11. Behavioral Finance and Corporate Finance

Tversky and Kahneman’s (1986, p. S268-S269) medical treatment of tumor experiment (Case 3) is exactly the same as Example 11.1 except that the subjects are not required to make a choice before the game starts. Tversky et al. argue that people made mistakes by not using the probabilities: 0.25 × 0.80 = 0.20 and 0.25 × 1.0 = 0.25 and claim that it is ‘pseudocertainty effect’. This is wrong since the probability 0.25 of the testing result that the tumor is treatable in the first stage is not up to the subjects to decide. If the tumor is not treatable, i.e., the subject cannot survive, it will be meaningless to ask which choice (treatment) the subject will choose in the second stage.

See also Thaler (1980).

For the second half of the season, Arkes et al. find that all the groups attend about the same number of plays. However, this may be due to that people in the second half of the season had new choices which can produce higher net utilities rather than Arkes et al.’s ‘diminishing sunk cost effect’. Gourville and Soman’s (1998) experiment of gym memberships and attendance also finds that the price paid for an item has a diminishing effect on consumption behavior as time goes on, and there was a substantial spike in attendance following payment.

See Appendix A for a real story of the sunk cost fallacy.

Buchanan (1969, p. 28) introduces Ronald Coase’s definition of opportunity cost as: “Any profit opportunity that is within the realm of possibility but which is rejected becomes a cost of undertaking the preferred course of action”.

Suppose that the increment of wealth is $200,000 and initial wealth is $1,000,000. Although the relative wealth ratios show: \(1,200,000/1,000,000 = 1.2/1\) > \(1,400,000/1,200,000 = 1.167/1,\) people may feel equally happy because relative to people’s income, $200,000 is a huge amount of money which can be used to buy many pricy commodities.

This result refutes Kahneman and Tversky’s (1979) claim that “… utility theory. In that theory, for example, the same utility is assigned to a wealth of $100,000, regardless of whether it was reached from a prior wealth of $95,000 or $105,000. Consequently, the choice between a total wealth of $100,000 and even chances to own $95,000 or $105,000 should be independent of whether one currently owns the smaller or the larger of these two amounts” (p. 273).

Thaler (1980, p. 50) argues that this is the Weber-Frechner law: the just noticeable difference in any stimulus is proportional to the stimulus. However, this law is an application of relative price ratio in decision-making.

See also Thaler (1980, p. 50).

In Kahneman et al. (1979), 3,000 is the median net monthly income for a family in Israel currency (p. 264).

This experiment was done at Xi’an Jiao Tong University in 2018. The number of the subjects (most are undergraduates) is 158. CNY3,000 is about the median monthly income of a new college graduate. CNY3 is the price of a lottery. The author wishes to thank Professor Qin, Botao for his help in designing this experiment.

Thaler and Johnson’s (1990) experiment find that a large majority of subjects prefer temporal separation of gains to have them occur together. They also find that most subjects prefer temporal separation of losses to have them occur together. I think this may due to the fact that large sum of loss could seriously affect people’s consumption levels (life style). People will prefer to amortize the loss to separate periods (as companies always do to avoid a big drop in their stock prices).

Microeconomics states that if a good is a normal good and hence a non-Giffen good, then WTA is greater than WTP. When there is no income effect, WTA and WTP are equal.

Barberis (2013) suggests that “upon receiving a negative income shock, the individual prefers to lower future consumption rather than current consumption. After all, news that future consumption will be lower than expected is less painful than news that current consumption is lower than expected.” (p. 188). This indicates that people care more about the current consumption level than the future consumption level because lower consumption now is painful, and if people know that the future consumption may be lower, they still have a chance/choice to work hard to fix it.

