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.

Setting boundaries: brain dynamics of modal and amodal illusory shape completion in humans.

Normal visual perception requires differentiating foreground from background objects. Differences in physical attributes sometimes determine this relationship. Often such differences must instead be inferred, as when two objects or their parts have the same luminance. Modal completion refers to such perceptual "filling-in" of object borders that are accompanied by concurrent brightness enhancement, in turn termed illusory contours (ICs). Amodal completion is filling-in without concurrent brightness enhancement. Presently there are controversies regarding whether both completion processes use a common neural mechanism and whether perceptual filling-in is a bottom-up, feedforward process initiating at the lowest levels of the cortical visual pathway or commences at higher-tier regions. We previously examined modal completion (Murray et al., 2002) and provided evidence that the earliest modal IC sensitivity occurs within higher-tier object recognition areas of the lateral occipital complex (LOC). We further proposed that previous observations of IC sensitivity in lower-tier regions likely reflect feedback modulation from the LOC. The present study tested these proposals, examining the commonality between modal and amodal completion mechanisms with high-density electrical mapping, spatiotemporal topographic analyses, and the local autoregressive average distributed linear inverse source estimation. A common initial mechanism for both types of completion processes (140 msec) that manifested as a modulation in response strength within higher-tier visual areas, including the LOC and parietal structures, is demonstrated, whereas differential mechanisms were evident only at a subsequent time period (240 msec), with amodal completion relying on continued strong responses in these structures.