Topic 10: Behavioral Finance

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Topic 10 Behavioral Finance
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Traditional Finance

• Markowitz, Fama and the rest of the boys
• Rational decisions and unbiased predictions
• Risk, return, covariance
• Semi strong market efficiency and portfolio
  theory
• MM (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

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What do we observe?

• Should be low trading low volume?
• Trade on info low volatility?
• Growth/Value or Small/Large shouldnt matter?
• Dividends shouldnt matter
• Equity premium of 7 is too high for risk
• Momentum shouldnt exist
• Positive news boosts depressed stocks more than
  up stocks
• IPOs underperform long term
• Addition to SP 500 permanently increases
• Buffett is just a chance happening

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Whats 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

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Behavioralism

• Along come Kahneman, Thaler, Schliefer, Odean,
  and pals in the 1990s
• 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

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Whats the diff?

• Information Investors food which determines
  activity and prices
• EM prices integrate all info quickly
• BF some info neglected and other exaggerated
• Noise trading uncorrelated with changes in
  fundmental/intrinsic value.
• EM just that, noise! nothing in aggregate
• BF may be biased
• See other differences play out in slides that
  follow

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Behavioralism

• Its 1896 and the Dow is at 40.
• Its 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

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Prospect Theory
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Prospect TheoryNormal Distribution
The probability that yearly return will fall
within /- one std. dev. (20)Is 68
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Shleifer and Vishny (1997)Limits to Arbitrage

• Econs Law of One Price
• Finance assumes riskless and available arb
• Limits
• 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 dont want the risk
• Closed-End funds individual investors
• Palm/3com

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More evidence

• 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 shouldnt matter??

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Indicators Influences

• Overconfidence
• Pride/Regret
• Past history Info?
• Mental Accounting
• Portfolio construction
• Representativeness
• Herding
• Emotions
• Self Control

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1 - Overconfidence

• A little knowledge is a dangerous thing
• Excessive trading
• Excessive risk taking
• Portfolio losses
• Survey of 3000 new small business owners
• 2001 survey of individual investors
• 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

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2 Pride/Regret

• Pride ? Disposition effect reluctance to
  realize losses
• Remember prospect theory
• Sell winners too soon
• Ride the losers for too long
• Reference point
• Need not be purchase price
• Regret if sell below previous high

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3 Past History Info?

• Buy high and sell low Sounds like a winner to
  me?
• 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

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4 Mental Accounting

• 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 cant walk the walk
• Hold losers too long
• Sell winners too soon
• No consideration of interaction.

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5 Portfolio construction

• Covariance and diversification hard b/c of mental
  accounting
• Decisions made at individual stock level
• Accumulate money ? Whats a good buy ? consider
  acquisition in isolation
• 401K plans
• Pensions funds, too

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6 Representativeness

• History again and familiarity Stereotypes
• 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?
• 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
• why value outperforms growth
• Winner chasing in mutual funds
• Ivo Welch studied 226 Fin professors
• Believe in mean reversion and historical trends

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6 Representativeness contd

• Given two risky options, will pick more familiar
  home bias
• Breakup of ATT in 1984 ownership is regionally
  concentrated
• Coke 16 Georgia owned and most in Atlanta
• Money managers most buys are 100 miles closer
  to managers office than typical
• Pensions invested in firm stock, Enron
• Conservatism is flip-side New evidence ?
  beliefs dont change as much as should

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7 Herding

• 1989 32 American own stock
• 1998 50 investing is more a part of our
  lives
• Since is social and need a heuristic ? herding
• 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

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8 Emotions

• 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.
• 1630 tulip bulbs
• 1850 railroad
• 1920s Federal Reserve or radio
• 1950s New deal
• 1990 Biotech
• 1998 Internet
• Other emotions

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9 Self control

• Understand your biases
• Know why you are investing set goals
• Establish Quantitative investment criteria
• Diversify if you cont have time, discipline,
  skill
• Review portfolio annually, but dont check prices
  hourly
• If this sounds familiar, it should

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Firm Managers are people, too!

• 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)
• Smart managers and dumb markets
• Smart markets and dumb managers

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Smart managers and dumb markets

• Take advantage of investors (rational manager)
• 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

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Smart markets and dumb managers

• 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
• 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

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MYTH Behavioral Finance is a formula to beat
the market

• NO!!!!! If it is so easy, why aint you rich?
• Market price and fundamental value may
  temporarily part company
• A number of academics are walkin the walk
• 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 companys prospects. They underweight
  evidence that disconfirms their prior views and
  overweight confirming evidence. They interpret a
  permanent change as if it were temporary.

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Buy on Rumor, Sell on news

• What lies behind this?
• Perceived risk vs. reward utility
• High probability of small to large reward or very
  low proability of very large reward non-normal
  distribution
• Minimal dissemination of information about the
  events risk
• Delivery of the reward leads to neutral state

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Thaler/Benartzis Save More Tomorrow (see WSJ
handout)

• What lies behind this change to 401-Ks?
• 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)

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Whats it mean for you?

• 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