MFE 230S and MBA 237-2
Mondays and Wednesdays 2-4 PM
Andersen Auditorium (F-295)
1. General Information
Office hours: Wednesdays 4-5 PM or by appointment.
Personal website: www.odean.us
2. Course Description
The course begins with a discussion of market efficiency, the “Winner’s
Curse,” speculative bubbles, and IPOs. We then discuss limits to arbitrage, the relative mispricing of common stocks, and the tendency of individual investors to trade in a highly correlated fashion. We look at an event study of a market anomaly, post-earnings announcement drift. We then turn to heuristic and biases identified by behavioral decision theorists and how these affect investor behavior. Topics include overconfidence, attribution theory, the representative heuristic, the availability heuristic, anchoring and adjustment, fairness, hindsight bias, and prospect theory. We then discuss how these biases and heuristics affect the behavior and welfare of investors. We look a number of market anomalies and at explanations, behavioral and otherwise, for anomalies. We discuss the pro’s and con’s of privatizing
social security. And we examine the applications of behavioral decision theory to corporate finance. Final topics may include ethics, the recent mutual fund scandal, fairness, and advertising in the securities industry. Due to time limitations we may not cover all final topics. The course consists of lectures and occasional interactive demonstrations.
Grading will be based on class participation and brief in-class summaries of articles read outside of class (15%), one homework assignment (35%), and a final exam (50%). The classroom presentation and the homework assignment can be done in teams of up to four students each.
The final exam is scheduled for May 15, 2005 from 2-4 PM.
Core course in finance.
5. Classroom demonstrations.
A variety of classroom demonstrations will be conducted. Some of these are in the form of games and auctions played for real money. Students may win
or lose money during these demonstrations. You will be paid their winnings and expected to pay your losses according to the rules of the game. (E.g., if yours is the winning bid in an auction, you must pay your bid—and receive
your prize—according to the rules of the game.) Be sure that you
understand the rules of the game before you play. You are not required to
participate in any game or demonstration involving real money. Choosing not to participate will not affect your grade. You must decide whether or
not to participate before the game or demonstration begins. During the
course of all the games and demonstrations, more money will be paid out to students than paid in by them. However, some students will pay more money than they receive, and some demonstrations will result in net losses to students in aggregate.
6. Readings, class notes, and handouts.
Class notes and the homework assignment will be posted to Catalyst (http://catalyst.haas.berkeley.edu). Most readings for this class are available online on www.study.net which students should access via Catalyst.
Additional readings, both required and recommended, will be posted online and/or distributed in class. The following articles are currently available on study.net:
1. Caginalp, Gunduz, David Porter, and, Vernon Smith, “Financial Bubbles: Excess Cash, Momentum,
and Incomplete Information,” Journal of Psychology and Financial Markets, 2001, Vol. 2, No. 2, pp.
2. Fama, Eugene F., “Market Efficiency, long-term returns, and behavioral finance,” Journal of Financial
Economics, 49, 1998, 283-306. (Recommended)
3. Garber, Peter M., “Famous First Bubbles,” Journal of Economic Perspectives, Spring 1990, pp. 35-54.
4. Thaler, Richard H., “Anomalies: The Winner’s Curse,” Journal of Economic Perspectives, Winter
1988, 191-202. (Required)
5. Shleifer, Andrei and Lawrence H. Summers, “The Noise Trader Approach to Finance,” Journal of
Economic Perspectives, Spring 1990, pp. 19-33. (Required)
6. Jones, Charles M., and Owen A. Lamont, “Short-sale constraints and stock returns,” Journal of
Financial Economics, 66, 2002, 207-239. (Recommended)
7. Taylor, Shelley E. and Jonathan D. Brown, “Illusion and Well-Being: A Social Psychological
Perspective on Mental Health,” Psychological Bulletin, 1988, vol 103, no. 2, pp. 193-210. (Required) 8. Odean, Terrance, “Volume, Volatility, Price, and Profit When All Traders Are Above Average,”
Journal of Finance, 53, 6, 1998, 1887-1934. (Sections I, II, IV, & V required; skip Section III and the
9. Barber, Brad M., and Terrance Odean, “The Internet and the Investor,” Journal of Economic
Perspectives, Winter, 2001, 41-54. (Required)
10. Tversky, Amos and Daniel Kahneman, “Judgment under uncertainty: heuristics and biases,” Science,
1974, 185, 1124-1131. (Required)
11. Tversky, Amos and Daniel Kahneman, “Rational Choice and the Framing of Decisions,” Journal of
Business, 1986, vol. 59, no. 4, pt. 2. (Required)
12. Thaler, Richard H., “Mental Accounting Matters,” Journal of Behavioral Decision Making, 1999, 21,
pp. 183-206. (Required)
13. Rabin, Matthew and Richard H. Thaler, “Anomalies: Risk Aversion,” Journal of Economic
Perspectives, Winter, 2001, 219-232. (Required)
14. Kahneman, Daniel and Dan Lovallo, “Timid Choices and Bold Forecasts: A Cognitive Perspective on
Risk Taking,” Management Science, vol. 39, no. 1, pp. 17-31. (Required)
15. Messik, David M. and Max H. Bazerman, “Ethical Leadership and the Psychology of Decision
Making,” Sloan Management Review, Winter 1996, pp. 9-22. (Required)
The Winner’s Curse, Bubbles, and IPOs
Introduction to course
The Winner’s Curse
Ingredients of the Winner’s Curse
Difficult or impossible to prove
Japanese real estate
Limits of Arbitrage & Systematic Trading
Limits of Arbitrage--theory
Closed-end Mutual Funds
Anomalies, a first look
Post-earnings announcement drift
Tests of joint hypotheses
Biases, heuristics, and the individual investor
Individual investors—why should we care?
Our own welfare
The investor’s problem
Match with own preferences, i.e., choose portfolio
Integrate new information
Intuition versus reasoning
Probability not intuitive
Positive self illusions--psychology Overconfidence
Entrepreneurs’ perceived chances for success
Illusion of control
Information based overconfidence Advantages of positive self-illusions Disadvantages of positive self-illusions Lowering overconfidence
Positive self illusions—investors
Volume Volatility Price and Profit
Learning to be overconfident
Do investors trade too much?
Trading is hazardous to your wealth.
Boys will be boys.
Online Investors: Do the slow die first?
Representativeness, Availability, Anchoring & Adjustment—
Ignoring base rates
Regression to the mean
Representativeness, Availability, Anchoring & Adjustment—investors
The Inside View
Preferences: Framing, Prospect Theory, and violations of Expected Utility
Violations of Expected Utility
Risk aversion—Rabin and Thaler
Mental accounting, Prospect Theory, & Attention
Prospect Theory & mental accounting—investors
Are investors reluctant to realize their losses?
IPOs revisited—money on the table
All that Glitters
Accounting based anomalies
Celestial and meteorological anomalies
Attention based anomalies
Value vs. growth
Behavioral theories of momentum
Overconfidence and self-attribution bias—DHS
EMH point of view
Own company stock
Default savings rates and allocations
Should Social Security be privatized?
Behavioral corporate finance
Limits of arbitrage
No need for aggregation
Executive compensation (HOS)
Capital budgeting (MT)
Mutual Fund Scandal
Advertising to investors
Where do new investors learn what to do?
Illusion of control
Information based overconfidence