New Insights into Behavioral Finance

This thesis applies insights from psychology and other behavioral sciences to overcome the shortcomings of the traditional finance approach (which assumes that agents and markets are rational) and improves our understanding of financial markets and its participants. More specific, this thesis provides important new insights into the preferences of investors, their investment decisions, and the behavior of financial markets. The results show that people dislike downside risk and employ decision-making patterns that may result in risk-taking behavior of which they are not aware, or in which they normally would not engage, and that can result in non-optimal behavior. More specific, people behave 'non-optimal' by changing their behavior in response to previous outcomes and by letting their preferences depend heavily on the other outcomes that are or were available, even when hundred thousands of euros are at stake. Moreover, people tend to use simplifying heuri! stics to construct their investment portfolios by focusing on the outcomes of the individual assets available instead of their total investment portfolio. Furthermore, this thesis shows that incorporating behavioral-based preference patterns has substantial influence on investorâ?Ts optimal behavior in financial markets. More specific, the value premium (the empirical finding that stocks with an high measure of book value relative to market value earn higher returns than stocks with a low measure) is nearly absent for investors with an substantial fixed income exposure, an annual evaluation horizon and an aversion to losses

Deal or No Deal? Decision-making under Risk in a Large-payoff Game Show

The popular television game show deal or No Deal offers a unique opportunity for analyzing decision making under risk: it involves very large stakes, simple take-or-leave decisions that require minimal skill or strategy and near-certainty about the probability distribution. Based on a panel data set of the choices of contestants in all game rounds of 53 episodes from Australia and the Netherlands, we find an average Pratt-Arrow relative risk aversion (RRA) between roughly 1 and 2 for initial wealth levels between 0 and 50,000. The RRA differs substantially across the contestants and some even exhibit risk seeking behavior. The cross-sectional differences in RRA can be explained in large part by the previous outcomes experienced by the contestants during the game. Most notably, consistent with the break-even effect,the RRA strongly decreases following earlier losses and risk seeking arises after large losses.To be published in American Economic Revie

Random incentive systems in a dynamic choice experiment

Experiments frequently use a random incentive system (RIS), where only tasks that are randomly selected at the end of the experiment are for real. The most common type pays every subject one out of her multiple tasks (within-subjects randomization). Recently, another type has become popular, where a subset of subjects is randomly selected, and only these subjects receive one real payment (between-subjects randomization). In earlier tests with simple, static tasks, RISs performed well. The present study investigates RISs in a more complex, dynamic choice experiment. We find that between-subjects randomization reduces risk aversion. While within-subjects randomization delivers unbiased measurements of risk aversion, it does not eliminate carry-over effects from previous tasks. Both types generate an increase in subjects' error rates. These results suggest that caution is warranted when applying RISs to more complex and dynamic tasks

Brain Processes Underlying the Influence of Prior Gains and Losses on Decisions Under Risk

The risk attitudes of consumers generally depend on previous outcomes. Here we study behavioral changes and differential brain activations related to prior relative gains and losses. Subjects showed decreased risk aversion after both relative gains and losses. Neuroimaging results revealed that relative gains and losses are processed similarly to actual gains and losses, indicated by ventral striatum and medial prefrontal cortex activity. During subsequent choices, however, insular cortex and right inferior frontal gyrus showed differential activation depending on the prior experience. Activity in these neural regions, related to emotion and control, also correlated with the magnitude of observed behavioral changes

When Equity Factors Drop Their Shorts

Although factor premiums originate in both long and short legs of factor portfolios, we found that (1) most added value comes from the long legs, (2) the long legs offer more diversification than the short legs, and (3) the performance of the short legs is generally subsumed by that of the long legs. These results are robust over size, time, and markets and cannot be attributed to differences in tail risk. We also found that the claim that the value and low-risk factors are subsumed by the new (post-2015) Fama–French factors does not hold for the long legs of these factors.Disclosure: The authors disclose that they are employed by Robeco, a firm that offers various investment products. The construction of these products may, at times, draw on insights related to this research. No other person or party at Robeco except the authors had the right to review this article prior to its circulation. The views and results presented in this article were not driven by the views o

Deal or no deal? Decision making under risk in a large-payoff game show.

Abstract We examine the risky choices of contestants in the popular TV game show "Deal or No Deal" and related classroom experiments. Contrary to the traditional view of expected utility theory, the choices can be explained in large part by previous outcomes experienced during the game. Risk aversion decreases after earlier expectations have been shattered by unfavorable outcomes or surpassed by favorable outcomes. Our results point to reference-dependent choice theories such as prospect theory, and suggest that path-dependence is relevant, even when the choice problems are simple and well-defined, and when large real monetary amounts are at stake

Risky choice in the limelight

This paper examines how risk behavior in the limelight differs from that in anonymity. In two separate experiments we find that subjects are more risk averse in the limelight. However, risky choices are similarly path dependent in the different treatments. Under both limelight and anonymous laboratory conditions, a simple prospect theory model with a path-dependent reference point provides a better explanation for subjects’ behavior than a flexible specification of expected utility theory. Additionally, our findings suggest that ambiguity aversion depends on being in the limelight, that passive experience has little effect on risk taking, and that reference points are determined by imperfectly updated expectations