Behavioral finance

Behavioral finance is one of the most important areas that any firm should be concerned with if profits are to be realized on a consistent basis. Finance officers fail because they do not comprehend this field of study. Behavioral finance is the study of psychological influences on financial practitioners’ conduct and the resulting effect on markets. Because of a lack of interest in this sector, many markets are inefficient. Understanding the client’s needs is critical to ensuring that you deliver at a better level as a consultant. Most institutions overlooked this area and ended up failing miserably and failing to meet their needs. Investors who don’t understand this sector will end up investing where it will not profit them. Financial markets understand well that there are numerous variables that affect the securities markets. The decision made by investors to either buy or sell anything is driven by their understanding of the market. This paper will act as a guide to the consulting firm that can be referred in the future to realize continued success.

The main role of behavioral finance can be described as a guide to the investors and markets analysts in understanding the price movements. This is possible when there are no intrinsic changes in the sectors and companies. Many investors are curious about how biases and emotions affect the share prices. Hence they consider psychology as one of the areas which can profit the behavioral finance officers. There are theories that have been brought up to explain this idea of how psychology affects the stock market and increase its efficiency. Therefore, it is for finance practitioners to decide which theory to follow to ensure they understand and give the relevant appropriate advice to their clients (Grinblatt, & Han, 2005). Therefore, this paper will cover a case study as well as give a white paper on the behavioral finance. The paper will also address the questions raised by the clients to0 ensure that they are satisfied and they will consider the advice given.

White Paper on Prospect Theory

Prospect theory is an economic theory of behavior which describes how different people decide between alternatives which have a lot of risks. This theory concludes that people make financial decisions depending on financial gains and losses instead of the outcomes at the end (Grinblatt, & Han, 2005). The models involved are descriptive and they model the choices in the real life instead of optimal decisions. The theory is very interesting in the way it explains the decision processes as shown below:

At first, the stage called ‘editing’, the outcomes of any decision depend on a given heuristic. This means that people make decisions on outcomes that to them are equivalent. They set reference points as they consider the outcomes that are lesser as losses and those that are greater as gains. The framing effects are alleviated through the editing phase. The phase also resolves any isolation effects arising from an individual propensity to isolate probabilities consecutively rather than treating them as one (Ritter, 2003). Therefore this process can be seen as a composition of combination, coding, segregation, simplification, cancellation and dominance detection.

The other phase is the subsequent evaluation where people behave in a manner to compute utility value basing this on the expected outcomes and their probabilities respectively and they later make a choice depending on the highest utility.

The distortion of probability is that people don’t consider the probability value uniform. This makes the prospect theory applicable in some behaviors seen in economics, for instance, disposition effect, risk-seeking and endowment effect where if there arises cases of gains and losses are called reflection effect (Ritter, 2003). A pseudo-certainty effect indicates that people can either be risk-acceptant or risk-averse depending on the resources involved. This explains the fact that same people buy a rotary ticket and insurance policy.

A very great implication of this theory is because economic agents figure out an outcome in their minds according to the utility they derive from it. People evaluate the upcoming gambles by ignoring any risk. The phenomenon is indicated in the reaction that people have to fluctuations in the stock markets compared with aspects of the overall wealth. Investors are very sensitive to changes in the stock market but not in the housing market and labor income (Grinblatt, & Han, 2005). The theory is applicable in the stock market where investors are evaluating the expected outcome.

The utility theory indicates that people will only prefer a good because it is satisfying their needs. The theory describes how people avoid purchasing certain products than others while leaving those that have low utility. The theory states that it is not possible to describe a good depending on the utility driven from it rather according to preferences of the consumer. The value of goods and services related directly to the marginal utility and any consumer will buy it accordingly. Whereas the prospect theory explains this idea by assuming the fact that gains and losses are differently valued hence if two goods were placed equally for an individual to choose, with these goods brought out as potential gains and the other one as potential losses where the first option will pass (Ritter, 2003). Another difference between these theories is that prospect theory belonged to economic subgroup dealing with behavior. The explanation for this individual behavior lies in the fact that choices are singular and interdependent.

