UNIVERSITY OF SOUTHERN CALIFORNIA
Marshall School of Business
BUAD 499
SPECIAL TOPICS: INTRODUCTION TO BEHAVIORAL
FINANCE
Spring 2012
Fernando Zapatero
HOH 712
Ph: (213) 740-6538
Email: fzapatero@marshall.usc.edu
http://marshallinside.usc.edu/zapatero
Office hours: M,W, 1-2, or by appointment
COURSE OBJECTIVES
The study of the motivations of economic agents is at the core of economics in general,
and financial economics in particular. Over decades of work, economics scholars
have developed a paradigm that intends to rationalize how consumers, investors and
managers make decisions. However, evidence that the standard paradigm is unable
to explain economic observations has been accumulating. In particular, economists
and scholars from related disciplines like psychology and sociology have documented
that economic agents behave in ways inconsistent with standard assumptions. In
addition, a growing body or research illustrates that economic models often fail to
explain the economic reality, possibly as the result of inadequate assumptions about
the motivation and properties of agents decisions. This growing body of research is
collectively denominated Behavioral Economics, with Behavioral Finance referring to
the subfield that deals with financial decisions of individuals and corporations. In this
course we attempt to offer an overview of the state of the art in Behavioral Finance.
In particular, we will discuss the inconsistencies between economic reality and the
predictions of traditional economic models. However, the emphasis of the course will
be on possible explanations to these inconsistencies. We will consider the suggestions
in the literature, but through class discussion we will also make an effort to come up
with our own proposals.
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GRADING
The grade will be based on class participation, one midterm exam a group project
and the final exam. The grade will be assigned according to a distribution of grades
resulting from the better of the two following possibilities:
A)
Class participation: 10%
Midterm:
20%
Group Project
35%
Final:
35%
B)
Class participation: 10%
Group Project
35%
Final:
55%
Groups for the group project will be formed by 3 to 6 students so that the total
of groups does not exceed 10. The project will produce a paper that analyzes some
financial or economic pattern that appears to be at odds with the predictions of
standard economic theory. The project can be based on: i) either the replication of
a particular puzzle discussed in the literature, ii) or the suggestion of another puzzle
not covered by the specialized literature. In both cases, the project has to provide
data documenting the conclusions of the project. In case i) the data has to be new
over that presented in the literature and the paper has to analyze the evolution of the
puzzle over the years and discuss possible changes. In case ii) the data has to support
the fact that this observation is inconsistent with traditional predictions. Projects
require instructor approval before the end of the sixth week of classes. The project
should not have more than five pages of text plus tables and bibliography. The text
has to detail the data sources and possible shortcomings of the data. Project and
peer evaluations are due in electronic format the last day of class.
LEARNING OBJECTIVES
At the end of the semester, the students are expected to be familiar with the
main advances of the literature on behavioral finance and the main extensions to
the standard paradigms in finance and economics. In particular, Marshall undergraduate students are exposed to the building blocks of current finance and business
economics in required classes like ECON 251 (Microeconomics for Business), ECON
252 (Macroeconomics for Business) and BUAD 306 (Business Finance), as well as
electives like FBE 441 (Investments) or FBE 459 (Financial Derivatives). However,
there is plenty of evidence that further elements are necessary to explain how financial markets work and how individual agents make financial decisions. This class will
provide the students with some of these elements. More importantly, this class will
train students to develop the economic critical thinking that employers increasingly
expect from job applicants.
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ACADEMIC INTEGRITY
I will enforce the university rules “ The use of unauthorized material, communication with fellow students during an exam, attempting to benefit from the work of
another student, and similar behavior that defeats the intent of an examination or
other class work is unacceptable to the University. It is often difficult to distinguish
between a culpable act and inadvertent behavior resulting from the nervous tensions
accompanying examinations. Where a clear violation occurs, however, the instructor
may disqualify the student’s work as unacceptable and assign a failing mark on the
paper. All students at the University of Southern California have an inherent responsibility to uphold the principles of academic integrity and to support each other and
the faculty in maintaining a classroom atmosphere that is conducive to orderly and
honest conduct. Students must understand and uphold the rules printed in the Student Conduct Code in the USC SCampus handbook, regarding examination behavior,
fabrication, plagiarism, and other types of academic dishonesty. Violations will result
in a failing course grade and referral to the University’s judicial system.”
STUDENTS WITH DISABILITIES
Any student requesting academic accommodations based on a disability is required
to register with Disability Services and Programs (DSP) each semester. A letter of
verification for approved accommodations can be obtained from DSP. Please be
sure the letter is delivered to me as early in the semester as possible. DSP
is located in STU 301 and is open 8:30 a.m. - 5:00 p.m., Monday through Friday.
