Topic 10: Behavioral Finance

1. Topic 10: Behavioral Finance

2. 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 • 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”

3. What do we observe? • 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

4. 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”

5. 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

6. What’s 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

7. Behavioralism • 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

8. Prospect Theory 2 1 3

9. Prospect TheoryNormal Distribution The probability that yearly return will fall within +/- one std. dev. (20%)Is 68%

10. Shleifer and Vishny (1997)Limits to Arbitrage • Econ’s 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 don’t want the risk • Closed-End funds = individual investors • Palm/3com

11. 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 shouldn’t matter??

12. Indicators & Influences • Overconfidence • Pride/Regret • Past history = Info? • Mental Accounting • Portfolio construction • Representativeness • Herding • Emotions • Self Control

13. #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”

14. #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

15. #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

16. #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 can’t walk the walk • Hold losers too long • Sell winners too soon • No consideration of interaction.

17. #5 – Portfolio construction • Covariance and diversification hard b/c of mental accounting • Decisions made at individual stock level • Accumulate money → What’s a good buy→ consider acquisition in isolation • 401–K plans • Pensions funds, too

18. #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

19. #6 – Representativeness cont’d • 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

20. #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

21. #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

22. #9 – Self control • 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

23. 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

24. 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

25. 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

26. MYTH = Behavioral Finance is a formula to beat the market • 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 • 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.”

27. 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 event’s risk • Delivery of the reward leads to neutral state

28. Thaler/Benartzi’s “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)

29. What’s 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