PROSPECT THEORY, FRAMING, MENTAL ACCOUNTING, ANOMALIES, NOISE

TRADING AND LIMITS TO ARBITRAGE

PROSPECT THEORY
According to the expected utility theory, the economic agent is rational and selfish, and has
stable tastes. Psychologists, however, challenge this assumption. They believe that people are
neither fully rational, nor completely selfish. Further, their tastes tend to change over time. The
two disciplines seemed to be studying different species which the renowned behavioural
economist Richard Thaler labelled Econs and Humans. As Amos Tversky, a distinguished
psychologist famously remarked, “While my colleagues in the economics department study artifi
cial intelligence, we study natural stupidity.” For several years, Daniel Kahneman and Amos
Tversky looked at how people make decisions in the face of risk. They established a dozen facts
and several of these were inconsistent with expected utility theory. So, they developed a theory
that modified expected utility theory just enough to explain the collection of their observations
and called it prospect theory in their seminal paper titled “Prospect Theory: An Analysis of
Decision under Risk.
Choices among risky prospects exhibit several pervasive effects that are inconsistent with the
basic tenets of utility theory. In particular, people underweight outcomes that are merely
probable in comparison with outcomes that are obtained with certainty. This tendency, called
certainty effects, contributes to risk aversion in choices involving sure gains and to risk seeking
in choices involving sure losses.” While the prospect theory was closely modeled on utility
theory, it departed from the latter in fundamental ways. It is a purely descriptive model which
seeks to document and explain systematic violations of the axioms of rationality in choices
between gambles. The approach taken by prospect theory was in the spirit of a field of
psychology called psychophysics founded by Gustav Fechner, a German psychologist, who was
obsessed with how mind and matter are related.
This theory is developed by Kahneman and Tversky in 1979. The second groups of illusions
which may impact the decision process are grouped in prospect theory. He discussed several
states of mind which may influence an investor’s decision making process. The key concepts
which he discussed are as follows:
1. Loss aversion: Loss aversion is an important psychological concept which receives increasing
attention in economic analysis. The investor is a risk-seeker when faced with the prospect of
losses, but is risk-averse when faced with the prospects of enjoying gains. This phenomenon is
called loss aversion. Ulrich Schmidta, and Horst Zankb discussed the loss aversion theory with
risk aversion and he aceepted the Kahneman and Tversky views.
2. Regret Aversion: It arises from the investors’ desire to avoid pain of regret arising from a poor
investment decision. This aversion encourages investors to hold poorly performing shares as
avoiding their sale also avoids the recognition of the associated loss and bad investment decision.
Regret aversion creates a tax inefficient investment strategy because investors can reduce their
taxable income by realizing capital losses.
3. Mental Accounting: Mental accounting is the set of cognitive operations used by the investors
to organise, evaluate and keep track of investment activities. Three components of mental
accounting receive the most attention. This first captures how outcomes are perceived and
experienced, and how decisions are made and subsequently evaluated. A second component of
mental accounting involves the assignment of activities to specific accounts. Both the sources
and uses of funds are labelled in real as well as in mental accounting systems. The third
component of mental accounting concerns the frequency with which accounts are evaluated and
'choice bracketing'. Accounts can be balanced daily, weekly, yearly, and so on, and can be
defined narrowly or broadly. Each of the components of mental accounting violates the
economic principle of fungibility. As a result, mental accounting influences choice, that is, it
matters.
4. Self Control: It requires for all the investors to avoid the losses and protect the investments.
As noted by Thaler and shefrin, investors are subject to temptation and they look for tools to
improve self control. By mentally separating their financial resources into capital and ‘available
for expenditure’ pools, investors can control their urge to over consume.
Traditionally, it was believed the net effect of the gains and losses involved with each choice are
combined to present an overall evaluation of whether a choice is desirable. Academics tend to
use "utility" to describe enjoyment and contend that we prefer instances that maximize our
utility. However, research has found that we don't actually process information in such a rational
way.
Prospect theory contends that people value gains and losses differently, and, as such, will base
decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal
choices, one expressed in terms of possible gains and the other in possible losses, people would
choose the former - even when they achieve the same economic end result. According to
prospect theory, losses have more emotional impact than an equivalent amount of gains.
For example, in a traditional way of thinking, the amount of utility gained from receiving $50
should be equal to a situation in which you gained $100 and then lost $50. In both situations, the
end result is a net gain of $50. However, despite the fact that you still end up with a $50 gain in
either case, most people view a single gain of $50 more favorably than gaining $100 and then
losing $50.
Evidence for Irrational Behavior
Kahneman and Tversky conducted a series of studies in which subjects answered questions that
involved making judgments between two monetary decisions that involved prospective losses
and gains. For example, the following questions were used in their study:
1. You have $1,000 and you must pick one of the following choices:
 Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of
gaining $0.
 Choice B: You have a 100% chance of gaining $500.
2. You have $2,000 and you must pick one of the following choices:
 Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0.
 Choice B: You have a 100% chance of losing $500.
If the subjects had answered logically, they would pick either "A" or "B" in both situations.
(People choosing "B" would be more risk adverse than those choosing "A"). However, the
results of this study showed that an overwhelming majority of people chose "B" for question 1
and "A" for question 2.
The implication is that people are willing to settle for a reasonable level of gains (even if they
have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors
where they can limit their losses. In other words, losses are weighted more heavily than an
equivalent amount of gains. It is this line of thinking that created the asymmetric value function:
This function is a representation of the difference in utility (amount of pain or joy) that is
achieved as a result of a certain amount of gain or loss. It is key to note that not everyone would
have a value function that looks exactly like this; this is the general trend. The most evident
feature is how a loss creates a greater feeling of pain compared to the joy created by an
equivalent gain. For example, the absolute joy felt in finding $50 is a lot less than the absolute
pain caused by losing $50.