The phone number for DSP is (213) 740-0776.
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READINGS
[AD] Akerlof, G. and W. Dickens, 1982. The Economic Consequences of Cognitive Dissonance, American Economic Review 72, 307-319.
[BRW] Baker, M., Ruback, R. and J. Wurgler, J., 2007. Behavioral Corporate Finance: A Survey, B Eckbo (editor), Handbook of Corporate Finance:
Empirical Corporate Finance, North Holland.
[BO] Barber, B. and T. Odean, 2001. Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment, Quarterly Journal of Economics 116,
261-292.
[BT] Barberis, N. and R. Thaler, 2003. A Survey of Behavioral Finance, in G.
Constantinides (editor), M. Harris (editor) and R. Stulz (editor), Handbook of
the Economics of Finance, North Holland.
[B] Basak, S. 2005. Asset Pricing with Heterogeneous Beliefs, Journal of Banking and Finance 29, 2849-2881.
[BeT] Benartzi, S. and R. Thaler. 1995. Myopic Loss Aversion and the Equity
Premium Puzzle, Quarterly Journal of Economics 110, 73-92.
[B] Black, F. 1976. The Dividend Puzzle, Journal of Portfolio Management 2,
5-8.
[BHS] Brown, K., W. Harlow, and L. Starks, 1996. Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry,
Journal of Finance 51, 85110.
[CPV] Caginalp, G., D. Porter and V. Smith, 2001. Financial Bubbles: Excess Cash, Momentum, and Incomplete Information, Journal of Psychology and
Financial Markets 2, 80-99
[CE] Chevalier, J., and G. Ellison, 1999. Career Concerns of Mutual Fund
Managers, Quarterly Journal of Economics 114, 389432.
[CM] Coval, J. and T. Moskowitz. 1999. Home Bias at Home: Local Equity
Preference in Domestic Portfolios, Journal of Finance 54, 1695-1704.
[DT] De Bondt, W. and R. Thaler. 1985. Does the Stock Market Overreact?
Journal of Finance 40, 793-805.
[DR] Dynan, K. and E. Ravina. 2007. Increasing Income Inequality, External
Habits, and Self-Reported Happiness, American Economic Review Papers and
Proceedings 97, 226-231.
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[HT] Hirshleifer, D. and S. H. Teoh, 2003. Herd Behavior and Cascading in
Capital Markets: A Review and Synthesis, European Financial Management 9,
25-66.
[HKS] Hong, H., J. Kubik, and J. Stein, 2005. Thy Neighbor’s Portfolio, Journal
of Finance 60, 2801-2824.
[H] Huberman, G. 2001. Familiarity Breeds Investment, Review of Financial
Studies 14, 659-680.
[HJ] Huberman, G. and W. Jiang, 2006. Offering versus Choice in 401(k) Plans:
Equity Exposure and Number of Funds, Journal of Finance 61, 763-801.
[KT] Kahneman, D. and A. Tversky, 1979. Prospect Theory: An Analysis of
Decisions Under Risk, Econometrica 47, 263-291.
[KL] Kraus, A. and R. Litzenberger. 1976. Skewness Preference and the Valuation of Risk Assets, Journal of Finance 31, 1085-1100.
[LBG] Laster, D., P. Bennett and In S. Geoum, 1999. Rational Bias in Macroeconomic Forecasts, Quarterly Journal of Economics 114, 293-318.
[L] Loewenstein, G., S. Rick and J. Cohen, 2008. Neuroeconomics, Annual
Review of Psychology 59, 647672.
[MT] Malmendier, U. and G. Tate, 2005. CEO Overconfidence and Corporate
Investment, Journal of Finance 60, 2661-2700.
[MU] Mitchell, O. and S. Utkus, 2004. Lessons from Behavioral Finance for
Retirement Plan Design, in O. Mitchell (Editor), S. Utkus (Editor), Pension
Design and Structure: New Lessons from Behavioral Finance, Oxford University
Press.
[M] Montier, J., 2010. Value Investing: Tools and Techniques for Intelligent
Investment. Wiley.
[O] Odean, T, 1998. Are Investors Reluctant to Realize Their Losses? Journal
of Finance 53, 1775-1798.
[R] Roll, R., 1986. The Hubris Hypothesis of Corporate Takeovers, Journal of
Business 59, 197-216
[RH] Ryder, H. and G. Heal, 1973. Optimal Growth with Intertemporal Dependent Preferences, Review of Economic Studies 40, 1-33.
[She] Shefrin, H., 2002. Beyond Greed and Fear: Understanding Behavioral
Finance and the Psychology of Investing. Oxford University Press.
