BAFI 3259 Behavioural Finance 

Assessment 3: Individual assessment (35 marks)

In this assessment, student is required to accomplish two tasks, which include a list of discussion questions related to Behavioural Finance topics. The details of the assessment will be released on Monday Week 11.

Please submit your answers/discussions to the two tasks in one combined report. To successfully accomplish the assignment, students are required to collect industrial data, academic literature, examples and other relevant information to initiate their own analysis and form a discussion summary of up to 3,000 words limit. Student is allowed to have up to 3-page Appendix, appendix and reference list are not included in the words limit.

All submissions must be made electronically on Canvas. Students should ensure that the submission is free from problems like copying and plagiarism.

Unless extension is granted, severe penalties apply for late submission. For late submission, the mark awarded will be reduced by 10% for each day (1.5 points) the submission is late. Submissions that are late by 7 days or more will not be marked and zero marks will be awarded.

An application for extension of an assessment task of up to seven calendar days after the original submission due date must be lodged with the course coordinator via email, and where appropriate supporting documents such as a medical certificate in case of illness should be provided. Applications for extensions for submission of assessment tasks greater than seven calendar days after the original submission due date should be made via the Special Consideration Procedure.

Students are required to keep back-ups of all submitted work just in case any are lost.

 

 

             

Task 1 (23 marks)

Read the following two articles and discuss:

• What is Prospect Theory and how does it challenge the Traditional Finance. (7 marks)

 

 

• Provide two examples that Loss Aversion affect manager and/or investor decision. (8 marks)

 

 

• Discuss “Is Loss Aversion theory correct?” (8 marks)

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Article 1: A Challenge to the Biggest Idea in Behavioral Finance

Barry Ritholtz

August 10 2018, 7:30 AM

(Bloomberg Opinion) — A recent paper summarized in Scientific American raises an intriguing question: Is one of the founding theories of behavioral finance known as loss aversion — the idea that people place more weight on avoiding losses than gains — correct?

In the magazine, one of the study’s authors, David Gal of the University of Illinois – Chicago, writes:

“Why has such profound importance been attributed to loss aversion? Largely, it is because it is thought to reflect a fundamental truth about human beings—that we are more motivated by our fears than by our aspirations. This conclusion has implications for almost every aspect of how we live our lives, especially for finance and economics. “

But Gal doesn’t see it that way. He writes that “loss aversion is essentially a fallacy.” He suggests that cognitive bias via loss avoidance doesn’t exist, and messages framed in terms of losses are no more persuasive than those framed in terms of gains.

Since this is an extraordinary claim, it requires extraordinary evidence. I don’t believe that standard has been met and that the authors failed to make a case that convincingly rebuts the accumulated research.

Let’s look at some of the hypotheticals Gal cites: “People do not rate the pain of losing $10 to be more intense than the pleasure of gaining $10.” That is not what most of the studies on the subject have found to be case; nor does it square with my personal experiences in dealing with any investor who has suffered losses.

He further writes: “People do not report their favorite sports team losing a game will be more impactful than their favorite sports team winning a game.” Again, numerous studies have found that despite the pleasures associated with being a sports fan, the opposite is true.

And one more: “And people are not particularly likely to sell a stock they believe has even odds of going up or down in price (in fact, in one study I performed, over 80 percent of participants said they would hold on to it).” Even if that is true (and I do not believe it is), the endowment effect easily explains why we place greater financial value on that which we already possess.

My pop psychology thesis on this is based on the asymmetrical impact of losses and gains. From an evolutionary perspective, the biological penalties for losses are existential threats to an individual’s or a specie’s survival; the upside of gains are modest — you live to hunt (or avoid being hunted) another day.

In the modern human world, a loss can feel permanent. You exchanged your finite time for some money (this is otherwise known as employment). Or you risked capital and lost it. That money is gone forever. But get lucky in the markets or a casino and it is ephemeral “house money,” easy to spend thoughtlessly.

When Richard Thaler, Nobel laureate in 2017, was asked about the $1.1 million award that came along with the Prize in Economic Sciences, he cheekily said “I will try to spend it as irrationally as possible.” Thaler’s bon mots are a subtle admission of how humans behave in the real world. That’s what he was awarded the prize for in the first place.

No matter, the paper drew a good deal of attention from those like Drew Dickson, chief investment officer and managing partner at Albert Bridge Capital. In a pointed tweetstorm, he succinctly summed up their position, challenged their thesis, while noting that they perhaps have identified “other motivations for well-known biases.” But he too reaches the conclusion that loss aversion is alive and well.

