New Insights into Behavioral Finance Nieuwe inzichten in financiële gedragseconomie ISBN 978 90 5170 920 9 Cover design: Crasborn Graphic Designers bno, Valkenburg a.d. Geul This book is no. 429 of the Tinbergen Institute Research Series, established through cooperation between Thela Thesis and the Tinbergen Institute. A list of books which already appeared in the series can be found in the back. New Insights into Behavioral Finance Nieuwe inzichten in financiële gedragseconomie Thesis to obtain the degree of Doctor from the Erasmus University Rotterdam by command of the rector magnificus Prof.dr. S.W.J. Lamberts and in accordance with the decision of the Doctorate Board The public defence shall be held on Thursday 4 December 2008 at 16.00 hrs by GUIDO BALTUSSEN born in Hengelo (Overijssel), the Netherlands Doctoral Committee Promotor: Prof.dr. J. Spronk Other members: Prof.dr. H. Bleichrodt Prof.dr. W.F.M. De Bondt Prof.dr. P.P. Wakker Acknowledgments The completion of my PhD required a tremendous amount of work, which I could not have done without help and support of others. Therefore, I would like to thank everyone who has helped and supported me. In particular the following persons come to my mind. First and foremost I would like to thank Thierry Post for guiding and supporting me all along the way and helping me push my research (skills) to a higher level in every way I can think off. Similarly, I thank Martijn van den Assem, especially for teaching me the importance of (all kinds of) details. The three of us have had lots of fun (often also together with our girlfriends), in particular during the “Deal or No Deal” project and the various conferences we have visited. There have been times that I doubted about my PhD, but you have helped me through! I also thank Pim van Vliet for his support, great comments, and contributions, especially during the start and end of my thesis. My special thanks also go to the ‘godfather’ of behavioral finance and my other co-author, Dick Thaler, for his support, tremendous expertise, contributions and his work that inspired me to start and finish this thesis. Similarly, Peter Wakker has helped me greatly with his expertise, insightful comments, and contributions during all stages of my PhD, and therefore my gratitude. My thankfulness also goes to the other members of the small committee, Han Bleichrodt and Werner de Bondt, and to Jaap Spronk for support all along the way and acting as the head of my promotion commission in a difficult time. Furthermore I thank my co- authors on other projects; Kaisa Hytönen, Vasily Klucharev, and Ale Smidts. Acknowledgments My thanks also go to Gus Garita for the fun we have had and the help and comments you have given. It was a pleasure to share an office with you! To same holds for Jan-Frederik Slijkerman and Pim van Vliet. Thanks go out also to Nick de Heer and Marc Schauten for help during various stages of this thesis. Similarly, I thank Simon Lansdorp, Michiel de Pooter, Sandra Philippen, Stefan Trautmann, Sjoerd van Bekkum, Nico van der Sar, Philippe Versijp, and other colleagues at the Tinbergen Institute and the Finance department for a pleasant and challenging work environment. I am also indebted to the staff of the Tinbergen Institute, the Finance department and the Economics faculty; Jaap Abbring, Ursula David, Ine Driessen, Trudy van Florestein, Hans Gortemaker, Jacques van Hees, Carine Horbach, Arianne de Jong, Judith van Kronenburg, Helene Molenaar, Betty Rietveld, Willem Verschoor, Gerald de Wild, and Daphne Willems for their great help. Doing a PhD involves hard work which consumed most of my time. During this whole trajectory friends and family have always been a great support, also in remembering to enjoy other aspects of life. Special and many thanks go to my partner Cheryl and my twin brother Maarten for their patience, help and support. The same holds for my brother Simon, my sister Anne, my mother and father, my grandmother and grandfather, Cheryl’s father, the rest of my and Cheryl’s family, and all my friends. Guido Baltussen Rotterdam, July 2008. Table of Contents Chapter 1 Introduction ...........................................................................1 1.1 A brief outline...................................................................................1 1.2 The traditional finance paradigm ...................................................4 1.3 Behavioral finance ...........................................................................6 1.3.1 How people handle decisions .........................................................7 1.3.2 Psychological foundations for beliefs and judgments .................10 1.3.3 Psychological foundations for preferences...................................14 1.3.4 Limits to Arbitrage.......................................................................23 1.4 Main methodologies .......................................................................25 1.5 Outline of remaining chapters.......................................................26 Chapter 2 Violations of CPT in Mixed Gambles with Moderate Probabilities .............................................................................................31 2.1 Experimental design ......................................................................32 2.2 Experimental results .....................................................................35 2.3 Conclusions.....................................................................................36 Chapter 3 Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show........................................................................39 3.1 Description of the game show........................................................44 3.2 Data ................................................................................................48 3.3 Preliminary analysis......................................................................53 3.4 Expected Utility theory..................................................................62 3.5 Prospect Theory..............................................................................74 3.6 Experiments ...................................................................................84 3.7 Conclusions.....................................................................................90 3.8 Epilogue..........................................................................................92 Chapter 4 Risky Choice and the Relative Size of Stakes...............97 4.1 The psychology of the relative size of stakes ..............................101 4.2 Descriptions of editions and data ................................................103 4.3 Probit regression analysis............................................................115 4.4 Evidence from other countries and cross-country analyses .......121 4.5 Summary and concluding remarks .............................................126 Chapter 5 Irrational Diversification; An Experimental Examination of Portfolio Construction .............................................129 5.1 The experimental design..............................................................133 5.1.1 The basics of our experimental design ......................................133 5.1.2 The tasks.....................................................................................136 5.1.3 Testing for FSD-efficiency: the Kuosmanen test ......................137 5.1.4 Logical inference.........................................................................144 5.1.5 The subjects ................................................................................146 5.2 The experimental results.............................................................149 5.3 Concluding remarks.....................................................................158 5.A Appendix.......................................................................................161 Chapter 6 Loss Aversion and the Value Premium Puzzle ...........169 6.1 Theoretical framework.................................................................176 6.2 Empirical methodology ................................................................180 6.3 Data ..............................................................................................184 6.4 Empirical results..........................................................................187 6.4.1 Main results................................................................................188 6.4.2 Using institutional investor’s portfolio weights........................193 6.4.3 Choice of stock portfolios............................................................195 6.4.4 Choice of return frequency.........................................................200 6.4.5 Choice of bond index...................................................................205 6.4.6 Choice of parameterization ........................................................207 6.5 Concluding remarks.....................................................................210 Chapter 7 Summary and Conclusions..............................................217 Nederlandse Samenvatting (Summary in Dutch)............................221 References ...........................................................................................225 Chapter 1 Introduction 1.1 A brief outline Over the past few decades, behavioral finance has become a household name in the finance industry. Many financial institutions now offer financial services which trade on strategies that