Escolar Documentos
Profissional Documentos
Cultura Documentos
THE BEHAVIORAL
PROSPECT
Risk, Exuberance, and Abnormal Markets
Series Editor
James MingChen
College of Law
Michigan State University
East Lansing,Michigan, USA
Aims of the Series
The economic enterprise has firmly established itself as one of evaluating
human responses to scarcity not as a rigidly rational game of optimiza-
tion, but as a holistic behavioral phenomenon. The full spectrum of social
sciences that inform economics, ranging from game theory to evolution-
ary psychology, has revealed the extent to which economic decisions and
their consequences hinge on psychological, social, cognitive, and emo-
tional factors beyond the reach of classical and neoclassical approaches
to economics. Bounded rational decisions generate prices, returns, and
resource allocation decisions that no purely rational approach to optimiza-
tion would predict, let alone prescribe.
Behavioral considerations hold the key to longstanding problems in
economics and finance. Market imperfections such as bubbles and crashes,
herd behavior, and the equity premium puzzle represent merely a few
of the phenomena whose principal causes arise from the comprehensi-
ble mysteries of human perception and behavior. Within the heterodox,
broad-ranging fields of behavioral economics, a distinct branch of behav-
ioral finance has arisen.
Finance has established itself as a distinct branch of economics by apply-
ing the full arsenal of mathematical learning on questions of risk manage-
ment. Mathematical finance has become so specialized that its practitioners
often divide themselves into distinct subfields. Whereas the P branch of
mathematical finance seeks to model the future by managing portfolios
through multivariate statistics, the Q world attempts to extrapolate the
present and guide risk-neutral management through the use of partial dif-
ferential equations to compute the proper price of derivatives.
The emerging field of behavioral finance, worthy of designation by the
Greek letter psi (), has identified deep psychological limitations on the
claims of the more traditional P and Q branches of mathematical finance.
From Markowitzs original exercises in mean-variance optimization to the
Black-Scholes pricing model, the foundations of mathematical finance
rest on a seductively beautiful Gaussian edifice of symmetrical models and
crisp quantitative modeling. When these models fail, the results are often
catastrophic.
The branch of behavioral finance, along with other postmodern
critiques of traditional financial wisdom, can guide theorists and practi-
tioners alike toward a more complete understanding of the behavior of
capital markets. It will no longer suffice to extrapolate prices and forecast
market trends without validating these techniques according to the full
range of economic theories and empirical data. Superior modeling and
data-gathering have made it not only possible, but also imperative to har-
monize mathematical finance with other branches of economics.
Likewise, if behavioral finance wishes to fulfill its promise of transcend-
ing mere critique and providing a more comprehensive account of finan-
cial markets, behavioralists must engage the full mathematical apparatus
known in all other branches of finance. In a world that simultaneously lauds
Eugene Famas efficiency hypotheses and heeds Robert Shillers warnings
against irrational exuberance, progress lies in Lars Peter Hansens com-
mitment to quantitative rigor. Theory and empiricism, one and indivisible,
now and forever.
This book incorporates ideas from papers I have presented at the University
of Cincinnati, Florida State University, Georgetown University, Michigan
State University, the University of Pennsylvania, the University of Virginia,
and the Faculty of Economics of the University of Zagreb (Ekonomski
Fakultet, Sveuilite u Zagrebu). The International Atlantic Economic
Society and the ACRN Oxford Academic Research Network have pro-
vided multiple platforms for the work underlying this book. Along the
way, I have benefited from scholarly and professional interactions with
Anna Agrapetidou, Abdel Razzaq Al Rababaa, Moisa Altar, Christopher
J.Brummer, Irene Maria Buso, Adam Candeub, Seth J.Chandler, Felix
B. Chang, Tendai Charasika, Csar Crousillat, David Dixon, Robert
Dubois, John F. Duffy, Daniel A. Farber, Christopher C. French,
Santanu K. Ganguli, Tomislav Gelo, Periklis Gogas, Gil Grantmore,
Andy Greenberg, Losbichler Heimo, Hemantha Herath, Jesper Lyng
Jensen, Jagoda Kaszowska, Daniel Martin Katz, Yuri Katz, Imre Kondor,
Carolina Laureti, Cordell Lawrence Jr., Cordell Lawrence Sr., Matthew
Lee, Othmar Lehner, Heimo Losbichler, Gerry Mahar, Milivoj Markovi,
L. Thorne McCarty, Steven C. Michael, Ludmila Mitkova, Jos Mara
Montero Lorenzo, Kevin Lynch, Laura Muro, Vivian Okere, Merav
Ozair, Elizabeth Porter, Mobeen Ur Rehman, Carol Royal, Bob Schmidt,
Jeffrey A.Sexton, Galen Sher, Ted Sichelman, Jurica imurina, Nika Sokol
imurina, Robert Sonora, Lisa Grow Sun, Elvira Takli, Peter Urbani,
Robert R.M.Verchick, Benjamin Walther, Karen Wendt, Gal Zahavi, and
Johanna F. Ziegel. Christian Diego Alcocer Argello of Michigan State
Universitys Department of Economics provided very capable research
ix
x ACKNOWLEDGMENTS
xi
xii CONTENTS
Index 327
CHAPTER 1
model is the uncertainty facing investors, and the substance of every financial
model involves the impact of uncertainty on the behavior of investors and,
ultimately, on market prices.6 The interplay between theory and empiri-
cal work is a dialectic in which [t]heorists develop models with testable
predictions and empiricists document puzzles, or stylized facts that
fail to fit established theories and thereby stimulate[] the development of
new theories.7 What makes finance in general and asset pricing in particular
such fantastic instances of the scientific process is that the random shocks
that propel knowledge forward happen also to be the subject matter to
which these branches of economic theory devote themselves.8
The presence of efficiency-defying anomalies such as market swings
in the absence of new information and prolonged deviations from under-
lying asset values invites challenges to the efficient markets hypothesis.9
Not all departures from market efficiency carry the same cognitive weight,
however. Chapters 4 and 7 of Postmodern Portfolio Theory distinguished
between the volatility and correlation components of beta partly on the
basis of differences in the way investors perceive, evaluate, and respond to
those quantifiable aspects of financial markets. Even in the shadow of high-
frequency trading,10 contemporary markets exhibit meaningful differences
in the rate at which they absorb different types of information. Differences
in processing speed distinguish two basic models of human reasoning: a
speedy, intuitive mode prone to cognitive bias and mistakes in judgment,
and a slower, more rational mode that counterbalances humans innate
heuristics with comprehensive evaluation of evidence.
Behavioral finance reflects the interplay between the fast heuristics of
human behavior and the slow processing of rational evidence.11 Adopting
labels proposed in the psychological literature,12 Daniel Kahneman has
assigned the names System 1 and System 2, respectively, to these fast and
slow modes of thought.13 System 1 operates automatically and quickly, with
little or no effort and no sense of voluntary control.14 Intuitive, fast think-
ing, such as the automatic[] and effortless[] recognition of anger in a
human face, requires no work.15 It just happen[s].16 By contrast, System
2 allocates attention to effortful mental activities, often those associ-
ated with the subjective experience of agency, choice, and concentration.17
Solving even a simple multiplication problem such as 17 24 demands
slow thinking. Ponder, even for a second, whether the right answer to
that problem is 568 or 408.18 Slow thinking slogs through a sequence of
steps requiring deliberate, effortful, and orderly mental work.19
Complex financial computations presumably belong to the domain of
System 2.20 The common connection among the highly diverse operations
6 J.M. CHEN
fashion into security prices.52 In tacit homage to the fraud on the mar-
ket doctrine in federal securities law, we may call this phenomenon law
on the market.53 The Supreme Court of the USA routinely decides cases
involving publicly traded parties, or at least significant legal issues with
potential impact on security prices. Applying standard event study meth-
odology,54 one survey of Supreme Court decisions from October Term
1999 through October Term 2013 (which ended in June 2014) found
79 decisions associated with abnormal returns on 118 securities.55 Those
79 decisions represented 5.5% of the Courts docket during the relevant
time span.56 Share price changes in 118 securities in direct response to a
Supreme Court decision reached an estimated total of $140 billion.57
For our purposes, the crucial finding of this survey was the rate at which
new information from a Supreme Court decision diffused through the
securities market. In the algorithmically driven, high-frequency trading
environment of contemporary markets,58 security prices often move within
fractions of a second in response to central bank announcements,59 sur-
veys of consumer sentiment,60 and other financial news.61 High-frequency
trades typically move in the direction of permanent price changes, which
presumably reflect future efficient price moves, and in the opposite
direction of transitory pricing errors.62 Although high-frequency traders
impose adverse selection costs on other investors, they play a beneficial
role in price efficiency and supply liquidity in stressful times such as the
most volatile days and around macroeconomic news announcements.63
By contrast, the full diffusion of Supreme Court decisions through
financial markets may take hours, even an entire trading day.64 In spec-
tacular instances, the market affirmatively misinterprets a Supreme Court
decision and, at least initially, sends the prices of affected securities in the
wrong direction. In the 2012 case of National Federation of Independent
Business v. Sebelius,65 apparent misreporting on the actual nature of the
closely watched, hotly controversial Obamacare decision66 sparked very
high volatility in the stock prices of health insurance companies such as
Aetna (AET), Humana (HUM), and Anthem/WellPoint (WLP).67
Even more dramatically, the 2013 decision in Association for Molecular
Pathology v. Myriad Genetics Inc.68 accounted for a 10% abnormal increase
in the stock price of Myriad Genetics (MYGN) in the first hour of trading
after the 10a.m. announcement of the decision, which was reversed into
a 10% abnormal decrease during the final two hours of the trading day.69
Over two trading days, the Supreme Courts decision accounted for 20%
negative abnormal returns in the price of MYGN.70
THE STRUCTURE OFABEHAVIORAL REVOLUTION 9
S 6/25/2014
SBGI 6/25/2014
FOXA 6/25/2014
CBS 6/25/2014
HAL 6/23/2014
BHI 6/23/2014
XOP 6/23/2014
XLE 6/23/2014
XES 6/23/2014
C 6/23/2014
SANM 6/9/2014
CTS 6/9/2014
LLNW 6/2/2014
XLK 1/14/2014
XTL 12/10/2013
VOX 12/10/2013
F 12/2/2013
MA 6/20/2013
XPH 6/17/2013
ACT 6/17/2013
MYGN 6/13/2013
XLP 5/13/2013
XOP 4/17/2013
XLE 4/17/2013
PSO 3/19/2013
WLP 6/28/2012
MGLN 6/28/2012
HUM 6/28/2012
HNT 6/28/2012
HCA 6/28/2012
CI 6/28/2012
AET 6/28/2012
XLE 6/21/2012
KMI 6/21/2012
XHE 6/18/2012
STN 6/18/2012
XLV 4/17/2012
UBS 3/26/2012
DB 3/26/2012
CS 3/26/2012
GT 6/27/2011
XLY 6/20/2011
XES 6/6/2011
XLY 5/31/2011
JAH 5/31/2011
XLF 5/16/2011
XTL 4/27/2011
XPH 3/29/2011
XTL 3/1/2011
VOX 3/1/2011
GM 2/23/2011
WEX 1/24/2011
AXP 1/24/2011
XLI 4/21/2010
CDE 6/22/2009
CNA 6/18/2009
PFE 3/4/2009
DD 1/26/2009
MO 12/15/2008
XLY 6/23/2008
S 6/23/2008
XLV 2/20/2008
VOX 4/30/2007
TFX 4/30/2007
VOX 4/17/2007
GLBC 4/17/2007
MO 2/20/2007
EBAY 5/15/2006
MER 3/21/2006
ITW 3/1/2006
YRCW 6/20/2005
MRK 6/13/2005
XLP 5/16/2005
XLI 12/13/2004
XOM 6/24/2004
HES 6/24/2004
CVX 6/24/2004
UNH 6/21/2004
XLI 5/3/2004
V 4/21/2004
XLF 12/2/2003
XLY 6/26/2003
TRV 6/23/2003
XLP 6/9/2003
XLV 5/19/2003
PFE 5/19/2003
BMY 5/19/2003
AZN 5/19/2003
PHS 4/7/2003
XLI 3/10/2003
UNP 3/10/2003
NSC 3/10/2003
WLB 1/15/2003
XLY 5/20/2002
T 5/20/2002
T 5/13/2002
XLE 1/9/2002
GWO 1/8/2002
XLP 12/10/2001
XLI 12/10/2001
VGR 6/28/2001
XLI 6/4/2001
CC 3/21/2001
HMC 2/27/2001
GM 2/27/2001
XLV 2/21/2001
XLE 12/4/2000
XLF 6/12/2000
PLA 5/22/2000
KSU 4/17/2000
JNJ 4/3/2000
BMY 4/3/2000
ABT 4/3/2000
XOM 3/6/2000
CVX 3/6/2000
9:30 10:00 Day 1 Close Day 2 Close
Fig. 1.1 Cumulative abnormal returns from Supreme Courts decisions, 1999
through 2014, as a function of time
THE STRUCTURE OFABEHAVIORAL REVOLUTION 11
investors simply do not behave like the stylized actors of neoclassical eco-
nomics rational expectations hypothesis.86 We will never really under-
stand important economic events unless we confront the fact that their
causes are largely mental in nature.87 Risk, the prime mover in finance, is
experienced and understood in emotional terms.88 And the primary forces
that appeal to emotion take verbal, visual, and narrative form: [M]uch of
the human thinking that results in action is not quantitative, but instead
takes the form of storytelling and justification.89
And storytelling is gossip, the steady deliverer of secrets, , the carrier
of speculation and suspicion.90 To live without gossip is to forfeit the
perilous cost of being born human:91
[T]here is one story in the world, and only one .93 (Or perhaps as
many as seven, as we shall soon see.) Every individual,94 every organiza-
tion,95 every country,96 every religion97 lays claim to some form of unique-
ness: Cultures of all kinds stress uniqueness and claim to be superior or
to offer the one true faith.98 But claims to organizational uniqueness ulti-
mately reduce to no more than seven stories, which are not unique at all,
but universal.99 The simultaneous recognition of these stories in diverse
domains resembles the scientific phenomenon of multiple discovery,100
which arguably portrays the typical way by which science advances.101
Social organizations, including businesses, thus repeat the human sto-
rytelling experience, which consists of seven basic plots.102 Of particular
interest to finance is the archetypical tale of rags to riches.103 Implicit in the
tale of successful rise from obscurity, poverty and misery to a state of great
splendor and happiness104 is the dark version of the Rags to Riches
plot, in which failed or pyrrhically victorious protagonists reach their
self-destructive [destiny] by precisely the same rules which govern the
attainment of material and spiritual satisfaction.105 So perhaps, there is only
one story in the world after all, and we revel in telling it again and again.106
Unsurprisingly, the impact of language, down to the very words we use,
depends on its connection to the physical senses.107 When making financial
decisions, investors weigh[] a story, which has no quantitative dimension,
against the observed quantity of financial wealth that they have available
for consumption.108 Over time, the most cognitively appealing narratives
congeal into conventional wisdom,109 which investors, financial advisors,
THE STRUCTURE OFABEHAVIORAL REVOLUTION 13
commentators, and politicians can all exploit, with varying degrees of per-
sonal success and societal impact. [P]opular narratives, particularly human
interest stories, are fundamental drivers of motivation.110
At a minimum, the mixed, and changing, feelings that accompany
the admittedly arbitrary social convention of starting a new year may
drive a large number of calendar effects, of the sort described in 1.2.111
[P]eople love almanacs and have an irrational belief in them because
they purport to find order in random events, like weather or the seasons.112
More ambitiously, all storytellershistorians, novelists, psychoanalysts, or
even behavioral economistsstrive to feel[] what [they] believe[] others
are feeling and to attribute[] what [they] remember[] to others as [they]
observe[] or describe[] their subjects in order to achieve verisimilitude
or, in the narrative craft at its finest, wonderfully vivid mimesis.113
Although the earliest critiques of modern portfolio theory emphasized
downside risk,114 fear of loss is hardly the only behavioral pitfall in finance.
Arguably greater danger lurks in the allure of speculation, fueled by unre-
alistic expectations of runaway gains (a special concern in ground floor
investment opportunities perceived as offering lottery-like returns, such as
venture capital, business development companies, initial public offerings,
crowdfunding, and even penny stocks).115 Not even John Maynard Keynes
was immune.116 While managing an investment fund at Cambridge,
Keynes allegedly engaged in speculative investment practices and reached
cowboy proportions of risk,117 in the sense that he reached 80% of the
maximum levels justified under the Kelly criterion for determining the
optimal size of a series of bets.118
The performance of real markets provides no basis for the traditional,
sanguine assumption that all actors are rational and aim to maximize their
own welfare in a universally uniform, objective way. Brain-damaged peo-
ple, unconstrained by fear or memory, actually beat unimpaired people at
an investment game, because those players performances were hobbled
by the memory of losses from previous rounds.119 (Of course, stacking
the deck the other wayquite literallyso that players with damage to
their prefrontal lobes could not remember dangerous aspects of the game
would tilt the contest back in favor of unimpaired players.)120 If anything,
overconfidence in personal business acumen explains a meaningful mea-
sure of price movements in capital markets.121
At worst, the affect heuristic122 encourages economic agents to evaluate
the magnitude of risk and expected loss according to raw likes and dis-
likes.123 In more conventional financial settings, after all, the addition or
14 J.M. CHEN
that men respond more strongly to greed and that women respond more
strongly to fear.136 But much of that literature rests on the prisoners
dilemma, a game known to contain elements of both fear and greed.137
The quest for empirical evidence to verify or falsify the greedy men/fear-
ful women hypothesis now hinges on the design of experiments that are
better able to isolate sex-specific responses to fear and to greed.138
Using a more sophisticated two-parameter specification of prospect the-
orys weighting function,139 one study has found that women are indeed
more pessimistic than men with respect to their evaluation of potential
gains.140 Relative to men, women are less sensitive to changes in probabil-
ity.141 Women also tend to lower their estimates that they will secure large
gains.142 These findings align research on men and womens distinctive
approaches to financial decision making with traditional scholarship on
gender-specific differences in response to non-financial risks, especially
physical or life-threatening risks.143
Specifically:
accounts with bonds than with stocks.150 This apparent difference, how-
ever, evaporates upon consideration of marital status: [T]hough women
and men do not differ, married women are more likely than single women
to choose mostly bonds.151 Just as [s]urprisingly, perhaps, neither
education nor age seems to affect allocation decisions.152 Filtering away
these factors leaves something not likely to be coded within defined con-
tribution retirement accounts: the presence of children and intertemporal
(indeed, intergenerational) financial considerations spanning not only dif-
ferent periods of an investors life, but also the lives of her heirs.
More recent research evaluating investor behavior within defined con-
tribution retirement plans shows that women are 14% likelier than men
to participate in a workplace savings plan.153 Once enrolled, women at all
income levels save at higher rates than their male counterparts.154 Though
women and men take similar levels of portfolio risk (partly because the use
of target-date plans as a default subjects a large number of participants,
female or male, to identical levels of risk), men have greater marginal pro-
pensity to trade and to hold more aggressive equity allocations.155 Because
they earn more, men hold higher balances in absolute terms.156 Controlling
for income, however, women save more and have higher balances.157
Studies emphasizing sex-based differences in financial behavior encoun-
ter the limitations that constrain all efforts to describe behavioral hetero-
geneity by identifying demographic distinctions such as sex or age and
assuming, somewhat ironically, that all investors fitting that characteristic
behave alike.158 It is quite evident that trading like a girl involves far
more than a binary, state-switching algorithm devised by a rogue sociobi-
ologist. Even as it sorts humanity into distinct male and female bins, the
opening passage in the classic American novel, Their Eyes Were Watching
God, offers a subtler, more persuasive view:
Ships at a distance have every mans wish on board. For some they come
in with the tide. For others they sail forever on the horizon, never out of
sight, never landing until the Watcher turns his eyes away in resignation, his
dreams mocked to death by Time. That is the life of men.
Now, women forget all those things they want to remember, and remem-
ber everything they dont want to forget. The dream is the truth. Then they
act and do things accordingly.159
NOTES
1. James Ming Chen, Postmodern Portfolio Theory: Navigating Abnormal
Markets and Investor Behavior (2016).
2. See Thomas S.Kuhn, The Structure of Scientific Revolutions 52 (2d ed.
enlarged, 1970).
3. Id. at 5253.
4. See id. at 6667.
5. John Y.Campbell, Andrew W.Lo & A.Craig MacKinlay, the Econometrics
of Financial Markets 3 (1997).
6. Id.
7. John Y. Campbell, Asset Pricing at the Millennium, 55 J. Fin. 1515
1567, 1515 (2000).
8. See id.
9. Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2421
(2014) (Thomas, J., concurring in the judgment) (quoting Donald
C. Langevoort, Taming the Animal Spirits of the Stock Markets: A
Behavioral Approach to Securities Regulation, 97 Nw. U. L. Rev. 135
188, 141 (2002)).
10. See, e.g., Jonathan Brogaard, Terrence Hendershott & Ryan Riordan,
High-Frequency Trading and Price Discovery, 27 Rev. Fin. Stud. 2267
2306 (2014); Terrence Hendershott, Charles M. Jones & Albert
J. Menkveld, Does Algorithmic Trading Improve Liquidity?, 66 J. Fin.
133 (2011); Albert J.Menkveld, High Frequency Trading and the New
Market Makers, 16J.Fin. Mkts. 712740 (2013); Martin L.Scholtus,
Dick J.C. Van Dijk & Bart Frijns, Speed, Algorithmic Trading, and
Market Quality Around Macroeconomic News Announcements,
38J.Banking & Fin. 89105 (2014).
18 J.M. CHEN
11. See generally Daniel Kahneman, Thinking, Fast and Slow 19105 (2011);
Chen, Postmodern Portfolio Theory, supra note 1, 4.4, at 4449 (sum-
marizing Kahnemans dichotomy between System 1 and System 2
thinking).
12. See Keith E. Stanovich & Richard F. West, Individual Differences in
Reasoning: Implications for the Rationality Debate, 23 Behav. & Brain
Scis. 645665 (2000); see also In Two Minds: Dual Processes and Beyond
(Jonathan St. B.T. Evans & Keith Frankish eds., 2009) (recognizing a
similar divide within the dual nature of human thought); Jonathan St.
B. T. Evans, Dual-Processing Accounts of Reasoning, Judgment, and
Social Cognition, 59 Ann. Rev. Psych. 255278 (2008) (same).
13. See Kahneman, Thinking, Fast and Slow, supra note 11, at 2021, 450.
14. Id. at 20 (emphasis in original).
15. Id. at 1920.
16. Id. at 20.
17. Id. at 21 (emphasis in original).
18. Id. at 20. The right answer is 1724=408.
19. Id. at 20.
20. Id. at 22.
21. Id.
22. See id.
23. Id. at 23.
24. Id. at 42. See generally Martin S.Hagger, Chantelle Wood, Chris Stiff &
Nikos L.D.Chatzisarantis, Ego Depletion and the Strength Model of Self-
Control: A Meta-Analysis, 136 Psych. Bull. 495525 (2010).
25. Kahneman, Thinking, Fast and Slow, supra note 11, at 43.
26. See generally Matthew T.Gailliot & Roy F.Baumeister, The Physiology of
Willpower: Linking Blood Glucose to Self-Control, 11 Personality & Soc.
Psych. Rev. 303327 (2007); Matthew T. Gailliot, Roy F. Baumeister,
C. Nathan DeWall, John K. Maner, E. Ashby Plant, Dianne M. Tice,
Lauren E.Brewer & Brandon J.Schmeichel, Self-Control Relies on Glucose
as a Limited Energy Source: Willpower Is More Than a Metaphor,
92J.Personality & Soc. Psych. 325336 (2007); cf. Roy F.Baumeister,
W.Scott Simpson, Stephen J.Ware & Daniel S.Weber, The Glucose Model
of Mediation: Physiological Bases of Willpower as Important Explanations for
Common Mediation Behavior, 15 Pepperdine Dispute Resolution L.J.
377413 (2015).
27. See generally, e.g., Daniel Kahneman & Shane Frederick, Representativeness
Revisited: Attribute Substitution in Intuitive Judgment, in Heuristics and
Biases: The Psychology of Intuitive Judgment 4981 (Thomas Gilovich,
Dale W.Griffin & Daniel Kahneman eds., 2002); Daniel Kahneman &
Shane Frederick, A Model of Heuristic Judgment, in The Cambridge
Handbook of Thinking and Reasoning 267293 (Keith J. Holyoak &
Robert G.Morrison eds., 2005).
THE STRUCTURE OFABEHAVIORAL REVOLUTION 19
28. Kahneman, Thinking, Fast and Slow, supra note 11, at 21.
29. Id.
30. Id.
31. Id.
32. See, e.g., Jane L.Risen & Thomas Gilovich, Why People Are Reluctant to
Tempt Fate, 95J.Personality & Soc. Psych. 293307 (2008).
33. See Jane L. Risen, Believing What We Do Not Believe: Acquiescence to
Superstitious Beliefs and Other Powerful Intuitions, Psych. Rev. (Oct. 19,
2015) (available online at http://psycnet.apa.org/index.cfm?fa=buy.opt
ionToBuy&id=2015-47838-001).
34. See id.
35. See, e.g., M.Hakan Berument & Nukhet Dogan, Stock Market Return
and Volatility: Day-of-the-Week Effect, 36 J. Econ. & Fin. 282302
(2011); Kenneth R. French, Stock Returns and the Weekend Effect,
8J.Fin. Econ. 5569 (1980).
36. See Sven Bouman & Ben Jacobsen, The Halloween Indicator, Sell in May
and Go Away: Another Puzzle, 92 Am. Econ. Rev. 16181635 (2002);
Sandro C.Andrade, Vidhi Chhaochharia & Michael E.Fuerst, Sell in
May and Go Away Just Wont Go Away, 69:4 Fin. Analysts J. 94105
(July/Aug. 2013).
37. See Edwin D. Maberly & Raylene M. Pierce, Stock Market Efficiency
Withstands Another Challenge: Solving the Sell in May/Buy After
Halloween Puzzle, 1 Econ. J.Watch 2946 (2004).
38. Eugene F. Fama, Efficient Capital Markets II, 46 J. Fin. 15751617,
15861587 (1991) (noting, in addition, that much of the higher
January return on small stocks comes on the last trading day in December
and the first 5 trading days in January); see also Werner F.M. de Bondt
& Richard H. Thaler, Further Evidence on Investor Overreaction and
Stock Market Seasonality, 42J.Fin. 557581 (1987); Donald B.Keim,
Size-Related Anomalies and Stock Return Seasonality: Further Empirical
Evidence, 12J.Fin. Econ. 1332 (1983); Richard Roll, Vas Ist Das? The
Turn-of-the-Year Effect and the Return Premia of Small Firms,
9:2 J. Portfolio Mgmt. 1828 (Winter 1983); Michael S. Rozeff &
William R. Kinney Jr., Capital Market Seasonality: The Case of Stock
Returns, 3 J. Fin. Econ. 379402 (1976); Seha M. Tinic & Richard
R.West, Risk and Return: January Versus the Rest of the Year, 13J.Fin.
Econ. 561574 (1984); cf. James N.Bodurtha, Jr. & Nelson C.Mark,
Testing the CAPM with Time-Varying Risks and Returns, 46 J. Fin.
14851505 (1991) (devising a conditional, time-varying capital asset
pricing model to test the January effect).
39. Maberly & Pierce, supra note 37, at 30; see also id. (quoting Burton Malkiel
and Richard Roll for the proposition that calendar time anomalies, to
serve as evidence of market inefficiency, should present an exploitable
opportunity). See generally Michael C.Jensen, Some Anomalous Evidence
20 J.M. CHEN
53. See Basic Inc. v. Levinson, 485 U.S. 224, 241247 (1988); Halliburton
Co. v. Erica P.John Fund, Inc., 134 S.Ct. 2398, 24072413 (2014).
54. See generally A.Craig MacKinlay, Event Studies in Economics and Finance,
35 J. Econ. Lit. 1339 (1997); cf. Sanjai Bhagat & Roberta Romano,
Event Studies and the Law, Part I: Technique and Corporate Litigation, 4
Am. L. & Econ. Rev. 141168 (2002).
55. See Daniel Martin Katz, Michael J. Bommarito II, Tyler Soellinger &
James Ming Chen, Law on the Market? Evaluating the Securities Impact
of Supreme Court Decisions 5, 22 (Aug. 24, 2015) (available at http://
ssrn.com/abstract=2649726).
56. See id. at 22.
57. See id. at 3.
58. See, e.g., Terrence Hendershott, Charles M.Jones & Albert J.Menkveld,
Does Algorithmic Trading Improve Liquidity?, 66 J. Fin. 133 (2011);
Albert J.Menkveld, High Frequency Trading and the New Market Makers,
16J.Fin. Mkts. 712740 (2013); Martin L.Scholtus, Dick J.C.Van Dijk
& Bart Frijns, Speed, Algorithmic Trading, and Market Quality Around
Macroeconomic News Announcements, 38 J. Banking & Fin. 89105
(2014).
59. Compare Benjamin S.Bernanke & Kenneth N.Kuttner, What Explains
the Stock Markets Reaction to Federal Reserve Policy?, 60J.Fin. 1221
1257 (2005) (Federal Reserve System of the USA) with David-Jan.
Jansen & Jakob de Haan, Were Verbal Efforts to Support the Euro Effective?
A High-Frequency Analysis of ECB Statements, 23 Eur. J.Pol. Econ. 245
259 (2007) (European Central Bank).
60. See Shumi Akhtar, Robert Faff, Barry R. Oliver & Avanidhar
Subrahmanyam, Stock Salience and the Asymmetric Market Effect of
Consumer Sentiment News, 36J.Banking & Fin. 32893301 (2012).
61. See Axel Gro-Klussmann & Nikolaus Hautsch, When Machines Read the
News: Using Automated Text Analytics to Quantify High Frequency News-
Implied Market Reactions, 18J.Empirical Fin. 321340 (2011); Robert
F.Schumaker & Hsinchun Chen, A Quantitative Stock Prediction System
Based on Financial News, 45 Info. Processing & Mgmt. 571583 (2009).
62. Jonathan Brogaard, Terrence Hendershott & Ryan Riordan, High-
Frequency Trading and Price Discovery, 27 Rev. Fin. Stud. 22672306,
2268 (2014).
63. Id.
64. See Katz, Bommarito, Soellinger & Chen, supra note 55, at 2021.
65. 132 S.Ct. 2566 (2012).
66. See Josh Blackman, Unprecedented: The Constitutional Challenge to
Obamacare 237252 (2013).
67. See Katz, Bommarito, Soellinger & Chen, supra note 55, at 19.
22 J.M. CHEN
97. See Craig Ott & Harold A.Netland, Globalizing Theology: Belief and
Practice in a Era of World Christianity (2006).
98. Joanne Martin, Martha S.Feldman, Mary Jo Hatch & Sim B.Sitkin, The
Uniqueness Paradox in Organizational Stories, 2 Admin. Sci. Q. 438
453, 438 (1983).
99. See id.
100. See generally, e.g., David Lamb & Susan M.Easton, Multiple Discovery:
The Pattern of Scientific Progress (1984); Robert K.Merton, Resistance
to the Systematic Study of Multiple Discoveries in Science, 4 Eur. J.Sociol.
237282 (1963), reprinted in Robert K. Merton, The Sociology of
Science: Theoretical and Empirical Investigations 371382 (1973).
101. See Robert K.Merton, Singletons and Multiples in Scientific Discovery: a
Chapter in the Sociology of Science, 105 Proc. Am. Phil. Socy 470486
(1961), reprinted in Merton, The Sociology of Science, supra note 100,
at 343370.
102. See generally Christopher Booker, The Seven Basic Plots: Why We Tell
Stories (2004).
103. See generally id. at 5168.
104. Id. at 65.
105. Id. at 66, 68.
106. See id. at 4 (identifying five identifiable stages in all stories, from the
initial mood of anticipation, through a dream stage when all seems to be
going unbelievably well, to the frustration stage when things begin to
go mysteriously wrong, to the nightmare stage where everything goes
horrendously wrong, and ultimately to a climactic resolution).
107. See Ezgi Akpinar & Jonah Berger, Drivers of Cultural Success: The Case of
Sensory Metaphors, 109J.Personality & Soc. Psych. 2034 (2015) (sug-
gesting that linguistic phrases that relate to physical senses in metaphoric
ways, such as a cold person, have enjoyed greater cultural success).
108. Shiller, Irrational Exuberance, supra note 89, at 168.
109. See John Kenneth Galbraith, The Affluent Society 617 (2002) (1st ed.
1958).
110. Robert J.Shiller, How Stories Drive the Stock Market, N.Y.Times, Jan. 24,
2016, at BU5 (available at http://nyti.ms/1OCxI7F). See generally
Jerome Bruner, Actual Minds, Possible Worlds (1987) (propounding a
theory of narrative psychology, in which the imaginative creation of pos-
sible worlds propels a large number of human endeavors).
111. Shiller, How Stories Drive the Stock Market, supra note 110.
112. James B. Stewart, For Stock Markets, January Is a Cloudy Crystal Ball,
N.Y.Times, Jan. 8, 2016, at B1 (available at http://nyti.ms/1VMMw6g)
(quoting Nassim Nicholas Taleb).
113. Ramsay MacMullen, Feelings in History: Ancient and Modern 8 (2012;
1st ed. 2003).
THE STRUCTURE OFABEHAVIORAL REVOLUTION 25
114. See generally Chen, Postmodern Portfolio Theory, supra note 1, 5.1, at
5960.
115. See infra 9.1 and 9.2, at 215224.
116. See Rachel E.S. Ziemba & William T. Ziemba, Scenarios for Risk
Management and Global Investment Strategies 2931 (2007) (Good
and Bad Properties of the Kelly Criterion); Leonard C. Maclean,
Edward O.Thorp & William T.Ziemba, Long-Term Capital Growth: The
Good and Bad Properties of the Kelly and Fractional Kelly Capital Growth
Criteria, 10 Quant. Fin. 681687 (2010). The speculative spirit of the
Jazz Age is captured by Philip Carret, The Art of Speculation (1930).
117. See J.H.Chua & R.S.Woodward, The Investment Wizardry of J.M.Keynes,
39:3 Fin. Analysts J. 3537 (MayJune 1983); cf. J.E.Woods, On Keynes
as an Investor, 37 Camb. J. Econ. 423442 (2013) (tracing Keyness
eventual abandonment of speculation in favor of an approach that
would be recognizable today as value investing).
118. See generally J.L. Kelly, A New Interpretation of Information Rate, 35
Bell Sys. Tech. J. 917926 (1956); Edward O.Thorp, The Kelly Criterion
in Blackjack, Sports Betting, and the Stock Market, in 1 Handbook of
Asset and Liability Management: Theory and Methodology 385428
(Stavros A. Zenios & William T. Ziemba eds., 2006); E.O. Thorp,
Optimal Gambling Systems for Favorable Games, 37 Rev. Intl Stat. Inst.
273293 (1969); Vasily Nekrasov, Kelly Criterion for Multivariate
Portfolios: A Model-Free Approach (Sept. 30, 2014) (available at http://
ssrn.com/abstract=2259133). f*, the fraction of a bankroll that a gam-
bler should wager on a single bet, may be expressed as the ratio of
expected net proceeds from a winning bet to the nominal value of the net
winnings from a winning bet. Formally:
bp - q p ( b + 1) - 1
f* = =
b b
128. See, e.g., Daniel Kahneman & Dan Lovallo, Timid Choices and Bold
Forecasts: A Cognitive Perspective on Risk Taking, 39 Mgmt. Sci. 1731
(1993); Stuart Oskamp, Overconfidence in Case-Study Judgments,
29 J. Consulting Psych. 261265 (1965); cf. William B. Locander &
Peter W. Hermann, The Effect of Self-Confidence and Anxiety on
Information-Seeking in Consumer Risk Reduction, 16 J. Marketing
Research 268274 (1979).
129. See David W.Fulker, Sybil B.G.Eysenck & Marvin Zuckerman, A Genetic
and Environmental Analysis of Sensation Seeking, 14 J. Research in
Personality 261281 (1980).
130. See Daniel Dorn & Paul Sengmueller, Trading as Entertainment?, 55
Mgmt. Sci. 591603 (2009); William N. Goetzmann & Alok Kumar,
Equity Portfolio Diversification, 12 Rev. Fin. 433463 (2008).
131. Michael Lewis, Boomerang: Travels in the New Third World 37 (2011).
132. See LouAnn Lofton, Warren Buffett Invests Like a Girl: And Why You
Should, Too (2011).
133. See generally Hersh Shefrin, Beyond Greed and Fear: Understanding
Behavioral Finance and the Psychology of Investing (2000).
134. See Andrew W.Lo, Dimitry V.Repin & Brett N.Steenbarger. Fear and
Greed in Financial Markets: A Clinical Study of Day-Traders, 95 Am.
Econ. Rev. 352359, 357 (2005).
135. See id.
136. See Brent Simpson, Sex, Fear, and Greed: A Social Dilemma Analysis of
Gender and Cooperation, 82 Soc. Forces 3552, 36 (2003).
137. See id. at 3738.
138. See id. at 4748; Ko Kuwabara, Nothing to Fear But Fear Itself: Fear of
Fear, Fear of Greed and Gender Effects in Two-Person Asymmetric Social
Dilemmas, 84 Soc. Forces 12571272 (2005).
139. See infra 10.3. Prospect theory is the subject of Chapter. 8.
140. See Helga Fehr-Duda, Maneule de Gennaro & Renate Schubert, Gender,
Financial Risk, and Probability Weights, 60 Theory & Decision 283
313, 299 (2006).
141. See id.
142. See id.
143. Id. at 283; cf., e.g., James P.Byrnes, David C.Miller & William D.Schafer,
Gender Differences in Risk Taking: A Meta-Analysis, 125 Psych. Bull.
367383 (1999).
144. Fehr-Duda, de Gennaro & Schubert, supra note 140, at 285; see also id.
at 304305. For insight into systematic, cohort-specific differences in
probability weighting functions, see generally Herbert Walther, Normal-
Randomness Expected Utility, Time Preferences, and Emotional Distortions,
52J.Econ. Behav. & Org. 253266 (2003).
28 J.M. CHEN
where the firm scored on the rewards scale [i.e., nonmanagerial employees
access to stock options and profit-sharing] was even more dramatic, with a
difference in five-year survival probability of 42 percent between firms in the
upper and lower tails of the distribution.99
The results are so compelling that prudent investors may want to use
these results in evaluating new companies.100 The same wisdom may be
generalizable to ongoing enterprises: You get the distinct impression that
if youre trying to decide where to make an investment, the best place to
look is those annual lists of the 100 best places to work.101 Hierarchical
theories of needs thus connect the economics of human capital,102 by way
of the exit-voice-loyalty-neglect model of organizational behavior,103 to
mathematical and behavioral finance.
human intellect that masters [it] all,111 serves as an apt reminder that
neither finance nor any other branch of economics can be severed from
aesthetic judgment and human emotion.112 Homebuyers do not just see
a house; they see a handsome house, an ugly house, or a pretentious
house.113 The recognition that even the briefest introduction to a sub-
jectmere exposurealters emotional reactions to novel stimuli114 opens
the door to complete economic consideration of the affect heuristic.115
Instantaneous, automatic feelings associated with [such] stimulus words
[as] treasure or hate116 motivate entire branches of business and econom-
ics associated with advertising, marketing, and publicity.117 We should like-
wise expect the affect heuristic to influence evaluations of risk.
