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Behavioral Financ 101

Behavioral Financ 101

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Behavioral finance coursebook
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Sections

  • BEHAVIORAL FINANCE 101
  • Preface: An introduction to behavioral finance as a paradigm shift vs. just
  • another module within financial economics
  • REFERENCES
  • Introduction & setting the stage: discussion and some definitions
  • WHAT IS FINANCE?
  • WHAT IS, AND WHY, BEHAVIORAL FINANCE?
  • Chapter 1: Are the markets „efficient‟?
  • A FEW REMINDERS AND SOME THEMES
  • I LEAVE YOU WITH A GRAPH, A FEW QUESTIONS, AND A PIECE OF ADVICE
  • Chapter 2: The „rational‟ economic agent
  • Chapter 3: Efficient Markets and Efficient Market Theory (“EMT”)
  • THE ASSUMPTIONS BEHIND ‗MARKET EFFICIENCY‘ AND THE EMH/EMT
  • A BRIEF HISTORY AND REVIEW OF ‗MARKET EFFICIENCY‘ AND THE EMH/EMT
  • A FEW KEY ARTICLES ON THE EMH/EMT
  • WHERE DO WE STAND TODAY?
  • THE ISSUE WITH PREDICTABILITY
  • APPENDIX A: TWO BASIC LOGICAL FALLACIES IN FINANCE AND ECONOMICS
  • APPENDIX B: SOME COMMONLY USED EXCESS RETURN MEASURES
  • Chapter 4: Limits to arbitrage or the first „pillar‟ of behavioral finance
  • ‗TWIN SHARES‘ OR ‗DUAL-LISTED COMPANIES‘
  • ‗CARVE-OUTS‘
  • CLOSED-END FUNDS (―CEFS‖)
  • THE ISSUE OF ABSOLUTE VS. RELATIVE PRICES AND ARBITRAGE
  • ‘INDEX INCLUSIONS‘ OR INDEX ADDS AND DROPS
  • Chapter 5: Psychology or the second „pillar‟ of behavioral finance
  • THE SHORT LIST OF KNOWN OFFENSES
  • THE RELATIVELY LONG LIST OF KNOWN DECISION MAKING OFFENSES
  • NEUROECONOMICS – LINKING THE HUMAN MIND TO THE MARKET
  • A SAD EXAMPLE OF PSYCHOLOGY AFFECTING SECURITY PRICING
  • Chapter 6: What do we know about the individuals, agents and institutions
  • who push financial market prices around (or: Who buys and sells this stuff
  • THE ‗SMART MONEY‘ – THE ‗ANALYSTS‘ AND PORTFOLIO MANAGERS (―PMS‖)
  • THE ‗SMART MONEY‘ – THE ANALYSTS
  • THE ‗SMART‘ ANLAYSTS – THE EARNINGS ANALYSTS
  • THE ‗SMART MONEY‘ – THE PMS
  • THE PERSONNEL FILTER – A TENDENCY FOR THE ADVERSE SELECTION OF PMS –
  • INDIVIDUAL INVESTORS – THE MOST MALIGNED GROUP
  • Chapter 7: Bubbles
  • WHAT IS A BUBBLE?
  • WHAT DOES A BUBBLE LOOK LIKE?
  • WHAT IS/ARE THE LIKELY CAUSE(S) OF FINANCIAL BUBBLES?
  • BURSTING EFFECTS OF FINANCIAL BUBBLES (ESPECIALLY MACROECONOMIC
  • WHEN IS IT ‗RATIONAL‘ TO BE ‗IRRATIONAL‘?
  • OUR LAST BEST HOPE – HEDGE FUNDS (―HFS‖)256
  • Chapter 8: When does EMT seem to apply? – The Iceberg
  • Chapter 9: What could go wrong with financial market prices?
  • THE PRICING MODEL – DISCOUNTED PRESENT VALUE
  • APPENDIX A: SOME USEFUL TERMS TO KNOW, ESPECIALLY FOR THIS CHAPTER
  • APPENDIX B: WHAT HAPPENED TO THE U.S. CPI?
  • Chapter 10: Overreaction and Underreaction (overshooting and
  • OVERREACTION – MOSTLY IN THE MEDIUM- TO LONG-RUN
  • UNDERREACTION – THE EXAMPLE OF EARNINGS ANNOUNCEMENTS – MOSTLY IN
  • THE EVENT OF BANKRUPTCY OR RESTRUCTURING
  • BANKRUPTCY PREDICTION AND MARKET EFFICIENCY
  • BEFORE, DURING AND AFTER BANKRUPTCY
  • FINAL TWO COMMENTS FOR CHAPTER 11
  • Chapter 12: Illusions
  • ‘MONEY ILLUSION‘ – A BRIEF EXPLANATION OF THE BIAS OR NOMINAL VS. REAL
  • BIASED INTEREST RATE EXPECTATIONS OR NOT – BONDS
  • A FEW FINAL THOUGHTS ON INFLATION AND FINANCE ILLUSIONS
  • Chapter 13: Descriptive theories in finance
  • A TEMPLATE FOR DESCRIPTIVE FINANCIAL MARKETS HYPOTHESES
  • MODIGLIANI-COHN THEORY & RELATED HYPOTHESES
  • CLOSED-END FUNDS (―CEFS‖), AND IPO SIMILARITIES
  • PROSPECT THEORY
  • SAD AND STOCK EXCHANGE DISTANCE FROM THE EQUATOR
  • Chapter 14: Volatility & volume (V & V) – or why so much trading?
  • VOLATILITY
  • VOLUME
  • Chapter 15: Corporate events
  • A LIST OF CORPORATE EVENTS
  • CONCERNING THE ―POWER‖ OF THE EVENT STUDY TESTS AND RELATED
  • SO, WHAT CAN WE SAY ABOUT CORPORATE EVENT STUDIES?
  • Chapter 16: Can we learn our way to normative market efficiency?386
  • THE ‗DUAL BURDEN‘
  • HOW DO WE LEARN?
  • PSYCHOLOGICAL ISSUES AND CANCELLATION
  • Chapter 17: Conclusion

BEHAVIORAL FINANCE 101

By John Kihn



Kihn / Behavioral Finance 101 / 2


Table of Contents
Behavioral Finance 101 1
By John Kihn 1
Preface: An introduction to behavioral finance as a paradigm shift vs. just another
module within financial economics 6
Why not approach behavioral finance as an additional module or add-on to ‗modern finance‘? 10
References 10
Introduction & setting the stage: discussion and some definitions 13
What is finance? 13
What is, and why, behavioral finance? 15
Three theoretical approaches, one that fits finance (and economics), but it‘s not the one currently
used (and it should be) 17
References 22
Chapter 1: Are the markets „efficient‟? 23
A few reminders and some themes 27
I leave you with a graph, a few questions, and a piece of advice 31
References 35
Chapter 2: The „rational‟ economic agent 37
References 42
Chapter 3: Efficient Markets and Efficient Market Theory (“EMT”) 45
The assumptions behind ‗market efficiency‘ and the EMH/EMT 46
A brief history and review of ‗market efficiency‘ and the EMH/EMT 54
A few key articles on the EMH/EMT 55
Where do we stand today? 67
The issue with predictability 68
References 80
Appendix A: Two basic logical fallacies in finance and economics 86
Appendix B: Some commonly used excess return measures 92
Chapter 4: Limits to arbitrage or the first „pillar‟ of behavioral finance 98
‗Twin shares‘ or ‗dual-listed companies‘ 109
‗Carve-outs‘ 113
Kihn / Behavioral Finance 101 / 3

Closed-end funds (―CEFs‖) 120
The issue of absolute vs. relative prices and arbitrage 130
‘Index inclusions‘ or index adds and drops 132
References 136
Chapter 5: Psychology or the second „pillar‟ of behavioral finance 141
The short list of known offenses 143
The relatively long list of known decision making offenses 148
Neuroeconomics – linking the human mind to the market choice/action 153
A SAD example of psychology affecting security pricing 162
References 180
Chapter 6: What do we know about the individuals, agents and institutions who push
financial market prices around (or: Who buys and sells this stuff anyways?)? 186
The ‗smart money‘ – the ‗analysts‘ and Portfolio Managers (―PMs‖) 191
The ‗smart money‘ – the analysts 193
The ‗smart‘ anlaysts – the earnings analysts 198
The ‗smart money‘ – the PMs 203
The personnel filter – a tendency for the adverse selection of PMs – or why aren‘t only rational
arbitrageurs selected to be PMs? 213
Individual investors – the most maligned group 218
References 230
Chapter 7: Bubbles 242
What is a bubble? 245
What does a bubble look like? 253
What is/are the likely cause(s) of financial bubbles? 276
Bursting effects of financial bubbles (especially macroeconomic ones) 285
When is it ‗rational‘ to be ‗irrational‘? 293
Our last best hope – Hedge Funds (―HFs‖) 295
References 302
Chapter 8: When does EMT seem to apply? – The Iceberg 309
References 316
Chapter 9: What could go wrong with financial market prices? 317
The pricing model – discounted present value 317
References 334
Kihn / Behavioral Finance 101 / 4

Appendix A: Some useful terms to know, especially for this chapter 338
Appendix B: What happened to the U.S. CPI? 347
Chapter 10: Overreaction and Underreaction (overshooting and undershooting) 360
Overreaction – mostly in the medium- to long-run 362
Underreaction – the example of earnings announcements – mostly in the short-run 370
Overreaction and underreaction in the same market at the same time – an EMH/EMT
proponent‘s worst nightmare 377
References 381
Chapter 11: Chapter 11 391
The event of bankruptcy or restructuring 392
Bankruptcy prediction and market efficiency 396
Before, during and after bankruptcy 397
Periods of economic distress – when many firms hit the skids (recessionary and depressionary
periods) 401
Final two comments for Chapter 11 410
References 412
Chapter 12: Illusions 416
‘Money illusion‘ – a brief explanation of the bias or nominal vs. real evaluations 418
Inflation illusion – stocks (accepting the Modigliani-Cohn hypothesis) & real estate 420
Biased interest rate expectations or not – bonds 424
Biased exchange rate expectations or not – exchange rates & the forward discount bias (or two
wrongs don‘t make it right) 431
A few final thoughts on inflation and finance illusions 435
References 437
Chapter 13: Descriptive theories in finance 442
A template for descriptive financial markets hypotheses 443
Modigliani-Cohn theory & related hypotheses 444
Closed-end funds (―CEFs‖), and IPO similarities 449
Prospect theory 460
SAD and stock exchange distance from the equator 473
References 474
Chapter 14: Volatility & volume (V & V) – or why so much trading? 480
Volatility 481
Volume 486
Kihn / Behavioral Finance 101 / 5

References 494
Chapter 15: Corporate events 500
A list of corporate events 502
Concerning the ―power‖ of the event study tests and related issues 506
So, what can we say about corporate event studies? 511
References 512
Chapter 16: Can we learn our way to normative market efficiency? 514
The ‗dual burden‘ 518
How do we learn? 530
Psychological issues and cancellation 534
Correcting cognitive biases and learning – the cases of overconfidence and hindsight bias 535
References 542
Chapter 17: Conclusion 545
References 548


Kihn / Behavioral Finance 101 / 6

Preface: An introduction to behavioral finance as a paradigm shift vs. just
another module within financial economics

Sometimes ―what you don‘t know can‘t hurt you‖, sometimes it can. I am of the opinion that,
especially during this ‗financial crisis‘, not knowing about what drives financial markets can hurt
you, at least financially. For example, going long the stock market during the up move in a stock
market craze or ‗bubble‘ and not knowing how stocks are valued might be financially beneficial;
but after the peak and subsequent bust it could hurt you. Wouldn‘t it be better just to have some
understanding of what likely causes extreme movements in the prices of stocks, or any other
financial instrument?

If you are of the opinion that true knowledge can be helpful, note that all academically accepted
financial models are wrong
1
; but that doesn‘t mean they are not possibly useful on some level.
First, an explanation for the first part of that statement: minimally, modern finance is literally
wrong because it has relied almost entirely on financial theories that make explicit and implicit

1
As Fama (1991, p. 1596) noted that: ―we know all models are false.‖ Actually, this seems to be an unattributed
quote from the famous statistician (of Box-Jenkins, etc. fame) George E.P. Box: ―Essentially, all models are wrong,
but some are useful.‖ My use of this observation is not exactly as Box meant it. He was referring to econometric
models, I generally am not. My reference is primarily normative financial market models. To the extent
econometrics is always wrong is a matter of degree, whereas, financial models are wrong by construction and/or
design.
Kihn / Behavioral Finance 101 / 7

assumptions that are incorrect, if not silly. For example, the Capital Asset Pricing Model (the
―CAPM‖)
2
assumes the following
3
(among other assumptions):
1. ―Investors are risk-averse individuals who maximize the expected utility of their end-of-
period wealth.
2. Investors are price takers and have homogeneous expectations about asset returns that
have joint normal distributions.
3. There exists a risk-free asset such that investors may borrow or lend unlimited amounts at
the risk-free rate.
4. The quantities of assets are fixed. Also, all assets are marketable and perfectly divisible.
5. Asset markets are frictionless and information is costless and simultaneously available to
all investors.
6. There are no market imperfections such as taxes, regulations, or restrictions on short
selling.‖
Let‘s look at the last assumption first (i.e., #6), are there no taxes or regulations? Clearly there
are. In fact, every assumption listed is incorrect. Yet the aforementioned list of assumptions is
standard. Also, although not listed, it is assumed that all investors are always rational
4
, which
again is not the case (i.e., in the relatively strict economics sense of the term). Therefore, the
derivation may be mathematically correct, but the proof and results must be wrong. Then why
make such patently absurd assumptions that we know are empirically and/or logically
contradicted? The likely answer is mathematical tractability (i.e., to get an answer). The short

2
See Sharpe, W., ―Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk‖, Journal of
Finance, Volume 19, Issue 3 (Sep., 1964), 425-442.
3
See, for example, Copeland and Weston (1988, p. 194).
4
Patel et al. (1991, p. 232) call it ―an article of faith‖, that economists insist that in the aggregate individuals will
reach ‗rational‘ outcomes.
Kihn / Behavioral Finance 101 / 8

answer, and suspicion, is that getting an answer and using math has outweighed the importance
of dovetailing with empirical reality.
5
This book approaches the subject matter of finance from
exactly the opposite direction; that is, it is of the most critical importance to reflect reality not
theory.

Regarding the second part of the statement concerning the usefulness of theories, such as the
CAPM, it is not as clear as the logic and math would suggest. That is, while the CAPM is clearly
wrong, I would submit that it is still useful for equities in particular. In fact, I have found that
some of the more useful financial concepts may be those the furthest from actual market reality.

In addition, at the time of writing this book, the future of finance as an academic discipline, and
even as an industry, has been somewhat clouded by the current ‗financial crisis‘. In fact, some of
the current blame has been placed on financial models that were ‗wrong‘ and professional
economists (both academic and more practitioner oriented) that didn‘t see the crisis coming, have
no idea when it will end, and offer no insightful views as to the conditions under which it will
end.

A rather long, somewhat disjointed quote might be of help:
―We trace the deeper roots of this failure to the profession‟s insistence on constructing models
that, by design, disregard key elements driving outcomes in real-world markets. …

5
Along these lines, Krugman (2009) notes: ―As I see it, the economics profession went astray because economists,
as a group, mistook beauty, clad in impressive-looking mathematics, for truth.‖ Of course, ‗beauty is in the eye of
the beholder‘. To me, being systematically incorrect is hardly beautiful.
Kihn / Behavioral Finance 101 / 9

Many economic models are built upon the twin assumptions of ‗rational expectations‘ and a
representative agent. …
The major problem is that despite its many refinements, this is not at all an approach based on,
and confirmed by, empirical research. In fact, it stands in stark contrast to a broad set of
regularities in human behavior discovered in both psychology and what is called behavioral and
experimental economics. … despite all the contradictory evidence …
It is highly problematic to insist on a specific view of humans in economic settings that is
irreconcilable with evidence.‖
Colander et al. (2009, p. 1, 7-8) – ―The Financial Crisis and the Systemic Failure of Academic
Economics‖

In other words, economists, and especially financial economists, have known that their models
are often very wrong, by design, yet insist on their application anyway, with often, and especially
recently, disastrous results. Clearly, something more in line with reality might be more useful.
6



6
As Statman (1999, p. 26) points out, essentially ―standard finance‖ expects ―perfect self-control‖ that ―normal
people‖ don‘t display; therefore, essentially something closer to reality might be a more useful starting point for a
‗model‘.
Kihn / Behavioral Finance 101 / 10

WHY NOT APPROACH BEHAVIORAL FINANCE AS AN ADDITIONAL MODULE OR
ADD-ON TO ‗MODERN FINANCE‘?
This book doesn‘t try to approach behavioral finance as an add-on to classic finance (as most
currently do) because current and past textbook finance is wrong not just in the output of its
‗models‘, but in its overall approach to finance. The reliance on theoretical models with mostly
patently wrong assumptions isn‘t the problem per say, it‘s largely the approach itself which
encouraged and accepted such models in the first place. I don‘t, and you shouldn‘t; and by the
end of this book I endeavor to explain why.

REFERENCES
Colander, D., Follmer, H., Haas, A., Goldberg, M., Juselius, K., Kirman, A., Lux, T., and B.
Sloth, ―The Financial Crisis and the Systemic Failure of Academic Economics‖. Working Paper,
2009, 1-17.

Kihn / Behavioral Finance 101 / 11

Copeland, Thomas E.., and John J. Weston, Financial Theory and Corporate Policy (Third
Edition), Addison-Wesley Publishing Company, Inc., 1988.

Fama, E., ―Efficient Capital Markets: II‖, Journal of Finance, Volume 46, Issue 5, 1991, 1575-
1617.

Krugman, P., ―How Did Economists Get It So Wrong?‖, New York Times, September 2, 2009.

Patel, J., Zeckhauser, R., and D. Hendricks, ―The Rationality Struggle: Illustrations from
Financial Markets‖, American Economic Review, Volume 81, Number 2, Papers and
Proceedings o the Hundred and Third Annual Meeting of the American Economic Association,
May 1991, 232-236.

Sharpe, W., ―Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk‖,
Journal of Finance, Volume 19, Issue 3 (Sep., 1964), 425-442.

Statman, M., ―Behavioral Finance: Past Battles and Future Engagements‖, Financial Analysts
Journal‖, Volume 55, Number 6, November/December 1999, 18-27.





Kihn / Behavioral Finance 101 / 12



Kihn / Behavioral Finance 101 / 13

Introduction & setting the stage: discussion and some definitions

All that you learn in finance (and economics) is wrong; but that doesn‘t mean it is all useless. By
the end of this book the reader should be able to understand why this is true and why it may not
matter much.

WHAT IS FINANCE?
Finance is a subset of economics.
7
That is, if economics is essentially the study of potentially
unlimited wants/demand in a world with limited resources/supply, then the information,
knowledge, and concepts associated with finance are completely contained within economics.
This is important in that the weaknesses of economics will likely ultimately apply to finance as
well (i.e., to the extent they overlap, which they do). Therefore, any general (and sometimes
specific) issues related to economics are likely impacting finance (and vice-versa).

7
In contrast, Ross (1987) has indicated that he thinks that a large part of modern finance is outside of economics,
but ends up being subsumed by economics eventually (i.e., as economics picks up on it).
Kihn / Behavioral Finance 101 / 14


At its core, finance is relatively simple: it is the study of discounted cash flows, which can also
be called present values. In short, there are only two things that make up discounted cash flows:
1. The cash flows themselves, and
2. The discount rates associated with them.
Therefore, from the simplest model to the seemingly most complicated contingent claims/option
pricing model there are essentially only two practical questions that require actual answers:
1. What is/are the cash flow(s)?
2. What is/are the discount rate(s)?
What could be simpler? But like so many subjects, it is often the case that ―the devil is in the
details.‖

Given that in the real financial markets, for example the equity markets, we are largely
concerned with stock price movements, one should understand the usefulness of understanding
finance through this prism of cash flows and discount rates. The additional benefit is that it
doesn‘t require making wrong or even absurd assumptions to understand what is actually
happening in the actual financial markets; and, therefore, only requires that any theory parallel
what is actually known about one or more financial markets.

Kihn / Behavioral Finance 101 / 15

WHAT IS, AND WHY, BEHAVIORAL FINANCE?
―All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third,
it is accepted as self-evident.‖
Arthur Schopenhauer

This book doesn‘t try to approach behavioral finance as an add-on to classic finance (as most do)
because current and past textbook finance is wrong not just in the output of its models, but in its
insistence on accepting the incorrect models themselves as correct. It bears repeating, the models
are wrong, but some may be useful to varying degrees. Which brings us to behavioral finance,
and unlike current academic finance, it is reconcilable with the evidence.
8
Again, this doesn‘t
mean some of the mathematically derived wrong ―models‖ aren‘t useful on some level. The
point is that, given the actual reality of the financial markets, while the models (to varying
degrees) may be salvageable the approach is not. In short, what is required is an approach that
much better fits the evidence. This, in turn, brings us to behavioral finance.

Behavioral finance is defined as follows
9
:

8
It has recently been noted (Krugman (2009)): ―But what‘s almost certain is that economists will have to learn to
live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable
behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‗theory of
everything‘ is a long way off. In practical terms, this will translate into more cautious policy advice‖. Although,
especially with regard to ‗policy advice‘, I suspect he doesn‘t practice what he preaches.
9
Barberis and Thaler credit Shleifer and Summers (1990) with identifying these ―two pillars‖ of behavioral finance
(limits to arbitrage and investor psychology).
Also, ―note that most asset pricing models use the Rational Expectations Equilibrium framework (REE), which
assumes not only individual rationality but also consistent beliefs (Sargent (1993)). Consistent beliefs means that
agents‘ beliefs are correct: the subjective distribution they use to forecast future realizations of unknown variables is
indeed the distribution that those realizations are drawn from. This requires not only that agents process new
information correctly, but they have enough information about the structure of the economy to be able to figure out
the correct distribution for the variables of interest.‖ (Barberis and Thaler (2002, p. 2 footnote #1)) Obviously, few,
if any, investors have ―consistent beliefs‖.
Kihn / Behavioral Finance 101 / 16

―Behavioral finance argues that some financial phenomena can plausibly be understood using
models in which some agents are not fully rational.
The field has two building blocks:
(1) Limits to arbitrage, which argues that it can be difficult for rational traders to undo the
dislocations caused by less rational traders; and
(2) Psychology, which catalogues the kinds of deviations from full rationality we might
expect to see.‖
Barberis and Thaler (2002, p. 1)
I would add to that definition that actually, as it turns out, not ―some‖ but most, if not all,
―financial phenomena can plausibly be understood using models in which some agents are not
fully rational.‖ It is important to note that it is likely without limits to arbitrage the psychology
part might be of limited interest. That is, it is likely that limits to arbitrage are a necessary but
possibly not sufficient condition for psychology to impact pricing in the financial markets.
Therefore, the reader should rightfully be convinced empirically and logically that there are
limits to arbitrage before he or she accepts that psychology has a significant impact on pricing.
Finally, I wouldn‘t stress the ‗models‘ part of the first part of the definition, and that to the extent
behavioral ‗models‘ are developed they, by definition, should emphasize reality.



Kihn / Behavioral Finance 101 / 17

THREE THEORETICAL APPROACHES, ONE THAT FITS FINANCE (AND ECONOMICS),
BUT IT‘S NOT THE ONE CURRENTLY USED (AND IT SHOULD BE)
According to Bell et al. (1988) there are three kinds of theories of decision making under
uncertainty
10
:
1. Normative theories state how agents should behave (i.e., typically as ‗rational‘ agents).
2. Descriptive theories describe how agents actually behave.
3. Prescriptive theories advise agents on how to behave when confronted with their own
cognitive limitations.
More to the point, economics has been and is largely a ‗normative‘ field of study (e.g., game
theory, etc.). It spends most of its time (and research), and often implicitly, concerned with how
economic agents should behave. Remember, finance is a subset of economics and is therefore
another normative field of study (at least currently
11
). Now contrast economics and finance with
psychology, which has been and is largely a ‗descriptive‘ field of study. In psychology,
psychology researchers often first observe what humans do, then develop theories and related
models. In finance (and economics) it is often the opposite. In finance and economics researchers
assume economic agents behave in certain ways (e.g., rationally) and markets, etc. function in
certain ways (e.g., ―efficiently‖), then a model and/or theory is proposed. Which should better fit
the field of finance, normative or descriptive? My answer would be that, clearly, finance should
be primarily a descriptive field of study.


10
Especially see Bell et al. (1988, pp. 9-30).
11
Olsen (2001, p. 54) has indicated that he considered finance prior to ‗modern finance‘ (circa 1951-1952) to be a
―descriptive discipline‖. If that is accepted, then it went from descriptive to normative around the early 1950s, to
where it has stayed until at least the writing of this book. Either way, it is has been principally normative since
around the time it was recognized as its own discipline (i.e., around the 1950s).
Kihn / Behavioral Finance 101 / 18

It is absurd for finance (and economics) to organize itself as a normative field of study when its
natural design should
12
be descriptive. Given that finance (and economics) has largely turned
down a dead end street, behavioral finance is a natural paradigm shift for finance.
13
Again, its
two pillars are limits to arbitrage (which depends largely on actual market microstructure) and
psychology (which in some cases can directly depend on things like human biology and related
natural science). Psychology has and is largely a descriptive endeavor; whereas limits to
arbitrage is largely an area of finance that was, until more recently, an area of finance that was
neglected because it was assumed not to matter (e.g., think ―efficient markets‖, ―no free lunch‖,
etc.). The actual reality of the financial markets is that it is best suited for descriptive study, not
normative. Unfortunately, most financial economists insist that behavioral finance is some add-
on to the larger study of normative financial economics. It is not. Finance by its very nature is a
naturally descriptive field of study, not normative. There are actual people and markets that can
be observed. There is limited or no need in finance to theorize in a vacuum. We can observe
many discounted present values or financial asset prices and their movements and levels are
increasingly difficult to reconcile with normative theories. Might it be time to switch to a more
descriptive field of study, or just call a naturally descriptive field of study for what it is?

As an aside, I have mentioned that some financial ‗models‘ may be useful, even if they are
clearly wrong (e.g., mathematically). It is the dichotomy between normative and descriptive that

12
This, of course, is a normative statement. My rationale for making this statement is empirically driven. To wit,
finance is the study of discounted cash flows, which in turn are influenced by economic agents, driven by human
psychology and related things, which are very different from say the laws of physics. This should become clearer by
the end of the book.
13
In response to where economics should now go in the future (i.e., given that it has miserably and catastrophically
failed), even Krugman (2009) states: ―There‘s already a fairly well developed example of the kind of economics I
have in mind: the school of thought known as behavioral finance.‖
Kihn / Behavioral Finance 101 / 19

largely drives my rationale. First, something like the CAPM is a normative theory. Few, if any,
of its explicit or implicit assumptions are realistic. It is a contrived bit of math for actual markets
that cannot, by definition, truly reflect that reality, but possibly by accident. Even so, to the
extent that actual humans drive actual prices away from normative theory (which they do), but
those prices eventually reflect something close to the contrived math (which they might), then
using those ―wrong‖ models might be of some prescriptive use (that is, assuming they do, which
they might not). Hopefully this will become clearer to the reader as the book progresses and
these and related issues are addressed. The important takeaway is that not all wrong models in
finance are as useful, and it can depend on the model and timeframe we are looking at.

The aforementioned brings us to the point of mentioning the prescriptive part of this book
specifically and behavioral finance in general. In short, given that actual humans don‘t often
follow (if ever) the insights and forecast of normative models, and we can descriptively observe
what they actually do in the actual markets, then there may be room to guide those humans with
prescriptive advice, or at least offer some. This book will offer some prescriptive advice to better
allow those humans that so desire to make more optimal financial market decisions (i.e., ceteris
paribus from a wealth maximization perspective) than those documented by empirical research
(with or without the guidance of normative models). In effect, what this book will try to do is
help guide actual agents in what is currently a normative field of study by focusing more on
descriptive proof and applying a modicum of logic.

To summarize up to this point:
Kihn / Behavioral Finance 101 / 20

1. Everything you will learn in economics and finance that is based on normative theory is
wrong (which is most, if not all, of economics and finance).
2. Although, even though those largely ―normative‖ theories are wrong (i.e., empirical
reality is not generally supportive) it does not mean that they are not useful (the key is
in what ways & conditions under which they might be useful and especially which ones
might be useful).
3. But there is a circularity problem. Specifically, because most of us humans are biased
14

and irrational (specifically, in ways that affect pricing in the financial markets) it would
seem that it is likely that we need tools (be they models and/or theories) to guide us in our
decision making. Without a normative toolkit, we are likely to continue to mess up
pricing in the financial markets. But because we are so messed up (i.e., from a normative
perspective, e.g., ―hindsight bias‖) we tend to use normative tools in a way that only
reinforces our biases (e.g., in searching for confirming evidence we may use the
normative based tools of statistics to confirm our biased belief).
The key is the last point (#3). We must be careful to use tools and techniques to avoid costly
wealth minimizing decisions that we, as humans in the financial markets, are prone to do.
Because we are so messed up (i.e., from a normative economics perspective) we need normative
based tools like statistics, for example; but because we are so messed up we tend to use any tool
and pervert it in an attempt to ―rationalize‖ our irrational judgment and beliefs. Hindsight bias
and the search for confirming evidence are examples of this. I can think of what seems like to me

14
Most humans seem hardwired for denial. Essentially our emotions (particularly the way we register information)
can overwhelm our cognitive (the way we organize information) thoughts. In particular, it tends to be difficult for us
to unemotionally approach investing, and even science itself. Once we hold some view, for example that the markets
are ―efficient‖, we tend to have an emotional vested interest in keeping that view alive and well. This makes it
especially difficult to breaking out of this circle of thoughts and emotion.
Kihn / Behavioral Finance 101 / 21

an endless string of events in my working life where I have witnessed firsthand examples of
this.
15
In fact, we tend to pervert these tools when we need them most (e.g., during bubbles we
tend to use the ―new paradigm‖ argument more than during ―normal‖ times; thus, for example,
suggesting that our typical valuation techniques no longer apply).
16


In the final analysis, learning/training is the only way out of this, but, given how messed up we
are as humans (i.e., specifically in terms of normative finance and economics), learning for most
is best done in a strict organizational setting where feedback and motivation are present (which is
atypical in the ―real world‖, let alone in the financial markets). This should be clearer as the book
progresses, but keep in mind that care and concentration are critical in avoiding typical pitfalls in
training one-self to avoid typically human actions and reactions in the financial markets.


15
One example is the term ‗hedge‖. By hedge academics typically mean two largely offsetting positions often meant
to reduce risk, whereas most practitioners I have observed only refer to hedging when they have a loss they can
blame on it. Therefore, for many, if not most, practitioners a hedge is an unexpected loss, which is very different
from the standard textbook definition.
16
Again, our need to deny that which we have a vested interested in perpetrating, even if the interest is only
emotional and not economic and/or logical, makes it especially difficult to break out of this circle of bias and denial.
Kihn / Behavioral Finance 101 / 22

REFERENCES
Barberis, N., and R. Thaler, ―A Survey of Behavioral Finance‖, NBER Working Paper #9222,
Addison-Wesley Publishing Company, Inc., September 2002, 1-78.

Bell, David E., Raiffa, Howard, and Amos Tversky (edited by), Decision Making (Descriptive,
normative, and prescriptive interactions), Cambridge University Press, New York, N.Y., 1988.

Krugman, P., ―How Did Economists Get It So Wrong?‖, New York Times, September 2, 2009.

Olsen, R., ―Professor Burrell‘s Proposal for a Behavioral Finance: Some Reflections‖, Journal of
Psychology and Financial Markets, Volume 2, Number 1, March 2001, 54-56.

Ross, S., ―Finance and Economics: The Interrelations of Finance and Economics: Theoretical
Perspectives‖, American Economic Review, Volume 77, Number 2, May 1987, 29-34.

Sargent, Thomas, Bounded Rationality in Macroeconomics, Oxford: Oxford University Press,
1993.

Shleifer, A., and L. Summers, ―The Noise Trader Approach to Finance‖, Journal of Economic
Perspectives, Volume 3, Number 2, Spring 1990, 19-33.
Kihn / Behavioral Finance 101 / 23

Chapter 1: Are the markets „efficient‟?

I advise all students in economics when asked an open ended question to, as a rule, begin their
answer with ―it depends‖.
17
Therefore, regarding ‗market efficiency‘, are the markets efficient?
Generally the answer is no, but that depends primarily on your definition of efficiency. More
recent (and normative) tortured definitions will tend to cloud the issue. That said, the most
common textbook definition is that of Fama (1970, p. 383):
―… security prices at any time ‗fully reflect‘ all available information. A market in which prices
always ‗fully reflect‘ available information is called ‗efficient‘.
… efficient markets model. … First, weak form tests, in which the information set is just
historical prices, are discussed. Then semi-strong form tests, in which the concern is whether
prices efficiently adjust to other information that is obviously publicly available (e.g.,
announcements of annual earnings, stock splits, etc.) are considered. Finally, strong form tests
concerned with whether given investors or groups have monopolistic access to any information
relevant for price formation are reviewed. We shall conclude that, with but few exceptions, the
efficient markets model stands up well.‖
18



17
Bill McTague suggested this to me in 1985.
18
Remember, to quickly incorporate the information means that those receiving the news late shouldn‘t be able to
profit (e.g., reading it in newspapers or company reports). To correctly incorporate the information means that the
price adjustment in response to the news should be accurate on average (i.e., no overreaction or underreaction to the
news). Also, since a security‘s price should equal its value, prices should not change without any news about the
value of the security (i.e., prices should not react to changes in supply or demand of a security that are not
accompanied by news about its fundamental value). Stale information is relatively easy to define (the ‖weak form of
EMH‖ defines it as past prices and returns, the ‖semi-strong form of the EMH‖ defines it as any publicly available
information, and the ‖strong form of the EMH‖ defines it as insiders‘ information or information not publicly
available).
Kihn / Behavioral Finance 101 / 24

First, note there is essentially one general hypothesis (i.e., ―security prices at any time ‗fully
reflect‘ all available information‖) and three more specific ones (i.e., ―weak‖, ―semi-strong‖, and
―strong‖ forms). Henceforth, I will refer to the general hypothesis as the Efficient Market
Hypothesis (―EMH‖) and that larger set of hypotheses and theory as the Efficient Market Theory
(―EMT‖). Thus, I will refer to this set as the EMH/EMT
19
.

Therefore, the textbook ‗efficient markets‘ theory or model has at least three testable hypotheses:
1. Weak form – All past prices or information are incorporated into prices.
2. Semi-strong form – All publically available information is incorporated into prices.
3. Strong form – All information, whether public or private, is incorporated into prices.
Note, the EMH/EMT doesn‘t just state that information should be reflected into prices, but that it
should correctly reflect the information. In short, there shouldn‘t be too much reaction or too
little, but just the right amount. For example, a headline and story that conveys no fundamentally

19
‗Modern finance no longer seems to be able to identify the basic difference between a hypothesis and a theory.
For the following go to Wikpedia.com – ―Karl Popper‗s … demands falsifiable hypotheses, framed in such a
manner that the scientific community can prove them false (usually by observation). According to this view, a
hypothesis cannot be ‗confirmed‘; because there is always the possibility that a future experiment will show that it is
false. Hence, failing to falsify a hypothesis does not prove that hypothesis: it remains provisional. However, a
hypothesis that has been rigorously tested and not falsified can form a reasonable basis for action, i.e., we can act as
if it is true, until such time as it is falsified. …
In science a theory is a testable model of the manner of interaction of a set of natural phenomena, capable of
predicting future occurrences or observations of the same kind, and capable of being tested through
experiment or otherwise verified through empirical observation. … In common usage, the word theory is often
used to signify a conjecture, an opinion, a speculation, or a hypothesis. In this usage, a theory is not necessarily
based on fact; in other words, it is not required to be consistent with true descriptions of reality. … According to the
United States National Academy of Sciences, some scientific explanations are so well established that no new
evidence is likely to alter them. The explanation becomes a scientific theory. In everyday language a theory means a
hunch or speculation. Not so in science. In science, the word theory refers to a comprehensive explanation of an
important feature of nature that is supported by many facts gathered over time. Theories also allow scientists
to make predictions about as yet unobserved phenomena.‖ Therefore, based on standard accepted ‗scientific‘
definitions, the EMH is no longer a hypothesis and the EMT has never been a theory (i.e., the evidence has
falsified the hypothesis (i.e., the EMH), and it has not been in support of the theory). Actually, the EMT/EMH is
really neither hypothesis nor theory. It used to be a hypothesis (i.e., in the Popper sense of being testable, but not
since the 1990s or so, since the tests falsified it) but is no longer.
Kihn / Behavioral Finance 101 / 25

significant information concerning XYZ Company should not affect the price of the stock of the
XYZ Company. Based on Fama (1970), the markets are not efficient by any stretch of a rational
person‘s imagination. In fact, a careful review of the key early empirical work in the field
contradicts the assertion made in the Fama quote at the time the quote was made. Since 1970,
there has been a flood of evidence against the original definition of ‗market efficiency‘. In fact,
the original more normative definition has been and continues to be modified as evidence has
tended to reject all three more specific hypotheses. Somewhat ironically, the EMH/EMT has
turned from a more normative theory to a more descriptive one, some might even argue it has
become a form of religious ‗faith‘ (see, Ross (1987, p. 33)). ―After all, finance has progressed
very far by having a faith – some would say religious but I prefer to think of it as a proven first-
order approach to problems – in the broad efficiency of markets.‖
20


At this point, the notion of ―arbitrage‖ should be mentioned. Standard finance (and economics)
relies heavily on the notion that ―arbitrage‖ corrects any prices that differ from the ―efficient‖
price (i.e., one that reflects all past and public information, and possibly some or all private
information). For example, assume we know the true economic or fundamental price of a share
of IBM is $100 yet the price is $90. The traditional argument is that one or more arbitrageurs
will enter the market for IBM shares and continue buying shares until the price is driven up to
$100. Conversely, if the price is $110 per share, one or more arbitrageurs will enter the market

20
Additionally, Patel et al. (1991, p. 232) state: ―For most economists it is an article of faith that financial markets
reach rational aggregate outcomes, despite the irrational behavior of some participants, since sophisticated players
stand ready to capitalize on the mistakes of the naïve. (This process, which we call poaching, includes but is not
limited to arbitrage.) … Descriptive decision theory, especially psychology (see D. Kahneman et al. (1982) can help
to explain such aberrant macrophenomena.‖ Indeed, the one part I would correct is that most and not ―some
participants‖ display ‗irrational‘ behavior.
Kihn / Behavioral Finance 101 / 26

and short shares until the price is driven down to $100 per share. Note for upcoming chapters,
critical to this description is that:
- There are no limits to arbitrage (e.g., no taxes, transaction costs, etc.). Yet there are. We
will review some evidence in a forthcoming chapter.
- Only one arbitrageur is required. That is, standard financial theory works at the margin.
Thus, we only require one rational arbitrageur to offset a theoretically unlimited number
of investors willing to accept a mispricing. We will show at least one case were this not
only didn‘t happen, but the likely arbitrageurs helped to pushed the price away from the
―efficient‖ price.
- We know what the true fundamental or economic price is; when in fact we rarely, if ever,
do. We will review the evidence in forthcoming chapters.
In short, the standard arbitrage story hardly fits what actually occurs in the markets and we have
plenty of descriptive evidence to show this. Finally, note, the EMH specifically and the EMT
more generally rely on arbitrage or the normative academic equivalent of ‗all hell breaks loose.‘

Kihn / Behavioral Finance 101 / 27

A FEW REMINDERS AND SOME THEMES
Before proceeding it may be useful to warn against what psychologists call implicit and explicit
processing
21
(i.e., as it concerns the EMH/EMT). Implicit processing is more automatic vs.
explicit which requires more cognitive effort and training. Regarding the EMH/EMT, the
evidence would suggest one thing, but most of what is learned keeps telling you that you
explicitly process that evidence by ignoring it. Don‘t do it! If so, then reconcile your implicit and
explicit processing of the EMH/EMT by searching for evidence and trying to make up your mind
by yourself without the author‘s or anyone else‘s input. Because the academic field of finance
still relies on normative models (like the EMH/EMT) that are wrong, it spends a great deal of
energy dismissing the empirical evidence in favor of the normative theory itself (e.g., investors
should maximize their own risk adjusted returns vs. what we observe is that investors often
don‘t).

A list of themes:
• The markets are not efficient (not in the Fama (1970) sense of markets fully reflecting all
available information), but it is difficult/tricky taking advantage of this. Thus, market
inefficiency is the norm, not the anomaly or exception.
• Some reasons why ‗market efficiency‘ doesn‘t dominate is that there are (1) limits to
arbitrage, and (2) it is still hard to say that one can make risk-free excess returns (i.e.,
some form of risk is typically encountered along the way and it may not be simple to

21
Psychologists have shown that there are two different types of processing systems—the implicit and the explicit.
Implicit processing – automatic and unconscious (e.g., face recognition). Explicit processing – more ―evolved‖ and
requires effort and control (e.g., performing calculus); and it can suppress the implicit processing (e.g.,
brainwashing). Note: There can be conflicts, but that in general is usually not healthy.

Kihn / Behavioral Finance 101 / 28

measure or observe, e.g., irrational trader or ―noise trader risk‖). Therefore, due to
realistic costs & other constraints and risk misspecification there really is ‗no free lunch‘;
in fact, the ‗free lunch‘ may be a kind of normative illusion.
• Agents/actors in the financial markets are not generally the ‗rational‘ economic beings
described by normative finance and economics. In fact, we are only generally rational in
more of a dictionary sense, not that which normative economics has defined. In short,
based on the economics and finance strict normative definition, we are not ‗rational‘ at
all; rather we tend toward the irrational.
• Arbitrage still bounds the markets, but is typically risky in the real world and limited in
other ways. In short, what looks like a ‗free lunch‘ may turn out to be difficult to eat.
• Behavioral explanations are key and accurate at the micro level (i.e., in terms of the root
plausible causation), but tend to be more nuanced and complicated as financial market
data is aggregated.
• Whether purely academic or practitioner, you would be wise to study the behavioral
aspects of finance.

Always keep in mind that behavioral finance is not a panacea for the ‗anomalies‘ that have been
observed in the financial markets, but it is useful, if not true. Behavioral finance builds upon
individual studies (more micro foundations) and works toward the markets, while traditional
finance has tended to work in the other direction (observing first then fitting square pegs into
assumed square holes that sometimes turn out to be round – think Fama). Often EMH/EMT
promoters have been and are focused on the symptom not the cause. Of course, as in medical
Kihn / Behavioral Finance 101 / 29

care, often the cure is derived by focusing on the cause, not the symptom (e.g., for mutual funds,
the market typically makes the manager).

Also, a few words should be devoted to the normative importance of individual rationality
(which is a basic assumption embedded in most financial models). Note that the rational
expectations equilibrium framework ―assumes not only individual rationality, but also consistent
beliefs (Sargent (1993)).
22
Consistent beliefs mean that agents‘ beliefs are correct:‖ (and maybe
that investors apply Bayes‘ law correctly). Therefore, economic agents need to both process
information correctly and have enough information (as well as the right model). Bounded
rationality typically assumes investors are initially limited in their information set (e.g., investors
do not initially know the growth rate of an asset, but learn as best they can from the data). Thus
bounded rationality tends in the same direction of more strict rationality with typically similar
results. Behavioral finance typically relaxes the assumption of strict rationality. Thus behavioral
finance is unique in that respect, and reflects descriptive reality.

Finally, I wish to make statement that should make much more sense to the reader by the end of
the book: there may appear to be „free lunches‟, but no truly free lunch. As evidence is
reviewed it should become clear that the original EMH/EMT emphasis on information being
embedded in pricing in an ‗efficient‘ manner is not very helpful in describing actual financial

22
Also, as Shiller (1990, p. 55) points out, rational expectations models collapse both the model economic agents
use and the one they use to generate their expectations into one ‗elegant‘ model. That is, by assuming people‘s
expectations are always optimal, we don‘t have to worry about them. Additionally, he notes this is a ―gross
oversimplification‖ done for tractability. Reality is not a strong suit of normative economics. In my opinion the
rational expectations assumption is just another ridiculous simplifying assumption of normative economics, made
principally for mathematical tractability (i.e., to get an answer, not to enhance the odds of that answer reflecting
reality). The original academic reference, regarding individuals always having exactly the same predictions as the
―relevant economic theory‖, is Muth (1961).
Kihn / Behavioral Finance 101 / 30

market reality. Incidentally, this suggests there are ‗free lunches‘ to be had in those markets. This
is doubtful. Even though there may appear to be ‗free lunches‘ it is likely these are artifacts of
things like limits to arbitrage and/or the inability to measure the true economic ‗risk(s)‘
associated with the financial asset or liability examined.

I will now proceed in the following way:
1. Review of rationality.
2. Summary/review of key early evidence and theory supposedly in favor of the EMH/EMT
and list examples of mostly predictable ―free lunch(es)‖.
3. Limits to arbitrage – Pillar I.
4. Psychology and its links to finance and financial decision making – Pillar II.
5. What we know about the agents.
6. ‗Bubbles‘.
7. The true anomaly (i.e., when prices are ‗right‘ and under what conditions).
8. A rough measure of how ‗wrong‘ price levels can be.
9. ‗Overearction‘/‘underreaction‘.
10. Bankruptcy.
11. Illusions.
12. Descriptive theories.
13. Volume & volatility.
14. Corporate events.
15. Can we expect to learn our way out of this?
Kihn / Behavioral Finance 101 / 31

I will cover the core pieces and provide actual evidence. Again, given the nature of finance, the
approach will be more descriptive than normative.

I LEAVE YOU WITH A GRAPH, A FEW QUESTIONS, AND A PIECE OF ADVICE
What follows is a graph with two lines that should be of some interest to the reader:
Kihn / Behavioral Finance 101 / 32


Based on monthly data, the graph covers the period January 1997 through July 2009. The blue
line represents the annual total return on the Standard & Poor‘s 500 equity index (S&P 500).
Note, that arguably, and especially over the time period examined, the S&P 500 is world‘s best
known stock index. As an example of reading data points on the S&P 500 return line, around
May 2009 (time is on the horizontal axis) a person who had invested in the S&P 500 from May
of 2008 and held through May of 2009 would have lost about 40% of his or her investment
(annual return for the S&P 500 is on the left vertical axis). The red line represents Wall Street
Strategists (―WSSs‖) recommended stock allocation. As an example of reading data points on the
WSSs recommendation line, on May 2009 they were recommending an about 52% allocation to
50%
55%
60%
65%
70%
75%
-45%
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
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Wall Street 'Strategists' and Market Timing
SPX
STALSTOX
Kihn / Behavioral Finance 101 / 33

stocks (recommended stock allocation is on the right vertical axis – therefore, 48% outside of
stocks, or equivalently 100% - 52%). First, note that WSSs are some of the best paid and most
listened to people in the actual financial markets. Second, note that what is generally important is
not the level of their stock allocation but when they increase or decrease their allocation (e.g.,
from 50% to say 60%, or vice versa, i.e., up or down). In short, they always recommend some
stock allocation and it generally has varied between 50 and 70 percent. Third and most
importantly, note that the stock market tends to go in the opposite direction of their
recommendations, with a lag.
23
In fact, it is an excellent signal for timing the stock market; it‘s
just that you must systematically do the opposite of what the ―experts‖ are telling you.
24


You may be asking yourself some version of the following question: How can you be that
consistently bad and keep your job (or possibly: How does one get that job?)? Could it be that
maybe, just maybe, they actually know something about the stock market, or how else could they
have achieved consistently negative timing ability? Could it be that maybe, just maybe, they are
paid to essentially lie? The reader might then ask: Lying isn‘t exactly what could be considered a
highly paid skill, is it? Furthermore, how does the EMH/EMT fit into this? Answer: It really
doesn‘t? Remember, the EMH/EMT is about information getting embedded into pricing in an

23
More recently, that is since the ‗financial crisis‘ began after July-August 2007; this has not been the case. In this
author‘s opinion, it is likely some structural changes in the industry threaten this relationship.
24
See, for example, Fisher and Statman (2000). They also find a significant negative relationship between small,
individual investors‘ sentiment and future S&P 500 returns. Note that Fisher and Statman (2000) find significance at
the 5% level; and if the projection is longer term and the regression equation is expanded one can find statistical
significance well beyond the 1% level. Also note that going back in time as far as data has been kept on WSSs‘
stock allocations (December, 1985), the relationship holds. In essence, it is not a far stretch to argue that WSSs have
some notion of whether the stock market will be going up or down, they just tell investors to do the opposite. Thus,
investors would be well advised to do the opposite of what they tell them to do.
Even ‗superstar‘ money managers tend to have no useful insight (e.g., see Desai and Jain (1995), regarding stock
recommendations).
Kihn / Behavioral Finance 101 / 34

‗efficient‘ manner; it is not about wrong/false information impacting pricing and/or behavior. In
fact, the more the average person or economist looks at such a relationship the more they might
be tempted to ignore it altogether as an ‗anomaly‘. But I would recommend being careful, WSSs
and the like aren‘t anomalous, but rather closer to normal with respect to what actually happens
in the recent world of actual finance. The reader now has the rest of this book to be convinced
that this sort of thing isn‘t anomalous, but is quite ordinary. And, yes, additionally it contradicts
the ―semi-strong form‖ of market efficiency (i.e., you shouldn‘t be able to use public information
to forecast security prices (in this case, the U.S. stock market itself).

The aforementioned then brings us to our first bit of prescriptive advice:
As a general rule, do the opposite of what WSSs advise. Therefore, if WSSs advice
increasing your stock allocation, consider lowering it; and if they advise decreasing your
stock allocation, consider increasing it. Actually it‟s a fair thing to say that any prescriptive
advice from Wall Street, and related firms, should be minimally ignored and possibly
turned on its head.
25



25
The best way to consider this is to imagine you are a hen chicken and you ask a fox for advice on living in the
proverbial hen house. If the fox advises you to say step out of the hen house and go to his or her den, what would
you do? Do you follow the fox‘s advice to probably be never seen again, or do you do the opposite?
Kihn / Behavioral Finance 101 / 35

REFERENCES
Desai, H., and P. Jain, ―An Analysis of the Recommendations of the ‗Superstar‘ Money
Managers‖, Journal of Finance, Volume 50, Issue 4, September 1995, 1257-1273.

Fama, E., ―Efficient Capital Markets: A Review of Theory and Empirical Work‖, Journal of
Finance, Volume 25, Issue 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of
the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), 383-
417.

Fisher, K., and M. Statman, ―Investor Sentiment and Stock Returns‖, Financial Analysts Journal,
Volume 56, Issue 2, May/April 2000, 16-23.

Muth, J., ―Rational Expectations and the Theory of Price Movements‖, Econometrica, Volume
29, Number 3, July 1961, 315-335.

Patel, J., Zeckhauser, R., and D. Hendricks, ―The Rationality Struggle: Illustrations from
Financial Markets‖, American Economic Review, Volume 81, Number 2, Papers and
Proceedings o the Hundred and Third Annual Meeting of the American Economic Association,
May 1991, 232-236.

Ross, S., ―Finance and Economics: The Interrelations of Finance and Economics: Theoretical
Perspectives‖, American Economic Review, Volume 77, Number 2, May 1987, 29-34.
Kihn / Behavioral Finance 101 / 36


Sargent, Thomas, Bounded Rationality in Macroeconomics, Oxford: Oxford University Press,
1993.

Shiller, R., ―Speculative Prices and Popular Models‖, Journal of Economic Perspectives, Volume
4, Issue 2, Spring 1990, 55-65.


Kihn / Behavioral Finance 101 / 37

Chapter 2: The „rational‟ economic agent

Let us begin at the more general definition and move to the more specific. That is, we will begin
with a dictionary definition of rationality and then lay out what economists (general and
financial) mean when they write or speak of ―rationality‖. Also, note that rationality is a
necessary, but not sufficient, condition for ‗modern‘ economics (and finance) to have a fighting
chance of being applicable. What you will learn in this section is that as it is defined by
economists (and financial economists), it isn‘t applicable. It bears repeating, if the strict
economic definition of rationality doesn‘t hold most economic ―models‖ (i.e., those currently
taught and in your textbooks, at least at the time of this writing) don‘t strictly hold (i.e.,
tautologically or mathematically, and likely descriptively).
26


First, a dictionary definition of rational:
―rational: adj. 1. based on or agreeable to reason: a rational decision. 2. exercising reason: a
rational negotiator. 3. sane; lucid: The patient seems rational. 4. Math. …‖
Webster‘s College Dictionary (1998)
What‘s to argue with there? Contrast that seemingly innocuous definition with that relied on by
finance (and economics): Rational behavior is consistent behavior that maximizes an individual‘s
satisfaction (i.e., utility). It rests on the following three assumptions (see McKenzie and Lee
(2006, p. 100)):

26
This is especially true of those models that assume ―all expectations are optimal forecast‖, such as made by the
―rational expectations‖ modelers (see, e.g., Shiller (1975) for a critique).
Kihn / Behavioral Finance 101 / 38

1. The individual has an identifiable preference (within limits/constraints) as to
what he or she wants.
2. The individual is capable of ordering his or her wants consistently (i.e., most to
least preferred).
3. The individual will choose consistently from these ordered preferences to
maximize his or her satisfaction (i.e., utility).
None of the three fundamental assumptions consistently hold for most people in the actual
world.
27
With respect to rationality, and particularly economic rationality and assumed
consistency, the principal problem is that humans‘ actions and decisions tend to be context
dependent. Specifically, I may have nicely ordered preferences under one set of conditions, yet
revise and/or reverse those under another. For example, when the price of IBM shares is
generally increasing I may be a buyer, yet when it is dropping I may turn into a seller, ceteris
paribus. Unfortunately, finance models generally don‘t allow for this very human behavior. This
version of strict rationality is a key assumption for all of economics, especially something like
finance (which is a subset of economics) where agents are trading financial assets on a regular
basis. Most of us break all of these assumptions.

Descriptively, humans in the financial markets often change their preferences and are anything
but consistent in ordering their wants and preferences. Currently, mainstream economics (and
finance) does not recognize natural human inconsistency, but holds to a very tight definition of
rationality that does not accurately describe decision making and the subsequent actual price

27
See, for example, Tversky and Simonson (1993). That article concerns the context dependent nature of actual
human preferences vs. those assumed by standard utility theory (which is foundational for economics).
Kihn / Behavioral Finance 101 / 39

setting in most financial markets most of the time. While the assumption based theory of choice
assumes stable and consistent preferences, the reality is context dependent preferences and
values.
28
Preferences and values are constructed dependent on context and ―these constructions
are contingent on the framing of the problem, the method of elicitation, and the context of
choice.‖ (Tversky and Simonson (1993, p. 1187)) In short, nothing, or almost nothing, about the

28
Or example, Tversky and Simonson (1993): Context-dependent preferences contradict the standard theory of
choice, based on value maximization. Value maximization suggests that the highest value option is always chosen.
Often the choice between x and y, for example, is influenced by a third option z, and the value of an option can be
increased by enlarging the offering set (i.e., a violation of regularity: implies P(x, R) ≥ P(x, S)).
Therefore, the independence of irrelevant alternatives is violated. In short, most of the underlying assumptions of
Utility Theory are violated. For example, a liberal candidate x may defeat a conservative candidate y in a two person
race, but lose if another liberal candidate is included (i.e., get fewer votes). Or, for example, the introduction of a
top-of-the-line camera is expected to reduce the market share of a midline camera more than the share of a basic
camera. Tradeoff Contrast not only applies to a single attribute, such as size, but also to the tradeoff between
attributes (e.g., price and quality). Background Context example (Simonson and Tversky (1992)) – tires (price and
mileage warranty) and books (coupons). For tires, first exposed to a small change in price/large change in mileage
warranty vs. another group first exposed to the opposite, tended to select less expensive tires and vice versa. Local
Context (market share increase example by Huber et al. (1982), also, Simonson and Tversky (1992)) - $6 vs. high-
end Cross pen (64% chose cash), then a cheap pen introduced (now, the Cross pen increased from 36% to 46%,
contrary to regularity). Extremeness Aversion (Kahneman et al (1991), Tversky and Kahneman (1991)) – Gains and
losses are defined relative to a neutral reference point that generally corresponds to the decision maker‘s status quo
or current endowment. In some situations, however, decision makers may evaluate options in terms of their
advantages and disadvantages, defined relative to each other (disadvantages loom large). As a consequence, options
with extreme values within an offered set will be relatively less attractive than options with intermediate values
(Extremeness Aversion Hypothesis), which gives rise to tow effects: compromise (take the middle option if there is
a symmetric form of extremeness aversion) and polarization (if extremeness aversion is with respect to one attribute
only, e.g., radios of varying quality).
The findings of tradeoff contrast and extremeness aversion, which violate the assumption of value maximization,
have both theoretical and practical implications. Context is clearly important (in perception as well as choice) and
people tend to complicate rather than simplify. This is unfortunate for models of consumer behavior based on
standard definitions of rationality/logic.
Kahneman and Tversky (1979) – Prospect theory is an alternative descriptive model of decision making under risk
(i.e., as opposed to expected utility theory). People tend to underweight outcomes that are merely probable in
comparison with outcomes that are obtained with certainty (i.e., the certainty effect). This effect contributes to risk
aversion in choices involving sure gains and to risk seeking in choices involving sure losses. For example, a sure
loss of –100 vs. the following: a 50% chance of losing 300 and a 50% chance of gaining 90 (i.e., -150 + 45 = -105).
Also, people tend to discard components that are shared by all prospects under consideration (i.e., the isolation
effect). This leads to inconsistent preferences when the same choice is presented in different forms (for example, the
gamble example above).
Kahneman and Tversky (1992) – Cumulative prospect theory employs cumulative rather than separable decision
weights. Two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic
curvature of the value function and the weighting functions. Fourfold pattern of risk attitudes: (1&2) risk aversion
for gains and risk seeking for losses of high probability, and (3&4) risk seeking for gains and risk aversion for losses
of low probability.

Kihn / Behavioral Finance 101 / 40

standard assumption laden description of decision making under uncertainty actually applies to
what economic agents actually do in the financial markets.

Finally, there are six ‗axioms‘ (they are also called the ‗von Neumann/Morgenstern Axioms‘
29
or
‗Savage Axioms‘) of ‗expected utility theory‘ that mathematically summarize the economic
foundation of ‗rationality‘ (i.e., as used by economists and financial economists)
30
:
Axiom 1: Comparability – For any pair of investment opportunities, A and B, one of the
following must be true: the investor prefers A to B, B to A, or is indifferent between A and B.
Axiom 2: Transitivity – If A is preferred to B, and B is preferred to C, than A is preferred to C.
Axiom 3: Continuity – If investment outcome A is preferred to B, and B to C, then there is some
probability P such that the investor would be indifferent between the certain event B and the
uncertain event {P * A + (1 – P) * C}.
Axiom 4: Independence – If an investor is indifferent between the certain outcomes A and B,
and C is any other certain outcome, then the investor is also indifferent between the uncertain
events
{P * A + (1 – P) * C} and {P * B + (1 – P) * C}.

29
Financial economics is grounded on the paradigm of expected utility of wealth. Frankfurter and McGoun (2001, p.
422-423) state that ―in excess of 60,000 ‗scientific‘ papers both published and presented before learned societies, is
exclusively based on the VM axioms.‖ Axiom 6 is explicitly assumed by Markowitz (1952) (and it is hard to get by
without assuming the first four), and Sharpe‘s derivation of the CAPM is based on Markowitz‘s results, plus
homogeneous expectations, etc.
Also, given that axioms 5 & 6 depend on axioms 1 through 4, and the people seems to violate 1 through 4,
essentially humans violate all of these axioms. Finally, Shiller (1998, p. 4) thinks: ―The axioms (Savage, 1954) from
which expected utility theory is derived are undeniably sensible representations of basic requirements of rationality.‖
Again, being sensible in the dictionary sense doesn‘t make them true.
30
The original references are von Neumann & Morgenstern (1944 & especially the 1947 2
nd
edition with appendix
containing the axioms of utility) and Savage (1954). Frankfurter and Phillips (1994) provided the actual six axioms
listed.
Kihn / Behavioral Finance 101 / 41

Axiom 5: Interchangeability – If an investor is indifferent between two uncorrelated risky
income streams, then the securities that produce them are interchangeable in any investment
strategy – simple or complex.
Axiom 6: Risk Aversion – If securities A and B offer the same positive rate of return, R = X,
with probabilities Pa and Pb, respectively, and otherwise R = 0 with probabilities (1 – Pa) and (1
– Pb), respectively, then A is preferred to B if Pa > Pb. Moreover, one‘s relative preference for A
in this case is a (possibly complex) monotonic function of the relative certainty coefficient Pa/Pb
(Frankfurter and Phillips (1994, p. 7)).
Like much concerning economics and ‗rationality‘, the six listed axioms seem normatively
sensible but are descriptively wrong. If an axiom is defined as a ―self evident or universally
recognized truth‖, then the aforementioned six axioms are not axioms at all, but falsifiable
assumptions that can in fact be falsified. For example, ask yourself, do all humans all the time
actually follow the six ‗axioms‘ listed? If they don‘t, which they don‘t, then all that flows
mathematically from them is wrong.

Kihn / Behavioral Finance 101 / 42

REFERENCES
Frankfurter, G. and H. Phillips, Forty Years of Normative Portfolio Theory, JAI Press,
Greenwich, CT, 1994.

Frankfurter, G., and E. McGoun, ―Anomalies in finance: What are they and what are they good
for?‖, International Review of Financial Analysis, Volume 10, 2001, 407-429.

Huber, J., Payne, J., and C. Puto, ―Adding Asymmetrically Dominated Alternative: Violations of
Regularity and the Similarity Hypothesis‖, Journal of Consumer Research, Volume 9, June 1982,
90-98.

Kahneman, D., Knetsch, J., and R. Thaler, ―Anomalies: The endowment effect, loss aversion,
and status quo bias‖, Journal of Economic Perspectives, Volume 5, Issue 1, Winter 1991, 193-
206.

Kahneman, D., and A. Tversky, ―Prospect Theory: An Analysis of Decision Under Risk‖,
Econometrica, Volume 47, Number 2, March 1979, 263-291.

Markowitz, H., ―Portfolio Selection‖, Journal of Finance, Volume 7, Issue 1, March 1952, 77-91.

Markowitz, H., ―The Utility of Wealth‖, Journal of Political Economy, Cowles Foundation paper
57, Volume LX, Number 2, April 1952, 151-158.
Kihn / Behavioral Finance 101 / 43


McKenzie, Richard B., and Dwight R. Lee, Microeconomics for MBAs: The Economic Way of
Thinking for Managers, February 13, 2006, Cambridge University Press.

Random House Webster‘s College Dictionary (2
nd
edition), Random House, New York, N.Y.,
1998.

Savage, Leonard J., The Foundations of Statistics, John Wiley and Sons, New York, N.Y., 1954.

Shiller, R., ―Rational Expectations and the Dynamic Structure of Macroeconomic Models: A
Critical Review‖, NBER Working Paper Series, Working Paper No. 93, Cambridge,
Massachusetts, June 1975, 1-38.

Shiller, R., ―Human Behavior and the Efficiency of the Financial System‖, National Bureau of
Economic Research, NBER Working Paper Series, Working Paper 6376, January 1998, 1-56.

Simonson, I., and A. Tversky, ―Choice in Context: Tradeoff Contrast and Extremeness
Aversion‖, Journal of Marketing Research, Volume XXIX, August 1992, 281-295.

