Psychology, Financial Decision Making, and Financial Crises

Question 1

Economic Risk Taking:

• different kinds
• risk events
• mediators

Answer 1

Distinction betwen

• instrumental risk taking (e.g. investing) - oriented towards future benefits
• and stimulating risk taking (e.g. gambling) - more present time oriented

definition of risk-events:

• probability of decision outcome (expected-utility theories)
  
  • e.g. lottery (probablility of wnning is known)
• uncertainty if no quantitive value can be expressed
  
  • e.g. investing (probability is unknown)
• risk taking is domain specific (financial risk taking is completely different for health risk taking)
• mediators are risk perception, risk attitude (e.g. assymetric risk attitude), and risk propensity, also personality and situational factors

Question 2

Risk Perception

• concept
• factors

Answer 2

• people are more influenced by perceived risk than by objective risk
• concept: risk perception is a subjective construct influenced by how an event is interpreted
• factors:
  
  1. degree of situational uncertainty,
  2. controllability of that uncertainty,
  3. confidence in these previous estimates
     
     • outcome of genuine uncertainty, lack of knowledge and seriousness of possible consequences
• risk perception is a cognitive assessment… also influenced by affects (fear, regret and optimism), it is susceptible to cognitive biases (e.g. overconfidence)

Question 3

Cognitive biases: overconfidence

• consequences

Answer 3

• believing that their knowledge is more accurate than it is
• think their abilities are above average
• illusion of control
• excessive optimism
• with experience: tendency to focus on successes instead o situational factors, rely on routines, won’t process all relevant informations
• result: underestimate actual risks

Question 4

Risk Propensity

• definition
• measurements
• risk avoiders v. risk seekers

Answer 4

• general behavioural tendency to take or avoid risk
  
  • closely related to actual risk taking behaviour
  • determined by perceived risk, risk attitude, and price consciuousness
• Kogan and Wallach developed the Choice Dilemma Questionnaire (CDQ) now used to assess risk propensity as well
  
  • Weber et al. (2002) developed a domain specific risk propensity scale (distinguishes investing and gambling)
  • Meertens and Lion (2008) devloped a risk propensity scale to distinguish risk takers and risk avoiders (not domain specific)
• risk avoiders are more likely to attend to negative outcomes and overestimate probalility of losses relative to gains
  
  • they require a higher probability of gains to tolerate possibility of losses
• similar distinction as in regulatory focus theory between prevention and promotion focus (striving for positive outcomes)
• risk propensity is relatively stable over time unless a pattern of risk taking is proven unsuccessful (negative outcomes lead to change)

Question 5

Sociodemographic factors on risk taking

Answer 5

• women are less risk taking than men
  
  • tend to own less risky assets than single men
  • reduce assets with more children
• parenthood seems to reduce risk taking
• older people take less risk
• lack of financial knowledge or motivation to gain this knowledge is a big factor
  
  • tendency to buyfinancial products that do not meet their financial needs or budgets
• half or variance for economic risk taking seems to be genetic

Question 6

Personality factors on risk taking:

• sensation seeking,
• extraversion
• impulsivity,
• opennnes to experience
• conscientiousness
• anxiety
• neuroticism

Answer 6

• sensation seeking (need to arouse central nervous system) - tend to take more and larger risks
• extraversion is positively asscoiated with sensation seeking adn young people are more likely to be extraverted which may explain why young people take more risks
• impulsive individuals take more risks because they do not analyze all choice alternatives
  
  • want to decide quickly to enjoy the benefits of the chosen alternative, avoid effort of trading off alternatives, and opportunity costs of processing more information
  • impulsivity is higher order personlity trait of openness to experience and conscientiousnes (higher in openness and lower in conscientiousness)
• openness is related to a need for arousal thus higher risk propensity
• conscientiousness is related to processing more information and focusing on the most certain alternative
• impulsivity i also related to time preference
  
  • present-time preference is related to spending moneay immediately instead of saving for the future
  • future time preference (low-time preference) are willing to delay gratification, prefer to save
• trait anxiety, closest relation with risk taking
  
  • bias to processing threatening information (biased risk perception)
  • those with low extraversion and high trait anxiety have a risk avoiding propensity

