Topics in Behavioral Finance (I) · PDF fileTopics in Behavioral Finance (I) ... equally as...

Topics in Behavioral Finance (I)

Mei Wang

Brownbag Lunch Seminar, March 3, 2008

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Mei Wang, Topics in Behavioral Finance Brownbag Lunch Seminar, March 3rd, 2008

About myself...• Bachelor in Computer Science, Xiamen University, China• PhD in Decision Science, Carnegie Mellon University,

Pittsburgh, USA

Assistant professor of Finance and Financial Markets.

Leader of University Priority Research Program “Finance and Financial Markets”: subproject “Behavioral Finance”

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Research:

•Behavioral Finance

•Decision Theory

•Cultural Finance

Teaching:

•Behavioral Finance

•Banking: Structured products

•Behavioral Decision Theory


A couple of words about Carnegie Mellon University

Department of Social and Decision Science:

• Behavioral Economics

• Experimental economics

• Policy analysis

• Active in interdisciplinary research

• Herbert Simon: Bounded Rationality


What is behavioral finance?

Behavioral Finance = “open-minded Finance”

“Sometimes, in order to find the solution to an empirical puzzle, it is necessary to entertain the possibility that some of the agents in the economy behave less than fully rationally some of the time. Any financial economist willing to consider this possibility seriously is ready to take a try at behavioral finance.”

(Thaler, 1993)

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Key issues in BF

Does further empirical evidence supports the improved model?

Empirical work: Phenomena inconsistent

with fully-rational framework

Theoretical work: What if we relax

rational assumptions?

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A brief overview of my research

1. Prospect Theory

• Empirical tests

• Theoretical improvements

2. Risk Perception (in financial investments)

3. Cross-cultural comparison

• Risk-attitudes

• Financial data (e.g. equity premium)

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1. Prospect TheoryADVANCES IN PROSPECT THEORY 313

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Figure 3. Weighting functions for gains (w + ) and for losses (w - ) based on median estimates of y and 8 in equation (12).

Figures 4a and 4b are in general agreement with the main empirical generalizations

that have emerged from the studies of the triangle diagram; see Camerer (1992), and

Camerer and Ho (1991) for reviews. First, departures from linearity, which violate ex-

pected utility theory, are most pronounced near the edges of the triangle. Second, the

indifference curves exhibit both fanning in and fanning out. Third, the curves are concave

in the upper part of the triangle and convex in the lower right. Finally, the indifference

curves for nonpositive prospects resemble the curves for nonnegative prospects reflected

around the 45 ° line, which represents risk neutrality. For example, a sure gain of $100 is

equally as attractive as a 71% chance to win $200 or nothing (see figure 4a), and a sure

loss of $100 is equally as aversive as a 64% chance to lose $200 or nothing (see figure 4b).

The approximate reflection of the curves is of special interest because it distinguishes the

present theory from the standard rank-dependent model in which the two sets of curves

are essentially the same.

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Utility function depends on reference point and is convex–concave.

Descriptive extension of Expected Utility Theory. Main ideas:

Small probabilities are overweighted with a nonlinear function w.


Empirical studies on PT

Comparison of Chinese and American

• Experiments (with Fischbeck, J. of Risk Research, 2008)

• Field data (with Fischbeck, J. of Risk & Uncertainty, 2004)

Predictive power of PT

• Disposition effect (with Martin Vlcek, working paper)

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Theoretical studies on PT(with M. O. Rieger)

• St. Petersburg Paradox in PT (Economic Theory 2007)

• PT for continuous distribution (J. of Risk & Uncertainty 2008)

• PT compared with other heuristics (Psy. Rev., 2008)

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2. Risk perception

• Perceived risk on financial products (with Siegrist & Keller, working paper)

• Are pension fund managers overconfident? (with Gort & Siegrist; J. of Beh. Finance, 2008)


Perceived risk of financial products

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bank account

private house

third pillar

life insurance

gold

art/antique

blue chip Switzerland

blue chip USA

first-class bond CHF

first-class bond Euro

first-class bond dollarequity fund Switzerland

equity fund world wide

equity fund Europe

real estate fund

commodity fund

sustainable fund

bond Switzerland

bond worldwidebond Europe

1

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1 2 3 4 5

understanding

perc

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ris

k

Easy Difficult

High

Low

High risk

Low risk

Easy Difficult


Are pension fund managers overconfident?