Tversky, A., and D. Kahneman, ―Loss Aversion in Riskless Choice: A Reference-Dependent
Model‖, Quarterly Journal of Economics, Volume 106, Issue 4, November 1991, 1039-1061.

Kihn / Behavioral Finance 101 / 44

Tversky, A., and D. Kahneman, ―Advances in Prospect Theory: Cumulative Representation of
Uncertainty‖, Journal of Risk and Uncertainty, Volume 5, Issue 4, October 1992, 297-323.

Tversky, A., and I. Simonson, ―Context-dependent Preferences‖, Management Science, Volume
39, Number 10, October 1993, 1179-1189.

Von Neumann, John and Oscar Morgenstern, Theory of Games and Economic Behavior,
Princeton University Press, Princeton, N.J., 1944.

Von Neumann, John and Oscar Morgenstern, Theory of Games and Economic Behavior (second
edition with appendix containing axioms of expected utility), Princeton University Press,
Princeton, N.J., 1947.




Kihn / Behavioral Finance 101 / 45

Chapter 3: Efficient Markets and Efficient Market Theory (“EMT”)

An EMT economist and his companion are walking down the street one day when they come
upon a $100 bill lying on the ground. The companion immediately reaches down to pick it up,
whereupon the economist abruptly stops him and says: ‗Don‘t bother, if it was a real $100 bill,
someone would have already picked it up.‘ They resume their march down the street with the
companion looking back over his shoulder and the economist looking directly ahead.
Taken/modified from: Findlay and Williams (2000, p. 195)

Most academics, and many practitioners, assume that ‗if there is no free-lunch, then the markets
are ‗efficient‘.‘ This is not logical or descriptively true. Based on the commonly accepted finance
definition of ‗market efficiency‘ (i.e., Fama (1970)), the markets appear to contain many ‗free-
lunches‘ and yet they are clearly ‗inefficient‘. In addition, I would assert, that what might appear
to be a free-lunch, is generally an artifact of the definition of market efficiency and/or the
‗model‘ used to control for ‗market risk‘
31
.

Furthermore, the assumption that there is no ‗free‘ $100 bill lying around, because if that was
true ―someone would have already picked it up‖, presupposes or assumes that there are no limits
to picking it up in the real world (translated, no limits to arbitrage), which there are. We will
review some ‗free lunches‘ and some of the limits to ―picking them up‖ in upcoming chapters.

31
It might be added/emphasized that neither of which financial economists currently agree upon.
Kihn / Behavioral Finance 101 / 46

Again, note that the limits to arbitrage are a necessary, but not a sufficient, argument for the
psychology piece to matter.

THE ASSUMPTIONS BEHIND ‗MARKET EFFICIENCY‘ AND THE EMH/EMT
First, it is important to remember that the EMH is a direct consequence of equilibrium in
competitive markets with fully rational investors (for the mathematical origin of this see
Samuelson (1965) and Mandelbrot (1966)
32
). As defined by economists, most, if not all, of us are
not ‗fully rational‘. Therefore, the results of the mathematical derivations assuming such are
wrong.

Even ignoring the descriptive contradiction with ‗full rationality‘, according to Shleifer (2000),
three arguments and series of assumptions underlie the EMH:

32
Although, it should be noted that Mandelbrot (1966) expanded the definition beyond ―random walk‖ to include
martingales. Essentially, even though Samuelson is credited with the mathematical definition of ‗efficient markets‘,
it is Mandelbrot‘s more general definition that the EMH/EMT as evolved into (particularly as ‗anomalies‘ have
essentially eliminated the more easily dismissed ‗random walk‘ version of the EMH and seriously compromised or
destroyed what is left of the EMT, i.e., depending on your view of these things).
Kihn / Behavioral Finance 101 / 47

1. Investors are assumed rational and hence to value securities rationally (i.e., in addition to
being ‗fully rational‘, security valuation is always assumed „rational‘).
2. To the extent that some investors are not rational, their trades are random and therefore
cancel each other out without affecting prices (also known as ‗cancelation‘).
3. To the extent that investors are irrational in similar ways, they are met in the market by
rational arbitrageurs who eliminate their influence on prices.
In addition, there are three key empirical implications and issues associated with the EMH:
1. When news about the value of a security hits the market, its price should react and
incorporate this news both quickly and correctly.
2. Therefore, not just quick and accurate reaction to fundamental information, but non-
reaction to non-information.
3. Keys are defining ‗stale‘ information and adjusting for risk (if not defining it).

Let‘s begin at the top with the part concerning investors being assumed ‗rational‘, remember that
financial economists (and economists generally) don‘t use the dictionary definition of ―rational‖.
With respect to rationality and human behavior, economists assume that which doesn‘t exist. For
example, Friedman (1953, p. 14) is often quoted in defense of this fact: ―Truly important and
significant hypotheses will be found to have ‗assumptions‘ that are wildly inaccurate descriptive
representations of reality, and, in general, the more significant the theory, the more unrealistic
the assumptions.‖
33
Regarding the EMH/EMT specifically, none of the three assumptions or

33
In this famous essay Friedman pointed out that, of course, this was only true as far as the theory with the wildly
incorrect assumptions (i.e., that wildly differed from actual reality) was excellent at predicting/forecasting
(essentially he applied a version of Occam‘s razor). Hardly something that describes economics (and financial
economics) even some half century later (i.e., at this time), especially based on normative models. Also, this is
Kihn / Behavioral Finance 101 / 48

arguments strictly holds in all markets all the time (actually not most of the time in most); and
none of the three empirical implications seems to hold. Could this be that the theory isn‘t
‗significant‘ enough, just plain wrong, or both? Again, we come back to the descriptive reality of
the financial markets vs. traditional normative theory.

As De Bondt (1996, p. 185) stated:
―The psychological analysis of preference and belief indicates that it is not possible in general
to reconcile normative and descriptive accounts of individual choice. The reason for this
conclusion – which may be regarded by some as pessimistic or even negative – is that decision-
making is a constructive process. In contrast to the classical theory that assumes consistent
preferences, it appears that people often do not have well-defined values, and that their choices
are commonly constructed, not merely revealed, in the elicitation process. Furthermore, different
constructions can give rise to systematically different choices, contrary to the basic principles
that underlie classical decision theory.‖
Again, ―it is not possible to reconcile normative and descriptive accounts of individual choice.‖
Therefore, while there may be specific cases where a rational economic individual consistently

almost the opposite of the ‗hard sciences‘ like chemistry and physics. The irony or likely contradiction here is that
normative economics has pushed math and wildly incorrect assumptions under the methodological theory that only
the forecasts matter (actually, ―fruitfulness‖ and ―simplicity‖). In fact, the forecasts suck vs. say particle physics
where the predictions/forecasts are extraordinarily precise (i.e., from an economists viewpoint) yet theory in such
descriptively oriented fields is grounded in empirical reality. Which brings us back to my point about economics
(and finance) being more conducive to descriptive theories vs. the current normative emphasis with methodological
justifications made that rely on principally beliefs that forecast accuracy will be coming any day now. This is
especially true in such sub-fields of economics such as macroeconomics, where predictions and reality may not even
have the same sign. This is ironic on two levels: (1) the article by Friedman appeared in a larger body of work that
was pushing the notion that economics was/is/will be a positive science; whereas Friedman emphasized the
normative, the book interpreted positive to mean descriptive. (2) There is no known true ‗science‘ that emphasizes
the wilder the assumptions, the better the theory.
Kihn / Behavioral Finance 101 / 49

displays coherence and invariance, these individuals are not average people acting in a manner
we normally observe.

Regarding the second assumption concerning irrational trades/traders cancelling each other out
due to their inherent randomness (also called ‗cancellation‘), there is little empirical reason to
believe this. In fact, a case will be shown where the exact opposite of ‗cancellation‘ occurs.
34

That is, in many cases (and possibly most) ‗irrational‘ (i.e., based on traditional economics
definitions of rationality) traders/agents often push prices further away from their fundamental
economic basis (i.e., efficiency).

Regarding ‗irrational‘ traders being met in the market by ‗rational‘ arbitrageurs, I believe this is
the key argument that could hold, but empirically doesn‘t seem to. This is also why I have noted
that limits to arbitrage is a necessary condition for the psychology part to matter (i.e., for
behavioral finance to have predictive power). There is no doubt that descriptively there are
rational (or maybe it would be more accurate to call them less irrational) economic agents who
stand ready to push prices back toward more fundamentally justified or efficient pricing; but it
would seem that they are often foiled by various limits to arbitrage in the actual financial
markets. This is especially where the response ―it depends‖ applies. For example, it may be the
case that the nature of limits to arbitrage may be very different in the market for foreign

34
The one case/area where cancellation may have been found to occur is racetrack betting (Camerer (1998)); but
then again upon reading that case I doubt it. For example, the bet is made and then withdrawn, which would
logically tend to show no effect anyway. In addition, there is some evidence that for ―maiden‖ horses even this can
impact betting patterns.
Kihn / Behavioral Finance 101 / 50

currencies than it is for say domestic small-cap stocks; and this seems to indeed be the case, but
it can also change over time, depending on a host of factors.

Much of financial economics relies on the notion/story that ‗rational‘ arbitrageurs (note that
rational and arbitrageur is essentially synonymous in finance) will always and anywhere (i.e.,
irrespective of market or time) correct mispricing. Finance theory (e.g., Friedman (1953) and
Fama (1965)) relies on arbitrageurs. Whether over- or under-priced from fundamental value,
arbitrageurs are assumed to bring the price back in line. The corollary is that relative to their
rational peers, irrational investors lose money. But what if the reverse holds? Furthermore, what
if sometimes and in some markets more ‗rational‘ investors made money at the expense of
‗irrational‘ investors and in the very same markets (at other times) they lose money. Is it possible
that ―it depends‖ on the market and timing in that market whether the ‗irrational‘ or ‗rational‘
tend to set pricing and/or make money at the expense of the other?
35
This book aims to show that
the normal efficient market narrative can sometimes apply, but normally it does not. If that is
true empirically then the nuanced and a much more behavioral narrative/story is more applicable.

Regarding the empirical implications, prices don‘t incorporate ―news both quickly and
correctly‖, and they react to non-information. We will review examples of both of these basic
contradictions to the EMH/EMT.


35
If the arbitrage narrative well describes financial market reality, one would expect that one should find a set of
systematically good market timers.
Kihn / Behavioral Finance 101 / 51

Regarding adjusting for risk, we would have to have an accepted model to do that. We don‘t;
therefore, adjusting for risk is somewhat incongruously impossible in finance at this time. Worse
yet, remember, all finance models are wrong. Essentially, finance has become so seemingly
sensitive or touchy regarding the breadth and scope of so called ‗anomalies‘ that it no longer
cares to even open itself up basic hypothesis testing. Fama (1970) pointed out that there is a
dependence of most tests of market efficiency on a model of risk and expected return. It seems
that as ‗anomalies‘ have been found, critics have argued that the market model used was wrong
(even if they recommend and/or recommended the model). As De Bondt (1995, p. 9) pointed out:
―Thus, the sad but honest truth is that modern finance theory offers only a set of asset-
pricing theories for which no empirical support exists and a set of empirical tests for which
no theory exists.‖
By now the reader may be coming around to understand why behavioral finance is really an
alternative methodology, because we really don‘t need more ―asset-pricing theories for which no
empirical support exists‖.

Therefore, again, never forget, we need:
1) To know what true fundamental or economic value is.
2) One or more fully rational well informed arbitrageurs must correct any mispricing (i.e.,
when pricing deviates from efficient fundamental value).
3) Failing 1 and/or 2, irrational trades must cancel each other out.
Or else we are in trouble. In fact, it seems that the prime argument/condition in old or newer
versions of the EMH/EMT is that fully rational well informed arbitrageurs correct any
Kihn / Behavioral Finance 101 / 52

mispricing (i.e., when pricing deviates from fundamental value) and/or irrational trades cancel
each other out. Assuming we know the true definition of fundamental, economic, or intrinsic
value (i.e., the true economic pricing model for each financial asset), it is both necessary and
sufficient for this to happen under the EMT for the ―efficient‖ pricing of financial assets.
Therefore, without the ability for one or more fully rational economic agents/actors correcting
mispricing (again, assuming we know what that is) at the margin (and assuming the margin is
always where prices are set) and if irrationally based trades do not cancel each other out, the
EMT pricing argument breaks down (i.e., at least in theory, if not actually), and in reality it does.

First, with respect to irrationally based trades canceling each other out, there is little or no
evidence in psychology or empirical finance to suggest this happens in any meaningful way (e.g.,
see Tversky and Kahneman). In fact, the empirical finance research and clinical psychological
research would strongly suggest that the opposite happens (i.e., irrational human biases tend to
either remain or be reinforced). Although, it is possible that irrational traders can learn their way
out of this (i.e., such that biased pricing will either be reduced or ideally disappear). But given
the current structure of the finance industry combined with human nature, this is currently not the
case as well as unlikely to happen any time soon.

Second, therefore the sole argument that remains (i.e., in order for the EMT/EMH to hold in any
meaningful way) is that fully rational well informed arbitrageur(s) is/are left to correct any
deviations from ―efficient‖ asset pricing. As Kahneman (1996, p. 203) stated: ―The assumption
that agents are rational is central to much theory in the social sciences. Its role is particularly
Kihn / Behavioral Finance 101 / 53

obvious in economic analysis, where it supports the useful corollary that no significant
opportunity will remain unexploited.‖ Again, as it turns out, it seems there are some well
informed arbitrageurs (maybe not always so ‗rational‘), but they do not set pricing in all markets
at all times. It would seem that in most financial asset markets most of the time it is some
combination of well informed arbitrageurs and less rational traders that set pricing (and this is at
least in part determined by the breadth and depth of the limits to arbitrage in the particular asset
market under consideration). Therefore, ‗it depends‘, at least in part, on limits to arbitrage.

That is, for example (and assuming we know the true pricing model, which we don‘t):
1) Investors don‘t seem to act strictly rational.
2) Irrational trades don‘t seem to cancel each other out.
3) Rational arbitrageurs seem to have limited impact, or even encourage mispricing.
Therefore, the EMH/EMT is descriptively challenged, and actually rejected, by financial
market(s) reality.
36



36
Given that irrational trades tend not to cancel each other out and fully rational arbitrageurs do not determine
pricing in all financial markets all the time, the reliance of finance on normative mathematical models where strict
rationality is implicitly or explicitly assumed seems misguided at best and counterproductive at worst. Furthermore,
based on the Fama (1970) definition of ―market efficiency‖, due to the biased and seemingly irrational pricing that
seems to occur in even the most liquid financial markets much of the time, it seems rather odd that finance models
continue to rely on mathematical tractability (e.g., the ability to integrate or differentiate) over the actual descriptive
reality of the markets, that is, unless they do so out of mathematical tractability itself.
Kihn / Behavioral Finance 101 / 54

A BRIEF HISTORY AND REVIEW OF ‗MARKET EFFICIENCY‘ AND THE EMH/EMT
―The idea behind the term ‗efficient markets hypothesis‘, a term coined by Harry Roberts
(1967), has a long distinguished history in financial research, a far longer history than the term
itself has. The hypothesis (without the words efficient markets) was given a clear statement in
Gibson (1889), and has apparently been widely known at least since then, if not long before.‖
Shiller (1998, p. 1)

The more modern precursors to EMT
37
and the EMH itself can be traced to Friedman (1953) and
Fama (1965) as well as mathematically to Samuelson (1965) and Mandelbrot (1966).
That is, with Fama (1970) being used as the primary definition of the EMH and a broader body
of work setting the foundation for EMT.

―The efficient markets theory reached the height of its dominance in academic circles around the
1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the
1980s, and evidence of excess volatility of returns. Finance literature in this decade and after
suggests a more nuanced view of the value of the efficient markets theory, and, starting in the
1990s, a blossoming of research on behavioral finance. … Wishful thinking can dominate
much of the work of a profession for a decade, but not indefinitely.‖
Shiller (2002, pp. 1, 3)


37
Remember, the EMT argument is an ideal that was accepted as empirical fact some forty years ago. But even
though it is descriptively wrong, that doesn‘t mean it isn‘t useful in some way (e.g., measuring when pricing isn‘t
―efficient‖). Today, it is really a question of how useful it is, not whether it describes reality per say.
Kihn / Behavioral Finance 101 / 55

Essentially, efficient markets are a very good idealized representation of what we should
normatively strive for, but it is not a reflection of reality. It is the direct empirical contradictions
that have lead to psychological analysis being added to finance; but, again, this has been done
without modifying the fundamental method or approach of finance (or economics), which is still
normative.

A FEW KEY ARTICLES ON THE EMH/EMT
―Every finance professional employs the concept of market efficiency. The theory, evidence and
counter-evidence focus on a couple of dozen highly influential articles published during the
twentieth century.‖
Dimson and Mussavian, (1998, p. 91)

Considering its pervasiveness in the field of finance, it is rather surprising that finance textbooks
do not review at least a few of the critical articles supposedly responsible for the EMH/EMT.
There are at least two reasons to review some of the key historical works in the area of the
Kihn / Behavioral Finance 101 / 56

EMH/EMT: (1) as stated, they are important to understanding ‗modern finance‘, and (2) ignoring
other more plausible interpretations, the empirical articles are not exactly in full support of the
theory. Thus, even decades ago, the normative theory of finance has never matched its
descriptive reality. In chronological order, we will now do so here.

Bachelier‘s (1900) dissertation is considered to be the first mathematical finance paper, and he
could be considered the first normative finance academic. Thus, even though that dissertation
was essentially discovered by Cootner, and published in English by him in 1964, it can be
considered the first normative finance paper. Bachelier anticipated the Wiener process of
Brownian motion and noted that ―past, present and even discounted future events are reflected in
market price, but often show no apparent relation to price changes.‖ Bachelier was the first to
formally state the ―Random Walk Hypothesis‖ (―RWH‖ – which is essentially a mathematical
representation of Fama‘s ‗weak-form‘ EMH, i.e., past prices are incorporated into current prices)
and lay the foundations for the EMH/EMT. It is not an overstatement to suggest that over half
the early literature in finance associated with questions of the EMH were concerned with the
RWH and related issues covered by Bachelier‘s dissertation (although most at the time were
probably unaware of it).
38


Pearson (1905) came up with the term and formula for ―random walk‖. Pearson (1905, p. 342) –
―The lesson of Lord Rayleigh‘s solution is that in open country the most likely place to find a
drunken man who is at all capable of keeping on his feet is somewhere near his starting point!‖

38
Bachelier was not discovered until after his death. Thus credit was not given until well after his death. In addition,
the basis for option pricing and/or contingent claims analysis can be credited to him. It may be worth noting that he
died an untenured academic in an unremarkable college in France, and without much money to his name.
Kihn / Behavioral Finance 101 / 57

Hence, the ‗random walk‘ and the notion that returns are serially independent. Rayleigh‘s
response to Pearson‘s (1905, p. 318) question was: ―If n be very great, the probability sought is:

.‖ Pearson‘s (1905, p. 294) question was: ―A Man starts from a point O and walks l
yards in a straight line. He repeats this process n times. I require the probability that after these n
stretches he is at a distance between r and from his starting point, O.‖ Thus, the ―random
walk‖ turns out to be a mathematical description of how a drunken man walks across a field, but
ends up being applied to the process by which financial asset prices evolve over time.
39


Cowles (1933) – An empirical study on stock market forecasting/forecasters (essentially stock
recommendations by various finance companies) over 4-1/2 years ending July 1932 (beginning
January 1928).
40
He concluded (1933, p. 324): ―the most successful records are little, if any,
better than what might be expected to result from pure chance. There is some evidence, on the
other hand, to indicate that the least successful records are worse than what could reasonably be
attributed to chance.‖ (e.g., of the 16 financial service companies and 20 fire insurance
companies, the average common stock underperformed by 1.43% and 1.20% per year,
respectively). Therefore, Cowles provides the first empirical proof that ‗smart money‘ isn‘t (i.e.,
smart).
41
That noted, he does find systematic evidence that although the stock market forecasters
seem unable to systematically ―beat the market‖, some systematically lose. Thus, the evidence is
not unambiguously supportive of randomness.

39
The EMH (‖weak form‖) reduces to the RWH (i.e., ―prices have no memory‖), but goes beyond that with the
―semi-strong‖ and ―strong‖ forms.
40
Note, this is a very volatile period and it contains the famous crash of 1929.
41
As an aside, it is astonishing to me the lengths to which EMH/EMT promoters will go to rationalize what seems
almost impossible to rationalize (e.g., Barsky and De Long (1990) using ―smart money‖ earnings analysts‘ forecasts
of earnings to justify the notion that there is no such thing as an asset bubble, specifically U.S. equities).
Kihn / Behavioral Finance 101 / 58


Working (1934) is the first to directly show what a random series looks like and then check
commodities (Cowles was looking at stocks and stock pickers). Working (1934) showed that a
―random-difference series‖ might look non-random. Specifically, he stated that (1934, p. 12):
―An outstanding characteristic of a series of this type is that its changes are largely random and
unpredictable.‖ After presenting ―experimental‖ random-difference series, he presented a wheat
price series and stated (1934, p.24): ―I find that to the important extent that wheat prices
resemble a random-difference series, they resemble most closely one that might be derived by
cumulating random numbers drawn from a slightly skewed population of standard deviation
varying rather systematically through time.‖ Thus, again, the evidence is not purely supportive of
randomness.

Cowles and Jones (1937) extended Cowles‘ (1933) results to other economic series (e.g., stock
price indices over various periods of time – 26 different ones were considered) and they included
transaction costs. They concluded that (1937, p. 294): ―This type of forecasting could not be
employed by speculators with any assurance of consistent or large profits. On the other hand, the
significant excess of sequences over reversals for all units from 20 minutes up to 6 months, with
the exception of units of 2 weeks and 3 weeks mentioned previously, represents conclusive
evidence of structure in stock prices.‖ Therefore, they may be the first to formally indicate the
existence of an ‗anomaly‘.
42



42
To me, it is quite amazing that Cowles and Jones (1937) found an ‗anomaly‘ (actually, many of them), yet most of
the work after them ignores this.
Kihn / Behavioral Finance 101 / 59

Cowles (1944) was a direct extension of his 1933 study (he now had ten to 15-1/2 years of data
from eleven ―leading financial periodicals‖). The conclusions regarding ‗professional‘ stock
market forecasters were as follows (Cowles (1944, p. 214)): (1) Over the entire sample of eleven
forecasting periodicals, they ―fail to disclose evidence of ability to predict successfully the future
course of the stock market.‖ (2) ―The record of the forecasting agency with the best results …
3.3 per cent per year better … than the Dow-Jones industrial average … capital-gains tax might
wipe out most of this advantage.‖ (3) Even though the stock market was in a ‗bear market‘ over
most of the period under study and lost about 2/3rds of its value, ―more than four times as many
were bullish as bearish (of the 6,904 forecasts recorded).‖ Although the study is probably the
first to analyze stock newsletters, with essentially the result that they are mostly negative market
timers, he didn‘t point this out. The early EMH papers are specifically focused on one tailed
tests, when in fact it should have been about two tailed tests (i.e., positive or negative timing).
Also, key to the Cowles (1944) study is that in the conclusion he mentions that the market has
―structure‖ (i.e., it seems inefficient in some way, but the newsletters don‘t key on this statistical
anomaly, instead they forecast/recommend by feel or ‗seat of the pants‘). Specifically, he again
states (1944, p. 214): ―While prospects for the speculator are, therefore, not particularly alluring,
statistical tests disclose positive evidence of structure in stock prices which indicates a likelihood
that whatever success may be claimed for the very consistent 40-year record is not entirely
accidental. A simple application of the ‗inertia‘ principle
43
, such as buying at turning points in
the market after prices for a month averaged higher, and selling after they have averaged lower,

43
Cowles (1944) proposed a trading rule (called the ‗inertia‘ rule). This may be the first academic reference to a
quantifiable trading rule, yet it ignored (e.g., academics pushing the EMH did not point this out).
Kihn / Behavioral Finance 101 / 60

than for the previous month, would have resulted in substantial gains for the period under
consideration.‖ In short, he found predictable structure.

Kendall and Hill (1953) analyzed 22 weekly time series (twenty stock series and a wheat and
cotton series) and fitted time series models to them. They summarized their findings by stating
(1953, p. 11): (1) ―In series of prices which are observed at fairly close intervals the random
changes from one term to the next are so large as to swamp any systematic effect which may be
present. The data behave almost like wandering series. (2) … difficult to distinguish by statistical
methods between a genuine wandering series and one wherein the systematic element is weak.‖
(3) Therefore, ―trend fitting … is a highly hazardous undertaking. …, but it may be impossible to
discriminate between quite different hypotheses which all fit the data.‖ (4) … ―aggregate index
numbers behave more systematically than their components.‖ (5) ―Unless individual stocks
behave differently from the average of similar stocks, there is no hope of being able to predict
movements on the exchange for a week ahead without extraneous information.‖ (6) Although not
emphasized, he found significant serial correlations (see p. 34). This article is odd; they
emphasized the noise in the data, but go ahead and analyze it regardless.
44
They push the notion
that due to the noise and overall structure of the time series one shouldn‘t try to make heads or
tails of it (points #2 & #3), but do so anyway. Most importantly, they find structure in the time
series (e.g., p. 23), but dismiss it. Then a discussant (Professor Cox, pp. 32-33) points out: ―It is
worth pointing out explicitly that the presence of certain types of non-randomness is shown,
not the occurrence of high serial correlations, but by other features of the correlogram, such as

44
As a general rule, the noisier the return series (or any series for that matter) the harder it is to make sense of the
series (i.e., even if there was indeed something to be made sense of to begin with). Thus, and furthermore, ‗noise
traders‘ can turn financial data from useful to useless by the simple act of trading on the noise they create.
Kihn / Behavioral Finance 101 / 61

the existence of a run of coefficients all with the same sign. For example, if the successive
differences of price were completely random, price itself would undergo a simple random walk
and would not be stationary. If there were in addition some tendency to return to a stable level of
price, the correlations of differences would be small and negative (see, for example, Table 2, last
column.)‖ Note, this was the wheat price series, which went from serial correlations of –, +, +,
then the next seven were negative. In responding to Cox, Kendall (p. 34) stated: ―… agree with
him except on one point. He calls attention to patterns of signs in the serial correlations which
indicate that, although small, the correlations are not haphazard. I think he is probably right, but I
do not regard the point as settled beyond all doubt.‖ Again, the research finds structure, but it is
largely ignored, or just dismissed.
45


Roberts (1959) was a follow up to Kendall and Hill (1953) where he (1959, p. 3) describes ―the
chance model more precisely,‖ and discusses its ―common-sense interpretation‖. Roberts (1959)
is really a theoretical discussion/argument of why ―chance‖ (random) describes particularly well
stock price movements, both short-run and long-run (see p. 6-7). He goes through various
arguments (e.g., smart money removing obvious patterns).

Working‘s (1960) note on the correlation of first differences of averages in a random chain
showed that autocorrelation could be introduced into a series by using time averaged security

45
I do like his final quote (p. 34) in response to a discussant saying their results are silly without ―an acceptable
theoretical framework‖: ―I have tried to elicit certain facts about economic series. They may be wrong, but if they
are correct they are facts, irrespective of any theoretical framework.‖ Those are words to live by, but obviously
largely lost on normative frameworks (e.g., ‗modern finance‘).
Kihn / Behavioral Finance 101 / 62

prices (he also gave some approximate magnitudes for this effect). Essentially, he warned about
taking differences and then averaging (i.e., you may think you have something, when there isn‘t).

Based on a general stochastic model, Samuelson (1965, p. 41) in his ―Proof That Properly
Anticipated Prices Fluctuate Randomly‖ really set up the notion that in competitive markets
where buyer and seller settle on one price to transact: ―‘If one could be sure that a price will rise,
it would have already risen.‘ Arguments like this are used to deduce that competitive prices must
display price changes over time … that perform a random walk with no predictable bias.‖ Also,
into his model is embedded the notion of a ‗fair game‘/martingale property (i.e., zero expected
capital gain is replaced by a fair rate of return). Interestingly, he states at one point (p. 45): ―The
theorem is so general that I must confess to having oscillated over the years in my own mind
between regarding it as trivially obvious (and almost trivially vacuous) and regarding it as
remarkably sweeping. Such perhaps is characteristic of basic results.‖ In short, Samuelson in
large part laid the mathematical foundation for the normative notion of ‗market efficiency‘.

Fama (1965) essentially published his dissertation. In it he extensively reviewed and empirically
tested ―the ‗random walk‘ model of stock price behavior‖ and summarized the primary result as
follows (p. 34): ―The main conclusion will be that the data seem to present consistent and strong
support for the model. This implies, of course, that chart reading, though perhaps an interesting
pastime, is of no real value to the stock market investor. This is an extreme statement and the
chart reader is certainly free to take exception. We suggest, however, that since the empirical
evidence produced by this and other studies in support of the random-walk model are now so
Kihn / Behavioral Finance 101 / 63

voluminous, the counterarguments of the chart reader will be completely lacking in force if they
are not equally well supported by the empirical work.‖ Although targeting so called ―technical
analysis‖, little effort was made to dispute contrary evidence to the RWH. Fama‘s (1965, p. 34)
main question was: ―To what extent can the past history of a common stock‘s price be used to
make meaningful predictions concerning the future price of the stock?‖ He described the theory
of the random-walk (p. 34) as: ―By contrast the theory of random walk says the future path of the
price level of a security is no more predictable than the path of a series of cumulated random
numbers. In statistical terms the theory says that successive price changes are independent,
identically distributed random variables. Most simply this implies that the series of price changes
has no memory, that is, the past cannot be used to predict the future in any meaningful way.‖
Fama (1965, p. 35) stated: ―The theory of random-walks in stock prices actually involves two
separate hypotheses: (1) successive price changes are independent, and (2) the price changes
conform to some probability distribution. We shall now examine each of the hypotheses in detail.
…‖ Fama (1965, p. 41) noted that Osborne (1959) essentially independently derived Bachelier‘s
result almost fifty years later (―assuming that price changes from transaction to transaction are
independently, identically distributed random variables.‖). Fama (1965) also noted what he
called the Mandelbrot hypothesis about stock prices not being normally distributed (empirically a
Paretian, not a Guassian distribution), and on p. 87 noted ―some evidence of that large changes
tend to be followed by large changes of either sign‖.
46
Therefore, counter evidence was found
even for the RWH.


46
What is especially odd is that he essentially taunts ―chartists‖, then later on claims they may be responsible for the
―efficient‖ pricing (and/or with fundamental stock pickers).
Kihn / Behavioral Finance 101 / 64

In what may be his most famous article, Fama (1970, p. 383) reviewed ‗fair game‘ models (e.g.,
the CAPM), the submartingale model, and the random walk model; then made an empirical
literature synthesis follow-up to the now three famous forms of ‗market efficiency‘:
1. Weak form (past prices),
2. Semi-strong form (publicly available), and
3. Strong form (all information, both public and private).
As a reminder: ―A market in which prices always ‗fully reflect‘ available information is called
‗efficient‘.‖ The final rather lengthy summary and conclusions (p. 413-416) he summed up to
provide strong evidence in support of ‗market efficiency‘. As in most, if not all, of his articles, he
at least dismisses, or just ignores, any contrary evidence.

Grossman and Stiglitz (1980) mathematically formalized the idea that with costly information
there is room for sensible information gathering on the part of stock analysts, brokers, etc.
Furthermore, they stated (p. 404): ―We showed that when the efficient markets hypothesis is true
and information is costly, competitive markets break down.‖ Specifically, they noted (p.404):
―‘Efficient Markets theorists have claimed that ‗at any time prices fully reflect all available
information‘ (see Eugene Fama, p. 383). If this were so then informed traders could not earn a
return on their information. … Efficient Markets theorists seem to be aware that costless
information is a sufficient condition for prices to fully reflect all available information (see Fama.
P. 387); they are not aware that it is a necessary condition. … We are attempting to redefine the
Efficient Markets notion, not destroy it.‖ Even more important is the irony here, because they
have been, in a sense, ―hoisted on their own petard‖ (i.e., the EMH/EMT promoters have been
Kihn / Behavioral Finance 101 / 65

ignoring contrary evidence with such comments as: well if that was the case you would be rich;
and transaction costs and/or taxes would eat up any profits, etc.). Now consider information costs
are analogous to transaction costs and taxes, and Grossman and Stiglitz (1980) show,
information must be costless for markets to be efficient, then, assuming their normative model
applies, if there are such things as information costs (and transaction costs and taxes, etc.) then it
is impossible for the markets to be efficient, because market participants must garner a return on
this costly information (and transactions costs, taxes, etc.). Therefore, by definition, there must
be a tradeoff/equilibrium between information costs and efficiency. Ironic, isn‘t it? But of
course, it doesn‘t stop the EMH/EMT promoters from redefining market efficiency as Grossman
and Stiglitz (1980, p. 404) do, or as others have done over time as ‗anomalies‘ have emerged.
Regardless, it is ironic that for the same type of reason(s) that EMH/EMT promoters had been
ignoring evidence against the EMH/EMT, they now have problems with it (i.e., from a normative
perspective).

I cannot let the last point about information costs slide; therefore a thought on the notion of
transactions costs, costly information, taxes, etc. and market efficiency. It is inconsistent to use
these as arguments to ignore real evidence yet use them as reasons to modify normative models.
Economics and financial economics focus on prices being set at the margin, yet the reference to
transactions costs is often an absolute reference or even a reverse margin point, that is, the exact
opposite of a marginal analysis. For example, if the highest transaction costs for an asset is 500
basis points (―BPs‖)
47
and the lowest are 5BPs (i.e., for an institution), then the relevant
boundary condition is 5BPs, not 500BPs as the EMH/EMT promoters would indicate, and

47
A basis point of ―BP‖ is 100
th
of 1%. Therefore, for example, 100 BPs is 1%.
Kihn / Behavioral Finance 101 / 66

therefore, transaction costs are not much of an issue, except for very illiquid securities, but
certainly not most equities that are studied on the CRSP tapes
48
.

Finally, note that every classic referenced empirical study had contradictory evidence. In
addition, I didn‘t read any alternative explanations that might better fit the complete set of
evidence. Therefore, the empirical work was actually far from universally supportive; and it was
based on only one interpretation of the data (vs., for example, another normative
theory/hypothesis).


48
CRSP stands for Center for Research in Securities Pricing. It is a database of primarily security prices and related
information started by James Lorie at the University of Chicago in 1960, based on a request from Merrill Lynch‘s
Louis Engel in 1959 (Merrill Lynch made an initial $300,000 grant to start the database). It was first intended to
cover all NYSE stocks, and was later expanded to cover a larger universe. It was originally a magnetic tape of daily
U.S. stock prices, hence the term, ―the CRSP tapes‖.
Kihn / Behavioral Finance 101 / 67

WHERE DO WE STAND TODAY?
You may at this point be asking yourself, what is the current state of knowledge in finance? The
following table summarizes what we now know with a fairly high level of statistical confidence
(see Cochrane (1999)):

Therefore, for example, finance spent a great deal of time and effort ignoring or marginalizing
evidence against the EMH/EMT only to accumulate enough evidence to conclude that not only
were we wrong, but we had it essentially reversed. For example, not only doesn‘t the stock
market follow a random walk, but it is predictable (i.e., has predictable components).
49

Therefore, the most basic theory and hypothesis don‘t seem to fit the facts. Could it be that the
normative route wasn‘t a productive path to proceed down? Therefore, regarding the RWH, the
EMH, and EMT in general, the assumptions, the theory, and reality turn out to be wrong (i.e., at
least from a normative perspective).


49
In addition, even liquid stock markets (e.g., the U.S. equity markets) do not appear to even adapt to this. See, for
example, Daniel and Titman (1999, p. 28): ―To examine whether unexploited profit opportunities exist, we tested for
a somewhat weak form of market efficiency, adaptive efficiency, that allows for the appearance of profit
opportunities in historical data but requires these profit opportunities to dissipate when they become apparent. Our
tests rejected the notion that the U.S. equity market is adaptive efficient.‖ Therefore, even ‗weak-form‘ inefficiency
persists.
Cochrane's 'New Facts in Finance' - What we thought we knew, and what we now know.
What was thought (until about the mid-1980s): What we now know:
1 "The CAPM is a good measure of risk and thus a good explanation of
the fact that some assets earn higher average returns than others."
"There are assets whose average returns can not be explained by their
beta." Multifactor models help the explanation.
2 "Returns are unpredictable, like a coin flip. This is the 'random walk'
theory of stock prices."
"Returns are predictable. In particular: Variables including the
dividend/price (d/p) ratio and term premium can predict …"
3 "Bonds returns are not predictable. This is the 'expectations model' of
the term structure." "Bond returns are predictable."
4
"Foreign exchange rates are not predictable." "Foreign exchange rates are predictable."
5
"Stock market volatility does not change much through time." "Volatility does change through time."
6 "Professional managers do not reliably outperform simple indexes and
passive portfolios once one corrects for risk (beta)."
"Some mutual funds seem to outperform simple indexes, … However,
multifactor models explain most fund persistence."
7 These views "reflect a guiding principle that assets markets are, to a
good approximation, informationally efficient (Fama 1970, 1991)."
In short, although "many results are hotly debated … the old world is
gone."
Kihn / Behavioral Finance 101 / 68

THE ISSUE WITH PREDICTABILITY
One of the primary empirical problems with the EMH/EMT is predictability. A major problem
with finance being so dependent on the EMH (e.g., Fama (1970)), and then around the 1990s
until recent later versions of EMT, is the issue of return predictability and its cause(s). As it has
become more and more difficult, if not impossible, to reconcile the 1970 version of EMH/EMT
with empirical reality, a new and evolving view has emerged in parallel with all perceived threats
to its view and related agenda.

What sorts of empirical proof have made the original version, and even recent versions, of the
EMH/EMT untenable? As it turns out quit a wide variety of proof has emerged over the decades.
The following list is just a list of predictability, ignoring for the time being other possibly more
damming proof. What now follows is a partial list of predictable patterns, largely taken from an
article by Daniel et al. (2002).
50


1. Closed-end fund discounts/premia predict future returns on small firms.
2. Long-term bond returns are positively predicted by the difference between long-term
interest rates and the short-term rate, or based on the difference between the forward rate
and the short-term spot rate.
3. Increases in a country‘s bond yield relative to another country‘s bond yield forecasts
future appreciation of the country‘s currency (i.e., the ‗forward discount puzzle‘).

50
Also, who knows how much of this may be due to the ―perceived irrelevance of history‖ (a common
psychological bias).
Kihn / Behavioral Finance 101 / 69

4. Cross-sectionally, small market value and high fundamental/price ratios predict high
stock returns in many countries, even after controlling for beta (e.g., B/Mkt, E/P, CF/P,
S/P, D/E, etc.
51
).
5. For the stock market as a whole, high fundamental/price ratios (D/Mkt or B/Mkt) seem to
predict high long-horizon stock returns.
6. For the stock market as a whole, stock market returns are predictable based on various
macro variables (e.g., term spreads and default spreads).
7. Investors are surprised by the good subsequent performance of value stocks and the poor
performance of growth stocks (i.e., part of the ‗earnings drift‘ phenomenon). Note, in
order for purely ‗rational‘ stories/models to apply, the implied levels of covariance risk
on earnings announcement dates would have to be extreme.
8. Accounting ratios provide additional power to predict returns (they are roughly divided
into the following three types: (1) fundamental ratio analysis, (2) accruals analysis, and
(3) fundamental value analysis).
52

9. Accruals (adjustments to accounting earnings) are strong negative predictors of future
stock returns. These non-cash flow effects are independent of B/Mkt and size effects.
Note these tend to lend more direct support to the behavioral approach (i.e., baring
extreme forms of collusion/illegal behavior), in that investors and analysts seem to be
rather easily systematically fooled by not adjusting for these systematic errors.

51
B = Book, Mkt = Market, E = Earnings, P = Price, CF = Cash Flow, S = Sales, and D = Dividends.
52
Add to #8, that accounting method matters (see Daniel et al. (2002, p. 170-171)). For example, for M&A
‗pooling-of-interests‘ method is treated differently than ‗purchase‘ method accounting and managers seem to like it
more (as well as analysts). This doesn‘t sound like EMT and it further suggests that framing is critical in the finance
for accounting information.
Kihn / Behavioral Finance 101 / 70

10. Constructed fundamental value indices predict future stock returns (e.g., a residual
income model). In fact, cross country trading strategies using those types of valuation
models can be very profitable. Like accruals, this type of result tends to be supportive of
the notion of systematic errors on the part of investors.
11. There are positive short-lag autocorrelations (e.g., gold, bonds, and foreign exchange)
and negative long-lag autocorrelations (e.g., stock markets in general) in many asset and
security markets. That is, momentum in the shorter run and mean reversion in the longer
run.
12. Cross-sectionally, there is strong short-run momentum and long-run reversal. Again,
although cross-sectionally, that is, momentum in the shorter run and mean reversion in
the longer run. The Sharpe ratios achievable through U.S. momentum strategies alone
appear to be too large to be consistent with a rational frictionless model. Also, note that
the momentum effect is strongest in (1) small firms, (2) growth firms, and (3) using
industry components; and it doesn‘t appear to be related to macroeconomic conditioning
variables. Finally, real estate displays predictable price momentum (both residential and
commercial).
13. Momentum is associated with subsequent abnormal performance at earnings
announcement dates (about ¼ of the returns from the momentum strategy are from
returns on announcement dates).
Kihn / Behavioral Finance 101 / 71

14. The selection, timing, and manipulation surrounding ―corporate events‖ indicate some
predictability of the event itself. For example, the ―timing‖ view of corporate events
indicates mispricing.
53

15. Stock returns after discretionary corporate events exhibit post-event continuation (with
the same sign as that on the event-date), except for private placements (where the
incentive is the reverse).
54
That is, the ―post-event continuation hypothesis‖.
16. The equity share in total new issues predicts poor future performance of the U.S stock
market.
17. Investor expectations and analysts‘ forecasts about seasoned equity offering firms are
favorably biased, and the long run post-event abnormal returns of these firms are
associated with corrections of these biases. This is a type of almost direct evidence that
investors expectations are systematically wrong (e.g., negative ‗surprises‘/abnormal
returns for new issue firms around earnings announcement dates, and positive
‗surprises‘/abnormal returns for post-split firms around earnings announcement dates).
55

The new EMT would argue that there is a great deal of uncertainty resolved around these
dates. This is unlikely. Why should covariance with the stock market suddenly become
very high or low a few days a year? For example, does information jump out on quarterly
reporting dates?

53
This is my own interpretation, with some additional insight/speculation.
54
#15 includes: equity carve-outs, spinoffs, tender offers, open market repurchases, stock splits, dividend omissions,
dividend initiations, seasoned equity and debt offerings, public announcements of insider trades, venture capital
distributions, and accounting write-offs (Daniel et al. (2002, footnote 21, p. 162)).
55
#17 could be called the Homer Simpson effect, earnings announcement ―doh‖, then an earnings announcement,
―doh‖, etc. In essence, the same mistake is exposed and repeated over and over again.
Kihn / Behavioral Finance 101 / 72

18. Investors entrust large amounts of resources to mutual funds that, net of fees and costs,
do poorly. Hence, a kind of reverse market timing that is predictable.
56

19. While abnormally positive mutual fund performance is questionably predictable (with the
possible exception of shorter run momentum effects), negative abnormal performance is
almost a sure bet.
57

20. Analysts forecast revisions and recommendations are associated with subsequent
abnormal returns. Unfavorable recommendations have significantly stronger forecasting
power than favorable ones (e.g., strong underperformance after a downgrade, but weak
outperformance after an upgrade).
58
Note, given that analysts make poor use of
observable predictable variables, it is unlikely that the effect is due purely to expert
observation (i.e., vs. an inside information explanation).
21. Firms in which long-horizon analyst forecasts of earnings are relatively high earn low
subsequent stock returns.
59

22. WSS recommendations are significant negative forecasting signals for the overall
market.
60


56
See e.g., Karceski (2002).
57
This one is actually not in their list.
58
They also differ if made by analysts at investment banks or independent research firms, whether they are buy or
sell recommendations, and if during a bubble. Barber et al. (2004, abstract) summarize their findings as: ―daily
abnormal return to independent research firm buy recommendations exceeds that of the investment banks by 3.1
basis points, or almost 8 percentage points annualized. In contrast, investment bank hold and sell recommendations
outperform those of independent research firms by 1.8 basis points daily, or 4½ percentage points annualized.
Investment bank buy recommendation underperformance is concentrated in the subperiod subsequent to the
NASDAQ market peak (March 10, 2000), where it averages 6.9 basis points per day, or slightly more than
17 percent annualized. More strikingly, during this period those investment bank buy recommendations outstanding
subsequent to equity offerings underperform those of independent research firms by 8.7 basis points (almost 22
percent annualized).‖ Investment bank analysts are not to be trusted with buy recommendations, yet the vast
majority of their recommendations are buys.
59
―The predictability of returns from forecast errors is possible if investors rely too heavily on the forecasts, or
investors and analysts are subject to similar cognitive biases, or both rely too heavily on some other information.‖
Daniel et al. (2002, p. 166) This would also apply to #21.
Kihn / Behavioral Finance 101 / 73

23. Cash or earnings surprises are followed by positive abnormal returns in the short run,
especially for firms with low institutional ownership. The case of ‗earnings drift‘.
61
Note
there is a debate as to whether earnings surprises are followed by negative abnormal
returns in the long run, and whether it has disappeared more recently.
24. Short sellers make abnormal profits through value strategies.
25. Time changes, weather, and feelings affect security prices (e.g., changes to and from
daylight savings time, and cloud cover in New York City causes low returns).
62

26. Seasonality predicts security returns (e.g., the ‗January effect‘, and winter).
63

27. Etc., etc., …
It seems that the more interesting, if not simpler, question is not what is associated with the
possibility of mispricing and/or inefficiency, but what is not?

In summary on predictability, note the specifics are broad and deep:
• Past returns predict future returns (even Fama himself shows this, see Fama (1991)). This
is a firm rejection of even ―weak-form‖ efficiency.
• Measures of value predict future returns (e.g., price-to-earnings, book-to-earnings, etc.).

60
This one is actually not in their list.
61
Like #17, this could be called the Homer Simpson effect, earnings announcement ―doh‖, then an earnings
announcement, ―doh‖, etc. In essence, the same mistake is exposed and repeated over and over again.
Concerning #23, Daniel et al. (2002, p. 167) point out that Daniel and Titman (2000) find that ―stock price
movements which can be linked to changes in accounting variables do not reverse, while price movements that
cannot be linked to accounting variable changes experience strong reversals. Daniel and Titman interpret this
evidence as consistent with overconfidence, based upon psychological studies showing that investors exhibit more
overconfidence about vague or intangible information.‖
62
Obviously, there could be a list of related effects. This has been modified this from the original.
63
This one is actually not in their list; and obviously, there could be a list of related seasonal effects. Also, winter
seems to cause return changes by the amount of daylight. For a study on seasonality see, for example, Lakonishok
and Smidt (1988). They confirm the existence of the: (1) turn of the week, (2) turn of the month, (3) turn of the year,
(4) holidays predictable/persistent returns over a ninety year period of the Dow Jones Industrial Average.
Kihn / Behavioral Finance 101 / 74

• Corporate events predict future returns (e.g., dividend changes, share repurchases,
seasoned equity offerings, etc.).
• Etc.
Predictability alone
64
shows this is clearly not the case of ‗data mining‘ or specification search,
since almost every corporate ‗trigger‘ event seems to have predictable power. Therefore, not
only is it not data mining, but the reverse in the case of EMH/EMT promoters.

Please note: ―Most of the patterns of return predictability summarized have alternative (though
not equally plausible) explanations based on either risk premia or mispricing.‖ (See Daniel et al.
(2002, p. 150)) Also note, that when I write that ―returns are predictable‖ I am not saying they
are perfectly predictable, or that all risk has been controlled for. There is, in many cases, a great
deal of some form of risk associated with the prediction. Which is why I continually state that
even though there appear to be many ―free lunches‖, it is important to remember that those ‗free
lunches‘ are only free as defined by EMT type finance, not behavioral finance. Finally, it is not
clear what the causes of return predictability are; but again, the most likely causes are

64
Regarding evidence for the EMH/EMT, essentially, there are few portfolio managers who systematically seem to
‗beat the market‘. That is, the superficial appearance of ‗no free lunch‘.
―It is our view, this fact is interesting but not particularly supportive of market efficiency. Under free choice the
funds that attract investors will be those that appeal to investors‘ emotions and beliefs, however biased. For
example, if at some point investors are irrationally thrilled about the tech sector, cash will flow to funds heavy in
tech portfolios. More rational portfolios that are light on tech will on average earn high subsequent returns, but at the
relevant moment will be unpopular with investors – that‘s the very source of the mispricing.
The fact that vast amounts of invested wealth are placed in funds that appear to be wasting resources on active
management does not support the view that investors are good at choosing funds, nor that funds make good choices
on behalf of investors. There is some dissonance between the views that investors trade foolishly to create potential
inefficiencies, and that they are smart enough to invest in mutual funds designed to exploit these inefficiencies.‖
Daniel et al. (2002, p. 165)
Kihn / Behavioral Finance 101 / 75

behaviorally based, not EMH/EMT based
65
. That is, because the behavioral approach is based on
a descriptive method, it will fit the facts better, by definition.

Also, note the following:
• Patterns of return predictability can have alternative explanations, and not all
explanations are equally plausible (specifically, strictly ‗rational‘ vs. behavioral).
• The behavioral approach is consistent with risk based factor premia (i.e., people do price
various forms of risk, but there are other psychologically based things going on,
specifically, psychological biases influence pricing). Actually, it was the original
EMH/EMT and the CAPM that lead the majority of academics and practitioners to
believe that there was only one risk
66
worth taking account of, whereas the behavioral
approach has always maintained that explaining what motivates investors is more
nuanced.
• The mispricing of factors is consistent with those factors identified as new additions to
the evolving EMT asset pricing model (i.e., the three factor model of Fama and French
(1993) or the four factor model of Carhart (1997)). Therefore, the ex post identification
and subsequent addition of new risk factors to the evolving EMT asset pricing model
doesn‘t mean those factors are anything more than the mispriced factors they were
identified as being in the first place.

65
Daniel et al (2002, p. 162-163) have a very good discussion on methodological problems of the new EMT models
and what they actually show (especially with respect to event studies). In my opinion, they make the new EMT look
a bit silly.
66
That is, ‗market risk‘.
Kihn / Behavioral Finance 101 / 76

• In particular, the cross-section of securities returns is very difficult to rationalize based
upon ‗rational‘ risk measures (i.e., using size, value (B/Mkt as a proxy), and momentum).
Again, for example, the Fama and French (1993) and Carhart (1997) asset pricing models
may help to ‗explain‘ away a great deal of the mispricing or ‗anomaly‘, but that doesn‘t
mean it isn‘t caused by mispricing and/or is in fact mispricing. The seemingly important
question has been largely ignored. That is, are those factors true risk factors?
• Ignoring for a moment that they were added after the fact (ex post identification, which is
a type of theoretical specification search, ironically a claim made against others) and they
have no real theoretical grounding in economics, what is a momentum, value, or size risk
anyways? If those factors were truly risk factors then the factor realizations should
strongly covary with investors‟ marginal utility across states. Specifically, rational
asset pricing models would suggest that low marginal utility states (e.g., economic
booms) should be associated with high relative returns for ‗value‘ stocks and high
marginal utility states (e.g., recessions/depressions) should be associated with low
relative returns for ‗value‘ stocks. In fact, they either don‘t seem to move much or move
in the opposite direction as that expected by the newly evolved theory. Therefore, there is
little or no evidence to support the ‗insurance‘ theory proposed by the evolving theory
(see Cochrane (1999) on an outline of what is predicted by this type of theory).
• The bottom line is that, short of extreme preferences not accepted by or incorporated into
any ‗rational‘ model, it is very difficult to explain the very high Sharpe ratios achieved by
forming portfolios based on size, value, and/or momentum. This is true no matter how
high the correlations between the returns of portfolios based on these ‗factors‘ and
Kihn / Behavioral Finance 101 / 77

innovations in macroeconomic variables (see Daniel et al. (2002, p. 152-153)), that is,
those studies that produce statistics with signs in the ‗right‘ direction.
• In addition to there being little evidence to suggest these returns are correlated with
macroeconomic variables that might proxy for marginal utility, there is very little
evidence of size, value, and momentum returns being correlated across countries.
Therefore, forming these types of portfolios internationally would result in even higher
risk-adjusted returns with even more problems for the evolving theory.
• Therefore, stay tuned for the next adjustment(s) to the theory.
In summary of these notes:
―Taken together, this evidence seems to imply that a frictionless, rational model which would
explain this evidence would have to have very unusual (and perhaps implausible) preferences
to accommodate very large variability in marginal utility across states.‖
Daniel et al. (2002, p. 153)

Again, just because people are influenced by their biases doesn‘t mean that they do not care
about risk or risk factors (quit the contrary, as humans they may be unduly motivated to ‗fear‘
risk more than a ‗rational‘ model would indicate). As mentioned, the data mining accusation is
truly absurd and hypocritical given that Fama in particular has thrown this one at almost anyone
pointing out an ‗anomaly‘. The critical point is that ‗value‘ stocks return more than ‗growth‘
stocks (part of the ‗good stock/good company‘ effect), then in a ‗rational‘ world this extra return
is due to extra risk, and this extra risk will become more clearly visible in the extreme negative
states of the world (specifically, recessions or depressions). Furthermore, most of these types of
Kihn / Behavioral Finance 101 / 78

risk are a kind of ‗insurance‘ against bad states that people are rationally worried about when
pricing assets (again, think recessions and depressions). Therefore, for example, during
recessions ‗value‘ stocks should return significantly less than ‗growth‘ stocks. In fact, they return
significantly more than ‗growth‘ stocks. Actually, this type of contradiction and/or evidence
against more recent versions of the EMT tends to be generally true of most of the ‗anomalies‘.
67

Finally, note that much of this comes down to consumption risk (see Daniel et al. (2002, p. 152)).
Lakonishok et al. (1994) present evidence in strong support of the behavioral view (i.e., they
look at recessions).

The bottom line question is whether they are factors, mispricings, or both? For example (Daniel
et al. (2002, p. 156-157)): ―There is a factor associated with book/market, but there is no clear
evidence as to whether this factor earns a risk premium.‖ It has been theorized that these types of
‗factors‘ represent hedges against shifts in the investment opportunity set, particularly financial
or economic distress. But, for example, if this was true why do so many that can invest in their
own company‘s stock do so (i.e., it is doubtful they are hedging future distress risk, quit the
contrary)? In my opinion, it is likely they are both and the ―factor‖ label has been somewhat
misapplied (Daniel et al. (2002) might call them characteristics). In addition, isn‘t it nice that
psychology can help explain this part of finance and why certain academics have a very difficult
time letting go of the EMH/EMT (e.g., various forms of rationalization/cognitive dissonance,

67
One study in partial support of the evolved theory is Liew and Vassalou (2000) on ten countries, and using the
book/market ratio to predict economic growth (‗most‘ countries support the view that returns of a portfolio based on
book/market and size are positively associated with GDP growth). It is important to point out that the key is
recession, not growth, and that the study produced some evidence only regarding the sign, not magnitude. Therefore,
the evidence is only slightly supportive in sign only, and also only for a few countries. Actually, the study finds
contradictory evidence in Japan. Thus, on a market weighted basis the results are not supportive (i.e., given Japan‘s
overall size relative to the others).
Kihn / Behavioral Finance 101 / 79

etc.).
68
And a final note, we will indirectly and possibly directly come back to these types of
questions again. I want the reader to think about what is causing them. It seems to me if they are
‗factors‘ people don‘t go out and think, well momentum is worth X to me forever. They may do
that but not in a way that is easily specified.

To me the obvious analogous debate of this ‗factor‘ vs. ‗characteristic‘ debate is the Earth being
just a planet in a larger solar system/galaxy/etc. vs. its being the center of the universe. As new
evidence is brought forth it became harder and harder to view the Earth as the center of all things
larger than itself. Again, just because people are influenced by their biases doesn‘t mean that
they do not care about risks or risk ‗factors‘ (quit the contrary, as humans they may be unduly
motivated to ‗fear‘ risk more than a ‗rational‘ model would indicate), but there seems to be other
more behaviorally based influences.

Therefore, I have good and bad news. The bad news is that the markets are inefficient (i.e., in the
traditional finance sense). The good news is that the markets are inefficient (but unfortunately
not in the traditional sense). Therefore, it may be of little or no practical use to know that they
are ‘inefficient‘; but at least the message seems consistent.
69



68
Again, denial is strong motivator for many most humans, and EMT proponents are no exception.
69
This is much like the good and bad news with respect to the social ―sciences‖. That is, the bad news is that
everything you learn therein is wrong, but the good news is that some of it is useful.
Kihn / Behavioral Finance 101 / 80

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Financial Economics, Volume 33, Issue 1, February 1993, 3-53.

Findlay, M., and E. Williams, ―A fresh look at the efficient market hypothesis: how the
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Friedman, M., Essays in Positive Economics: Part I – The Methodology of Positive Economics,
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Gallo, J., and L. Lockwood, ―Fund Management Changes and Equity Style Shifts‖, Financial
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APPENDIX A: TWO BASIC LOGICAL FALLACIES IN FINANCE AND ECONOMICS
Often based on or derived from the efficient market debate, there are two common logical
fallacies that exist with finance and economics, and they both have similar root causes regarding
Kihn / Behavioral Finance 101 / 87

their lack of logical consistency. The first is that ―if there is no ‗free lunch‘, the markets must be
efficient (and ‗prices are right‘).‖ The second is that ―if the markets are inefficient, then the
government must intervene.‖ Both statements are logically, and factually, false.

In the traditional framework, agents are rational and there are no frictions. Again, for example,
the EMH states that prices reflect their ‗fundamental‘ values. The agents in such an ‗efficient
market‘ understand ‗Bayes‘ rule‘
70
and have well behaved utility functions. Under the EMH:
―‘prices are right‘‖, (Barberis and Thaler (2002, p. 3)) and any deviation from fundamental
value will be met by an arbitrager who will correct the mispricing (i.e., the ‗no free lunch‘
argument). Barberis and Thaler (2002, p. 4) point out the following:
―Prices are right‖ => ―no free lunch‖, but ―no free lunch‖ ≠>‖prices are right‖.
Restated, ‗prices are right‘ implies ‗no free lunch‘, but ‗no free lunch‘ doesn‘t imply ‗prices are
right‘.

Thus they, and I, would argue that in the case of ‗efficient‘ prices and ‗free lunches‘, the
causality only runs in one direction. Therefore, the two statements are not equivalent. Yes, if
prices are ‗efficient‘ (i.e., by the definition established by economics and finance), then, it is
tautologically true that there should be ‗no free lunches‘. Whether this can be proven without an
acceptable valuation ‗model‘ is another issue. But, yes, I can live with the implication that

70
Bayes‘ rule/law/theorem is about conditional probabilities (prior and posterior probabilities) which people have a
notoriously bad habit of messing up; and few have well behaved utility functions meeting all the basic axioms of
utility (e.g., independence).
Kihn / Behavioral Finance 101 / 88

‗efficient prices‘ mean ‗no free lunch‘ based on current normative definitions.
71
That noted, it is
far from clear that not being able to find a clear ‗free lunch‘ means ‗prices are wrong‘.

To show this, think of the following sets of information and pricing:


71
Although, I should note that I have read normative EMH/EMT proponents claim that prices don‘t have to be
efficient in order for market efficiency to hold (this argumentation tends to run through martingales, sub-
martingales, and related fair games).
The set of all financial market prices
Prices are right Prices are wrong
‘No free lunch’
Kihn / Behavioral Finance 101 / 89

Divide the set of all financial market prices into two non-overlapping sets, where prices are
either ‗right‘ or ‗wrong‘ (i.e., according to normative finance). Thus, all that is required is that if
within the set of all finance prices (which is the sum of ‗prices are right‘ and ‗prices are wrong‘)
there is just one ‗wrong price‘ where there is ‗no free lunch‘, then the ‗price is wrong‘ but there
is ‗no free lunch‘. I will argue that, in fact, most prices today fall into this set of being incorrect
from a market efficiency standpoint, yet you would be hard pressed to extract a purely free lunch
from them.

Regarding factual or empirical proof of at least one example of this, it will be shown in one of
the following chapters that factually there are limits to arbitrage; additionally, several cases will
be presented where we know that: (1) prices were ‗wrong‘, yet (2) no ‗free lunch‘ seemed
available (e.g., many ―Internet ‗carve-outs‘‖). This is important not just in its bearing on the
argument concerning market efficiency, but also on its potential impact on the second fallacy.

Regarding prices being ‗wrong‘ and government intervention a similar argument and factual
accounting can be made. But, in addition, it should be noted that:
―Much of the scientific debate over market efficiency has a policy undercurrent. The efficient
markets hypothesis is associated with the free market school of thought traditionally championed
at the Universities of Chicago and Rochester. Imperfect rationality approaches are in part
associated with East Coast schools that have tended to be much more enthusiastic about
government activism.
Kihn / Behavioral Finance 101 / 90

… Proponents of laissez faire seem to have drawn a brittle defensive line: if markets turn out to
be substantially inefficient, the city of freedom is open to be sacked.
We argue that this link between efficient markets and the desirability of laissez faire is logically
weak. An important weakness is that even if investors are imperfectly rational and assets are
systematically mispriced, policymakers should still show some deference to market prices.
Individual political participants are not immune to biases and self-interest exhibited in private
settings. … Indeed, the economic incentives of officials to overcome their biases in evaluating
fundamental value are likely to be weaker than the incentives of market participants. … In sum,
advocates of laissez faire who rest their case on market efficiency are in some respects
needlessly vacating the high ground of the debate without clash of arms.‖
Daniel et al. (2002, p. 141-142)

In short, there are ideological ―axes to grind‖ that tend to push people to claim that a ‗failure of
the market‘ is sufficient justification for increased government involvement, and it is not. In fact,
it is neither justified from a logical or factual perspective. Logically, as with the ‗free lunch‘ and
‗right prices‘ vs. ‗wrong prices‘ logical inconsistency, it does not follow that:
Prices are wrong => government intervention, in fact it isn‘t clear that:
Prices are wrong => intervention (i.e., any kind of intervention, let alone governmental). What I
would argue is that intervention is only warranted if and only if (―iff‖) it is proven empirically to
improve pricing. In fact, government intervention tends to move prices further away from market
Kihn / Behavioral Finance 101 / 91

efficiency (this will be shown in one of the following chapters).
72
Therefore, and assuming
‗prices are wrong‘, what could be implied is the following:
Prices are wrong => intervention, but intervention ≠> improved pricing (i.e., prices pushed
toward being economically optimal). Again, therefore, intervention is only warranted iff it
improves pricing. Factually, and as a general rule (if not absolute rule), government historically
and currently hurts more than it helps.
73


Furthermore, and stated slightly differently, it is important to say that even though I am highly
confident that in many ways, as of today, ‗prices are wrong‘ this doesn‘t mean government
should determine the pricing mechanism(s) (Daniel et al. (2002)). This would be tantamount to
making the same type of logic mistake made by those who professed that the lack of a clear ‗free
lunch‘ establishes the fact that ‗prices are right‘. Beyond that, it will be shown that government
involvement in the financial markets, on balance, is, has and continues to contribute to large and
persistent miss-pricings in the financial markets. If that point proves to be true, then not only
isn‘t it clear that government involvement won‘t help improve pricing, but that type of
involvement is almost assured to make it worse.
74


72
At a minimum, the reason for this is that government tends to cause wrong/inefficient prices. For example, interest
rates matter (and shouldn‘t be pushed below what the market(s) would set. ―… rational economic activity is
impossible in a socialist commonwealth.‖ See Ludwid von Mises, 1920, "Economic Calculation in the Socialist
Commonwealth". The effect: misallocation of capital (i.e., ―malinvestment‖), which will need to be reallocated
away from the malinvestments. This will likely be painful; but the sooner the better.
73
Comments made by Daniel et al (2002), seem most appropriate here: ―Investor credulity and systematic
mispricing in general suggest a possible role for regulation to protect ignorant investors, and to improve risk sharing.
The potential for improvement does not imply that government activism will help. The political process is subject to
manipulation by interest groups, and political players have self-interested motives. So a global default to laissez
faire is superior to a hair-trigger readiness to bring the coercive power of government into play. … Just as much as if
markets were perfectly efficient, government can do great good simply by doing no harm.‖ Daniel et al. (2002, p.
142)
74
In my opinion, government involvement is best to probably adjust information to help correct for biases (e.g.,
S.E.C. should have individual investors become aware of fundamental value, volatility, expenses, etc.) and set up a
Kihn / Behavioral Finance 101 / 92


APPENDIX B: SOME COMMONLY USED EXCESS RETURN MEASURES
This appendix is intended to provide background on the following terms associated with excess
returns:
1. ―alpha‖ (both ―Jensen‘s alpha‖ and the ―Treynor-Mazuy quadratic performance
measure‖),
2. ―Sharpe ratio‖, and
3. ―information ratio‖.
75

The reason for this digression is that the one critical set of empirical proof primarily running
contrary to the EMH/EMT is the fact that so many strategies show statistically significant
statistics for strategies and/or tactics that shouldn‘t show them (i.e., according to normative

consistent, simple, and rational legal framework. This type of involvement would likely be useful in the brokerage
and money management industries.
75
Therefore, I am reviewing four measures. For example, Jensen‘s alpha equation is used to proxy for unsystematic
risk while its beta is a proxy for systematic risk. Note, there are potentially an infinite number of these equations, but
those listed are early ones that have withstood the test of time, and that have an intuitive appeal.
Kihn / Behavioral Finance 101 / 93

financial theories associated with the EMT). Specifically, the ―alphas‖ of certain well
documented strategies and/or tactics show statistically significant and often large ―alphas‖.