Question 7

Confidence

• situational factors

Answer 7

• optimism v. pessimism
• in time of financial crises peope are less confident and more pessimistic about the future
  
  • subsequently, they avoid risky decisions with great consequences (buying houses, cars, save more take less credits, prefer to pay back loans)
• in economic upswing people are more optimistic
  
  • just the opposite
• optimism may also be stable (dispositional optimism)
  
  • strong relation with entrepreneurship (entrepreneurs are also more risk tolerant)
  • more risk seeking

Question 8

Summary Nr. 1:

Answer 8

• risk taking is mediated by risk perception, risk attitude, and risk propensity
• people high in sensation seeking and openness to experience take more and higher risks
• people high in conscientiousness, anxiety, and neuroticism take fewer
• women, parents and older people also take less risks
• overconfidence and optimism can lead people to take more risks with sometimes diasastrous consequences
  
  • crises may be more conseqquential for those who tke more risks

Question 9

What are the three biases in Financial Decision Making that will be discussed here?

Answer 9

1. difference between subjective and objective value of money
2. framing of outcomes as gains or losses (assymetric risk attitudes)
3. loss aversion

Question 10

What is known about the subjective value of money?

Answer 10

• Bernoullie stated that money has a subjective value that differs from its nominal value
  
  • that the subjective value of money increaes with its nominal value according to a concave logarithmic function
  • Galanter (1990) showed a similar function was true for losses, even though Kahneman and Tversky (1992) showed that for losses its twice as steep
  • concave function referred to as diminishing sensitivity similar to the relation of sound pressure to loudness
  • Chater and Brown (2006) state that a monetary value may be assessed via comparison in long term memory
    
    • so, the greater the values are, the less frequently they are encountered
  • Linville and Fischer (1991) think its because people have limited cognitive and affective resources
• if a certain amount is needed to purchase something specific, its subjective value becomes temporarily higher than it snominal one (so it breaks with the concave form)
  
  • e.g. the break-even effects… a lost aomount of money becomes very attractve to win back

Question 11

How is the monetary value learned and what can the Euro-Experience tell us about it?

Answer 11

• it is conjected that money’s value is linked to its purchasig power in markets
• Marques and Dehaene (2004) tried to distinguish between the rescaling (conversion from domestic currency to euro through multiplication by a multiple or a fraction) and the relearning (relearning product prices in the new currency) hypotheses
  
  • after implementation of euro variability in price estimates by participants decreased with time- indicating that the value of the euro was learned
  • those products (in Austria) that were purchased more often were estimated more precisely quicker
  • rescaling was more often used for exceptional purchases
• Juliusson et al. (2005) hypothesised that learning product prices is only the first stage of the relearning model. in the second stage the reversal of product prices tells people how much their money is worth, however, that is more difficult if the inverse is a fraction than when it is multiple

Question 12

What is the money illusion? And what is the euro-illusion?

Answer 12

• its the tendency to disregard the real value (e.g. purchasing power) of money and instead focus on its nominal value
  
  • inflationary changes are not perceived
  • leads to sometimes sub-optimal decisions
• the euro-illusion is related to the money illusion… its also called the face-value illusion: it means that changes in exchange rate influence price evaluations
  
  • price in euro is perceived cheaper when compared to a currency with higher nominal values (e.g. italian Lire), but more expensive when compared to one that is nominally larger (e.g. German Mark)
    
    • illusion reverses whenif the price is evaluated relative to income or budget
• this illusion could be the result of the numerosity heuristic
  
  • it refers a sensible cognitive oversimplification (e.g. two different cakes usually contain more kalories than one but not necessarily)
• expectation that the euro would lead to higher prices (e.g. Teuro) led people to disregard cheap price conversions and more easily accept higher ones

Question 13

What is meant by loss aversion?

Answer 13

• people’s tendency to dislike losses more than they like gains
  
  • as seen in the steepness of prospect theory’s function of losses
    
    • an even amount of winning or losing a small amount of money is therefore preferred to an even chance of winning or losing a large amount
    • example of loss averson is the endowment effect
  • Kahneman and Novemsky (2005) argue that loss aversion is only invoked when spending a certain amount is above one’s budget, not when it is within it

Question 14

What’s the endowment effect?

