The Johns Hopkins University Department of Psychology The Psychology of Decision-Making: Behavioral Finance (Psychology 200.355 Lawrence J.

Raifman, J.D., Ph.D. !all "emester 200# Phone$ %#0&%33&#2'( )&mail$ l*raifman+home.com ,ffice Ho-rs$ T-es.ays #&3 p.m./ 232 0mes Hall Teaching 0ssistant$ 1e2ecca Piorko3ski 4eeting Time$ T-es.ays 3&5 p.m.5 "haffer Hall5 room 303 o!rse "verview
6hat .oes psychology have to offer stock market investors5 portfolio managers5 an. finance economists7 ,ver the past fo-r .eca.es5 investment .ecisions have 2een g-i.e. 2y efficient markets theory. The theory is 2ase. on the notion that investors 2ehave in a rational5 pre.icta2le an. an -n2iase. manner. The mo.el ass-mes that investors in the aggregate correctly price stocks to reflect all p-2licly availa2le information. 8ehavioral finance challenges this tra.itionally hel. notion. 1eliant -pon cognitive psychology .ecision theory5 2ehavioral finance is the st-.y of ho3 investors9 interpret an. act on availa2le5 falli2le information. :ts fin.ings s-ggest5 among other things5 the e;istence of$ (# in.ivi.-al investor he-ristics/ that is5 mental short c-ts -se. in place of p-rely (-n2o-n.e.ly rational thinking/ an. (2 marketplace anomalies/ economic p-<<les not e;plaine. 2y efficient markets theory5 consistent 3ith the concl-sion that in the aggregate investors .o not 2ehave rationally. Th-s5 2ehavioral finance i.entifies marketplace investor mistakes5 3ith an e;pectation that if one 3ere to f-lly 2ecome kno3le.gea2le a2o-t the psychological (incl-.ing =-asi&rational aspects of .ecision&making5 investors 3o-l. o-t&smart the market tra.ers5 an. 2eat the market 2enchmarks. 8ehavioral finance has recently 2ecome a 2-<<3or. in the investment comm-nity. >-mero-s articles have appeare. in the financial press reporting a2o-t 2ehavioral finance st-.ies5 an. there have 2een an increasing n-m2er of seminars on the s-2*ect. Despite its recent attention5 ho3ever5 the st-.y of 2ehavioral finance is not a ne3 phenomenon. T3o 2ooks 3ritten in the #?00@s5 The Crowd 2y A-stave Be 8on an. Extraordinary Popular Delusions and the Madness of Crowds 2y Charles 4ackay5 are still consi.ere. 2y many investors as classics in the fiel. of gro-p 2ehavior 3ith application to the investment markets. :n the #'(0s5 Dr. 0mos Tversky5 the late5 prominent "tanfor. University cognitive psychologist5 an. Daniel Dahneman5 presently a professor of psychology at Princeton University5 .ecrie. the ever&rational economic person as not correspon.ing to act-al h-man 2ehavior. Professor "cott Plo-s concisely s-mmari<e. the psychological research in he-ristics in his 2ook5 The psychology of judgment and decision

