1. Fin 4201/8001 1 “Traditional finance is more concerned with checking that two 8 oz. bottles of ketchup is close to the price of one 16 oz bottle, than in understanding the price of the 16 oz bottle.” –Larry Summers EMH adherents scream NO!!! to behavioral jumbo-mumbo Prices are right → no free lunch Two basic assumptions People make rational decisions People unbiased in predictions of the future Any inefficiencies will be arbitraged away quickly Based on risk and return Traditional Finance – What is it?

2. Fin 4201/8001 2 Should be low trading – Why is volume so high? “The stock market is the best investment for long term holders, who can just buy and hold through the ups and downs of the market.” – 76% strongly agree & 26% somewhat agree Trade only on new info should mean low volatility Dividends shouldn’t matter Equity premium of 7% too high for just risk Short term momentum and long term reversion shouldn’t exist What do we observe?

3. Fin 4201/8001 3 Positive news boosts depressed stocks more than “up” stocks IPOs initially underpriced & underperform longer term WB, Legg Mason, et.al. are just 6-sigma flukes “Bubbles” happen frequently Cries of a “new paradigm” Book printed: Dow 35,000 “We are in a new era. ____ has ushered in a new type of economy. What do we observe?

4. Fin 4201/8001 4 Predictability strongest in small, less liquid Liquidity can also make easier to arb away efficent Volume high in “up” markets and low in “down” Lowest decile based on B/M earns less than Rf Cries of a “new paradigm” Book printed: Dow 35,000 “We are in a new era. ____ has ushered in a new type of economy. Yes, even more observations

5. Fin 4201/8001 5 Dow in 1896 = 40, 1998 = 9181. What would it have been if dividends were reinvested? Piece of paper is folded in half, then half again. After 100 folds how thick will it be? Compared with what you see on the street, how many are above average drivers? A fair coin has come up “tails” four times in a row. What do you bet on next? Equal chance win $19 vs. lose $20. Bet? Does it change if you are already up $200? Time out for games

6. Fin 4201/8001 6 You buy basketball tickets for $40. If it snows will you go? Now what if the tickets had been given to you? Mary is librarian, Mary is librarian and member of Sierra, Mary works in banking. More likely? Killed by falling airplane parts or by a shark? Mean IQ of population of 5000 people is known to be 100. A sample of 50 is selected. The first IQ = 150. What is mean of sample? Time out for games – the sequel

7. Fin 4201/8001 7 Markets always efficient? “…I’d be a bum on the street with a tin cup.” Two features – limits to arbitrage and psychology Is it so hard to believe participant psychology enters the transaction of financial assets? Yields insight into investments and how market participants function Risk & return → Fear & Greed → Pride & Regret Prices reflect rational and irrational Behavioral Finance – What is it?

8. Fin 4201/8001 8 Not a sure-fire way to beat the market “The market can stay irrational longer than you can stay solvent” – JM Keynes Does it mean anything in the aggregate? Does it matter or is it just wealth transfer from stupid to smart? Isn’t a unified theory, just a collection of tools Behavioral Finance – What isn’t it?

9. Fin 4201/8001 9 Markets usually efficient Water seeks it own level = oceans are flat “…I’d be a bum on the street with a tin cup.” Investors are basically bad Bayesians Reconcile the two?

10. Fin 4201/8001 10 Based on “Bounded rationality” Biases in heuristics Self Deception Reference points Representativeness Conservatism Cognitive dissonance Kahneman & Tversky – Prospect Theory

11. Fin 4201/8001 11 Overconfidence – belief personal knowledge (or illusion of it) is more accurate Biased self-attribution – Good outcomes are ability, bad outcomes are someone else’s fault = ex-post rationalization – Odean 1998 Individuals trade too much Buys do worse than sells and reluctant to sell losers Sold names returned 2.6% vs..11% for replacements Men trade more than women and do worse Self Deception

12. Fin 4201/8001 12 Compare present to some point in past Purchase price Strike price of options Feeling of loss if down and elation if up Analyst forecast revisions – under reaction to new information This oversimplification is why Buffett doesn’t look at short term Reference Points

13. Fin 4201/8001 13 “ Law of small numbers” – heuristics problem Investors may let too little information drive their decisions = beliefs change too quickly Overweight recent history→ trend chasing or over-reaction to “hot hands” Like lemmings to the sea – ebay PE 3300 in 1999 or etoys mkt cap $8B vs. toys-r-us at $6B Could explain value outperforming growth Confuse good company with good investment Previous mention of short term focus in bubbles Representativeness

14. Fin 4201/8001 14 Flip side of the representativeness coin In face of new evidence, beliefs don’t change as much as should Over-weight strength of signal, under-weight the weight of signal E.g. a positive earnings surprise may take up to 60 days to fully incorporate Conservatism

