Project : Summary of Results

Transcription

1 Project : Summary of Results The results from the project are organized in three scientific papers: We here make brief summaries of the papers: Myopic Investment Management (Eriksen and Kvaløy; forthcoming in Review of Finance): Institutional investors hold more than 50 % of the stocks listed on the New York Stock Exchange. These institutions range from private and governmental pension funds to life insurance companies, mutual funds and private hedge funds. The majority of these institutions offer funds with limited constraints. Although fund managers meet constraints such as prohibitions against short-selling or holding of equity options, most fund managers have substantial discretion over how to allocate between stocks and bonds, and the general trend is that fund managers are becoming less constrained (Almazan et al., 2004). Despite this, the economic agents in most academic analysis of financial markets are private individual investors, investing their own endowment. One of the fundamental problems in finance, based on the expected preferences of private investors, is the so-called "the equity premium puzzle". The equity premium puzzle was put forward by Mehra and Prescott in 1985, and refers to the unreasonable high levels of risk aversion needed to explain why investors are willing to hold bonds and not put everything in stocks. A plausible explanation for the puzzle is based on the concept of myopic loss aversion (MLA). MLA relies on two behavioral assumptions: loss aversion and mental accounting. An individual exhibits loss aversion if the disutility from suffering a loss is higher than the utility from receiving an equally high gain (see Kahneman and Tversky, 1979) Mental accounting refers to the implicit method people use in order to organize and evaluate transactions and investments, in particular the tendencies people have of evaluating their investments frequently and independently (see Kahneman and Tversky, 1984, and Thaler, 1985). Benartzi and Thaler (1995) show that the observed equity premium in the U.S. stock market is consistent with investors having a moderate degree of loss aversion (i.e. investors who weigh losses two times larger than gains), and who evaluate their portfolios annually. Experimental evidence on individual investment choices shows that people take less risk the more often they evaluate their investments, supporting Benartzi and Thaler's explanation for the equity premium puzzle (see Gneezy and Potters, 1997; Thaler et al., 1997; Gneezy et al., 2003; Haigh and List, 2005; Bellemare at al.,2005; Sutter, 2007; Langer and Weber, 2008, and Fellner and Sutter, 2009). But a caveat with this evidence is that a substantial bulk of financial assets is managed by investment managers who do not always have the same objective as private investors and stock holders. The most important differences between managers and private investors are that the former manage other people's money and are governed by a more complex incentive system. Understanding how these issues affect risktaking and MLA behavior is highly relevant because investment managers have a great deal of discretion when making investment choices for their clients. Although clients can affect their portfolios' risk profile, the daily investment choices of investment managers affect the clients' risk exposure. In this paper we investigate experimentally how people take risk with other people's money. We hypothesize that people have so-called other-regarding preferences - in our framing meaning that the investment managers care about their clients' monetary outcome. In our baseline experiment based on Gneezy and Potters (1997), subjects were confronted with nine