Where I suspect the authors went astray was in the conflation of various cognitive failures, biases and heuristics with loss aversion. Consider for a moment a Las Vegas casino. If people were truly loss averse, the counterargument might suggest that casinos shouldn’t exist. But they not only survive, but thrive. This is due to other powerful cognitive errors: 1) people tend not to understand how the odds are stacked against them and in the house’s favor; 2) others understand the probabilities, but irrationally believe they are an above-average gambler; 3) others simply gamble for its entertainment value and are willing to accept the inevitable losses.

The mere fact that gain-seeking behavior exists hardly eliminates loss aversion as a phenomena.

What is most fascinating to me about the premise that Gal and co-author Derek Rucker of Northwestern University’s Kellogg School of Management have pushed forward is around the meta-concept that challenging the status quo is an uphill battle. They are on to something here, though surely they recognize that Daniel Kahneman and Amos Tversky’s famous theory was itself not accepted for a long time. Kahneman and Tversky’s ground-breaking 1979 paper was an assault on the status quo at the time, and it took decades before their thesis was assimilated into psychology and economics.

But this does bring up an intriguing concept: As any counterintuitive idea slowly becomes mainstream, it too is eventually challenged as the status quo. Perhaps this is what physicist Max Planck meant what he stated that “science advances one funeral at a time.”

For many good reasons, loss aversion has become accepted wisdom on how people make decisions under conditions of uncertainty. I suspect it will be a long time before that explanation is overthrown. This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.” ©2018 Bloomberg L.P. Bloomberg

 

Read more at: https://www.bloombergquint.com/view/a–challenge–to–the–biggest–idea–in–behavioralfinance

Copyright © BloombergQuint

 

 

             

Article 2: What Does Loss Aversion Mean for Investors? Not Much

By David Gal

Posted In: Behavioral Finance, Economics, Portfolio Management, Risk Management

Daniel Kahneman, a winner of the 2002 Nobel Prize in Economics, wrote that “The concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics.” When Richard Thaler, the father of behavioral economics, won the Nobel Prize in Economics in 2017, the phrase “loss aversion” appeared 24 times in the Nobel Prize committee’s description of his contributions to science.

Why have people attributed such profound importance to loss aversion? In large part because they believe loss aversion has critical implications for investment decision making. For example, in his recent address at the 71st CFA Institute Annual Conference, Kahneman stated that loss aversion causes investors to overweight losses relative to gains and therefore leads to flawed investment decision making. Investors become irrationally risk averse and overly fearful.

Some degree of risk aversion in investing is perfectly rational. For example, if losing $10,000 in your investment account means you won’t be able to make your monthly rent, while gaining an additional $10,000 means you can go on an extra vacation, it makes perfect sense for you to play it safe rather than risk the roof over your head. As such, it is not irrational for investors to expect higher returns for taking on more risk.

However, loss aversion holds that all else being equal, losses fundamentally loom larger than gains. This includes cases where, win or lose, the outcome will have little material effect on someone’s life circumstances, and thus suggests that people are too risk averse.

To identify loss aversion, researchers have examined how people make decisions in the context of small gambles. For example, they might ask whether an individual would take a $10 bet with 50-50 odds. Obviously, few people’s lives would be drastically altered either way. Yet, most test subjects don’t take the bet, a result that researchers say is evidence of loss aversion. Based on these findings, they’ve extrapolated further and determined that loss aversion influences more consequential investment decisions.

What’s wrong with this conclusion? One problem is that when people are asked how a $10 bet will affect them, on average, they do not report the potential loss to be more consequential than the gain. Moreover, the decision to take on risk in small bets depends on how the gamble is framed. In a critical forthcoming review of loss aversion for the Journal of Consumer Psychology, Derek Rucker and I conclude that the studies of low-stakes wagers that supposedly establish loss aversion typically frame the choice to take the bet as a change to the status quo. As a result, researchers have confused simple inertia, the tendency to stick with the status quo in the absence of a meaningful incentive to change, with loss aversion.

Indeed, when decisions about losses and gains are decoupled from a choice between change and the status quo, there is no evidence for loss aversion. For example, asked to select between receiving $0 or accepting a bet with 50% odds of either losing or winning $10, about half the test subjects choose to take the bet. In other words, if the status quo option is presented as an active choice — to “receive $0” rather than “not accept the bet” — the preference for safety vanishes.

Thus, what looks like loss aversion in these small wagers is due to an experimental context that reflects inertia, not irrational risk aversion. To be sure, inertia could lead people to be overly risk averse if they start out with a large cash allocation. But it could also cause them to take on too much risk, for example, by allocating too much of their savings to their employer’s stock through an employee stock ownership plan.

