Essays on behavioral finance

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One of the cornerstones of most economic and asset pricing models is how decision makers evaluate risk. Despite the fact that almost everyone faces risk in their lives and it is a crucial ingredient in economic models including asset pricing models, it is still an open debate how decision-makers or even investors evaluate risk. A large body of research assumes the standard expected utility framework to model the risk attitude of people and investors. However, experimental and empirical evidence shows that the standard expected utility theory falls short of explaining many economic and asset pricing phenomena. Behavioral finance provides alternative conceptual frameworks to explain these phenomena.

In Chapter 1, I investigate the potential impacts of the expected utility theory with an aspiration level on stock returns. Expected utility theory with an aspiration level departs from the standard expected utility theory. It assumes that achieving a given aspiration level generates an additional utility for the decision-maker yielding several implications different from those of the standard expected utility theory. For instance, marathon runners set a target time as an aspiration level, cabdrivers set a daily target for their income as an aspiration level, and investors might set an aspiration level return for a given time period which could explain why stocks have much higher expected returns than bonds (equity premium puzzle). 1 Motivated by this evidence, I investigate whether this conceptual framework can also shed light on predicting the cross-section of expected stock returns. I hypothesize that stocks that have higher probability of achieving the aspiration level return are more preferred, yielding a lower expected return. I find a significant negative relation between the probability of success and the expected stock return consistent with the hypothesis.

In Chapter 2, I investigate the impact of the law of small numbers on stock returns. According to the law of small numbers, people tend to infer too much from a small sample. For instance, people tend to believe that prior signals predict immediate reversal, while they also seem to believe that an unlikely long streak is a sign for continuation. The first phenomenon is known as the gambler’s fallacy, while the second phenomenon is known as the hot-hand fallacy. I assume that these phenomena might have an impact on stock returns as well and I test how these errors in the perception of risk can influence the risk-return trade-off. I find a significant and robust relation between the risk-return trade-off and prior signals of stocks consistent with these behavioral phenomena.

In Chapter 3, we investigate the relation between time discounting and risk taking in an experiment. Standard expected utility theory assumes independence between risk taking and time discounting yielding puzzling experimental and empirical results in behavioral finance literature. We test a model in an experiment that provides a theoretical framework for explaining these puzzling results. We also find evidence on the relation between risk taking and time discounting and we find supporting evidence for the model.

Gabor Neszveda
Tilburg University