Emotions drive the price of the assets that are putatively invisible to
conventional pricing models. Art,118 collectibles,119 anything beautiful.120
Ye gods, real estate.121 No less than prices for wine,122 stock market prices
reflect investor sentiment as well as rational factors.123 What does come
at a price is relaxing the supposition, embedded in standard financial
theory, that affect plays no role in the pricing of financial assets.124
Human emotion and behavior do affect financial markets and portfolios,
and the corresponding recognition that affect plays a role in pricing
models of financial assets gives rise to the development of a behavioral
asset-pricing model.125
Vigilance against downside risk animates the most temperamentally
(if not politically) conservative principle in environmental law and safety
regulation. As a counterweight to conventional cost-benefit analysis, the
precautionary principle discourages risk-taking that may hurt the public at
large, or an especially vulnerable segment of it.126 The need to accumu-
late and safeguard wealth for immediate consumption, directed at survival
or safety, is likelier to consume a deeper portion of a poor familys total
wealth.127 This sensitivity to unforeseen, even unforeseeable, risk and to
wealth effects finds a welcome home in the normative toolkit of environ-
mental economics.
On the other hand, the risk of excessive social consumption in dis-
regard for environmental disruption and other long-term consequences
does appear to reach its apex during periods of nominal economic growth.
Environmental hazards that are viewed as familiar, commonplace,
everyday risks are often underestimated, especially by local residents
who rely (mistakenly) on the perceived collective judgment of others
around them who have seemingly concluded that their community is safe
enough.128 Too often, public responses to environmental risk fall under
40 J.M. CHEN
bears greatest value may lie in its role in providing a basis for applying the
Endangered Species Act to problems of climate change that Congress has
persistently ignored.154
The incorporation of behavioral psychology into environmental eco-
nomics is, if nothing else, the story of an intellectual discipline that has
come to embrace the richness of analytical tools transcending austerely
beautiful but excessively rigid mathematical models. The long reaches of
the peaks of song, whether delivered by La Fontaines cicada or a human
master of music as mathematics made flesh, rebuff the formic formalist
of the French fable.155 If indeed the ant symbolizes the entomological
equivalent of poet Edwin Markhams [s]lave of the wheel of labor, a
nuanced approach to environmental as well as financial economics may
rightfully ask, what to [her]/Are Plato and the swing of Pleiades?156
Understanding the impact of investor behavior on the performance of an
individual portfolio or perhaps even the financial marketplace as a whole
indeed begins with the rift of dawn, the reddening of the rose.157
NOTES
1. See, e.g., Alenco Communications, Inc. v. FCC, 201 F.3d 608, 615 (5th
Cir. 2000) (recognizing that historical investments are sunk costs
and have no relevance to current costs or business decisions based on
them); Armen A.Alchian & William R.Allen, Exchange and Production
222 (3d ed. 1983) (observing that the cost of an item, onceacquired,
is irrelevant to any future decision); James D. Gwartney & Richard
L.Stroup, Economics 417419 (4th ed. 1982) (If they are to minimize
costs, business decision-makers must recognize the irrelevance of sunk
costs.); N.Gregory Mankiw, Principles of Economics 291 (1997) (The
irrelevance of sunk costs explains how real businesses make decisions.);
Robert S.Pindyck & Daniel L.Rubenfeld, Microeconomics 7.1, at 199
(2d ed. 1992) (arguing that sunk costs, though usually visible, should
always be ignored when making economic decisions); Richard A.Posner,
Economic Analysis of Law 1.1, at 7 (3d ed. 1986) ([C]ost to an econ-
omist is a forward-looking concept; costs already incurred do not
affect decisions on price and quantity.).
2. See Rudolf Conradi & August Conradi, Die Familie Padde 26 (1858)
(available at https://books.google.com/books?id=WNGVZMZethcC):
Whats past is past; we will speak no more of it.
3. Paul A.Samuelson & William D.Nordhaus, Economics 227 (19th ed.
2010).
MENTAL ACCOUNTING, EMOTIONAL HIERARCHIES, ANDBEHAVIORAL... 43
4. See generally, e.g., Ziv Carmon & Dan Ariely, Focusing on the Forgone:
How Value Can Appear So Different to Buyers and Sellers, 27J.Consumer
Research 360370 (2000); Herbert J.Hovencamp, Legal Policy and the
Endowment Effect, 20J.Leg. Stud. 225247 (1991); Daniel Kahneman,
Jack L.Knetsch & Richard H.Thaler, Experimental Tests of the Endowment
Effect and the Coase Theorem, 98J.Pol. Econ. 13251348 (1990); Jack
L. Knetsch, The Endowment Effect and Evidence of Nonreversible
Indifference Curves, 79 Am. Econ. Rev. 12771284 (1989); Nathan
Novemsky & Daniel Kahneman, The Boundaries of Loss Aversion,
42J.Marketing Research 119128 (2005).
5. See Andrew Healy & Neil Malhotra, Myopic Voters and Natural Disaster
Policy, 103 Am. Pol. Sci. Rev. 387406, 396 (2009) (estimating the
total benefit of a dollar of preparedness spending as all future reduc-
tions in damage, while discounting those benefitsfor the fact that
resources invested today in other ways could have yielded their own
return and that preparedness investments will depreciate); cf. M.Ishaq
Nadiri & Ingmar Prucha, Estimation of Depreciation Rate of Physical and
R&D Capital in the U.S.Total Manufacturing Sector, 34 Econ. Inquiry
4356 (1996) (estimating that physical capital in American manufactur-
ing depreciates 5.9% per year). Combining Nadiri and Pruchas 5.9%
depreciation rate with their own estimate of a 4% annual interest rate,
Healy and Malhotra estimate the [net present value] of $1 of disaster
preparedness to be about $15.
6. See Ben Depoorter, Horizontal Political Externalities: The Supply and
Demand of Disaster Management, 56 Duke L.J. 101125, 103 (2006);
Howard Kunreuther, Mitigating Disaster Losses Through Insurance,
12J.Risk & Uncertainty 171187, 177 (1996).
7. See Charles Cohen & Eric Werker, The Political Economy of Natural
Disasters, 52J.Conflict Resolution 795819 (2008).
8. Jean-Pierre Benot & Juan Dubra, On the Problem of Prevention, 54 Intl
Econ. Rev. 787805, 787 (2013).
9. Richard A. Epstein, Catastrophic Responses to Catastrophic Risks,
12 J. Risk & Uncertainty 287308 (1996). See generally James Ming
Chen, Correlation, Coverage, and Catastrophe: The Contours of Financial
Preparedness for Disaster, 26 Fordham Envtl. L. Rev. 5694, 7985
(2014).
10. New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J.,
dissenting).
11. See generally Nicholas Barberis & Ming Huang, Mental Accounting, Loss
Aversion, and Individual Stock Returns, 56J.Fin. 12471292 (2001).
12. See Eric J. Allen, Patricia M. Dechow, Devin G. Pope & George Wu,
Reference-Dependent Preferences: Evidence from Marathon Runners
2329, 26 (July 18, 2014) (figure 9(b)) (available at http://faculty.chi-
cagobooth.edu/devin.pope/research/pdf/Website_Marathons.pdf).
44 J.M. CHEN
Risk Taking and Risk Learning After a Rare Event: Evidence from a Field
Experiment in Pakistan, 118J.Econ. Behav. & Org. 167183 (2015)
(documenting levels of risk aversion as a function of the number of floods
and the severity of losses experienced by rural Punjabis).
17. See generally Gina Nicolosi, Liang Peng & Ning Zhu, Do Individual
Investors Learn from Their Trading Experience?, 12J.Fin. Markets 317
336 (2009).
18. See Markus Glaser & Martin Weber, Why Inexperienced Investors Do Not
Learn: They Do Not Know Their Past Portfolio Performance, 4 Fin.
Research Letters 203216 (2007); cf. Amit Seru, Tyler Shumway &
Noah Stoffman, Learning by Trading, 23 Rev. Fin. Stud. 705739
(2010) (cautioning that a significant number of traders stop trading upon
discovering their lack of aptitude and that studies purporting to find posi-
tive learning effects without accounting for this attrition reflects survivor-
ship bias).
19. See generally, e.g., Richard H.Thaler, Mental Accounting and Consumer
Choice, 3 Marketing Sci. 199214 (1985); Richard H.Thaler, Toward a
Positive Theory of Consumer Choice, 1 J. Econ. Behav. & Org. 3960
(1980).
20. Shlomo Benartzi & Richard H. Thaler, Myopic Loss Aversion and the
Equity Premium Puzzle, 110 Q.J.Econ. 7392, 74 (1995).
21. See Amos Tversky & Daniel Kahneman, Rational Choice and the Framing
of Decisions, 59 J. Bus. S251-S278 (1986); Amos Tversky & Daniel
Kahneman, The Framing of Decisions and the Psychology of Choice, 211
Science 453481 (1981).
22. See Amos Tversky, Elimination by Aspects: A Theory of Choice, 79 Psych.
Rev. 281299 (1972).
23. Statman, Fisher & Anginer, supra note 122 (Chapter 1), at 21. See gener-
ally Baba Shiv & Alexander Fedorikhin, Heart and Mind in Conflict: The
Interplay of Affect and Cognition in Consumer Decision Making,
26J.Consumer Research 278292 (1999).
24. See Haim Levy & Amnon Rapoport, Experimental Tests of the Separation
Theorem and the Capital Asset Pricing Model, 7 Am. Econ. Rev. 500518
(1988); Hersh Shefrin & Meir Statman, Behavioral Portfolio Theory,
35J.Fin. & Quant. Analysis 127151, 142 (2000).
25. See Philippe Jorion, Mean/Variance Analysis of Currency Overlays, 50:3
Fin. Analysts J. 4856 (May/June 1994).
26. See id. at 49, 52.
27. See Victor DeMiguel, Lorenzo Garlappi & Raman Uppal, Optimal Versus
Nave Diversification: How Inefficient Is the 1/N Portfolio Design?, 22
Rev. Fin. Stud. 19151953 (2009). See generally Shlomo Benartzi &
46 J.M. CHEN
40. See infra 5 1., text accompanying notes 1418 (Chapter 5).
41. See De Brouwer, Maslowian Portfolio Theory, supra note 33, at 361.
42. Sanjiv Das, Harry Markowitz, Jonathan Scheid & Meir Statman, Portfolio
Optimization with Mental Accounts, 45J.Fin. & Quant. Analysis 311
334, 313 (2010).
43. Id. at 312. See generally Wilbur G.Lewellen, Ronald C.Lease & Gary
G. Schlarbaum, Portfolio Design and Portfolio Performance: The
Individual Investor, 32J.Econ. & Bus. 185197 (1980).
44. Das, Markowitz, Scheid & Statman, supra note 42, at 312.
45. De Brouwer, Maslowian Portfolio Theory, supra note 33, at 361; see also
Das, Markowitz, Scheid & Statman, supra note 42, at 313.
46. Das, Markowitz, Scheid & Statman, supra note 42, at 313.
47. Philippe J.S.De Brouwer, Target-Oriented Investment Advice, 13J.Asset
Mgmt. 102114, 104 (2012).
48. Id. at 105.
49. Id. at 104.
50. Das, Markowitz, Scheid & Statman, supra note 42, at 312.
51. Id.
52. Id. at 313.
53. Id. at 315; see also id. at 318.
54. Peter Brooks, Greg B. Davies & Robert E.D. Smith, A Behavioral
Perspective on Goal-Based Investing, Invs. & Wealth Monitor, Nov./Dec.
2015, at 1618 & 37, 16.
55. See Lola L.Lopes & Gregg C.Oden, The Role of Aspiration Level in Risky
Choice: A Comparison of Cumulative Prospect Theory and SP/A Theory,
43J.Math. Psych. 286313, 307 (1999).
56. See Das, Markowitz, Scheid & Statman, supra note 42, at 315 n.4; cf.
Robert B. Barsky, F. Thomas Juster, Miles S. Kimball & Matthew
D. Shapiro, Preference Parameters and Behavioral Heterogeneity: An
Experimental Approach in the Health and Retirement Study, 112
Q.J. Econ. 537579, 545 (1997) (defining risk tolerance in terms of
choices over risky behaviorsthe decisions to smoke and drink, to buy
insurance, to immigrate, to be self-employed, and to hold stock); Miles
S. Kimball, Claudia R. Sahm & Matthew D. Shapiro, Imputing Risk
Tolerance from Survey Responses, 103 J. Am. Stat. Assn 10281038,
1029 (2008) (observing that the subjective wording of measures for
risk tolerance may generate uninterpretable variation).
57. De Brouwer, Target-Oriented Investment Advice, supra note 47, at 112.
58. Id. at 103.
59. Douglas T.Kenrick, Vladas Griskevicius & Mark Schaller, Renovating the
Pyramid of Needs: Contemporary Extensions Built upon Ancient
Foundations, 5 Persp. on Psych. Sci. 292314, 292 (2010).
48 J.M. CHEN
76. See Maberly & Pierce, supra note 37 (Chapter 1), at 30.
77. These titles come from Harvard Business Review alone, including the
journals related press: Teresa Amabile & Steve Kramer, What Makes
Work Worth Doing?, Harv. Bus. Rev. Online (Aug. 31, 2012) (available at
https://hbr.org/2012/08/what-makes-work-worth-doing); Teresa
Amabile & Steven J.Kramer, Inner Work Life: Understanding the Subtext
of Business Performance, Harv. Bus. Rev. (May 2007) (available at
https://hbr.org/2007/05/inner-work-life-understanding-the-subtext-
of-business-performance); Adam Grant, How Customers Can Rally Your
Troops, Harv. Bus. Rev. (June 2011) (available at https://hbr.
org/2011/06/how-customers-can-rally-your-troops). See generally
Teresa M.Amabile & Steven J.Kramer, The Progress Principle: Using
Small Wins to Ignite Joy, Engagement, and Creativity at Work (2011).
78. See Amy Wrzesniewski & Jane E. Dutton, Crafting a Job: Revisioning
Employees as Active Crafters of Their Work, 26 Acad. Mgmt. Rev. 179
201 (2001).
79. The seminal source arguing no to this proposition is Milton Friedman,
Capitalism and Freedom: Fortieth Anniversary Edition 119136 (2002;
1st ed. 1962).
80. See generally, e.g., C.B. Bhattacharya, Sankar San & Daniel Korschun,
Leveraging Corporate Social Responsibility: The Stakeholder Route to
Business and Social Value (2011).
81. Alexander Kempf & Peer Osthoff, The Effect of Socially Responsible
Investing on Portfolio Performance, 13 Eur. Fin. Mgmt. 908922 (2007);
see also Bryan W. Hustead & Jos de Jesus Salazar, Taking Friedman
Seriously: Maximizing Profits and Social Performance, 43J.Mgmt. Stud.
7591 (2006).
82. See Rob Bauer, Kees Koedijk & Rogr Otten, International Evidence on
Ethical Mutual Fund Performance and Investment Style, 29J.Banking &
Fin. 17511767 (2006).
83. See Luc Reeneborg, Jenke Ter Horst & Chendi Zhang, The Price of Ethics
and Stakeholder Governance: The Performance of Socially Responsible
Mutual Funds, 14 J. Corp. Fin. 302322 (2008). On the four-factor
FamaFrenchCarhart model, see infra 12.2.; Chen, Postmodern
Portfolio Theory, supra note 1 (Chapter 1), 3.3.
84. See Raphie Hayat & Roman Kraeussl, Risk and Return Characteristics of
Islamic Equity Funds, 12 Emerging Mkts. Rev. 189203 (2011) (finding
that Islamic equity funds underperform both Islamic and conventional
equity benchmarks); Saida Daly, Sonia Ghorbel-Zouari & Mohamed
Frikha, Islamic Financial Stability During the US Sub-Prime Crisis: Using
from Data Panel, 1J.Behav. Econ., Fin., Entrepreneurship, Accounting
& Transp. 112 (2013) (finding that adherence to Islamic banking prin-
50 J.M. CHEN
107. See, e.g., Ida Kubiszewski, Robert Costanza, Carol Franco, Philip Lawn,
John Talberth, Tim Jackson & Camille Aylmer, Beyond GDP: Measuring
and Achieving Global Genuine Progress, 93 Ecol. Econ. 5768 (2013).
108. See, e.g., Philip A.Lawn, A Theoretical Foundation to Support the Index of
Sustainable Economic Welfare (ISEW), Genuine Progress Indicator (GPI),
and Other Related Indexes, 44 Ecol. Econ. 105118 (2003).
109. See, e.g., Farhad Noorbaksh, A Modified Human Development Index, 26
World Dev. 517528 (1998); Ambuj D.Sagar & Adil Najam, The Human
Development Index: A Critical Review, 25 Ecol. Econ. 249264 (1998).
110. See Stefan Preisner, Gross National Happiness: Bhutans Vision of
Development and Its Challenges, in Indigeneity and Universality in Social
Science: A South Asian Response 212232 (Partha Nath Mukherji &
Chandan Sengupta eds., 2004). See generally, e.g., Philip Layard,
Happiness: Lessons from a New Science (2005); Economics and
Happiness: Framing the Analysis (Luigino Bruni & Pier Luigi Porta eds.,
2006).
111. Edward O.Wilson, Consilience: The Unity of Knowledge 237 (1998).
With respect to the notion that humans feel an innate emotional connec-
tion to other species, see generally Edward O. Wilson, Biophilia: The
Human Bond with Other Species (1984); Ursula Goodenough, The
Sacred Depths of Nature (1998).
112. See, e.g., Jia Wei Zhang, Ryan T.Howell & Ravi Iyer, Engagement with
Natural Beauty Moderates the Positive Relation Between Connectedness
with Nature and Psychological Well-Being, 38 J. Envtl. Psych. 5563
(2014).
113. Robert B.Zajonc, Feeling and Thinking: Preferences Need No Inferences,
35 Am. Psychologist 151175, 154 (1980); accord Statman, Fisher &
Anginer, supra note 122 (Chapter 1), at 20.
114. See Robert B.Zajonc, Mere Exposure: A Gateway to the Subliminal, 10
Current Directions in Psych. Sci. 224228 (2001).
115. See generally, e.g., Melissa L. Finucane, Ali Alhakami, Paul Slovic &
Stephen M. Johnson, The Affect Heuristic in Judgments of Risks and
Benefits, 13J.Behav. Decision Making 117 (2000); Paul Slovic, Ellen
Peters, Melissa L.Finucane & Donald G.MacGregor, Affect, Risk, and
Decision Making, 24 Health Psych. S35S40 (2005); Meir Statman,
Kenneth L.Fisher & Deniz Anginer, Affect in a Behavioral Asset-Pricing
Model, 64:2 Fin. Analysts J. 2029 (March/April 2008); R.B. Zajonc,
Feeling and Thinking: Preferences Need No Inferences, 35 Am. Psychologist
151175 (1980). Paul Slovic, Melissa Finucane, Ellen Peters & Donald
G. Macgregor, The Affect Heuristic, in Heuristics and Biases: The
Psychology of Intuitive Judgment 397420 (Thomas Gilovich, Dale
Griffin & Daniel Kahneman eds., 2002).
MENTAL ACCOUNTING, EMOTIONAL HIERARCHIES, ANDBEHAVIORAL... 53
116. Paul Slovic, Melissa Finucane, Ellen Peters & Donald G.Macgregor, The
Affect Heuristic, in Heuristics and Biases: The Psychology of Intuitive
Judgment 397420, 397 (Thomas Gilovich, Dale Griffin & Daniel
Kahneman eds., 2002).
117. See, e.g., Baba Shiv & Alexander Fedorikhin, Heart and Mind in Conflict:
The Interplay of Affect and Cognition in Consumer Decision Making,
26J.Consumer Research 278292 (1999).
118. See, e.g., Graldine David, Kim Oosterlinck & Ariane Szafarz, Art Market
Inefficiency, 121 Econ. Letters 2325 (2013); Pter Erdos & Mihly
Ormos, Random Walk Theory and the Weak-Form Efficiency of the US Art
Auction Prices, 34J.Banking & Fin. 10621076 (2010).
119. See, e.g., Elroy Dimson & Christophe Spaenjers, Ex Post: The Investment
Performance of Collectible Stamps, 110J.Fin. Econ. 443458 (2011).
120. See, e.g., Luc Renneboog & Christophe Spaenjers, Buying Beauty: On
Prices and Returns in the Art Market, 59 Mgmt. Sci. 3653 (2013).
121. See Edward L. Glaeser, A Nation of Gamblers: Real Estate Speculation
and American History (Feb. 2013) (NBER Working Paper No. 18825)
(available at http://www.nber.org/papers/w18825).
122. See Orley Ashenfelter, How Auctions Work for Wine and Art, 3J.Econ.
Perspectives 2326 (1989).
123. See Malcolm Baker & Jeffrey Wurgler, Investor Sentiment and the Cross-
Section of Stock Returns, 61J.Fin. 16451680 (2006); Malcolm Baker &
Jeffrey Wurgler, Investor Sentiment in the Stock Market, 21 J. Econ.
Perspectives 129151 (2007); Gregory W. Brown & Michael T. Cliff,
Investor Sentiment and Asset Valuation, 78J.Bus. 405440 (2005).
124. Statman, Fisher & Anginer, supra note 113, at 20.
125. Id.
126. See, e.g., U.N. Conference on Environment and Development, Rio de
Janeiro, June 314, 1992, Rio Declaration on Environment and
Development, U.N.Doc. A/CONF. 151/26 (vol I), annex 1, principle
15 (Aug. 12, 1992) (Where there are threats of serious or irreversible
damage, lack of full scientific certainty shall not be used as a reason for
postponing cost-effective measures to prevent environmental degrada-
tion.); John Applegate, The Precautionary Preference: An American
Perspective on the Precautionary Principle, 6 Hum. & Ecol. Risk Assessment
413 (2000). For efforts to reconcile the precautionary principle with cost-
benefit analysis, see Daniel H.Cole, Reconciling Cost-Benefit Analysis with
the Precautionary Principle (March 5, 2012) (available online at https://
www.law.upenn.edu/blogs/regblog/2012/03/reconciling-cost-
benefit- analysis-with-the-precautionar y-principle.html ); Douglas
A. Kysar, It Might Have Been: Risk, Precaution and Opportunity Costs,
22J.Land Use & Envtl. L. 157 (2006).
54 J.M. CHEN
127. Compare Jrgen Haug, Thorsten Hens & Peter Woehrmann, Risk
Aversion in the Large and in the Small, 118 Econ. Letters 310313
(2013) with Miles S.Kimball, Precautionary Saving in the Small and in
the Large, 58 Econometrica 5373 (1990).
128. Lisa Grow Sun, Smart Growth in Dumb Places: Sustainability, Disaster,
and the Future of the American City, 2011 BYU L. Rev. 21572201,
21922193; see also id. at 2193 (Individuals who live in cities vulnerable
to natural disasters may adopt the attitude that every place is risky in
some way andview that vulnerability as just one of the many risks of
modern life.); cf. Justin Pidot, Deconstructing Disaster, 2013 BYU
L.Rev. 213257, 213 (observing that the public may fall into a danger-
ous state of complacency about environmental risks after a long period
of calm, as thoughnatural hazards no longer exist).
129. See generally Tristam McPherson, Moorean Arguments and Moral
Revisionism, 3:2J.Ethics & Soc. Phil. 124, 20 (June 2009); Stephen
P.Stitch & Richard E.Nisbett, Justification and the Psychology of Human
Reasoning, 47 Phil. Sci. 188202, 192193, 196197 (1988).
130. Pidot, supra note 128, at 138.
131. Lisa Grow Sun & Brigham Daniels, Mirrored Externalities, 90 Notre
Dame L. Rev. 135185, 161162 (2014); cf. Michele Landis Dauber,
The Sympathetic State: Disaster Relief and the Origins of the American
Welfare State 6 (2013) (tracing disaster policy and the modern welfare
state in general to the Depression-era imperative to respond to blame-
less suffering).
132. See generally, e.g., Hein Fennema & Peter Wakker, Original and
Cumulative Prospect Theory: A Discussion of Empirical Differences,
10J.Behav. Decision Making 5364 (1997).
133. See Christine Jolls, Cass R.Sunstein & Richard H.Thaler, A Behavioral
Approach to Law and Economics, 50 Stan. L. Rev. 14711550, 1477
1478 (1998).
134. See generally Markus K. Brunnermeier, Herding and Informational
Cascades, in Asset Pricing Under Asymmetrical Information: Bubbles,
Crashes, Technical Analysis, and Herding 147164 (2001); Timur Kuran
& Cass R.Sunstein, Availability Cascades and Risk Regulation, 51 Stan.
L.Rev. 683768 (1999).
135. See Lisa Grow Sun., Disaster Mythology and Availability Cascades, 23
Duke Envtl. L. & Poly F. 7392, 7781 (2012); Lisa Grow Sun.,
Disaster Mythology and the Law, 96 Cornell L.Rev. 11311207, 1150
1152 (2011).
136. See, e.g., Jan. Bonhoeffer & Ulrich Heininger, Adverse Events Following
Immunization: Perception and Evidence, 20 Current Opin. In Infectious
Diseases 237246 (2007); Mark B. Pepys, Science and Serendipity, 7
Clin. Med. 562578 (2007).
MENTAL ACCOUNTING, EMOTIONAL HIERARCHIES, ANDBEHAVIORAL... 55
137. See, e.g., Aaron M. McCright & Riley E. Dunlap, Challenging Global
Warming as a Social Problem: An Analysis of the Conservative Movements
Counter-Claims, 47 Soc. Probs. 499522 (2000).
138. See generally Scott Plous, The Psychology of Judgment and Decision
Making 233 (1993); Maria Lewicka, Confirmation Bias: Cognitive Error
or Adaptive Strategy of Action Control?, in Personal Control in Action:
Cognitive and Motivational Mechanisms 233255 (Mirosaw Kofta,
Gifford Weary & Grzegorz Sedek eds., 1998); Raymond S.Nickerson,
Confirmation Bias: A Ubiquitous Phenomenon in Many Guises, 2 Rev.
Gen. Psych. 175220 (1998).
139. See Dan M.Kahan etal., The Polarizing Impact of Science Literacy and
Numeracy on Perceived Climate Change Risks, 2 Nature Climate Change
732735 (2012).
140. See generally Mary Douglas & Aaron B.Wildavsky, Risk and Culture: An
Essay on the Selection of Technical and Environmental Dangers (1982)
(propounding a cultural theory of risk); Paul Slovic, The Perception of
Risk (200) (propounding a psychometric paradigm for risk manage-
ment through public policy).
141. See Lennart Sjberg, World Views, Political Attitudes, and Risk Perception,
9 Risk: Health, Safety & Envt 137152 (1998) (arguing that cultural
cognition theory accounts for only a portion of the diversity in attitudes
toward risk).
142. See Robert R.M.Verchick, Culture, Cognition, and Climate, 2016 U.Ill.
L.Rev. (forthcoming); cf. Lisa Grow Sun, Disaggregating Disasters, 60
UCLA L.Rev. 884948, 887 (2013) (criticizing the framing of natural
and technological disasters within the narrative of war and national secu-
rity, as though those disasters involved an anthropomorphic enemy to
be demonized and defeated).
143. New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J.,
dissenting).
144. See, e.g., Aesops Fables 6566 (Laura Gibbs trans., 2003).
145. Proverbs 6:68 (Revised Standard Version); see also Proverbs 30:2425
(Four things on earth are small, but they are exceedingly wise: the ants
are a people not strong, yet they provide their food in the summer).
146. Jim Chen, Webs of Life: Biodiversity Conservation as a Species of Information
Policy, 89 Iowa L. Rev. 495608, 603 (2004) (quoting David Takacs,
The Idea of Biodiversity: Philosophies of Paradise 255 (1996)).
147. The original French version of La Cigale et la Fourmi, alongside a ser-
viceable if pedantically literal English translation, appears in Jean de La
Fontaine, Selected Fables/Fables Choisies: A Dual Language Book 23
(Stanley Appelbaum trans., 1997).
56 J.M. CHEN
148. See Andrew Calder, The Fables of La Fontaine: Wisdom Brought Down
to Earth 1824 (2001).
149. The Complete Fables of Jean de La Fontaine 5 (Norman R. Shapiro
trans., 2007).
150. Id. In the original French, these are the pivotal lines: Je vous paierai, lui
dit-elle,/Avant laot, foi danimal,/Intrt et principal./La fourmi
nest pas prteuse:/Cest l son moindre dfaut. La Fontaine, supra
note 147, at 2. In Appelbaums translation, Ill pay you/before har-
vest time, on my word as an animal/both interest and principal./The
ant wasnt the lending kind;/if she had any fault, it wasnt that one. Id.
at 3.
151. See, e.g., Jesse Graham, Brian A. Nosek, Jonathan Haidt, Ravi Iyer,
Spassena Koleva & Peter H. Ditto, Mapping the Moral Domain,
101J.Personality & Soc. Psych. 366385 (2011); Spassena P.Koleva,
Jesse Graham, Ravi Iyer, Peter H.Ditto & Jonathan Haidt, Tracing the
Threads: How Five Moral Concerns (Especially Purity) Help Explain
Culture War Attitudes, 46J.Research in Personality 184194 (2012).
152. Mark Sagoff, Muddle or Muddle Through? Takings Jurisprudence Meets
the Endangered Species Act, 38 Wm. & Mary L. Rev. 825993, 844
(1997); accord Chen, supra note 146, at 602608.
153. See coRessources Consultants, Evidence of the Socio-Economic Importance
of Polar Bears for Canada (2011) (available at http://www.registrelep.
gc.ca/document/default_e.cfm?documentID=2307); Leslie Richardson
& John Loomis, Total Economic Valuation of Endangered Species: A
Summary and Comparison of the United States and the Rest of the World
Estimates, in Conserving and Valuing Ecosystem Services and Biodiversity
2546 (K.N.Ninan ed., 2009). See generally John B.Loomis & Douglas
S.White, Economic Benefits of Rare and Endangered Species: A Summary
and Meta-Analysis, 18 Ecol. Econ. 197206 (1996).
154. See generally James Ming Chen, : Protecting Biodiversity
Against the Effects of Climate Change Through the Endangered Species
Act, 47 Wash. U.J.L. & Poly 1127 (2015).
155. See Edwin Markham, The Man with a Hoe, in The Man with a Hoe and
Other Poems 1518 (Doubleday & McClure 1899).
156. Id. at 16. Jean de La Fontaine referred to both insects in his fable, con-
sistent with the rules of the French language, by the feminine gender.
157. Id.
CHAPTER 3
Ra = R f + a ( Rm R f )
where Ra, Rm, and Rf, respectively, represent returns on the asset, on the
broader market of comparable investments, and on a risk-free investment,
and where a represents the individual assets beta vis--vis the broader
market portfolio.13 This formula takes the form of a linear equation where
the return on an asset (Ra) is expressed as a function of the premium over
a risk-free baseline (RmRf).14
Modest algebraic rearrangement of the CAPM yields the following
relationship:
HIGHER-MOMENT CAPITAL ASSET PRICING... 59
Ra R f
Rm R f =
a
The left side of the foregoing equation represents the risk premium
demanded for the entire asset class represented by a particular segment
of the market.15 The risk premium is the difference between returns on
a specific investment or class of investments and some sort of risk-free
benchmark.16 This premium dictates a firms cost of capital. Capital asset
pricing, in its original incarnation, offered a solution to the problem of
determining the price that investors would demand for bearing risk in
excess of a risk-free alternative.17
Another common application of the CAPM compares an index of equi-
ties designed to track the Standard & Poors 500 against the putatively
risk-free baseline of short-term Treasury bills.18 This market-wide risk pre-
mium is equivalent to the risk-adjusted premium expressed on the right
side of the equationnamely, the risk premium for the asset vis--vis a
risk-free investment, divided by the individual assets beta.19
This ratio between risk-adjusted return and volatility bears closer exam-
ination. Recall that the foregoing equation is merely an algebraically refor-
mulated version of the basic CAPM:
Ra = R f + a ( Rm R f )
The ratio of (1) the premium over a baseline return to (2) the volatility
associated with that asset or portfolio demonstrates how market returns
are adjusted for a measure of risk such as volatility or beta:
Ra Rb
Treynor ratio =
a
The Treynor ratio demonstrates that the general risk premium of a class
of investments is equivalent to the premium for a specific investment over
risk-free return, discounted by the volatility of returns on that specific
asset relative to returns on the benchmark class as a whole. In other words,
we can extrapolate the Treynor ratio from the CAPM, and the CAPM
from the Treynor ratio.
The Treynor ratio measures reward as return on an asset, Ra, above
some benchmark return, Rb, relative to the volatility of that assets return
as expressed by its beta, a.21 The benchmark return, Rb, often is, but need
not be, equivalent to the risk-free baseline, Rf. The Treynor ratio closely
resembles a generalized version of the Sharpe ratio of reward to variability
(as measured by the standard deviation of portfolio returns):22
Ra Rb
Generalized Sharpe ratio =
Both the Sharpe and Treynor ratios evaluate portfolio returns or port-
folio manager performance according to the relationship between returns
and some proxy for risk.23
f (a) f ( a ) f ( a )
f ( x) = f (a) + ( x a) + ( x a) ( x a) +
2 3
+
1! 2! 3!
f(
n)
(a)
f ( x) = ( x a)
n
n=0 n!
U ( w ) = U ( w ) f ( w ) dw
U(
n)
(w)(w w)
n
U (w) =
n =0 n!
rt ( k ) = ln 1 + Rt ( k ) = ln (1 + Rt ) (1 + Rt 1 ) (1 + Rt k +1 )
rt ( k ) = ln (1 + Rt ) + ln (1 + Rt 1 ) + + ln (1 + Rt k +1 )
rt ( k ) = rt + rt 1 + + rt k +1
xn
ln (1 + x ) = ( 1)
n +1
n =1 n
HIGHER-MOMENT CAPITAL ASSET PRICING... 63
x (x ) (x ) (x )
2 3 4
ln (1 + ) + + o ( x )
5
+
1 + 2 (1 + ) 3 (1 + ) 4 (1 + )
2 3 4
where o[(x)5] represents remaining terms of the fifth order and above.41
Inasmuch as time series also rely on logarithmic returns, a more elabo-
rate third-order (or higher) Taylor series expansion may be derived by
relat[ing] the discount factor to the marginal rate of substitution between
periods t and t + 1in a two-period economy.42
Somewhat optimistically, Javier Estrada leaps directly from this model
to a Taylor series expansion that consists exclusively of alternative central
statistical moments. He is partially correctand almost entirely correct if
we modify the definition of skewness and kurtosis. If we let and [rep-
resent] the mean and variance of R, then the conventional CAPM takes
the form of a Taylor series expansion of expected returns:43
x 1 2
r = ln (1 + R ) ln (1 + ) + + R2 ln (1 + R )
1 + 2 (1 + )2
where Rn(x) designates the remaining terms of the Taylor series expan-
sion beyond order n (which in this example is 2).44 Estrada omits the sec-
x
ond term of the series, , and takes no explicit account of the Taylor
1+
remainder.
More explicitly, Estrada proposes to interpret the remainder term as
direct implementations of skewness and kurtosis:45
1 2 1 Skew 1 Kurt
r = ln (1 + R ) ln (1 + ) +
2 (1 + )2 3 (1 + )3 4 (1 + )4
1 2 1 Skew 1 Kurt
AEU Kurt ln (1 + ) +
2 (1 + ) 3 (1 + ) 4 (1 + )4
2 3
ln (1 + x ) at ( x = )
x (x ) (x ) (x )
2 3 4
ln (1 + ) + + o ( x )
5
+
1 + 2 (1 + ) 3 (1 + )3 4 (1 + )4
2
x 2 3 4
ln (1 + ) + + + o ( 5 )
1 + 2 (1 + )2 3 (1 + )3 4 (1 + )4
ln (1 + x ) at ( x = )
x 2 1 3 2 4
ln (1 + ) + + + o ( 5 )
1 + 2 (1 + ) 3 (1 + ) 4 (1 + )4
2 3
x 2 1 3 ( 2 + 3) 4
ln (1 + ) + + + o ( 5 )
1 + 2 (1 + )2 3 (1 + )3 4 (1 + )4
HIGHER-MOMENT CAPITAL ASSET PRICING... 65
U(
n)
( w ) > 0 w, if n is odd and
U ( n)
( w ) < 0 w, if n is even.
1! 2! 3!
an even simpler approximation of expected returns or investor utility as a
preference function:68
1 (2) 1 3 1 4
U (w) U (w) + U ( w ) 2 + U ( ) ( w ) s3 + U ( ) ( w ) k 4
2! 3! 4!
Notes
1. The companion volume to this book, Chen, Postmodern Portfolio Theory,
supra note 1 (Chapter 1), addresses these topics in Chapter 2, at 525
(conventional CAPM) and Chapters 1011, at 189213 (higher-moment
capital asset pricing).
2. See, e.g., Fischer Black, Capital Market Equilibrium with Restricted
Borrowing, 45J.Bus. 444455 (1972); Fischer Black, Michael C.Jensen &
Myron S.Scholes, The Capital Asset Pricing Model: Some Empirical Tests, in
Studies in the Theory of Capital Markets 79121 (Michael C.Jensen ed.,
68 J.M. CHEN
1972); John Lintner, Security Prices, Risk and Maximal Gains from
Diversification, 20J.Fin. 587615 (1965); John Lintner, The Valuation of
Risk Assets and the Selection of Risky Investments in Stock Portfolios and
Capital Budgets, 73 Rev. Econ. & Stats. 1337 (1965); Jan. Mossin,
Equilibrium in a Capital Asset Market, 34 Econometrica 768783 (1966);
William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium
Under Conditions of Risk, 19 J. Fin. 425442 (1964); Jack L. Treynor,
Toward a Theory of Market Value of Risky Assets, in Asset Pricing and
Portfolio Performance: Models, Strategy and Performance Metrics 1522
(Robert A. Korajczyk ed., 1999); Jack L. Treynor & Fischer Black,
Corporate Investment Decisions, in Modern Developments in Financial
Management 310327 (Stewart C.Myers ed., 1976). See generally Bernell
K.Stone, Risk, Return, and Equilibrium: A General Single-Period Theory
of Asset Selection and Capital Market Equilibrium (1970); Eugene F.Fama
& Kenneth R. French, The Capital Asset Pricing Model: Theory and
Evidence, 18:3J.Econ. Persp. 2546 (Summer 2004).
3. See Levy, CAPM in the 21st Century, supra note 41 (Chapter 1), at 45
(describing the CAPM and its constituent concepts as probably the most
widely employed measures used by academic researchers and even more
intensively used by investment firms and practitioners).
4. Philip H.Dybvig & Jonathan E.Ingersoll, Jr., Mean-Variance Theory in
Complete Markets, 55J.Bus. 233251, 233 (1982).
5. See Eugene F.Fama & Kenneth R.French, The Cross-Section of Expected
Stock Returns, 47J.Fin. 427465 (1992); see also Marc R.Reinganum, A
New Empirical Perspective on the CAPM, 16 Fin. & Quant. Analysis 439
462 (1981).
6. Ravi Jagannathan & Zhenyu Wang, The Conditional CAPM and the Cross-
Section of Expected Returns, 51 J. Fin. 353, 4 (1996) (footnote
omitted).
7. Tim Koller, Marc Goedhart & David Wessels, Valuation: Measuring and
Managing the Value of Companies 261 (5th ed. 2010).
8. Eugene F. Fama, Efficient Capital Markets: II, 46 J. Fin. 15751617,
1593 (1991); accord Glenn N.Pettengill, Sridhar Sundaram & Ike Mathur,
The Conditional Relation Between Beta and Returns, 30J.Fin. & Quant.
Analysis 101116, 102 (1995).
9. See, e.g., In re American Classic Voyages Co., 367 B.R. 500, 513 n. 19
(D.Del. Bankr. 2007) (While there are other models to determine equity,
CAPM is probably the most widely used. [quoting Peter V.Pantaleo &
Barry W.Ridings, Reorganization Value, 51 Bus. Law. 419442, 433 n.52
(1996)]); cf. AEP Texas North Co. v. Surface Transp. Bd., 609 F.3d 432,
443 (D.C.Cir. 2010) (observing that courts do not sit aspanel[s] of
statisticians, but aspanels of generalist judges).
