Why Do Investors Buy Bad Financial Products? Probability Misestimation and Preferences in Financial Investment Decision

Abstract

We study the influence of systematic probability misestimation on complex financial investment decisions on the context of structured financial products. Structured products have become more and more complex. We study the question whether this complexity might be a sophisticated method to exploit systematic biases in probability estimation of investors in order to make products look safer and more attractive than they actually are. We present results of an experiment that focused on probability estimates in the context of certain classes of structured products, in particular barrier reverse convertibles, bonus certificates, and worst-of basket certificates. We find that behavioral biases, for example, the conjunction fallacy, increase the subjective attractiveness of these product types. We also investigate potential ways to de-bias investors by providing additional information.

Keywords:

• Structured financial products
• Equity linked notes
• Index linked notes
• Probability misestimation
• Barriers
• Correlation estimates
• Conjunction fallacy

ACKNOWLEDGMENTS

I would like to thank foremost my former student Meike Bradbury for her help with the design of the experiment and her ideas contributing to this project. I am also grateful to many fruitful discussions with Thorsten Hens, Mei Wang, and other colleagues. Several of our research assistants helped with the experiments and the data preparation, and I would like to thank them as well. Support by the National Centre of Competence in Research “Financial Valuation and Risk Management” (NCCR FINRISK), Project 3, “Evolution and Foundations of Financial Markets,” and by the University Priority Program “Finance and Financial Markets” of the University of Zürich are gratefully acknowledged.

We used z-Tree for the experimental design and SPSS and JMP for the data analysis.

Notes

1. For an overview on studies on this subject we refer to Shefrin [2005].

2. In the United States, barrier reverse convertibles had a share of 18.37% on all issued structured products for 2006. In Germany, bonus certificates had a share of 19.3% on all structured products (outstanding volume November 2007, N = 270’254). There are no numbers available for barrier reverse convertibles or worst-of baskets, but the latter had a share of 5.2% on the trading volume of structured products on the Stuttgart stock exchange which specializes in structured products and reverse convertibles (including barrier reverse convertibles) had a share of 42.3% on the outstanding volume in November 2007. In Switzerland, 9.9% of all emitted structured products were bonus certificates and 30.5% barrier reverse convertibles (March–November 2007, N = 47’362), 29.4% of the products listed in April 2007 were worst-of baskets (Hens and Rieger [2008], Wallmeier and Diethelm [2008]).

3. Five selected probability estimates were used to compute a score, based on which the participants received a payment depending on their rank among the participants of that day. Moreover they had a 50% chance to play one randomly chosen lottery they had selected.

4. This typical worst-of basket product (“callable yield note”) has been issued by Credit Suisse on May 2006.

5. Many indices (such as the SMI) do not include dividends; thus products with 100% participation are possible.