REVISION: The Loser's Curse: Decision Making & Market Efficiency in the National Football League Draft
Date Posted: Sep 05, 2012
A question of increasing interest to researchers in a variety of fields is whether the biases found in judgment and decision making research remain present in contexts in which experienced participants face strong economic incentives. To investigate this question, we analyze the decision making of National Football League teams during their annual player draft. This is a domain in which monetary stakes are exceedingly high and the opportunities for learning are rich. It is also a domain in whic
REVISION: Split or Steal? Cooperative Behavior When the Stakes Are Large
Date Posted: May 14, 2012
We examine cooperative behavior when large sums of money are at stake, using data from the TV game show “Golden Balls.” At the end of each episode, contestants play a variant on the classic Prisoner’s Dilemma for large and widely ranging stakes averaging over $20,000. Cooperation is surprisingly high for amounts that would normally be considered consequential but look tiny in their current context, what we call a “big peanuts” phenomenon. Utilizing the prior interaction among contestants, we fin
REVISION: Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show
Date Posted: Feb 21, 2012
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 sugg
New: Annuity Puzzles
Date Posted: Oct 14, 2011
We analyze the long-standing “annuity puzzle” through the lens of behavioral economics. We provide novel evidence that lessens the extent of the puzzle and shed some additional light on the real drivers of the decision to annuitize. Last, we discuss the policy implications of our findings.
New: Who's on First: Book Review of Moneyball by Michael Lewis
Date Posted: Oct 01, 2011
Moneyball by Michael Lewis is reviewed from the perspective of behavioral economics.
New: Helping Consumers Know Themselves
Date Posted: Jan 18, 2011
Firms sometimes know more about a consumer's expected usage than the consumer herself. We explore the consequences of this reversal in the information asymmetry. We analyze the consequences of making consumers more informed about themselves. While making consumers more informed decreases their expenditure conditional on a given set of prices, equilibrium prices may increase, offsetting the direct benefit of information. We discuss theoretical and practical issues surrounding so-called RECAP regu
New: Choice Architecture
Date Posted: Apr 02, 2010
Decision makers do not make choices in a vacuum. They make them in an environment where many features, noticed and unnoticed, can influence their decisions. The person who creates that environment is, in our terminology, a choice architect. In this paper we analyze some of the tools that are available to choice architects. Our goal is to show how choice architecture can be used to help nudge people to make better choices (as judged by themselves) without forcing certain outcomes upon anyone,
Individual Preferences, Monetary Gambles and the Equity Premium
Date Posted: Sep 18, 2009
We argue that narrow framing, whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making under risk than previously realized. To demonstrate this, we present evidence on typical attitudes to independent monetary gambles with both large and small stakes and show that across a wide range of utility functions, including all expected utility and many non-expected utility specificat
New: Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choic
Date Posted: Jun 29, 2009
How is risk-taking affected by prior gains and losses? While normative theory implores decision makers to only consider incremental outcomes, real decision makers are influenced by prior outcomes. We first consider how prior outcomes are combined with the potential payoffs offered by current choices. We propose an editing rule to describe how decision makers frame such problems. We also present data from real money experiments supporting a "house money effect" (increased risk seeking in the pres
New: Choice Architecture and Retirement Saving Plans
Date Posted: Feb 11, 2009
In this paper, we apply basic principles from the domain of design and architecture to choices made by employees saving for retirement. Three of the basic principles of design we apply are: (1) there is no neutral design, (2) design does matter, and (3) many of the seemingly minor design elements could matter as well. Applying these principles to the domain of retirement savings, we show that the design of retirement saving vehicles has a large effect on saving rates and investment elections, an
New: Window Dressing by Pension Fund Managers
Date Posted: Jan 08, 2008
No abstract is available for this paper.