The major changes of the prospect theory are relative to the utility expected where risks and uncertainties are not modeled nowadays according to the utility curve. Risk attitude is more concerned more than the feeling decision makers have. The prospect theory concentrates more on the outcome of a thing more than utility theory which goes for consumer preferences. The consumer doesn’t care very much about the losses that he or she may get from consuming a good. The investors basing their investments on this theory will tend to consider areas of investment that are more satisfying than those which are not. Risks experienced in investing in areas such as those with natural catastrophes will not matter to a consumer or investor as long as he or she realizes the taste expected (List, 2004). Evading risks becomes hard for these consumers according to this theory.

Example of an expected utility theory

Given the following gamble, calculate the expected utility value

15% chance of $97

40% chance of $240

20% chance of $120

55% chance $11, 45% chance of $54

33% chance of $33, 77% chance of $91

26% chance of $51, 74% chance of losing $23

Which of the above is most preferred?

Solution: according to the EV theory, option ‘c’ is the highly preferred since it gives the consumer the highest taste. Thou many people would choose option ‘e’ because c is a gamble but it has a lower preference and if the utility is considered then ‘c’ is the best.

The main implication of the prospect theory is the loss aversion. Most people don’t like losses and this is seen where if a loss occurs, people are psychologically affected more than when a gain happens (Fromlet, 2001). Hence many people will better choose risk to evade losses than look at the gain realized.

Another implication is that value is made relative to a given reference point. Hence the value perception is dependent on the changes rather than on the resulting value. For example, if an individual gets started with $120k in asset possession and gets a win of $880k from a lottery has a net worth of $1M. If another person gets started with $3M and losses $2M, has a net worth of $1M. Despite the fact that both stands at the same point of net worth, the individual A will have a better feeling than individual B (List, 2004). This indicates that the end of a gamble determines the utility of a good. Therefore whether a given gamble is regarded as loss or gain remain irrelevant.

More also, the diminishing sensitivity of gains and losses is another implication of this theory where value function is convex to losses and concave to gains (Ritter, 2003). Hence the impact of any additional loss of a given amount of good will increase the overall while the overall gain of a given amount will also increase with an additional gain.

An excellent example of prospect theory is the purchase of insurance plan. When people are choosing between alternatives they try to avoid losses as much as they can to ensure they have sure wins because in case they lose they will have too much pain than they would be happy in case of a win (List, 2004). Therefore, people would like to secure their goods instead of incurring the losses.

Bias Identification

Taking option II as the most preferred comment, the colleague is taking a very great risk in the Omega Corporation. With the knowledge that this organization is experiencing great losses and might be closed due to these continued losses, the colleague should have withdrawn his investments instead of putting more. This is because the individual is not aware of any rise. Therefore, in such a business which the rate of falling is higher than that of rising up, investors would not take such a very high risk to buy shares. This idea also becomes riskier in the fact that the business is not having a future hope to rise. The colleague might not recover; actually, the advice would be to look for another organization to work with where there is growth. The stock is a good investment but it becomes good when done on safe grounds (Grinblatt, & Han, 2005). Most investors would have gone for the same idea but considering this situation, most neither would nor risk their wealth in such a business.

Holding a large position in an under developing business is riskier for his wealth. Investing where there is no gain is an unsafe ground. The individual reports that the corporations have a large unrealized loss (Shefrin, 2002). This means that the organization might not recover the losses. Another evidence is the fact the business also didn’t the expectation of the analyst hence indicate that there is poor management.

The only good thing about the idea of this colleague is that he will get the stock at very low mounts and in case of the company recovers; he will be among the biggest shareholders in this institution. This is one of the strategies that most of the investors must consider before making a step in investing their resources (Shefrin, 2002). The colleague also had started securing a higher position in the business which will give him a good position to control the stocks more than others. His salary also will rise as the company grows.

