The Behavioral Paradigm Shift
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Risk, Return, and the Overthrow of the Capital Asset Pricing Model Andrew West, CFA Manager, Investment Research
Special Topics: Fundamental Research March 2014 Risk, Return, and the Overthrow of the Capital Asset Pricing Model Andrew West, CFA Manager, Investment Research Harding Loevner invests based on common-sense principles drawn Competitive advantage within a favorable industry structure is a from our founders’ experience: we stick to high-quality, growing prerequisite for durable profitability in a company. A company in companies that we can identify through fundamental research. This an industry with unfavorable dynamics has a much steeper chal- general philosophy flows naturally from our nature as cautious, pa- lenge than one well-positioned with few rivals and strong bargain- tient people. It has been a constant throughout our firm’s existence ing power over buyers and suppliers. But, we also require that our since it was founded in 1989. In contrast to the boring continuity of companies possess competitive advantages that will allow them to thought in our little community, the prevailing wisdom in the larger sustain superior levels of return over time. Our analysts are primarily world of academic investment theory has turned about completely organized by industry rather than by geography as we believe that over this same quarter century. Theories regarding market behavior the understanding of industry structure and peer groups is key to and investment outcomes that were proclaimed as essential verities identifying such investment opportunities. and celebrated with Nobel Prizes at the beginning of this period were subsequently overturned at the end. That academic battle is an en- Sustainable growth allows cash flow and earnings to compound as grossing tale that we have followed with interest. -
Hyperbolic Discounting and Pension Design the Case of Germany
Stefan Zimmermann Hyperbolic Discounting and Pension Design The Case of Germany MSc Thesis 2010 Hyperbolic Discounting and Pension Design: The Case of Germany Master Thesis to achieve the degree Master of Science (M.Sc.) in Economics at the Faculty of Economics and Management at Tilburg University submitted by Stefan Zimmermann ANR: 661647 Words: 9509 Supervisor: Johannes Binswanger, PhD Second Reader: Nathanaël Vellekoop, Drs Berlin, August 17th, 2010 Abstract Both data and people’s self-reports reveal that there is a undersaving problem. Be- havioral economics seeks to explain this phenomenon with the concept of hyperbolic discounting. In essence, short-term actions are inconsistent with long-term goals. This is applied to the German pension system in this text. The results lean on a theoretical life-cycle model that is simulated in Matlab, whereby the parameters are calibrated to match the German economy. It is shown that myopic preferences lead to deviations from outcomes that would be desirable from a normative point of view. The savings rate is considerably lower for hyperbolic discounters, compared to standard discounters. Moreover, a fully funded pension scheme seems preferable to the current Pay-As-You-Go system. Contents List of Tables4 List of Figures4 1 Introduction5 2 Survey6 2.1 Facts about the German Pension System................7 2.2 Behavioral Aspects............................7 3 The Life-Cycle Model - LCM 10 3.1 The Life-Cycle Model without a Pension Scheme............ 11 3.1.1 Behavior of Private Agents.................... 11 3.2 The Life-Cycle Model with a Pension Scheme............. 16 3.2.1 Pay-As-You-Go Pension - PAYG............... -
Myron S. Scholes [Ideological Profiles of the Economics Laureates] Daniel B
Myron S. Scholes [Ideological Profiles of the Economics Laureates] Daniel B. Klein, Ryan Daza, and Hannah Mead Econ Journal Watch 10(3), September 2013: 590-593 Abstract Myron S. Scholes is among the 71 individuals who were awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel between 1969 and 2012. This ideological profile is part of the project called “The Ideological Migration of the Economics Laureates,” which fills the September 2013 issue of Econ Journal Watch. Keywords Classical liberalism, economists, Nobel Prize in economics, ideology, ideological migration, intellectual biography. JEL classification A11, A13, B2, B3 Link to this document http://econjwatch.org/file_download/766/ScholesIPEL.pdf ECON JOURNAL WATCH Schelling, Thomas C. 2007. Strategies of Commitment and Other Essays. Cambridge, Mass.: Harvard University Press. Schelling, Thomas C. 2013. Email correspondence with Daniel Klein, June 12. Schelling, Thomas C., and Morton H. Halperin. 1961. Strategy and Arms Control. New York: The Twentieth Century Fund. Myron S. Scholes by Daniel B. Klein, Ryan Daza, and Hannah Mead Myron Scholes (1941–) was born and raised in Ontario. His father, born in New York City, was a teacher in Rochester. He moved to Ontario to practice dentistry in 1930. Scholes’s mother moved as a young girl to Ontario from Russia and its pogroms (Scholes 2009a, 235). His mother and his uncle ran a successful chain of department stores. Scholes’s “first exposure to agency and contracting problems” was a family dispute that left his mother out of much of the business (Scholes 2009a, 235). In high school, he “enjoyed puzzles and financial issues,” succeeded in mathematics, physics, and biology, and subsequently was solicited to enter a engineering program by McMaster University (Scholes 2009a, 236-237). -
