With growing empirical evidence on persistent overconfidence, much attention has been paid to the question of why people are overconfident and experience does not lead them to become more realistic, especially in activities like investing where results can be calculated ex post. Existing studies demonstrate that self-serving attribution bias (past successes tend to exacerbate overconfidence as people take too much credit for their successes, while past failures tend to be ignored as people blame their failures on forces beyond their control), confirmatory bias and cognitive dissonance (tendency to overweigh data confirming prior beliefs while to dismiss data contradicting prior beliefs), illusion of control, and forces related to evolution and tournaments or contests, can all contribute to generating persistent overconfidence throughout the life cycle. Gervais and Odean (2001) find that, with attribution bias at work, people may even learn to become more overconfident rather than more realistic over the life cycle.

Akerlof and Dickens (1982) considered a formal model of the implications of cognitive dissonance on workers in hazardous industries. Specifically, such workers would suffer from cognitive dissonance and convince themselves that the industry where they were working was safe. If safety equipment were to become available in the future, they would not purchase it.

Group thinking: (Nir 2004) Classic studies include those of Sherif (1936) who showed that different answers given by individuals converge to a single answer when the individuals are in a group. Asch (1951) showed that subjects consciously give wrong answers in order to conform to group norms.

A behavioral model of consumption patterns : the effects of cognitive dissonance and conformity, Nir, A. (Tilburg University, Center for Economic Research 2004)

Abstract: Cognitive dissonance causes people to rationalize actions that differ from their own preferences. Conformity, on the other hand, causes people to change their behavior as a result of pressure from others. This paper investigates the consequences of preference dynamic that occur when individuals rationalize their preferences, are conformists and have a minimum consumption constraint. The main results are: (1) Individuals who have a greater tendency toward conformity will rationalize their preferences to a greater degree, (2) Individuals' optimal consumption pattern will be unstable and scatter over time, (3) Average consumption in society will increase along a cyclical path and (4) An increase in either cognitive dissonance or conformity induces greater volatility of average consumption.

How to get out of stock: (The Journal of Portfolio Management, Christophe Faugere, Hany A. Shawky, and David M. Smith 2004) The professors determined that during the bear market months from April 2000 to December 2002, investors who fared the best - relative to their market benchmarks, at least - were those with restrictive rules that did not allow much leeway for hanging onto stocks for emotional reasons.

more than a third of the 4,332 institutional money managers in the study relied primarily on a strategy called "valuation level" selling. That is a fancy way of saying that they sold stocks because they became too pricey, based on measures like earnings or book value.

The study's authors regard such a strategy as highly disciplined and objective. Managers who relied on this method outperformed their chosen benchmarks by 0.46 percentage points a month or 5.5 points a year, on average, during this period.

By comparison, institutional managers who relied on more flexible sell strategies - requiring judgment calls on the health of a business - fared worse. They beat their benchmarks by just 0.08 percentage points a month or just less than 1 point a year, on average, during the downturn, despite outperforming the more disciplined sellers during the roaring bull market of the late 1990's.

What does this mean for investors who may not have the skills or the resources of professional money managers?

For starters, it is a reminder that some kind of selling discipline is better than none. "Without any kind of strategy, emotions will come into play and emotions are almost always wrong,"

Academic research tells us that individual investors have a knack for hanging onto money-losing stocks.

Selling losing positions: (Kahneman 2004) the unwillingness to sell dogs, now that’s what we call the disposition effect and it’s something that we understand really well. There are many reasons not to want to sell a stock that has lost a lot of money. So you would be punishing yourself right now by selling it, and in addition it seems cheap to hang on to a loser. But perhaps the key point is that for an untrained individual to make decisions about specific stocks is already a mistake. Some of sensible clients want you to make these decisions, and don’t really want to know what you are doing: “I think you make such choices better than I could.” Merely being dispassionate about the outcome gives you, the advisors, a big advantage in getting things right. It is clear from research on individual investors that the great majority of them are out of their league. They are bound to lose money, on average, because they are hyperactive, they churn their accounts, and they don’t even know how well they are doing. Many people think they are successful when in fact they are not. Somehow they manage to delude themselves.

The problem with Kahneman's comments is the assumption that advisors are dispassionate. Why? It's not taught at any level of becoming a financial planner. It's not part of any college curriculum. It's not part of growing up or living. The issue of cognitive dissonance and emotional actions is understood by research and application. With he advisors I have seen to date, most couldn't spell "cognitive" never mind apply it to their work.

Optimism: people are generally optimistic. In a 1990 study, undergraduates were asked  to relate how likely various life events were to happen to them. The result: students systematically thought that good events were likely to happen to them while bad events were more likely to happen to other students. What about as one got older. In studies ages 35 to 55, all with at least 10 years of management experience, they were just as optimistic- except a little more so.

Managerial optimism can result in all kinds of flawed and risky decisions.

Self serving biases: These motivate people to reach conclusions that favor them. Narrowly defined, self serving biases leads people to see data in the way they want to see it which may prompt them to take credit for successes and shun blame for failures. More broadly, this bias can refer to a person's inclination to unintentionally select or distorts facts to suit his preferences. Self serving biases can also wreak havoc on a group undertaking where afflicted people may perceive that others are not doing their fair share of work.

Such biases, like others, can be mitigated but are to strong to eliminate entirely. They this require structured fixes such as formal checks and balances for project approval and monitoring.

Some biases and behavioral patterns: (WSJ 2004)

Recency bias: People tend to focus too much on what has happened recently. "That is true in terms of unfavorable, unsettling negative events, but it's also true for positive events

Anchoring: Investors become married to certain reference points that influence their decisions. For instance, an investor buys a stock at $50, and it falls to $40 because the fundamentals have changed. The best thing to do might be to sell at $40. However, many people, he explained, are prone to wait for the price to recover to the $50 they're anchored against.

Loss Aversion: Investors are reluctant to realize losses, and conversely, investors are inclined to sell (sometimes too early) because they want that positive reinforcement that comes from securing a gain. "People have a tendency to hold on to their losers and sell their winners.

Mental Accounting: The idea that we treat money differently based on the source or where we hold it. "It's incredible how people will treat tax-return money as lottery winnings or found money, though its true nature is really from wages or salary earned."

Behavorial Economics: (Kahneman) A basic assumption is that in standard economics and in financial analysis, people are assumed to be rational. What is meant by that is not that they know everything, but that they have a consistent system of beliefs, that they act on their beliefs and that they have consistent preferences.

Now, when you abandon those assumptions of rationality or similar assumptions that people make within the context of finance, and you accept assumptions that are psychologically realistic, then you are doing behavioral economics, and if you are doing finance you are doing behavioral finance.

People are probably more rational when they take a very broad view and derive their specific decisions from a broader view. The idea is to begin with strategic decisions—like how safe you want to be, what the basic allocation is going to be. These general rules should govern decisions. As an individual investor, you shouldn’t be spending too much effort in trying to guess about a particular stock or about the trends of particular economic indicators. That, I think, is one of the main lessons of behavioral economics. When people put too much emphasis on being right in very specific choices, they end up doing the wrong thing.

One of the major findings from academic studies of the behavior of individual investors is the disposition effect: When people are selling stocks from their portfolio, they tend to sell winners and hang on to their losers. It’s very natural why people do that. If you sell a stock that is currently worth more than you paid for it, then you can pat yourself on the shoulder for a successful investment. When you cut your losses on the stock, in contrast, you have to accept punishment right now for having made a choice that didn’t turn out well. It is not surprising that people prefer rewarding themselves rather than punishing themselves. But recent research by Terry Odean has shown that this is really very costly, for several reasons. On average, you will do much better if you sell losers and hang on to your winners. This is a pretty good example of normal investor behavior leading to generally bad outcomes.

people very frequently ask for advice about a specific investment—should I sell this, should I buy that? In principle, advisors should resist such requests to give advice about specific investments without knowing the whole picture about that individual’s portfolio, the amount of risks that they are carrying. People should be educated to ask for advice about the big picture, and always to consider particular decisions in the context of their overall situation and objectives.

Investors and professionals: (Kahneman) Byron Wien of Morgan Stanley has said that there is not much difference between the behavior of individuals and institutional investors. Does the same problem apply to professionals as well as individuals? Terrance Odean at the University of California is studying these issues. There are good reasons to expect that the considerations that affect institutions and individuals are different. The people who act as agents on behalf of institutions have reputations to maintain. There is evidence of a lot of window dressing before reporting periods and a lot of cleaning up. But the professionals have a broader picture of what is going on. They probably have much better information.

Odean has been doing studies on individual investors. He gets records from brokerage houses, so that he knows every transaction that an investor engaged in over a period of years. This data enables him to identify when an investor has an idea. If you see that an investor sold one stock and bought another within a short period of time, then you know that this individual had an idea about the value of these stocks. What Odean did a number of years ago was to follow those stocks in order to find out what happened to the stocks the individuals bought and to the stocks they sold, one year later. The remarkable result is that on average, the stock that people sell does better than the stock they buy by 3.5%. If you add transaction costs, then the cost to an individual investor of having an idea is roughly 4%.

Now, clearly there is somebody on the other side of the transaction, and probably the other people on the other side of the transaction are institutions. So institutions, although they are not very good at picking stocks themselves, can do better than individuals.

Most studies show that 80% or 90% of money managers think that they are above the average. They are in a business in which every participant thinks he or she is better than average, and able to beat the market even if no one else can. The people who self-select into that occupation are bound to exaggerate their skill. This is almost a statistical regularity. It has to be that way. If they didn’t think they were above average, they would be doing something else where they think they would have a competitive advantage.

So I don’t think that overconfidence is fixable, it is always going to be there. But it’s also true that many financial professionals have a lot of confidence in their ability to do things that they simply cannot do. They are confident about individual decisions, and about particular opinions and general forecasts about what the market will do, even when there is no foundation for that confidence.

Risk: Well, it certainly doesn’t mean standard deviation. People mainly think of risk in terms of downside risk. They are concerned about the maximum they can lose. So that’s what risk means. In contrast, the professional view defines risk in terms of variance, and doesn’t discriminate gains from losses. There is a great deal miscommunication and misunderstanding because of these very different views of risk. Beta does not do it for most people, who are more concerned with the possibility of loss

Daniel Kahneman

“People cheat. Why? “Because they are motivated to hit the goal, and when they come very close to meeting it but don’t, it is very tempting to fudge the numbers.” In addition, individuals can easily justify their decision to cheat by telling themselves that they deserve to meet the goal, and also deserve the reward that comes with doing so. And how often does this happens? “Within the business community, I think it’s epidemic.”


Open mindedness: Benefits of Open-Mindedness (Ben Dean, Ph.D. 2004)

Research suggests the following benefits of open-mindedness:

· Open-minded, cognitively complex individuals are less swayed by singular events and are more resistant to suggestion and manipulation.

· Open-minded individuals are better able to predict how others will behave and are less prone to projection.

· Open-minded individuals tend to score better on tests of general cognitive ability like the SAT or an IQ test. (Of course we don’t know whether being open-minded makes one smarter or vice versa.)

Open-Mindedness as a “Corrective Virtue”

Social and cognitive psychologists have noted widespread errors in judgment/thinking to which we are all vulnerable. In order to be open-minded, we have to work against these basic tendencies, leading virtue ethicists to call open-mindedness a corrective virtue.

In addition to the myside bias described above, here are three other cognitive tendencies that work against open-minded thinking:

1) Selective Exposure

We maintain our beliefs by selectively exposing ourselves to information that we already know is likely to support those beliefs. Liberals tend to read liberal newspapers, and Conservatives tend to read conservative newspapers.

2) Primacy Effects

The evidence that comes first matters more than evidence presented later. Trial lawyers are very aware of this phenomenon. Once jurors form a belief, that belief becomes resistant to counterevidence.

3) Polarization

We tend to be less critical of evidence that supports our beliefs than evidence that runs counter to our beliefs. In an interesting experiment that demonstrates this phenomenon[1], researchers presented individuals with mixed evidence on the effectiveness of capital punishment on reducing crime. Even though the evidence on both sides of the issue was perfectly balanced, individuals became stronger in their initial position for or against capital punishment. They rated evidence that supported their initial belief as more convincing, and they found flaws more easily in the evidence that countered their initial beliefs.

What Encourages Open-Mindedness?

· Research suggests that people are more likely to be open-minded when they are not under time pressure. (Our gut reactions aren’t always the most accurate.)

· Individuals are more likely to be open-minded when they believe they are making an important decision. (This is when we start making lists of pros and cons, seeking the perspectives of others, etc.)

· Some research suggests that the way in which an idea is presented can affect how open-minded someone is when considering it. For example, a typical method of assessing open-mindedness in the laboratory is to ask a participant to list arguments on both sides of a complicated issue (e.g., the death penalty, abortion, animal testing). What typically happens is that individuals are able to list far more arguments on their favored side. However, if the researcher then encourages the participant to come up with more arguments on the opposing side, most people are able to do so without too much difficulty. It seems that individuals have these counter-arguments stored in memory but they don’t draw on them when first asked.

Dissonance (2004) Recency Bias: People tend to focus too much on what has happened recently.

Anchoring: Some investors become "anchored" to certain reference points that influence their decisions. Say an investor buys a stock at $50 and it falls to $40 because the fundamentals have changed or bad news has come to light. The best thing to do might be to sell the stock for $40. But he says many people are prone to wait for the price to recover to the amount they have become anchored to: $50.

Loss Aversion: Investors are reluctant to realize losses, and conversely, investors are inclined to sell (sometimes too early) because they want the positive reinforcement that comes from securing a gain.

Mental Accounting: This is the idea that we treat money differently based on where it came from or where we hold it.

Cognitive impairment: Three types (National Underwriter)

Loss Aversion: Two different studies. The first group was asked to choose between a 100% chance of gain8ng $240 vs. a  25% chance to gain $1,000 couple with a 75% chance to gain nothing. More than 3/4 went for the sure gain. The second group was a a sure loss of $240 vs. a 25% chance to lose $1,000 coupled with a 75% chance to lose nothing. More than 2/3 opted for the latter- the chance to lose nothing

The lesson: People will avoid a sure loss at all costs because to them, losses loom larger than gains, even if it is not true.

Framing. 2 groups were asked the same question in 2 ways. roughly 50% said they could not when asked "Could you comfortably ave 20% of your household's income at this point in  your life. but more than 7 in 10 said they could when asked Could you comfortably line on 80% of your household income today

The lesson: Framing often depends on a person't reference point and what is most likely to influence them

Mental Accounting. The questions related to mental accounting asked group how they would spend their money in 2 apparently different retain situations

Would they buy a much needed alarm clock from a local store for $18 or from a store 20 minutes away selling the same clock for $10. And would they buy a new television from a local store for $250 or from a store 20 minutes away for $242. In both cases the savings was $8

Two thirds said they would drive 20 minutes to save the money on the clock but almost 75% would not drive the 20 minutes for the savings on the TV

The lesson: We approach decision differently depending on the context in which they are embedded. In this case, people categorize money based on relative, rather than absolute costs.