Disposition effect underlying Prospect theory

Prospect theory also explains the occurrence of the disposition effect, which is the tendency for
investors to hold on to losing stocks for too long and sell winning stocks too soon. The most
logical course of action would be to hold on to winning stocks in order to further gains and to
sell losing stocks in order to prevent escalating losses. When it comes to selling winning stocks
prematurely, consider Kahneman and Tversky's study in which people were willing to settle for a
lower guaranteed gain of $500 compared to choosing a riskier option that either yields a gain of
$1,000 or $0. This explains why investors realize the gains of winning stocks too soon: in each
situation, both the subjects in the study and investors seek to cash in on the amount of gains that
have already been guaranteed. This represents typical risk-averse behavior.
The flip side of the coin is investors that hold on to losing stocks for too long. Like the study's
subjects, investors are willing to assume a higher level of risk in order to avoid the negative
utility of a prospective loss. Unfortunately, many of the losing stocks never recover, and the
losses incurred continued to mount, with often disastrous results.

Limitations or Blind Spots of Prospect Theory

We have so far criticised the rational model and expected utility theory and praised the prospect
theory. It is time for restoring some balance. The omission of prospect theory and loss aversion
in most introductory texts in economics may seem odd, but it appears that there are good reasons
for this.
 As Daniel Kahneman explains, “The basic concepts of economics are essential
intellectual tools, which are not easy to grasp even with simplified and unrealistic
assumptions about the nature of the economic agents who interact in markets. Raising
questions about these assumptions even as they are introduced would be confusing and
perhaps demoralising.” Like the expected utility theory, the prospect theory too has its
flaws.
 In prospect theory it is assumed that the reference point, usually the status quo, has a
value of zero. While reasonable, this assumption can lead to some absurd consequences.
To illustrate this, Kahneman presents an interesting choice situation. Consider the
following gambles.
A. One chance in a million to win $1 million
B. 90% chance to win $12 and 10% chance to win nothing
C. 90% chance to win $1 million and 10% chance to win nothing.
In all the three gambles, winning nothing is a possible outcome, and prospect theory assigns the
same value to that outcome in all the cases. Since winning nothing is the reference point, its
value is zero. Do you think it to be so? Of course not. In the first two cases, winning nothing is a
non-event and assigning it a zero value makes sense. However, in the third case, winning nothing
is intensely disappointing. Relative to the high probability of winning a large sum, winning
nothing will be experienced as a hugely adverse consequence. But prospect theory does not
reckon this reality, because it does not allow the value of an outcome to change when the
alternative is very desirable. As Kahneman admits, “In simple words, prospect theory cannot
deal with disappointment.
FRAMING
There can be different ways of presenting a decision problem and it appears that people’s
decisions are influenced by the manner of presentation. A decision frame represents how a
decision maker views the problem and its possible consequences. To demonstrate frame
dependence, Tversky and Kahneman posed simple problems like the following to their students.
The government estimates that 600 people will die due to a deadly outbreak of Asian fl u, if
nothing is done. To tackle this problem, the government is considering two alternative
programmes.
 Programme A: Develop a vaccine which can save 200 lives.
 Programme B: Develop a vaccine which will stop anyone from dying provided it works.
The probability that it will work is one-third. If it doesn’t work no one will be cured.
When students were asked to choose one of the two programmes, 75% of them chose programme
A. The risk of seeing all 600 victims die was considered too much to be compensated by the
hope that all would be saved.
Kahneman and Tversky reformulated the question and posed it to a different group of students.
To tackle the same health problem, two choices were offered:
 Programme C: Accept that 400 victims of the flu will die.
 Programme D: Cure all the 600 victims of the flu with a probability of one-third.
When students were asked to choose between these two options, two-thirds of the students chose
programme D. The statement ‘400 would die’ scared most students, even though it is actually the
same outcome as that of programme A above, but expressed in more dire terms. It is evident that
what matters it is not just what you ask, but also how you ask.

