Behavioral Aspects of Financial Decision Making: Three Essays

Emanuela Trifan

Publications of Darmstadt Technical University, Institute for Business Studies (BWL) from Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL)

Abstract: Economic agents are not fully rational machines, but humans with limited capacities, feelings, and subjective perceptions and beliefs. Such less rational aspects of behavior can become extremely important, especially in financial markets. This dissertation aims at quantifying different behavioral aspects of financial decision making. The first behavioral aspect addressed relates to the implementation of practical trading rules. These rules are mostly simplifying and provide only imperfectly accurate information. Nevertheless, this information may induce sufficient asymmetry among market participants in order to affect prices. This holds in a market where imperfectly informed users of practical trading rules meet perfectly informed traders and uninformed liquidity traders. Both the accuracy of practical trading rules and the number of their users can change the trade conditions, primarily the gap between the two prices set for buying and selling the same asset. Particular trading rules of wide practical use appear to be successful in terms of monetary profits. Affective states, in particular emotions, represent the second behavioral aspect analyzed. They impact on traders' beliefs and actions and thus are transmitted into prices. We design a particular agent category, the emotional traders, who exclusively follow their affect and intuition in both thinking and acting. They face rational traders, who form beliefs in a traditional way and maximize the expected utility of wealth, as well as randomly acting noise traders. The presence of emotional traders clearly influences market prices. An appropriate rational strategy requires the adaption to the consequent market conditions. Emotional trade does not necessarily impede market stability and efficiency. Certain emotional profiles are apt to survive, and can even outperform, in terms of profits, rational strategies. Third, we study subjective perceptions of financial risks. These perceptions change the attitude of non-professional investors towards financial investments and the potential losses they generate, as well as their decisions on wealth allocation. Subjective perceptions depend on different behavioral parameters. The past performance of risky investments and the revision frequency of risky portfolios impact investors' perceptions and decisions. Substantial differences result depending on whether or not consumption is regarded as a utility generator, besides financial wealth.

Date: 2008-11-17
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