HIGHER-MOMENT CAPITAL ASSET PRICING... 69
10. See Haim Levy, The CAPM Is Alive and Well: A Review and Synthesis, 16
Eur. Fin. Mgmt. 4371 (2009); cf. Levy, CAPM in the 21st Century, supra
note 41 (Chapter 1), at 22 (describing the CAPM and related models of
mean-variance optimization as still alive and kicking).
11. Eugene Fama, Risk, Return, and Equilibrium: Some Clarifying Comments,
23J.Fin. 2940, 40 (1968).
12. See Robert A. Korajczyk, Introduction, in Asset Pricing and Portfolio
Performance, supra note 2, at viii, xv.
13. See id.
14. See id.
15. See id.
16. See William F.Sharpe, Capital Asset Prices: A Theory of Market Equilibrium
Under Conditions of Risk, 19J.Fin. 425442, 426427 (1964).
17. See Franco Modigliani & Merton Miller, The Cost of Capital, Corporate
Finance, and the Theory of Investment, 48 Am. Econ. Rev. 261297 (1958).
18. See 1 Handbook of Quantitative Finance and Risk Management 1.5, at
333, 1012 (Cheng-Few Lee, Alice C.Lee & John Lee. eds., 2010).
19. See Korajczyk, supra note 12, at xv.
20. See Richard Roll, A Critique of the Asset Pricing Theorys Tests, 4 J. Fin.
Econ. 129176, 136 (1977).
21. See Treynor, supra note 2, at 1617.
22. See William F. Sharpe, Mutual Fund Performance, 39 J. Bus. 119138
(1966); William F. Sharpe, Adjusting for Risk in Portfolio Performance
Measurement. 1:2J.Portfolio Mgmt. 2934 (Winter 1975).
23. See J.D.Jobson & Bob M.Korkie, Performance Hypothesis Testing with the
Sharpe and Treynor Measures. 36J.Fin. 888908 (1981); Sharpe, Mutual
Fund Performance, supra note 22, at 121122.
24. See, e.g., Ole Hagen, Separation of Cardinal Utility and Specific Utility of
Risk in Theory of Choices Under Uncertainty, 3 Saertrykk av Statskonomisk
Tidsskrift 81107, 9299 (1969).
25. Campbell R.Harvey, John C.Liechty, Merrill W.Liechty & Peter Mller,
Portfolio Selection with Higher Moments, 10 Quant. Fin. 469485, 471
(2010); Gustavo M. de Athayde & Renato G. Flres, Jr., Finding a
Maximum Skewness PortfolioA General Solution to Three- Moments
Portfolio Choice, 28J.Econ. Dyn. & Control 13351352, 1342 (2004).
26. See Eric Jondeau & Michael Rockinger, Optimal Portfolio Allocation Under
Higher Moments, 12 Eur. Fin. Mgmt. 2955, 33 (2006).
27. Id. at 30.
28. Harvey, Liechty, Liechty & Mller, supra note 25, at 470.
29. Id. at 469.
30. Jondeau & Rockinger, supra note 26, at 33.
31. See George B.Arfken & Hans J.Weber, Taylors Expansion, in Mathematical
Methods for Physicists 5.6, at 303313 (3d ed. 1985); https://en.wikipedia.
70 J.M. CHEN
57. Gary G.Venter, Utility with Decreasing Risk Aversion, 70 Casualty Actuarial
Socy Forum 144155, 147 (1983); see also Leonard R. Freifelder, A
Decision Theoretic Approach to Insurance Ratemaking 35 (1976).
58. See generally Yora Kroll, Moshe Leshno, Haim Levy & Yishay Spector,
Increasing Risk, Decreasing Absolute Risk Aversion and Diversification,
24J.Math. Econ. 537556 (1995); Liqun Liu & Jack Meyer, Decreasing
Absolute Risk Aversion, Prudence, and Increased Downside Risk Aversion,
3J.Risk & Uncertainty 243260 (2012).
59. Levy, CAPM in the 21st Century, supra note 3, at 70. Skewness prefer-
ences and positive third derivatives are related to third degree Stochastic
Dominance. Id. at 61 n.4. See generally G.A. Whitmore, Third-Degree
Stochastic Dominance, 60 Am. Econ. Rev. 457459 (1970).
60. Scott & Howath, supra note 52, at 91718.
61. Estrada, An Alternative Behavioural Model, supra note 33, at 241.
62. Id.
63. Balzer, supra note 47, at 130.
64. Athayde & Flres, supra note 25, at 1336.
65. Id.
66. See Turan G.Bali, Nusret Cakici & Robert Whitelaw, Maxing Out: Stocks
as Lotteries and the Cross-Section of Expected Returns, 99J.Fin. Econ. 427
446 (2011).
67. Athayde & Flres, supra note 25, at 1336.
68. Jondeau & Rockinger, supra note 26, at 35.
69. Id.
70. See infra 5.1 at 97.
71. See infra 6.1, at 112113; 6.3, at 114115.
72. See infra Chapters 8 and 9.
73. See infra Chapter 10.
74. See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter
1), 7.17.10, at 107151.
CHAPTER 4
negative slope between risk and return, albeit through accounting data
rather than the cross section of financial returns.22 Bowmans findings pre-
sented a paradox because they implie[d] that managers accept higher risk
at the same time that they expect lower returns.23 What is now known as
Bowmans paradox joins the low-volatility anomaly in contradicting the
established financial economics tenet that higher risk must be compensated
by higher return in order to motivate agents to undertake risky ventures.24
For the first 12 years after the 1980 publication of Bowmans original
article documenting low returns among risky firms, academic literature on
mathematical finance made no citation of Bowmans paradox.25 To this
day, finance and strategic management, as academic disciplines, continue
to maintain different perspectives on risk.26 In finance, market forces
determine the relationship between risk and return.27 By contrast, strate-
gic management assumes that risk management strategies are proprietary,
inaccessible, and illiquid and that any one firms strategic opportunity or
innovation may have little value to other firms.28
The strategic management literature evaluating Bowmans paradox in
its native environment and on its own terms has generated considerable
controversy while reaching no consensus.29 It is nevertheless evident
that the strategic management literature is striving to explain the same
phenomenon that the financial literature calls the low-volatility anomaly.30
At least one source tests Bowmans paradox differently in bull markets
and in bear markets,31 in harmony with the bifurcation of beta depicted
in Chapters 4 through 7 of Postmodern Portfolio Theory.32 At a more
abstractly theoretical level, strong correlation between empirical measures
of market risk (the subject of financial economics) and accounting risk
(the subject of strategic management) permit comparisons between the
low-volatility anomaly and Bowmans paradox, and between the bodies of
knowledge brought to bear on both phenomena.33
Three streams of literature seek to explain Bowmans paradox. One
treats the paradox as the product of misspecification.34 Another ascribes
its origins to theories of organizational strategy and behavior.35 Section
2.3s discussion of abnormal returns from firms with high corporate and
social responsibility ratings fits within the tradition emphasizing strategy
and behavior. The third stream, consisting of works aligning Bowmans
paradox with prospect theory, comes closest to harmonizing this bedrock
of strategic management theory with mathematical finance through the
behavioral sciences.36 Section 9.3 of this book will take a closer look at this
line of thinking.
76 J.M. CHEN
Notes
1. William J.Bernstein, The Intelligent Asset Allocator: How to Build Your
Portfolio to Maximize Returns and Minimize Risk 174 (2000).
2. Mark Grinblatt & Sheridan Titman, Financial Markets and Corporate
Strategy 392 (2d ed. 2001).
3. Id.
4. Lu Zhang, The Value Premium, 60J.Fin. 67103, 67 (2005).
5. Bernstein, supra note 1, at 174.
6. Id. See generally Benjamin Graham & David L. Dodd, Security Analysis
548558 (6th ed. 2008).
7. David Morelli, Beta, Size, Book-to-Market Equity and Returns: A Study
Based on UK Data, 17J.Multinatl Fin. Mgmt. 257272, 267 (2007). See
generally K.C.Chan & Nai-Fu Chen, Structural and Return Characteristics
of Small and Large Firms, 46J.Fin. 14671484 (1991).
8. See Malcolm Baker, Brendan Bradley & Jeffrey Wurgler, Benchmarks as
Limits to Arbitrage: Understanding the Low-Volatility Anomaly, 67:1 Fin.
Analysts J. 4054, 46 (Jan./Feb. 2011).
9. Zhang, The Value Premium, supra note 4, at 67.
10. Andrew Ang, Joseph Chen & Yuhang Xing, Downside Risk, 19 Rev. Fin.
Stud. 11911239, 1193 (2006).
11. Baker, Bradley & Wurgler, supra note 8, at 40.
12. Id. (emphasis in original).
13. Robert A. Haugen & A. James Heins, Risk and the Rate of Return on
Financial Assets: Some Old Wine in New Bottles, 10J.Fin. & Quant. Analysis
775784, 782 (1975) (emphasis added).
14. Andrew Ang, Robert J.Hodrick, Yuhang Xing & Xiaoyan Zhang, The Cross-
Section of Volatility and Expected Returns, 61J.Fin. 259299, 296 (2006);
accord Baker, Bradley & Wurgler, supra note 8, at 43; see also Andrew Ang,
Robert J. Hodrick, Yuhang Xing & Xiaoyan Zhang, High Idiosyncratic
Volatility and Low Returns: International and Further U.S.Evidence, 91J.Fin.
Econ. 123 (2009).
15. See, e.g., David C.Blitz & Pim van Vliet, The Volatility Effect: Lower Risk
Without Lower Return, 34:1J.Portfolio Mgmt. 102113 (Fall 2007); Roger
Clarke, Harindra de Silva & Steven Thorley, Minimum-Variance Portfolios in
the U.S.Equity Market, 33:1J.Portfolio Mgmt. 1024 (Fall 2006); Andrea
Frazzini & Lasse Heje Pedersen, Betting Against Beta, 111 J. Fin. Econ.
125 (2014); Robert A.Haugen & Nardin L.Baker, The Efficient Market
Inefficiency of Capitalization-Weighted Stock Portfolios, 17:3 J. Portfolio
Mgmt. 3540 (Spring 1991); cf. Javier Estrada & Ana Paula Serra, Risk and
Return in Emerging Markets: Family Matters, 15J.Multinatl Fin. Mgmt.
257272, 267 (2004) (finding, counterintuitively, that low risk portfo-
lios in emerging markets outperformhigh-risk portfolios over 20years,
at least when portfolios are rebalanced every 10years).
86 J.M. CHEN
33. See William Beaver, Paul Kettler & Myron Scholes, The Association Between
Market Determined and Accounting Determined Risk Measures, 45
Accounting Rev. 654682 (1970); William Beaver & James Manegold, The
Association Between Market-Determined and Accounting-Determined
Measures of Systematic Risk: Some Further Evidence, 10 J. Fin. & Quant.
Analysis 231284 (1975); Robert G.Bowman, The Theoretical Relationship
Between Systematic Risk and Financial (Accounting) Variables, 34 J. Fin.
617630 (1979).
34. See, e.g., Joachim Henkel, The Risk-Return Paradox for Strategic
Management: Disentangling True and Spurious Effects, 30 Strat. Mgmt. J.
287303 (2009); Benjamin M. Oviatt & Alan D. Bauerschmidt, Business
Risk and Return: A Test of Simultaneous Relationships, 37 Mgmt. Sci.
14051423 (1991); Robert M.Wiseman & Philip Bromiley, Risk-Return
Associations: Paradox or Artifact? An Empirically Tested Explanation, 12
Strat. Mgmt. J. 231241 (1991).
35. See, e.g., Torben J.Andersen, Jerker Denrell & Richard A.Bettis, Strategic
Responsiveness and Bowmans Risk-Return Paradox, 28 Strat. Mgmt. J.
407429 (2007); David B. Jemison, Risk and the Relationship Among
Strategy, Organizational Processes, and Performance, 33 Mgmt. Sci. 1087
1101 (1987).
36. See generally Nickel & Rodriguez, supra note 22, at 45.
37. M.A. Bellelah, M.O. Bellelah, H. Ben Ameur & R. Ben Hafsia, Does the
Equity Premium Puzzle Persist During Financial Crisis? The Case of the
French Equity Market, Research in Intl Bus. & Fin. (2015) (preprint at 14)
(available at http://dx.doi.org/10.1016/j.ribaf.2015.02.018).
38. Guy Kaplanski, Traditional Beta, Downside Risk Beta and Market Risk
Premiums, 44 Q.Rev. Econ. & Fin. 636653, 637 (2004).
39. Levy, CAPM in the 21st Century, supra note 41 (Chapter 1), at 4 (emphasis
in original).
40. See Martin L. Leibowitz, Anthony Bova & P. Brett Hammond, The
Endowment Model of Investing: Return, Risk, and Diversification 14 (2010)
(defining beta as the correlation between the asset (or portfolio) return and
the market return, multiplied by the ratio of their volatilities); Michael
B.Miller, Mathematics and Statistics for Financial Risk Management 198,
213, 292 (2d ed. 2014) (defining beta as the product of correlation between
the returns on two assets and the ratio of their volatilities); Shannon P.Pratt
& Roger J.Grabowski, Cost of Capital: Applications and Examples 305306
(4th ed. 2010).
41. See generally Chicago Board Options Exchange, The CBOE Volatility
IndexVIX (2009) (available online at http://www.cboe.com/micro/
vix/vixwhite.pdf).
42. See Menachem Brenner & Dan Galai, New Financial Instruments for
Hedging Changes in Volatility, 45:4 Fin. Analysts J. 6165 (July/Aug.
88 J.M. CHEN
Stability of Shock Transmission, 33J.Intl Fin. Mkts., Insts. & Money 137
154 (2014); cf. John Francis T.Diaz, Do Scarce Precious Metals Equate to
Safe Harbor Investments? The Case of Platinum and Palladium, 2016 Econ.
Research Intl 2361954 (arguing that platinum but not palladium provides
a financial safe haven because only platinum has a symmetric volatility
response to shocksbecause negative and positive shocks have equal effects
onreturns and volatilities).
55. See generally, e.g., Mark Burgin & Gunter Meissner, Negative Probabilities
in Financial Modeling, 58 Wilmott 6065 (2012); Carina Moselund Jensen
& Morten Spange, Interest Rate Pass-Through and the Demand for Cash at
Negative Interest Rates, Danmarks Nationalbank Monet. Rev., 2d quarter
2015, at 5566.
56. See Lasse Heje Pedersen, When Everyone Runs for the Exit, 5 Intl J.Cent.
Banking 177179 (2009).
57. See generally Geert Bekaert, Campbell R. Harvey & Angela Ng, Market
Integration and Contagion, 78J.Bus. 3969 (2005).
58. Thomas J. Flavin & Ekaterini Panopoulou, Detecting Shift and Pure
Contagion in East Asian Equity Markets: A Unified Approach, 15 Pac. Econ.
Rev. 401421, 401 (2010).
59. Id. See generally Toni Gravelle, Maral Kichian & James Morley, Detecting
Shift-Contagion in Currency and Bond Markets, 68J.Intl Econ. 409423
(2006).
60. Flavin & Panopoulou, supra note 58, at 401402.
61. Id. at 402. See generally Marcello Pericoli & Massimo Sbracia, A Primer in
Financial Contagion, 17J.Econ. Surveys 571608 (2003).
62. Flavin & Panopoulou, supra note 58, at 402.
63. See id.
64. Campbell R.Harvey, Predictable Risk and Returns in Emerging Markets, 8
Rev. Fin. Stud. 773816, 780 (1995).
65. Id. at 781; see also Vihang R.Erruzna, Emerging Markets: New Opportunity
for Improving Global Portfolio Performance, 39:5 Fin. Analysts J. 5158
(Sept./Oct. 1983).
66. Harvey, Predictable Risk and Returns in Emerging Markets, supra note 64,
at 811.
67. See, e.g., Christopher J.Adcock & Karl Shutes, An Analysis of Skewness and
Skewness Persistence in Three Emerging Markets, 6 Emerging Mkts. Rev.
396418 (2005) (reporting significant skewness in daily returns on stocks
in Kenya, Poland, and the Czech Republic); Soonsung Hwang & Christian
S.Pedersen, Asymmetrical Risk Measures When Modelling Emerging Markets
Equities: Evidence for Regional and Timing Effects, 5 Emerging Mkts. Rev.
109128 (2004).
90 J.M. CHEN
68. Harvey, Predictable Risk and Returns in Emerging Markets, supra note 64, at
787; see also id. at 801 (concluding that local information materially affects
returns in emerging markets, while most of the variation in developed markets
is driven by global information variables rather than local information);
Geert Bekaert & Campbell R. Harvey, Emerging Equity Market Volatility,
43J.Fin. Econ. 2977 (1997); Geert Bekaert & Campbell R.Harvey, Time-
Varying World-Market Integration, 50J.Fin. 403444 (1995). On the impact
of foreign exchange markets on stock prices, especially in emerging markets,
see Geert Bekaert & Robert J.Hodrick, Characterizing Predictable Components
in Excess Returns on Equity and Foreign Exchange Markets, 47J.Fin. 467509
(1992); Richard Roll, Industrial Structure and the Comparative Behavior of
International Stock Market Indexes, 47J.Fin. 341 (1992). On the impact of
foreign speculators, see Geert Bekaert & Campbell R. Harvey, Foreign
Speculators and Emerging Equity Markets, 55J.Fin. 565613 (2000).
69. Estrada & Serra, supra note 15, at 268.
70. Eduardo A. Sandoval & Rodrigo N. Saens, The Conditional Relationship
Between Portfolio Beta and Return: Evidence from Latin America, 41
Cuadernos de Economa 6589, 75 (2004).
71. Id. at 82.
72. Gordon Y.N.Tang & Wai C.Shum, The Conditional Relationship Between
Beta and Returns: Recent Evidence from International Stock Markets, 12
Intl Bus. Rev. 109126, 110 (2003).
73. See Fletcher, On the Conditional Relationship Between Beta and Return in
International Stock Markets, supra note 19.
74. Tang & Shum, The Conditional Relationship Between Beta and Returns,
supra note 72, at 110.
75. Javier Estrada, Systematic Risk in Emerging Markets: The D-CAPM, 3
Emerging Mkts. Rev. 365377, 374 (2002).
76. Id.; see also id. at 378 (table A1) (tabulating summary statistics).
77. See Javier Estrada, Mean-Semivariance Behavior: Downside Risk and Capital
Asset Pricing, 16 Intl Rev. Econ. & Fin. 169185, 175176 (2007) (exhibit 1).
78. See Estrada, Systematic Risk in Emerging Markets, supra note 75, at 378;
Estrada, Downside Risk and Capital Asset Pricing, supra note 77, at 175176.
79. Estrada, Downside Risk and Capital Asset Pricing, supra note 77, at 177.
80. See Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1), 7.6, at
122126.
81. Felipe M. Aparicio & Javier Estrada, Empirical Distributions of Stock
Returns: European Securities Markets, 199095, 7 Eur. J.Fin. 121, 1516
(2001). See generally, e.g., Joseph Chen, Harrison Hong & Jeremy C.Stein,
Forecasting Crashes: Trading Volume, Past Returns, and Conditional
Skewness in Stock Prices, 61J.Fin. Econ. 345391 (2001); Eugene F.Fama,
The Behavior of Stock Market Prices, 38 J. Bus. 34105 (1965); Amado
TRACKING THELOW-VOLATILITY ANOMALY ACROSS BEHAVIORAL SPACE 91
100. See Leibowitz, Bova & Hammond, supra note 40, at 235, 265.
101. See Louis K.C. Chan & Josef Lakonishok, Are Reports of Betas Death
Premature?, 19:4J.Portfolio Mgmt. 5162 (Summer 1993).
102. See Kevin Grundy & Burton G. Malkiel, Reports of Betas Death Have
Been Greatly Exaggerated, 22:3J.Portfolio Mgmt. 3644 (Spring 1996);
cf. Fama & French, The Cross-Section of Expected Stock Returns, supra
note 5 (Chapter. 3).
103. Baker, Bradley & Wurgler, supra note 8, at 43.
104. Id.; cf. R. Burr Porter, Semivariance and Stochastic Dominance: A
Comparison, 64 Am. Econ. Rev. 200204 (1974) (finding that portfolios
with below-target semivariance showed statistic dominance over their
benchmark, but that porfolios with below-mean semivariance did not).
105. Ang, Chen & Xing, supra note 10, at 1228.
106. See sources cited supra note 14.
107. Ang, Chen & Xing, supra note 10, at 1228 n.15.
108. See Zhanhui Chen & Ralitsa Petkova, Does Idiosyncratic Volatility Proxy
for Risk Exposure, 25 Rev. Fin. Stud. 27452787, 2746 (2012).
109. Id. (emphasis in original).
110. Id.
111. Id. at 2747.
112. Id.
113. See Driessen, Maenhout & Vilkov, supra note 88.
114. Chen & Petkova, supra note 108, at 2747 (emphasis added); see also id.
at 2750 (observing that Driessen, Maenhout, and Vilkov, supra note 88,
show that individual options are not exposed to correlation risk, while
index options are.).
115. Driessen, Maenhout & Vilkov, supra note 88, at 1377 (abstract) (empha-
sis added).
116. Id. (abstract) (emphasis added).
117. Chen & Petkova, supra note 108, at 2747.
118. See Kent Daniel & Sheridan Titman, Evidence on the Characteristics of
Cross Sectional Variation in Stock Returns, 52J.Fin. 133 (1997).
119. Chen & Petkova, supra note 108, at 2746. See generally Chen, Postmodern
Portfolio Theory, supra note 1 (Chapter. 1), 4.17.10, at 40151.
120. Chen & Petkova, supra note 108, at 2747.
121. Id.
CHAPTER 5
the value of [an] insured portfolio, at some specified date, will not fall
below some specified level, even though it is well understood that under
almost all circumstances, a simple portfolio insurance strategy is inconsis-
tent with expected-utility maximization.29
Sequence of returns risk, a particularly pernicious threat to retirement
security,30 especially when retirement coincides with a particularly sharp
market downturn,31 has inspired the creative use of put options and other
hedges to reduce vulnerability to poor returns at the beginning of an
investors retirement.32 Structured financial products perform this func-
tion, at a price, for other investors.33 Still other investors maintain distinct
subportfolios that accept reduced returns in exchange for a hedge against
future declines in investment or consumption opportunities. The inter-
temporal CAPM can be readily adapted to address this option.
Under the intertemporal CAPM, the return on an investors overall
portfolio return must reflect the systematic risk of the overall market as
well as the systematic risk of the hedged portfolio:34
a p = rf + b m ( a m - rf ) + b h ( a h - rf )
x-m s2 g 1s 3 b 2s 4
r = ln (1 + m ) + - + - + o ( m5 )
1 + m 2 (1 + m )2 3 (1 + m )3 4 (1 + m )4
rp = wm rm + wh rh
b a , m = b a , CF + b a , DR
update to Bad Beta, Good Beta acknowledged, even the more intuitive
impact of idiosyncratic volatility on future returns requires consideration
of more subtle influences on the variance of those future returns.
These three approaches, typified by the work of John Campbell,
Zhanhui Chen, and Ralitsa Petkova, and Javier Estrada, ultimately bifur-
cate beta in three radically different ways. Bad Beta, Good Beta and
Campbells 2015 update evaluate the difference between cash-flow and
discount-rate beta. The application of intertemporal asset pricing theory
by Campbell and his coauthors demonstrates that the distinction between
cash-flow and discount-rate beta actually follows a temporal boundary
separating tomorrow from today. Chen and Petkova, on the one hand,
and Estrada, on the other, split beta along two different spatial bound-
aries. Betas relative volatility and correlation components are not only
distinct from one another and from the composite, unconditional form of
beta used in the conventional CAPM.Instead, the relative volatility and
correlation components of beta assume different shapes on the upside and
downside of mean returns.
It should come as no surprise, then, that such divergent approaches
to beta should yield such diverse answers to the low-volatility anomaly
(Table 5.1). In light of the foregoing, perhaps it is enough to recognize,
as Campbell has, that volatility betas vary with multiple stock characteris-
tics, and that techniques that take this into account may be more effective
in explaining the low-volatility anomaly.86 Fully reconciling the bifurcation
of beta across time, as between volatility and correlation, and on either
side of mean returns would bring this financial puzzle into a more refined,
multidimensional focus.
Table 5.1 Three ways to bifurcate beta, with three divergent explanations for the
low-volatility anomaly
Bifurcation of beta Source(s)
Average volatility versus average Zhanhui Chen & Ralitsa Petkova, Does
correlation ( versus ) Idiosyncratic Volatility Proxy for Risk Exposure?
(2012)
Discount rate versus cash flow John Campbell & Tuomo Vuolteenaho, Bad
(implicitly current versus future Beta, Good Beta (2004); Campbell etal., An
investment or consumption under Intertemporal CAPM with Stochastic Volatility
intertemporal CAPM) (2015)
104 J.M. CHEN
Notes
1. See Robert C.Merton, An Intertemporal Capital Asset Pricing Model, 41
Econometrica 867887 (1973). Notably, Zhanhui Chen and Ralitsa
Petkova describe their evaluation of idiosyncratic volatility, systematic vola-
tility, and correlation as being motivated by the intertemporal
CAPM.Chen & Petkova, supra note 108 (Chapter 4), at 2746.
2. See Merton, Intertemporal CAPM, supra note 1, at 870.
3. See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1),
8.18.5, at 155172.
4. Ravi Jagannathan & Zhenyu Wang, The Conditional CAPM and the Cross-
Section of Expected Returns, 51J.Fin. 353, 4 (1996).
5. Philip H. Dybvig, Distributional Analysis of Portfolio Choice, 61 J. Bus.
369394, 369 (1988).
6. George G.Szpiro, Risk Aversion: An Alternative Approach, 68 Rev. Econ.
& Stat. 156159, 156 n.1 (1986).
7. Id.
8. Id.
9. See, e.g., Robert C.Merton, Optimum Consumption and Portfolio Rules in
a Continuous-Time Model, 3 J. Econ. Theory 373413 (1971); Jan.
Mossin, Optimal Multiperiod Portfolio Policies, 41J.Bus. 215229 (1968).
10. See, e.g., John C.Cox, Jonathan E.Ingersoll, Jr. & Stephen A.Ross, An
Intertemporal General Equilibrium Model of Asset Prices, 53 Econometrica
363384 (1985); Cox, Ingersoll & Ross, A Theory of the Term Structure of
Interest Rates, supra note 81 (Chapter 1); Robert E.Lucas, Jr., Asset Prices
in an Exchange Economy, 46 Econometrica 14291445 (1978).
11. See Kenneth J.Arrow & Grard Debreu, Existence of an Equilibrium for a
Competitive Economy, 22 Econometrica 265290 (1954) (describing
markets whose prices allow aggregate supplies of every commodity in the
economy to satisfy aggregate demand); Linel W. McKenzie, On the
Existence of General Equilibrium for a Competitive Economy, 27
Econometrica 5471 (1959). See generally Kartik B.Athreya, The Modern
Macroeconomic Approach and the Arrow-Debreu-McKenzie Model, in Big
Ideas in Macroeconomics: A Nontechnical View 1146 (2013); John
Geanakoplos, Arrow-Debreu Model of General Equilibrium, 1 The New
Palgrave: A Dictionary of Economics 116124 (Peter Newman, John
Eatwell & Murray Milgate eds., 1987).
12. See Fischer Black & Myron S.Scholes, The Pricing of Options and Corporate
Liabilities, 81J.Pol. Econ. 637654 (1973).
13. Robert J.Elliot, Hong Miao & Jin Yu, General Equilibrium Asset Pricing
Under Regime Switching, 2 Communications on Stochastic Analysis 445
THE INTERTEMPORAL CAPITAL ASSET PRICING MODEL 105
458, 445446 (2008); accord, e.g., Abraham Lioui & Patrice Poncet,
General Equilibrium Pricing of Nonredundant Forward Contracts,
23J.Futures Mkts. 817840 (2003); Julien Hugonnier, Erwan Morellec
& Suresh Sundaresan, Irreversible Investment in General Equilibrium
(June 2005); Jae W.Sim, Uncertainty, Irreversible Investment and General
Equilibrium (Aug. 2007) (available at http://web.stanford.edu/group/
SITE/archive/SITE_2007/segment_8/sim_UIRRGE.pdf).
14. See James Tobin, Liquidity Preference as Behavior Towards Risk, 67 Rev.
Econ. Stud. 6586 (1958). See generally John Hicks, Liquidity, 72 Econ.
J. 787802 (1962).
15. See David Cass & Joseph E.Stiglitz, The Structure of Investor Preferences
and Asset Returns, and Separability in Portfolio Allocation, 2 J. Econ.
Theory 122160 (1970); Robert C.Merton, An Analytic Derivation of
the Efficient Portfolio Frontier, 7 J. Fin. & Quant. Analysis 18511872
(1972); Stephen A.Ross, Mutual Fund Separation and Financial Theory
The Separating Distributions, 17J.Econ. Theory 254286 (1978).
16. Philip H. Dybvig & Stephen A. Ross, Portfolio Efficient Sets, 50
Econometrica 15261546, 1526 (1982). The term simplicial refers to a
simplex, which in algebraic topology is the generalization of a tetrahedral
region of space to n dimensions. See generally James R.Munkres, Elements
of Algebraic Topology 1.11.2, at 214 (1993) (Simplices and
Simplicial Complexes and Simplicial Maps); F. Buekenhoutt &
M.Parker, The Number of Nets of the Regular Convex Polytopes in Dimension
4, 186 Discrete Math. 6994 (1998) (describing a simplex as a
hypertetrahedron).
17. Dybvig & Ross, supra note 16, at 1526.
18. See id.
19. See, e.g., Martin Browning & Thomas F.Crossley, The Life-Cycle Model of
Consumption and Saving, 15 J. Econ. Persp. 322 (2001); cf. Hersh
M.Shefrin & Richard H.Thaler, The Behavioral Life-Cycle Hypothesis, 26
Econ. Inq. 609643 (1988).
20. See infra 7.5, at 148150; cf. infra 9.49.5, at 230234 (presenting
proposed solutions to the equity premium puzzle from the point of view of
prospect theory).
21. Merton, Intertemporal CAPM, supra note 1, at 876.
22. Id.
23. Id. at 875.
24. Id. at 877.
25. See generally John Y. Campbell & Robert J. Shiller, The Dividend Price
Ratio and Expectations of Future Dividends and Discount Factors, 1 Rev.
Fin. Stud. 195228 (1988); John Y.Campbell & Robert J.Shiller, Stock
Prices, Earnings, and Expected Dividends, 43J.Fin. 66176 (1988).
106 J.M. CHEN
26. See Ang, Hodrick, Xing & Zhang, The Cross-Section of Volatility and
Expected Returns, supra note 14 (Chapter 4), at 260; George Chacko &
Luis M.Viceira, Dynamic Consumption and Portfolio Choice with Stochastic
Volatility in Incomplete Markets, 18 Rev. Fin. Stud. 13691402, 1370
(2005).
27. Bo Young Chang, Peter Christoffersen & Kris Jacobs, Market Skewness
Risk and the Cross Section of Stock Returns, 107J.Fin. Econ. 4668, 64.
28. Id.
29. Michael J. Brennan & Eduardo S. Schwartz, Time-Invariant Portfolio
Insurance Strategies, 43J.Fin. 283299, 283 (1988). See generally Michael
J. Brennan & Ray Solanki, Optimal Portfolio Insurance, 16 J. Fin. &
Quant. Analysis 279300 (1981); Michael J. Brennan & Eduardo
S. Schwartz, Portfolio Insurance and Financial Market Equilibrium,
62J.Bus. 455472 (1989); Simon Benninga & Marshall Blume, On the
Optimality of Portfolio Insurance, 40J.Fin. 13411352 (1985).
30. See generally, e.g., Anup K. Basu, Brett Doran & Michael E. Drew,
Sequencing Risk: The Worst Returns in Their Worst Order, 4 JASSA: Finasia
J.Applied Fin. 713 (2013); Larry R.Frank, John B.Mitchell & David
M. Blanchett, Probability-of-Failure-Based Decisions Rules to Manage
Sequence Risk in Retirement, 24:11J.Fin. Planning 4480 (Nov. 2011);
Matthew B.Kenigsberg, Prasenjit Dey Mazumdar & Steven Feinschreiber,
Return Sequence and Volatility: Their Impact on Sustainable Withdrawal
Rates, 2:2J.Retirement 8198 (Fall 2014).
31. See generally, e.g., Robert Argento, Victoria L.Bryant & John Sabelhaus,
Early Withdrawals from Retirement Accounts During the Great Recession,
33 Contemp. Econ. Poly 116 (2015); Robert L.Clark & John Sabelhaus,
How Will the Stock Market Crash Affect the Choice of Pension Plans?, 62:3
Natl Tax J. 120 (Sept. 2009); Christopher R.Tamborini, Patrick Purcell
& Howard M. Iams, The Relationship Between Job Characteristics and
Retirement Savings in Defined Contribution Plans During the 20072009
Recession, 136 Monthly Labor Rev. 316 (May 2013); cf. Gordon B.Pye,
The Effect of Emergencies on Retirement Savings and Withdrawals,
23:11J.Fin. Planning 5762 (Nov. 2010).
32. See W.V.Harlow & Keith C.Brown, Improving the Outlook for a Successful
Retirement: A Case for Using Downside Hedging, 3:3J.Retirement 3550
(Winter 2016).
33. Under former Rule 434 of its regulations implementing the Securities Act
of 1933, the Securities and Exchange Commission defined structured secu-
rities as securities whose cash flow characteristics depend upon one or
more indices or that have embedded forwards or options or securities where
an investors investment return and the issuers payment obligations are
contingent on, or highly sensitive to, changes in the value of underlying
THE INTERTEMPORAL CAPITAL ASSET PRICING MODEL 107
48. John Y.Campbell & Tuomo Vuolteenaho, Bad Beta, Good Beta, 94 Am.
Econ. Rev. 12491275, 1249 (2004).
49. Id. at 12511252.
50. Mark Twain, Life on the Mississippi, in Mississippi Writings 217616,
489490 (Library of America ed. 1982) (1st ed. 1883) (We picked up
one excellent worda word worth travelling to New Orleans to get; a
nice, limber, expressive, handy wordlagniappe. They pronounce it
lanny-yapIt is the equivalent of the thirteenth roll in a bakers dozen.
It is something thrown in, gratis, for good measure.); accord http://
etymonline.com/index.php?term=lagniappe; see also Life on the
Mississippi, supra, at 71 (Chapter 2) (the English were trading beads and
blankets to [native Americans] for a consideration, and throwing in civili-
zation and whiskey, for lagniappe).
51. Campbell & Vuolteenaho, supra note 48, at 1252.
52. Id. at 1257.
53. See Ravi Bansal & Amir Yaron, Risks for the Long Run: A Potential
Resolution of Asset Pricing Puzzles, 59J.Fin. 14811509 (2004).
54. See John Cochrane, Discount Rates, 66J.Fin. 10471108 (2011).
55. Campbell & Vuolteenaho, supra note 48, at 1252.
56. Id. at 12521253.
57. See generally Nai-Fu Chen, Richard Roll & Stephen A. Ross, Economic
Forces and the Stock Market, 59J.Bus. 383403 (1986).
58. See Campbell & Vuolteenaho, supra note 48, at 1250.
59. Id.
60. Id. at 1271; cf. Robert J. Shiller, Do Stock Prices Move Too Much to Be
Justified by Subsequent Changes in Dividends?, 71 Am. Econ. Rev. 421436
(1981).
61. Campbell & Vuolteenaho, supra note 48, at 1261.
62. Id. at 1271.
63. Id.
64. Id.
65. See Jimmy Liew & Maria Vassalou, Can Book-to-Market, Size and
Momentum Be Risk Factors That Predict Economic Growth?, 57 J. Fin.
Econ. 221245 (2000).
66. See Maria Vassalou, News Related to Future GDP Growth as a Risk Factor
in Equity Returns, 68J.Fin. Econ. 4773 (2003); cf. Randolph B.Cohen,
Christopher Polk & Tuomo Vuolteenaho, The Value Spread, 58 J. Fin.
609641 (2003).
67. Campbell & Vuolteenaho, supra note 48, at 1258.
68. Id. at 1272.
69. Id.
THE INTERTEMPORAL CAPITAL ASSET PRICING MODEL 109
70. See John Y.Campbell, Stefano Giglio, Christopher Polk & Robert Turley,
An Intertemporal CAPM with Stochastic Volatility (June 2015) (available
at http://scholar.harvard.edu/campbell/files/cgpt_volatilityrisk
_20150619.pdf).
71. Id. at 29. On the vector-autoregressive time series methodology, see gen-
erally John Y. Campbell & Robert J. Shiller, Cointegration and Tests of
Present Value Models, 95J.Pol. Econ. 10621088 (1987).
72. Campbell, Giglio, Polk & Turley, supra note 70, at 30.
73. Id. (emphases added).
74. Id. (citing Ang, Hodrick, Xing & Zhang, The Cross-Section of Volatility and
Expected Returns, supra note 14 (Chapter 4)).
75. Campbell, Giglio, Polk & Turley, supra note 70, at 32.
76. Id.
77. Baker, Bradley & Wurgler, supra note 8 (Chapter 4), at 43.
78. See Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1), 7.6, at
122126.
79. Chen & Petkova, supra note 108 (Chapter 4), at 2746.
80. Campbell, Giglio, Polk & Turley, supra note 70, at 32 n.17.
81. Id.
82. See Ralitsa Petkova & Lu Zhang, Is Value Riskier Than Growth?, 78J.Fin.
Econ. 187202 (2005).
83. Harvey, Predictable Risk and Returns in Emerging Markets, supra note 64
(Chapter 4), at 787 (attributing variation among emerging markets to
market liquidity, political risk, and other [f]actors such as taxes, which
in the aggregate keep emerging markets from becoming fully integrated
with the global financial system); see also id. at 801 (concluding that local
information materially affects emerging markets, whereas developed mar-
kets tend to be driven by global information variables rather than local
information); cf. Bekaert & Harvey, Foreign Speculators and Emerging
Equity Markets, supra note 68 (Chapter 4).
84. See Geert Bekaert & Robert J. Hodrick, Characterizing Predictable
Components in Excess Returns on Equity and Foreign Exchange Markets,
47 J. Fin. 467509 (1992); Richard Roll, Industrial Structure and the
Comparative Behavior of International Stock Market Indexes, 47 J. Fin.
341 (1992); cf. Bekaert & Harvey, Emerging Equity Market Volatility,
supra note 68 (Chapter 4); Bekaert & Harvey, Time-Varying World-Market
Integration, supra note 68 (Chapter 4).
85. See Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1),
7.17.10, at 107151.
86. Campbell, Giglio, Polk & Turley, supra note 70, at 32.
CHAPTER 6
Risk Aversion
+z with probability p
z with probability 1p
If U(w) represents our utility function, then we can describe risk aver-
sion in mathematical terms by solving this equation:
U ( w ) = U w + z
U ( w ) = p U ( w + z ) + (1 p ) U ( w z )
The key to solving this equation lies in performing the Taylor series
expansion of the terms U(wz) on the right side. Recall from 3.2 the
formula for a Taylor series expansion for a function, f(x), that is infinitely
differentiable at value a:11
f (a) f ( a ) f ( a )
f ( x) f (a) + ( x a) + ( x a) ( x a)
2 3
+ +
1! 2! 3!
U(w) U ( w )
U ( w ) = p U ( w ) +
1!
(w + z w) +
2!
( w + z w ) + o z3
2
( )
U(w) U ( w )
+ (1 p ) U ( w ) +
1!
(w z w) +
2!