In either case, inertia rather than irrational aversion (or attraction) to risk is a better explanation.

Researchers have used evidence of loss aversion in small bet experiments to explain the equity premium puzzle, the finding that stock returns have sometimes appeared to demonstrate a high degree of risk aversion. But there are many other potential causes of this phenomenon, including the compelling notion that investors simply may not have anticipated that the market would perform as well as it did.

The disposition effect — the tendency among investors to sell stock market winners too soon and hold on to losers too long — has also been attributed to loss aversion. But the disposition effect means wanting to both realize gains and avoid losses, not favoring the latter over the former. There are other compelling loss aversion-free explanations for this. For one, investors may simply believe in mean reversion, that equities that go up must eventually come down and vice versa.

In sum, the concept of loss aversion holds that investors are too risk averse. While that no doubt applies to some, it does not apply to all, and just as many may be too prone to risk.

Indeed, our research demonstrates that loss aversion may not be nearly as significant an influence on investment decision making as Kahneman’s and Thaler’s scholarship would suggest.

Source: https://blogs.cfainstitute.org/investor/2018/06/05/what–does–loss–aversion–mean–forinvestors–not–much/

 

 

             

Task 2 (12 marks)

Read the following Case Study and answer the required questions. 

Mrs. Marvel (“Mrs. M”) is a 75-year-old widow from Melbourne with a modest lifestyle and no income beyond what her investment portfolio of AUD $1,500,000 generates (about $90,000 per year) and a small government pension of $10,000 annually. Her adviser, Mr. Tony Stark, has known Mrs. M for about five years. Although Mrs. M did not clearly articulate her investment goals when Stark first started working with her, over time Stark has learned that Mrs. M’s primary investment goals are 1) to not lose money and 2) to maintain the purchasing power of her assets after fees and taxes. Her desire to not lose money stems from the fact that she recalls that her parents lost money before during the financial market crash; she has a “Depression Era” mentality. One of her tendencies is to spread her money around many different banks, and she speaks regularly about various “pots” of money—such as one for generating her income, one for her grandson’s education, and one for paying her bills.

Stark has been challenged by the fact that Mrs. M is quite stubborn in her opinions and rarely, if ever, listens to Stark when he recommends that she change her way of thinking about her investment money and portfolio allocation. Her knowledge of financial concepts is limited, but she is willing to meet regularly and discuss issues with Stark.

Stark is concerned that she is too conservative in her approach and will not accomplish one of her key goals, keeping her purchasing power, because she only invests in government bonds and cash. By taking this approach, her portfolio will not keep up with her spending after inflation and taxes in the long run; therefore, she is putting herself at risk to outlive her assets.

As Stark reflects one day on his relationship with Mrs. M, he realizes that the only recommendation she has accepted is to buy investment-grade corporate bonds to slightly increase her returns. Stark suspects that behavioral biases are influencing Mrs. M and not permitting her to feel comfortable with changing her portfolio. Stark asks her if she will take a 15-question assessment to examine her investor personality. She agrees. Based on the answers to the assessment, Stark decides to dig further into three biases: anchoring, mental accounting, and loss aversion. Stark provides Mrs. M with additional questions on these three biases. Exhibit 1 shows Mrs. M’s answers in bold.

 

Exhibit 1. Mrs. M’s Bias Diagnostic Tests

Anchoring Bias Diagnostic

 

               

Mental Accounting Bias Diagnostic Test

 

Loss-Aversion Diagnostic Test

 

As part of the original asset allocation process, Stark also administered a risk tolerance questionnaire to Mrs. M for the purpose of generating a mean–variance optimization portfolio recommendation. When Stark generated the optimization recommendation, Mrs. Maradona’s “rational” asset allocation was 70 percent bonds, 20 percent stocks, and 10 percent cash; her actual allocation is 100 percent bonds. Stark is convinced that Mrs. M needs to have a riskier portfolio than the one she currently has and that the reason she is invested so conservatively is primarily because of behavioural biases.

Please discuss the following:

1. From Mrs. M’s answers to the above questions, provide discussion on whether she is subject to Anchoring bias, Overconfidence bias and Loss-aversion bias.

 

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1. What effect do Mrs. M’s biases have on the asset allocation decision?

 

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1. Should Stark moderate or adapt to Mrs. M’s biases AND why?
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1. What is an appropriate behaviourally modified asset allocation for Mrs. M?

 

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