15. Fin 4201/8001 15 Bad experiences are painful – try to ignore the pain rather than incorporate Seek to reduce pain by adjusting beliefs about past successes Cognitive Dissonance

16. Fin 4201/8001 16 How Normal distribution is actually realized Extreme tails underestimated. Intermediate tails overestimated Skewed right Diminishing sensitivity (will see graphically) Loss is convex, gains concave (double return/loss is not twice as good/bad) Losses hurt more in absolute than gains (steeper slope for losses) Kink at reference point Considered in isolation – no covariance Disposition effect – hold losers, sell gainers (see later) Other parts of K & T theory (non-normal distribution & kink in utility curve)

17. How do the pieces fit? Pt.II A large enough sample drawn from a normal distribution looks like a bell-shaped curve. Probability Return on large company common stocks 99.74% – 3  – 49.3% – 2  – 28.8% – 1  – 8.3% Mean 12.2% + 1  32.7% + 2  53.2% + 3  73.7% The probability that a yearly return will fall within ± 1 standard deviation (± 20.5%) of the mean is approximately 68%. 68.26% 95.44%

18. Fin 4201/8001 18 How do the pieces fit together?

19. Fin 4201/8001 19 Gambler’s Fallacy Confirmation bias Mental Accounting Self deception Other tools

20. Fin 4201/8001 20 “Bad Bayesian” to the extreme A fair die had rolled 4 fours in a row. What’s the chance of another 4? Mean reversion Confirmation Bias Side with opinions that support own view, ignore information contrary to that view Gambler’s Fallacy & Confirmation Bias

21. Fin 4201/8001 21 Kind of like a bunch of file folders in a file cabinet Transactions assigned to specific accounts then evaluated in isolation (no covariance) Misperception of risk of adding another security to portfolio Not just individuals. E.g. pension fund restrictions Sunk costs still seem to matter Dividends – don’t touch the principal Mental Accounting – Thaler 1985

22. Fin 4201/8001 22 House money – Investor factors in previous independent outcomes into current risky decision Previous winner is willing to take on more risk Could partially explain bubbles “snake-bite” or “once-bitten” is the flip side (some investors from the 90s still haven’t returned) In the extreme may take on “double or nothing” attitude to get to reference point CBT Treasury futures traders if lose in morning, increase risk in afternoon to get back Mental Accounting – Thaler 1985

23. Fin 4201/8001 23 Better than a poke in the eye with a sharp stick Disposition effect – Avoid losses, seek gains Exact opposite of tax code Ferris 88 – low volume for decliners, high for gainers Chicago Merc – best futures traders sold losers and rode winners Reference points – saw previously Want something to brag to friends about Pride & Regret = Pain & Pleasure

24. Fin 4201/8001 24 Averse to ambiguity Weather = mood – sunny days outperform miserable days by 24% Returns lower if less daylight – fall months, worse further north (England and Sweden) and reversed for southern hemisphere Important b/c price of stock usually set by optimists Disposition effect = avoid realizing paper losses and seek realizing paper gains (remember Odean) Emotion, self-control and Decision

25. Fin 4201/8001 25 Finance assumes “law of one price” holds Risks and Limits Arbitrage isn’t costless – may have to cover when misvaluations greatest = implementation costs Fundamental risk – may be a reason (private info) for pricing Noise trader risk worsens in short run – Royal Dutch/Shell Lots of investors can’t and others don’t want risk May not be able to identify peaks and troughs No good substitute – Palm/3com Closed end funds example Limits to Arbitrage

26. Fin 4201/8001 26 Is psychology even more important here? Assume managers will act in self interest, but they may not be able to identify appropriate if biased. Are managers rational & unbiased Limited number → greater impact of bias Two ways to look at it: (probably a combo of both) Smart managers and dumb markets or Smart markets and dumb managers Firm managers are people, too!

27. Fin 4201/8001 27 Take advantage of investors? (rational manager) IPO clusters or equity when overvalued – issue equity when overvalued. Investors may not be able to short. CEOs judged on longer time frame – Managers can “spin” one bad quarter Dividend policy – catering viewpoint = Investors may interpret as good sign “Dot.com” – 1999 =74% announcement effect and 2001 70% for the reversal Earnings management Sticky dividends Managers smart, markets dumb

28. Fin 4201/8001 28 Reference points & mental accounting IPO under pricing Throw good money after bad Bounded rationality <10% of firms use NPV Optimism and overconfidence All CEOs are above average mergers may not realize synergies (hubris) capital budgeting projects may be overvalued Too much cash leads to bad decisions Biased self-attribution Success is skill and failure is bad luck Markets smart, managers dumb

29. Fin 4201/8001 29 Be aware of predispositions and don’t fall prey Know your competition. (Incorporate their actions into your plan) Understand how your firm’s managers might perform So what does it all mean for you?