1. Lecture 14 Behavioral Finance

2. The primary source of this lecture is from the book by Hersh Shefrin, “Beyond Greed and Fear; Understanding Behavioral Finance and the Psychology of Investing,” Harvard Business School Press, 2000.

3. Behavioral Finance Financial practitioners commit errors because: 1. They use rules of thumb or heuristics. 2. They are influenced by form as well as substance. These errors cause market prices to deviate from fundamental values.

4. Heuristic-Driven Bias Heuristic refers to the process by which people find things out for themselves, usually by trial and error. Trial and error leads people to develop rules of thumb which often causes errors.

5. Heuristic-Driven Bias Representativeness > Refers to judgments based on stereotypes. > People believe that a small sample is representative of the entire population.

6. Heuristic-Driven Bias Gambler’s fallacy > In a coin toss, what is the probability of a tail after five straight heads? > The law of large numbers. If x is a random variable with E[x]=, then the sample mean of x approaches  as the sample size increases.

7. Heuristic-Driven Bias Overconfidence > People set overly narrow confidence intervals. > They get surprised more frequently than they anticipate.

8. Heuristic-Driven Bias Anchoring-and-Adjustment > People do not adjust their expectations sufficiently in response to new information. > They are anchored to their initial expectations.

9. Predictions DeBondt’s study “Betting on Trends.” People tend to naively project trends that they perceive in the charts. They are overconfident about their ability to predict accurately. Their confidence intervals are skewed.

10. Heuristic Diversity Those that bet on trends extrapolate. Those who commit gambler’s fallacy predict reversal. Both predictions stem from representativeness. They differ because of different perspectives.

11. Heuristic-Driven Bias Confirmation bias—the illusion of validity. > Most people have difficulty assessing the validity of statements like “if X, then Y”. > They look for confirming evidence (X and Y hold) instead of disconfirming evidence (where X and not-Y hold.)

12. Bullish Sentiment Index The Bullish Sentiment Index measures the percent of newsletter writers that are bullish. The indicator is viewed as a contrarian indicator. “Since most advisory services are trend followers, they are most bearish at market bottoms and least bearish at market tops.”

13. Heuristic-Driven Bias The fear of regret leads to loss aversion. Regret is more than the pain of a loss. It is the pain associated with feeling responsible for the loss. Hindsight bias—events are viewed as far more likely than they looked before the fact.

14. Heuristic-Driven Bias Loss aversion—regret makes losses very painful. Faced with a loss, which choice would you make. A. A sure loss of $7,500. B. A 25% chance of losing $0 and a 75% chance of losing $10,000.

15. Heuristic-Driven Bias “My intention was to minimize my future regret. So I split my contribution fifty-fifty between bonds and stocks.” Harry Markowitz

16. Heuristic-Driven Bias Aversion to ambiguity—There is a fear of the unknown. The bailout of Long-Term Capital Management. “It was a very large unknown. It wasn’t worth a jump into the abyss to find out how deep it was.” Herbert Allison, Merrill Lynch President.

17. Frame Dependency The form used to describe a decision problem is called its frame. Traditional finance assumes that frames are transparent. Non-transparent frames can affect decisions, thereby making behavior frame dependent.

18. Frame Dependency First decision: Choose A. A sure gain of $2,400, or B. A 25% chance to gain $10,000 and a 75% chance to gain nothing. Second decision: Choose C. A sure loss of $7,500, or D. A 75% chance to lose $10,000 and a 25% chance to lose nothing.

19. Frame Dependency People separate choices into mental accounts in order to help maintain self control. The dividend puzzle. For some investors dividends are a way to maintain self control. Don’t dip into capital is a self control mechanism.

20. Frame Dependency People split dividends and capital gains into separate mental accounts to protect funds designated for other goals. Selling assets to satisfy current consumption can cause regret if the security price increases after it is sold.

21. Frame Dependence Money illusion. > People naturally think in terms of nominal values. > Emotional reaction is driven by nominal values even though people know the affect of inflation.

