Applications of Behavioral Finance to

Entrepreneurs and Venture Capitalists:

Decision Making Under Risk and
Uncertainty in Futures and Options
Markets
Authors
Authors and affiliations
Fabio MattosEmail author
Philip Garcia

1. 1.
Chapter
First Online: 12 October 2010
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Abstract
A key dimension of entrepreneurship is risk-taking behavior, and often it is assumed that
entrepreneurs exhibit a higher tolerance for risk than non-entrepreneurs. However, empirical
evidence provides mixed findings, raising the question whether entrepreneur’s judgment is
influenced by emotion and heuristics which leads them to misperceive the risk in the market.
Our findings support this idea. Empirical results indicate these investors generally take more
risk than would be anticipated. Higher risk propensity is due to probability weighting and is
also consistent with the idea that entrepreneurs and possible venture capitalists perceive risky
situations more optimistically than non-entrepreneurs.

Appendix 1
The trade-off method is explained for the case of positive outcomes (gains), but its use for
negative outcomes (losses) is straightforward. The first step is to determine probability p,
reference outcomes R and R *, and the starting outcome x 0. Those values are set by the
experimenter such that x 0 > R > R*, and they are held fixed through the whole experiment.
Given x i−1, x i is elicited such that the subject is indifferent between prospects (x 0, p, R) and
(x1, p; R*). The elicitation of each outcome in the sequence x 1,…, x n is obtained through an
iterative procedure in which elicited outcomes are derived from observed choice rather than
assessed by subjects. For example, as can be seen in Table 8.5, x 1 is the value that makes the
subject indifferent between prospects (x 0, p; R) and (x 1, p; R*). The next step is to
elicit X 2such that the subject is indifferent between prospects (x 1, p; R) and (x 2, p; R*)
(X 2, p; R*). Outcomes x 3,…, x n can be elicited by following the same steps.
Table 8.5
Trade-off procedure to elicit sequence of outcomes x 1,,x n under risk
Step Fixed Prospect Prospect Elicited v(x i )
values A B outcome x i

1 R, R*, p, x 0 (x 0, p; R) (x 1, p; R *) x1 1/n

2 R, R*, p, x 1 (x 1, p; R) (x 2, p; R *) x2 2/n

3 R, R*, p, x 2 (x 2, p; R) (x 3, p; R *) x3 3/n

4 R, R*, p, x 3 (x 3, p; R) (x 4, p; R *) x4 4/n

\( \( ?\) \( ?\) \( ?\) \( ?\) \( ?\)

?\)

n R, R*, p, x n−1 (x 0, p; R) (x 1, p; R*) xn 1

The elicitation of each outcome in the sequence x 1,…, x n is obtained through an iterative
procedure in which elicited outcomes are derived from observed choice rather than assessed
by subjects. After the sequence of outcomes x 1,…, x n is obtained it is possible to use the same
procedure to elicit probabilities p 1,…,p n−1. In the probability elicitation process subjects are
asked a new series of choice questions, and probability p i is determined such that the subject
is indifferent between the certain outcome x i and a prospect (x n , p i , x 0), as illustrated in
Table 8.6. Similar to the elicitation of outcomes, the process to assess probabilities is also
based on an iterative procedure in which elicited probabilities are derived from observed
choice.
Table 8.6
Tradeoff procedure to elicit sequence of probabilities P 1, …, P n −1 under risk

Step Fixed Prospect Prospect Elicited Probability

values A B probability p i weight w(p i )

1 x 0, x 1, x n x1 (x n , p 1; x0) p1 1/n

2 x 0, x 2, x n x2 (x n , p 2; x0) p2 2/n

3 x 0, x 3, x n x3 (x n , p 3; x0) p3 3/n

4 x 0, x 4, x n x4 (x n , p 4; x0) p4 4/n

\( \( ?\) \( ?\) \( ?\) \( ?\) \( ?\)

?\)

n−1 x 0, x n−1, xn x n−1 (x n , p n−1; x 0) p n−1 n−1/n

The design of the experiment is critical for a good assessment of values and probability
weights. Hershey et al. (1982) discuss several steps for selecting an elicitation procedure in
order to reduce the occurrence of bias. The choices related to the decision context and also
the dimension of outcomes and probabilities are made based on conversations with the
manager of the traders participating in the experiment, along with the experimental
procedures adopted by Abdellaoui (2000) and Abdellaoui et al. (2005). The experiment
should be as close as possible to the subjects’ environment, which means that in the current
study it should reflect trading decisions commonly experienced in the CME Group markets.
Traders are asked to choose between two trading strategies (x i , p; R) and (x i+1, p; R*)
yielding different monetary outcomes, where x i , R, x i+1, and R * represent possible gains or
losses and p is the probability associated with the outcomes. Based on numbers discussed
with the manager of the trading group participating in this study, small traders usually make
profits (losses) in a range between US$800 and US$1,000 per trade, while large traders can
make (lose) up to US$15,000 per trade. Therefore, in the initial step of the elicitation
procedure x 0 is set to $1,000 (−$1,000), which then increases (decreases) from x 1 (x −1)
through x n (x −n ) according to each trader’s choices during the experiment. The values
of R and R * are set to $500 (−$500) and $0, respectively.