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[SS] Shefrin, H. and M. Statman, 1984. Explaining Investor Preference for
Cash-Dividends, Journal of Financial Economics 13, 253-282.
[Shi] Shiller, R. 2003. From Efficient Markets Theory to Behavioral Finance,
Journal of Economic Perspectives 17, 83-104.
[Shl] Shleifer, A., 2000. Inefficient Markets: An Introduction to Behavioral
Finance. Oxford University Press.
[SV] Shleifer, A. and R. Vishny, 1997. A Survey of Corporate Governance,
Journal of Finance 52, 737-784.
[St] Stein, J. 1996. Rational Capital Budgeting in an Irrational World, Journal
of Business 69, 429-455.
[T] Thaler, R. 1999. Mental Accounting Matters, Journal of Behavioral Decision
Making 12, 183-206.
[V] Veblen, T. 1899. The Theory of the Leisure Class, www.gutenberg.org.
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OUTLINE
A) Overview.
Lecture 1-2: Traditional View of Preferences and Markets.
• Properties of Preferences.
• Risk Aversion.
• Market Efficiency.
• CAPM and other Models.
Readings: Shl-Ch 1.
Lecture 3: Alternative Directions.
• Bounded Rationality.
• Non-Standard Preferences.
• Biases and Other Biological Explanations.
• Heterogeneous Agents.
Readings: BT, She-Preface.
B) Psychological Foundations.
Lecture 4-5: Heuristics and Other Biases.
• Representation.
• Framing.
• Overconfidence.
• Mental Accounting.
Readings: BT, She-Ch 2,3, T.
Lecture 6-7: Affect and Social Aspects.
• Emotions.
• Cognitive Dissonance.
• Disposition Effect.
• Home Bias.
Readings: AD, BO, CM, H, O.
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C) Non-Standard Preferences.
Lecture 8-9: Prospect Theory.
• Loss Aversion.
• Experimental Evidence
• Implications for Investment Behavior.
Readings: BeT, KT.
Lecture 10: Habit Formation.
• Notion of Habit.
• Addiction.
• Economic Implications.
Readings: RH.
Lecture 11-12: Relative Wealth Concerns and Status.
• Keeping Up with the Joneses.
• Implications for Investment Behavior.
Readings: DR, KL, V.
Lecture 13: Investors with Different Beliefs.
• Agreeing to Disagree.
• Learning.
• Beliefs and Volatility.
Readings: B.
D) Household Finance Anomalies.
Lecture 14: Pension Fund Allocation.
• Behavioral Biases.
• Choosing Allocation.
• Own Firm Stock.
Readings: HJ, MU.
Midterm: March 5.
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E) Financial Markets Anomalies.
Lecture 16-17: Deviations from Standard Models.
• Market Overreaction.
• Bubbles.
• Challenges to CAPM.
Readings: CPV, DT, M-Ch 2, Shi, Shl-Ch 1.
Lecture 18: Some Market Puzzles.
• Closed-end Fund Puzzle.
• Growth-Value Puzzle.
Readings: M-Ch 2, Shl-Ch 1, .
F) Behavioral Issues in Corporations
Lecture 19: Governance and Agency Problems.
• Behavioral Biases of Managers.
• Status Concerns.
• Managerial Compensation.
Readings: BRW, MT, SV.
Lecture 20: Financial Structure.
• Optimism and Overconfidence.
• Behavioral Explanations of the Theories of the Term Structure.
• Capital Budgeting.
Readings: MT, St.
Lecture 21: Dividends and Payout Policies.
• Dividend Puzzle.
• Disappearing Dividends.
• Behavioral Biases.
Readings: B, SS.
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Lecture 22: Mergers and Acquisitions.
• Misvaluation Hypothesis.
• The Winner’s Curse.
• The Hubris Hypothesis and Overbidding.
Readings: BRW, R, She-Chap 16.
Lecture 23: IPO’s.
• Initial Underpricing.
• Long-Term Under-performance.
• The Decision to Go Public.
Readings: She-Chap 17.
G) Institutional Agents
Lecture 24: Herding and Biases of Analysts.
• Conflicts of Interest.
• Asymmetric Information.
• Relative Performance Concerns.
Readings: LBG.
Lecture 25-26: Mutual Funds Managers.
• Career Concerns.
• Tournament Behavior.
• Compensation Structure.
Readings: BHS, CE.
H) Recent Trends
Lecture 27: Social Networks.
• Social Interaction.
• Asset Pricing Implications.
• Institutional Herding.
Readings: HKS, HT.
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Lecture 28: Neuroeconomics.
• Technical Aspects.
• Some Findings.
• The Future.
Readings: LRC.
Final Exam: May 7, 8–10m.
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