Behavioral Finance

Utility of Money

Introduction

Why are we inclined to sell the shares in our portfolio that are performing well,
and hold onto those that are performing poorly?
Why should you always buy auto insurance and never buy electronics
insurance?
Why do we over-estimate the probability of plane crashes and under-estimate
the probability of car crashes?
Why is it significant that the recent credit crisis, the worst economic recession
that the US has seen since the 1930s, took place 75 years after the Great
Depression?

Behavioral finance is a relatively new school of thought that addresses and

provides insight into questions like these. All of us have innate psychological biases
that can lead to predictable errors in how we make important financial decisions.
Behavioral finance catalogues these errors and helps us to anticipate, and hopefully
avoid, these decision-making traps.
As you work through this course, be prepared to make mistakes
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Rational Expected Utility

In this section, we look at the traditional economic model of consumer choice, which
seeks to describe how people are expected to behave when making financial decisions.
This traditional model assumes that individuals are rational, and that they make
decisions in ways that maximize their expected utility (or happiness) from money
made or lost.

We will specify various axioms (assumptions about behavior that traditional

economists view as self-evident), and show under what circumstances we frequently
and reliably violate those very assumptions.
When you have completed this section, you will understand:
What economists mean when they talk about risk aversion
Budget constraints, indifference curves, and how we utilize both to optimize our
consumption
Some rational utility axioms, and under what circumstances these axioms fail to
describe the way most people behave.
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Utility of Money

See the Lecture:

Utility of Money

Utility
U(10)
U(5)

Utility = happiness

U(0)
0

10

Wealth

Implications of the graph:

More money is undoubtedly better than less: U(10) > U(5), BUT
The incremental (marginal) value of an additional dollar gets smaller as our
wealth increases: U(5) U(0) > U(10) U(5)

The Utility of a Gamble: Risk Aversion

Ask yourself what is the most you would pay to play the following game:
Toss a fair coin.
If it lands heads, you get $15
If it lands tails, you get $5
The fair (or expected) value of the game is x 15 + x 5 = $10
Would you pay $10 to play? If not, how much would you pay?
What is your utility for the game?
U(G) = U(15) + U(5)

where U(G) = the utility of the Game

How much will you pay to play the game?

You will pay $G, where:
U(G) = U(15) + U(5)
*To calculate expected value, multiply each possible outcome
with the probability of that outcome, and add all of these
probability-weighted outcomes together

Risk Aversion
Utility
U(15)
These two
distances are
the same

U(10)
U(G)
U(5)

U(G) = U(5) + U(15)

<

The probability-weighted sum

of the utilities for each
outcome

Is less
than

10

15

Wealth

U( x 5 + x 15) = U(10)
the utility of the expected
value of the outcomes

The St Petersburg Paradox

A Demonstration of risk aversion
Imagine you are going to play a game with two rules:

(1) An unbiased coin is tossed until it lands on Tails

(2) The player is paid $2 if Tails comes up on the opening toss, $4 if Tails first
appears on the second toss, $8 if Tails first appears on the third toss, etc.
Q1: How much would you be willing to play this game?____
Q2: What is the expected value of this game (in dollars)?* _____
St. Petersburg Simulation
Harvard professor Dr. Oliver Knill created a simulation available at Mathematik.com. Try the St. Petersburg
Paradox for yourself...Play the Simulation! Return here when done.

*To calculate expected value, multiply each possible

outcome with the probability of that outcome, and add
all of these probability-weighted outcomes together

Make a note of your answers

to Q1 and Q2

The St Petersburg Paradox

Whats the Expected Value?
Theres 50% chance the coin lands on Tails on the first toss. In this case, you earn $2
and the game is over.
Theres also the possibility that the coin lands on Heads first. In this case, youll toss
again if it now lands on Tails, youll make $4 and the game is over. The probability
of Heads, then Tails, is 25%
What about if you get Heads on both the first and second tosses, and then Tails on
the third? The probability of this outcome is 12.5%, and youll earn $8. And so on

Expected Value = (50% * $2) + (25% * $4) + (12.5% * $8) +

=
So: would you pay a
very large amount to
play this game?

$1 +

$1

$1

= an infinite amount of money!