Therefore, let‘s just establish what we mean by the terms ―alpha‖ and ―information ratio‖ (a
related concept). In addition, we will be referring to many studies that focus on these concepts.
Also, if you get a job in the ―real world‖ of finance these are useful terms/concepts to know.
Remember, as with most or all of empirical finance, these are subject to semantics and
interpretation. Therefore, let‘s set the semantics and definitions.

From Gallo and Lockwood (1999, see p. 45):
Sharpe‘s Reward-to-VARiability (―RVAR‖) is:

=

, where

= mean monthly return for mutual fund i,

= risk-free rate (the 30-
day U.S. T-bill rate), and

= standard deviation of monthly returns for fund i. RVAR was used
to compute the average excess return per unit of the fund‘s total risk. It‘s a basic, useful measure
of risk-adjusted return.

Jensen‘s (1968) alpha:

-

=

+(

-

)+

, where for month t:

= return for fund i,

= return for the market portfolio (they used the Wilshire 5000 Index), and

= the random error term.
Kihn / Behavioral Finance 101 / 94

The alpha is intended to represent the difference between the realized mean return of the fund
and its risk-adjusted required return (i.e., as determined by the CAPM). Therefore, a positive and
statistically significant alpha is considered to be the overall goal of a Portfolio Manager (―PM‖).
Whereas, from an EMH/EMT perspective any statistically significant deviation from zero is
evidence against (i.e., assuming it is the ‗correct‘ model, which of course, according to most, if
not all, EMT supporters, all models are wrong; therefore, the exercise of checking for
inefficiencies is virtually impossible, if not silly
76
).

Treynor-Mazuy (1966) quadratic performance measure (i.e., a form of attribution model):

+

=

+(

-

+

, where:

= the security selection ability of the manager, and

= the manager‘s market-timing skill.
The quadratic equation is derived by assuming that the fund beta in the Jensen‘s alpha equation
may change in response to the market index (specifically,

is replaced with

=

-

)). A positive

implies superior market timing skill, and a positive

implies superior
security-selection skill.

Regarding deriving the ‗information ratio‘, Grinold and Kahn‘s (1992) suggested technique
relies on a series of regressions. First, perform the following regression:
(1) (

-

) =

-

) +

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Of course, by extension, scientific method cannot be applied, because no evidence is then admissible. Thus, one
must accept some form of test or there can be no rejection or acceptance of a hypothesis or hypotheses. Again, we
seem to be at a stage where, as De Bondt stated, we cannot test any theory and yet the actual facts seem to contradict
the theories we cannot test.
Kihn / Behavioral Finance 101 / 95

in order to estimate the portfolio‘s alpha and beta. Therefore, alpha =

. Second, evaluate whether alpha is significantly different from zero:
(2) t-stat =

where SE = the standard error of the estimate. Third, measure PM ‗Value-Added‘ (―VA‖):
(3)

where VA = alpha minus a risk tolerance (lambda) times the annualized residual risk (Note:
Grinold and Kahn assume the manager tries to maximize this risk-adjusted annual alpha).
Therefore, the investor‘s risk tolerance will tend to drive the level of aggressiveness of the PM to
maximize this VA.

A few things to note or highlight before proceeding:
- Most key values are annualized. This is standard practice (e.g., if monthly data, then
alpha needs to be multiplied by twelve, and the number of months will determine what
you need to do to residual risk).
- The basic equation is a Sharpe invention (i.e., maximize return/alpha less risk tolerance
adjusted risk).
- Lambda or risk tolerance is a key part and typically is between two and three (actually
institutions have typically used three), but has been shown to vary under different
conditions for people (e.g., behavioral approach and framing).
Please remember, although these methods/techniques are based on normative theories, they are
very practical and useful.

Kihn / Behavioral Finance 101 / 96

Furthermore, Grinold and Kahn (1992, p. 19) state: ―Detailed analysis shows that the maximum
value-added rises in proportion to the square of the manager‘s information ratio, IR, the ratio of
annual alpha to annual risk:
(4)

,
(5) with

.
The information ratio is essentially an investment signal-to-noise ratio. An information ratio of
0.75 means that we can expect 3% alpha per year if we take a 4% per year residual risk. …
value-added rises with the manager‘s information ratio, regardless of the level of risk aversion.
Because of this direct connection to investment value-added, the information ratio is the best
overall statistic to use for information analysis.‖ Although the IR may not be the ―best overall
statistic to use for information analysis‖, it is very useful.

Note, the IR and t-statistic are closely related (at least by definition), in fact:
(6)

,
therefore, the two tend to converge as the number of observations increases.

Summing up the t-stat and IR, Grinold and Kahn (1992, p. 19) state: ―Overall, the t-statistic
measures the statistical significance of the return, but the information ratio also captures the risk-
reward trade-off of the strategy and manager‘s value-added. … An information ratio of 0.5
observed over five years may be statistically more significant than an information ratio of 0.5
observed over one year, but their value-added will be equal‖ (because risk was arbitrarily defined
over one year). A critical practical point about the IR (i.e., as defined here) is that in the real
Kihn / Behavioral Finance 101 / 97

world it is useful to have more time to prove that good performance wasn‘t a statistical fluke, but
the reality is that you may not have the time to prove it.

Finally, most practitioners would recognize the following as the IR:
IR = [portfolio return – benchmark return]/standard deviation (of portfolio return – benchmark
return).
77

This takes its inspiration directly from the ‗Sharpe ratio‘ (i.e., which uses a risk-free rate of
return in place of the benchmark return). Keep in mind, although generally a useful concept, it is
important to note what exactly someone means by IR.


77
The difference between this and the Sharpe measure is the risk-free rate is used in the Sharpe ratio and the
benchmark return here.
Kihn / Behavioral Finance 101 / 98

Chapter 4: Limits to arbitrage or the first „pillar‟ of behavioral finance

Again, there are two key parts to behavioral finance: (1) limits to arbitrage, and (2) psychology.
This chapter will focus on the limits to arbitrage part. Specifically, I will focus on those clear and
relatively unambiguous cases where limits to arbitrage must exist.
78
Also, as already mentioned,
after reading this chapter the reader should at least begin to understand why limits to arbitrage is
a necessary but not sufficient condition for the psychology part to matter, as well as begin to
contemplate or understand the possible importance of the psychology part.

It has been stated that behavioral finance: can practically be applied to those situations where
cognitive psychology and microeconomics are best employed in combination. For example,
Thaler (1994, p. 62) states: ―The key ingredient is the existence of a cognitive illusion, a mental
task that induces a substantial majority of subjects to make systematic error. … Whenever such
an illusion can be demonstrated, the possibility that market outcomes will diverge from
predictions of economic theory is present.‖ Although true, I would argue that in those cases
where we would expect no divergence or ‗systemic error‘ would then be in those areas where no
‗cognitive illusion‘ at all applies. Simply stated, if no ‗cognitive illusion‘ is even possible, then
something else must be driving pricing. We will shortly cover such cases, that is, cases were we
know with a very high degree of confidence what the price should be and expect no ‗cognitive‘
or other type of illusion, yet prices diverge anyway. The likely explanation is limits to arbitrage

78
If the answer isn‘t limits to arbitrage, the reader will see that finance and economics has more fundamental
problems than a poor methodology.
Kihn / Behavioral Finance 101 / 99

(for a classic more normative model based view on how this is likely, see Shleifer and Vishny
(1997)
79
).

First begin by thinking (and assuming, i.e., before it is proven) of the following two extremes of
arbitrage, and then reality:
1. No arbitrage of any kind anywhere (i.e., in any market).
2. Pure arbitrage everywhere (i.e., in every market).
3. We live in a world where there are limits to pure arbitrage (i.e., somewhere in between),
and many, if not most, investors are not being strictly rational (in the traditional
economic/Savage sense).

In the case of no arbitrage anywhere at any time, imagine that prices could be at any level with
no particular reason for them being there. Now this is unlikely. Isn‘t it likely that at some point
there must be some boundary condition? Minimally, remember that finance is essentially
discounted cash flow analysis. The trick is to figure out the cash flows and associated discount
rates. For example, assume the simplest case, a case of a riskless
80
one cash flow and one
discount rate (e.g., a T-bill where you get back your original investment plus some implicit
interest – one payment with principal and interest combined). Therefore, the cash flow and
discount rate are known. How likely is it that if you are to receive in exactly one year a riskless
cash flow of $11,000 for a security you paid $10,000 for, that its price will deviate greatly over

79
Thus, it is possible to construct normative models where there are limits to arbitrage. The critical consideration is
that descriptively the evidence strongly suggests they exist, not that one can mathematically construct a model with
the typical assumptions (e.g., extreme economic rationality, etc.).
80
Of course, there really is no such thing as a ‗riskless‘ risky security, but bear with me for the example.
Kihn / Behavioral Finance 101 / 100

the next 365 days? Isn‘t it likely at some point, ceteris paribus, if say the price drops to say
$5,000 someone will step in (an arbitrageur) and buy the security and just wait to collect the cash
flow? Clearly, and with the general caveat of ―it depends‖, at some point someone will act like a
rational arbitrageur and limit the amount of deviation from $11,000. At least for fairly low risk
cash flows, it isn‘t that much of a stretch to conclude mentally that there must be some limit to
how far away from something approaching a general reasonable value that cash flow can deviate.

Now taking the aforementioned one riskless cash flow example and imagine that there is always
and everywhere some arbitrageur prepared to step in if there is any deviation from true value. In
this case, assume the discount rate is zero. Therefore, the true discounted cash flow value or
present value is $11,000. Therefore, any deviation from $11,000 will be met by an arbitrageur
coming into the market and pushing the price back to $11,000. But how likely is that? In this
contrived case, based on incorrect assumptions, we left out, for example, transaction costs. Now
imagine that transaction costs for any arbitrageur were say $1,000 per transaction, and all the
other previous assumptions held. Based on this one change, who would actually bother to enter
the market and buy or short that security if the price didn‘t deviate more than $1,000 from
$11,000? Certainly no ‗rational‘ economic being would.

At this point, I am not really trying to prove that we live in a world where there are limits to
arbitrage, I just want the reader to entertain the thought that it is reasonable to expect that there
would be limits. Therefore, I would like the reader to mentally picture at least one case
theoretically where this could be the case, and why it could be the case.
Kihn / Behavioral Finance 101 / 101


Again, the real key is the lack of pure arbitrage, without it the psychological factors might be of
limited interest. It is a necessary condition for the psychological part to matter in an economic
sense. Although, the psychological factors seem to at least in part be responsible for the lack of a
pure arbitrage (so ultimately they depend on and/or cause the other).

Arbitrage is often required to make markets efficient (see Scholes (1972) on large block sales).
Exact substitutes are easy cases, where you go long the cheap asset and short the expensive asset
to make money and bring prices back in line with market efficiency. Ultimately, it comes back to
cash flows and discount rates. To the extent two cash flows are similar or mirror opposites of
each other, then they are useful substitutes.
81
Where arbitrage is closer to one for one (e.g., short
government debt), arbitrage tends to work, but this tends to have little to do with informational
efficiency per say.
82
Given that there aren‘t any ‗pure arbitrage‘ opportunities, unless criminal
behavior is included, it should be viewed as an ideal, not as reality.

Here is a list of some major limits to arbitrage:
(1) transaction costs (e.g., brokerage commissions, taxes, etc.),

81
Michael Milken, of ‗junk bond‘ fame made a point close to this. He once was asked why he preferred distressed
bonds over stocks. He explained that with stocks, given that they essentially have very small cash flows (i.e.,
dividends) you could grow old before you realized a positive return (i.e., you were waiting for the market price to go
up), therefore you were largely dependent on other people to realize the stock had value (which might be never),
whereas with distressed bonds you often had such high cash flows (i.e., coupon payments) that you might not even
care whether the market thought the company would ever pay you coupons, let alone the principal. In short, what
mattered with debt was whether you got the cash flows (i.e., coupons, and eventually the principal) not what the
market thought about the price. Essentially, he felt more comfortable on a cash flow basis with debt over equity in
the same company because the debt had a shorter duration, ceteris paribus.
82
Although now it is generally accepted in academic circles that there is much autocorrelation in financial time
series, ala things like ARCH/GARCH etc.
Kihn / Behavioral Finance 101 / 102

(2) noise or various other behavioral limits to arbitrage (e.g., LTCM type where perceived
inefficiency increases rather than decreases)
83
,
(3) capital constraints (depending on the investor), and
(4) liquidity constraints (related to the other three, especially #1).
And here is a list of some problems with pure arbitrage:
1. Fundamental risk (e.g., Nokia vs. Ericsson example), since no close substitute.
84

2. ‗Noise trader‘ and/or ‗irrational‘ trader risk.
85

3. Implementation costs (transaction costs, price impact, short-sales constraints
86
, legal
constraints, horizon, information costs (e.g., buying and/or reading this book), taxes,
etc.).
But the evidence of limits to arbitrage is problematic for at least the following reason: Because of
the ‗joint hypothesis problem‘ of testing a mispricing and the model of fundamental valuation, it
is difficult to find cases where a mispricing can be proved beyond a reasonable doubt. We must
have both a value function or ‗model‘ where we are certain any price deviation from it is wrong

83
Note, and as mentioned before, as a general rule, the noisier the return series (or any series for that matter) the
harder it is to make sense of the series (i.e., even if there was indeed something to be made sense of to begin with).
Thus, and furthermore, ‗noise traders‘ can turn financial data from useful to useless by the simple act of trading on
the noise they create. Therefore, noise trading can turn what should normatively be a fundamental series into a
largely useless string of numbers, or not.
84
Summers (1986) makes a very strong argument that it is impossible for an arbitrageur or academic to know what
the true value should be. Essentially, he argues that current tests of market efficiency have very ―low power‖ in a
statistical sense. He argues that just as academics cannot effectively determine whether prices are efficient or not
with such tests and/or models, by extension neither can an actual trader know because they are using the same tests
and/or models. Thus EMH/EMT supporters are essentially ―hoisted on their own pittard‖. To the extent they argue
all models are wrong, then the statistical power of those models must also be low, and the obvious question is not
only what the price should be, but how could any price be corrrect from a market efficiency perspective, especially
the actual one?
85
Even in theory irrational traders can essentially take money from rational traders (see, e.g., Hirshleifer et al.
(2002)). In practice one only has to imagine what generally happened as technology shares drifted further away from
fundamental values during the technology/Dot.com mania, especially during the late 1990s.
86
For example, see Jones and Lamont (2002). They found significant overpricing for stocks with high loan rates.
Based on short sales constraints alone, they indicated that their evidence and analysis was consistent with the notion
of limits to arbitrage.
Kihn / Behavioral Finance 101 / 103

(i.e., from a market efficiency standpoint)
87
, and/or a case where we can derive a value we know
must have certain properties (e.g., being negative, positive, or zero). There are precious few
cases like that, but there are some (we will cover all the known ones in this chapter, and one
more directly related to arbitrage and demand for securities).

Given limits to arbitrage, try to imagine, for example, what you would do to actually carry out
the ‗arbitrage‘ strategy of say going long Nokia and short Ericson (two cell phone manufacturing
companies). That is, say your analysis informs you that the fundamental value of Nokia is too
low relative to Ericson. Specifically, how would you calculate how many shares of each to buy
or sell, then effect that trade (i.e., of going long Nokia stock and short Ericson). Keep in mind
this is a relatively simple example as it only involves two like companies‘ equity securities.
Some things to consider are the following: (1) currency, (2) timing, (3) short sales constraints
88
,
(4) costs, and (5) idiosyncratic risk. Regarding currency, Nokia is headquartered in Finland while
Ericson is headquartered in Sweden. Currently, Finland uses the Euro while Sweden the Swedish
Krona. Therefore, one would need to go long and short Euros and Swedish Krona in order to
eliminate currency risk. Consider how you would make that calculation; then consider the risk of
one or both countries changing their currencies during the trade. Regarding timing, imagine that
in order to be confident that you are shorting one and going long the other you must trade each at
exactly the same time. For example, imagine that you first go short 100 shares on Ericson, but

87
In addition, we need to show the capital is flowing to rational arbitrageurs and away from those who have moved
prices away from their fundamental value. Even Treynor (1998) doesn‘t believe this always and everywhere
happens. And, again there is Summers‘ (1986) argument concerning the logical impossibility of any price being
provable as normatively efficient, or practically and actually correct (i.e., from a market efficiency perspective).
88
Apparently, besides loan supply, loan fees and recalls either influence security pricing and/or are symptomatic of
demand/supply differentials that cause deviations in price (see D‘Avolio (2002)).
Kihn / Behavioral Finance 101 / 104

you are unable to buy an equivalent number of Nokia shares (i.e., assuming you needed the same
number) at exactly the same time (a common occurrence), but before you can purchase the Nokia
shares their price increases and/or Ericson shares decrease in price. How would you assure that
that doesn‘t happen? Regarding short sale constraints, imagine that you short shares, but then the
government wherever you are domiciled for investment purposes passes a law against short
sales; or there is already a law passed that limits price movements for short sales, etc. How do
you eliminate that/those risks? Regarding costs, imagine that transactions costs alone change
from the time you enter the first leg of the trade (i.e., before you unwind it) and say the
government passes a law increasing or lowering the tax on short term gains, or loses, or
something else. How would you control for that/those risks? Regarding ‗idiosyncratic risk‖,
clearly Nokia isn‘t exactly structured like Ericson (e.g., Ericson has a higher exposure to
transmission equipment relative to cell phones than Nokia, and sales are geographically different
in their span and concentration for each company). How do you take account of that kind of
specific business risk, or any other related risk for that matter? Of course I could go on. The
point to be made here is that what might seem a simple trade isn‘t. When one begins to consider
what it would take to truly perform an arbitrage or hedge, you begin to realize there really isn‘t
one where you are not exposed to many forms of risks and costs you hadn‘t originally considered
or wanted to be exposed to, any of which has an impact on both your ability and desire to make
the trade in the first place. In short, limits to arbitrage are ubiquitous; you just have to think about
it.

Kihn / Behavioral Finance 101 / 105

In addition to clear limits to arbitrage, there are at least two reasons prices may not be driven
toward their fundamental values quickly (or ever) by ‗smart money‘:
(1) prices can reflect an average of beliefs and/or expectations (e.g., if investors are risk
averse); and
(2) there are some psychological biases most, if not all, people will be unable to overcome
(e.g., overconfidence
89
).
Furthermore: ―Just as rational investors trade to arbitrage away mispricing, irrational investors
trade to arbitrage away rational pricing. The presumption that rational beliefs will be
victorious is based on the premise that wealth must flow from foolish to wise investors.
However, if investors are foolishly aggressive in their trading, they may earn higher rewards for
bearing more risk or for exploiting information signals more aggressively, and may gain from
intimidating competing informed traders. Indeed, one would expect wealth to flow from smart
to dumb traders exactly when mispricing becomes more severe, which could contribute to
self-feeding bubbles.‖
Daniel et al. (2002, p. 141)

In finance and economics all hell breaks loose when the marginal investor/bidder/buyer doesn‘t
determine price. For example, asymmetric information, and specifically the ‗lemons problem‘ is
a study in average pricing driving all sellers of non-lemons out of the market, which then results
in the market effectively locking up and no trades taking place (see Akerlof (1970)). The

89
It is important to note that even though it has been suspected that overconfidence and/or miscalibration causes, for
example, excessive trading, it is not exactly clear what effects it has in financial markets (see, e.g., Glaser and
Weber (2003) on their finding that miscalibration doesn‘t appear to be associated with trading volume, it seems
more likely that the extent of a differences of opinion is driving much of the result, at least for ‗day traders‘).
Kihn / Behavioral Finance 101 / 106

economic ‗lemons problem‘ originally resulted due to sellers having ‗asymmetric information‘
relative to buyers. That noted, what drives the result is, as usual, the math. The math is driven by
the price not being set at the margin. This is a general issue in economics, whereby when
marginal buyers and sellers don‘t set pricing we have a fundamental problem. Specifically, even
assuming specific economic forms of rationality, the theoretically normative market is likely not
to clear. In fact, there is reason to believe prices are not generally set purely by marginal
analysis.

Regarding psychological biases that are difficult to overcome, and although I am getting slightly
ahead of the subject, they almost surely exist. Common examples are overconfidence and
regret
90
.
―The field of modern financial economics assumes that people behave with extreme rationality,
but they do not. Furthermore, people‘s deviations from rationality are often systematic.
Behavioral finance relaxes the traditional assumptions of financial economics by incorporating
these observable, systematic, and very human departures from rationality into standard models of
financial markets. We highlight two common mistakes investors make: excessive trading and the
tendency to disproportionately hold on to losing investments while selling winners. We argue
that these systematic biases have their origins in human psychology. The tendency for human
beings to be overconfident causes the first bias in investors, and the human desire to avoid regret
prompts the second.‖

90
Regret is more than the pain of loss. It is the pain associated with feeling responsible for the loss, and the intensity
of that can vary with the loss. For example, I choose to drive to work according to a new route on a whim one day
and wreck my car in an accident, or short Nokia and the price immediately increases, etc., etc ... Regret will tend to
encourage me to not change my driving habits or investing habits in those two cases.
Kihn / Behavioral Finance 101 / 107

Barber and Odean (1999, p. 41 – abstract)

Regardless of reason, traditionally, if prices deviate from fundamental or economically intrinsic
value finance assumes that a rational arbitrageur will push prices back in the proper direction.
The one problem we now have is that finance academics no longer can agree on the pricing
model. If we cannot know the true economic value of a security, then we cannot say if prices
deviate from it, or whether the tale/story of the arbitrageur applies. Therefore, because no finance
‗model‘ is correct, it is impossible to know what is the true price is in economic modeling
terms.
91
But what if we actually knew the model? What if we could know what the true price
should be? Do we have any cases such as that? Answer: Yes we do, and let‘s review all of
them.
92


Actually, it‘s not much of a ―model‖; it‘s more of an identity called the Law Of One Price
(―LOOP‖), and basic algebra. Specifically, the LOOP is really a statement that the price of two
goods that are the same must be the same.
93
It directly applies to commodities, and clearly must
apply to something like two shares of the IBM. That is, specifically, there can be a slight bid-
offer spread between two identical shares, but their prices must be about the same if they are sold
around the same time. The nice thing about the LOOP is that it is something even EMT
academics can agree with. But note if LOOP breaks down, then there is not much we can say

91
Again, as Summers‘ (1986, p. 591) notes: ―speculation is unlikely to ensure rational valuations, since similar
problems of identification plague both financial economists and would be speculators.‖ Therefore, to the extent
academics don‘t know the model, why would prospective arbitrageurs be expected to know it?
92
I am leaving one related case for another chapter.
93
Of course, regarding the financial markets, small discrepancies can exist for things like transaction costs, and
larger differentials for timing differentials.
Kihn / Behavioral Finance 101 / 108

about anything in finance or economics. By extension, basic algebra should apply. In short, if
one plus one doesn‘t equal two, well then there isn‘t much we can say mathematically is there
(and effectively all ‗modern‘ finance and economics depend on mathematics)? Therefore, instead
of a model we are really just applying common sense and very basic math. That is why, the cases
selected were chosen, if one questions the ‗model‘ then basic logic and math can no longer be
applied.

Of the following four areas of evidence of mispricing and limits to arbitrage, three are cases of
the LOOP and/or basic addition, and the last is related more to limits to arbitrage and demand for
securities.
1. ‗Twin shares‘ or ‗dual-listed companies‘ (e.g., Royal Dutch 60% vs. Shell Transport
40% of cash flow implies 1.5 times ratio of pricing of Royal Dutch to Shell Transport). In
the Shell case they were virtually perfect substitutes.
2. ‗Internet carve-outs‘ (e.g., 3Com selling 5% of Palm Inc., the implied price of all of
3Com‘s other businesses was -$60 a share or at one point or -$23 billion). These are
direct violations of the LOOP and/or basic math. In 3Com case, the sum ≠ parts.
3. Closed-end fund discounts/premiums (e.g., most, if not all, closed-end funds –
‖CEFs‖). Also, these are direct violations of the ‗law of one price‘ and/or basic math. In
this case also, the sum ≠ parts.
4. ‗Index inclusions‘ (e.g., S&P 500 adds and drops, especially when pricing adjustment
lags).
Kihn / Behavioral Finance 101 / 109

In each and every case economic ‗law‘ is violated. Therefore, in every case we know the ‗model‘
or what should or shouldn‘t happen, yet it is violated anyway. My bet is that this isn‘t a random
thing, but I‘ll let the reader decide.

‗TWIN SHARES‘ OR ‗DUAL-LISTED COMPANIES‘
‗Twin shares‘ or ‗dual-listed companies‘ are also referred to as a ‗Siamese twin‘. They are two
companies incorporated in different countries, but possessing a contract where they agree to
operate their businesses as if they where one company. Each of the two legal entities effectively
agrees to a legal document where this structure is explicitly stated, and without agreement from
both, cannot be broken or changed in any way. In addition, they retain separate legal identities
and each is listed on a stock exchange. There is no economic or financial difference between the
two companies; in theory they should trade in an exactly parallel fashion. In short, there are no
known limits to arbitrage and we know the relative pricing function or ‗model‘ for each pair of
‗twins‘. For example, if company A and company B are the ‗twin shares‘ and their legal
agreement states that one share of company A is entitled to 60% of the combined company and
Kihn / Behavioral Finance 101 / 110

one share of company B is entitled to the remaining 40%, then A‘s shares must always trade at
1.5 times B‘s shares (0.6/0.4 = 1.5). Any deviation from this theoretical parity is not suppose to
happen (i.e., from a normative finance perspective) and, at a minimum, is likely due to limits to
arbitrage.

One classic case of ‗twin shares‘ is Royal Dutch NV (listed in Amsterdam) and Shell Transport
(listed in London) with a theoretical parity ratio of 1.5X. Therefore, any deviation is a clear sign
of the wrong relative price. What follows is such a graph where deviations from zero are
deviations from theoretical parity. Again, in normative theory there should be no deviations from
the zero line.


-32.0%
-30.0%
-28.0%
-26.0%
-24.0%
-22.0%
-20.0%
-18.0%
-16.0%
-14.0%
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
Royal Dutch NV to Shell Transport Deviation from Theoretical Value
January 1, 1980 - July 20, 2005
Kihn / Behavioral Finance 101 / 111

Source: Underlying data is from Mathijs A. van Dijk (webpage: http://mathijsavandijk.com/dual-listed-companies).

Even in the worst normative case what we should see is the blue line tightly oscillating around
0.0%. That is, if the markets were ‗efficient‘ in a traditional sense the relative differential or
value between the two companies‘ shares should be zero, or very close to it. They aren‘t.

Regarding the issue of magnitude, the maximum deviation from expected value is about 20%,
while the minimum deviation from expected value is about 30%. Therefore, historically the
overall swing around is about 50%.
94
This is large and very problematic. Did you expect such a
deviation from a known value?
95
Note also that the two shares are rarely equivalently priced (i.e.,
theoretical parity is rarely achieved). Therefore, based on relative pricing, most of the time the
prices of the two shares must be wrong (i.e., from a market efficiency perspective). Even if we
only had this one case
96
, it would be problematic, but as far as I know it happens in every ‗twin
share‘ case, similar to Shell‘s.

Furthermore, in case the reader had any doubts about the relative value of the two shares or
‗model‘, note that on October 28, 2004 the two companies announced they would be formally
unifying; and on July 20, 2005 the two shares were delisted.
97
As of delisting the relative values

94
Froot and Dabora (1999) find a similar swing relative to parity.
95
It is also problematic for ‗arbitrageurs‘ trying to take advantage of relative differentials narrowing (e.g., LTCM
trafficked in this one). Arbitragers are notoriously short-horizoned with limited risk tolerance Also, see Rosenthal
and Young (1990).
96
For mathematical purposes you only need one case to prove something is mathematically wrong. Therefore, this is
highly problematic for a field like finance that generally uses mathematical proofs to form normative models and
theory.
97
One share of Royal Dutch Petroleum Company was exchanged for two shares of Royal Dutch Shell plc class ‗A‘
shares (i.e., Shell Transport and Royal Dutch were merged at a 2-1 ratio, as the original ratio was legally stipulated).
Kihn / Behavioral Finance 101 / 112

converged to the expected differential of 0%. If the ‗model‘ were incorrect, why would that
happen?

How about another ‗twin share‘?

Source: Underlying data is from Mathijs A. van Dijk (webpage: http://mathijsavandijk.com/dual-listed-companies).

Again, what we should see is the blue line tightly oscillating around 0.0%. It doesn‘t, at least not
for long. The maximum deviation from expected value is about 44%, while the minimum
deviation from expected value is about 45% (although, both occurred relatively early in the
series). Therefore, historically the overall swing around true value is about 90%. Again, this is
large and very problematic. I could list others, but it seems that other cases illustrate the same
-45.0%
-40.0%
-35.0%
-30.0%
-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
Unilever NV to Unilever PLC Deviation from Theoretical Value
January 1, 1975 - October 3, 2002
Kihn / Behavioral Finance 101 / 113

kinds of lessons (albeit, regarding the magnitude of absolute deviation, the others wouldn‘t be as
dramatic as the two shown). Therefore, it isn‘t just that I sought out a single counter example to
prove some obscure point. In fact, this is the norm for the dozen or so ‗twin shares‘ cases that
exist and have been documented (see De Jong et al. (2008)).

Perhaps, other types of examples are available? What about another area where we know the
‗model‘, for example, how about ‗carve-outs‘?

‗CARVE-OUTS‘
An equity ‗carve-out‘ typically refers to the Initial Public Offering (―IPO‖) sale of common stock
by a corporation of one of its business units (i.e., the parent company publically sells a portion of
one of its subsidiary companies).
98
Typically, this involves selling less than the entire amount
(usually less than a controlling interest, or less than 50%), such that that parent retains a

98
There is a well established relationship between stock IPOs and market returns (see, e.g., Lowry and Schwert
(2002)). This would plausibly suggest that a ‗carve-out‘ is likely to be prompted by the expectation of a fundamental
difference between the parent‘s stock and the partial IPO candidate.
Kihn / Behavioral Finance 101 / 114

controlling equity stake in the subsidiary company. During the late 1990s, there was a relative
surge in this type of IPO, especially for technology companies.

The ‗model‘ in the case of ‗carve-outs‘ is algebra. Logically, the sum of a parent company‘s
parts should add up to the whole. For example, say parent company YZ is composed of company
Y and company Z. Algebraically, YZ = Y + Z (or at least very close to that).
99
That is, short of
logically justified extenuating circumstances, YZ cannot be worth significantly more or less than
the sum of its parts.

In their article aptly titled: ―Can the Market Add and Subtract? Mispricing in Tech Stock Carve-
outs‖, Lamont and Thaler (2003, p. 228) state: ―The most basic test of relative valuation is the
law of one price: the same asset cannot trade simultaneously at different prices. … the law of one
price is in many ways the central precept in financial economics.‖ Indeed, as we saw with ‗twin
shares‘, it isn‘t clear how normal violations are. Perhaps, violations are just a ‗twin shares‘
phenomenon, then again, perhaps they are the norm. If the latter is descriptively true, then the
basic normative foundations of finance must be called into question.

Furthermore, Lamont and Thaler (2003, p. 228) state: ―The driver of the law of one price is
arbitrage, defined as the simultaneous buying and selling of the same security for two different
prices. The profits from such arbitrage trades give arbitrageurs the incentive to eliminate any
violations of the law of one price. Arbitrage is the basis of much of modern financial theory,

99
Or possibly, that is, if the parent has positive net worth on its own, YZ ≥ Y + Z; or possibly, YZ ≤ Y + Z, if the
parent has negative net worth on its own. But, as a general rule, it is unlikely the value of the sum of the parts will
diverge significantly from the whole.
Kihn / Behavioral Finance 101 / 115

including the Modigliani-Miller capital structure propositions, the Black-Scholes option pricing
formula, and the arbitrage pricing theory.‖ Indeed, if the LOOP doesn‘t hold in one case, the
math of the aforementioned ‗models‘ can be called into question; but if the LOOP doesn‘t hold
in most known cases, then it is far from hyperbole to state that the basis for almost any normative
financial model is questionable (i.e., the ones that depend on arbitrage to derive their results).

Lamont and Thaler (2003) looked at eighteen ‗high-tech‘ equity ‗carve-outs‘ that are followed by
a ‗spin-off‘
100
during the period April 1996 through August 2000. Of particular note was their
definition of the ‗stub‘ (i.e., the remaining value of the parent company‘s business(es)). This is
critical because this is the algebraically implied value (i.e., given that we can observe the price of
the parent company‘s common shares and subsidiary‘s shares after IPO, and we know the
amount of outstanding shares for each). Their argument was that those cases of a ‗negative stub‘
are clear violations of the LOOP, whereas a positive stub may or might not be.
101
Given their
filter for selecting ‗carve-outs‘ that also had defined ‗spin-offs‘, their formula for ‗stub‘ was the
following:

100
In these cases, they identified those cases where the ‗spin-off‘ consisted of the parent company giving the non-
IPOed remaining subsidiary shares to the parent‘s shareholders. They were attempting to limit the argument that
their relative price comparison was being something other than actual observed prices for the parent and IPOed
subsidiary.
101
That is, we expect that the equity value parent company‘s other businesses are worth something positive, we just
don‘t know how much. Thus, for example, the true value of the parent company‘s other businesses might be 100, yet
we observe 1,100. Clearly, this appears to be a large positive mispricing, but we cannot know this without an
accepted valuation ‗model‘. Again, there is the ‗joint hypothesis‘ issue. Specifically, we don‘t have a clearly
accepted valuation model with which to analyze and test mispricing. But we do know that logically the value cannot
be negative, or else finance is turned on its head.
Of course, based on the same logic, a zero value also might denote mispricing.
Kihn / Behavioral Finance 101 / 116

, where

= the ‗stub‘ as a fraction of the parent,

= the parent stock price per share at date 0,

= the subsidiary stock price per share at date 0, x = the ratio of subsidiary shares that are
given to parent shareholders at the distribution date (i.e., for the ‗spin-off‘), and

= the ‗stub‘
value. Again, they are trying to imply the value of the unknown ‗stub‘ from the known parent
and subsidiary values (traded share prices and known shares amounts). The major point of the
analysis is that in no case should the parent‘s other businesses be negative in value. Thus, in no
case should there be a ‗negative stub‘; additionally, it follows that a ‗negative stub‘ is a clear
violation of the LOOP.
102


Of the eighteen cases analyzed, six or one third turned out to be ‗negative stubs‘. Of those six,
the case of the parent 3Com and its subsidiary Palm is particularly striking (see the following
graph of the implied stub share price). At one point the ‗negative stub‘ was valued at -$22 billion
or about -77% of the parent 3Com (i.e., all other businesses outside of Palm).
103
Per share, the
‗negative stub‘ worked out to be about -$60 per share (i.e., per the above calculation) at its
greatest deviation from intrinsic value.


102
In a sense this would be a violation of a simple and logical boundary condition.
103
Mitchell et al. (2002) make a similar analysis of 3Com and Palm, and also find a significant ‗negative stub‘.
Kihn / Behavioral Finance 101 / 117



Source: Lamont and Thaler (2003, p. 240).

Kihn / Behavioral Finance 101 / 118

It has been proposed that at least part of the explanation for the mispricing in cases like
3Com/Palm can be explained by investor overconfidence and salience/limited-attention effects
104

(see, e.g., Daniel et al. (2002, p. 154)). In addition, ‗noise traders‘ may often play some role in
creating risk that is difficult to quantify, but may retard arbitrage efforts.
105
Finally, Lamont and
Thaler (2001) and Mitchell et al. (2001) describe some of the frictions not allowing people to
short Palm and go long 3-Com. Whatever the reasons, it seems very likely there are limits to
arbitrage that effectively stifle arbitrage of what are viewed by academics as clear cases that
should be arbitraged, yet are not (i.e., at least in the way that traditional finance textbooks
suggest).

Lamont and Thaler (2003, p. 265) concluded by stating: ―There are two key findings of this
paper that need to be understood as a package. First, we observe gross violations of the law of
one price. Second, they do not present exploitable arbitrage opportunities because of the costs of
shorting the subsidiary. In other words, the no free lunch component of the efficient market
hypothesis is intact, but the price equals intrinsic value component takes another beating.
… Why should we be concerned? …
We think that a sensible reading of our evidence should cast doubt on the claim that market
prices reflect rational valuations because the cases we have studied should be the ones that are
particularly easy for the market to get right.‖

104
One of the more egregious documented set of cases is corporate name changes during the technology bubble,
where, for example, Cooper et al. (2001) found that companies that merely changed their names to Internet related
or ‗dotcom‘ names produced excess returns of around 74% for the ten days around the announcement, and the effect
seemed permanent.
105
‗Noise traders‘ are often put forth as a possible reason/excuse for deviations from market efficiency, especially
more recently. A classic theoretical reference on ‗noise traders‘ is De Long et al. (1990).
Kihn / Behavioral Finance 101 / 119


In short, the cases they reviewed received relatively high publicity and at the time analyzed
represented relatively large, liquid companies. If the markets don‘t get the price right on each of
those cases, which ones would we expect them to get the price fundamentally correct? Therefore,
by inference, what hope do we have for less liquid assets? Answer: ―Not bloody likely.‖ In fact,
there are many more cases where negative ‗stubs‘ have existed and persisted (see, e.g., Mitchell
et al. (2002)).
106
In the final analysis, it often isn‘t even arbitrageurs that correct such obvious
deviations from intrinsic or true value, but the companies themselves.

Again, not only are such direct tests of the ―price is right‖ rare, but the current version of
EMH/EMT may be completely insulated from what proof we do have. Although, at a minimum,
the following can be inferred:
1. Internet ―carve-outs‖ clearly show that the price can be wrong.
2. Internet ―carve-outs‖ seem to show that ―free lunches‖ are hard to come by.
3. Therefore, Internet ―carve-outs‖ can be said to be cases where there is no ―free lunch‖,
but the market is not efficient (or alternatively, the price is not right).
In fact, Internet ―carve-outs‖ show that irrational traders can determine pricing for some large
seemingly liquid financial securities. Thus, the price is wrong, but there is no ‗free lunch‘,

106
In their study, they analyze 82 cases where the subsidiary is worth more than their parent (i.e., all ‗negative stub‘
cases). They also find (Mitchell et al. (2002, p. 553) that ―negative stub values are not risk-free arbitrage
opportunities.‖ In many cases the parent companies ultimately devise ways to eliminate the arbitrage or an outside
entity may acquire the parent and/or subsidiary, but the arbitrage may last for longs periods of time. Like Lamont
and Thaler (2003), they too interpret their results to strongly support the ―package‖ notion that: (1) the equity
markets analyzed are not priced correctly, yet (2) it may be difficult to take advantage of this (especially risklessly).
Kihn / Behavioral Finance 101 / 120

whereas textbook finance has always assumed that as long as there was no ‗free lunch‘ the prices
must be right. The key to this seeming contradiction of basic finance is limits to arbitrage.

If ‗twin shares‘ and ‗carve-outs‘ don‘t support basic economic arguments concerning arbitrage,
are there any other areas where we are confident of the ‗model‘ and/or analysis to show whether
basic arbitrage is of questionable validity? A third area we could check is CEFs; and by now the
reader should be realizing that these examples are more likely to be the ―tip of the iceberg‖ than
the iceberg.

CLOSED-END FUNDS (―CEFS‖)
In its typical and most simple configuration, a CEF is a fund with a fixed number of shares
outstanding.
107
Typically, these shares are offered for public purchase in an IPO, after which they
are often traded on a stock exchange (but can also often be traded Over-The-Counter or ―OTC‖).

107
There are some that will issue shares periodically, but unlike an open-ended fund this is typically not done daily.
This also ignores levered CEFs.
Kihn / Behavioral Finance 101 / 121

These shares represent an underlying interest in a portfolio, often bonds or stocks, but also
covering most other standard financial assets. The market price for CEFs is determined at one or
more stock exchanges by buyers and sellers of the CEFs. In practice the traded exchange derived
price can and usually does diverge from its theoretical intrinsic value called Net Asset Value
(―NAV‖). If the market price is less than its NAV it is said to be trading at a ―discount‖, if the
market price is higher than its NAV it is said to be trading at a ―premium‖. Normatively, market
prices should not diverge from their respective NAVs, but they do.
108


For CEFs the intrinsic model/formula is as follows:

, where

= Net Asset Value of fund i at time t, and

= the value of the fund i
at time t is equal to the sum of the value of its N securities (i.e., the sum of all j securities from 1
to N at time t). Like equity ‗carve-outs‘ we are relying on the LOOP to check mispricings, but
unlike equity ‗carve-outs‘ there is no need to infer any pricing (i.e., with ‗carve-outs‘ we implied
the value of the ‗stub‘). Thus, the value of a fund at any time is simply the sum of its known and
valued parts. Therefore, unlike carve-outs we can check for all deviations from zero (negative
and positive). Also, note that for our purposes and for the sake of simplicity, the term fund and
portfolio are interchangeable.


108
In addition they tend to be significantly more volatile than their underlying asset values would indicate (see, e.g.,
Pontiff (1997)). Pontiff (1997) indicates that they are about 64% more volatile on a month-end average basis, and it
is not caused by non-synchronous or infrequent trading. This is relatively strong evidence against basic efficient
market theory.
Kihn / Behavioral Finance 101 / 122

For example, if a portfolio consisted of only two equity securities (call them A and B) that had a
per share market value of $10 and $20 at time t, respectively, and the portfolio owned 2 million
and 1 million shares at time t, respectively, then the value of the portfolio/fund would be $40
million, by definition. It is simply the LOOP establishing what should minimally be the
normative case regarding valuation.

With CEFs we actually know the pricing model, or at least we are very confident of it. Besides
‗twin shares‘ and certain equity ‗carve-outs‘, this may be the one area of finance where we
actually know the pricing model with precision, which is why it is such a clean example of the
first pillar of behavioral finance (i.e., limits to arbitrage)
109
, as well as possibly being a good
example of the second pillar.

Regarding other possible explanations of the pricing ‗model‘ for CEFs, academics have tried to
put forth rationalizations of why NAV is not the appropriate ‗model‘ (see, e.g., Schnabel‘s
discussion (1992, pp. 392-394)). In short, the excuses have been pathetic, convoluted, complex,
and mostly normative with little or no actual evidence, or complex and strained interpretations of
the evidence (see, e.g., Malkiel (1977) or Malkiel (1995)
110
). More recently, finance academics

109
Pontiff (1996, p. 1135) explicitly states that: ―Arbitrage costs lead to large deviations of prices from
fundamentals.‖ Also, he finds that deviations (whether discount/negative or premium/positive are increased by
funds: (1) that are difficult to replicate, (2) with smaller dividends, (3) with lower market values, and (4) when
interest rates are high.
110
Malkiel (1995) cited the following possible reasons for deviations from NAV: (1) turnover of fund shares, (2)
dividend distribution or payout policy, (3) insider ownership, and (4)-(8) ―other variables‖ – which include, but are
not limited to, (4) expense ratios, (5) previous track record of the fund, (6) foreign ownership, (7) absolute price
level of the fund, and (8) fund size. In addition, although not analyzed, he posits a ninth variable, ―reputation and
public relations effects‖ (Malkiel (1995, p. 37)). That most, or all, of these potential explanations don‘t directly
support the notion that discounts and/or premiums can be well explained by the EMH/EMT doesn‘t seem to bother
Kihn / Behavioral Finance 101 / 123

have seemed to reconcile themselves to NAV (see, e.g., Brickely and Schallheim (1985) on
opening CEFs and convergence to NAV), but it has taken time and they do not seem to have
gone without reservations. In short, admitting to a pricing model opens one up to an actual test,
and we can‘t have that, can we? Academic history aside, there are two basic yet conclusive
reasons to be confident in why NAV is the appropriate pricing model: (1) the portfolio managers,
and their related investment companies, of the funds say and act as if it is, and (2) when a CEF is
―opened‖ the market price converges to NAV.
111
Thus, even ignoring what the ―professionals‖
say or do, and much like the case of ‗spin-offs‘ combined with an equity ‗carve-out‘, the opening
of a CEF results in a price convergence to NAV, thereby proving that even the market
understands what the true value model is when forced to (i.e., regardless of what financial
economists normatively theorize).

Assuming we have the correct ‗pricing model‘ (which I have great confidence that we do), any
deviation of a fund‘s market price from NAV represents mispricing. Do we have evidence of
mispriced CEFs?

As of one date
112
I took the largest discount and premium CEFs and two others as examples.
First, the largest discount CEF.

the author, yet he suggests as much. Although, Malkiel (1977, p. 857) does admit that: ―This suggests that market
psychology has an important bearing on the level and structure of discounts.‖
111
That is, when the portfolio of the fund is actually closed and sold off, the overall value it receives for the portfolio
is approximately, if not exactly, equal to its NAV. Again, see, for example, Brickley and Schallheim (1985), or
Brauer (1984).
112
September 5, 2009, for data typically ending on September 4, 2009 or August 31, 2009.
Kihn / Behavioral Finance 101 / 124


Source: Data from www.etfconnect.com/.

Not exactly a pillar of market efficiency? Remember, normatively the line should be right on top
of zero, but during this time period it seems to be always and significantly below zero.
Therefore, it is always discounted from July 1993 through August 2009 (and moves from a high
discount of about 73% to a low discount of about 10%, which translates to a swing of about 63%,
but market values are always below NAVs during this period, which was as far back as the data
went).

How about the largest premium CEF for that date?
-75.0%
-70.0%
-65.0%
-60.0%
-55.0%
-50.0%
-45.0%
-40.0%
-35.0%
-30.0%
-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
J
u
l
-
9
3
M
a
r
-
9
4
N
o
v
-
9
4
J
u
l
-
9
5
M
a
r
-
9
6
N
o
v
-
9
6
J
u
l
-
9
7
M
a
r
-
9
8
N
o
v
-
9
8
J
u
l
-
9
9
M
a
r
-
0
0
N
o
v
-
0
0
J
u
l
-
0
1
M
a
r
-
0
2
N
o
v
-
0
2
J
u
l
-
0
3
M
a
r
-
0
4
N
o
v
-
0
4
J
u
l
-
0
5
M
a
r
-
0
6
N
o
v
-
0
6
J
u
l
-
0
7
M
a
r
-
0
8
N
o
v
-
0
8
J
u
l
-
0
9
Discounts/Premiums for the Equus Total Return Fund
Kihn / Behavioral Finance 101 / 125


Source: Data from www.etfconnect.com/.

For the last nine months or so the fund has been selling at a premium to its NAV, but before that
it has swung from premium to discount and back again. The absolute deviation from May 2005
until August 2009 has been in excess of 80%.

Given that the first two were recent extremes, how about a specialty stock CEF and a bond CEF?
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
55.0%
60.0%
65.0%
70.0%
M
a
y
-
0
5
J
u
l
-
0
5
S
e
p
-
0
5
N
o
v
-
0
5
J
a
n
-
0
6
M
a
r
-
0
6
M
a
y
-
0
6
J
u
l
-
0
6
S
e
p
-
0
6
N
o
v
-
0
6
J
a
n
-
0
7
M
a
r
-
0
7
M
a
y
-
0
7
J
u
l
-
0
7
S
e
p
-
0
7
N
o
v
-
0
7
J
a
n
-
0
8
M
a
r
-
0
8
M
a
y
-
0
8
J
u
l
-
0
8
S
e
p
-
0
8
N
o
v
-
0
8
J
a
n
-
0
9
M
a
r
-
0
9
M
a
y
-
0
9
J
u
l
-
0
9
S
e
p
-
0
9
Discounts/Premiums for the PIMCO Global Stock+Income Fund
Kihn / Behavioral Finance 101 / 126


Source: Data from www.etfconnect.com/.

In this case we have a relatively long history of relatively volatile discounts and premiums,
especially premiums. The absolute deviation from September 1995 through August 2009 is over
90%.

-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
55.0%
60.0%
65.0%
70.0%
75.0%
S
e
p
-
9
5
A
p
r
-
9
6
N
o
v
-
9
6
J
u
n
-
9
7
J
a
n
-
9
8
A
u
g
-
9
8
M
a
r
-
9
9
O
c
t
-
9
9
M
a
y
-
0
0
D
e
c
-
0
0
J
u
l
-
0
1
F
e
b
-
0
2
S
e
p
-
0
2
A
p
r
-
0
3
N
o
v
-
0
3
J
u
n
-
0
4
J
a
n
-
0
5
A
u
g
-
0
5
M
a
r
-
0
6
O
c
t
-
0
6
M
a
y
-
0
7
D
e
c
-
0
7
J
u
l
-
0
8
F
e
b
-
0
9
S
e
p
-
0
9
Discounts/Premiums for the Templeton Russia & East European Fund
Kihn / Behavioral Finance 101 / 127


Source: Data from www.etfconnect.com/.

In this case we have a tax-exempt New York bond CEF that even with relatively less volatile
underlying securities (i.e., say relative to the previous Russian and Eastern Europe stock CEF)
still manages to realize an about 30% absolute movement over about ten and one half years. I
could go over more individual cases, but it now might help to be more aggregated.

What follows are showing median discounts/premiums for groups of CEFs.
113


113
According to the Closed-End Fund Association‘s website, as of September 4, 2009 there were 676 CEFs
representing about $185 billion in NAV.
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
J
a
n
-
9
9
J
u
n
-
9
9
N
o
v
-
9
9
A
p
r
-
0
0
S
e
p
-
0
0
F
e
b
-
0
1
J
u
l
-
0
1
D
e
c
-
0
1
M
a
y
-
0
2
O
c
t
-
0
2
M
a
r
-
0
3
A
u
g
-
0
3
J
a
n
-
0
4
J
u
n
-
0
4
N
o
v
-
0
4
A
p
r
-
0
5
S
e
p
-
0
5
F
e
b
-
0
6
J
u
l
-
0
6
D
e
c
-
0
6
M
a
y
-
0
7
O
c
t
-
0
7
M
a
r
-
0
8
A
u
g
-
0
8
J
a
n
-
0
9
J
u
n
-
0
9
Discounts/Premiums for the Eaton Vance New York Muni Income Trust
Kihn / Behavioral Finance 101 / 128


As you can see, sometimes the discounts and premiums of various groupings of CEFs move
together and sometimes they don‘t (but mostly they do). One thing that can be said with a high
degree of confidence is that there are large discounts and sometimes premiums across the five
groupings in the graph (Latin American equities, Pacific equities excluding Japanese, value,
growth, and general bond), and, of course, these markets aren‘t efficient in the current textbook
sense of the term. In fact, it is normal for the market price of the median CEF to significantly
diverge from its NAV. It could be said, that much like a broken clock, to the extent the price is
right, it seems more due to random chance than by the forces of something like arbitrage.

Regarding the specific co-movements of the median group discount/premium to that of the other
four, the following table should provide some background.
-45
-25
-5
15
35
55
75
D
i
s
c
o
u
n
t
/
P
r
e
m
i
u
m
Date
Various Closed-End Fund Groupings' Median Discounts/Premiums
Latin American Funds
Pacific Ex Japan Funds
Value Funds
Growth Funds
General Bond Funds
Kihn / Behavioral Finance 101 / 129


More specifically, the correlations between the five groups are interesting. For some pairs the
correlations are negative (e.g., Latin American and General Bond) and for others positive (e.g.,
Pacific and General Bond). Therefore, clearly, not only do individual market prices significantly
deviate from NAVs, but groups can and do as well. In addition, not only do group market values
deviate from their NAVs, but group deviations can significantly deviate from other groups.
114

Furthermore, not only do groups deviate from other groups, but the sign of that deviation can be
negative or positive (i.e., not all groups are impacted by the same discount/premium forces at the
same time).
115


If individual and group discount and premiums are all over the place, could actual underlying
security prices deviate from economic or intrinsic value?


114
Although, they generally move together, it is just that that is not always the case.
115
Thus far, the best explanation for deviations of the NAV from market price has been Lee et al. (1991). Small
investors are the primary power behind this explanation. Changes in small investor sentiment are correlated with the
discounts, and issuance itself.

Correlations among the Lipper CEF Groupings (monthly data - August 1988 through December 2002)
Latin American Funds Pacific Ex Japan Funds Value Funds Growth Funds General Bond Funds
Latin American Funds 1
Pacific Ex Japan Funds 0.021 1
Value Funds (0.068) (0.050) 1
Growth Funds (0.088) 0.377 0.587 1
General Bond Funds (0.174) 0.592 0.256 0.399 1
Kihn / Behavioral Finance 101 / 130

THE ISSUE OF ABSOLUTE VS. RELATIVE PRICES AND ARBITRAGE
Regarding limits to arbitrage and pricing efficiency, in the three set of examples examined in this
chapter thus far (‗twin shares‘, ‗carve-outs‘, or CEFs) none were remotely supportive of the
textbook story concerning arbitrage. What is important to point out before proceeding is that all
the preceding violations of the LOOP were in many cases large and discouraging from a standard
normative financial economics standpoint, but they do not address price levels themselves being
right (i.e., efficient). At this point I have only shown cases of the LOOP were we know or are
very confident of the ‗model‘ to use to judge whether pricing is wrong from an efficiency
standpoint, but that doesn‘t mean there isn‘t even more disturbing pricing news for the
EMH/EMT.

For example, a CEF may not have a market price equal to its NAV and that is a violation of the
LOOP, but it doesn‘t mean that the prices of the securities in its portfolio are correct from a
pricing efficiency standpoint. Specifically, an equity CEF may have shares of IBM, but we
haven‘t examined whether the price of IBM is right, we only know with a high degree of
confidence that its relative market value to NAV is off say by -25%. In effect, we cannot be
confident of any of the absolute underlying stocks in the portfolio of the CEF.

Ironically, this is an endemic problem to finance. This is odd because practical finance (i.e., the
actual financial markets upon which the field of study must ultimately explain) is largely
concerned with valuing securities on an absolute basis. In academic and actual finance, most
pricing ‗models‘ assume that price levels are correct or efficient. This is highly unlikely. I will
Kihn / Behavioral Finance 101 / 131

come back to this issue in a later chapter, but it should be noted that to the extent the LOOP on a
relative basis can be off by more than 50% (and as shown by the examples in this chapter, it
can), it is dubious at best that absolute prices cannot diverge from true value by much more than
some of the more egregious cases of relative pricing inefficiency we have witnessed thus far.

To the best of my knowledge, most, or likely all, normative financial pricing models assume
(either implicitly or explicitly) that the absolute price of the asset is correct. Generally, normative
financial models (e.g., option pricing models) are not concerned with the initial price or
underlying price (it is assumed ‗correct‘). Therefore, empirical tests and analysis in finance
generally ignores whether absolute pricing is efficient and often infers that it is because relative
prices tend to move together. For example, bond prices tend to move together, yet the base level
seems to have heavy input from one market participant (i.e., the Central Bank – ―CB‖).
116

Therefore, it could be said that on a relative price movement basis the government bond
market may be the most “efficient” financial market, yet on an absolute basis one of the
least efficient financial markets.
117
Finally, as usual, the simplifying assumption is often done
for mathematical tractability (i.e., think derivatives); but by ignoring a critical issue that turns out
to be both relevant and significant, the results are dubious at best, and the pricing is anything but
efficient.


116
Note, regarding the comment about the bond market(s), the absolute pricing is heavily dependent on the current
fiat system vs. traditional monetary systems throughout history. We will get to this again in the chapter concerning
absolute pricing and market efficiency.
117
As per the above, we will address this issue in the chapter concerning absolute pricing and market efficiency.
Kihn / Behavioral Finance 101 / 132

‘INDEX INCLUSIONS‘ OR INDEX ADDS AND DROPS
As with clean examples of the LOOP, it is difficult to find clean examples of non-information.
That is, with the LOOP it is difficult to find cases where we can agree on the pricing ‗model‘;
correspondingly with informational efficiency it is difficult to find cases where we can control
for the information part of the price and information question. That is because, normally, many
things can affect market prices, by the simple fact that markets are not closed environments for
social experiments. Regarding clean cases of information and market prices, ‗index inclusions‘
or index adds and drops are one relatively clean set of examples, and they have the added benefit
of showing another relatively clean set of examples of limits to arbitrage.
118


A key central tenant of efficient pricing is that information, especially public information, should
be imbedded in prices and non-information shouldn‘t move prices; in addition, it is assumed that
arbitrage is unlimited. Thus, not only should known information or non-information not move
prices, but, in addition, unlimited arbitrage means that demand curves for securities are infinitely
elastic (or perfectly flat). That is, arbitrage causes flat demand curves for securities. Related to
these two assumptions/arguments of ‗modern finance‘, and although not a LOOP issue per say,
as securities are added and dropped from indices this is not (i.e., from a normative finance
perspective) supposed to move prices. The rationale behind this is that the market for financial
securities is supposed to possess a ‗flat demand curve‘ (i.e., and/or perfect competition is
assumed). In such a market each share is assumed a perfect substitute for another. Remember,

118
―IPO lock-up‖ periods might be another set, that also provide strong evidence that: (1) the demand curve for
stocks is not flat but downward sloping (like the basic result for index adds and drops), and (2) there appears to be a
‘free lunch‘, but seems unavailable for eating (much like the basic result for ―Internet carve-outs‖). See Ofek and
Richardson (2000) for an enlightening example of these two results that add clearly to our view that the markets are
inefficient, there are limits to arbitrage, and ‗free lunches‘ appear but are hard to come by.
Kihn / Behavioral Finance 101 / 133

finance is all about discounted cash flows. To the extent I can exactly or very nearly replicate a
cash flow or cash flows at the same discount rate(s), I am indifferent between the two cash flows
(or sets of cash flows), or so the normative argument goes. In short, if the cash flow(s) and
discount rate(s) is/are the same, it shouldn‘t matter where the cash flow(s) comes from. In a
market where securities are perfect substitutes, the price shouldn‘t move at all.
119
Add to that,
the fact that prices move when the announcement of an inclusion is made and often after the
announcement, means that, at a minimum, we can infer that the demand curves for these
securities are not flat. Therefore, prices are being set where supply is clearly constrained
120
and
demand is clearly not infinitely elastic.
121
It is the demand part that is particularly problematic for
normative finance, and it should not be happening (i.e., not from a normative theory
perspective).

Let‘s take the S&P 500 as an example. Based on several public criteria, a committee establishes
which stocks are included in the index, and conversely which ones will be dropped (see the
standardandpoors.com website for details).
122
The index is supposed to represent many of the
500 largest U.S. companies listed on the major U.S. exchanges (typically these 500 are over
3/4
ths
of the market capitalization of all U.S. common stocks). For the S&P 500 index a public
announcement is made toward the end of the month at least several days before the physical
change in the index is made concerning which stock(s)s will be excluded and which will replace
that/those being dropped, or just added to replace a merger, etc.. In a normal month at least one

119
This is the classic argument/story as described by, for example, Scholes (1972) regarding large blocks of stocks.
120
This is to be expected in the short run.
121
This is the normative surprise.
122
Of course, if a firm is merged or goes bankrupt, etc., then an addition must be made.
Kihn / Behavioral Finance 101 / 134

common stock is dropped and another is added (hence the constant 500 moniker). There have
been several academic studies tracking the ‗anomalous‘ pricing behavior of those shares added to
and dropped from the S&P 500 index (which could be argued to be the most liquid, and hence,
least susceptible to this type of normatively inefficient pricing behavior).

Again, as mentioned at the top of the chapter, the problem with hedging is that there really are no
perfect hedges and/or arbitrage, and ‗index inclusions‘ is a good set of examples of that.
Sometimes, for example, there just isn‘t an exact substitute for a share of IBM. If you are
indexed to the S&P 500 and it is dropped from the index and XYZ company shares are added, it
is simply the case that you must sell your IBM shares and buy XYZ shares (i.e., unless you
desire to be exposed to more risks than are included in the S&P 500 index). Normative theory
might suggest alternatives, but the descriptive reality of the financial markets is that there just
isn‘t a riskless substitute for the two sets of cash flows.

Based on academic research, it has been found by Harris and Gurel (1986) that inclusions to the
S&P 500 index result in slightly more than a positive 3% price move following the
announcement
123
, while the smaller set of drops examined resulted in about a 1.4% decline in
price following the announcement.
124
Furthermore, they find that much of that movement is then
reversed within two weeks. Unless there is some information conveyed by the announcement
that fundamentally indicates future prospects for the adds are greater than the day before and

123
The finding is supported by others (e.g., see Wurgler and Zhuravskaya (2002)).
124
In addition, Barberis et al. (2003) find that after inclusion in the S&P 500 a stock‘s ‗Beta‘ goes up. This type of
result is also more easily, and more likely, explained by limits to arbitrage, rather than traditional fundamental based
market efficiency.
Kihn / Behavioral Finance 101 / 135

future prospects for the drops are worse than the day before, these moves are not suppose to
happen. Also, given the evidence, it is highly unlikely future profitability is what is impacting
prices (see, e.g., Harris and Gurel (1986) and Wurgler and Zhuravskaya (2002)). The most
plausible explanation is demand, and that is both evidence against unlimited arbitrage and
informationally efficient markets.

As Wurgler and Zhuravskaya (2002, p. 605), stated:
―The results of this article lead us to differ with Ross (1987), who writes, ‗not to say that the
intuition and the theories of finance cannot be fit into the framework of supply and demand,
rather that doing so does not gain us much. The fit is awkward and irrelevant at best.‘ A
methodological investigation of the limits to arbitrage, and the implications of these limits for the
shapes of excess demand curves for stocks, seems likely to improve our understanding of the
growing set of empirical findings that are difficult to explain with models that assume unlimited
arbitrage.‖
Indeed, there is no evidence that unlimited arbitrage exists, yet there is growing evidence that
there are significant and varied limits to arbitrage that affect pricing in the actual financial
markets. Therefore, and although ‗awkward‘, it seems advisable to structure finance around the
notions that demand curves aren‘t flat and limits to arbitrage not only exist, but are also
significant and important.