When the procedure is finished there is a sequence of outcomes x 1,…,x n and their respective
values v(x 1),…,v(x n ), and also a sequence of probabilities p 1,…,p n−1 and their respective
weights w(p 1),…,w(p n−1). These values are used to estimate the parameters of a power value
function and Prelec (1998)’s weighting function.

An extension of the experiment deals with decision making under uncertainty, and the
experimental procedure in this part follows Abdellaoui et al. (2005). The procedure is very
similar to the previous elicitation, except that probability p is now replaced by an
event Erepresenting some occurrence which traders are familiar with, and an extra step is
added to elicit probability functions. Now participants need to infer the probability of the
event based on their own capabilities. Based on Abdellaoui et al. (2005) and conversations
with the trading manager of the group participating in this study, two types of events will be
used. For the elicitation of v(x i ) event E will be “USDA report is bullish,” while for the
elicitation of w(q(E j )) event E will be the percentage change of the Dow Jones Industrial
Average (DJIA) stock index over the next 6 months. Four elementary events will be defined
based on historical performance of the DJIA: ∆DJIA < −4%, −4% < ∆DJIA < 0%, 0 <
∆DJIA 4%, and ∆DJIA > 4%. Five other events will also be defined from all unions of
elementary events that result in contiguous intervals, yielding a total of nine events. The
output of this second experiment will be two sequences of ten outcomes: x 1, x 2,…,x 10 in the
domain of gains, and x −1, x −2,…,x −10 in the domain of losses; and two sequences of nine
choice-based probabilities: q(E 1), q(E 2),…,q(E9) in the domain of gains,
and q(E −1), q(E −2),…,q(E −9) in the domain of losses. So for each trader and in each domain
there will be ten pairs of outcomes and values (x i , v(x i )) to assess their value functions, and
ten pairs of probabilities and weights (q(E j ), w(q(E j ))) to assess their weighting functions.
Again, these values are used to estimate the parameters of a power value function and Prelec
(1998)’s weighting function.

Research on Trading Behavior: Experiment in Decision Making Under Risk

Instructions

This is an experiment in the economics of decision making under risk. The experiment is
simple and should take approximately 60 min. Please remember that there are no right or
wrong answers in this experiment and you are expected to make decisions as honestly as
possible.

During the whole experiment you will be asked to choose between two strategies. Each
strategy is based on gains or losses, and all values refer to monetary amounts. You should
think of those strategies as decisions you make every day in the market. Example 1 provides
an example of the kind of choice you will be faced with during the experiment. If you choose
strategy A you have a 67% chance to gain $1,000 and a 33% chance to gain $500. If you
decide to follow strategy B you have a 67% chance to gain $3,500 and a 33% chance to gain
nothing.

Example 1

Strategy A Strategy B

Gain Probability Gain Probability

1,000 67% 3,500 67%

500 33% 0 33%

In Example 2 you have strategies involving losses. If you choose strategy A you have a 50%
chance to lose $18,000 and a 50% chance to lose 1,000. If you decide to follow strategy B
you have a 100% chance to lose 5,500.

Example 2

Strategy A Strategy B

Loss Probability Loss Probability

−18,000 50% −5,500 100%

−1,000 50%

The two examples above provide a very accurate picture of the kind of choices you will be
faced during the experiment. The experiment is computer-based and all you need to complete
the experiment is to use the mouse to choose your strategies. Please don’t use the keyboard.

The first few questions in the experiment are for practice purposes so that you can become
more familiar with the program. Feel free to ask the researcher any questions you might have
about the experiment.

Research on Trading Behavior: Experiment inDecision Making Under Uncertainty

Instructions

This is an experiment in the economics of decision making under uncertainty. The

experiment is simple and should take approximately 40 min. Please remember that there are
no right or wrong answers in this experiment and you are expected to make decisions as
honestly as possible.

During the whole experiment you will be asked to choose between two strategies. Each
strategy is based on gains or losses, and all values refer to monetary amounts. You should
think of those strategies as decisions you make everyday in the market. Examples 1 and 2
provide an example of the kind of choice you will be faced with during the experiment.
 Example 1: USDA report refers to the market(s) you trade.

Strategy A Strategy B

Gain/Loss If: Gain/Loss If:

0 USDA report is bullish 3,500 USDA report is bullish

−500 USDA report is bearish −1,000 USDA report is bearish

If you choose trading strategy A you will make nothing if the coming USDA report is bullish,
and you will lose $500 if the coming USDA report is bearish. If you decide to follow strategy
B you will make $3,500 if the coming USDA report is bullish, and you will lose $1,000 if the
coming USDA report is bearish.

Example 2: ∆DJ refers to the percentage change you expect in the Dow Jones Industrial
Average Index (DJ) over the next 6 months.

Strategy A Strategy B

Gain/Loss If: Gain/Loss If:

−11,000 ∆DJ ≤ 4% −5,000 ∆DJ ≤ 4%

0 ∆DJ > 4% −5,000 ∆DJ > 4%

If you choose trading strategy A you will lose $11,000 if the DJ changes by 4% or less over
the next 6 months, and you will lose nothing if the DJ changes by more than 4% over the next
6 months. If you decide to follow strategy B you will lose $5,000 either if the DJ changes by
4% or less or if the DJ changes by more than 4% over the next 6 months.