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The St Petersburg Paradox

How much would you be willing to pay?
The amount we are willing to pay can be measured by the Games Utility, which, as weve
seen, is NOT the same as its Expected Value.
If the coin lands on Tails first (50% probability), you earn $2. Your Utility is U[2], with
probability 50%.
If the coin lands first Heads then Tails (with probability 25%), you earn $4. Your utility is
U[4]. As shown on the graph we looked at earlier, your utility for $4 is greater than your
utility for $2, but its not quite twice as great. That is: U[4] < 2 * U[2].
Similarly for each successive outcome. The probability of each successive outcome falls by
half each time, but the Utility of each outcome grows by less than half. So, unlike the
Expected Value, which is infinite, our Utility is significantly less than infinite.
Utility

= 50% * U[2] + 25% * U[4] +

= much less than an infinite amount of $$!
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The St Petersburg Paradox

In summary, we see that while the Expected Value of this game is infinite, the Utility of
the game as measured by how much we are willing to pay to play it is considerably less
than infinite.
Most people would only pay a few dollars to play.

Utility

= 50% * U[2] + 25% * U[4] +

= much less than an infinite amount of $$!

This graph shows one example of a riskaverse utility function:

Risk-Averse Utility Function

Utility

U[X] = X0.7
Where X = dollar amount
U[X] = our utility (or happiness) from
those dollars

An individual with this utility function would

be willing to pay about $4.35 to play the St
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Petersburg Paradox game.

Are we Rational Decision-Makers?

Much of behavioral finance involves identifying and categorizing common behavioral
patterns that defy the so-called rational model of consumer choice.
In the next few slides, we look at the classical economic theory of rational behavior,
including three axioms of rational consumer choice. We then show some examples
of ways in which our day-to-day choices may be considered irrational, because they
violate the axioms.

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Budget Constraint
For simplicity, we will begin with a world in which a consumer must select
between just two goods, coffee & donuts, subject to a budget constraint that
determines the maximum she can afford.
The numbers on the axes reflect
units of each good, while the
budget constraint line represents
all affordable combinations, given
consumers budget and the costs
of each item.

Coffee

Budget constraint
6

In this example, donuts are $1,

while coffee is $2

Your budget constraint is $17

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Donuts

One possible combination is 7 donuts, and 5 cups of coffee (see )

Another is 5 donuts, and 6 cups of coffee (see )
An increase in consumption of one good leads to a reduction in consumption of the other, because of the
budget constraint
Does it seem likely that each of the available combinations is equally attractive? Would the consumer be as
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happy with 17 donuts but no coffee (see ), versus the other two options?

Indifference Curves
We also assume that each consumer has a set of indifference curves that reflect her
preferences for different combinations of the two goods.
Unlike budget constraints, indifference curves are not typically linear
Coffee
Increasing
satisfaction
7
6

I-curve
I-curve

10

Donuts

Each indifference curve reflects a combination of options between which the consumer is
indifferent
She would be equally happy with 7 cups of coffee, and 5 donuts, versus 3 cups of coffee, and 10
donuts
She would experience greater overall happiness if she were able to jump to a higher indifference
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curve; e.g., one in which she could have 6 coffees, and 9 donuts

Indifference Curves Across Consumers

Coffee

Sarahs I-curve
Johns I-curve
Donuts

Within this theory of consumer choice, it is feasible for different individuals

to have different indifference curves:
In the above example, John would need a substantial increase in the
quantity of his coffee to offset the loss of just one donut (the slope of
his indifference curve is steep)
Sarah, however, would willingly relinquish several donuts in order to
secure an extra coffee

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Using Indifference Curves to Optimize Consumption

Coffee
Sarahs optimum
combination
Sarahs
budget
constraint

Sarahs I-curves

Donuts

Given the shape of Sarahs indifference curves, and her budget constraint, we can
identify the optimum combination of coffee and donuts, as indicated.

With these relatively straightforward concepts in place, we can now identify some
axioms implied by this model of consumers indifference curves and budget
constraints

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Axiom 1:
Dominance, or More Is Better

In this axiom, we are simply stating that, all else equal, more of a particular good is
better than less.
In reality, we need some assumptions about the ability to store, or sell, excess amounts
of a good over a given time period. Even John does not want 25 cups of coffee on a
single day. If he cannot either profit by selling them, or put them aside to be used
tomorrow, then at a certain point, he has a limit to how many he would like to
consume.
However, the More is Better axiom fits with the graph of the indifference curves, which
clearly represent higher levels of satisfaction given increasing quantities of each good.
Violations of this axiom are common, and many relate to a set of biases known
collectively as the Disposition Effect.

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Axiom 2:
Invariance, or Consistency
A decision-maker should not be affected by the way alternatives are presented. That
is, her preference between option A and option B should not change based on the
language used to describe the two.