Kihn / Behavioral Finance 101 / 136

REFERENCES
Akerlof, G., ―The Market for ‗Lemons‘: Quality Uncertainty and the Market Mechanism‖,
Quarterly Journal of Economics, Volume 84, Issue 3, August 1970, 488-500.

Barber, B., and T. Odean, ―The Courage of Misguided Convictions‖, Financial Analysts Journal,
Volume 55, Number 6, November/December 1999, 41-46.

Baberis, N., Shleifer, A., and J. Wurgler, ―Comovement‖, Working Paper, October 2003, 1-45.

Brauer, G., ―‘Open-ending‘ closed-end funds‖, Journal of Financial Economics, Volume 13,
Issue 2, December 1984, 491-507.

Brickley, J., and J. Schallheim, ―Lifting the Lid on Closed-End Investment Companies: A Case
of Abnormal Returns‖, Journal of Financial and Economic Analysis, Volume 20, Number 1,
March 1985, 107-117.

Cooper, M., Dimitrov, O., and P. Rau, ―A Rose.com by Any Other Name‖, Journal of Finance,
Volume LVI, Number 6, December 2001, 2371-2388.

Daniel, K., Hirshleifer, D., and S. Teoh, ―Investor psychology in capital markets: evidence and
policy implications‖, Journal of Monetary Economics, Volume 49, Issue 1, January 2002, 139-
209.
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D‘Avolio, G., ―The market for borrowing stock‖, Journal of Financial Economics, Volume 66,
Issues 2-3, November-December 2002, 271-306.

De Jong, A., Rosenthal, L., and M. van Dijk, ―The Risk and Return of Arbitrage in Dual-Listed
Companies‖, Working Paper, August 2008, 1-36.

De Long, J., Shleifer, A., Summers, L., and R. Waldmann, ―Noise Trader Risk in Financial
Markets‖, Journal of Political Economy, Volume 98, Number 4, August 1990, 703-738.

Froot, K., and E. Dabora, ―How are stock prices affected by the location of trade?‖, Journal of
Financial Economics, Volume 53, Number 2, August 1999, 189-216.

Glaser, M., and M. Weber, ―Overconfidence and Trading Volume‖, Working Paper, April 2003,
1-55.

Harris, L., and E. Gurel, ―Price and Volume Effects Associated with Changes in the S&P 500
List: New Evidence for the Existence of Price Pressures‖, Journal of Finance, Volume XLI,
Number 4, September 1986, 815-829.

Hirschleifer, D., Subrahmanyam, A., and S. Titman, ―Feedback and the Success of Irrational
Traders‖, Working Paper, June 2002, 1-41.
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Jones, C., and O. Lamont, ―Short-sale constraints and stock returns‖, Journal of Financial
Economics, Volume 66, Issues 2-3, November-December 2002, 207-239.

Lamont, O., and R. Thaler, Can the Market Add and Subtract? Mispricing in Tech Stock Carve-
outs‖, Journal of Political Economy, Volume 111, Issue 2, April 2003, 227-268.

Lee, C., Shleifer, A., and R. Thaler, ‖Investor Sentiment and the Closed-end Fund Puzzle‖,
Journal of Finance, Volume 46, Issue 1, March 1991, 75-109.

Lowry, M., and W. Schwert, ―IPO Market Cycles: Bubbles or Sequential Learning?‖, Journal of
Finance, Volume LXVII, Number 3, June 2002, 1171-1198.

Malkiel, B., ―The Valuation of Closed-End Investment-Company Shares‖, Journal of Finance,
Volume 32, Number 3, June 1977, 847-859.

Malkiel, B., ―The Structure of Closed-End Fund Discounts Revisited‖, Journal of Portfolio
Management, Volume 21, Number 4, Summer 1995, 32-38.

Mitchell, M., Pulvino, T., and E. Stafford, ―Limited Arbitrage in Equity Markets‖, Journal of
Finance, Volume LVII, Number 2, April 2002, 551-584.

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Ofek, E., and M. Richardson, ―The IPO Lock-Up Period: Implications for Market Efficiency and
Downward Sloping Demand Curves‖, Working Paper, January 2000, 1-38.

Pontiff, J., ―Costly Arbitrage: Evidence from Closed-End Funds‖, Quarterly Journal of
Economics, Volume 111, Issue 4, November 1996, 1135-1151.

Pontiff, J., ―Excess Volatility and Closed-End Funds‖, American Economic Review, Volume 87,
Number 1, March 1997, 155-169.

Rosenthal, L., and C. Young, ―The seemingly anomalous price behavior of Royal Dutch/Shell
and Unilever N.V./PLC‖, Journal of Financial Economics, Volume 26, Issue 1, July 1990, 123-
141.

Shleifer, A., R. Vishny, ―The Limits of Arbitrage‖, Journal of Finance, Volume LII, Number 1,
March 1997, 35-55.

Scholes, M., ―The Market for Securities: Substitution versus Price Pressure and Effects of
Information on Share Prices‖, Journal of Business, Volume 45, Number 2, April 1972, 179-211.

Schnabel, J., ―Corporate Spin-Offs and Closed-End Funds in a State-Preference Framework‖,
Financial Review, Volume 27, Number 3, August 1992, 391-409.

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Summers, L., ―Does the Stock Market Rationally Reflect Fundamental Values?‖, Journal of
Finance, Volume 41, Number 3, July 1986, 591-601.

Thaler, Richard, The Winner‘s Curse: Paradoxes and Anomalies of Economic Life, Princeton
University Press, Princeton, New Jersey, 1994 (originally published 1992).

Treynor, J., ―Bulls, Bears, and Market Bubbles‖, Financial Analysts Journal, Volume 54,
Number 2, March/April 1998, 69-74.

Wurgler, J., and E. Zhuravskaya, ―Does arbitrage flatten demand curves for stocks?‖, Journal of
Business, Volume 75, Number 4, October 2002, 583-608.








Kihn / Behavioral Finance 101 / 141

Chapter 5: Psychology or the second „pillar‟ of behavioral finance

Again, if economically rational arbitrageurs would likely correct most mispricing in most
markets without any limits to arbitrage, then, with respect to pricing in the financial markets, the
psychology part might be irrelevant.
125
But there are limits to arbitrage, and depending on such
things as to which market and securities we are interested in, they can be ubiquitous, large, and
lasting. Thus, we have the necessary, but not sufficient condition for psychology to matter in the
financial markets. Of course, even if psychology turned out to be descriptively unimportant,
limits to arbitrage could mean that normative finance is still just plain silly. That is, specifically,
basing mathematical finance ‗models‘ on assumptions that are known empirically to be untrue
could be, at best, counterproductive. Furthermore, if it turned out to be the case that of the two
‗pillars‘ to behavioral finance that only the limits to arbitrage piece survived true empirical
scientific scrutiny, then I would still argue that the current normative emphasis in finance is
badly misplaced and should be replaced with a descriptive methodology and emphasis.
126

Therefore, consider the psychology part of behavioral finance a kind of descriptive bonus gift.

In this chapter we will proceed as follows:
1. List off the short list of documented psychological biases that are likely to impact pricing
in the financial markets.

125
Of course, in the first place, there is the issue of pricing itself and whether we can ever know what market
efficiency is empirically.
126
The problem with behavioral finance, and especially psychology, isn‘t that it can‘t explain actual financial market
phenomenon, the problem is that it can potentially explain anything. Therefore, in a sense, it often explains too
much without the typical normative simplifications we have come to expect within economics. That is, it can often
lack the parsimony we often find in natural science theories.
Kihn / Behavioral Finance 101 / 142

2. Regarding decision biases, list off a more complete list of documented psychological
biases that cover most of what could possibly affect decision making in the financial
markets.
3. Briefly review neuroeconomics.
4. Give an example of likely direct link from psychology to pricing in certain specific
financial markets.
It is important to remember, that these lists of ―offenses‖ are only offenses to normative finance,
statistics, economics, etc. Psychology doesn‘t consider them odd, by definition and descriptively,
they just are. Thus, from a psychological and/or biological viewpoint humans on average don‘t
have ―cognitive biases‖ per say, but they probably serve some purpose, possibly evolutionary at
some stage of evolution, even if they systematically result in financial losses due to trading in the
financial markets.

Kihn / Behavioral Finance 101 / 143

THE SHORT LIST OF KNOWN OFFENSES
Cognitive psychologists have noted the following systematic biases that relate to markets (mostly
related to beliefs and preferences):
1. Overconfidence (people are ‗poorly calibrated‘ when estimating probabilities and tend to
provide too narrow ranges).
2. Optimism and wishful thinking (e.g., everyone is above average, and underestimates
how quickly a task will be accomplished).
3. Representativeness (e.g., Tversky‘s and Kahneman‘s (1974) example).
4. Conservatism (seemingly in contradiction to representativeness).
5. Belief perseverance and confirmation bias (which is a stronger version of belief
perseverance). In short, denial is easy for most of us.
6. Anchoring (too much weight on initial value, then adjust too slowly).
7. Availability biases (e.g., probability of getting mugged in NYC).

A specific measurable characteristic of overconfidence is that when people are ‗poorly
calibrated‘ when estimating probabilities they tend to provide too narrow ranges.
127
To the extent
to which there is a mainstream
128
behavioral finance, overconfidence is probably considered one
of the most important psychological biases displayed by most humans. This is because
overconfidence may have significant impacts on both pricing and the willingness to trade itself.
In addition, it may be due to at least two other biases (see Barberis and Thaler (2002, p. 12

127
When overconfident the range is too small, whereas when underconfident the range is too wide – which covers
only a small fraction of the population relative to overconfidence.
128
Given that it is marginalized, often ignored, and assumed to be an add-on to normative finance, this is a bit of an
oxymoron. The point is that those that have published in primarily mainstream finance journals have spent a good
deal of time referring to this as a potential psychological cause of much financial market mayhem.
Kihn / Behavioral Finance 101 / 144

footnote #10)): self-attribution bias (where people see their own talents as being responsible for
something positive, and blaming bad luck for negative outcomes) and hindsight bias (after an
event has occurred many people tend to take credit for predicting it; and people tend to claim
they predicted the past better than they actually did). Obviously, if overconfidence is a good
example, then the psychological piece isn‘t easy to compartmentalize. Like overconfidence,
many psychological phenomena are interrelated with other psychological phenomena (and likely
limits to arbitrage).

Some classic biases related to optimism and wishful thinking are: (1) Students systematically
overestimate how they will do on exams. (2) Even after knowing the actual statistics, almost all
newlyweds expect their marriages to last forever. (3) Typically over 90% of people believe they
are above average in driving skill, humor, and ability to get along with others, etc. (see Weinstein
1980)). Simply put, people tend to be overly optimistic about positive outcomes and under
optimistic about negative outcomes.
129
It results in applying too high of probabilities to positive
outcomes and too low of probabilities to negative outcomes. This is fine, but applied to buying
and selling financial assets it may be normatively problematic for the investor and overall
pricing.

Representativeness or how alike something is to that which is known. Tversky and Kahneman
(1973) originated the notion of a representative heuristic, which is a rule of thumb wherein
people tend to judge the probability or frequency of something by considering how much that
thing or concept resembles available data on like things or concepts, as opposed to using a

129
Although, there is a tendency for people to overestimate small negative probability events.
Kihn / Behavioral Finance 101 / 145

Bayesian
130
calculation. Specifically, using a representativeness heuristic can result in neglect of
relevant base rates and other cognitive biases. Representativeness also leads to another bias
called sample size neglect (people often fail to take account of the sample size when judging
probabilities; also known as the ‗law of small numbers‘, which can generate the ‗gambler‟s
fallacy‟ effect where people will say or insist that a tail event is due). Shefrin (2007, pp. 14-16)
provides an example of incoming freshman and how well they will do based on high school
grades vs. how well they actually do. It can also lead to such silliness as ‗hot hand‘ phenomenon
(where people expect, for example, an athlete to perform above their normal ability level during
a ‗streak‘). Regarding occupations, Kahneman and Tversky (1974) showed people who tried to
predict by taking the closest match to past patterns, without attention to the observed probability
of matching the pattern (also, see Shiller (2002, p. 18)). Specifically, for example, if an
occupation is very rare, but a person knows someone with that occupation and a description of
another person seems representative of that person with the rare occupation people tend to
indicate the probability of the other person having that occupation is much higher than it really
is. The relationship to finance is that saliency and related representativeness may drive decisions
and associated probabilities much more than they normatively should.

Conservatism leads to an over-emphasis on base rates, while representativeness leads to an
underweighting of base rates. This is due to the saliency of the model used.
131
For example, in

130
From Wikipedia: ―Bayesian probability is one of the most popular interpretations of the concept of probability.
The Bayesian interpretation of probability can be seen as an extension of logic that enables reasoning with uncertain
statements. To evaluate the probability of a hypothesis, the Bayesian probabilist specifies some prior probability,
which is then updated in the light of new relevant data. The Bayesian interpretation provides a standard set of
procedures and formulae to perform this calculation.‖
131
For example, Shiller and Pound (1986) create an epidemic contagion model where saliency ―infects‖ institutional
investors. The survey they circulated strongly indicated the importance of social contagion and saliency.
Kihn / Behavioral Finance 101 / 146

the conservative case if a data sample is presented as old, people overweight their priors (i.e.,
conservatism); and if the data presented is new, they tend to overweight that (i.e.,
representativeness).

Under belief perseverance one could consider the EMH and EMT as examples. It is emotionally
difficult for most, if not all, people to allow their beliefs to be subject to potent logical or
empirical challenges. Some people can even survive the total destruction of their original
evidential bases (see Ross and Anderson (1982)). It seems that the need to maintain a false belief
is strongly related to maintaining a positive self-image and can be independent of reasoning (see
Guenther and Alick (2007)). In short, people ignore and/or pervert logic and/or evidence that
contradicts their beliefs; while under confirmation bias, people will reinterpret evidence against
as evidence in favor (again, think of the supporters of the EMH and EMT). Also, consider the
importance of cognitive dissonance, in supporting both belief perseverance and confirmation
bias, and would also seem directly related to the two.

Anchoring is a bias that describes the tendency to rely too heavily on one piece of information
when making decisions. Typically people anchor on specific information or a specific value and
then adjust from that value. Once the anchor is set, there tends to be a clear bias toward that
anchor value. Thus, different starting points can, and usually do, result in different estimates (see
Tversky and Kahneman (1974)). This is especially problematic for optimal pricing. As an
example, one test requires people to submit two digits from an identification number then shortly
Kihn / Behavioral Finance 101 / 147

after to submit a bid price for a security. Normatively the two numbers are unrelated, but there is
a strong and significant tendency for people to anchor on their essentially random identification
numbers.

Availability bias results from people tending to search for actual experiences and work from
there (e.g., if they have been to NYC and not been mugged, then they put a low probability on
being mugged in NYC, largely irrespective of the true odds of being mugged).
132
Therefore,
saliency is very important for this kind of bias. For example, if the media tends to report shark
attacks but not automobile accidents, then people who have seen those reports tend to
significantly overestimate the probability of a shark attack relative to a car accident. Clearly, this
doesn‘t aid in making accurate forecasts for financial market events and related pricing in those
markets.

Although this list of seven is indeed short, most, if not all, of the seven listed offenses to
normative finance involve one or more of the other seven and one or more other concepts.
Psychology, by its nature, is nuanced. Therefore, keep in mind that underlying psychological
causes are likely to be more complicated than a simple equation.


132
The opposite effect of the availability bias is denial. Something may be so disturbing that a person is willing to
view that outcome as even less likely, regardless of the probability of it happening.
Kihn / Behavioral Finance 101 / 148

THE RELATIVELY LONG LIST OF KNOWN DECISION MAKING OFFENSES
In the spirit of not ―reinventing the wheel‖, the long list is taken directly from Olsen (1998).

Source: Olsen, R., ―Behavioral Finance and Its Implications for Stock-Price Volatility‖, Financial Analysts Journal,
Volume 54, Number 2, March/April 1998, p. 12.

What follows is the table represented in list format:
1. Heuristics or rules-of-thumb are relied on by decision makers. This includes, but is not
limited to, stereotypical, analogic, or other intuitive or experiential decision processes
as decisions become more complex, time grows short, or emotions run high.
Kihn / Behavioral Finance 101 / 149

2. Affect influences decisions (i.e., people want to have a positive affect). Decision makers
want to feel good about their decisions, sometimes (or often) even if the decision is
suboptimal from a normative economic viewpoint.
3. Outcomes tend to be discounted inversely with the size of the outcome.
4. Tendency to overweight confirming evidence and underweight disconfirming evidence.
Again, positive affect can drive the decision.
5. Overweight probabilities of favorable outcomes and underweight probabilities of
unfavorable outcomes. Again, the need for positive affect can drive the even the
evaluation of the decision.
6. Overweight salient and/or memorable facts and evidence. We tend to focus on saliency,
often at the expense of more normative statistical method.
7. Overweight low-probability events and underweight high-probability events (low-
probability events are often treated as certain not to occur, and high-probability events are
often treated as certain to occur).
8. Fail to take account of regression to the mean (i.e., they tend not to be regressive). Thus
decision makers are often surprised by what should often normatively be expected.
9. People are social animals; therefore, decisions are heavily influenced by needs for
group acceptance and their fear of group regret. Essentially, herding is difficult to
avoid.
133

10. Discount future losses at higher rates than future gains.

133
Even PMs show a very strong tendency to herd (see, e.g., Hong et al. (2005)).
Kihn / Behavioral Finance 101 / 150

11. Mental accounts based on social and economic criteria. For example, one pool of money
is set aside for a college fund, and is treated differently than one set aside for a vacation
trip to Spain next year.
12. In actuality, people are loss averse not risk averse. Essentially, normative economics has
misinterpreted human risk, and/or ignored its descriptive reality.
13. Preference for an ascending pattern of returns. Therefore, the pattern of returns can be a
critical factor in an investment decision (i.e., even if normatively it shouldn‘t).
14. Diminishing returns for gains and losses.
15. Focus on changes in vs. absolute levels of decision attributes. This would seem to be
reference point phenomenon related.
16. Outcome gain and loss segregation and/or aggregation among decisions to enhance
perceived net benefit.
17. Perceptions of risk vary inversely with perceptions of control. This can be critical in an
organizational context (e.g., would rather not make money than encounter even the
chance of a partial loss of control).
18. More weight is placed on information that is presented in a format consistent with the
choice format (e.g., a numerical decision and numerical information vs. a verbal decision
and verbal information). Often, the format and/or framing matters.
19. Stress induces a heavier weight on negative evidence. Stress can often short circuit
explicit processing.
20. Stress tends to reduce the portion of information considered. Again, stress can often short
circuit explicit processing, and in this case even contribute to ignoring basic information.
Kihn / Behavioral Finance 101 / 151

21. Tendency to overestimate the probability of conjunctive events. People just have a
tendency to be bad at probability and especially contingent probabilities.
22. Small samples are treated as overly representative of populations.
23. People tend to be unaware of the weights they place on pieces of information in a
decision. Thus, you can get probabilities summing up to more or less than unity.
24. More weight is placed on personal information than impersonal information (e.g., family
members‘ advice).
25. Tendency to overestimate one‘s ability to forecast past events (hindsight bias).
134

26. Tendency to overestimate one‘s ability to forecast, and generally make correct decisions
(see Fisher and Statman (2000)).
27. Information tends to be used in the form given.
28. Tendency to overestimate the variability of a series, especially a random series.
29. Confusion between precision and reliability (and to view quantitative information as
more reliable than non-quantitative information).
135

30. Forecasting tends to be based on an anchor value and adjustments from the anchor tend to
be insufficient.
31. Greater weight is placed on information that has been made to seem complete by adding
nondiagnostic facts.
32. Greater weight is placed on nondiagnostic information as diagnostic information becomes
ambiguous.

134
This one is can be related to cognitive dissonance. For example, Goetzmann and Peles (1997) ―find that mutual
fund owners recollect that their funds performed much better than was in fact the case.‖ Biais and Weber (2009)
found that investment bankers in London and Frankfurt had ―significant hindsight bias‖, and that the majority
remained biased even after being informed of the degree of their bias.
135
There is also a tendency to reject all numbers if just one is wrong (and this can be aided by confirmation bias).
Kihn / Behavioral Finance 101 / 152

33. Information is weighted by its arrival timing/date (the earliest data gets the most weight
for simple decisions, while the latest data tends to receive the most weight for the more
complex decisions).
34. More stress causes more inconsistency.
35. Consensus judgments are overestimated (the ―two heads are better than one‖ approach).
36. As numeric information becomes more ambiguous, more weight is given to nonnumeric
information.
37. The physical format of the information supplied influences the accuracy and speed of the
decision process.
38. Task participation is enhanced by immediate and dynamic feedback.
39. Tendency to overweight current beliefs and feelings results in very inaccurate forecasts of
future hedonic (pleasurable) states (people are ‗locked into the present‘).
40. As forecasting becomes more difficult, greater weight is placed on the anchor value.

Based on the forty item list, it should be clear that forecasting specifically, and decision making
generally, based on data and other information, just isn‘t a strong suit of humans. There is much
that can go wrong and often does. It is really a question of personnel, organizational structure,
and incentives as to whether these types of biases can be overcome.

Kihn / Behavioral Finance 101 / 153

NEUROECONOMICS – LINKING THE HUMAN MIND TO THE MARKET
CHOICE/ACTION
Neuroscience is the study of the nervous system. The nervous system in turn is composed of
cells called neurons, and other supportive cells. Neurons are cells that produce intellectual
behavior (e.g., choice), cognition, emotion, and physiological response. Neuroeconomics is an
attempt to combine neuroscience (especially cognitive and behavioral neuroscience) with
normative and descriptive economics (but especially normative). With respect to economics
generally, the seemingly obviously applicability of neuroeconomics is more on the demand than
supply side.

In addition, like those that propose behavioral finance as an add-on to finance, many currently in
the field seem hypersensitive of the need to: (1) not anger those economists that promote the
current normative economic paradigm (e.g., Camerer et al (2005, p. 55) first suggest an
‗incremental‘ approach ―in the short run‖, but ―we believe that in the long run a more ‗radical‘
departure from current theory will become necessary‖, or Glimcher et al. (2007, p. 146)), and (2)
to create mathematical ‗models‘ (e.g., Caplin and Dean (2008)). Obviously this is misguided. To
the extent neuroeconomics is descriptively true, it will often and likely lead, not follow; and with
respect to mathematics, to the extent the brain can be modeled accurately in a purely
mathematically way, great. Psychologists, psychiatrists, neurologists, and other scientists have
been modelling human behavior for some time, it is only logical that relatively inaccurate
economic ‗models‘ be swapped for more accurate behavioral ones without all the silly
assumptions.
Kihn / Behavioral Finance 101 / 154


The potential of neuroeconomics helping behavioral finance can be summed up with the
following quote from Camerer (2008, p. 419): ―Neuroscience will show more clearly conflicts in
which behavior is biologically plausible rather than logical.‖ In short, by appliyng a true science
(neuroscience) to economics what actually happens will, by definition, be emphasized over the
normative theory with its strict interpretations of such things as rationality. Put another way,
human biological reality will confront normative theory directly.
136


The following diagram contrasts neuroscience with behavioral economics and economics.



136
My guess is that actual science will win.
Kihn / Behavioral Finance 101 / 155

Source: Camerer, C., ―Neuroeconomics: Opening the Gray Box‖, Neuron, Volume 60, Issue 3, November 2008, p.
417.

The neuroscience view is composed of the left two columns of five boxes with connecting lines
and arrows, the behavioral economics view the second from the right column of four
unconnected boxes, and the classic economics view the far right column of four unconnected
boxes. As should be painfully clear, cognition and related things like economic choice are in
reality processes. Under neuroscience we move from representation to valuation to action, then
outcome evaluation and learning with connections and feedback sometimes occuring, sometimes
not. Under traditionial/current economics and finance, representation and valuation (which for
most depend on internal and external states) never happens, yet utility is maximized. Under
behavioral economics the possibility of representation and valuation mattering is there, yet there
is no connection between the actions. It is important to remember that this is the representation
of someone who fancies himself or herself a neuroeconomist, and hence behavioral economics
and, of course, economics are found wanting. For me, I see rationally designed behavioral
finance as something like the following:

Kihn / Behavioral Finance 101 / 156


Source: modified from Camerer, C., ―Neuroeconomics: Opening the Gray Box‖, Neuron, Volume 60, Issue 3,
November 2008, p. 417 and Nov, Y., and O. Nov, ―Living in a bubble? Toward a unified bubble theory‖,
International Journal of General Systems, Volume 37, Issue 5, October 2008, p. 629.

Therefore, I find no problem integrating that which fits the above concpetual model of
behavioral finance as I have tried to lay it out in this book. In my mind, neuroscience must be
included as it will reconcile biological and cognitive reality with financial market reality. In
addition, there are normative valuation approaches that ceratinly indicate that actual prices trend
toward them, at least, in the long run; but over the short to medium term (which can be decades)
values can drift away from those anchors. Clearly, it is some combination of market
Financial Object’s
Driving Value
(i.e., financial market
determined price or actual
price)
Financial Object’s
External Value
(i.e., it’s fundamental or true
economic value)
Behavior
(i.e., buying, and/or selling,
and/or holding behavior)
Behavioral Finance Components of Valuation
Limits to Arbitrage/
Market Microstructure
(i.e., taxes, transaction costs, legal
issues, irrational traders, lack of
an exact substitute, etc.)
Psychology &
Neuroscience
(i.e., biological predisposition,
cognitive predisposition, cognitive
limitations, etc.)
Normative
Economics
(e.g., discounted
present value)
Kihn / Behavioral Finance 101 / 157

microstructure and its associated limits to arbitrage interacting with human cognitive limitations
and their associated biases that results in ‗market inefficiency‘ seemingly dominating pricing in
most financial markets most of the time. For me, this seems obvious, yet I also realize
established ‗authorities‘ and ‗professionals‘ that have based their careers on largely normative
theory can have difficulty accepting a primarily descriptive methodology (hence, this book).

Contrast the above diagram with a representation of normative finance:

Normative finance strictly holds that the ‗price is right‘ always and in all markets (i.e., strict
EMH/EMT), and ‗bubbles‘, etc. are therefore impossible with unlimited arbitrage and one or
more ‗rational‘ investors. Therefore, limits to arbitrage and market microstructure are largely
irrelevant. Additionally, psychology is irrelevant in a world with unlimited arbitrage and
‗rational‘ economic agents/actors. Finally, the models of normative finance merely reflect all the
Financial Object’s Driving Value =
Financial Object’s External Value
(i.e., financial market determined price or
actual price = it’s fundamental or true
economic value)
Behavior
(i.e., buying, and/or selling,
and/or holding behavior)
Purely „rational‟ behavior
Normative Finance Components of Valuation
Normative
Economics
(e.g., discounted
present value, CAPM,
Black & Scholes, etc.)
Kihn / Behavioral Finance 101 / 158

‗rational‘ agents and unlimited arbitrage, and are not required for valuation because market
participants who set prices at all times and in all markets already derive a similar, if not exact,
version in their minds, as their actions should reflect this.

Yet descriptive reality is considerably different than the normative finance diagram. I believe the
facts are much closer to, and more plausibly fit, the behavioral finance version. Furthermore, if
that is true, I suspect that neuroscience will have a large impact on connecting the proverbial dots
between the physical realities of the market with the physical realities of the markets.

Currently, when neuroeconomics is considered, I suspect that most people first consider
cognitive neuroscience. Cognitive neuroscience examines questions concerning how
psychological and/or cognitive functions are produced by the neural circuitry. Probably the most
common images today are the measurement techniques associated with various forms of ―brain
scanning‖ devices (e.g., fMRI – functional Magnetic Resonance Imaging, PET – Positron
Emission Tomography, etc.). Much of the work to date has indeed focused on using such
techniques to identify and map areas of the human brain (i.e., map the specific neural circuits)
that are used to address questions of economic choice (i.e., choice behavior as it relates to
economics). Clearly, the ability to directly measure thoughts and feelings should be
extraordinarily useful in analyzing decisions and choice, especially in finance and economics.

Some examples of this are:
Kihn / Behavioral Finance 101 / 159

- Uncertainty itself strongly biases decisions/choice (see, e.g., Platt and Huettel (2008)).
Therefore, uncertainty itself is important and can, for example, impact an individual‘s
uncertain choices. Furthermore, this bias varies significantly across individuals and brain
systems. Although significant, standard finance models do not incorporate this bias.
- Normal adults are capable of both mentalizing (i.e., a form of ‗mind reading‘) and
empathizing (see Singer and Fehr (2005)). These abilities are especially useful for
making choices when other people are involved in the decision making (e.g., related to
game theory type constructs, but real ones), yet standard financial models and related
game theory models include neither documented affective trait/ability.
- ‗Money illusion‘ is real. Normative economics strongly assumes that people value money
in real not nominal terms, yet they tend not to. Based on fMRI, a direct link between
money illusion and brain activity has been found (see Weber et al. (2009)). Money
illusion is extraordinarily important for finance and economics, yet standard finance
models do not even acknowledge its existence.
- Not only is a lack of trust thought to inhibit economic transactions, but responses are
asymmetric between the genders. When distrustful, men generally show heightened
levels of DHT (a hormone) that women do not show, which translates into heightened
levels of agression for men (see Zak et al. (2005)). Given that it has been shown that
‗high trust‘ societies tend economically to perform signficantly better than ‗low trust‘
societies, these sorts of neurological links to economics might be important, yet standard
finance and economic models do not even acknowledge their existence.
Kihn / Behavioral Finance 101 / 160

- Beliefs matter. They matter because they ―play a substantial role in the behavior of the
financial markets.‖ (see de Bondt (1995, p. 7) for a review)
- When faced with a loss, people tend to act differently than with gains. In fact, this is a
mild form of the same behavior seen in addictive gamblers (see Chew and Peterson
(2005) for a summary). Therefore, people tend to act as ―risk lovers‖ under one set of
conditions and typically ―risk averse‖ in another. These types of well documented
behaviors are not incorporated into standard finance and economics models.
- Contrary to standard Discounted Utility Theory (―DUT‖), humans generally are irrational
with respect to intertemporal decisions (i.e., irrational in the economics sense of the
term). A biological connection for these basic time-preference violations has been found
(see Kalenscher and Pennartz (2008) for a review of evidence and theory). Even though
these violations appear real, DUT relies on them not existing.
- Aging impacts decision making. Over an adult lifespan an individual‘s dopamine and
serotine system changes. In particular, the ability to produce those two compounds
decreases. It has been noted that generally humans‘ behavior toward such things as
financial market risk also changes with age. Thus, financial decision making changes
significantly with age. Neuroeconomists have shown the direct link between dopamine &
serotine systems, aging, and decision making (see Mohr et al. (2009)). These are
critically important findings for a normative field, such as modern finance, that doesn‘t
account for such physical realities.
- Etc.
Kihn / Behavioral Finance 101 / 161

Clearly, the list is not meant to be exhaustive. What the reader should glean from
neuroeconomics is that it emphasizes the descriptive causal links from and to economics and
neuroscience. I believe it not only shows promise, but may end up being critical to behavioral
finance‘s primarily descriptive development.

In my opinion, the current gap between econimcs as a ‗social science‘ and say neuroscience as a
‗natural science‘ should largely be eliminated. If economics (and finance) want to be considered
a science, then it needs to become more natural (specifically, more natural science) and less
assumption driven. Sure, we tend to be social creatures, but economics and finance have been too
long drifting in their oddly mathematical and assumption laden realm where reality and theory
seemed to be meeting less and less often.

Kihn / Behavioral Finance 101 / 162

A SAD EXAMPLE OF PSYCHOLOGY AFFECTING SECURITY PRICING
This chapter wouldn‘t be complete without some example of the second ‗pillar‘ of behavioral
finance affecting pricing in the financial markets. Although difficult to prove conclusively
137
, the
example selected is what is called Seasonal Affective Disorder (―SAD‖) or the ―winter blues‖
(also called ―winter depression‖). SAD is essentially depression that is thought to be caused by
fewer daylight hours.
138
It is also thought to cause anxiety.
139
Minimally, its impact depends on
the relative latitude, sunlight hours actually experienced, and person or possibly population. For
example, among the very high latitude countries Iceland is considered to be an exception,
140
and
women tend to be more affected more than men. It is hypothesized that given the reduced food
availability during winter the farther north, ceteris paribus, reduced activity during that time
likely would have conferred a reproductive advantage. Normative finance would not recognize
such a thing as having the potential to affect asset prices, whereas behavioral finance would be
more open to the possibility (especially given actual limits to arbitrage).

―Affective‖ in this case means emotional. SAD is a condition that is caused by fewer daylight
hours. ―Experimental research in psychology has documented a clear link between depression
and lowered risk-taking behavior in a wide range of settings, including those of a financial
nature.‖ (Kamstra et al. (2002, p. 1)) ―SAD is clinically defined as a major depressive disorder.
While usually described in terms of prolonged periods of sadness and profound, chronic fatigue,

137
One never actually proves anything with 100% certainty using the Western scientific method (or just called
‗scientific method‘).
138
See, for example, Avery et al. (2001) for a treatment example.
139
Remember, anxiety predisposes decision makers to a host of potential cognitive biases, especially with respect to
information, forecasting, and decision making generally.
140
See Magnusson et al. (2000). Interestingly, although a diet high in fish is sighted as a possible reason why
Icelanders seem relatively unaffected, people of Icelandic ancestry in Canada also show the same relative lack of
SAD, compared to, for example, Japanese (who also have a diet high in fish) or Swedes.
Kihn / Behavioral Finance 101 / 163

evidence suggests that SAD is connected to serotonin dysregulation in the brain. Furthermore,
positron emission tomography (PET) scans reveal abnormalities in the prefrontal and parietal
cortex areas due to diminished daylight, as described in the National Institute of Mental Health
study by Robert M. Cohen et al [1992]. That is, there appears to be a physiological source to the
depression related to shorter days. SAD symptoms include difficulty concentrating, loss of
interest in sex, social withdrawal, loss of energy, lethargy, sleep disturbance, and carbohydrate or
sugar craving often accompanied by weight gain. For those affected, the annual onset of SAD
symptoms can occur as early as September, around the time of autumn equinox.‖ (i.e., in the
Northern Hemisphere, Kamstra et al. (2002, p. 2-3))

To sum up, the key parts of an academic hypothesis and test of a link from SAD to equity market
returns:
1. Psychology has documented a link between SAD and depression (e.g., about 10% of
most populations affected, with about 1/3
rd
of that percentage being clinical and about
2/3
rd
of that percentage being mild cases). Therefore, it is a marginal condition, unlike,
for example, overconfidence which is much more general. Thus, if it has an impact that
would be suggestive that more general conditions could be even more important.
2. Psychology has documented a direct link between depression and heightened risk
aversion (i.e., depressive symptoms are significantly correlated with risk aversion); as
well as to decision making more generally.
3. Therefore, SAD can affect market equilibrium through its impact on prices where
marginal sellers (i.e., SAD cases/investors in the fall being net sellers of risky assets, e.g.,
Kihn / Behavioral Finance 101 / 164

stocks) affect market equilibrium as the length of their day shortens (i.e., as the number
of daylight hours decreases).
4. Therefore, the testable hypothesis is the following: ―The depressive effects of SAD and
hence risk aversion may be asymmetric about the winter solstice (in the Northern
Hemisphere about mid-December, with the Southern Hemisphere being in opposite
synchronicity). Thus two dates symmetric about the winter solstice have the same length
of night but possibly different expected returns. We anticipate seeing unusually low
returns before winter solstice and abnormally high returns following winter solstice.
Lower returns should commence with autumn … followed by abnormally high returns
when days begin to lengthen ...‖ Kamstra et al. (2002, p. 4). Note, that the hypothesis
relates to the length of daylight hours or the length of the day, not to changes in the
length of day or changes in daylight hours. Therefore, the alternative hypothesis is that
short days lead to lower returns in the fall and relatively higher returns in the winter.
5. This is a descriptive/psychology driven theory with prescriptive implications vs.
normative theory.
141


Therefore, the links we care about (i.e., from a finance and financial markets perspective) are
from daylight hours to depression to risk-taking to security returns. The seemingly simple and
direct testable hypothesis that SAD affects security returns is as follows: as daylight hours
decrease/increase security returns decrease/increase. In addition, because of the increasing

141
A conditional asset pricing model/version of the newer EMT/EMH allowing for ―time varying risk premia‖
would probably capture this effect and suggest it is not even an ―anomaly‖. Do you think SAD is an efficient market
type risk? Therefore, ironically, it is possible SAD can affect and/or, at least partially, cause time-varying risk
premia, which is a key comeback line for modern EMT. Therefore, it is possible that at least part of time-varying
risk premia is associated and/or caused by psychological phenomena, which are assumed to be irrelevent.
Kihn / Behavioral Finance 101 / 165

variation in daylight hours each day over a normal year as we approach the poles, it is clear we
would expect to see this effect more pronounced the further from the equator we travel.
Therefore, we would expect security prices to be more affected based not just on geography and
the resulting annual variation in daylight hours, but possibly nonlinearly by relative proximity to
the poles. Add to this the complicating simple empirical observation that people (i.e., in general)
are not affected in a linear fashion as we move further away from the poles, and it is not at all
clear that SAD will have much of an effect on financial market prices at all. For example, it has
been documented that about 1.5% of the people in south Florida vs. about 9% in the northern
U.S. are impacted. Thus, per unit of latitude from the equator is not linear with respect to the
incidence, or probably even degree, of SAD observed. In addition, there is nonlinearity with
respect to the temporal impact of the depressive symptoms themselves, as evidenced by the
following graph of percentage of clinically SAD U.S. patients displaying certain symptoms over
calendar year (i.e., in the Northern Hemisphere).

Source: Taken from Modell et al. (2005, p. 663, part of Figure 4 – Pattern of reported historical seasonal changes by
month (data double-plotted to show cyclicality; n = 1042)).

Kihn / Behavioral Finance 101 / 166

As the reader will see shortly, this actual clinical pattern of the disorder only roughly matches the
actual number of estimated daylight hours (which is much more of a muted sign wave than the
above). In short, the additional complicating factors of a nonlinear relationship between
incidence and latitude combined with the actual impact itself not matching the number of
daylight hours compounds the potential complexity of the effect (and hasn‘t been taken into
account in finance related studies thus far). That noted, it should be clear from the above graph
that SAD will tend not to have much of an impact until September and October (i.e., in the
Northern Hemisphere) and quickly recede during March and April (therefore, peaking around
November/early December, but beginning September/October). Thus, and ignoring any extra
anticipatory effect, the refined hypothesis is that security returns are actually expected to be
impacted about two months before the actual minimum number of daylight hours (possibly due
to anticipatory effects of SAD as illustrated by the aforementioned graph
142
).

Based on day and latitude, an estimate for the number of daylight hours can be made as follows
(see Forsythe et al. (1995)):





where D = day length (in hours), L = latitude (in degrees), and J = day of the year. There are a
number of cities with stock exchanges, but a limited number far enough from the equator to
provide useful tests of the SAD hypothesis. Here are a few important cities and their associated
latitudes.

142
Given its timing, the graph makes me wonder if this could at least be a contributing cause of the ―January effect‖.
Kihn / Behavioral Finance 101 / 167



Not only is the bulk of the world‘s financial capital is in the Northern Hemisphere, but there are
more extreme latitude stock exchange cities in the north than in the south. Therefore, we are
somewhat limited in our ability to test in the Southern Hemisphere. For example, the furthest
south we have is 34 degrees, while the furthest north is slightly more than 60. Thus, assuming a
nonlinear effect of SAD given latitude, any tests are really testing for the potential effect in the
Northern Hemisphere (because empirically there wouldn‘t appear to be enough measurable stock
markets being impacted in the Southern Hemisphere).

What follows is a graph of approximate daylight hours over a normal year for Stockholm,
Sweden (a Northern Hemisphere stock exchange city).
Some cities with stock exchanges
Latitude
Helsinki, Finland 60 10 N
Stockholm, Sweden 59 17 N
London, England 51 32 N
New York, N.Y. 40 47 N
Tokyo, Japan 35 40 N
Sydney, Australia 34 0 S
Johannesburg, South Africa 26 12 S
Kihn / Behavioral Finance 101 / 168



For Stockholm, the average is around 12.4 hours per day, they peak at about 18.6 during the last
part of June (at the summer solstice) and shrink about six months later to a minimum of about
6.1 hours (i.e., during the last part of December during the winter solstice). This would
essentially be the reverse for someone living in the Southern Hemisphere at the same latitude.

Next, here are the estimated daylight hours for Sydney, Australia (a southern hemisphere stock
exchange city).
0
2
4
6
8
10
12
14
16
18
20
22
24
1
-
J
a
n
1
5
-
J
a
n
2
9
-
J
a
n
1
2
-
F
e
b
2
6
-
F
e
b
1
1
-
M
a
r
2
5
-
M
a
r
8
-
A
p
r
2
2
-
A
p
r
6
-
M
a
y
2
0
-
M
a
y
3
-
J
u
n
1
7
-
J
u
n
1
-
J
u
l
1
5
-
J
u
l
2
9
-
J
u
l
1
2
-
A
u
g
2
6
-
A
u
g
9
-
S
e
p
2
3
-
S
e
p
7
-
O
c
t
2
1
-
O
c
t
4
-
N
o
v
1
8
-
N
o
v
2
-
D
e
c
1
6
-
D
e
c
3
0
-
D
e
c
D
a
y
l
i
g
h
t

H
o
u
r
s

E
s
t
i
m
a
t
e
Day Length Estimate for Stockholm, Sweden
Kihn / Behavioral Finance 101 / 169



As you can see, Sydney isn‘t nearly as south as Stockholm is north (about 34.0 degrees below
the equator vs. about 59.3 degrees above, respectively). For Sydney, the average is around 12.1
hours per day; they peak at about 14.4 during the last part of December (at the summer solstice
for the Southern Hemisphere) and shrink about six months later to a minimum of about 9.8
hours.

Combining the lines gives a visual clue as to the north-south daylight hour differential and its
timing.
0
2
4
6
8
10
12
14
16
18
20
22
24
1
-
J
a
n
1
5
-
J
a
n
2
9
-
J
a
n
1
2
-
F
e
b
2
6
-
F
e
b
1
1
-
M
a
r
2
5
-
M
a
r
8
-
A
p
r
2
2
-
A
p
r
6
-
M
a
y
2
0
-
M
a
y
3
-
J
u
n
1
7
-
J
u
n
1
-
J
u
l
1
5
-
J
u
l
2
9
-
J
u
l
1
2
-
A
u
g
2
6
-
A
u
g
9
-
S
e
p
2
3
-
S
e
p
7
-
O
c
t
2
1
-
O
c
t
4
-
N
o
v
1
8
-
N
o
v
2
-
D
e
c
1
6
-
D
e
c
3
0
-
D
e
c
D
a
y
l
i
g
h
t

H
o
u
r
s

E
s
t
i
m
a
t
e
Day Length Estimate for Sydney, Australia
Kihn / Behavioral Finance 101 / 170



Therefore, as well as the effect expected to be impact at about opposite times between the two
cities (remember to factor in what I am calling the anticipatory effect of about two months), in
addition, the effect should be much more pronounced in Stockholm than Sydney (if much at all
in Sydney). Also, given the sinusoidal pattern (and accounting for the descriptive impact of the
timing of the actual associated symptoms), SAD should mostly impact during mid-September
through mid-December in the northern latitudes (and especially the far north), and conversely
mid-April through mid-July in the southern latitudes (and especially the far south).

As far as the actual, unadjusted returns look across different stocks markets that are located
physically at different latitudes, it might be helpful to visually inspect some preliminary
evidence. Going from most south to most north here are five graphs (the first two are from the
Southern Hemisphere, then the next three are from the Northern Hemisphere) showing median
0
2
4
6
8
10
12
14
16
18
20
22
24
D
a
y
l
i
g
h
t

H
o
u
r
s

E
s
t
i
m
a
t
e
Stockholm, Sweden and Sydney, Australia City Day Length Estimates
Stockholm Daylight Hours Estimate
Sydney Daylight Hours Estimate
Kihn / Behavioral Finance 101 / 171

and mean rolling returns with a SAD perspective (i.e., they are rolling six month returns across
the set of calendar years each set of data for each exchange covers).


Sydney, Australia (latitude 34.0 south – All Ordinaries Index – daily data covering the
period January 1958 through October 2004))

-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
C
o
m
p
o
u
n
d
e
d

d
a
i
l
y

r
e
t
u
r
n
AUS (rolling price returns) - 1/1958 through 10/2004
AUS_avg
AUS_med
Kihn / Behavioral Finance 101 / 172


Johannesburg, South Africa (latitude 26.2 south – FTSE/JSE All Share Index – daily data
covering the period May 1986 through October 2004))

0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
16.00%
17.00%
18.00%
19.00%
20.00%
21.00%
C
o
m
p
o
u
n
d
e
d

d
a
i
l
y

r
e
t
u
r
n
ZAR (rolling price return) - 5/1986 through 10/2004
ZAR_avg
ZAR_med
Kihn / Behavioral Finance 101 / 173


New York City, U.S. (latitude 40.8 north – S&P 500 Index – daily data covering the period
January 1985 through August 2004))

0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
C
o
m
p
u
n
d
e
d

d
a
i
l
y

r
e
t
u
r
n
U.S. rolling price return - (1/1985 through 8/2004)
US_avg
US_med
Kihn / Behavioral Finance 101 / 174


Stockholm, Sweden (latitude 59.3 north – Affarsvarlden General Index – daily data
covering the period July 1980 through October 2004))

-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
16.00%
17.00%
18.00%
19.00%
C
o
m
p
o
u
n
d
e
d

d
a
i
l
y

r
e
t
u
r
n
SWE (rolling price return) - 7/1980 through 10/2004
SWE_avg
SWE_med
Kihn / Behavioral Finance 101 / 175


Helsinki, Finland (latitude 60.2 north – HEX Index – daily data covering the period
January 1987 through September 2004))

A few things to note (all somewhat expected):
1. There are noticeable seasonal patterns in all of them.
2. The seasonal patterns are roughly offset in the two Southern Hemisphere based equity
markets vs. the three Northern Hemisphere based equity.
3. Especially in the north, the further away from the equator (or, conversely the closer to the
pole), the more pronounced the pattern.
4. Especially at the extreme, the unadjusted magnitude seems large.
For me, if there is something somewhat surprising it is the magnitude.

-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
16.00%
17.00%
18.00%
19.00%
20.00%
21.00%
22.00%
C
o
m
p
o
u
n
d
e
d

d
a
i
l
y

r
e
t
u
r
n
FIN rolling price return - (1/1987-9/2003)
FIN_avg
FIN_med
Kihn / Behavioral Finance 101 / 176

As you might have guessed, the SAD effect has been tested (Kamstra et al. (2002, p. 1)) and the
―results strongly support a SAD effect in the seasonal cycle of stock returns that is both
significant and substantial, even after controlling for well-known market seasonal and other
experimental factors
143
. … higher latitude markets show more pronounced SAD effects and
results in the Southern Hemisphere are six months out of phase, as are the seasons.‖ Thus, at
least one suspected psychological reason for a type of annual seasonality.

Controlling for ‗risk‘, Kamstra et al. (2002) find the following apparent ‗free lunches‘:

143
The Kamstra et al (2002) regression used to control for risk was:

, where two lagged returns

and

, were used to control for residual
autocorrelation (i.e., two business days‘ worth), a Monday dummy variable to control for the ―turn-of-the-week
effect‖ (equal to one on the trading day after the week-end), a tax dummy variable to control for tax loss selling
effects (equal to one on the last trading day of the year and first five trading days of the new year), daylight hours for
SAD, a dummy variable to control for the Fall at that latitude, percentage cloud cover, millimeters of precipitation,
and temperature in degrees Celsius (all based on daily returns data). The key results are the SAD coefficient and fall
dummy, which strongly support the hypothesis.
Kihn / Behavioral Finance 101 / 177


Source: Kamstra et al. (2002, p. 27)

Kamstra et al. (2002, p. 27) - Table 3
Average Annual Percentage Return
Due to SAD and Due to Fall Dummy
Country Annual Return Annual Return Unconditional
(Latitude) Due to SAD Due to Fall Dummy Annual Return
US: S&P 500 9.2*** -5.1** 6.3***
(41° N)
US: NYSE 6.1* -3.5* 9.2***
41° N
US: NASDAQ 17.5*** -11*** 12.5***
41° N
US: AMEX 8.5*** -7.3*** 8.4***
41° N
Sweden 13.5*** -9.7** 17.1***
59° N
Britain 10.2** -3.1 9.6***
51° N
Germany 8.2* -6.1** 6.5**
50° N
Canada 13.2*** -6.0** 6.1***
43° N
New Zealand 10.9** -13*** 3.3
37° S
Japan 7.0* -5.3** 9.7***
36° N
Australia 5.7 0.7 8.8***
34° S
South Africa 17.4* -3.0 14.6***
26° S
Level s of stati sti cal si gni fi cance: *** 1%, ** 5%, and * 10%.
Kihn / Behavioral Finance 101 / 178

According to Kamstra et al. (2002, p. 15), as an example, after controlling for
144
residual
autocorrelation, the ‗weekend effect‘, tax loss selling, cloud cover, precipitation, temperature,
Fall, and SAD related nighttime hours, we could expect to return about 21.1% per year excess
returns by going long Sweden in the Northern Hemisphere‘s Fall and Winter, and then doing the
same in Australia during its Fall and Winter (i.e., twice a year we would need to reallocate 100%
of our portfolio). Obviously, these excess returns (an apparent ‗free lunch‘) could be increased
by shorting the other market at the same time.

In addition, and as mentioned, it bears repeating that the bulk of the world‘s capital is in the
Northern Hemisphere, where the SAD effect is most pronounced. Beyond that, it seems to effect
both large-cap and small-cap stocks, even American Depository Receipts (―ADRs‖), suggesting
that even large Southern Hemisphere firms or large Northern Hemisphere firms located at a
different latitude than New York City experience this effect regardless of the possibility of an
apparent arbitrage.
145
Thus, as you may have noticed by now, what looks like an available ‗free
lunch‘ may not exist; and there must be some form or forms of limits to arbitrage across the
various stocks that are cross-listed on more than one stock exchange and located at more than
one latitude. In effect it may turn out the location and/or latitude is a form of limits to
arbitrage.
146


144
As always one assumes in normative finance that we correctly control for risk in such a way that the apparent
excess returns or ‗free lunch‘ is in fact what we think it is. This is also a convenient way of ignoring results we don‘t
want to admit as evidence (i.e., just say the ‗model‘ was ―wrong‖; and it most likely is wrong anyway, but usually
not for the normative reason or reasons given).
145
ADRs should mean no limits to arbitrage (or close to it), but still there seem to be, which makes the ADRs thing
even more bizarre. Many ‗anomalies‘ impact small-caps, but here we have a case of large-caps also being impacted.
146
Then again, maybe not; that is, ADRs may not be able to limit limits to arbitrage because of something, e.g., Van
Nieuwerburgh and Veldkamp (2009, p. 1202) point out. Specifically, the evidence seems to support the notion that
there are strong enough information asymmetries between, for example, earnings analysts country to country, that
Kihn / Behavioral Finance 101 / 179


And most importantly for our purposes, with SAD we have a relatively clean link from pricing in
the equity markets to psychology (the second ‗pillar‘ of behavioral finance), that, incidentally, is
very nearly perfectly predictable. So with SAD it appears we have both ‗pillars‘ of behavioral
finance: (1) apparent limits to arbitrage, and (2) psychology.

I will end the chapter with prescriptive advice with respect to SAD and the financial markets:
• Don‘t change your level of risk aversion according to the number of daylight hours.
• If you are thinking about buying stocks in the fall, try to wait until late fall or early winter
(especially the further away from the equator you are).
• In general, try your best not to be sad or contract SAD (you know what I mean).


the relative precision is enough to effectively insulate most markets from outsiders using instruments like ADRs to
eliminate pricing inefficiencies, like those likely caused by SAD. Therefore, ADRs may help, but one or more
geographic advantage may affect pricing in such a way as to make outsiders reluctant to move against the pricing
signals given more locally. The specific study showing this advantage is Bae et al. (2008).
Kihn / Behavioral Finance 101 / 180

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Bae, K., Stulz, R., and H. Tan, ―Do local analysts know more? A cross-country study of the
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Barberis, N., and R. Thaler, ―A Survey of Behavioral Finance‖, NBER Working Paper #9222,
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Caplin, A., and M. Dean, ―Economic Insight from ‗Neuroeconomic Data‖, American Economic
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Chew, S., and R. Peterson, ―Neuroeconomics of Gambling‖, Innovation, Volume 5, Issue 3,
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Forsythe, W., Rykiel, E., Stahl, R., Wu, H., and R. Schoolfield, ―A model comparison for day
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Goetzmann, W., and N. Peles, ―Cognitive Dissonance and Mutual Fund Investors‖, Journal of
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Guenther, C., and M. Alicke, ―Self-enhancement and belief perseverance‖, Journal of
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Hong, H., Kubik, J., and J. Stein, ―Thy Neighbor‘s Portfolio: Word-of-Mouth Effects in the
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Kalenscher, T., and C. Pennartz, ―Is a bird in the hand worth two in the future? The
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Kamstra, M., Kramer, L., and M. Levi, ―Winter Blues: A SAD Stock Market Cycle‖, Federal
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Kihn / Behavioral Finance 101 / 186

Chapter 6: What do we know about the individuals, agents and institutions
who push financial market prices around (or: Who buys and sells this stuff
anyways?)?

Although limited in empirical detail, now we will look at the financial market agents and what
they know, think, and do that might be important with respect to pricing in the financial markets.
That is, we will look at what is considered ―smart‖ and not so smart money in the financial
markets.
147
Depending on various things, each has an impact on pricing in the actual markets. Of
course, the notion that the characteristics and/or organizational setting of market participants
might have an influence on pricing in the financial markets would seem to contradict traditional
normative finance. Under traditional EMH/EMT finance the participants are incidental to the
story of price setting in any financial market (i.e., ultimately, not just the people, but additionally
market microstructure itself was not considered to be very important).

It turns out that who, what, and when are important.
148
Nevertheless, let‘s focus mostly on the
who part of that trinity this chapter. For example, Fisher and Statman (2000) find that WSSs‘
sentiment and individual investors‘ sentiment is a negative market timing signal that is

147
Clearly, even though I generalize between ‗smart money‘ (i.e., institutional investors) and not so smart money
(i.e., individuals), not all individuals display the biases and somewhat self-destructive financial behavior shown by
the average individual investor. For example, Zheng (1999) shows that some mutual fund investors seem to
systematically enjoy a certain level of short-run market timing, especially with respect to small-cap mutual funds.
Therefore, I mean on average, not that all institutional investors display more financial acumen than individual
investors. Also, see Lewellen et al. (1979) as the original article pointing out the actual heterogeneous nature of
individual investors.
148
See, for example, Madhavan (2002). Market microstructure not only matters, but it tends to be more complex
than commonly thought (i.e., as assumed by standard finance). Thus, who, what, and when can be critical to price
development, depending on those details in a particular market at a particular time.
Kihn / Behavioral Finance 101 / 187

statistically significant (i.e., it can be profitably used for Tactical Asset Allocation – ―TAA‖), but
they are largely unrelated. In addition, newsletter writers and individual investors have sentiment
that tends to covary (although, not perfectly) while the same is not true of WSSs.
149
Therefore, at
least for forecasting purposes, some groups‘ opinions seem to matter.

In the actual markets, effort is generally not rewarded per say. Especially with respect to poor
investment process (―IP‖), whether the answer takes five minutes of moderate thought or five
years of extensive research to arrive at may be of no relevance to the outcome (financial
management may be unique in this).
150
Of course, as a general rule, learning and focused effort
shouldn‘t hurt the process or outcome, but, again, it may not change the outcome.

With respect to the agents/actors themselves, there are essentially two sets (and possible subsets
for each) individual and institutional (i.e., those that get paid for investing for others –
professional money managers, brokerage related professionals, etc.) investors, which can be
broken down in subsets:

149
Fisher and Statman (2000) is based on:
(1) The WSS sentiment indicator was measured monthly by Merrill Lynch‘s average recommended stock allocation
of between about 15 to 20 WSSs over the period September 1987 through July 1998 (ML‘s ―Quantitative
Viewpoint‖).
(2) The newsletter writers sentiment was derived from Chartcraft‘s Investor Intelligence newsletter (a survey of over
130 investment newsletter writers where sentiment is classified into the following three categories: ―bullish‖,
―bearish‖, or ―waiting for a correction‖), and the signal is marketed by them as a contrary indicator (they have
weekly data since 1964, but only overlapping data was used). The study used ―bullish‖ newsletter writer percentage
in the last week of the month.
(3) The individual investor sentiment indicator was derived from the American Association of Individual Investors‘
(―AAII‖) mail survey of about 100 survey questionnaires to members each weekday and collects a little over 200
each week (the questions asks the investor to categorize themselves as ―bullish‖, ―bearish‖, or ―neutral‖). The AAII
performs a weekly tabulation on Thursday of each week (again, the average number of responses is over 200), and
has been doing this since July 1987. The study used the percentage of respondents that were ―bullish‖ the last week
of the month as the sentiment signal.
150
I credit Joe Eagleeye and Hilary Till with this insight.
Kihn / Behavioral Finance 101 / 188

1. Institutional sell- and buy-side (―sell-side‖ include brokers vs. ―buy-side‖ are the money
managers). For our purposes, the ―buy-side‖ are the key institutional actors (given that
they have the greatest potential for moving markets), and they can be further broken
down into analysts and PMs. Of course, it is distinctly possible, for example, that sell side
can impact buy-side and vice versa.
2. Institutional money managers can be broken down into retail and institutional orientated
money managers (one catering to pension funds and the like, the other to individual/retail
investors).
3. Individual investors (they can be further broken down by income, e.g., ―high-net-worth‖,
etc.).
Note, there is overlap between the sets, but it isn‘t as bad as it all seems at first. Furthermore,
most jobs are on the retail side, but the largest potential for moving the markets with the fewest
bodies is on the institutional side. At least for the U.S., the rough asset numbers look something
like this:
Kihn / Behavioral Finance 101 / 189


Source: Goldstein, M., ―The Future of the Money Management Industry‖, Empirical Research Partners LLC, New
York, New York, 2008, p. 3.
The U.S. Money Management Industry: Assets ($ billions)
Professionally Managed Assets Assets (2007) Percentage
Legally Defined Retirement Assets:
Defined-Benefit Plans ($5,505 total):
Corporate $1,967 3.5%
State and Local $3,152 5.6%
Union $386 0.7%
401(k) Plans $3,047 5.4%
Union DC Plans $112 0.2%
Other Corporate Defined-Contribution Plans $401 0.7%
403(b) Plans $739 1.3%
457 Plans $173 0.3%
Public DC Plans $353 0.6%
IRA Accounts $4,747 8.4%
Legally Defined Retirement Total $15,077 26.7%
Retail Assets:
Retail Mutual Funds $3,741 6.6%
Exchange Traded Funds ("ETFs") $187 0.3%
Variable Annuities $1,028 1.8%
Separate Accounts $2,329 4.1%
Bank Personal Trusts $1,036 1.8%
Hedge Funds Held by Individuals $842 1.5%
Private Equity $585 1.0%
Retail Total $9,748 17.3%
Other Categories:
Endowments $411 0.7%
Foundations $670 1.2%
Insurance Company Outsourcing $800 1.4%
College Savings Plan $130 0.2%
Other Categories Total $2,011 3.6%
Professionally Managed Assets Grand Total $26,836 47.6%
All Financial Assets $56,422 100.0%
Implied Non-Professionally Managed Assets Grand Total $29,586 52.4%
Kihn / Behavioral Finance 101 / 190


As of 2007, and focusing on the last three numbers, of the approximately $56 trillion of financial
assets reportedly held by Americans, just slightly less than half was ―professionally managed‖
151
,
the remaining was mostly managed by individuals. Regardless of how it is broken up, it is likely
that both institutions and individuals have the wherewithal to ―move markets‖, whether they
likely move them systematically toward or away from efficiency is the key question.

Is there any reason to think that either one or more sets of institutional investors or individual
investors systematically bias their investment decision making (i.e., their IP) in such a way that
market prices are driven away from efficient pricing? Financial institutions are essentially in the
data management business, and information and/or data is the single most important input into an
optimal IP. Furthermore, most good IP are essentially well organized ―data management
exercises‖.
152
―Information is the vital input into any active management strategy. Information
separates active management from passive management. Information, properly applied, allows
active managers to outperform their informationless benchmarks.‖
153
Information analysis can
be presented as a two step process:
1. Turn information/predictions into portfolios.
2. Analyze and evaluate the performance of those portfolios.
Short of well structured organizations that consistently act as rational arbitrageurs, and given the
list of psychologically driven decision making biases listed in the previous chapter, it is hard to

151
The largest concentration of assets in the fewest hands is probably on the institutional pension side.
152
This quote is attributed to Joe Eagleeye (late 1990s).
153
See Grinold and Kahn (1992, p. 14).
Kihn / Behavioral Finance 101 / 191

imagine that some biases don‘t manifest themselves in the respective IPs of the various agents
and organizations found in the financial markets.

THE ‗SMART MONEY‘ – THE ‗ANALYSTS‘ AND PORTFOLIO MANAGERS (―PMS‖)
Could it be that humans have some impact on pricing in the financial markets? Let‘s rephrase
that, is it possible that humans don‘t have a significant impact on pricing in the financial
markets? Answer: ‗Not bloody likely.‘ Obviously, if there are limits to arbitrage the human part
has the potential to be very important, if not dominant. Again, there being limits to arbitrage is a
necessary condition but not a sufficient condition for the psychology part to matter. Regardless,
as long as there are significant limits to arbitrage, the structure of the markets is likely to be an
important determinant in influencing pricing in the financial markets.

Furthermore, regarding the various agents and organizations that have the capital that would
allow them to have a significant impact on pricing, is it possible that not all agents are created
equal? Of course, even the EMH/EMT supporters would argue that it is effectively only the true
Kihn / Behavioral Finance 101 / 192

arbitrageurs that constantly correct mispricing that ultimately matter. For our purposes, and
assuming the arbitrageurs don‘t always bail us out, isn‘t it likely that the humans that make the
buy and sell decisions and/or have an influence on them and things like the structure of their
organizations (e.g., compensation, applicable regulations, etc.) can have a significant impact on
pricing in the actual markets? I ask that question, not just because it is likely to be self-evidently
true, but also because the structure of the markets could be structured to primarily reflect
mechanistic considerations (e.g., the evolution of the speed and capability of computers), but is
more likely to be primarily influenced and shaped by the humans (and, if there is a filtering
mechanism, possibly the types of humans), that occupy the critical nodes of decision making in
the financial markets.