Availability bias: the tendency of people to give too much weight to readily available information.

Mental accounting- the name given to the propensity for people to compartmentalize their money by placing it in different mental "buckets".  Rather than examine their portfolios as a whole, they make decisions in pieces, not recognizing that each marginal decision affects the entire portfolio.

Gender and Overconfidence; (2004) Bengtsson, Claes; Persson, Mats; Willenhag, Peter; Abstract: Do males differ from females in terms of self-confidence? The structure of the Economics I exam at Stockholm University provides an opportunity to shed some light on this question. By answering an extra, optional question, the students can aim for a higher mark. We find a clear gender difference in that male students are more inclined than female students to take this opportunity. This difference in selfassessment is more pronounced among younger than among older students.

"Behavioral Corporate Finance: A Survey" , MALCOLM P. BAKER, RICHARD S. RUBACK, JEFFREY A. WURGLER

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

Beliefs:  (2005) Behavioral economics provides several motivations for the common observation that agents appear somewhat unwilling to deviate from recent choices: salience, inertia, the formation of habits, the use of rules of thumb, or the locking in on certain modes of behavior due to learning by doing. This paper provides discrete-time adjustment processes for strategic games in which players display precisely such a bias towards recent choices. In addition, players choose best replies to beliefs supported by observed play in the recent past, in line with much of the literature on learning. These processes eventually settle down in the minimal prep sets of Voorneveld (2004, 2005).

Behavorial: (Werner Güth, Matteo Ploner, Vittoria Levati 2005) No matter how arbitrary and trivial the group distinction is, individuals are more likely to act in a trustworthy and cooperative fashion when interacting with ingroup rather than outgroup members. Several explanations have been suggested for these findings. According to some authors, the expectations of reciprocity are critical for the emergence of ingroup-favoring behavior.

Thus, trust behavior in group settings must be understood as an economic decision about risk and benefit. Along these lines, the process of psychological group formation leads to the perception of the self as an interchangeable exemplar of the group and, through this process, \others' interests become our own interests". Trust behavior must, hence, be understood as a social decision.

this type of trust is "depersonalized", in the sense that it does not depend on kinship or past interaction between the parties, but it is extended to strangers when a common identity is evoked. A perceived common group identity enhances not only depersonalized trust but also the perception that others will be trustworthy (remind you of affinity scams?)

Studies find that 79% of participants cooperate when paired with an ingroup member, but only 30% when paired with an outgroup member. Kramer et al. investigate the relevance of group identity for negotiation research, showing that, when group identity is made salient, negotiators are more concerned about what the other person obtains.

(This report is 38 pages long and not for the feint of heart- or head for that matter. A most interesting element is that Americans fall into the path addressed above but the chinese do not follow that pattern.)  

More behavorial economics:  (2005) Sweden allowed its workers to pick the investments for their own retirement- or let it go to default funds. So what happened?

when those millions of selection forms flooded back into the agency’s offices, fully two-thirds of participants had eschewed the default fund and selected their own portfolio. (Women, interestingly, were more likely to actively choose than men, perhaps because, Thaler suggests, women may be less likely to lose mail-in forms.) In mid-February 2001 the Wall Street Journal reported that, although analysts had expected the largest Swedish banks to pick up most new private pension accounts, many Swedes chose smaller providers and even foreign companies. Free-market thinkers took this as a good sign; the Cato Institute’s Social Security This Week newsletter opined, “It seems that given a free choice and plenty of information, Swedish investors are hungry for new alternatives.

How did Swedes’ selections fare? The original default portfolio was allocated mainly toward non-Swedish stocks (65 percent). Another 17 percent went into Swedish stocks, 10 percent into inflation-indexed bonds, 4 percent into hedge funds, and 4 percent private equity. More than half of the default’s funds were indexed, meaning they represented a broad cross-section of the stock market and were managed passively (the whole “buy and hold” idea); as a result the fund’s management fees were low.

Analysts calculated the mean aggregate portfolio of Swedes who chose their own funds. Despite initial enthusiastic reports, that portfolio, they found, leaned even more heavily toward stocks than the default fund—96.2 percent, of which 48.2 percent were Swedish stocks. Only 4.1 percent of the funds were indexed, and as a result participants paid higher fees. The fund that attracted the largest market share, aside from the default, was Robur Aktiefond Contura, specializing in Swedish technology and health-care stocks, whose value soared 534.2 percent over the five years preceding the PPM launch. Three years later, however, it had lost 69.5 percent of its value. Overall the mean aggregate portfolio was down 39.6 percent after three years. The default fund, on the other hand, was down significantly less, 29.9 percent—not too terrible given that markets were falling worldwide.

They suggest that a default fund must be devised carefully, because human nature dictates a large portion of investors’ money will go there. With a U.S. economy 30 times the size of Sweden’s, free-market entry for funds could result in thousands of choices, paralyzing the average consumer. Instead, the authors recommend offering a small number of funds, perhaps three, investing in index funds and bonds, with varying levels of risk.

Right and wrong: (2005) 1992 Nobelist Gary Becker, SM’53, PhD’55, wrote in his 1976 The Economic Approach to Human Behavior, “[A]ll human behavior can be viewed as involving participants who maximize their utility from a stable set of preferences and accumulate an optimal amount of information and other inputs in a variety of markets.” In other words, Becker says, people know what they want from the start, and they update their preferences as new information comes in. Tversky and Kahneman’s research on heuristics, however, demonstrates that people do not always start with a stable set of preferences; particularly in unfamiliar situations, they use rules of thumb to cobble their preferences together as they go.

While rational-choice theory argues that people “maximize utility,” making decisions in absolute terms, prospect theory argues that people make decisions according to how they perceive their current state, or wealth, will change. And, prospect theory goes on, like moving or standing objects, people are prone to inertia. That’s one reason why default options are so popular. It’s also why, once a decision is made, such as allocating savings into a certain mix of funds, the chooser tends to stick with it even when circumstances change, such as a high-tech stock bubble bursting. The theory also postulates that most people find losses more agonizing than gains pleasurable. In 1998 Thaler and UCLA’s Shlomo Benartzi drew upon prospect theory and other psychological insights to design a program called Save More Tomorrow (SMarT), in which participants at a mid-sized manufacturing firm committed in advance to allocating a portion of their future salary increases toward retirement savings. The results were dramatic. The average saving rates rose from 3.5 percent to 11.6 percent over 28 months. With savings tied to pay increases, participants never saw their paychecks decrease, and thus their aversion to loss did not override a wise decision.

Another prospect-theory hypothesis is that people make decisions based on whether they view each option as a gain or a loss. Thus the way in which choices are worded becomes incredibly important. In Sweden the initial PPM advertising campaign, with its emphasis on active choice, established a powerful frame within which 67 percent of participants decided it was in their best interest to select their own portfolio. Now that the ad blitz has ended, new enrollees are far more likely to select the default fund. In fact, only 8.4 percent of new enrollees pick their own portfolios, from an offering of some 600 funds. The massive drop-off in active enrollment has made Thaler and Cronqvist wonder, “Is it worth spending the extra money to offer choices?” When partially privatizing U.S. Social Security, they ask, why bother to offer even three funds? Why not offer only one well-designed, low-fee index fund?

My additional comment- There are pundits that feel that the study of behavorial finance is flawed by various reasons. But I take a slightly different validation. Go outside in any city and look at all the REALLY fat people. Each one of these people has had every opportunity to read the nutritional label on a Twinkie or Whopper but took the "feel good" approach or the flawed position that such activity would not negatively affect them.  Behavorial finance can be broken down into simplistic calories. Rational people are an exception. Emotional people are the rule. It's all logical. Just go to McDonalds.

Food for Thought: (NY Times 2005) "Traditional finance theory tells us markets are efficient and rational," . "Behavioral finance tells us that human psychology affects investment decisions. Irrational behavior gives rise to market inefficiencies."

Behavioral finance theory has gained currency among academics and economists as an alternative to the efficient-market theory, the belief that investors are rational and that the price of an asset is fair and accurate and reflects all available information about it.

Fund managers, apart from operators of index trackers, tend to reject the efficient-market notion, which would render them irrelevant if it were shown to be strictly true. Exceptional fund performance would be impossible, except by chance, because all assets would be fairly priced.

Neither has the behavioral finance theory won many converts at investment houses, although the theory's disciples are not alone in basing investment decisions on the frailties of the human mind. Technical analysts who follow indicators of market sentiment already practice a kind of behavioral finance.

Well, here is a different spin on the entire theory of the "new" behavorial finance. It's simply the Big Mac, Twinkies, Pizza Hut and the like. Say what? Obviously everyone can read the nutritional value on a Whopper versus that on a head of lettuce. Everyone knows what they should do, what is rational and objective, what is the best thing for them, for their community and on and on. And what happens?- 2/3 of the U.S. population is overweight- 1/3 is obese. Further. the impact of poor decisionmaking is seen in their waistlines everyday. The efficiency of each individual, each workforce, each whatever is reduced and every one can see it. Even more recently there was a low carb craze. You can say it was a reality check. But did it do any good? Did it last? Nope. Right back to the extra calorie Burger King breakfast sandwiches. So there is your behavorial science theory in real life practice. If people refuse to acknowledge the objectivity of their own health every single day, there is no way they are ever going to take an obscure item like their investments, retirement, insurance, etc. and look at it properly.

Lastly, as a commentary, people will never make true sense out of a financial statement if they refuse to look at the caloric content on the wrapper of a Big Mac.  

Trust among Strangers, : Teck-Hua Ho (University of California, Berkeley 2005), Keith Weigelt (University of Pennsylvania) The trust building process is basic to social science. We investigate it in a laboratory setting using a novel multi-stage trust game where social gains are achieved if players trust each other in each stage. And in each stage, players have an opportunity to appropriate these gains or be trustworthy by sharing them. Players are strangers because they do not know the identity of others and they will not play them again in the future. Thus there is no prospect of future interaction to induce trusting behavior. So, we study the trust building process where there is little scope for social relations and networks. Standard game theory, which assumes all players are opportunistic, untrustworthy, and should have zero trust for others is used to construct a null hypothesis. We test whether people are trusting or trustworthy and examine how inferring the intentions of those who trust affects trustworthiness. We also investigate the effect of stake on trust, and study the evolution of trust. Results show subjects exhibit some degree of trusting behavior though a majority of them are not trustworthy and claim the entire social gain. Players are more reluctant to trust in later stages than in earlier ones and are more trustworthy if they are certain of the trustee’s intention. Surprisingly, subjects are more trusting and trustworthy when the stake size increases. Finally, we find the sub- population who invests in initiating the trust building process modifies its trusting behavior based on the relative fitness of trust.

How humans behave (Neer 2005) The standard models of human behavior in economics, which assume that people are well-informed economic agents striving to maximize a set of consistent preferences, frequently produce patently faulty predictions.

Behavior: (2005) A example of behavior involves the opportunity to sample and buy jams at the supermarket: The availability of 24 jams increases traffic, but the share of people actually buying falls sharply—from 30 percent for 6 jams to 3 percent for 24 jams. One reason choice can create conflict is that people are not sure how to compare and assign weights to various attributes. Attribute weights are influenced by the way a question is phrased (is one choosing an option because of its pros or rejecting it because of its cons?), by when information becomes available (information sought and awaited acquires more weight), and by whether an agent is making decisions in a setting where attributes can be compared directly.

Behavorial economics: (2005) George Lowenstein noted that the discounted utility model of intertemporal choice suggests that some people are always impatient and others are always far-sighted, while in fact individuals are wildly inconsistent. They invest in their careers, for instance, while simultaneously smoking or getting involved in a scandal. Further, much of the variation in individual discount rates appears to reflect the influence of emotions or drives like anger, frustration, and arousal, which tend to shorten time horizons. Avoiding the wrong risks (driving instead of flying), helping the wrong victim (a single Iraqi child in Britain versus many wounded soldiers in Iraq), and exhibiting problems with self-control (overeating, addiction) provide other examples of prediction failure (or irrelevance) where affect plays a role.

* modern psychology shows that affect is actually highly regular and that it is cognition that introduces unpredictability into behavior. Unconscious behaviors generally occur in fully predictable patterns unless consciousness overrides them. As a result, humans are less predictable than rats.

George Lowenstein

Much of what we have learned from this research that is relevant to economics can be distilled into three


(1) Affective reactions usually happen first, while cognitive interpretations come second;

(2) Affect has the capacity to turn us into virtually different people;

(3) We tend to underestimate the impact of affect, especially when we try to predict our future or explain our past behavior.

Sadness and disgust alter in a predictable way the average price at which people are willing to buy or sell an object. Sadness lowers the selling price but raises the buying price while disgust lowers both the buying and the selling price. Similarly, frustration (in the form of an unopened bag of candy) makes people impatient, changing their intertemporal choices. Affect can also alter people’s taste for risk and their empathy with others. We are wired, Lowenstein said, to be caring towards identified people but surprisingly uncaring towards statistical people. Simply identifying a victim by number significantly increases the donations directed to that victim. Finally, Lowenstein drew on another set of studies to show that we tend to underestimate the influence of affect on ourselves and on others. For instance, it is easier to imagine what it is like to be thirsty when one is thirst than when one is fully statiated.

Affect matters. It influences behavior, it changes us profoundly, and we tend to underestimate its impact. Nevertheless, from neuroscientists to insurance salesmen, and now, even to economists, people are increasingly recognizing the importance of drive states. This new understanding may help us strengthen both micro and macro policies. It may improve corporate ethics training by demonstrating the unexpected power of emotions like greed and rationalization, for instance. And it may help us understand better the macro impact of the anger and fear triggered by events like 9/11 and SARS.

* Research in behavioral economics and cognitive psychology finds that people can make bad decisions, harming their welfare, because their preferences are often poorly formed and their choices depend strongly on variable factors that can make a big difference: their starting point, the way alternatives are framed for their consideration, and default rules that apply if they take no action.

Cass R. Sunstein, Richard H. Thaler, 

For three decades, research has questioned the rationality of people’s decisions. For example, people frequently exhibit a bias favoring the status quo: The existing arrangements, whether they are set by private or public institutions, tend to prevail, even when people have the ability to alter these arrangements. Although institutions may set their rules to encourage people to do what they would have done in the absence of those rules, sometimes people lack stable or consistent preferences or are strongly influenced by the rules.

