Examples of Psychology in Finance

Question

I'm currently taking a course in Risk Management and we have been asked to give a presentation on Psychology and its effect on investment/market behavior. My group has created a solid presentation but we thought that it might be cool to perform a class activity that demonstrates some real life effects. We're considering offering people in the class a fair bet but analysing their decision, or something simple in a similar style. Does anyone know of any easy/cool demonstrations that might be worth looking into?

Answer 1

This is quite a broad question, and the feasibility of any answer will depend on the time and resources available for performing a demonstration, assuming the objective isn't just to present a summary of existing research. A relatively simple principle to demonstrate in a risk management context would be the framing effect, whereby the emphasis on gain or loss in a given decision can affect people's preferences.

To demonstrate this quickly and easily, you could pass out a shuffled deck of small cards to your audience, with one of two versions of a question printed on each card. The question can present a single dilemma from two perspectives: one that frames a decision in terms of how much the respondent stands to gain with one of two choices, and another that frames it in terms of the cost of each choice. If half of the audience gets one version of the question, and the other half gets the other version of the question, you may be able to demonstrate a difference in the choices people make based on which version they receive with a couple polling questions. Wikipedia cites Tversky and Kahneman's ⁽¹⁹⁸¹⁾ example of a dilemma framed from gain and loss perspectives:

^{[Text from Tversky and Kahneman, 1981:]} Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences are as follows:

$$\begin{array}{c|c|c}{\rm Framing}&{\rm Treatment A}&{\rm Treatment B}\\\hline{\rm Positive}&\text{"Saves 200 lives"}&\text{"A 33% chance of saving all 600 people,}\\&&\text{66% possibility of saving no one."}\\\hline{\rm Negative}&\text{"400 people will die"}&\text{"A 33% chance that no people will die,}\\&&\text{66% probability that all 600 will die."}\end{array}$$ ^{[Table from Wikipedia]}

Other examples are available, and the principle is general enough that you could probably expect it to work with your own variations on the theme. This particular version produced a 72% preference for Treatment A in the positively framed version, and a 22% preference for Treatment A in the negatively framed version. Tversky and Kahneman also describe several examples with risk framed in terms of financial gain and loss, but they might require a different setup for demonstration. An experimental effect of this size ought to stand a decent chance of appearing even in a fairly small audience.

^{Reference
Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211(4481), 453–458. Retrieved from http://psych.hanover.edu/classes/cognition/papers/tversky81.pdf.}