Behavioral aspects of financial decision-making
There is growing effort to incorporate psychological behaviors into decision models from economics and finance. This research focuses on how anticipated feelings, such as regret and pride, affect decision-making with regard to portfolio decisions, and whether these models can explain phenomena documented in the literature. We first examine the effect of envy on the portfolio allocation of a worker in a Defined Contribution (DC) pension plan. If a worker's DC plan performs better than his co-worker's, he may gloat; if his DC plan performs worse, he may feel envy. We model anticipated envy when a worker makes his portfolio allocation. In equilibrium, workers will mimic their co-workers' allocation; this allocation results in a riskier portfolio than that of a worker who is not envious. Next, we develop a dynamic portfolio choice model which incorporates anticipated regret and pride in individuals' preferences. If the risky asset has a positive return, the investor feels pride for having bought it; whereas, if the stock has a negative return, the individual feels regret. We show that anticipating such preferences can cause investors to sell winning stocks and hold losing stocks. Therefore, anticipating regret and pride can help explain the disposition effect, a phenomena which has been documented in the literature. Finally, we examine the effect of anticipated regret on procrastination in making portfolio allocation changes within DC pension plans. Previous literature has shown that DC plan participants often postpone changing allocations. We assume DC plan participants are given a default allocation and have the opportunity to change allocations. We investigate under what circumstances participants delay changing their allocation. We then examine investors who anticipate regret in making a change in their allocation; if the new allocation performs worse than the default allocation, the investor feels regret, and if the new allocation performs better, he rejoices. We find anticipating regret and rejoicing does not cause participants to procrastinate in making allocation changes. That is, anticipating regret and rejoicing actually induces investors to take action and deviate from the status quo of the default allocation.
|Year of publication:||
|Authors:||Volkman, Jacqueline M|
|Type of publication:||Other|
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