Behavioral Finance Psychology, Decision-Making, and Markets 1st Edition

Allais Paradox 11

Framing 14

Looking Forward 14

Chapter Highlights 14

Discussion Questions and Problems 15

Appendix: More on Expected Utility Theory 16

Definitions 16

Axioms Required to Derive Expected Utility 17

Sketch of a Proof 17

Characteristics of Utility Functions 18

Endnotes 18

CHAPTER 2 Foundations of Finance II: Asset Pricing, Market Efficiency, and Agency Relationships 19

Introduction 19

The Pricing of Risk 20

Risk and Return for Individual Assets 20

Risk and Return for Portfolios of Assets 21

The Optimal Portfolio 22

Weighting Function 42

Hypothetical Value and Weighting Functions 44

Some Examples 45

Other Issues 45

Riskless Loss Aversion 45

Origins of Prospect Theory 46

Prospect Theory and Psychology 47

Competing Alternative Theories 47

Framing 47

Does Prospect Theory Work with Nonmonetary Outcomes? 48

Integration vs. Segregation 48

Mental Accounting 50

Opening and Closing Accounts 50

Evaluating Accounts and Choosing When to Close Them 51

Closure, Integration, and Segregation 52 From Theory to Practice 52

Chapter Highlights 53

Discussion Questions and Problems 53

Appendix: Conditions Required for the Prospect

Theory Weighting

Function 55

Conditions 55

Endnotes 56

CHAPTER 4 Challenges to Market Efficiency 60

Introduction 60

Some Key Anomalies 61

Lagged Reactions to Earnings Announcements 61

Small-Firm Effect 62

Value vs. Growth 63

Momentum and Reversal 65

Noise-Trading and Limits to Arbitrage 67

Theoretical Requirements for Market Efficiency 67

Support 1: All Investors Are Always Rational 67

Support 2: Investor Errors Are Uncorrelated 68

Shiller’s Model 68

Support 3: There are no Limits to Arbitrage 71

What Limits Arbitrage? 72

Fundamental Risk 72

Noise-Trader Risk 72

Implementation Costs 73

Looking Forward 75

Chapter Highlights 75

Discussion Questions and Problems 76

Appendix: Proofs for Shiller Model 77

Endnotes 78

PART II

BEHAVIORAL SCIENCE FOUNDATIONS 81

CHAPTER 5 Heuristics and Biases 83

Introduction 83

Perception, Memory, and Heuristics 84

Perception 84

Memory 84

Framing Effects 85

Ease of Processing and Information Overload 86

Heuristics 86

Examples of Heuristics 87

Familiarity and Related Heuristics 87

Familiarity 87

Ambiguity Aversion 88

Diversification Heuristic 89

Status Quo Bias and Endowment Effect 89

Heuristics and Biases, Prospect Theory, and Emotion 90

Representativeness and Related Biases 90

Conjunction Fallacy 91

Base Rate Neglect 91

Bayesian updating 92

Hot Hand Phenomenon 93

Gambler’s Fallacy vs. Hot Hand 95

Overestimating Predictability 95

Availability, Recency, and Salience 96

Anchoring 97

What Explains Anchoring? 98

Anchoring vs. Representativeness 99

Irrationality and Adaptation 99

Fast and Frugal Heuristics 99

Response to Critique 100

Looking Ahead 100

Heuristics and Biases and Financial DecisionMaking 100

Do Heuristic-Induced Errors Cancel Out? 101

Chapter Highlights 101

Discussion Questions and Problems 102

Endnotes 103

CHAPTER 6 Overconfidence 106

Introduction 106

Miscalibration 106

What Is It? 106

Example of a Calibration Test 107

Other Strains of Overconfidence 110

Better-Than-Average Effect 110

Illusion of Control 111

Excessive Optimism 111

Being Overconfident in More than One Sense 112

Are People Equally Overconfident? 112

Are People Consistently Overconfident? 113

Factors Impeding Correction 114

Biases Interfering with Learning 114

Is Overconfidence an Unmitigated Flaw? 114

Looking Ahead to Financial Applications 115

Chapter Highlights 116

Discussion Questions and Problems 116

117

Chapter Highlights 132

Discussion Questions and Problems 132

Endnotes 133

PART III INVESTOR BEHAVIOR 135

CHAPTER 8 Implications of Heuristics and Biases for Financial Decision-Making 137