Per Thaler- people frequently exhibit a bias favoring the status quo: The existing arrangements, whether they are set by private or public institutions, tend to prevail, even when people have the ability to alter these arrangements. Although institutions may set their rules to encourage people to do what they would have done in the absence of those rules, sometimes people lack stable or consistent preferences or are strongly influenced by the rules.

When employees first become eligible to participate in their employers’ tax-deferred 401(k) saving plans featuring a matching contribution from the employer, most eventually do participate, but enrollments occur much sooner if the default specifies an automatic contribution rather than no contribution. Although it is paternalistic to have the enrollment be automatic, such a default steers employees toward decisions that will improve their welfare. A perfect example of "default": States’ rules with respect to mandatory auto insurance also exhibit the influence of defaults. In New Jersey, the default sets a low premium with no right to sue, and policyholders have the option to purchase the right to sue. In Pennsylvania, the default sets a high premium with the right to sue, and policyholders have the option to reduce their premium by forgoing the ability to sue. In New Jersey and Pennsylvania, 80 percent and 75 percent of policyholders, respectively, have accepted the default policy—a substantial difference, as there is no reason to think the citizens of the two states have such different preferences in this matter. Starting points strongly influence people’s decisions, evidence that people’s values depend on their circumstances.

Anchors or starting points strongly influence people’s decisions, evidence that people’s values depend on their circumstances. This point is illustrated by surveys of people’s willingness to pay a sum of money to reduce risks or threats in situations in which an initial price is adjusted upward or downward until it is accepted. These surveys show that the final price rises with the arbitrary initial price. When people are uncertain, starting points can have a large influence on their decisions.

Framing: The framing of alternatives also affects decisions.

For example, when people (including doctors) who are

considering a risky medical procedure are told that 90 percent survive five years, they are far more likely to accept the procedure than when they are told that 10 percent do not survive five years. Because framing affects people’s behavior, providing more information cannot remedy matters, unless the information is presented in a fully neutral fashion. In some cases, additional information only increases people’s anxiety and confusion, thereby reducing their welfare.

Sunstein and Thaler contend that the making of rules inevitably entails paternalism, because the rules must contain defaults, starting points, and framing, all of which influence people’s choices. The paternalism inherent in rulemaking might also be used to encourage people to move in directions that they say they prefer.

Examples of Default Bias

401(k) Enrollment    Default                                        Initial enrollment

Automatic enrollment unless employee opts out           86 percent

 Nonautomatic enrollment, employee must opt in         49 percent

Auto Insurance Default structure                                   Accept default

New Jersey – low premium, no right to sue                   80 percent

Pennsylvania – high premium, right to sue                      75 percent

Organ Donation Default structure                                 Organ donor share

Presumed consent nation, person must opt out                90 percent

Non-presumed consent nation, person must opt in        < 20 percent

Pension Annuities Default structure                               Joint-and-survivor annuity option

Pre-1974,                                                                   no default 48 percent

Post-1974,                                                                  joint-and-survivor annuity 62 percent

Human behavior"  (2005) While economists usually assume that agents are well informed, that their preferences are well ordered and stable, and that their behavior is controlled, selfish, and calculating, psychological research indicates that people&rsquo;s judgments are biased and their preferences malleable and unstable. Further, people can be impulsive, shortsighted, trusting, and vengeful; they often have mistaken intuitions about their behavior; and they frequently effect outcomes they themselves view as bad. Briefly reviewing themes from behavioral research related to decision making, Shafir noted that psychological evidence indicates that people care more about gains and losses (of income, say) than about absolute levels and that they are loss averse and, thus, reluctant to change the status quo.They fail to disregard sunk costs, fail to consider opportunity costs, and fall prey to money illusion.

Supposedly foresighted and consistent, individuals actually have a hard time predicting their future preferences and show higher discount rates for distant than for near-term outcomes, resulting in dynamic inconsistencies. And far from being generally calculating and selfish, people seem to value fairness and procedural justice and to be subject to passing moods and emotions.

People do not produce predetermined responses to objective experience; rather they analyze, interpret, and (mis)understand stimuli and react to those interpretations. We do not choose between objective states of the world but between our representations of those states. We are forced into that mode because our brains are not built to take alternative construals of the same event and create a canonical representation&mdash;although in the realms of language and vision our brains do just that .We understand an active or passive sentence in the same way, for instance, and we see a blackboard as a rectangle no matter the angle from which we view it.

Why Do So Many Consumers Choose Frills When Plain-Old Will Do? Pure Laziness (Title from NY Times)- the central message is that most of us are too busy with life to spend a lot of time on every decision we face. When others give us a chance to avoid a choice, we often take them up on it.

At McDonald's, people buy the combo meal when they might rather just have a small order of fries with their Quarter Pounder. Car buyers take the options that come as part of the most heavily promoted package even if they do not want all of them. For their 401(k), many workers simply accept the contribution rate and the investment choices their company picks for them. In countries where being an organ donor is the default choice on driver's licenses, many more people are listed as organ donors.

The habit is so widespread that some economists have begun making a novel argument. Sometimes, they say, the more severe and the worse that a default option is, the better off people will be. Only then will they take matters into their own hands.

Recency: (Swedroe 2005) As we age, our long-term memory skills tend to remain strong, while our short-term memory skills erode. Unfortunately, individuals don&rsquo;t benefit from that tendency when it comes to investing. It seems to be a simple human failing to fall prey to &ldquo;recency&rdquo;&mdash;the tendency to give too much weight to recent experience, while ignoring the lessons provided by historical evidence.

Investors subject to recency make the mistake of extrapolating the most recent past into the future&mdash;as if it is ordained that the recent trend will continue. Evidence on the dangers of recency is provided by three studies done by

Morningstar. The first tracked the performance of the least popular fund categories from 1987 through 2000. They defined popularity by the amount of cash flowing in or out (redemptions) of funds. The least popular funds are those that are either receiving the least amount of inflow or experiencing the most amount of outflow. As it turns out, the three least popular categories of funds beat the average fund 75 percent of the time and the most popular funds 90 percent of the time.1

The second study, covering the period 1987&ndash;94, compared returns each year with the returns for the next one, two, and three years. Morningstar found that funds from the three least popular equity categories (based on net cash inflows) outperformed funds from the three most popular categories twenty-two out of twenty-four times.2

The third, and most recent, study examined the reported returns of mutual funds and the actual returns earned by investors in those funds. Morningstar found that in all seventeen fund categories they examined the return earned by investors was below the return of the funds. For example, among large growth funds the ten-year annualized dollar-weighted return was 3.4 percent less than the unweighted return. For mid-cap growth and small-cap growth funds the underperformance was 2.5 and 3.0 percent. Investors in sectors funds fared much worse, with tech investors producing particularly disastrous results, underperforming the very funds they invest in by 14 percent per annum. Health care investors underperformed by 4 percent per annum and investors in financial sector funds underperformed by 1.6 percent per annum. Even value investors fared poorly, though their underperformance was not as severe. Large value investors underperformed the funds they invest in by 0.4 percent per annum and small value investors underperformed by 2.0 percent per annum.3

Recency results in investors adopting a buy high/sell low investment strategy. Like generals fighting the last war, investors observe yesterday&rsquo;s winners and jump on the bandwagon, buying high. Similarly, they observe yesterday&rsquo;s losers and abandon ship, selling low. It is as if investors believe that they can buy yesterday&rsquo;s returns, when, of course, they can only buy tomorrow&rsquo;s. This problem can be avoided by ignoring the media, the financial press, and &ldquo;expert&rdquo; advice from Wall Street urging investors to act on the mistaken assumption that somehow this time it&rsquo;s different and the trend will continue. Investors would be far better served if they did the reverse of what their instincts and emotions lead them to do. The winning strategy is to observe yesterday&rsquo;s losers and buy low, and observe yesterday&rsquo;s winners and sell high. This can be accomplished by the process known as rebalancing&mdash;the process of restoring the portfolio to its desired asset allocation, eliminating the style drift caused by market movement.

The conclusion to draw is that having a well-thought-out investment plan is only a necessary condition for investment success. The sufficient condition is to have the discipline to stay the course. In fact, perhaps the most important role of a financial advisor is to ensure that investors act like postage stamps&mdash;adhering to their mission until they arrive at their destination.

Behavorial economics (Federal Reserve Bank of Boston 2005)

Because human brains have evolved to solve complex social problems, people's behavior tends to change as their circumstances change undermining consistency across time and context; however this lack of consistency is not a fault- rather it is a defining capacity that enables us to engage in complex social situations

Although individual perceive themselves to be unitary creatures, that impression is largely illusory; the brain consists of multiple subsystems and, although the various subsystems do communicate, the dominant rile shifts across subsystems according to context;

Unconscious behaviors are the ones that are relatively predictable, it is the consciousness that introduces the the element of unpredictability in human behavior;

Given the structure of the human brain, it is unlikely that humans will behave as if they are consistently maximizing any single utility function;

Neural evidence distinguishes four different kinds of utility- anticipated, remembered, choice and experienced

The roles of fairness and trust in informal contractual realigns is especially crucial for understanding the limits to markets and the roles of relational contracts.

Behavorial Economics:  (2006) &ldquo;To discourage parents from picking their children up late, a day-care center instituted a fine for each minute that parents arrived late at the center. The fine had the perverse effect of increasing parental lateness. The authors postulated that the fine eliminated the moral disapprobation associated with arriving late and replaced it with a simple monetary cost that some parents decided was worth incurring. Their results show that the effect of price changes can be quite different than in economic theory when behavior has moral components that wages and prices alter.&rdquo;

Does Investment Skill Decline due to Cognitive Aging or Improve with Experience? (2006) This study focuses on the stock investment choices of older investors. Consistent with the theoretical predictions of life-cycle and learning models, we find that older and more experienced investors hold less risky portfolios, exhibit stronger preference for diversification, trade less frequently, and exhibit greater propensity for year-end tax-loss selling. However, consistent with the psychological evidence on cognitive aging, we find that: (i) older investors have worse stock selection ability and poor diversification skill, and (ii) these adverse aging effects are stronger among older investors who are relatively less educated, earn lower income, and belong to a minority ethnic group. The economic costs of aging are significant - older investors earn roughly 2% lower annual returns on a risk-adjusted basis. Collectively, our results are consistent with the hypothesis that older investors' portfolio choices reflect greater knowledge about investing but their investment skill deteriorates with age due to declining cognitive abilities.

Why the smartest investors make the dumbest decisions. (Forbes 2006)

Greed, of course. They wouldn't be in this game if they didn't hope to rake it in. But we're talking about sophisticated investors who rarely take people--or balance sheets--at face value. Avarice alone can't explain why so many of them fall for flimflammery, from hedge funds and secretive offshore commodities pools to ordinary Ponzi schemes. How, for example, could a buyout artist like Thomas H. Lee be taken in by Phillip Bennett, the Refco chairman eventually caught hiding (so say prosecutors; Bennett denies the charge) $430 million in bad debt?

A certain predisposition to folly is hard-wired into the human species. Decision making means processing an immense amount of data, and so the brain takes shortcuts. "Authority, scarcity, consensus, social proof--these are relatively primitive decision-making strategies we deploy. In other words, we're all susceptible to suggestions by influential people; we gravitate to something if it seems to be unavailable to everyone else, and we trust strangers who appear to be like us.

How well do these "weapons of influence" work? One of Cialdini's students ran an experiment in which customers of a meat wholesaler were exposed to three different stories: The first group heard the standard sales pitch about high-quality meat; the second, that beef prices were rising because of a drought in Australia; the last, that the wholesaler heard from a confidential source within the Australian weather service that a drought was expected and that could drive up beef prices. Orders from the third group were six times those of the first. The perception that somebody has the inside track "creates this irrational desire to jump at what's scarce or rare.One of the most effective--and potentially dangerous--shortcuts is relying on someone's family background and pedigree as proxies for reliability.

At some point everyone becomes committed, when we go over the line, and we're part of this and we have to make it work," says James Byrne, professor of commercial law at George Mason University. "Once I have put my life savings into this thing, I'm saying, &lsquo;Dear God, it can't go wrong.' Then you're in denial."Stepping over that line is easy when you fall into the trap of conformity. Cialdini's research has shown that hotel guests are 27% more likely to comply with requests to reuse bath towels, for example, if there is a sign suggesting that previous occupants of that same room did the same, instead of one that simply makes a plea for the environment. "You follow the lead of people like you,"

"There's a lemming effect. Once money managers hear a colleague has invested, "they tend to think most of the [due diligence] work has been done."

Another powerful draw: the fear of getting left behind. Experiments have repeatedly shown that people--even professional currency traders--bid up investment prices to insane levels if they believe somebody else will pay even more. "In the short run it is rational to go with the crowd" and get in early. But in the long run it's a prescription for asset evaporation.

What drives it is word of mouth. "Once a person with a good reputation recommends it, it spreads like wildfire."

Investment Behavior Issues (Journal of Financial Planning 2006)

Behavioral finance is a rapidly growing area of study that examines a wide variety of human actions that affect investment performance. Many basic investment errors caused by human behavior have been cited to justify common strategies recommended by financial advisors. These investment strategies are portfolio rebalancing (Buetow et al. 2002), dollar-cost averaging (Statman 1995), and the "let it ride" strategy that is generally based upon the expectation of time diversification (Fisher and Statman 1999). In addition, research indicates that overconfident investors trade too much, diminishing their performance (Barber and Odean 2000), and that Internet trading leads to costly overconfidence (Odean and Barber 2002).

Often cited in the investment research literature are several behavioral issues that influence investment performance. Issues discussed in this paper are herd mentality, regret aversion, and mental accounting.

Herd Mentality

The herd mentality reflects the natural tendency for individuals to do what is currently popular. The herd mentality feeds the penchant for investors to buy securities after the market has risen and sell securities when the market is down. Individuals tend to place more money into the stock market as fashion dictates that stock market investing is the "in" thing to do. "Herding is defined as a group of investors following each other into (or out of) the same securities over a period of time" (Sias 2004). The result is that investors who follow the crowd can miss opportunities to realize major gains. Individual investors are not alone in following the crowd. The herd mentality of institutional investors is also clearly documented (Nofsinger and Sias 1999).

Regret Aversion

People wish to avoid the pain of regret associated with bad decisions. This reaction is especially true in investment decision-making. We have a natural desire to avoid admitting an error and realizing a loss (Kahneman and Tversky 1982). Regret aversion can cause investors to hold onto losing positions too long. Regret aversion also keeps investors out of a market that has recently generated losses, when investment bargains may be most readily available. Having experienced stock market losses, our instincts tell us that to continue investing is not a prudent decision. Yet these periods of depressed prices often present the greatest buying opportunities. Regret aversion can persuade us to stay out of the stock market just when the time is right for investing more.

