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Journal Article

Behavioral Aspects of the Design and Marketing of Financial Products

Hersh Shefrin and Meir Statman
Financial Management
Vol. 22, No. 2 (Summer, 1993), pp. 123-134
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665864
Page Count: 12
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Behavioral Aspects of the Design and Marketing of Financial Products
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Abstract

Many people believe the yield enhancement produced by covered options writing is the trading world's version of a free lunch.... The writer of the call option agrees to sell a portion of the future upside appreciation of a long stock position; in exchange, the writer gains a one-time cash receipt of the option's premium. The only way the seller of the call option can gain from this deal is for a buyer to pay more than the option is worth consistently. However, common sense says this can't always happen. [R. Binnewies, "What's Wrong With Covered Writes," Futures, July 1992, p. 32.] Covered calls are an enduring and successful financial product. What makes covered calls successful? Are users of covered calls ignorant, or do they have needs that not everyone understands? We suggest that there is merit in both answers, and that the two answers apply to financial products much beyond covered calls. We have two audiences in mind for this paper, practitioners and academics. Practitioners already know that some investors are ignorant and that the standard framework of finance does not provide a comprehensive framework for the design of financial products. We offer practitioners a behavioral framework that extends beyond the standard framework. We also offer specific tools that can be used by both designers and users of financial products. Academics generally believe that the design of financial products is guided by issues of substance such as the minimization of taxes or solutions to agency conflicts. Academics generally admit that some investors are ignorant but believe that ignorance has no role in the design of financial products because ignorance can be stamped out through arbitrage or education. We offer academics insights into the preferences of investors, both individual and institutional, beyond those captured in the standard framework and suggest that arbitrage and education are not always effective remedies. Moreover, we suggest that it is impossible to understand the wide range of existing financial products without admitting behavioral elements. The world of standard finance is the world of frame invariance where investors can distinguish substance from form. It is also a world where investors care about cash flows, but are indifferent among frames of cash flows. However, we suggest that even sophisticated investors are not always able to distinguish substance from form and that they are not indifferent to frames. Practitioners tend to have a good intuitive understanding of the importance of frames in the determination of the demand for financial products. Consider, for example, the way stockbrokers sell covered calls. The following is taken from a manual for stockbrokers: Joe Salesman: "Starting tomorrow, how would you like to have three sources of profit every time you buy a common stock?" John Prospect: "Three profit sources? What are they?" Joe Salesman: "First, you could collect a lot of dollars -- maybe hundreds, sometimes thousands -- for simply agreeing to sell your just-bought stock at a higher price than you paid. This agreement money is paid to you right away, on the very next business day -- money that's yours to keep forever. Your second source of profit could be the cash dividends due you as the owner of the stock. The third source of profit would be in the increase in price of the shares from what you paid, to the agreed selling price." "By agreeing to sell at a higher price than you bought, all you are giving up is the unknown, unknowable profit possibility above the agreed price. In return, for relinquishing some of the profit potential you collect a handsome amount of cash that you can immediately spend or reinvest, as you choose." [L. Gross, The Art of Selling Intangibles: How to Make Your Million($) by Investing Other People's Money, New York, New York Institute of Finance, 1982, p. 166] Note the way Gross creates the impression of a free lunch by framing the cash flow of a covered call into three mental accounts or "three sources of profit." He plays up the call premium, the dividend, and the capital gain on the stock, and the downplays the "unknowable profit opportunity" that covered call writers relinquish. We discuss covered calls, LYONs, money market funds, premium bonds, PRIMES, SCORES, and dividend-paying stocks. We provide a behavioral framework that explains the popularity of some financial products and we offer tools for the design and marketing of new ones.

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