Integrated Study on Behavioral Finance Case Study

Pages: 14 (4252 words)  ·  Bibliography Sources: 11  ·  File: .docx  ·  Level: Master's  ·  Topic: Finance  ·  Written: April 23, 2019

SAMPLE EXCERPT . . .
Risk aversion is often related to somebody who sees downside risk as catastrophic in nature, as is the case with retirement plan participants. A sophisticated investor may be perfectly rational under the assumption that any money lost can be recouped later – that investments will balance each other out. Someone saving for retirement might have a different view, especially the closer to retirement they get. Risk aversion is going to lead my colleague to make more conservative decisions in investing. She might prefer fixed income securities, stocks that pay high dividend rates, or simply stick to index funds, rather than attempt to build a portfolio with a higher risk profile. Such an approach may work just fine, but it is an example of how risk aversion can change one’s behavior versus what they should be doing with their investments.

Behavioral Finance and Investments

Siosan has demonstrated behaviors that are consistent with a convex utility function. She spends money on luxuries, so does not exhibit strong risk aversion behavior, but she also spends within the means of her salary and a part of her sizable bonus. She has committed to saving the other portion of her bonus, so therefore is not spending in a risky manner. She could certainly have a bit more fiscal discipline, but Siosan seems to fall within the convex utility curve.

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The convex utility curve for Siosan highlights some deviations from the traditional utility function in finance theory. That traditional function, as elaborated in expected utility theory, holds that people are predominantly rational in the economic sense, and will make decisions based on expected utility. Hey and Orme (1994) were unable to conclude that there are significant differences among subjects in their study with respect to expected utility theory – that this theory fit just as well with responses as any other theory might have.

Case Study on Integrated Study on Behavioral Finance Assignment

Rabin (1999) found that “a person has lower marginal utility for additional wealth when she is wealthy than when she is poor” (p.1), in the sense that any concave utility function over small stakes is irrational. Siosan does not demonstrate a concave utility function, and therefore her behavior is more consistent with what might be expected, even if it does step outside the realm of pure economic rationality. For her, there are some activities that provide a certain utility in her current day-to-day life that justify spending the money she spends, but she maintains some discipline and balance in her spending.

Siosan’s behavior reflects a slight bias towards risk-taking in the sense that she is not investing all of her money. Her present spending is probably more than a person would undertake given a purely rational decision-making process. Siosan, however, derives utility from this spending, in particular as this spending is on herself and within her means. This is the nature of the convex utility function – it incorporates some risk taking, or at least a lack of risk aversion. She is still making investments with some of her bonus money, but a more rational approach would not be to assume a bonus every year.

A more traditionally rational individual would behave differently. Such an individual would seek to maximize economic utility. At her age and stage of career, this would mean that she should be investing more, and spending less. She should be less indulgent in that sense. Furthermore, she should do something more like invest her entire bonus, and finance her lifestyle from her salary, or even save some of her salary as well. So her behavior is not quite as conservative as might be expected under traditional economic rationality.

Siosan’s portfolio allocation should be a little more realistic. I feel that she is not investing enough into the portfolio, and that might be what is leading her to take on some of the riskier behaviors. Buying out-of-money options on stocks is usually something that should be a part of an overall strategic plan for the portfolio, but Siosan appears to be basically gambling with these, treating her retirement savings a bit too much like a casino. This is the same thing as with the earthquake insurance. Her entire approach to investing at this points seem to be to gamble to make up for underinvesting.

Siosan is still at a good stage of her career, with twenty-odd working years in front of her, and those should be her prime earning years. As such, the gambles she has made to this point will not necessarily have a negative impact, depending on where her earning ceiling is. Not all lawyers are rich, after all. But Siosan has put herself at a disadvantage by spending too much of her income at the expense of saving, and taking advantage of the benefits of compounding. She should curtail her spending somewhat and invest more, in order to compound over the course of the next twenty-odd years until retirement. This might mean putting all of her bonus into savings, instead of spending half of it. It should also mean putting some of her salary into savings as well, if she can be that disciplined.

Siosan should also adopt more sound investing strategies. Options trading, especially the out of market stuff to try to score big, is more gambling than investing, and she probably is not earning good returns on this. She is demonstrating the risk-taking aspect of the convex utility function, the prospect theory part. The retirement account needs to be built, but on a sound foundation of equity investments, not options, and with more money flowing into it. Siosan cannot continue to count on either big options wins, or her future salary. At her present age, the future is now and she has to start investing like it – she should have done that several years ago.

Behavioral Corporate Finance

To: CFO

From: Me

Re: Recent literature on behavioral corporate finance

At your request, I am providing you with this brief overview of the recent literature on behavioral corporate finance. The field of behavioral corporate finance is a newly-emerging one, aimed at building frameworks by which the biases that influence decision-making find their way into corporate behavior. The rationale is much the same as for behavioral finance in general – markets assume rational behavior and yet irrational behavior can be observed.

One study on this topic, by Malmendier and Tate (2015) looks at overconfidence in senior executives – CEOs in particular – as a form of bias that can negatively affect corporate finance decisions. C-suite executives are often richly rewarded for work that leads to stock appreciation, but are seldom punished in any meaningful way when their company struggles. They might lose their jobs, but often have golden parachutes in their contracts, so the downside risk is lower than the upside risk. Plus, these are typically individuals with high levels of confidence. In their work, the authors are seeking to develop a framework to estimate overconfidence and apply that definition to studies that measure the influence of this bias on corporate decision-making. Garcia-Meca et al (2015) studied whether having institutional investors on boards affects the behavior of firms, finding mainly that there are different types of institutional investors and behaviors, and therefore they cannot be taken as a singular body, but broken up into categories for further study.

Hrnjic, Reeb and Yeung (2019) are among the authors that have studied behavioral corporate finance in the context of international markets. For companies that trade in the US, Sarbanes-Oxley creates specific risks for CFOs and CEOs, but the same governance structures do not exist in foreign countries. By applying behavioral corporate finance theories to foreign companies, it is possible not only to learn how cultural differences can influence behavior, but also to generate hypotheses as to the influence of different governance structures. Xu, Jin and Xin (2018) have also contributed to emerging market behavioral finance, by studying the differences between executive behavior in state-controlled firms in China, versus private ones.

The research is typical of a new field, with a lot of threads of research starting to emerge. These studies reflect that academics are investigating the topic from a number of angles, changing different variables in order to better understand behavioral corporate finance. There are no clear models for study, either, but there is some work being done to develop out such models. It is important to stay abreast of the latest research in this field, for when breakthoughs do occur.

Your Future and Behavioral Finance

There are several issues relating to behavioral finance that the firm can and should focus on going forward. The first is that the field of behavioral finance is still a work in progress. Aspects of it… [END OF PREVIEW] . . . READ MORE

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