The two examples above provide an accurate picture of the kind of choices you will be faced
during the experiment. The experiment is computer-based and all you need to do to complete
the experiment is to use the mouse to choose your strategies. Please don’t use the keyboard.

The first few questions in the experiment are for practice purposes so that you can become
more familiar with the program. Feel free to ask the researcher any questions you might have
about the experiment.

Appendix 2
Assuming a prospect x that yields outcomes x 1 with probability p and x n with
probability 1−p, the two components of the risk premium are given by EV(x) = px 1+(1
− p)x n and v −1(V(x)) = v−1(w(p)v(x 1)+w(1−p)v(x n )). Considering the absence of probability
weighting (w(p) = p) and a power value function with a reference point separating gains and
losses as in Eq. 8.9, the expected utility (EU) premium can be calculated as in Eqs. 8.10–
8.13 for the gain domain and Eqs. 8.14–8.17 for the loss domain.
$$ v\left(x\right)=\{\begin{array}{l}{x}^{a}x > 0\\ -l{\left(-x\right)}^{b}x\le 0\end{array}
$$
(8.9)
 $$ V(x)=v\left(EV(x)-{r}_{G}^{EU}\right)$$
(8.10)
$$ pv\left({x}_{1}\right)+\left(1-p\right)v\left({x}_{n}\right)=v\left(p{x}_{1}+\left(1-
p\right){x}_{n}-{r}_{G}^{EU}\right)$$
(8.11)
$$ p{x}_{1}^{\alpha }+\left(1-p\right){x}_{n}^{a}={\left(p{x}_{1}+\left(1-
p\right){x}_{n}-{r}_{G}^{EU}\right)}^{a}$$
(8.12)
$${r}_{G}^{EU}=p{x}_{1}+\left(1-p\right){x}_{n}-{\left(p{x}_{1}^{a}+\left(1-
p\right){x}_{n}^{a}\right)}^{1/a}$$
(8.13)
$$ V(x)=v\left(EV(x)-{r}_{L}^{EU}\right)$$
(8.14)
$$ pv\left({x}_{1}\right)+\left(1-p\right)v\left({x}_{n}\right)=v\left(p{x}_{1}+\left(1-
p\right){x}_{n}-{r}_{L}^{EU}\right)$$
(8.15)
$$ p\left[ { - \lambda {{\left( { - {x_1}} \right)}^\beta }} \right] + \left( {1 - p} \right)\left[ {
- \lambda {{\left( { - {x_n}} \right)}^\beta }} \right] = - \lambda \left\{ { - {{\left[ {p\left( { -
{x_1}} \right) + \left( {1 - p} \right)\left( { - {x_n}} \right) - r_L^{EU}} \right]}^\beta }}
\right\} $$
(8.16)
$$ {r}_{L}^{EU}=p{x}_{1}+\left(1-p\right){x}_{n}+{\left[p{\left(-
{x}_{1}\right)}^{b}+\left(1-p\right){\left(-{x}_{n}\right)}^{b}\right]}^{1/b}.$$
(8.17)

The premiums are calculated from the data obtained in the lab experiment with traders.
Points x 1 and x n are the first and last points elicited in the experiment. The first point is
always 1,000 but the last point depends on how each trader makes choices during the
experiment. In the experiment for risk, x n ranges from 4,200 to 41,900 for gains and from
−2,100 to −31,500 for losses. In the experiment for uncertainty it goes from 4,500 to 38,800
for gains and −1,000 to −36,200 for losses.

Appendix 3
Figure 8.4
 Open image in new window

Fig. 8.4
Risk – Weighting function for gains (gray line) and losses (dark line)

Appendix 4
Figures 8.5 and 8.6
Open image in new window

Fig. 8.5
Proportional risk premiums in the gain domain – EU (large dashed line), standard (tiny
dashed line), and behavioral (dark line)
 Open image in new window

Fig. 8.6
Proportional risk premiums in the loss domain – EU (large dashed line), standard (tiny
dashed line), and behavioral (dark line)

Appendix 5
Figure 8.7
 Open image in new window

Fig. 8.7
Uncertainty – Weighing function for gains (gray line) and losses (dark line)

Appendix 6
Figures 8.8 and 8.9
Open image in new window

Fig. 8.8
Proportional uncertainty premiums in gain domain – EU (large dashed line), standard (tiny
dashed line), and behavioral (dark line)
 Open image in new window

Fig. 8.9
Proportional uncertainty premiums in loss domain – EU (large dashed line), standard (tiny
dashed line), and behavioral (dark line)

Appendix 7
Figures 8.10 and 8.11
Open image in new window

Fig. 8.10
Gain domain – Behavioral proportional premium: risk (dashed line) and uncertainty (dark
line)
 Open image in new window

Fig. 8.11
Loss domain – Behavioral proportional premium: risk (dashed line) and uncertainty (dark
line)

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