Introduction 137

Financial Behaviors Stemming from Familiarity 138

Home Bias 138

Distance, Culture and Language 139

Local Investing and Informational Advantages 140

Investing in Your Employer or Brands that You Know 141

Financial Behaviors Stemming from Representativeness 141

Good Companies vs. Good Investments 142

Chasing Winners 143

Availability and Attention-Grabbing 145

Anchoring to Available Economic Cues 145

An Experimental Study of Real Estate Appraisals

145

Anchoring vs. Herding and Analysts 147

Chapter Highlights 147

Discussion Questions and Problems 148

Endnotes 148

CHAPTER 9 Implications of Overconfidence for Financial Decision-Making 151

Introduction 151

Overconfidence and Excessive Trading 151

Overconfident Traders: A Simple Model 152

Evidence from the Field 157

Evidence from Surveys and the Lab 159

Demographics and Dynamics 161

Gender and Overconfidence in the Financial Realm 161

Dynamics of Overconfidence among Market

Practitioners 161

Underdiversification and Excessive Risk Taking 162

Excessive Optimism and Analysts 163

Chapter Highlights 164

Discussion Questions and Problems 164

Endnotes 165

CHAPTER 10 Individual Investors and the Force of Emotion 168

Introduction 168

Is the Mood of the Investor the Mood of the Market?

169

Pride and Regret 170

The Disposition Effect 171

Empirical Evidence 171

Prospect Theory as an Explanation for the Disposition Effect 172

Another Possible Explanation 174

Experimental Evidence 174

House Money 175

Evidence of a House Money Effect on a Large Scale 175

Prospect Theory and Sequential Decisions 176

Affect 177

Chapter Highlights 178

Discussion Questions and Problems 179

Endnotes 179

PART IV

SOCIAL FORCES 183

CHAPTER 11 Social Forces: Selfishness or Altruism? 185

Introduction 185

Homo Economicus 186

Fairness, Reciprocity, and Trust 186

Ultimatum and Dictator Games 187

The Trust Game 189

Who Is More Fair? 191

Social Influences Matter 192

Competition in Markets 193

Incentives and Contract Design 194

Conformity 196

Testing Conformity 196

Obedience to Authority 197

Social Behavior and Emotion 198

Social Behavior and Evolution 198

Chapter Highlights 199

Discussion Questions and Problems 199

Endnotes 200

CHAPTER 12 Social Forces at Work: The Collapse of an American

Corporation 202

Introduction 202

Corporate Boards 203

Benefits of a Corporate Board 203

Outside Directors 204

It’s a Small World 205

Directors, Compensation, and Self-Interest 205

Directors and Loyalty 206 Analysts 206 What Do Professional Security Analysts Do? 207

