11/16/2012
Models Behaving Badly: Introduction to
Behavioral Economics and Behavioral
Finance (Now with More Simpsons)
Jodi N. Beggs
Northeastern University
Economists Do It With Models
Northeastern University Economics Society
November 15, 2012
www.economistsdoitwithmodels.com
What Is Behavioral
Economics?
What Is Behavioral
Finance?
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What Is Behavioral
Economics?
Like the Real World,
behavioral economics/finance
is what happens when people
stop being rational and start
getting real.
What Is Behavioral
Finance?
What does “rationality” mean in an
economic sense, anyway?
• Utility maximizing
• Able to process all necessary information fully
and objectively
• Not susceptible to framing manipulations
• Well-defined and well-behaved utility and
preferences
• Transitive preferences
• Time consistent
• Long planning horizon
• Etc.
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A Brief History of
Behavioral
Economics…
Source: http://www.foreignpolicy.com/articles/2009/04/15/anthropology_of_an_idea_behavioral_economics
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Who Is Interested in Behavioral
Economics/Finance?
• Researchers
• Policy Makers
• Marketers
• Finance Professionals
• Etc.
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A Partial List of Topics in
Behavioral Economics…
Loss Aversion/Prospect Theory
• Framing Effects
• The Endowment Effect
• Status-Quo Bias
Measuring Happiness
• Peak-end Rule
Mental Accounting
• Choice Bracketing
• Windfall Spending
• House Money Effect
Anchoring
Overchoice
Expectations/Social Preferences
• Price vs. Effectiveness
The Power of FREE!
Representativeness Bias
Biases in Predicting Tastes
• Preferences for Variety
• State-dependent Consumption
• Habit Formation and the
Hedonic Treadmill
Visceral vs. Cognitive Choices
Social Norms vs. Market Norms
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A Partial List of Topics in
Behavioral Finance…
Adaptive Attitudes
Affect Heuristic
Aversion to Ambiguity Anchoring and Adjustment
Attention Anomalies
Attribution Substitution Heuristic
Availability Heuristic
Barn Door Closing
Base Rate Neglect
Bid-Ask Spread
Book-to-market
Bubbles
Calendar Effects
Cascades Causality Heuristic
Certainty Effect
Choosing by Default Heuristic
Choosing By Liking Heuristic
Closed end Funds
Clustering Cognitive Dissonance
Cognitive Diversity
Communal Reinforcement
Confirmation Bias
Conjunction Fallacy
Conservatism Bias
Contagions Contrarian Culture
Curse of knowledge
Disjunction Effect
Disposition Effect
Dividends Dotcom Earnings
Endowment Effect
Equity premium
Event Selection
Evolutionary
Expected Utility Hypothesis
False Consensus
Favorite-Longshot Bias Fear
Fluency Heuristic Framing
Frequency Illusions
Fungibility
Gamblers Fallacy
Gambling/Speculation Geomagnetic Storms Glamour vs. Value
Global/Domestic
Herding/Crowd
Heuristics Hindsight Bias
Holidays
Hot Hand Illusion of Control
Illusion of Knowledge
Illusion of Validity
Intraday Effects
Intramonth Effects
Irrelevance of History
January Effect
Law of Small Numbers Loss Aversion
Magical Thinking
Mean Reversion
Mental Accounting
Momentum
Money Illusion
Noise
Optimism Outrage Heuristic
Overconfidence
Over- and Underreaction
Persistence
Persuasion Effect
Pessimism and Doubt
Press Coverage
Price Reversals
Prototype Heuristic Recognition Heuristic
Regret
Representativeness Heuristic
Reward Pursuit
Selective Thinking
Self Control
Self-attribution Bias
Self Deception
Sentiment
Serial Correlation
Similarity Heuristic
Size Effect Sport
Status Quo Bias
Style
Sunk Cost Surprise Heuristic
Survival
Touchy-feely Syndrome Trend
Unpacking Effect
Weather Weekend Effect
Window Dressing
Winner’s Curse
Prospect Theory: The Cornerstone of
Behavioral Economics
Consider the following:
In addition to whatever you own, you have been given
$1000. You are now asked to choose between
• $1,000 with probability .5 (16%)
• $500 with probability 1 (84%)
In addition to whatever you own, you have been given
$2000. You are now asked to choose between
• -$1,000 with probability .5 (69%)
• -$500 with probability 1 (31%)
Source: Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk”
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Prospect Theory: The Cornerstone of
Behavioral Economics
Consider the following:
In addition to whatever you own, you have been given
$1000. You are now asked to choose between
• $1,000 with probability .5 (16%)
• $500 with probability 1 (84%)
Framing matters,
since these are
In addition to whatever you own,
you havethe
been given
objectively
$2000. You are now asked to choose
between
same choices.