In advising this colleague, he should consider evaluating the expected future of this company. He should check if the company will last for a longer period of time than others. My take on this issue is that the colleague should also consider taking the measure which will help the company grow. Investing for his future is a good idea but he should not forget the idea about the future changes that may occur. His educations and level of knowledge may become primitive hence make him be demoted or lose his job (Shefrin, 2002). Therefore the idea being taken is not profiting or promising for investment.

Financial concepts chosen by colleague III is quite a great one and should be considered for investment. It is a promising idea with the potential to make high profits. The risks in the idea are very few yet the business will make high profits. The chances of making gains more than the losses are more hence I would prefer going for such an idea. Being a long-term investment creates room for growth and establishment. Real estate is an area that never depreciates especially when constructed for commercial work (Thaler, 2005). But it has some challenges such as natural catastrophes for example earthquake, terrorism, and improvement in technology might also challenge this kind of an investment.

Looking at the case of a colleague I idea is also another risky business with very high chances of gains. This is because people have started shifting to online trading. With the knowledge about this situation, people can make very high profits. Through online trading, time is saved and chances of theft are low hence most of the investors currently prefer online trading (Thaler, 2005). Buying and selling of shares online have become popular of late and many like it because it saves space, and no much capital is required.

Therefore, it is evident clearly that these colleagues have very great ideas and interesting ones but there is need to check on the advantages and disadvantages of each. Investors like where profit is most. They prefer to risk their money where the gains have a higher rate of occurrence. These colleagues had a view about their future life since most of them invested for their future (Shefrin, 2002). It is important to look for businesses which will bring profit faster than those that which are slow and risky like that of colleague II.

Behavioral Finance and Investments

To start with, taking the case study of Violet, there are a number of issues that arise which need to be discussed. Violet is a very enthusiastic hardworking but also an outgoing woman. She works in a well-paying organization which gives her a chance to enjoy so many opportunities for life. She has been overspending her money on luxuries and other liabilities making her incur huge losses. Violet has been purchasing a short-term out of money call and put options with low probabilities of paying off (Fromlet, 2001). This is an error that she has made as far as behavioral finance is considered. She has not considered other areas which could give her very high returns. As with her salary she can be able to invest in stock trading where she will acquire much gain, she should consider withdrawing her stock from such a market (Shefrin, 2002). This is because she hasn’t made any profit and might not in the near future. Hence it is advisable for her to look for other areas of investment.

Violet should also consider withdrawing from housing insurance especially because her house is not an area prone to earthquakes. There were other insurance products she can buy for example ensuring her house against theft, fire or other damages, she considers buying such. This makes her salary to be depleted very fast (Shefrin, 2002).

It is also evident that violet has been purchasing a new luxury vehicle every two years and takes expensive vacations. These are all liabilities that she should consider reducing by half and direct her money into other key investment areas which will profit her. Most of these luxury vehicles consume a lot of fuel which will continually deplete her salary. Considering the fact that she has very few areas she has invested to ensure her future is secure and that she will continually gain more money, violet should at least stay with one car in a longer period of time or buy a cheaper vehicle. Violet should also reduce the number of vacation she is going. Seeing that these vacations are liabilities create a path for her to become poor just after retiring. Therefore she should save much money for her future (Fromlet, 2001). The best way to save such money is through long-term investment such as purchasing land and commercial building which appreciate every year. Other ways will include buying stock in highly profiting companies.

Another observable issue with Violet’s finance behavior is the fact that she has been spending too much on restaurants possibly she may be eating too many expensive foods or purchasing foods for friends. These make her incur huge costs of upkeep. Given that her annual consumption cost comes from her salary and half of her annual bonus indicates that she will not be able to maintain that level after retirement. Managing her finances will require her to exercise higher levels of discipline in her general expenditure.

