ChapterMcGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Behavioral Finance and the Psychology of Investing8-2“The investor’s chief problem, and even his worst enemy, is likely to be himself.”“There are three factors that influence the market: Fear, Greed, and Greed.”— Benjamin Graham— Market folklore8-3Behavioral Finance, Introduction.• Sooner or later, you are going to make an investment decision that winds up costing you a lot of money.• Why is this going to happen? – You made a sound decision, but you are “unlucky.”– You made a bad decision—one that could have been avoided. • The beginning of investment wisdom:– Learn to recognize circumstances leading to poor decisions.– Then, you will reduce the damage from investment blunders.8-4Behavioral Finance, Definition.• Behavioral Finance The area of research that attempts to understand and explain how reasoning errors influence investor decisions and market prices.• Much of behavioral finance research stems from the research in the area of cognitive psychology.– Cognitive psychology: the study of how people (including investors) think, reason, and make decisions.– Reasoning errors are often called cognitive errors.• Some people believe that cognitive (reasoning) errors made by investors will cause market inefficiencies.8-5Three Economic Conditions thatLead to Market Efficiency.1) Investor rationality2) Independent deviations from rationality3) Arbitrage • For a market to be inefficient, all three conditions must be absent. That is, – it must be that many, many investors make irrational investment decisions, and– the collective irrationality of these investors leads to an overly optimistic or pessimistic market situation, and– this situation cannot be corrected via arbitrage by rational, well-capitalized investors.• Whether these conditions can all be absent is the subject of a raging debate among financial market researchers.8-6Prospect Theory.• Prospect theory provides an alternative to classical, rational economic decision-making. • The foundation of prospect theory: investors are much more distressed by prospective losses than they are happy about prospective gains.– Researchers have found that a typical investor considers the pain of a $1 loss to be about twice as great as the pleasure received from the gain of $1. – Also, researchers have found that investors respond in different ways to identical situations. – The difference depends on whether the situation is presented in terms of losses or in terms of gains.8-7Investor Behavior Consistentwith Prospect Theory Predictions.• There are three major judgment errors consistent with the predictions of prospect theory.– Frame Dependence– Mental Accounting– The House Money Effect• There are other judgment errors that are also consistent with the predictions of prospect theory.8-8Frame Dependence, I.• If an investment problem is presented in two different (but really equivalent) ways, investors often make inconsistent choices.• That is, how a problem is described, or framed, seems to matter to people. • Some people believe that frames are transparent. Are they?• Try this: Jot down your answers in the following two scenarios.8-9Frame Dependence, II.• Scenario One. Suppose we give you $1,000. Then, you have the following choice to make: A. You can receive another $500 for sure.B. You can flip a fair coin. If the coin-flip comes up “heads,” you getanother $1,000, but if it comes up “tails,” you get nothing.• Scenario Two. Suppose we give you $2,000. Then, you have the following choice to make:A. You can lose $500 for sure.B. You can flip a fair coin. If the coin-flip comes up “heads,” you loseanother $1,000, but if it comes up “tails,” you lose nothing.8-10Frame Dependence, III.• What were your answers? • Did you: choose option A in the first scenario and choose option B in the second scenario?– If you did, you are guilty of focusing on gains and losses, and not paying attention to what is important—the impact on your wealth.– However, you are not alone. • About 85 percent of the people who are presented with the first scenario choose option A.• About 70 percent of the people who are presented with the second scenario choose option B.8-11Frame Dependence, IV.• But, the two scenarios are actually identical.• In each scenario:– You end up with $1,500 for sure if you pick option A.– You end up with a 50-50 chance of either $1,000 or $2,000 if you pick option B.– So, you should pick the same option in both scenarios.• Which option you prefer is up to you.• But, if you are focusing on wealth, you should never pick option A in one scenario and option B in the other. • The reason people do is that the phrasing, or framing, of the question causes people to answer the questions differently.8-12Mental Accounting and Loss Aversion.• Mental Accounting: Associating a stock with its purchase price.• If you are engaging in mental accounting:– You find it is difficult to sell a stock at a price lower than your purchase price. – If you sell a stock at a loss:• It may be hard for you to think that purchasing the stock in the first place was correct. • You may feel this way even if the decision to buy was actually a very good decision. – A further complication of mental accounting is loss aversion.• Loss Aversion: A reluctance to sell investments after they have fallen in value. Also known as the “breakeven” effect or “disposition” effect.• If you suffer from Loss Aversion, you will think that if you can just somehow “get even,” you will be able to sell the stock.• If you suffer from Loss Aversion, it is sometimes said that you have “get-evenitis.”8-13Do You Suffer from “Get-Evenitis?” Part I.• Consider the following two investments:Investment One. A year ago, you bought shares in FamaEnterprises for $40 per share. Today, these shares are worth $20 each.Investment Two. A year ago, you bought shares in French Company for $5 per share. Today, these shares are worth $20 each. • What will you do? Will you: (1) sell one of these stocks; (2) sell both of these stocks; (3) hold one of these stocks; or, (4) hold both of these stocks?8-14Do You Suffer from “Get-Evenitis?” Part II.• Suppose you are considering a new investment in FamaEnterprises. • Does your rational analysis say that it is