This is not to say that self-control problem, e.g., drug or alcohol addiction, does not exist. DellaVigna, and Malmendier (2006) use a data of three U.S. health club to find that “members who choose a contract with a flat monthly fee of over $70 attend on average fewer than 4.5 times per month. They pay a price per expected visit of more than $17, even though they could pay $10 per visit using a ten-visit pass. On average, these users forego savings of over $600 during their membership” (p. 716). This shows that people feel they will use the gym more than seven times a month, and hence, choose to pay $70 a month. However, later on, people may choose other activities which give them higher utilities.

Let the initial wealth be \(x\) where \(x > \$ 2000\). Then \(\left( {x + \$ 2,000} \right)/x - x/\left( {x - \$ 2,000} \right) = - \$ 4,000,000/\left[ {x\left( {x - \$ 2,000} \right)} \right] < 0\).

The existence of a real-valued utility function requires three assumptions: (i) Completeness: for any two alternatives bundles A and B, at least one of three conditions exists: \({\text{A}}\underset{\raise0.3em\hbox{$\smash{\scriptscriptstyle\thicksim}$}}{ \succ } {\text{B}}\), \({\text{B}}\underset{\raise0.3em\hbox{$\smash{\scriptscriptstyle\thicksim}$}}{ \succ } {\text{A}}\) or \({\text{A}}\sim {\text{B}}\) (where \(\tilde{ \succ }\) denotes “at least as good as …..”, and \(\sim\) denotes “indifferent to”); (ii) Transitivity: for any three alternatives A, B and C, if \({\text{A}}\underset{\raise0.3em\hbox{$\smash{\scriptscriptstyle\thicksim}$}}{ \succ } {\text{B}}\) and \({\text{B}}\underset{\raise0.3em\hbox{$\smash{\scriptscriptstyle\thicksim}$}}{ \succ } {\text{C}}\), then \({\text{A}}\underset{\raise0.3em\hbox{$\smash{\scriptscriptstyle\thicksim}$}}{ \succ } {\text{C}}\); (iii) Continuous Preference: for any \(x\) and \(z\) consumption bundles, if \(x \succ z\), then for any alternative \(y\) which is very close to\(x\), we still have\(y \succ z\). The first and second assumptions are also called ‘rational preference’ which are the features of the real number system \({\mathbb{R}}\).

Rabin, Matthew and Richard Thaler (2001) Anomalies: risk Aversion. Journal of Economic Perspectives 15: 219-232.

Also, it won’t be easy for a very high-income person to voluntarily pay a tithe.

Some scholars claim that investors may have the so-called narrow framing bias, i.e., investors make investment decisions without considering the context of their entire portfolio. However, using portfolio to diversify cannot create or add value i.e., financial diversification irrelevancy. Also, since stocks and house are the main part of a household’s wealth, investors of course will pay much more attention to these two assets.

There are some other biases which may be related to transaction costs. (1) Herd behavior: people do what others are doing instead of using their own information or making independent decisions. Investors may believe others have already done enough research and imitate their actions. (2) Home bias: individuals and institutions in most countries hold only modest amounts of foreign equity, and tend to strongly favor company stock from their home nation. This may be the result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs. (3) Overconfidence: people’s tendency to overestimate their abilities to make very risky investments. Probably, all start-ups and entrepreneurs have the overconfidence feature to innovate. (4) People rely too much on extrapolation of recent trends. Recent information may signal the beginning of a different path. People will regret if they miss this information/signal. (5) Affect: investors and consumers may feel good about a company that has a good reputation of corporate social responsibility. Good reputation may save the search cost of finding a good investment or product. (6) Equity carve-outs. For example, company A has sold a stake of a subsidiary (company B) to the public and has announced its intention to spin off the remaining shares in company B at some point in the not-too-distant future. However, the market value of A is found lower than the value of the shares of B that it owns. This is an example of limits to arbitrage: the difficulty of short-selling the overpriced carveout shares.

Odean, Terrance (1998) Are investors reluctant to realize their losses? Journal of Finance 53: 1775–1798.

Mankiw, Gregory and Stephen Zeldes (1991), “The consumption of stockholders and nonstockholders,” Journal of Financial Economics 29: 97–111.