making. Pa-l "lovic5 like3ise5 3as translating psychological research metho.s5 an. research res-lts on .ecision&making into economic lang-age. :n .oing so5 Tversky5 Dahneman5 Plo-s5 "lovic5 an. other psychologists intro.-ce. psychological research metho.s an. fin.ings to economistsEfinance researchers 3ho 3ere looking for a more acc-rate mo.el for h-man *-.gment5 than Fhomo economic-s.G Their concl-sion 3as that investor9s act -n.er cognitive constraints&&&failing to achieve rationality&&&tho-gh5 in a manner that can potentially 2e acco-nte. for5 pre.icte.5 an. e;ploite.. They fo-n.5 for e;ample5 investors foc-s more on risk (losses than 2enefits (gains 5 kno3n as the HProspect Theory.H "everal research economistsEfinance professors5 s-ch as5 1ichar. Thaler at the University of Chicago5 1o2ert J. "hiller at Iale University5 an. others5 have recogni<e. psychology9s applica2ility in st-.ying in.ivi.-al an. marketplace finance .ecisions. To ignore psychology9s contri2-tion to .ecision&making an. *-.gment is to s-2stit-te for it an inacc-rate5 normative version. . This class investigates psychology9s contri2-tion to mo.ern finance theory5 economics5 an. specifically 2ehavioral finance. Re#!ire$ Rea$ings: "cott Plo-s5 (#''3 The Psychology of Judgment and Decision Making5 4cAra3 Hill. Daniel Dahneman an. 0mos Tversky (e.s. (2000 Choices, alues and !rames/ >e3 Iork$ 1-ssell "age !o-n.ation5 Cam2ri.ge UD$ >e3 Iork5 Cam2ri.ge University Press. Recommen$e$ Rea$ings: 1ichar. Thaler5 (#''# "uasi#$ational Economics5 1-ssell "age !o-n.ation Press. Aary 8elsky an. Thomas Ailovich5 (#''' %hy &mart People Make 'ig Money Mistakes5 "imon an. "ch-ster. 0n.rei "hleifer5 (2000 5 (nefficient Markets5 ,;for.$ >e3 Iork$ ,;for. University Press. Hersh "hefrin5 (2000 'eyond )reed and !ear5 Harvar. 8-siness "chool Press. Daniel Dahneman5 Pa-l "lovic5 an. 0mos Tversky (e.s. (#'?2 Judgment under *ncertainty+ ,euristics and -iases, ,;for./ >e3 Iork$ ,;for. University Press. %ra$ing$ Ara.es 3ill 2e calc-late. from three 3eighte. components$ mi.term #E35 final J 5 an. home3ork pro2lems #EK. : 3ill assign t3o pro2lem sets over the co-rse of the semester. They 3ill 2e ma.e availa2le one 3eek 2efore they are .-e. To calc-late yo-r pro2lem set gra.e : 3ill -se yo-r average gra.e from the t3o pro2lem sets. The .ate for the mi.term an. the final 3ill 2e .etermine. 2y the en. of the secon. 3eek of class. The final 3ill 2e incl-sive of the entire class rea.ings an. lect-res. : 3ill make pro2lem set sol-tions availa2le on the 3e2 (or thro-gh my teaching assistant imme.iately after each pro2lem set is .-e. Bate pro2lem sets 3ill not 2e accepte.. "t-.ents may choose to colla2orate on pro2lem sets5 2-t sho-l. ackno3le.ge their colla2orators an. .escri2e the e;tent of their colla2oration at the top of the relevant assignments. Pro2lems sets sho-l. 2e 3ritten in.epen.ently.

Prere#!isi&es: This is an -pper level psychology co-rse. Those 3ho =-alify have taken lo3er level psychology co-rses5 an. have some e;perience either having taken economics co-rses or have familiarity 3ith finance markets. 'e( rea$ings$ 1e=-ire. rea.ings that are not in the re=-ire. te;ts a2ove 3ill 2e availa2le on the co-rse 3e site5 or in a photocopie. rea.ing packet availa2le thro-gh the teaching assistant. )isenhower Li(rary$ The re=-ire. te;ts5 the optional te;ts5 an. the rea.ing packet 3ill 2e availa2le at )isenho3er Bi2rary. Behavioral Finance *ylla(!s

0. !o-n.ations
+. +,TR"D- T+", .*e/&em(er 00&h, an$ 01&h, 23304 6hat .oes psychology have to offer stock market investors5 portfolio managers5 an. finance economists7 Prere=-isites for 1ational Choice5 L-asi&1ational Choice )fficient 4arkets Hypothesis an. the 8ehavioral !inance alternative

"cott Plo-s5 (#''3 The psychology of judgment and decision#making. >I$ 4cAra3&Hill. "ection :$ :ntro.-ction an. Chapters #&%/ "ection ::$ Chapters 5&K5 pp. #&K% Aary 8elsky an. Thomas Ailovich5 (#''' %hy &mart People Make 'ig Money Mistakes5 "imon an. "ch-ster. :ntro.-ction. P. #3&2#. ++. )FF+ +),T 5P+T5L M5R6)T* .*e/&em(er 27, 23304 8eing 1ational )fficient 4arkets Hypothesis

