Vicentiu Covrig 1 Behavioral Finance Behavioral Finance (see chapter 8 Hirschey and Nofsinger)

Vicentiu Covrig 2 Behavioral Finance vs Standard Finance Behavioral finance considers how cognitive errors and emotions affect financial decision makers Behavioral finance (positive approach) recognizes that the standard finance model of rational behavior (normative approach) can be true within specific boundaries but argues that this model is incomplete since it does not consider the individual behavior. Currently there is no unified theory of behavioral finance, thus the emphasis has been on identifying investment anomalies that can be explained by various psychological traits.

Vicentiu Covrig 3 Prospect theory: Loss Aversion First decision: Choose between Choice 1: sure gain of $ 85,000 Choice 2: 85% chance of receiving $100,000 and 15% chance of receiving nothing Second decision: Choose between Choice 1: sure loss of $ 85,000 Choice 2: 85% chance of losing $100,000 and 15% chance of losing nothing Loss aversion: psychologically, people experience a loss more acutely than a gain of the same magnitude

Vicentiu Covrig 4 Familiarity bias People overvalue and overinvest in the familiar Choice overload hypothesis: people don’t like excess options 1/n heuristic: employees contribute equal amount to each option

Vicentiu Covrig 5 Representativeness and the perceived Relationship Between Risk and Return (or A good company is not necessary a good stock) People assign affective labels or tags to images, objects, and concepts. Imagery is important, e.g. adding “dot.com” to name of firm in second half of 1990s. Traditional finance teaches that risk and return are positively related, that higher expected returns are associated with higher risk. Representativeness: people make judgments based on stereotypical thinking Representativeness induces managers to view the relationship as going the other way, namely that less risky, larger and more well know firms will provide a higher return

Vicentiu Covrig 6 Gambler’s fallacy or hot-hand fallacy Is the market hotter if it's recently been hot? Based on data going back to 1926 when the S&P 500 index was formulated, the probability of an up-year is about 2/3. The probability is about the same after up-years as after down-years. Most individual investors extrapolate the past performance so, are momentum investors; many institutional investors predict reversals (are contrarians) so suffer of gambler’s fallacy Most value investors are contrarian, most growth investors are trend followers (momentum)

Vicentiu Covrig 7 Mental accounting Mental Accounting Individuals tend to keep a mental account for each investment option, instead of looking at the investment decisions as a “package” Many investors are highly risk averse with money in some accounts and risk lovers with money in other accounts Buying and selling securities based on a reference point Why a $1 dividend is different than a $1 capital gain in the mind of some investors?

Vicentiu Covrig 8 Regret aversion: Seeking pride and avoiding regret Rational individuals feel no greater disappointment when they miss their plane by a minute as when they miss it by an hour. What about most of us? Most of the investors sell winners too early, riding losers too long (called the disposition effect) Individuals who make decisions that turn out badly have more regret when that decisions were more unconventional

Vicentiu Covrig 9 Regret: Corporate finance implication In the traditional agency theory the managers make suboptimal decisions because incentive system fail to align their interests with those of shareholders. Behavioral influences lead to suboptimal decisions, too. Some managers do not want to close some failed projects earlier. This behavior also depends not so much how much money was involved but how visible the decision was. Some managers will put more money into a failure they feel responsible for than into a successful project.

Vicentiu Covrig 10 Overconfidence Overconfidence : people tend to overestimate their ability More than 70% of drivers ranked themselves as above the average Overconfident investors trade more Overconfident managers make poor decisions about both investment and mergers and acquisitions, when their firms are cash rich.

Vicentiu Covrig 11 Excessively Optimistic Investors? During the stock market bubble between January 1997 and June 2000, irrational exuberance drove up the prices of both the S&P 500 and Sun’s stock. No firm the size of Sun has historically merited a price- to-earnings ratio (P/E) over 100. In March 2000, at the height of the bubble, Sun’s P/E reached 119. Exhibit 1.2

Vicentiu Covrig 12 Social influences and herding Herding : following others An investor buy a stock because he/she knows other investors buying it Investors’ choices might be affected by social interaction (ie Who trades based on Jim Cramer’s recommendations? Millions.)

Vicentiu Covrig 13 Investment rules of thumb (p. 227 text) Stay the course Long-run returns reflect fundamental business prospects Don’t confuse luck with brain Cut your losses and let your profits run Be skeptical of buy–sell recommendations Few market professionals make money for investors If everyone were right, everyone would be rich Significant capital accumulation requires time and money

Vicentiu Covrig 14 Learning outcomes: Define, explain and provide a short example for the following behavioral “flaws” as applied to finance: - Prospect theory/loss aversion - Familiarity bias (including choice overload hypothesis) -Representativeness bias - Gambler’s fallacy and extrapolation bias -Mental accounting - Regret aversion -Overconfidence - Herding -Investment rules of thumb