Behavioral Economics of Investor Decision-Making
Friday, Jan. 6, 2017 2:30 PM – 4:30 PM
Swissotel Chicago, Zurich A
- Chair: Alexander F. Wagner, Swiss Finance Institute and University of Zurich
Peer Effects in Financial Decision Making — A Case of the Blind Leading the Blind?
AbstractOften, 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
AbstractThe 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
AbstractHow 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.
University of Southern California
IDC Herzliya and University of Texas-Austin
- D0 - General
- G1 - Asset Markets and Pricing