FIN 437 Vicentiu Covrig 1 Behavioral Finance Behavioral Finance (see chapters 1 and 4 from Shefrin)

FIN 437 Vicentiu Covrig 2 Behavioral Finance vs Standard Finance Behavioral finance considers how various psychological traits affect investors Behavioral finance recognizes that the standard finance model of rational behavior 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.

FIN 437 Vicentiu Covrig 3 Aversion to a Sure Loss 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

FIN 437 Vicentiu Covrig 4 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

FIN 437 Vicentiu Covrig 5 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.

FIN 437 Vicentiu Covrig 6 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. Sun Microsystems’ increased spending on research and development in 2000 and its acquisition of Cobalt are cases in point. (see text)

FIN 437 Vicentiu Covrig 7 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

FIN 437 Vicentiu Covrig 8 Illusion of Control In 1997, Sun could purchase Intel’s chips for 30% less than what it cost them to produce their own comparable chips. Despite the desire of some Sun executives to “buy” Intel chips instead of “making” their own, Scott McNealy felt that Sun’s chip design group exerted enough control to close the gap. In retrospect, McNealy describes his decision about using Intel chips as one of his biggest regrets.

FIN 437 Vicentiu Covrig 9 Representativeness and the perceived Relationship Between Risk and Return (or A good company is not necessary a good stock) 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

FIN 437 Vicentiu Covrig 10 Affect Heuristic Reinforces Representativeness Affect heuristic: basing decisions primarily on intuition and instinct 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. The affect heuristic is a mental shortcut that people use to search for benefits and avoid risks. For example some investors, employees and managers perceived the “most admired firms” as the best investments

FIN 437 Vicentiu Covrig 11 Analysts Unlike executives, analysts treat the relationship between beta and expected return as being positive. Holding beta constant, analysts expect smaller capitalization stocks to earn higher returns than larger capitalization stocks. Analysts expect growth stocks to earn higher returns than value stocks. Analyst target prices are excessively optimistic, very often due to agency conflicts What agency conflicts? Most analysts work for investment banks that do or/and seek business with the covered companies

FIN 437 Vicentiu Covrig 12 Extrapolation bias 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 contrarian

FIN 437 Vicentiu Covrig 13 Learning outcomes: Define, explain and provide a short example for the following behavioral “flaws” as applied to finance: - Loss aversion - overconfidence -Avoiding regret and the disposition effect - Representativeness and the relation between risk and return (see slide 10) - Affect heuristic (see slides 11 and 12) - Extrapolation bias