The client also has been saving half of her bonus and other incomes to her retirement accounts. This is the opposite of the expected because even in future she will not maintain such a high lifestyle. She should be saving half of her income while spending the other half if she has to maintain such a lifestyle. The behavioral financial expenditure exhibited by Violet should be adjusted. Violet feels satisfied with such higher life which she cannot maintain in her lifetime.

Besides that, violet retirement portfolio allocation is also not correctly put in that it is not in line with the mean-variance framework. She might not benefit much from these investments that she chose. Therefore there is needed to look for more modern speculative stocks that are promising. The reason for investing is gain and not losses, her wealth should, therefore, be in places where they will continually rise in value. She will enjoy the benefits for a limited time period. These practices interfere with her optimal consumption and saving allocation.

According to Susan’s utility function, a consumer should be risk loving to ensure she gets more outcome from the investments made. The differential salary needs to be compensated in the straight salary to ensure that the utility expected is realized. Therefore, in the case of Violet, it was necessary for her employer to ensure that she will continually enjoy the same utility.

According to traditional finance theory, it lays focus on individual’s behavior by considering them as ‘Rational Economic men’ which leads to the availability of price reflection in the market. Behavioral finance, on the other hand, recognizes the process in which information is presented to people who are investors (Fromlet, 2001). This means that it can cause cognitive and emotional biases. It shows reasons as to why investors have their unique behavior. The theory exhibit biases which in the long run interfere with the optimal savings. These biases include self-control and mental auction. The Susan’s retirement portfolio has been correctly allocated because it lines with the mean framework (Fromlet, 2001). Therefore, the behavior of the individual will not be affected rather she will enjoy the same benefits.

Behavioral Corporate Finance

Shefrain Consulting Memo

To: CFO

Cc: Board of Directors

From: Student name

Date:

Subject: Behavioral Finance

Behavioral finance creates a better understanding of the financial market to the investors hence enabling them to make the right choices based on the potential pitfalls understanding. It is one of the topics that each adviser should learn biases they make to ensure that the clients receive the best advice and coaching. Behavioral finance, over the last thirty years, has been growing because the investors no longer behave as per the assumptions created by traditional financial and theory of economics (Fromlet, 2001). Therefore, behavioral finance examines the psychology of decision making in the finance sector. Since most of the people are aware that emotions affect the decisions made for investment, hence the need for psychological research. All consultants should consider learning this area to provide the best guidance to our clients and for more understanding.

Future and Behavioral Finance Post 2008

The understanding of behavioral finance is very useful to the development and achievement of any financial institution. It helps to guide clients on the best saving methods as well as explain to them the economic models which relate to their business field.

There are several lessons learned from behavioral finance which are very useful in creating opportunities to the company as listed below;

Loss aversion: investors run for the most profiting deals while averting those which are likely to bring losses

Sunk costs: according to this theory ‘sunk costs’ cannot be recovered.

Anchoring: anchoring makes innovation hard because most investors tend to invest in only places they are aware of.

Framing effect: it explains how a reference point can affect the decision-making process. These effects come into action when real performance is likened to the prior plan.

In conclusion, it is evident that behavioral finance is a key to the growth of any given company hence should not be ignored. It will guide advisers on the best ways to direct their clients.

References

Fromlet, H. (2001). Behavioral Finance-Theory and Practical Application: systematic analysis of departures from the homo economics paradigm is essential for realistic financial research and analysis. Business economics, 63-69.

Grinblatt, M., & Han, B. (2005). Prospect theory, mental accounting, and momentum. Journal of financial economics, 78(2), 311-339.

List, J. A. (2004). Neoclassical theory versus prospect theory: Evidence from the marketplace. Econometrica, 72(2), 615-625.

Ritter, J. R. (2003). Behavioral finance. Pacific-Basin finance journal, 11(4), 429-437.

Shefrin, H. (2002). Beyond greed and fear: Understanding behavioral finance and the psychology of investing. Oxford University Press on Demand.

Thaler, R. H. (Ed.). (2005). Advances in behavioral finance(Vol. 2). Princeton University Press.