Integration vs. Segregation

In the examples given above, the questions were posed to suggest a particular reference point
(e.g. lives saved or lives lost). However, in many cases, the decision maker himself chooses the
reference point, and whether an outcome is considered as positive or negative will depend on the
reference point selected by the decision maker.
To illustrate, suppose that Mohan has lost ` 4,500 on the horse track today. He is looking at the
possibility of betting another ` 500 in the last race of the day on a horse, with 10:1 odds. If his
horse wins, his payoff will be ` 5,000, but if his horse loses, he will lose another ` 500. The
reference point that he chooses is very relevant.
If he considers the previous losses of ` 4,500, the bet of ` 500 will enable him to break even if the
horse wins, or result in a cumulative loss of ` 5,000, if the horse loses. Should he ignore the
previous losses of ` 4,500 and consider the last race as a fresh bet, the outcome would be either a
gain of ` 4,500 (` 5,000 – ` 500) or a loss of ` 500.
According to prospect theory, if Mohan takes the first reference point, he is integrating the
outcomes of all the bets of the day. Since he is in the domain of losses (of ` 4,500) and the last
bet provides an opportunity to break even, he will tend to take the risk.
If Mohan takes the second reference point, he is segregating the outcomes of different bets. In
this case, he will tend to shun the risk, because the gamble crosses over between a loss and gain
and loss aversion bothers him.
Integration means that the positions are lumped together and segregation means that the positions
are viewed separately. The less knowledgeable a person is about an issue, the more easily he is
influenced about how it is framed. The British philosopher Herbert Spencer said “How often
misused words generate misleading thoughts.”
Our preferences are influenced by how a choice is presented. You are likely to choose a product
that is presented as “95% fat free” rather than “5% fat.” Likewise, you are likely to choose a
surgical procedure that has a 40% chance of success than one that has a 60% chance of failure. In
general, our response depends on whether something is presented in terms of gains or in terms of
losses.

Money Illusion
An important theme of behavioural finance is frame dependence which holds that differences in
form may also be substantive. An example of frame dependence is money illusion. To
understand money illusion, let us look at the following questions from a 1997 study by Eldar
Shafir, Peter Diamond, and Amos Tversky. Example: Consider two girls Ann and Barbara, who
passed out from the same college a year apart and took up similar jobs.
Ann started with a yearly salary of $30,000. After one year; during which there was no inflation,
Ann got a 2 per cent ($600) raise in salary.
Barbara too started with a yearly salary of $30000. After one year, during which there was 4 per
cent inflation, Barbara got a 5 per cent ($1500) raise in salary.
As they entered the second year on the job
(a) Who was better off economically?
(b) Who do you think was happier? and
(c) Who do you think was more likely to leave her present job for another job? Most people think
that Ann is better off economically, Barbara is happier, and Ann is more likely to leave her
present job for another job. This is somewhat puzzling. Why is Ann less happy and more likely
to look for another position, if she is better off economically? According to Shafir, Diamond, and
Tversky, although people know how to adjust for inflation it is natural for them to think in term
of nominal terms. Hence, people’s emotional reaction is guided by nominal values, and those
seem to be better for Barbara than they do for Ann.

MENTAL ACCOUNTING
Traditional finance holds that wealth in general and money in particular must be regarded as
“fungible” and every financial decision should be based on a rational calculation of its effects on
overall wealth position. In reality, however, people do not have the computational skills and will
power to evaluate decisions in terms of their impact on overall wealth. It is intellectually difficult
and emotionally burdensome to figure out how every short-term decision (like buying a new
phone or throwing a party) will bear on what will happen to the wealth position in the long run.
So, as a practical expedient, people separate their money into various mental accounts and treat a
rupee in one account differently from a rupee in another because each account has a different
significance to them. The concept of mental accounting was proposed by Richard Thaler, one of
the brightest stars of behavioural finance. Businesses, governments, and other establishments use
accounting systems to track, separate, and categorize various financial transactions. People, on
the other hand, use a system of mental accounting. The human brain is similar to a file cabinet in
which there is a separate for each decision, which contains the costs and benefits associated with
that decision. Once an outcome is assigned to a mental account, it is difficult to view it in any
other way. Mental accounting can influence a person’s decisions in unexpected ways as the
following example suggests:
Mr. and Mrs. Sharma have saved ` 10 lakhs for their daughter’s wedding that may take place 3
years from now. The money earns interest at the rate of 9% in a bank fixed deposit account. They
just bought a new car for ` 6 lakhs on which they have taken a 3 year car loan at 12%. The above
example suggests that people often have money in a fixed deposit account (earmarked for a
certain purpose) that earns a low rate of interest and yet they borrow money at a high rate of
interest for some other purpose. While money does not come with labels, the human mind puts
labels on it. Mr. and Mrs. Sharma labelled their fixed deposit as “daughter’s wedding provision”
in a separate mental account and did not want to draw on it to finance a car even though it made
sense to do that.

