MGT 641b Behavioral Finance

By Eddie Reed,2014-08-08 03:46
10 views 0
MGT 641b Behavioral Finance

     Behavioral Finance


MFE 230S and MBA 237-2

    Spring 2006

    Mondays and Wednesdays 2-4 PM

    Andersen Auditorium (F-295)

1. General Information

Terrance Odean


    Phone: 510-642-6767

    Office: F495

    Office hours: Wednesdays 4-5 PM or by appointment.

    Personal website:

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.

3. Grading

    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.

4. Prerequisites

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 bidand receive

    your prizeaccording 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 ( Most readings for this class are available online on 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

    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.

    80-99. (Required)

    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

     Market Efficiency

     The Winner’s Curse


     Ingredients of the Winner’s Curse

     Valuation uncertainty

     Many bidders

     Historical Bubbles

     Difficult or impossible to prove


     South Sea

     British railroads

     Japanese real estate

     Experimental Bubbles



     Closed book

     Internet Bubble?

     Uncertain Values


     Many investors


Limits of Arbitrage & Systematic Trading

     Limits of Arbitrage--theory

     Relative mispricing

     Closed-end Mutual Funds

     Equity Carveouts

     Systematic Noise

    Anomalies, a first look

     Post-earnings announcement drift

     Event studies

     Tests of joint hypotheses

    Biases, heuristics, and the individual investor

     Individual investorswhy should we care?

    Asset prices

    Investor welfare

    Our own welfare

    The investor’s problem

    Estimate probabilities




    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


    Self-attribution bias

    Illusion of control

    Information based overconfidence Advantages of positive self-illusions Disadvantages of positive self-illusions Lowering overconfidence

Positive self illusionsinvestors

     Volume Volatility Price and Profit


     Frequent feedback

     Quick feedback

     Clear feedback

     Weather forecasters


     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


    Hot hand

    Ignoring base rates

    Regression to the mean

    Hindsight bias

    Confirmation bias

    Representativeness, Availability, Anchoring & Adjustmentinvestors

    Mutual funds

     The Inside View

Preferences: Framing, Prospect Theory, and violations of Expected Utility

     Expected Utility





     Violations of Expected Utility

    Prospect Theory

     Risk aversionRabin and Thaler

     “Coherent Arbitrariness”

Mental accounting, Prospect Theory, & Attention

     Mental accounting

     Prospect Theory & mental accountinginvestors

     Disposition effect

     Are investors reluctant to realize their losses?

     IPOs revisitedmoney on the table


     All that Glitters

Anomalies, revisited

     Accounting based anomalies

     Calendar anomalies

     Celestial and meteorological anomalies

     Attention based anomalies

     Value vs. growth


     Equity premium



     Behavioral theories of momentum


     Overconfidence and self-attribution biasDHS

     Disposition effectG&H

     EMH point of view

Savings behavior

     Own company stock

     Naïve diversification

     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)

Additional topcis



     Mutual Fund Scandal

    Advertising to investors

     Where do new investors learn what to do?

     Illusion of control

     Information based overconfidence


     Loss aversion

Report this document

For any questions or suggestions please email