Do Stock Prices Move Too Much to Be Justified by Subsequent Changes
Do Stock Prices Move Too Much to be Justifiedby SubsequentChanges in Dividends? By ROBERTJ. SHILLER* A simple model that is commonlyused to and RichardPorter on the stock market,and interpret movements in corporate common by myself on the bond market. stock. price indexes asserts that real stock To illustrategraphically why it seems that prices equal the present value of rationally stock pricesare too volatile,I have plotted in expected or optimally forecastedfuture real Figure 1 a stock price index p, with its ex dividendsdiscounted by a constant real dis- post rational counterpart p* (data set 1).' count rate. This valuation model (or varia- The stock price index pt is the real Standard tions on it in which the real discount rate is and Poor's Composite Stock Price Index (de- not constant but fairly stable) is often used trended by dividing by a factor proportional by economistsand marketanalysts alike as a to the long-run exponential growth path) and plausible model to describe the behaviorof p* is the present discounted value of the aggregatemarket indexes and is viewed as actual subsequentreal dividends (also as a providing a reasonable story to tell when proportionof the same long-rungrowth fac- people ask what accounts for a sudden tor).2 The analogous series for a modified movement in stock price indexes. Such Dow Jones IndustrialAverage appear in Fig- movementsare then attributedto "new in- ure 2 (data set 2). One is struck by the formation" about future dividends. I will smoothness and stability of the ex post ra- refer to this model as the "efficientmarkets tional price series p* when compared with model"although it shouldbe recognizedthat the actualprice series.This behaviorof p* is this name has also been applied to other due to the fact that the presentvalue relation models. -
Editor's Letter
Why I Shall Miss Merton Miller Peter L. Bernstein erton Miller’s death received the proper somewhere,” he recalls. Miller was instrumental in tak- notices due a winner of the Nobel Prize, but ing Sharpe to the Quadrangle Club in Chicago, where Mthese reports emphasize the importance of he could present his ideas to faculty members like his intellectual contributions rather than his significance Miller, Lorie, and Fama. The invitation led to an as a human being. Nobody gives out Nobel Prizes for appointment to join the Chicago faculty, and Sharpe being a superior member of the human race, but Miller and his theories were on their way. would surely have been a laureate if someone had ever Miller’s role in launching the Black-Scholes- decided to create such a prize. Merton option pricing model was even more deter- Quite aside from the extraordinary insights gained mining. In October 1970, the three young scholars from Modigliani-Miller, we owe Merton Miller a deep had completed their work, and began the search for a debt of gratitude for his efforts to promote the careers journal that would publish it. “A Theoretical Valuation of young scholars whose little-noted innovations would Formula for Options, Warrants, and Other in time rock the world of finance. Works at the core of Securities”—subsequently given the more palatable modern investment theory might still be gathering dust title of “The Pricing of Options and Corporate somewhere—or might not even have been created— Liabilities”—was promptly rejected by Chicago’s by guest on October 1, 2021. -
The International Monetary System: Quo Vadis
Columbia University Department of Economics Discussion Paper Series The International Monetary System: Quo Vadis Robert A. Mundell Discussion Paper #:0102-34 Department of Economics Columbia University New York, NY 10027 March 2002 The International Monetary System: Quo Vadis Robert Mundell Columbia University February 8, 2001 Manuel Guitian Memorial Lecture, International Monetary Fund, February 8, 2001 I. Manuel Guitian Manuel Guitian was one of two brilliant students I met in 1965 at the Graduate Institute of International Studies in Geneva. Both went on to the University of Chicago for the Ph.D. program and to great distinction as economists. The other student was Rudiger Dornbusch. My students at Geneva were required to write a research paper on international monetary economics. Manuel and I agreed that he should look into the Poincare-Rist stabilization of the franc in 1926. That got him interested in exchange rate theory and it was an interest that persisted throughout his life. The quality of his analysis of that important episode from the inter-war years convinced me that Manuel had a good future as an economist and I encouraged him to go to Chicago for his Ph.D. University of Chicago Economics in the late 1960s was in one of its golden periods, maybe comparable to Vienna in the 1880s or Harvard, Chicago or Cambridge in the 1930s. There were Frank Knight (emeritus), Earl Hamilton (emeritus), Milton Friedman, Theodore Schultz, Harry Johnson, George Stigler, Hiro Uzawa, Arnold Harberger, Merton Miller, Bert Hoselitz, Robert Fogel, D. Gale Johnson, Gary Becker, Robert Aliber, Arthur Laffer, Stanley Fischer, Herbert Grubel, and myself. -