Probably most importantly, who are those arbitrageurs anyways? Are they not likely to be among
those institutional and/or individuals with the most capital? Based on the money management
table, clearly the institutional or retail oriented money managers, as well as individual investors,
have plenty of capital to ―move the markets‖ (i.e., assuming little or no ‗cancellation‘).
Therefore, if it turns out all relevant groups can be shown to think or behave in ways that are an
anathema to rational economic arbitrage, then what are odds of them correctly pricing in a
timely, let alone sufficient, manner? Answer: ‗Not bloody likely.‘

Kihn / Behavioral Finance 101 / 193

THE ‗SMART MONEY‘ – THE ANALYSTS
―Yet, we are becoming increasingly aware that much of this work may be a waste of time and
that surely too much of it is duplicative. In fact, we either have to restructure the analyst‘s tasks
or dispose of analysts altogether.‖
Bernstein (1998, p. 4)
154


According to Bernstein security analysts should not be doing the following two things that they
almost exclusively spend their time doing (see Bernstein (1998)):
1. Presenting known facts as new information, especially consensus thoughts.
2. Looking for ‗undervalued‘ stocks (i.e., they should be looking for overvalued stocks
instead).
It seems that some people believe that most analysts spend their time effectively rationalizing
decisions that have already effectively been made. As previously mentioned in the psychology
part, humans tend to spend a great deal of resources justifying decisions as opposed to improving
them, and it is likely many financial market buy- and sell-side analysts are in fact doing just that.

A survey was sent out to a supposed representative sample of AIMR members
155
, and the
following were some of the findings (Block (1999)):
1. 84.8% of respondents ―sometimes‖ or ―never‖ used PV techniques (45.7% ―never‖).

154
The Bernstein (1998) piece is an opinion piece and it is kind of silly, but makes two good points about what
analysts (anyone for that matter) should not be doing in the IP. Otherwise, he confuses stock pickers from
quantitative analysts, risk management with stock selection, etc.
155
The survey was sent to Association for Investment Management and Research (―AIMR‖) members (297 out of
880 mailings of about 32,000 AIMR members at the time. This implies about a 1/3
rd
response rate, and about 2/3
rd

CFAs and about 54% MBAs, but no PhDs. AIMR is responsible for Chartered Financial Analysts (―CFAs‖)
credentialing, an ethical code of conduct, etc. There have essentially tried to set up the finance equivalent of
Certified Public Accountants (―CPAs‖) with the associated rules, ethical considerations, and organization.
Kihn / Behavioral Finance 101 / 194

2. When broken-down by finance industry type, 100% of the investment bankers (18
respondents) ―sometimes‖ or ―never‖ used PV techniques (83.3% ―never‖).
3. Among four ―inputs of importance‖ for valuing stocks, earnings (1
st
) and cash flow (2
nd
)
were ranked above book value (3
rd
) and dividends (4
th
) by large margins.
If people matter in the financial markets, and given that these people would be expected to be
some of the most quantitative of the ―profession‖, the results should be especially disturbing to
EMH/EMT proponents. Again, remember finance is all about discounted cash flows (i.e., PV
analysis). A clear majority (and 100% of the investment bankers
156
) ―sometimes‖ or ―never‖
used PV techniques. How could that be? Who is able to price, let alone set pricing, in the
financial markets without using PV analysis? Therefore, items #1 and #2 are especially
disturbing from a traditional finance perspective. Regarding the ―inputs of importance‖ (#3),
except for cash flow (which should be ranked 1
st
not 2
nd
), the other three should be reversed. The
numbers behind the rankings for the ―inputs of importance‖ are:

Source: Block, S., ―A Study of Financial Analysts: Practice and Theory‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, p. 89.


156
Investment bankers in London and Frankfurt have been shown to display high levels of hindsight bias; and that
bias appears to impact their compensation, especially for those few that are the least biased (see Biais and Weber
(2009)).
Table 6. Rank of Inputs in Importance
Variable First Second Third Fourth Avg. Ranking
Earnings 156 118 23 0 1.55
Cash flow 133 140 19 5 1.65
Book value 5 32 133 127 3.29
Dividends 3 7 122 165 3.51
Kihn / Behavioral Finance 101 / 195

For example, remember, for stocks, dividends and cash flow are largely one in the same, so why
such divergent rankings for the two?

4. Trading ranges seem to drive sales and purchases.

Source: Block, S., ―A Study of Financial Analysts: Practice and Theory‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, p. 89.

#4 is amazing (i.e., in a normatively bad way), especially given that those answering the
questionnaire tend to be ‗long-term investors‘, and they directly contradict themselves in Table
12. Therefore, from #3 they overwhelmingly think earnings are a critical input yet actual
decisions to ―buy, sell, or hold‖ should be made on basic weak-form market efficiency deviations
(i.e., ―current vs. historical trading range‖) over EPS (and by a wide margin). What is going on
here?

5. Given their other beliefs, responses and opinions, the respondents seem to possess some
bizarre beliefs about portfolio management.
Table 8. Rank of Variables in Determing Buy, Hold, and Sell Decisions Table 10. Beliefs about Portfolio Management
Variable First Second Third Avg. Ranking
Current versus historical trading range 216 67 14 1.32
Long-term outlook for the company 76 171 50 1.91
Next quarter's EPS 5 59 233 2.77
Kihn / Behavioral Finance 101 / 196


Source: Block, S., ―A Study of Financial Analysts: Practice and Theory‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, p. 90.

Market timing doesn‘t enhance portfolio return? Who are these people? Furthermore, they expect
a reversion to the mean for yields and P/E (which in 1999 meant prices should likely be expected
to dramatically go down), yet they rely on ―current vs. historical trading range‖ to establish buy,
sell, and hold decisions? I repeat, who are these people?

6. And about market efficiency (note the ―strongly disagree‖ and ―neutral‖ percentages).

Source: Block, S., ―A Study of Financial Analysts: Practice and Theory‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, p. 91.
Only about 3% agree with their professors, while more than twenty times more strongly disagree.

7. And about the importance of trading, risk, and skill in determining portfolio return
Table 10. Beliefs about Portfolio Management
Among those
Belief Number Percent with Opinions
A. Does market timing enhance portoflio return?
Yes 85 28.6 32.7
No 175 58.9 67.3
No opinion 37 12.5
Total 297 100 100
C. Will there be a reversion to the mean in the next decade for yields and P/Es?
Yes 171 57.6 71.6
No 68 22.9 28.4
No opinion 58 19.5
Total 297 100 100
Table 11. Opinion of the Efficient Market Hypothesis
Opinion Number Percent
Strongly agree 8 2.7
Neutral 101 34.2
Strongly disagree 186 63.1
Total 295 100
Kihn / Behavioral Finance 101 / 197


Source: Block, S., ―A Study of Financial Analysts: Practice and Theory‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, p. 91.

I believe it was Winston Churchill that mentioned something about the triumph of hope over
reality. Is it not at least somewhat contradictory to believe (as shown in Table 8) that ―trading
ranges‖ should determine whether you buy or sell a security, yet also believe that ―the amount of
trading in the portfolio‖ is irrelevant (less than 1% thought it important in ―determining portfolio
return‖)?
157


Although many of the opinions are contradictory, and often run counter to basic finance
thought
158
, they do mesh reasonably well with results by two anthropologists (O‘Barr and Conley
(1992)). In essence, they found that following two things drove investment decision making in
the large institutional money managers they interviewed:
1. The ―most important finding is the extent to which economic and financial analyses do
not dominate investment decision making. Instead, in choosing investment strategies,
evaluating investment options and hiring, firing and retaining external managers, fund

157
Again, especially note the 0.6% who think trading is the most important impact (clearly a problem, especially
given most PM‘s think of themselves as ‗traders‘ and trading costs do matter).
158
It is important to remember, assuming this is an informed crowd and crowds set the pricing in the markets (i.e.,
not just one marginal buyer/seller), there is a real potential for sustained inefficiency.
Table 12. Most Important Variable in Determing Portfolio Return
Variable Number Percent
The skill and training of the portfolio manager 179 60.3
The amount of risk in the portfolio 116 39.1
The amount of trading in the portfolio 2 0.6
Total 297 100
Kihn / Behavioral Finance 101 / 198

executives appear to be motivated more by the kinds of cultural influences that drive less
consequential decisions.
2. These include the quirks of institutional history and corporate politics, the desire to
displace responsibility, and the demands of maintaining smooth personal relationships.‖
In short, if that is true, then it is potentially an EMH/EMT proponent‘s nightmare. Alright, most
analysts and all investment bankers seem not to be concerned about PV analysis, are not
interested much in cash flows, and appear to laugh at market efficiency, but what about PMs;
PMs can‘t do such things and keep their jobs can they?

THE ‗SMART‘ ANLAYSTS – THE EARNINGS ANALYSTS
Although before proceeding to PMs, in the actual world of finance I would like to point out that
there are analysts and there are analysts. Security analysts that work for buy side firms (e.g.,
mutual fund companies and hedge funds) represent one type of financial analyst. The more
qualitative types of buy side analysts will typically pass judgment on the credit quality of an
issuer, recommend issuers to buy or sell, etc., while the more quantitative types will value or
Kihn / Behavioral Finance 101 / 199

price more obscure securities and related derivatives. In addition, there are corporate analysts
working in finance or treasury departments of financial or nonfinancial firms or partnerships who
run the gamut. The aforementioned survey likely encompasses all of them.

But as on the Orwell‘s animal farm, in the eyes of normative finance, ―all analysts are equal, but
some are more equal than others.‖ It could be argued that the most famous analysts, and likely
highest paid on average, are the earnings analysts working at sell side firms (i.e., traditional
―Wall Street‖ type firms). These are the people whose job it is to recommend firms and make
estimates/forecasts of their earnings. Given that they have documented impacts on pricing in the
financial markets, one obvious question is: How are they at their job? Answer: Generally not
very good, or at least not as well as a normative economist would expect.

Specifically with respect to earnings forecasts and recommendations, what seems to be the
problem or what is it that they seem to be doing? Even more specifically, how and why do
earnings analysts make the kinds of biased recommendations and forecasts that they do? Keep in
mind: ―Investors pay attention to the pronouncements of executives and analysts, so these
pronouncements affect stock prices. But do the actions of investors lead prices to correctly
reflect fundamental values?‖ Shefrin (2007, p. 257) It isn‘t just earnings analysts that are prone
to biases, but these types of analysts have special power over pricing in the market that most
analysts do not.

Kihn / Behavioral Finance 101 / 200

One problem is sell side analysts have a conflict between buy side clients (broker dealer clients)
and the firms they are recommending (i.e., they are reluctant to write or say bad things about
firms they cover, even if that ostensibly is the job). Thus, the conflict is ultimately between retail
and institutional stockbrokers and buy-side institutions. Given the investment banking
relationship with the firms they cover, the analysts are encouraged to become more optimistic.
Barber et al. (2004) show that, particularly in the case of buy recommendations during the
NASDAQ/technology bubble, investment bank analysts underperformed independent analysts by
about 22 percent annualized. There is an explicit tie between analyst optimism and investment
banking business. For example, in the U.S. 25 days after an IPO is the ―quiet period‖ when an
underwriter/investment bank cannot issue a forecast or opinion concerning revenues, income, or
earnings per share during the period. Michaely and Womack (1999) analyzed analysts‘ IPO
recommendations and compared underwriters‘ ‗buy‘ recommendations of those nonaffiliated
‗buy‘ recommendations for IPOs in their first year of trading and found:
- As expected, firms that are covered but not brought to the market by the firm are more
accurately analyzed (i.e., still biased, just not as much).
- The first month after the ‗quiet period‘, 50% more ‗buys‘ are issued by affiliated firms
than from unaffiliated firms (and the ‗buy‘ is issued sooner than normal), and poorly
performing IPOs tend to be propped up.
- Investors‘ reaction to a buy recommendation depends on who issued the buy (+2.8% for
affiliated and +4.4% for nonaffiliated). Clearly, investors do some discounting of the
bias, but they do not fully discount the bias.
Kihn / Behavioral Finance 101 / 201

- Poorly performing IPOs did not have a non-underwriter analyst recommendation (i.e.,
during the period 1990 – 1991 that was studied). That is, unaffilated analysts just choose
not to make a recommendation rather than make a negative one.
Finally, not only is it important to note that investors are not fully incorporating known analyst
biases, but it is important to note that analysts are biased for economic (i.e., their paychecks and
bonuses) and behavioral reasons (i.e., they are human and prone to it without training).

Darrough and Russell (2002, p. 132) actually checked to see numerically what analysts do. They
modeled analysts forecasting as a two-stage heuristic for long-range forecasts. In order, the two
stages are:
1. Forecasts – Forecast average company‘s earnings will grow by about 34% more than
current reported earnings of the company (for S&P 500 firms).
2. Revisions – Downward revision is about 1% per month, and forecasts are then adjusted
by about 90 cents per 100 cents as new earnings reports come out (e.g., if earnings go up
100 cents, then they adjust by about 90% toward that change – underreaction).
Therefore, analysts are anchored on a relatively impossibly optimistic growth rate overall, and
they seem to adjust almost exclusively on reported earnings. Overall, their job is forecasting, but
they do it in a nonoptimal way.

In my opinion the most plausible explanation for their behavior is that these types of analysts are
much like WSSs. In short, they are paid to lie and bias their results. Otherwise, ―well calibrated‖
analysts would dominate, but empirically they do not. In addition, they are clearly biased just
Kihn / Behavioral Finance 101 / 202

like any other human, but there seems no significant selection mechanism (filter) at the corporate
level to emphasize forecasting calibration over lying. Given that they work in the very firms that
WSSs work in, might it be possible that they are exposed to the same filtering and expectations
that WSSs are exposed to? Clearly, the corporate value function emphasizes lying over earnings
forecasting calibration, yet the market must provide some feedback for this (i.e., customers, on
some level, both institutional and individual must demand the lying over calibration)
159
. Clearly,
as long as there is a positive relationship between optimistic lying and say IPO business, analysts
will tend to be relatively poor forecasters.

I will finish this sub-part with some prescriptive advice for those who are or are interested in
becoming earnings analysts:
1. Don‘t apply the previous two-stage heuristic for long-range forecasts.
2. Don‘t forecast average company‘s earnings will grow by some overly optimistic fixed
number per year (e.g., try an AR process as a better first guess, and then improve it from
there).
3. Don‘t underreact and don‘t overreact to information (i.e., when in doubt, use logic and
statistics to guide you). For example, use Bayes‘ rule when you can.

159
Companies try to ―guide‖ earnings analysts. Knowing that analysts tend to underreact to new information, it is
possible to induce pessimism in analysts‘ earnings forecasts. Companies may try to ‗guide‘ analysts lower (e.g.,
Microsoft & Intel) so they can ‗beat‘ expectations. Degeorge et al. (1999) find several thresholds in earnings
manipulation. They note that there are three benchmarks/reference points or earnings thresholds:
1. ―‘Red ink‘, meaning zero earnings,
2. the previous period‘s earnings, and
3. analysts‘ consensus earnings forecasts.‖
First, try to surpass all three then scale back to two, then to one. Thus, evaluate outcomes relative to a
benchmark/reference point. There is very strong evidence on this (also general/anecdotal evidence on CEOs, etc.
making easy targets to beat and inducing pessimism). The key is setting a benchmark or reference point that is likely
to be exceeded.
Kihn / Behavioral Finance 101 / 203


THE ‗SMART MONEY‘ – THE PMS
This group is important for the following reasons:
1. They (combined with individual investors) directly influence pricing in the market (i.e.,
they have a market impact, sometimes even individually).
2. Of those two general sets of actors in the financial markets, they are considered the truely
‗smart money‘. Therefore, if they fail to enforce ‗efficiency‘, what are the odds that the
much maligned individual investors are able to enforce it?
3. Given numbers 1 & 2, and to the extent they do not enforce informational efficiency
and/or generate exploitable inefficiencies, there may be strategies and/or tactics which
can be profitably exploited in the market (i.e., possibly regardless of what individual
investors do).
4. They exhibit odd and sometimes illegal behavior, which should concern society (even if
it seems to be uninteresting to the oversight bodies, e.g., the SEC). That is, suboptimal
Kihn / Behavioral Finance 101 / 204

behavior, even if unexploitable by other actors in the financial markets, should be of
interest to society from an efficiency standpoint (specifically, resource allocation).
5. Labor market reasons and efficiency associated with #4 (e.g., to the extent certain
characteristics are associated with more optimal performance; then we may by being
selective end up creating a force for economic efficiency).
6. In terms of structuring an IP, who you select to be a PM or the equivalent and how you
set up the PM position or its equivalent is important (especially given what is known).

One finding concerning PMs is that characteristics matter. That is, some details concerning the
people matter, and normatively they shouldn‘t.
―We begin by showing that simple regressions of market excess returns on the managerial
characteristics in our data with no other controls suggest relationships between education, age,
and performance which are so strong as to make it seem unlikely that ‗ability‘ differences could
be the whole story.‖
Chevalier and Ellison (1999, p. 876)
160


What they found:
1. Strongest result was that PMs from undergraduate institutions with higher average SAT
scores produce higher returns (e.g., Princeton with a composite 1355 score vs. the mean
school in the sample with a composite 1142 score produces about 100 BPs per year
excess risk-adjusted returns).

160
Chevalier and Ellison (1999) checked a sample of 492 growth or growth and income funds for at least some part
of 1988-1994 period (using cross-sectional regressions).
Kihn / Behavioral Finance 101 / 205

2. Next strongest result was that younger PMs had higher returns than older PMs (about 100
BPs per 12 year differential, e.g., a 25yr. old vs. a 37yr. old). Although, much of this
differential was due to younger managers working for firms with lower expenses and
survivorship bias (due to hiring and firing sensitivity for younger PMs vs. older).
161

3. MBAs outperform non-MBAs by about 63 BPs per year, but it is entirely due to their
holding of higher levels of systematic risk (thus, getting an MBA suggests you don‘t
improve risk-adjusted performance, but you do get someone who will tend to try to game
the system).

The lessons are simple, going to higher SAT schools and age seem to matter in predicting
relative better risk-adjusted performance (therefore, you want high SATs and younger
managers), but these results tend to go against very established finance firm advertising
campaigns and conventional wisdom that suggest that age and ‗street smarts‘ are critical PM
characteristics. In short, it is very likely that IQ and age matter, and that observation is not very
EMH friendly.
162
Remember, under the EMT both dumb and ‗smart money‘ in equilibrium
receive the same returns.
163



161
Costa and Porter (2003) also find that ―tenure‖ and PM job performance (i.e., as related to relative risk-adjusted
returns) does seem to matter. They focused on analyzing PMs that had been managing the same portfolio for ten or
more years and found that excess returns tended to be concentrated in a few years, and subsequently tended to not be
repeated again. Again, this supports the opposite of the common contention that ―experience matters‖ (i.e., regarding
at least equity mutual fund PMs).
162
Although the authors try their best to support it (e.g., they suggest school networks may be the cause, not IQ,
which is unlikely).
163
This suggests hiring for an investment manager seems relatively easy (the higher the I.Q. and the younger the
better, and if you decide for some other reason to hire an MBA watch him or her closely).
Kihn / Behavioral Finance 101 / 206

In addition to undergraduate institution and age, what other things might be predictive of PM
performance or lack thereof? As it turns out, many PMs seem to spend an inordinate amount of
time trying to game the system. For example, it has been found that PMs often ―boost variance‖
in their attempt to catch the competition. This is called ―boosting variance‖.

Brown et al. (1996) tends to confirm other research and suspicions. Based on ―over 330 growth-
oriented mutual funds‖ (during the 1980-1991 test period), it was found that PMs in the sample
that were behind their competitors tended to increase their portfolio‘s variance, while those that
were ahead tended to decrease their variance.
164
Two quotes from the study should put this into
perspective:
―To this end, our goal in this paper is to test the hypothesis that given the profession‘s current
system of assessing and reporting fund performance on an annual basis, managers with either
extremely good or bad relative returns at mid-year have incentives to alter the investment
characteristics of their portfolios. The central testable implication that emerges from our analysis
is that the set of funds most likely to be ‗losers‘ in the final tournament results will see their risk
levels increase relative to the group of probable ‗winners‘.‖
―Perhaps the most important implication of this research is that it is possible that the current
tournament structure of the mutual fund industry truly does provide adverse incentives to fund
managers. That is, by focusing so much attention on relative return performance that is assessed
annually, the industry may be effectively changing managerial objectives for a long-term to
short-term perspective.‖

164
Also, the effect was more pronounced over the last six years of the sample period. Therefore, things have tended
to have only gotten worse (i.e., from an overall variance perspective).
Kihn / Behavioral Finance 101 / 207

Brown et al. (1996, p. 86, 109)

The understatement here is with respect to ―adverse incentives‖. The incentive structure, and
overall structure, of much of the industry creates incentives for some PMs to increase variance
beyond what is optimal and others to decrease their variance below what is optimal. Maybe this
is some version of ‗cancellation‘, but because it is targeted at variance, and not price, it is likely
to be doubly inefficient. Thus, ‗winner‘ portfolios begin to sub-optimally decrease variance
around the half-way mark of the ‗tournament‘ (about six months into the year) and ‗loser‘
portfolios begin to sub-optimally increase variance around the same time. Therefore, not only is
variance sub-optimal but, in addition, PMs have an investment horizon (the average PM‘s
horizon any year is ½ year), which doesn‘t even remotely match their clients‘ investment horizon
(covered in the individual investor section).
165
Thus, some PMs are actually causing increased
volatility and others decreased volatility, but both ‗winners‘ and ‗losers‘ are focused on too short
an investment time horizon.
166


Another example of economically inefficient PM behavior in the financial markets is something
called ‗portfolio pumping‘. PMs will drive up the prices of securities they hold at key reporting
times (especially year-end, also quarter-ends). Effectively PMs buy high and shortly thereafter
sell low; which reverses the notion of ―buy low and sell high‖. Imagine ―buy high and sell low‖

165
In addition, it is also possible that PMs may be simply trying to buy time. In effect, and analogous to
Hirshleifer‘s (1993) point about corporate investment decisions, PMs may be using other peoples‘ money to stay in
power and cloud the ability of others to judge their performance, at least in the short run.
166
Given that most PMs (and possibly most other finance ‗professionals‘) have about one year investment horizons,
and that many successful mean reversion strategies take a long horizon to be successful, this would suggest that long
horizon strategies would have a basis for possible success.
Kihn / Behavioral Finance 101 / 208

as investment advice? ‗Portfolio pumping‘ distorts prices (i.e., is inefficient), increases variance,
and is illegal, yet it commonly happens.
―… managers inflate quarter-end and portfolio prices with last-minute purchases of stocks
already held. The magnitude of price inflation ranges from 0.5 percent per year for large-cap
funds to well over 2 percent for small-cap funds. … and that the inflation is greatest for the
stocks held by funds with the most incentive to inflate‖
Carhart et al. (2002, p. 661)

Other Carhart et al. (2002) findings and thoughts:
• There is a ―surge of transactions‖ in the ―last few minutes‖ at quarter-end, and especially
year-end, with a corresponding abnormal increase in price that day and an abnormal
decrease in price the next day (there is no effect at month-ends that are not quarter-ends).
• This ―is a significant opportunity for potential sellers, and a significant hazard for
everybody else.‖ Carhart et al. (2002, p. 661)
• The ‗benchmark-beating hypothesis‘ is rejected and the ‗leaning-for-the-tape hypothesis‘
is accepted (i.e., due to the nature of flows, equity mutual fund PMs ‗portfolio pump‘ in
order to increase an already high annual ranking, not to beat the S&P 500 index
benchmark).
• Some, ―if not all‖, of the inflation associated with ―best-performing funds‖ at year-end is
explained by ‗portfolio pumping‘.
• There may be a profitable strategy for mutual fund investors, especially for small-stock
funds.
Kihn / Behavioral Finance 101 / 209

• ‗Portfolio pumping‘ also ―comes from the same source as the incentive to boost variance,
which is the convex relation between net new investment and performance.‖ (Carhart et
al. (2002, p. 690))
• This type of activity is illegal, but not punished (at least not in the U.S.).
167

• Unlike ‗window dressing‘, this effect will tend to moderate the ‗January effect‘ (i.e.,
without this type of behavior, the ‗January effect‘ would be more pronounced).
• ―The usual perspective on an investor purchasing a security is that he wants the lowest
price and the least impact.‖ Carhart et al. (2002, p. 691) This is the opposite of what was
found.

Again, the highest price with the most impact, how‘s that for a strategy? It‘s certainly doable,
and not very challenging, and has the added benefit of helping the annual bonus.

Another perverse (i.e., from a market efficiency standpoint) behavior on the part of PMs is called
‗window dressing‘. It is the practice of temporarily modifying portfolio structure (especially
money market funds) to present the appearance of a less risky portfolio. For example, Musto
(1999) found:
―The evidence presented here indicates that money fund managers do not manage their
claimholders‘ money as they would manage their own.‖
―The analysis shows that funds allocating between government and private issues hold more in
government issues around disclosures than at other times, consistent with the theory that

167
The authors try to rationalize the illegal and immoral aspect of the behavior; although it is ―considered illegal‖
they say that ―the aggregate monetary effect of marking up across a fund‘s investors is zero.‖ Carhart et al. (2002, p.
690) Also, only in Canada has anyone been penalized for this type of activity (Carhart et al. (2002, p. 691)).
Kihn / Behavioral Finance 101 / 210

intermediaries prefer to disclose safer portfolios. Cross-sectional comparisons locate the most
intense rebalancing in the worst recent performers.‖
Musto (1999, pp. 950, 935)
Therefore, the ‗window dressing‘ is accentuated for ‗loser‘ portfolios. As with the other effects,
the incentives seem to be most perverted for those with the most to gain.

Therefore, the various mutual fund gaming literature (‗tournaments‘, ‗portfolio pumping‘, and
‗window dressing‘
168
) indicate that:
1. Additional transaction costs are incurred for dysfunctional reasons.
2. PMs do not manage their clients‘ money as they would their own.
3. Extra risk is introduced as a result of the annual investment horizon (i.e., especially for
‗loser‘ portfolios). Therefore, not only is risk for ‗loser‘ funds too high, but the
investment horizon may be too short (and ‗winner‘ funds risk may be too low).
4. Performance takes a back seat to games, or who has time to manage?
5. Pricing is driven by annual tournaments and incentive structure.
6. Where is the SEC or other legal and regulatory authorities?

To summarize:

168
Lakonishok et al. (1991) also find that equity pension fund managers have a strong tendency to ‗window dress‘ at
quarter ends and especially the end of the year. This is somewhat unexpected on two levels: (1) in that it is
commonly thought that institutional PMs are not under the same pressures as mutual fund PMs, and (2) this is
shown for equity portfolios where the concern should not be the same as say money market mutual funds.
Kihn / Behavioral Finance 101 / 211



Many EMH/EMT proponents would say that taken as a group ‗anomalies‘ cancel each other out
(e.g., there is as much overreaction as underreaction, etc.). This is nonsense. As can be seen by
this summary graph, most documented economically dysfunctional games tend to push in the
same direction for the simple reason it is easier for most agents to do things like buy high and
sell low than the reverse.
169
In addition, and as a sort of perverse compliment to that basic
observation, because it is easier to pay too much than too little, it is easier to achieve greater
volatility than is optimal. This simple logic for both is that if, as a PM, I push prices too far (i.e.,
ignoring pushing them too low) by paying too much (an easy thing to do) then I also have
increased the volatility of those prices beyond that which would have naturally happened without
the action. Therefore, the easy, and inefficient, impacts are: (1) prices being too high, (2)
volumes being too much, and (3) volatility being too high (i.e., from a normative efficiency
standpoint).


169
We will go over other cases where this is shown to be true.
Empirically Identified Portfolio Manager ("PM") Dysfunctional Behavior that Impacts the Market
Impact on Impact on Impact on
Behavior Original Academic Study Asset Class Price Volume Volatility Comment
"boosting variance" Brown et al. (1996) equities ↑ ↑ ↑ & ↓ losers' & 'winners' go in opposite directions
"portfolio pumping" Carhart et al. (2002) small-cap equities ↑ ↑ ↑ strictly illegal, yet hard to prove
"window dressing" Musto (1999) short-term securities ↑ & ↓ ↑ ↑ a response to perceived market demand
Note, the one unambiguous result is that there is more trading (i.e., volumes tend to increase in all cases).
Regarding "boosting variance", by definition, there is a larger number of "losers" than "winners", thus, overall, volatility is likely to increase.
Regarding "window dressing", by definition, those securities perceived to be less risky are less liquid and will decrease in price more than the securities
purchased, thus prices are likely to increase.
Thus, overall, there is a general tendency for upward price pressure and vol. (therefore, these types of behavior tend to push markets in the observed directions).
Kihn / Behavioral Finance 101 / 212

You may be asking yourself, given the issues with PMs, why aren‘t the bad ones just identified
and fired?
170
Clearly, the overall structure of the firms and the industry isn‘t conducive to hire,
promote, and retain those that would most likely be averse to pushing prices, volumes, and
volatility beyond efficient levels.
171
To the extent PMs are replaced, an older PM would have to
normally underperform severely for several bonus periods in order to be terminated (see, e.g.,
Gallo and Lockwood (1999).
172



170
Of course, ultimately if performance is systematically bad enough long enough firing won‘t matter; the fund will
just disappear due to outflows of assets (i.e., assuming it isn‘t a closed-end fund). See, for example, Brown and
Goetzmann (1995) on this.
171
Of course, there are likely exceptions.
172
Gallo and Lockwood (1999) found for equity mutual funds:
1. ―Results show that funds experiencing a managerial change performed poorly before the change, primarily
as a result of inferior security selection. Risk-adjusted performance, on average, improved 200 basis points
annually and systematic risk increased significantly after the management change.‖ (p. 44) The t-statistic
associated with the change in alphas was around 3.65, and the betas ―reverted to the mean.‖ (p. 51)
2. Over 65% ―experienced a shift in investment style‖.
3. ―Thus, performance generally was below the benchmark prior to the management change and matched the
benchmark after the management change.‖ (p. 46)
4. In terms of performance attribution, security selection improved to about average, while market timing
stayed about the same (i.e., based on the Treynor-Mazuy method).
5. Therefore, most funds changed performance, risk profile, and style by changing the PM.
Given these results, why not change more often? Clearly, the incentives and/or structure aren‘t generally supportive
of performance related change (i.e., ignoring the case of young PMs).
Kihn / Behavioral Finance 101 / 213

THE PERSONNEL FILTER – A TENDENCY FOR THE ADVERSE SELECTION OF PMS –
OR WHY AREN‘T ONLY RATIONAL ARBITRAGEURS SELECTED TO BE PMS?
It is understandable if the reader is confused as to how such highly paid people (i.e., PMs) can
operate in the markets where some are consistently breaking laws/rules (i.e., at least in the
mutual fund or retail area) and most seem to ignore obvious arbitrage possibilities (i.e., in the
traditional finance sense). In fact, some even purposely buy high and sell low (i.e., the opposite
of arbitrage or call it reverse arbitrage).

Combined with the fact that many non-PM investors are not acting strictly rational, the most
plausible answer is related to the following expression: ―the markets make the manager‖. Dunn
and Theisen (1983) researched the issue of ―how consistently do active managers win?‖
173
Their
answer (Dunn and Theisen (1983, p. 47)) was: ―Essentially not at all. Or, perhaps, they lose with
the same degree of consistency.‖ In reference to PMs that were top quartile performers, they
found (Dunn and Theisen (1983, p. 49)) that ―the success of these managers seemed to reflect a
high level of market dependence.‖ In short, they found that if the market doesn‘t make the PM,
it doesn‘t seem to be anything else. Again, the essential finding is that those PMs that did well in
up markets tended to do well in up markets and poorly in down markets, while those that did
well in down markets tended to do well in down markets and poorly in up markets.
174
Of course,
this is a general result and especially depending on the degree of underperformance, there is

173
Theirs is one of a limited number of articles on institutional PMs. Most academic research on PMs has been
focused on mutual fund PMs. This is likely due to data availability.
174
Consistent, albeit indirectly so, with this general finding are the results of Bauman and Miller (1995) where they
measured performance for pension funds and mutual funds over a ―complete stock market cycle‖. Essentially, by
measuring over a full cycle (i.e., up and down market combined), outside of style differences resulting in significant
differential performance, no significant differences would be expected to be found (which is what was generally
found). Interestingly though, they found that pension funds and mutual funds had similar profiles vs. bank pooled
funds and insurance company pension accounts (i.e., with respect to performance consistency).
Kihn / Behavioral Finance 101 / 214

some evidence to suggest that very poor institutional performers survive and tend to poorly
perform across up and down markets (see, e.g., Christopherson et al. (1998)), which is similar to
mutual funds.
175


In the ―markets make managers‖, we have a crude personnel filter.
176
Clearly, at least with
respect to institutional active managers, there has been a tendency for momentum or asymmetric
beta (i.e., high in either an up or down market) traders to survive, otherwise you would see a
tendency for markets to unmake managers. Therefore, if there was a filter for consistent PMs,
one should see the opposite of that which has been documented. Instead of observing managers
that are consistent we observe PMs that seem to display high ―betas‖ in increasing and
decreasing markets.
177
For example, Ankrim and Ding (2002) document increasing volatility and
dispersion among active institutional managers (worldwide, not just a U.S. phenomenon, and not
just for the current up cycle), which they warned would predictably result in future poor returns
for those ―chasing‖ such portfolio returns. Essentially, they documented increasing betas in an
increasing market. Thus, you have a set of active managers that have high betas for up markets
and relatively low betas for down markets and vice versa, but relatively few in the middle (i.e.,

175
The obvious question is why aren‘t these managers fired? At least with mutual funds there can be a disconnect
from client to PM and/or management company, but with pension funds and the like there isn‘t suppose to be.
176
There is subtle evidence to suggest to me that this filtering is encouraged by the length and degree of mispricing
in the market. For example, an annual survey of institutional investors found that ―there are fewer and fewer truly
disciplined investors.‖ (see Bernstein and Kirschner (2003)) Thus, to the extent stock values continued to deviate
from economic fundamentals, fewer and fewer investors that keyed on those fundamentals are left in the market.
177
Odean (1999, pp. 1279-1280) makes proffers argument that ―There are reasons, though, why we might expect
those who actively trade in financial markets to be more overconfident than the general population. People who are
more overconfident in their investment abilities may be more likely to seek jobs as traders or to actively trade on
their own account. This would result in a selection bias in favor of overconfidence in the population of investors.
Survivorship bias may also favor overconfidence. Traders who have been successful in the past may overestimate
the degree to which they were responsible for their own successes—as people do in general (Ellen J. Langer and
Jane Roth, 1975; Dale T. Miller and Michael Ross, 1975)—and grow increasingly overconfident. These traders will
continue to trade and will control more wealth, while others may leave the market (e.g., lose their jobs or their
money).‖ Of course, this directly applies to active PMs.
Kihn / Behavioral Finance 101 / 215

―market neutral‖ overall). This should be especially disconcerting to investors that rely on active
managers to avoid market downturns.
178
Logically, if institutional investors were truly concerned
with risk-adjusted performance and most worried about downside risk, they should be
encouraging the selection of PMs that do relatively well in down markets. In contrast, in the case
of mutual funds, Howe and Pope (1996, p. 37) find that: ―The ability of Forbes down-market
ratings to predict risk-adjusted performance during future down-markets appears to be much
better than the ability of Forbes up-market ratings to predict risk-adjusted performance during
future up-markets.‖ Therefore, and although not based on a strong statistical result, if the Howe
and Pope (1996) result is true, then there is virtually no risk-reward benefit to keeping up market
retail PMs around, yet not only are they kept around, but they seem to be in the majority.
179


Obviously, adverse or negative selection doesn‘t only apply to fields such as insurance, used
cars, and ‗no doc‘ loans. It seems clear that the active PM personnel filter is not keying on
rational arbitrageurs with significant market timing skill.
180
In reality, quite the reverse seems to
be happening. PMs that expose their clients‘ capital to excessive risk in up and down markets
tend to be filtered. If anything, this would argue that active institutional PMs (as well as retail

178
Commonly, brokers and financial advisors will market that the primary reason an investor should pay extra for
active management is that they will tend to avoid market downturns, not make it worse.
179
It is important to keep in mind that mutual fund betas tend to be much more stable than their alphas; and, hence,
predicting standard risk-adjusted retail PMs performance can be somewhat of a ‗crap shoot‘ in the best of times.
180
For example, if it were, we should expect to see more female PMs (i.e., based on the fact that females tend to
have a better trading record than men (see Barber and Odean (2001)) as well as a better overall demeanor for
transacting in the financial markets. In fact, the majority of past and present PMs are male. Furthermore, of those
females selected they perform about the same as the men (see, e.g., Atkinson et. al. (2003)). Therefore, there seems
to be a relative improvement in the gender selection toward men and away from women that seems to somewhat
compensate for men‘s general tendencies to overtrade and underperform (i.e., at least underperform relative to
women).
Kihn / Behavioral Finance 101 / 216

PMs) display behavior that reinforces market inefficiencies
181
, and whatever aggregate personnel
filtering across the industry is happening
182
, it isn‘t generally weeding out those that display this
behavior.
183


Finally, there seems to be a significant difference between retail and institutional fund flows that
is likely to result in at least somewhat different personnel filters in each area. Del Guercio and
Tkac (2002, p. 523) find that: ―In contrast to mutual fund investors, pension clients punish poorly
performing managers by withdrawing assets under management and do not flock
disproportionately to recent winners. … We conclude that pension fund managers have little
incentive to engage in the risk-shifting behavior previously identified among mutual fund
managers.‖ Unlike institutional investors, ―return chasing‖ is in fact very common among mutual
fund investors, and fund companies know this (e.g., see Karceski (2002)). Clearly, given the
―market makes the manager‖ results found for active pension fund managers, the selection
process for institutional PMs is not without issues; but also clear is the fact that retail investors
display much more lax standards, if not downright perverse standards, when evaluating PMs than

181
In addition, confirmation bias itself is likely to play a role in this dynamic. For example, and although not directly
related to PMs, Sabourian and Sibert (2009, p. 26) remark concerning the financial services industry: ―people whose
rewards are determined by the perceived ability, as well as their long-term performance.‖ Although, because most
PMs are mostly concerned with annual bonuses which in most cases do not have explicit long-term components
(i.e., excluding HFs), I disagree with the ―long-term‖ portion of the comment, but the point about perception seems
apt. Therefore, without an explicit mechanism to counter perceptions, then those perceptions will tend to hold and be
reinforced (e.g., confirmation and related baises like hindsight bias).
182
Furthermore, to the extent that PMs are clustered in certain geographic locales Hong et al. (2005) have found that
there is a strong tendency to imitate other PMs in that locality (independent of geographic bias). Therefore, to the
extent a high level of geographic PM herding occurs, filtering is likely to be subject to a geographic component as
well as a market determined piece. On common strategies more generally, also see, for example, Brown and
Goetzmann (1995).
183
I would expect that this behavior might be worse for retail PMs than institutional. My reasoning is that the
average institutional money management firm and those that evaluate them are significantly more rigorous in their
evaluations than the average mutual fund organization and their average clientele.
Kihn / Behavioral Finance 101 / 217

do purely institutional clients. The result is likely to be a dysfunctional spectrum as we proceed
from passive institutional to more active institutional to finally active retail.

In summary, I would minimally expect to see the active retail PMs to set the dysfunctional
boundary conditions for active institutional PMs. If the basic filter for active institutional PMs is
that the ―market makes the manager‖, I would expect that that would minimally hold true for
active retail PMs. In fact, given their incentives and organizational structure, I would expect a
whole lot more adverse or negative selection to occur in the retail arena. In short, unless
evaluation criteria change greatly in the future, don‘t expect most institutional or retail PMs to be
the rational arbitrageurs required to keep market pricing efficient.

Kihn / Behavioral Finance 101 / 218

INDIVIDUAL INVESTORS – THE MOST MALIGNED GROUP
So far, the ‗smart money‘ has been a disappointment, and although I haven‘t covered hedge
funds
184
, what about individual investors? For example, given that they don‘t have incentives to
buy high and sell low, they should be alright? If you thought that institutional ‗smart money‘
buying and selling securities wasn‘t exactly acting within the purely rational economic animal
paradigm (i.e., unless we emphasize rather tortured agency rationalizations), then I‘m not sure
how to present this group, other than to say that nobody is above suspicion and the reader should
at least begin to see the validity of the behavioral approach (at a minimum as a lens with which
to view the financial markets).

Firstly, how do individuals actually construct their portfolios? Statman (1999, p. 14) has a useful
representation contrasting a standard finance normative representation with something closer to
descriptive reality:


184
Institutionally, due largely to data availability, we have mostly covered retail institutional PMs, for example.
Kihn / Behavioral Finance 101 / 219

From: Statman, M., ―Foreign Stocks in Behavioral Portfolios‖, Financial Analysts Journal, March/April 1999, 55, 2,
12, 16, p.14.

These two diagrams contrast an abstract Markowitz
185
(1952) on the left vs. an abstract
behavioral view of individual portfolio construction on the right. As pointed out by Lopes
(1987), for the individual, portfolio construction and ‗risk‘ is much about hope and fear (not fear
and greed), but it almost universally begins with hope and/or fear. The behavioral approach also
explains why people can simultaneously buy lottery tickets and money market funds. Essentially,
they want what seem normatively as contradictory desires (e.g., they hope for large positive
gains from the lottery ticket, and they feel they need to insure against financial calamity with the
money market fund).
186
Normative finance, especially mean-variance portfolio optimization,
doesn‘t easily reconcile such a simple combination. Even if normatively nonsensical, we observe
people routinely making such combinations.

More specifically, individuals tend to view their portfolios as a ―layered pyramid‖ (diagram is
from Statman (2007, p.122)).

185
Even though credited with it, Markowitz personally didn‘t believe in pure mean-variance optimization. In
addition, William Sharpe helped to develop a Website called ―financial engines‖ that performs a mean-variance
analysis, but presents information on portfolios in terms of fear, hope, and aspiration. In short, even those largely
responsible for ―modern finance‖ don‘t think of actually forming portfolios for themselves or others based solely on
mean-variance analysis.
186
Some securities seem especially designed to cater to these kinds of needs. For example, British Premium Bonds
have lottery tickets instead of interest/coupons.
―Most investors do not choose securities by ascertaining where the risk-return profiles place the securities on the
mean-variance frontier. Rather, investors‘ choices stem from their emotional reaction to the features promised by the
securities.‖
Kihn / Behavioral Finance 101 / 220


Source: Shefrin, H., Beyond Greed and Fear, Oxford University Press, New York, New York, 2007, p. 122.

Kihn / Behavioral Finance 101 / 221

What is powering this type of construction isn‘t the standard finance definition of risk, or return.
For individuals, risk can span a wide spectrum and is ultimately context dependent.
187
For
example, someone who is very worried about losing their job (or just lost it) might be much more
interested in investment safety considerations vs. another who is most hopeful about early
retirement. Security, potential, & aspiration are all critical goals. Examples of specific goals
include, for example, buy a home, fund college, retirement, etc. Financial
planners/advisors/brokers will often suggest that investors earmark particular investments for
specific goals.
188
In addition, ―anticipation has value.‖ For example, Lowenstein (1987) found
that a kiss from a movie star has the most value at three days vs. immediately, three hours, or one
day. This contrasts with anxiety (anxiety is a manifestation of fear). These sorts of considerations
are real, impact portfolio construction, but are hardly mean-variance arguments.
189


Of particular importance are hope and fear (see Lopes (1987)). Hope and fear affect the decisions
investors make. Hope encourages an investor to focus on the ―best case scenario‖, whereas fear
encourages an investor to focus on the ―worst case scenario‖. There is a tension between our
hopes for the best investment/gamble outcome, and our fear for the worst investment/gamble
outcome. All the while we wait anticipation either converts our hope into pride (if it works out as
hoped) or our fear, then anxiety, into regret (if it works out as feared). All humans seem to have

187
Statman (2003) makes the point that investors haven‘t changed that much over the years, that conflicting
emotions and/or desires often drive investment decisions (e.g., they ―aspire to be rich‖, yet want to ―avoid the pain
of regret‖).
188
Financial planners/brokers/etc. will often advise people to decrease stocks as you age. But the critical normative
consideration in that case is investment horizon not age. In reality decreasing stocks is a regret avoidance strategy.
189
As Fisher and Statman (1997) point out: ―investors care about more than expected returns and variance as they
construct their securities portfolios‖.
Kihn / Behavioral Finance 101 / 222

these two somewhat equally matched polar extremes, but one tends to dominate (although that
can also be context and experience dependent).

Given their overall importance to people, what is it about hope and fear (with hope and fear
being polar opposites, with hope being positive, fear being negative)? Lopes‘ places four pieces
on the ―emotional time line‖ (and in order of importance) thusly: (1) fear, (2) hope, (3) goals, and
(4) greed. Investors generally evaluate investments this way. First we make investment
decisions, then we wait, then the outcome exposes itself (and along the way, many emotions are
commonly experienced). Polar extremes can quickly be experienced, from one extreme to the
other. For example, hope to fear and back again. Risk tolerance is formed by many based on the
tension between various emotions and even their goals or aspirations. It is important to note that
if there is a change (e.g., the stock market drops substantially, a war, etc.) even the timeline or
investment horizon can get compressed. Almost regardless of the definition, emotions heavily
influence the tolerance for risk, which in turn influences portfolio construction. Therefore, our
hopes, fears, other emotions, goals or aspirations, and the events themselves all combine to
impact portfolio construction (and the context of those emotions and goals). Thus, the tension
between our various emotions and aspirations ultimately determines what we invest in (be it
government bonds, commodities, stocks, etc.).

It may useful to even make a few parting comments upon the emotion of regret and its potential
impact in the financial markets. Firstly, the hiring of financial ―advisors‖, brokers, etc. could be
argued to be largely driven by the need to shift responsibility, but the primary motivating factor
Kihn / Behavioral Finance 101 / 223

may be largely the need to minimize regret. It is convenient for individuals to avoid self-
attribution for mistakes they might make. This is especially true of areas where the probabilities
are ill-defined before the outcomes are known (e.g., future prices in the financial markets). In
short, by hiring a financial ―professional‖, given what we known descriptively about investors,
isn‘t it likely that what they are hiring is not so much an advisor but a future scapegoat? By
hiring a ―professional‖ I may just be mostly shifting responsibility at some future time from
myself to them. Secondly, as Kahneman & Tversky (1982) pointed out– ―regret is
counterfactual‖. It is especially painful for most people to deviate from the norm. Thirdly,
Gilovich & Husted-Medvec (1995) point out that there is a difference between short-term vs.
long-term regret. Specifically, they found ―that most people regret the things they didn‘t do.
When it comes to the long-term, we regret inaction.‖ Therefore, in the short-run we regret our
actions, but in the long-run we regret our inaction. For example, after you put in the purchase
order and the price goes down the next day, ―I knew I shouldn‘t have purchased IBM!‖;
conversely, if you didn‘t put in the purchase order and you happen to notice the price went up, ―I
knew I should have purchased IBM!‖ Isn‘t it likely that hiring or quoting a financial
―professional‖ is just a psychological call option? Finally and ultimately, any discussion of
investments and regret will involve self-attribution bias. If it goes well you take the credit (chalk
it up to skill), otherwise it‘s someone else‘s fault, or just bad luck. Also as mentioned already,
regret is more than the pain of loss, it is the pain associated with being responsible for the loss,
and its intensity can vary greatly. Thus, many seemingly odd behaviors (i.e., from a normative
perspective) are likely to be driven by issues like minimizing regret and needing to feel good
about yourself and your financial decisions.
Kihn / Behavioral Finance 101 / 224


We have some idea of how individuals make investment decisions and construct portfolios, but
do we know how that manifests itself in the actual financial markets? Luckily, we have a decent
amount of descriptive research on individual investors in the financial markets. Some of the
observations are the following:
• Their biases and sentiment affect asset prices (see Barber et al. (2003)).
• They ―follow the advice of false experts‖ and ―believe excessively in momentum
strategies‖ (see Avery and Chevalier (1999)).
• They have limited attention, fall prey to the representative heuristic, and the disposition
effect (see Barber et al. (2003)).
• They tend to buy and sell stocks with ―strong past returns‖ (this tends to be stronger at
short horizons (one or two quarters) for sales vs. buys and weaker at long horizons (up to
twelve quarters for buys vs. sales). See Barber et al. (2003)
• Their buys are concentrated in fewer stocks than their sales, and ―they are net buyers of
stocks with unusually high trading volume‖ (also, see Barber et al. (2003)).
• They ―are more likely to be net buyers of attention grabbing stocks than institutional
investors‖, and tend to systematically lose when trading against institutions trafficking in
the same ―attention grabbing stocks‖ (Barber and Odean (2006), or, to a lesser degree,
even based on overall trading (Barber et al. (2006)).
• Most don‘t seem to systematically incorporate taxes into their trading activities (Barber
and Odean (2004)). In short, some notice and act upon the effects of taxes, but they could
generally do much better to ―optimally allocate their assets‖.
Kihn / Behavioral Finance 101 / 225

• ―They do not appear to manage their assets across retirement and nonretirement accounts
to maximize tax efficiency.‖ (Bodie and Crane (1997, p. 13))
• They tend to buy mutual funds with high loads/brokerage commissions and ―attention
grabbing information‖. (Barber et al. (2006)) There is a strong negative relation between
fund flows and load fess, but not operating expenses (where the marketing and
advertising expenses used to garner attention are imbedded – see, e.g., O‘Neal (1999) on
mutual fund share classes and expenses, and Jones and Smythe (2003) on the lack of
information on risk and fees).
190

• The proportion of assets held in equities declines with age and rises with wealth (Bodie
and Crane (1997)).
• They cause noise and/or excess volatility. For example, ―unusual levels of individual
investor sentiment are associated with greater volatility of closed-end investment funds.
Furthermore, this volatility occurs only when the market is open and is associated with
heightened trading activity. It persists after controlling for market wide volatility and
changes in fund discounts.‖ (Brown (1999, p. 82)
• The true speculators among them feel that ―being in the action is more important than the
financial consequences. … for the majority of the speculators studied, the primary
motivation for continuous trading is the recreational utility derived largely from having a
market position.‖ (Canoles et al. 1997, p. 1)) This is in spite of the fact that the majority
consistently lose money.
191


190
For a more comprehensive view of this, see Kihn (1996).
191
For example, Linnainmaa (2003) noted that ―day traders‖ in Finland were found to systematically lose relative to
a control group, especially after brokerage commissions. Apparently, they will tend to keep trading as long as they
have sufficient capital.
Kihn / Behavioral Finance 101 / 226

• Have heterogeneous beliefs; but generally differ from WSSs, and are more in line with
the views of newsletter writers. Although, there is a negative and statistically significant
relationship between WSSs‘ market sentiment and individual investors‘ (i.e., they are
contra-forecasters of the market). See Fisher and Statman (2000).
• Are generally reluctant to realize a loss (i.e., one half of the ―disposition effect‖
192
).
193

See Shefrin and Statman (1985) & Odean (1998)
194
for stocks and Heisler (1994)
195
for
futures.
• Are generally happy to realize a gain (i.e., the other half of the ―disposition effect‖).
Odean (1998) Also, this propensity to realize a gain is likely a driver of excess volume
(and likely volatility as well) during a rising market (Barber et al. (2007)).
• Although tax-motivated selling is most evident in December, the tendency to hold
‗losers‘ and sell ‗winners‘ is ―suboptimal and leads to lower after-tax returns.‖ (Odean
(1998, p. 1775))
• Risk aversion varies with wealth, age, education, and income (Riley and Chow (1992)).

192
Shefrin and Statman (1985) ―coined the term ‗disposition effect‘ as a predisposition toward ‗get-evenitis.‘‖ Get-
evenitis - ―difficulty people experience in making peace with their losses.‖ Loss aversion plays a role and people‘s
tendency to create an investment price reference point (which is central to Prospect Theory – ―PT‖).
193
Also, see Barber et al. (2007).
194
The Odean (1998) study of about 163,000 customer accounts confirms the ‗disposition effect‘ (see Shefrin and
Statman (1985). It largely seems to be a self-control issue. Specifically: ―Investors who are risk averse realize more
of their paper gains than they do their paper losses. … realize gains 1.68 times more frequently than they realize
losses. This means that a stock that is up in value is almost 70% more likely to be sold than a stock that is down.
Only in the month of December do investors realize losses more rapidly than gains, though only by 2%.‖ In
addition, they tend to realize small losses and hold larger losses, and tend to sell the wrong stocks (i.e., ones that
tend to do very well after they sell them).
195
Heisler‘s (1994) study was on the impact of loss aversion on futures traders (more than 2,000 individual futures
account trading histories or over 19,000 trades of Treasury bond futures on the CBOT were analyzed (11/1989
through 10/1992). They found (1) traders held losers longer than initial gainers, (2) when losers held, trading activity
is non-profitable, and (3) only 24% showed a profit over the period (on average, off-floor traders lose $17 per
contract traded).

Kihn / Behavioral Finance 101 / 227

• Fail to diversify (e.g., Blume et al. (1974)), practice ―naïve diversification‖ (see Benartzi
and Thaler (2001)), and exhibit a ―home bias‖ (French and Poterba (1991) and, e.g.,
Grinblatt and Keloharju (2001)). Overall, diversification seems of distant importance to
them.
• They trade too much (Odean (1999) and Barber and Odean (2000)
196
), and both relative
to institutions and overall lose great sums doing it (Barber et al. (2006)). Men trade more
than women, and it costs them more (Barber and Odean (2001)
197
).
198
Furthermore:
―The surprising finding is that not only do the securities that these investors buy not
outperform the securities they sell by enough to cover trading costs, but on average the
securities they buy underperform those they sell. This is the case even when trading is not
apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to
lower-risk securities.
While investors‘ overconfidence in the precision of their information may contribute to this
finding, it is not sufficient to explain it. These investors must be systematically
misinterpreting information available to them. They do not simply misconstrue the
precision of their information, but its very meaning.‖

196
And it costs them a great deal to do so (Barber and Odean (2000, pp. 799-800)): ―the average household
underperforms … by about 9BPs per month (or 1.1 percent annually). … the 20 percent of the households that trade
the most often. … The net returns lag a value-weighted market index by 46BPs per month (or 5.5 percent annually).
… After a reasonable accounting … the underperformance averages 86BPs per month (or 10.3 percent annually)."
In short, they ―pay a tremendous performance penalty for active trading.‖ Barber and Odean (2000, p. 773)
197
Barber and Odean (2001, p. 261) found that: ―men trade 45 percent more than women. Trading reduces men‘s net
returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women.‖
198
Although, based on a study of fixed income mutual funds, Atkinson et al. (2003) find no significant difference
between women and men PMs. Thus, at least for that particular sample, whatever personnel filtering is going on, it
is resulting in selecting women that produce about the same portfolio characteristics as their male counterparts.
Therefore, relative to Barber and Odean (2001) sample, which I take to be representative of the population at large,
the men selected to be fixed income PMs are relatively better than the women selected for similar positions. As a
side note, they did find that funds flows themselves favored men over women, ceteris paribus, especially in the
initial year of managing; which would seem to contribute to sub-optimal gender selection.
Kihn / Behavioral Finance 101 / 228

Odean (1999, p. 1280)
• Although seemingly responsible for many ‗anomalies‘, they do not appear responsible for
the ‗day-of-the-week anomaly‘. (see Sias and Starks (1995))

The last two are important for two different reasons. Firstly, if it is true (which it seems to be the
case) that investors misinterpret the ―very meaning‖ of the information they are presented with,
then information itself is a problem, let alone embedding it into pricing, and the traditional focus
on information and prices may be largely misguided. Secondly, regarding the ‗week-end effect‘,
it seems that individual investors are not completely responsible for all normative market
oddities and inefficiencies (i.e., from an EMT perspective). Therefore, it is entirely possible, if
not likely, different sets of agents/actors in the financial markets not only don‘t cancel each other
out, but indeed cause deviations by their apparent buying and/or selling pressure at the same time
in the same market(s) (the opposite of ‗cancelation‘).

We know descriptively that all the aforementioned behavior and/or biases result in the following
general profile of and stylized facts for individual investors (see the De Bondt (1998)
199
study):
1. Investors are excessively optimistic about their own shares.
2. Investors are overconfident.

199
De Bondt (1998) studied a group of 45 investors at the NAIC (National Association of Investment Clubs). Of
those studied, 2/3
rd
were men, the average age was 58, trading stocks for about 18 years, financial portfolios of about
$310,000 (72% stocks), and spent about 7 hours per week on investments. Findings (after tracking their forecasts for
the DJIA and their own stocks): (1) Excessively optimistic about their own shares, but not the DJIA (which implies
overconfidence). (2) Were overconfident (successively surprised by actual changes in prices). (3) Forecasts were
anchored on past performance (and they expected reversals). (4) Underestimated beta (or the degree to which their
own stocks moved with the market). A general description of their attitudes was as follows: (1) Do not believe in
throwing darts (i.e., when picking stocks). (2) Believed a solid understanding of firms is better risk-management tool
than diversification. (3) Reject beta as a measure of risk, and reject that risk/return are positively related.
Kihn / Behavioral Finance 101 / 229

3. Investors anchor on past performance.
4. Investors underestimate ‗beta‘.
5. Investors discount diversification (and reject ‗beta‘ as a measure of risk).
6. Investors reject the notion of tradeoff between risk and return.
It is fairly safe to say that, individual investors are not exactly the pool from which we would
expect large numbers of rational arbitrageurs to emerge, or find normally using normative tools
and/or models of finance and economics.

Finally, remember that the analysis of actual individual behavior in the financial markets matters
because outside a strong institutional framework/structure most individuals will behave as if
there were no framework/structure in place, by definition. Therefore, even if large institutions
were the only ones determining pricing in the financial markets (which they are not) it might
give some insight into their unconstrained behavior (i.e., a kind of behavioral boundary
condition), whereas the alternative would not be true of individuals, again, by definition.

I will end the chapter with prescriptive advice with respect to investors and prospective investors
in the financial markets:
• Don‘t trade too much.
• Don‘t hold ‗losers‘ too long and sell ‗winners‘ too quickly.
• Don‘t respond too much to noise & saliency and too little to fundamentals.
• Don‘t create excess volume and volatility.
• Don‘t follow the wrong advice.
Kihn / Behavioral Finance 101 / 230

• Don‘t pay too little attention to taxes.
• At least as a starting point, try a mean-variance optimizer.
Essentially, do the opposite of what most of us are predisposed toward doing.

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Chapter 7: Bubbles

―They soon received the name of Bubbles, the most appropriate that imagination could devise.
The populace are often most happy in the nicknames they employ. None could be more apt than
that of Bubbles.‖
Mackay (1980, p. 57)

I would argue that up until this global ―financial crisis‖, as a rule, finance academics didn‘t use
the term ―bubble‖.
200
In fact, even a recent search on the term in academic article databases
returns a relatively de minimus number of economics oriented articles.
201
This may be due to the
common practice of many academics to ridicule anyone that uses the term. Also, given that
prices are always and everywhere assumed ‗right‘, of course, EMT proponents generally don‘t
believe bubbles can even exist.
202
Therefore, if we accept the notion that a bubble is an extreme
deviation from fundamental or true economic value, then one can see why EMT proponents
might have trouble with the subject in any form. Much like the $100 bill lying on the street in the
EMH/EMT joke, it must be an illusion. Even, and maybe especially, the former Chairman of the

200
In reference to financial academics and other economists (especially Alan Greenspan), Krugman (2009) stated
that there is: ―a general belief that bubbles just don‘t happen. What‘s striking, when you reread Greenspan‘s
assurances, is that they weren‘t based on evidence — they were based on the a priori assertion that there simply
can‘t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview,
Eugene Fama, the father of the efficient-market hypothesis, declared that ‗the word ―bubble‖ drives me nuts,‘ and
went on to explain why we can trust the housing market‖. Therefore, if something like a housing ‗bubble‘ is not
even possible, then what is there to discuss, let alone research?
201
And many of those use the term ‗rational bubble‘. See, e.g., Treynor (1998) who insists that bubbles can be
rational, all the while using normative theory as his basis for the argument. In addition, economists have, it seems
unsuccessfully, to create normative models to show that bubbles can be ‗rational‘ (see, e.g., Froot and Obstfeld
(1991)).
202
Also, see Shiller (2002) on this issue.
Kihn / Behavioral Finance 101 / 243

Federal Reserve Bank was reluctant to suggest that they could exist.
203
For example, even at near
the peak of the U.S. real estate bubble, a Congressman had to coax the following comment from
him:
―Although a 'bubble' in home prices for the nation as a whole does not appear likely, there do
appear to be, at a minimum, signs of froth in some local markets where home prices seem to
have risen to unsustainable levels."
Alan Greenspan (Chairman of the Federal Reserve Board) testifying before the U.S. Congress,
June 9, 2005

Therefore, even at the peak of arguably the largest real estate bubble in the history of mankind
the best you can get is effectively: ―Bubble? What bubble? Oh, you mean that spotty localized
‗froth‘?‖
204
Remember, the Federal Reserve has the largest staff of Ph.D. economists and
financial economists on the planet. Clearly, the ultimate leader of that brain trust wasn‘t
concerned, let alone the staff. Suffice it to say that, and as long as the EMH/EMT religion
dominates, financial bubbles will not be a focus of economics or finance.

203
In fact, he was always reluctant to acknowledge their existence, even after the fact. He was almost famous for
repeating the folk wisdom of mainstream economics and finance that: ―it was very difficult to definitely identify a
bubble until after the fact – that is when bursting confirmed its existence.‖ This sentiment was used to justify the
avoidance of popping the stock bubble that appeared to peak out in 2000, but that may have at partially re-inflated
recently as I write this book (spring and summer of 2009).
204
Indeed, his successor wouldn‘t use the term bubble when testifying to Congress during April 2006, when it was
becoming increasingly clear that the peak had been reached in housing prices in the U.S. Bernanke said that: ―House
prices, which have increased rapidly during the past several years, appear to be in the process of decelerating, which
will imply slower additions to household wealth and, thereby, less impetus to consumer spending. At this point, the
available data on the housing market, together with ongoing support for housing demand from factors such as strong
job creation and still-low mortgage rates, suggest that this sector will most likely experience a gradual cooling rather
than a sharp slowdown. However, significant uncertainty attends the outlook for housing, and the risk exists that a
slowdown more pronounced than we currently expect could prove a drag on growth this year and next. The Federal
Reserve will continue to monitor housing markets closely.‖ Therefore, Greenspan‘s successor didn‘t even consider
that prices would stop increasing, just that the rate of growth would slow (he mentions ―slower additions to
household wealth‖, not losses); and, even if asked directly about it, nowhere did he mention a bubble.
Kihn / Behavioral Finance 101 / 244


But this book is about behavioral finance, and I would be remiss, at a minimum, not to cover
financial market bubbles, if not bubbles more generally. Therefore, this chapter will cover
financial bubbles and related issues. It will proceed as follows:
1. Define the term bubble.
2. Discuss likely and/or possible cause(s).
3. Discuss bursting effects.
4. Link them to behavioral finance. For example: When can it be ‗rational‘ to be ‗irrational‘
(i.e., if ever)?
Note that all four areas covered are highly debatable within finance and economics, if not
acrimonious. Again, the issue is largely one of the basic assumptions of finance and economics
in that up until recently there has been no place to even discuss the subject of ―bubbles‖ because
market efficiency doesn‘t really allow their existence and/or the ability to recognize them before
popping/bursting. Obviously, I beg to differ, and, as per my norm, I really on descriptive work
and basic logic to work my way through the subjects in question.

Kihn / Behavioral Finance 101 / 245

WHAT IS A BUBBLE?
Definition(s)
My focus here is to remain as intuitive as possible while moving from the most general to more
specific, then add a functioning mathematical definition.

