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Behavioural Finance

Mental FramingSession 4Read Thaler, 2000

Thaler, 1999

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Who is better off?

Anna and Barbara graduated from Cass a year apart. Upon graduation both took similar jobs with publishing firms. Ann started with a yearly salary of £30,000. During her first year on the job there was no inflation and in her second year Ann received a 2 percent (£600) raise in salary. Barbara also started with a salary of £30,000 per year. During her first year on the job, there was 4 percent inflation and in her second year Barbara received a 5% (£1,500) raise in salary.

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Who is better off?

As they enter their second year on the job, who was doing better in economic terms? Ann or Barbara?

As they entered their second year on the job, who do you think was happier? Ann or Barbara?

As they entered their second year on the job, each received a job offer from another firm. Who do you think is more likely to leave her present position for another job? Ann or Barbara?

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How does Markowitz construct his portfolio?

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Framing

Difference between form and substance Framing is about form

it reflects a mix of cognitive and emotional elements!

Regret is an emotionpeople who have difficulty controlling emotions

are said to lack self controlpeople use framing effects to constructively help

themselves deal with self control difficulties!

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What would you do?

Imagine that you are about to purchase a t-shirt from Marks and Spencers at the corner for £15. The salesman informs you that the t-shirt is on sale for £10 at the Oxford Street branch. Would you make the trip to Oxford Street?

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What would you do?

Imagine that you are about to purchase a black trouser suit from Marks and Spencers at the corner for £150. The salesman informs you that the t-shirt is on sale for £145 at the Oxford Street branch. Would you make the trip to Oxford Street?

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Hedonic Framing

The way the decision is made will not alter choices if the decision maker is using a wealth based analysis! You save £5 in either case!

Framing does alter choice because people make decisions piecemeal! £5 is a significant saving on a £15

purchase but not so on a £150 purchase!

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Have you ever?

Bought something because it was on sale?

Made two budgets? One for entertainment? One for food?

Invested windfall gains into something luxurious?

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Mental Accounting

A mental account is a frame for evaluation!

Accounting a system of recording an summarizing

financial transactions in books and analyzing, verifying and reporting results

Money in one mental account is not a perfect substitute for money in

another mental account!

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How much would you pay?

Holiday time! You are in Southern France! You are lying on the beach on a hot day! A companion has to make a phone call and gets up to go and offers to bring back a pint of beer from the only nearby place beer is sold. A fancy resort hotel! He says beer might be expensive and asks you how much you are willing to pay.

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How much would you pay?

Holiday time! You are in Southern France! You are lying on the beach on a hot day! A companion has to make a phone call and gets up to go and offers to bring back a pint of beer from the only nearby place beer is sold. A small run-down corner shop! He says beer might be expensive and asks you how much you are willing to pay.

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Acquisition vs Transaction UtilityAcquisition Utility

a measure of the value of the good relative to its price

Value as a gift minus the price

Transaction UtilityPerceived value of the deal!Difference between amount paid and reference

price If you pay £5 for a pint from the resort but only £2.5

from a corner shop, you will miss the same pleasant feeling of drinking beer lying on the beach on a hot day!

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Riding losers too long

Shefrin and Statman, 1987 we discussed last week

Odeon, 1998 trades of individual investors likely to sell stocks that increase in value

Closing an account at a loss is painful you might feel regret! People are reluctant to sell securities at a

loss!

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Who would buy another ticket?

You bought tickets for the Musical Chicago for £45. On the way to the theater you lost your ticket. Would you buy another ticket and go anyway?

You are on your way for the Musical Chicago. Tickets for the show are £45. On the way to the theater you lost your purse and your £40 in it. You have your debit card with you. Would you buy another ticket and go anyway?

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Sunk CostsMental accounts

Buying another ticket is difficult because it is included in the mental account for the theater outing. The loss of money is not in that account!

Arkes and Blumer (1985)Season tickets to a campus theater group

• one group pays full price• one group receives 13% discount• one group receives 47% discount

Who attended more plays?Is there any difference during the second season?

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What would you do?

You have just won £30! Now chose between

%50 chance to gain £9 No further gain or loss%50 chance to lose £9

You have just lost £30! Now chose between

%50 chance to gain £9 No further gain or loss%50 chance to lose £9

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What would you do?

You have just lost £30! Now chose between

%33 chance to gain £30 No further gain or loss

%67 chance to gain nothing

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Prior outcomes and risky choices

Prior outcomes affect risky choices Prior gain >>> risk seeking prior loss >>> risk aversion

unless there is a chance to break even!

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Combine all the points

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Narrow Framing

Equity premium puzzle• Benartzi and Thaler, 1995• Mehra and Prescot, 1985

Equity premium in the US is about 6%1 dollar invested in 1926 worth $1800 in 1998!the level of risk aversion that can explain this

• is 40 (log utility function 1)

If people rebalance portfolios once a year they will be indifferent between stocks and bonds!

Myopic loss aversion!

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Narrow framing

Myopic loss aversion remedy for excessive risk aversion is

aggregation• either through time or across divisions

Cab drivers establish a target level per day

quit early on good days!Mental accounting one day at a time!

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Is mental accounting good for us?

“I started a little side savings account eight years ago. During the day I try to accumulate change. If I spend $4.50 at a store, I give the cashier a $5 bill, even if I have 50 cents in my pocket. At the end of each day the money is put aside. I add income tax refunds, money from products I purchased and returned for a refund…. I end up painlessly saving between $500 and $1000 a year”

A reader of Wall Street Journal giving tips about how he saves money!

A rational economistwould argue it would be less painful to write a check

once a year and send to his savings account!

In realityMental accounting matters!