New: Investor Sentiment and the Closed-End Fund Puzzle
Date Posted: Jun 27, 2007
REVISION: The Nominal Price Puzzle
Date Posted: Apr 06, 2007
Nominal prices of common stocks have remained constant at around $30 per share since the Great Depression as a result of firms splitting their stocks. It is surprising that firms actively maintained constant nominal price for their shares while general prices in the economy went up more than ten fold. This is especially puzzling given that commissions paid by investors on trading ten $30 shares are about ten times those paid on a single $300 share. We estimate, for example, that had share prices
A Survey of Behavioral Finance
Date Posted: Feb 08, 2007
Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: Limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then present a number of behavioral finance appli
New: Heuristics and Biases in Retirement Savings Behavior
Date Posted: Jan 22, 2007
Saving for retirement is a difficult problem, and most employees have little training upon which to draw in making the relevant decisions. Perhaps as a result, investors are relatively passive. They are slow to join advantageous plans; they make infrequent changes; and they adopt naïve diversification strategies. In short, they need all the help they can get. Fortunately, many effective ways to help participants are also the least costly interventions: namely, small changes in plan design, sensi
New: Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing
Date Posted: Jul 10, 2006
We argue that "narrow framing," whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making than previously realized. Our starting point is the evidence that people are often averse to a small, independent gamble, even when the gamble is actuarially favorable. We find that a surprisingly wide range of utility functions, including many non-expected utility specifications, have tr
New: Invest Now, Drink Later, Spend Never: The Mental Accounting of Delayed Consumption
Date Posted: May 17, 2006
Monetary transactions in which consumption is temporally separated from purchase naturally lend themselves to multiple frames and to alternative accounting schemes, which nonetheless maintain a modicum of discipline and authenticity. We investigate some of the relevant accounting rules, and find that advanced purchases (e.g., a case of wine) are typically treated as "investments" rather than spending. At the same time, consumption of a good purchased earlier and used as planned (a wine bottle
Anomalies: Utility Maximization and Experienced Utility
Date Posted: Dec 16, 2005
The assumption that utility is always maximized allows often surprising inferences about the nature of the desires that guide people's ever-rational choices. This methodology has had many uses and undeniably has charm for economists, but it rests on the shaky foundation of an implausible and untestable assumption. In this paper we discuss a version of the utility maximization hypothesis that can be tested - and we find that it is false.
Overconfidence vs. Market Efficiency in the National Football League
Date Posted: May 31, 2005
A question of increasing interest to researchers in a variety of fields is whether the incentives and experience present in many "real world" settings mitigate judgment and decision-making biases. To investigate this question, we analyze the decision making of National Football League teams during their annual player draft. This is a domain in which incentives are exceedingly high and the opportunities for learning rich. It is also a domain in which multiple psychological factors suggest teams m
Company Stock, Market Rationality, and Legal Reform
Date Posted: Aug 23, 2004
Some eleven million 401(k) plan participants take a concentrated equity position in their retirement savings account, investing more than 20% of the balance in their employer's common stock. Yet investing in the stock of one's employer is a risky investment on two counts: single securities are riskier than diversified portfolios (such as mutual funds), and the employee's human capital is typically positively correlated with the performance of the company. In the worst-case scenario, illustrate
Public Policy Toward Life Saving: Maximize Lives Saved vs. Consumer Sovereignty
Date Posted: Jun 28, 2004
No abstract is available for this paper.
Myopic Loss Aversion and the Equity Premium Puzzle
Date Posted: Jun 19, 2004
The equity premium puzzle, first documented by Mehra and Prescott, refers to the empirical fact that stocks have greatly outperformed bonds over the last century. As Mehra and Prescott point out, it appears difficult to explain the magnitude of the equity premium within the usual economics paradigm because the level of risk aversion necessary to justify such a large premium is implausibly large. We offer a new explanation based on Kahneman and Tversky's 'prospect theory'. The explanation has two
Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving
Date Posted: Mar 24, 2004
As firms switch from defined-benefit plans to defined-contribution plans, employees bear more responsibility for making decisions about how much to save. The employees who fail to join the plan or who participate at a very low level appear to be saving at less than the predicted life cycle savings rates. Behavioral explanations for this behavior stress bounded rationality and self-control and suggest that at least some of the low-saving households are making a mistake and would welcome aid in ma
Individual Preferences, Monetary Gambles and the Equity Premium
Date Posted: Feb 03, 2004
We argue that narrow framing, whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making under risk than previously realized. To demonstrate this, we present evidence on typical attitudes to independent monetary gambles with both large and small stakes and show that across a wide range of utility functions, including all expected utility and many non-expected utility specificat
How Much Is Investor Autonomy Worth?
