The Behavioral Finance Puzzles (Chapter 7)

Question 1

Do payments of dividends affect the total wealth of investors?

Answer 1

No. The price of shares declines when a company pays dividends whereas the cash added to shareholders bank accounts by receiving dividend payments equals out.

The capital only declines among investors who spend their dividends. Always reinvest dividends!

Question 2

How can a fruit tree symbolize the dividend puzzle?

Answer 2

The fruit tree frames capital of a stock whereas the fruits frame the dividends.

If the investor consumes fruits, he decreases his wealth (normal-ignorant behavior).

The rational investor sells the fruits and buys other fruit trees to expand his wealth.

Question 3

Are homemade dividends identical to company paid dividends in subtance and in form?

Answer 3

First, they are identical in substance, but not in form.

Only when considering taxes, they are not identical in substance. This is due to tax benefits when selling stocks in loss-domain and tax benefits when selling stocks in gain-domain compared to company paid dividends (reduces wealth by paying taxes on dividends).

-> homemade dividends yield tax advantage

Question 4

What are ways of self-control to avoid spending dividends?

Answer 4

1. Separate mental accounts for income (salary), dividends and capital (stocks) -> spend income but dont dip into capital rule
2. Invest in stocks that pay no dividends
3. Invest in mutual funds with automatic reinvestment (compound interest effect)

Question 5

How can prospect theory affect payment of dividends in terms of regret?

Answer 5

1. Company paid dividends have an advantage over homemade dividends because they are less likely to inflict regret (no responsibility)
   -> this is consistent with loss aversion in prospect theory

Question 6

How does framing affect EUT and PT when comparing a stock with dividend payment to a stock without dividend payment with equal expected utility.

Answer 6

Company paid dividend payment feels satisfying although same expected utility when comparing stock with dividend payment with stock without dividend payment.

In EUT: same expected utility, therefore investor is indifferent

In PT: Focus on gain-loss utility leads to choice of stock with dividend payment due to higher satisfaction.

Same accounts for loss domain -> dividend payment makes up for loss

Question 7

What is the Disposition Puzzle?

Answer 7

=the tendency of investors to hold onto losing investments for too long and to sell winning investment too soon.

Question 8

Why do investors find themselves in the Disposition Puzzle?

Answer 8

Wants, shortcuts and errors:
Realizing losses imposes emotional cost of regret while realizing gains yiels emotional benefits of pride.

Question 9

What are typical examples of the Disposition Puzzle?

Answer 9

1. Unwillingness to repurchase stocks whose prices increased subsequent to sales, even though repurchases are optimal.
2. Strength of reluctance to repurchase greater when measures of regret are higher
3. More losses are realized in December than in any other month -> due to mental account “tax reduction” in December

Question 10

How does EUT and PT differ in the Disposition Puzzle?

Answer 10

in EUT: Losses are realized to earn tax benefit.

in PT: predicts reluctance to realize losses but also an eagerness to realize gains

Question 11

How to counter the disposition puzzle?

Answer 11

-Rebalance regularly
-stay disciplined
-seek professional advice
-diversify
-stopp-loss order

Question 12

What is Dollar Cost Averaging (DCA)?

Answer 12

=investing a fixed amount at equal intervals and continue to do so over a long period

Question 13

What is Lump Sum Investing?

Answer 13

Lump sum investing refers to the practice of investing a large sum of money in a single transaction, rather than investing the same amount over a period of time through smaller, regular investments.

Question 14

Despite evidence that Lump Sum outperforms DCA, why do knowledgeable investors choose DCA?

Answer 14

1. Bolster self-control
2. Counter fear
3. Mitigate regret

-> DCA is the more safer alternative

Question 15

What is the “Equity Premium Puzzle?

Answer 15

Investors underestimate the long-term returns of equities. Specifically, investors may mentally categorize equities as high-risk investments and demand a higher return to compensate for this perceived risk.

However, by focusing on short-term fluctuations in the stock market and neglecting the historical evidence of higher long-term returns, investors may be missing out on the potential benefits of investing in equities.

In short, the equity premium puzzle can be explained by the mental accounting bias, which leads investors to undervalue equities relative to other investments due to an overemphasis on short-term risk and return expectations.

Question 16

How is mental accounting related to the equity premium puzzle?

Answer 16

The equity premium puzzle can be explained by the concept of mental accounting.

In mental accounting, investors categorize their financial resources into different mental accounts such as risk, return or investment type. This can lead result in an overvaluation of low-risk investments and an undervaluation of high-risk investments like equity stocks.

This mental accounting bias lead investors to underestimate the long-term returns of equities.

Question 17

Why do people invest in DCA? Whats the reasoning in terms of PT behind it?

Answer 17

Dollar-cost averaging overcomes loss aversion in frame highlighting gains + obscuring losses.

Investors mitigate anticipated emotional cost of regret accompanied by losses by only investing a part of cash today.

DCA bolsters self-control, counters fear and mitigates regret.

Question 18

What is Reverse Dollar-Cost Average?

Answer 18

=DCA overcomes the problem that investors want to cash out their stocks. Because of a high loss utility when cashing out, that is higher than the gain utility, the investors chooses to keep her stocks.

Question 19

What is the illusory happy ending error?

Answer 19

Stands in contrast to the myopic loss aversion error. When looking at long time horizons, investors always increases his portfolio largely. This lead people to overestimate the likelihood of positive outcomes in their investments, leading them to overvalue risky investments or failing to consider potential downside risks.

Question 20

What are the three magic words to counter disposition effect?

Answer 20

1. Transfer your assets
   * Sell shares, realize losses, buy other shares with proceeds
   * Diverts attention from closing of one account to opening of new account
   * Find different attractive uses of money made available from realizing losses e.g. reaching savings goal -> facilitates realizing losses by highlighting hopeful opening of new account
   * Found in December effect -> investors become more willing to realize losses when sanitized to tax benefits of loss realization
2. Harvest your losses
   * Replaces frame of realizing rotten losses with plucking ripe peaches
   * Stop-loss-orders: precommitment and automatic action; takes away choice of manually closing mental account at loss
3. Framing
   * Framing blurs purchase price as reference point for gains and losses -> mutes disposition effect
   * Can also highlight purchase price, e.g. via “Cash-Out” Displays -> bolsters disposition effect

Question 21

What are failures to terminate corporate investments?

Answer 21

• Utilitarian costs of loss of job / bonus;
• expressive costs of loss of status;
• emotional costs of regret about choosing project that turned out to be a mistake