Posted: December 20th, 2021

Final-Project – Behavioral Finance and the Psychology of Financial Decisions

Learning Demonstration 11
(MS FM)

Behavioral
Finance and the Psychology of Financial Decisions
[Individual Integrated Case
Analysis]

I. Introduction:
You
were recently hired as an associate consultant by a major consulting firm (Shefrain Consulting). This learning
demonstration will guide you through several challenges allowing you to
demonstrate competencies in understanding the importance of psychology on
financial decisions and how to avoid common psychological mistakes in financial
decision making.Behavioral Finance
covers “individual and group emotion, and behavior in markets. The field brings
together specialists in personality, social, cognitive and clinical psychology;
psychiatry; organizational behavior; accounting; marketing; sociology;
anthropology; behavioral economics; finance andthe multidisciplinary study of judgment
and decision making”. (Source: Journal of Behavioral Finance).Developed in the
1970s and 1980s by academics including Amos Tversky, Daniel Kahneman, Richard
Thayer and Meir Statman, behavioral finance stresses that psychology and
emotion prompt investors to behave in ways that are inconsistent with what is
considered rational in traditional finance. The 2010World Wealth Reportdevoted a special ten-page section to
behavioral finance, stemming from the conclusion that one of the most profound
consequences of the financial crisis has been the increasing prominence of
“emotional factors” in the financial decision-making process of large investors.
II. Steps to Completion:
Over
the course of this learning demonstration you will be required to complete a six
part deliverable for your new employer, Shefrain Consulting to demonstrate your
competence in the important field of Behavioral Finance. In particular, you will be required to
demonstrate a high level understanding of Prospect
Theory and the implications of this theory on traditional financial
decision making, understand major biases common in financial decision making
and the process of debiasing, demonstrate your knowledge of behavioral finance
in the context of a client’s investment decisions and portfolio allocation,
understand that behavioral factors impact many important corporate financial
decisions, and clearly articulate the important aspects of behavioral finance
on your career and the prospects for Shefrain Consulting. Since you are a recent hire of Shefrain
Consulting, it is important to make a good impression. Throughout this learning demonstration be
sure to always support your arguments with reputable sources, sound logic, and
your own unique insights.
Professionalism throughout this learning demonstration is expected and
required as Shefrain has a large pool of potential junior consultants if your
report is deficient. At the conclusion
of this learning demonstration, you will be required to submit a final report
with sixparts addressing each of the hypothetical issues raised throughout this
learning demonstration.

1.
Prospect
Theory
“We really want to help
clients make better decisions,” said Stephanie Jones, senior consultant at
Shefrain Consulting, LLC, “and if we understand their biases and tendencies in
making choices, it helps us be better consultants.”
Stephanie continues, “I
noticed you graduatedfrom UMUC and took a
class in behavioral finance.”
You
respond in the affirmative. “We have a
lot of new consultants that are unfamiliar with the core foundations of
behavioral economics…” Stephanie’s Samsung Galaxy S6 Edge interrupts her as
she ducks around the corner to take a client’s call. When Miss Jones returns, she seems on edge
as it’s been a volatile day on Wall Street.
She asks you to prepare a ‘white paper’ on Prospect Theory and its
behavioral foundations. You agree and head
to your corner office to get to work on the ‘white paper’. After a frustrating morning of writing you
come across a Dropbox folder with some of your old UMUC notes and
resources.
Biases and Debiasing
Relieved
to have completed your first assignment, you head out to JoJo’s Tavern for a
couple pints with some fellow associate consultants. Your colleagues brief you on some basic
office politics and you share some details of your conversation with Miss
Jones. The conversation turns to
investing as the past several years have been very good financially for your
new colleagues. During your conversation, several of your colleagues’ comments
seemed to demonstrate commonly known biases in behavioral finance. The most interesting of these are listed
below.
I. “My
father was a buy-and-hold investor but I am an active trader. To keep trading
costs low, I use an online brokerage firm. I have done well investing in
technology companies because I know the industry.”

