Psychology, Risk and Investment Daniel Kahneman, PhD Princeton University,The standard theory,The rational agent of economic theory: has consistent opinions and beliefs uses all available information unbiased by emotion, herd effects has coherent preferences tangible motives (wealth, security) unaffected by framing of problems,Behavioral Finance,Inputs from psychology Cognitive errors Emotional factors Our agenda today Bold forecasts - errors in judging the odds Narrow framing of decisions Loss aversion - errors in valuing risks Focus on individual investors . But experts are not immune,Bold ForecastsOptimism Bias,Rosy view of likely outcomes Becoming rich and famous Becoming an alcoholic Having cancer Exaggeration of skills 80-90% are above median Driving skill Sense of humor,Bold ForecastsOptimism Bias (continued),Illusion of control Exaggerate element of skill Deny the role of chance Optimism about specific choices Why do people open a restaurant where many restaurants have failed?,Overconfidence,Make a HIGH estimate of the exchange rate on 1/1/04 You should be 99% sure that your estimate is too high Make a LOW estimate of the exchange rate on 1/1/04 You should be 99% sure that your estimate is too low,Overconfidence (continued),You should be 98% sure that the true value will fall inside your confidence interval You should have a probability of 2% that the outcome will be a surprise at the 2% level,Overconfidence (continued),FACT: massive overconfidence Often 20% surprises at the 2% level 10-15% surprises when “absolutely sure” CAUSE: Limited imagination Surprises occur in many unlikely ways RESULT: underestimation of uncertainty,Optimistic Overconfidence in the Market,Why do you think YOU can beat the market? The cost of having ideas (Terry Odeans research) When an investor sells a stock and immediately buys another: the stock that is sold does better by 3.5% in the following year,Framing: different ways to think about a decision,Different ways to think about cold cuts: 10% fat or 90% fat-free People frame their own decisions: some ways to think about a decision problem are more natural than others,Frames vary in breadth: people tend to adopt frames that are overly narrow,Framing a financial decision: Gains/losses vs. wealth,would you accept this gamble? 50% chance to win $15,000 50% chance to lose $10,000 Now make a crude estimate of your wealth would you accept this gamble? 50% chance: your wealth + 15K 50% chance: your wealth - 10K gain/loss frame vs wealth frame,Comparing the frames,Which frame is more natural? we normally think in terms of gain/loss Which frame is more reasonable? the broader view Effects of the frames gain/loss frame - extreme risk aversion wealth frame - closer to risk neutrality,The aversion to losses,Consider this gamble 50% to lose $100 50% to win $X What X makes the gamble acceptable? A common answer: $200 - $250 Coefficient of loss aversion is about 2.5,Another pair of choices,Would you accept this gamble? 50% to lose $1000 50% to win $1500 most people refuse Would you accept 10 such gambles? most people accept Is this your last risky decision? Which frame is broader? more reasonable?,Loss aversion & narrow framing: the disposition effect,Selling stocks: People tend to hang on to losers, stocks that are now worth less than their purchase price. They tend to sell winners But taxes And winners do better in the short run The moral: Having different attitudes to winners and losers costs money,“Near-proportional” risk attitudes,What is your cash equivalent for (100, .5)? What is your cash equivalent for (1,000, .5)? How about (10,000, .50)? The CE rises almost as fast as the stakes Coefficient of loss aversion also stable Why does this not make sense? life offers more small gambles, and the law of large numbers reduces relative risk,Applications to understanding of market phenomena,Two major puzzles: The equity-premium has been about 7% High volume of trade - little information The answers: “Myopic loss aversion” (Benartzi and Thaler) Overconfidence of traders (Odean),Exceptions to risk aversion: Long shots,People buy lottery tickets Choose between 50% to win 5K and 50% to win 15K 95% to win 9K and 5% to win 29K,Exceptions to risk aversion: Risk seeking in losses,Choose between 90% to lose $2,000 lose $1,800 for sure This is a choice between a sure loss and a high probability of an even larger loss, with a small chance to stay even People choose to gamble The certainty of a loss makes it more aversive,Risk-seeking decisions,Accepting defeat, or fighting on Settling a bad case, or litigating a bad case? Escalating commitment The difficulty of “cutting losses” Very common in bad investments The “agency problem” in commitment Perseverance in the face of adversity Decisions of executives with nothing to lose,Behavioral Theory: The Real Investor,Narrow framing exacerbates two biases Optimistic bias bold forecasts Risk aversion ti