Existence of cash dividends could be explained best from the perspective of self-control in the following way:

many investors have problems controlling their temptation for immediate spending; cash dividends help investors to mitigate this problem by setting a simple rule which puts a cap on spending out of financial wealth

In forming our view on what things are worth we use anchors. Which of the following describe the effect anchoring has on our decisions:

• People use adjusting from an anchor to yield a final answer; adjustments from anchors are usually not sufficient.
• People often develop estimates by starting from an initial anchor, based on whatever information is provided.
• Existence of anchor leads people to access information that is consistent with that anchor and not access information that is inconsistent with the anchor.

Individual investors on average underperform buy-and-hold portfolio. The reasons of their suboptimal performance are best described by:

• individual investors are overconfident about their abilities, e.g. stock-picking skills
• the more overconfident investor, the more he/she trades
• they do not fully take into account transaction costs they pay when trading

• When there are many alternatives, options that attract attention are more likely to be considered, hence more likely to be chosen.
• Which attention-grabbing stocks investors buy will depend on their personal preferences.

Some of the conclusions of the effect of framing on portfolio choice are:

i) Categories (e.g. mutual fund style categories) which offer more options are chosen disproportionally more

ii) If for some exogenous reason the number of options in a specific category (i.e., growth funds) rises, the investors rebalance their portfolios increasing their investment in such a category.

iii) This is the case for both the new funds being offered as well as the already existing in the category (i.e., growth category) whose fund number has increased.

Provide a brief explanation of why investors make their choices this way.

Unsophisticated investors try to substitute for their lack of knowledge by falling in to representativeness bias: the bigger the better.

Investor attention may result in permanent effect on stock prices

• Provide and briefly describe 3 channels through which attention of investors toward a particular company could be permanently affected.

1. Media Coverage
2. Product Market advertisement
3. Social Norms

Higher permanent/long-term attention could have a permanent effect on stock prices and returns. Provide and briefly discuss 2 (out of 3) economic mechanisms of why higher long-term attention (reflected in larger shareholder base of the company) would have a permanent effect on prices/returns. Does higher attention lead to lower or higher prices? Returns?

• Better idiosyncratic risk sharing
• More analyst coverage
• More incentives to acquire and trade on private information which leads to more informative price

Consider the following example:

}  You are shopping for a new car.

}  The car dealer has three cars which are within your budget and you seem to be interested in all of them.

}  One of these cars is Toyota RAV4 and two others are Honda CRVs. (in the same cross-over class).

}   All three cost about the same; they are all equally desirable; and the only difference is that one of the Hondas has a less advanced stereo system and the color is less attractive to your eyes; the dealer therefore knocked down a couple of thousands off the price.

Explain how the existence of a somewhat less attractive Honda CRV may affect your choice of the new car.

Compare comparables. Less advanced Honda CRV works as a decoy for more luxurious one.

We discussed three different behavioral finance explanations of cash dividends existence: self-control, mental accounting and regret.

Briefly describe the existence of cash dividends from the perspective of regret.

Consuming out of capital gains involves active decision. Consuming out of dividends is a passive decision. We tend to regret more when active decisions backfire.

(Expected Utility)

Expectation

(Expected Utility)

Asset integration

(Expected Utility)

Risk Aversion

• u is concave
• A person who is risk averse prefers a certain prospect x to an risky prospect with expected value of x

Expected Utility

1. Utility function is defined in terms of deviation from reference point
2. Risk-averse(concave) in gains; risk-seeking(convex) in losses
3. Sensitivity (steepness) is higher in domain losses
4. Decision weights are not true probabilities

• Underweighting of middle range probabilities
• Overweighting extreme probabilities

Narrow Framing

• What is common to these examples is that people tend to evaluate individual decisions separately from other portions of their wealth
• Instead of investigating each event from the prospective of its effect on total wealth we have separate accounts for different needs: “retirement” , “food”, “windfall gains”, “mortgage payments”.
• “Food” budget does not permit you to spend $150 on a dinner, however, if these money comes from “windfall gain” account it is acceptable.
• Drawing money from “retirement” account is unacceptable even though you pay higher interest rate from your “mortgage account”.

Dynamic Aggregation

• Simple repetitions of the same outcome are unattractive if evaluated one at a time
  
  
• When investors are loss averse, they will more willing to take risks if they evaluate their performance (or have their performance evaluated) infrequently
  
  
• Playing the same gamble multiple amount of times is perceived as less risky
  

• }Investor must decide how much to save and how much to consume and what portfolio of assets to hold
• }Investors care only about wealth, but consume out of wealth and derive utility from consumption (increasing, concave)
• }Financial assets help investors to optimize their consumption over time
  
  • If investor is wealthy today, but anticipates a low     income tomorrow  she can consume part of its wealth today, invest the rest in financial asset
  • In the future she can liquidate financial asset  and spend the proceeds to increase its future consumption

Goods of CCAPM

• Neat link between preferences of individual investors and retlurns on securities
• Very intuitive and power tool, nice to deal with mathematically

Bads of CCAPM

• Does not explain reality very well:

1. Equity premium puzzle
2. Excess stock return volatility
3. Predicts high correlation between stock returns and consumption growth

Benartzi & Thaler:

Myopic Loss Aversion

Idea

• take experimentally estimated parameters for the prospect utility function
• see how do they fit with retruns on stocks nad portfolio allocation choices

Findings:

• Estimated parameters imply 1 year evaluation window for the investor to be indifferent between stocks & bonds
• Economy-wide fraction of wealth invested in stocks 20-60%

• fincancial forecasting
• political elections
• stock market participation
• business reports