II. “I am
holding a large position in Omega Corporation with a large unrealized loss.
Omega’s stock price declined last year when reported sales and earnings failed
to meet analyst expectations. I took advantage of the decline to increase my
position.” Omega sales growth has continued to slow over the last year, but I
believe the stock is still a good investment.”

III.“I
read a newspaper article reporting that commercial property values in the city
have increased 14 percent annually since 2000. According to the article, the
average commercial property in the city sold for $1.5 million last year. This
makes me very happy because I just purchased a piece of commercial property
last month. There is no doubt that it will be a good investment.”

2.
Applied
Behavioral Finance
Upon
your happy return to your small flat on the west side of town, you sleep well
after the couple of pints you enjoyed with your friends and the long day at
work. You are awaken early by your
neighbor’s barking dog and you have an opportunity to review the file for your
first client of the day. Impressed by
your description of Prospect theory,
Stephanie has rewarded you with your first client. Mrs.
Violet Siosan is a 42-year-old lawyer at a prestigious law firm. She needs you to organize her finances.
You
jump in your Honda Accord and head to the office, it is raining today, but
fortunately your parking space is near to the door as you forgot your
umbrella. Violet enters your office
shortly after you arrive and you begin to get to know each other. During the interview process, Violet tells
you that she has been purchasing short-term, out-of-the-money call and put
options. Violet acknowledges these options have a low probability of paying off
and that the expected return from her options trading is negative. However, she
states that she is attracted by the possibility of high returns when she can
exercise in-the-money options. At the same time, you note that Violet has been
purchasing low-payoff earthquake insurance on her home, which is located in a
low-probability earthquake zone.
Additionally,
Violet purchases a new luxury vehicle every two years and takes expensive
annual vacations. She has a reputation for paying the entire bill at the
upscale restaurants where she dines regularly with her friends. Violet’s annual
consumption, options trading, and housing expenditures are paid for entirely
out of her salary income and half of her modest annual bonus. She deposits the
other half of her annual bonus and any other non-salary sources of income into
her relatively small retirement account, which excludes her options trading.
Violet is reluctant to incur debt and has only a small mortgage on her home,
despite the fact that she will soon be made a partner in her firm and will have
much higher earnings. Having
recently read,Beyond Markowitz: A comprehensive Wealth Allocation
Framework for Individual Investorswhichcovered some of the key concepts of behavioral
finance, such as mental accounting, or an approach people use to organize their
financial assets by creating separate compartments for money they’ve designated
for specific purposes.You are concerned that Violet exhibits
behavioral biases that interfere with an optimal savings and consumption
allocation.
Finally, Violet’s retirement portfolio is
allocated 50% to money-market securities and 50% to a few speculative stocks
that she read about in an investment newsletter. Believing thatbehavioral
finance can aid in identifying deficiencies in modern portfolio theory when
applied to real clients in the real world.You observe that Violet’s
retirement portfolio allocation is consistent with Behavioral Portfolio Theory
and not consistent with a mean–variance framework.