Beyond Greed and Fear Financial Management Association Survey and Synthesis Series
Beyond Greed and Fear Financial Management Association Survey and Synthesis Series The Search for Value: Measuring the Company's Cost of Capital Michael C. Ehrhardt Managing Pension Plans: A Comprehensive Guide to Improving Plan Performance Dennis E. Logue and Jack S. Rader Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation Richard O. Michaud Real Options: Managing Strategic Investment in an Uncertain World Martha Amram and Nalin Kulatilaka Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin Dividend Policy: Its Impact on Form Value Ronald C. Lease, Kose John, Avner Kalay, Uri Loewenstein, and Oded H. Sarig Value Based Management: The Corporate Response to Shareholder Revolution John D. Martin and J. William Petty Debt Management: A Practitioner's Guide John D. Finnerty and Douglas R. Emery Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities Su Han Chan, John Erickson, and Ko Wang Trading and Exchanges: Market Microstructure for Practitioners Larry Harris Beyond Greed and Fear Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin 2002 198 Madison Avenue, New York, New York 10016 Oxford University Press is a department of the University of Oxford It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Bangkok Buenos Aires Cape Town Chennai Dar es Salaam Delhi Hong Kong Istanbul Karachi Kolkata Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi São Paulo Shanghai Taipei Tokyo Toronto Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Copyright © 2002 by Oxford University Press, Inc. -
Eugene F. Fama Booth School, University of Chicago, Chicago, IL, USA
Two Pillars of Asset Pricing Prize Lecture, December 8, 2013 by Eugene F. Fama Booth School, University of Chicago, Chicago, IL, USA. he Nobel Foundation asks that the Prize lecture cover the work for which T the Prize is awarded. Te announcement of this year’s Prize cites empirical work in asset pricing. I interpret this to include work on efcient capital markets and work on developing and testing asset pricing models—the two pillars, or perhaps more descriptive, the Siamese twins of asset pricing. I start with ef- cient markets and then move on to asset pricing models. EFFICIENT CAPITAL MARKEts A. Early Work Te year 1962 was a propitious time for Ph.D. research at the University of Chi- cago. Computers were coming into their own, liberating econometricians from their mechanical calculators. It became possible to process large amounts of data quickly, at least by previous standards. Stock prices are among the most acces- sible data, and there was burgeoning interest in studying the behavior of stock returns, centered at the University of Chicago (Merton Miller, Harry Roberts, Lester Telser, and Benoit Mandelbrot as a frequent visitor) and MIT (Sidney Alexander, Paul Cootner, Franco Modigliani, and Paul Samuelson). Modigli- ani ofen visited Chicago to work with his longtime coauthor Merton Miller, so there was frequent exchange of ideas between the two schools. It was clear from the beginning that the central question is whether asset prices refect all available information—what I labeled the efcient markets hy- pothesis (Fama 1965b). Te difculty is making the hypothesis testable. We can’t 365 6490_Book.indb 365 11/4/14 2:30 PM 366 The Nobel Prizes test whether the market does what it is supposed to do unless we specify what it is supposed to do. -
Building on Kahneman's Insights in the Development of Behavioral
7_SHEFRIN.DOCX 5/15/2013 12:46 PM Building On Kahneman’s Insights in the Development of Behavioral Finance Hersh Shefrin* INTRODUCTION First, I want to thank Michael Kaufman for inviting me to be part of this esteemed panel. And second, I would like to thank Danny Kahneman for his wisdom, insights, generosity, kindness, and much more. On a personal dimension, I first met Danny in 1978 when he and Amos Tversky were visiting Stanford University’s Center for Advanced Study in the Behavioral Sciences. At the time I was working with Dick Thaler, who was also visiting Stanford, on developing a System 1/System 2 model of economic choice.1 It should come as no surprise that what I learned from Danny and Amos in those first interactions, and subsequently over the years, dramatically influenced my own research and indeed the entire field of economics.2 * Mario L. Belotti Professor of Finance, Santa Clara University. This Article stems from remarks that I gave in response to Daniel Kahneman’s keynote address at Loyola University Chicago School of Law’s Second Annual Investor Protection Conference, “Behavioral Economics and Investor Protection.” 1. See generally DANIEL KAHNEMAN, THINKING, FAST AND SLOW 19–109 (2011) (describing System 1 and System 2 decision making processes). Professor Adam Zimmerman briefly summarizes the two Systems as follows: Cognitive psychologists and neurologists have identified two types of decisionmaking processes: intuitive and deliberative. Intuitive decisionmaking processes, which are sometimes called System I processes, are intuitive, automatic, and quick, encompassing the types of instantaneous judgments that permit a person to size up a situation. -