Most general definition
205
:
A bubble is an unsustainable rise in the price of something.
206


Finance general definition:
A financial bubble is an unsustainable rise in the price of a financial asset (typically associated
with a large and pervasive deviation from fundamental value)
207
. For example (and related to a
financial bubble):
―A bubble exists when asset price inflation rises beyond what incomes can sustain.‖
//www.chrismartenson.com/

Therefore, the key term is ‖unsustainable‖. The reader might admit that those are reasonable
definitions, but that begs the question: What do you mean by unsustainable? By ‖unsustainable‖,
I mean just that. Maybe an example is in order. During the 1980s the stock bubble of the time
was arguabley IBM. IBM, a very large company at the time (relative to other companies and the

205
Actually, the most general definition I have seen is Nov and Nov (2008), where they extend the definition to
include non-monetary things, such as article citations.
206
Always keep in mind that basic economics applies. That is, prices are set by supply and demand, and the price is
generally set by the highest bidder.
207
Although it is rare that we can agree on what is truly ―fundamental value‖, there are cases where, by almost any
definition, values are deviating so far from generally agreed fundamentals that we can be highly confident in
inferring a bubble and even that its cause is likely behaviorally based (e.g., Chan et al. (2000)).
Kihn / Behavioral Finance 101 / 246

economy), was valued by standard present value techniques (i.e., for the common stock this
meant present valuing its expected cash flows, which were its expected dividends) to be worth a
trading value that implied a growth rate of distributable cash flows to be somewhere in excess of
a 25% growth rate to infinity. Now that‘s unsustainable, and let me inform you of at least one
way how we know. In effect, and assuming a modern economy could grow at around 4% annual
growth to infinity (which itself is debateable), then based on IBM‘s size at the time, combined
with this implied growth rate relative to the larger economy‘s growth rate, meant that IBM would
take over the U.S economy, then shortly thereafter all economys of the world in a few decades.
The question wasn‘t really so much if that implied growth could be sustained, but when the stock
market would recognize that it couldn‘t, for it was clearly ‖unsustainable‖, and therefore a
‖bubble‖.
208


Also, is is important to reconcile this general definition with finance in general. That is, if
finance is concerned with present values (cash flows and associated discount rates), then
shouldn‘t we have a definition based on present values? Answer: Yes, but this, as usual
presupposes financial academics can agree on one, which they don‘t.
209
Therefore, even if they

208
Another way to look at this is a heuristic called the ―rule of 72‖. For example, how long does it take to double at
8%? Divide the interest rate into 72 and the answer is 9 years (i.e., roughly). Therefore, at 25% it takes about 3 years
to double. As an extension is the ‖rule of 10‖ which applied to 2 is

= 1,024 or roughly 1,000. Therefore, if you
double 10 times, 1 turns into about 1,000. Thus, at 25%, after say three decades (30 years), millions turns into
billions, billions turn into trillions, etc. If IBM is worth $100 billion today, and is expected to grow at about 25% for
about 30 years, it will roughly be worth $10 trillion, or more than half of the U.S. GDP.
209
Siegel (2002) attempted this, but made several huge assumptions which are difficult to reconcile with logic or
empirical reality (e.g., as long as ½ of the future discounted cash flows – discounted at a rate we only know after the
fact as well - for the next 30 years cover the price within 2 standard deviations then there is no ‗bubble‘, otherwise a
bubble). In short, he constructs a measure of a stock bubble which is loosely based on cash flows and almost
impossible to find a bubble, and if one is found it comes at odd times. Thus, for example, he finds that the Dow
Jones at its peak in 1929 is considered fair value, while the 1987 crash stock market is undervalued by the measure.
The method seems contrived and illogical, while the results are absurd.
Kihn / Behavioral Finance 101 / 247

don‘t rely primarily on present value, I find it more productive to rely on definitions that are
intuitive, generally acceptable, and reconcilable with reality.

With that example in mind, let‘s move onto a function mathematical definition of a bubble that
essentially is the math equivalent of our verbal definition(s) and has the added benefit that it
doesn‘t even require a fundamental model for the price level (this example is from Zhou and
Sornette (2006, pp. 299-300)):
―Mathematically, these ideas are captured by the power law
| |
m
c
t t B A t p ) ( ) ( ln ÷ + = , (1)
where p(t) is the house price index,
c
t is an estimate of the end of a bubble so that t <
c
t and A,
B, m are coefficients. If the exponent m is negative, | | ) ( ln t p is singular when
÷
÷
c
t t and B > 0
ensuring that | | ) ( ln t p increases. If 0 < m < 1, | | ) ( ln t p is finite but its first derivative d | | ) ( ln t p /dt
is singular at
c
t and B < 0 ensuring that | | ) ( ln t p increases. Extension of this power law (1) takes
the form of log-periodic power law (LPPL) for the logarithm of price
| | | | | e ÷ ÷ ÷ + ÷ + = ) log( cos ) ( ) ( ) ( ln t t t t C t t B A t p
c
m
c
m
c
, (2)
where | is a phase constant and e is the angular log-frequency. This first version (2) amounts
to assume that the potential correction or crash at the end of the bubble is proportional to the total
price [3]. In contrast, a second version assumes that the potential correction or crash at the end of
the bubble is proportional to the bubble part of the total price, that is to the total price minus the
fundamental price [3]. This gives the following price evolution:
| | | e ÷ ÷ ÷ + ÷ + = ) log( cos ) ( ) ( ) ( t t t t C t t B A t p
c
m
c
m
c
. (3)
Kihn / Behavioral Finance 101 / 248

As explained in [13,6], we diagnose a bubble using these models by demonstrating a faster-
than-exponential increase of p(t), possibly decorated by log-periodic oscillations. …‖
Source: taken from Zhou, W., and D. Sornette, ―Is there a real-estate bubble in the US?‖, Physica A, Volume 361,
Issue 1, February 2006, pp. 299-300.

Even though these equations were for a real estate bubble, they apply generally (also, see, e.g.,
Watanabe et al. (2007)). Essentially, almost irrespective of its fundamental value, any financial
asset price that grows at ever increasing rates is mathematically and physically unsustainable.
That is, and ignoring the deviation from fundamental value issue, if the rate of growth becomes
faster than an exponential increase in the price of the financial object of interest to us (e.g., a
stock, a stock market, a house, a real estate market, a commodity like oil, etc.), the probability of
a crash or correction toward fundamental value increases.
210
The usefulness of this ―power law‖
approach is that prices can be viewed over time, and if the price begins to outpace its assumed
fundamental value, or even only its absolute value in this case, at an increasing speed it is likely
to crash, or at least stop growing.
211
In short, although the formulas may not be obvious, the
results are intuitive.

A simplified application of the power law approach can be applied as follows:
212


210
For more on the ―crash‖, see, e.g., Ferguson (1989) on the October 1987 probable dynamics, but note that these
types of ―crashes‖ are not the norm. Also, Andersen and Sornette (2004) have a useful method for using volatility to
measure the likelihood of a ―fearful bubble‖ that is more likely to result in a dramatic movement down than a
―fearless bubble‖ where volatility is little changed on the way to the peak.
211
Again, we don‘t normally have an idea as to the actual fundamental value. Therefore, we will typically use
market derived price change as our measure.
212
I credit Mike Davis for suggesting this approach.
Kihn / Behavioral Finance 101 / 249

, where

is the price of a financial asset at time t,

is its starting price, and k is not
constant (k is what we are trying to measure to evaluate sustainability), and is an increasing
function of t, k(t) where

. Note that the time to double for a given k is log2/k.
The value k can be estimated by looking at a lagged time series. For example,

,
for a monthly series. If the values of k increase every month, then this is indicative of a bubble.
In short, increasing growth is possible (maybe not likely for financial asset prices, but possible),
but an increasing rate of growth every period is clearly unsustainable (actually physically
impossible in a finite world). Therefore, if the price of a financial asset in question continues to
increase at an increasing rate (i.e., k continues increasing), it is a likely bubble and it will
decrease or pop, it is only a question of when.
213


The following graph represents one application of this approach to the month-end price of oil ($
price per barrel of West Texas-Okl. crude oil):

213
In addition, Andersen and Sornette (2004) developed an interesting approach where a series‘ stochasticity (and
nonlinear feedback) is used to enhance identification of bubbles and to bifurcate categorization into ―fearful singular
bubbles‖ (where volatility is generally increasing as the peak is approached) and those that are ―fearless‖ (where
fearlessness is reflected by no significant change in volatility, e.g., the NASDAQ bubble).
Kihn / Behavioral Finance 101 / 250



The red line is the monthly estimate for

, and the blue line is the six month rolling
percentage of months where k is increasing (called the ―bubble indicator‖). Therefore, if the
estimate for k increases each month for six months in a row, the ―bubble indicator is 100% (6/6),
if three months then 50% (3/6), etc. The only point where k increased for six consecutive months
was the six months ending June 1992. Therefore, that period could be defined as the front side of
a relatively short bubble in the price of West Texas crude oil. Also, as you can see, based on this
‗power law‘ derived definition there are several periods that could be defined as bubbles (e.g.,
one peaking around the end of May 2008).
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Applying the 'Power Law' to the Price of Oil
k
Bubble indicator
Kihn / Behavioral Finance 101 / 251


In addition, I tried the halving time as another ―bubble indicator‖ (again, the time to double for a
given k is log2/k).


In this case I filtered the time it takes to double the price of oil to any positive value less than two
years (i.e., the red line). Where it spikes are periods when the price increases in oil are clearly
unsustainable. For example, at the end of May 2008, the price of West Texas crude oil was
doubling every year, clearly unsustainable.
214
Indeed, the price peaked at around $140 per barrel

214
Of course, assuming monetary induced price inflation itself isn‘t running rampant.
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Applying the 'Power Law' to the Price of Oil - Halving Time
k
Time to double
Kihn / Behavioral Finance 101 / 252

at the end of June 2008 and bottomed out around $42 per barrel at the end of January 2008.
Again, this is just one way to identify unsustainable price series.

The primary purpose of this exercise is to show: (1) price bubbles can be mathematically defined
as a function of the rate of price increase, and (2) that definition can be used to detect clearly
unsustainable periods of price increase (e.g., depending on how stringent your ―bubble
indicator‖).
215
That noted, even mathematical methods may have a large dose of art when applied
to bubble detection.
216



215
Watanabe et al. (2007, p. 120) actually claim that: ―It is shown that the whole period of a bubble or a crash can be
determined purely from the past data, and the start of a bubble can be identified even before its burst.‖ Of course, if
that is true, then identifying all three major phases of the bubble could be relatively straightforward.
216
Of course, and as usual in finance, it would help to know the ‗pricing model‘ for the asset in question, but none is
available (i.e., that is acceptable to the academic ‗profession‘). Therefore, the analysis here relies on the lack of
sustainability of the overall price (i.e., not relative to fundamental or true value).
Kihn / Behavioral Finance 101 / 253

WHAT DOES A BUBBLE LOOK LIKE?

Source: Wikipedia – ―Anonymous 17th-century watercolor of the Semper Augustus, famous for being the most
expensive tulip sold during tulip mania.‖

Behold the Semper Augustus! At the peak of the bubble/‖tulip mania‖, one Semper Augustus
bulb sold for a record price of 6,000 florins. This was the equivalent of forty years of income for
the average person at the time (i.e., at 150 florins per year).
217
Although I like tulips, and
certainly a Semper Augustus is a fine looking tulip, would you pay essentially a life‘s earnings
for one bulb, and especially knowing that it might not even turn into a flower? Moreover, does
that seem like something that economists and/or finance types would call ‗rational‘?

The ―Tulip Bulb Mania‖ in the Netherlands in the early 1600s is considered by many historians

217
For another method of estimating tulip prices during the peak of that bubble, see Hirschey (1998).
Kihn / Behavioral Finance 101 / 254

to be the greatest market bubble of all times. Of course, such things depend on your definitions
and perspective, but it seems fair to say that it was a bubble (i.e., unsustainable).

In terms of sustainability, how did or does this U.S. residential housing price series look?

Source: Shiller, R., Irrational Exuberance (second edition), Princeton University Press, Princeton, N.J., 2006.

The chart ends approximately when the chairman of the Federal Reserve made his comments
about the lack of a national housing bubble (i.e., that it was ―unlikely‖), and it coincides
approximately with the bursting of that bubble. If anything, aside from being unprecedented, the
Kihn / Behavioral Finance 101 / 255

series represents anything but a sustainable looking series. Let‘s see whether incomes could
support it. Basic logic dictates that the average or median house price must be affordable for the
correspondingly average or median wage earner or the price is unsustainable.
218
Thus, one rough
and basic measure of sustainability is price to earnings or cash flow. What follows is a graph of
median U.S. house price to median U.S. income.




218
Most appropriate would be the median income of the median homebuyer, but as a rough approximation we‘ll
look at median wage earners and median price.
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Ratio of Median House Price to Median Household Income
Kihn / Behavioral Finance 101 / 256

As you can see, from the beginning to the end of the series the spike that began around 2000 has
no historical precedent in this series (1968 through 2007). The only other significant spike where
affordability (i.e., as defined in this way) was pushed was during the 1970s.
219
Normally, the
ratio of price to income has been around 2.5 to 2.6. The rough rule of thumb (heuristic) is that if
the ratio is beyond 2 & ½ that buyers should be wary of purchasing a house. Also, this says
nothing about location specific affordability. During the U.S. real estate bubble this ratio was
over five times in certain areas of California, for example (even around ten times in some
locations).

Additionally, there has been large variation between countries. For example, contrast the
following ratio for the U.K. (although the numbers aren‘t exactly comparable) to the previous
U.S. graph:

219
I am also ignoring the likely case where incomes during the bubble period were inflated and thus unsustainable
themselves.
Kihn / Behavioral Finance 101 / 257


Source of graph: Nationwide.

In the U.K., the national market has been progressively driven by the London, England; therefore
London was well over five times earnings (actually well over seven). The U.S. residential real
estate bubble was almost contemporaneous with the U.K. real estate bubble and many others.
The degree to which prices bounded away from fundamental drivers of valuation depended on
the country and even the more local market, but bound they did in many areas to clearly
unsustainable levels. The question wasn‘t so much whether certain real estate markets
constituted a bubble, but exactly when they would burst.

Kihn / Behavioral Finance 101 / 258

Before proceeding, it is important to expand on the fairly general dynamics of the largely
unprecedented (in terms of scope and magnitude) real estate bubbles that occurred in the U.S., in
particular. Here are some of the more important drivers of that market during the buildup in
prices:
- Supply & demand
220
imbalances – Clearly, any bubble like the U.S. real estate bubble
that peaked out around the spring-summer of 2005 (i.e., nationally, as opposed to locally)
must have had general supply/demand imbalances (predominantly being relatively more
demand than supply in most geographic areas). The fundamental issue is what caused this
general imbalance over many years? One clear driver was that potential buyers kept
entering the market for homes. In particular, the median required income to purchase a
home generally kept going down with mortgage rates (and other drivers as well). Given
that mortgage rates were largely drive by Treasury rates, which in turn were largely
driven by monetary authorities generally pushing rates down over the period. Therefore,
ultimately, a primary cause, if not the primary cause, was Federal Reserve actions. For
example, a $100,000 fixed rate 30-year mortgage at 10% would require $877.57 per
month payments, whereas the same loan at 5% would require $536.82 in payments (an
approximately 39% reduction in monthly payments from the higher rate).
221
In fact, the
30-year ―conventional mortgage rate‖ over the period January 1990 through December
2006 (the period encompassing the front-side of the bubble), as reported by the Board of
Governors of the Federal Reserve (the rate is entitled ―MORTG‖), peaked at 10.48% in

220
Normally as prices increase, demand decreases (ceteris paribus), but it would seem for bubbles especially, as
price increases demand seems to increase almost irrespective of changes in supply or no change n supply (i.e., they
appear as ―Giffen goods‖).
221
The calculation was done by the mortgage calculator at http://www.mortgage-
calc.com/mortgage/simple_results.html.
Kihn / Behavioral Finance 101 / 259

May 1990 and bottomed at 5.23% in June 2003. Clearly, lower interest rates had a huge
impact on the supply/demand imbalances that generally resulted in unsustainable housing
prices. Specifically, lower interest rates make it possible for more demand, as well as
larger loans, ceteris paribus.
- The terms of mortgage loans were relaxed – As the bubble progressed various loan terms
and types of loans generally encouraged more demand. For example, down payments
generally kept being reduced until they were, in some cases, eliminated altogether. Thus,
if a potential buyer is required to save $20,000 to make a 20% down payment for a
$100,000 loan; now assume only a 10% down payment on the same loan amount (i.e.,
$10,000); clearly, many more potential buyers would tend enter the market.
222
Needless
to say, ―no money down‖ loans opened the set of potential homebuyers to virtually
anyone able to breathe. Obviously, these sorts of inducements also had an impact on
speculation, and not just housing speculation. For example, with no money down why not
buy two or three houses? Why not purchase apartments or a shopping mall? As one can
imagine the combination of lower payments (and in some cases no payments, e.g.,
―negative amortizing‖ loans) and relaxed loans terms meant that demand had almost no
limits (i.e., as long as prices were generally perceived to be increasing).
- Deferred payments – As the bubble progressed, many new types of loans were
introduced. Not only did payments generally come down, but for some loans the
payments were deferred. For example, for some loans, especially popular near the peak,
debtors didn‘t have to make any payments until two years later. Thus, one could

222
In addition, if prices head south, they are more likely to walk away. This is a current problem as many financial
institutions are seem somewhat perplexed by the, at least at the time of this writing, high level of defaults they are
facing.
Kihn / Behavioral Finance 101 / 260

theoretically get a loan where no payment of any kind was required for several years.
Talk about encouraging speculation; if the price goes up sufficiently you make the
payment(s), otherwise default.
I could go on, but as this point it seems clear that the market for residential real estate, and even
the more commercial real estate markets, was driven by a combination of things, but the
common thread was decreasing rates and terms.

Beyond the aforementioned U.S. real estate market dynamics are a host of other more specific
dynamics that were either exacerbated by CB or other government actions, and/or increasing
prices themselves, and/or momentum built up from the first two. Specifically, these contributing
causes impacted residential real estate loans themselves (this is not meant to be an exhaustive
list, but is intended to give an indication of some of the more important specific dynamics that
exacerbated, if not partially caused, the bubble):
223

(1) Around 1996 Fannie Mae and Freddie Mac (two quasi-government agencies at the time)
began to push affordable low income loans. They would in fact begin to securitize these
loans (i.e., re-packaging them in pooled structures). Given the nature of geographic
differences in pricing, certain localities (and in some cases much of certain states) would
not qualify for this treatment because the loan amount would typically be over the
―conforming limit‖ (i.e., the maximum amount allowed to be called ―affordable‖). As the
bubble progressed, more and more loans would not be able to meet the ―conforming
limit‖, because generally rising prices drove a higher and higher percentage into the
―nonconforming‖ category.

223
This discussion is primarily based on information provided to me by Mike Davis.
Kihn / Behavioral Finance 101 / 261

(2) Those loans were primarily funded by banks and Savings & Loans ((―S&Ls‖) – as are
most residential loans in the U.S.). In addition, banks could set up entities that qualified
them to borrow money from the Federal Home Loan Bank system (i.e., banks could
borrow from the ―FHLB‖ system, which was originally established for S&Ls only). All
these types of loans used a standardized Housing and Urban Development (―HUD‖ – a
federal government agency) application form. Thus, there were uniform national
guidelines for lending. This was a result of at least two things. First, the banks held these
assets on their books (i.e., they are stated on their balance sheets). The banks would look
at income, job stability, assets, a property appraisal, credit outstanding, and use their own
credit scoring guidelines. Second, there were regulations against discrimination and
―redlining‖ (the alleged practice of discriminating against certain groups for non-
economic reasons, which turned out to be wrong).
224

(3) As a result of low nominal interest rates on Treasury and corporate bonds, there was an
increased demand for investment grade fixed-income products. Wall Street rose to the
occasion by providing a stream of securitized non-conforming mortgage backed
securities. Now, the loan originators no longer held the loans in their own portfolios.
Therefore, they had no incentive to do anything more than provide the rating agencies
with the information to score these loans. In many cases this was a standardized credit
score using Fair Isaac COrporation (―FICO‖ – a private rating agency for rating
individuals) and typically a formulaic appraisal (e.g., typically using the Case-Shiller-

224
Although, this government driven mistake was clearly a major contributing factor to the bubble and subsequent
crash, I will focus on a bit more general dynamics.
Kihn / Behavioral Finance 101 / 262

Weiss resale index – ―CSW‖ – a housing price index).
225
Hence the term ―NINJA loans‖
(i.e., No Income, No Job and no Assets) was born during this period. CSW gives a single
number for a zip-code (a general U.S. geographic reference for the postal service) and
does not take into account the individual characteristics and location of the property.
(4) The market did adjust to consumer behavior. With virtually zero cost financing (and in
some cases literally zero cost financing), lenders were anxious to hang on to their
borrowers. Prepayment was seen as the major driver of profitability. As house prices kept
rising and interest rate kept falling, increasing numbers of people with good credit would
do a ―cash-out refi‖ (i.e., they would borrow more money on the same mortgaged
property) at almost every opportunity. Mortgage brokers would call them at regular
intervals. ―Low-doc‖ (i.e., low documentation) was often the key to getting paid a
commission. The brokers steered their customers to the easiest lenders. Not only were
monthly payments lowered by interest only loans, but by negative amortization loans.
Down payments dropped from the customary 20% to get a good rate, to 10% then to 5%
then to 0%. In some cases, you could even borrow more that the property was worth! The
rationale was that if you don‘t like the loan-to-value ratio, wait a year! After all,
everybody knows that property prices increase by at least 5% a year, and 1% a month in a
―good‖ economy like California.
(5) The final irony occurred when Fannie and Freddie started using their own capital to buy
the AAA rated tranches off of other people‘s securitized ―jumbo‖ mortgages. That is, we

225
CSW gives a single number for a zip-code (a general U.S. geographic reference for the postal service) and does
not take into account the individual characteristics and location of the property. However, they probably did as good
a job as a drive-by appraisal did during that time. The most accurate would be a local real estate broker‘s opinion,
since they know all the quirks and trends of the local market. However, using a broker would be a conflict of
interest. Therefore, independent appraisers are usually used for a full appraisal.
Kihn / Behavioral Finance 101 / 263

have come full circle in that the government agencies that originally ignored
nonconforming loans (i.e., ―jumbo‖ mortgages are mortgages that are nonconforming to
original Fannie and Freddie size limitations) ended up being the primary buyers of those
loans, and, in addition, buying them at the highest credit rating (amazingly, and
somewhat ironically, much higher than they could have achieved at the beginning of the
process just detailed).
So there you have it, a cycle that began with nominal mortgage rates above 10%, banks and
S&Ls holding real estate loans on their balance sheets, 20% typical down payments, and other
practices of limiting downside to the lender; then it mutated in fits and starts to one where most
institutions making the loans no longer expected to hold the loans on their balance sheets, rates
kept generally going down, down payments became unusual, NINJA loans, cash refis, etc. In
short, we went from somewhat limited credit to a situation where essentially breathing got you a
loan. The effect on demand and prices over time seemed almost constant, that is, until the
summer of 2007 when it began to be apparent that not only couldn‘t demand be dramatically
increased anymore, but the odds of many debtors paying back their loans was lower than
expected and getting lower with time.

That gives us some insight into the general and somewhat more specific dynamics of the U.S.
real estate bubble that is still unwinding. What about other famous bubbles? Some of the more
famous bubbles have been:
Kihn / Behavioral Finance 101 / 264


Source: Wikipedia, 03-30-2009.

Based on our definition, it is important to remember that a bubble doesn‘t need to be a class of
assets, collectibles, etc., that it can be anything where the price inflation is unsustainable.
Therefore, by our definition, there have been many, many more bubbles than shown by the
Examples of economic bubbles include:
- Tulip mania (top 1637)
- The South Sea Company (1720)
- Mississippi Company (1720)
- Railway Mania (1840s)
- Florida speculative building bubble (1926)
- 1920s American Economic Bubble (circa 1922-1929)
- The Nifty Fifty American stocks of the late 1960s and early 1970s
- Poseidon bubble (1970)
- Sports cards and comic books in the 1980s and early 1990s
- TY Beanie Babies (1996)
- The Dot-com bubble (circa 1995–2001)
- Japanese asset price bubble (1980s)
- 1997 Asian Financial Crisis (1997)
- Real estate bubble
o British property bubble (as of 2006)
o Irish property bubble (as of 2006)
o United States housing bubble (as of 2007)
 (The former Florida swampland real estate bubble)
o Spanish property bubble (as of 2006)
o China stock and property bubble (as of 2007)
o Romanian property bubble (as of 2008)
Commodity bubble (As of 2008)
- Exotic Livestock production in North America (i.e. llamas, white tail deer, elk, wild boar,
and to a lesser extent bison)
[citation needed]

Other goods which have produced bubbles include postage stamps and coin collecting.
Kihn / Behavioral Finance 101 / 265

preceding table. In fact, as of this writing there are many aggregate asset bubbles occurring (e.g.,
Chinese property markets, U.S. government debt, etc.), and even more individual ones.
226


Particularly with respect to those that take some time to build up
227
, one seemingly odd property
of bubbles is that they seem to display a relatively consistent pattern. This typical pattern seems
in direct contradiction to EMT proponents‘ arguments. Specifically, if a popped price tends to
take roughly (actually very roughly) about as much time to return to fundamentally based levels
than it took to drift away from fundamental or intrinsic value, in the traditional sense of
arbitrage, then it should be arbitrageable. And if it‘s arbitrageable, why does it normally take so
long to drift back to fundamental or intrinsic value? A case in point is the now burst U.S. real
estate bubble. U.S. real estate prices should take at least until 2012 until they return roughly to a
value more in line with at least fundamental reality. Surely, rational arbitrageurs know this and
will speed the process up? Furthermore, to the extent academics (e.g., Greenspan) claim that a
bubble (i.e., assuming they could be proven to exist at all) can be identified, it is only after it has
burst. If that were true, and it was also true that many (if not most) are relatively symmetric
about the bursting point, then a rational arbitrageur might be reluctant to short on the way up,
because of identification problems
228
, would certainly do so on the way down (i.e., after it was

226
In the extreme one could define even a single day IPO as a bubble. For example, Lowry and Schwert (2002)
define individual company mispricings on the day of issuance as bubbles.
227
It seems that it is more typical, for example, in laboratory settings for a ―bubble-and-crash‖ pattern to occur. See,
for example Caginalp et al. (2000) where they additionally note that this pattern seems ―robust‖ to a number of
variables (brokerage fees, short-selling constraints, etc.).
228
Of course, by a similar rationale, at some point during the period when price was moving away from true
economic value one would expect that some more rational traders would be able to profit arbitraging by going long
on the upward portion of the bubble process. In fact, this seems to be what happens (as we will see at the end of this
chapter). Therefore, instead of arbitrageurs correcting mispricing they will tend to encourage it (i.e., by going long
once the price has clearly entered a bubble cycle, and possibly short once the peak has clearly been reached, and
Kihn / Behavioral Finance 101 / 266

more clearly identified as a bubble). Yet if that were true, then why the roughly symmetric
pattern that shows up again and again?

As an example of a classic bubble pattern (i.e., to the extent a general form or shape, if not
pattern, can be identified), here is a South Sea Bubble
229
graph:


assuming they can). If this indeed happens, which is likely, it is the opposite of the rational arbitrageur story given
by EMT proponents.
229
From Wikipedia April 1, 2009: ―The South Sea Company was a British joint stock company that traded in
South America during the 18th century. Founded in 1711, the company was granted a monopoly to trade in Spain's
South American colonies as part of a treaty during the War of Spanish Succession. In return, the company assumed
the national debt England had incurred during the war. Speculation in the company's stock led to a great economic
bubble known as the South Sea Bubble in 1720, which caused financial ruin for many. In spite of this it was
restructured and continued to operate for more than a century after the Bubble.‖
Kihn / Behavioral Finance 101 / 267

Source: Wikipedia, 04-01-2009, attributed to Larry Neil.

Clearly, this seems a relatively, albeit rough, symmetrical pattern. Now what about the U.S.
residential real estate bubble?

Source: Wikipedia, 04-01-2009.

It likely won‘t be perfectly symmetrical, but it seems to be pointing to a return to more
fundamentally based levels around 2012 or beyond (i.e., three or so years from now). Again, I
ask is there a classic bubble pattern? There probably isn‘t an exact repeatable pattern to every
Kihn / Behavioral Finance 101 / 268

bubble, but there may be a somewhat systematic and more realistic psychological sequence of
events or pattern.

I like Nov and Nov‘s (2008) approach and most general conceptualization of bubbles (whether or
not financial, or economic, in nature):

Source: Nov, Y., and O. Nov, ―Living in a bubble? Toward a unified bubble theory‖, International Journal of
General Systems, Volume 37, Issue 5, October 2008, p. 629.

Of course, again, the problem here is that most financial economists and economists admit to no
readily definable fundamental pricing ‗model‘. Therefore, we rarely, if ever, know when prices
Object’s Driving Value Object’s External Value
Behavior
The Information Feedback Loop Generating Bubbles
Kihn / Behavioral Finance 101 / 269

deviate from fundamental value. That noted, it is the general process that is intuitively appealing,
for example:

―A bubble develops when a positive feedback loop is formed between an object‘s external and
driving values, mediated by people‘s behaviour and accompanied by little or no change to its
fundamental value (see ‗The Information Feedback Loop Generating Bubbles‘ diagram). The
tulip example definitely demonstrated this pattern: people‘s demand for tulip bulbs (behaviour)
caused the bulb prices (external value) to soar; the growing prices caused the bulbs to seem more
attractive as an investment (driving value), generating further demand, and so on. Crucially,
while this loop was taking place, the pleasure the tulips gave people while looking at them
(fundamental value) was not changing.‖
Nov and Nov (2008, p. 629)

Alternatively, but still mostly in line with this general approach, is the time line of the bubble, as
the following example provides:
Kihn / Behavioral Finance 101 / 270


Source: http://www.oftwominds.com/blogapr09/housing04-09.html?ref=patrick.net, April 20, 2009.

It is the interplay between group psychology and the collapse (whether fast, slow or moderate)
that can be horribly fascinating. Think framing, but imagine the frame changes as the price
corrects toward fundamental value and beyond (what follows is a somewhat stylized version).
The sequence presented is somewhat of a restatement of the sequence and description made on
the oftwominds.com website, with my own behavioral finance bias.

The model of a financial bubble should be generic, that is, it should apply to all bubbles
regardless of whether a security or asset class, or the time period/era. The basic assumption
underling a theory of financial bubbles is that predicting the precise timing of the peak may be
difficult, if not impossible (and probably not for reasons given by central bankers), but bubbles
tend to follow a similar pattern because they are likely largely driven by psychology and limits to
arbitrage. The general four stages are as follows:
Kihn / Behavioral Finance 101 / 271

1. The front side of the bubble & building euphoria – price(s) increases at times relatively
steeply, and many believe there is ―no end to the trend‖.
230
Along the way, more and more
irrational (and possibly rational)
231
traders jump on board and create a generally sustained
imbalance between supply and demand (i.e., on the side of demand).
232
Classically, the
psychological ―positive feedback‖ mechanism is critical (see, e.g., Shiller (2002)).
2. Peak – Most arbitrageurs have given up trying to push price(s) back toward fundamental
value(s) and/or have joined the irrational traders, and the irrational traders themselves mentally
strongly believe there is no reason why price(s) cannot continue to increase. What often causes
the peak is that price(s) are shown to be unsustainable. This is the cognitive equivalent of yelling
―fire!‖
233
For example, in the current financial crisis the peak happened around the last week of
July 2007 when the market for certain U.S. residential mortgages hit a wall (i.e., it was
recognized that the large swaths of loans would not be paid back, and, therefore the values of
packaged mortgage products were physically unsustainable). After the peak, the rational
arbitrageurs begin to either remove themselves from supporting price increases or begin placing

230
To complicate matters, investors tend to expect a reversal after any run-up or rundown in prices (see, e.g., Shiller
et al. (1991), Shiller (1990), and Shiller (1999)). Therefore, unless short and idiosyncratic, it is predictable that
bubbles don‘t increase or decrease in a straight line.
231
In reality, there is a continuum between rational and irrational traders.
232
This isn‘t to say that investors‘/speculators‘ expectations don‘t change as the bubble builds. For example, Shiller
(1999) showed that, based on periodic surveys during the buildup phase of the last major U.S. stock bubble (the
survey covered 1989 through 1998, and the market peaked around March 2000), investor expectations (both
individual and institutional) changed significantly as the bubble progressed. In a sense, the expectations need to
change in order for those agents/actors involved to continue to push prices ever higher (i.e., if they thought prices
had peaked they might be inclined to sell).
233
One classic anecdotal story is about how Joe Kennedy made a timely exit from the stock market before the Crash
of 1929 after a shoeshine boy gave him some stock tips. Essentially, when the bottom rungs of the economic ladder
show an overwhelming interest in a bubble market, then the base of the pyramid has expanded as far as it can
possibly go and is ripe for a collapse. In short, it is a sign there are no more ―suckers‖ to be found.
Kihn / Behavioral Finance 101 / 272

downward pressure on prices by shorting, for example. On the other hand, most irrational traders
do not stop believing in the upward trend (i.e., even when it stops).
234

3. Back side of the bubble – Anchoring & bouncing interacting with the ‗disposition effect‘ –
Irrational traders will use almost any excuse to re-inflate the bubble, but especially important is
the relative price they bought in. For example, as long as the price is above their buy in price,
they will tend to be net buyers (i.e., as a group), but as prices drift or bounce below the price they
bought in, they tend to be holders. The pattern on the backside of a bubble, especially for asset
classes, tends to follow a more erratic pattern (i.e., relative to the front side of the bubble, and
with the possible exception of individual securities, commodities, etc.). Thus, there are periods,
sometimes extending up to a year or even more where a re-inflation appears possible to mostly
irrational traders. In essence, there is now a tension between supply and demand as rational
arbitrageurs and irrational traders ebb and flow, while fundamentals try to assert themselves
(with varying degrees of success). But things like anchoring and ―playing with the house‘s
money‖ tend to assert themselves much more so on the way down than on the way up (i.e., by
definition). For example, currently this is the situation for the ―global financial crisis‖.
Fundamentally huge amounts of debt will be written off, but they have yet to be. As the
market(s) recognize this prices of those financial assets will increase or decrease, but
fundamentally they will be forced to generally decrease and many, if not most, irrational traders
will hold well past the point they bought in.

234
One curiosity is why not more outright crashes? For example, why don‘t more suddenly realize the game is over
earlier? Even the crash of October 1987 required an ―unusual confluence of events‖ (see Wigmore (1998, p. 47)). In
addition, Shiller (1987) found that investors generally believed the stock market was overvalued and that it wasn‘t
so much news that drove the selling pressure but their belief that other investors‘ psychology was paramount (i.e.,
not their own, because they generally felt they could intuitively predict the market). In short, investors expressed
somewhat complicated and contradictory views about the ―crash‖.
Kihn / Behavioral Finance 101 / 273

4. Fundamentals reassert themselves – At some point the fundamentals reassert themselves and,
subsequently supply and demand become more balanced. Most irrational traders that are still
holding are holding losing investments and more rational traders are no longer overly influenced
by the threat of waves of irrational traders buying. The supposed truisms that fed the bubble and
even the earlier portion of post-bubble decline(s) and recovery(ies) are discredited. Cognitive
dissonance now rules supreme, and most of those who irrationally bought in believe they saw the
end (even if they are still holding their initial investments).

As a quick summary, a bubble has three critical parts: (1) front side, (2) peak, and (3) back side.
Essentially the process goes from a drift away from fundamentals and back again. It is
characterized by shifting supply and demand
235
, but mostly by generally demand imbalances on
the front side and a general lack thereof on the back side. Simple, but as usual, the ―devil is in the
details‖, and it tends to have links to limits to arbitrage and psychology.

Given the above generic description, it is unlikely that a decade long bubble will reach its bottom
where fundamentals reassert themselves in two days, let alone two years. It is more likely it will
take roughly ten years (thus roughly twenty years, or two decades from beginning to end).
Especially with respect to an asset class, a bubble is a process. So imagine what group
psychology it takes to pump it up and conversely how that must change over time to bring it
down. That is, it is likely that some of the same people who helped to inflate the bubble will
participate in deflating it, and this tends for drawn out processes to be a drawn out process.

235
Again, it is important to note that especially during the front side of a bubble, the object of the bubble tends to
display the basic perverse ―Giffen good‖ attribute of increasing prices tending to increase demand (i.e., perverse by
normal standards and standard logic).
Kihn / Behavioral Finance 101 / 274


Mathematically driven economics has generally assumed that market partcipants have perfect
information and knowledge and act on that basis; yet we know that agents/actors do not possess
perfect knowledge/information, nor do they even act strictly ‘rationally‘ on the basis on what
little information and knowledge they do have. Accordingly, it has been pointed out (see, e.g.,
Hirschey (1998, p. 16)) that there is a cicular feedback loop between investors‘ perceptions of
the market(s) and market prices themselves. Hence, it is difficult to separate perceptions from
pricing, because agents/actors ‖cannot obtain perfect information of the markets because their
thinking is always affecting the market and the market is affecting their thinking.‖ Clearly this
issue is enhanced during bubbles, where feedback loops and circular reasoning affect the prices
and particpants at each step up and back down.

Regarding economic ‖models‖ in general, and his, in particular, Hayek may have had the best
answer to the form and substance of a prediction in economics:
‖ still adequately explained by my theory — but not adequately to the statisticians, because,
again, all I can explain is that a certain pattern will appear. I cannot specify how the
pattern will look in particular, because that would require much more information than
anyone has. So, again, I limit the possible achievement of economics to the explanation of a
type … Just as you have a formula for, say, a hyperbola; if you haven‘t got the constants set in,
you don‘t know what the shape of the hyperbola is — all you know is it‘s a hyperbola. So I can
say it will be a certain type of pattern, but what specific quantitative dimensions it will have, I
Kihn / Behavioral Finance 101 / 275

cannot predict, because for that I would have to have more information than anybody actually
has.‖
236


Again, in finance (largely because it is a subset of economics), we can, at best, give a general
outline of the pattern, but specifics will tend to be lacking. Therefore, and especially for asset
class bubbles, the pattern will typically look like a triangle (i.e., somewhat rounded and spiky,
but a triangle nevertheless), but can certainly look rather jagged in both the upside and downside
from the peak, but especially on the downside as the process that built the price(s) up to
unsustainable levels unwinds itself.

Now that we have adequate working definitions of bubbles, have a sense of what they look like,
and even have a list of some of the more famous ones, the question should naturally arise as to
what might cause a price to increase at such a rate that it becomes unsustainable?


236
From http://hayekcenter.org/?p=882#more-882 on April 20, 2009. This is a quote from an interview with
Friedrich Hayek on statistics and macroeconomics and the post was written by Greg Ransom on April 19, 2009 and
posted under: Biography, Explanation, Probability Theory, Statistics The interviewer was Leo Rosen, and the
interview itself took place in 1978 ―in which Hayek presents some of his conclusions about the relationships
between statistics, probability theory, and macroeconomic explanation.‖
At one point in the interview he points out that a primary issue in especially macroeconomics is that the ―law of
large numbers‖ does not apply, while in say physics it can.
Kihn / Behavioral Finance 101 / 276

WHAT IS/ARE THE LIKELY CAUSE(S) OF FINANCIAL BUBBLES?
Unfortunately given the sorry state of macroeconomics, this is one of the more debatble topics in
this book. In the previous section we went from the most general to more specific, not so in this
section. My focus in this section is on cause or causes and will be more macro than micro. For
example, I am more concerned with the primary driver or drivers for asset class type bubbles
than more idiosycratic types (e.g., short bubbles in the price of oil or the share price of IBM
stock). Thus, although clearly the price of for example oil can have a macroeconomic impact, I
am more concerned with identifying the causes of those bubbles that are most likley to have
economywide impacts (including effects on more idiosyncratic things like oil, for example).

My reasoning for this focus is primarily because I do not wish to be sidetracked into writing
about the importance of, for example, the growing season for tulips in the Netherlands. My
attempt is to accept that in some more idiosyncratic cases (e.g., the price of IBM common stock
during the 1980s) idiosnycratic causes can dominate, but my concern are those more general
causes that are of concern across temporal and geographic coordinates. In short, I accept that, by
definition, idiosyncratic causes can be critical in some cases, but given that bubbles keep
popping up, there is likley to be one or more more universal causes.

Outside of the classic ‖Extraordinary Popular Delusions and the Madness of Crowds‖ by Charles
Mackay (first published in 1841), which is more of a straight history (i.e., noneconomic history)
Kihn / Behavioral Finance 101 / 277

of three financial bubbles and a sequence of seemingly unrelated ‖popular follies‖
237
, only two
relatively well known economists have directly taken up the task of trying to explain financial
bubbles: (1) Charles Kindleberger, and (2) Robert Shiller. Kindleberger is an economic historian,
and Shiller could be considered to be a financial behavioralist. Again, to date, academic articles
in the field that directly deal with finacial bubbles are rare (e.g., Bernanke and Gertler (1999)
238
),
or nonexistent. It should be noted that Kindleberger actually focused on ‖financial crises‖, not
bubbles per say, but many of these crisies were percipitated by the bursting of financial bubbles.

Kindleberger‘s thesis for causation can be reduced to the folowing (see Kindleberger (2005)):
easy money or credit especially and capital market institutions (and the interaction between of
the two) cause bubbles (which tend to turn into, i.e., after bursting, ‖financial crises).
239
My
impression is that Kindleberger reduces the importance of human irrationality, because it may be
safe to assume that humans are not signifcantly more irrational now than they were during say
‖Tulipmania‖. The constant theme is expansionary or easy monetary policy and who and how
that easy money or liquidty impacts the market or markets in question.

‖The failure of banks, the overshooting and undershooting of exchange rates around their long-
run equilibrium values, and the bubbles in real estate and stock markets were systematically

237
The three financial bubbles covered are (1) ―the Mississippi Scheme‖, (2) ―the South-Sea Bubble‖, and (3) ―the
Tulipmania‖. These three are covered in the first 101 pages of a 740 page book that mostly dealt with subjects such
as alchymists, the Crusades, witches, etc.
238
Even though the article is about financial asset bubbles they cannot bring themselves to use the word ―bubble‖ in
the title of the article. Bernanke and Gertler (1999, p. 24) define a bubble as a ―temporary deviation of asset prices
from fundamental values, for example, because of ‗bubbles‘ or ‗fads‘.‖ Thus, a ‗bubble‘ in their world is caused by a
bubble. Finally, the article is purely normative with no empirical data or analysis, but loaded with opinions on what
makes good CB policy.
239
Again, he posits that the general cause is: An accommodative monetary authority that in turn causes debt/credit to
surge (e.g., the South Sea Bubble in London, the Mississippi Bubble in Paris, etc., etc. …).
Kihn / Behavioral Finance 101 / 278

related and resulted from various shocks that led to changes in the scope and driection of cross-
border money flows.‖
Kindleberger (2005, p. 243)
Under ‖The causes of financial tumult‖, ‖The financial tumult since the early 1970s resulted
from the impacts of monetary shocks on the driection and scope of the flows across national
borders.‖
Kindleberger (2005, p. 244)

Kindleberger noted that in some cases it was ‖the relaxation or elimination of financial
regulations‖ that enahanced the impact of monetary policies (i.e., especially loose money or
credit). My interpretation is that loose monetary policy is a necessary and possibly suffcient
condition for a large asset class level bubble, but often some changes with respect to regulatory
changes interact to heighten the impact (i.e., as it runs through the affected institutions and
ultimately individuals). It seems that the interaction of, first and foremost, increasing money
supply, with credit & capital market conditions and reactions (including exchange rates, and
working through affected institutions and ultimately individuals) both feeds and causes bubbles
and is the popping mechanism (i.e., if money supply decreases and/or interest rates increase in a
way that appears to ‖shock‖ the market(s)). Also, there appears to be a sequencing where
economy wide bubbles often begin as stock bubbles and end two or so years later as real estate
bubbles (as financial capital runs away from a collapsing stock market and seeks shelter in other
assets, typically real estate, i.e., assuming the CB allows it to happen that way).
240



240
This appears to even be the case in Holland after tulip bulb prices crashed.
Kihn / Behavioral Finance 101 / 279

For Shiller (at least with respect to the recent U.S. stock and real estate bubbles):
―some factors that have seemed, at certain times, to ‗explain‘ movements in the stock market,
notably long-term interest rates; these might help explain home prices as well. But one of the
first lessons of economics should be that there are many factors that seem sometimes to ‗explain‘
speculative price prices, too many for us to analyze comfortably. We have to resist the
temptation to oversimplify by singling out only one. Besides, long-term interest rates are really
exogenous factors. ... We have to try to understand the origins of market psychology itself.‖
Shiller (2005, pp. 31-32)

Firstly, I agree with both Shiller and Kindleberger, and also disagree with part of Shiller‘s
statement. I agree with Kindleberger that the empirical evidence and most plausible single cause
of larger asset class level bubbles is likely monetary in nature, but also agree with Shiller that
other factors surely must be involved (and possibly some on a case by case basis). Where I
vehemently disagree is the Shiller comment about interest rates being purely ―exogenous
factors‖, especially under the current monetary and currency regime, but I will deal more directly
with this critical issue in another chapter.
241



241
In fact, Shiller (1979) has shown his own comment to be incorrect (see, e.g., Shiller (1979)). Actually, it is even
worse, he has shown that it is highly probable that the U.S. central bank endogenously influences not only nominal
rates, but real rates as well. Furthermore, it doesn‘t take exogenous influences to create a bubble (see e.g., Smith et
al. (1988)).
Kihn / Behavioral Finance 101 / 280

With respect to Shiller‘s other factors
242
, he lists the following twelve as his short list (i.e.,
specifically with respect to the recent U.S. stock market and real estate bubbles) (see Shiller
(2005, pp. 33-55)):
1. The capitalist explosion and the ―ownership society‖ (speculative activity is viewed
generally positively).
2. Cultural and political changes favoring business success.
3. New information technology impresses people as never before (e.g., the Internet, cell
phones, etc.).
4. Supportive monetary policy and the ―Greenspan put‖. Obviously this may be the key
factor. The ―Greenspan put‖ is reference to the fact that the U.S. central bank
systematically lowered interest rates (increased money supply) whenever financial asset
prices seemed to falter. Therefore, it is an extreme form of monetary easing.
5. The ―baby boom‖ and bust and their perceived effects on the markets. The ―baby boom‖
is a reference to a U.S. demographic bulge that occurred after the end of WWII. Common
wisdom has it that that group had altered demand for stocks and real estate in such a way
that encouraged higher prices, and when they retire it may cause the reverse.
6. An expansion in media reporting of business news. Given that humans do respond to
saliency and there was more reporting of business news (and positively biased reporting),
it is likely this helped inflate prices.
7. Analysts‘ optimistic forecast. Shiller is referring to earnings analysts. He specifically
notes that at the peak of the U.S. stock bubble (see Shiller (2005, pp. 44-45)) out of about

242
He places more emphasis on the ―herd‖ aspects and social psychology, feedback loops, etc.

Kihn / Behavioral Finance 101 / 281

6,000 stocks around 1% were ―sell‖ recommendations, 69.5% ―buys‖, and 29.9%
―holds‖. Ten years before the fraction of ―sells‖ was nine times higher. Therefore,
analysts were always very biased against making ―sell‖ recommendations, but that bias
moved dramatically in the biased direction as the bubble progressed.
8. The expansion of defined contribution plans. Again, like the ―boomers‖, this is an
asymmetric demand side boost argument that as retirement plans increased, demand
increased for financial assets, especially in this case stocks.
9. The growth of mutual funds. Even though mutual funds had been around since 1924, they
seemed to grow as the market grew, and people seemed to forget the conflicts of interest
inherent in such structures.
10. The decline of inflation and the effects of money illusion. People are often confused and
conflicted over inflation. In addition, the reported Consumer Price Index (―CPI‖) doesn‘t
effectively pick up asset price inflation, thus confusing matters and average perceptions
even more.
11. Expansion of the volume of trade: discount brokers, ―day traders‖, and twenty-four-hour
trading. Essentially it became easier to trade.
12. The rise of gambling opportunities.
Even though the list applies to a geographic specific asset bubble in stocks and real estate, it‘s a
good general list (although, it would require some adjustments for other assets and time
periods/eras, e.g., the growth of mutual funds probably wouldn‘t probably matter much to an oil
price bubble; and recent modern technology wouldn‘t matter for ―Tulip mania‖, etc.).
Regardless, note that many of Shiller‘s factors still lead us back to loose monetary policy (e.g.,
Kihn / Behavioral Finance 101 / 282

the ―Greenspan put‖, mutual fund growth, retirement plan growth, inflation illusion, etc. feed
back into money supply growth and/or are caused directly by it).

Shiller also stresses the process nature of bubbles. He lists off several ―amplification
mechanisms‖: (1) ―Ponzi‖ processes, (2) feedback
243
, and (3) outright fraud. Try to keep in mind
that speculation is a symptom and not the cause of bubbles. Agents/actors drive the price up
largely in search of a kind of irrational arbitrage (which seems an oxymoron, but it nevertheless
seems to be the case). The ―Ponzi scheme‖ or ―pyramid scheme‖ nature is a reference to the fact
that the front side of bubbles tend to use current profits to create expected future profits.
244

Clearly, it is likely that feedback (e.g., between bubble investors) and outright fraud (e.g., it is
physically impossible to have infinite price growth in a finite entity like a company or even an
economy) interact with these irrational expectations to keep the game going.

Clearly, bubbles can be rather complicated phenomenon. The combined process of buildup,
peak, and breakdown can be confusing and dependent on a host of factors. Although each case
can be argued to depend on many things, I find that the single greatest cause, especially of asset
class level bubbles like stocks and real estate recently, is monetary in nature (money supply or
credit
245
).

243
I would include in this things such as social conformity and fads & fashions, as well as ―informational cascades‖
(see, e.g., Bikhchandani et al. (1992)). In addition, even experimental settings generate bubbles (e.g., Smith et al.
1988)).
244
This also works well with the ―greater fool‖ theory. That is, often people rationalize overpaying for something
because they are convinced they will be able to sell to someone else at a greater price than their purchase price (i.e.,
the ―greater fool‖).
245
Obviously, leverage can be part of the credit portion of the causal equation. In addition, it is hard to dismiss
Minsky‘s three finance unit classifications as being unimportant, especially as they relate to economy wide asset
bubbles: (1) ―Hedge financial units‖ are the most stable and self-funding. (2) ―Speculative finance units‖ are capable
Kihn / Behavioral Finance 101 / 283


As mentioned, mainstream economics, particularly macroeconomics largely ignores bubbles.
Although, there is one school that does seem to have both theory and predictive content that
seems to match well with economy wide bubbles, it‘s called the ‗Austrian school‘ of economics.
Even though ‗Austrians‘ have been ignored or marginalized by the academic profession, they
seem to outline the primary cause of economy wide asset class bubbles quit well, and it works
well with Kindleberger‘s thesis.

The ‗Austrians‘ take on bubbles is as follows:
―Austrian economists focus on the amplifying, ‗wave-like‘ effects of the credit cycle as the
primary cause of most business cycles. Austrian economists assert that inherently damaging and
ineffective central bank policies are the predominant cause of most business cycles, as they
tend to set ‗artificial‘ interest rates too low for too long, resulting in excessive credit creation,
speculative ‗bubbles‘ and ‗artificially‘ low savings.
246

According to the Austrian business cycle theory, the business cycle unfolds in the following way.
Low interest rates tend to stimulate borrowing from the banking system. This expansion of
credit causes an expansion of the supply of money, through the money creation process in a
fractional reserve banking system. This in turn leads to an unsustainable ‗monetary boom‘

of funding running or interest payments, but not principal; and thus are less stable than ‗hedge financing units‖. (3)
―‘Ponzi‘ units‖ are incapable of paying principal or interest payments; and thus are the least stable of the three.
Therefore, one can see the usefulness of monitoring these respective groupings as an economy wide bubble
progresses toward a peak (i.e., as the ―speculative‖ and ‗Ponzi‘ units grow relative to the ―hedge units‖ we are
clearly nearing the peak – i.e., the ―Minsky moment‖).
246
For example, interest rates matter, and shouldn‘t be pushed below what the market(s) would set. If they are, then
it will result in the misallocation of capital, which they call ―malinvestment‖. After a period of ―malinvestment‖, the
economy will need to be restructured in such a way that investment will need to be reallocated away from the
malinvestments, not toward them.
Kihn / Behavioral Finance 101 / 284

during which the ‗artificially stimulated‘ borrowing seeks out diminishing investment
opportunities. This boom results in widespread malinvestments, causing capital resources to be
misallocated into areas which would not attract investment if the money supply remained stable.
The global economic crisis of 2008 represents, according to some pundits, an example of the
Austrian business cycle theory's dependability.‖ (See Wikipedia)

Additionally, it isn‘t that I think that psychology and limits to arbitrage are unimportant with
respect to bubbles, they are. It is somewhat tautological to note that, however the psychology and
limits to arbitrage play out, the larger causal connection seems to run through easy credit and
financial intermediaries themselves (and associated regulations, etc.). Therefore, the makings
that largely cause the macroeconomic bubble in the first place need to be there in order for the
limits to arbitrage and psychology to matter. For example, without the ability for a financial
institution (government, private, or mix) or individual to lever up 10 to 1, 20 to 1, etc., there
wouldn‘t necessarily be as large a deviation from fundamental value in the first place. Thus,
psychology and limits to arbitrage are critical, but they are attached to the bubble as necessary
but not sufficient conditions (again, in the case of a more macroeconomic bubble), whereas the
monetary policy piece is required for things to truly get out of hand on a macro scale.
247


247
The Economist magazine just previous to the U.S. stock market peak (September 23, 1999) had an article arguing
that ―pricking‖ asset bubbles is an essential job of central banks. This, of course, begs the question of who actually
created the bubble(s). Therefore, if the central bank was largely responsible, or a large contributor, why would they
destroy exactly that which they created, or helped to create?
Of course CBs, or at least CB economists in the last few decades have tended to indicate that CBs believe that they
should not pop bubbles unless certain conditions are met that are unlikely to be met, e.g., two conditions are met: (1)
only if the asset boom is driven only by non-fundamentals, and (2) they know exactly when it will burst (see
Bernanke and Gertler (2001) on this one). Of course, much like ―global warming‖ arguments these CB bubble
related arguments and beliefs are driven almost soley by ‗models‘ of their own construction. Thus, actual evidence,
at best, has a secondary role. Although, basic logic would suggest that if a bubble is bad, one twice as big would be
Kihn / Behavioral Finance 101 / 285


Again, besides relatively accurately describing what happened in the latest U.S. stock and real
estate bubbles, the Austrian theory seems to overlap with Kindleberger‘s research and thoughts.
Regardless, that which is fundamentally unsustainable will not be sustained, and eventually will
end, by definition. In turn, when a bubble ends it tends to have considerable negative
consequences, especially for economy wide bubbles.

BURSTING EFFECTS OF FINANCIAL BUBBLES (ESPECIALLY MACROECONOMIC
ONES)
What happens after a bubble bursts?
248
Consider this, if central bankers receive a
disproportionate share of the blame for causing them, then they must have good reason for aiding

at least twice as bad. Furthermore, if bubbles are bad for the economy on balance, then popping one would be a
good policy; although I would think it might be easier just not to fuel the bubble in the first place.
248
Note that even standard normative economic models can show that bubbles are destructive to the overall
economy (e.g., Wang and Wen‘s (2009) ―general equilibrium model with ―speculative bubbles‖).
Kihn / Behavioral Finance 101 / 286

and abetting them as they grow, or do they?
249
They must judge the benefits to outweigh the
costs (i.e., assuming there are tangible benefits and costs), or do they? More specifically, is the
size of a bubble indicative of the size of its economic impact? If it is, then why do central
bankers allow it in the first place?
250
Anyways we have several questions and some descriptive
work to analyze, but let‘s begin with some more insight from those crazy ‗Austrians‘
251
.

―There is no means of avoiding the final collapse of a boom brought about by credit
expansion. The alternative is only whether the crisis should come sooner as a result of a
voluntary abandonment of further credit expansion, or later as a final and total
catastrophe of the currency system involved. …
The credit expansion boom is built on the sands of banknotes and deposits. It must collapse.‖

249
See, e.g., Bernanke and Kuttner (2005) for an empirical estimate of the stock market impact of ―unexpected‖
changes in the Federal Funds rate on U.S. stock prices. Their estimate is a 1% increase in stock prices for every
25BPs reduction in the Fed Funds rate (this number does not include anticipated increases, by their ‗model‘ design).
Furthermore, they find (i.e., based on their econometric ‗model‘) that it is excess returns not changes in the ―real
rate‖ of interest that drive the result (they expected it would be the ―real rate‖ driving the result). Clearly, they did
not, and do not, understand exactly how and why monetary policy impacts financial asset prices. In fact, they
conclude by noting that it may be the case that the stock market overreacts to monetary policy (i.e., market
―overreaction‖, see Bernanke and Kuttner (2005, p. 1254)). In summary, and ironically, their work would seem very
supports Austrian theory.
250
Two Riksbank economists Dillen and Sellin (2003, p. 119) state that: ―Our main concern, however, is a central
bank‘s approach to such price developments: should it try to identify and counter the bubble at an early stage or wait
until the bubble has burst before taking measures to limit its harmful effects? We consider that a largely preventive
strategy is ruled out by the lack of knowledge about how a price bubble can be countered with measures of monetary
policy. Still, there are grounds for continuing to analyse financial asset markets and identifying different types of
imbalances ...‖ Therefore they express the common opinion that central banks should just let them blow up, and then
do something. In addition, they indicate bubbles should be monitored? To me this seemingly common CB attitude
seems like cynical full-employment for CB economists. First, cause a problem, second monitor its growth, then step
back and wait for the blowup, whereupon you step in to clean it up and expand your mandate. Clearly, if these types
of bubbles are so bad and you can identify them, then logically you should burst them as soon as possible, yet this is
the opposite of what today‘s CBs seem to advocate.
251
The Austrians really are the only ‗economists‘ with a theory of cause and effect on this (at least as of today).
Also, I would argue that Minsky (see Minsky (1993)) may also have a theory (that is coincidently also non-
mathematically based), but I find his approach stresses more the increasing levels of implicit, if not outright, fraud
that seem to manifest themselves as the credit expansion runs out of places to stuff the credit. Hence, debt tends to
take on an increasing resemblance to ―‘Ponzi‘ units‖ with increasingly smaller and smaller probability of interest, let
alone principal, payments being made.
Kihn / Behavioral Finance 101 / 287

Ludwid von Mises

Needless to say, the Austrians are not big fans of the macro bubble, not to mention that
―collapse‖ is a strong word. They don‘t generally think they are a good idea because they cause
costly dislocations of resources (―malinvestments‖). Although a bit simplified, I would sum up
their motto on this as ―it‘s the credit/debt stupid‖. If they are correct, then minimally the U.S. is
in predictable economic trouble.


Figure 1: This chart compares total debt (or “credit”) in the U.S. to GDP (or Gross Domestic Product) on a
percentage basis.
Source: Graph was taken from http://www.chrismartenson.com/blog/crisis-explained-one-chart-debt-gdp/11570
(entitled Figure 1).
Values from the Federal Reserve and do not include unfunded liabilities like Medicaid/Medicare and Social Security
(also, exclude any shortfalls that may occur from overly optimistic projection/assumptions, e.g., government or
private pensions, state unemployment benefit shortfalls, etc.).
Kihn / Behavioral Finance 101 / 288


The last time the U.S. was carrying a debt load comparable to the current one (incidentally, that
is still growing) was during the early stages of the ―Great Depression‖. If the ‗Austrians‘ are
correct and debt/credit matters as much as they think it can, then the future looks bleak. For
example, Hebling et al. (2002, pp. 61, 74) state that average stock market asset bubble bursts
between 1960 and 2002 cost affected economies about 4% of GDP, and that comparable real
estate bubble bursts cost about 8% of GDP (i.e., they can be much worse, especially if real estate
displays the same peak to trough relative price drop as stocks). They also noted ―spillover‖
across other asset classes, and a slowdown in investment growth. Given that the current real
estate and stock bubbles are unprecedented in scale (both relative, and, obviously, on an absolute
level), scope (I can‘t think of a country that hasn‘t been touched by them), and duration (i.e., the
length of price buildup), it is likely the costs will be commensurate with their size, scope, and
length.
252


In fact, if one includes other liabilities, the numbers are much worse.

252
In Japan, after their massive financial bubbles and stocks and real estate burst, the debt levels assumed during the
period are now credited with disastrous effects on businesses‘ employment demand, as well as significantly reduced
fixed and R&D investments; for the individual it is credited with dramatically reduced consumption as well as a
dramatic shift in the makeup of consumption (see, e.g., Ogawa and Wen (2007)). Importantly, these effects appear to
be beyond the incremental addition of debt on the front side of the bubble. That is, and assuming it is viewed as
positive, whatever good happened on the front side was more than offset by what happened on the back side of the
bubble. It is unlikely this will be significantly different in the U.S. or anywhere else that tries to use debt to pull
forward consumption.
Kihn / Behavioral Finance 101 / 289


Source: Graphs were taken from the ―Grandfather Economic Report‖.

As can been inferred from the previous two graphs, once additional debt and the lack of savings
are factored in, it is worse than the previously presented graph. One rather ―Austrian‖ way to
look at this is something called the ―Marginal Productivity of Debt‖ (―MPD‖).
253
In the U.S.,
prior to the 1970s an increase of $1 in debt likely saw a greater than $1 increase in income or
GDP. Shortly thereafter it went to less than 1 to 1, and more recently 5 or 6 to 1, and most
recently possibly negative.


253
The idea behind the MPD is that debt should generally be taken on for reasons at least related to being able to pay
it back, or it is unsustainable, by definition. For example, borrowing $1 million to set up a factory producing ping
pong balls makes fundamental long-term economic sense as long as it can make enough to pay off all its expenses
(including interest and principal on the debt). On the other hand, if one takes out a $1 million loan and subsequently
uses it to buy expensive meals and other purely consumable goods and services for oneself, then one would not
expect that debt to be contributing to the productivity of society, and the overall MPD will go down.
Kihn / Behavioral Finance 101 / 290

―In actual fact, there used to be a very stable relationship between money or credit growth and
GDP or income growth until the early 1980s. Growth of aggregate outstanding indebtedness of
all nonfinancial borrowers … had narrowly hovered around $1.40 for each $1 of the economy‘s
gross national product. Debt growth of the financial sector was minimal.
The breakdown of this relationship started in the early 1980s. … But the most important
change definitely occurred in the link between money and credit growth to asset markets. Money
and credit began to pour into asset markets, boosting their prices, while the traditional inflation
rates of goods and services declined. …‖
Richebacher, March 20, 2007 (The Daily Reckoning)

Richebacher was noting that the MPD has been eroding, and around the time of the U.S. real
estate bubble peak has deteriorated even more dramatically. Also, this is shown in the following
two graphs:
Kihn / Behavioral Finance 101 / 291


Source: Graphs were taken from the ―Grandfather Economic Report‖.