( w z w ) + o z3
2
( )
Simplifying somewhat:
U ( w )
U ( w ) = p U ( w ) + U ( w ) z +
2
z2 + o z3 ( )
U ( w )
+ (1 p ) U ( w ) U ( w ) z +
2
z2 + o z3 ( )
RISK AVERSION 113
1
U ( w ) p U ( w ) + U ( w ) z + U ( w ) z 2
2
1
+ (1 p ) U ( w ) U ( w ) z + U ( w ) z 2
2
In turn, multiplying out and adding all terms yields a final approxima-
tion of the utility function:
1
U ( w ) U ( w ) + ( 2 p 1) U ( w ) z + U ( w ) z 2
2
All that remains in this exercise is to solve for p in terms of the first and
second derivatives of the utility function:
1
2 p U ( w ) z U ( w ) z U ( w ) z 2
2
1 1 U ( )
w
p z
2 4 U(w)
1 1
p + z A( x)
2 4
114 J.M. CHEN
1 1
p + z R (w)
2 4
U ( w )
R ( w ) = w
U(w)
U w + z ( w, z ) = U ( w + z ) = U ( w )
U ( w ) = U ( w ) U ( w ) + O 2 ( )
1
U ( w + z ) = U ( w ) + z2 U ( w ) + o ( )
2
z
2
where, consistent with Taylor series notation, O() means terms of order
at most and o() means terms of smaller order than.15
These equations open a path to approximating the risk-averse insurance
premium in terms of the derivatives of the utility function and the vari-
ance of the unwanted gamble:
1
U ( w ) . U ( w ) = U ( w ) + z2 . U ( w )
2
1
. U ( w ) = z . U ( w )
2
2
1 U ( w )
= z2 .
2 U ( w )
1
= z2 A ( w )
2
U ( w ) 1
A(w) = = >0
U(w) w b
+
1 a
aw
1; a > 0; + b > 0; b = 1 if =
1
1 U(w) w b
T (w) = = = +
A(w) U ( w ) 1 a
Whence arises the name linear risk tolerance, since risk tolerance T(w) is
linear in form and risk aversion A(w) is hyperbolic.19
Solving A(w) or T(w) as differential equations defines the correspond-
ing utility function, U(w), as a member of the HARA class of utility func-
tions if and only if U(w) has the form:20
1 aw
U (w) = + b
1
=1 Linear (risk-neutral)
=2 Quadratic
Exponential: U(w)=eaw
<1; a=1 Power: U(w)=w/
<1; a=1; b=0 Isoelastic, with constant relative risk
aversion
0; a=1 Logarithmic
0; a=1; b=0 Constant relative risk aversion:
U(w)=ln w
The final line of Table 6.1 also bears further explanation. For condi-
tions 0, a=1, and b=0, the resulting utility function can be defined
only as a limit:
w 1
U ( w ) = lim
0
The application of LHpitals rule24 makes it clear that the utility func-
tion for constant relative risk aversion (CRRA) takes logarithmic form:25
f ( x) f ( x)
lim = lim
x c g ( x) x c g ( x )
w 1 w ln w
U ( w ) = lim = lim = ln w
0 0 1
Or simply: U(w)=ln w.
The scale-invariant nature of CRRA makes it the preference func-
tion of choice in much of the literature on growth and in Real Business
Cycle theory.26 For purposes of solving the equity premium puzzle that
will be the subject of Chapter 7, the scale-invariant property of CRRA
enables us to compare investors within the aggregate market without
needing to make complex and highly contestable judgments on the impact
of individual wealth on risk aversion.27 A logarithmic utility function guar-
antees optimization through maximizing the geometric mean of returns.28
118 J.M. CHEN
with finite second moments of returns, and often finite higher moments
as well.45 Reliance on stable distributions arose from a previous gen-
erations self-imposed methodological constraints, which dictated an
all-or-nothing choice between normally distributed or infinitely variable
returns.46 That brittle statistical assumption is a matter of choice, not a
reflection of immutable truth.
U ( w )
A(w) =
U(w)
1 U(w)
T (w) = =
A(w) U ( w )
E ( Rp ) R f
E ( Rc ) = R f + c
p
rp rf
Sharpe ratio = =
p
d
As ( w ) =
d
120 J.M. CHEN
The risk-free rate or the target return, being defined as a constant, disappears
upon differentiation. This definition of risk aversion is indistinguishable from
the first derivative of the ratio of financial returns signal-to-noise ratio, which
is the ratio of mean to standard deviation.
The ArrowPratt measures of risk aversion bear a close relationship to
a mathematically related family of single-sided risk measures examined in
6.8 through 6.10 of Postmodern Portfolio Theory.49 Unlike the Sharpe
ratio, which measures only the sign and magnitude of the average risk
premium relative to the risk incurred in achieving it, these single-sided
risk measures focus[] [instead] on the likelihood of not meeting some
target return.50 These measures share a primary goal of anticipating the
reaction of investors to losses and a secondary goal of retaining sensitivity
to prospective gains. In other words, the postmodern quest in portfolio
theory is heightened vigilance against downside risk, without complete
sacrifice of upside potential.
William Shadwick and Con Keating have developed what they call
the omega measure, consisting of the ratio of the first-order upper and
lower partial moments of the distribution of returns, each about the target
return, :51
1 F ( x ) dx
( ) =
F ( x ) dx
where is the target return and F(x) is the cumulative distribution func-
tion of returns about that target. Or, in terms of partial and complete
moments of the probability density function:52
( ) f ( x ) dx
( ) =
( ) f ( x ) dx
+ ( ) f ( x ) dx
( ) =
=
+1
( ) f ( x ) dx ( ) f ( x ) dx
n ( ) =
n
( ) f ( x ) dx
n =
n
n
It is very easy to define a variant of kappa as the ratio of the mean less
target return to any normalized complete moment of order n:
n =
n
n
d d
A ( w ) = =
d n
n n d n
d
Ts ( w ) =
d
n d n
T ( w ) =
d
wealth, suggested that the same person might be risk averse when poor
(as indicated by the purchase of insurance) and risk seeking upon gaining
more wealth (as suggested by a willingness to gamble).63 Harry Markowitz
protested that the FriedmanSavage utility function, taken to its logical
conclusion, implied that poor people would never buy lottery tickets and
middle-income people would never buy insurance against small losses.64
Empirical evidence against both of these propositions, especially regard-
ing lottery expenditures by the poor, is overwhelming.65 To move past
both the FriedmanSavage utility function and Markowitzs critique of
it, we need a credible account of an everyday paradox: putatively rational
individuals routinely play the lottery and buy insurance, with no sense of
contradiction.66
A subtler version of this puzzle involves the admittedly bourgeois
dilemma in which an affluent albeit not wealthy family holds securities in a
taxable brokerage account (including bonds paying lower rates of interest
than the rate charged by the mortgage lender), but would not think of
liquidating its portfolio in order to prepay its home loan. This issue arises
with some regularity in popular writing on personal finance.67 Prepaying
the mortgage guarantees some return in the form of a more quickly retired
RISK AVERSION 125
home loan. On the other hand, investing in the stock market offers returns
that often but not invariably exceed those on the family home.
Any practical resolution of this problem is confounded by the sheer
size and illiquidity of the typical households financial stake in residential
real estate. Owner-occupied housing, especially in the form of a single-
family home, represents a significant portion of many households overall
financial portfolio.68 Consumption demand for housing imposes a port-
folio constraint on the typical households optimal holdings of financial
assets, since the households demand for real estate is overdetermined
in the sense that the optimal level of housing for consumption purposes
may differ from the optimal share of housing in a households portfolio.69
Especially among younger and poorer households, house price risk crowds
out stock market investments.70 Relative to other households, households
with mortgage debt are 9.8 % less likely to own stocks and 37.3 % less
likely to own bonds.71 The effect on bonds is especially strong since debt
repayment and bonds serve as substitute assets72 and since repayment
of outstanding debt almost always yields a higher rate of return than
short-term Treasury bills or long-term government bonds.73
Maurice Allais identified a specific instance in which seemingly plau-
sible choices by the same rational person were logically impossible under
expected utility theory.74 Imagine that our hypothetically rational person
were given a choice of either of these payouts:
1 1 1
E= 2 + 4 + 8 +
2 4 8
E = 1 + 1 + 1 +
E=
Given infinite expected value, a player should pay any price to play this
game. The paradox arises from the fact that most humans would refuse to
pay even a modest amount to play.84
Technically, the St. Petersburg paradox may be characterized as a reverse
martingale:85 The gambler surrenders her or his entire stake up front as
the price of entry into the game, in exchange for a chance at a stream of
wealth whose expected value is infinite.86 The instinctive aversion to this
game arguably reflects an intuitive grasp of gamblers ruin, the certainty
with which a bettor with finite wealth playing against a foe with infinite
wealth will eventually lose everything, even with fair odds.87 But the value
of the game remains infinite, and human players routinely refuse to play
it. The St. Petersburg paradox therefore presents a particularly extreme
illustration of the failure of conventional risk-aversion models expected
outcome criterion to account for risk.88
Paul Samuelson pinpoints the technical flaw that prevents many utility
functions from being able to provide a plausible explanation for the St.
Petersburg paradox. To provide consistent rankings of risky prospects, a
utility function must be bounded from above and from below.89 In addi-
tion, in their original article outlining prospect theory, Daniel Kahneman
and Amos Tversky credited Harry Markowitz with a more sophisticated
128 J.M. CHEN
Those who are tempted to insist upon both an upper and lower bound for
utility must sacrifice the property of utility concavity and general risk aver-
sion everywhere. They gain the property that, for any defined probability
distribution of outcomes, a transitive ordering is well defined.92
There are many ways to put an upper and lower bound on utility and to
relax the assumption that preferences are invariably concave. Many cumu-
lative distribution functions exhibit well-behaved properties that make
them good candidates for modeling utility. They are positive, have posi-
tive first derivativesthe probability densitiesand if they are unimodal,
have negative second derivatives beyond the mode.93 As we will see in
8.4 and 8.5, the value function in prospect theory, one of the most impor-
tant expressions of behavioral economics, may be rendered in precisely this
sort of sigmoid form.
Notes
1. Cf. Michael Lewis, The Blind Side 167 (Michael Lewis afterword, 2009)
(1st ed. 2006) (describing future professional football player Michael
Ohers superlative score for protective instincts on an aptitude test).
2. See generally, e.g., Levy, CAPM in the 21st Century, supra note 41 (Chapter
1), at 2362.
3. See generally Paul J.H. Schoemaker, The Expected Utility Model: Its
Variants, Purpose, Evidence and Limitations, 20 J. Econ. Lit. 529563
(1982).
4. Compare John Neumann & Oskar Morgenstern, Theory of Games and
Economic Behavior (1953); and William J. Baumol, The Neumann-
Morgenstern Utility IndexAn Ordinalist View, 59 J. Pol. Econ. 6166
(1951) with, e.g., Peter C. Fishburn, Nonlinear Preference and Utility
RISK AVERSION 129
26. Rajnish Mehra, The Equity Premium: Why Is It a Puzzle?, 59:1 Fin. Analysts
J. 5469, 57 (Jan./Feb. 2003); Mehra & Prescott, The Equity Premium in
Retrospect, supra note 37 (Chapter 3), at 901. On real business cycle theory,
see Thomas F.Cooley, Frontiers of Business Cycle Research (1995); David
Romer, Real-Business-Cycle Theory, in Advanced Macroeconomics 189237
(4th ed. 2011); Robert J. Hodrick & Edward C. Prescott, Postwar
U.S. Business Cycles: An Empirical Investigation, 29 J. Money, Credit &
Banking 116 (1997); Finn E. Kydland & Edward C. Prescott, Time to
Build and Aggregate Fluctuations, 50 Econometrica 13451370 (1982);
George W.Stadler, Real Business Cycles, 32J.Econ. Lit. 17501783 (1994);
Lawrence H.Summers, Some Skeptical Observations on Real Business Cycle
Theory, 10:4 Fed. Reserve Bank Minneapolis Q.Rev. 2327 (Fall 1986).
27. For different approaches to capital asset pricing given the presence of het-
erogeneous investor beliefs, see Anat R. Admati, A Noisy Rational
Expectation for Multi-Asset Securities Markets, 53 Econometrica 629658
(1985); Suleyman Basak, Asset Pricing with Heterogeneous Beliefs,
29 J. Banking & Fin. 28492881 (2005); Peter DeMarzo & Costis
Skiadas, Aggregation, Determinacy, and Informational Efficiency for a
Class of Economics with Asymmetric Information, 80J.Econ. Theory 123
152 (1998); Jerome Detemple & Shashidhar Murthy, Intertemporal Asset
Pricing with Heterogeneous Beliefs, 62J.Econ. Theory 294320 (1994);
Haim Levy, Moshe Levy & Golan Benita, Capital Asset Pricing with
Heterogeneous Beliefs, 79 J. Bus. 13171353 (2006); John Lintner, The
Aggregation of Investors Diverse Judgments and Preferences in Purely
Competitive Security Markets, 4J.Fin. & Quant. Analysis 347400 (1969);
Joseph T.Williams, Capital Asset Prices with Heterogeneous Beliefs, 5J.Fin.
Econ. 219239 (1977).
28. See Henry Allen Latan, Criteria for Choice Among Risky Ventures,
67J.Pol. Econ. 144155 (1959); Harry M.Markowitz, Investment for the
Long Run: New Evidence for an Old Rule, 31J.Fin. 12731286 (1976).
29. Levy, CAPM in the 21st Century, supra note 41 (Chapter 1), at 172; see
sources cited supra notes 1518 (Chapter 5) (describing the separation
theorem).
30. See generally Paul Lvy, Calcul des Probabilits (1925); Benoit Mandelbrot,
The Pareto-Lvy Law and the Distribution of Income, 1 Intl Econ. Rev.
79106 (1960); Benoit Mandelbrot, Stable Paretian Random Functions and
the Multiplicative Variation of Income, 29 Econometrica 517543 (1961);
Paul A.Samuelson, Efficient Portfolio Selection for Pareto-Lvy Investments,
2J.Fin. & Quant. Analysis 107122 (1967); Chen, Postmodern Portfolio
Theory, supra note 1 (Chapter 1), 14.2, at 262263.
31. James A.Xiong & Thomas M.Idzorek, The Impact of Skewness and Fat
Tails on the Asset Allocation Decision, 67:2 Fin. Analysts J. 2335, 24
(March/April 2011).
RISK AVERSION 131
51. See William F.Shadwick & Con Keating, A Universal Performance Measure,
6:3J.Performance Measurement 5984 (Spring 2002).
52. See Kaplan & Knowles, supra note 50, at 15.
53. See id.
54. See id. at 3.
55. See Hossein Kazemi, Thomas Schneeweis & Raj Gupta, Omega as a
Performance Measure (June 15, 2003) (available at http://faculty.fuqua.
duke.edu/~charvey/Teaching/BA453_2006/Schneeweis_Omega_as_a.
pdf) (developing a closely related measure called Sharpe-Omega).
56. See Kaplan & Knowles, supra note 50, at 3 n.1
57. See id. at 15.
58. See, e.g., Stephen A.Ross, Some Stronger Measures of Risk Aversion in the
Small and in the Large with Applications, 49 Econometrica 621639
(1981); cf. Denis Conniffe, The Flexible Three Parameter Utility Function,
8 Annals Econ. & Fin. 5763, 58 (2007) (proposing a flexible three
parameterutility function capable of encompass[ing] other systems of
utility functions including the hyperbolic absolute risk aversion (HARA)
family and incorporat[ing] properties, such as subsistence and satura-
tion, that elude other utility functions).
59. See generally Lola L.Lopes, Psychology and Economics: Perspectives on Risk,
Cooperation, and the Marketplace, 45 Ann. Rev. Psych. 197227, 199203
(1994).
60. See, e.g., Robert Libby & Peter C. Fishburn, Behavioral Models of Risk
Taking in Business, 15 J. Accounting Research 272292 (1977); Ralph
O.Swalm, Utility TheoryInsights into Risk Taking, 44 Harv. Bus. Rev.
123136 (1966).
61. Compare, e.g., Pratt, supra note 8, at 122 (characterizing utility functions
with decreasing absolute risk aversion as logical candidates for describ-
ing actual human behavior) with Joseph G. Eisenhauer, Risk Aversion,
Wealth, and the DARA Hypothesis: A New Test, 3 Intl Advances Econ.
Research 4653 (1997) (presenting evidence that absolute risk aversion
affirmatively increases with wealth).
62. Charles Wolf & Larry Pohlman, The Recovery of Risk Preferences from
Actual Choices, 51 Econometrica 843850, 847 (1983); accord Saha,
supra note 21, at 905.
63. See Milton Friedman & L.J.Savage, Utility Analysis of Choices Involving
Risk, 56J.Pol. Econ. 279304 (1948).
64. Harry Markowitz, The Utility of Wealth, 60J.Pol. Econ. 151158 (1952);
accord Shefrin & Statman, Behavioral Portfolio Theory, supra note 24
(Chapter 2), at 128.
65. See generally infra 9.1, at 217218.
66. See Elie Applebaum & Eliakim Katz, Market Constraints as a Rationale for
the Friedman-Savage Utility Function, 89J.Pol. Econ. 819825 (1981);
RISK AVERSION 133
Philip R.P.Coelho & James E.McClure, Social Context and the Utility of
Wealth: Addressing the Markowitz Challenge, 37J.Econ. Behav. & Org.
305314 (1998); Nils H.Hakansson, Friedman-Savage Utility Functions
Consistent with Risk Aversion, 84 Q.J.Econ. 472487 (1970); cf. Roger
Hartley & Lisa Farrell, Can Expected Utility Theory Explain Gambling, 92
Am. Econ. Rev. 613624 (2002). For legal scholarship exploring the fun-
damental economic challenge that lotteries pose to assumptions such as
wealth maximization and risk aversion, see Lloyd R.Cohen, The Lure of the
Lottery, 36 Wake Forest L.Rev. 705745 (2001); Edward J.McCaffery,
Why People Play Lotteries and Why It Matters, 1994 Wis. L.Rev. 71122.
67. See Matthew Amster-Burton, Paying Down Your Mortgage vs. Investing More
(Nov. 22, 2011) (available at http://blog.mint.com/investing/paying-
down-your-mortgage-vs-investing-more-112011); Michael Kitces, Why Is It
Risky to Buy Stocks on Margin But Prudent to Buy Them On Mortgage?
(Oct. 24, 2011) (available at https://www.kitces.com/blog/Why-Is-It-
Risky-To-Buy-Stocks-On-Margin-B ut-Prudent-To-Buy-Them-On-
Mortgage); Michael Kitces, Why Keeping a Mortgage and a Portfolio May Not
Be Worth the Risk (May 2, 2012) (available at https://www.kitces.com/
blog/why-keeping-a-mortgage-and-a-portfolio-may-not-be-worth-
the-risk).
68. See William Nelson Goetzmann, The Single Family Home in the Investment
Portfolio, 6 J. Real Estate Fin. & Econ. 201222 (1993); cf. John
Y.Campbell, Household Finance, 61J.Fin. 15531604, 15641565 (2006)
(describing the share of asset classesranging from safe assets to vehicles,
real estate, private business, and public equityamong households in the
USA by percentile in the distribution of total assets); Alessandro Bucciol &
Raffaele Mianiaci, Household Portfolio Risk, 19 Rev. Fin. 739783 (2015)
(updating Campbells survey of the distribution of asset classes in household
portfolios according to their percentile rank within the overall population);
Luigi Guiso & Paolo Sodini, Household Finance: An Emerging Field, 2
Handbook of the Economics of Finance 13971532, 14061417 (George
M.Constantinides, Milton Harris & Ren M.Stulz eds., 2013) (same).
69. Marjorie Flavin & Takashi Yamashita, Owner-Occupied Housing and the
Composition of the Household Portfolio, 92 Am. Econ. Rev. 345362, 345
(2002). See generally Roger G.Ibbotson & Laurence B.Siegel, Real Estate
Returns: A Comparison with Other Investments, 12 Real Estate Econ. 219
242 (1989).
70. See Joo F.Cocco, Portfolio Choice in the Presence of Housing, 19 Rev. Fin.
Stud. 535567 (2005).
71. See Thomas A. Becker & Reza Shabani, Outstanding Debt and the
Household Portfolio, 23 Rev. Fin. Stud. 29002934, 2918, 2920 (2010).
72. Id. at 2908; see also Zvi Bodie, Robert C.Merton & William F.Samuelson,
Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model,
134 J.M. CHEN
16J.Econ. Dynamics & Control 427449 (1992) (reasoning that the lack
of correlation between income from labor and equity returns leads to low
levels of bond ownership); cf. Stephen J.Davis, Felix Kubler & Paul Willen,
Borrowing Costs and the Demand for Equity over the Life Cycle, 88 Rev.
Econ. & Stat. 348362, 356357 (2006) (observing that bonds and
income from labor are substitutes in the sense that neither is correlated
with investment income); Rui Yao & Harold H. Zhang, Optimal
Consumption and Portfolio Choice with Risky Housing and Borrowing
Constraints, 18 Rev. Fin. Stud. 197239, 212 (2005) (same).
73. Becker & Shabani, supra note 71, at 2931.
74. See M.Allais, Le Comportement de lHomme Rationnel Devant le Risque:
Critique des Postulats et Axiomes de lcole Amricaine, 21 Econometrica
503546, 525528 (1953). In accord with Levy, CAPM in the 21st
Century, supra note 41 (Chapter 1), at 3940, I have converted Allaiss
choice of currency from the (old) French franc to the modern US dollar
and reduced the sums in his paradox by two orders of decimal magnitude.
Inasmuch as the French franc traded at levels between 119.1 and 350 and
eventually 493.7 francs to the dollar between the institution of the Bretton
Woods foreign exchange system and the 1960 introduction of the new
franc, this 100:1 reduction is not entirely out of line. It also appears that
the old franc was worth roughly two-hundredths of a euro in 2007 terms.
See https://en.wikipedia.org/wiki/French_franc
75. See, e.g., Daniel Ellsberg, Risk, Ambiguity, and the Savage Axioms, 75
Q.J.Econ. 643669 (1961); Howard Raiffa, Risk, Ambiguity, and the Savage
Axioms: Comment, 75 Q.J. Econ. 690694 (1961); Paul Slovic & Amos
Tversky, Who Accepts Savages Axioms?, 19 Behav. Sci. 368374 (1974).
76. See, e.g., Expected Utility Hypotheses and the Allais Paradox: Contemporary
Discussions of Decisions Under Uncertainty with Allais Rejoinder
(Maurice Allais & Ole Hagen eds., 2013); David M.Kreps, Notes on the
Theory of Choice 192 (1988); Maurice Allais, An Outline of My Main
Contributions to Economic Science, 87 Am. Econ. Rev. 312 (1997); Adam
Oliver, A Quantitative and Qualitative Test of the Allais Paradox Using
Health Outcomes, 24J.Econ. Psych. 3548 (2003).
77. Levy, CAPM in the 21st Century, supra note 41 (Chapter 1), at 306.
78. Id.
79. Matthew Rabin, Risk Aversion and Expected-Utility Theory: A Calibration
Theorem, 68 Econometrica 12811292, 1282 (2000).
80. Id. (emphasis in original).
81. Id.; accord Olof Johansson-Stenman, Risk Aversion and Expected Utility of
Consumption over Time, 68 Games & Econ. Behav. 208219 (2010); see
also Mark J. Machina, Expected Utility Theory Without the Independence
Axiom, 50 Econometrica 277323 (1982).
RISK AVERSION 135
The sheer length of these studies ameliorates concerns that the equity
risk premium is subject to shifts in probability distribution aptly described
as structural breaks, or systematic disruptions in the relationship
between risk and return, including the magnitude of the equity risk pre-
mium.15 The presence of structural breaks in the risk-return relationship
is arguably the financial manifestation of punctuated equilibria in evolu-
tionary biology, the idea that speciation, far from being gradual, uniform,
and constant, occurs in rare and geologically rapid spurts.16 Other social
sciences17 (including computational linguistics and the anthropological
analysis of mythology)18 have consciously incorporated the idea of punc-
tuated equilibria. It remains an open question whether the importation
of this insight from evolutionary biology will significantly enhance finan-
cial understanding of structural breaks in the equity premium, speculative
bubbles, and other similar phenomena.
In fairness, advocates of fixed-income investing have marshaled some
evidence contradicting the magnitude and durability of an equity risk pre-
mium. Robert Arnott argues that historic expectations of 8% real returns
on stock and a 5% risk premium over bonds are not supported by evidence
of long-run dividend growth and inflation expectations and concluding
instead that the long-term, forward-looking risk premium may be near
zero or even negative.19 In response to the provocative question Bonds:
why bother? Arnott argues that bonds have beaten stocks for the past
40 yearsor at least have delivered real returns in excess of those on
stocks during certain 10-, 20-, and 40-year periods.20
Despite this contrary line of argument, Rajnish Mehras 2003 survey
of the equity risk premium around the world retains its power to surprise
(Table 7.1).21 As Mehra took pains to point out, these five markets (USA,
Table 7.1 The equity risk premium in major markets during part or all of the
twentieth century
Country Period Mean real return (in percentage points) Equity risk premium
(in percentage points)
Market index Relatively riskless
security
UK, Japan, Germany, France) comprised more than 85% of the worlds
capitalized equity value.22 The equity risk premium prevails around the
world. In absolute terms, it is substantial.
Or stated somewhat differently: The terminal (real) value, as of 2000, of
$1 invested in stocks in 1926 would be $266.47, while the same $1 invested
in Treasury bills that year would be worth $1.71 in real terms by 2000,
assuming reinvestment of all dividends and interest and zero taxes.23 Those
numbers imply an average equity risk premium of 7.1% from 1976 to 2000
(7.8% annual real return on stocks, versus 0.7% on T-bills).24 Comparable
back-of-the-envelope calculations report ratios of 66:1 for all-stock ver-
sus all-bond portfolios from 1925 to 199725 and up to 7:1 for retirement
accounts built over 40-year time frames between 1876 and 1900.26
All of this has occurred against the backdrop of dire predictions of lack
of preparedness for retirement.46 Among the ways in which the federal
government hopes to exploit behavioral science insightsdefined as
research findings from behavioral economics and psychology about
how people make decisionsa desire to help Americans accumulate
additional savings ranks very high.47 Boston Colleges Center for
Retirement Research estimates that financial retirement insecurity plagues
more than half of the American population;48 other sources sound an
even louder alarm.49 The Congressional Research Service estimates that
the average household in which the head was aged 6267in 2010 had
$341,417 in total retirement assets (defined as individual retirement
accounts and other defined contribution vehicles).50 The median house-
hold in this category had $150,000in total retirement assets.51 Even at
an arguably unsustainable withdrawal rate of 46%, the higher $341,417
figure generates between $13,657 and $20,485in annual gross income.
Other sources of retirement income come at a steep price. Early claiming
of Social Security benefits locks in a lower lifetime annuity; it increased
during the recession of 20072009.52 Reverse mortgages can help retirees
unlock their home equity, but these expensive, highly complex products
are viewed as a retirement planning tool of last resort.53
It may be mere coincidence that the 2013 rate of stock market partici-
pation, direct and indirect, reported by the Federal Reserve (48.8 %) is
almost exactly the mirror image of that years at-risk percentage reported
by Boston Colleges National Retirement Risk Index (52 %). Although
other factorsranging from outright poverty to a behavioral tendency
to consign retirement savings behind other financial priorities54plainly
affect preparedness for retirement,55 aversion to stock market participation
contributes to American social insecurity. Even accounting for inertia,56
the impact of differences in financial literacy on stock market participa-
tion,57 and the possibility of simple misunderstanding that leaves many
people confused about the relative safety of different investments over
long horizons,58 we are left to explain the presence of a nontrivial num-
ber of individuals [who] are highly averse to investing more than a small
percentage of their financial assets in stocks.59 The question is no lon-
ger, strictly speaking, why many wealthy households hold no stock at
all,60 but rather why so few hold stocksperiod.61
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 143
E0 b tU ( ct ) , 0 < b < 1
t =0
where:
E0() = expectation operator, conditional on information available at t = 0
= a subjective time discount factor describing the households
impatience as its unwillingness to defer consumption
U() = a concave, monotonically increasing, continuously differentia-
ble utility function
ct = per capital consumption
We further restrict U() to the class of CRRA utility functions:
c1-a
U ( c, a ) = , 0 <a <
1-a
c1-a
E0 b t , 0 < a < , 0 < b < 1
t =0 1 - a
Mehra and Prescott assume that this stylized economy has a single
equity share, whose share price is pt and which represents a claim on pro-
ductivity from the stochastic process {yt}. The application of a fundamental
pricing relationship70 allows the expected gross return on equity to be
expressed in the familiar form of the conventional CAPM:
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 145
-U ( ct +1 ) , Re, t +1
Et ( Re, t +1 ) = R f , t +1 + cov t
Et U ( ct +1 )
Expected asset returns equal the risk-free rate plus a premium for bearing
risk, which depends on the covariance of the asset returns with the marginal
utility of consumption. Assets that covary positively with consumption
that is, assets that pay off in states when consumption is high and marginal
utility is lowcommand a high premium because these assets destabilize
consumption.71
The question is whether covariance between the assets and the marginal
utility of consumption is large enough to justify the observed equity
premium.72
By adopting a model proposed by Andrew Abel,73 Mehra and Prescotts
2003 restatement of the equity premium puzzle subjected their original
1985 presentation of the puzzle74 to certain simplifying assumptions:
The growth rate of consumption (xt) and the growth rate of divi-
dends (zt) are both identically and independently distributed (i.i.d.).
Those growth rates (consumption, dividends) are jointly lognor-
mally distributed.
As a consequence of those assumptions, gross return on equity is
also i.i.d.
As a further consequence, gross return on equity (Re, t) and the growth
rate of consumption are also jointly lognormally distributed.75
E t ( z t +1 )
Et ( Re, t +1 ) =
b Et ( zt +1 xt-+a1 )
1
Re,t +1 =
b Et ( xt-+a1 )
ln E ( Re ) - ln R f = as x2
{ ( )
U ct , Et (U t +1 ) = (1 - b ) ct1-a /q + b Et U t1+-1a }
1/q q / (1-a )
( ct + s - l ct + s -1 )
1 -a
U ( c ) = Et b s
,l >0
s =0 1-a
(c - x )
1-a
u (c) =
1-a
(c )
1-a
/ Ctg-1
U ( c ) = Et b
t
s
,a > 0
s =0 1-a
The further insight that investors care not only about overall volatil-
ity, but also about the temporal distribution of that volatility139 directly
connects the habit formation explanation of the equity risk premium to
John Campbells observation that growth stocks provide a hedge not
only against declines in future real stock returns, but also against the
variance of [those] return[s].140 Combining habit formation with inter-
temporal models of consumption and risk aversion thus eases some of
the tension in the equity premium puzzle.141 Defining the market port-
folio according to societal or peer group per capita consumption har-
monizes the catching-up-with-the-Joneses models with conventional
mean-variance optimization and the CAPM.142 Even more simply, habit
formation provides a straightforward reason for a phenomenon that more
elaborate theories of risk aversion struggle to explain: Why do rich people
save as much as they do?143 Because its good to be rich, and even better
to stay that way.144
the ratio of wealth to income is lower the faster the rate of growth of the
economy, and is at its largest when the rate of growth is zero.172 And even
individuals who have succeeded in saving for retirement remain vulnerable
to bad timing in the guise of sequence-of-returns risk.173
The answer to the equity premium puzzle thus lies in idiosyncratic
income shocks from job loss or other major personal disasters that
consumers cannot hedge[] against or insure away:174
This model unites risk aversion with finance, labor economics, and
macroeconomics.176 More broadly, the life cycle hypothesis has informed
the grandest issues in economics, such as retirement policy, the impact
of stock market returns on saving and spending, and thrift [as] the well-
spring of growth or simply its consequence.177 This branch of economics
explains why the equity risk premium behaves in counter-cyclical fash-
ion: the risk premium is highest in a recession since equities are a poor
hedge against the potential loss of employment.178
Moreover, the countercyclical nature of the equity risk premium is con-
sistent with one account of the value premium within three- and four-factor
models of stock market returns.179 In bad times, value firms are burdened
with more unproductive capital, finding it more difficult to reduce their
capital stocks than growth firms do.180 Worse, these previously incurred
commitments of capital are harder to reverse, since the general economic
principle of costly reversibility implies that firms face higher costs in cut-
ting than in expanding capital.181 Coupled with growth firms relative
ease in expanding capital investments during good times,182 value firms
disproportionately greater challenge of reallocating unproductive capital
during recessions accounts for value firms greater cyclicality riskand the
higher returns commanded by equity stakes in these firms.183
Habit formation, the life cycle hypothesis, and kindred branches of eco-
nomics thus provide the most persuasive answer available to the equity pre-
mium puzzle. In line with Rolls second critique of the CAPM, this literature
shows that a tradable investment portfolio represents only part of larger
portfolio of resources, including labor as a noncapitalizable, uninsurable
156 J.M. CHEN
one master of the academic universe. The president does bestride the cam-
pus like a colossus,232 or even like Sauron, J.R.R.Tolkeins ominous Lord
of the Rings:
One Ring to bring them all and in the darkness bind them
In the Land of [Knowledge] where the Shadows lie.233
All of this would be cause for bemusement, but for the very real human
impact of reductions in university endowment payouts. A negative endow-
ment shock equivalent to a 10 % reduction in the universitys budget
translates to a reduction of 5% in tenure-system faculty and in support
employees such as secretaries.234 Tellingly, the original National Bureau of
Economic Research working paper revealing these academic foibles bore
the title, Why I Lost My Secretary: The Effect of Endowment Shocks
on University Operations.235 In contrast to large effects on other
employees, however, university administrators are largely unaffected
when the university endowment, like a blindsided quarterback on the var-
sity football team, is thrown for a loss.236 If anything, their ranks actually
increase by 1.4 percent following [a] negative shock.237
Habit formation, so it seems, does affect universities. Just not the same
way it affects real human beings. Vivat academia, indeed. Alma mater
floreat / Quae nos educavit.238
Notes
1. See Henk Grootveld & Winfried Hallerbach, Variance vs. Downside Risk:
Is There Really That Much Difference?, 114 Eur. J. Oper. Research
304319, 315 (1999).
2. See Guido Baltussen, Thierry Post & Pim Van Vliet, Downside Risk
Aversion, Fixed Income Exposure, and the Value Premium Puzzle,
36J.Banking & Fin. 33823398 (2012).
3. Id. at 3383.
4. Rajnish Mehra & Edward C.Prescott, The Equity Premium: A Puzzle,
15J.Monetary Econ. 145161, 146 (1985). On pure exchange econo-
mies, see generally Robert E. Lucas, Jr., Asset Prices in an Exchange
Economy, 46 Econometrica 14291445 (1978).
5. Mehra & Prescott, The Equity Premium, supra note 4, at 146.
6. Mehra, supra note 26 (Chapter 6), at 54; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 889.
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 161
7. Mehra, supra note 26 (Chapter 6), at 60; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 909.
8. Mehra, supra note 26 (Chapter 6), at 60; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 909.
9. See Narayana R. Kocherlakota, The Equity Premium: Its Still a Puzzle,
34J.Econ. Lit. 4271 (1996).
10. See Jeremy J.Siegel, Stocks for the Long Run: The Definitive Guide to
Financial Market Returns and Long-Term Investment Strategies 6 (5th
ed. 2013).
11. See Roger G. Ibbotson & Peng Chen, Long-Run Stock Returns:
Participating in the Real Economy, 59:1 Fin. Analysts J. 8898 (Jan./
Feb. 2003).
12. See John R.Graham & Campbell R.Harvey, The Equity Risk Premium in
2014 (April 7, 2014) (available at http://ssrn.com/abstract=2422008).
13. Elroy Dimson, Paul Marsh & Mike Staunton, The Worldwide Equity
Premium: A Smaller Puzzle, in Handbook of the Equity Risk Premium
467529, 468 (Rajnish Mehra ed., 2008).
14. Philippe Jorion & William N. Goetzmann, Global Stock Markets in the
Twentieth Century, 54 J. Fin. 953980, 954955, 978 (1999); accord
Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 217.
15. See ubo Pstor & Robert F. Stambaugh, The Equity Premium and
Structural Breaks, 56J.Fin. 12071239 (2001).
16. See Niles Eldredge & Stephen Jay Gould, Punctuated Equilibria: An
Alternative to Phyletic Gradualism, in Models in Paleobiology 82115
(Thomas J.M. Schopf ed., 1972), reprinted in Niles Eldredge, Time
Frames 193223 (1985); Stephen Jay Gould & Niles Eldredge,
Punctuated Equilibria: The Tempo and Mode of Evolution Reconsidered, 3
Paleobiology 115151, 145 (1975). See generally Stephen Jay Gould,
The Structure of Evolutionary Theory (2002).
17. See, e.g., Claudio Cioffi-Revilla, The Political Uncertainty of Interstate
Rivalries: A Punctuated Equilibrium Model, in The Dynamics of
Enduring Rivalries 6497 (Paul Diehl ed., 1998); Daniel A.Levinthal,
The Slow Pace of Rapid Technological Change: Gradualism and
Punctuation in Technological Change, 7 Indus. & Corp. Change 217247
(1998); Andrs Tilcsik & Christopher Marquis, Punctuated Generosity:
How Mega-Events and Natural Disasters Affect Corporate Philanthropy in
U.S.Communities, 58 Admin. Sci. Q. 111148 (2013).
18. See Quentin D. Atkinson, Andrew Meade, Chris Venditti, Simon
J. Greenhill & Mark Pagel, Languages Evolve in Punctuational Bursts,
319 Science 588 (2008); Dan Dediu & Stephen C.Levinson, Abstract
Profiles of Structural Stability Point to Universal T
endencies, Family-
Specific Factors, and Ancient Connections Between Languages, 7 PLoS
162 J.M. CHEN
54. See Shefrin & Thaler, Behavioral Life-Cycle Hypothesis, supra note 19
(Chapter 5); Richard H.Thaler & Hersh M.Shefrin, An Economic Theory
of Self-Control, 89J.Pol. Econ. 392406 (1981).
55. See Richard H.Thaler & Shlomo Benartzi, Save More Tomorrow: Using
Behavioral Economics to Increase Employee Saving, 112 J. Pol. Econ.
S164S187 (2004); Steven A. Sass & Jorge D. Ramos-Mercado, Are
Americans of All Ages and Income Levels Shortsighted About Their
Finances? (Center for Retirement Research Issues in Brief, No. 159. May
2015) (available at http://crr.bc.edu/wp-content/uploads/2015/05/
IB_15-9.pdf).
56. See John Beshears, James J.Choi, David Laibson & Brigitte C.Madrian,
The Importance of Default Options for Retirement, in Lessons from
Pension Reform in the Americas 5987 (Stephen J.Kay & Tapen Sinha
eds., 2007) (finding that the default option dictates investment choices
for 80 % of participants in 401(k) plans); Olivia S. Mitchell, Gary
R. Mottola, Stephen P. Utkus & Takeshi Yamaguchi, The Inattentive
Participant: Portfolio Trading Behavior in 401(k) Plans (June 2006)
(University of Michigan Retirement Research Center, Working Paper
2006115) (available at http://www.mrrc.isr.umich.edu/publications/
papers/pdf/wp115.pdf) (finding that 80% of 401(k) participants con-
ducted no trades within two years and 11% conducted only one trade).
57. See, e.g., Douglas B.Bernheim, Patrick J.Bayer & John Karl Scholz, The
Effects of Financial Education in the Workplace: Evidence from a Survey of
Employers, 47 Econ. Inquiry 605624 (2009); Maarten van Rooij,
Annamaria Lusardi & Rob Alessie, Financial Literacy and Stock Market
Participation, 101 J. Fin. Econ. 449472 (2011); Maarten van Rooij,
Annamaria Lusardi & Rob Alessie, Financial Literacy, Retirement
Planning and Household Wealth, 122 Econ. J. 449478 (2012). See gen-
erally John Y. Campbell, Restoring Rational Choice: The Challenge of
Consumer Financial Regulation (Jan. 2016) (available at http://scholar.
harvard.edu/files/campbell/files/elylecturejan182016.pdf) (arguing
that the complexity of financial products compounds pervasive financial
ignorance and disables many households from effective management of
their financial affairs).
58. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at 77
(quoting Thomas MaCurdy and John Shoven).
59. Sundn & Surette, supra note 149 (Chapter 1), at 210.
60. N.Gregory Mankiw & Stephen P.Zeldes, The Consumption of Stockholders
and Nonstockholders, 29J.Fin. Econ. 97112, 110 (1991).
61. Haliassos & Bertaut, supra note 28, at 1110 (reporting that the propor-
tion of nonstockholding households in the USA is remarkably stable
through time).
166 J.M. CHEN
62. Simon Grant & John Quiggin, The Risk Premium for Equity: Implications
for Resource Allocation, Welfare and Policy, 45 Austral. Econ. Papers
253265, 259 (2006).
63. Id.
64. See id. at 262.
65. Id.; accord David Miles, Testing for Short Termism in the UK Stock Market,
103 Econ. J. 13791396 (1993).
66. Few if any insurance companies are willing to underwrite policies promis-
ing steady income, lest such policies attract shirkers and malingerers. See,
e.g., N.Gregory Mankiw, The Equity Premium and the Concentration of
Aggregate Shocks, 17J.Fin. Econ. 211219 (1986).
67. See Grant & Quiggin, supra note 62, at 26465; Simon Grant & John
Quiggin, Public Investment and the Risk Premium for Equity, 70
Economica 118 (2003).
68. See Mehra, supra note 26 (Chapter 6), at 5758 (equations (1) through
(16)); id. at 6768 (Appendix A); Mehra & Prescott, The Equity Premium
in Retrospect, supra note 37 (Chapter 3), at 900909.
69. See supra 6.4, at 117.
70. See John B.Donaldson & Rajnish Mehra, Comparative Dynamics of an
Equilibrium Intertemporal Asset Pricing Model, 51 Rev. Econ. Stud.
491508 (1984); Edward C. Prescott & Rajnish Mehra, Recursive
Competitive Equilibrium: The Case of Homogeneous Households, 48
Econometrica 13651379 (1980)
71. Mehra, supra note 26 (Chapter 6), at 57; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 902.
72. Mehra, supra note 26 (Chapter 6), at 58; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 902.
73. See Andrew B.Abel, Stock Prices Under Time Varying Dividend Risk: An
Exact Solution in an Infinite-Horizon General Equilibrium Model,
22J.Monetary Econ. 375394 (1988).
74. See Mehra & Prescott, The Equity Premium Puzzle in Retrospect, supra
note 37 (Chapter 3), at 928933; Mehra & Prescott, The Equity
Premium: A Puzzle, supra note 4, at 150156.
75. See Mehra, supra note 26 (Chapter 6), at 58; Mehra & Prescott, The
Equity Premium in Retrospect, supra note 37 (Chapter 3), at 903. For
more background on the lognormal distribution, see generally J.Aitchison
& J.A.C.Brown, The Lognormal Distribution, with Special Reference to
Its Use in Econometrics (1957); Hal Forsey, The Mathematicians View:
Modelling Uncertainty with the Three Parameter Lognormal, in Managing
Downside Risk in Financial Markets 5158 (Frank A.Sortino & Stephen
E.Satchell eds., 2001); K.Krishnamoorthy & Thomas Mathew, Inferences
on the Means of Lognormal Distributions Using Generalized p-Values and
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 167
90. Campbell, Asset Pricing at the Millennium, supra note 7 (Chapter 1), at
1544. Compare Robert E. Hall, Intertemporal Substitution in
Consumption, 96J.Pol. Econ. 221273 (1988) and John Y.Campbell &
N. Gregory Mankiw, Consumption, Income, and Interest Rates:
Reinterpreting the Time-Series Evidence, in National Bureau of Economic
Research Macroeconomics Annual 185215, 19899 (Olivier Jean
Blanchard & Stanley Fischer eds., 1989) (reporting low elasticity) with
Orazio P.Attansio & Guglielmo Weber, Consumption Growth, the Interest
Rate, and Aggregation, 60 Rev. Econ. Stud. 631649 (1993) and Paul
Beaudry & Eric van Wincoop, The Intertemporal Elasticity of Substitution:
An Exploration Using a U.S.Panel of State Data, 63 Economica 495512
(1996) (reporting greater elasticity).
91. Campbell, Asset Pricing at the Millennium, supra note 7 (Chapter 1), at
1544.
92. Id.
93. Id.
94. See, e.g., Steffen Andersen, Glenn W.Harrison, Morten Lau & Elisabet
E. Rutstrm, Discounting Behavior: A Reconsideration, 71 Eur. Econ.
Rev. 1533 (2014); Shane Frederick, George Loewenstein & Ted
ODonoghue, Time Discounting and Time Preference: A Critical Review,
40 J. Econ. Lit. 351401 (2002); Ariel Rubinstein, Economics and
Psychology? The Case of Hyperbolic Discounting, 44 Intl Econ. Rev.
12071216 (2003); cf. Daniel Read, Is Time-Discounting Hyperbolic or
Subadditive?, 23J.Risk & Uncertainty 532 (2001).
95. Campbell, Asset Pricing at the Millennium, supra note 7 (Chapter 1), at
1544.
96. See Mehra, supra note 26 (Chapter 6), at 59; Mehra & Prescott, The
Equity Premium in Retrospect, supra note 37 (Chapter 3), at 905.
97. See Philippe Weil, The Equity Premium Puzzle and the Risk-Free Rate
Puzzle, 24J.Monetary Econ. 401421 (1989).
98. See Baker, Bradley & Wurgler, supra note 8 (Chapter 4), at 43.
99. Id.
100. Kocherlakota, supra note 9, at 44.
101. Id.
102. Id.
103. See, e.g., David K. Backus & Allan W. Gregory, Theoretical Relations
Between Risk Premiums and Conditional Variances, 11J.Bus. & Econ.
Stat. 177185 (1993); John Y. Campbell, Intertemporal Asset Pricing
Without Consumption Data, 83 Am. Econ. Rev. 487512 (1993);
Lawrence R.Gloston, Ravi Jagannathan & David Runkle, On the Relation
Between the Expected Value and the Volatility of the Nominal Excess Return
on Stocks, 48J.Fin. 17791901 (1993); John T.Scruggs, Resolving the
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 169
110. Id.
111. Mehra & Prescott, The Equity Premium in Retrospect, supra note ,37
(Chapter 3), at 913 (equation 30); see also Mehra, supra note 26 (Chapter
6), at 61 (equation 21).
112. Mehra, supra note 26 (Chapter 6), at 61.
113. Mehra & Prescott, The Equity Premium in Retrospect, supra note 37
(Chapter 3), at 913 (equation 31).
114. Mehra, supra note 26 (Chapter 6), at 61; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 913.
115. See Suresh M.Sundaresan, Intertemporally Dependent Preferences and the
Volatility of Consumption and Wealth, 2 Rev. Fin. Stud. 7389 (1989).
116. See George Loewenstein, Ted ODonoghue & Matthew Rabin, Projection
Bias in Predicting Future Utility, 118 Q.J.Econ. 12091248 (2003).
117. See Albert Ando & Franco Modigliani, The Life Cycle Hypothesis of
Saving: Aggregate Implications and Tests, 53 Am. Econ. Rev. 5584
(1963); Franco Modigliani & Richard H.Brumberg, Utility Analysis and
Aggregate Consumption Functions: An Attempt at Integration, in 2 The
Collected Papers of Franco Modigliani: The Life Cycle Hypothesis of
Saving 128197 (Andrew B. Abel ed., 1980); Franco Modigliani &
Richard H. Brumberg, Utility Analysis and the Consumption Function:
An Interpretation of Cross-Sectional Data, in Post Keynesian Economics
388-436 (Kenneth K. Kurihara ed., 1954). See generally Browning &
Crossley, supra note 19 (Chapter 5).
118. Mauro Baranzini, Modiglianis Life-Cycle Theory of Savings Fifty Years
Later, 58 Banco Nazionale del Lavoro Q.Rev. 109172, 109 (2005).
119. Angus Deaton, Francisco Modigliani and the Life-Cycle Theory of
Consumption, 58 Banco Nazionale del Lavoro Q. Rev. 91107, 95
(2005).
120. Id. at 9596.
121. Id. at 96.
122. Id.
123. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at
78; see supra 7.2, at 140143.
124. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at
78.
125. See Karl E.Case, John M.Quigley & Robert J.Shiller, Comparing Wealth
Effects: The Stock Market Versus the Housing Market, 5:1 Advances in
Macroecon., art. 1, at 26 (2005) (available at http://www.econ.yale.
edu/~shiller/pubs/p1181.pdf). See generally, e.g., Kul B. Bhatia, Real
Estate Assets and Consumer Spending, 102 Q.J.Econ. 437443 (1987);
Richard K. Green, Stock Prices and House Prices in California: New
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 171
175. Mehra, supra note 26 (Chapter 6), at 61; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 917.
176. Cf. Valery Polkovnichenko, Life-Cycle Portfolio Choice with Additive Habit
Formation Preferences and Uninsurable Labor Income Risk, 20 Rev. Fin.
Stud. 83124 (2007) (predicting that households with low-to-moderate
wealth may increase the share of stocks in their financial holdings as wealth
increases and suggesting that younger people may consequently have
more conservative portfolios than conventional retirement planning
would otherwise predict or counsel).
177. Deaton, supra note 119, at 93.
178. Mehra, supra note 26 (Chapter 6), at 61; Mehra & Prescott, The Equity
Premium in Retrospect, supra note 37 (Chapter 3), at 917; cf. Bucciol &
Miniaci, supra note 68 (Chapter 6) (finding that ex ante risk in household
portfolios rises and falls with the business cycle).
179. See infra 12.2, at 305307.
180. Lu Zhang, The Value Premium, 60J.Fin. 67103, 68 (2005).
181. Id. On costly reversibility, see generally Andrew B. Abel & Janice
C. Eberly, A Unified Model of Investment Under Uncertainty, 84 Am.
Econ. Rev. 13691384 (1994); Andrew B. Abel & Janice C. Eberly,
Optimal Investment with Costly Reversibility, 63 Rev. Econ. Stud. 581-
593 (1996); Valerie A. Ramsey & Matthew D. Shapiro, Displaced
Capital: A Study of Aerospace Plant Closings, 109J.Pol. Econ. 958992
(2001).
182. See Zhang, supra note 180, at 68.
183. See id. at 9092.
184. See Roll, supra note 20 (Chapter 3), at 155; Chen, Postmodern Portfolio
Theory, supra note 1 (Chapter 1), 3.3, at 2931.
185. On the behavioral economics of retirement savings, see generally Shlomo
Benartzi & Richard H. Thaler, Heuristics and Biases in Retirement
Savings Behavior, 21J.Econ. Persp. 81104 (2007); Shlomo Benartzi &
Richard H. Thaler, Behavioral Economics and the Retirement Savings
Crisis, 339 Science 11521153 (2013).
186. See, e.g., Shlomo Benartzi, Richard H.Thaler, Stephen P.Utkus & Cass
R.Sunstein, The Law and Economics Company Stock in 401(k) Plans, 50
J.L. & Econ. 4579 (2007); James M. Poterba, Employer Stock and
401(k) Plans, 93 Am. Econ. Rev. 398404 (2003); Andrew Stumpff &
Norman Stein, Repeal Tax Incentives for ESOPs, 125 Tax Notes 337340,
339340 (2009). For summaries of studies showing that employee stock
ownership plans do little in themselves to improve productivity, see Brett
McDonnell, ESOPs Failures: Fiduciary Duties When Managers of
Employee-Owned Companies Vote to Entrench Themselves, 2000 Colum.
176 J.M. CHEN
Bus. L.Rev. 199260, 235; Ezra S.Field, Note, Money for Nothing and
Leverage for Free, 97 Colum. Bus. L.Rev. 740785, 752 n.82 (1997).
187. See sources cited supra note 164; cf. Joshua D. Coval & Tobias
J.Moskowitz, Home Bias at Home: Local Equity Preference in Domestic
Portfolios, 54J.Fin. 20452073 (1999) (documenting a strong prefer-
ence for locally headquartered firms, particularly small firms with high
levels of leverage that produce nontraded goods). See generally Gur
Huberman, Familiarity Breeds Investment, 14 Rev. Fin. Stud. 659680
(2001) (documenting investors preference for geographically proximate
stocks within their domestic portfolios).
188. Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 169.
189. See Beni Lauterbach & Haim Reisman, Keeping Up with the Joneses and
the Home Bias, 10 Eur. Fin. Mgmt. 225234 (2004).
190. See John R. Graham, Campbell R. Harvey & Hai Huang, Investor
Competence, Trading Frequency, and Home Bias, 55 Mgmt. Sci.
10941106 (2009).
191. See Meir Statman, The Diversification Puzzle, 60:4 Fin. Analysts J. 4453
(July/Aug. 2004).
192. See Marie-Hlne Broihanne, Maxime Merli & Patrick Roger,
Diversification, Gambling and Market Forces, Rev. Quant. Fin. &
Accounting (Jan. 29, 2015) (available at http://link.springer.com/arti-
cle/10.1007/s11156-015-0497-1); Goetzmann & Kumar, supra note
130 (Chapter 1); Todd Mitton & Keith Vorkink, Equilibrium
Undiversification and the Preference for Skewness, 20 Rev. Fin. Stud.
1255-1288 (2007); Valery Polkovnichenko, Household Portfolio
Diversification: A Case for Rank-Dependent Preferences, 18 Rev. Fin.
Stud. 14671502 (2005).
193. See generally infra Chaps. 8 and 9.
194. Compare Zoran Ivkovi & Scott Weisbenner, Local Does as Local Is:
Information Content of the Geography of Individual Investors Common
Stock, 60J.Fin. 267306 (2005) (asserting that home bias does translate
into positive returns) with Mark S. Seasholes & Ning Zhu, Individual
Investors and Local Bias, 65J.Fin. 19872010 (2010) (concluding that
individual investors do not realize excess returns on local stocks).
195. See Massimo Massa & Andrei Simonov, Hedging, Familiarity, and
Portfolio Choice, 19 Rev. Fin. Stud. 633685 (2006).
196. See Trond M.Dskeland & Hans K.Hvide, Do Individual Investors Have
Asymmetric Information Based on Work Experience?, 66J.Fin. 10111041
(2011).
197. Brad M.Barber & Terrance Odean, The Behavior of Individual Investors,
in 2 Handbook of the Economics of Finance, supra note 68 (Chapter 6),
at 15331570, 1563; see also id. at 1563 n.7 (observing that any return
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 177
213. Id. Individuals seeking to leave a legacy, presumably to their own off-
spring, might focus on the amount of wealth they can transmit to suc-
ceeding generations. There is at least indirect evidence that married
women (presumably with children or with an expectation of having chil-
dren) are more sensitive to this consideration than any other demo-
graphic group among individual investors. See Sundn & Surette, supra
note 149 (Chapter 1), at 209; supra 1.6.
214. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at
89.
215. See Fischer Black, The Investment Policy Spectrum: Individuals,
Endowment Funds, and Pension Funds, 32:1 Fin. Analysts J. 2331 (Jan./
Feb. 1976).
216. See James Tobin, What Is Permanent Endowment Income?, 64 Am. Econ.
Rev. 427432 (1974).
217. See Robert C. Merton, Optimal Investment Strategies for University
Endowment Funds, in Continuous Time Finance 649674 (rev. ed.
1992); Robert C.Merton, Optimal Investment Strategies for University
Endowment Funds, in Studies of Supply and Demand in Higher Education
211242 (Charles T.Clotfelter & Michael Rothschild eds., 1993).
218. See Miles Kimball & Philippe Weil, Precautionary Saving and Consumption
Smoothing Across Time and Possibilities, 41J.Money, Credit & Banking
245284 (2009); cf. Kimball, supra note 143.
219. See, e.g., Gregory P. Ho, Haim A. Mozes & Pavel Greenfield, The
Sustainability of Endowment Spending Levels: A Wake-Up Call for
University Endowments, 37:1J.Portfolio Mgmt. 133146 (Fall 2010).
220. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at
89.
221. Id.
222. Id.; see also id. (The fact that stocks have outperformed bonds over every
twenty-year period in history is cold comfort after a decade of zero nomi-
nal returns.).
223. Jeffrey R. Brown, Stephen G. Dimmock, Jun-Koo Kang & Scott
J.Weisbenner, How University Endowments Respond to Financial Market
Shocks: Evidence and Implications, 104 Am. Econ. Rev. 931962 (2014).
224. See id. at 932933.
225. Id. at 954; cf. Raymond Fishman & R.Glenn Hubbard, Precautionary
Savings and the Governance of Nonprofit Organizations, 89J.Pub. Econ.
22312243 (2005) (exploring the incentives motivating nonprofit orga-
nizations to hoard assets).
226. Brown, Dimmock, Kang & Weisbenner, supra note 223, at 933 (quoting
Conti-Brown, supra note 206, at 704).
THE EQUITY RISK PREMIUM ANDTHEEQUITY PREMIUM PUZZLE 179
Prospect Theory
constant risk aversion, people often prefer insurance programs that offer
limited coverage with low or zero deductibles over comparable policies
that offer higher maximal coverage with higher deductibles.13 Formally
speaking, purchasers of insurance act as though reducing the probability
of a loss from p to p/2 is less valuable than reducing the probability of that
loss from p/2 to 0.14 This preference is particularly intriguing because
all insurance is, in a sense, probabilistic insofar as even the most avid
buyer of insurance remains vulnerable to many financial and other risks
which his policies do not cover.15
Put another way, there is no such product as comprehensive, all-risks,
zero-deductible insurance. Preferences within the realm of insurance reveal
an intuitive aversion to insurance policies whose coverage is probabilistic
rather than complete, and which therefore fail to entirely eliminate[] the
element of risk.16 It is quite evident that the assumed concavity of the
utility function fails to adequately capture[] this intuitive notion of
risk.17
Within the nomenclature of prospect theory, that intuitive notion of
risk is called the certainty effect.18 The certainty effect enables prospect
theory to account for the Allais paradox.19 In a situation where winning
is possible but not probable, most people choose the prospect that offers
the larger gain.20 The possibility of a certain outcome within a mixed
prospect renders certainty a special case of a broader isolation effect,
whereby the evaluation of distinct components of alternative choices can
produce inconsistent preferences.21 The obverse of the certainty effect
is ambiguity aversion, or discomfort arising from the lack of knowledge of
the probabilities underlying a gamble.22
Moreover, upon examining not only positive prospects, or pros-
pects that involve no losses, but also the impact of reversing the signs
of the outcomes so that gains are replaced by losses, Kahneman and
Tversky identified a reflection effect.23 The significance of the reflection
effect lies in its implication that risk aversion in the positive domain is
accompanied by risk seeking in the negative domain.24 Combining the
certainty effect with the reflection effect dramatically changes the nature
of risk aversion. In the positive domain, the certainty effect contributes
to a risk averse preference for a sure gain over a larger gain that is merely
probable.25
By contrast, [i]n the negative domain, the certainty effect leads to
a risk-seeking preference for a loss that is merely probable over a smaller
184 J.M. CHEN
loss that is certain.26 Because the reflection effect eliminates aversion for
uncertainty or variability for losses, the same psychological principlethe
overweighting of certaintyfavors risk aversion in the domain of gains
and risk seeking in the domain of losses.27 In other words, certainty
increases the aversiveness of losses as well as the desirability of gains.28
The resulting division between risk aversion in the domain of gains and
risk seeking in the domain of losses has been observed, of all places, in the
behavior of pigeons.29
rules people follow.53 The Supreme Court of the USA long ago rendered
this sentiment in more straightforward terms: Threat of loss, not hope of
gain, is the essence of economic coercion.54 Even more plainly, [l]osing
hurts worse than winning feels good.55
Third and finally, diminishing sensitivity applies to upward and down-
ward perceptions and to evaluation of changes of wealth. In concert, these
three principlesneutral reference point, loss aversion, diminishing sen-
sitivitycan be illustrated through a graph showing an asymmetrical sig-
moid curve whose inflection point occurs at the neutral adaptation level,
whose steeper slope below the adaptation level demonstrates loss aversion,
and whose declining rate of change in both directions reflects diminishing
sensitivity to gains and to losses.56
Accounting for all three of these properties generates a value function
as shown in Fig. 8.1.
Value
109
100
90
40 5060
$ 40 50 6 $
(Losses) (Gains)
200
222
234
v ( x ) -l sgn ( x ) x , a b
dx, - x a
Substituting the values 0.88, 2.25 into the foregoing formula gen-
erates the image in Fig. 8.2.70
On the other hand, if Tversky and Kahnemans specification of the
value function is merely intended as a general guide to depicting prospect
theorys interpretation of utility, risk aversion, and risk seeking, then there
are numerous other ways to represent the value function. If only for con-
venience, let us restate how prospect theorys asymmetrical utility function
illustrates three basic features of human beings core cognitive system:71
Fig. 8.2 Prospect theorys value function according to Tversky and Kahnemans
original parameters
PROSPECT THEORY 189
a > 0; b > 0
1
F ( x; a , b ) = -b
x
1+
a
b
x
Multiplying both the numerator and the denominator by yields:
a
b
x
a
F ( x; a , b ) = b
x
1+
a
Multiplying both the numerator and the denominator again, this time by
, yields an even more elegant expression of the log-logistic distributions
CDF:
xb
F ( x; a , b ) =
a b + xb
Fig. 8.3 Flagging prospect theory: the cumulative distribution function of the
log-logistic distribution
(x +a )
b
F ( x; a , b)=
a + (x +a )
b b
(x +a )
b
1
F ( x; a , b)= -
a + (x +a )
b
b 2
192 J.M. CHEN
2 (x +a )
b
F ( x; a , b ) = -1
a b + (x +a )
b
Figure 8.6 shows how our flag of prospect theory looks like after all three
transformations.80
We have therefore accomplished our goal of parameterizing a basic
model of prospect theorys utility function in closed form with elementary
functions and using only integers, at least in the first instance, to define
scale parameter and shape parameter . By placing both x and F(x; , )
within a range between 1 and 1, we have specified a model that can rep-
resent actual gains and losses along the x-axis and subjective value along
the y-axis.
Fig. 8.6 Flagging prospect theory: a parametric depiction of the value function
according to the log-logistic distribution
194 J.M. CHEN
normal distribution does not have a CDF that can be written in closed
form with elementary functions. That function, however, can be written
with erf, the error function, where erf(x) denotes:82
x
2
erf ( x ) =
2
e - t dt
p 0
1 ( ln x - m )2
f ( ln x; m , s ) = exp - , x > 0
xs 2p 2s 2
1 1 ln x - m
F ( ln x; m , s ) = + erf
2 2 s 2
3 5 25 ( ln x )2
f ln x; m = 0, s = = exp - , x > 0
5 x 6p 6
5x 4
f ( x; a = 1, b = 5 ) = , x>0
(1 + x )
2
5
Plotting the two probability density functions together in Fig. 8.7 shows
the closeness of the two distributions.84
All that remains is a straightforward application of the three operations
outlined in 8.4 to the CDF of the lognormal distribution: (1) Add 1 to
x so that the CDF is shifted left along the x-axis. (2) Subtract from the
value of the equation so that the CDF is shifted down along the y-axis. (3)
Multiply by 3 to rescale the flag so that it displays entirely within the
range of 1x1 and 1y1. The resulting function for the CDF
of a lognormal distribution with parameters =0 and =3/5 takes the
following form:
ln ( x + 1) - m
F ( ln x; m , s ) = erf
s 2
3 5 ln ( x + 1)
F ln x; m = 0, s = = erf
5 6
Fig. 8.7 A comparison of the probability density functions for the log-logistic
(red) and the two-parameter lognormal (blue) distributions
196 J.M. CHEN
Fig. 8.8 Flagging prospect theory: comparing the log-logistic and two-parameter
lognormal representations of prospect theorys value function
2 ( x + 1)
5
the prospect theory flag derived in 8.4 from the CDF of the log-
logistic distribution, is depicted in Fig. 8.8.85
Whether rendered for a log-logistic or a lognormal distribution, the
methodology outlined here satisfies all three conditions imposed by pros-
pect theory: (1) an inflection point at the reference point, recentered at
the origin, (2) plus a steeper slope for subjective value assigned to losses
vis--vis the comparatively modest slope for subjective value ascribed to
gains, and (3) diminishing sensitivity to losses and to gains. One can there-
fore illustrate prospect theory in vivid, graphic form, with an extremely
parsimonious mathematical apparatus.
n
V(f)= p i v ( xi )
i =- m
PROSPECT THEORY 199
pg
w+ ( p ) = 1/ g
pg + (1 - p )g
d
p
w- ( p ) = 1/ d
pd + (1 - p )d
High E.g., a 95% chance to win E.g., a 95% chance to lose $10,000
probability $10,000 leads to risk aversion leads to risk seeking (rogue trading
(certainty (annuities and sinecures) and other reckless gambles)
effect)
Low E.g., a 5% chance to win E.g., a 5% chance to lose $10,000
probability $10,000 leads to risk seeking leads to risk aversion (insurance)
(possibility (lotteries)
effect)
choices and risk.134 The fourfold pattern arises from the interaction of
prospect theorys value and weighting functions (Table 8.1). The shapes
of those functions imply risk-averse and risk-seeking preferences, respec-
tively, for gains and for losses of moderate or high probability.135 As long
as the outcomes are not extreme, the shape of the weighting functions
(one each for the domain of gains and the domain of losses) favors risk
seeking for small probabilities of gains and risk aversion for small probabili-
ties of loss.136
Let us examine more closely each of the four corners in prospect theo-
rys fourfold pattern. Three of these four behavioral possibilities had long
been understood before Kahneman and Tversky; prospect theory merely
provided the means by which to describe them formally.137 The cell at top
left describes how risk aversion leads people to lock in a sure gain below
the expected value of a gamble. Annuities work on this principle, as do
employment guarantees in unionized trades or on tenure-protected uni-
versity faculties.
The cell at lower right describes insurance: Individuals will pay much
more than the expected value of a loss to insure themselves against the
disturbing prospect of a catastrophic loss. On the flip side of that transac-
tion, insurance companies can pool risks assigned to them by risk-averse
policyholders and profit from the spread between expected losses and
premium payments. These risk-averse decisions reflect one of the core
instincts within prospect theory. Prospect theorys defensive account res-
onates with mental accounting, other behaviorally sensitive approaches
to portfolio design and asset pricing, and postmodern portfolio theorys
early emphasis on downside risk measures.138
PROSPECT THEORY 203
framing effects or to apply linear decision weights.159 Far from being cha-
otic and intractable, the human choices under risk and uncertainty are
orderly, even if they are not always rational in the traditional sense.160
Notes
1. Nicholas C. Barberis, Thirty Years of Prospect Theory in Economics: A
Review and Assessment, 27J.Econ. Persp. 173196, 173 (2013).
2. See Daniel Kahneman, Maps of Bounded Rationality: A Perspective on
Intuitive Judgment and Choice (Dec. 8, 2002) (available at http://www.
nobelprize.org/nobel_prizes/economic-sciences/laureates/2002/kahne-
mann-lecture.pdf), published sub nom. Daniel Kahneman, Maps of Bounded
Rationality: Psychology for Behavioral Economics, 93 Am. Econ. Rev. 1449
1475 (2003). Amos Tversky presumably would have shared Kahnemans
Nobel Prize, but he had flunked a core eligibility criterion by dying in 1996.
3. For Daniel Kahnemans own summary of prospect theory, see Kahneman,
Thinking, Fast and Slow, supra note 11 (Chapter 1), at 278288. See also,
e.g., Peter P.Wakker, Prospect Theory: For Risk and Ambiguity (2010).
4. See sources cited supra notes 34 (Chapter 6).
5. See generally supra 6.16.3, at 111115.
6. See generally, e.g., Steven T.Buccola, Portfolio Selection Under Exponential
and Quadratic Utility, 7 W.J. Agric. Econ. 4251 (1982); Steven
D.Hanson & George W.Ladd, Robustness of the Mean-Variance Model
with Truncated Probability Distributions, 73 Am. J.Agric. Econ. 436445
(1991); Liping Liu, A New Foundation for the Mean-Variance Analysis,
158 Eur. J.Oper. Research 229242 (2004).
7. See generally supra. 6.4, at 115117.
8. Levy, CAPM in the 21st Century, supra note 41 (Chapter 1), at 85.
9. Id. at 84.
10. Robert A. Collins & Edward E. Gbur, Quadratic Utility and Linear
Mean-Variance: A Pedagogic Note, 13 Rev. Agric. Econ. 289291, 289
(1991).
11. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 264.
12. Id. at 269.
13. Id. (citing Victor R.Fuchs, From Bismark to Woodcock: The Irrational
Pursuit of National Health Insurance, 19 J.L. & Econ. 347359 (1976)).
14. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 270.
15. Id.
16. Id.
17. Id.
18. See id. at 265267.
19. See id.
206 J.M. CHEN
104. See supra 7.7, at 154; 7.8, at 156; source cited supra note 164 (Chapter 7).
105. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at 298
(citing Heath & Tversky, supra note 22).
106. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
298.
107. Id.
108. Id.
109. Id.
110. Id.
111. See id. at 300; Benartzi & Thaler, Myopic Loss Aversion, supra note 20
(Chapter 2), at 79.
112. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
309.
113. See id. at 300.
114. George Wu & Richard Gonzalez, Curvature of the Probability Weighting
Function, 42 Mgmt. Sci. 16761690, 1677 (1996).
115. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
310; accord Benartzi & Thaler, Myopic Loss Aversion, supra note 20
(Chapter 2), at 80 (acknowledging cumulative prospect theorys one-
parameter approximation of its weighting function); see also John
Quiggin, On the Optimal Design of Lotteries, 58 Economica 116 (1991).
116. See Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
309.
117. See Nicholas Barberis & Ming Huang, Stocks as Lotteries: The Implications
of Probability Weighting for Security Prices, 98 Am. Econ. Rev. 2066
2100, 2071 (2008) (recognizing that setting the shape parameter to
=1corresponds to no probability weighting at all).
118. See Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
312.
119. See http://www.wolframalpha.com/input/?i=plot+x%5E.61%2F%28x%
5E.61%2B%281-x%29%5E.61%29%5E%281%2F.61%29+and+x%5E.69%
2F%28x%5E.69%2B%281-x%29%5E.69%29%5E%281%2F.69%29+and+x
+for+x%3D0+to+1&f=1
120. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
312.
121. Id.
122. Id.
123. Id.
124. Gregory Gurevich, Doron Kliger & Ori Levy, Decision-Making Under
UncertaintyA Field Study of Cumulative Prospect Theory, 33J.Banking
& Fin. 12211229, 12241225 (2009); see also id. at 1226 (table 5)
(comparing field data from 30 stock samples with Tversky and
Kahnemans 1992 laboratory results). Figure 8.10 was generated at
PROSPECT THEORY 211
http://www.wolframalpha.com/input/?i=plot+x%5E.84%2F%28x%5E
.84%2B%281-x%29%5E.84%29%5E%281%2F.84%29+and+x%5E.76%2
F%28x%5E.76%2B%281-x%29%5E.76%29%5E%281%2F.76%29+and+x
+for+x%3D0+to+1
125. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
312.
126. Id.
127. See Kahneman, supra note 3, at 285.
128. See sources cited supra note 55.
129. See Kahneman, supra note 3, at 285.
130. Id. at 316317.
131. Id. at 317.
132. Wu & Gonzalez, supra note 114, at 1676.
133. Kahneman, supra note 3, at 317; accord Wu & Gonzalez, supra note
114, at 1676 (Together, these two regularities capture the fourfold pat-
tern of risk attitudes: risk aversion for most gains and low probability
losses, and risk seeking for most losses and low probability gains.); see
also Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
306 (The most distinctive implication of prospect theory is the fourfold
pattern of risk attitudes.).
134. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
307.
135. Id. at 306.
136. Id.
137. See Kahneman, supra note 3, at 317318.
138. See Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1),
5.16.11, at 59105.
139. See supra 3.2, at 6066.
140. See infra 9.19.2, at 215224.
141. See Kahneman, supra note 3, at 318.
142. Id.
143. Id. at 319.
144. See Stephen Gandel, How JPMorgan Made Its Multi-Billion Dollar
Blunder, CNN Money (May 15, 2012) (available at http://finance.for-
tune.cnn.com/2012/05/15/jpmorgan-london-whale-blunder).
145. See Roger Parloff, How MF Globals Missing $1.5 Billion Was Lostand
Found, CNN Money (Nov. 15, 2013) (available at http://features.blogs.
fortune.cnn.com/2013/11/15/mf-global-joncorzine).
146. See The Economy: How Leeson Broke the Bank, BBC News Business (June
22, 1999) (available at http://news.bbc.co.uk/2/hi/business/375259.
stm).
147. See, e.g., Nicholas Dunbar, Inventing Money: The Story of Long-Term
Capital Management and the Legends Behind It (2000); Laurent
L. Jacque, Global Derivative Debacles: From Theory to Malpractice
212 J.M. CHEN
245273 (2010); Roger Lowenstein, When Genius Failed: The Rise and
Fall of Long-Term Capital Management (2000).
148. See infra 9.1, at 215222.
149. Nassim Nicholas Taleb, Bleed or Blowup? Why Do We Prefer Asymmetric
Payoffs?, 5J.Behav. Fin. 27, 2 (2004).
150. Kahneman, supra note 3, at 319.
151. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 285.
152. See Glen Whyte, Escalating Commitment to a Course of Action: A
Reinterpretation, 11 Acad. Mgmt. Rev. 311321 (1986).
153. See, e.g., Barry M.Staw, Knee-Deep in the Big Muddy: A Study of Escalating
Commitment to a Chosen Course of Action, 16 Org. Behav. & Human
Performance 2744 (1976); Barry M.Staw, The Escalation of Commitment
to a Course of Action, 6 Acad. Mgmt. Rev. 577587 (1981); Barry
M.Staw, The Escalation of Commitment: An Update and Appraisal, in
Organizational Decision Making 191215 (Zur Shapira ed., 1997); Karl
E.Weick, Reduction of Cognitive Dissonance Through Task Enhancement
and Effort Expenditure, 56J.Abnormal & Soc. Psych. 152155 (1964).
154. Cf. Glen Whyte, Diffusion of Responsibility: Effects on the Escalation
Tendency, 76J.Applied Psych. 408415, 411413 (1991) (finding less
support for the self-justification account of escalation of commitment in
collective decision-making settings). See generally Joel Brockner, The
Escalation of Commitment to a Failing Course of Action: Toward
Theoretical Progress, 17 Acad. Mgmt. Rev. 3961 (1992) (reviewing the
relationship between self-justification explanations for the escalation of
commitment and alternative accounts, including prospect theory).
155. See Donald C.Hambrick & Richard A.DAveni, Large Corporate Failures
as Downward Spirals, 33 Admin. Sci. Q. 123 (1988).
156. See generally, e.g., Will Steffen, Jacques Grinewald, Paul Crutzen & John
McNeil, The Anthropocene: Conceptual and Historical Perspectives, 369
Phil. Trans. Royal Socy A 842867 (2011); Jan Zalasiewicz, Mark
Williams, Will Steffen & Paul Crutzen, The New World of the Anthropocene,
44 Envtl. Sci. & Tech. 22282231 (2010).
157. See generally Keith E.Stanovich & Richard F.West, Individual Differences
in Reasoning: Implications for the Rationality Debate, 23 Behav. & Brain
Sci. 645726 (2000).
158. Tversky & Kahneman, Advances in Prospect Theory, supra note 58, at
317.
159. Id.
160. Id. (emphasis in original).
CHAPTER 9
Fig. 9.1 Shifting prospect theorys weighting function so that it reflects skew-
ness preference.
prices.24 Research into the risky choices made by pigeons, long a staple
of studies into animal psychology paralleling work on prospect theory in
humans,25 has revealed a similar pattern in avian behavior. As between fixed
payouts offering a higher amount of food and variable payouts offering
occasional bonanzas but a lower expected amount, pigeons prefer variable
payouts.26 This evidently innate preference for gambling may reveal a bio-
logical mechanism for gambling in birds and in humans.27
The relationship between low returns, positive skewness, and investor
affinity toward investments offering lottery-like payoffs appears across a
wide variety of financial settings:
Prize-linked savings accounts. Americans spent $70.2 billion on lottery
tickets in fiscal year 2014.28 That amount, confined to the jurisdictions
where lotteries are legal (44 states and the District of Columbia), exceeds
the amount spent in the entire country on sports tickets, books, video
games, movie tickets, and recorded music sales.29 Of the $70.2 billion in
lottery sales, $19.9 billion was remitted to lottery-sponsoring jurisdictions
as revenue.30 Worldwide lottery sales totaled $284 billion in 2014.31 The
profoundly negative economic impact of the lottery falls disproportion-
ately on the poor,32 many of whom treat the regular purchase of lottery
tickets as a form of savings.33 Even the economic impact of winning the
lottery falls far short of being unambiguously positive.34 The most that
might be said in defense of lottery participation is that syndicate play
buying tickets as part of a pool of friends, relatives, and/or coworkers
conveys social value independent of economic losses.35
The yearning for lotteries is sufficiently powerful that banks and credit
unions, with the strong backing of advocates for higher levels of savings
216 J.M. CHEN
and financial literacy among the poor, have resorted to depositor lotter-
ies to induce lower- to middle-income customers to open and fund sav-
ings accounts.36 Although prize-linked savings accounts are illegal in states
that treat them as nonsanctioned lotteries, they are prevalent around the
world.37 They operate on the same principle as lottery bonds, typically
issued by a sovereign that promises to redeem a select number of bonds
(substantially) above face value.38 The practice is actually quite old, with
American39 and European40 antecedents predating the twentieth century.
The oldest lottery bond may be the UKs Million Adventure of 1694,
a lottery intended to retire debt from the then-ongoing Nine Years War
(168997).41
Private equity. At the opposite end of the socioeconomic spectrum
from state-sponsored lotteries, wealthier households indulge in private
equity. Skewness preference may explain why anyone willingly invests
large amounts in a single privately held firm,42 despite a wretched trade-
off between risk and return. Returns on private equity are typically no bet-
ter than those on publicly traded stocks, and high correlation with public
equity reduces any diversification value that private equity might otherwise
offer.43 Investment in private equity, to say the least, is extremely concen-
trated: About 75 percent of all private equity is owned by households
for whom it constitutes at least half of their total net worth.44 Households
holding entrepreneurial equity invest on average more than 70 percent
of their private holdings in a single private company in which they have an
active management interest.45 In many households, income from entre-
preneurial venturesmore generally designated as proprietary business
incomerepresents a large source of undiversifiable risk that is more
highly correlated with common stock returns.46
In exchange for this dramatic lack of diversification, to say noth-
ing of the risk inherent in aligning returns from investment with highly
compensated but easily terminated personal labor, private equity investors
realize rather unimpressive returns that are no higher than the mar-
ket return on all publicly traded equity.47 Ownership of entrepreneur-
ial equity therefore constitutes not so much an exercise in staking out a
personalized corner along the efficient frontier, but rather a plunge off
that frontier in search of extreme skewness. Older households, at least, do
seem to understand the risk inherent in relying too heavily on proprietary
business income. As households age, they tend to move to safer assets,
by substituting riskier proprietary business ownership with stocks, bonds,
and especially cash.48
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 217
money in the pink sheets.94 At least in the movies, [p]lot lines within
the genre of gambling stories are not only simplethe gambler falls into
debt; the gambler goes after one big score to get even; the gambler either
does or does not get evenbut also offer some chance of redemption as
long as the filmmaker sees gambling as a charming hustle rather than
a catastrophic vice.95 By contrast, gambling in any number of real-life
venuescasinos, racetracks, state-sponsored lotteries, the pink sheets, one-
week fantasy sportshas an even simpler narrative: the house always wins.
