Three essays on the psychology of investment and financial markets

Préface My thesis consists of three essays where I consider equilibrium asset prices and investment strategies when the market is likely to experience crashes and possibly sharp windfalls. Although each part is written as an independent and self contained article, the papers share a common behavioral approach in representing investors preferences regarding to extremal returns. Investors utility is defined over their relative performance rather than over their final wealth position, a method first proposed by Markowitz (1952b) and by Kahneman and Tversky (1979), that I extend to incorporate preferences over extremal outcomes. With the failure of the traditional expected utility models in reproducing the observed stylized features of financial markets, the Prospect theory of Kahneman and Tversky (1979) offered the first significant alternative to the expected utility paradigm by considering that people focus on gains and losses rather than on final positions. Under this setting, Barberis, Huang, and Santos (2000) and McQueen and Vorkink (2004) were able to build a representative agent optimization model which solution reproduced some of the observed risk premium and excess volatility. The research in behavioral finance is relatively new and its potential still to explore. The three essays composing my thesis propose to use and extend this setting to study investors behavior and investment strategies in a market where crashes and sharp windfalls are likely to occur. In the first paper, the preferences of a representative agent, relative to time varying positive and negative extremal thresholds are modelled and estimated. A new utility function that conciliates between expected utility maximization and tail-related performance measures is proposed. The model estimation shows that the representative agent preferences reveals a significant level of crash aversion and lottery-pursuit. Assuming a single risky asset economy the proposed specification is able to reproduce some of the distributional features exhibited by financial return series. The second part proposes and illustrates a preference-based asset allocation model taking into account investors crash aversion. Using the skewed t distribution, optimal allocations are characterized as a resulting tradeoff between the distribution four moments. The specification highlights the preference for odd moments and the aversion for even moments. Qualitatively, optimal portfolios are analyzed in terms of firm characteristics and in a setting that reflects real-time asset allocation, a systematic over-performance is obtained compared to the aggregate stock market. Finally, in my third article, dynamic option-based investment strategies are derived and illustrated for investors presenting downside loss aversion. The problem is solved in closed form when the stock market exhibits stochastic volatility and jumps. The specification of downside loss averse utility functions allows corresponding terminal wealth profiles to be expressed as options on the stochastic discount factor contingent on the loss aversion level. Therefore dynamic strategies reduce to the replicating portfolio using exchange traded and well selected options, and the risky stock.

The relationship between subjective experiences during first use of tobacco and cannabis and the effect of the substance experienced first.

INTRODUCTION: We examined the positive and negative subjective feelings associated with initial tobacco and cannabis use as well as the role of these experiences in regular use. Additionally, we investigated the effect of the first substance experienced on initial subjective experiences and later regular use. METHODS: Baseline data from a representative sample of young Swiss men were obtained from an ongoing Cohort Study on Substance Use Risk Factors, which includes 2,321 lifetime tobacco and cannabis users. We assessed the age of first tobacco and cannabis use along with the subjective experiences associated with initial use. Additionally, subjective experiences related to regular use of both substances were analyzed. RESULTS: The initial subjective experiences were divided into positive and negative for each substance, and we found that the feelings associated with first use of tobacco and cannabis were similar. Moreover, the participants who used cannabis before tobacco reported fewer negative experiences associated with first tobacco use, whereas the participants who initially used tobacco reported more negative experiences related to first cannabis use. Also, we identified that regular use was encouraged by positive experiences and that negative experiences were more adverse for regular use of cannabis compared with tobacco. CONCLUSIONS: Taken together, these results indicate that similar subjective experiences were associated with the first use of tobacco and cannabis. Also, the use of cannabis before tobacco, which occurred in only a minority of users, had the potential to enhance the effects of initial tobacco use.

Factor structure of early smoking experiences and associations with smoking behavior: valence or sensitivity model?

The Early Smoking Experience (ESE) questionnaire is the most widely used questionnaire to assess initial subjective experiences of cigarette smoking. However, its factor structure is not clearly defined and can be perceived from two main standpoints: valence, or positive and negative experiences, and sensitivity to nicotine. This article explores the ESE's factor structure and determines which standpoint was more relevant. It compares two groups of young Swiss men (German- and French-speaking). We examined baseline data on 3,368 tobacco users from a representative sample in the ongoing Cohort Study on Substance Use Risk Factors (C-SURF). ESE, continued tobacco use, weekly smoking and nicotine dependence were assessed. Exploratory structural equation modeling (ESEM) and structural equation modeling (SEM) were performed. ESEM clearly distinguished positive experiences from negative experiences, but negative experiences were divided in experiences related to dizziness and experiences related to irritations. SEM underlined the reinforcing effects of positive experiences, but also of experiences related to dizziness on nicotine dependence and weekly smoking. The best ESE structure for predictive accuracy of experiences on smoking behavior was a compromise between the valence and sensitivity standpoints, which showed clinical relevance.