The trend is clear. The first graph shows debt per unit of income, and the second graph shows the
reciprocal of that (e.g., we now need more than $5 debt per $1 of income). Therefore, around the
early 1980s the MPD deteriorated and has continued to do so. We must be careful though in our
interpretation, to some extent this may be misleading. That is, to the extent we implicitly and/or
explicitly assume there is a direct causal relationship only between these two variables (i.e.,
running from debt to income and/or GDP). In reality, it may end up effectively a two variable
race, but in the beginning it is clearly more than that (i.e., it may in the end be the case the
collapse is all about too much debt, but clearly the earlier success is not due to debt, but things
like entrepreneurs, real capital, useful education/real labor capital, etc.). Regardless, a MPD of
below one is problematic. Furthermore, it is clearly now unstable and this has recently become
self-reinforcing if it continues to climb (as it has over the last two or three decades).
Kihn / Behavioral Finance 101 / 292


Regarding the bursting effect, the reader may be asking themselves why something like the MPD
even matters. It matters to the extent that macroeconomic scale bubbles are merely a symptom of
a larger disease (e.g., as the ‗Austrians‘ seem to think). If indeed the 4% loss of GDP (in the case
of equity bubbles) and 8% loss of GDP (in the case of real estate bubbles) are indicative of much
smaller bubbles within a larger credit bubble, then the current unwinding will likely be multiples
of the approximate macroeconomic loss numbers quoted by Hebling et al. (2002). Thus, you
have a continuum of unsustainable bubbles: (1) idiosyncratic financial bubbles (e.g., IBM stock
in the 1980s) at one end, (2) asset class specific bubbles (e.g., Dot.com stocks during the 1990s,
and peaking March 2000), and (3) macroeconomic bubbles ala the ‗Austrian school‘ at the other
end. If the ‗Austrians‘ are largely correct, then it is likely that all three are influenced by easy
credit, but the last two are almost certainly largely caused by it. Finally, the costs and associated
effects are largely driven by what type of bubble it is and whether it is a bubble of a larger
macroeconomic credit cycle or not (mostly, if not totally caused by human intervention).

Therefore, the effects and associated costs of a bubble will have a heavy dependence on the type
of bubble. Is it an idiosyncratic bubble or a macroeconomic bubble? The more idiosyncratic, for
example the price of IBM common stock during a two year period in the 1980s, the smaller the
macroeconomic costs, by definition, yet its specific impact on IBM might be great. At the other
end of the bubble scale, an ‗Austrian‘ type CB enhanced credit cycle is, by definition, the most
costly event that can happen to society overall (i.e., outside of war). Kindleberger is worried
about ―financial crises‖ associated with the macroeconomic credit events, while the Austrians are
Kihn / Behavioral Finance 101 / 293

worried about the collapse.
254
At the other extreme are people that jumped into an idiosyncratic
bubble at the peak and were forced to declare bankruptcy as a result. In either extreme you can
get insolvency for one or more individuals or for virtually the whole economy.

WHEN IS IT ‗RATIONAL‘ TO BE ‗IRRATIONAL‘?
―If you can keep your head while others are losing theirs, perhaps you have misjudged the
situation.‖
255

Joker, The Short Timers (by Gustav Hasford)


254
Related to this is a quote from Ludwig von Mises: ―The boom produces impoverishment. But still more
disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the
illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always
ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent,
application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity
of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles
them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are
the only remedy against the evils which inflation and credit expansion have brought about.‖
255
My intention was to make this quote more understandable by the end of this chapter, but it may take the whole
chapter to accomplish that.
Kihn / Behavioral Finance 101 / 294

Before going full out on this topic, I would like to introduce an institutional agent/actor that I
might have introduced in the previous chapter, ―hedge funds‖, but held off on so doing. The
reason I waited until now is twofold: (1) that we do have some empirical work linking them to a
commonly accepted financial bubble, and (2) of all the agents/actors in the financial markets
they could be argued to have the best change of representing a close approximation to traditional
rational arbitrageurs. Therefore, we can analyze the impact of what are considered to be
arbitrageurs/hedgers at a market and time when we would most expect them to drive prices back
toward fundamental value. If it turns out that this group fails to correct mispricing during a
―bubble‖, the obvious next questions are who would be expected to do so and under what
conditions? Answers: With respect to who, likely nobody; and with respect to conditions, most
likely practically never, and likely nowhere.

Kihn / Behavioral Finance 101 / 295

OUR LAST BEST HOPE – HEDGE FUNDS (―HFS‖)
256

Recall, especially from the previous chapter, that analysts, PMs, and individual investors, etc. all
seem to systematically fall prey to their very human biases and the classic rational trader doesn‘t
seem ready to fill the gap and correct prices for all asset classes at all times. In contrast to the
WSSs, PMs, analysts, etc. reviewed, HFs may be the one institutional investor that could fill the
role of rational arbitrageur.

The key to HFs is that their incentives differ from the majority of institutional investors (retail or
institutionally oriented). The following table highlights some differences on three levels: (1)
compensation, (2) investment flexibility, and (3) other.

From: Kao, D., ―Battle for Alphas: Hedge Funds versus Long-Only Portfolios‖, Financial Analysts Journal, Volume
52, Number 2, March/April 2002, p.24.

As a general rule their compensation is more in line with their clients (although still somewhat
asymmetric), their IP can be more flexible, and other factors are in their favor for acting as an
arbitrageur/hedger. For example, HFs neither display the risk/reward profiles of mutual funds nor

256
I would also include in this group Commodity Trading Advisors (―CTAs‖), which could be another section.
Table 1. Structural Factors in Favor of Hedge Funds
Compensation Investment Flexibility Other Factors
Management fees (not unique) Leverage Lockup period**
Incentive fees Short selling Nil disclosure requirements
Hurdle rates Use of derivatives Fund size
High-water marks* Concentrated positions Simple benchmarks
Management capital Few investment guidelines
* High-water marks are used to ensure that incentive fees are earned only if cumulative
performance recovers any past shortfalls.
** The lockup period is a time restriction for redeeming hedge-fund investments.
Kihn / Behavioral Finance 101 / 296

do they have similar incentives (coincidence?). Liang (1999) documents some of the more
noteworthy differences:
1. Hedge funds have a special fee structure that is designed to align managers‘ incentives
with their clients‘. For example, ―hurdle rates‖, incentive fees (averaged about 16%, and
the median was 20%), and ―high watermarks‖.
2. Funds with high watermarks significantly outperform those without high watermarks.
Also, typically, hurdle rates are combined with high watermarks.
3. The incentive fee structure does indeed align manager and client interests.
4. Average hedge fund returns are positively related to fund size/assets and lockup period,
and negatively related to fund age.
257

5. Onshore funds with offshore equivalents outperform onshore only and offshore only
funds.
258

6. Hedge funds have relatively low correlations with traditional asset classes, thus providing
diversification potential for asset allocation.
7. Overall, hedge funds provided superior performance when compared to mutual funds
(i.e., on a risk-adjusted basis), and this difference is not due to survivorship bias.
259


Based on this evidence, and basic incentives logic, at least some of these agents/actors are the
most likely candidates to keep the market honest in a traditional market efficiency sense. In

257
It is interesting to speculate that the fund age may be related to manager age for mutual funds. Remember from
Chevalier and Ellison (1998) that, ceteris paribus, you want a younger manager to manage your money; and for HFs
the age of the fund and manager age tend to be one in the same.
258
This is probably a selection bias (i.e., if the fund has done well onshore, it is marketed offshore).
259
For what it‘s worth, I am not completely convinced of the lack of relative survivorship bias in the HFs
performance numbers relative to mutual funds. For example, there is a unique ‗self-delisting bias‘ among HFs, and
CTAs (e.g., some very successful ones are not listed, others are yanked to avoid data errors, etc.).
Kihn / Behavioral Finance 101 / 297

addition, we know the other agents/actors don‘t seem to be doing the job, hence our ―last, best
hope‖.

Given this is the bubbles chapter, what, the reader might ask, do HFs have to do with bubbles?
This question brings us to the point of answering the question: When and under what
circumstances might it appear ‗rational‘ to act ‗irrational‘ (of course, I mean in the normative
sense of the words)? Answer: Possibly during a bubble?

Whether or not a bubble is the time to act rationally irrational minimally depends on the
following:
1) Your ability to evaluate the mispricing or more specifically the deviation from true economic
value (therefore, you need at least two models, the one used by those irrational enough to
misvalue, although there are probably many, and a model of the true economic or fundamental
value).
260

2) Your ability to forecast when the irrationnal traders will no longer value according to their
irriational valuation model (the peak or turning point).
3) Also, probably, things like the distribution and impact of the various parts of market demand
and when they will remove themselves from the demand function as price begins to drift toward
fundamental value, etc.

260
Also, this implicitly assumes that fraud isn‘t influencing pricing or agents can correctly account for it and modify
their pricing accordingly. For a discussion on one typical aspect of fraud in the financial markets (called
―overpromotion‖ by the author) see Kane (2005).
Kihn / Behavioral Finance 101 / 298

This is likely not easy, nor is it assured to be risk-free (i.e., in the traditional finance sense). And,
as always, we have very few cases were we know the ―pricing model‖.
261
Perhaps, an easier
method, and ignoring the pricing method for the moment, is to focus on cases where most of us
‗rational‘ finance people can agree the pricing was way out of line (we just don‘t know how far).
One case of this must be the technology craze or mania of the mid- to late-1990s (the ―Dot.com
boom‖, peaking around March 2000)
262
. This affected not just pricing of U.S. technology shares,
but affected stocks markets internationally as well. Two academics looked into this very question
by analyzing hedge fund holdings of technology shares up to and through the peak of the
technology craze around March 2000.

―Overall, our findings cast doubt on the classical view that it is always optimal for rational
arbitragers to attack a bubble. While the exact implications of our results for the mechanism
limiting arbitrage may be open to different interpretations, one point seems clear: There is no
evidence that hedge funds as a whole exerted a correcting force on prices during the
technology bubble. Among the few large hedge funds that did, the manager with the least
exposure to technology stocks – Tiger Management – did not survive until the bubble burst. …
Nevertheless, we add much needed empirical evidence to the predominantly theoretical work on
limits of arbitrage.‖

261
The problem is that EMT/EMH proponents cannot admit that there are financial bubbles. If they do, the ―jig is
up‖. In addition, but related, is how to define them. We must agree on what constitutes fundamental value, then we
can say that economic/fundamental values are diverging enough to say this or that is a ―bubble‖ (i.e., unless we
apply an ―unsustainable‖ vs. ―sustainable‖ type definition). But, of course, the instant you do that, the ―jig is up‖ for
EMT proponents. What a vicious circle for the field of finance. For example, things like ―time varying risk
premiums‖ get you out of saying there is a hard and fast economic valuation (hence, EMT proponents not being too
concerned that the CAPM is largely dead, since it made hard and fast interpretations of these things). Therefore, by
making the right assumptions, you can get any price at any time (and we end up where we started, i.e., with
effectively no definition possible, so no possibility of being proved wrong, or right).
262
See, for example, Cooper et al. (2001) as an example of this.
Kihn / Behavioral Finance 101 / 299

Brunnermeier and Nagel (2002, p. 3)

Here is a graphic representation of the above comment:

From: Brunnermeier, M., and S. Nagel, ―Arbitrage at its Limits: Hedge Funds and the Technology Bubble‖,
Working Paper, November 2002, p. 41.

You can see that far from trying to prick the bubble, they contributed to it! As the NASDAQ (a
primarily technology stock oriented index) increased and peaked on March 2000, HFs roughly
mimicked its ascent with their holdings of technology stocks (the blue bars roughly represent the
Kihn / Behavioral Finance 101 / 300

weight of technology stocks in HFs‘ portfolios).
263
What the graph shows is how the weight of
technology shares in the ―market portfolio‖ (the relative market value weight of technology
shares over all measured shares in the CRSP database) roughly mimics the technology holdings
of HFs. Normative theory would suggest that if the prices of technology shares were drifting
away from fundamental values (as they were over most of the period shown, i.e., at least until
March 2000) then one or more arbitrageurs will enter to drive prices back to correct
valuations.
264
Where is our ―rational‖ arbitrageur? In fact, we just eliminated our final private
institutional savior.

Note that besides the normal limits to arbitrage (transaction costs, no exact substitutes, etc.):
• Many/most institutional and retail, and even HF, PMs have short horizons due to the fact
that investors will pull money at some point and they know it (see the literature on
portfolio flows). Hence, bucking the trend of a bubble on the front side can be hazardous
if you don‘t get the timing right.
• Idiosyncratic risk also limits arbitrage (see Wurgler and Zhuravskaya (2002)). Also, if
you make an idiosyncratic trade during an asset class bubble, you may be overwhelmed
more by the systemic bubble risk
265
than the idiosyncratic risk.

263
Apparently, this is not influenced by a size effect, as, e.g., Schwert (2002) shows that during the technology stock
bubble the driving force weren‘t small firms in the NASDAQ index but technology itself.
264
It is likely that the drift from fundamental value was of historic or at least near historic proportions (see, e.g.,
Hirschey (2001) where he compares ―NASDAQ 100‖ valuations at their peak to the ―Nifty Fifty‖ at their peak in
1929). Specifically, the finding (see Hirschey (2001, p. 58)) of ―conventional expectations of 20-50 percent long-
term EPS growth for giant tech companies‖ is not only unsustainable, but absurd. Therefore, if there was a time and
asset group that arbitrageurs should have been shorting, but didn‘t, this was it.
265
This type of risk is not necessarily of the systemic kind (see, e.g., Baker and Wurgler (2003) where they find that,
for example, ‗sentiment‘s‘ effects on stock returns are not likely ―to reflect an alternative explanation based on
compensation for systematic risk.‖). Therefore, what I call ―bubble risk‖ is probably not a standard normative
financial market ‗risk‘, that is, in the traditional sense of the term.
Kihn / Behavioral Finance 101 / 301

• It is risky to attach a bubble without coordination (e.g., Julian Robertson of Tiger
Management).
266

The key is that if you have some timing ability (or perceive that you do) then it may or may not
be optimal to ride the bubble. In short, the strategic or long term bet may indicate the likelihood
that the bubble will burst, but it may make tactical sense to hang on and ride it for a time (i.e., in
the short-run). Either way, and ignored by the EMT, there are clearly times when it can be
―rational to be irrational‖
267
, and the technology bubble is one example of that (clearly, given the
mechanism uncovered in this example, there must be many others).
268


I will end the chapter with prescriptive advice with respect to investors and prospective investors
in the financial markets during bubbles:
• It is never a good idea to be irrational (i.e., in the dictionary sense, not the EMT sense).
Therefore, when I write there are times when it may be ―‘rational‘ to be ‗irrational‘‖, I
mean in the normative economics and finance sense of the terms.
• Be especially careful of bubbles, in that they can represent some of the more extreme
pricing deviations from true economic value. Thus, be especially wary of the peak. It is
the dividing line between when an investor, or potential investor, will switch from
favoring a net long to a net short position.

266
Even normative ‗models‘ can get the result that it makes sense to contribute to a bubble (e.g., Wang and Wen
(2009), where the key assumption is merely heterogeneous agents).
267 Even Dillen and Sellin (2003, p. 123) note: ―for the individual, it may not be irrational to invest in an asset
with a price bubble.‖
268
Thus, in those situations where a true ‗fad‘ is in play, it can be a ‗rational‘ tactic (i.e., ‗fad‘ in the Bikhchandani et
al. (1992) sense), but clearly not an advisable strategy.
Kihn / Behavioral Finance 101 / 302

• Distinguish between what type of bubble it is. For example, is it a purely idiosyncratic
short-term bubble, or is it one of those ‗Austrian‘ macroeconomic monsters? The
differences can make or break your tactics and/or strategies.
In short, be wary of bubbles, and understand why many suggest they cannot exist (although, they
obviously do).

REFERENCES
Andersen, J., and D. Sornette, ―Fearless versus fearful speculative financial bubbles‖, Physica A,
Volume 337, Issues 3-4, June 2004, 565-585.

Baker, M., and Wurgler, J., ―Investor sentiment and the cross-section of stock returns‖, Working
Paper, December 2003, 1-47.

Bernanke, B., and M. Gertler, ―Monetary Policy and Asset Price Volatility‖, Economic Review,
Federal Reserve Bank of Kansas City, Fourth Quarter, 1999, 17-51.
Kihn / Behavioral Finance 101 / 303


Bernanke, B., and M. Gertler, ―Should Central Banks Respond to Movements in Asset Prices?‖,
AER Papers and Proceedings: Quantitative Policy Implications of New Normative
Macroeconomic Research, American Economic Review, Volume 91, Number 2, May 2001, 253-
257.

Bernanke, B., and K. Kuttner, ―What Explains the Stock Market‘s Reaction to Federal Reserve
Policy‖, Journal of Finance, Volume LX, Number 3, June 2005, 1221-1257.

Bikhchandani, S., Hirshleifer, D., and I. Welch, ―A Theory of Fads, Fashion, Custom, and
Cultural Change as Informational Cascades‖, Journal of Political Economy, Volume 100,
Number 5, October 1992, 992-1026.

Brunnermeier, M., and S. Nagel, ―Arbitrage at its Limits: Hedge Funds and the Technology
Bubble‖, Working Paper, November 2002, 1-46.

Caginalp, G., Porter, D., and V. Smith, ―Overreactions, Momentum, Liquidity, and Price
Bubbles in Laboratory and Field Asset Markets‖, Journal of Psychology and Financial Markets,
Volume 1, Number 1, March 2000, 24-48.

Chan, L., Karceski, J., and J. Lakonishok, ―New Paradigm or Same Old Hype in Equity
Investing?‖, Financial Analysts Journal, Volume 56, Number 4, July/August 2000, 23-36.
Kihn / Behavioral Finance 101 / 304


Cooper, M., Dimitrov, O., and P. Rau, ―A Rose.com by Any Other Name‖, Journal of Finance,
Volume LVI, Number 6, December 2001, 2371-2388.

Dillen, H., and P. Sellin, ―Financial bubbles and monetary policy‖, Sveriges Riksbank Economic
Review, Issue 3, 2003, 119-145.

The Economist. ―Hubble, Bubble, Asset Price Trouble‖, September 23, 1999.

Ferguson, R., ―On Crashes‖, Financial Analysts Journal, Volume 45, Number 2, March/April
1989, 42-52.

Froot, K., and M. Obstfeld, ―Intrinsic Bubbles: The Case of Stock Prices‖, American Economic
Review, Volume 81, Issue 5, December 1991, 1189-1214.

Hebling, T., Terrones, M., and E. Conover, ―Chapter II: when bubbles burst‖, in IMF‘s World
Economic Outlook (―WEO‖), April 2003, 61-94.

Hirschey, M., ―How Much Is a Tulip Worth?‖, Financial Analysts Journal, Volume 54, Number
4, July/August 1998, 11-17.

Kihn / Behavioral Finance 101 / 305

Hirschey, M., ―Cisco and the Kids‖, Financial Analysts Journal, Volume 57, Number 4,
July/August 2001, 48-59.

Kane, E., ―Charles Kindleberger: An Impressionist in a Minimalist World‖, Atlantic Economic
Journal, Volume 33, Issue 1, March 2005, 35-42.

Kao, D., ―Battle for Alphas: Hedge Funds versus Long-Only Portfolios‖, Financial Analysts
Journal, Volume 58, Number 2, March/April 2002, 16-36.

Kindleberger, Charles and Robert Aliber, Manias, Panics, and Crashes: A History of Financial
Crises (fifth edition), John Wiley & Sons, Inc., Hoboken, New Jersey, 2005 (first edition 1978).

Krugman, P., ―How Did Economists Get It So Wrong?‖, New York Times, September 2, 2009.

Liang, B., ―On the Performance of Hedge Funds‖, Financial Analysts Journal, Volume 55,
Number 4, July/August 1999, 72-85.

Lowry, M., and W. Schwert, ―IPO Market Cycles: Bubbles or Sequential Learning?‖, Journal of
Finance, Volume LXVII, Number 3, June 2002, 1171-1198.

Mackay, Charles, Extraordinary Popular Delusions & the Madness of Crowds, Three Rivers
Press, New York, New York, 1980 (first published in 1841).
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Minsky, H., ―The Financial Instability Hypothesis‖, Prepared for Handbook of Radical Political
Economy, edited by Philip Arestis and Malcolm Sawyer, Edward Elgar: Aldershot, 1993,
Working Paper No. 74, May 1993, 1-9.

Nov, Y., and O. Nov, ―Living in a bubble? Toward a unified bubble theory‖, International
Journal of General Systems, Volume 37, Issue 5, October 2008, 627-635.

Ogawa, K., and J. Wan, ―Household debt and consumption: A Quantitative analysis based on
household micro data for Japan, Journal of Housing Economics, Volume 16, Issue 2, June 2007,
127-142.

Schwert, G., ―Stock volatility in the new millennium: how wacky is NASDAQ?‖, Journal of
Monetary Economics, Volume 49, Issue 1, January 2002, 3-26.

Shiller, R., ―Can the Fed Control Real Interest Rates?‖, NBER Working Paper Series, National
Bureau of Economic Research, Working Paper No. 348, Cambridge, Massachusetts, May 1979,
1-29.

Shiller, R., ―Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence‖,
NBER Working Paper Series, National Bureau of Economic Research, Working Paper No. 2446,
Cambridge, Massachusetts, November 1987, 1-41.
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Shiller, R., ―Speculative Prices and Popular Models‖, Journal of Economic Perspectives, Volume
4, Issue 2, Spring 1990, 55-65.

Shiller, R., ―Measuring Bubble Expectations and Investor Confidence‖, NBER Working Paper
Series, National Bureau of Economic Research, Working Paper No. 7008, Cambridge,
Massachusetts, March 1999, 1-29.

Shiller, R., ―Bubbles, Human Judgment, and Expert Opinion‖, Financial Analysts Journal,
Volume 58, Number 3, May/June 2002, 18-26.

Shiller, Robert, Irrational Exuberance (second edition), Princeton University Press, Princeton,
New Jersey, 2005.

Shiller, R., Kon-Ya, F., and Y. Tsutsui, ―Speculative Behavior in the Stock Market: Evidence
from the United States and Japan‖, NBER Working Paper Series, Working Paper No. 3613,
February 1991, 1-19.

Siegel, J., ―What is an Asset Price Bubble? An Operational Definition‖, Working Paper,
September 2002, 1-16.

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Smith, V., Suchanek, G., and A. Williams, ―Bubbles, Crashes, and Endogenous Expectations in
Experimental Spot Asset Markets‖, Econometrica, Volume 56, Number 5, September 1988,
1119-1151.

Treynor, J., ―Bulls, Bears, and Market Bubbles‖, Financial Analysts Journal, Volume 54,
Number 2, March/April 1998, 69-74.

Wang, P., and Y. Wen, ―Speculative Bubbles and Financial Crisis‖, Research Division: Federal
Reserve Bank of St. Louis Working Paper Series, Working Paper 2009-029B, June 2009, 1-23.

Watanabe, K., Takayasu, H., and M. Takayasu, ―A mathematical definition of the financial
bubbles and crashes‖, Physica A, Volume 383, Issue 1, September 2007, 120-124.

Wigmore, B., ―Revisiting the October 1987 Crash‖, Financial Analysts Journal, Volume 54,
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Issue 1, February 2006, 297-308.


Kihn / Behavioral Finance 101 / 309

Chapter 8: When does EMT seem to apply? – The Iceberg

Regarding the EMT, thus far we have no real world descriptive cases where it strictly applies;
and by now the reader should be aware that every empirically known case where we know the
‗model‘, the relative price is wrong most of the time in every market that was reviewed
(specifically, ―twin shares‖, equity ―carve-outs‖
269
, and CEFs). Traditionally, the EMT
description of the markets has focused on explaining the reaction of stock prices to trading
activity and especially arbitrage (the classic reference being Scholes (1972)). Is there any market
were the traditional arbitrageur forces price back to true value seems to apply? Answer: A very
qualified yes; and the primary qualification is that it doesn‘t work according to traditional theory.
That is, the descriptive reality of markets where certain relative prices (not absolute levels) trend
strongly toward market efficiency is relatively unique and contrived.

The market where it seems to work (i.e., and only for relative prices)
First, it is necessary to distinguish between three types of funds:
- Closed-End Funds (―CEFs‖),
- Open-End Funds (―OEFs‖), and
- Exchange Traded Funds (―ETFs‖).

269
As mentioned, with ―carve-outs‖, we can only rationally conclude that a ―stub‖ with negative value must be
wrong, all other cases we cannot know whether the price is wrong or correct, we just cannot say one way or the
other definitively without an acceptable pricing ‗model‘.
Kihn / Behavioral Finance 101 / 310

The most common attribute that each shares, is that each typically represents a portfolio of
securities (i.e., they represent some interest in a pooled set of assets/securities). Among their key
differences (and ignoring that taxes, fees, and level of transparency tend to differ):
- CEFs are typically a one time issuance (but then there is also in some cases a leverage
issue). Most important is that the market, not the fund company, is responsible for the
trading price.
- OEFs are priced daily (i.e., at the end of the ‖trading day‖). Most important is that
redemption occurs at NAV at the end of each trading day. Also, note there is no bid/ask
spread, but there may be a penalty for redemption.
- ETFs are traded on an exchange like CEFs, but have at least one crucial difference from
CEFs trading on an exchange. Most important is the price and method of redemption
(they are not redeemed at NAV).
- ETFs are unique in that holdings are published daily.
Also, common to all three is that we have a relative pricing ‗model‘ that is most accurate for
tradeable securities, such as those in most OEFs, CEFs, and ETFs. Many are composed only of
exchange traded common stocks. Again, like CEFs, that ‗model‘ is the LOOP and the notion that
the price of the portfolio must equal the sum of its parts.

Now for the more critical distinctions between OEFs, CEFs, and ETFs:
- Most retail ETF investors can buy or sell ETF shares in transactions on the exchange they
are traded on (e.g., the American Stock Exchange – the ―Amex‖) through a broker-dealer;
but certain institutional investors can create or redeem blocks of shares of ETFs (known
Kihn / Behavioral Finance 101 / 311

as ―creation units‖).
270
Therefore, those institutions are able to arbitrage differentials
between the trading value of the ETF and the NAV of the underlying assets or securities
by either creating new ETF shares or redeeming them. This is a critical difference, and it
is typically written into the ETF prospectus as a contractual obligation of the manager of
the ETF.
- Unlike OEFs, CEFs and ETFs do not stand ready to redeem individual shares at NAV.
But ETFs, unlike CEFs, are typically contractually obligated to create or extinguish
creation units if traded values diverge from the NAV of the ETF (typically at the end of
each trading day). Like the arbitrage mechanism itself, the size of these blocks of creation
units are also typically stipulated contractually (i.e., in the ETF prospectus). Therefore,
the block size (currently, typically 50,000 shares) and other characteristics of the
arbitrage mechanism can vary from ETF to ETF, and typically from institution to
institution. In some cases institutions may trade securities ―in kind‖ (e.g., for the S&P
500 an investor may need all 500 stocks in the correct proportions) for creation units, in
other cases cash is used or an adequate substitute, again depending on the legal
stipulations.
- Therefore, unlike deviations from NAV for CEFs, ETFs have a contractually stipulated
arbitrage mechanism whenever share values deviate from NAVs. The intent is obvious, to
minimize deviations of market prices from the NAVs of the ETF. In short, the intent is to
minimize relative price inefficiencies, and that is unique not just compared to CEFs, but
in the financial markets in general.

270
Actually, depending on the ETF, some individual investors may also redeem creation units, but as a general rule
they do not.
Kihn / Behavioral Finance 101 / 312

- In the U.S., most ETFs are structured as OEFs, while some are structured as unit
investment trusts (including the most popular ETF, the SPDR). A new ETF must receive
a S.E.C. exemption from the Investment Company Act of 1940 (that rule may change in
the near future). Therefore, functionally an ETF is typically a cross between an OEF (in
the sense it redeems shares, albeit in a different manner than an OEF), and a CEF (in the
sense that shares trade on an exchange rather than the management company redeeming
or issuing at the end of the trading day at NAV).

So those are the key functional differences that lead to the question: Does the creation unit
arbitrage mechanism actually eliminate the arbitrage between the traded value of an ETF and its
NAV? Answer: Yes and no. In many cases it doesn‘t seem to have the intended effect, but
especially for a few of the larger ETFs it seems to do the trick most of the time. For example in
the following case it seems to work most of the time (daily data for the S&P 500 ETF – SPDR):

Kihn / Behavioral Finance 101 / 313


Data source: American Stock Exchange website (http://www.amex.com/amextrader/tradingData/ETFData/index.jsp)
September 25, 2009.

Most of the time, there is almost no deviation from relative fair value (i.e., the dots oscillate
around zero). The average over the period is a 0.04% discount to NAV, the largest discount to
NAV occurred on May 14, 2009 (-22.51%); and the largest premium occurred on November 20,
2008 (4.82%). But, as you can see, these are truly outliers and not the norm. Therefore, for at
least the largest and arguably the most liquid ETF, and ignoring some outliers, it seems we have
found a case where relative (again, not absolute) efficiency reins most of the time!

-24.00%
-23.00%
-22.00%
-21.00%
-20.00%
-19.00%
-18.00%
-17.00%
-16.00%
-15.00%
-14.00%
-13.00%
-12.00%
-11.00%
-10.00%
-9.00%
-8.00%
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
S&P 500 ETF (SPDR) Premium/Discount to NAV
March 26, 2007 through September 24, 2009
Kihn / Behavioral Finance 101 / 314

In contrast to the SPDR and some other ETFs, many ETFs display similar deviations from NAV
that CEFs display
271
; but there seems little doubt that the ―creation unit‖ mechanism works to
largely eliminate deviations from NAV for some ETFs. Thus, the key is that ETFs can ―open‖
when prices deviate from NAV (i.e., the true fundamental value). Also, recall that I am not
saying the prices of the underlying shares, securities, commodities, etc. in the portfolio are
correct, only that the relative price changes are correct for certain ETFs most of the time.
Therefore, I do believe those prices are normally ―wrong‖ (i.e., the level of prices themselves),
but the price changes, at least in the case of ETFs, are generally ―right‖ for certain ETFs (mostly
the larger more liquid ETFs, like the SPDR).

It is important to note why we now have faith again in relative price changes, because:
1. There are effectively no limits to arbitrage (i.e., contractually).
2. We know the pricing formula (i.e., NAV). In fact, it is not really much of a formula at all,
but a tautology.
3. Depending on the ETF, one or more institutional investors is/are the rational
arbitrageur(s) making this happen at the margin. Therefore, while individual trades
matter, their impact on pricing can be completely offset by this arbitrageur, and therefore
the average is largely irrelevant.
4. Thus, based on 1-3, investor psychology (whether individual or institution) doesn‟t have
to matter and relative pricing efficiency can rule.

271
For example, Jares and Lavin (2004) find that discounts and premiums for Japan and Hong Kong ETFs are so
large and so predictable, based on changes in U.S. discounts and premiums for the same ETFs, that they were able to
construct a trading strategy that generated cumulative returns of 542.25% and 12,119% for Japan and Hong ETFs,
respectively. This clearly indicates that ETFs display many of the same apparent relative pricing inefficiencies that
CEFs possess.
Kihn / Behavioral Finance 101 / 315

5. No learning is required (i.e., the one marginal investor/market maker can be the primary
price setter).
272

Again, the driver here is the contractual obligation of the ―creation units‖ (of course, being able
to both create ETF shares – in the case of traded price being less than NAV – and redeem ETF
shares – in the case of traded price being more than NAV). In a sense, arbitrage is not only
possible, but encouraged.

Ignoring the absolute price level issue, how many markets can the reader think of that are
structured like most ETF markets? I can only think of one, ETFs, and, again, it doesn‘t seem to
work for all, or even most, ETF markets.

In summary, ETFs are a truly anomalous market, a solitary iceberg. No other market where we
have the valuation formula (in this case relative valuation), or can infer one, do we see such
relatively well behaved pricing behavior, and all because of a contractual obligation to allow
shares to be increased or decreased through the creation or redemption of ―creation units‖
273
,
which doesn‘t exist in any other market as of the writing of this book.


272
This last point is important, for if the market is set up correctly, we don‘t need to worry about irrational traders
(which are most traders), because money flows from the many irrational traders to the rational arbitrageur (just like
the EMH/EMT story), but in this case it is driven by the rules and laws of the specific ETF market that allow a BGI
or State Street type investor to do this, otherwise it doesn‘t seem to happen.
273
See the SPDR prospectus (pp. 32-41).
Kihn / Behavioral Finance 101 / 316

REFERENCES
Jares, T., and A. Lavin, ―Japan and Hong Kong Exchange-Traded Funds (ETFs): Discounts,
Returns, and Trading Strategies‖, Journal of Financial Services Research, Volume 25, Issue 1,
February 2004, 57-69.

Scholes, M., ―The Market for Securities: Substitution versus Price Pressure and Effects of
Information on Share Prices‖, Journal of Business, Volume 45, Number 2, April 1972, 179-211.

Standard & Poor‘s Depository Receipts (―SPDRs‖) Prospectus, SPDR Trust, Series 1, Sponsor:
PDR Services LLC, Prospectus Dated: February 24, 2009, 1-75.






Kihn / Behavioral Finance 101 / 317

Chapter 9: What could go wrong with financial market prices?

I have repeatedly noted that all the cases where we know or are highly confident of a pricing
‗model‘ we have not directly addressed the issue of whether, for example, the price of IBM
should be $10 per share or $1,000. It is time to shed some light on my contention that it is likely
they can be far away from the efficient market price. I will argue that under current conditions I
would expect them to be generally very far from market efficiency.

THE PRICING MODEL – DISCOUNTED PRESENT VALUE
I have mentioned that finance is ―simple‖; it is all about discounted present values. Again, we
only need to know cash flows and their associated discount rates. The difficulty is in identifying
the cash flows and selecting the correctly adjusted discount rates; yet I will argue we can greatly
simplify the issue and infer a basic premise concerning the pricing of most, if not all, financial
asset prices.
Kihn / Behavioral Finance 101 / 318


Historically, most, if not all, normative financial ―models‖ ignored specific market details and
implicitly assumed that they were irrelevant (e.g., the CAPM). This is highly unlikely. For
example, in most financial markets, often or largely due to limits to arbitrage, details matter (e.g.,
transactions costs, taxes, the influence of largely irrational traders with capital, etc.). In short, by
definition, market details not only matter, but they can be crucial to understanding a particular
market.

Historically, most empirical studies in finance analyze price changes (typically returns) and
implicitly assume that the absolute level of prices are correct (i.e., efficient). This is highly
unlikely. For example, what few examples we have of known financial market LOOP cases are
disappointing from that viewpoint (e.g., NAV vs. market price, ‗internet carve-outs‘, and ―twin
shares‖). In addition, the overwhelming majority of finance empirical studies concern themselves
with stocks/equities. But given that discount rates can and do have such a large impact on any
discounted present value calculation, I find that a more close examination of what drives
―riskless‖ bond pricing is likely to shed insight into the issue of the absolute level of prices.
Specifically, if ‗riskless‘ discount rates are found to be inefficient, then all discount rates are
likely inefficient, and thus all price levels are likely inefficient or wrong (i.e., from a market
efficiency standpoint).

Kihn / Behavioral Finance 101 / 319

Therefore, what about the market(s) for ‗riskless‘ bills, bonds, and notes? Given its size, scope,
and influence on virtually all other markets, let‘s focus on the market for U.S. Treasury
securities.
Question(s):
1. Do the details of the market matter?
2. Is it really ‗riskless‘?
3. Do relative changes differ from absolute levels?
4. Does the answer to #3 matter
Answers: (1) Yes, (2) no, (3) yes, and (4) very likely yes.
Let‘s now focus on questions #s 3 & 4.

First off, who are/is the marginal buyer(s)? Answer: One CB or multiple CBs are often the
marginal price setters. Are CBs ‗rational‘ arbitrageurs? As the reader will see, that is very, very,
unlikely, and it matters.

In order to address this issue the reader will need to be somewhat familiar with the following
foundational finance terms: duration, modified duration, yield curve, ‗term structure of interest
rates‘ (the ―term structure‖), spot rates, forward rates, and the ―expectations hypothesis‖ (―EH‖).
If unfamiliar with these terms, I encourage the reader to either read Appendix A of this chapter,
or some other brief review of the terms in possibly a textbook.

Kihn / Behavioral Finance 101 / 320

With presumed background knowledge, I will construct my argument for why I strongly believe
absolute prices are very likely to deviate substantially from market efficiency most, if not all, of
the time (i.e., at least for the last few decades). Ultimately, my case rests on both some form of
the EH and the Fisher equation (named after Irving Fisher
274
). Thus, if you generally buy into the
EH and Fisher equation very roughly holding, then I will argue it will be difficult to conclude
that the level of almost all prices in the financial markets are correct. In fact, it is likely that the
level of prices seriously deviate from fundamental or true economic values by substantial
amounts most of the time. There, you have been warned, now it‘s time to present the case.

In order to present my case I need to use two traditional mainstays of finance: (1) the
approximate Fisher equation, and (2) the real rate of interest. The Fisher equation typically
estimates the relationship between real and nominal rates with inflation (and is typically applied
as an approximation), and is defined as:
Actual: 1 + i = (1 + r) (1 + π)
Approximation
275
: i ≈ r + π or r ≈ i - π
where i = the nominal rate, r = the real rate, and π = expected inflation
276
. Therefore, the nominal
rate of interest is approximately equal to the real rate plus expected inflation; conversely, the real

274
See Fisher (1930). Besides being the first person to receive a Ph.D. in economics from Yale in 1891, he is
probably most famous for stating the following just before the stock market crash of 1929: ―Stock prices have
reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break
from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few
months." Irving Fisher, October 17, 1929
Not to be outdone, Keynes said in 1927: ―"We will not have any more crashes in our time." John Maynard Keynes
1927
275
Typically cross products are dropped. Short of very high inflation expectations and/or a very high real rate, they
tend to be small.
276
Note, that it is common for central bankers to claim, or even to have shown, that the CB can influence inflation
expectations (see, e.g., Bernanke et al. (2004)). I don‘t even as far in my assumptions as the current head of the
Kihn / Behavioral Finance 101 / 321

rate is approximately equal to the nominal rate minus expected inflation. The equation is simple,
intuitive, and has lasted the test of time.
277


One practical problem with the Fisher equation is that it refers to a ―real rate‖ and a ―nominal
rate‖. In reality, and only considering government debt, we know there are a multitude of
nominal rates. By extension, there may be a multiple of real rates as well; and it is likely there is
some term structure of inflation expectations. For example, investors might generally think
inflation will be 2% this year and 5% the year after that, etc. Given the potentially complicating
impact of a term structure for nominal rates, real rates, and inflation expectations, one
historically useful academic simplification has been the EH. If, as the EH posits, the term
structure of nominal rates (or even real rates, and possibly inflation expectations) is determined
by the consensus forecast of future nominal interest rates, then a focus on some short nominal
rate is not unwarranted. That is, to the extent longer nominal (or possibly real and/or inflation
expectations) are largely determined by a sequence of shorter nominal rates, then a focus on
short rates should be sufficient as time precedes from one period to the next (i.e., by definition).
In fact, because arbitrage is more assured for short term government debt than long term debt,
empirically it seems to be the case that short nominal rates (and even derived real rates) appear to

Federal Reserve. If it is true that the CB has both nominal rates and inflation expectations largely under their
influence or control, and the Fisher equation is largely true, then they effectively control all three variables (nominal,
real, and inflation expectations). Bernanke et al. (2004, p. 81) state: ―Shaping investor expectations through
communication does appear to be a viable strategy‖. If they truly believe that investors can be influenced merely by
words, even if misleading words, then even the basic tenants of the EMH/EMT are doomed (without even my basic
argument even only roughly holding.
277
As with most, if not all, textbook finance models, the Fisher equation is problematic for several reasons: (1) it is
largely impossible to reject it (at least due to the ‗joint hypothesis problem‘), but (2) it is wrong (at least due to
underlying assumptions being wrong). See for example Nelson and Schwert (1977) on these and related issues.
Kihn / Behavioral Finance 101 / 322

drive longer term rates.
278
Thus causality, at least over the last few decades, seems to run from
short to longer rates and not the other way around. Furthermore, it is not a stretch to imagine that
what is true for nominal rates is true of real rates and possibly inflation expectations.

By using the Fisher equation and replacing inflation expectations with realized inflation
(ironically much like a rational expectations economist
279
might), one can infer what various
theoretical real rates have been (i.e., the one unknown is the real rate).

278
For example, Romer and Romer (2000, p. 429) state that their ―findings may explain why long-term interest rates
typically rise in response to shifts in monetary policy.‖ Their key finding is that the Federal Reserve seems to
possess far superior inflation information that the evidenced by commercial inflation forecasts. In short, I would
contend that most macroeconomists believe that shorter maturity rate changes generally cause longer maturity rate
changes. That doesn‘t make it true, but it does seem macroeconomists as a group credit monetary policy with a
tremendous amount of power over short and long rates.
279
Although, we are not really assuming this, as essentially we only assume that investors generally follow what the
Federal Reserve is doing to the short rate, which is not nearly the equivalent of assuming they get all relevant
economic theories and ‗models‘ exactly right (see Muth (1961)). The irony here is that we use a kind of rational
expectations argument to show it results in pricing inefficiency because the CB is manipulating the short rate, which
in turn affects the other rates as we move out along the term structure.
Kihn / Behavioral Finance 101 / 323


Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download.

The graph represents the approximate month-end real rates/yields for the following four generic
nominal government rates: (1) effective Federal Funds rate, (2) 3-month Treasury bill secondary
market rate, (3) 1-year constant maturity Treasury rate, and (4) the 10-year constant maturity
Treasury rate over a 55 year period. Essentially each was calculated using a rough approximation
of the Fisher equation: r ≈ i – π, where i (the nominal rate) is replaced by each of the four rates
reported by the Federal Reserve Bank, and in all cases π (expected inflation) is replaced by
actual inflation as reported by the government‘s CPI (Consumer Price Index for all urban
consumers: all items – CPIAUCNS). What should be clear is that, with few exceptions, over the
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Real Rates/Yields (July 1954 through August 2009)
Real_FF
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Real_10yrTrs
Kihn / Behavioral Finance 101 / 324

55 years examined, all four ―real‖ (and nominal) rates tended to move closely together. The big
question for my purposes is whether the CB (i.e., the Federal Reserve Bank) is driving the U.S.
government yield curve (i.e., the 3-month T-bill, 1-year Treasury, and 10-year Treasury) through
the rate that they consider themselves to control (i.e., the Federal Funds rate)? At least most
academics seem to think that the CB has an overwhelming influence on shorter nominal rates
and minimally at least a large influence on longer nominal rates (e.g., Shiller (1979))
280
, and
those working at the CB itself (e.g., Bernanke et al. (2004)).

The next graph should shed some light on causality (i.e., at least for one rate). Essentially I have
taken the nominal daily Federal Funds rate (DFF) and compared it to what is called the ―Federal
Funds target rate‖ (DFEDTAR). The effective Federal Funds rate sometimes spikes markedly
relative to the target rate. Clearly, the target rate is not a natural looking pattern, but it also seems
clear that the effective rate follows it no matter how far it might spike away. Clearly, the
effective rate may deviate, even substantially, for a few days but it always has returned to the
target rate‘s level. Therefore, it seems abundantly clear that the Federal Reserve target causes the
effective rate and not the other way around.

280
The primary question in this article was not so much the CB‘s impact on nominal rates (that was more or less
taken as a given), but its influence on real rates.
Kihn / Behavioral Finance 101 / 325


Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download.

It would seem that over time, if anything, the deviation from the target rate has lessened. Thus, it
is no exaggeration to state that the Federal Reserve effectively determines the ―short end‖ of the
yield curve and by extension the term structure of interest rates. The remaining question is
whether the Federal Reserve determines the ―long end‖ of the yield curve and the term
structure?
281
The previous graph to this graph would strongly suggest they have a large and
persistent impact on long rates as well as the clear impact on shorter ones.


281
Again, e.g., see Romer and Romer (2000) as to the view that the Federal Reserve has an overwhelming impact on
long rates.
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Federal Funds Target Rate vs. Effective Federal Funds Rate
(daily - 1982-09-27 through 2009-09-23)
DFEDTAR
DFF
Kihn / Behavioral Finance 101 / 326

If it is true, if not axiomatic, that the Federal Reserve/U.S. CB has an overwhelming influence in
determining both short and long rates, then one more look at the real rates graph with only the
real Federal Funds rate estimate shown might clarify the evolution of roughly measured real rates
over the last 55 years.

Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download.

Given that the Federal Funds rate is the cost of member bank borrowing from the Federal
Reserve, at a minimum, there seem to have been times when the Federal Reserve paid member
banks to borrow (e.g., at least all of 1975). Again, all this hangs on the notion that one can
approximate the real rate (i.e., since it is unobservable), and that the Federal Reserve largely
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Kihn / Behavioral Finance 101 / 327

determines the nominal Federal Funds rate (which they claim to do). If both of these contentions
are accepted, then it is very likely the Federal Reserve has influenced rates in such a way that at
times people were paid to borrow. Does that sound like an efficient market? In essence, if it‘s
true that CBs, like the Federal Reserve, determine the ‗risk-free‘ discount rates, and they don‘t
do it from an financial market efficiency standpoint (which they clearly do not), then we are in
trouble (i.e., from a market efficiency perspective). More specifically, does paying people to
borrow sound like a good method for setting pricing efficiency in the financial markets? Answer:
‗Not bloody likely.‘

What I have failed to mention thus far is that the CPI used is not a consistent series (see
Appendix B entitled ―What happened to the CPI?‖). In fact, especially during the early to mid-
1980s it has been altered in such a way that it is difficult to compare consumer inflation now
with consumer inflation pre-1980.
282
Therefore, the next graph I present will correct for that.

282
In fact, even the people responsible for the CPI contend that the current CPI reports significantly lower inflation
than the earlier version (see, e.g., Stewart and Reed (1999)). As they state (Stewart and Reed (1999, p. 37): ―the
CPI-U does not incorporate changes retroactively.‖ Therefore, earlier CPI values are not remotely comparable to
current values. Furthermore, I would contend the changes have been systematically biased the CPI downward, with
the result being that the CPI itself is of little use as anything other than a rough measure of directional changes in
consumer inflation.
Kihn / Behavioral Finance 101 / 328


Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download, and Shadow Statistics –
September 27, 2009 download of adjusted CPI series.

The red line is the corrected series. That is, the consistent series is a combination of the blue line
until the early 1980s and the red line thereafter. Thus, a more consistent methodology would
show something historically unprecedented with respect to the real Federal Funds rate.
Specifically, the length and depth of the extent to which the Federal Reserve has influenced
nominal rates in such a way as to effectively pay people to borrow since the early 1990s is
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Real_FF
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Kihn / Behavioral Finance 101 / 329

unprecedented.
283
Assuming my methodology is only roughly correct it is still quit shocking.
Again, does paying people to borrow seem efficient?

Keep in mind that all discounted financial assets (which are virtually all financial assets) are
impacted by discounts rates, by definition. Therefore, to the extent the basic ‗risk-free‘ or
government rates are impacted by what the Federal Reserve does (which is highly likely, and
more a question of degree), and the Federal Reserve chooses to push, for example, the real rate
below zero, how likely is it that any financial asset price is efficiently set? Answer: ‗Not bloody
likely.‘ In short, prices are discounted present values, and all discount rates (and most cash
flows) are impacted directly by the government yields and/or spot rates. To the extent those rates
are not set efficiently, then we are in a world of trouble with respect to efficiency. In fact, to the
extent one accepts the notion the CB can push real effective rates below zero, then we likely end
up in a very inefficient world indeed (whether or not it‘s due to limits to arbitrage and/or
psychology).

Finally, given the above I tried to quantify the possible extent to which the Federal Reserve has
in the past pushed ‗risk-free‘ present values away from market efficiency.

283
See Bernanke et al. (2004) on monetary policy and ‗quantitative easing‘. Bernanke et al. (2004) clearly believe
that pushing effective interest below zero is not only possible, but can be desirable.
Kihn / Behavioral Finance 101 / 330



Consider this to be a cautionary tale concerning the behavioral boundary condition for the
Federal Reserve. My intent is to roughly measure the theoretical maximum actual deviation in
real rates caused by the Federal Reserve and use that deviation to form present values (i.e.,
theoretical price levels). Note that both the minimum and maximum ‗real‘ Federal Funds rate
occurred after the final remaining behavioral constraint was lifted around the early 1970s (i.e.,
since the last link to gold was removed, and the move to purely fiat based money established).
284

Thus, there is no longer a real limit to monetary policy looseness or tightness since the early
1970s.
285
As to the actual values, the maximum theoretical real Federal Funds rate value was

284
It is important to keep in mind that, outside of major wars, including the Revolutionary War and the Civil War,
inflation has not been a big issue in the U.S. until the last few decades (coinciding with the creation of the Federal
Reserve and especially the delinking the dollar from gold). For a decent review of this and going back about 150
more years than I do, see Arnott and Bernstein (2002, pp. 76-77).
285
With respect to things like nominal rates and inflation expectations, it is important that analyzing different
monetary regimes can give rise to very different answers to effectively the same question. For example, Shiller and
Siegel (1977, p. 891) found that ―prior to World War I nominal long and short rates of interest can be regarded as
Range of 'real rate' (July-1954 through July-2008)
High Low Increment
9.55% -11.35% 1.05%
Discount rate -10.31% -9.26% -8.22% -7.17% -6.13% -5.08% -4.04% -2.99% -1.95% -0.90% 0.15% 1.19% 2.24% 3.28% 4.33% 5.37% 6.42% 7.46% 8.51% 9.55%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Ratio
Year PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV PV min to max
0.083333333 $1.01 $1.01 $1.01 $1.01 $1.01 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $0.99 $0.99 $0.99 $0.99 1.02
1 $1.11 $1.10 $1.09 $1.08 $1.07 $1.05 $1.04 $1.03 $1.02 $1.01 $1.00 $0.99 $0.98 $0.97 $0.96 $0.95 $0.94 $0.93 $0.92 $0.91 1.22
2 $1.24 $1.21 $1.19 $1.16 $1.13 $1.11 $1.09 $1.06 $1.04 $1.02 $1.00 $0.98 $0.96 $0.94 $0.92 $0.90 $0.88 $0.87 $0.85 $0.83 1.49
3 $1.39 $1.34 $1.29 $1.25 $1.21 $1.17 $1.13 $1.10 $1.06 $1.03 $1.00 $0.97 $0.94 $0.91 $0.88 $0.85 $0.83 $0.81 $0.78 $0.76 1.82
4 $1.54 $1.48 $1.41 $1.35 $1.29 $1.23 $1.18 $1.13 $1.08 $1.04 $0.99 $0.95 $0.92 $0.88 $0.84 $0.81 $0.78 $0.75 $0.72 $0.69 2.23
5 $1.72 $1.63 $1.54 $1.45 $1.37 $1.30 $1.23 $1.16 $1.10 $1.05 $0.99 $0.94 $0.90 $0.85 $0.81 $0.77 $0.73 $0.70 $0.66 $0.63 2.72
6 $1.92 $1.79 $1.67 $1.56 $1.46 $1.37 $1.28 $1.20 $1.13 $1.06 $0.99 $0.93 $0.88 $0.82 $0.78 $0.73 $0.69 $0.65 $0.61 $0.58 3.32
7 $2.14 $1.97 $1.82 $1.68 $1.56 $1.44 $1.33 $1.24 $1.15 $1.07 $0.99 $0.92 $0.86 $0.80 $0.74 $0.69 $0.65 $0.60 $0.56 $0.53 4.05
8 $2.39 $2.18 $1.99 $1.81 $1.66 $1.52 $1.39 $1.27 $1.17 $1.08 $0.99 $0.91 $0.84 $0.77 $0.71 $0.66 $0.61 $0.56 $0.52 $0.48 4.95
9 $2.66 $2.40 $2.16 $1.95 $1.77 $1.60 $1.45 $1.31 $1.19 $1.08 $0.99 $0.90 $0.82 $0.75 $0.68 $0.62 $0.57 $0.52 $0.48 $0.44 6.05
10 $2.97 $2.64 $2.36 $2.10 $1.88 $1.68 $1.51 $1.35 $1.22 $1.09 $0.99 $0.89 $0.80 $0.72 $0.65 $0.59 $0.54 $0.49 $0.44 $0.40 7.39
11 $3.31 $2.91 $2.57 $2.27 $2.00 $1.77 $1.57 $1.40 $1.24 $1.10 $0.98 $0.88 $0.78 $0.70 $0.63 $0.56 $0.50 $0.45 $0.41 $0.37 9.02
12 $3.69 $3.21 $2.80 $2.44 $2.14 $1.87 $1.64 $1.44 $1.27 $1.11 $0.98 $0.87 $0.77 $0.68 $0.60 $0.53 $0.47 $0.42 $0.38 $0.33 11.02
13 $4.11 $3.54 $3.05 $2.63 $2.27 $1.97 $1.71 $1.48 $1.29 $1.12 $0.98 $0.86 $0.75 $0.66 $0.58 $0.51 $0.45 $0.39 $0.35 $0.31 13.46
14 $4.58 $3.90 $3.32 $2.83 $2.42 $2.07 $1.78 $1.53 $1.32 $1.13 $0.98 $0.85 $0.73 $0.64 $0.55 $0.48 $0.42 $0.37 $0.32 $0.28 16.44
15 $5.11 $4.30 $3.62 $3.05 $2.58 $2.19 $1.85 $1.58 $1.34 $1.15 $0.98 $0.84 $0.72 $0.62 $0.53 $0.46 $0.39 $0.34 $0.29 $0.25 20.08
16 $5.70 $4.73 $3.94 $3.29 $2.75 $2.30 $1.93 $1.63 $1.37 $1.16 $0.98 $0.83 $0.70 $0.60 $0.51 $0.43 $0.37 $0.32 $0.27 $0.23 24.52
17 $6.35 $5.22 $4.29 $3.54 $2.93 $2.43 $2.01 $1.68 $1.40 $1.17 $0.98 $0.82 $0.69 $0.58 $0.49 $0.41 $0.35 $0.29 $0.25 $0.21 29.95
18 $7.08 $5.75 $4.68 $3.82 $3.12 $2.56 $2.10 $1.73 $1.42 $1.18 $0.97 $0.81 $0.67 $0.56 $0.47 $0.39 $0.33 $0.27 $0.23 $0.19 36.58
19 $7.90 $6.34 $5.10 $4.11 $3.32 $2.69 $2.19 $1.78 $1.45 $1.19 $0.97 $0.80 $0.66 $0.54 $0.45 $0.37 $0.31 $0.25 $0.21 $0.18 44.67
20 $8.80 $6.98 $5.55 $4.43 $3.54 $2.84 $2.28 $1.84 $1.48 $1.20 $0.97 $0.79 $0.64 $0.52 $0.43 $0.35 $0.29 $0.24 $0.20 $0.16 54.56
21 $9.81 $7.70 $6.05 $4.77 $3.77 $2.99 $2.37 $1.89 $1.51 $1.21 $0.97 $0.78 $0.63 $0.51 $0.41 $0.33 $0.27 $0.22 $0.18 $0.15 66.64
22 $10.94 $8.48 $6.59 $5.14 $4.02 $3.15 $2.47 $1.95 $1.54 $1.22 $0.97 $0.77 $0.61 $0.49 $0.39 $0.32 $0.25 $0.21 $0.17 $0.13 81.39
23 $12.20 $9.35 $7.18 $5.54 $4.28 $3.32 $2.58 $2.01 $1.57 $1.23 $0.97 $0.76 $0.60 $0.48 $0.38 $0.30 $0.24 $0.19 $0.15 $0.12 99.41
24 $13.60 $10.30 $7.82 $5.96 $4.56 $3.49 $2.69 $2.07 $1.60 $1.24 $0.97 $0.75 $0.59 $0.46 $0.36 $0.28 $0.22 $0.18 $0.14 $0.11 121.41
25 $15.16 $11.35 $8.53 $6.42 $4.86 $3.68 $2.80 $2.14 $1.63 $1.25 $0.96 $0.74 $0.58 $0.45 $0.35 $0.27 $0.21 $0.17 $0.13 $0.10 148.29
26 $16.91 $12.51 $9.29 $6.92 $5.17 $3.88 $2.92 $2.20 $1.67 $1.26 $0.96 $0.74 $0.56 $0.43 $0.33 $0.26 $0.20 $0.15 $0.12 $0.09 181.11
27 $18.85 $13.79 $10.12 $7.45 $5.51 $4.09 $3.04 $2.27 $1.70 $1.28 $0.96 $0.73 $0.55 $0.42 $0.32 $0.24 $0.19 $0.14 $0.11 $0.09 221.20
28 $21.01 $15.19 $11.03 $8.03 $5.87 $4.31 $3.17 $2.34 $1.73 $1.29 $0.96 $0.72 $0.54 $0.41 $0.31 $0.23 $0.18 $0.13 $0.10 $0.08 270.17
29 $23.43 $16.74 $12.01 $8.65 $6.25 $4.54 $3.30 $2.41 $1.77 $1.30 $0.96 $0.71 $0.53 $0.39 $0.29 $0.22 $0.16 $0.12 $0.09 $0.07 329.97
30 $26.12 $18.45 $13.09 $9.32 $6.66 $4.78 $3.44 $2.49 $1.80 $1.31 $0.96 $0.70 $0.52 $0.38 $0.28 $0.21 $0.15 $0.12 $0.09 $0.06 403.02
Kihn / Behavioral Finance 101 / 331

established at 9.55% in June 1981 (about a year before CPI methodology began to systematically
bias estimates downward); whereas the minimum real Federal Funds rate was established at -
11.35% in July 2008 (well after most major CPI methodology changes). Of course, the Federal
Reserve may still have time to push this approximately 20.9% absolute spread in the real Federal
Funds rate further, but then again maybe not.

What is shown, and assuming the method is even roughly correct, is a two dimensional
representation of theoretical price levels where the discount rate is varied by 20 increments from
the maximum real effective Federal Funds rate almost to its minimum (a spread of about 20%)
and maturities are varied from 3-months to 30 years. Keep in mind that most stocks today have
durations much closer to 30-year bonds than probably any other theoretical bond on this table.
For example, at a discount rate of +6.42% (PV column # 17) a twenty year $1 non-coupon
paying bond‘s present value or theoretical price is $0.29 cents, while the same bond at -6.13%
(PV column # 5) is $3.54. It should begin to dawn on the reader how a price level can be
dramatically altered by monetary policy.

The key column for this table is last column on the right hand side (i.e., the farthest right column
entitled ―Ratio – min to max‖). That column shows the theoretically maximum deviation from
the lowest to highest that monetary policy has theoretically influenced price levels for each
maturity. For example, due to its duration, the most extreme example is the longest maturity
security (the 30-year bond with no embedded options or coupons) at about 403. What this means

real rates.‖ Therefore, prior to WWI there is no Fisher equation, because it reduces to i ≈ r. Clearly, the current fiat
money regime needs to account for inflation.
Kihn / Behavioral Finance 101 / 332

is that theoretically, and assuming the reader accepts the methodology, the real value of a 30-
year risk-free cash flow can vary by as much as roughly 40,300% from intrinsic or fundamental
value based on Federal Reserve policy alone.
286
Therefore, in answer to the question what can go
wrong with financial market prices; a great deal can go wrong. In fact, for example, the share
price of IBM could be pushed from say $10 to $4,030 or vice versa depending on irrational
Federal Reserve policy at the time it is present valued (i.e., at least based on their record for the
last fifty or so years, and especially since the early 1970s). Thus, in the future, and given the
current currency regime, it could be worse.

Therefore, if all PVs (i.e., all past and current prices) in all financial markets are at least in part
based on the ‗risk-free‘ rate(s) of discount/interest, and if CBs largely determine the ‗risk-free‘
discount rate(s), then, why would you expect any price to be ‗efficiently priced‘ (i.e., in the true
fundamental sense)? Answer: You wouldn‘t! Which is why it is much safer to assume that
absolute prices are ‗right‘ (when we know, in reality, that descriptively they are not) and
henceforth focus on price changes (i.e., rather than price levels). Thus, as with the proverbial tree
falling in the forest and nobody sees it, surely it never fell (or in this case the whole forest
falling)? Again, the two questions we generally concern ourselves with in finance are:
1 What is/are the cash flow(s)?
2 What is/are the discount rate(s)?

286
Of course, this does not include the possibility, even expressed by the current Fed Chairman that equities, and if
equities then likley other asset classes, ‗overreact‘ to monetary policy. Bernanke and Kuttner (2005, p. 1254)
suggest that ―further exploration of the link between monetary policy and the excess return on equities is an
intriguing topic‖.
Kihn / Behavioral Finance 101 / 333

And if the ‗risk-free‘ rate is of questionable value (i.e., from a market efficiency standpoint);
then what chance do we have of any present value analysis that is wholly dependent (like the
government bond market) or significantly dependent (like all others) on such rate(s) being
efficiently priced?
Answer: You don‟t!
Which brings us to the final question of this chapter, if the price level of financial assets can be
off by say 40,300% or more
287
due to the actions of one CB, what are the odds that relative
prices (i.e., outside of the ones empirically documented) are not also off by large amounts?
Therefore, given demonstrated monetary policy and the conditions that allowed it to push the
government term structure around, combined with our descriptive knowledge and understanding
of actual relative prices and related price changes, both relative and absolute prices are in fact
likely to be way off the mark from anything even approaching market efficiency of the
traditional informational sort, except if largely by accident, but certainly not likely by the intent
of government sponsored entities like CBs.


287
Therefore, there is certainly the possibility of a deviation beyond the aforementioned 400+ at thirty years
maturity (i.e., beyond 40,000%). Thus, for example, if an equity didn‘t pay a dividend (i.e., no cash flow) the
difference could be almost infinite (remember that some of the Dot.com companies paid no positive cash flow or
dividend). Thu, it is certainly in the realm of the theoretically possible that differentials could easily trend toward the
infinite. Again, this wouldn‘t account for LOOP violations, etc., just the ―risk-free‖ rate impact on absolute price
levels.
Kihn / Behavioral Finance 101 / 334

REFERENCES
Arnott, R., and P. Bernstein, ―What Risk Premium is ‗Normal‘?‖, Financial Analysts Journal,
Volume 58, Number 2, March/April 2002, 64-85.

Bernanke, B., and K. Kuttner, ―What Explains the Stock Market‘s Reaction to Federal Reserve
Policy‖, Journal of Finance, Volume LX, Number 3, June 2005, 1221-1257.

Bernanke, B., Reinhart, V., and B. Stack, ―Monetary Policy Alternatives at the Zero Bound: An
Empirical Assessment‖, Finance and Economics Discussion Series, Divisions of Research &
Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., Staff Working Paper
No. 2004-48, September 2004, 1-86.

Chance, D., and D. Rich, ―The False Teachings of the Unbiased Expectations Hypothesis‖,
Journal of Portfolio Management, Volume 27, Issue 4, Summer 2001, 83-95.

Fabozzi, F., Pitts, M., and R. Dattatreya, R., ―Chapter 5: Price Volatility Characteristics of Fixed
Income Securities‖, 77-105, in The Handbook of Fixed Income Securities (Fifth Edition), Frank
Fabozzi (Editor), McGraw Hill Companies, New York, New York, 1997.

Fisher, Irving, The Theory of Interest, Macmillan, New York, New York, 1930.

Kihn / Behavioral Finance 101 / 335

Gultekin, N., and R. Rogalski, ―Alternative Duration Specifications and the Measurement of
Basis Risk: Empirical Tests‖, Journal of Business, Volume 57, Number 2, April 1984, 241-264.

Kritzman, M., ―What Practitioners Need to Know … … About Duration and Convexity‖,
Financial Analysts Journal, Volume 48, Issue 6, November/December 1992, 17-20.

Kritzman, M., ―What Practitioners Need to Know … … About the Term Structure of Interest
Rates‖, Financial Analysts Journal, Volume 49, Issue 4, July/August 1993, 14-18.

Lintner, J., ―Inflation and Security Returns‖, Journal of Finance, Volume 30, Number 2, Papers
and Proceedings of the Thirty-Third Annual Meeting of the American Finance Association, San
Francisco, California, December 28-30, 1974, May 1975, 259-280.

Macaulay, Frederick., Some Theoretical Problems Suggested by the Movements of Interest
Rates, Bond Yields and Stock Prices in the United States since 1865, No. 33, National Bureau of
Economic Research, Inc., New York, New York, 1938.