"hleifer5 0n.rei5 (nefficient Markets, ,;for. University Press5 20005 Chapter #. Plo-s5 ". (#''3 . The psychology of judgment and decision#making. >I$ 4cAra3&Hill5 "ection :::$ Chapters (&'5 pp. ((&#0(. +++. M",)8 M5,5%)M),T +,D-*TR8 ."c&o(er 2, 23304 Do 2rokerage analysts9 recommen.ation have investment val-e7 6in.o3 .ressing 2y pension f-n. managers :mportance of transaction costs

6erner De 8on.t (#''5 H6hat are :nvestment 0.visors Pai. for7H in 1. Jarro35 M 4aksimovic5 an. 6. T. Niem2a (e.s. !inance5 "eries of Han.2ooks in ,perations 1esearch an. 4anagement "cience5 )lsevier&>orth Hollan..

Dent B. 6omack5 FDo 8rokerage 0nalysts9 1ecommen.ations Have :nvestment Mal-e7G Journal of !inance5 Mol. 5#5 4arch #''K5 p. #3(&#K(. +9. L+M+T* T" 5RB+TR5%) ."c&o(er :, 23304 Bimits to 0r2itrage DeBong5 J. 8ra.for.5 0n.rei "hleifer5 Ba3rence H. "-mmers5 an. 1o2ert 6al.mann5 H>oise Tra.er 1isk in !inancial 4arketsH5 Journal of Political Economy '?5 (03&(3? /in 0d1ances in 'eha1ioral !inance, Ch.2 an. in 0n.rei "hleifer5 (2000 (nefficient Markets5 Chapter 25 ,;for. University PressO "hleifer5 0n.rei5 an. 1o2ert Mishny (#''( 5 HBimits of 0r2itrageH5 Journal of !inance 525 p. 35& 55. an. in 0n.rei "hleifer5 (2000 (nefficient Markets5 Chapter %5 ,;for. University PressO 0pplication to Close. en. f-n.s an. Bong Term Capital 4anagement$ "hleifer5 0n.rei5 (2000 (nefficient Markets, ,;for. University Press5 Chapter 3$ FThe Close. )n. !-n. P-<<le5G previo-sly p-2lishe. as F:nvestor "entiment an. the Close. )n. !-n. P-<<le5G Charles Bee5 0n.rei "hleifer5 an. 1ichar. Thaler (#''# Journal of !inance5 Bo3enstein5 1oger5 (2000 %hen )enius !ailed+ The $ise and !all of 2ong Term Capital Management, 1an.om Ho-se. 0ggregate markets an. in.ivi.-al irrationality Theory Bimits of 0r2itrage 0pplication$ Close. en. f-n. pricing 0pplication$ Professional 0r2itrage$ Bong Term Capital

B. on&ri(!&ions
+. )9+D), ) FR"M P*8 ;"L"%8 ."c&o(er 0< an$ 2=r$4 Contri2-tions from Cognitive&8ehavioral Psychology o o The Psychology of 8o-n.e. 1ationality He-ristics an. 8iases$ J-.gment -n.er -ncertainty

"cott Plo-s5 The psychology of judgment and decision#making. >I$ 4cAra3&Hill5 #''3. "ection :M$ Chapters #0P#K5 pp. #0(&#?'. Aary 8elsky an. Thomas Ailovich5 (#''' %hy &mart People Make 'ig Money Mistakes5 "imon an. "ch-ster. Chapters %&K5 pp. #05&#(5. Contri2-tions from "ocial Psychology

"cott Plo-s5 The psychology of judgment and decision making. >I$ 4cAra3&Hill5 #''3. "ection M$ Chapters #(&#?5 pp. #?'&2#5. Aary 8elsky an. Thomas Ailovich5 (#''' %hy &mart People Make 'ig Money Mistakes5 "imon an. "ch-ster. Chapter (5 pp. #(5&#''. o Contri2-tions from Clinical Psychology

Peter J. Tano-s5 (#''' FChapter T3o$ Defining Io-r :nvestment Personality5G The %ealth E3uation, >e3 Iork :nstit-te of !inance5 p. #(&%2. 9. PR"*P) T T;)"R8 ."c&o(er =3 an$ ,ovem(er <&h4 o o !raming5 "-nk Costs5 6eighting Pro2a2ilities )=-ity Premi-m P-<<le5 an. 4ental 0cco-nting