 Mental Budgeting
Just the way people use financial budgets to monitor and control their spending, the brain uses
mental budgets to reflect the psychological benefits and costs in each mental account. A pay-as-
you-go payment system is usually preferred because of the tight match between costs and
benefits of the purchase. When the pay-as-you-go system is not available, things get more
complicated. In a study, respondents were asked to choose between the following payment
options for a hypothetical purchase of a clothes washer and dryer costing $1200:
A. Six monthly payments of $200 each before the arrival of the washer and dryer.
B. Six monthly payments of $200 each during the six months beginning after the arrival of the
washer and dryer.
Eighty-four per cent of the respondents chose postponed payment option B. Since the benefits of
the washer and dryer is derived over a long period (hopefully years) after their purchase, the
choice of option B is consistent with the cost/benefit matching of mental budgeting. Further,
option B is consistent with traditional economics, because it allows borrowing at 0% interest
rate. In the same study, the respondents were asked two further questions.
In the second question they were asked to choose between the following payment options for a
hypothetical one week vacation to the Caribbean costing $1200.
A. Monthly payments of $200 each during the six months prior to the vacation.
B. Monthly payments of $200 each in the six months period beginning after the vacation.
Sixty per cent of the respondents chose option A, the prepaid option, an option that is
inconsistent with traditional economics. People seem to find a prepaid vacation more
pleasurable than one that must be paid for subsequently. If the payment is made earlier, the pain
associated with payment is over and hence, the vacation is more pleasurable. If the payment is to
be made later, the pleasure of the vacation diminishes by wondering, “How much is this
pleasure going to cost?” In the third question, the respondents were asked how they would like
to be paid for doing few weeks of work on the weekends in the next six months—before doing
the work or after? Surprisingly, 73 per cent of the respondents said that they would like to be
paid after doing the work instead of before. Again, this is not consistent with traditional
economics as it violates the wealth-maximizing principle. The above examples suggest that
people are willing to incur monetary costs to facilitate their mental budgeting process. They are
willing to accelerate payments and delay income to match better the emotional costs and
benefits, ignoring the time value of money principles.
 Sunk Cost Effect
Traditional economics assumes that while making a decision, people ignore past costs and
consider only the present and future costs and benefits associated with that decision. In reality,
however, people routinely consider historical costs when making decisions about the future.
Such behavior is called the sunk-cost effect. It may be viewed as a tendency to continue an
endeavor, once an investment of money, time, or effort has been made. There are two
dimensions of sunk costs, viz., size and timing.
To understand the size dimension consider the following scenario:
You have a ticket to attend a live musical concert by your favourite rockstar. The ticket is worth
` 2,000. On the day of the concert there is a big thunderstorm. While you can still attend the
concert, the thunderstorm will cause considerable inconvenience. Are you likely to go to the
concert if you had purchased the ticket for ` 2,000 or if you had received the ticket for free? If
you had purchased the ticket for ` 2,000, you are likely to go to the concert, but if you had
received the ticket for free, you are not likely to go to the concert. Why? When you purchase the
ticket for ` 2,000, you open a mental account with a ` 2,000 cost attached to it. If you do not
attend the concert, you have to close the mental account without the benefi t of enjoying the
concert, resulting in a perceived loss. To avoid the emotional pain of this loss, you are likely to
attend the concert. On the other hand, if you receive the ticket for free, you can close the mental
account without a benefit or a cost.
To understand the timing dimension of the sunk cost, consider the following scenario. You have
long anticipated going to the musical concert by your favourite rockstar. On the day of the
concert, there is a thunderstorm. Are you likely to go to the concert if you had purchased the
ticket for ` 2,000 yesterday or one year ago? The purchase price of ` 2,000 is a sunk cost in both
cases, but the timing of the sunk cost seems to matter. You are more likely to go to the concert if
you had purchased the ticket yesterday than if you had purchased the ticket last year. As
Nofsinger put it, “The pain of closing a mental account without a benefit decreases over time. In
other words, the negative impact of a sunk cost declines over time.”
 Mental Accounting and Investing
Mental accounting adversely affects your wealth in two ways. First, it accentuates the disposition
effect, which is reflected in the tendency on the part of an investor to sell the winners and ride
the losers. You have an aversion to sell a stock because doing so closes the mental account and
causes regret. Mental accounting compounds this aversion. With the passage of time, the
purchase of the stock becomes a sunk cost. The emotional pain associated with wasting some of
the sunk cost on a loser decreases over time. So, you are likely to sell the losing stock later as
opposed to earlier. Second, mental accounting affects how we view our investment portfolios.
Thanks to mental accounting, we segregate our portfolio into different mental accounts.