The inescapable implication is that trading in stocks, at least for some
investors, is a thrilling form of gambling, interchangeable with other
forms of risk-seeking entertainment.96 Such thrill-seeking may even be
detectable through neural scans (functional magnetic resonance imaging)
of brain activity during trading.97 At the same time, cognitive bias evi-
dently keeps investors and gamblers from recognizing the rather inconve-
nient truth that the preference for positively skewed assets systematically
lowers returns on those assets, from stocks in general to initial public
offerings (IPOs).98 Financial assets are subject to the same psychology that
affects gambling assets such as lottery tickets and long-shot bets in horse
racing.99 At its most destructive, the thrill of gambling mixes with the fear
of regret to form an all-consuming fear of missing out on some fantastic
financial opportunity.100
Intriguingly, religious differences appear to affect the propensity to
gamble.101 Although Americans are presumably drawn to positively skewed
assets, as people around the world appear to be, the Protestant churches
harsh stance toward gambling suppresses that preference in certain regions
of the USA, while the Catholic Churchs more lenient view of gambling
makes it easier for people in Catholic regions to act on their prefer-
ence for skewness.102 It was a devout Catholic, after all, who framed the
choice to believe in God as a wager.103 In harmony with these conclusions,
a study of health and retirement choices found noticeable differences in
risk tolerance by religion.104 Protestants are the least risk tolerant,
and Jews the most.105 Blaise Pascals Catholics come about halfway [in]
between.106
performance.219 On the one hand, prior gains reduce loss aversion; they
cushion any subsequent loss, making it more bearable both financially
and psychologically. But prior losses increase loss aversion: after being
burned by the initial loss, an investor becomes more sensitive to addi-
tional setbacks.220 These reactions combine the predictions of prospect
theory with those of the house money effect, which holds that people
faced with sequential gambles are more willing to take risk if they
made money on prior gambles, than if they lost.221 Put simply, gamblers
are more willing to bet when they are ahead because losses are less pain-
ful if they [follow] prior gains, and more painful if they follow prior
losses.222
Quite evidently, this models consideration of past investment out-
comes is congruent with time series analysis and with the intertemporal
CAPM, both of which reject a static, single-period approach to returns
and volatility.223 In addition, this model is entirely in line with prospect
theory. In their original article on prospect theory, Daniel Kahneman and
Amos Tversky invoked the well known observation that the tendency to
bet on long shots increases in the course of the betting day.224 They used
this insight to defend their hypothesis that a failure to adapt to losses or
to attain an expected gain induces risk seeking.225
Barberis, Huang, and Santos address Kahneman and Tverskys con-
cern that prospect theory was originally developed only for elemen-
tary, one-shot gambles and that any application of prospect theory to
a dynamic context demanded further evidence on how people think
about sequences of gains and losses.226 Ignoring the psychological reac-
tion to sequences of investment outcomes is tantamount to assuming that
investors aggregate the totality of their stock market gains and losses
over vast periods of time, in contradiction of prospect theorys emphasis
on changes in wealth over absolute levels of wealth.227
The value of Barberis, Huang, and Santoss second factor becomes evi-
dent as their model confronts otherwise perplexing features of the tra-
ditional asset pricing framework, including the equity risk premium, the
otherwise bafflingly low risk-free rate, volatility clustering, return momen-
tum, and the low-volatility anomaly.228 Allowing risk aversion to change as
a dynamic function of investment outcomes allows returns to be much
more volatile than the underlying dividends.229 Although an unusually
good dividend raises prices, the resulting price increase also makes the
investor less risk averse and drives prices even higher.230 As a result, sub-
sequent returns are on average lower. At the same time, this model
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 231
NOTES
1. Barberis, Thirty Years of Prospect Theory, supra note 1 (Chapter 8), at 173
174 (emphasis in original).
2. Guthrie, supra note 45 (Chapter 8), at 1163.
3. See Yan Li & Liyan Yang, Prospect Theory, the Disposition Effect, and Asset
Prices, 107J.Fin. Econ. 715739 (2013).
4. See Wilbur G. Lewellen, Gary E. Schlarbaum & Ronald C. Lease, The
Individual Investor: Attributes and Attitudes, 29 J. Fin. 413433, 425
(1974) (table 4). See generally Wilbur G.Lewellen, Ronald C.Lease & Gary
E. Schlarbaum, Patterns of Investment Strategy and Behavior Among
Individual Investors, 50J.Bus. 296333 (1977).
5. See, e.g., Hal R. Arkes, Lisa Tandy Herren & Alice M. Isen, The Role of
Potential Loss in the Influence of Affect on Risk-Taking Behavior, 42 Org.
Behav. & Human Decision Processes 181193 (1988); Gordon H.Bower,
Mood and Memory, 36 Am. Psychologist 129148 (1981); William
F. Wright & Gordon H. Bower, Mood Effects on Subjective Probability
Assessment, 52 Org. Behav. & Human Decision Processes 276291 (1992).
6. See Goetzmann & Kumar, supra note 130 (Chapter 1); Statman,
Diversification Puzzle, supra note 191 (Chapter 7).
7. See Manju Puri & David T. Robinson, Optimism and Economic Choice,
86J.Fin. Econ. 7199 (2007).
8. See supra 1.6, at 1417.
9. See Werner F.M. de Bondt & Richard H. Thaler, Does the Stock Market
Overreact?, 40J.Fin. 793805 (1985).
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 233
10. See Brad M. Barber & Terrance Odean, Boys Will Be Boys: Gender,
Overconfidence, and Common Stock Investment, 116 Q.J. Econ. 261292
(2001); Terrance Odean, Volume, Volatility, Price, and Profit When All
Traders Are Above Average, 53J.Fin. 18871934 (1998).
11. See Andrew B.Abel, An Exploration of the Effects of Pessimism and Doubt on
Asset Returns, 26J.Econ. Dynamics & Control 10751092 (2002).
12. See Tomasz Zaleskiewicz, Agata Gasiorowska, Pelin Kesebir, Aleksandra
Luszczynska & Tom Pyszczynski, Money and the Fear of Death: The Symbolic
Power of Money as an Existential Anxiety Buffer, 36J.Econ. Psych. 5567
(2013).
13. See Wei-Yin Hu & Jason S. Scott, Behavioral Obstacles in the Annuity
Market, 63:6 Fin. Analysts J. 7182 (Nov./Dec. 2007).
14. See Daniel R. Smith, Conditional Coskewness and Asset Pricing,
14J.Empirical Fin. 91119, 103 (2007) ([I]nvestors are more interested
in positive skewness than they are averse to negative skewness).
15. See Tang & Shum, Unsystematic Risk, Skewness and Stock Returns, supra
note 34 (Chapter 7).
16. See Bali, Cakici & Whitelaw, supra note 66 (Chapter 3); Barberis & Huang,
Stocks as Lotteries, supra note 117 (Chapter 8), at 20802082.
17. See Brian Boyer, Todd Mitton & Keith Vorkink, Expected Idiosyncratic
Skewness, 23 Rev. Fin. Stud. 169202 (2010).
18. Barberis & Huang, Stocks as Lotteries, supra note 117 (Chapter 8), at 2071.
19. Cf. Tversky & Kahneman, supra note 58 (Chapter 7), at 312.
20. Barberis & Huang, Stocks as Lotteries, supra note 117 (Chapter 8), at 2071.
The following image was generated at http://www.wolframalpha.com/inp
ut/?i=plot+x%5E.4%2F%28x%5E.4%2B%281-x%29%5E.4%29%5E%281%2
F.4%29+and+x%5E.65%2F%28x%5E.65%2B%281-x%29%5E.65%29%5E%2
81%2F.65%29+and+x+for+x%3D0+to+1.
21. See, e.g., Camerer & Ho, supra note 153 (Chapter 7); Tversky & Kahneman,
Advances in Prospect Theory, supra note 58 (Chapter 8); Wu & Gonzalez,
supra note 58 (Chapter 8).
22. See Tennessee Williams, The Catastrophe of Success, in N.Y.Times, Nov. 30,
1947, reprinted in Tennessee Williams, The Glass Menagerie 99103
(Robert Bray introd., 1999) (1st ed. 1945).
23. See, e.g., Statman, Diversification Puzzle, supra note 191 (Chapter 7).
24. See Thierry Post & Haim Levy, Does Risk Seeking Drive Stock Prices? A
Stochastic Dominance Analysis of Aggregate Investor Preferences and Beliefs,
18 Rev. Fin. Stud. 925853 (2005).
25. See Hamm & Shettleworth, supra note 29 (Chapter 8).
26. See Carla H.Lagorio & Timothy D.Hackenberg, Risky Choice in Pigeons:
Preference for Amount Variability Using a Token-Reinforcement System,
98J.Experimental Analysis Behav. 139154 (2012).
234 J.M. CHEN
27. See Thomas R.Zentall & Jessica P.Stagner, Maladaptive Choice Behavior by
Pigeons: An Animal Analogue and Possible Mechanism for Gambling (Sub-
Optimal Human Decision-Making Behavior), 278 Proc. Royal Socy Biol.
Scis. 12031208 (2011).
28. See North American Association of State and Provincial Lotteries (data com-
piled at http://www.naspl.org/index.cfm?fuseaction=content&menuid=1
7&pageid=1025) (hereinafter National Lottery Data).
29. Derek Thompson, Lotteries: Americas $70 Billion Shame, The Atlantic,
May 11, 2015 (available at http://www.theatlantic.com/business/archive/
2015/05/lotteries-americas-70-billion-shame/392870).
30. See National Lottery Data, supra note 28.
31. See La Fleurs 2015 World Lottery Almanac (23d ed. 2015).
32. See Charles T.Clotfelter, Philip J.Cook, Julie A.Edell & Marian Moore,
State Lotteries at the Turn of the Century: Report to the National Gambling
Impact Study Commission 13 (April 23, 1999) (reporting that lottery
expenditures represent a much larger burden on the household budget for
those with low incomes than for those with high incomes) (available at
http://govinfo.library.unt.edu/ngisc/reports/lotfinal.pdf).
33. See Tina Rosenberg, Playing the Odds on Savings, N.Y.Times, Jan. 15, 2014
(available at http://opinionator.blogs.nytimes.com/2014/01/15/playing-
the-odds-on-saving).
34. See, e.g., Scott Hankings, Mark Hoekstra & Paige Marta Skiba, The Ticket to
Easy Street? The Financial Consequences of Winning the Lottery, 93 Rev. Econ.
& Stat. 961969 (2011) (concluding that lottery prizes merely postpone
rather than prevent bankruptcy); Guido W. Imbens, Donald B. Rubin &
Bruce I. Sacerdote, Estimating the Effect of Unearned Income on Labor
Earnings, Savings, and Consumption: Evidence from a Survey of Lottery Players,
91 Am. Econ. Rev. 778794 (2001) (finding that unearned income from lot-
teries reduces labor earnings, especially for players between 55 and 65 years
old, and that lottery winners saved approximately 16% of their proceeds).
35. See Mauro F.Guilln, Roberto Garva & Andrs Santana, Embedded Play:
Economic and Social Motivations for Sharing Lottery Tickets, 28 Eur. Sociol.
Rev. 344354, 346347 (2012).
36. See generally Melissa Schettini Kearney, Peter Tufano, Janathan Guryan &
Erik Hurst, Making Savers Winners: An Overview of Prize-Linked Savings
Products, in Financial Literacy: Implications for Retirement Security and the
Financial Marketplace 218240 (Olivia S. Mitchell & Annamaria Lusardi
eds., 2011) (originally published as National Bureau of Economic Research
[NBER] Working Paper 16433 [Oct. 2010] and available at http://www.
nber.org/papers/w16433).
37. See Mauro F.Guilln & Adrian E.Tschoegl, Banking on Gambling: Banks and
Lottery-Linked Deposit Accounts, 21J.Fin. Servs. Research 219231 (2002).
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 235
38. See, e.g., Bjarne Florentsen & Kristian Rydqvist, Ex-Day Behavior When
Investors and Professional Traders Assume Reverse Roles: The Case of Danish
Lottery Bonds, 11J.Fin. Intermediation 152175 (2002); Richard C.Green
& Kristian Rydqvist, Ex-Day Behavior with Dividend Preference and
Limitations to Short-Term Arbitrage: The Case of Swedish Lottery Bonds,
53J.Fin. Econ. 145187 (1999).
39. See Charles W. Calomiris, The Motives of U.S. Debt-Management Policy,
17901880: Efficient Discrimination and Time Consistency, 13 Research in
Econ. Hist. 67105 (1991); Robert M. Jennings, Donald F. Swanson &
Andrew P.Trout, Alexander Hamiltons Tontine Proposal, 45 Wm. & Mary
Q. 107115 (1988).
40. See Henri Lvy-Ullmann, Lottery Bonds in France and in the Principal
Countries of Europe, 9 Harv. L.Rev. 386405 (1896).
41. Anne L.Murphy, Lotteries in the 1690s: Investment or Gamble?, 12 Fin. Hist.
Rev. 227245 (2005) (describing the Million Adventure as an offering of
100,000 tickets at 10 each, with 2.5 % (or 2500 tickets) paying prizes
ranging from 10 per year to 1,000 per year for 16 years); accord Kearney,
Tufano, Guryan & Hurst, supra note 36, at 223.
42. See Todd Mitton & Keith Vorkink, Equilibrium Underdiversification and
Preference for Skewness, 20 Rev. Fin. Stud. 12551288 (2007); cf. Campbell,
Household Finance, supra note 68 (Chapter 6), at 1564 (observing that
private business assets take the place of public equity holdings in many
wealthy households); William M. Gentry & Glenn R. Hubbard,
Entrepreneurship and Household Saving, 4:1 Advances in Econ. Analysis &
Poly, art. 8 (2004) (electronic copy at 8) (available at https://www0.gsb.
columbia.edu/faculty/ghubbard/Articles%20for%20Web%20Site/
Entrepreneurship%20and%20Household%20Saving.pdf).
43. See Tobias J. Moskowitz & Annette Vissing-Jrgensen, The Returns to
Entrepreneurial Investment: A Private Equity Premium Puzzle?, 92 Am.
Econ. Rev. 745778, 745746 (2002).
44. Id. at 745.
45. Id.
46. John Heaton & Deborah J. Lucas, Portfolio Choice and Asset Prices: The
Importance of Entrepreneurial Risk, 55J.Fin. 11631199, 1163 (2000).
47. Moskowitz & Vissing-Jrgensen, supra note 43, at 745.
48. Heaton & Lucas, supra note 46, at 1168.
49. See generally, e.g., C. Steven Bradford, Crowdfunding and the Federal
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236 J.M. CHEN
72. See Chance Barnett, SEC Approves Title III of JOBS Act, Equity Crowdfunding
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73. See Philip G. Berger & Eli Ofek, Diversifications Effect on Firm Value,
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74. See Todd Mitton & Keith Vorkink, Why Do Firms with Diversification
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20012013, 42:1J.Portfolio Mgmt. 143152 (Fall 2015).
76. See McConnell, Sibley & Wu, supra note 75.
77. See Chris Veld & Yulia V.Veld-Merkoulova, Value Creation Through Spin-
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78. See McConnell, Sibley & Wu, supra note 75.
79. See Veld & Veld-Merkoulova, supra note 77.
80. Stephen Davidoff Solomon, A Test to See If the Parts Are Worth More Than
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81. See generally, e.g., Mark B.Garman & James A.Ohlson, Valuation of Risky
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82. See Owen A. Lamont & Richard H. Thaler, Can the Market Add and
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84. See Oliver G. Spalt, Probability Weighting and Employee Stock Options,
48J.Fin. & Quant. Analysis 10851118 (2013).
85. See generally Brian H. Boyer & Keith Vorkink, Stock Options as Lotteries,
69J.Fin. 14851527 (2014).
86. See supra 7.8, at 155156.
87. See John Y.Campbell, Jens Hischer & Jan Szilagyi, In Search of Distress Risk,
63J.Fin. 28992939 (2008).
238 J.M. CHEN
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89. See, e.g., George A. Akerlof & Paul M. Romer, Looting: The Economic
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91. See Meir Statman, Lottery Players/Stock Traders, 58:1 Fin. Analysts J. 1421
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92. See Xiaohui Gao Bakshi & Tse-Chun Lin, Do Individual Investors Treat
Trading as a Fun and Exciting Gambling Activity? Evidence from Repeated
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93. See Bjrn Eraker & Mark J. Ready, Do Investors Overpay for Stocks with
Lottery-Like Payoffs? An Examination of the Returns on OTC Stocks,
115J.Fin. Econ. 486504 (2011).
94. See id.
95. Jay Caspian Kang, The Perfect Predictability of Gambling Movies, N.Y.Times
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96. See generally Nicholas Barberis, A Model of Casino Gambling, 58 Mgmt. Sci.
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99. See id.; cf. Eric Snowberg & Justin Wolfers, Explaining the Favorite-Long Shot
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100. Compare Andrew K. Przybylski, Kou, Murayama, Cody R. DeHaan &
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with John Grable, Ruth Lytton & Barbara ONeill, Projection Bias and
Financial Risk Tolerance, 5J.Behav. Fin. 142147 (2004) (exploring how
projection bias and regret theory may shape individuals tolerance and taste
for financial risk).
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 239
101. See Alok Kumar, Jeremy K. Page & Oliver G. Spalt, Religious Beliefs,
Gambling Attitudes, and Financial Market Outcomes, 102 J. Fin. Econ.
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of Financial Planning and Investing, supra note 158 (Chapter 1), at
135152.
102. Nicholas Barberis, The Psychology of Tail Events: Progress and Challenges, 103
Am. Econ. Rev. 611616, 615 (2013).
103. See generally Nicholas Rescher, Pascals Wager: A Study of Practical
Reasoning in Philosophical Theology (1985).
104. Robert B.Barsky, F.Thomas Juster, Miles S.Kimball & Matthew D.Shapiro,
Preference Parameters and Behavioral Heterogeneity: An Experimental
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550 (1997).
105. Id.
106. Id.
107. See, e.g., Jay R.Ritter, The Long-Run Performance of Initial Public Offerings,
46J.Fin. 327 (1991).
108. See id. at 3.
109. See Tim Loughran & Jay R. Ritter, Why Dont Issuers Get Upset About
Leaving Money on the Table in IPOs?, 15 Rev. Fin. Stud. 413443, 414
(2002).
110. Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance
389 (5th ed. 1996); accord Loughran & Ritter, supra note 109, at 414.
111. Loughran & Ritter, supra note 109, at 414.
112. Id.
113. Id. at 416; see also Alexander Ljungqvist & William J. Wilhelm, Jr., Does
Prospect Theory Explain IPO Market Behavior?, 60J.Fin. 17591790, 1782,
1789 (2005) (concluding that underwriters defer their compensation by
extract higher fees from satisfied IPO participantsissuers and purchasers
alikein future transactions).
114. See Loughran & Ritter, supra note 109, at 416.
115. Id. (citing Richard H.Thaler, Toward a Positive Theory of Consumer Choice,
1J.Econ. Behav. & Org. 3960 (1980)).
116. See Kathleen Weiss Hanley, Underpricing of Initial Public Offerings and the
Partial Adjustment Phenomenon, 34J.Fin. Econ. 231250 (1993); see also
Michel A.Habib & Alexander Ljungqvist, Underpricing and Entrepreneurial
Wealth Losses: Theory and Evidence, 14 Rev. Fin Stud. 433458 (2001).
117. Ritter, supra note 107, at 3. See generally Roger G. Ibbotson, Jody
L.Sindelar & Jay R.Ritter, Initial Public Offerings, 1J.Applied Corp. Fin.
3745 (1988).
118. Ritter, supra note 107, at 3 (emphasis added).
240 J.M. CHEN
119. Id. at 4. See generally Edward M.Miller, Risk, Uncertainty, and Divergence
of Opinion, 32J.Fin. 11511168 (1977); cf. Robert J.Shiller, Speculative
Prices and Population Models, 4J.Econ. Persp. 5565 (1990) (describing
the vulnerability of nave investors to fads).
120. See Reena Aggarwal & Pietra Rivoli, Fads in the Initial Public Offering
Market, 19:4 Fin. Mgmt. 4557 (Winter 1990) (finding negative returns to
investors who buy stock in an IPO and hold it for one year and even more
negative returns to investors who buy stock in early aftermarket trading
immediately after an IPO and hold that stock for one year).
121. See, e.g., Nicholas Barberis, Ming Huang & Tano Santos, Prospect Theory
and Asset Prices, 116 Q.J.Econ. 153 (2001).
122. Barberis & Huang, Stocks as Lotteries, supra note 57, at 2091.
123. See T.Clifton Green & Byoung-Hyoun Hwang, Initial Public Offerings as
Lotteries: Skewness Preference and First-Day Returns, 58 Mgmt. Sci. 43244
(2012).
124. See Jennifer Conrad, Robert F.Dittmar & Eric Ghysels, Ex Ante Skewness
and Expected Stock Returns, 68J.Fin. 85124, 87, 104106 (2013).
125. See Estrada, An Alternative Behavioural Model, supra note 33 (Chapter 3),
at 241; supra 3.2, at 6066.
126. See Alon Brav & Paul A. Gompers, Myth or Reality? The Long-Run
Underperformance of Initial Public Offerings: Evidence from Venture and
Nonventure Capital-Backed Companies, 52J.Fin. 17911821 (1997).
127. See id. at 1791.
128. Id. at 1792.
129. Id.
130. See id. See generally Charles Lee, Andrei Shleifer & Richard H. Thaler,
Investor Sentiment and the Closed-End Fund Puzzle, 46 J. Fin. 2948
(1991).
131. Brav & Gompers, supra note 126, at 1792.
132. See Richard Carter & Steven Manaster, Initial Public Offerings and
Underwriter Reputation, 45J.Fin. 10451067 (1990).
133. See id. at 1046; Randolph P Beatty & Jay R.Ritter, Investment Banking,
Reputation, and the Underpricing of IPOs, 15 J. Fin. Econ. 213232
(1986); Richard B.Carter, Frederick H.Dark & Ajai H.Singh, Underwriter
Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks,
53J.Fin. 285311 (1998); cf. Randolph P.Beatty, Auditor Reputation and
the Pricing of Initial Public Offerings, 64 Accounting Rev. 693709 (1989).
134. See Barberis & Huang, Stocks as Lotteries, supra note 57, at 2068, 2073
2074; Enrico G. de Giorgi, Thorsten Hens & Haim Levy, CAPM Equilibria
with Prospect Theory Preferences (Aug. 30, 2011) (available at http://ssrn.
com/abstract=420184).
135. See Barberis & Huang, Stocks as Lotteries, supra note 57, at 2074, 2096.
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 241
176. Cf., e.g., Javier Estrada & Ana Paula Serra, Risk and Return in Emerging
Markets: Family Matters, 15J.Multinatl Fin. Mgmt. 257272, 259 (2004)
(distinguishing between the traditional family of measures based on the
conventional CAPM and the factor family of measures emphasizing value,
size, and momentum).
177. Zhang, The Value Premium, supra note 4 (Chapter 4), at 67.
178. Fiegenbaum & Thomas, supra note 138, at 99.
179. See generally, e.g., Harvey Leibenstein, Allocative Efficiency vs. X-Efficiency,
56 Am. Econ. Rev. 392415 (1966); George J. Stigler, The Xistence of
X-Efficiency, 66 Am. Econ. Rev. 213216 (1976).
180. Knowledge spillovers within a large firm may be regarded as a special case of
MarshallArrowRomer, or MAR, spillovers among geographically concen-
trated firms within a common industry. See generally, e.g., Edward L.Glaeser,
Hedi D. Kallal, Jos A. Scheinkman & Andrei Shleifer, Growth in Cities,
100J.Pol. Econ. 11261152 (1992); Adam B.Jaffe, Manuel Trajtenberg
& Michael S.Fogarty, Knowledge Spillovers and Patent Citations: Evidence
from a Survey of Inventors, 90 Am. Econ. Rev. 215218 (2000); Alfred
Marshall, Principles of Economics (1890); Kenneth J.Arrow, The Economic
Implications of Learning by Doing, 29 Rev. Econ. Stud. 155173 (1962);
Paul M.Romer, Increasing Returns and Long-Run Growth, 94J.Pol. Econ.
10021037 (1986).
181. See, e.g., Rebecca Henderson & Iain Cockburn, Scale, Scope, and Spillovers:
The Determinants of Research Productivity in Drug Discovery, 27 Rand
J.Econ. 3259 (1996).
182. See, e.g., Allen N. Berger, Gerald A. Hanweck & David B. Humphrey,
Competitive Viability in Banking: Scale, Scope, and Product Mix Economies,
20J.Monet. Econ. 501520 (1987); Jeffrey A.Clark, Economies of Scale
and Scope at Depository Financial Institutions: A Review of the Literature,
Fed. Reserve Bank Kansas City Econ. Rev., Sept./Oct. 1988, at 1633.
183. See, e.g., Elchanan Cohn, Sherrie L.W.Rhine & Maria C.Santos, Institutions
of Higher Education as Multi-Product Firms: Economies of Scale and Scope,
71 Rev. Econ. & Stat. 284290 (1989); Rajinder K.Koshal & Manjulika
Koshal, Economies of Scale and Scope in Higher Education: A Case of
Comprehensive Universities, 18 Econ. Educ. Rev. 269277 (1999).
184. See Jay J.Ebben & Alec C.Johnson, Efficiency, Flexibility, or Both? Evidence
Linking Strategy to Performance in Small Firms, 26 Strat. Mgmt. J. 1249
1259, 12561257 (2005).
185. Fiegenbaum & Thomas, supra note 138, at 99 (citing Ian C.MacMillan &
M.L. McCaffery, Strategy for Low Entry Barrier Markets, 2 J. Bus. Strat.
115119 (1982)).
186. See sources cited supra notes 152155 (Chapter 8).
187. Bowman, Risk/Return Paradox, supra note 20 (Chapter 4), at 27; accord
Fiegenbaum & Thomas, supra note 138, at 99.
244 J.M. CHEN
188. See, e.g., David A.Aaker & Robert Jackobson, The Role of Risk in Explaining
Differences in Profitability, 30 Acad. Mgmt. J. 277296 (1987); David
B. Jemison, Risk and the Relationship Among Strategy, Organizational
Processes, and Performance, 9 Mgmt. Sci. 10871101 (1987); Carolyn
Y. Woo, Path Analysis of the Relationship Between Market Share, Business-
Level Conduct and Risk, 8 Strat. Mgmt. J. 149168 (1987). On method-
ologies for studying managerial strategy within a specific industry, see
generally Inga Skromme Baird & Howard Thomas, Toward a Contingency
Model of Strategic Risk Taking, 10 Acad. Mgmt. Rev. 230243 (1985);
Kathryn R.Harrigan, Research Methodologies for Contingency Approaches to
Business Strategy, 8 Acad. Mgmt. Rev. 398405 (1983).
189. See Luis R.Gmez-Meja, Katalin Takcs Haynes, Manuel Nez-Nickel,
Kathryn J.L.Jacobson & Jos Moyano-Fuentes, Socioemotional Wealth and
Business Risks in Family-Controlled Firms: Evidence from Spanish Olive Oil
Mills, 52 Admin. Sci. Q. 106137 (2007).
190. Id. at 107.
191. Fiegenbaum, supra note 141, at 188.
192. Fiegenbaum & Thomas, supra note 138, at 86. See generally Avi Fiegenbaum
& Howard Thomas, Dynamic and Risk Measurement Perspectives on
Bowmans Risk-Return Paradox for Strategic Management: An Empirical
Study, 7 Strat. Mgmt. J. 395407 (1986).
193. See Bettis & Mahajan, supra note 170; Fiegenbaum, supra note 141, at 188.
In addition, whereas financial data exists solely by virtue of regulatory obli-
gations borne by publicly traded companies, accounting data is available to
and used by regulators, privately held firms, and state-owned enterprises. See
Fiegenbaum, supra note 141, at 188.
194. Fiegenbaum & Thomas, supra note 138, at 100 (emphasis added).
195. Id.
196. Jegers, supra note 165, at 223.
197. Id.; cf. Michael C. Jensen & William H. Meckling, Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership Structure, 3J.Fin. Econ.
305360, 311 (1976) (The firm is not an individual. It is a legal fiction
which serves as a focus for a complex process in which the conflicting objec-
tives of individualsincluding managers and shareholdersare brought
into equilibrium within a framework of contractual relations. [emphasis in
original]).
198. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at 75.
199. Id.
200. Id. at 76.
201. Id.
202. Nicholas Barberis & Ming Huang, The Loss Aversion/Narrow Framing
Approach to the Equity Premium Puzzle, in Handbook of the Equity Risk
Premium 199229, 201 (Rajnish Mehra ed., 2008).
SPECIFIC APPLICATIONS OFPROSPECT THEORY TOBEHAVIORAL FINANCE 245
203. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at 83.
204. Id.
205. Id. at 86.
206. Id. at 87.
207. Id. at 81.
208. Id.
209. Id. at 81 & n.7; see Robert C. Merton, Lifetime Portfolio Selection and
Uncertainty: The Continuous Time Case, 51 Rev. Econ. & Stat. 247257
(1969); Paul A.Samuelson, Lifetime Portfolio Selection by Dynamic Stochastic
Programming, 51 Rev. Econ. & Stat. 238246 (1969).
210. Benartzi & Thaler, Myopic Loss Aversion, supra note 20 (Chapter 2), at 81.
211. See generally, e.g., Turan G.Bali, K.Ozgur Demirtas, Haim Levy & Avner
Wolf, Bonds Versus Stocks: Investors Age and Risk Taking, 56J.Monetary
Econ. 817830 (2009); Anup K.Basu, Alistair Byrne & Michael E.Drew,
Dynamic Lifecycle Strategies for Target Date Retirement Funds,
37:2J.Portfolio Mgmt. 8396 (Winter 2011); John J.Spitzer & Sandeep
Singh, Shortfall Risk of Target-Date Funds During Retirement, 17 Fin.
Servs. Rev. 143153 (2008).
212. See Barberis, Huang & Santos, supra note 121.
213. Id. at 2.
214. Id.
215. Barberis & Huang, Stocks as Lotteries, supra note 117, at 2090 (emphasis in
original). See generally Markus K.Brunnermeier, Christian Gollier & Jonathan
A.Parker, Optimal Beliefs Asset Prices, and the Preference for Skewed Returns,
97 Am. Econ. Rev. 159165 (2007); Markus K.Brunnermeier & Jonathan
A.Parker, Optimal Expectations, 95 Am. Econ. Rev. 10921118 (2005).
216. Barberis & Huang, Stocks as Lotteries, supra note 117, at 2090.
217. See Barberis, Huang & Santos, supra note 121, at 2.
218. Id.
219. Id.
220. Id.
221. Id. at 4; see also id. at 1719 (discussing Thaler & Johnson, supra note 15
(Chapter 2)).
222. Barberis, Huang & Santos, supra note 121, at 4.
223. See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1),
8.18.5, at 155172 (time series); supra 5.1, at 9398 (intertemporal
CAPM).
224. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 287
(citing William H. McGlothlin, Stability of Choices Among Uncertain
Alternatives, 69 Am. J.Psych. 604615 (1956)).
225. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 287.
226. Barberis, Huang & Santos, supra note 121, at 19 (emphases added) (citing
Tversky & Kahneman, The Framing of Decisions and the Psychology of Choice,
supra note 21 (Chapter 2)).
246 J.M. CHEN
227. See Barberis, Huang & Santos, supra note 121, at 19 n.16.
228. Id. at 2.
229. Id.
230. Id. at 23.
231. Id. at 3.
232. Id. at 44.
233. Id. at 4 (emphasis in original).
234. Id.
235. Id.
236. Id. at 48.
237. Id. at 47; accord Michaela Pagel, Expectations Based Reference-Dependent
Preferences and Asset Pricing, J.Eur. Econ. Assn (forthcoming 2015).
238. See Nicholas Barberis & Ming Huang, Mental Accounting, Loss Aversion,
and Individual Stock Returns, 56J.Fin. 12471292, 1255 (2001).
239. Id.
240. Id.
241. Id.
242. See supra 7.8, at 155156.
243. See supra 9.1, at 215216.
244. Barberis & Huang, Individual Stock Returns, supra note 238, at 1255;
accord Gurevich, Kliger & Levy, supra note 124 (Chapter 8), at 1222 & n.5
(confirming narrow framing at the level of individual stocks); see also Klaus
Abbink & Bettina Rockenbach, Option Pricing by Students and Professional
Traders: A Behavioural Investigation, 27 Managerial & Decision Econ.
497510 (2006).
245. Nicholas Barberis, Ming Huang & Richard H. Thaler, Individual
Preferences, Monetary Gambles, and Stock Market Participation: A Case for
Narrow Framing, 96 Am. Econ. Rev. 10691090, 1069 (2006).
246. Id. at 1085. See generally Kahneman, Maps of Bounded Rationality:
Psychology for Behavioral Economics, supra note 2 (Chapter 8); Daniel
Kahneman & Dan Lovallo, Timid Choices and Bold Forecasts: A Cognitive
Perspective on Risk Taking, 39 Mgmt. Sci. 1731 (1993).
247. Kahneman & Tversky, Prospect Theory, supra note 90 (Chapter 6), at 285.
248. Id.
249. Id.
250. Barberis, Huang & Santos, supra note 121, at 17 n.14.
CHAPTER 10
potential.45 The former disposition is risk averse; the latter, risk seeking.
Risk averse people appear to be motivated by a desire for security, whereas
risk seeking people appear to be motivated by a desire for potential. The
former motivation values safety and the latter, opportunity.46 Notably,
these traits represent the two poles, refuge and prospect, in Jay Appletons
pathbreaking analysis of landscape painting as a projection of human aes-
thetics onto the environment.47 Every picture tells a story, either of risk-
averse refuge or of risk-seeking prospect.
Lopess distinction between the risk-averse desire for security and risk-
seeking yearning for potential invites the deployment of a two-parameter
probability weighting function that distinguishes between [d]iscrim-
inability (how people discriminate probabilities in an interval bounded
away from 0 and 1) and [a]ttractiveness (the degree of over/under
weighting).48 If the parameter represents curvature (discriminability)
(in the sense of an individuals responsiveness to changes in the probability
of success) and represents elevation, we can define probability weights
as a function of these parameters:49
d pg
w ( p) =
d pg + (1 - p )
g
Because weighting function w(p) is fixed at both ends in the sense that
w(0)=0 and w(1)=1, the [e]levation and slope of this function can-
not be varied totally independently from each other.57
As between the two dispositions, security motivation (or risk aversion)
is the far more common patternso common that models such as the
ArrowPratt equations treat risk aversion as the pattern for Everyman.58
A pair of maxims about gambling illustrates the contrast between the
risk-averse security motivation and the risk-seeking potential motivation.
American journalist Damon Runyon (18801946) once advised the risk
averse, the race is not always to the swift nor the battle to the strong, but
thats the way to bet.59 For his part, Nkos Dndolos (18831966)bet-
ter known as Nick the Greekcelebrated the [r]isk seekers who dog
the long slots, waiting for that one streak of luck, properly ridden and
encouraged to compensate them for all the bad times.60 For riches
do not fall to the intelligent, nor favor to [people] of skill; but time and
chance happen to them all.61
By contrast, the situational factor describes peoples responses to
immediate needs and opportunities.62 People occasionally act contrary
to their own dispositions: [R]isk seekers may play it safe from time to
time, and even the most risk averse person will take chanceseven big
chanceswhen necessary.63 The aspiration level is a situational variable
that reflects the opportunities at hand (What can I get) as well as the
constraints imposed by the environment (What do I need?).64 In formal
terms, the aspiration criterion assumes that individuals assess the attrac-
tiveness of lotteries by the probability that a given lottery will yield an
outcome at or above the aspiration level, :65
A = p (v a )
of modern portfolio theory.111 Roy was among the first financial w riters
to recognize a difference in financial decision-making that arose from
varying behavioral sensitivities according to the magnitude of a potential
loss: whereas small-scale financial decisions may seek some target rate
of return, larger commitments involve[] the danger of insolvency.112
Most investors perceive a low probability of a large loss to be far more
risky than a high probability of a small loss, even when the expected losses
are the same.113 Although this perception does reject perfect rationality
and other economic assumptions underlying the efficient capital markets
hypothesis, it is more realistic to model financial markets with awareness
of this nearly universal human heuristic.
Properly extracting the foundation of behavioral finance from Roys
safety-first criterion would liberate Roys study [from] the shadow of
Markowitzs contemporaneous work on modern portfolio theory.114 In
the logic of behavioral finance, Roys safety-first criterion may be char-
acterized as the goal of minimizing the probability of ruin.115 Ruin
occurs when w, a variable representing terminal wealth, falls short of
subsistence level s, the probability of which we may formally indicate
as prob{w<s}.116
Roys original safety-first criterion may be treated as a special case based
on certain narrow assumptions, such as the absence of a risk-free security,
a low value for s (achieved by defining s to be less than the expected value
of all possible portfolios), and normally distributed returns.117 Dispensing
with the requirement that s meet any predetermined subsistence level,
let us redefine the goal of the safety-first criterion as that of ensuring that
the probability of remaining above subsistence, prob{w<s}, does not
exceed some probability .118 Optimizing a behaviorally sensitive inves-
tors portfolio would therefore require the maximization of w subject to
the constraint, prob{w<s}.119
One final elaboration of this framework consists of allowing , the
probability of ruin, to vary. This modification takes advantage of Arthur
Roys own modification of d, his disastrous rate of return, as a continu-
ously variable function rather than a constant.120 Should wealth fall below
the subsistence level, utility would fall by some fixed quantity:121
u ( w ) = w prob {w < s} a
u ( w ) = w - c prob {w < s} a
BEYOND HOPE ANDFEAR: BEHAVIORAL PORTFOLIO THEORY 257
All of these models define financial danger as the possibility that wealth
might fall below a particular minimum level.122
Safetyfirst:u(E (w),)
SP/A: u[Eh (w),D (A)]
security) and the strength of hope (the need for potential) are equal and
therefore neutralize each other.153
In practical terms, the contrast between conventional portfolio theory
and SP/A theory parallels the contrast between the two leading schools
of retirement planning.154 Conventional, probability-based approaches to
retirement income management aspire to determine a safe withdrawal
rate, in the sense of a rate of consumption that gives retirees a comfort-
ably high probability of not exhausting their resources before death.155
Probability-based retirement planning supplies the rule of thumb that
retirees may safely withdraw 4% of their portfolios per year.156 That bench-
mark has come under attack.157 SP/A theory and related work in behav-
ioral finance (especially life cycle theories of savings and consumption)
inform a competing safety-first school of retirement planning.158
At a (much) higher level of theoretical abstraction, portfolio optimi-
zation under SP/A theory closely resembles conventional mean-variance
optimization. Just as investors prefer higher mean return with lower vari-
ance, they prefer a higher decumulative expected return and a lower prob-
ability of failure to attain their aspiration level.159 SP/A theorys analogue
to modern portfolio theorys {, } space may therefore be defined as
{Eh(w), prob(wA)}, the space within which Eh(w) is maximized for a
given value of prob(wA).160 In other respects, however, SP/A theory
transcends modern portfolio theory. SP/A theorys multidimensional
treatment of risk stands in stark contrast with the reliance of modern port-
folio theory and expected value theory on risk tolerance as a single, free-
standing risk parameter.161 SP/A theory uses five parameters to describe
different dimensions of behavioral portfolio theory:
-VaR
e= f ( x ) dx
-
For the investor with a $1 million position in an S&P 500 Index fund,
= 10.01, or 0.99. f(x) refers to the probability density functionin this
case, of the distribution of returns on the S&P 500 Index fund. VaR may
also be defined as the greatest lower bound (infimum) on the cumulative
distribution function F of any financial position Y, expressed as a real-
valued, random variable:239
z p = F -1 ( p ) = 2 erf -1 ( 2 p - 1)
VaR = - z p s v
VaR = -F -1 (a ) s v
H = m v - F -1 (a ) s v
H = v m - F -1 (a ) s
Notes
1. See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1).
2. See, e.g., Tore Ellingsen, Cardinal Utility: A History of Hedonimetry, in
Cardinalism: A Fundamental Approach 105165 (Maurice Allais &
Ole Hagen eds., 1994); Hagen, supra note 24 (Chapter 3); Ole
270 J.M. CHEN
73. See Robert Frock, Changing How the World Does Business: FedExs
Incredible Journey to Success The Inside Story 101 (2006) (quoting
founder Fred Smith: What difference does it make? Without the funds
for the fuel companies, we could not have flown anyway.).