Aary 8elsky an. Thomas Ailovich5 (#''' %hy &mart People Make 'ig Money Mistakes5 "imon an. "ch-ster. Chapters #&35 pp. 3#&#05. Hersh "hefrin an. 4eir "tatman5 FThe Disposition to "ell 6inners Too )arly an. 1i.e Bosers Too Bong$ Theory an. Practice5G Jo-rnal of !inance5 Mol. %05 J-ly #'?55 p.. (((&('0. 1ichar. Thaler5 "uasi#$ational Economics5 1-ssell "age !o-n.ation Press5 #''#5 Chapters ($ FThe Psychology of Choice an. the 0ss-mptions of )conomics5G pp. #3(&#KK.

0pplications
9+. R+*6 5,D R)T-R, .,ovem(er <4 o o Taking a 4eas-re of 1isk !-t-re of 1isk 0nalysis$ 8lack 8o;es5 an. 8ehavioral !inance

!rank 0rmstrong5 FChapter T3o$ 0ssessing the 1isk5G (n1estment strategies for the 45st Century, at http$EE333.fee&onlya.visor.comE2ookEch2Ech2.html 8-rton A. 4alkiel5 (#''' F1eaping 1e3ar. 2y :ncreasing 1isk5G in 8-rton A. 4alkiel5 0 $andom %alk Down %all &treet, 6. 6. >orton Press5 >e3 Iork5 p. 220&2%0. ++. B);59+"R5L F+,5, ): 5%%R)%5T) M5R6)T* .,ovem(er 0=, 234

a. The /sychology of financial marke&s

i. )#!i&y /remi!m /!>>le "hlomo 8enart<i an. 1ichar. H. Thaler5 (#''5 F4yopic Boss 0version an. the )=-ity Premi-m P-<<le5G The "uarterly Journal of Economics5 p. (3&'2. ii. 9ola&ili&y /!>>le

1o2ert "hiller (#'?# FDo stock prices move too m-ch to 2e *-stifie. 2y s-2se=-ent changes in .ivi.en.s7G 0merican Economic $e1iew5 Mol. (#5 pp. %2#&3K also in 0.vances5 chapter %

(. The /sychology of inves&or (ehavior

8ra. 8ar2er an. Terrance ,.ean5 FThe tra.ing 2ehavior of in.ivi.-al investors5G .raft paper5 J-ly #'''. 6erner De 8on.t5 (#''? FPortrait of the :n.ivi.-al :nvestor5G European Economic $e1iew Daniel Dahneman an. 4ark 6. 1iepe5 (#''? F0spects of :nvestor Psychology$ 8eliefs5 Preferences5 an. 8iases :nvestment 0.visors "ho-l. Dno3 02o-t5G Jo-rnal of Portfolio 4anagement5 Mol. 2%5 pp. o Dis/osi&ion )ffec&

Hersh "hefrin an. 4eir "tatman5 FThe Disposition to "ell 6inners Too )arly an. 1i.e Bosers Too Bong$ Theory an. Practice5G Journal of !inance5 Mol. %05 J-ly #'?55 p.. (((&('0. Terrance ,.ean5 (#''? F0re :nvestors 1el-ctant to 1eali<e Their Bosses 6,7 Journal of !inance5 Mol. 535 pp. #((5&#('?. o )n$owmen& )ffec& an$ &he 5vaila(ili&y ;e!ris&ic

Daniel Dahneman5 J. Dnetsch5 an. 1ichar. Thaler5 (#''# F0nomalies$ the )n.o3ment )ffect5 Boss 0version5 an. "tat-s L-o 8ias5G Journal of Economic Perspecti1es5 Mol. 55 p. #'3&20K. o Myo/ic Loss 5version, an$ Men&al 5cco!n&ing

>icholas 8ar2eris an. 4ing H-ang5 F4ental 0cco-nting5 Boss 0version5 an. :n.ivi.-al "tock 1et-rns5G .raft !e2r-ary 200#. "hlomo 8enart<i an. 1ichar. Thaler5 (#''5 F4yopic Boss 0version an. the )=-ity Premi-m P-<<le5 "uarterly Journal of Economics5 o ,a?ve Diversifica&ion: Po/!lar *&ra&egies