• -$1,000 with probability .5 (69%)
• -$500 with probability 1 (31%)
Source: Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk”
utility
value
Expected Utility Theory Versus Prospect Theory…
losses
gains
$
Source: Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk”
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utility
value
Expected Utility Theory Versus Prospect Theory…
losses
$
gains
Prospect theory allows
for different treatment
of gains and losses,
whereas expected
utility theory only
considers final levels of
wealth.
Source: Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk”
Prospect Theory: The Cornerstone of
Behavioral Economics
What irrational behaviors are implied by
Prospect Theory?
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Prospect Theory: The Cornerstone of
Behavioral Economics
Loss aversion (n.) The fact that people
tend to dislike losses (i.e. giving things
up) more than they like equivalent gains
(i.e. getting things)
• Prospect theory directly address this phenomenon by
the way the value function is shaped
Source:Kahneman, Knetsch, and Thaler, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias”
Prospect Theory: The Cornerstone of
Behavioral Economics
Status-quo bias (n.) The fact that people
can irrationally prefer their current state
to states that are perceived as different
• Arises because different is often better in
some ways (gains) and worse in others
(losses), but losses are weighted more
• This is the basis for Thaler and
Sunstein’s “nudges”
Source:Kahneman, Knetsch, and Thaler, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias”
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What Are the Relevant Implications of
Loss Aversion?
Disposition effect (n.) The tendency of
investors to sell winning investments too
soon and hold losing investments too
long
• i.e. the tendency to disproportionately sell
winning investments
For more, see Terrance Odean, “Are Investors Reluctant to
Realize Their Losses?”
Behavioral Finance and Violations of the
Efficient Markets Hypothesis
The Equity Premium Puzzle (n.) The
difference between long-term stock returns
and risk-free returns is too large to be
explained by standard risk models
• What could explain the equity premium
puzzle? (loss aversion and myopia)
• Does the equity premium really exist?
Jeremy Siegel and Richard Thaler, “Anomalies: The Equity-Premium Puzzle”
Shlomo Benartzi and Richard Thaler, “Myopic Loss Aversion and the Equity
Premium Puzzle”
J. Bradford DeLong and Konstantin Magin, “The U.S. Equity Return Premium:
Past, Present and Future”
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Behavioral Finance and Violations of the
Efficient Markets Hypothesis
The Law of One Price (n.) Identical assets (or
assets with identical payment streams)
should trade at the same price
•
•
Why “should” this law hold?
Does this law hold?
Owen Lamont and Richard Thaler, “Anomalies: The Law of One Price in Financial
Markets”
Behavioral Finance and Violations of the
Efficient Markets Hypothesis
The Law of One Price (n.) Identical assets (or assets with
identical payment streams) should trade at the same price
• Enter the story of Royal Dutch and Shell
Owen Lamont and Richard Thaler, “Anomalies: The Law of One Price in Financial
Markets”
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Behavioral Finance and Violations of the
Efficient Markets Hypothesis
What is the behavioral finance explanation for
such inefficiencies in financial markets?
• Individual irrationality
• The presence of noise traders
• The limits of professional arbitrage
For Further Reading…
Academic(ish) Books:
• Kahneman and Tversky, eds.
“Choices, Values, and Frames”
• Andrei Shleifer, “Inefficient Markets:
An Introduction to Behavioral
Finance”
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For Further Reading…
Non-Academic Books:
• Richard Thaler, “The Winner’s Curse”
• Daniel Kahneman, “Thinking, Fast
and Slow”
• Richard Thaler and Cass Sunstein,
“Nudge”
• Dan Ariely, “Predictably Irrational”
A Little About
Economists Do It With
Models…
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Lesson 1:
“Econ Funny” = “Funny”
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Me
The Stand-Up
Economist*
Austan Goolsbee
Avinash Dixit
* don’t tell him I said that
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Austan Goolsbee
Me
The Stand-Up
Economist*
Avinash Dixit
My advisor
* don’t tell him I said that
Lesson 2:
Start Small
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Q: Why did the chicken
cross the road?
Q: Why did the chicken
cross the road?
A: Because it had the proper
incentives.
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Lesson 3:
Keep It Simple, Stupid
Abstract: We consider economies and
diseconomies of scope for large U.S. banks by
employing ordinary and hybrid translog cost
functions. We examine the regularity conditions
in output space where scope estimates are
calculated and reject all models for which these
conditions fail. The translog model always
possesses violations. For the hybrid translog,
violations occur in every case except one. In this
one case, we find economies of scope.