74. See, e.g., Bowman, Risk/Return Paradox, supra note 20 (Chapter 4);
Bowman, Risk Seeking by Troubled Firms, supra note 21 (Chapter 4);
Andersen, Denrell & Bettis, supra note 35 (Chapter 4).
75. See supra 8.8, at 203207. See generally Lopes & Oden, supra note 55
(Chapter 2).
76. Lopes, Between Hope and Fear, supra note 4 (Chapter 1), at 284; see also
Sandra L. Schneider & Lola L. Lopes, Reflection in Preferences Under
Risk: Who and When May Suggest Why, 12J.Experimental Psych. 533
548 (1986).
77. Lopes, Between Hope and Fear, supra note 4 (Chapter 1), at 275.
78. Id. at 279.
79. See Thomas C.Schelling, Self-Command in Practice, in Policy, and in a
Theory of Rational Choice, 74 Am. Econ. Rev. 111 (1984).
80. William Faulkner, Acceptance, in Nobel Lectures, Literature 19011967,
at 444445, 444 (Horst Frenz ed., 1969).
81. Lopes, Between Hope and Fear, supra note 4 (Chapter 1), at 279.
82. Id.
83. Id. at 280.
84. Id.
85. Id. at 281; see also id. at 285.
86. Id. at 282.
87. Id.
88. Id.
89. Id. at 283.
90. Id. at 283284.
91. Id. at 284; see also id. at 286 (observing that risk-averse and risk-seeking
people are basically doing the same thing, but their values differ at least
on the security/potential factor, and probably on aspiration level as
well).
92. Marc Oliver Rieger, SP/A and Cumulative Prospect Theory: A
Reconciliation of Two Behavioral Decision Theories, 108 Econ. Letters
327329, 327 (2010).
93. Hersh Shefrin, A Behavioral Approach to Asset Pricing 429 (2d ed.
2008).
94. Id.
95. Id.
96. Lopes & Oden, supra note 55 (Chapter 2), at 310.
97. Rieger, supra note 92, at 327.
98. Lopes & Oden, supra note 55 (Chapter 2), at 310.
274 J.M. CHEN
99. Id. at 311. See generally Charles F. Manski, Ordinal Utility Models of
Decision Making Under Uncertainty, 25 Theory & Decision 79104
(1988).
100. Shefrin, supra note 93 (Chapter 1), at 429.
101. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 127.
102. Id. at 131.
103. Id.
104. Id.
105. Id.
106. Lopes & Oden, supra note 55 (Chapter 2), at 310.
107. See Arthur D.Roy, Safety First and the Holding of Assets, 20 Econometrica
431449 (1952). See generally Chen, Postmodern Portfolio Theory,
supra note 1 (Chapter 1), 4.2.
108. See Roy, Safety First, supra note 107 (Chapter 1), at 433.
109. See Arthur D. Roy, Risk and Rank in Safety-First Generalized, 23
Economica 214228 (1956). See generally Haim Levy & Marshall Sarnat,
Safety FirstAn Expected Utility Principle, 7J.Fin. & Quant. Analysis
18291834 (1972); David H.Pyle & Stephen J.Turnowsky, Safety-First
and Expected Utility Maximization in Mean-Standard Deviation Portfolio
Analysis, 52 Rev. Econ. & Stat. 7581 (1970).
110. Roy, Safety First, supra note 107 (Chapter 1), at 433; accord Levy, The
CAPM Is Alive and Well, supra note 10 (Chapter 3), at 45 n.1.
111. Harry M. Markowitz, Mean-Variance Analysis in Portfolio Choice and
Capital Markets 37 (1987). The other paper was Harry M.Markowitz,
Foundations of Portfolio Theory, 46 J. Fin. 469477 (1991). Other
sources trace the origins of portfolio selection to Helen Makower &
Jacob Marschak, Assets, Prices and Monetary Theory, 5 Economica 261
288 (1938) and Jacob Marschak, Money and the Theory of Assets, 6
Econometrica 311325 (1938). See Justin Fox, The Myth of the Rational
Market: A History of Risk, Reward, and Delusion on Wall Street 347
(2009).
112. James C.T. Mao, Survey of Capital Budgeting: Theory and Practice,
25J.Fin. 349360, 354 (1970).
113. Balzer, supra note 47 (Chapter 3), at 115.
114. V.I.Norkin & S.V.Boyko, Safety-First Portfolio Selection, 48 Cybernetics
& Sys. Analysis 180191, 180 (2012).
115. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 130.
116. Id.
117. See id.
118. See Shinji Kataoka, A Stochastic Programming Model, 31 Econometrica
181196 (1963).
BEYOND HOPE ANDFEAR: BEHAVIORAL PORTFOLIO THEORY 275
119. See Leslie G.Telser, Safety-First and Hedging, 23 Rev. Fin. Stud. 116
(1955).
120. See Roy, Risk and Rank, supra note 109 (Chapter 1).
121. See Enrique R.Arzac & Vijay S.Bawa, Portfolio Choice and Equilibrium
in Capital Markets with Safety-First Investors, 4J.Fin. Econ. 277288
(1977).
122. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 131.
123. See, e.g., Yuanyao Ding & Bo Zhang, Optimal Portfolio of Safety-First
Models, 139 J. Stat. Planning & Inference 29522962 (2009); Jos
Encarnacin, Jr., Portfolio Choice and Risk, 16J.Econ. Behav. & Org.
347353 (1991); Haim Levy & Moshe Levy, The Safety First Expected
Utility Model: Experimental Evidence and Economic Implications,
33 J. Banking & Fin. 14941506 (2009) (proposing an optimization
approach that uses the weighted average of expected utility and a safety-
first maximization of utility).
124. See D.Li, T.F.Chan & W.L.Ng, Safety-First Dynamic Portfolio Selection,
4 Dynamics Continuous, Discrete & Impulsive Sys. 585600 (1998);
Wei Yan, Continuous-Time Safety-First Portfolio Selection with Jump-
Diffusion Processes, 43 IntlJ.Sys. Sci. 622628 (2012).
125. See Dennis W.Jansen, Kees G.Koedijk & Casper G. de Vries, Portfolio
Selection with Limited Downside Risk, 7 J. Empirical Fin. 247269
(2000).
126. See Mahfuzul Haque, M. Kabir Hassan & Oscar Varela, Safety-First
Portfolio Optimization for U.S.Investors in Emerging Global, Asian and
Latin American Markets, 12 Pac. Basin Fin. J. 91116 (2004); Mahfuzul
Haque, Oscar Varela & M.Kabir Hassan, Safety-First and Extreme Value
Bilateral U.S.-Mexican Portfolio Optimization Around the Peso Crisis and
NAFTA in 1994, 47 Q.Rev. Econ. & Fin. 449469 (2007).
127. See Shefrin & Statman, Behavioral Portfolio Theory, supra note 24
(Chapter 2), at 131132.
128. Id. at 131.
129. See id. at 132.
130. Id.
131. Lopes & Oden, supra note 55 (Chapter 2), at 291. See generally Gregg
C.Oden & Lola L.Lopes, Risky Choice with Fuzzy Criteria, in Qualitative
Aspects of Decision Making 5682 (Roland W.Scholz & Alf C.Zimmer
eds., 1997).
132. Rieger, supra note 92 (Chapter 1), at 328.
133. Lopes & Oden, supra note 55 (Chapter 2), at 291.
134. Id.
135. Id.
136. Id.
276 J.M. CHEN
137. Id.
138. Rieger, supra note 92 (Chapter 1), at 327.
139. See, e.g., Antoni Bosch-Domnech & Joaquim Silvestre, Reflection on
Gains and Losses: A 227 Experiment, 33J.Risk & Uncertainty 217
235 (2006).
140. See generally Thorsten Hens & Marc Oliver Rieger, Financial
Economics A Concise Introduction to Classical and Behavioral
Finance 7580 (2010).
141. Lopes & Oden, supra note 55 (Chapter 2), at 291.
142. Id.
143. Id.
144. Jos Encarnacin, Portfolio Choice and Risk, 16J.Econ. Behav. & Org.
347353, 352 (1991).
145. Lopes & Oden, supra note 55 (Chapter 2), at 291.
146. Id. See generally Lola Lopes, Algebra and Process in the Modeling of Risky
Choice, in 32 Decision Making from a Cognitive Perspective 177220
(Jerome Busemeyer, Reid Hastie & Douglas L.Medin eds., 1995).
147. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 132.
148. Id.
149. Id.
150. Id.
151. Id.
152. Id.
153. See id.
154. See generally Wade D. Pfau & Jeremy Cooper, The Yin and Yang of
Retirement Income Philosophies (Nov. 10, 2014) (available at http://ssrn.
com/abstract=2548114).
155. See Philip L. Cooley, Carl M. Hubbard & Daniel T. Walz, Retirement
Savings: Choosing a Withdrawal Rate That Is Sustainable, 20:2 Am. Assn
Indiv. Investors J. 1621 (Feb. 1998). Because these authors taught
finance at Trinity University of Texas, this article is known as the Trinity
study. See also Philip L.Cooley, Carl M.Hubbard & Daniel T.Walz,
Portfolio Success Rates: Where to Draw the Line, 24:4 J. Fin. Planning
4860 (April 2011).
156. See William P.Bengen, Determining Withdrawal Rates Using Historical
Data, 7:4J.Fin. Planning 171180 (Oct. 1994); cf. sources cited supra
notes 3031 (Chapter 5) (describing sequence-of-returns risk, which
may undermine assumptions about safe withdrawal rates).
157. See, e.g., Wade D.Pfau, An International Perspective on Safe Withdrawal
Rates from Retirement Savings: The Demise of the 4 Percent Rule,
23:12 J. Fin. Planning 5261 (Dec. 2010); Jason S. Scott, William
F.Sharpe & John G.Watson, The 4% Rule At What Price? (April 2008)
BEYOND HOPE ANDFEAR: BEHAVIORAL PORTFOLIO THEORY 277
(available at http://www.stanford.edu/~wfsharpe/retecon/4percent.
pdf and http://ssrn.com/abstract=1115023) (decrying the 4% rule, the
advice most often given to retirees for managing spending and investing,
for prescribing a constant, non-volatile spending plan according to a
risky, volatile investment strategy that leads retirees to accumulate
unspent surpluses when markets outperform and to face spending
shortfalls when markets underperform).
158. See, e.g., Zvi Bodie, On the Risks of Stocks in the Long Run, 51:3 Fin.
Analysts J. 1822 (May/June 1995); Jason K. Branning & M. Ray
Grubbs, Using a Hierarchy of Funds to Reach Client Goals, 23:12J.Fin.
Planning 3133 (Dec. 2010).
159. See Shefrin & Statman, Behavioral Portfolio Theory, supra note 24
(Chapter 2), at 132.
160. See id.
161. See id. at 137.
162. Id.
163. See generally, e.g., Hirotugu Akaike, Information Theory and an Extension
of the Maximum Likelihood Principle, in Second International Symposium
on Information Theory 267281 (B.N.Petrov & F.Cski eds., 1973);
Hirotugu Akaike, A New Look at the Statistical Model Identification, 19
IEEE Transactions on Auto. Control 716723 (1974); Wei Pan, Akaikes
Information Criterion in Generalized Estimating Equations, 57
Biometrics 120125 (2001).
164. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 128.
165. See Das, Markowitz, Scheid & Statman, supra note 42 (Chapter 2), at
314.
166. Id.
167. See id. at 332 n.10; Alexandre M.Baptista, Optimal Delegated Portfolio
Management with Background Risk, 32 J. Banking & Fin. 977985
(2008).
168. See Shefrin & Statman, Behavioral Portfolio Theory, supra note 24
(Chapter 2), at 128, 135.
169. See id. at 135. See generally sources cited supra notes 1518 (Chapter 5)
(describing the separation theorem).
170. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 128.
171. Id.
172. Id. at 139.
173. See id. at 142. See generally, e.g., John B.Shoven & Clemens Sialm, Asset
Location in Tax-Deferred and Conventional Savings Accounts, 88J.Pub.
Econ. 2338 (2004); Edward A. Zelinsky, The Defined Contribution
Paradigm, 114 Yale L.J. 451534 (2004).
278 J.M. CHEN
supra note 35 (Chapter 2), at 213230; Lopes, Between Hope and Fear,
supra note 4 (Chapter 1), at 287.
199. Sutti Ortiz, The Effect of Risk Aversion Strategies on Subsistence and Cash
Crop Decisions, in Risk, Uncertainty, and Agricultural Development,
supra note 35 (Chapter 2), at 231246, 235; accord Lopes, Between Hope
and Fear, supra note 4 (Chapter 1), at 287.
200. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 137 (emphasis in original).
201. Quazi Shahabuddin, Farmers Crop Growing Decisions Under
Uncertainty A Safety-First Approach, 10 Bangladesh Dev. Stud.
95100, 95 (1982).
202. See generally Victor A.B.Davies, Sierra Leone: Ironic Tragedy, 9J.African
Econs. 349369 (2000); Victor A.B. Davies, Sierra Leones Economic
Growth Performance, 19612000, in 2 The Political Economy of
Economic Growth in Africa, 19602000: Country Case Studies 660
696 (Benno J.Ndulu etal. eds., 2008).
203. Victor A.B.Davies, Alluvial Diamonds: A New Resource Curse Theory 3
(Feb. 2009) (available at http://www.csae.ox.ac.uk/conferences/2009-
EDiA/papers/128-Davies.pdf).
204. Id. See generally Akerlof & Romer, supra note 89 (Chapter 9); White,
supra note 89 (Chapter 9).
205. See, e.g., Roy Maconachie & Tony Binns, Beyond the Resource Curse?
Diamond Mining, Development and Post-Conflict Reconstruction in
Sierra Leone, 32 Resources Poly 104115 (2007).
206. Shefrin & Statman, Behavioral Portfolio Theory, supra note 24 (Chapter
2), at 141.
207. Id.
208. Id. at 145.
209. Id.
210. Id.
211. See id. at 128, 135.
212. Das, Markowitz, Scheid & Statman, supra note 42 (Chapter 2), at 315
(citing William F. Sharpe, Gordon J. Alexander & Jeffrey V. Bailey,
Investments 194 (6th ed. 1999)).
213. Das, Markowitz, Scheid & Statman, supra note 42 (Chapter 2), at 315
(citing Jean L.P.Brunel, How Suboptimal If at All Is Goal-Based
Asset Allocation?, 9:2 J. Wealth Mgmt. 1934 (Fall 2006)); cf.
E.Ballestero, M.Gnther, D.Pla-Santamaria & C.Stummer, Portfolio
Selection Under Strict Uncertainty: A Multi-Criteria Methodology and Its
Application to the Frankfurt and Vienna Stock Exchanges, 181 Eur.
J.Oper. Research 14761487, 1477 (2007) (applying compromise pro-
gramming model[s] such as those described by E. Ballestero &
C. Romero, Portfolio Selection: A Compromise Programming Solution,
280 J.M. CHEN
Economic losses from trading by individual investors are not trivial. One
study, focusing exclusively on Taiwan from 1995 to 1999, estimated that
individual investors aggregate losses in the worlds 12th largest financial
market stripped an annual 3.8% in annual return, roughly equivalent to
2.8% of total personal income and a staggering 2.2% of the countrys gross
domestic product.6
The benchmark for investor returns depends on the financial instru-
ment being traded. For trading in individual stocks, one plausible bench-
mark is whether investor returns on brokerage accounts, net of trading
costs, can match a passive index.7 For mutual funds, where differences in
investor preferences are reflected in choices within a galaxy of passively
and actively managed funds,8 close examination of net inflows and out-
flows should reveal whether fund investors are realizing the same return
as a hypothetical buy-and-hold investment in the fund, or whether behav-
iorally motivated decisions to buy and redeem fund shares affect realized
investor returns. This chapter will focus on the latter question. In focusing
on mutual funds, I remain mindful of evidence that individual investors are
likelier to treat winning and losing stocks, as a class, differently from the
way they treat winning and losing mutual funds.9 The difference between
asymmetrical treatment of stocks and asymmetrical treatment of mutual
funds suggest[s] that households motive for mutual funds investment is
different from individual stocks investment.10
Persistent gaps between actual investor returns and hypothetical invest-
ment returns expose a deep flaw in portfolio theorys mechanical reliance
on simple mean-variance optimization. The financial services industry, or
at least the financial academy, should devise and deploy sophisticated mea-
sures of the impact of investor behavior on portfolio-wide performance.
This chapter will formalize the definition of the behaviorally driven inves-
tor gap. After surveying the literature exploring gaps between hypotheti-
cal investment returns and the actual financial performance attained by
real-life investors, this chapter defines a statistic that it will call , which
quantifies this performance gap.
The disposition effect is quite subtle and may not be dismissed merely as
the artifact of an irrational belief that security prices will eventually, inevi-
tably revert to the mean.12
The disposition effect appears to have some relationship to prospect
theory, even if the connection is rather complex. It is crucial to define
prospect theorys contribution to the disposition effect according to an
assumption that investors distinguish between paper and realized gains.13
The more straightforward application of portfolio theory to annual gains
and losses does not predict the disposition effect.14 Notably, even though
the disposition effect is consistent with prospect theory ex postin other
words, differential treatment of winning and losing stocks by an investor,
once it has occurred, would be predicted by prospect theoryit must be
acknowledged that prospect theory cannot explain how investors who sell
winners and hold losers came to buy stocks in the first place.15
The disposition effect does arise to some degree from prospect theorys
S-shaped utility function, insofar as an investor realizing gains is risk
averse and therefore unwilling to gamble about future uncertain gains,
while risk seeking in the domain of losses will spur an investor to gamble
and postpone realizing losses.16 This purely static argument, however,
consider[s] only a single sale and takes no account of any effects of
reinvestment.17 In the dynamic context of sequential purchases and
sales of stock, prospect theorys sigmoid value function actually serves
to reduce the disposition effect.18 The very act of realizing a loss resets
the reference point for future possible gains.19 The potential to offset
the direct disutility of [a] loss transforms the realization of a loss into
some sort of valuable option.20 Such intertemporal realization util-
ity therefore explains why investors realize any voluntary losses at all,
rather than none.21
Among other consequences of the disposition effect, the tendency to
sell winners and hold losers biases the results of any analysis of the inter-
nal rate of return on round-trip trades toward positive performance.22
The work of Brad Barber and Terrance Odean sharpened the focus on the
mostly negative contribution of investor behavior to actual investment
returns.23 In their review of 66,465 accounts at a discount retail broker-
age from 1991 through 1996, Barber and Odean found a significant
underperformance of 15 to 31 basis points per month, equivalent to 1.8
percent to 3.7 percent per year.24 The disposition effect also emerges
in real estate markets, where powerful emotions associated with homes
make owners extremely reluctant to sell at a loss, relative to their original
purchase price.25
286 J.M. CHEN
[O]n average, retail investors direct their money to funds which invest in
stocks that have low future returns. To achieve high returns, it is best to do
the oppose of those investors. [M]utual fund investors experience total
returns that are significantly lower due to their reallocations. Therefore,
mutual fund investors are dumb in the sense that their reallocations
reduce their wealth on average. We call this predictability the dumb
money effect.52
rt ( k ) = ln (1 + Rt ) + ln (1 + Rt -1 ) + + ln (1 + Rt - k +1 )
rt ( k ) = rt + rt -1 + + rt - k +1
vk
rt ( k ) = k -1
v0
ct = vt - vt -1 (1 + rt )
The computation of rt(k), the buy-and-hold return for the fund over k
periods, and the sequence of periodic net cash flows enables the computa-
tion of an internal rate of return based on the initial NAV of the fund and
the cash flow sequence for periods 1 to k. Investor return is given by the
internal rate of return, ri, in the following formula for zero net present
value (NPV):70
k cj
NPV = =0
(1 + ri )
n
j =0
rj - rj -1
rj +1 = rj - NPV j
NPVn - NPVn -1
ri = IRR -v0 , c1 , c2 , , cn -1 , cn - vn ; rt ( k )
T
vT = v0 (1 + ri ) + ct (1 + ri )
T T -t
t =1
T
vT ct
= v0 +
(1 + ri ) (1 + ri )
T T
t =1
ct = vt - vt -1 (1 + rt ) - dt bt
292 J.M. CHEN
The final NAV may be expressed as the sum of the compounded value
of the initial NAV, the sum of all net cash flows over the relevant inter-
val, and the sum of all distributions, net of reinvestment, over the same
interval:
k k
vk = v0 (1 + ri ) + ct (1 + ri ) + dt bt
k k -t
t =1 t =1
y = rt ( k ) - ri
only blunts the utility from the immediate realization of gains, but also
postpones the harvesting of losses by reducing the value of gains relative
to the reference point that would be reset by a realization event.80
In fairness, there is evidence of tax-minimizing loss harvesting,81 con-
sistent with standard financial advice to recoup some investment losses
through the tax codes favorable treatment of capital losses.82 Even the
January effect, an otherwise annoying calendar anomaly, appears to
be an artifact of different countries tax systems and conscious efforts
by investors to minimize their tax exposure.83 Every so often, rationality
does claim a victory, however modest, over cognitive bias and behavioral
heuristics.
Notes
1. Warren Bailey, Alok Kumar & David Ng, Behavioral Biases of Mutual Fund
Investors, 102J.Fin. Econ. 127, 3 (2011).
2. Id.
3. See id.
4. See id.
5. Id.
6. See Brad M.Barber, Yi-Tsung Lee, Yu-Jane Liu & Terrance Odean, Just
How Much Do Individual Investors Lose by Trading?, 53 Rev. Fin. Stud.
609632, 610611 (2009).
7. See Gary E.Schlarbaum, Wilbur G.Lewellen & Ronald C.Lease, Realized
Returns on Common Stock Investments: The Experience of Individual
Investors, 51J.Bus. 299325, 300 (1978).
8. See Ronald T. Wilcox, Bargain Hunting or Star Gazing? Investors
Preferences for Stock Mutual Funds, 76J.Bus. 645663 (2003).
9. See Laurent E.Calvet, John Y.Campbell & Paolo Sodini, Fight or Flight?
Portfolio Rebalancing by Individual Investors, 124 Q.J. Econ. 301348,
334, 342, 346 (2009).
10. Ingersoll & Jin, supra note 51 (Chapter 8), at 753 n.42.
11. See Hersh Shefrin & Meir Statman, The Disposition to Sell Winners Too
Early and Ride Losers Too Long: Theory and Evidence, 40J.Fin. 777782
(1985); see also, e.g., Calvet, Campbell & Sodini, supra note 9; Andrea
Frazzini, The Disposition Effect and Underreaction to News, 61 J. Fin.
21172144 (2006); Hyun-Jung Lee, Jongwon Park, Jin- Yong Lee &
Robert S. Wyer, Disposition Effects and Underlying Mechanisms in
E-Trading of Stocks, 45J.Marketing Research 362378 (2008).
12. See Barberis & Xiong, Realization Utility, supra note 51 (Chapter 8), at
263; Markku Kaustia, Prospect Theory and the Disposition Effect, 45J.Fin.
294 J.M. CHEN
& Quant. Analysis 791812 (2010); Martin Weber & Colin F.Camerer,
The Disposition Effect in Securities Trading: An Experimental Analysis,
33J.Econ. Behav. & Org. 167184 (1998).
13. Nicholas Barberis & Wei Xiong, What Drives the Disposition Effect? An
Analysis of a Long-Standing Preference-Based Explanation, 64J.Fin. 751
784, 753 (2009). See generally Barberis & Xiong, Realization Utility,
supra note 51 (Chapter 8).
14. Barberis & Xiong, Disposition Effect, supra note 13, at 753 (emphasis
added). See generally id. at 76570.
15. See Thorsten Hens & Martin Vlcek, Does Prospect Theory Explain the
Disposition Effect?, 12J.Behav. Fin. 141157 (2006).
16. Ingersoll & Jin, supra note 51 (Chapter 8), at 731.
17. Id.
18. Id. at 732.
19. Id.
20. Id.
21. Id. at 733.
22. Barber & Odean, The Behavior of Individual Investors, supra note 197
(Chapter 7), at 1535 n.1.
23. See Terrance Odean, Are Investors Reluctant to Realize Their Losses?,
53 J. Fin. 17751798 (1998); Terrance Odean, Do Investors Trade Too
Much? 89 Am. Econ. Rev. 12791298 (1999).
24. Brad M.Barber & Terrance Odean, Trading Is Hazardous to Your Wealth:
The Common Stock Investment Performance of Individual Investors,
40J.Fin. 773806, 789 (2000).
25. See David Genesove & Christopher Mayer, Loss Aversion and Seller
Behavior: Evidence from the Housing Market, 116 Q.J.Econ. 12331260
(2001).
26. Cf. Abdellaoui, Bleichrodt & Kammoun, supra note 136 (Chapter 9);
Ravi Dhar & Ning Zhu, Up Close and Personal: Investor Sophistication and
the Disposition Effect, 52 Mgmt. Sci. 726740 (2006).
27. See George J. Jiang, Tong Yao & Tong Yu, Do Mutual Funds Time the
Market? Evidence from Portfolio Holdings, 86 J. Fin. Econ. 724758
(2007).
28. See id. at 727, 744, 750. See generally Marcin Kacperczyk, Clemens Sialm
& Lu Zheng, On the Industry Concentration of Actively Managed Equity
Mutual Funds, 60J.Fin. 19832011 (2005) (devising an industry con-
centration index).
29. See generally, e.g., Bruno Solnik & Dennis McLeavey, Global Performance
Evaluation, in International Investments 469526 (6th ed. 2008); Jeffrey
V.Bailey, Thomas M.Richards & David E.Tierney, Evaluating Portfolio
Performance, in Managing Investment Portfolios: A Dynamic Process
BEHAVIORAL GAPS BETWEEN HYPOTHETICAL INVESTMENT RETURNS... 295
39. Barber & Odean, The Behavior of Individual Investors, supra note 197
(Chapter 7), at 1539.
40. Id.
41. See DALBAR, Inc., Research & Communications Division, Quantitative
Analysis of Investor Behavior: Volatility Unchecked (March 2012) (described
at http://www.qaib.com/public/about.aspx; previewed at http://www.
qaib.com/public/downloadfile.aspx?filePath=freelook&fileName=fulledit
ionfreelook.pdf).
42. See Morningstar Investor Return: Morningstar Methodology Paper (Aug.
31, 2010) (available at http://corporate.morningstar.com/us/docu-
ments/MethodologyDocuments/MethodologyPapers/
InvestorReturnMethodology.pdf); Fact Sheet: Morningstar Investor
Return (2006) (available at http://corporate.morningstar.com/US/
documents/MethodologyDocuments/FactSheets/InvestorReturns.pdf).
Morningstars most recent Investor Return report, Russel Kinnel, Mind
the Gap 2015 (Aug. 11, 2015), is available at http://news.morningstar.
com/articlenet/article.aspx?id=710248.
43. See Geoffrey C. Friesen & Travis R.A. Sapp, Mutual Fund Flows and
Investor Returns: An Empirical Examination of Fund Investor Timing
Ability, 31J.Banking & Fin. 27962816 (2007).
44. See Ilia D. Dichev, What Are Stock Investors Actual Historical Returns?
Evidence from Dollar-Weighted Returns, 97 Am. Econ. Rev. 386401
(2007).
45. Friesen & Sapp, supra note 43, at 2802.
46. See Oded Braverman, Shmuel Kandel & Avi Wohl, The (Bad?) Timing of
Mutual Fund Investors? 8 (Aug. 2005) (available at http://www.econ-pol.
unisi.it/labsi/papers2006/Kandel.pdf).
47. See Rajeeva Sinha & Vijay Jog, Fund Flows and Performance: A Study of
Canadian Equity Funds (2004) (available at http://economics.ca/2005/
papers/0387.pdf and http://www.centerforpbbefr.rutgers.edu/2005/
Paper%202005/PBFEA85.pdf).
48. See Andrew Clare & Nick Motson, Do UK Retail Investors Buy at the Top
and Sell at the Bottom? (Sept. 2010) (available at http://www.cass.city.
ac.uk/__data/assets/pdf_file/0003/69933/Do-UK-retail-investors-
buy-at-the-top-and-sell-at-the-bottom.pdf).
49. See Ilia D.Dichev & Gwen Yu, Higher Risk, Lower Returns: What Hedge
Fund Investors Really Earn, 100J.Fin. Econ. 248263 (2011).
50. See Mercer Bullard, Geoff Friesen & Travis Sapp, Investor Timing and
Fund Distribution Channels (2007) (available at http://funddemocracy.
com/Investor%20Timing%20final%20final&2012.4.07.pdf).
51. Id. See generally Erik R.Sirri & Peter Tufano, Costly Search and Mutual
Fund Flows, 53J.Fin. 15891622 (1998) (identifying search costs as the
BEHAVIORAL GAPS BETWEEN HYPOTHETICAL INVESTMENT RETURNS... 297
as well as stock, see generally John Morley, The Regulation of Mutual Fund
Debt, 30 Yale J. on Reg. 343376 (2013). In 2008, the SEC proposed
rules for exchange-traded funds (ETFs), whose shares may be traded
throughout the trading day, but those rules have not been codified. See
Exchange-Traded Funds, 73 Fed. Reg. 14,618, 14,65558 (March 18,
2008). See generally David Herzig, Exchange Funds: A Proposal for
Regulations, Finally, 135 Tax Notes 865 (2012).
65. 17 C.F.R. 270.22c-1(a).
66. See 17 C.F.R. 270.22c-1(b)(1).
67. 15 U.S.C. 80a-22(e).
68. Campbell, Lo & MacKinlay, supra note 5 (Chapter 1), at 11.
69. Id.
70. See https://en.wikipedia.org/wiki/Internal_rate_of_return.
71. See id.; https://en.wikipedia.org/wiki/Secant_method.
72. See James Matthew Moten, Jr. & Chris Thron, Improvements on Secant
Method for Estimating Internal Rate of Return, 42 Intl J.Applied Math.
& Stat. 8493 (2013).
73. See Friesen & Sapp, supra note 43, at 2801.
74. See Dichev & Yu, supra note 44, at 251.
75. Barber & Odean, The Behavior of Individual Investors, supra note 197
(Chapter 7), at 1539.
76. See Barber & Odean, Trading Is Hazardous to Your Wealth, supra note 24,
at 781. Other estimates of the average holding period for stocks in the
USA range from one year, see Levy, CAPM in the 21st Century, supra note
41 (Chapter 1), at 224226; Benartzi & Thaler, Myopic Loss Aversion,
supra note 20 (Chapter 2), at 83 (reaching, more precisely, an equilib-
rium evaluation period of roughly thirteen months for nominal
returns and a period between ten and eleven months for real returns),
to two or three years, see Allen B.Atkins & Edward A.Dyl, Transaction
Costs and the Holding Periods for Common Stocks, 52 J. Fin. 309325
(1997) (concluding that holding periods vary in response to the size of
bid-ask spreads on a stock exchange).
77. Barber & Odean, The Behavior of Individual Investors, supra note 197
(Chapter 7), at 1539.
78. See I.R.C. 1(h) (specifying maximum statutory federal income tax rates
on capital gains); id. 1001(c) (providing for recognition in full of all capi-
tal gains or losses unless otherwise provided); id. 1222 (defining terms
such as net short-term capital loss, net long-term capital gain, and
net capital gain); id. 1211 (generally limiting the deduction for capital
losses in any taxable year to $3000). The full mechanics of the income tax
treatment of capital gains and losses are specified at I.R.C. 10011288.
For discussions of the policies underlying preferential tax treatment of
BEHAVIORAL GAPS BETWEEN HYPOTHETICAL INVESTMENT RETURNS... 299
capital gains and the distinct case for limitations on the deductibility of
capital losses, see Nol B.Cunningham & Deborah H.Schenk, The Case
for a Capital Gains Preference, 48 Tax L.Rev. 319380 (1993); Robert
H. Scarborough, Risk, Diversification and the Design of Loss Limitations
Under a Realization-Based Income Tax, 48 Tax L.Rev. 677717 (1993).
79. See Ingersoll & Jin, supra note 51 (Chapter 8), at 752.
80. See id.
81. See S.G. Badrinath & Wilbur G. Lewellen, Evidence on Tax-Motivated
Securities Trading Behavior, 46J.Fin. 369382 (1991) (reporting some
evidence of tax-loss harvesting); Brad M.Barber & Terrance Odean, Are
Individual Investors Tax Savvy? Evidence from Retail and Discount
Brokerage Accounts, 88J.Pub. Econ. 419442 (2004) (finding, consistent
with tax-based considerations, that investors do sell losing stocks in taxable
accounts in December, but not in tax-deferred accounts); Zoran Ivkovi,
James M. Poterba & Scott Weisbenner, Tax-Motivated Trading by
Individual Investors, 95 Am. Econ. Rev. 16051630 (2005) (finding
meaningful differences between taxable and tax-sheltered brokerage
accounts throughout the year); Josef Lakonishok & Seymour Smidt,
Volume for Winners and Losers: Taxation and Other Motives for Trading,
41 J. Fin. 951974 (1986) (finding limited evidence of tax-motivated
trading in December and January).
82. See George M.Constantinides, Optimal Stock Trading with Personal Taxes:
Implication for Prices and the Abnormal January Returns, 13J.Fin. Econ.
6589 (1984); Edward A. Dyl, Capital Gains Taxation and Year-End
Stock Market Behavior, 32J.Fin. 165175 (1977).
83. Compare Marc R. Reinganum, The Anomalous Stock Market Behavior of
Small Firms in January: Empirical Tests for Tax-Loss Selling Effects,
12J.Fin. Econ. 89104 (1983) (attributing the January effect, as docu-
mented by sources such as those cited supra note 38 (Chapter 1), to tax-
driven loss-harvesting activities) with Mustafa N. Gultekin & N. Bulent
Gultekin, Stock Market Seasonality: International Evidence, 12 J. Fin.
Econ. 469481 (1983) (confirming that stock market seasonality does
appear in developed countries around the world and, where it exists,
appears to coincide with the turn of the tax year in those countries).
CHAPTER 12
[M]omentum captures the most popular trades, being long the assets whose
prices have recently appreciated as fickle investors flocked to these assets.
Value, on the other hand, expresses a contrarian view, where assets have
experienced price declines over several years. When a liquidity shock occurs,
investor liquidations (from cash needs, redemptions, risk management, run-
ning for the exit at the same time ) put[] more price pressure on the more
crowded trades. These liquidations may affect crowded high momentum
securities more than the less popular contrarian/value securities.78
Dt + k
Pt =
(1 + d )
k +1
k =0
Et Rt - r
Qt =
j
Dt + k + j Yt + k
Pt = ,0 <j <
(1 + r + j )
k +1
k =0
In other words, the real price is the present value, discounted at rate
+ , of both the expected future dividend payments and times the
expected future demand by ordinary investors.129 The two decisive vari-
ables in this model of stock price are (the risk premium) and Yt (ordi-
nary investors demand for stock per share).
The extreme limits on this definition of the stock price describe all-or-
nothing dominance of the stock market by either smart money or dumb
312 J.M. CHEN
Dt + k
Pt =
(1 + d )
k +1
k =0
This equation defines the ordinary efficient markets model that equates
price with the present value of expected dividends.131 On the other
hand, as , smart money drops out in favor of dumb money, and the
equation for stock price collapses to Pt=Yt in a market where ordinary
investors determine the price.132
The truly interesting situation arises in the intermediate case where
approaches neither zero nor infinity.133 In the intermediate case, price
may have low predictability from day to day or month to month, con-
sistent with efficient markets theory, even if animal spirits dominate the
broad movements in the stock price.134 Finite, nonzero risk premium
means that [l]ong, slow swings in Yt, dumb money stock demand, may
produce [correspondingly] long slow swings in stock prices, all the way
to the so-called multiyear bull and bear markets.135 The actual price
of stock now responds not solely to news about future dividends, as it
would in a perfectly efficient market, but also to news about animal spir-
its, or uninformed dumb money demand for stock.136 Given everything
we have discovered about the disposition effect, investors under- and
overreaction to news, the performance gap measure , and the mechan-
ics of momentum and liquidity, we should express no surprise whatsoever
that the interaction of the risk premium and the dumb money demand for
stock may generate immense market bubbles and even more spectacular
crashes.
Throughout it all, smart money exercises at best limited influence
on the pricing dynamics of the market. Inertia is the ultimate limit on
arbitrage; surrounded by an overwhelming miasma of noise, otherwise
informed traders may elect not to rebut nave investors mistaken evalu-
ation of companies and their securities.137 Meanwhile, competing, noisy
narratives may propagate along pathways resembling biological mecha-
nisms, such as those by which infections spread and ants recruit others
to food sources.138 All theories of herd behavior in financial markets are
ultimately theories of the failure of information about true fundamental
value to be disseminated and evaluated.139
IRRATIONAL EXUBERANCE: MOMENTUM CRASHES ANDSPECULATIVE BUBBLES 313
Notes
1. See generally Cass R. Sunstein, Incompletely Theorized Agreements, 108
Harv. L.Rev. 17331772 (1995).
2. Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 12. Rather
obviously, this chapters allusion to irrational exuberance pays homage
to Robert Shillers book as well as Federal Reserve Chairman Alan
Greenspans December 1996 speech, The Challenge of Central Banking
in a Democratic Society (Dec. 5, 1996) (available at http://www.federal-
reserve.gov/boarddocs/speeches/1996/19961205.htm).
3. John Kenneth Galbraith, The Great Crash: 1929, at 194 (1954); accord
Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 243.
4. Annette Vissing-Jrgensen, Perspectives on Behavioral Finance: Does
Irrationality Disappear with Wealth? Evidence from Expectations and
Actions, in NBER Macroeconomics Annual 2003, at 137194, 162164
(Mark Gertler & Kenneth Rogoff eds., 2004); accord Markus
K. Brunnermeier, Christian Gollier & Jonathan A. Parker, Optimal
Beliefs, Asset Prices, and the Preference for Skewed Returns, 97 Am. Econ.
Rev. 159167, 159 & n.3 (2007).
5. Andrei Shleifer & Robert Vishny, The Limits of Arbitrage, 52 J. Fin.
3555 (1997); accord Vissing-Jrgensen, supra note 4, at 140, 150151.
See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter
1), 9.2, at 174176.
6. See generally Markus K.Brunnermeier, Herding in Finance, Stock Market
Crashes, Frenzies, and Bank Runs, in Asset Pricing Under Asymmetrical
Information: Bubbles, Crashes, Technical Analysis, and Herding 165220
(2001).
7. See J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers &
Robert J.Waldman, Noise Trader Risk in Financial Markets, 98J.Pol.
Econ. 703738, 705 (1990).
8. Brunnermeier, supra note 6, at 191.
9. Id.
10. See Richard W.Sias, Institutional Herding, 17 Rev. Fin. Stud. 165206
(2004).
11. See generally Kenneth A.Froot, David B.Scharfstein & Jeremy C.Stein,
Herd on the Street: Informational Efficiencies in a Market with Short-Term
Speculation, 47 J. Fin. 14611484 (1992); David B. Scharfstein &
Jeremy C.Stein, Herd Behavior and Investment, 80 Am. Econ. Rev. 465
479 (1990).
12. See Dilip Abreu & Markus K.Brunnermeier, Synchronization Risk and
Delayed Arbitrage, 66J.Fin. Econ. 341360 (2002).
13. See Dilip Abreu & Markus K. Brunnermeier, Bubbles and Crashes, 71
Econometrica 173204 (2003).