BEHAVIORAL FINANCE AND MARKET ANOMALIES

Behavioral finance is the study of investor behavior, individually and collectively, as it is
observed in the market. Traditional finance assumes that markets are rational. It is because if
individual investors are irrational, others observe the deviation and respond accordingly, but
behavioral finance argues that such reinforcement of rationality does not occur in reality in
financial markets and that individual and collective biases can potentially explain why pricing
anomalies exist.
The human decision making process involves three stages, which are the information perception,
information processing and decision making. In all of those three stages behavioural anomalies
arise. These irrationalities will be described in the following.
  INFORMATION PERCEPTION ANOMALIES
The information perception is the first stage of the decision making process. As humans have
bounded information processing capacities, they try to filter the most important information
already in this stage. Arising anomalies during the information perception are framing, risk
sensitiveness, selective perception and adoption of authoritarian opinions. In order not to
extrapolate the frame of this thesis, the focus will be laid only on the first three mentioned
anomalies.
A.) Framing Effect
Framing is the way how an information, situation or choice will be presented respectively
framed, e.g. orally, in written, but also the sequence of the information and the environment
where the information will be perceived.24
This anomaly influences the perception and hence the decision, i.e. leads to the result, that the
same information will be differently perceived, evaluated and thus faulty allocated.
This will be illustrated with reference to the Asian disease problem investigated by Tversky and
Kahneman:
Scientists were preparing for the outbreak of an Asian disease, which was expected to hit the
USA. Therefore they proposed two programs to reduce the number of affected victims. If the
first program is accepted, 4,000 of the captioned 10,000 people will certainly be saved. If the
second program is accepted, there is a 40 percent probability, that 10,000 will be saved and a 60
percent probability, that nobody will be saved. Most of the people surveyed selected the first
program. Now these two options were presented in another way. If the first program is accepted,
6,000 of the captioned 10,000 people will certainly die. If the second program is accepted, there
is a 40 percent probability, that nobody will die and a 60 percent probability, that 10,000 will die.
Most of the peo- ple surveyed selected the second program.
Whereby both presentations lead to the same result, most of the surveyed choose the first
alternative in the first presentation, named winner’s perspective or survival frame and the second
alternative in the second presentation, named loss perspective or mortal- ity frame. The most
overvalued secure values in the first presentation in a positive way, i.e. to safe life and in the
second presentation in a negative way, i.e. to kill life. It also implies, that the most act risk avers
in the first presentation and risk seeking in the second presentation.
 B.) Risk Sensitiveness
Risk sensitiveness is human’s perception of dangers and evaluation of the risks or con-
sequences involved, which are affected by human’s subjective understanding of the term risk.
Human’s risk sensitiveness depends on quantitative (objective) and qualita- tive (subjective)
factors, which lead to different perception and evaluation of risks and hence faulty decisions.27
Quantitative factors are the probability or the relative frequency of the risk occurrence and the
amount or extend of damage. Risks, which are faced more often will be undervalued, e.g. car
accidents whereas those, who are rarely faced, will be overvalued, e.g. accidents during go by
train. The same phenomenon applies also to risks, which amount or extend of damage is high,
e.g. flying. These risks will be overvalued whereas those with a minor damage, e.g. driving, will
be undervalued.
This anomaly is linked to the next explained anomaly, named selective perception.
C.) Selective Perception
Selective perception is human’s tendency to notice, filter and perceive only information, which
corresponds to their own conceptions, hypotheses, actions and opinions. Contrary information
will be eliminated, ignored or neglected. The reason for this behaviour is the cognitive
dissonance. More in detail, humans seek for consistency and thus try to avoid the internal
conflict, which arises, if they notice, that their conceptions, hypotheses, actions and opinions are
inconsistent. Easily explained, it is a justification process, which makes the misfit fit, in order to
avoid the psychological pain. Hence selective perception serves as a protective shield for
human’s psyche.
This anomaly leads to an alleviated perception, due to which only information in con- text to the
conceptions, hypotheses, actions and opinions are accepted while contradic- tory information are
ignored. It also leads to confirmation bias, due to the unconsciously searching of information,
which confirm the conceptions, hypotheses, actions and opinions. Moreover it results in selective
bias, were contradictory information will be interpreted in a way, that they conform to the initial
conceptions, hypotheses, actions and opinions. Also it leads to overhasty decisions, in order to
avoid a justification pressure. Finally, it involves the adherence of prejudices too.
This will be illustrated by the following example:
A smoker developed health problems, due to which his doctor advised him to stop smoking and
handed out an information brochure for a rehabilitation to support his re- covery. Upon reading
the information, that smoking causes cancer the internal conflict arose, which he reduced by
neglecting the information, that it causes cancer. Addition- ally he achieved internal harmony by
searching for supporting information, which proved that he is right. In this case he stated, that his
grandpa is a smoker aged 90 years and in good health. Another way is that he said, that smoking
provides relaxation and that positive effects like that cannot promote health problems or cause
cancer. Another method to which he applied to, was to tell, that cancer will only arise, when
smoking too much.
This example shows that the smoker neglects, ignores and eliminates contradictory information,
which in turn leads to biases in its risk perception.