Mental Accounting

According to behavioral portfolio theory, mental accounting is used by investors to build portfolios as separate accounts. Experimental research indicates that investors do not consider the correlations among assets (Kroll, Levy, and Rapoport 1988). Tversky and Kahneman (1986) contend that the difficulty individuals have in addressing the interaction of different investments leads investors to construct portfolios in a layered pyramid format. Each layer of the portfolio addresses a particular investment goal, independent of the other investment goals. Investors target low-risk investments like cash and money market funds to preserve wealth, target bonds and dividend-paying stocks to provide income, and target risky investments like emerging market stocks and IPOs to have a chance to get rich. Opportunities to reduce risk by combining assets with low correlations may be neglected, and inefficient investing may result from offsetting positions in the various layers (Shefrin and Statman 2000). Investors quite often do not evaluate investments based on the contribution to the overall portfolio return and total risk, but only upon the recent performance of the asset layer.

Investors may feel overwhelmed by the complexity of the investment environment. While wealth maximization is the generally accepted paradigm guiding investment decisions, a landmark study of the decision-making process shows that individual decision makers are more likely to "satisfice" than "maximize" (Cyert and March 1963). To maximize, an investor must select the best alternative from among all available options. This process is complex and time consuming and beyond the ability of most decision makers. But more decision makers merely look for a course of action that will suffice or that will be "good enough" within the overwhelming complexity of the real world (Simon 1955).

Learning to be prepared (2006) Behavioral economics provides several motivations for the common observation that agents appear somewhat unwilling to deviate from recent choices. More recent choices can be more salient than other choices, or more readily available in the agent's mind. Alternatively, agents may have formed habits, use rules of thumb, or lock in on certain modes of behavior as a result of learning by doing. This paper provides discrete-time adjustment processes for strategic games in which players display precisely such a bias towards recent choices. In addition, players choose best replies to beliefs supported by observed play in the recent past, in line with much of the literature on learning

"The evidence from cognitive aging research suggests that decision-making ability is likely to deteriorate with age due to a decline in general intelligence and information processing ability,. "Effective and timely reaction to new information is one of the key defining characteristics of investment skill."

the average 65-year-old investor's stock picks lagged behind those of the average 30-year-old investor's by 1.8 percent a year. The overall effect of the aging process was for 65-year-olds to have an average annual return about 1.1 percent lower than the typical 30-year-old's.

George M. Korniotis and Alok Kumar.

Weakening memory slows down the information processing ability of individuals, where the decline begins at a relatively younger age of 30 (Grady and Craik (2000)). Researchers have also found that memory impairment leads to a decline in older people&rsquo;s ability to perceive conditional probabilities (Spaniol and Bayen (2005)). Additionally, due to a decline in attentional ability, older people get distracted easily and are unable to distinguish between relevant and irrelevant information. Overall, the psychological evidence indicates that older people are slower and less effective at processing and integrating new information, and therefore, they may react to new information inappropriately.

Older people are also likely to experience a decline in their general intelligence level. The aging process influences general intelligence through two distinct channels. First, general intelligence declines with age (e.g., Lindenberger and Baltes (1994), Baltes and Lindenberger (1997)) due to the adverse effects of aging on memory and attention. Second, with aging, there is also a decline in the sensory (vision and hearing) functioning, which leads to a decline in general intelligence. The decline in intelligence is much steeper after the age of 70 (Lindenberger and Baltes (1997)), while the rate is attenuated in people&rsquo;s area of expertise because of frequent practicing (Masunaga and Horn (2001)). In sum, the psychological evidence on aging indicates that decline in cognitive abilities is a normal consequence of biological aging and the phenomenon is observed across different cultures

* people who are more educated, more resourceful (higher income and wealth), and undertake intellectually stimulating jobs are able to actively compensate for the adverse effects of aging

Collectively, the evidence from cognitive aging research suggests that decision-making ability is likely to deteriorate with age due to a decline in general intelligence and information processing ability. Because effective and timely reaction to new information is one of the key defining characteristics of investment skill, a decline in intelligence and information processing speed would adversely affect the investment skill of individuals. Therefore, older investors are likely to hold stock portfolios which provide sub-optimal risk-return trade-offs.

* older and more experienced investors hold less risky portfolios, exhibit stronger preference for diversification, trade less frequently, and exhibit greater propensity for year-end tax-loss selling. Overall, their choices reflect greater knowledge about investing. However, consistent with the psychological evidence on aging, we also find that older investors have worse stock selection ability and poor diversification skill. Additionally, we find that these adverse effects of aging are stronger among older investors who are relatively less educated, earn lower income, and belong to the Hispanic ethnic group. These results are remarkably consistent with the extant psychological evidence. Examining the economic costs of aging, we find that older investors earn about 2% lower returns on a risk-adjusted basis.

A Simple Model of Self-Assessments (2006) We develop a simple model that describes individuals' self-assessments of their abilities. We assume that individuals learn about their abilities from appraisals of others and experience. Our model predicts that if communication is imperfect, then (i) appraisals of others tend to be too positive, and (ii) overconfidence leading to too much activism is more likely than underconfidence leading to too much passivity. The predictions of our model are consistent with findings in the social psychological literature.

Understanding pensions: cognitive function, numerical ability and retirement saving, (2006) As the degree to which individuals are expected to provide their own resources for retirement increases, there is a correspondingly increasing importance of individuals being able to understand the financial choices they face and to choose savings products, portfolios and contribution rates accordingly. In this paper we look at numerical ability and other dimensions of cognitive function in a sample of older adults in England and examine the extent to which these abilities are correlated with various measures of wealth and retirement saving outcomes. The key findings are: a) Relatively large fractions of the population can be seen to have relatively low levels of financial numeracy and these numeracy levels decline systematically with age. b) Numeracy levels are correlated with measures of retirement saving and investment portfolios, even when we control for other cognitive ability and education. c) Numeracy is correlated with knowledge and understanding of pension arrangements, and with perceived financial security, even when we control for other cognitive ability, education and the level of overall retirement saving. The lessons of our analysis are threefold, even though at this point we have only crosssectional data available on which to base our analysis. Firstly, it shows yet another dimension in which inequalities amongst older individuals are apparent. Second, the analysis suggests that in the short run there may be a role for targeting simple retirement planning information at low numeracy, low wealth, low education groups. Third, it suggests that a longer run policy goal might want to target numeracy levels more generally in order to reduce the fraction of the population with low basic skills. Whether such a policy would have knock on effects on to retirement planning arrangements, however, is a more difficult question to answer on the basis of the conditional correlations we present here. On this topic in particular, there is much further work to be done.

Herd Behavior in Efficient Financial Markets (2006) we argue that people may be subject to herding if and only if there is sufficient amount of noise and, loosely, their information leads them to believe that extreme outcomes are more likely than moderate ones. We then show that herding has a significant effect on prices: prices can move substantially during herding and they become more volatile than if there were no herding. Furthermore, herding can be persistent and can affect the process of learning. We also characterize conditions for contrarian behavior. Our analysis suggests that herding (and contrarian behavior) may be more pervasive than was originally thought.

Behavioral Finance  (Barbara Luppi) It attempts at explaining some observed financial phenomenon by studying models in which agents are not fully rational. The departures from traditional paradigm used by Behavioral Finance literature are mainly two: on one side beliefs are not assumed to be formed according to standard rational Bayesian paradigm and on the other, preferences are not consistent with subjective expected utility. The present paper tries at establishing a connection between these two strands of literature: the one based on beliefs and the other one based on changes in preferences.

People recognize &rdquo;order in chaos&rdquo;, i.e. they believe to see patterns in a truly random sequence and consequently, they infer incorrectly that the earnings are expected to grow in the future at the same positive (negative) rate. This pushes prices up (down) too much in case of a positive (negative) news sequence; as a consequence, firms become over(under)valued and investors earn lower (higher) rates of return on their investment than the expected ones. This generates the phenomenon of financial overreaction. On the other hand, conservatism appears to be suggestive of the observed empirical phenomenon of underreaction. When investors receive a good (negative) piece of information on firm&rsquo;s earnings, they tend to disregard the information to be noisy, for example because it contains many temporary components. Therefore, investors rely more on their initial firm&rsquo;s evaluation and update their beliefs only by too little. Consequently, in case of positive (negative) news, returns rate on investment will be higher (lower) than the expected one, generating underreaction.

Who Are the Trustworthy, We Think?  (2006) Trust between people is important for how well the society is functioning in many different ways. From an individual point of view, however, it is less clear that increased trust is beneficial, since it depends on whether others will exploit the vulnerability that is associated with trusting someone. On the other hand, it is always beneficial for an individual to be perceived trustworthy, whether he actually is trustworthy or not.

Moreover, and more fundamentally, what we are interested in here is not trust but perceived trustworthiness. The distinction is important since I may trust another person because I believe that he or she (e.g. ones spouse or close friend) will behave particularly trustworthy towards me. A Hells Angels member Adam may trust another member Bill more than he trusts Carl who is not a member, but at the same time realize that Bill is generally less trustworthy than Carl.

We are interested in the broader underlying issue of whether it is true that we consider people that are more similar to ourselves to be more trustworthy, ceteris paribus? The answer from this study is Yes.

Trusting the Stock Market We provide a new explanation to the limited stock market participation puzzle. In deciding whether to buy stocks, investors factor in the risk of being cheated. The perception of this risk is a function not only of the objective characteristics of the stock, but also of the subjective characteristics of the investor. Less trusting individuals are less likely to buy stock and, conditional on buying stock, they will buy less. The calibration of the model shows that this problem is sufficiently severe to account for the lack of participation of some of the richest investors in the United States as well as for differences in the rate of participation across countries.

Awareness and Stock Market Participation The paper documents lack of awareness of financial assets in the 1995 and 1998 Bank of Italy Surveys of Household Income and Wealth. It then explores the determinants of awareness, and finds that the probability that survey respondents are aware of stocks, mutual funds and investment accounts is positively correlated with education, household resources, long-term bank relations and proxies for social interaction. Lack of financial awareness has important implications for understanding the stockholding puzzle and for estimating stock market participation costs.

Overconfidence:  (2007) Man is an overconfident breed. Overconfidence arises when knowledge perception exceeds its reality. While we should not be overly surprised if individuals operating outside their natural domains fall prey to this flaw, naturally it is to be hoped that, for an individual making his living in a certain field of expertise, the actual knowledge level is high, and the perception of this level accurate. Unfortunately the reality is that experts can be quite overconfident.

Theory suggests that overconfidence is likely to be more prevalent if feedback is infrequent and ambiguous.

What damage is wrought by overconfidence? A good example is Odean (1998), who has formulated a behavioral model that suggests that overconfident investors, believing that they possess greater precision on security valuations than is merited, trade too much and thereby lower their wealth (and expected utility). The intuition is clear: the more certain you are of your view, the less credence you will accord those of others, and the more likely you will be to transact at a price perceived favorable to your view.

The dynamics of overconfidence is clearly an important issue. It is logical to think that if we recall our successes and failures equally clearly, over time we should obtain an accurate view. Experience should make us wise. On the other hand, the prevalence and persistence of overconfidence suggest that forces able to eliminate it are weak. The reality is that we prefer to forget what did not go our way: this is called cognitive dissonance.

Working in tandem, self-attribution bias leads us to remember our successes with great clarity, if not embellishment . And confirmatory bias, the tendency to search out evidence consistent with one&rsquo;s prior beliefs and to ignore conflicting data, may also contribute.

While overconfidence can afflict individuals, it can also be endemic in markets. The most likely trigger is high past market returns.

An experiment on corruption and gender (Fernanda Rivas 2007) There exists evidence in the social science literature that women may be more relationship oriented, may have higher standards of ethical behavior and may be more concerned with the common good than men are. This would imply that women are more willing to sacrifice private profit for the public good, and this would be especially important for political life. Many papers with field data have found deference&rsquo;s in the corrupt activities of males and females, but given their different insertion in the labor market and in politics, it is not clear if the differences are due to differences in opportunities or real gender differences. The aim of this paper is to see if women and men, facing the same situation behave in a different way, as suggested in the field-data studies, or on the contrary, when women are in the same position as men they behave in the same way. The results found in the experiment show that women are indeed less corrupt than men. This suggests that increasing women&rsquo;s participation in the labor force and politics would help to reduce corruption.

Do Sophisticated Investors Believe in the Law of Small Numbers? (Baquero, Verbeek, 2007)

Believers in the law of small numbers tend to overinfer the outcome of a random process after a small series of observations. They believe that small samples replicate the probability distribution properties of the population. We provide empirical evidence indicating that investors are mistakenly driven by this psychological bias when hiring or firing a fund manager after a successful (or losing) performance streak. Using quarterly data between 1994 and 2000 of 752 hedge funds, we analyze actual money flows into and out of hedge funds and their relationship with the length of the streak. We first show that persistence patterns have a predictive ability of future relative performance of a manager: the longer the winner streak, the larger the probability for a fund to remain a winner. Investors, in turn, appear to be aware of quality dispersion across managers and respond by following a momentum strategy: the longer the winning (losing) streak, the more likely they will invest in (divest from) that fund. Yet, we find that investors place excessive weight in the managers track record as a criterion for decision. Our model shows that the length of the streak has an economically and statistically significant impact on money flows beyond rationally expected performance, which confirms a "hot-hand" bias driving to a large extent momentum investing. Apparently, even sophisticated investors exhibit psychological biases that may have adverse effects on their wealth.

Overconfidence in financial markets and consumption over the life cycle  (2007) Overconfidence is a widely documented phenomenon. Empirical evidence reveal two types of overconfidence in financial markets: investors both overestimate the average rate of return to their assets and underestimate uncertainty associated with the return. This paper explores implications of overconfidence in financial markets for consumption over the life cycle. The authors obtain a closed-form solution to the time-inconsistent problem facing an overconfident investor/consumer who has a CRRA utility function. They use this solution to show that overestimation of the mean return gives rise to a hump in consumption during the work life if and only if the elasticity of intertemporal substitution in consumption is less than unit. They find that underestimation of uncertainty has little effect on the long-run average behavior of consumption over the work life. Their calibrated model produces a hump-shaped work-life consumption profile with both the age and the amplitude of peak consumption consistent with empirical observations.

* We have to stress that messages that are uninformative under the common knowledge of rationality assumption may appear to be informative if traders are not fully rational.

We believe that these three dimensions may influence experimental asset prices. 1. reliability of the sender, 2. content of the message, 3. frequency of the message.Reliability of the person sending the message will influence the degree to which the message is &ldquo;focal&rdquo; to the agent (the agent is sensitive to the reception of the message).

