Econ 368 Behavioral Finance Spring 2020

Behavioral Finance: A Taxonomy of Money Mistakes

Thursdays, 11:45 – 1:00, Soc Sci 327

Professor John Forlines III -- [email protected] Office Hours: By appointment and look for
Announcements on Sakai for additional opportunities; I’ll have some time on Thursdays
prior to and after class and select Wednesday afternoons and Fridays throughout the
semester -- email me and copy [email protected]. Try to have an
office hours session done before spring break so we can brainstorm essay/project
topics. Office: SocSci 326, right next to classroom. For any additional questions
regarding classes, due dates, homework assignments, etc., email
[email protected]

Course Synopsis

The field of Behavioral Finance uses psychology to explain anomalies that we observe in the
financial markets—apparent mis-pricings and inefficiencies that are not consistent with the
classical economic models of rational behavior. In behavioral models, we recognize that
individuals (and markets) may behave irrationally, sometimes for extended periods of time. We
also acknowledge that, for structural reasons, there may be limits to arbitrage, so that the
markets cannot automatically push prices back to their fundamental values.

Using some of the more popular and accepted theories of human behavior from the fields of
psychology and decision-making, we will characterize some prevalent features of irrational
behavior in the financial markets. We will discuss typical errors made by financial market
participants as a result of behavioral biases and examine the extent to which irrationality can
affect financial markets at the aggregate level (“bubbles”), how long irrationality may persist, and
what factors will eventually cause these bubbles to burst (“crashes”).

Course Structure

This class will meet in person just once a week. A substantial portion of the class material is
online, via the Sakai platform. Students will be expected to work though the online material
each week prior to the Wednesday class and come to class with questions and points for
discussion. The online material is expected to take approximately 90 minutes to complete each
week. Students are encouraged, but not required, to work through each week’s online material
in a single session.

Online Content

Your first step in accessing each week’s online content is to go to the Resources tab on the
course Sakai site, and download that week’s PowerPoint file. For example, in week 1 you will
download Week1_Intro_Utility.pptx. Within these PowerPoint files, you will find material to read,
questions to answer, and videos to watch. Each week’s PowerPoint file either contains directly,
or provides directions on how to access, all of that week’s content.

There are 5 types of online content:

(1) Reading Materials: these are primarily papers that you can download from the
Resources tab in Sakai. Some weeks have required reading; some do not. Required
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readings are listed in the Course Outline below, as well as in that week’s PowerPoint file
when applicable. There is one required text that you need to purchase – “Devil Take the
Hindmost” – please see instructions under Required Reading below.

(2) Flipbooks: these are simply PowerPoint slides that you will read, which may also
contain links to other media (such as URLs to a particular website). If you have
questions about the material as you review it, please make a note and bring your
questions to class.

(3) Questions: Some of the slides may ask you to answer one or more questions. Please
make a note of your answer, and bring your notes to class as those questions will be
discussed in the class sessions.

(4) Surveys: As with the questions, some of the slides may ask you to respond to one or
more surveys. Please make a note of your answers, and bring your notes to class as
those surveys will be discussed in the class sessions.

(5) Videos: These videos are available under the “Course Videos” tab on Sakai. For
example, in Week 1, you will view the “Week 1: Utility of Money” video. Once you’ve
finished the video, please return to the PowerPoint slides to continue with that week’s
material.

If you have questions about accessing the online material, don’t hesitate to email me. This is the
first time that we have used Sakai/Warpwire to deliver the online content; so inevitably there will
be some bugs. We will work with you to smooth those out, and appreciate your collaborative
approach as we beta-test this method of content delivery.

Assignments and Grading

The course will be graded on the basis of six problem sets (each worth 5%), one essay/project
(40%) and class participation during the in-class discussion sections (30%).

Articles and Books

Required Reading

“Devil Take the Hindmost”, Edward Chancellor, Plume 2000, Chapters 1, 3, 5, 7, & 8. [Please
purchase a copy. Cheap 2nd hand copies are available on Amazon. Be aware that when you
purchase 2nd hand books, they sometimes take a few weeks to arrive; so don’t wait until you
need it – in Week 12 – to order it!]

