Articlediamond2016

Can Financial Education Extend the Border of Bounded Rationality?

19 citations0/0 files storedModern Economy

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Decision-Making and Behavioral Economics Financial Markets and Investment Strategies Financial Literacy, Pension, Retirement Analysis

Abstract

When choosing a particular alternative from a number of financial assets, risk is an important feature. According to the classic Capital Assets Pricing Model (CAPM), we would expect to receive a positive correlation between risk and return of financial assets. However, studies show that investors judge financial assets in terms of "good" or "bad". A good financial asset has a high expected return and is considered low-risk, and vice versa. This type of thinking is biased, as it is both irrational and contradicts the classical theory of finance. One explanation for this bias is the affect heuristic. According to this heuristic, the investor forms her attitude about the asset in the first stage, and then links all of her subsequent judgments to this attitude. The aim of this study is to examine how this bias is affected by studying the CAPM in Finance entry courses. An experiment was conducted in which each subject made both risk judgments and return judgments in regard to 25 domestic stocks chosen randomly from the Tel Aviv 100 stock index. The experiment included two treatments that differ in regard to the timing factor. Some of the subjects were asked to judge the return and risk ratings before learning about the CAPM in class; the others were asked after studying the CAPM material. Finance education reduced the bias, but did not prevent it. The results show that in the teaching of Economics, there should be a balance between providing a coherent theoretical framework together with behavioral aspects. Moreover, given that finance education did not prevent the bias among students with background in quantitative analysis, it is reasonable to assume that other agents without this background would have more difficulties to apply the principles of investments under uncertainty.

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1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1987Perception of Risk 1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1968Attitudinal effects of mere exposure.1997Models of Bounded Rationality 1978How safe is safe enough? A psychometric study of attitudes towards technological risks and benefits 1994A Psychological Study of the Inverse Relationship Between Perceived Risk and Perceived Benefit

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