The Performance of Security Analysts 207 Do Analysts Herd? 208

Enron 209

The Performance and Business of Enron 209

The Directors 211

The Analysts 212

Other Players in Enron’s Downfall 213

Organizational Culture and Personal Identity 213

Chapter Highlights 214

Discussion Questions and Problems 214

Endnotes 215

PART V MARKET OUTCOMES 217

CHAPTER 13 Behavioral Explanations for Anomalies 219

Introduction 219

Earnings Announcements and Value vs. Growth 220

What is Behind Lagged Reactions to Earnings Announcements? 219

What Is Behind the Value Advantage? 220

What is Behind Momentum and Reversal? 221

Daniel-Hirshleifer-Subrahmanyam Model and Explaining Reversal 222

Grinblatt-Han Model and Explaining Momentum 224

Barberis-Shleifer-Vishny Model and Explaining Momentum and Reversal 227

Rational Explanations 230

Inappropriate Risk Adjustment 230

Fama-French Three-Factor Model 232

Explaining Momentum 232

Temporary Deviations from Efficiency and the Adaptive Markets

Hypothesis 233

Chapter Highlights 233

Discussion Questions and Problems 234

Endnotes 234

CHAPTER 14 Do Behavioral Factors Explain Stock Market Puzzles? 237

Introduction 237

The Equity Premium Puzzle 238

The Equity Premium 238

Why Is the Equity Premium a Puzzle? 238

What Can Explain This Puzzle? 240

Real-World Bubbles 243

Tulip Mania 244

The Tech/Internet Bubble 245

Experimental Bubbles Markets 247

Design of Bubbles Markets 248

What Can We Learn From These Experiments? 249

Behavioral Finance and Market Valuations 251

Excessive Volatility 251

Do Prices Move Too Much? 251

Demonstrating Excessive Volatility 252

Explaining Excessive Volatility 253

Volatility Forecasts and the Spike of 2008 253

Markets in 2008 254

Chapter Highlights 258

Discussion Questions and Problems 259

Endnotes 259

PART VI CORPORATE FINANCE 263

CHAPTER 15 Rational Managers and Irrational Investors 265

Introduction 265

Mispricing and the Goals of Managers 266

A Simple Heuristic Model 266

First Order Conditions 267

Examples of Managerial Actions Taking Advantage of Mispricing 268

Company Name Changes 268

Explaining Dividend Patterns 269

Share Issues and Repurchases 272

Mergers and Acquisitions 272

Irrational Managers or Irrational Investors? 274

Chapter Highlights 275

Discussion Questions and Problems 275

Payback and Ease of Processing 280

Allowing Sunk Costs to Influence the Abandonment

Decision 280

Allowing Affect to Influence Choices 280

Managerial Overconfidence 282

Investment and Overconfidence 282

Overinvestment 282

Investment Sensitivity to Cash Flows 283

Mergers and Acquisitions 284 Start-ups 285

Can Managerial Overconfidence Have a Positive Side? 288 Chapter Highlights 288 Discussion

CHAPTER

17 Understanding Retirement Saving Behavior and

Improving DC Pensions 295

Introduction 295

The World-Wide Move to DC Pensions and its Consequences 296

DBs vs. DCs 296

Problems Faced by Employee-Investors 298

Saving with Limited Self-Control and Procrastination 298

How Much Needs to be Saved? 298

Limited Self-Control 300

Exponential and Hyperbolic Discount Functions 301

Procrastination 302

Evidence on Retirement Preparedness 303

Asset Allocation Confusion 303

Documenting the Problem 303

Are There “Correct” Asset Allocations? 305

Moving toward a Solution 306

Is Education the Answer? 307

Improvements in DC Pension Design 307

Automatic Enrollment 308

Scheduled Deferral Increase Programs 310

Asset Allocation Funds 311

Moving toward the Ideal 401(k) 313

Chapter Highlights 313

Discussion Questions and Problems 314

Endnotes 315

CHAPTER 18 Debiasing, Education, and Client Management 319

Introduction 319

Can Bias be Eliminated? 319

Steps Required to Eliminate Bias 319

Strategies for Helping Those Affected by Bias 321

Debiasing Through Education 322

Psychographic Profiling, Personality Types, and Money Attitudes 323

Optimizing Education 325

Client Management Using Behavioral Finance 326

Traditional Process of Asset Allocation

Determination 326

Using Behavioral Finance to Refine Process 328

Chapter Highlights 330

Discussion Questions and Problems 330

Endnotes 331

PART VIII

MONEY MANAGEMENT 333

CHAPTER 19 Behavioral Investing 335

Introduction 335

Anomaly Attenuation, Style Peer Groups, and Style Investing 335

Refining Anomaly Capture 337

Refining Value Investing Using Accounting Data 337

Refining Momentum-Investing Using Volume 337

Momentum and Reversal 339

Momentum and Value 341

Multivariate Approaches 342

Style Rotation 345

Is it Possible to Enhance Portfolio Performance

Using

Behavioral Finance? 346

Early Evidence 346

What is Behavioral Investing? 347

Chapter Highlights 348

Discussion Questions and Problems 348

Endnotes 348

CHAPTER 20 Neurofinance and the Trader’s Brain

351

Introduction 351

Expertise and Implicit Learning 351

Neurofinance 353

Insights from Neurofinance 354

Expertise and Emotion 355

Chapter Highlights 356

Discussion Questions and Problems 356

Endnotes 357

GLOSSARY 359

INTRODUCTION

The rapidly growing field of behavioral finance uses insights from psychology to understand how human behavior influences the decisions of individual and professional investors, markets, and managers. We are all human, which means that our behavior is