The content of the message is as well important, a vague statement (&ldquo;the average price is too low or too high&rdquo;) may have a more reduced impact on subjects&rsquo; beliefs than a precise statement like: &ldquo;the average price is x cents of euro too low or x cents of euro too high.&rdquo;

Finally, the frequency of the messages is an important variable, we believe that the more frequent is a message, the higher is its impact on traders&rsquo; beliefs and then on experimental prices.


The impact of uninformative messages on expected asset prices is strongest when the message sender is highly reliable and the message is very precise. (Note however that the message is UNinformative)

* Bubbles can arise either because subjects are not rational or because they do not believe in others&rsquo; rationality.

Committees Versus Individuals: An Experimental Analysis of Monetary Policy Decision Making  (2007) We report the results of an experimental analysis of monetary policy decision making under uncertainty. A large sample of economics students played a simple monetary policy game, both as individuals and in committees of five players. Our findings - that groups make better decisions than individuals - accord with previous work by Blinder and Morgan. We also attempt to establish why this is so. Some of the improvement is related to the ability of committees to strip out the effect of bad play, but there is a significant additional improvement, which we associate with players learning from each other&rsquo;s interest rate decisions.

The Speed of Trust (Steve Covey 2007) Low trust is an unseen cost in life and business, because it creates hidden agendas and guarded communication, thereby slowing decision-making. A lack of trust stymies innovation and productivity. Trust, on the other hand, produces speed because it feeds collaboration, loyalty and ultimately, results.

&bull;Talk straight. Be honest and tell the truth.

&bull;Demonstrate respect. Treat everyone with respect, especially those who can't do anything for you.

&bull;Create transparency. Operate on the premise of "what you see is what you get."

&bull;Right wrongs. Apologize quickly. Don't let pride get in the way of doing the right thing.

&bull;Show loyalty. Acknowledge others' contributions. Speak about others as if they were present.

&bull;Deliver results. Accomplish what you're hired to do on time and within budget.

&bull;Practice accountability. Don't blame others when things go wrong.

&bull;Keep commitments. When you make a commitment, you build hope. When you keep it, you build trust.

Where I disagree is not with his comments but just how easily trust is "earned". The ads for Katie Curic says you can trust her. Same with Charlie Gibson. So what? They read a teleprompter. People "trust" their bank. No they don't. They "trust" FDIC. But the perception of trust is the reason why so many people buy stuff at at a bank that makes no sense at all.

If you want to trust your doctor, maybe O.K. since they have an extensive background. Trusting an insurance agent, broker or financial planner is not valid. They don't have a background of effectively any type. Trust needs to be earned by people who know something.

Consumer-finance myths and other obstacles to financial literacy, William R. Emmons St Louis Fed

(My email to him- Darn, you are good. I just happen to have read your 2005 article above and frankly think it is one of the best independent articles ever written on the subject. Well researched and well written- and since I have written about the subject as much as anyone, the comment is more than just idle commentary (see Click my name for the resume). Unfortunately, I just don't think there is any way to getting to the general consumer outside of 'hitting them upside the head with a 2x4'. Or, 'people do not read, do not know and will never find out'. I don't think there is anyway of getting them away from the TV soundbites or the simplistic format of the marketing of the industry (that works so very, very well).

This paper focuses not on inadequate choices, inadequate competition or regulation, but on the difficulty many middle and upper-income households encounter in making good financial decisions&mdash;that is, a low average level of financial literacy. Millions of households are unable to make wise financial decisions even when adequate information is available. Low levels of financial skills provide a fertile environment for consumer-finance myths to arise and gain widespread acceptance.

The seventh consumer-finance myth afflicts not just consumers but also those scholars, policy-makers, regulators, and consumer advocates who believe that just a little more time, or money, or education, or financial-literacy training will create a financially literate population once and for all.

* One general conclusion one can draw is that U.S. households do not consistently demonstrate the basic skills of financial literacy.

* a clear majority of U.S. households with credit cards do not shop around when applying for a card and end up paying finance charges on the cards they use. These facts alone might support the conclusion that credit management is poor in the average U.S. household. Another indication of poor credit management is the fact that virtually all households that are paying high rates of interest on credit-card balances simultaneously hold balances in low-yielding assets, such as checking or savings deposits or money-market mutual funds, or have housing equity against which they could borrow at a lower rate.

* Perhaps the clearest evidence of U.S. households&rsquo; poor credit-management skills is the more than 13 million non-business bankruptcy filings in the United States during the ten years ending Sept. 30, 2004&mdash;a period of generally falling interest rates and low unemployment rates.7 A high rate of bankruptcy filings suggests that a large segment of the population lacks adequate credit-management skills.

* In sum, U.S. households&rsquo; average level of basic financial literacy is moderate at best. Cash management is done reasonably well by most households, while long-term investment decision-making&mdash;including retirement planning&mdash;is done poorly by the average household (in some cases by doing nothing at all).

* The third obstacle to widespread financial literacy is the undeniable fact that the literacy bar keeps rising&mdash;that is, the typical household&rsquo;s responsibilities for managing its financial affairs are increasing. Moreover, the tasks are becoming more and more complex.

Two potentially far-reaching examples of increasing demands on consumers to make complex financial decisions are &ldquo;personal retirement accounts&rdquo; and &ldquo;health savings accounts.&rdquo;

Behavioral Finance: (2007) Modern portfolio theory is premised on a universe of rational actors, but this species is very rare in the real world. In recent years, behavioral finance -- the science of real-life returns, which are driven not by investment performance but by investor behavior -- has come to the fore, and indeed one of its pioneers has been awarded a Nobel Prize in economics. Even Morningstar has recently been publishing research in what it calls "investor returns," showing the horrific gap between the nominal returns of mutual funds and the actual returns earned by the average investor in those funds, who typically buys and sells at the wrong times for the wrong reasons.

The implications of behavioral finance for the careers of financial advisors are very profound. For this approach suggests that much of the time and energy spent by today's advisors on selection and timing might better be directed toward identifying and moderating the classically self-destructive behaviors which cause investors to self-sabotage. In this presentation -- which might further be subtitled "behavioral finance in plain English" -- Nick Murray develops a theory of behavior modification as an advisor's value proposition, and identifies eight classic psychological traps ("heuristics," in the jargon) into which the vigilant advisor may prevent clients from falling, to return-enhancing effect.

Behavioral Economics and Climate Change Policy (John M. Gowdy )

The policy recommendations of most economists are based on the rational actor model of human behavior. Behavior is assumed to be self-regarding, preferences are assumed to be stable, and decisions are assumed to be unaffected by social context or frame of reference. The related fields of behavioral economics, game theory, and neuroscience have confirmed that human behavior is other regarding, and that people exhibit systematic patterns of decision-making that are "irrational" according to the standard behavioral model. This paper takes the position that it is these "irrational" patterns of behavior that uniquely define human decision making and that effective economic policies must take these behaviors as the starting point. This argument is supported by game theory experiments involving humans, closely related primates, and other animals with more limited cognitive ability. The policy focus of the paper is global climate change. The research surveyed in this paper suggests that the standard economic approach to climate change policy, with its almost exclusive emphasis on rational responses to monetary incentives, is seriously flawed. In fact, monetary incentives may actually be counter-productive. Humans are unique among animal species in their ability to cooperate across cultures, geographical space and generations. Tapping into this uniquely human attribute, and understanding how cooperation is enforced, holds the key to limiting the potentially calamitous effects of global climate change.

Collective Trust Behavior This paper investigates trust in situations, where decision-makers are large groups and the decision-mechanism is collective, by developing a game to study trust behavior. Theories from behavioral economics and psychology suggest that trust in such situations may differ from individual trust. Experimental results here reveal a large difference in trust but not in trustworthiness between the individual and collective setting. Furthermore, an artefactual field experiment captures the determinants of collective trust behavior among two cohorts in the Swedish population. One result is that beliefs about the other and the own group are strongly associated with collective trustworthiness and trust behavior.

Individual and Couple Decision Behavior under Risk: The Power of Ultimate Control (2007) This paper reports results of an experiment designed to analyze the link between risky decisions made by couples, and risky decisions made separately by each spouse. We estimate both the individuals and the couples&rsquo; degrees of risk aversion, and we analyze how the risk preferences of the two spouses aggregate when they have to perform joint decisions under risk. We show that the man has more decision power than the woman, but the woman&rsquo;s decision power increases when she has ultimate control over the joint decision.

Choosing to Have Less Choice This paper investigates choice between opportunity sets. I argue that individuals may prefer to have fewer options for two reasons: First, smaller choice sets may provide information and reduce the need for the agent to contemplate the alternatives. Second, contemplation costs may be increasing in the size of the choice set, making smaller sets more desirable even when they do not provide any information to the agent. I identify which of these reasons drives individual behavior in a laboratory experiment. I find strong support for both the information and cognitive overload arguments. The effects do not disappear as participants gain experience with the task. Applications of these results include firms&rsquo; choices of product variety, as costs increase with the number of products offered, and the design of government policies, such as the Medicare Drug Discount Card Program, in which older citizens can choose among numerous cards for discounts in prescription drugs.

Attitudes to economic risk taking, sensation seeking and values of economists specializing in finance, Sjöberg, Lennart, Engelberg, Elisabeth (Center for Risk Research)

Financial decision making rarely follows models derived from economic theory which postulate that people are rational economic actors. Psychological alternatives abound. The Tversky-Kahneman heuristics approach is currently dominating, but it needs to be complemented with emotional and personality factors, since cognitive limitations by no means provide exhaustive explanations of the psychology of decision making. In this paper, attitudes to financial risk taking and gambling are related to sensation seeking, emotional intelligence, the perceived importance of money (money concern), and over-arching values, in groups of students of financial economics (N=93). Most of the students planned a career in finance. Comparative data were collected for a group of non-students. Data on values were also available from a random sample of the population for a comparison. It was found that a positive attitude to economic risk taking and gambling behavior were associated with a high level of sensation seeking, a lower level of money concern, and giving low priority to altruistic values concerning peace and the environment. The subgroup of participants planning a career in finance showed an even more pronounced interest in gambling and a lower level of emotional intelligence.




Is the veil of ignorance only a concept about risk? An experiment (2007)We implement the Rawlsian thought experiment of a veil of ignorance in the laboratory which introduces risk and possibly social preferences. We find that both men and women react to the risk introduced by the veil of ignorance. Only the women additionally exhibit social preferences that reflect an increased concern for equality. Our results for women imply that maximin preferences can also be derived from a combination of some, not necessarily infinite risk aversion and social preferences. This result contrasts the Utilitarians' claim that maximin preferences necessarily represent preferences with infinite risk aversion.

Overconfidence (2007)

* In a study based on a sample of nearly 15; 000 individual investors surveyed by the Gallup Organization, Barber and Odean (2001) find that men estimate the rate of return to their investments by nearly 3 percentage points higher than the market average return and women by almost 2 percentage points higher. According to Daniel Houston, a senior vice president for retirement and investor services at the Principal Financial Group Inc., a survey on retirement planning released in April 2005 indicates that Americans are way too confident about the future performance of their assets.

* The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued.

The over-weening conceit which the greater part of men have of their own abilities, is an ancient evil remarked by philosophers and moralists of all ages.

Adam Smith

Overconfidence does not just belong to those elite school students. If you think you are safer and more skillful than your fellow drivers, you are not alone: in Svenson's (1981) study of Texas car drivers, 90% of those assessed believe they have above-average skills and 82% rank themselves among the top 30% of safe drivers. Anything you think you are better at or have better luck with than others, your peers are likely to think the same way: 70% of lawyers in civil cases believe their sides will prevail; doctors consistently overestimate their abilities in detecting certain diseases; parents feel their children are smarter than others'; lottery pickers bet that tickets they choose have greater odds to win than randomly selected ones; professional athletes and military personnel may even be trained to be overconfident and overoptimistic.

The presence of overconfidence in the business world is also well known. A large body of literature documents that managers are prone to the wishful thinking that projects they have command of are bound to succeed.1 In Copper, Woo, and Dunkelberg's (1988) survey of nearly 3000 new business owners, 81% percent of those sampled believe their businesses have more than a 70% chance to succeed while 33% believe they will thrive for sure. In actuality, 75% of new ventures do not even survive the first five years. The phenomena of overconfidence and overoptimism are widespread and have long been documented in the cognitive psychology and behavior science literature based on data from interviews, surveys, experiments, and clinical studies. Perhaps what is more overwhelming than the mere existence of overconfidence itself is the fact that the degree of overconfidence is rather persistent and generally does not wane over time. In the car-driver example, Camerer (1997) notes that even after suffering serious car accidents, drivers still rate themselves as above-average, and Bob Deierlein reports in a 2001 issue of WasteAge that more experienced drivers can develop a higher degree of overconfidence in their ability to avoid accidents but can in fact have accidents more frequently.

* In another study of 78; 000 individual investors, Barber and Odean (2000) also find substantial persistence of investor overconfidence, which results in high trading volume and high turnover rates in the face of repeatedly lower-than-expected realizations of asset returns.

Managing a 401(k) Account: An Experiment on Asset Allocation  The study reports the results of an asset allocation experiment in which subjects managed an endowment of money over a 20 "year" time period. While grounded in theory, the study takes an applied look at the ability of subjects to efficiently and effectively make asset allocation decisions similar to those found in 401(k) accounts. The main conclusions are as follows. First, efficient portfolios are more easily created when the set of assets to choose from is carefully constructed. Thus, financial engineers should be given the responsibility for choosing the assets available to plan participants and ensuring that combinations of these assets will fall on the efficient frontier. If followed, this advice would likely significantly reduce the amount of individual company stock offered in Defined Contribution (DC) plans in place of well-constructed low cost index funds from multiple asset classes. Second, if the assets selected for inclusion in DC plans allow the investor to easily create portfolios on the efficient frontier, then the challenge for the investor is not how to get onto the frontier but where to locate on it. The simplistic surveys that are commonly used by DC plan providers to determine risk tolerance and to recommend asset allocations are woefully inadequate for this task. More sophisticated and theoretically driven instruments must be created to educate investors on the risks and the benefits available at different points along the efficient frontier.

Detrimental to your health. (2007) Marcy Yager "If you were to prioritize one issue in financial planning as the most problematic for us, as a nation, what would it be, and why?

People aren&rsquo;t innately skilled in making complex decisions, and when they are required to make choices when they aren&rsquo;t confident that their choice will be right, they tend to do nothing, even if nothing is obviously detrimental. This is a major reason why so few people sign up for participation in 401k plans, and why when they do, they tend to leave their money in the money market fund. In the past governmental policy acknowledged this tendency to avoid hard decisions by creating or supporting conditions to encourage private creation of programs that made the decisions on behalf of participants (such as defined benefit plans and social security).

