely observe other investors’ decisions. (iv) price
of asset remains same
Lecture 09 – Overreaction and Underreaction