314 J.M. CHEN
14. See Markus K. Brunnermeier & Stefan Nagel, Hedge Funds and the
Technology Bubble, 59 Econometrica 20132040 (2004).
15. Robert J. Shiller, Speculative Asset Prices, 104 Am. Econ. Rev. 1486
1517 (2014), reprinted in Shiller, Irrational Exuberance, supra note 89
(Chapter 1), at 239279. Subsequent references to Shillers Nobel Prize
lecture will be made to the reprinted version in Irrational Exuberance,
where the lecture serves as an appendix to the third edition of the book.
16. See also Chen, Postmodern Portfolio Theory, supra note 1 (Chapter 1),
4.2, at 4445 (discussing how the prospect of upside gain exposes
investors to the catastrophe of success identified by Williams, supra
note 22 (Chapter 9)).
17. Barber & Odean, The Behavior of Individual Investors, supra note 197
(Chapter 7), at 1535.
18. Id.
19. See generally supra 3.1; Chen, Postmodern Portfolio Theory, supra
note 1 (Chapter 1), 2.22.8, at 617.
20. See, e.g., Rolf W. Banz, The Relationship Between Return and Market
Valuation of Common Stocks, 9J.Fin. Econ. 318 (1981).
21. See, e.g., S.Basu, Investment Performance of Common Stocks in Relation
to Their Price-Earning Ratios: A Test of the Efficient Market Hypothesis,
32J.Fin. 663682 (1977); cf. Marc R.Reinganum, Misspecification of
Capital Asset Pricing: Empirical Anomalies Based on Earnings Yield and
Market Values, 9J.Fin. Econ. 1946 (1981) (identifying both the size
and the value anomalies).
22. Eugene F. Fama & Kenneth R. French, The Cross-Section of Expected
Stock Returns, 47J.Fin. 427465, 464 (1992).
23. See, e.g., Kent Daniel & Sheridan Titman, Evidence on the Characteristics
of Cross-Sectional Variation in Stock Returns, 52 J. Fin. 133 (1997);
Eugene Fama & Kenneth R.French, Size and Book-to-Market Factors in
Earnings and Returns, 50J.Fin. 131155 (1995).
24. See generally, e.g., John M. Griffin, Are the Fama and French Factors
Global or Country Specific?, 15 Rev. Fin. Stud. 783803 (2002); Adam
Borchert, Lisa Ensz, Joep Knijn, Greg Pope & Aaron Smith,
Understanding Risk and Return, the CAPM, and the Fama-French Three-
Factor Model (Tuck School of Business Case No. 03111, supervised by
Kent Womack & Ying Zhang) (Dec. 2003) (available at http://ssrn.
com/abstract=481881).
25. See Mark M. Carhart, On Persistence in Mutual Fund Performance,
52 J. Fin. 5782 (1997); Mark Grinblatt, Sheridan Titman & Russ
Wermers, Momentum Investment Strategies, Portfolio Performance, and
Herding: A Study of Mutual Fund Behavior, 85 Am. Econ. Rev. 1088
1105 (1995); Narasimhan Jegadeesh & Sheridan Titman, Returns to
IRRATIONAL EXUBERANCE: MOMENTUM CRASHES ANDSPECULATIVE BUBBLES 315
36. See Jolle Miffre & Georgios Rallis, Momentum Strategies in Commodity
Futures Markets, 31J.Banking & Fin. 18631886 (2007).
37. See Tobias J. Moskowitz & Mark Grinblatt, Do Industries Explain
Momentum?, 54J.Fin. 12491290 (1999).
38. See Navin Chopra, Josef Lakonishok & Jay R.Ritter, Measuring Abnormal
Performance: Do Stocks Overreact?, 31 J. Fin. Econ. 235268 (1985);
Werner F.M. De Bondt & Richard H. Thaler, Does the Stock Market
Overreact?, 40 J. Fin. 793805 (1985); Andrew W. Lo & A. Craig
MacKinlay, When Are Contrarian Profits Due to Stock Market
Overreaction?, 3 Rev. Fin. Stud. 175205 (1990).
39. See Dong H.Ahn, Jennifer Conrad & Robert F.Dittmar, Risk Adjustment
and Trading Strategies, 16 Rev. Fin. Stud. 459485 (2002); Tarun
Chordia & Lakshmanan Shivakumar, Momentum, Business Cycle, and
Time-Varying Expected Returns, 57J.Fin. 9851019 (2002); Timothy
Johnson, Rational Momentum Effects, 57J.Fin. 585605 (2002); Laura
Xiaolei Liu & Lu Zhang, Momentum Profits, Factor Pricing, and
Macroeconomic Risk, 21 Rev. Fin. Stud. 24172448 (2009); Jacob Sagi
& Mark Seasholes, Firm- Specific Attributes and the Cross-Section of
Momentum, 84 J. Fin. Econ. 389434 (2008); Tong Yao, Dynamic
Factors and the Source of Momentum Profits, 26 J. Bus. & Econ. Stat.
211226 (2008).
40. See Kent D.Daniel & Sheridan Titman, Testing Factor-Model Explanations
of Market Anomalies, 1 Critical Fin. Rev. 103139 (2012) (failing to find
correlation between momentum and the usual indicators of macroeco-
nomic risk, such as growth in consumption); John M.Griffin, Xiuqing Ji
& J. Spencer Martin, Momentum Investing and Business Cycle Risk:
Evidence from Pole to Pole, 58J.Fin. 25152547, 2515 (2003) (finding
no evidence that macroeconomic risk variables can explain momentum
and concluding instead that momentum profits around the world are
large and statistically reliable in both good and bad economic states).
41. See Nicholas Barberis, Andrei Shleifer & Robert Vishny, A Model of
Investor Sentiment, 49 J. Fin. Econ. 307343 (1998); cf. Narasimhan
Jegadeesh & Sheridan Titman, Profitability of Momentum Strategies: An
Evaluation of Alternative Explanations, 56J.Fin. 699720, 719 (2001)
(concluding that behavioral models provide at best a partial
explanation).
42. See Charles M.C.Lee & Bhaskaran Swaminathan, Price Momentum and
Trading Volume, 55J.Fin. 20172069 (2000); cf. Shefrin & Statman,
Behavioral Capital Asset Pricing Theory, supra note 79 (Chapter 1), at
334 (explaining how noise trading in rational markets generates volume
rather than price effects).
IRRATIONAL EXUBERANCE: MOMENTUM CRASHES ANDSPECULATIVE BUBBLES 317
43. See Mark Grinblatt & Bing Han, Prospect Theory, Mental Accounting and
Momentum, 78J.Fin. Econ. 311339 (2005).
44. Id. at 312.
45. See Frazzini, supra note 11 (Chapter 11).
46. See Simon Gervais & Terrance Odean, Learning to Be Overconfident, 14
Rev. Fin. Stud. 127 (2001).
47. See Kent D. Daniel, David Hirshleifer & Avanidhar Subrahmanyam,
Overconfidence, Arbitrage, and Equilibrium Asset Pricing, 56 J. Fin.
921965 (2001).
48. Shefrin & Statman, Behavioral Capital Asset Pricing Theory, supra note
79 (Chapter 1), at 331 n.21. See generally Hillel J. Einhorn & Robin
M. Hogarth, Confidence in Judgment: Persistence in the Illusion of
Validity, 85 Psych. Rev. 395416 (1978).
49. See Craig W. Holden & Avanidhar Subrahmanyam, News, Events,
Information Acquisition, and Serial Correlation, 75J.Bus. 132 (2002).
50. Louis K.C.Chan, Narasimhan Jegadeesh & Josef Lakonishok, Momentum
Strategies, 51J.Fin. 16811713, 1709 (1996).
51. Id. at 17091710.
52. Id. at 1710.
53. Constantinos Antoniou, John A.Doukas & Avanidhar Subrahmanyam,
Cognitive Dissonance, Sentiment, and Momentum, 48J.Fin. & Quant.
Analysis 245275, 246 (2013).
54. See id.
55. Chan, Jegadeesh & Lakonishok, supra note 50, at 1710.
56. Shefrin & Statman, Behavioral Capital Asset Pricing Theory, supra note
79 (Chapter 1), at 324.
57. See Pedro Bordalo, Nicola Gennaioli & Andrei Shleifer, Salience and
Asset Prices, 103 Am. Econ. Rev. 623628 (2013); Kent Daniel, David
Hirshleifer & Siew Hong Teoh, Investor Psychology in Capital Markets:
Evidence and Policy Implications, 49J.Monetary Econ. 139209 (2002).
58. See Navin Chopra, Josef Lakonishok & Jay R.Ritter, Measuring Abnormal
Performance: Do Stocks Overreact?, 31 J. Fin. Econ. 235268 (1985);
Navin Chopra, Josef Lakonishok & Jay R. Ritter, Performance
Measurements Methodology and the Question of Whether Stocks Overreact,
31 J. Fin. Econ. 235268 (1992); de Bondt & Thaler, Does the Stock
Market Overreact?, supra note 9 (Chap 9); Andrew W.Lo & A.Craig
MacKinlay, When Are Contrarian Profits Due to Stock Market
Overreaction?, 3 Rev. Fin. Stud. 175205 (1990).
59. Moskowitz & Grinblatt, supra note 37, at 12491250; see also id. at
1250 n.1 (documenting sources that have revealed [a]nomalous strong
autocorrelation in stock market momentum).
318 J.M. CHEN
60. See Harrison Hong & Jeremy C.Stein, A Unified Theory of Underreaction,
Momentum Trading, and Overreaction in Asset Markets, 54J.Fin. 2143
2184 (1999); Kent D. Daniel, David Hirshleifer & Avanidhar
Subrahmanyam, Investor Psychology and Security Market Under- and
Over-Reactions, 53 J. Fin. 18391886 (1998). See generally Brad
M.Barber & Terrance Odean, All That Glitters: The Effect of Attention
and News on the Buying Behavior of Individual and Institutional Investors,
21 Rev. Fin. Stud. 785818 (2008).
61. Kent Daniel & Tobias J. Moskowitz, Momentum Crashes 1 (Aug. 8,
2014) (available at http://faculty.chicagobooth.edu/tobias.moskowitz/
research/mom11.pdf).
62. Id.
63. Michael J. Cooper, Roberto C. Gutierrez Jr. & Allaudeen Hameed,
Market States and Momentum, 59J.Fin. 13451365, 1347 (2004).
64. Id.; see also Dayong Huang, Market States and International Momentum
Strategies, 46 Q. Rev. Econ. & Fin. 437446 (2006) (confirming the
statistically significant presence of momentum profits in upside markets,
but also finding profits, albeit statistically insignificant ones, in downside
markets).
65. See Chris Stivers & Licheng Sun., Cross-Sectional Return Dispersion and
Time-Variation in Value and Momentum Premia, 45 J. Fin. & Quant.
Analysis 9871014 (2010).
66. Cooper, Gutierrez & Hameed, supra note 63, at 1347.
67. Antoniou, Dokas & Subrahmanyam, supra note 53, at 267.
68. See Clive W.J. Granger & Oskar Morgenstern, Spectral Analysis of
NewYork Stock Market Prices, 16 Kyklos 127 (1963).
69. See S.P. Kothari & Jay Shanken, Stock Return Variation and Expected
Dividends, 31J.Fin. Econ. 177210 (1992).
70. See Bruce Grundy & J.Spencer Martin, Understanding the Nature of the
Risks and the Source of the Rewards to Momentum Investing, 14 Rev. Fin.
Stud. 2978, 30 (2001); Jennifer Conrad & Gautam Kaul, An Anatomy
of Trading Strategies, 11 Rev. Fin. Stud. 489519 (1998). But cf.
Narasimhan Jegadeesh & Sheridan Titman, Cross-Sectional and Time-
Series Determinants of Momentum Returns, 15 Rev. Fin. Stud. 143157
(2002) (rejecting the suggestion that momentum profits are attributable
to cross-sectional differences in expected returns rather than time-series
dependence in returns and concluding instead that cross-sectional differ-
ences account for little or no momentum).
71. Daniel & Moskowitz, supra note 61, at 2.
72. Id. at 3.
73. Id. at 40.
IRRATIONAL EXUBERANCE: MOMENTUM CRASHES ANDSPECULATIVE BUBBLES 319
74. See Clifford S. Asness, Tobias J. Moskowitz & Lasse Heje Pedersen,
Value and Momentum Everywhere, 68J.Fin. 929985, 930 (2013).
75. See generally Markus K.Brunnermeier & Lasse Heje Pedersen, Market
Liquidity and Funding Liquidity, 22 Rev. Fin. Stud. 22012238 (2009).
76. Asness, Moskowitz & Pedersen, supra note 74, at 962 (describing the
ability of value to earn a risk premium under these conditions an even
deeper puzzle).
77. Id.
78. Id. (citing Pedersen, When Everyone Runs for the Exit, supra note 56
(Chapter 4)).
79. See Yakov Amihud, Haim Mendelson & Lasse Heje Pedersen, Liquidity
and Asset Prices, 1 Foundations & Trends in Fin. 269364, 341350
(2006).
80. See id. at 322329.
81. See id. at 310311.
82. J.Michael Harrison & David M.Kreps, Speculative Investor Behavior in
a Stock Market with Heterogeneous Expectations, 92 Q.J.Econ. 323336,
323324 (1978).
83. See generally Cars H.Hommes, Heterogeneous Agent Models in Economics
and Finance, in 2 Handbook of Computational Economics 11091186
(Leigh Tesfatsion & Kenneth L.Judd eds., 2006).
84. See Carl Chiarella, Roberto Dieci & Laura Gardini, Asset Price and Wealth
Dynamics in a Financial Market with Heterogeneous Agents, 30J.Econ.
Dynamics & Control 17551786 (2006); Carl Chiarella & Xue-Zhong
He, Asset Price and Wealth Dynamics Under Heterogeneous Expectations,
1 Quant. Fin. 509526 (2001); Carl Chiarella, Xue-Zhong He & Duo
Wang, A Behavioral Asset Pricing Model with a Time-Varying Second
Moment, 29 Chaos, Solitons & Fractals 535555 (2006).
85. Compare Evan W. Anderson, Eric Ghysels & Jennifer L. Juergens, Do
Heterogeneous Beliefs Matter for Asset Pricing?, 18 Rev. Fin. Stud. 875924
(2005) (modeling asset prices on the basis of disagreement among analysts
about expected short-term and long-term earnings) with Simon Benninga
& Joram Mayshar, Heterogeneity and Option Pricing, 4 Rev. Derivatives
Research 727 (2000) (predicting option prices according to heterogene-
ity among traders based on the cohort holding out-of-the-money put
options, either as a function of relatively high risk aversion or as a function
of relatively high subjective expectations of low market outcomes).
86. See, e.g., James J. Heckman, Micro Data, Heterogeneity, and the
Evaluation of Public Policy: Nobel Lecture, 109 J. Pol. Econ. 673648
(2001); Joost M.E. Pennings & Philip Garcia, Risk and Hedging
Behavior: The Role and Determinants of Latent Heterogeneity, 33J.Fin.
Research 373401 (2010).
320 J.M. CHEN
87. See Jeffrey R. Brown, Stephen G. Dimmock, Jun-Koo Kang & Scott
J.Weisbenner, How University Endowments Respond to Financial Market
Shocks: Evidence and Implications, 104 Am. Econ. Rev. 931962 (2014).
88. Grinblatt & Hann, supra note 43, at 313.
89. Id. at 314.
90. See Stephen Morris, Speculative Investor Behavior and Learning, 111
Q.J.Econ. 11111133 (1996).
91. See Wei Xiong & Hongjun Yan, Heterogeneous Expectations and Bond
Markets, 23 Rev. Fin. Stud. 14331466 (2000) (arguing that this
dynamic explains several strange aspects of bond markets, including
excess volatility in yields and the ability of a tent-shaped linear combina-
tion of forward rates to predict bond returns).
92. Amihud, Mendelson & Pederson, supra note 79, at 290. Compare Viral
V. Acharya & Lasse Heje Pedersen, Asset Pricing with Liquidity Risk,
77J.Fin. Econ. 375410 (2005) (outlining the theoretical basis for per-
sistence in liquidity over time) with Yakov Amihud, Illiquidity and Stock
Returns: Cross-Section and Time Series Effects, 5 J. Fin. Mkts. 3156
(2002) (providing empirical evidence that illiquidity persists over time).
See generally Markus Brunnermeier & Lasse Heje Pedersen, Market
Liquidity and Funding Liquidity, 22 Rev. Fin. Stud. 22012238 (2009)
(explaining intertemporal variations in liquidity according to changes in
the funding conditions faced by market makers).
93. Amihud, Mendelson & Pederson, supra note 79, at 290.
94. Barberis & Huang, Stocks as Lotteries, supra note 117 (Chapter 8), at
2092.
95. Benartzi & Thaler, Myopic Loss Aversion, supra note 180 (Chapter 2), at
88.
96. Id.
97. Id.
98. Kenneth D.West, Bubbles, Fads and Stock Price Volatility Tests: A Partial
Evaluation, 43J.Fin. 639656, 640 (1988).
99. Id.
100. Shefrin & Statman, Behavioral Capital Asset Pricing Theory, supra note
79 (Chapter 1), at 334 (emphasis omitted).
101. Id.
102. See Bart Frijns, Ester Koellen & Thorsten Lehnert, On the Determinants
of Portfolio Choice, 66J.Econ. Behav. & Org. 373386, 385 (2008).
103. Shefrin & Statman, Behavioral Capital Asset Pricing Theory, supra note
79 (Chapter 1), at 334. See generally Jonathan M.Karpoff, A Theory of
Trading Volume, 41 J. Fin. 10691098 (1986); Jonathan M. Karpoff,
The Relation Between Price Changes and Trading Volume: A Survey,
22J.Fin. & Quant. Analysis 109123 (1987).
IRRATIONAL EXUBERANCE: MOMENTUM CRASHES ANDSPECULATIVE BUBBLES 321
104. See John M. Griffin, Federico Nardari & Ren M. Stulz, Do Investors
Trade More When Stocks Have Performed Well? Evidence from 46
Countries, 20 Rev. Fin. Stud. 905951 (2007); Meir Statman, Steven
Thorley & Keith Vorkink, Investor Overconfidence and Trading Volume,
19 Rev. Fin. Stud. 15311565 (2006).
105. Malcolm Baker & Jeffrey Wurgler, Investor Sentiment in the Stock Market,
21J.Econ. Persp. 129151, 137 (2007); see also Jos Scheinkman & Wei
Xiong, Overconfidence and Speculative Bubbles, 111J.Pol. Econ. 1183
1219 (2003).
106. See Harrison Hong & Jeremy C. Stein, Disagreement and the Stock
Market, 12J.Econ. Persp. 109128 (2007).
107. See Barberis & Xiong, Realization Utility, supra note 51 (Chapter 8), at
265, 267.
108. See Jeremy C.Stein, Prices and Trading Volume in the Housing Market: A
Model with Down-Payment Effects, 110 Q.J.Econ. 379406 (1995).
109. Ana Fostel & John Geanakoplos, Leverage Cycles and the Anxious
Economy, 98 Am. Econ. Rev. 12111244, 1211 (2008) (emphasis
omitted).
110. Id. at 1214.
111. Id. at 1211.
112. See Barberis & Huang, Realization Utility, supra note 51 (Chapter 8), at
267.
113. Markus K. Brunnermeier, Stefan Nagel & Lasse H. Pedersen, Carry
Trades and Currency Crashes, in NBER Macroeconomics Annual 2008,
at 313347, 315 (Daron Acemoglu, Kenneth Rogoff & Michael
Woodford eds., 2009).
114. Cf. Flannery OConnor, Everything That Rises Must Converge (1965).
See generally Chen, Postmodern Portfolio Theory, supra note 1 (Chapter
1), 4.1, at 4144 (introducing the idea of dividing systematic risk into
its upside and downside components).
115. See, e.g., Acharya & Pedersen, supra note 92; Franklin Allen & Douglas
Gale, Financial Fragility, Liquidity, and Asset Prices, 2 J. Eur. Econ.
Assn 10151048 (2005); Sanford J. Grossman & Merton H. Miller,
Liquidity and Market Structure, 43 J. Fin. 617633 (1988); Lubo
Pstor & Robert F. Stambaugh, Liquidity Risk and Expected Stock
Returns, 111J.Pol. Econ. 642685 (2003).
116. See supra 4.2, at 78.
117. Flavin & Panopoulou, supra note 58 (Chapter 4), at 401. See generally
Gravelle, Kichian & Morley, supra note 59 (Chapter 4).
118. Flavin & Panopoulou, supra note 58 (Chapter 4), at 401402. See gener-
ally Pericoli & Sbracia, supra note 61 (Chapter 4).
119. Flavin & Panopoulou, supra note 58 (Chapter 4), at 402.
322 J.M. CHEN
120. See generally, e.g., Shefrin, A Behavioral Approach to Asset Pricing, supra
note 93 (Chapter 10); Didier Sornette, Critical Market Crashes, 378
Phys. Reports 198 (2003).
121. Robert J.Shiller, Stock Prices and Social Dynamics, 2 Brookings Papers on
Econ. Activity 457510, 477481 (1984); accord Shiller, Irrational
Exuberance, supra note 89 (Chapter 1), at 254255.
122. Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 243.
123. See id.; Shiller, Stock Prices and Social Dynamics, supra note 121, at 475
(equation 1).
124. Shiller, Stock Prices and Social Dynamics, supra note 121, at 477 (equa-
tion 2).
125. Id.
126. Id. On fads, see generally Shiller, Speculative Prices and Population
Models, supra note 119 (Chapter 9).
127. Shiller, Stock Prices and Social Dynamics, supra note 121, at 478; cf.
Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 254 (elect-
ing to designate this variable as At, in honor of animal spirits).
128. Shiller, Stock Prices and Social Dynamics, supra note 121, at 478 (equa-
tion 3)
129. Id.
130. Id.
131. Id.
132. Id.
133. See Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 255.
134. Id.
135. Id.
136. Id.
137. See Christopher Avery & Peter Zemsky, Multidimensional Uncertainty
and Herd Behavior in Financial Markets, 88 Am. Econ. Rev. 724748
(1998); In Ho Lee, Market Crashes and Informational Avalanches, 65
Rev. Econ. Stud. 741760 (1998); cf. Abhijit V. Banerjee, A Simple
Model of Herd Behavior, 107 Q.J. Econ. 787817 (1992) (outlining a
more general theory of herd behavior involving otherwise rational
agents); S.D.Bikhchandani, David Hirshleifer & Ivo Welch, A Theory of
Fashion, Social Custom and Cultural Change, 81J.Pol. Econ. 647654
(1992) (same).
138. See Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 182184
(citing Norman T. Bailey, The Mathematical Theory of Epidemics
(1957); Alan Kirman, Ants, Rationality and Recruitment, 108 Q.J.Econ.
137156 (1993)).
139. Shiller, Irrational Exuberance, supra note 89 (Chapter 1), at 178 (empha-
sis in original).
CHAPTER 13
Nicht Gott sondern Mensch wrfelt mit dem Universum: It is not God,
but rather humanity, that plays dice with the universe.14 Behavioral finance
reflects the quantum mechanics of human judgment. The human animal
has its own elaborate mechanism for making decisions under uncertainty.
An analogy to linguistics may be helpful. Natural language is not just a
cultural artifact, but a species property arising from human biology, like
echolocation in bats or stereopsis in monkeys.15 Risk-taking is likewise
a species property, one whose underlying dispositions are susceptible to
formal description, mathematical specification, and empirical verification
or falsification. Behavioral finance may not be rational in a conventional
economic sense, but it arises from the same material as universal grammar
and the atoms of language.16
Cognitive biases, innate heuristics, and the entire apparatus of behav-
ioral finance coexist alongside the stylized rationality of neoclassic econom-
ics. As humans, we should strive to speak of our own condition exactly as
we find it. [N]othing extenuate / Nor set down aught in malice.17 What
we discover may give cause to shudder or adore / Before the flame of
financial behavior:
NOTES
1. Queensboro Farms Prods., Inc. v. Wickard, 137 F.2d 969, 975 (2d Cir.
1943).
2. Lopes & Oden, supra note 55 (Chapter 2), at 310.
3. George A. Akerlof & Robert J. Shiller, Animal Spirits: How Human
Psychology Drives the Economy, and Why That Matters for Global
Capitalism 1 (2009).
4. See supra 10.3, at 252256.
5. Joseph LeDoux, The Emotional Brain 19 (1996).
6. See Daniel Read, Which Side Are You On? The Ethics of Self-Command,
27J.Econ. Psych. 681-693 (2006).
326 J.M. CHEN
7. See, e.g., Jesse Graham, Brian A.Nosek, Jonathan Haidt, Ravi Iyer, Spassena
Koleva & Peter H.Ditto, Mapping the Moral Domain, 101J.Personality
& Soc. Psych. 366385 (2011); Spassena P.Koleva, Jesse Graham, Ravi
Iyer, Peter H. Ditto & Jonathan Haidt, Tracing the Threads: How Five
Moral Concerns (Especially Purity) Help Explain Culture War Attitudes,
46J.Research in Personality 184194 (2012).
8. Tversky & Kahneman, Advances in Prospect Theory, supra note 58 (Chapter
8), at 317.
9. Isaiah Berlin, Alleged Relativism in Eighteenth-Century European Thought,
in The Crooked Timber of Humanity: Essays and Chapters in the History
of Ideas 7394, 83 (2d ed. 2013, John Banville foreword).
10. Greg B.Davies & Arnaud de Servigny, Behavioral Investment Management:
An Efficient Alternative to Modern Portfolio Theory, at viii (2012).
11. Lopes & Oden, supra note 55 (Chapter 2), at 310.
12. Edwin A.Abbott, Flatland: A Romance of Many Dimensions 64 (Dover
thrift ed., 1992) (1st ed. 1884).
13. Id.
14. God does not play dice with the universe, a saying attributed to Albert
Einstein, arises from a December 4, 1926, letter to Max Born:
Die Quantenmechanik ist sehr achtunggebietend. Aber eine innere Stimme
sagt mir, da das noch nicht der wahre Jakob ist. Die Theorie liefert viel,
aber dem Geheimnis des Alten bringt sie uns kaum nher. Jedenfalls bin
ich berzeugt, da der nicht wrfelt.
Max Born, Physik im Wandel Meiner Zeit 244 (3d ed. 1959); Albert Einstein,
Hedwig und Max Born: Briefwechsel 19161955, at 97 (Bertrand Russell
preface, Werner Heisenberg intro., 1972). In my English translation:
Quantum mechanics is certainly impressive. But a voice inside tells me that
its not yet the real McCoy. The theory says a lot, but it barely gets us
closer to the secrets of God. Anyway, I am convinced that He does not play
dice.
15. Steven Pinker & Paul Bloom, Natural Language and Natural Selection, in
The Adapted Mind: Evolutionary Psychology and the Generation of
Culture 451493, 451 (Jerome H.Barkow, Leda Cosmides & John Tooby
eds., 1992).
16. See generally Mark C.Baker, The Atoms of Language: The Minds Hidden
Rules of Grammar (2002).
17. Shakespeare, Othello, act V, sc. 2, ll. 351352, in The Oxford Shakespeare,
supra note 232 (Chapter 7), at 819853, 853; cf. Bernhard Schlink, The
Reader 217 (Carol Brown Janeway trans., 1997) (concluding that once we
know that a story is true, the question of whether it is sad or happy has
no meaning whatever).
18. Stephen Vincent Bent, John Browns Body 336 (1990) (1st ed. 1928).
INDEX
A annuities, 202
Abel, Andrew B., 145, 151, 152, anomalies. See also paradoxes and
166n73, 170n117, 171n131, puzzles
175n181, 233n11 calendar anomalies (e.g., the
adaptation level, 1846, 188, 189. See January effect and sell in May
also prospect theoryreference and go away), 7, 11, 19n39,
point 293, 299n83
adverse selection, 8, 143, 154 generally, 1, 2, 4, 7, 11, 16, 67, 73,
affect heuristic, 13, 39 93, 101, 182, 301
Affordable Care Act, 9 geomagnetic storms, 7
Africa, 263 The Ant and the Grasshopper (La
agriculture, 157, 262, 323 Cigale et la Fourmi), 40, 41
Akaike information criterion, 259 anthropology, 34
Allais, Maurice, 125, 126, 134n74, Appleton, Jay, 251, 271n47
134n76, 183, 269n2 arbitrage and limits to arbitrage, 4,
Allais paradox, 1226, 183, 198, 249 7, 219, 288, 302, 303,
alpha, 37, 74, 100, 208n7780, 306, 312
209n84, 209n85, 248, 286 Argentina, 79
alternative investments, 268 Arnott, Robert D., 139, 162n19,
American Stock Exchange, 287 162n20
Ang, Andrew, 81, 83, 85n10, 85n14, Arrow-Debreu model of complete
86n17, 91n86, 91n9294, markets, 94
91n96, 91n98, 92n105, 92n107, Arrow, Kenneth J., 104n11, 111,
106n26, 109n74, 169n104 129n7, 243n180
capital asset pricing model (CAPM) certainty effect, 126, 183, 202, 203
(cont.) cognitive dissonance, 305
and the equity premium puzzle, 1, discounting (exponential,
3, 95, 137, 143, 144, 148, hyperbolic, etc.), 99, 147
152, 153, 155 disposition effect, 213, 2836, 292,
and the equity risk premium, 3, 137, 304, 308, 312
143, 144, 148, 152, 153, 155 endowment effect, 29, 149, 187
four-moment (higher-moment) framing effects, 197, 205
CAPM, 57, 607, 76, 97, 116, generally, 11, 17, 41, 302, 305, 325
203, 222, 247, 250 house money effect, 230
generally, 1, 5760, 93, 95100, loss aversion, 1859, 198, 201,
137, 222, 226, 250 22831, 308
and initial public offerings (IPOs), myopic loss aversion, 2289, 231,
3, 203, 222 308
intertemporal CAPM, 67, 76, 938, narrow framing, 231, 283
102, 103, 148, 158, 230 projection bias, 97, 150
unobservability (Rolls critique), 96, rank effect, rankings, 31
155 realization utility, 185, 285, 309
capital gains, 95, 289, 2913, 298n78, reflection effect, 183, 184
308 status quo bias, 185
CAPM. See capital asset pricing model colleges and universities
Carhart, Mark M., 97, 303, 314n25. Boston College, 142
See also factor models, momentum Cornell University, 187
carry trade, 310 university endowments, 15760, 308
catastrophe of success, 214, 314n16 Yale University, 157
catching up with the Joneses, 151, commodities markets, 157, 304, 306
152, 156. See also Abel, Andrew concentration (of assets or portfolios),
B.; lagged consumption 5, 225, 286. See also
Catholic Church, 220 diversification
CBOE. See Chicago Board Options conglomerates, 218
Exchange (CBOE) conspicuous consumption, 151
Chen, Joseph, 81, 83, 85n10, 90n81, Constantinides, George M., 20n40,
91n86 133n68, 14952, 169n106,
Chen, Zhanhui, 83, 92n108, 102, 172n139, 174n168, 174n170,
103, 104n1 174n171, 299n82
Chicago Board Options Exchange constant relative risk aversion (CRRA),
(CBOE), 77 117, 118, 128, 144, 149, 264
Chile, 79 consumption smoothing, 95, 154, 158
China, 153 contagion, 78, 302, 309, 310, 324
cognitive biases Cornell University, 187
affect heuristic, 5, 11, 31, 41, corporate distress, 73
293, 325 corporate social responsibility (CSR), 36
INDEX 331
myopic loss aversion, 210n115, optimism and pessimism, 15, 34, 156,
2289, 231, 298n76, 308 213, 214, 263, 308, 309
mythology and storytelling, 12, options pricing, 22n80, 81, 96, 101,
40, 139 106n33, 185, 319n85
overconfidence
sex-based differences, 14
N over-the-counter (OTC) stocks, 219,
nave asset allocation (1/n), 31 238n93
narrow framing, 231
NASDAQ, 287
National Bureau of Economic P
Research (NBER), 160, 168n90, Panel Study of Income Dynamics, 140
179n235, 234n36, 235n49, paradoxes and puzzles. See also
321n113 anomalies
NBER. See National Bureau of Allais paradox, 1226
Economic Research contrasted with normal science, 4
net asset value (NAV), 287, 28992 equity premium puzzle, 3, 13779,
net present value (NPV), 43n5, 181, 2289
290, 291 low-volatility anomaly, 13, 37,
New York Stock Exchange (NYSE), 7392, 223, 2258
287, 289 risk-free rate puzzle, 148
Nobel Prizes St. Petersburg paradox, 122, 1268
economics, 182, 205n2, 253, 303 stock market participation puzzle, 140
literature, 253, 314n15 Pascal, Blaise, 220, 239n103
noise, noise trading, 288, 297n52, passive indexing and investment,
297n54, 302, 309, 310, 316n42 284, 286
noisy markets hypothesis, 22n79 patent law, 9
Norway, 156 pensions, pension funds, and pension
NYSE. See New York Stock Exchange managers, 28n150, 100, 140, 143,
(NYSE) 157, 158, 178n215, 204, 320
perfect competition, 225
Petkova, Railitsa, 83, 84, 92n108,
O 92n114, 92n117, 92n119,
Obamacare (Affordable Care Act), 92n120, 102, 103, 104n1,
8, 21n66 109n79, 109n82
O'Connor, Flannery, 310, 321n114 pharmaceutical industry, 226
Odean, Terrence, 22n74, 26n126, physical perception, 184
44n16, 88n48, 176n197, pigeons, 184, 215, 233n26, 234n27
233n10, 285, 293n6, 294n224, polar bears, 41, 56n153
296n39, 297n53, 297n60, postmodern portfolio theory, 17n1,
298n757, 299n81, 303, 18n11, 49n83, 131n48, 202,
314n17, 317n46, 317n60 281n237, 281n249, 306,
omega, 86n22, 120, 121, 132n55, 248 314n16, 321n114, 323
338 INDEX
Roll, Richard, 19n38, 19n39, 69n20, Shadwick, William F., 120, 132n51
90n68, 108n57, 109n84 Sharpe ratio, 60, 11921, 305
Roll's critique, 96, 155 and Roy's safety-first criterion,
Roy, Arthur D., 274n10710, 2547
275n120 Sharpe, William F., 58, 68n2, 69n16,
Roy's safety-first criterion, 2547, 265 69n22, 69n23, 276n157,
Runyon, Damon, 252 279n212, 295n37. See also Sharpe
Russia, 153 ratio
Shefrin, Hersh, 22n79, 23n82, 23n84,
27n133, 45n24, 46n31, 105n19,
S 132n64, 165n54, 255, 273n93,
SAD. See seasonal affective 274n100, 274n101, 274n115,
disorder (SAD) 275n122, 275n127, 276n147,
safety-first criterion, 2547, 260, 277n159, 277n164, 277n168,
263, 265 277n170, 278n175, 278n180,
Sagoff, Mark, 41, 56n152 278n184, 278n186, 278n196,
Samuelson, Paul A, 42n3, 127, 128, 279n200, 279n206,
130n30, 133n72, 135n89, 280n21518, 280n224,
135n92, 245n209 281n249, 284, 293n11, 316n42,
Santos, Tano, 229, 230, 240n121, 317n48, 317n56, 320n100,
245n212, 245n217, 245n222, 320n103, 322n120
245n226, 246n227, 246n250 Shiller, Robert J., 23n87, 23n89,
Sapp, Travis R.A., 287, 296n43, 24n108, 24n110, 24n111,
296n45, 296n50, 298n73 88n49, 88n50, 105n25, 108n60,
Scandinavia, 156 109n71, 161n14, 170n125,
science, history and philosophy of 174n166, 174n167, 176n188,
anomalies, 2, 46 240n119, 303, 310, 313n2,
multiple discovery, 12 313n3, 314n15, 322n1214,
normal science, 4 322n1268, 322n133, 322n138,
seasonal affective disorder (SAD), 322n139, 325n3
20n48 short-termism, 143
Securities and Exchange Commission Sierra Leone, 263
(SEC), 106n33, 217, 218, 289. sigmoid curves, 186, 189
See also federal securities law skewness
security-potential/aspiration theory. and higher-moment CAPM, 60,
See SP/A theory 222, 247
semiconductors, 37 negative skewness preference, 204
separation theorem, 2, 32, 94, 95, skewness preference, 3, 35, 71n59,
118, 141, 260 116, 203, 204, 21320,
sequence of returns risk, 96, 155, 264, 222, 231
276n156 small firm factor, small-cap stocks, 99,
sex-based differences, 14, 16 100, 102, 226, 286, 303
INDEX 341
smart money, 288, 302, 311, 312. See Statman, Meir, 22n79, 23n82, 23n84,
also arbitrage; information 26n122, 45n23, 45n24, 46n31,
trading, informed trading 47n42, 47n446, 47n50, 47n56,
Social Security, 142, 143 52n113, 52n115, 53n124,
Solnik, Bruno, 80, 91n82, 174n164, 132n64, 163n39, 169n104,
294n29 176n191, 232n6, 233n23,
Spain, 227 238n91, 255, 271n38, 274n101,
SP/A (security, potential, aspiration) 274n115, 275n122, 275n127,
theory 276n147, 277n159, 277n164,
aspiration level, 2579, 262, 277n165, 277n168, 277n170,
265, 266 278n175, 278n180, 278n183,
and behavioral portfolio theory, 4, 278n184, 278n186, 278n196,
67, 181, 24850, 2535, 279n206, 279n212, 279n213,
25760, 262, 265, 268, 269 280m224, 280n21418,
conflicts within risky choice, 253 280n226, 280n229, 281n249,
curvature and elevation 284, 293n11, 295m30, 316n42,
parameters, 251 317n48, 317n56, 320n100,
dispositional vs. aspirational factors, 320n103, 321n104, 279n200
250, 253 stochastic dominance, 71n59, 92n104,
generally, 250, 253 197, 222
high- and low-aspiration accounts, stock exchanges
258, 261, 263 265, 266 American Stock Exchange
and modern portfolio theory, 3, 4, (AMEX), 287
248, 250, 259, 265, 266 Chicago Board Options Exchange
probability of ruin, 257, 258 (CBOE), 77
and prospect theory, 3, 4, 67, 181, NASDAQ, 287
24850, 2535, 257, 258, 269 New York Stock Exchange (NYSE),
and retirement planning, 259 287, 289
Roy's safety-first criterion, 254, 255, stock options (as part of executive
257, 265 compensation), 219
security-seeking vs. potential-seeking St. Petersburg paradox, 122, 1268
dispositions, 3, 4, 248, 251, strategic management, 67, 74, 75,
2535, 2579, 262 223, 225, 227, 228. See also
and value-at-risk (VaR) analysis, 4, Bowmans paradox
248, 265, 266, 269 structural breaks, 139
speculative bubbles, 1, 3, 4, 139, 182, structured financial products, 96
30122 sunk costs, 29, 42n1
spillover effects and knowledge Supreme Court of the United States,
spillovers, 226, 243n180 8, 9, 11, 186
Standard & Poor's (S&P) 500 Sweden, 156
(securities index), 77 Swensen, David F., 157, 177n203,
standard score, 267 177n209, 297n61
342 INDEX
V X
value-at-risk (VaR) analysis, 4, 248, X-inefficiency, 226
2659 Xing, Yuhang, 83, 85n10, 85n14,
value factor (book-to-market), 86n17, 91n92, 91n93, 91n96,
value stocks, 73, 74, 83, 98102, 91n98, 92n105, 92n107,
226, 303 106n26, 109n74, 169n104,
vaunted Volatility Index (VIX), 77, 238n90
80, 81
venture capital, 13, 218, 222
Vilkov, Grigory, 84, 91n88, Y
92n11315 Yale University, 157
volatility
clustering, 230, 307
high-volatility portfolios, 82 Z
implied, 77 Zhang, Lu, 85n4, 85n9, 102, 109n82,
in initial public offerings (IPOs), 3, 175n180, 316n39
37, 222 Zin, Stanley E., 146, 147, 167n80