With the sea change in government&rsquo;s perception of its role vis a vis its citizens, people have been forced into participation in programs for which they don&rsquo;t have sufficient information to make judgments that they can be confident of (the prescription drug plan is an obvious example). How will this fundamental and critical gap between the significance of the decisions to be made and the ability to make those decisions be addressed? Financial advisors fancy themselves as the ones best positioned to provide the necessary education, but the masses can&rsquo;t afford to buy access to advisors. In addition, most advisors don&rsquo;t focus on helping people explore the hidden factors (emotions, biases, beliefs) that so often short-circuit good decision-making. The media try to fill in the gap with articles, books, and shows on financial principles, but they can&rsquo;t teach people how to interpret and apply these principles to the specifics of their own lives.

There are many major issues that the people of this nation are being called on to face, but if our society isn&rsquo;t realistic about what people are practically (not theoretically) capable of, we&rsquo;ll continue to lurch from one unintended consequence to the next."

Are you happy??:  (2007) An adequate theory of happiness or subjective well-being (SWB) needs to link at least three sets of variables: stable person characteristics (including personality traits), life events and measures of well-being (life satisfaction, positive affects) and ill-being (anxiety, depression, negative affects). It also needs to be based on long term data in order to account for long term change in SWB. By including personality measures in the 2005 survey, SOEP becomes the first available dataset to provide long term evidence about personality, life events and change in one key measure of SWB, namely life satisfaction. Using these data, the paper suggests a major revision the set point or dynamic equilibrium theory of SWB in order to account for long term change (Brickman and Campbell, 1971; Costa and McCrae, 1980; Headey and Wearing, 1989; Lykken and Tellegen, 1996). Previously, theory focused on evidence that individuals have their own equilibrium level set point of SWB and revert to that equilibrium once the psychological impact of major life events has dissipated. But the new SOEP panel data show that small but non-trivial minorities record substantial and apparently permanent upward or downward changes in SWB. The paper aims to explain why most people's SWB levels do not change, but why a minority do. The main new result, which must be regarded as highly tentative until replicated, is that the people most likely to record large changes in life satisfaction are those who score high on the personality traits of extraversion (E) and/or neuroticism (N) and/or openness to experience (O). These people in a sense 'roll the dice' more often than others and so have a higher than average probability of recording long term changes in life satisfaction. Data come from the 2843 SOEP respondents who rated their life satisfaction every year from 1985 onwards and then also completed a set of questions about their personality in 2005.

Trustworthiness: [Image]

Behavioral Economics and Climate Change Policy (John M. Gowdy 2007)

The policy recommendations of most economists are based on the rational actor model of human behavior. Behavior is assumed to be self-regarding, preferences are assumed to be stable, and decisions are assumed to be unaffected by social context or frame of reference. The related fields of behavioral economics, game theory, and neuroscience have confirmed that human behavior is other regarding, and that people exhibit systematic patterns of decision-making that are "irrational" according to the standard behavioral model. This paper takes the position that it is these "irrational" patterns of behavior that uniquely define human decision making and that effective economic policies must take these behaviors as the starting point. This argument is supported by game theory experiments involving humans, closely related primates, and other animals with more limited cognitive ability. The policy focus of the paper is global climate change. The research surveyed in this paper suggests that the standard economic approach to climate change policy, with its almost exclusive emphasis on rational responses to monetary incentives, is seriously flawed. In fact, monetary incentives may actually be counter-productive. Humans are unique among animal species in their ability to cooperate across cultures, geographical space and generations. Tapping into this uniquely human attribute, and understanding how cooperation is enforced, holds the key to limiting the potentially calamitous effects of global climate change.

Affective and rational consumer choice modes: The role of intuition, analytical decision-making, and attitudes to money ( Andersson, Patric (Dept. of Business Administration, Stockholm School of Economics), Engelberg, Elisabeth (Dept. of Business Administration, Stockholm School of Economics 2007) This paper was motivated by a paucity of research addressing how consumer decision-making is related to beliefs about money and different modes of reasoning. To investigate this issue, data were collected from 142 participants, who filled out questionnaires involving scales aimed to measure affective and rational purchase approaches, intuitive and analytical decision-making styles, as well as money attitudes. One finding was that consumers interchangeably rely on affective and rational approaches when interacting with the marketplace. Another finding was that those approaches were not only related to either intuitive or analytical decision-making styles but also to money attitudes. The findings are argued to provide an impetus to continuous investigation of the role of decision-making styles and money beliefs for consumer choice modes.

The effect of education on cognitive ability   (2007) We analyze whether the amount of schooling influences intelligence as measured by IQ tests. By use of a novel longitudinal dataset we are able to condition on early cognitive ability to account for selection into non-compulsory schooling when estimating the effect on cognitive ability at age 20. OLS estimates indicate that one year of schooling increases IQ by 2.8-3.5 points (about 0.2 standard deviations). When family income per family member and teacher evaluations of the individuals at age 10 are used as instruments for schooling and early cognitive ability, the return to schooling is estimated to 3.5-3.8 IQ points.

Trust Responsiveness: On the Dynamics of Fiduciary Interactions (Vittorio Pelligra)

Trust and trustworthiness are key elements, both at the micro and macro level, in sustaining the working of modern economies and their institutions. However, despite its centrality, trust continues to be considered as a &ldquo;conceptual bumblebee&rdquo;, it works in practice but not in theory. In particular, its behavioural rationale still represents a puzzle for traditional rational choice theory and game theory. In this paper &ldquo;trust responsiveness&rdquo;, an alternative explanatory principle that can account for trustful and trustworthy behaviour, is proposed. Such principle assumes that people can be motivated to behave trustworthily by trustful actions. The paper discusses the philosophical roots, the historical development, as well as the relational nature of this principle as well as its theoretical implications.

Trust  This paper investigates trust in situations, where decision-makers are large groups and the decision-mechanism is collective, by developing a game to study trust behavior. Theories from behavioral economics and psychology suggest that trust in such situations may differ from individual trust. Experimental results here reveal a large difference in trust but not in trustworthiness between the individual and collective setting. Furthermore, an artefactual field experiment captures the determinants of collective trust behavior among two cohorts in the Swedish population. One result is that beliefs about the other and the own group are strongly associated with collective trustworthiness and trust behavior.

Veil of Ignorance:  (2007) We implement the Rawlsian thought experiment of a veil of ignorance in the laboratory which introduces risk and possibly social preferences. We find that both men and women react to the risk introduced by the veil of ignorance. Only the women additionally exhibit social preferences that reflect an increased concern for equality. Our results for women imply that maximin preferences can also be derived from a combination of some, not necessarily infinite risk aversion and social preferences. This result contrasts the Utilitarians' claim that maximin preferences necessarily represent preferences with infinite risk aversion.

Men, women and risk Conclusion

Whether the disposition effect is due to cognitive illusion (such as loss aversion) or rational behavior (mean-reversion) remains unsettled. Yet the experiment in this paper shows that girls do not keep losing stocks and sell winners as the reference point shifts from the purchasing price to the previous price. We speculate this might be related to the fact that male and female brains interpret changing reference points differently.

: Heuristics [Image][Image]

:Prudential Study on Behavioral investing: Understanding Behavioral Risk in The Retirement Red Zone (2007)

1 Prudential Financial has identified a critical time period for retirement investors&mdash;The Retirement Red Zone.

&bull; If you plan to retire within five years, or have retired less than five years ago, you are in The Retirement Red Zone.

&bull; The Retirement Red Zone represents an important time for Americans to both strengthen their retirement savings and protect against key risks.

2 Certain risks confront investors in The Retirement Red Zone:

&bull; Longevity Risk &ndash; People are living longer and need to ensure they have the means to generate a lifetime of income.

Investors need to grow their assets far longer than any previous generation.

&bull; Sequence Risk &ndash; Unpredictability of negative market performance within The Retirement Red Zone can have negative effects on retirement assets. Negative performance during this time can greatly reduce the level of assets counted on for later in life.

&bull; Behavioral Risk is the risk that emotionally driven behavior can have an adverse affect on investment decisions.

3 Behavioral risk is an often overlooked challenge to retirement investors:

&bull; The findings of this study show behavioral risk affects nearly all investors to some degree. Three out of four individuals (76%) rate moderate or high on their Retirement Emotion Quotient (EQ) score.

&bull; No single group is free from the influence of behavioral risk. Seventy-two percent (72%) of men and 80% of women have moderate or high EQ scores.

&bull; Yet, only a third of Retirement Red Zone Americans (35%) feel emotions have an impact on their investment decisions.

4 The effects of behavioral risk are witnessed through five distinct emotions or tendencies that are most influential to investors.

&bull; Of the most prominent emotions, 80% and 71% of investors register high or moderate degrees of regret and fear, respectively, that can influence financial decisions.

&bull; Over half display high or moderate degrees of inertia (57%) or susceptibility (58%), and one-third (37%) have high scores for aggressiveness.

&bull; Even at low levels, these five emotions have the potential to influence investors to make less than optimal investment decisions.

5 Behavioral risk can influence investors to react in ways that may not be in their best interests.

&bull; For example, investors influenced by fear are less likely to take managed risks or to plan steps to secure their future.

&bull; Those influenced by aggressiveness may display overly ambitious investing behaviors without adequate risk management.

&bull; Investors experiencing regret are unlikely to take positive future steps toward a secure retirement for fear of regretting their actions.

6 When confronted with the possibility of significant losses within The Retirement Red Zone, investors question their confidence in their retirement planning.

&bull; Eighty-nine percent (89%) of pre-retirees and 80% of retired investors wish they had incorporated better downside protection of their retirement assets.

&bull; Most wish they had planned better as they approached retirement (85% preretired, 63% retired).

&bull; Investors driven by specific emotions (susceptibility or fear) would be even more likely to overreact by taking money out of the stock market, potentially further limiting their chances for financial recovery.

&bull; Eighty percent wondered if there were products that could help protect or manage early retirement portfolio losses.

7 Products that provide both accumulation and income guarantees help mitigate the effects of behavioral risk and improve beneficial investor behaviors.

&bull; Half or more were not aware of guarantees available to either lock in market gains (61%) or to protect against principal losses (46%) on investments used to generate lifetime income.

&bull; Yet three in four (75%) would consider an investment product that could provide various guaranteed protections including guarantees that protect account values, lock in market gains, provide a minimum annual growth rate and

provide lifetime income.

&bull; With the benefit of these guarantees, nearly all would be likely to weather out short-term losses (85%), choose more aggressive investments with greater potential returns (71%) and invest for the longer term (80%).

Difficult Choices: To Agonize or not to Agonize? (2007)Good stuff- though a little heavy at times.

What makes a choice difficult, beyond being complex or difficult to calculate? Characterizing difficult choices as posing a special challenge to the agent, and as typically involving consequences of significant moment as well as clashes of values, the article proceeds to compare the way difficult choices are handled by rational choice theory and by the theory that preceded it, Kurt Lewin's "conflict theory." The argument is put forward that within rational choice theory no choice is in principle difficult: if the object is to maximize some value, the difficulty can be at most calculative. Several prototypes of choices that challenge this argument are surveyed and discussed (picking, multidimensionality, "big decisions" and dilemmas); special attention is given to difficult choices faced by doctors and layers. The last section discusses a number of devices people employ in their attempt to cope with difficult choices: escape, "reduction" to non-difficult choices, and second-order strategies.

"a choice whose outcome is likely directly to affect the agent's own life and career is more difficult than a choice whose outcome is likely directly to affect the lives of many people other than the agent's &ndash; even when the effect on the lives of the many might be momentous."

"The costs of choice are the costs of coming to closure on some action or set of actions. They are of diverse kinds: time, money, unpopularity, anxiety, boredom, agitation, anticipated ex-post regret or remorse, feelings of responsibility for harm done to self or others, injury to self-perception, guilt, or shame. The costs of error relate to achieving suboptimal outcomes, whatever the criteria for deciding what is optimal.

These costs are assessed by examining the number, the magnitude, and the kinds of possible mistakes. The anticipated costs constitute an important motivation for the adoption of "second-order decisions," meaning decisions about an appropriate strategy for avoiding decisions or for reducing the difficulties associated with making them. Sometimes, second-order strategies are a response to motivational difficulties rather than to cognitive problems; people try, for example, to counteract their own tendencies toward impulsiveness, myopia, and unrealistic optimism. (Weinstein 1987) A second-order decision is made when people choose one from among several possible strategies: when they adopt a firm rule or a softer presumption; when they create standards and follow routines; when they delegate authority to others; when they take small reversible steps; when they pick rather than choose.12

People frequently adopt rules, presumptions, or self-conscious routines in order to guide decisions that they know might be too difficult or costly to make, or might be made incorrectly because of their own motivational problems.

Herding behavior - (NY Times 2007) When making changes in their portfolios, people pay a great deal of attention to what their neighbors are doing.  There is the  likelihood that a household would follow the lead of other investors was greatest when they lived nearby. It tended to shrink quickly as the distance grew.

One possible cause of this pattern is that investors &mdash; by word of mouth, whether over the garden fence or at the gym &mdash; learn which stocks their neighbors are buying and then tend to favor those stocks themselves.

But the professors also looked into other possible causes, including the fact that some local economies are dominated by a single company or industry. In Silicon Valley, for example, investors are more apt to buy tech stocks than investors elsewhere, even if they never talk to one another about the latest hot software company.

Is the word-of-mouth effect necessarily bad? You may be inclined to think so, especially if you have a statistical bent. But the professors are careful to stress that your neighbors&rsquo; influence may have some benefits. It may be that in an increasingly complex world, word of mouth is an efficient, inexpensive way to find out about promising opportunities.

Nevertheless, there are obvious pitfalls to basing stock selections on what your neighbors are buying. One that the professors addressed is its effect on portfolio diversification. When we discuss the latest hot stocks with our neighbors, it&rsquo;s unlikely that we will talk about more than just a handful of companies. As a result, this word-of-mouth effect is likely to make our portfolios too concentrated in just a few stocks. All other things being equal, underdiversified portfolios tend to be riskier than those with a broader sampling of stocks.

Are Risk Aversion and Impatience Related to Cognitive Ability? (2007)

Is the way that people make risky choices, or tradeoffs over time, related to cognitive ability? This paper investigates whether there is a link between cognitive ability, risk aversion, and impatience, using a representative sample of the population and incentive compatible measures. We conduct choice experiments measuring risk aversion, and impatience over an annual time horizon, for a randomly drawn sample of roughly 1,000 German adults. Subjects also take part in two different tests of cognitive ability, which correspond to sub-modules of one of the most widely used IQ tests. Interviews are conducted in subjects' own homes. We find that lower cognitive ability is associated with significantly more impatient behavior in the experiments, and with greater risk aversion. This relationship is robust to controlling for personal characteristics, educational attainment, income, and measures of credit constraints. We perform a series of additional robustness checks, which help rule out other possible confounds.