influenced by psychology. Some decisions are simple, day-to-day choices, such as how hard we are going to study for the next test, or what brand of soda we are going to buy, but others significantly impact our financial well-being, such as whether we should buy a particular stock, or how we should allocate our 401(k) money among various investment funds. The purpose of this book is to present what we have learned about financial decision-making from behavioral finance research, while recognizing the challenges that remain.

Looking ahead, we will see that behavioral finance is very useful in helping us understand certain puzzles at the level of the investor. For example, why do people tend to invest in local companies? Why do investors confuse a good company and a good stock? Why do people increase the amount of risk they are willing to take on if they have experienced good or bad portfolio performance? Why are they reluctant to eliminate poorly performing investments from their portfolios? Why do many investors trade as often as they do? Why do they insufficiently diversify their asset holdings? Why do people follow the crowd?

While it would be difficult to find anyone who would seriously question the contention that psychology impacts individual financial decisions, there is less agreement on whether market outcomes are also impacted. This is because the belief that human psychology affects markets is inconsistent with the traditional view that market forces lead to efficient outcomes. However, if human psychology can lead to individual behavior that is not optimal and such errors are sometimes correlated, and there are limits to arbitration, then, provided there limits to arbitration, the traditional view of markets is likely an incomplete story.

More recently, behavioral finance has also made strides in providing insight into the behavior of managers. Given what we have learned about investor psychology, it would be surprising if behavioral factors did not play a role in managerial decision-making. On the one hand, can managers take information relating to individual psychology into account in an effort to achieve improvements in personal performance? On the other hand, do managers, being themselves human, fall prey to their own behavioral errors?

PLAN OF THE BOOK

To make sense of how human psychology impacts individuals and markets, we need to take a few steps back. We begin, in Part I of the book, by reviewing the foundations of modern finance, its inability to account for various paradoxes and anomalies, and the genesis of behavioral finance as reflected in prospect theory and the limits to arbitration perspective. Expected utility theory, reviewed in Chapter 1, is an axiomatic, normative model that demonstrates how people should behave when facing decisions involving risk. In comparing prospects, which are simply probability distributions of final wealth levels, the basic procedure is to assign a utility level to each possible wealth outcome, weight each utility value by the associated probability, and choose the prospect with the highest expected utility.

Although expected utility theory has been very useful in modeling individual decision-making, financial theorists required a paradigm to describe how investors evaluated risk and determined prices in markets. Mean-variance analysis and the CAPM, reviewed in Chapter 2, were central developments, providing for the first time guidance on how risk

should be measured and risky assets priced. At around the same time, the notion of market efficiency became prominent. This is the view that, because competitive markets embody all relevant information, the price of an asset should be virtually identical to its fundamental value. The realization that information was not costless, along with the impossibility theorem of Grossman and Stiglitz, caused this to be altered to the contention that nobody should be able to earn excess (riskadjusted) returns on a consistent basis.

1 Importantly, market efficiency is inextricably linked to asset pricing models because of the joint hypothesis problem, the fact that tests of market efficiency also require the use of a particular riskadjustment mechanism.

Despite the elegance of these foundations, it was not long before holes were found. Careful analysis of people’s current choices revealed a number of violations of expected utility theory. For example, while risk aversion was the norm for many, at times risk-seeking behavior was patently obvious, people's willingness to buy lottery tickets being a prime example. It soon became evident that a new theory

of individual choice was required, one that would be grounded in current behavior and research in psychology. Among alternative models that have been proposed, Kahneman and Tversky's prospect theory has attracted the most attention.

2 Positive rather than normative in nature, prospect theory is reviewed in Chapter 3. For some purposes, prospect theory is supplemented with mental accounting, an important thrust of which is path dependence. The key elements of these models include evaluating outcomes relative to a reference point (such as the status quo), a strong aversion to losses, and context-dependent risk attitudes.