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Tables and Figures Figure 1: Confidence intervals for historical returns

Figure 1 shows the median lower and the median upper boundaries for the confidence intervals in the professional and the laypeople sample for historical return estimates of 6 different asset classes as well as the upper and lower boundaries of the realized return of those asset classes over the last 36 years.

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3. Cross-cultural comparison

• Important to know cultural differences (e.g. when offering financial services in different cultures).

• Studies can help to find influencing factors (different countries as “natural experiment”).

• Hens, T. & Wang M. (2007): Does finance have a cultural dimension? NCCR working paper.

I present two ongoing projects as examples:

• International Test of Risk-attitudes, INTRA

• Equity premium – a meta-analysis


Ongoing projects (1)

INTRA International comparison of risk attitudes (with Thorsten Hens and Marc Oliver Rieger)

Goals:

• compare risk-attitudes (PT framework), time discounting, ambiguity aversion and cultural dimensions across 30-40 countries

• test predictive power of cultural and macro-economic variables for risk-attitudes

• results can be used as input variables for further studies on international markets

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Ongoing projects (2)

Equity premium – an international comparison (with M.O. Rieger)

• Meta-analysis of 13 studies on the equity premium in 44 countries.

• Goal: finding common factors that can help to explain the equity premium puzzle.

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Equity Premium and Uncertainty Avoidance

Short-term Equity Premium vs. Uncertainty avoidance

-5

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0 10 20 30 40 50 60 70 80 90 100

Uncertainty avoidance

equi

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YPredicted Y


Equity Premium and Individualism

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INdividualism

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eqyu


Value of information (with Daniel Hausmann and Marc Oliver Rieger)

Experimental study on the reasons why people tend to oversearch for information in investment decisions.

• Goal is to distinguish mistakes in the estimation of the objective probability for usefulness of information from attributing an intrinsic (irrational) “value” to information.

• Relation to underreaction on stock markets.

Further ongoing projects (1)

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Further ongoing projects (2)

Experiments on:

• Real option pricing (with Marc Chesney)

• Emission trading (with Marc Chesney & Luca Taschini)

• Framing in financial decisions(with Marc Oliver Rieger)

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Potential topics

So much about my current research. – What about other potential topics for

Your PhD thesis?


Potential topics (1)Reaction to news

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Methodology on reaction to news

Experiment

• design experiment to control the timing of events

• real option experiment data (with Chesney)

Proxies of perceived probability in the field

• prediction market

• news analysis

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Potential topics (2)Cross-country comparison of home bias

Huber, G. (2001) Familarity breeds Investment. Review of Financial Studies. 14(3):259-280.

French, K. R. and J. M. Poterba (1991). Investor Diversification and International Equity Markets. American Economic Review, 81(2):222–226.

Merton, R. C. (1987). A simple model of capital market equilibrium with incomplete information. Journal of Finance, 42:483–510.

Lane, Philip R. Gian Maria Milesi-Ferretti: The external wealth of nations mark II:Revised and extended estimates of foreign assets and liabilities, 1970-2004. 06/69, IMF working paper, 2006.

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What determines the degree of home bias? (Institutional factors, transaction cost, familiarity bias)


Some general advice...

• Start early when searching for a topic and an advisor!

• Work together with your advisor and other professors!


Why should you start early?There is a lot to do before you can actually start writing your summer research paper:

• literature review

• feasibility check

• match faculty

• narrow down your research question

• trial and error

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Important to know:

Independent research ≠

no collaborations

You can and should work with senior researchers to learn and to avoid mistakes.

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Why should you work together?

Thanks for your interest!Mei

[email protected]

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