Can Financial Education Extend the Border of Bounded Rationality?

Abstract

When choosing a particular alternative from a number of financial assets, risk is an important feature. According to the classic Capital Assets Pricing Model (CAPM), we would expect to receive a positive correlation between risk and return of financial assets. However, studies show that investors judge financial assets in terms of "good" or "bad". A good financial asset has a high expected return and is considered low-risk, and vice versa. This type of thinking is biased, as it is both irrational and contradicts the classical theory of finance. One explanation for this bias is the affect heuristic. According to this heuristic, the investor forms her attitude about the asset in the first stage, and then links all of her subsequent judgments to this attitude. The aim of this study is to examine how this bias is affected by studying the CAPM in Finance entry courses. An experiment was conducted in which each subject made both risk judgments and return judgments in regard to 25 domestic stocks chosen randomly from the Tel Aviv 100 stock index. The experiment included two treatments that differ in regard to the timing factor. Some of the subjects were asked to judge the return and risk ratings before learning about the CAPM in class; the others were asked after studying the CAPM material. Finance education reduced the bias, but did not prevent it. The results show that in the teaching of Economics, there should be a balance between providing a coherent theoretical framework together with behavioral aspects. Moreover, given that finance education did not prevent the bias among students with background in quantitative analysis, it is reasonable to assume that other agents without this background would have more difficulties to apply the principles of investments under uncertainty.

Keywords: Experiment, Affect heuristic, Familiarity effect, CAPM

JEL Classification: C91, A20, G02