This axiom sounds universally applicable, but we will see that it is one of the most
violated axioms. We are in fact strongly influenced by how options are presented to
us. It has been shown repeatedly, for example, that meat labeled as 75% lean will
sell better than the same product marked 25% fat.
We will see numerous examples of violation of this axiom throughout this course.
These examples fit within the set of biases generally referred to as Framing issues
or Preference Reversals.*

*In the formal theory of Expected Utility, Preference Reversals are usually considered to defy a slightly different
Axiom known as Transitivity. However, distinguishing the two (i.e., separating Framing Issues from Preference
Reversals) adds some complexity with minimal additional insight, so for our purposes we have combined the two 17
axioms under the single heading.

Axiom 3:
Independence, or Cancellation
This axiom states that choices should be independent of proportional reductions.
That is, introducing a third option that has no bearing on the choice between the
first two should not affect your earlier choice.
As a more intuitive (if rather flippant) example, consider the following:
A man comes into a delicatessen and asks what kinds of sandwiches they have. The
attendant answers that they have roast beef and chicken. The patron thinks for a
minute and then selects the roast beef. The server then says, Oh, I forgot to
mention, we also have tuna. The patron responds, Well, in that case I guess Ill
have chicken.

Unlike Dominance and Invariance, Independence seems somewhat nuanced,

although this axiom is as much a requirement of the classical economic theory of
rational decision-making as the other two. Violations of this axiom are often
related to a bias known as the Certainty Effect.

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Examples of Irrational Behavior

It is important to keep in mind that
rationality is an assumption in
economics, not a demonstrated fact*

The following slides invite you to examine your own decision-making, to see
whether your choices are consistent with the axioms of rational behavior, or
whether you exhibit irrationality in some circumstances.
As you work through these three examples, think about which axiom is violated
in each case.

Professor Richard Thaler, University of Chicago

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Example 1:
Two Decisions with Gains and Losses
Here are two decisions, each of which has two alternatives. Please decide which
alternative you prefer among the two in Decision 1, and which you prefer in
Decision 2. Make a note of your selections before moving on.
Decision 1

Which do you prefer:

A or B?

Alternative A:

A sure gain of $240

Alternative B:

A 25% chance to gain $1,000, and a 75% chance to

gain nothing

Which do you prefer:

C or D?

Decision 2

Alternative C:

A sure loss of $750

Alternative D:

A 75% chance to lose $1,000, and a 25% chance to

lose nothing
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Example 1:
Two Decisions with Gains and Losses

Decision 1

A
C

-$510

Decision 2

-$750

-$760

$250

75%

100%

$240

75%

25%

-$1000
56%

25%

$0
38%

$1000

6%

Each of the 4 rectangles above shows the range of outcomes and outcome probabilities from
the combination of the two decisions, based on the two possible alternatives in each case.
For example, if you picked A & C (the top left outcome), you will lose exactly $510

If you picked B & D (bottom right), you will:

lose $1,000 with 56% probability
neither win nor lose with 38% probability
win $1,000 with 6% probability

But these are not the

interesting outcomeskeep
reading
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Example 1:
Two Decisions with Gains and Losses

Decision 1

A
C

-$510

B
-$750

Decision 2

$250

75%

-$760
75%

$240
25%

-$1000
56%

25%

$0
38%

$1000

6%

Did you select A & D (bottom left)? If so, you are like about 50% of people who play this game. You will:
Lose $760 with probability 75%
Win $240 with probability 25%
Now compare A & D (bottom left) with B & C (top right). They look very similar, except that B & C is
better in both cases! For B & C, you have:
The same 75% probability of losing money, but you lose a little less (only $750, instead of $760).
The same 25% probability of making money, but you make a little more ($250 instead of just $240).
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Example 1:
Two Decisions with Gains and Losses

Decision 1

A
C

-$510

B
-$750

Decision 2

$250

75%

-$760

$240

75%

25%

-$1000
56%

25%

$0
38%

$1000

6%

Economists would say that B & C dominates A & D, because with the former combination, you do a little
bit better in either probability scenario. So why do around 50% of respondents typically select the
dominated A & D outcome?
There are two principal reasons:
(1) We are not good at looking at outcomes over multiple games (in this case, Decision 1 followed by
Decision 2). We tend to treat each one as a stand-alone decision (well see later that this provokes
irrational decisions about whether to buy product insurance)
(2) We are inclined to be riskseeking in certain predictable scenarios. We will see that this has
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significant implications across a whole host of financial decisions.

Example 2:
Choosing and Pricing

You are offered the choice between these two Gambles. Make a note of your
response before moving on.

Gamble A

Gamble B

11/36 chance of winning $80

25/36 chance of losing $7.50

35/36 chance of winning $20

1/36 chance of losing $5

Which Gamble would you

PREFER to play: A or B?

