Reaction paper by: Kumar Pallav Corporate law: Policy Analysis

Reaction paper on: Investment in Financial Structured Products from a Rational and Behavioral Choice Perspective

Author: Moran Ofir and Zvi Wiener

Structured products are investment instruments and can be used as an alternative to direct investments in financial assets. The present paper makes first steps towards providing as how the retail investors are tend to affected several common behavioral biases in the area of decision making under uncertainty, including: loss aversion, the disposition effects, herd behavior, the ostrich effect and the hindsight bias. This paper performs various examinations and experiments to find out the characteristics of structured products and analyze the association between these features and the corresponding behavioral bias.

In this reaction paper I intend to focus on the issue as how the authors could argue and analyze that specific regulation for structured products is warranted in order to protect retail investors. Authors are successfully analyzed that how the experiments results demonstrate a significant influence of the behavioral biases on investors decisions.

In this paper authors focuses on five features commonly found in structured products, and the behavioral biases associated with them. Authors have produced the evidence that how the retail investors are tend to affected several common behavioral biases in the area of decision making due to these five features. In order to support the effect on investors decision making, authors provided empirical estimates of loss

Reaction paper by: Kumar Pallav Corporate law: Policy Analysis

aversion, demonstrating that the perceived disutility of loss is twice as great as the utility of gain.1

Authors analyzed that investors believe that the structured products as less risky investments. The reason behind it as they are most promise principal protection. Generally principal protection enables lossaverting investors to avoid losses and enjoy gains in certain circumstances. However for retail investors, as they do consider principal protection a very attractive feature, their decision whether to invest in a structured product is strongly affected by it. However it is worth noting in this context that principal protection is usually nominal and it does not carry any compensation for the time value of money. Foreign currency with great exposed foreign currency exchange rate risks is the biggest example of it. However this study supports that how loss aversion, referred as the tendency for people strongly to prefer avoiding losses than acquiring gains, will affect investors decision making.

At the other end of the spectrum, recently, studies have questioned the existence of loss aversion. In several studies examining the effect of losses in decision making under risk and uncertainty no loss aversion was found. There are several explanations for these findings: One is that loss aversion does not exist in small payoff magnitudes i.e. for small investment. The other, is that the generality of the loss aversion pattern is lower than that thought previously. Alternatively, Gal (2006) argues that the phenomena previously attributed to loss aversion are more parsimoniously explained by inertia than by a loss/gain asymmetry.2

There is a possible objection to the explanation of the authors that their study is based on a model of individual decision-making, while the bulk of the assets are
Tversky, A. and D. Kahneman, Loss Aversion and Riskless Choice: A Reference Dependent Model, J. Eco., 106,1039-1061 (1991). 2 Harinck, F., Van Dijk, E., Van Beest, I., & Mersmann, When gains loom larger than losses: Reversed loss aversion for small amounts of money. Psychological Science,1099-1105 (2007).
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Reaction paper by: Kumar Pallav Corporate law: Policy Analysis

concerned and held by organizations, in particular pension funds and endowments. This is a reasonable concern with respect to Authors paper.3

I admire finding in this paper which bring to light, identifying second feature, the disposition effect, as it refers to an aversion to loss realization. Authors supported the study by Shefrin and Statman (1985). Their study examined disposition effect within the context of financial markets and suggests that investors tend to sell winners too early and ride losers too long; such tendency applies in real-life financial markets. Furthermore this paper demonstrates the impact of these behavioral biases on investors and supports the institution of specific regulation for structured products to improve investor protection. Paper also proposed regulation that can be shaped in different forms; as sale prohibition to unprofessional investors or as different levels of mandatory disclosure.

Shlomo Benartzi; Richard H. Thaler, Myopic Loss Aversion and the Equity Premium Puzzle J. Eco., 73-92 (1995).
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