Behavioral Economics of Investor Decision-Making

Paper Session

Friday, Jan. 6, 2017 2:30 PM – 4:30 PM

Swissotel Chicago, Zurich A
Hosted By: American Economic Association
  • Chair: Alexander F. Wagner, Swiss Finance Institute and University of Zurich

Stock Ownership and Learning From Financial Information

Camelia Kuhnen
,
University of North Carolina-Chapel Hill
Sarah Rudorf
,
University of Bern
Bernd Weber
,
University of Bonn

Abstract

We document that people’s prior portfolio choices influence the way they learn from new information about available investment options. Specifically, we find that people update more from information which is consistent with their prior choice. This behavioral effect is mirrored by a bias in activation in brain centers important for valuation, as these centers are more responsive to new information about investment options which matches the participants’ prior portfolio choice. These findings can help shed light on puzzling patterns in investor behavior, such as the low participation rate of households in equity markets and people’s reluctance to sell losing stocks.

Peer Effects in Financial Decision Making — A Case of the Blind Leading the Blind?

Sandro Ambuehl
,
Stanford University
Douglas Bernheim
,
Stanford University
Fulya Ersoy
,
Stanford University
Donna Harris
,
University of Oxford

Abstract

Often, people consult with others for advice before they make financial decisions. Previous research argues that such communication amounts to a case of the blind leading the blind. In this paper, we document that it can be beneficial, and explore mechanisms. In our laboratory experiment, subjects make private decisions about investments involving compound interest both before and after they communicate with a randomly assigned partner. Communication not only improves decision making for the specific tasks they have sought advice about, but subjects successfully generalize these skills to novel decision problems. We find that communication is most beneficial when pair members’ skills are at similar levels—the transmission of financial competence requires a common language, and is not merely a case of information flowing from those who have it to those who do not. Finally, communication leads subjects to reevaluate their privately revealed time preferences. Discount rates move towards the communication partners’ rate, and do so to a larger extent if the partner is more patient. We suggest policies to improve the quality of financial decision making.

Cumulative Prospect Theory, Option Prices, and the Variance Premium

Lieven Baerle
,
Tilburg University
Joost Driessen
,
Tilburg University
Juan Londono
,
Federal Reserve Board
Oliver Spalt
,
Tilburg University

Abstract

The variance premium and the pricing of out-of-the-money (OTM) equity index options
are major challenges to standard asset pricing models. We develop a tractable equilib-
rium model with Cumulative Prospect Theory (CPT) preferences that can overcome
both challenges. The key insight is that the variance premium can be written as the ex-
pected return on a portfolio of OTM call and put options, and the probability weighting
feature of CPT can explain the puzzlingly low returns observed for these options. Using
GMM on a sample of U.S. index option returns between 1996 and 2010, we show that
the CPT model fits well observed option prices and, therefore, the variance premium.
In a dynamic setting, probability weighting and time-varying equity return volatility
combine to match the observed time-series pattern of the variance premium.

Investing in Managerial Honesty

Rajna Gibson
,
Swiss Finance Institute and University of Geneva
Matthias Sohn
,
Zeppelin University
Carmen Tanner
,
Zeppelin University
Alexander F. Wagner
,
Swiss Finance Institute and University of Zurich

Abstract

How does investor perception of managerial honesty affect investment choices? Do some investors avoid “sinful” CEOs, like they avoid “sin stocks”? Two laboratory experiments shed light on these questions. We find that investors perceive a CEO to be more committed to honesty when he or she previously resisted engaging in earnings management at a personal cost. In their investment decisions, investors discount the announcements of a CEO whom they perceive as dishonest. Specifically, a one standard deviation increase in a CEO’s perceived commitment to honesty compared to another CEO reduces the relevance, for investment decisions, of announced return differences between the CEOs by about 40%. This effect is prominent among investors with a pro-self orientation. Pro-social investors are generally insensitive to returns, but seek to invest with a CEO with matching honesty values. Overall, these results suggest that (a) (perceived) honesty of the CEO matters, (b) investors’ personal values affect their investment choices, and (c) investors segment into stocks based on the joint effects of these two driving forces.
Discussant(s)
Cary Frydman
,
University of Southern California
Florian Ederer
,
Yale University
Shimon Kogan
,
IDC Herzliya and University of Texas-Austin
Harrison Hong
,
Columbia University
JEL Classifications
  • D0 - General
  • G1 - Asset Markets and Pricing