Date Posted: Dec 30, 2003
There is a worldwide trend towards defined contribution savings plans, where investors are often able to select their own portfolios. How much is this freedom of choice worth? We present retirement investors with information about the distribution of outcomes they could expect to obtain from the portfolios they picked for themselves, and the same information for the median portfolio selected by their peers. A majority of our survey participants actually prefer the median portfolio to the one the
Behavioral Economics
Date Posted: Nov 26, 2003
Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications. We begin with a preliminary question about relevance. Does some combination of market forces, learning and evolution render these human qualities irrelevant? No. Because of limits of arbitrage less than perfect agents survive and influence market outcomes. We then discuss three important ways in which humans de
Libertarian Paternalism Is Not An Oxymoron
Date Posted: Nov 13, 2003
The idea of libertarian paternalism might seem to be an oxymoron, but it is both possible and legitimate for private and public institutions to affect behavior while also respecting freedom of choice. Often people's preferences are ill-formed, and their choices will inevitably be influenced by default rules, framing effects, and starting points. In these circumstances, a form of paternalism cannot be avoided. Equipped with an understanding of behavioral findings of bounded rationality and bounde
Dividend Changes Do Not Signal Changes in Future Profitability
Date Posted: Oct 21, 2003
One of the most important predictions of the dividend-signaling hypothesis is that dividend changes are positively correlated with future changes in profitability and earnings. Contrary to this prediction, we show that after controlling for the well-known non-linear patterns in the behavior of earnings, dividend changes contain no information about future earnings changes. We also show that dividend changes are negatively correlated with future changes in profitability (return on assets). Finall
Financial Decision-Making in Markets and Firms: A Behavioral Perspective
Date Posted: Jul 01, 2003
In its attempt to model financial markets and the behavior of firms, modern finance theory starts from a set of normatively appealing axioms about individual behavior. Specifically, people are said to be risk-averse expected utility maximizers and unbiased Bayesian forecasters, i.e., agents make rational choices based on rational expectations. The rational paradigm may be criticized, however, because (1) the assumptions are descriptively false and incomplete, and (2) the theory often lacks pre
Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?
Date Posted: Jul 01, 2003
Initiations and omissions of dividend payments are important changes in corporate financial policy. This paper investigates the market reaction to such changes in terms of prices, volume, and changes in clientele. Consistent with the prior literature we find that short run price reactions to omissions are greater than for initiations (-7.0% vs. +3.4% three day return). However, we show that, when we control for the change in the magnitude of dividend yield (which is larger for omissions), the
Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs
Date Posted: Jun 16, 2003
Recent equity carve-outs in U.S. technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our 1998-2000 sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate this blatant mispricing due to short-sale constraints, so that B is overpriced but expensive or impossible to sell short.
Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs
Date Posted: Apr 13, 2003
Recent equity carve-outs in US technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our 1998-2000 sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate these blatant mispricing due to short sale constraints, so that B is overpriced but expensive or impossible to sell short.
A Survey of Behavioral Finance
Date Posted: Oct 25, 2002
Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then present a number of behavioral finance appli
How Much is Investor Autonomy Worth?
Date Posted: Jan 29, 2002
There is a worldwide trend towards increasing investor autonomy. Investors are increasingly able to pick their own portfolios. How good a job are they doing? We present individuals saving for retirement with information about the distribution of outcomes they could expect from the portfolios they picked and also the median portfolio selected by their peers. A majority of our survey participants actually prefer the median portfolio to the one they picked for themselves. Furthermore, we find that
An Economic Theory of Self-Control
Date Posted: Dec 31, 2001
Although many economists, most notably Strotz, have discussed dynamic inconsistency and precommitment, none have dealt directly with the essence of the problem: self-control. This paper attempts to fill that gap by modeling man as an organization. The Strotz model is recast to include the control features missing in his formulation. The organizational analogy permits us to draw on the theory of agency. We thus relate the individual's control problems with those that exist in agency relationships
Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs
Date Posted: Nov 12, 2001
Recently equity carve-outs in US technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our 1998-2000 sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate these blatant mispricing due to short sale constraints, so that B is overpriced but expensive or impossible to sell sho
Behavioral Economics
Date Posted: Oct 05, 2001
Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications. We begin with a preliminary question about relevance. Does some combination of market forces, learning and evolution render these human qualities irrelevant? No. Because of limits of arbitrage less than perfect agents survive and influence market outcomes. We then discuss three important ways in which humans dev
Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?
Date Posted: Nov 29, 2000
Initiations and omissions of dividend payments are important changes in corporate financial policy. This paper investigates the market reaction to such changes in terms of prices, volume, and changes in clientele. Consistent with the prior literature we find that short run price reactions to omissions are greater than for initiations (-7.0% vs. +3.4% three day return). However, we show that, when we control for the change in the magnitude of dividend yield (which is larger for omissions), the as
A Behavioral Approach to Law and Economics
Date Posted: Jul 07, 1998
Economic analysis of law usually proceeds with the behavioral assumptions of neoclassical economics. But empirical evidence gives us much reason to doubt these assumptions; people are boundedly rational and boundedly self-interested, and they have bounded willpower. The result is to call into question many of the predictions and prescriptions offered by traditional law and economics .In this paper we offer a broad vision of how law and economics analysis may be improved by increased attention
A Behavioral Approach to Law and Economics
Date Posted: Jun 30, 1998
Economic analysis of law usually proceeds with the behavioral assumptions of neoclassical economics. But empirical evidence gives us much reason to doubt these assumptions; people are boundedly rational and boundedly self-interested, and they have bounded willpower. The result is to call into question many of the predictions and prescriptions offered by traditional law and economics .In this paper we offer a broad vision of how law and economics analysis may be improved by increased attention