Richard Thaler and the Rise of Behavioral Economics
Richard Thaler and the Rise of Behavioral Economics Nicholas Barberis Yale University April 2018∗ Abstract Richard Thaler was awarded the 2017 Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. In this article, I review and discuss these contributions. JEL classification: B2, D9, G1 Keywords: endowment effect, prospect theory, mental accounting, nudge ∗I am grateful to Hunt Allcott, Ingvild Almas, James Choi, Stefano DellaVigna, Keith Ericson, Owen Lamont, Ulrike Malmendier, Matthew Rabin, and Jesse Shapiro for helpful discussions about the content of this article. 1 I. Introduction From the 18th century to the first half of the 20th century, the leading economists of the day – figures such as Adam Smith, John Maynard Keynes, and Irving Fisher – were known to bring aspects of human psychology into their analysis of the economy. By the middle of the 20th century, however, this practice was less common, and with the advent of the rational expectations revolution in the 1960s, economists began to focus almost exclusively on models with the same, tightly-specified assumptions about individual psychology: that people have rational beliefs, and that they make decisions according to Expected Utility. In the early 1980s, a small group of economists began to argue that the rational ex- pectations revolution had gone too far, and that to understand many important economic phenomena, it was critical to develop new models that made assumptions about human be- havior that were psychologically more realistic, and that, in particular, allowed for less than fully rational thinking. This message was roundly dismissed at first, sometimes in scornful terms, but it gradually gained traction. -
Matthew Rabin and Richard Ho Thaler
Journal of Economic Perspectives- .Volume 15, Number 1. -Winter 2001. -Pages 219-232 Matthew Rabin and Richard Ho Thaler conomics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that rational agents with I stable, well-<lefined preferences interact in markets that (eventually) clear. An empirical result qualifies as an anomaly if it i~ difficult to "rationalize" or if implausible assumptions are necessary to explain it within the paradigm. Sugges- tions for future topics should be sent to Richard Thaler, c/oJournal of Economic Perspectives, Graduate School of Business, University of Chicago, Chicago, IL 60637, or ([email protected]). Introduction Most of the columns in this "Anomalies" series have discussed empirical results that, if taken at face value, immediately strike economists as violations of the standard economic model. Risk aversion, the topic of this entry in the series, is rather different. Here the behavior we will point to--the hesitation over risky monetary prospects even when they involve an expected gain-will not strike most economists as surprising. Indeed, economists have a simple and elegant explanation for risk aversion: It derives from expected utility maximization of a concave utility-Qf-wealth function. This model is used ubiquitously in theoretical and empirical economic research. Despite its central .Matthew Rabin is Professor of Economics, University of California, Berkeley, and visiting BP Professor of Economics, London School of Economics, London, United Kingdom. Richard H. Thaler is the Robert P. Gwinn Professor of Economics and Behavioral Science, Graduate School of Business, University of Chicago, Chicago, Illinois. -
Behavioral Economics: Past, Present, and Future†
American Economic Review 2016, 106(7): 1577–1600 http://dx.doi.org/10.1257/aer.106.7.1577 Behavioral Economics: Past, Present, and Future† By Richard H. Thaler* In recent years there has been growing interest in the mixture of psychology and economics that has come to be known as “behavioral economics.” As is true with many seemingly overnight success stories, this one has been brewing for quite a while. My frst paper on the subject was published in 1980, hot on the heels of Kahneman and Tversky’s 1979 blockbuster on prospect theory, and there were ( ) earlier forerunners, most notably Simon 1955, 1957 and Katona 1951, 1953 . ( ) ( ) The rise of behavioral economics is sometimes characterized as a kind of paradigm-shifting revolution within economics, but I think that is a misreading of the history of economic thought. It would be more accurate to say that the method- ology of behavioral economics returns economic thinking to the way it began, with Adam Smith, and continued through the time of Irving Fisher and John Maynard Keynes in the 1930s. In spite of this early tradition within the feld, the behavioral approach to eco- nomics met with considerable resistance within the profession until relatively recently. In this essay I begin by documenting some of the historical precedents for utilizing a psychologically realistic depiction of the representative agent. I then turn to a discussion of the many arguments that have been put forward in favor of retaining the idealized model of Homo economicus even in the face of apparently contradictory evidence. I argue that such arguments have been refuted, both theo- retically and empirically, including in the realm where we might expect rationality to abound: the fnancial markets.