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Abstract: We want to understand whether large U.S. banks enjoy cost
advantages (or disadvantages) from offering multiple lines of business rather
than being focused on one product. We do this by looking at a dataset of
banks and trying to estimate their cost functions. In order to be able to do
this, we need some sort of guess as to the structure of the cost function so
that we can estimate the parameters of the function. We try a bunch of
specifications that are generally reasonable guesses for what a cost function
might look like and see what happens. After we've done the estimating, we
look at the resulting cost functions and see whether what STATA spit out
actually makes intuitive sense. (Such tests of what makes sense could be
things like: Is the estimated cost of producing nothing zero? Does the
estimated cost increase when quantity increases? And so on...)
Unfortunately, when we look at our estimated models, all of them except for
one give what we feel are nonsensical predictions, so they can't possibly be
right. In the one model that we have left once we've vetoed the nonsensical
models, we find evidence that large U.S. banks do in fact enjoy cost
advantages from offering a more diversified line of products.
Abstract: We spent our entire
research grant on weed and a
thesaurus.
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Lesson 4:
Graphs Help. Sometimes.
“Resources were not allocated efficiently.”
From Indexed - http://thisisindexed.com
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child’s SAT score
Money Can Buy Happiness?
Parents’ income
child’s SAT score
Better Call the Contractors…
Number of bathrooms in parents’ house
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Lesson 5:
“Econ Funny” Can Be
Educational
A Lesson in Auction Theory…
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Structural Unemployment in a Nutshell
Lesson 6:
As With Anything Else, Sex
Sells
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Luckily, Economics Has No Shortage of
(In)Appropriate Terminology…
Economics:
Finance:
supply
spread
demand
straddle
curves
call
stimulus
naked
package
yield to maturity
bust
integrate
diminishing returns
Slutsky
…or “Graphic Content”
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The Economics of The
Simpsons…
My Research Output
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Tradeoffs
Stewardess: Sir, what would you like for
dinner? One Steak or two steaks?
Homer: Can I have both?
Source: Episode FABF14, Catch ‘Em If You Can
Markets
Homer, looking for peanut under couch: Aw,
20 dollars…I wanted a peanut.
Inner monologue: 20 dollars can buy many
peanuts.
Homer: Explain how.
Inner monologue: Money can be exchanged
for goods and services.
Homer: Woohoo!
Source: Episode 1F06, Boy-Scoutz ‘N the Hood
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Absolute and Comparative Advantage
Homer: Ok, here's the deal...I'll do the
killing for hire and you stay home with the
kids.
Marge: I get $50,000 a hit- how much do
you make?
Homer: I just get to keep whatever's in the
guy's wallet.
Source: Episode JABF16, Treehouse of Horror XVIII
Rivalry in Consumption
Burns: Yes, but the problem is if you had
it, I wouldn't. You see the difficulty....
Also, “get your own crack”
Source: Episode KABF13, All About Lisa
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Revenue versus Profit
Homer: Look at this, Marge...$58, and all of
it profit. I'm the smartest businessman in
the world.
Marge: Stampy's food bill today was $300.
Homer: Please, don't humiliate me in front
of the money.
Source: Episode 1F15, Bart Gets an Elephant
Opportunity Cost
Homer: Second in line and all I had to do
was miss eight days of work.
random guy: With the money you would
have made working you could have bought
tickets from a scalper.
Homer: In theory, yes...jerk.
Source: Episode 1F14, Homer Loves Flanders
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Economic versus Accounting Profit
Homer: And you didn't think I'd make any
money...I found a dollar while I was waiting
for the bus.
Marge: While you were out *earning* that
dollar, you lost $40 by not going to work.
Source: Episode 1F17, Lisa’s Rival
Efficiency Wages
Lisa: Slave labor- you get what you pay for
Source: Episode AABF14, Simpsons Bible Stories
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Selection Bias
Lisa: I think a hurricane is coming.
Homer: Oh Lisa, there's no record of a
hurricane ever hitting Springfield.
Lisa: Yes, but the records only go back to
1978 when the hall of records was
mysteriously blown away.
Source: Episode 4F07, Hurricane Neddy
The Coase Theorem
border agent: Welcome to Alaska. Here's
$1000.
Homer: Well it's about time...but why?
border agent: We pay every resident
$1000 to allow the oil companies to
ravage our state's natural beauty.
Source: The Simpsons Movie
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Source: Episode MABF21, Elementary School Musical
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Also
http://www.econo
mistsdoitwithmode
ls.com/category/th
e-simpsons/
For more information, go to
http://www.economistsdoitwithmodels.com/Carlson
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