Topic 10: Behavioral Finance
Traditional Finance
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Markowitz, Fama and the rest of the boys
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Rational decisions and unbiased predictions
Risk, return, covariance
Semi strong market efficiency and portfolio theory
M&M (1961) –
assumes investors “always prefer more wealth to
less and are indifferent as to whether a given
increment to their wealth takes the form of cash
payments or an increase in the market value of
their holdings of shares”
What do we observe?
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Should be low trading – low volume?
Trade on info – low volatility?
Growth/Value or Small/Large shouldn’t matter?
Dividends shouldn’t matter
Equity premium of 7% is too high for risk
Momentum shouldn’t exist
Positive news boosts depressed stocks more than
“up” stocks
IPOs underperform long term
Addition to S&P 500 permanently increases $
Buffett is just a chance happening
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What’s going on in the “real”
world?
“Buy on the rumor, sell on the fact.”
“Buy the dips, sell the rallies”
“Cut losses short, let profits run”
“When in doubt, stay out”
“Manage the risks and profits will take
care of themselves”
“The more certain the crowd is, the surer
it is to be wrong”
Behavioralism
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Along come Kahneman, Thaler, Schliefer,
Odean, and pals in the 1990s
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Kahneman had right idea in the 1970s
Risk → Fear
Return → Greed
“Bounded rationality” – event is too complex
→ biases in heuristics
Not always rational and can make predictable
errors
What’s the diff?
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Information = Investors’ food which
determines activity and prices
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Noise trading – uncorrelated with changes in
fundmental/intrinsic value.
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EM – prices integrate all info quickly
BF – some info neglected and other exaggerated
EM – just that, noise! – nothing in aggregate
BF – may be biased
See other differences play out in slides that
follow
Behavioralism
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It’s 1896 and the “Dow” is at 40.
It’s 1998 and the “Dow” is at 9181
What would it have been if dividends had been
reinvested??
652,230 – like folding the paper 100 times
“Heuristics” enable dealing with many inputs
“anchoring” – take 9181 and add some
Kahneman & Tversky (1979) – Prospect Theory
(psychology)
Shleifer and Vishny (1997) – limits to Arbitrage
Prospect Theory
2
1
3
Prospect Theory
Normal Distribution
The probability
that yearly return
will fall within +/one std. dev.
(20%)Is 68%
Shleifer and Vishny (1997)
Limits to Arbitrage
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Econ’s Law of One Price
Finance assumes riskless and available arb
Limits
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Fundamental risk – arb fear price is right
Noise trader risk - Siamese twin stocks
Margin calls – Long Term Capital
No good substitute to short or may be unshortable
A lot of investors are precluded from it and still others
don’t want the risk
Closed-End funds = individual investors
Palm/3com
More evidence
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Liquidity from on-line trading makes arb
easier?
IPO underpricing?
Mergers & Acquistitons are quite frequently
bad – overconfidence
Lowest decile of stocks based on B/M earn
less than risk free rate
Dividends shouldn’t matter??
Indicators & Influences
1) Overconfidence
2) Pride/Regret
3) Past history = Info?
4) Mental Accounting
5) Portfolio construction
6) Representativeness
7) Herding
8) Emotions
9) Self Control
#1 - Overconfidence
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A little knowledge is a dangerous thing
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Survey of 3000 new small business owners
2001 survey of individual investors
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Excessive trading
Excessive risk taking
Portfolio losses
Stock market return next twelve months = 10.3%
Return on personal portfolio = 11.7
Success reinforces overconfidence, so more
pronounced in bull markets
“Biased self-attribution”
#2 – Pride/Regret
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Pride → “Disposition effect” = reluctance to
realize losses
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Remember prospect theory
Sell winners too soon
Ride the losers for too long
Reference point
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Need not be purchase price
Regret if sell below previous high
#3 – Past History = Info?
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Buy high and sell low – Sounds like a winner to
me?
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More willing to take higher risk after gains than losses
Gains → “house money” → overconfidence → seek
riskier
Losses → “snake bite” → avoid good opportunities
Big losses → really in a hole → try to break even
“Cognitive dissonance” – seek to reduce pain with
selective memory
“Confirmation bias” – side with opinions that support
own perceptions
#4 – Mental Accounting
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Each decision, action, and outcome filed in
separate folder
Ignore time value of money
“Sunk cost” effect – with anchoring and
reference points
Covariance & portfolio theory – even
finance professors can’t walk the walk
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Hold losers too long
Sell winners too soon
No consideration of interaction.