 INFORMATION PROCESSING ANOMALIES

The information processing is the penultimate step of the decision making process. Affiliated
irrational processes during the information perception are the reference point effect, mental
accounting and loss aversion.
A.) Reference Point Effect
Humans are geared to a subjective reference point respectively anchor. This reference point
represents a part also in the information processing. In this sense the reference point is human’s
subjective expectation. Consequences of an alternative, e.g. gains or losses will be not evaluated
absolutely, but relatively to this reference point. More detailed, deviations close to the reference
point will be evaluated higher than deviations, which are far apart from it.
This result in the fact, that the same consequences, e.g. gains or losses will be differently
evaluated, based on the distance to the individual set reference point, i.e. the difference between
the actual situation and the expectation.
This will be clarified by the following example:
Two women are visited a museum on a National Holiday. When woman A arrived at the
museum she was told, that due to National Holiday the entrance fee is 6 Euro instead of the
regular 10 Euro. Women B assumed, that due to the National Holiday the entrance would be for
free. When she arrived at the museum she was told, that the entrance fee is 6 Euro. Whereas both
cost situations are identical, women A sensed the price deduction as a gain of 4 Euro and women
B as a loss of 6 Euro.
This example shows, that the subjective reference point of both women - woman A 10 Euro and
woman B 0 Euro - influences, if a consequence will be considered as a gain or a loss.
The reference point effect serves as basis to the following described anomalies, which are mental
accounting and loss aversion.
B.) Mental Accounting
Mental accounting is a complex reducing mental process, which involves the categori- zation,
codification and evaluation of alternatives respectively its consequences, as well as the way how
they will be segregated or integrated. Easily explained, humans divide alternatives e.g.
expenditures, incomes, months, and allocate them to different, not con- nected mental accounts,
based on which they make their decisions. Each mental account involves a subjective reference
point, as well as a cost and benefit side respectively loss and gain side. This mental process can
be compared to the accounting of a company whereas companies create them according to the
accounting rules. The way human’s create their mental accounts and segregate or integrate its
sides is constituted by hedonic editing. Simplified said, it will be done in a way where they reach
the most satisfaction, feel more convenient, maximize their benefits and is more attractive, i.e.
avoids losses and cognitive dissonance.
Mental accounting leads to different evaluations and thus suboptimal decisions, as con-
sequences of an alternative will not be evaluated as a whole, but concentrated only on one
account. Thereby dependences and interdependences to other mental accounts will be neglected.
This will be exemplified by the research of Tversky and Kahneman:
They confronted test persons with the following situations. In the first situation they intended to
visit a theatre for which they had to purchase an entrance card for 10 dollar. When arriving at the
theatre they noticed that they lost 10 dollar. Would they spend an- other 10 dollar to visit the
theatre? In the second situation they already bought the en- trance card for 10 dollar beforehand.
When arriving at the theatre they noticed that they lost the entrance card. Would they spend
another 10 dollar to visit the theatre? The result of the survey was that in the first situation 88
percent of the test persons would spend another 10 dollar to visit the theatre whereas in the
second situation only 46 per- cent were willing to spend further 10 dollar.
Whereas the objective amount, which has to be spend in both situations - 20 dollar - is identical,
it results in different subjective evaluations and decisions. More precisely, in the first situation
two mental accounts have been created - one, which is classified as entertainment and one, which
is classified as bad luck - , i.e. segregation of conse- quences. Hence the loss of money has been
booked on the mental account bad luck whereas the mental account for entertainment hasn’t been
charged. Therefore the ex- pense of further 10 dollar would charge the mental account
entertainment only ones. Thus the subjective value of the card amounts to 10 dollar. In the
second situation only one mental account - entertainment - has been created, i.e. integration of
consequences. Hence the loss of the entrance card has been booked on this one account.
Therefore a further expense of 10 dollar would charge this account twice. Thus the subjective
value amounts to 20 dollar.
This anomaly has an impact on the next anomaly, named loss aversion.
C.)Loss Aversion
Loss aversion is human’s tendency to evaluate consequences, e.g. gains and losses, of the same
amount, differently. Thereby they refer to a subjective set reference point. Contrary to the
reference point effect, the evaluation of changes do not depend on the deviation to the reference
point, but the same deviation will be differently evaluated, namely realized losses will be
perceived higher than realized gains in the same extend. Loss aversion leads to the endowment
effect, status quo bias and disposition effect. The endowment effect is the phenomenon that
humans place a higher value on something they possess relative to something they do not. More
precisely, they demand a higher price for an item they own than they would be prepared to pay
for it. This in turn in- duces humans to stick to status quo, which is human’s tendency to avoid
changes and hence to remain at status quo as the reward for giving up the property will be
evaluated lower as the value they would receive in return. This again is connected with the
dispo- sition effect, while losses will be sit out whereas gains will be realized to fast.
This will be illustrated by the investigation of Thaler, Kahneman and Knetsch:
A group of students were divided into two groups - sellers and buyers. The sellers ob- tained a
coffee cup and should inform at which price they would be ready to sell the cup. The buyers
should decide at which price they would be ready to acquire the cup. The prices ranging from
0.50 Euro to 9.50 Euro. The sellers decided to sell the cup at a price of 7.12 Euro whereas the
buyers were ready to purchase the cup at a price of 3.12 Euro.
This example shows, that the sellers mentioned a higher sales price than the buyers.
Additionally, whereas both situations implicate the same changes in seller’s total assets, they
decided no to sell the cup, but to keep it in their property and to remain at status quo, i.e. they
preferred avoiding losses than acquiring gains.
Also this anomaly will be influenced by the information perception anomaly framing. This
irrationality has an impact on the decision making anomalies, named cognitive dissonance and
regret avoidance, which will be described in the following.