Answer 14

• a form of loss aversion in which people demand higher prices to sell something they own than they are willing to pay for buying it
  
  • it is immediate but it increases with the length of possession
  • it is reduced if a negative mood was induced shortly before the product was bought (Small and Loewenstein, 2004)
  • perhaps buyers perceive paying price as a loss but sellers perceive losing the benefit of the good as a loss

Question 15

What is the expected-utility theory?

Answer 15

• a normative theory on financiaal descision making, developed in the 1940s and 50s (Von Neumann)
• expected value is the sum that could be won times the probability that it will be won
  
  • surely winning 10€ or winning 1000€ with a probability of 0.01% have the same expected value
• risk attitude derives from this theory
  
  • in the example above, someone that is indifferent to either choice has a neutral risk attitude, someone who prefers sure 10€ is risk averse, and one who prefers 1000€ with a probability of 0.01% is risk seeking
• however, prospect theory claims that this value function is not linear but nonlinear

Question 16

What, then, is prospect theory?

• inlcuding reflection effect (assymetric risk attitudes)

Answer 16

• developed by Kahnemann and Tversky (1979)
• probably the most famous of what are referred to as the nonexpected- or generalised-utility theories
• it accounts for assymetric risk attitudes which refers to the finding that evaluations differ depending on whether they are coded as losses or gains…
  
  • for gains: less risky outcomes are preferred (risk verse)
  • for losses: more risky outcomes are preferred (risk seeking)
  • this is called the reflection effect
  • prospect theory account for this effect with its concave value function for gains but convex value function for losses
• in prospect theory the function for losses is twice as steep as the function for gains

Question 17

What are typical reactions to splits or reverse splits of stock shares?

Answer 17

• the split or reverse split does not cause the owner to receive more or less money, hence, it would not be logical to increase trading after a split
  
  • however, there is a tendency for these shares to go up after a split and g down after a reverse split
• signaling explanation says that a split contains information about future company values
  
  • however, this effect occurs on the day of announcement and on day of implementation
• trading-range explanation links splits to past rather than future performance
• money illusion states that nominal repressentation of money influences people’s percetion of money’s real value.
  
  • hence buyers would perceive the stock to be cheaper or more expensive after split/ reverse split
  • momentum investment strategy makes buyers less likely to buy low value shares
  • disposition effect sellers would be unwilling to sell when perceived as a loss, but after a reversed split they would be willing as it is experienced as a gain

Question 18

What is meant with naive risk diversification, what are its causes and why is it problematic.

Answer 18

• it is the allocation of money in different funds without concern for covariation
  
  • stocks of the same country are more likely to covary (Siemens covaries with the overall DAX)
  • so if one stock goes down the other one is likely to do the same, hence risk is not balanced out
• a cause may be the variety inducing diversification heuristic which refers to peoples tendency to prefer variety over the same, it just may fail to reduce risk if covariation is neglected
• maximum entropy heuristic is people’s tendency to allocate share evenly between stocks without considering their beliefs and preferences (often 80-20 is a more nuanced approach)
• education can reduce naive risk diversification and naive risk diversification is still better than no diversification

Question 19

In prospect theory, ther three deviations from the expected-utility theory.

1. reflection effect (it concave and convef value functions)
2. function for losses is twice as steep as for gains
3. and…?

Answer 19

• in contrast to multiplying evaluations times the objective probability, people multiply them with decision weights (subjective probability)
  
  • decision weights are nonlinearly related to probabilities
  • there are also second order probabilities (the certainty in a certain probability) that affects decision weights…
    
    • when certainty decreases or emotional content increases, the function becomes less steep, meaning decision weights are less important for the evaluation of choice alternatives.
  • when probability of outcome is large risk attitude shows the dicussed assymetry (risk aversion fir gains, risk seeking for losses)

Question 20

What is framing by Kahnemann and Tversky?

Answer 20

• based on the observation that a reference point may shift in a way that a gain appears to be a loss and a loss a gain
  
  • due to the reflection effect framing something as a loss leads to riskier choices than framing something as a gain
• whether a loss frame (reference point is the gain) or a gain frame (reference point is receiviing nothing) is adopted determines the evaluation

Question 21

How may different mental accounts be used by people?

