BEHAVIORAL FINANCE

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BEHAVIORAL FINANCE
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Behavioral Finance

• People are rational in standard finance.
• People are normal in Behavioral finance.
• Normal people
• commit cognitive errors
• Affected by frames
• Know the pain of regret
• Are both risk averse and risk seeking
• Cause bubbles in Markets

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• Behavioral finance research focuses on
• how investors make decisions to buy and sell
  securities, and
• how they choose between alternatives.

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Market Efficiency

• Two meanings
• Price equals (fundamental) value.
• You cannot beat the market (so buy and hold).
• The bubble of the late 1990s proves that the
  market is not efficient.
• In the sense that price equals value
• But, can you predict when the bubble will burst?
  It is very difficult.

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Errors in Information Processing

• Overconfidence
• Investors view themselves as more able to value
  securities than they actually are.
• Investors tend to over-weight their forecasts
  relative to those of others.

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Overconfidence in Info. Processing

• People tend to believe things that are easier to
  understand more readily than things that are more
  complicated.

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Representativeness Heuristic

• The representativeness heuristic takes one
  characteristic of a company and extends it to
  other aspects of the firm.
• In particular, many investors believe a well-run
  company represents a good investment.
• Mental Short-cuts used to solve complex problems.

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Behavioral BiasesLoss Aversion

• Investors do not like losses and often engage in
  mental gymnastics to reduce their psychological
  impact.
• Their tendency to sell a winning stock rather
  than a losing stock is called the disposition
  effect in some of the behavioral finance
  literature

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Myopic Loss Aversion

• Investors have a tendency to assign too much
  importance to routine daily fluctuations in the
  market.
• Abandoning a long-term investment program because
  of normal market behavior is sub optimal
  behavior.

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Anchoring

• Our decisions can be influenced by extraneous
  information contained in the problem statement.
• For example, investors tend to remember the price
  they paid for a stock, and this information
  influences their subsequent decisions about what
  to do with it.

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AnchoringEarnings Estimates

• Analysts may be anchored to old EPS estimates.
• Cockroach theory of earnings surprises. When
  good (or bad) announcements are made, other good
  (or bad) surprises follow.
• Analysts may be anchored and not understand the
  series of surprises to follow.

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Prospect Theory

• Risk averse investors get increasing utility from
  higher levels of wealth, but at a decreasing
  rate.
• Research shows that while risk aversion may
  accurately describe investor behavior with gains,
  investors often show risk seeking behavior when
  they face a loss

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Mental Accounting

• Mental accounting refers to our tendency to put
  things in boxes and track them individually.
• For example, investors tend to differentiate
  between dividend and capital dollars, and between
  realized and unrealized gains

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Availability Heuristic

• The availability heuristic is the contention that
  things that are easier to remember are thought to
  be more common.

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Empirical EvidenceValue v Growth

• Investors naively extrapolate a continuation of
  fast growth for growth firms and slow growth .
• Slow growers tend to improve and fast growers
  slow their growth in the future
• Errors by investors overprice growth firms and
  under-price value firms.
• Value stocks out-perform growth stocks in LT
  studies.
• Source Broussard, Neely, et al JABR 2004.

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Conclusions

• The Markets are not as Efficient as we once
  thought
• Investors should recognize the psychological,
  non-rational nature of people.
• We need to guard against the over-reactions of
  markets caused by mental shortcuts, etc.

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• Warren Buffett, etc.
• Need to Understand the Business
• Mr. Market is sometimes give high quotes and
  sometimes gives low quotes. Choose the price
  that is lower than your idea of Intrinsic Value
  (with a margin of safety because you are apt to
  make a mistake from time to time)
• More than a EMH Anomaly

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What should investors do?

• The market is still a very difficult boggy to
  beat
• Buy and hold and resist psychological factors
• It still pays to invest for the long-term.
• It still pays to Diversify