* individual measures of risk aversion and impatience predict a wide range of important economic outcomes

Do the right thing: But only if others do so  (2007) Social norms play an important role in individual decision making. Bicchieri (2006) argues that two different expectations influence our choice to obey a norm: what we expect others to do (empirical expectations) and what we believe others think ought to be done (normative expectations). Little is known about the relative importance of these two types of expectation in individuals&rsquo; decisions, an issue that is particularly important when normative and empirical expectations are in conflict (e.g., high crime cities). In this paper, we report data from Dictator game experiments where we exogenously manipulate dictators&rsquo; expectations in the direction of either selfishness or fairness. When normative and empirical expectations are in conflict, we find that empirical expectations about other dictators&rsquo; choices significantly predict a dictator&rsquo;s own choice. However, dictators&rsquo; expectations regarding what other dictators think should be done do not have a significant impact on their decisions. Our findings about the crucial influence of empirical expectations are important for those who design institutions or policies aimed at discouraging undesirable behavior.

* research suggests that people tend to do what they believe others who are similar to them would do in a similar situation

Yet expecting others to follow a pro-social norm may not be a compelling reason to conform. Because social norms usually prescribe behavior that may be in conflict with narrow, self-interested motives, sometimes such expectations will encourage defection.

A normative expectation is the belief that others expect one to conform to a given norm1. This is not simply a second-degree empirical expectation; a normative expectation involves the beliefs that others think one ought to conform to the norm in the appropriate circumstances, that one has an obligation to do so. For some individuals, recognizing the legitimacy of others&rsquo; expectations, and thus their disapproval of norm violation, is enough to induce a preference for conformity.

Other individuals need further inducements such as the possibility of monetary sanctions by those who expect (and want) their conformity. When a norm is largely followed, one&rsquo;s expectation regarding what people will do is often in line with one&rsquo;s expectation regarding what people think one ought to do. In this case, normative and empirical expectations work in the same direction and motivate the same behavior. For example, when most of your neighbors recycle, you form the empirical expectation that people do recycle. At the same time, your normative expectation is also that people think you should recycle. Thus, the presence of both expectations makes it more likely that you will recycle.

On the other hand, when a norm is largely violated we may experience an inconsistency between normative and empirical expectations. An example is corruption. Even in the presence of laws and social norms condemning corruption, the widespread occurrence of bribery and kickbacks can induce people to form empirical expectations that most people are corrupt, while simultaneously holding the normative expectation that most people disapprove of corruption. In cases such as this, which expectation might have a greater effect on public officers&rsquo; willingness to accept bribes?

punishment and emotions are two key factors in norm compliance

Who are the Behavioral Economists and what do they say?  The most important financial source for behavioral economics is the Russell Sage Foundation (RSF). The most prominent behavioral economists among the RSF&rsquo;s twenty-six member Behavioral Economics Roundtable (BER) are Kahneman, Tversky, Thaler, Camerer, Loewenstein, Rabin, and Laibson. The theoretical core of behavioral economics made up of the work of these seven researchers is positioned in opposition to Adam Smith/Hayek type of economics, as exemplified by experimental economists Vernon Smith and Plott; and what is referred to as &lsquo;mainstream&rsquo; or &lsquo;traditional&rsquo; economics, meaning the neoclassical economics that roughly builds on Samuelson. On the basis of an overview of the work of these seven behavioral economists, a theoretical division can be observed within behavioral economics. The first branch considers human decision-making to be a problem of exogenous uncertainty, which can be analyzed with decision theory. It employs traditional economics as a nor! mative benchmark and favors a normative-descriptive(-prescriptive) distinction for economics. The second branch considers human decision-making to be a problem of strategic interaction, in which the uncertainty is endogenous. Its main tool is game theory. It rejects traditional economics both positively and normatively.

Gender and Self-Selection Into a Competitive Environment: Are Women More Overconfident Than Men? Using a large running race in Sweden, this study shows that there are male-dominated environments in which the selection of women who participate are more likely to be confident/competitive and that, within this group, performance improves equally for both genders.

Weighting Function in the Behavioral Portfolio Theory.   (2007) The Behavioral Portfolio Theory (BTP) developed by Shefrin and Statman (2000) considers a probability weighting function rather than the real probability distribution used in Markowitz&rsquo;s Portfolio Theory (1952). The optimal portfolio of a BTP investor, which consists in a combination of bonds and lottery ticket, can differ from the perfectly diversified portfolio of Markowitz. We found that this particular form of portfolio is not due to the weighting function. In this article we explore the implication of weighting function in the portfolio construction. We prove that the expected wealth criteria (used by Shefrin and Statman), even if the objective probabilities were deformed, is not a sufficient condition for obtaining significantly different forms of portfolio. Not only probabilities but also future outcomes have to be transformed.

Individual Risk Attitudes: New Evidence from a Large, Representative, Experimentally-Validated Survey This paper presents new evidence on the distribution of risk attitudes in the population, using a novel set of survey questions and a representative sample of roughly 22,000 individuals living in Germany. Using a question that asks about willingness to take risks in general, on an 11-point scale, we find evidence of heterogeneity across individuals, and show that willingness to take risks is negatively related to age and being female, and positively related to height and parental education. We test the behavioral relevance of this survey measure by conducting a complementary field experiment, based on a representative sample of 450 subjects, and find that the general risk question is a good predictor of actual risk-taking behavior. We then use a more standard lottery question to measure risk preferences in our sample of 22,000, and find similar results regarding heterogeneity and determinants of risk preferences, compared to the general risk question. The lottery question also makes it possible to estimate the coefficient of relative risk aversion for each individual in the sample. Using five questions about willingness to take risks in specific domains - car driving, financial matters, sports and leisure, career, and health - the paper also studies the impact of context on risk attitudes, finding a strong but imperfect correlation across contexts. Using data on a collection of risky behaviors from different contexts, including traffic offenses, portfolio choice, smoking, occupational choice, participation in sports, and migration, the paper compares the predictive power of all of the risk measures. Strikingly, the general risk question predicts all behaviors whereas the standard lottery measure does not. The best predictor for any specific behavior is typically the corresponding context-specific measure.

Overcoming Biases to Promote Wise Investing, .(2008)

Financial literacy and stock market participation  Individuals are increasingly put in charge of their financial security after retirement. Moreover, the supply of complex financial products has increased considerably over the years. However, we still have little or no information about whether individuals have the financial knowledge and skills to navigate this new financial environment. To better understand financial literacy and its relation to financial decision-making, we have devised two special modules for the DNB Household Survey. We have designed questions to measure numeracy and basic knowledge related to the working of inflation and interest rates, as well as questions to measure more advanced financial knowledge related to financial market instruments (stocks, bonds, and mutual funds). We evaluate the importance of financial literacy by studying its relation to the stock market: Are more financially knowledgeable individuals more likely to hold stocks? To assess the direction of causality, we make use of questions measuring financial knowledge before investing in the stock market. We find that, while the understanding of basic economic concepts related to inflation and interest rate compounding is far from perfect, it outperforms the limited knowledge of stocks and bonds, the concept of risk diversification, and the working of financial markets. We also find that the measurement of financial literacy is very sensitive to the wording of survey questions. This provides additional evidence for limited financial knowledge. Finally, we report evidence of an independent effect of financial literacy on stock market participation: Those who have low financial literacy are significantly less likely to invest in stocks.

Reinforcement Learning and Investor Behavior* (2008) What affects individual investors&rsquo; willingness to invest in an asset? This paper presents evidence that &mdash; when there is no salient reference purchase price &mdash; investors tend to be return chasers and variance avoiders with respect to their idiosyncratic history with the asset.

Investors are reluctant to sell assets that have fallen below their purchase price and more likely to sell assets that have risen above their purchase price. This behavior is anomalous because the asset&rsquo;s purchase price is investor-specific and already sunk, and hence should not affect the selling decision in the absence of capital gains taxes.2 Odean (1998) shows that investors are also more likely to buy additional shares of stocks they already own if they have unrealized losses in those stocks. The most common explanation for the disposition effect is that prospect theory preferences (Kahneman and Tversky, 1979) cause investors to experience disutility from making a sale below the &ldquo;reference price&rdquo; at which they bought the asset, and to be risk-seeking for assets that are mentally classified in the loss domain.

we find that an investor&rsquo;s 401(k) contribution rate increases more if she has recently experienced a higher 401(k)  portfolio return and/or a lower 401(k) return variance. We find no evidence that this behavior is welfare-improving. These results are explained by a naïve reinforcement learning heuristic: investors expect that investments in which they experienced past success will be successful in the future, whether or not such a belief is logically justified. Consistent with reinforcement learning&rsquo;s Power Law of Practice, return chasing and variance avoidance diminish with age.

* we find no evidence that high past 401(k) alphas predict high future 401(k) alphas. If anything, a high alpha in the current year predicts a low alpha in the following year.

Our findings are explained by a naïve reinforcement learning heuristic: investors expect that investments in which they personally experienced past success will be successful in the future, whether or not such a belief is logically justified.

Past return performance positively affects estimates of future return performance through reinforcement learning. In the absence of a  reference price, these beliefs induce return chasing and variance avoidance. However, once a reference price becomes salient, the loss aversion induced by prospect theory preferences is activated and dominates the reinforcement learning effect, leading to reluctance to close out losing positions and a propensity to increase risk-taking in those securities.

Our paper is also related to the large literature finding that investors chase mutual fund returns.

Papers have studied how learning improves investing skill, as manifested in higher portfolio returns or decreasing strength of the disposition effect (Nicolosi, Peng, and Zhu, 2004; Feng and Seasholes, 2005; Seru, Shumway, and Stoffman, 2006). In contrast, our paper focuses on how investors update their portfolios in response to irrelevant information, although we do find that this responsiveness attenuates with experience

* We see that, if anything, a good 401(k) portfolio performance this year predicts poor performance the following year

In the 2001 Survey of Consumer Finances, among 401(k)- holding households earning between $20,000 and $70,000 a year&mdash;a sample roughly comparable to the one we use in our analysis&mdash;the median household has gross non-retirement financial assets equal to only 2.1 months of income, 76% of which is held in checking, savings, or money market accounts.21 It is only at the 82nd percentile that households have one year&rsquo;s income in gross non-retirement financial assets. These figures probably overstate outside asset holdings in our sample because the generosity of our 401(k) plans&rsquo; early withdrawal and loan provisions substantially mitigates the need for a precautionary wealth stock outside the 401(k).

We have presented evidence that when there is no salient reference purchase price, individual investors chase their own historical returns and shy away from their own historical return variance. Specifically, we find that investors who experience high returns or low variance in their 401(k) portfolio increase their 401(k) contributions more than workers in the same savings plan who experience low returns and/or high variance. This behavior cannot be accounted for by public news about asset returns, investor fixed effects, wealth effects, or time shocks that are correlated with the tendency to hold equities, bonds, or cash. Moreover, we find no evidence that the return chasing and volatility flight are welfare improving, since 401(k) portfolio performance is not persistent. These results are in sharp contrast to the disposition effect, which induces contrarian behavior when there is a salient reference purchase price. The observed patterns are explained by a naïve reinforcement learning heuristic: assets in  which one has personally experienced success are expected to be successful in the future.

Consistent with reinforcement learning, we also find evidence for the Power Law of Practice: return chasing and volatility avoidance decline with age as a large stock of experience is accumulated, though they remain present throughout the lifecycle.

Causes, consequences, and cures of myopic loss aversion - An experimental investigation (2008) 

Date: 2008-01
By: Gerlinde Fellner (Department of Economics, Vienna University of Economics & B.A.)
Matthias Sutter (University of Innsbruck, Deparment of Public Finance, and University of Goeteborg)
We examine in an experiment the causes, consequences and possible cures of myopic loss aversion (MLA) for investment behaviour under risk. We find that both, investment horizons and feedback frequency contribute almost equally to the effects of MLA. Longer investment horizons and less frequent feedback lead to higher investments. However, when given the choice, subjects prefer on average shorter investment horizons and more frequent feedback. Exploiting the status quo bias by setting a long investment horizon or low feedback frequency as a default turns out to be a successful behavioural intervention that increases investment levels.

  What is Behavioural Economics Like? (2008) Behavioural Economics&rsquo; milestones, Endowment Effect and Loss Aversion, have been recognized as &lsquo;well documented,&rsquo; &lsquo;robust,&rsquo; and &lsquo;important&rsquo; even by the critics. But well documented, robust, and important what? Are these stylized facts, theoretical constructs, or psychological truths? Do they express genuine preferences or are they judgement mistakes? We discuss the problems with the nature of these claims in the lights of the goals of Behavioural Economics: to improve economics&rsquo; realisticness and to be considered mainstream. We argue that, under sensible interpretations of Loss Aversion and Endowment Effect, Behavioural Economics is neither more realistic than, nor part of the mainstream

What Does Economics Assume About People&rsquo;s Knowledge? Who knows? (2008) 

The purpose of the paper is to explore, from an assessment viewpoint, the ideas below. Economics, as a social science, has always considered sets of individuals with assumed characteristics, namely the level of knowledge, although in an implicit way in most of the cases. In this sense, an influential approach in Economics assumed that society, as a global set of individuals, was characterised by a certain level of knowledge that, indeed, could be associated with the one of its representative agent. In fact, an attentive recall of the evolution of these matters in Economics will immediately recognise that, since the very first economic models of the government, it was assumed that the level of knowledge of society, represented by a set of voters, was not the same as the one of the agent being elected, i.e. the government. The irrelevance of the difference in the level of knowledge of economic agents was soon abandoned after some seminal works of Hayek and Friedman. More recently, the viewpoint of Economics has changed by focusing on the characteristics (e.g. knowledge) of individuals, who may interact in sub-sets of society. From this point of view is clearly relevant, given the close connection with the assumed level of knowledge, to distinguish the adaptive behaviour from the rational one, as well as the full rational from the bounded rationality behaviour by people. Quite recent developments in the Economics of Knowledge, i.e. the so-called learning models, have been considered as more realistic approaches to model the process by which individuals acquire knowledge, for instance from other individuals that are, themselves, acquiring knowledge.

