Posted: February 9th, 2015
Finance Behavioral
Paper, Order, or Assignment Requirements
1) Daniel Kahneman and Mark Riepe1 argue that behavioral finance can make a
substantial contribution to client management:
To advise effectively, advisers must be guided by an accurate picture of the
cognitive and emotional weaknesses of investors that relate to making investment
decisions: their occasional faulty assessment of their own interests and true wishes, the
relevant facts that they tend to ignore, and the limits of their ability to accept advice and
to live with the decisions that they make.
They go on to propose that a questionnaire be administered whose
purpose is to ascertain individual-specific “cognitive and emotional weaknesses.”
Based on how clients answer these questions, a number of recommendations to
improve the client management process are made. Consider the following
questionnaire:
- Recall the latest action of the Fed about which there was speculation in
the press. On the day before the event, what was your estimate of the
probability that the Fed would act as it did?
- Investor A owns a block of a stock, which he originally bought at $100
per share. Investor B owns a block of the same stock for which she
paid $200 per share. The value of the stock was $160 per share
yesterday, and today it dropped to $150 per share. Who is more
upset?
- In what percentage of months during the last 71 years did stocks make
money? What was the ratio of the average loss to the average gain?
Also answer the same questions for the percentage of consecutive fiveyear
periods (starting at the beginning of a month)?
For each question, what bias or suboptimal tendency is being investigated?
What recommendations might be appropriate?
1 Kahneman, D., and M. Riepe, 1998, “Aspects of investor psychology,” Journal of
Portfolio Management 24, (Summer), 52-652) How do we characterize a “rational” person? Is he a cool and unemotional
individual who bases decisions purely on logic? Let’s consider characters from
the popular television and movie series Star Trek. The first episode of the show
aired on NBC on September 8, 1966. Though the original series was canceled
after only three seasons, spin-offs and movies have kept the characters alive for
fans of the show. The episodes were set in the 23rd century and told the story of
the experiences of the crew of the starship Enterprise.
Two primary characters won the attention of many and they continue to
be part of popular culture. Mr. Spock, half-Vulcan, is portrayed as a strictly
rational thinker who thoroughly considers every piece of information. Vulcans,
as a species, are known to suppress emotions and prize logic thinking. Spock,
who is the Enterprise’s second in command, fully analyzes every decision at hand,
but sometimes seems to get too caught up in the details. In contrast, Captain
Kirk is purely human and likely to respond emotionally in difficult situations.
At the same time, Kirk is generally thought to be a good decision-maker. He is
the captain of the Enterprise, after all.
As an example of the characters’ natures, consider the events of a popular
episode, “The Galileo Seven,” which originally aired on January 6, 1967. (It is
likely available to view on Netflix or Hulu).
While on the way to deliver vaccines for a plague, the Enterprise stops to
investigate a strange phenomenon. Because they have a few days before they are
scheduled to deliver the vaccines, Kirk sends Spock and a team aboard a
shuttlecraft, the Galileo, to explore further. The two vessels soon lose contact due
to interference by a phenomenon, which appears to be some type of quasar. In
the end, Spock saves the shuttlecraft team by making a risky decision to lift off
the planet on which they had landed without sufficient power to remain in orbit.
The Enterprise crew saw a flare from the shuttlecraft and returned in time to save
them. Here is an excerpt of the dialogue between Kirk and Spock after the
rescue:
Kirk: Uh, Mr. Spock, there’s really something I don’t understand about all of this.
And maybe you can explain it to me. Logically, of course. When you jettisoned
the fuel and ignited it, you knew there was virtually no chance of it being seen,
yet you did it anyhow. That would seem to be an act of desperation.
Spock: Quite correct.
Kirk: We all know, and I’m sure the doctor agrees, that desperation is a highly
emotional state of mind. How does your well-known logic explain that?
Spock: Quite simply, Captain. I examined the problem from all angles, and it
was plainly hopeless. Logic informed me that, under the circumstances, the only
possible action would have to be one of desperation. Logical decision, logically
arrived at.Kirk: Aha, ha ha. I see. You mean you reasoned that it was time for an emotional
outburst.
Spock: Well, I… wouldn’t put it in exactly those terms, Captain, but…those are
essentially the facts.
Kirk: You’re not going to admit that for the first time in your life, you committed
a purely human, emotional act?
Spock: No, sir.
Kirk: Mr. Spock, you’re a stubborn man.
Spock: Yes, sir.
Do you think Spock is purely logical, as he is typically portrayed? Can
emotion and logic be separated, as personified in the characters of Kirk and
Spock? Do Kirk’s emotions have a positive side?3) Various behavioral finance theorists and practitioners have suggested several
market-wide measures of investor sentiment. Choose two such measures to use
to answer this question. (They can be measures we discussed in class and/or
measures that you discover in researching this question).
- a) Explain (in some detail) how each of the measures you selected is
calculated.
- b) Explain how each of the measures can be interpreted. What, if any, are
the strengths and/or weaknesses of the measures?
- c) Using data from the recent past (typically available online), construct
charts for each of the sentiment indicators you selected. Do the
sentiment indicators agree or disagree? What do you conclude?
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