minds and markets: some frontiers of behavioral finance...•prospect theory: –hate to lose...

BeFi Web Seminar for May 30, 2007

Minds and markets: Some frontiers of behavioral finance

by Colin CamererCaltech

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Minds and markets:Some frontiers of behavioral finance

Colin Camerer, Caltechcamerer@hss.caltech.edu

• See opportunities others don’t see– Psychology: Attention + curiosity

• Understand the fears and hopes of investors– Psychology: Prospect theory– Neuroscience: Fear of the economic unknown

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1. See opportunities others don’t see

• Conscious attention is limited– “Flicker” paradigm– Top-down encoding: “I’ll believe it when I see it”

• Visual and cognitive illusions

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How many F’s are there?

FINISHED FILES ARE THE RE-SULT OF YEARS OF SCIENTIF-IC STUDY COMBINED WITHTHE EXPERIENCE OF YEARS

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How many F’s are there?Answer: 6!

FINISHED FILES ARE THE RE-SULT OF YEARS OF SCIENTIF-IC STUDY COMBINED WITHTHE EXPERIENCE OF YEARS

• The brain ‘sees sounds’ andautomatically encodes “of” as “ov”

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How far can attention go?

• Attention can bestretched butmemory suffers

• E.g. “I Love Lucy”chocolate factoryepisode

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Do markets have ADD?• A. Earnings announcements

– Friday reaction is slower• B. Distant demographic effects are underpriced

– Bicycles and drugs• C. Attention-grabbing events drive volume

– Barber-Odean• D. ENMD (reading the market’s reading)

– Nature vs New York Times• E. Paying attention makes you smarter: Curiosity

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A. Earning reports:(dark blue) Fridays react more slowly

(Della Vigna-Pollet 06)

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B. Demographic profiles forbicycles (red) & drugs (blue): Investors

look only 5 (…years!) ahead

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C. Attention-grabbing events volume

• High-volume or high-volatility stocks get20% more individual investor trade (Barber-Odean 06)

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D. news (Nature) vs. NEWS (NYTimes)

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E: Paying attention makes you happyand smart(er):

Curiosity is the hunger pang of an info-vore

• Einstein: “I have no specialtalents. I am merelypassionately curious”

• The wick in the candleof learning

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Curiosity-piquing question

• What animal excrement is eaten as adelicacy?

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Curiosity-piquing question

• What animal excrement is eaten as adelicacy?

• A: Bat guano

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Curiosity activates reward areas…• “Striatum”

activated by:– Cocaine– Money– Expected

return– Faces of

cooperators– “warm glow”

charity– information…

when youare curious

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…and curiosity enhances memory:highly curious remember wrong

answers twice as often

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2. The fears and hopesof investors

• Prospect theory:– Hate to lose compared to a reference point– Overweight or ignore rare “black swan” events– Fama: “morbid fear of a recession”

• Preference for the familiar– “Home bias” (countries, Baby Bells, local firms)– Aversion to unfamiliar activates fear areas

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• Kahneman & Tversky (1979) most-cited empirical paper in economicspost-1970

Gains = x(ρ)

Losses = -λ*(-x)(ρ)

Prospect theory value FunctionA special role for losses

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Nonlinear weighting of probabiltiyin choices↓ and in the brain

↓

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Overweighting low probabilityis severe– a quantum of possibility?– π(p) =1/e(ln(1/p))α (α=1 linear)

– Typical measured value (α=.77)• π(.10)=.15 (x1.5)• π(.01)=.04 (x4)• π(.001)=.012 (x12)• π(.000001)=.000515 (x 515)

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(Tom et. al. 07 Sci) Increased gain/reduced lossactivates striatum…. brain (x) correlates

with behavior(y)

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Can investors be immunizedagainst loss-aversion? Maybe…

140 choices gamble vs. guaranteed

RiskyGamble

Guaranteed

p=0.5

p=0.5

Accept the gamble?

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Emotional down-regulation:Instructed to ‘think like a trader’…

One way to think of this instruction is to imagineyourself a trader. You take risks with money everyday, for a living. Imagine that this is your job, andthat the money at stake is not yours – it’s someoneelse’s. Of course, you still want to do well (your jobdepends on it). You’ve done this for a long time,though, and will continue to. All that matters is thatyou come out on top in the end – a loss here or therewon’t matter. In other words, you win some and youlose some.

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Down-regulation decreasesbiological response to actual loss

• Decreases skinconductance (not shown)

Decreases activity inright amygdala (cross-hair location)

217 voxelstmax= 72.78p < .006

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Down-regulation of loss-aversionlowers measured λ

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

INDIVIDUAL SUBJECTS

% D

EC

REA

SE I

N L

AM

BD

A

(λ”Attend” - λ”Regulate”) as percent of λ”Attend”

The down-regulation strategy decreasesloss aversion (t=5.40 p<.000003 N=45, Paired t-

test)

(caveat re: ρ)

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Fear of the economic unknown(e.g. home bias in investing)

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fMRI shows brain areas

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Activation when fearing theeconomic unknown

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In the news

April 20, 2006ECONOMIC SCENEEnter the Neuro-Economists: Why Do Investors DoWhat They Do?By TYLER COWEN

….A neuro-economics laboratory at CalTech, led by Colin F. Camerer…hasassembled the foremost group ofinterdisciplinary researchers….

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Conclusions & the future

• 1. Missing attention profits• 2. Fears and hopes of investors• Science fiction:

– Predicting bubble crashes from brain signals– Collective attention (herding…)– Measuring risk propensity neurally– Changing reactions to loss (down-regulation)– Identifying great traders, rogue traders, and

burnout.

P R E S E N T E D B Y

Shlomo BenartziCo-Founder, BeFiAssociate Professor Co-chair of theBehavioral Decision Making GroupThe Anderson School at UCLA

Warren CormierCo-Founder, BeFiPresident, Boston Research Group

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