Barberis, N and R Thaler, 2003, A Survey of Behavioral Finance, Handbook of the Economics
of Finance Chapter 18 [provided on Sakai under “Resources”]

Kahneman, D & A Tversky, 1979, Prospect Theory: An Analysis of Decision Under Risk,
Econometrica 47, 263-291 [provided on Sakai under “Resources”]

Hirshleifer, D, 2001, Investor Psychology and Asset Pricing, Journal of Finance 56, 1533-1597
[provided on Sakai under “Resources”]

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Optional Reading (Books)

“Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing”,
Hersh Shefrin, Oxford University Press 2007 (earlier additions are also fine)

“Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets”, Nassim
Nicholas Taleb, Random House 2008 (earlier editions are fine)

“Thinking Fast and Slow”, Daniel Kahneman, Farrar, Straus and Giroux 2013

Course Outline

SECTION 1: INTRODUCTION

To understand how behavioral models can explain financial market anomalies, we must first
consider how to categorize “anomalous” behavior. In the first few classes, we will review
standard models of expected utility and consumer preferences as discussed in the typical
introductory economics college course, as well as some general models of “non-expected utility”
and how these models seek to reflect actual human choices.

In addition to individuals’ preferences, behavioral models highlight systematic errors that people
make when assessing probabilities. We refer to these biases as “judgment errors” or “errors in
beliefs”. Before examining the different biases, we will review some basic lessons from
standard probability theory

Week 1. Jan 6 - Jan 10: Expected Utility

Review the Week 1 material online, by downloading the “Week 1.pptx” PowerPoint file under the
“Resources” tab on the course’s Sakai site, and following the instructions.

Topics:
 Classical Utility Theory
 Rational Preferences and Risk Aversion
 Expected Utility Axioms

Please Note: Jan 10 is our First Class

HOMEWORK 1 (DUE IN CLASS ON JAN 17)

Week 2. Jan 10 – Jan 17: Non-Expected Utility

Download Week 2.pptx to review the Week 2 material online.

Required Reading: “Prospect Theory” by Kahneman & Tversky

Topics:
 Bounded Rationality & Subjective Expected Utility

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 Regret Theory
 Prospect Theory & the Disposition effect

Jan 17: Class

Homework 2 (DUE IN CLASS ON JAN 24)

Week 3. Jan 17 – Jan 24: Problems with Probability, Part 1

Download Week 3.pptx to review the Week 3 material online.

Topics:
 Bayes Theorem & conditional probabilities
 Correlation / Causation errors
 Invisible correlation errors
 Frequency vs probability:
 The Independent Events fallacy

Jan 24: Class

Week 4. Jan 24 – Jan 31: Problems with Probability, Part 2

Download Week 4.pptx to review the Week 4 material online.

Topics
 Probability weighting & the weighting function
 Relative vs Absolute probabilities and ignoring base rates: health examples

Jan 31: Class

HOMEWORK 3 (DUE IN CLASS ON FEB 7)

SECTION 2: BELIEFS, BIASES & HEURISTICS

In this section of the course we will examine the errors that individuals routinely make when
assessing the likelihood of events. These systematic biases, or errors of judgment, can have
significant impact on both individual and market-wide investment behavior.

Week 5. Jan 31 – Feb 7: Availability

Required Reading: “Investor Psychology” by Hirshleifer, pp 1- 6 (Introduction) and Section I:

Judgment & Decision Biases

Download Week 5.pptx to review the Week 5 material online.

Topics:

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 Under-weighting the probability of less recent events

 Over-weighting recent but rare events
 Impact of imagination and vividness
 Signal vs noise
 Additional impact from frequency and timing
 Lotteries & Insurance
 The Conformity bias
 Availability and the Markets
 Availability bias and regulation
 The Dangers of the anecdote

Feb 7: Class

Week 6: Framing Part 1: Feb 7 – Feb 14

Download Week 6.pptx to review the Week 6 material online.

Topics:
 What is framing?
 Loss aversion and the endowment effect
 Mental Accounting & House Money
 Anchoring
 Preference reversals
 House money effect

Feb 14: Class

HOMEWORK 4: DUE IN CLASS ON FEB 21

Week 7: Framing Part 2: Feb 14 – Feb 21

Download Week 7.pptx to review the Week 7 material online.

Topics:
 Loss aversion and hedonic editing
 Money Illusion
 Visual framing
 The Compatibility Hypothesis

Feb 21: Class

Week 8: Representativeness: Feb 21 – Mar 7 (NO CLASS ON 2/28, ENJOY NEW ORLEANS)

Download Week 8.pptx to review the Week 8 material online.