What is Behavioural Economics Like? (2008) Behavioural Economics milestones, Endowment Effect and Loss Aversion, have been recognized as well documented,robust and important even by the critics. But well documented, robust, and important what? Are these stylized facts, theoretical constructs, or psychological truths? Do they express genuine preferences or are they judgement mistakes? We discuss the problems with the nature of these claims in the lights of the goals of Behavioural Economics: to improve economics; realisticness and to be considered mainstream. We argue that, under sensible interpretations of Loss Aversion and Endowment Effect, Behavioural Economics is neither more realistic than, nor part of the mainstream


This paper investigates how the presence of strong leadership influences an organization's ability to acquire and process information. The key concept is the leader's decisiveness. A decisive leader can make a bold move in response to a large change in the underlying landscape, whereas an indecisive leader biases her position excessively towards the status quo. An organization led by an indecisive leader needs to accumulate unrealistically strong evidence before it changes the course of action, thereby hindering the organization's ability to adapt to a changing environment. The analysis identifies several attributes and environmental factors that impair one's decisiveness and illuminates how leadership emerges or fades in organizations. The paper also sheds light on a classical issue of whether leaders can be made, rather than are born: our answer is partially `yes' in that mutual trust among members of the organization is a critical ingredient of effective leadership.

:No harm, no foul: The outcome bias in ethical judgments

Two studies investigated the influence of outcome information on ethical judgment. Participants read a series of vignettes describing ethically-questionable behaviors. We manipulated whether those behaviors were followed by a negative or positive consequence. As hypothesized, participants judged behavior as less ethical when it was followed by a negative consequence. In addition, they judged the behavior as more blameworthy and to be punished more harshly. Participants’ ethical judgments mediated their judgments of both blame and punishment. The results of the second experiment showed again that participants rated behavior as less ethical when it led to undesirable consequences, even if they saw that behavior as acceptable before they knew its consequences. Implications for both research and practice are discussed.

A Conceptual Model of Investor Behavior
Date: 2008-05-23
By: Lovric, M.
Kaymak, U.
Spronk, J. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)
Based on a survey of behavioral finance literature, this paper presents a descriptive model of individual investor behavior in which investment decisions are seen as an iterative process of interactions between the investor and the investment environment. This investment process is influenced by a number of interdependent variables and driven by dual mental systems, the interplay of which contributes to boundedly rational behavior where investors use various heuristics and may exhibit behavioral biases. In the modeling tradition of cognitive science and intelligent systems, the investor is seen as a learning, adapting, and evolving entity that perceives the environment, processes information, acts upon it, and updates his or her internal states. This conceptual model can be used to build stylized representations of (classes of) individual investors, and further studied using the paradigm of agent-based artificial financial markets. By allowing us to implement individual investor behavior, to choose various market mechanisms, and to analyze the obtained asset prices, agent-based models can bridge the gap between the micro level of individual investor behavior and the macro level of aggregate market phenomena. It has been recognized, yet not fully explored, that these models could be used as a tool to generate or test various behavioral hypothesis

Sensation Seeking, Overconfidence and Trading Activity, (2008) an investor's portfolio turnover rate rose 11 percent after each additional speeding ticket he received.. As people grow older, they are likely to become more conservative drivers &mdash; and, not coincidentally, to trade less often. But he stressed that he and his co-researcher controlled for factors like age when conducting their tests. So one way to interpret their findings is that, between two people of the same age, the one who gets a speeding ticket is likely to have 11 percent more turnover in his portfolio.

while overconfident investors tended to trade more, the trait was not correlated with their number of speeding tickets. the correlation between speeding tickets and more frequent trading was caused by something quite different: thrill-seeking. They found that thrill seekers &mdash; those who look for a new and risky experience just for the fun of it &mdash; trade more often not because they have an inflated belief that they can beat the market, but because they find a static portfolio too boring.

Self-Knowledge and Self-Deception
Date: 2008
By: H. Peyton Young
A person is concerned about self-image if his utility function depends, not only on his actions, but also on his beliefs about what sort of person he is. This dual motivation problem makes it difficult, and in some cases impossible, for someone to learn who he really is based solely on his revealed behavior. Indeed, there are very simple situations, involving just two actions and two possible identities, such that, if there is any initial uncertainty about one's true identity, it will never be resolved even when one has an infinite number of opportunities to act.

Determinants of Risk Taking Behavior: The role of Risk Attitudes, Risk Perceptions and Beliefs

Our study analyzes determinants of investors' risk taking behavior. We find that investors' risk taking behavior, i.e. portfolio choices can be predicted using risk attitudes, risk perceptions and belief measures such as optimism and overconfidence. However, the predictive power of these determinants heavily depends on the domain in which it was elicited. More specifically, risk attitudes, risk perceptions and beliefs only allow us to predict investors' risk taking behavior if they are elicited in an investment related context. We think that our results could also benefit practitioners who could incorporate some of the determinants we have used in their investment advisory process.

DECEPTION AND LYING BEHAVIOR LINK-Attempts have been made to define what lying actually is and these definitions vary. On the whole they consist of the idea of a false communication that is to the benefit of the communicator. A number of reasons are given as to why people lie including to make a goodimpression, to avoid punitive action or for the purpose of gaining an advantage.

1) Defining deception or lying.
2) Why and when do people deceive or lie?
3) What are some of the individual differences in lying?
4) What are the types of deception (lying)?
5) How and why do children practice deception?

There is also the question of whether lying is always wrong and indeed it is not. Zeltzer (2003) emphasises the value of lying or not be totally honest in ones dealing with others as a form of lubrication of socialisation. Telling a white lie, or “therafibbing” can be of value.

The distinction between misinformation and disinformation becomes especially important in political editorials, and advertising contexts where deliberate efforts are made to mislead, deceive, or confuse an audience in order to promote personal, religious, or ideological objectives. The difference consists in having an agenda. This bears comparison with lying because ‘lies’ are assertion that are false, that are known to be false, and that are used with the intention to mislead (Fetzer, 2004). They are also meant to confuse. As already mentioned earlier, deceiving oneself can also culminate into the fear of deception. Barnes (2004) indicates that the term ‘lie’ has a broad range of meaning; like many other recent writers on lying, not all forms of deception are lying and it is cited that a dictionary definition of a lie is but one component of what is the 57intention to deceive; the other component being a statement that the liar believes to be untrue.

Lying is most likely to occur in those who adopt what is termed the “Machiavellian approach to life,” i.e. being opportunistic and adapting any kind of behaviour necessary to get what one seeks.

Participants reported telling their serious lies to get what they wanted or to do what they thought they were entitled to do, or to avoid punishment. Lies also occurred to protect oneself from confrontation, in an attempt to appear to be the type of person they wish they were, to protect others, and to hurt others. The degree to which the liars and the targets felt distressed about the lies differed significantly across these different types of lies. Similar results were obtained by Grover (1997) in an earlier study indicating that self interest was the major reason for deception or lying.

Measuring Trust

We measure trust and trustworthiness in British society with an experiment using real monetary rewards and a sample of the British population. The study also asks the most typical survey question that aims to measure trust, showing that it does not predict ‘trust’ as measured in the experiment. Overall, about 40% of people were willing to trust a stranger in our experiment, and their trust was rewarded one-half of the time. Analysis of variation in the trust behaviour in our survey suggests that trust is more likely if people are older, their financial situation is ‘comfortable’, they are a homeowner, or they are divorced or separated. Trustworthiness is less likely if a person’s financial situation is perceived by them as ‘just getting by’ or difficult.

The psychology of financial markets: Keynes, Minsky and emotional finance
Date: 2008-05
By: Sheila Dow (SCEME, University of Stirling)
Keywords: uncertainty, Keynes, Minsky, emotional finance
JEL: B41
Good stuff

Cognitive Abilities and Behavioral Biases
Date: 2008-05
By: Oechssler, Jörg (University of Heidelberg)
Roider, Andreas (University of Heidelberg)
Schmitz, Patrick W. (University of Cologne)
We use a simple, three-item test for cognitive abilities to investigate whether established behavioral biases that play a prominent role in behavioral economics and finance are related to cognitive abilities. We find that higher test scores on the Cognitive Reflection Test of Frederick (2005) indeed are correlated with lower incidences of the conjunction fallacy, conservatism in updating probabilities, and overconfidence. Test scores are also significantly related to subjects’ time and risk preferences. We find no influence on anchoring. However, even if biases are lower for people with higher cognitive abilities, they still remain substantial.

Strategic Use of Trust
Date: 2008-05-15
By: Maroš Servátka (University of Canterbury)
Steven Tucker (University of Canterbury)
Radovan Vadovic
While most of the previous literature interprets trust as an action, we adopt a view that trust is represented by a belief that the other party will return a fair share. The agent’s action is then a commitment device that signals this belief. In this paper we propose and test a conjecture that economic agents use trust strategically. That is, the agents have incentives to inflate the perceived level of trust (the signal) in order to induce a more favorable outcome for themselves. In the experiment we study the behavior of subjects in a modified investment game which is played sequentially and simultaneously. While the sequential treatment allows for strategic use of trust, in the simultaneous treatment the first mover’s action is not observed and hence does not signal her belief. In line with our prediction we find that first movers send significantly more in the sequential treatment than in simultaneous. Moreover, second movers reward trusting action, but only if it is maximal. We also find that signaling with trust enhances welfare.

Do you do what you say or do you do what you say others do?
Date: 2008-06-12
By: Carlsson, Fredrik (Department of Economics, School of Business, Economics and Law, Göteborg University)
Daruvala, Dinky (Department of Economics, Karlstad University)
Jaldell, Henrik (Department of Economics, Karlstad University)
We design a donations vs. own money choice experiment comparing three different treatments. In two of the treatments the pay-offs are hypothetical. In the first of these, a short cheap talk script was used, and subjects were required to state their own preferences in this scenario. In the second, subjects were asked to state how they believed an average student would respond to the choices. In the third treatment the pay-offs were real, allowing us to use the results to compare the validity of the two hypothetical treatments. We find a strong hypothetical bias in both hypothetical treatments where the marginal willingness to pay for donations are higher when subjects state their own preferences but lower when subjects state what they believe are other students preferences. The explanation is probably a self-image effect in both cases. We find that it is mainly women who are prone to hypothetical bias in this study.<

Rationalization and Cognitive Dissonance: Do Choices Affect or Reflect Preferences?
Date: 2008-07
By: M. Keith Chen (Yale University)
Cognitive dissonance is one of the most influential theories in psychology, and its oldest experiential realization is choice-induced dissonance. In contrast to the economic approach of assuming a person's choices reveal their preferences, psychologists have claimed since 1956 that people alter their preferences to rationalize past choices by devaluing rejected alternatives and upgrading chosen ones. Here, I show that every study which has tested this preference-spreading effect has overlooked the potential that choices may reflect individual preferences. Specifically, these studies have implicitly assumed that subject's preferences can be measured perfectly, i.e., with infinite precision. Absent this, their methods, even with control groups, will mistakenly identify cognitive dissonance when there is none. Correctly interpreted, several prominent studies actually reject the presence of choice-induced dissonance. This suggests that mere choice may not always induce rationalization, a reversal that may significantly change the way we think about cognitive dissonance as a whole.

Do We Follow Others When We Should? A Simple Test of Rational Expectations
Date: 2008-07
By: Weizsäcker, Georg (London School of Economics)
The paper presents a new meta data set covering 13 experiments on the social learning games by Bikhchandani, Hirshleifer, and Welch (1992). The large amount of data makes it possible to estimate the empirically optimal action for a large variety of decision situations and ask about the economic significance of suboptimal play. For example, one can ask how much of the possible payoffs the players earn in situations where it is empirically optimal that they follow others and contradict their own information. The answer is 53% on average across all experiments – only slightly more than what they would earn by choosing at random. The players’ own information carries much more weight in the choices than the information conveyed by other players’ choices: the average player contradicts her own signal only if the empirical odds ratio of the own signal being wrong, conditional on all available information, is larger than 2:1, rather than 1:1 as would be implied by rational expectations. A regression analysis formulates a straightforward test of rational expectations, which rejects, and confirms that the reluctance to follow others generates a large part of the observed variance in payoffs, adding to the variance that is due to situational differences.

Is mistrust self-fulfilling?
Date: 2008-05
By: Reuben, Ernesto
Sapienza, Paola
Zingales, Luigi
We study experimentally the effect of expectations on trustworthiness. Most subjects respond with untrustworthy behavior if they find out that little is expected from them. This suggests that guilt aversion plays an important role in inducing trustworthiness.

Behavioral finance right and wrong: (Reuters 2008) 

Herd mentality rules during a financial crisis because people are wired to follow the crowd when times are uncertain

Brain and behavior studies clearly show that when information is scarce and threats seem imminent, people often stop listening to their own logic and look to see what others are doing.

"People are afraid, and the reason they are afraid is there tremendous uncertainty right now in the markets," Gregory Berns, a neuroeconomist at Emory University in Atlanta who studies the biology of economic behavior, said in a telephone interview.

Berns puts people in magnetic resonance imaging or MRI scanners while he tests their responses to various scenarios, and studies patterns of their brain activation.

One clear pattern -- the brain's "fear center" lights up when people are uncertain.

"When people are presented with a situation where they don't have information or the information is ambiguous, we see activation of the amygdala and insula,"

EFM Wrong- to a point. You see heard mentality at McDonalds, Burger King et al when people are clearly aware of what will happen (not necessarily- people rationalize just about anything no matter the repercussions). They  are going to get really fat and hurt their health. But people just aren't that bright- or if they are- refuse to do the reading and thinking to put an objective analysis to the situation. People's brains light up when they think it is going to taste good, feel good, etc. Think about the Dot com. Didn't they all 'feel good' about all the money they were making- while a prudent man had to look at it and say, 'this makes no sense'.

What about the mess we are in. Forgetting for a moment the fraud, people took on mortgages that any prudent person would have recognized would not work in  the the real world had they initiated any formal thought process. But their brains lit up in the illogical premise they could buy a house with no money down, no credit and that the prices would escalate ad infinitum.

Now the rest of us are going to bail them out? No we don't want to. But the 'bailout package' indicates all sorts of measure to prevent foreclosures. We do need some package, but I do  not like the idea of giving money to people who had not thought anything through at all. And the banks should have to eat the loans. And any mortgage broker committing fraud or greed should be fined AND put in jail

A package is needed but it does not have to be what was presented.

When Herding and Contrarianism Foster Market Efficiency : A Financial Trading Experiment (2008)
While herding has long been suspected to play a role in financial market booms and busts, theoretical analyses have struggled to identify conclusive causes for the effect. Recent theoretical work shows that informational herding is possible in a market with efficient asset prices if information is bi-polar, and contrarianism is possible with single-polar information. We present an experimental test for the validity of this theory, contrasting with all existing experiments where rational herding was theoretically impossible and subsequently not observed. Overall we observe that subjects generally behave according to theoretical predictions, yet the fit is lower for types who have the theoretical potential to herd. While herding is often not observed when predicted by theory, herding (sometimes irrational) does occur. Irrational contrarianism in particular leads observed prices to substantially differ from the efficient benchmark. Alternative models of behavior, such as risk aversion, loss aversion or error correction, either perform quite poorly or add little to our understanding.