Answer 21

• Tversky and Kahnemann proposed that coding (framing) of outcomes is made in seperate mental accounts
  
  • this violates the basic assumption that money is exchangeable (fungibility)
  • ist a set of elementary outcomes which are evaluated jointly, reference outcome that is considered neutral
  • participants were less likely to buy a new theater ticket if they had lost one than if they had lost the equivalent amount of money
• Shefrin and Thaler think there are higher order mental accounts, which are part of people’s financial knowledge (current income, current assets, and future income)
  
  • can be divided into subaccounts, or into categories specific to particular decisions as suggested by Kahnemann
  • what is gained through labeling them in this way? maybe self-control. propensity to consume is believed to be highest in current income, than in current assets and lowest in future income
    
    • this self-control strategy is less costly than pure willpower

Question 22

What is the disposition effect?

Answer 22

• selling winners and buying losers is the momentum investment strategy
  
  • believed to outperform the opposite strategy
• However, investors are disposed to sell winners too soon and hold losers too long
• in line with prospect theory: investors shall be risk averse when selling winners and risk seeking when selling losers
  
  • furthermore losses are disliked more than gains which increases the latter effect (loss aversion)
  • it is also more the reluctance to sell (if they did not have them, they would not buy them)
• disposition effect mainly obsrved for sellers while buyers seem to use the momentum investment strategy
• information searching bias reinforces disposition effect …
  
  • people avoid negative information (ostrich effect)
  • if news are positive they search more rigorously if its true
• framing place a role… the purchase price is usually the reference point, this determines whether a selling price is framed as a loss or a gain
  
  • sometimes a reference point is a hoped for price
• disposition effect shall increase trading volume in bullish stock markets (rising prices) due to overselling winners, but decrease trading volume in bearish markets due to holding losers.

Question 23

What is and how does herding work?

Answer 23

• investors tendency to follow each other in buying and selling stocks
  
  • four indirect causes of herding may be:
    
    1. common knowledge
    2. fads. (Buying popular stocks).
    3. common investment strategies
    4. similar compensation schemes. (investment firms often reward performane relative to that of others so they may earn less if they deviate a lot from markets)
  • direct causes may be
    
    • information cascades (choices based on observation of other people’s choices)
    • reputational herding (conform to other people’s choices lest they don’t impair their own reputation)
  • herding may be rational because:
    
    • other’s actions may convey useful information
    • wisdom of a crowd … aggregate collective judgements are moe accurate than individuals
  • tendency to follow others is highest in times of excessive uncertainty
  • also younger peope have a stronger tendency to follow (concern about reputation)

Question 24

Consumer confidence in financial crises.

Answer 24

• first index: Index of Consumer Confidence developed in US 1975 by Katona
  
  • macro psychology… aggregation of individuals’ evaluation and expectation of the state of the economy (optimism/pessimism)
• people are more optimistic about their own situation than about the general economy, confidence in own situation is more influenced by e.g. income changes
• pessimistic consumers will spend less, save more and are more inclined to repay debts
  
  • this decrease in spending leads to fewer sales of the economy thus further fall of the economy: downward spiral

Question 25

How do people cope with adverse financial developments?

Answer 25

• people are accustomed to a certain lifestyle… often it is very difficult to change their lifestyle and cut their expenses
• hierarchy of four curtailing tactics:
  
  1. price: buying same product at cheaper store, buying on sale/special offers
  2. quantity: buying less convenience product, delaying replacements of durable goods (house, car, TV), eating out less, taking fewer vacations
  3. quality:
     
     • high-income households: buy more high quality goods (so they last longer… pays off in long run)
     • low-income households: can only afford low quality, need more replacement, thus more expensive in long run
  4. lifestyle
     
     • most difficult for people, thus comes last
     • inclusdes more household production, selling goods (car), foregoing annual vacation etc.
     • socially unattractive as it shows clearly to others and themselves that they are affected
• people also mauy compensate with savings (if they are optimistic that it will get better)
• older people wth experience can cope better
• pessimistic people reduce their consumption, optimistic people try to maintain lifestyle

Question 26

Countermeasures in financially adverse situations.

Answer 26

• curtailing expenses may be possible when people are taught improved budgeting and mental accounting techniques
  
  • becoming aware of expenses my systematic accounting of them
  • setting targets:
    
    • upper limits for each ctegory (food, eating out, cloths etc.)
  • preferably not using credit cards
  • many people lack motivation to acquire financial knowledge

Question 27

What are determinants of trust in financials institutions?