 DECISION MAKING ANOMALIES

The last step of the human decision making process is the decision making itself. Related
anomalies in this step are the cognitive dissonance, regret avoidance and overconfidence.
A.)Cognitive Dissonance
This anomaly has already been touched on within the scope of the information perception
anomalies. In this sense, cognitive dissonance arises, if humans have to make decisions
respectively have to choose between two or more alternatives. The selected alter- native bears
consequences. These consequences are the advantages of the rejected alter- native, which in
return are the disadvantages of the selected alternative. An alternative respectively decision,
which has subsequently been proved as faulty place humans un- der pressure to justify and thus
an internal conflict respectively cognitive dissonance arises. As already mentioned, humans seek
for internal harmony, which will be reached by the reduction of this emotional condition.49
The reduction of this anomaly leads to selective decision bias. More precisely, further made
decisions orient on the previous one in order to prove and justify its accuracy. Hence the
previously made decision will be not revised, which in turn leads to further faulty decisions. It
also results in confirmation bias, which involves the consciously seek of information, which
confirm and support the selected alternative. At the same time contradictory information will be
rejected. The spreading apart effect, which is the upgrading of the selected alternative and
devaluation of the rejected alternative is a further bias, which arises during this justification
process. Latter involving effect is the disposition effect, i.e. humans tendency to rather realize
gains than losses.
This will be exemplified in the following:
A restaurant visitor has to decide between two dishes - veal or goose. After he come to the
decision to order the goose he observe a guess telling that the veal is extraordinary delicious. At
this moment cognitive dissonance arise and the justification process begin in order to avoid the
return of the dish. He devaluate the advantages of the veal by tell- ing that the veal is almost
looking burnt. At the same time he upgrade the disadvantages of the goose by telling that it is the
best he have ever eat. Another possibility is to ignore guest’s statement or to search for other
guests, who are satisfied with the goose too and thus confirm his decision.51
This example illustrates, that humans apply to methods to reduce this emotional state, instead of
confess having made a wrong decision, which in turn result into regret. Influencing factors,
which strengthen or weaken the cognitive dissonance are the grade of responsibility,
involvement, commitment, importance, irreversibility and similarity of the alternatives, which is
named cognitive overlap.
B.)Regret Avoidance
As already mentioned, decisions are implicated by positive and negative consequences. Positive
outcomes make humans feel proud whereas bad outcomes make them feel re- gret and place
them under pressure to justify their made decisions. This in turn increases human’s cognitive
dissonance. Therefore they avoid those situations respectively are regret averse.53
This anomaly leads to the omission bias and status quo bias. More detailed, humans tend to
remain passive as consequences of actively made decisions lead to stronger regret than for
similar consequences, which result from passivity. It also comes to the disposition effect, namely
humans are more willing to realize gains than losses. This will be demonstrated in the following
example:
An investor buys a share, which does not show any movement. Although he has been advised to
sell it he remains inactive respectively hold it as he fears to fell regret about subsequent stock
price increases. Additionally, upon loss realization he has to confess, that he made a wrong
decision, which in turn results in an increase in cognitive disso- nance. Contrary shares, which
show a good performance will be sold too early in order to avoid the pressure to justify
subsequent stock price decreases and hence the feeling of regret.
This example illustrates, that humans behave risk seeking in loss situations and risk aversion
gain situations.
NOISE TRADING
Noise trading is a   compulsive / hyperactive buying / selling activity in financial markets
that is done in the absence of meaningful new information, except erratic minor price moves,
trifle or misunderstood news or unverifiable rumors. Those frantic investor moves ,not only are
driven by market noises, as a flow of irrelevant information that do not really change the asset's
 fundamentals. But investors themselves are a main source of market noise that initiates more
erratic price moves unrelated to those fundamentals.
Definition - noise trader
A noise trader is somebody who practices noise trading, exclusively, continuously, and
indiscriminately.
Noise traders usually   imitate other traders and follow the trends. When they see a price rise or
fall, they ride that jumpy horse.
They might even give less importance to information that are more fundamental but which
potential effects take more time and efforts to analyze.