#5 – Portfolio construction
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Covariance and diversification hard b/c of
mental accounting
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Decisions made at individual stock level
Accumulate money → What’s a good buy →
consider acquisition in isolation
401–K plans
Pensions funds, too
#6 – Representativeness
History again and familiarity ≈ Stereotypes
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Mary is quiet, studious, and concerned with social issues. While
an undergraduate at Berkeley, she majored in English literature
and environmental studies. Given this information, indicate which
of the following three cases is most probable?
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a)
b)
c)
Mary is a Librarian
Mary is a Librarian and a member of the Sierra Club
Mary works in the banking industry
Confuse good company for good investment
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= why value outperforms growth
Winner chasing in mutual funds
Ivo Welch studied 226 Fin professors
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Believe in mean reversion and historical trends
#6 – Representativeness cont’d
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Given two risky options, will pick more familiar
– “home bias”
Breakup of AT&T in 1984 – ownership is
regionally concentrated
Coke – 16% Georgia owned and most in
Atlanta
Money managers – most buys are 100 miles
closer to manager’s office than typical
Pensions invested in firm stock, Enron
“Conservatism” is flip-side – New evidence →
beliefs don’t change as much as should
#7 – Herding
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1989 – 32% American own stock
1998 – 50% = investing is more a part of
our lives
Since is social and need a heuristic →
herding
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Germany fund ↑ 100% at fall of wall
ATT to purchase Tele-Communications, Inc
eToys grew to $8 B, but Toys r Us only $6 B
Dotcom name changes 1998-99
#8 – Emotions
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We are in a new era. _______ has ushered in a
new type of economy. Those stuck in the old
ways will quickly fall away. Traditional valuation
techniques do not capture the value of this
revolution.
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1630 – tulip bulbs
1850 – railroad
1920s – Federal Reserve or radio
1950s – New deal
1990 – Biotech
1998 – Internet
Other emotions
#9 – Self control
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Understand your biases
Know why you are investing = set goals
Establish Quantitative investment criteria
Diversify if you con’t have time, discipline,
skill…
Review portfolio annually, but don’t check
prices hourly
If this sounds familiar, it should
Firm Managers are people, too!
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Psychology may be even more important for
firms than investors
Assume managers will act in self-interest, but
are susceptible to same biases
Limited number of managers → greater impact
of biases
Recent study of mutual fund managers
Two ways to look at it (probably truth
somewhere in between)
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Smart managers and dumb markets
Smart markets and dumb managers
Smart managers and dumb
markets
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Take advantage of investors (rational manager)
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IPO clusters or issue equity when overvalued
CEOs judged on longer time frame than stocks –
Managers can “spin” one bad quarter
Set dividend policy – catering viewpoint = investors
may interpret as a good sign
Change name of firm to “dotcom” – investors fall for
it
Earnings management
Sticky dividends
Smart markets and dumb
managers
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IPO underpricing
Sunk cost good money after bad or hubris-based
acquisitions
“Bounded rationality” – less than 10% of firms
use NPV (payback period is common)
Optimism and over confidence
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All CEOs are above average
Capital budgeting projects may be overvalued
Too much cash leads to bad decisions
Biased self attribution – success is skill and failure
is bad luck
MYTH = Behavioral Finance is a
formula to beat the market
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NO!!!!! If it is so easy, why ain’t you rich?
Market price and fundamental value may temporarily part
company
A number of academics are walkin’ the walk
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David Dreman manages $8 B by taking positions contrary to what
efficiency would recommend
LSV – momentum plays
Fuller & Thaler – provide strategies to institutionals
“Analysts are slow to recognize the information associated with a
major earnings surprise. They are overconfidently anchored to
their prior view of the company’s prospects. They underweight
evidence that disconfirms their prior views and overweight
confirming evidence. They interpret a permanent change as if it
were temporary.”
Buy on Rumor, Sell on news
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What lies behind this?
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Perceived risk vs. reward – utility
High probability of small to large reward or very
low proability of very large reward – nonnormal distribution
Minimal dissemination of information about the
event’s risk
Delivery of the reward leads to neutral state
Thaler/Benartzi’s “Save More
Tomorrow” (see WSJ handout)
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What lies behind this change to 401-Ks?
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Investor savings low at firms that only offer
defined contribution plans
Determining how much to save is hard
(bounded rationality)
Savings for retirement requires self control
(willpower)
Procrastination – postpone unpleasant (Status
quo bias)
Saving more = lower standard of living (Loss
aversion)
What’s it mean for you?
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Be aware of predispositions
Know your competition (Incorporate their
actions into your plans)
Understand how managers at a firm you
are interested in might perform