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Topic 10: Behavioral Finance. Traditional Finance Markowitz, Fama and the rest of the boys Markowitz, Fama and the rest of the boys Rational decisions.

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Presentation on theme: "Topic 10: Behavioral Finance. Traditional Finance Markowitz, Fama and the rest of the boys Markowitz, Fama and the rest of the boys Rational decisions."— Presentation transcript:

1 Topic 10: Behavioral Finance

2 Traditional Finance Markowitz, Fama and the rest of the boys Markowitz, Fama and the rest of the boys Rational decisions and unbiased predictions Rational decisions and unbiased predictions Risk, return, covariance Risk, return, covariance Semi strong market efficiency and portfolio theory 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” 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? Should be low trading – low volume? Trade on info – low volatility? Trade on info – low volatility? Growth/Value or Small/Large shouldn’t matter? Growth/Value or Small/Large shouldn’t matter? Dividends shouldn’t matter Dividends shouldn’t matter Equity premium of 7% is too high for risk Equity premium of 7% is too high for risk Momentum shouldn’t exist Momentum shouldn’t exist Positive news boosts depressed stocks more than “up” stocks Positive news boosts depressed stocks more than “up” stocks IPOs underperform long term IPOs underperform long term Addition to S&P 500 permanently increases $ Addition to S&P 500 permanently increases $ Buffett is just a chance happening Buffett is just a chance happening

4 What’s going on in the “real” world? “Buy on the rumor, sell on the fact.” “Buy on the rumor, sell on the fact.” “Buy the dips, sell the rallies” “Buy the dips, sell the rallies” “Cut losses short, let profits run” “Cut losses short, let profits run” “When in doubt, stay out” “When in doubt, stay out” “Manage the risks and profits will take care of themselves” “Manage the risks and profits will take care of themselves” “The more certain the crowd is, the surer it is to be wrong” “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 Along come Kahneman, Thaler, Schliefer, Odean, and pals in the 1990s Kahneman had right idea in the 1970s Kahneman had right idea in the 1970s Risk → Fear Risk → Fear Return → Greed Return → Greed “Bounded rationality” – event is too complex → biases in heuristics “Bounded rationality” – event is too complex → biases in heuristics Not always rational and can make predictable errors Not always rational and can make predictable errors

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

7 Behavioralism It’s 1896 and the “Dow” is at 40. It’s 1896 and the “Dow” is at 40. It’s 1998 and the “Dow” is at 9181 It’s 1998 and the “Dow” is at 9181 What would it have been if dividends had been reinvested?? What would it have been if dividends had been reinvested?? 652,230 – like folding the paper 100 times 652,230 – like folding the paper 100 times “Heuristics” enable dealing with many inputs “Heuristics” enable dealing with many inputs “anchoring” – take 9181 and add some “anchoring” – take 9181 and add some Kahneman & Tversky (1979) – Prospect Theory (psychology) Kahneman & Tversky (1979) – Prospect Theory (psychology) Shleifer and Vishny (1997) – limits to Arbitrage Shleifer and Vishny (1997) – limits to Arbitrage

8 Prospect Theory 2 1 3

9 Prospect Theory Normal 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 Econ’s Law of One Price Finance assumes riskless and available arb Finance assumes riskless and available arb Limits Limits Fundamental risk – arb fear price is right Fundamental risk – arb fear price is right Noise trader risk - Siamese twin stocks Noise trader risk - Siamese twin stocks Margin calls – Long Term Capital Margin calls – Long Term Capital No good substitute to short or may be unshortable 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 A lot of investors are precluded from it and still others don’t want the risk Closed-End funds = individual investors Closed-End funds = individual investors Palm/3com Palm/3com

11 More evidence Liquidity from on-line trading makes arb easier? Liquidity from on-line trading makes arb easier? IPO underpricing? IPO underpricing? Mergers & Acquistitons are quite frequently bad – overconfidence Mergers & Acquistitons are quite frequently bad – overconfidence Lowest decile of stocks based on B/M earn less than risk free rate Lowest decile of stocks based on B/M earn less than risk free rate Dividends shouldn’t matter?? Dividends shouldn’t matter??