 What is Representativeness?
 Base Rate Neglect
 Sample size neglect, conservatism & the Law of Small Numbers
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 Gambler’s Fallacy
 Non-Regressive prediction
 Conjunction effect & Sample Size neglect
 Law of Small Numbers
 Conservatism and the stock picker game

Mar 7: Class

Mar 14: NO Class (Spring Break)

Week 9: Overconfidence: Mar 14 – Mar 21

Download Week 9.pptx to review the Week 9 material online.

Topics:
 Overconfidence and Planning Fallacy
 Overconfidence, over-trading & under-hedging
 Hindsight bias
 Self-attribution bias & self-fulfilling prophecy
 Belief Perseverance & Confirmation bias
 Corporate finance evidence of over-confidence
 Illusion of control and its implications
 Brief Introduction to the Winner’s Curse
 Sunk Cost bias

Mar 21: Class

HOMEWORK 5 (DUE IN CLASS ON MAR 28)

SECTION 3: BEHAVIORAL DECISION-MAKING IN THE FINANCIAL MARKETS

In this section of the course, we discuss the impact of people’s non-expected utility preferences
and judgment errors on both individual investment behavior and aggregate market prices. We
also address an important criticism of behavioral finance – the debate into why so-called
“rational” traders cannot always trade against “irrational” traders and thus push prices back to
fair value.

Week 10. How to Manage Your Investment Portfolio: Mar 21- Mar 28

Required Reading: Hirshleifer, Section II “Evidence of Risk & Mispricing Effects” and Section III
“Asset Pricing Theories based on Investor Psychology”

Download Week 10.pptx to review the Week 10 material online.

Topics:
 Which assets should you invest in?
 Risk v return and diversification
 Do mutual funds add value?
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 Indexing & ETFs

 Life cycle guide to investing
 Savings and retirement accounts
 Diversification
 Other suggestions for sensible money management

HOMEWORK 6 (DUE IN CLASS ON APRIL 4)

Class: March 28

Week 11. Financial Market Anomalies – Individuals: Mar 28 – Apr 4

Download Week 11.pptx to review the Week 11 material online.

 The Disposition Effect in the Financial Markets

 Money Management errors
 Thinking fast and slow
 Poor pensions and savings plans
 Market timing and stock picking strategies

HOMEWORK 7 (DUE IN CLASS ON APRIL 11)

Class: April 4

Week 12. History of Bubbles & Crashes: Apr 4 – Apr 11

Required Reading: “Devil Take the Hindmost”, Chancellor, Chapters 1, 3, 5, 7, & 8

Download Week 12.pptx to review the Week 12 material online.

Topics:
 Tulipmania: Dutch Republic, 1630s
 South Sea bubble, 1720s
 The Railway Mania, 1840s
 The Crash of 1929
 The Dot-Com Bubble
 The house price bubble and credit crash

Class: April 11

Weeks 13 &14 Limits to Arbitrage: Apr 11 – Apr 18

Limited Arbitrage & Financial Anomalies Topics are covered in Weekly PowerPoints Only

Required Reading: Barberis & Thaler, “A Survey of Behavioral Finance”

Download Week 14.pptx to review the Week 14 material online.

Topics:

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 Traditional Finance - redux

 Noise Traders & Rational Traders, problems with Incomplete information
 No perfect “substitute” security
 Limited Patience
 Limited liquidity
 High transactions & borrowing costs
 Herd behavior and contrarianism
 The Noise vs Information paradoxes
 Liquidity vs Efficiency
 Opportunity vs profitability

Week 14: Behavioral Finance for Investors:

Class April 18

Quick Class Project Overviews

LDOC Celebration on April 24

FINAL ESSAY/PROJECT DUE APRIL 28

Project topic: (Pick one of the three options):

1) Identify and report on one or more monetary “mistakes” that you, or your friends
and family, have made;

2) Identify and report on one or more consumption “mistakes” that you, your friends
and family, have made.

If you choose either of topic options 1) and 2), discuss which biases and/or
behavioral “errors” have led to the mistakes;

3) Write an essay or report on a topic relative to your career choices to date or a

passion that applies behavioral finance principles (reference points, framing,
risk/value function) as well as heuristics that you have learned.

Essays should be 4-6 pages (double-spaced); PowerPoints 10-15 slides