Assignment Report

1. 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 and the

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 2010 World Wealth Report devoted 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.

1. 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

six parts addressing each of the hypothetical issues raised throughout this learning demonstration.

 

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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 graduated from UMGC 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 UMGC 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.

1. “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.”

1. “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.”

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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 lowprobability 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 Investors which covered 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 that behavioral

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.

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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 UMGC, 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 were very 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 query.

“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 firm going forward.

I would like to emphasize going 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.

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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 UMGC 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)

White Paper on Prospect Theory

1. 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
4. 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
5. 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
6. 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
7. 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.