Assignment Report
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I.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
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010 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.
II. 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.
I. “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.”
II. “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 1
4
percent annually since 2000. According to the article, the average commercial
property in the city sold for $1.
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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
a. 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
a. 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
a. 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
a. 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
a. 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.