FIN 405 Week 1 Foundations of Behavioral Finance Example

Why Did Careful Clients Sell at the Bottom in March 2020? Efficient Markets, Prospect Theory and the Limits to Arbitrage at a Small Advisory Firm

[Student Name]

University of Phoenix

FIN/405: Behavioral Finance

Week 1 Assignment

[Instructor Name]

[Date]

The advisory firm and its clients are composites written for a model paper; market dates, theories and research findings come from the sources listed.

Ridgeline Advisors, a composite fee-only firm in Ohio with about 300 households, saw its phones ring constantly in the third week of March 2020. The S&P 500 had fallen about 34 percent from its February peak in roughly a month, closing at its low on March 23. Many callers were retired teachers with pensions, Social Security and portfolios built to last thirty years, people who had agreed on paper to ride out declines. Eleven households insisted on selling most of their stocks that week. By August the index had recovered its February level, and most of the eleven had not bought back in. Their decisions were not foolish by any ordinary standard; they were human, and the gap between human and rational is the subject of behavioral finance. This paper sets out the foundations of the field through that week.

The Traditional View

Traditional finance assumes investors are rational: they hold accurate beliefs, update them correctly when new information arrives and choose the option with the highest expected utility given their tolerance for risk. In this view, a retiree with a long horizon and secure income should not sell after a decline unless her circumstances or the expected returns have changed. If investors are rational, or if rational traders dominate prices, markets become efficient. Fama (1970) treated a market as efficient when its prices already incorporate the information available to traders. The weak form holds that prices reflect all past price information, the semi-strong form that they reflect all public information and the strong form that they reflect all information, including what insiders know. Most evidence supports the weak and largely the semi-strong forms, which is why few professional managers beat index funds after costs.

What the Traditional View Explains Well

The efficient market view explained much of what happened. Prices fell because expected profits fell and uncertainty rose sharply as the economy shut down. They rose again as the Federal Reserve cut rates to near zero, Congress passed relief laws and the outlook improved. No one at Ridgeline could have known on March 23 that it was the low; a strategy built on calling bottoms would have failed. In that sense the market was doing its job.

What It Leaves Out

The traditional view says less about why the eleven households sold. Their circumstances had not changed: pensions and Social Security kept paying, and none needed the money. Their expected returns had, if anything, risen, since prices were lower. A rational investor with their plans would have held or bought. Understanding their choice requires a different model of how people decide under risk.

Prospect Theory

Kahneman and Tversky (1979) proposed prospect theory after showing in experiments that people violate expected utility in systematic ways. First, people code each outcome as a gain or a loss measured from a reference point, often their purchase price or recent peak, rather than by final wealth. Second, losses hurt more than equal gains please, a pattern called loss aversion; in later work the ratio was estimated at about two to one. Third, people tend to be risk averse for gains but risk seeking for losses, and they overweight small probabilities. For a Ridgeline client whose portfolio stood 30 percent below its February value, the reference point was the peak, and each further drop registered as a painful loss. Selling ended the experience of watching losses grow, even at the cost of future gains.

Narrow Framing and Frequent Checking

The clients also watched their balances daily, sometimes hourly, on their phones. Each check set a new frame in which losses dominated. A client who looked at the account once a year would have seen a gain for 2020; a client who looked daily saw dozens of losing days in a row. Frequent evaluation magnifies the pain of loss aversion, which helps explain why the most anxious callers were often the most frequent checkers.

Limits to Arbitrage

Behavioral explanations of individual choices do not by themselves show that market prices go wrong, since rational traders could buy what panicked sellers dump. Shleifer and Vishny (1997) explained why that correction can fail. Professional arbitrageurs invest other people's money, and when prices move further against them, their clients withdraw funds, forcing them to sell exactly when the opportunity is best. In March 2020, many leveraged funds faced margin calls and redemptions and had to sell, adding to the decline. Prices overshot partly because those best placed to correct them were least able to act.

Bringing the Views Together

The two views are not rivals so much as tools for different questions. The efficient market view explains why prices respond quickly to news and why most attempts to beat the market fail. The behavioral view explains why individuals often act against their own plans and why prices can overshoot when arbitrage is constrained. A useful practice for an advisor draws on both: build portfolios on the assumption that the market cannot be outguessed, and build client relationships on the assumption that clients are human.

What Ridgeline Changed

After 2020, the firm made three changes. Advisors now show each client, during planning, a dollar figure for what a 35 percent decline would mean for the portfolio, so the reference point is set before a crisis. Clients receive quarterly rather than daily performance summaries by default. A written commitment, signed in calm conditions, records what the client agrees to do in a decline. In the 2022 bear market, only two households asked to sell.

The Cost of Selling

The eleven households sold about $9.4 million of stocks near the low. Had they held, the positions would have regained their February value by August and grown further by year end. The cost was not a market failure but a decision shaped by how losses feel, which is the strongest argument for studying behavior alongside prices.

Conclusion

Traditional finance explains why prices moved as they did in March 2020 and why no one could time the bottom. Prospect theory and loss aversion explain why careful clients sold, and limits to arbitrage explain why prices overshot. Behavioral finance adds to the traditional model rather than replacing it, and the combination helps advisors prepare clients for the next decline.

References

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. https://doi.org/10.2307/2325486

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291. https://doi.org/10.2307/1914185

Shleifer, A., & Vishny, R. W. (1997). The limits of arbitrage. The Journal of Finance, 52(1), 35-55. https://doi.org/10.1111/j.1540-6261.1997.tb03807.x