22. Picking Stocks Investors are consistent in the mistakes that they make. They believe that: 1. Growth stocks outperform value stocks. 2. Winners continue to be winners and losers continue to be losers. 3. Strong revenue growth will continue.

23. Picking Stocks Analysts recommend stocks of past winners more often than stocks of past losers. Investors believe that good stocks and the stocks of good companies. The DeBondt and Thaler study.

24. Picking Stocks It is difficult to arbitrage away these heuristic-driven biases. Some losers will continue to be losers. The strategy may not work in any given year. Hindsight bias will set in and the investor will feel like a fool.

25. Picking Stocks Long Term Capital Management example. Royal Dutch Petroleum and Shell Transport and Trading jointly own Royal Dutch/Shell. All cash flow of Royal Dutch/Shell are divided on a 60/40 basis. The market value of Royal Dutch should be 1.5 times that of Shell.

26. Picking Stocks Shell Transport has traditionally traded at an 18% discount relative to Royal Dutch. When the discount widened, LTCM bought Shell Transport and sold Royal Dutch short. Unfortunately, the discount widened.

27. Analysts’ Earnings Predictions Positive (negative) earning surprises are followed by positive (negative) earning surprises for up to three quarters. Trading strategies based on post- earnings-announcement drift generate abnormal returns.

28. Analysts’ Earnings Predictions Analysts and investors remain overconfidently anchored to their prior view of the company’s prospects. They underweight evidence that disconfirms their prior views and overweight confirming evidence.

29. Analysts’ Earnings Predictions Analysts and investors place little weight on changes in earnings unless there is salient news associated with the announcement. They tend to overreact to salient information.

30. Analysts’ Earnings Predictions Analysts long-term forecasts are overly optimistic. Analysts are highly dependent on executives of companies they follow for their information. Analysts are rewarded for bringing business to their company.

31. Analysts’ Earnings Predictions Analysts’ short-term forecasts tend to be pessimistic. Companies try to encourage pessimism just prior to earning announcements. Stock prices jump when earnings beat the forecasts.

32. Earnings Manipulation People have a tendency to evaluate outcomes relative to some benchmark. Three thresholds. 1. Zero earnings. 2. The previous periods earnings. 3. Analysts’ consensus forecast.

33. “Get-Evenitis” Most people exhibit loss aversion. Consequently, they tend to hold their loses too long and sell their winners too early. Realizing a loss is painful, despite the possible tax advantage.

34. “Get-Evenitis” Most people exhibit loss aversion. Consequently, they tend to hold their loses too long and sell their winners too early. Realizing a loss is painful, despite the possible tax advantage.

35. “Get-Evenitis” Collapse of Barings Bank. Apple Computer’s Newton project. “The definition of a good trader is a guy who takes loses.” Alan Greenberg, Bear Stearns Company chairman

36. Portfolio Decisions Investor’s decisions are driven by fear, hope and goal aspirations. Most investors think about portfolios in layers. > Bottom layer for security. > Middle layers for specific goals. > Top layer earmarked for potential. Each layer is treated separately.

37. Portfolio Decisions Investors are overconfident about their abilities to pick winners. They take bad bets because they fail to realize that they are at an informational disadvantage.

38. Portfolio Decisions Investors trade more frequently than prudent because of over-confidence and a false sense of control. Individual’s fail to diversify. > The rule of five. > Naive diversification—place an equal amount across all funds available in their 401(k) plan.

39. Security Design Financial markets are beginning to provide securities that appeal to both hope and fear. British premium bonds—safe principal plus lottery tickets in lieu of interest. Life USA’s Annu-a-dex—guaranteed 45% return over 7 years plus 50% of the market’s return over 45%.

40. Security Design Dean Witter’s Principle Guaranteed Portfolio—$50,000 investment in a zero-coupon bond with face value of $50,000 and risky stocks. A home made version—buy money market funds and use the interest to purchase call options.

41. Financial Advisors Having a financial advisor is like holding a psychological call option. Self-attribution bias—the investor attributes good outcomes to skill and bad outcomes to someone else or bad luck.