Behavioral aspects of the design and marketing of financial products - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Hersh Shefrin, Meir Statman

(July 1977), pp. 327-352.

46. A. Tversky and D. Kahneman, "The Framing of Decisions and the Psychology of Choice," Science (January 1981), pp. 453-458.

47. A. Tversky and D. Kahneman, "Rational Choice and the Framing of Decisions," Journal of Business (October 1986), pp. 251-278.

The design of financial products is guided by many considerations. The list includes alleviation of managerial entrenchment, catering to tax clienteles, and differences in preferences and endowments.(1) While these considerations vary, they are all within the standard finance world of frame invariance where investors care about cash flows, but are indifferent among frames of cash flows.

The pricing of options is a good example of frame invariance. The price of a call option on a stock is determined by the fact that the cash flows of the option can be replicated by the cash flows of a particular dynamic combination of a bond and the underlying stock. The fact that in the first case cash flows are described in terms of options, while in the second cash flows are described in terms of bonds and stocks is irrelevant to investors in a world of frame invariance.

Although the literature of standard finance has no relevant role for framing in the design of financial products, the behavioral literature is replete with studies on the effects of frames on choice (see Tversky and Kahneman |47~). We suggest that investors are not indifferent to the frames of cash flows and propose a behaviorally based framework for the design of financial products.

In this paper, we describe the role of four behavioral elements in the design of some financial products. The elements are prospect theory (Kahneman and Tversky |21~), hedonic framing (Thaler |44~), behavioral life cycle theory (Shefrin and Thaler |41~), and cognitive errors (Kahneman, Slovic, and Tversky |19A~). However, we want to emphasize that a behavioral framework for the design of financial products extends beyond these four elements.

All financial products are bundles of state primitives, securities that pay $1 if a particular state occurs. Some financial products, such as stocks, are bundled by corporations; some, such as listed stock options, are bundled by exchanges; and some, such as covered calls, are bundled by investors, typically with the help of brokers. Bundling cash flows, like designing and bundling the features of products, is part of marketing. As Allen and Gale |2~, Ross |35~, and Madan and Soubra |25~ emphasize, marketing considerations are important because financial products must appeal to sufficiently large clienteles if they are to be viable.

We use covered calls as a vehicle for our exposition of the design of financial products. We focus on "explicit" covered calls constructed by buying shares and selling calls. But the discussion also applies to implicit covered calls, such as "option income" mutual funds, "primes" and callable bonds.(2) Moreover, the framework applies to financial products beyond covered calls.

We suggest that behavioral considerations are indispensable in the design of financial products. For example, a covered call can be designed with an in-the-money call or an out-of-the-money call; it can be designed as fully covered or as partially covered; and it can be designed so that the investor sells shares if the call is in-the-money at expiration or repurchases the call. We shall argue that some of these design features are preferable to alternatives with identical cash flows.

The remainder of the paper is organized as follows. Section I describes the use of covered calls. Section II describes prospect theory and mental accounts. Section III describes the framing of covered calls. Section IV describes the application of behavioral life cycle theory to covered calls. Section V outlines some extensions of behavioral framework beyond the design of covered calls. Section VI concludes.

I. The Use of Covered Calls

Covered calls are frequently promoted by brokers and other investment advisors.(3) For example, the Research Institute of America, Inc., (RIA) provides the following advice in its Personal Money Guide |34~:

An investment strategy that can make you extra money is writing calls on securities you already own.... When you sell a call on stock you own, you receive a premium. Think of these premiums as extra dividends. By careful selection of stocks and timing of writing calls, you have the opportunity to earn annual rates of return of 11% to 19%: regular dividends of 4% to 9% and premium "dividends" of 7% to 10%.

The Philadelphia Stock Exchange conducted a survey of the attitudes and behavior of brokers and investors towards stock options |32~. The survey reveals that covered call writing is the most important objective of investors who use options. The authors of the survey note that:

Brokers see their options investing clients primarily as speculators. In reality, those investors that do invest in options are more interested in covered writing and hedging. Speculation is certainly important, but not as important as assumed by brokers.