24

Example 2:
Choosing and Pricing

You are now asked a slightly different question relating to these two gambles.
Again, make a note of your response before moving on.

Gamble A

Gamble B

11/36 chance of winning $80

25/36 chance of losing $7.50

35/36 chance of winning $20

1/36 chance of losing $5

How much would you be willing to

PAY to play Gamble A? How about
Gamble B?

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Example 2:
Choosing and Pricing
Gamble A

Gamble B

11/36 chance of winning $80

25/36 chance of losing $7.50

35/36 chance of winning $20

1/36 chance of losing $5

Which gamble would you prefer to play: Gamble A, or Gamble B?

How much would you be willing to pay to play Gamble A vs Gamble B?

On average, people would PREFER to play A but
would PAY MORE to play B

Choosing and pricing are different psychological

processes. Can you think of ways to take advantage of this
insight in a business context? Perhaps to steer a vote
towards your preferred outcome?
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Example 3:
The Allais Paradox
10 White

89 Brown

1 Blue

Imagine that you are offered a bag containing 100 balls of different colors.
10 of the balls are white

89 of the balls are brown

1 of the balls is blue

You will reach in and pull out a ball at random, and you will win money depending on the
balls color. Would you prefer to win money on the basis of Option A, or on Option B?

CHOICE 1

White

Option A: $1 million
Option B: $2.5 million

Brown

Blue

$1 million
$1 million

$1 million
$0
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Example 3:
The Allais Paradox - continued
10 White

89 Brown

1 Blue

Now imagine that you are offered the same bag, with the same distribution of balls, but a
slightly different set of Options. Which option will you pick this time, Option C or Option D?
CHOICE 2

White

Option C: $1 million
Option D: $2.5 million

Brown
$0
$0

Blue
$1 million
$0

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Example 3:
The Allais Paradox
10 White

89 Brown

1 Blue

Most people pick Option A

CHOICE 1

White

Option A: $1 million
Option B: $2.5 million

Brown

Blue

$1 million
$1 million

$1 million
$0
and Option D

CHOICE 2

White

Option C: $1 million
Option D: $2.5 million

Brown

Blue

$0
$0

$1 million
$0
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Example 3:
The Allais Paradox
Notice that the two pairs of Options are identical in all respects, except for the
outcomes with a Brown ball. In the first pair of Choices (A or B), a brown ball gives
you $1 million. In the second pair (C or D), it is worth nothing.
Why do identical outcomes subtracted from each of the two Choices change our view
of the desirability of one Option versus the other (i.e., the switch from A in Choice 1
to D in Choice 2)?

CHOICE 1

White

Brown

Blue

Option A: $1 million
Option B: $2.5 million

$1 million
$1 million

$1 million
$0

CHOICE 2

Brown

Blue

$0
$0

$1 million
$0

White

Option C: $1 million
Option D: $2.5 million

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Visual Illusions

The next few slides contain some so-called visual illusions: examples of how
our brain interprets the 2-dimensional images in some surprising ways. As you
view the illusions, consider whether there may be parallels between how our
choices violate the Rational Decision-Making axioms, and the way in which
our brain perceives and manipulates these images.

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The Necker Cube

Stare at the red dot on the cube, and keep focusing on the red dot. What
happens to the cube as you stare at the dot?
No one fully understands why our brains choose to manipulate the cube in this
way. It simplyhappens. Can you prevent the change from happening?
Think of this illusion as a metaphor for our violation of the Invariance axiom.
Quite simply, our preferences are not consistent, and we cannot always control
(or even understand) the way in which they may change.

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How Many Triangles?

How many triangles do you

see on this page?
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How Many Triangles?

Suppose we add a new shape: an
incomplete circle, as shown below.
Does it change the number of
triangles that you see?

34

How Many Triangles?

Now lets add a second
incomplete circle. Is anything
changing in your perception of
the number of triangles?

35

How Many Triangles?

Now we have three incomplete
circles. We havent changed
the number of black triangles,
but has the addition of the
new shapes altered your
perception of the total number
of triangles on the page?

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What have we learned?

In this section, we examined the traditional economic model of consumer choice,
and examined its assumptions about human behavior:
that we are rational
that we make decisions in ways that maximize our expected utility (or
happiness) from money made or lost.

We discussed a number of axioms (assumptions about behavior that traditional

economists view as self-evident), and looked at examples in which we violate those
very assumptions.
We also defined risk aversion in terms of the rational expected utility model, and
examined how we use budget constraints and indifference curves to identify our
options as consumers.

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