12 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

13 #1 - Overconfidence A little knowledge is a dangerous thing A little knowledge is a dangerous thing Excessive trading Excessive trading Excessive risk taking Excessive risk taking Portfolio losses Portfolio losses Survey of 3000 new small business owners Survey of 3000 new small business owners 2001 survey of individual investors 2001 survey of individual investors Stock market return next twelve months = 10.3% Stock market return next twelve months = 10.3% Return on personal portfolio = 11.7 Return on personal portfolio = 11.7 Success reinforces overconfidence, so more pronounced in bull markets Success reinforces overconfidence, so more pronounced in bull markets “Biased self-attribution” “Biased self-attribution”

14 #2 – Pride/Regret Pride → “Disposition effect” = reluctance to realize losses Pride → “Disposition effect” = reluctance to realize losses Remember prospect theory Remember prospect theory Sell winners too soon Sell winners too soon Ride the losers for too long Ride the losers for too long Reference point Reference point Need not be purchase price Need not be purchase price Regret if sell below previous high Regret if sell below previous high

15 #3 – Past History = Info? Buy high and sell low – Sounds like a winner to me? Buy high and sell low – Sounds like a winner to me? More willing to take higher risk after gains than losses More willing to take higher risk after gains than losses Gains → “house money” → overconfidence → seek riskier Gains → “house money” → overconfidence → seek riskier Losses → “snake bite” → avoid good opportunities Losses → “snake bite” → avoid good opportunities Big losses → really in a hole → try to break even Big losses → really in a hole → try to break even “Cognitive dissonance” – seek to reduce pain with selective memory “Cognitive dissonance” – seek to reduce pain with selective memory “Confirmation bias” – side with opinions that support own perceptions “Confirmation bias” – side with opinions that support own perceptions

16 #4 – Mental Accounting Each decision, action, and outcome filed in separate folder Each decision, action, and outcome filed in separate folder Ignore time value of money Ignore time value of money “Sunk cost” effect – with anchoring and reference points “Sunk cost” effect – with anchoring and reference points Covariance & portfolio theory – even finance professors can’t walk the walk Covariance & portfolio theory – even finance professors can’t walk the walk Hold losers too long Hold losers too long Sell winners too soon Sell winners too soon No consideration of interaction. No consideration of interaction.

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

18 #6 – Representativeness History again and familiarity ≈ Stereotypes 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 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? a) Mary is a Librarian b) Mary is a Librarian and a member of the Sierra Club c) Mary works in the banking industry Confuse good company for good investment Confuse good company for good investment = why value outperforms growth = why value outperforms growth Winner chasing in mutual funds Winner chasing in mutual funds Ivo Welch studied 226 Fin professors Ivo Welch studied 226 Fin professors Believe in mean reversion and historical trends Believe in mean reversion and historical trends

19 #6 – Representativeness cont’d Given two risky options, will pick more familiar – “home bias” Given two risky options, will pick more familiar – “home bias” Breakup of AT&T in 1984 – ownership is regionally concentrated Breakup of AT&T in 1984 – ownership is regionally concentrated Coke – 16% Georgia owned and most in Atlanta Coke – 16% Georgia owned and most in Atlanta Money managers – most buys are 100 miles closer to manager’s office than typical Money managers – most buys are 100 miles closer to manager’s office than typical Pensions invested in firm stock, Enron Pensions invested in firm stock, Enron “Conservatism” is flip-side – New evidence → beliefs don’t change as much as should “Conservatism” is flip-side – New evidence → beliefs don’t change as much as should