2 rounds in which they could invest their endowment in a risky lottery. Two treatments were considered: in the "frequent treatment" subjects could decide how much to invest in every round and received feedback about the return after each round. In the "infrequent treatment", subjects could decide on their investment amount only every third round (which was then fixed for the next three rounds) and also received aggregated feedback after three rounds. In our main experiment we paired the subjects in "investment managers" and "clients" and manipulated both the investment managers' and the clients' evaluation rounds. We gave the investment managers no monetary incentives. This may be at odds with reality since an important issue in delegated portfolio management is the design of asset-based and performance-based compensation. However, if we enrich the experimental design by giving monetary incentives to the investment managers, it becomes difficult to identify the pure effect of investing other people's money, which is a crucial property of investment management. Hence, in our experiment the investment managers' incentives were solely related to the non-monetary utility from performing on behalf of clients. In order to test whether subjects really took on the role as investment managers, rather than just acting as hypothetical private investors, we also conducted a hypothetical version of the baseline experiment, in which subjects received hypothetical instead of real payments. We report on the following results: First, investment managers react to manipulation of evaluation frequency in the same manner as people who manage their own money. In other words, subjects exhibit behavior consistent with myopic loss aversion over other people's money, although to a lesser extent than subjects in our baseline experiment who invest their own endowment. Second, while manipulation of the investment managers' evaluation frequency has a significant effect on risk-taking, the clients' evaluation frequency has no effect on the managers' risk-taking. Third, men exhibit MLA-behavior over their clients' money to a larger extent than women. Fourth, subjects (and in particular men) take less risk with their clients' money than with their own. And finally, subjects take less risk with their clients' money than with hypothetical money. These results are interesting. Benartzi and Thaler argue convincingly that agency problems may cause investment managers to display myopic loss aversion, and lend empirical support from Leibowitz and Langetieg (1989), Schleifer and Vishny (1990) and Lakonishok et al. (1992): Short-term incentives generate short horizons, and long-term results are overshadowed by short-term losses. Our experimental results suggest that investment managers may exhibit MLA even in the absence of agency problems since even when investment managers have no monetary incentives, they behave consistently with MLA. In other words, the investment managers' objectives are (partly) aligned with their clients' objectives, even when there are no monetary incentives to secure alignment. Do Financial Advisors Exhibit Myopic Loss Aversion? (Eriksen and Kvaløy; forthcoming in Financial Markets and Portfolio Management) An increasing number of private investors with limited knowledge participate in the stock market by holding shares in different kinds of pension and mutual funds. Financial advisors are the connection between these small investors and complex financial markets, and they play an important role for millions of people who allocate their savings between stocks and bonds. Mutual fund investors often consider financial advisors as the most important information source (see Capon et al. 1996, and Alexander et al. 1998). Additionally, a paper

3 by Zhao (2005) documents that brokers and financial advisors serve as the true decisionmakers behind investments into load funds. Hence, one cannot fully understand financial markets without understanding the preferences and choices of these "middlemen." One of the financial puzzles still waiting to be fully understood is the size of the equity premium. The "equity premium puzzle" was put forward by Mehra and Prescott in 1985 and refers to the unreasonably high levels of risk aversion needed to explain why investors are willing to hold bonds, and not put everything into stocks. Several possible explanations for this puzzle have been proposed (for an overview, see Siegel and Thaler, 1997), and one explanation that has received much attention is Benartzi and Thaler theory of myopic loss aversion, as mentioned above. Experimental evidence on individual investment choices appears to support Benartzi and Thaler's explanation of the equity premium puzzle (see Gneezy and Potters, 1997; Thaler et al., 1997; Gneezy et al., 2003; Langer and Weber, 2003; Bellemare at al., 2005; Sutter, 2007; Fellner and Sutter, 2009). But a caveat to this evidence is that the subjects in the experiments are students, not professionals, and that a substantial bulk of financial assets is managed by investment managers, not by private investors. Hence, in this paper we make us of 50 professional financial advisors, who constitute the link between private investors and investment managers, and investigate their risk preferences. The financial advisors were recruited from the Norwegian bank SR-Bank. Their role is to inform private customers about the bank's financial products, and to provide advice on how to allocate between traditional deposits, bonds and different kinds of funds. Indeed, we find that the financial advisors exhibit behavior consistent with myopic loss aversion to a greater extent than students. This result is surprising. Except for a recent experiment by Haigh and List (2005), previous experiments and empirical research indicate that investor sophistication and market experience attenuate behavioral biases and market anomalies (e.g., List, 2002, 2003, 2004; and Feng and Seasholes, 2005). In contrast, Haigh and List (HL) find that "professional traders" exhibit myopic loss aversion to a greater extent than students. Our complementary result is important for several reasons: While our subject pool was a homogenous group of financial investment advisors whose main task is to advise people on how to allocate between stocks and bonds, HL's subject pool consisted of brokers, locals, clerks, floor managers and market reporters with only in common some kind of market experience. Moreover, while HL's subject pool was recruited from a pool of employees at the Chicago Board of Trade, we make use of all of SR-Bank's financial advisors, so we had no problems of self-selection. In this sense, our paper is a robustness check of HL's surprising findings, and we believe that these papers provide strong evidence that MLA is actually an important anomaly to understand, and a plausible explanation for the equity premium puzzle. More generally, our paper is part of the growing body of literature applying field experiments. Following Harrison and List's (2004) taxonomy, we conduct an artifactual field experiment, which is the same as a conventional lab experiment, but with a nonstandard subject pool. To our knowledge, no one has performed experiments on financial advisors, but there are several studies on financial investment advice, (see, e.g., Canner et al., 1997; Fisher and Statman, 1997; Siebenmorgen and Weber, 2003). Interestingly, these papers conclude that behavioral models of asset allocation are necessary to explain popular investment advice. Our experimental results support this hypothesis, since the advisors themselves reveal "behavioral" investment behavior.