Answer 27

• There are four dissatisfiers which are determinants of financial trust that are necessary to bring trust from negative to neutral. If these are not satisfied, trust is impssible:
  
  1. Competence
  2. Stability
  3. Integrity
     
     • honesty and carefulness in procedures, treating all customers equally
  4. And Benevolence
     
     • implies that a long term relationship with client (loyalty) is more important than short term gain
     • see and communicate from client’s perspective not only from the bank
  5. Transparency
     
     • openness and clear information. Transparency does not always lead to more trust (e.g. by knowing slaespersons provisions)
  6. Value Congruence
     
     • creates identification (e.g. A Green Bank, Fair Trade etc.)
  7. Reputation
     
     • e.g. Branding: creating positive evaluations through advertisements.
     • also customer experience, reviews, word of mouth etc.
     • positioning: low prices, competence or innovativeness
• The last three determinants are satisfiers, they bring trust from neutral to positive.

Question 28

Overreactions to news

Answer 28

• in efficient-market theory, news are assumed to be the only factor affecting stock-prices
  
  • bad news lead to falling stock prices (negative company reports; fundamentals, financial crises in various markets(e.g. credit or housing), strikes, wars, epidemias)
  • good news leading to rising stock prices (fundamentals, innovations etc.)
• type of overreaction is the extrapolation of price movements
  
  • e.g. future performance of stocks that had been extreme losers tend to outperfrom those that were extreme winners
  • trend extrapolation: because investors tend to overbuy winners and oversell losers they maintain the trend
  • also, overreacton to news is often preceded by underreaction, news have a diagnostic value
    
    • bayes’r rule says that people should be changing their beliefs after hearing news, but they tend to change them less than waaranted (non-bayesian conservatism)
  • possible that news tend to make people underweight previous news
  • news also need to be salient to affect
  • money illusion also plays a role; those that have nominally higher priced shares expected higher percentual gain than thoose with nominally lower priced shares

Question 29

What are affective influences in financial decisions, particularly the stock-market?

Answer 29

• judgement and decisions are affected by predecisional affective states (e.g. current mood, also called incidental affective influence), anticipatory affect (dread, optimism-pessimism), anticipated affect affect associated with decision outcome
• current mood varies in two dimensions:
  
  1. valence from positive to negative
  2. activation to deactivation
     
     • e.g. elation is high on valence and activation
     • disappointment is is low (negative) omn valence and activation
  • research shows that relaxation (high on valence, low on activation) leads to less thorough decision making processthan e.g. “distressed”(low on valence, high on activation)
  • things affecting mood (e.g. cloudy weather) seem to affect stock markets
  • people in positive mood are risk averse because they do not want a decision outcome to ruin their mood
  • people in negative moods tend to take more risks possibly for an outcome to repair their mood
    
    • in line with disposition effect (prior losses result in risk seeking [keeping losers], and prior gains results in risk aversion [selling winners])
    • experiment: give a prior loss one may adpot a loss frame or a gain frame (igrnoring prior losses)
      
      • those in a positive mood were adopting a gain frame and chose to sell
      • those in a negative mood adopted a loss fram and chose to keep the loser, thus disposition effect (keeping losers) was only observed when they were in a negative mood
  • when probability for a decision outcome increased anticipated effect was boosted, and anticipated displeasure form a loss was boosted resulting in disappointment
  • participants wre more likely to invest in sectors that eleicit strong positive effects

Question 30

What are typical repayment experience patterns?

Answer 30

• expected burden is usually smaller than actual perceived burden during the payback time
  
  • perceived burden remained similar over time
  • prediction and recall of experience differ a lot from actual experience
• prediction tend to be more positive than actual
• recall tends to be more negative than actual experience

Question 31

What are possible motives to take on credit?

Answer 31

• hedonic values
• present-time-orientation
• to maintain or improve lifestyle
• to deal with financial adversity
• keynes (1937) saw 6 motives:
  
  1. enjoyment
  2. extravagance
  3. short-sightedness
  4. miscalculation
  5. ostentation
  6. generosity
• also, social motives like envy (wanting what others have)
• people that have a need to belong to a wealthy class are more inclined to borrow to fill that gap