20 #7 – Herding 1989 – 32% American own stock 1989 – 32% American own stock 1998 – 50% = investing is more a part of our lives 1998 – 50% = investing is more a part of our lives Since is social and need a heuristic → herding Since is social and need a heuristic → herding Germany fund ↑ 100% at fall of wall Germany fund ↑ 100% at fall of wall ATT to purchase Tele-Communications, Inc ATT to purchase Tele-Communications, Inc eToys grew to $8 B, but Toys r Us only $6 B eToys grew to $8 B, but Toys r Us only $6 B Dotcom name changes Dotcom name changes

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

22 #9 – Self control Understand your biases Understand your biases Know why you are investing = set goals Know why you are investing = set goals Establish Quantitative investment criteria Establish Quantitative investment criteria Diversify if you con’t have time, discipline, skill… Diversify if you con’t have time, discipline, skill… Review portfolio annually, but don’t check prices hourly Review portfolio annually, but don’t check prices hourly If this sounds familiar, it should If this sounds familiar, it should

23 Firm Managers are people, too! Psychology may be even more important for firms than investors Psychology may be even more important for firms than investors Assume managers will act in self-interest, but are susceptible to same biases Assume managers will act in self-interest, but are susceptible to same biases Limited number of managers → greater impact of biases Limited number of managers → greater impact of biases Recent study of mutual fund managers Recent study of mutual fund managers Two ways to look at it (probably truth somewhere in between) Two ways to look at it (probably truth somewhere in between) Smart managers and dumb markets Smart managers and dumb markets Smart markets and dumb managers Smart markets and dumb managers

24 Smart managers and dumb markets Take advantage of investors (rational manager) Take advantage of investors (rational manager) IPO clusters or issue equity when overvalued IPO clusters or issue equity when overvalued CEOs judged on longer time frame than stocks – Managers can “spin” one bad quarter 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 Set dividend policy – catering viewpoint = investors may interpret as a good sign Change name of firm to “dotcom” – investors fall for it Change name of firm to “dotcom” – investors fall for it Earnings management Earnings management Sticky dividends Sticky dividends

25 Smart markets and dumb managers IPO underpricing IPO underpricing Sunk cost good money after bad or hubris-based acquisitions Sunk cost good money after bad or hubris-based acquisitions “Bounded rationality” – less than 10% of firms use NPV (payback period is common) “Bounded rationality” – less than 10% of firms use NPV (payback period is common) Optimism and over confidence Optimism and over confidence All CEOs are above average All CEOs are above average Capital budgeting projects may be overvalued Capital budgeting projects may be overvalued Too much cash leads to bad decisions Too much cash leads to bad decisions Biased self attribution – success is skill and failure is bad luck 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? NO!!!!! If it is so easy, why ain’t you rich? Market price and fundamental value may temporarily part company Market price and fundamental value may temporarily part company A number of academics are walkin’ the walk A number of academics are walkin’ the walk David Dreman manages $8 B by taking positions contrary to what efficiency would recommend David Dreman manages $8 B by taking positions contrary to what efficiency would recommend LSV – momentum plays LSV – momentum plays Fuller & Thaler – provide strategies to institutionals 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.” “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? What lies behind this? Perceived risk vs. reward – utility Perceived risk vs. reward – utility High probability of small to large reward or very low proability of very large reward – non- normal distribution 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 Minimal dissemination of information about the event’s risk Delivery of the reward leads to neutral state 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? What lies behind this change to 401-Ks? Investor savings low at firms that only offer defined contribution plans Investor savings low at firms that only offer defined contribution plans 1) Determining how much to save is hard (bounded rationality) 2) Savings for retirement requires self control (willpower) 3) Procrastination – postpone unpleasant (Status quo bias) 4) Saving more = lower standard of living (Loss aversion)

29 What’s it mean for you? Be aware of predispositions Be aware of predispositions Know your competition (Incorporate their actions into your plans) Know your competition (Incorporate their actions into your plans) Understand how managers at a firm you are interested in might perform Understand how managers at a firm you are interested in might perform


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