3.
Behavioral
Corporate Finance
You
notice that the time is getting late and you decide to leave the office for the
day, satisfied with your work thus far at Shefrain Consulting. Prior to leaving the office you check your
company mailbox for the first time and notice a copy of Fortune magazine with a
sticky note marking the page with the following quotation: “I have never asked to serve on a corporate
board, never even hinted at wanting to be on one. And I have never asked to be
on a compensation committee. I suspect that the reason I’ve been put on so many
is that word gets around that I believe in paying people very, very well… I
cannot sit and say to you what the right compensation number is. That’s the
judgment call, the business judgment call. That’s what a board of directors
does… What I know most of all is that when I see extraordinary effort and
results out of a CEO, you can’t pay him enough.”
Furthermore
you notice scribbled on the sticky note a brief note from your CFO indicating
that he has been asked to serve on a compensation committee for a large fortune
500 company. Having freshly graduated
from UMUC, he asks if you would be willing to brief him on the dynamics of
board of directors in the context of recent literature in Behavioral Finance.
Applied Behavioral Finance
“Good
morning”, you hear Stephanie’s voice from across the room.
“Just
had a great jujitsu workout, how are you doing?”
Frustrated
by the fact that you have not been to the gym in three weeks, you do not
respond.
“Nice
work with Violet, your insights werevery useful.”
You
nod knowingly. Stephanie then asks if
you would be willing to make a presentation tomorrow to the managing
partners. Shocked and honored by her
confidence in you, you quickly agree.
“Do you have a particular topic in mind?” you Question Assignment.
“Indeed”,
Stephanie chimes back as she continues, “Given the new economic and market
realities prevailing since the 2008 great recession – including employment
opportunities for yourself and opportunities for our firm, the managing
partners would like you to explain in detail the four (4) most important Behavioral
Finance lessons that can be of value to you and our firmgoing forward.
I would like to emphasizegoing forward because the partners
would like to know how to apply these lessons for the benefit of the firm and
to enhance your career development.
Please give your presentation from the perspective of your job; your
present job or a job that you envision you may have later on, thanks!” You
notice Stephanie’s new Samsung Galaxy S6 Edge lights up as she walks down the
hall. Maybe if this presentation goes
well, you can reward yourself with a new device.

III. Deliverable:
In
order to demonstrate competency in the behavioral finance you are required to
complete the following learning demonstration.
Please note this is an individual
learning demonstration and not a team or group effort. All relevant UMUC
policies- and especially those related to Academic Honesty- will be in full
force. So please keep that in mind at all times.Your completed learning demonstration should
be professionally prepared in Times New Roman 12 point font with one inch
margins throughout. In addition,
to answering each of the issues raised by your hypothetical employment at Shefrain
Consulting, please include a one page executive summary of the most important things
learned during this assignment. The
structure of your final assignment should be as follows.
1.
Executive
Summary (one-page)

2.
White
Paper on Prospect Theory
a. Prepare
a professional 3-4 page ‘white paper’, double-space, Times New Roman 12 point
font; reference page(s) do not count in the page limit. In your report be sure to include the following
topics: 1) Prospect theory vs. expected utility theory, 2) A numeric example
demonstrating violations of expected utility theory, 3) Description of the value
function, 4) Implications of prospect theory (or behavioral finance) for the Efficient
Market Hypothesis, and 5) An example of an anomaly that could be explained by
prospect theory.

3.
Bias
Identification
a. Select
the behavioral finance concept best exhibited in each of your colleagues’ three
statements at JoJo’s bar. Explain how the behavioral finance concept you
selected affects her investment decision making. Write your responses to these
issues raised by your colleagues. Provide clarity, organization and completeness
in your responses. This part should be
between 1-2 pages in length.

4.
Behavioral
Finance and Investments
a. Complete
a report on you observations of your first client, Violet. The report should be 2-3 pages in length,
double-space, Times New Roman 12 point font; reference page(s) do not count in
the page limit. Your report should
include the following: 1) Describe Siosan’s utility function. Contrast her
utility function with that assumed in traditional finance theory, 2) Discuss
what biases Siosan’s behavior reflects, 3) Explain how a rational economic
individual in traditional finance would behave differently with respect to each
bias, and 4) Determine whether your observation about Siosan’s retirement
portfolio allocation is correct. Justify your response.

5.
Behavioral
Corporate Finance
a. Prepare
a professional 1-2 page memo addressed to the CFO describing the recent
behavioral finance literature on the topic on issues related to the Board of
Directors, double-space, Times New Roman 12 point font; reference page(s) do
not count in the page limit. In your
report be sure to include at least 4 recent academic references.

6.
Your
Future and Behavioral Finance Post 2008
a. Respond
to the questions and issues raised by Stephanie in the final part of the
learning demonstration with a professional 3-4 page report, double-space, Times
New Roman 12 point font; reference page(s) do not count in the page limit. In your report be sure to address all of
Stephanie’s points.

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