Market disturbance by noisy players

Noise traders create   market anomalies, and risks for investors who base their valuations on
fundamental analysis. The risk is that, although market prices differ from their "fundamental"
valuations,the difference can get amplified instead of corrected.
 The reason is that noise traders trust other traders' moves more than the assets'
fundamentals. Therefore they mimic those other players even when they are erring (see cascade,
herding, mimicry....). They put themselves also in a risky position, as those other traders,
also hyperactive, can change erratically  their mood and behavior.
Types of market noises
Those rather meaningless market information, but which market traders are addictive to
interpret as decisive, usually take the form of:
 Some minor "exogenous" information ( anecdotic news, wrongly seen as changing the
economic fundamentals).
 The daily chatter of financial medias, bloggers, tip givers / sellers (oops, let us call them
"financial experts":
 Those people met at the village pub can always explain what is going around with a "good
 story". They also spread gossips and rumors, like did Madame de Sévigné commenting the
little events of the French Royal court...
 Or most often minor vibrations / zigzags in market prices and volumes.
They are random blips due mostly to... noise traders who act erratically, upon whims more than
rationally or on relevant information.
Noise traders interpret those noises, even if produced by other noise traders,
 Sometimes as mispricings that offer arbitrage opportunities, hoping the price will wing
back (why not, but an hazardous bet)
More often as signals of either the birth of a short price trend or a confirmation of a long
price trend.
They see an opportunity to make money by following the scent. Here comes the
representativeness heuristic" (see that phrase), when they see technical analysis configurations
everywhere, as signs in the sky.

LIMITS TO ARBITRAGE
Economists argue these behavioural biases and deviations from rationality are not material as the
people who repeatedly make mistakes will learn out of their mistakes and the biases will
disappear. Although learning can mitigate the mistakes but it cannot eliminate it altogether.
Further, the proponents of traditional finance point out that these behavioural biases would not
matter as any mis-pricing would be corrected by arbitrage. The proponents of behavioural
finance believe that stock prices can diverge from their intrinsic value because of limits of
arbitrage. The arbitrage depends on the law of one price, which states that identical
securities should sell at identical price. The most cited example of this violation is Royal
Dutch and Shell case. The twin securities show enormous divergence from the expected one.
This evidence is a deep challenge to efficient market theory. The explanations such as risk and
trading cost cannot account for such large deviations. The behavioural economists assert that
arbitrage can be limited due to fundamental risk, implementation costs and model risk. They
argue that arbitrageurs may be exposed to fundamental risk. The concept of arbitrage relies on
the notion of price convergence: that price of the security will eventually converge to
fundamental value. Suppose one buys an under priced security in the hope of earning profit. But
it may happen that price may not converge, or might diverge much before it converges, and the
investors may end up losing money. The irrational traders can infect prices with their irrational
beliefs and push it in wrong direction. Secondly, exploitation of arbitrage opportunity might be
difficult because of the costs involved such as margin requirements or restriction placed on short
selling may hamper it. Lastly, the model used to value security might be faulty. For instance,
Capital Asset pricing model is widely used model of asset pricing but it may be the case that
CAPM does not hold.