BEHAVIORAL FINANCE

Behavioral Finance People are rational in “standard finance.” People are normal in Behavioral finance. Normal people: commit cognitive errors Affected by frames Know the pain of regret Are both risk averse and risk seeking Cause bubbles in Markets

Behavioral finance research focuses on how investors make decisions to buy and sell securities, and how they choose between alternatives.

Market Efficiency Two meanings Price equals (fundamental) value. You cannot beat the market (so buy and hold). “The bubble of the late 1990s proves that the market is not efficient.” In the sense that price equals value But, can you predict when the bubble will burst? It is very difficult.

Errors in Information Processing Overconfidence Investors view themselves as more able to value securities than they actually are. Investors tend to over-weight their forecasts relative to those of others.

Overconfidence in Info. Processing People tend to believe things that are easier to understand more readily than things that are more complicated.

Representativeness Heuristic The representativeness heuristic takes one characteristic of a company and extends it to other aspects of the firm. In particular, many investors believe a well-run company represents a good investment. Mental Short-cuts used to solve complex problems.

Behavioral Biases: Loss Aversion Investors do not like losses and often engage in mental gymnastics to reduce their psychological impact. Their tendency to sell a winning stock rather than a losing stock is called the disposition effect in some of the behavioral finance literature

Myopic Loss Aversion Investors have a tendency to assign too much importance to routine daily fluctuations in the market. Abandoning a long-term investment program because of normal market behavior is sub optimal behavior.

Anchoring Our decisions can be influenced by extraneous information contained in the problem statement. For example, investors tend to remember the price they paid for a stock, and this information influences their subsequent decisions about what to do with it.

Anchoring—Earnings Estimates Analysts may be anchored to old EPS estimates. “Cockroach” theory of earnings surprises. When good (or bad) announcements are made, other good (or bad) surprises follow. Analysts may be anchored and not understand the series of surprises to follow.

Prospect Theory Risk averse investors get increasing utility from higher levels of wealth, but at a decreasing rate. Research shows that while risk aversion may accurately describe investor behavior with gains, investors often show risk seeking behavior when they face a loss

Mental Accounting Mental accounting refers to our tendency to “put things in boxes” and track them individually. For example, investors tend to differentiate between dividend and capital dollars, and between realized and unrealized gains

Availability Heuristic The availability heuristic is the contention that things that are easier to remember are thought to be more common.

Empirical Evidence: Value v Growth Investors naively extrapolate a continuation of fast growth for growth firms and slow growth …. Slow growers tend to improve and fast growers slow their growth in the future Errors by investors overprice growth firms and under-price value firms. Value stocks out-perform growth stocks in LT studies. Source: Broussard, Neely, et al JABR 2004.

Conclusions The Markets are not as Efficient as we once thought Investors should recognize the psychological, non-rational nature of people. We need to guard against the over-reactions of markets caused by mental shortcuts, etc.

Warren Buffett, etc. Need to Understand the Business Mr. Market is sometimes give high quotes and sometimes gives low quotes. Choose the price that is lower than your idea of “Intrinsic Value” (with a margin of safety because you are apt to make a mistake from time to time) More than a “EMH Anomaly”

What should investors do? The market is still a very difficult “boggy” to beat Buy and hold and resist psychological factors It still pays to invest for the long-term. It still pays to Diversify