4 Myopic Loss Aversion and the Gambler s Fallacy (Eriksen, Working paper, UiS) When people put money in the stock market, or play the roulette in Las Vegas, they take risky decisions and they (often) do it repeatedly. Under repeated risk-taking, both the history of outcomes, i.e. whether you win or loose, and how often outcomes are evaluated, matters. Two behavioral biases are of particular interest here: Gambler's fallacy and Myopic Loss Aversion (MLA). The gambler's fallacy arises from the misconception of laws of probability. People prone to the gambler's fallacy misinterpret the relevance of outcome sequences that stray away from the known underlying distribution, and mistakenly believe that immediate corrective events are due to occur. MLA arises from loss aversion and mental accounting, where the former implies that the disutility from suffering a loss is higher than the utility from receiving an equally high gain the latter implies that people frame risky decisions narrowly - in the sense that they evaluate their investments frequently and independently Interestingly, the gambler's fallacy implies that previous losses triggers risk-taking, while MLA implies that people take less risk the more frequently they evaluate the outcome of their investments. But if people are prone to the gambler's fallacy they should also take more risk the more frequently they observe losses. A question is then whether and how both these biases occur in a lottery game where losses are more likely than gains. In order to investigate this I analyze the time pattern of investments by making use of a data set from several experiments reported in Eriksen and Kvaløy (summary of papers above). While MLA behavior is caused by the failure to aggregate future prospects, gambler's fallacy concerns biases caused by the misinterpretation of the relevance that past observations have on future outcomes. The bias is associated with heuristic from the representativness family known as "the law of small numbers". Introduced by Tversky and Kahneman (1971) as a cognitive bias, it refers to individuals' tendency to look at outcomes in small random sequences as representative for the process's long run properties. The gambler's fallacy can be illustrated by the following example. Imagine that a subject participating in our experiment have just observed four negative outcomes in succession. He then makes the following chain of thought: If I observe a loss in the next round as well, this would complete a run of five successive losses. This would be a rare event, since the probability of five losses in succession must be very small [((2/3))⁵ 0.13]. I better invest in the lottery! The subject come to the erroneous conclusion that in this next round a positive outcome is more likely due to the successive losses just observed. Since the lottery is a random and independent process, and posses no memory of outcomes and no desire to balance out outcomes, the true probability of a loss is still 2/3. But the subjective probability of our subject is smaller. The main focus in this paper concerns the seemingly paradoxical relationship regarding behavior guided by MLA and behavior guided by the gambler's fallacy. A popular explanation of the MLA result is that since frequent evaluation of investments also is associated with more frequent experiences of losses, loss avers individuals should take less risk (compared to less frequent evaluation, where losses is less likely to be encountered). This is, however, a misinterpretation of MLA, since the MLA-hypothesis concerns prospect utility. MLA behavior should thus be triggered by the fear of losses, rather than the experiences of losses themselves. Indeed, this is what is found in the experiments. The main results are as follows: First, people are prone to the gambler's fallacy in the same lottery game that experimentally established MLA: People take significantly more risk after

5 observing a loss than after observing a gain. Hence, it is the fear of losing rather than the experience from losses that triggers MLA behavior. Second, the gambler's fallacy is associated with narrow framing: Those who evaluate investments frequently, significantly increases risk after observing losses, while those who evaluate infrequently does not. These results hold both for students and financial advisors, as well as people who invest other people's money and people who invest hypothetical instead of real money.