Finance and the Behavioral Prospect (eBook)

James Ming Chen holds the Justin Smith Morrill Chair in Law at Michigan State University, USA. He teaches, lectures, and writes widely on law, economics, and regulation. His books, Disaster Law and Policy and Postmodern Portfolio Theory, cover a broad range of issues concerning extreme events and risk management, from natural to financial disasters. He is of counsel to the Technology Law Group of Washington, D.C.; a public member of the Administrative Conference of the United States; and an elected member of the American Law Institute. A magna cum laude graduate of Harvard Law School and a former editor of the Harvard Law Review, Chen also served as a clerk to Justice Clarence Thomas of the Supreme Court of the United States.

Dedication 8
Acknowledgments 10
Contents 12
chapter 1: The Structure of a Behavioral Revolution 14
1.1 Abnormal Markets, Irrational Investors 14
1.2 Anomalies, Fast and Slow 17
1.3 Sell in May and Go Away? 19
1.4 Law on the Market 20
1.5 Raw Emotion 24
1.6 Trade Like a Girl 27
Notes 30
chapter 2: Mental Accounting, Emotional Hierarchies, and Behavioral Heuristics 42
2.1 Keeping Emotional Score 42
2.2 Maslowian Portfolio Theory 44
2.3 “Shots at Greatness”: Rehabilitating Self-­Actualization in Neo-Maslowian Thought as a Trading Strategy 48
2.4 Behavioral Environmental Economics 51
2.5 Fables of the Reconstruction 53
Notes 55
chapter 3: Higher-Moment Capital Asset Pricing and Its Behavioral Implications 70
3.1 The Conventional Capital Asset Pricing Model 70
3.2 Higher-Moment CAPM as a Taylor Series Expansion 73
3.3 A Bridge Between Econometric and Behavioral Views of Low Volatility 80
Notes 80
chapter 4: Tracking the Low-Volatility Anomaly Across Behavioral Space 85
4.1 The Low-Volatility Anomaly and Bowman’s Paradox 85
4.2 Beta as a Composite Measure of Volatility and Correlation 88
4.3 Downside Volatility and Correlation Tightening in Emerging Markets 90
4.4 Pricing and Predicting Correlation Risk 92
4.5 Evidence Against a Correlation Risk Premium 95
Notes 97
chapter 5: The Intertemporal Capital Asset Pricing Model: Hedging Investment Risk Across Time 105
5.1 The Intertemporal Capital Asset Pricing Model 105
5.2 Bad Beta, Good Beta 110
5.3 Addressing the Low-Volatility Anomaly Through Spatial and Temporal Bifurcations of Beta 113
Notes 116
chapter 6: Risk Aversion 122
6.1 The Arrow–Pratt Measures of Risk Aversion the Coefficient of Absolute Risk Aversion
6.2 The Coefficient of Relative Risk Aversion 125
6.3 Pratt’s Risk-Averse Insurance Premium 125
6.4 Hyperbolic Absolute Risk Aversion 126
6.5 A Comparison with Scale-Invariant Models of Financial Returns 129
6.6 Risk Aversion, Risk Tolerance, and Their Relationship to the Sharpe and Kappa Ratios 130
6.7 The Allais Paradox 133
6.8 The St. Petersburg Paradox 137
Notes 139
Chapter 7: The Equity Risk Premium and the Equity Premium Puzzle 147
7.1 The Equity Risk Premium 147
7.2 A Cautious Stroll off Wall Street 150
7.3 The Equity Premium Puzzle 154
7.4 Another Puzzle, and a Challenge 156
7.5 Proposed Solutions to the Equity Premium Puzzle Habit Formation and the Life Cycle Hypothesis
7.6 Catching Up with the Joneses 161
7.7 Macroeconomic Disaster and Personal Peril 162
7.8 Familiarity Breeds Irrationality 166
7.9 Gaudeamus Igitur:The familiar but curious economics of university endowments 167
Notes 170
Chapter 8: Prospect Theory 190
8.1 Comprehensive Accounts of Behavioral Finance 190
8.2 Responding to Anomalies in Expected Utility Theory 191
8.3 The Value Function 193
8.4 Flagging Prospect Theory: Log-Logistic Distribution 196
8.5 Flagging Prospect Theory: Two-Parameter Lognormal Distribution 202
8.6 Cumulative Prospect Theory 205
8.7 The Weighting Function 207
8.8 The Fourfold Pattern 210
Notes 214
chapter 9: Specific Applications of Prospect Theory to Behavioral Finance 222
9.1 Skewness Preference and the Longing for Lotteries 222
9.2 Initial Public Offerings 229
9.3 Prospect Theory and Bowman’s Paradox 232
9.4 Prospect Theory and the Equity Premium Puzzle: Myopic Loss Aversion 237
9.5 Another Equity Premium Solution: Prospect Theory and Asset Pricing. 238
Notes 241
chapter 10: Beyond Hope and Fear: Behavioral Portfolio Theory 256
10.1 Prospect’s Progress: Beyond Theories of Everyman 256
10.2 SP/A Theory 257
10.3 The Human Heart in Conflict with Itself 259
10.4 Roy’s Safety-First Criterion 263
10.5 Behavioral Portfolio Theory 266
10.6 The Practical Consequences of Behaviorally Sensitive Portfolio Optimization 269
10.7 Behavioral Portfolio Theory as a Form of Value-at-Risk (VaR) Analysis 274
Notes 278
chapter 11: Behavioral Gaps Between Hypothetical Investment Returns and Actual Investor Returns 291
11.1 Hypothetical Investment Returns Versus Actual Investor Returns 291
11.2 The Disposition Effect 292
11.3 The Behavioral Origins of the Investment Gap 295
11.4 Measuring Behavioral Gaps in Investment Performance 297
11.5 The Effect of Capital Gains Taxation 300
Notes 301
chapter 12: Irrational Exuberance: Momentum Crashes and Speculative Bubbles 308
12.1 Some Speculation About Speculative Bubbles 308
12.2 The Behavioral Origins of Stock Market Momentum 310
12.3 Momentum Crashes 312
12.4 Liquidity Risk 314
12.5 A Simple Model of Informed and Naïve Trading 317
Notes 320
chapter 13: The Monster and the Sleeping Queen 330
Notes 332
Index 334