"hlomo 8enart<i an. 1ichar Thaler5 (#''? F>aQve Diversification "trategies in Define. Contri2-tion "avings Plans5G .raft paper o "verconfi$ence an$ "/&imism

8ra. 8ar2er an. Terrance ,.ean5 (2000 F8oys 3ill 2e 8oys$ Aen.er5 ,verconfi.ence5 an. Common "tock :nvestment5G "uarterly Journal of Economics5 .raft paper

"imon Aervais an. Terrance ,.ean5 (#''' FBearning to 2e ,verconfi.ent5G .raft paper

c. Behavioral Finance Marke& *&ra&egies

Plo-s5 ". (#''3 . The psychology of judgment and decision#making >I$ 4cAra3&Hill. "ection M:$ Chapters #'&2# an. 0fter3ar.5 pp. 2#(&2K2. Davi$ Dreman an$ "verreac&ion on&rarian +nves&men& *&ra&egies:

1ichar. Thaler5 "uasi#$ational Economics5 1-ssell "age !o-n.ation Press5 #''#5 Part !ive5 Chapter #3. F6erner De8on.t an. 1ichar. Thaler5 FDoes the "tock 4arket ,verreact7G Journal of !inance5 Mol. %05 #'?55 pp. ('3&?05. 1ichar. Thaler5 "uasi#$ational Economics5 1-ssell "age !o-n.ation Press5 #''#5 Part !ive5 Chapters #%. 6erner De 8on.t an. 1ichar. Thaler (#'?( F!-rther )vi.ence on :nvestor ,verreaction an. "tock 4arket "easonality5G Journal of !inance5 Mol. %25 J-ly5 p. 55(&5?#. Davi. Dreman5 (#''' F:nvestor ,verreaction5G in Ba3rence ). Bifson an. 1ichar. 0. Aeist5 (#''' The Psychology of (n1esting, John 6iley an. "ons.

o Momen&!m *&ra&egies: -n$er-reac&ion

Harrison Hong5 Terrence Bim5 an. Jeremy "tein5 (2000 F8a. ne3s travels slo3ly$ si<e5 analyst coverage an. the profita2ility of moment-m strategies5G Journal of !inance5 Mol. 505 p. 2K5&2'5.

9++.

5PPL+ 5T+",: +nves&or *en&imen& .,ovem(er 2@, Decem(er A4

1ichar. Thaler5 "uasi#$ational Economics5 1-ssell "age !o-n.ation Press5 #''#5 Chapter #K. pp. 3#0&353. (Charles Bee5 0n.rei "hleifer5 an. 1ichar. Thaler5 (#''# F:nvestor "entiment an. the Close. en. !-n. P-<<le5G Journal of !inance5 %K 6erner De 8on.t5 (200# F0sset Prices an. 8ehavioral !inance5G $e1iew of !inancial &tudies5 .raft paper. o ;omo )conomic!s &o ;omo *a/iens "en.hil 4-llainathan an. 1ichar. Thaler5 (2000 F8ehavioral )conomics5G >8)1 6orking paper ('%?.

o )B/lana&ions for over an$ !n$er reac&ivi&y

>icholas 8ar2eris5 0n.rei "hleifer an. 1o2ert Mishny5 (#''? F0 mo.el of investor "entiment ,7 Journal of !inancial Economics5 Mol. %'5 pp. 30(&3%5 also in :nefficient 4arkets5 Chapter 5. J. 8ra.for. DeBong5 0n.rei "hleifer5 Ba3rence "-mmers5 an. 1o2ert 6al.man5 FPositive !ee.2ack :nvestment "trategies an. Desta2ili<ing 1ational "trategies5G Journal of !inance5 Mol. %55 #''05 p. 3('&3'55 also in :nefficient 4arkets5 Chapter K.

)!gene FamaCs Res/onse

)-gene !ama5 F4arket )fficiency5 Bong Term 1et-rns5 an. 8ehavioral !inance5G Journal of !inancial Economics5 Mol. %'5 p. 2?3&30(. o 'ha& &o $o in an irra&ional worl$D