Mishkin, Frederic, The Economics of Money, Banking, and Financial Markets (Sixth Edition
Update), Addison Wesley, New York, 2003.

Muth, J., ―Rational Expectations and the Theory of Price Movements‖, Econometrica, Volume
29, Number 3, July 1961, 315-335.
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Nelson, C., and W. Schwert, ―Short-Term Interest rates as Predictors of Inflation: On Testing the
Hypothesis that the Real Rate of Interest is Constant‖, American Economic Review. Volume 63,
Number 3, June 1977, 478-486.

Romer, C., and D. Romer, ―Federal Reserve Information and the Behavior of Interest Rates‖,
American Economic Review, Volume 90, Number 3, June 2000, 429-457.

Shafir, E., Diamond, P., and A. Tversky, ―Money Illusion‖, Quarterly Journal of Economics,
Volume 112, Number 2, May 1997, 341-374.

Sargent, T., ―Rational Expectations and the Term Structure of Interest Rates‖, Volume 4,
Number 1, Part 1, February 1972, 74-97.

Shiller, R., ―Rational Expectations and the Term Structure of Interest Rates: Comment‖, Journal
of Money, Credit and Banking, Volume 5, Issue 3, August 1973, 856-860.

Shiller, R., ―Can the Fed Control Real Interest Rates?‖, NBER Working Paper Series, NBER
Working Paper No. 348, National Bureau of Economic Research, Cambridge, Massachusetts,
May 1979, 1-66..

Kihn / Behavioral Finance 101 / 337

Shiller, R., and J. Siegel, ―The Gibson Paradox and Historical Movements in Real Interest
Rates‖, Journal of Political Economy, Volume 85, Issue 5, October 1977, 891-908.

Stewart, K., an S. Reed, ―CPI research series using current methods, 1978-98 (Inflation would
have been lower from 1978 t the present if the current methods of calculating the CPI had been
in place)‖, Monthly Labor Review: Research Series, U.S. Department of Labor: Bureau of Labor
Statistics, June 1999, 29-38.

Williams, W., ―Government Economic Reports: Things You've Probably Suspected But Perhaps
Were Afraid to Ask!", August 24, 2004 ( http://www.gillespieresearch.com/cgi-
bin/s/article/id=264).

Williams, W., ―ShadowStats.com Response to BLS Article on CPI Misconceptions‖, John
Williams‘ Shadow Government Statistics, Special Comment, September 10, 2008.

Kihn / Behavioral Finance 101 / 338

APPENDIX A: SOME USEFUL TERMS TO KNOW, ESPECIALLY FOR THIS CHAPTER
Duration and convexity are very useful concepts for describing certain risk related attributes of
financial securities. They both measure sensitivity to changes in interest rates. Duration is a
linear measure of the sensitivity of the price of a security (for typically a bond) in response to a
change in interest rates. Convexity is a measure of curvature of the price change for a move in
interest rates. Mathematically, duration and convexity represent the first and second derivatives
of price with respect to changes in interest rates (hence, duration is a linear measure and
convexity a measure of curvature), respectively. It is important to note that when calculating
duration and convexity it is common practice to use a securities yield and not interest rates.

The original definition of duration is Macaulay‟s Duration (named after Frederick Macaulay,
who wrote the original academic reference on it – Macaulay (1938)).
288
Because maturity seems
an inadequate measure of the sensitivity of a bond‘s price to changes in interest rates (e.g., it
ignores the effects of coupon or cash flow payments) and weighting by the time to receipt of
each cash flow ignores the time value of money, he weighted each cash flow by the present value
of its relative magnitude. The equation is:

, where n = number of cash flows, t = time
to receipt of cash flow, C = cash flow amount, and r = yield to maturity (or ―YTM‖). Therefore,
D depends on maturity, cash flows (i.e., in the case of a bond, typically coupon payments;
whereas for stocks dividends), and YTM. The effects of each are as follows: ) , , (
÷ ÷ +
= r C t f D .
Thus, Macaulay duration is the weighted average time until receipt of the cash flows. An

288
Somewhat in line with Bachelier being forgotten for a long period, Macaulay‘s duration was rediscovered and put
to use in finance around the 1970s.
Kihn / Behavioral Finance 101 / 339

increase in the time until receipt of a cash flow increases overall duration, an increase in the size
of the cash flow itself decreases duration, and an increase in YTM decreases duration.

As an example of a $1,000 priced bond possessing a 10 years to maturity, a 10% annual coupon
(thus paying $100 per year), with a 10% YTM (thus priced to ‗par‘):

Modified from: Kritzman, M., ―What Practitioners Need to Know … … About Duration and Convexity‘, Financial
Analysts Journal, Nov/Dec 1992, p. 18.

Therefore, the time to maturity is 10 years, but its Macaulay duration is about 6.8 years (i.e.,
based on the effects of t, C, and r or YTM). Macaulay duration is a useful measure (i.e., as a
measure of security risk) and seems an improvement over time to maturity.
289
Therefore,

289
In actuality, the effective difference between Macaulay duration, time to maturity, and other duration calculations
is typically not very great (see e.g., Gultekin and Rogalski (1984), where they test the effectiveness of seven
duration measures, including Macaulay duration, in predicting price movements given interest rate movements, and
found all wanting). Therefore, although useful, duration measures are not actually very accurate at predicting that
which they are designed to predict. In addition, to the extent a duration measure is desirable to use, which duration
measure is selected is not usually critical.
Macaulay duration for a 10% annual coupon bond with a 10% YTM
Time to
Receipt of Present Weighted-
Cash flow Value of Value time
Period Cash flow (C) (in years) Cash flow Weight to receipt
1 100 1 90.90909 0.0909 0.09090909
2 100 2 82.64463 0.0826 0.16528926
3 100 3 75.13148 0.0751 0.22539444
4 100 4 68.30135 0.0683 0.27320538
5 100 5 62.09213 0.0621 0.31046066
6 100 6 56.44739 0.0564 0.33868436
7 100 7 51.31581 0.0513 0.35921068
8 100 8 46.65074 0.0467 0.3732059
9 100 9 42.40976 0.0424 0.38168786
10 1100 10 424.0976 0.4241 4.24097618
Total 2000 1000 1 6.75902382
Kihn / Behavioral Finance 101 / 340

Macaulay duration can never be greater than maturity, but for a one cash flow security they are
the same. The following table takes the same 10% annual coupon bond and varies the maturity
date (i.e., time-to-maturity) and YTM.


Duration (in years) for a 10% annual coupon bond as t & YTM are varied
Time to maturity Yield-to-maturity (YTM)
(in years) 0% 2% 4% 6% 8% 10% 15% 20% 40% 60% 80% 100%
1 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0
2 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.8
3 2.8 2.8 2.8 2.7 2.7 2.7 2.7 2.7 2.6 2.6 2.5 2.4
4 3.6 3.6 3.5 3.5 3.5 3.5 3.4 3.4 3.2 3.0 2.8 2.6
5 4.3 4.3 4.3 4.2 4.2 4.2 4.1 4.0 3.6 3.2 2.9 2.6
6 5.1 5.0 5.0 4.9 4.8 4.8 4.6 4.5 3.9 3.3 2.8 2.5
7 5.8 5.7 5.6 5.5 5.4 5.4 5.1 4.9 4.0 3.3 2.7 2.3
8 6.4 6.3 6.2 6.1 6.0 5.9 5.6 5.2 4.1 3.2 2.6 2.2
9 7.1 7.0 6.8 6.7 6.5 6.3 5.9 5.5 4.0 3.1 2.5 2.1
10 7.8 7.6 7.4 7.2 7.0 6.8 6.2 5.7 4.0 3.0 2.4 2.1
11 8.4 8.1 7.9 7.7 7.4 7.1 6.5 5.9 3.9 2.9 2.3 2.0
12 9.0 8.7 8.4 8.1 7.8 7.5 6.7 6.0 3.9 2.8 2.3 2.0
13 9.6 9.3 8.9 8.5 8.2 7.8 6.9 6.1 3.8 2.8 2.3 2.0
14 10.2 9.8 9.4 9.0 8.5 8.1 7.1 6.1 3.7 2.7 2.3 2.0
15 10.8 10.3 9.8 9.4 8.9 8.4 7.2 6.2 3.7 2.7 2.3 2.0
16 11.4 10.8 10.3 9.7 9.2 8.6 7.3 6.2 3.7 2.7 2.3 2.0
17 12.0 11.3 10.7 10.1 9.4 8.8 7.4 6.2 3.6 2.7 2.3 2.0
18 12.5 11.8 11.1 10.4 9.7 9.0 7.5 6.2 3.6 2.7 2.3 2.0
19 13.1 12.3 11.5 10.7 10.0 9.2 7.5 6.2 3.6 2.7 2.3 2.0
20 13.7 12.8 11.9 11.0 10.2 9.4 7.6 6.2 3.6 2.7 2.3 2.0
21 14.2 13.3 12.3 11.3 10.4 9.5 7.6 6.2 3.5 2.7 2.3 2.0
22 14.8 13.7 12.7 11.6 10.6 9.6 7.6 6.2 3.5 2.7 2.3 2.0
23 15.3 14.2 13.0 11.9 10.8 9.8 7.7 6.2 3.5 2.7 2.3 2.0
24 15.9 14.6 13.4 12.1 11.0 9.9 7.7 6.1 3.5 2.7 2.3 2.0
25 16.4 15.1 13.7 12.4 11.1 10.0 7.7 6.1 3.5 2.7 2.3 2.0
26 17.0 15.5 14.0 12.6 11.3 10.1 7.7 6.1 3.5 2.7 2.3 2.0
27 17.5 15.9 14.4 12.8 11.4 10.2 7.7 6.1 3.5 2.7 2.3 2.0
28 18.1 16.4 14.7 13.0 11.6 10.2 7.7 6.1 3.5 2.7 2.3 2.0
29 18.6 16.8 15.0 13.2 11.7 10.3 7.7 6.1 3.5 2.7 2.3 2.0
30 19.1 17.2 15.3 13.4 11.8 10.4 7.7 6.1 3.5 2.7 2.3 2.0
Kihn / Behavioral Finance 101 / 341

For the one cash flow security (the one year or ‗zero coupon‘ bond), the time to maturity and
duration are equivalent, regardless of YTM. Otherwise, as YTM increases the duration
decreases; and as maturity increases the duration increases (neither in a linear fashion).

In order to estimate the price change associated with a change in interest rates, a slight change in
D (i.e., Macaulay‘s duration) is required (i.e., ‗modified duration‘ or

)
290
:

, and

, where B = the price of the bond. Note, that r is typically
divided by the number discounting periods in a year (i.e., normally two). But,

tends to
overestimate price declines and underestimate price increases with respect to changes in r (e.g.,
with YTM rising, the longest cash flow out will decrease more than the next furthest out and so
on, therefore the larger the change in YTM, the larger the asymmetric impact on discounted cash
flows and the less indicative this type of duration is). The larger the increase in YTM, the greater
the magnitude of the error by which

will overestimate the price decline; conversely, the
larger the decrease in YTM, the greater the magnitude of the error by which

will
underestimate the price increase (this effect is also called convexity).

In addition to duration and convexity, it is useful to have a notion of the ‗term structure of
interest rates‘, forward rates, and their relationship to the ―expectations hypothesis‖. The ―term
structure of interest rates‖ is the relationship between the interest rates of securities at different
maturities (i.e., securities that differ by maturity only, hence, the usual focus on government debt

290
For a more thorough review of this and duration and convexity more generally, see, for example, Fabozzi et al.
(1997).
Kihn / Behavioral Finance 101 / 342

that generally has no other features/embedded options).
291
In practice, the term ‗yield curve‘ is
used synonymously with the term ‗term structure‘, but also remember we used the term ‗interest
rate‘ and not ‗yield‘.

Firstly, YTM is not an ideal yardstick (it is an Internal Rate of Return – ―IRR‖ – calculation that
assumes all cash flows are reinvested at that rate, which may be fine in a ‗flat‘ term structure
environment). Secondly, YTM varies as a bond‘s coupon rate varies (due to the tax
consequences of discounts and premiums). Therefore, the yields on a pure non-coupon paying
bonds (or pure discount bonds, e.g., ‗zero coupon‘ bonds) without any embedded options are
typically used as ‗spot rates‘ of interest. Furthermore, the calculation for the price of a coupon
paying bond using YTM and spot interest rates are (respectively):
n
n
y
F C
y
C
y
C
P
) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+ +
+
+
+
= and
n
n
n
r
F C
r
C
r
C
P
) 1 (
...
) 1 ( ) 1 (
2
2
2
1
1
1
+
+
+ +
+
+
+
= , where
P = current price,
n
C C C ,..., ,
2 1
= coupon payment in periods 1 through n,
F = face value,
y = yield to maturity (YTM),
n = number of discounting periods, and
n
r r r ,..., ,
2 1
= spot rates of interest of pure discount bonds maturing in periods 1 through n.
One problem with using spot rates is that there may not be enough of them at all points along the
curve to fill out a full term structure (this is especially true at longer maturities).


291
The related review in this appendix essentially follows Kritzman‘s (1993) practical review.
Kihn / Behavioral Finance 101 / 343

We can also describe the term structure of interest rates with ‗forward rates‘.
292
For example, the
forward rate on a one year instrument one year hence is defined as (i.e., a no arbitrage
definition):
) 1 ( ) 1 ( ) 1 (
1 , 1 1
2
2
f r r + · + = + , where
2
r = spot rate for a two year instrument,
1
r = spot rate for a one year instrument, and
1 , 1
f = one year forward rate for a one year instrument.
The general formula for determining the forward rate is:
1 ] ) 1 /( ) 1 [(
) /( 1
,
÷ + + =
÷
÷
t n t
t
n
n t n t
r r f , where
t n t
f
÷ ,
= t-year forward rate for an n minus t year instrument,
n
r = spot rate for an n-year/maturity instrument, and
t
r = spot rate for a t-year/maturity instrument.

As if that wasn‘t enough, we can also describe the term structure of interest rates by relating
‗discount factors‘ to maturity (i.e., the reciprocal of 1 plus the spot rate raised to the maturity of
the instrument):
n
n
r n d ) 1 /( 1 ) ( + = , where
) (n d = discount factor for n periods (where n is the maturity of the pure discount instrument).
Note that the discount factor must fall between 0 and 1.


292
Based on Sargent (1972), Shiller (1973) points out that in the ‗rational expectation‘s‘ version of the term
structure, forward rates are optimal forecasts of spot rates; and that even in theory the PEH itself is ―untenable‖.
Kihn / Behavioral Finance 101 / 344

The concepts of the term structure and forward rates are important concepts in order to
understand the functional workings of the expectations hypothesis and its two other commonly
accepted academic hypotheses.

The classic three hypotheses for explaining the term structure of interest rates are:
1. Expectations Hypothesis (―EH‖) – Is essentially the rational expectations view of life,
where the current term structure is determined by the consensus forecast of future interest
rates (e.g., forward rates are forecasts and should not be biased). Furthermore, an upward
sloping term structure indicates that investors expect interest rates to rise, a downward
sloping term structure indicates that investors expect interest rates to fall, and a flat term
structure indicates that investors expect interest rates to remain unchanged.
2. Liquidity Premium Hypothesis (―LPH‖) – Because historically the term structure has had
an upward slope most of the time and it is unlikely investors actually believe all pure
bonds will generate the riskless return (more specifically, it is unlikely long-term bonds
aren‘t more risky than short-term bonds and investors won‘t demand some risk premium
for this); the LPH posits that investors will demand a premium which will increase with
maturity, but at a decreasing rate.
3. Segmented Markets Hypothesis (―SMH‖) – The SMH posits that various groups of
investors (e.g., insurance companies) favor certain segments of the term structure, thus
creating their own demand/supply dynamics.
Kihn / Behavioral Finance 101 / 345

In reality, all three tend to be combined to explain the term structure of interest rates. In my
opinion, the EH tends to be the most useful for fixed income strategies/tactics (i.e., even if
strictly wrong – see, e.g., Chance and Rich (2001) on its being normatively incorrect).

Those three are standard textbook economics and finance explanations of the term structure. In
additional, there is a more mathematical and rational expectations based version of the EH called
the ―Pure Expectations Hypothesis‖ (―PEH‖). Under the EH (Mishkin (2003, p. 138)): ―The
interest rate on a long-term bond will equal an average of short-term of short-term interest rates
that people expect to occur over the life of the long-term bond.‖ Therefore, longer rates are
dependent on what shorter rates are, and how they might evolve through time. Clearly if a CB
has complete or even partial control over shorter rates they, by this hypothesis, it will have
substantial, if not complete, control over longer rates. Under the PEH, we get the following
identity for a two period example:

, where:

= today‘s (time t) interest rate on a two-period bond,

= today‘s (time t) interest rate on a
one-period bond,

= expected future one-period interest rate, and

= forward one-period
rate. Therefore, the forward rate is equal to the market consensus expected future short-term (i.e.,

). This assumes bonds of different maturities are ―perfect substitutes‖, and, therefore,
the expected returns on bonds with various maturities are equal. In addition, assuming that
current short-term rates are as likely are as likely to rise as fall, it implies that the yield curve will
tend to have a flat shape over time (i.e., on average).
293
That is, an upward sloping yield curve

293
Under the PEH: the ―observed long-term rate is a geometric average of today‘s short-term rate and expected
future short-term rates. … Further, forward rates calculated from long-term yields are market consensus expected
future short-term rates‖. Obviously, like the more general EH, this contrasts with the Segmentation Theory (i.e.,
Kihn / Behavioral Finance 101 / 346

implies rising short-term rates, while, conversely a downward sloping yield curve implies
declining short-term rates.

Finally, one very useful technique for adjusting yields is called cubic spline smoothing (where
the discount factors are regressed on term to maturity, term to maturity squared, and term to
maturity cubed, then the estimated coefficients are used to adjust the discount factors):
3
3
2
2 1
) ( n b n b n b n d + + + =o , where
) (n d = discount factor for maturity n, and
n = term to maturity.
In general, splines are useful methods for adjusting yields (especially if you have holes in your
data and/or you need some convergence forecast); and there are many ways to smooth and fill
gaps in yield data.


buyers for certain securities are divided into certain market segments) and the Liquidity Premium Theory (investors
need to be compensated for bearing the increased risk of holding long-term securities).
Kihn / Behavioral Finance 101 / 347

APPENDIX B: WHAT HAPPENED TO THE U.S. CPI?
The CPI (Consumer Price Index) in the U.S. has been significantly modified starting around the
early to mid-1980s. Specifically two large sets of modifications have taken place (―hedonic
adjustments‖ and ―substitution‖
294
). Ignoring changes in methodology, what would the
inflation
295
rate have looked like?


294
If substitution occurs over long periods and/or periods of extreme economic hardship the products and services
used may end up representing a kind of survival basket.
295
See Wikipedia on inflation: ―In economics, inflation or price inflation refers to a general rise in the level of
prices of goods and services over a period of time. The term "inflation" originally referred to increases in the money
supply (monetary inflation); however, debates regarding cause and effect have led to its primary use today in
describing price inflation. Inflation can also be described as a decline in the real value of money—a loss of
purchasing power. When the general level of prices rises, each unit of currency buys fewer goods and services.
Price inflation is usually measured by calculating the inflation rate, which is the percentage change in a price index,
such as the consumer price index.‖ I bring this up because the term itself can be confusing if one mixes cause and
effect (e.g., the ultimate fundamental cause of price inflation is monetary).

-3.0%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
10.5%
11.0%
11.5%
12.0%
12.5%
13.0%
13.5%
14.0%
14.5%
15.0%
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9
CPI Inflation and Corrected CPI Inflation (July 1954 through August 2009)
SGS-alt_CPI CPIAUCNS
Kihn / Behavioral Finance 101 / 348

Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download, and Shadow Statistics –
September 27, 2009 download of adjusted CPI series.

The lines shown represent year-over-year CPI inflation rates. Prior to the early 1980s, both
methodologies resulted in the same inflation values. Thus, the red line (which represents the
―corrected CPI‖) overlaps the blue line (which represents the amalgamation of more than two
decades of efforts to bias the rate downward). Again, there is a large and seemingly increasing
disconnect between the old methodology and the cumulative effects of the changes made since
the early 1980s on the U.S. CPI. Although the lines shadow each other even after key changes,
they maintain a large distance, especially during the 1990s and beyond. The question for my
purposes is primarily one of consistency, not conspiracy. I do not want to base analysis on two
different series, or in this case a series that represents one thing spliced with one that shows
something else. The reported U.S. CPI is just such a spliced series now. Therefore, the CPI must
be corrected to give a consistent series whether biased downward or not; but preferably unbiased.

According to the agency in charge of the CPI, most of the major changes made were:
Kihn / Behavioral Finance 101 / 349


Source: Stewart and Reed (1999, p. 31).

The two major categories of changes made were (1) ‗hedonic adjustments‘, and (2)
‘substitution‘. Hedonic adjustments are essentially quality adjustments (e.g., the speed of a
computer model increases, but its stated price doesn‘t change). Substitution adjustments are
Changes made to the Consumer Price Index for All Urban Consumers (CPI-U) since 1978 and their effect on the CPI research series
Year
Change Description implemented
Use of rental equivalence to measure changes in
homeowner costs
Changed homeowners’ component from cost of purchase to value
of rental services 1983
Quality adjustment of used-car prices
Adjusted prices of used cars for differences in quality after
changeovers to new models 1987
Quality adjustment of sampled housing units to reflect
aging of the units
Adjusted rental values in CPI sample to reflect aging
1988
Quality adjustment of apparel prices
Used regression models to adjust apparel prices for changes in
quality when new clothing lines are introduced 1991
Treating shifts between brand-name and generic drugs as
price changes
Introduced new procedures that allow generic drugs to be priced
when a brand-name drug loses its patent 1995
Change in shelter formula to eliminate composite
estimator
Replaced composite estimator with a 6-month chain estimator.
Underreporting of 1-month rent charges had resulted in missing
price changes in residential rent and homeowners' equivalent rent 1995
Change in shelter formula to improve rental equivalence
estimator
Modified imputation of homeowners’ implicit rent to eliminate
upward-drift property of previous estimator 1995
Elimination of functional form bias for CPI food-at-home
categories
Introduced seasoning procedures to eliminate upward bias derived
by setting base-period prices of newly initiated items 1995
Elimination of functional form bias for other CPI
commodity and service categories
Extended food-at-home seasoning procedures to remainder of
commodities and services. Base-period prices were left unchanged
in most noncomparable substitutions 1996
Quality adjustment of personal-computer prices
Used regression models to adjust personal-computer prices for
changes in quality 1998
Elimination of automobile finance charges Deemed out of scope of definition of CPI 1998
Quality adjustment of television prices
Used regression models to adjust television prices for changes in
quality 1999
Accounting for consumer substitution within CPI item
categories
Introduced a geometric-mean formula that assumes a modest
degree of consumer substitution within most CPI item categories 1999
Treating mandated pollution control measures as price
increases
Adjustments are no longer made to changes in pollution control
regulations, which are now viewed as price changes and not quality
changes 1999
Kihn / Behavioral Finance 101 / 350

essentially a form of quality drift as prices rise (e.g., as the price of fillet mignon rises, people
will tend to substitute less expensive cuts of beef)
296
.

Regarding a substitution adjustment example, consider ‘geometric average‘ adjustments.
Williams (2008) states: ‖ Geometric weighting is a mathematical adjustment, not a model of
consumer behavior. The BLS touts the use of geometric weighting in the narrow CPI categories
as a way of measuring shifting consumer preferences based on changes in prices in related
items. The weights that shift based upon price changes (relatively higher price changes end up
with relatively lower weightings) do so by straight mathematical adjustment that the BLS once
described as ‗mimicking‘ substitution effects. The shifts are not calculated based on any
consumer surveying done, for example, as to how candy bar consumption would vary given
relative price changes. The BLS claims support for using geometric weightings in the CPI,
because everyone else does it. One also could argue that other sovereign statistical agencies, by
their nature, have a tendency to want to reduce reported inflation as much as possible‖.
In short, the BLS applies a version of geometric weighting that is not based on trying to ‗model‘
consumer behavior, but rather to reduce price inflation.

Regarding a hedonic adjustment example, in the above table, there is an item for ‖quality
adjustment of personal-computer prices‖. Specifically, computing power (speed and memory) is

296
See Williams (2008) on this specific issue. In reality, substitution seems only to occur within a category.
Therefore, a substitution from filet mignon to eventually chicken is only possible if the two are in the same category,
which they are not at this time, for example.
Kihn / Behavioral Finance 101 / 351

now used to adjust prices. Not only does this have an impact on the CPI, but in addition it
impacts GDP (apparently real GDP is what essentially remains after adjusting for inflation,
which in turn now makes several key hedonic adjustments). An example should prove
illustrative.

The following description is from Jim Willie (January 2004,
http://www.financialsense.com/fsu/editorials/willie/2004/0130.html):
―GDP manipulation takes place through a measure called the ‗Hedonic Price Index‘. This is a
statistical maneuver employed by government statisticians to measure computer output and
investment. It is meant to capture the increase of computer power in terms of speed and memory.
The government takes the actual increase in spending on computer investment and applies a
statistical wand which changes the actual number into a higher number reflecting the
hypothetical benefits of soaring computer power. Like corporations, which keep two sets of
books, one for financial reporting and another set of books for taxes, the government also keeps
two different sets of books. One set is the actual dollars spent on the output of goods and services
and the other set is called chained dollars, which is derived after various statistical manipulations
have been applied to the actual numbers. As this table shows, actual computer spending in actual
dollars went from $86.3 billion during the fourth quarter of 1998 to $114.2 billion in the second
quarter of this year. This represented an increase of $28 billion in actual dollars being spent
during the last six quarters.

Kihn / Behavioral Finance 101 / 352

Investment in Computers & Peripheral Equipment (billions of dollars)

Source: Department of Commerce: Survey of Current Business

However, after applying the hedonic deflator, that actual number is changed into $127 billion in
chained dollars for the same six quarters. This technique magnifies the actual contribution of
computer investment to GDP growth. This manipulated rise in GDP growth doesn't reflect actual
increases to GDP growth. Instead, it reflects the increase in computer power that businesses are
getting for their money. As the power of computers increases, so does the impact of the hedonic
deflator. Effectually, this creates a statistical mirage, which magnifies modest sums of money
spent in actual dollars into giant sums in chain-weighted dollars.

Official ‗annualized‘ GDP growth was claimed to be 8.2% for Q3 of 2003. A closer look at
treatment of information technology business activity in Q3 is highly revealing. Chain-weighted
figures show $93.1 billion in IT spending, of which only $11.5 billion occurred in real terms.
The remaining $81.6 billion, over 87% of the ledger item in the GDP calculation, incredibly was
attributed to adjustment for speed improvements, a treatment called ‗hedonic adjustment.‘ The
practice is highly deceptive, totally fallacious, and not based in any reality known to mankind.
1998 1999 2000
4th Qtr 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr 1st Qtr 2nd Qtr
Actual Dollars 86.3 88.1 92.8 97.6 98.9 104.3 114.2
Chained Dollars 171.3 186.1 208.5 230.9 243.9 264.1 298.5
Source: Department of Commerce: Survey of Current Business
Kihn / Behavioral Finance 101 / 353

That extra eighty billion in dollars flows nowhere, is available for business expansion nowhere,
can be devoted to worker payrolls or benefits nowhere, and appears nowhere on any financial
balance sheet. It is pure fiction, but serves a very valuable service in keeping the myth alive of
above normal growth.‖
Source: Willie, Jim, http://www.financialsense.com/fsu/editorials/willie/2004/0130.html),
January 2004

Another related area of statistical manipulation is computer software. Now economic growth
includes spending on software; it was formerly booked as a business expense but is now
regarded as an investment. Expenses are subtracted from revenues and thus reduce corporate
profits. Business expenses, until recently, were not included in GDP, especially as a GDP growth
item.

The following description is continuation from Jim Willie (January 2004,
http://www.financialsense.com/fsu/editorials/willie/2004/0130.html):
Investment in Software (billions of chained 1996 dollars)

1998 1999 2000
4th
Qtr
1st Qtr
2nd
Qtr
3rd
Qtr
4th
Qtr
1st
Qtr
2nd
Qtr
Softwa
re
167.3 173.3 181.1 192.5 205.3 215.0 227.5
Source: Department of Commerce: Survey of Current Business
Kihn / Behavioral Finance 101 / 354

Source: Department of Commerce: Survey of Current Business

―Software spending has been running above $200 billion per year. The combination of inflating
the dollars spent on computers, and including software spending as a capital asset, has artificially
inflated GDP by a sum of over $500 billion. These statistical manipulations accounted for 32%
of the reported GDP growth.

Accounting gimmicks also overstate U.S. productivity figures. Productivity is simply the
increase in total output as measured by GDP, divided by the increase in total hours of labor used
to create that output. Recently, those numbers have been remarkable. Tinkering with the GDP
Deflator and adding the Hedonic Deflator have artificially enhanced the actual GDP numbers.
The larger the GDP number in relation to the total hours of labor, the higher the rate of
productivity.

The results of these measures have produced an awe-inspiring statistical mirage that has
camouflaged the inherent weaknesses and vulnerability of the U.S. economy. This unique way in
which the U.S. measures and accounts for its GDP and productivity has captured the attention of
international organizations such as the OECD. Other well-known writers from the Austrian
school like Dr. Kurt Richebächer, and financial writer James Grant, a columnist for the Financial
Times, have called attention to these statistical fallacies.

Writers in the mainstream press have attacked these truth-tellers. The mainstream press argues
that increases in DRAM, hard drive capacity, and such things as DVDs, although not costing
Kihn / Behavioral Finance 101 / 355

more today, add additional value to a computer that is not captured in its price. Nobody would
argue that today's computer is faster and more powerful than the computers built back in 1996.
However, computers have become a commodity that is subject to intense price competition. The
price of computers has fallen as production has ramped up and competition has decreased their
price as with any other commodity.‖
Source: Willie, Jim, http://www.financialsense.com/fsu/editorials/willie/2004/0130.html),
January 2004

Whether intentionally or not, hedonics alone have had large and persistent impacts on such
values as GDP & the GDP deflator, productivity, and the CPI. The ‖devil is in the details‖ and
most people neither understand or acknowledge they are looking at effectively spliced series.

In addition, there is a doucmented psychological tendency for humans not to sufficiently adjust
nominal values for the effects of inflation (see, e.g., Shafir et al. (1997) on ‘money illusion‘).
297

Actually, as a general rule, people are systematically poor at adjusting almost any nominal value,
let alone a series. Their evaluations are biased toward a nominal evaluation, and normative
economics demands that they not be. Therefore, in fact nominal perceptions often drive real
actions by individuals in apparently predictable ways. This fact is not lost on, for example CBs,
who know this (as well as other governement bodies), and readily attempt to fashion policy
accordingly (see, e.g., Bernanke et al. (2004)). Of course, there are exceptions:

297
Financial academics have long been aware of the ‗money illusion‘ and related issues (see Lintner (1975) for a
review and normative analysis of its impact on normative ‗models‘ in finance).
Kihn / Behavioral Finance 101 / 356

―It is widely believed that the US has experienced a productivity miracle that has left the rest of
the world behind. Reality may well be very different. The reason lies in the way that output is
measured either side of the Atlantic. In general, the US statisticians use what is known as
'hedonic' pricing and Europeans don't. The difference is startling. The Office for National
Statistics has estimated that over the past four years the apparent rise in British industrial output
would have been three times the previous estimate had the US system been in place.
Reality, of course, is not changed by the way it is measured, but perceptions certainly are,
and US and European statistics give very different impressions about productivity and inflation
as well as about output. …
Whether or not hedonic pricing is sound and sensible is the cause of heated arguments. What
cannot be doubted is that the use of different systems makes nonsense of the relative
measures of growth, productivity and inflation. …
Just because a computer can do more things than before, or do them faster, does not mean people
using them will wish to or be able to take advantage of this. Hedonic pricing of computers,
which is the big issue, has been likened to saying that a car costing £15,000 which can go at 150
miles an hour has the same value as one costing £5,000 with a maximum speed of 50 mph. But
of course there is a vast difference between the speed at which cars can go and the one at which
they do. … ―
Dated 16 October 2000, from Smithers & Co. LTD

Remember, as always, be suspicious of others motives (including the author). Conflicting
interests and seemingly suspicious motivations don‘t invalidate someone‘s point, but it should
Kihn / Behavioral Finance 101 / 357

make you more cautious about accepting it. Organizations (especially governments) and
individuals can and do manipulate data for self interest (and governments are in an ideal position
to manipulate macroeconomic data).

"As former Labor Secretary Bob Reich explained in his memoirs, the Clinton administration had
found in its public polling that if the government inflated economic reporting, enough people
would believe it to swing a close election. Accordingly, whatever integrity had survived in the
economic reporting system disappeared during the Clinton years. Unemployment was redefined
to eliminate five million discouraged workers and to lower the unemployment rate;
methodologies were changed to reduce poverty reporting, to reduce reported CPI inflation, to
inflate reported GDP growth, among others. The current Bush administration has expanded upon
the Clinton era initiatives, particularly in setting the stage for the adoption of a new and lower-
inflation CPI and in further redefining the GDP and the concept of seasonal adjustment.

If the 1980 GDP methodology were applied to today's data, the 2004 second quarter's annualized
inflation-adjusted GDP growth of 3.0% would be roughly three percent lower (effectively netting
to zero percent or below). In like manner, current annual CPI inflation is understated by about
2.7% against the pre-Clinton CPI methodology (would be about 5.7%), and the unemployment
rate is understated by about seven percent against its original design and what many people
would consider to be actual unemployment (would be about 12.5%)."
Kihn / Behavioral Finance 101 / 358

Gillespie Research's "A Primer on Government Economic Reports -- Things You've Probably
Suspected But Perhaps Were Afraid to Ask!" by Walter J. "John" Williams - Aug. 24, 2004 –
http://www.gillespieresearch.com/cgi-bin/s/article/id=264)

Therefore, for example, a large segment of the unemployed are not defined as unemployed. Two
specific examples are that the modifications have resulted in many, if not most, unemployed
people stop being counted as "unemployed" when their benefits run out, or when they retire early
because they are unemployed. One must question why these people are left out of the
calculation, when they are unemployed (at least by non-Orwellian definitions)? To me the
answer is obvious; clearly someone or some group wants to reduce the number of those that are
perceived to be unemployed. In the same vein, it is clear that some have wanted to play down the
inflation numbers, and increase the GDP and productivity numbers. The issue for me is a
consistent and unbiased data series (failing unbiased, then at least consistent). If one isn‘t
comparing a consistently derived series but one that, for example, represents one definition of
unemployment, then evolves into a more biased notion of unemployment (if it measures it at all),
it is difficult, if not impossible, to determine things like empirical causality. Simply put, ―garbage
in, garbage out‖.

Also, remember one of the basic axioms of expected utility is being able to identify and order
things; without consistent and unbiased numbers
298
, and even if all of us were strictly rational in
the strict economic sense (which we aren‘t), the identification of something as basic as inflation

298
Obviously, this means most are unaware of the bias and consistency issues (which, as of today, most treat the
numbers as unbiased and consistent, at least in most of academia and the mainstream media).
Kihn / Behavioral Finance 101 / 359

is not feasible and the subsequent ordering of our wants would thus be rendered impossible.
Think of the series of economic tasks that would no longer be able to be optimized, all because
the numbers we based our economic decisions on couldn‘t be relied upon as being unbiased or
even consistent. Therefore, keep in mind that the estimates of PV deviations are likely to be
conservative, because I am not even taking account of the impact of these inconsistencies and
biases.





Kihn / Behavioral Finance 101 / 360

Chapter 10: Overreaction and Underreaction (overshooting and
undershooting)

It is commonly acknowledged among practitioners that the financial markets seem to overshoot
and undershoot.
299
Of course, given that academic finance doesn‘t have one accepted ‗model‘ of
what constitutes fundamental value this can only indirectly be inferred, if at all. Although, as in
the specific LOOP cases reviewed (e.g., ‗twin shares‘) it is relatively clear most relative prices
deviate from another adjusted value they shouldn‘t deviate from; but, again, the overall price
level remains elusive to the academic profession, at least as of today.

In addition, since a seminal academic article by De Bondt and Thaler (1985) on ‗overreaction‘
and two by Bernard and Thomas (1989 & 1990) on ‗underreaction‘ (more specifically, ‗earnings
drift‘), traditionally inclined finance academics have had the somewhat unenviable task of
disproving and trying to find contra evidence against what seems to be the obvious: that prices
are at least sometimes too low or too high, and sometimes that is caused by overshooting
(overreaction) and sometimes by undershooting (underreaction).

Furthermore, financial market overreaction and underreaction is a classic topic for this book
because it demonstrates the following principals:
(1) The markets are ‗inefficient‘ in the traditional finance textbook sense of the term.

299
In academic circles these terms are often applied to exchange rates, because there is a ‗model‘ using the terms.
Otherwise, they are largely absent from academic discourse in economics or finance.
Kihn / Behavioral Finance 101 / 361

(2) Market participants almost assuredly are acting in ‗irrational‘ ways in order to
cause these two effects. That is, the psychology piece of behavioral finance seems
obvious in these cases, although the specifics may be difficult to discern, and
especially to prove.
(3) Although there appears to be a ‗free lunch‘ (i.e., as defined traditionally by
normative textbook finance), because textbook finance doesn‘t account for: (A)
realistic costs (e.g., transaction costs, taxes, brokerage costs, etc.), and (B)
realistic risk and/or characteristics, there may not be a ‗free lunch‘ after all. That
is, the limits to arbitrage part of behavioral finance seems to loom large in these
cases.
(4) It is also relatively clear that you can have more than one type of inefficiency at
the same time in the same market. That is, little or no ‗cancelation‘ is the norm.
Those are four common themes of this book and they all (at least for the author) come together
nicely in this chapter.

The chapter is organized as follows: Firstly, overreaction will be reviewed. Secondly,
underreaction will be reviewed. Lastly, a summary and discussion of the empirical facts
established regarding overreaction and underreaction (e.g., they occur in the same markets at the
same time – little or no ‗cancelation‘).

Kihn / Behavioral Finance 101 / 362

OVERREACTION – MOSTLY IN THE MEDIUM- TO LONG-RUN
In 1985 an academic article came out that created what I consider to be an odd combination of
somewhat immediate and emotional rejection as well as a general denial among many finance
academics. The article was by De Bondt and Thaler (1985, p. 793) and was justified as a means
of testing whether market participants, at least in the U.S. stock market, conformed to or violated
Bayes‘ law (also called Bayes‘ Theorem or Bayes‘ rule)
300
: ―Bayes‘ rule prescribes the correct
reaction to new information. It has now been well-established that Bayes‘ rule is not an apt
characterization of how individuals actually respond to new data (Kahneman et al. [14]). In
revising their beliefs, individuals tend to overweight recent information and underweight prior
(or base rate) data. ... violates the statistical principal that the extremeness of predictions must be
moderated by considerations of probability.‖
301
De Bondt and Thaler‘s (1985) article on stock

300
Wikipedia (November 11, 2009) defined the theorem as: ―Bayes gave a special case involving continuous prior
and posterior probability distributions and discrete probability distributions of data, but in its simplest setting
involving only discrete distributions, Bayes' theorem relates the conditional and marginal probabilities of events A
and B, where B has a non-vanishing probability: P(A│B) = ((B│A)P(A))/(P(B)) . Each term in Bayes' theorem has a
conventional name: P(A) is the prior probability or marginal probability of A. It is "prior" in the sense that it does
not take into account any information about B. P(A|B) is the conditional probability of A, given B. It is also called
the posterior probability because it is derived from or depends upon the specified value of B. P(B|A) is the
conditional probability of B given A. P(B) is the prior or marginal probability of B, and acts as a normalizing
constant, Bayes' theorem in this form gives a mathematical representation of how the conditional probability of
event A given B is related to the converse conditional probability of B given A.‖
301
Important points to remember about Bayes‘ theorem:
1. Using what could be called ―probability logic‖, it is a logical mathematical identity applied to statistics.
Therefore, it is normative, but in the realm of mathematics and statistics.
2. It deals with conditional probabilities. In fact, it may be the first written work on conditional probability.
3. Explicitly, and most often implicitly, most normative finance models (which are most finance models, and
effectively all models before the 1990s) assumed it to hold (among many other explicit and implicit
assumptions).
4. Humans are just horrible at conditional probabilities (i.e., unless trained otherwise).
5. Therefore, descriptive reality is quit different than Bayes‘ theorem. In short, it is typically violated by
most people (individuals or groups) in most contexts most of the time, but it is assumed to hold for all
market participants all the time in most normative finance models.
Kihn / Behavioral Finance 101 / 363

market overreaction has withstood most, if not all, of the EMT proponent attacks mounted
against it.

Source: De Bondt and Thaler (1985, p. 800).

The empirical results are derived from what turned out to be a ―weak-form‖ test of market
efficiency (i.e., using past prices should not allow one to ‗beat the market‘). Their method was to
Kihn / Behavioral Finance 101 / 364

form two portfolios based on one to three year past returns.
302
These portfolios of the worst and
best performing stocks were then tracked (and adjusted for risk) in effectively what amounts to a
sequence of ―event studies‖. The worst performing stocks are named the ‗loser portfolio‘, and the
best performing stocks the ‗winner portfolio‘. Over a 50 year period, their best 3-year formation
period result, or worst if you are an efficient market proponent, was an average +19.6% excess
return for the ‗loser portfolio‘ and an average -5.0% excess return for the ‗winner portfolio‘, for a
total excess return of 24.6% over a 36-month or 3-year period (i.e., 24.6% represents going
―long‖ ‗losers‘ and ―short‖ ‗winners‘). As can be seen from the last graph, the ‗loser portfolio‘
spikes upward at months 1, 13, and 25. Those months are January. Therefore, this type of
portfolio formation results in what at first pass would seem a very concentrated ‗January effect‘
(which effect in turn tends to be concentrated in smaller firms; but doesn‘t seem to be the
primary cause for this effect – see, e.g., De Bondt and Thaler (1987)).

Their results can be summarized as follows:
• Over the last half century, loser portfolios of 35 stocks outperformed the market by, on
average, 19.6%, 36 months after portfolio formation.
• Winner portfolios earned about 5.0% less than the market (so that the difference in
ACAR or cumulative average residual between the extreme portfolios equals 24.6%, with
a t-statistic of 2.20).

302
As background on the De Bondt and Thaler (1985) sample, monthly data for NYSE common stocks from the
CRSP tapes for the period January 1926 through December 1982 were used as the dataset. An equally-weighted
arithmetic average rate of return for all CRSP listed securities served as the market index. They excluded stocks
without at least 85 months continuous return data, because they needed to be able to calculate 36 months of
cumulative excess returns. Given the dataset, there are 16 non-overlapping portfolio formation dates (Dec. 1932,
Dec. 1935, … , Dec. 1977); and they used the worst or best 35 or 50 stocks selected for the worst and best deciles.
Thus, the numbers discussed represent averages of the excess returns calculated over these periods.

Kihn / Behavioral Finance 101 / 365

• The ‗overreaction effect‘ is asymmetric (i.e., larger for losers than winners, at a ratio of
about four to one).
• Most of the excess returns are realized in January.
• For one year periods, no reversals for losers (actually slightly negative returns).
The key results are twofold (and in order of importance):
(1) That ‗loser‘ stock prices seem to overshoot and then positively correct back over a three
plus year period (especially each January).
(2) These ‗loser‘ excess returns are asymmetric relative to the ‗winners‘ excess returns,
which seem to overshoot in the other direction and then negatively correct back over a
three year plus period.
Again, what was most disconcerting for EMH/EMT proponents is that the excess returns are
generated by only using past prices as a signal of future returns. In addition, the general
behavioral bent of the study seemed to drive them crazy.

In general there were two sets of attacks on the ‗overreaction effect‘: (1) the most significant one
reduced down to essentially the claim that De Bondt and Thaler, among others, failed to properly
account for bid-ask spreads (i.e., transaction costs) (see Conrad and Kaul (1993)); and (2) of
lesser importance, was the point that the ‗overreaction effect‘ did not occur every period (e.g.,
during the Great Depression) (see Chen and Sauer (1997)). Both attacks were found wanting.
Regarding the second point first, yes indeed based on the original methodology there may be
some periods where the effect seems to recede in statistical significance (as could probably be
shown with virtually any real world effect), yet there still seems to be overwhelming evidence
Kihn / Behavioral Finance 101 / 366

that it exists. For example, see Antoniou et al. (2005) and Diacogainnis et al. (2005) on the effect
on the Athens Stock Exchange, see Mazouz and Li (2007) on the effect in the U.K. market, Fung
(1999) on Hong Kong large-caps, Wang et al. (2004) on Chinese A and B shares, Richie and
Madura (2004) on international ETFs, Poteshman (2001) and Stein (1989) on the options
markets, Larson and Madura on exchange rates, Rozeff and Zaman (1998) on insider
transactions, Seyhun (1989) on the October ―1987 crash‖, Vergin (2001) on NFL point spreads,
Dreman and Berry (1995), Dreman and Lufkin (2000), Howe (1986), Jegadeesh and Titman
(1995), and (Saleh (2007), etc. Also, there is evidence that directly contradicts their result (e.g.,
see Loughran and Ritter (1996)). Regarding the first point that specifically concerns accounting
for bid-ask spreads on U.S. stocks, especially small-cap stocks, it has been found to be wrong.
For example, Loughran and Ritter (1996, p. 1959) found: ―The difference in findings between
this study and Conrad and Kaul‘s is primarily due to their statistical methodology. They
confound cross-sectional patterns and aggregate time-series mean reversion, and introduce a
survivor bias.‖ In short, what they thought they were measuring they were not, and the effect
holds or even increases in intensity once this is taken account of.

In addition, to the initial bid-ask and time period issue complaints, one immediate criticism of
the original article was related to the ‗January effect‘. Specifically, proponents of the EMH/EMT
initially responded that De Bondt and Thaler‘s (1985) ‗overreaction‘ result was really just the
‗January effect anomaly‘, and hence nothing special, since the fact was that the bulk of excess
returns happened in January. It is empirically well established that the ‗January effect‘ is also
associated with a small firm effect. That is, much of the January effect is associated
Kihn / Behavioral Finance 101 / 367

overwhelmingly with small firms. Therefore, a priori it is possible, if not likely, that the
overreaction effect is entangled with whatever is/are causing the January and/or small-firm
effect. Recent standard normative practice in finance is to add a ‗risk factor‘ for size (e.g., small-
cap vs. large-cap stocks) and largely eliminate excess returns associated with small-cap stocks.
Again, even by normative standards, this has no real theoretical rational, but it achieves the
desired effect of largely eliminating excess returns associated with the supposed ‗anomaly‘ (this
is also done with value vs. growth stocks, and in some cases momentum). In response, De Bondt
and Thaler (1987, p. 557) did a follow-up piece showing this wasn‘t the case, and summarized
their results as follows: ―In this follow-up paper, additional evidence is reported that supports the
overreaction hypothesis and that is inconsistent with two alternative hypotheses based on firm
size and differences in risk, as measured by CAPM-betas. The seasonal pattern of returns is also
examined. Excess returns in January are related to both short-term and long-term past
performance, as well as to the previous year market return.‖ In response, Zarowin (1990, p. 113)
summarized his results as follows: ―This potential violation of the efficient markets hypothesis is
labeled the ‗overreaction‘ phenomenon. This paper shows that the tendency for losers to
outperform winners is not due to investor overreaction, but to the tendency for losers to be
smaller-sized firms than winners. When losers are compared to winners of equal size, there is
little evidence of any return discrepancy, and in periods when winners are smaller than losers,
winners outperform losers.‖
303
In short, the effect is still there it has merely been redefined as the

303
In fact, and oddly given his attempted arguments against overreaction, Zarowin (1990, pp. 121-124) finds
evidence that during periods when the winners‘ portfolio is composed of smaller firms than the losers‘ portfolio, the
winner part of the effect is much more dramatic than De Bondt and Thaler‘s original article. That is, winners seem
to outlose any losers‘ gain. This is interesting, but hardly contradicts overreaction. In fact, it would tend to support
it, and would seem to indicate (i.e., if true) that overreaction is a complicated phenomenon.
Kihn / Behavioral Finance 101 / 368

small-cap effect or anomaly.
304
This type of response is typical of normative finance. The
standard procedure for discrediting empirical results that counter the most basic tenants of the
EMH/EMT is often to redefine descriptive reality as ‗anomalous‘. Again, as mentioned before,
redefining some contrary finding and/or adding a ‗risk factor‘ to account for it does not make it
any less real, especially when the reason for doing so is specious. Ignoring this last point, in fact,
in this case even the small-cap issue is largely wrong, if not misstated. Specifically it is now
accepted that there is long-term mean reversion in many or most financial series (especially
stocks, see, e.g., Fama and French (1988)), and as it turns out most, if not all, of this reversion
happens in January (see Jegadeesh (1991)). Therefore, we now accept that many markets are not
even ‗random walks‘, but that especially in the case of equities much or all of that predictable
reversion to the mean (call it overreaction unwinding) happens in January for the market in
general (i.e., whether they be small-, medium-, or large-capitalization stocks). Thus, not only
does the ‗overreaction effect‘ appear to be real as well as it appears to mostly happen in January,
but it seems to be part of a larger pattern that is difficult to reconcile with normative finance
theory, even the portion that is evolving incongruously with the strong evidence against it.

Before proceeding to overreaction, I find it useful to linger on the issue of violations of not just
Bayes‘ rule (which motivated the De Bondt and Thaler (1985) study), but additionally the
axioms of utility (i.e., the Savage and Von Neumann & Morgernstern axioms), and other related

304
Of course, the effect itself can never completely be ruled out (i.e., unless the ‗January effect‘ is eliminated as a
normative finance ‗anomaly‘). In fact, Zarowin (1990, p. 121) stated: ―While the well known January phenomenon
may be responsible for this result, we cannot completely rule out investor overreaction as an explanation‖.
Therefore, the article is purported to show that ‗overreaction‘ is not the cause, yet it cannot be shown (i.e., unless the
‗January effect‘ itself is not real). Thus, the article claims to show something that even the author claims is largely
impossible to show.
Kihn / Behavioral Finance 101 / 369

‗rules‘ or ‗axioms‘ in finance and economics. Clearly, with respect to finance and economics
these are hardly rules or axioms. That is, they are clearly not physical laws in the realm of
economics and finance. Furthermore, these so called axioms or rules have been shown repeatedly
not to hold in many, if not most, cases. The primary reason I mention such things and expend
some energy explaining them is because:
1. Almost all finance theories and models implicitly or explicitly rely on them (i.e., at least
most or all those listed in standard textbooks at this time).
2. This reliance isn‘t just superficial. That is, if these do not hold then, outside of a
philosophical argument (i.e., faith) one cannot state the theories or models apply.
Therefore, it is not an overstatement to suggest that if Bayes‘ theorem/rule and the basic axioms
of EUT do not hold (which empirically they do not seem to hold for most humans),
305
then the
theories and models upon which they serve as a foundation do not hold. This would be analogous
to a house in which there is no foundation, plumbing, electrical wiring, insulation, etc. In short,
you can live there but it is not much of a house, and may only be called a house because you
alone call it one.


305
In addition, if prices are not determined at all times and all markets at the margin by traders for which they hold
(which empirically they do not seem to be determined in that way) or ―cancelation‖ happens (which empirically it
does not).
Kihn / Behavioral Finance 101 / 370

UNDERREACTION – THE EXAMPLE OF EARNINGS ANNOUNCEMENTS – MOSTLY IN
THE SHORT-RUN
Following some four years after De Bondt and Thaler‘s 1985 article, in 1989 an academic article
came out that also created what I consider to be an odd combination of somewhat immediate and
emotional rejection as well as a general denial among many finance academics. The effect came
to be known as ‗earnings drift‘. The article was by Bernard and Thomas (1989) and was justified
as a means of testing whether equity earnings were embedded appropriately (i.e., from an
efficient markets‘ perspective) into stock pricing. In addition, this is another way of testing
whether Bayes‘ rule is violated. Although from an EMH/EMT perspective, this was primarily a
test of ―semi-strong‖ market efficiency. That is, are earnings estimates (publically available
pieces of information) quickly and accurately embedded into equity prices? Answer: No. But
unlike the De Bondt and Thaler (1985) result, it appears that this is due to underreaction, not
overreaction. That is, with underreaction pricing in the equity market generally is slowly
catching up vs. overreaction where pricing generally went too far then drifted or reverted back.
More importantly, Bernard and Thomas‘ (1989) article on stock market underreaction/earnings
drift has withstood most, if not all, of the EMT proponent attacks mounted against it.

Kihn / Behavioral Finance 101 / 371


Source: Bernard and Thomas (1989, p. 10).

Kihn / Behavioral Finance 101 / 372

Their method for detecting deviation from earnings announcements was based on Foster (1977).
It revolves around producing something called Standardized Unexpected Earnings or ―SUE‖.
This involves producing a statistical forecast of earnings. ―The difference between actual
earnings and the forecast is scaled by the historical standard deviation of the forecast errors to
arrive at the SUE. For a given quarter, a firm‘s SUE is then compared to the distribution of all
sample firms‘ SUEs from the prior quarter to place the firm in a decile portfolio. Abnormal (size-
adjusted) returns for each portfolio are then cumulated beginning the day after the earnings
announcement to estimate the post-announcement drift.‖ (Bernard and Thomas (1989))

The last diagram (i.e., Figure 2) shows that post-announcement earnings abnormal returns
increase monotonically across the ten SUE decile portfolios. In other words, as we move from
those firms that are forecast to have the worst SUEs (decile 1) to those with the best SUEs
(decile 10) the lines stay in the same order. Normatively (i.e., according to the EMH/EMT) we
would expect that on and after the announcement (i.e., on and after time 0 or the announcement
date) the lines should oscillate around zero, but instead they do what they shouldn‘t do (i.e.,
based on normative finance theory). Over the sixty trading days subsequent to the earnings
announcements, firms with extreme good earnings news (i.e., SUE decile portfolio 10)
experience a mean abnormal return of nearly 2%, while firms with extreme bad news (i.e., SUE
decile portfolio 1) experience a negative abnormal return of approximately the same magnitude.
(Bernard and Thomas (1989)) Therefore, going from SUE 1 to SUE 10 generates about 4.2% of
abnormal returns over 60 days (i.e., or about 18% on an annual basis). The general thrust of the
effect is that the Cumulative Abnormal Returns (―CARs‖) for ―bad news‖ firms continued to
Kihn / Behavioral Finance 101 / 373

drift down, while for ―good news‖ firms they continued to drift up after the announcement of
earnings.
306
In addition, larger abnormal returns can be gained by altering the research design in
certain ways (see the next diagram).



306
It is important to note that forecast errors should not be autocorrelated (i.e., in an ―efficient market‖), but as you
can see they are. These types of studies are strong and direct evidence that ―stock prices reflect naïve earnings
expectations.‖

Kihn / Behavioral Finance 101 / 374

Source: Bernard and Thomas (1990, p. 323).

While generally firms seem to display ‗earnings drift‘, or underreaction to basic earnings
information, small and medium sized firms show more of the drift/momentum effect.
307

Therefore, one could increase the apparent ‗free lunch‘ or excess returns by skewing toward
smaller firms. In addition, it appears the effect doesn‘t completely disappear until six to nine
months out (i.e., compared to their original study where they showed only sixty business days, or
about three calendar months).

As the last diagram shows, much of the effect happens within the three days after each quarter-
end announcement (notice the upward jumps at quarter ends). Additionally, the magnitude of the
effect is declining each quarter and then reverses in the fourth quarter. Furthermore, the first
quarter encompasses over one-half the effect, and, as mentioned, it is monotonically declining
across size of firm (i.e., small, medium, and large). Clearly, this market-efficiency ‗anomaly‘ is
rooted in a failure of information to flow completely into price.
308


It is important to note that the Bernard and Thomas (1989) study was not the first academic
reference on this issue of ‗earnings drift‘. Claims of incomplete initial stock price reactions to

307
Therefore, both the magnitude and length of the drift/momentum effect is larger and longer, respectively, for
smaller firms. Therefore, instead of about 4.2% difference over 60 days between decile 10 and 1 SUE portfolios, ―a
combined long position in SUE portfolio 10 and a short position in SUE portfolio 1 generates an abnormal return of
approximately 10%, 9%, and 4.5% for small, medium, and large firms, respectively.‖ (Bernard and Thomas (1990))
Also, ―the drift is about 50% larger when SUEs are measured relative to analysts‘ forecasts rather than the statistical
forecasts used in Figures 1 and 2 (Freeman and Tse (1989, Table 7)).‖
308
Even Bernard and Thomas (1989, 1990) were somewhat perplexed by what they found and especially the
earnings analysts themselves. They seem to almost be asking things like who would hire these people, and how such
‗professionals‘ like these could exist in a competitive environment? My response would be that it is hardly a
competitive environment and possibly read the chapter on agents/actors in financial markets.
Kihn / Behavioral Finance 101 / 375

accounting earnings have existing at least since the late 1960s (probably Ball and Brown (1968)
were the first). What was unique was that their solid ―underreaction‖ documentation is a
relatively recent event. Some of the key studies in the area are Rendleman et al. (1982), Bernard
and Thomas (1989, 1990), Freeman and Tse (1989), Mendenhall (1991), and Wiggins (1991). As
a group, these studies imply that: ―post-announcement drift arises because stock prices fail to
reflect fully what current earnings imply, on average, about earnings in subsequent quarters.‖
Hence, predictable return patterns, and simple earnings information is not fully and accurately
reflected in pricing.

In contrast to the seemingly overwhelming evidence of underreaction to earnings, there is some
evidence of ―overreaction‖ in the case where earnings and price changes were reversed (e.g.,
inferior earnings and price changes were followed by superior earnings and price changes). Thus
there appears to be evidence that when market participants are subjected to earnings (and other
accounting type information) where extreme changes in the information occur (e.g., reversals),
they may overreact; while normally they tend to underreact (see De Bondt and Thaler (1987),
and Ou and Penman (1989)). From a behavioral finance standpoint, is this reversal shift to
overreaction truly overreaction or underreaction (Chopra et al. (1992) support De Bondt and
Thaler (1987) who find it akin to overreaction)? Either way, it doesn‘t look good for the ―semi-
strong‖ form of market efficiency.
309



309
Bernanke and Kuttner (2005, p. 1254) suggest that ―further exploration of the link between monetary
policy and the excess return on equities is an intriguing topic‖.
Kihn / Behavioral Finance 101 / 376

Although a bit confusing at times, most of the underreaction literature strongly supports the
notion that information is not embedded in pricing as expected by normative theory; in addition,
it should be mentioned that, and consistent with both the overreaction and underreaction effects,
there is a fair amount of evidence on overreaction to certain reversals and/or specific accounting
information. Regarding underreaction specifically, most of the research has focused on earnings
themselves, but some have examined other phenomena. Earnings analysts underreact to recent
company earnings, and may represent about half of the underreaction effect (Abarbanell and
Bernard (1992)). Stock splits tend to show drift or underreaction (Ikenberry and Ramnath (2002)
find about 9% price drift after stock splits). Momentum is found in stock prices of about 12% per
year for about three to twelve months (Jegadeesh and Titman (1993)). After dividend decrease or
elimination announcements there is a tendency for negative drift up to about one year afterward
(see, e.g., Liu et al. (2008)); and both dividend omissions and initiations show strong drift
afterward for up to one year (Michaely et al. (1995)). Taken as a group, the evidence in favor of
underreaction is both broad and compelling.

Kihn / Behavioral Finance 101 / 377

OVERREACTION AND UNDERREACTION IN THE SAME MARKET AT THE SAME
TIME – AN EMH/EMT PROPONENT‘S WORST NIGHTMARE
With ‗earnings drift‘ we have well documented underreaction over about six to nine months (two
to three quarters)
310
, while with overreaction we have well documented return reversal out to
three to five years (twelve to twenty quarters). Therefore, because of the general timing
differential between underreaction and overreaction we can have both occurring in the same
market without any significant ‗cancelation‘, arguably the EMH/EMT proponent‘s worst
nightmare.
311
In fact, all the original evidence concerned the U.S. equity market. Given, that at
least at the time of the studies largely confirming underreaction and overreaction, the U.S. equity
market was arguably the most liquid equity market, is it not reasonable to suppose that if U.S.
stock market was not weak- or strong-form efficient, the others were not likely to be either (i.e.,
just based on these two sets of indirect tests)?

The existence of overreaction and underreaction suggests that not only is it possible to earn
excess returns based on mean reversion (i.e., due to overreaction), but also to possibly combine
that with momentum (i.e., due to underreaction).
312
There is nothing in normative theory that
would seem to counter combining the ‗free lunch‘ of overreaction/reversal with

310
In fact, the evidence across all studies clearly shows that for at least the first two or three quarters (t + 1, t + 2,
and t + 3) after an earnings announcement there is autocorrelation, but it is declining over time; and theer seems to
be modest reversal in quarter t + 4 and maybe in t + 5. Thus, as we move beyond three quarters we begin to see very
slight evidence in favor of overreaction/reversal, even for earnings. Therefore, beyond three quarters strong
‗earnings drift‘ tends to turn into mild earnings reversal.
311
There are now several descriptive theories incorporating overreaction and underreaction (e.g., see Barberis et al.
(1998) and Daniel et al. (1998)).
312
See Kihn (2006) regarding the practical possibility of combining momentum/underreaction with
reversal/overreaction to enhace expected risk-adjusted returns.
Kihn / Behavioral Finance 101 / 378

underreaction/momentum. The larger question or questions seem to revolve more around cause
than effect.

Regarding causes, at this time, it is far from clear. For example, overconfidence has been
mentioned as a possible reason for underreaction. Scott et al. (1999, p. 56) state: ―the momentum
effect may actually have more to do with an overconfidence bias.‖ Therefore, they see it as a
cause, or at least partial cause, of underreaction. In addition, Odean (1998, p. 1916) states:
―When there are many overconfident traders, markets tend to underreact to the information of
rational traders. Markets also undereact to abstract, statistical, and highly relevant information
and overreact to salient, but less relevant information.‖ Therefore, generally it causes or at least
helps to cause underreaction to relevant information like earnings, but it may also cause
overreaction to other types of information like fundamentally meaningless news headlines.

Regarding the EMH/EMT standard explanation/excuse that the cause may be ‗time-varying risk
premia‘, or just misspecified risk itself, this is unlikely to be more than a very minor cause, at
least with respect to earnings drift/momentum. Bernard and Thomas (1989) checked and found
that about 8% to 13% of the drift/momentum effect could be due to misspecification of beta or
the CAPM. Regarding the possibility of macro type risk being neglected, the effect has been
found across large segments of time, and up or down market conditions, etc.
313
, and Arbitrage

313
If there were macro events (e.g., a war, etc.), then this should be picked up in the effect being magnified in one or
two key quarters, which wasn‘t the case. And if ―mean raw (total) returns on extreme bad news stocks were so low
as to raise doubts about whether declines in risk of any kind could plausibly explain their magnitude. Specifically,
the raw returns were less than the Treasury bill rates during the week after the earnings announcement, and were
only slightly greater than the Treasury bill rates during the first two months of the post-announcement period.‖ …
Bernard and Thomas (1989) CAPM Theory would almost suggest that only under special circumstances (that do not
seem to hold in this case) would this be possible (specifically, they would have to offer some peculiar hedging value
Kihn / Behavioral Finance 101 / 379

Picing Theory (―APT‖) type macro risk factors do not significantly alter the basic result. In fact,
the results seem to be so strong and stable across different specifications with respect to time and
method, that ‗risk misspecification‘ and/or ‗time-varying risk premia‘ are unlikely to be the
reasons for the effect, at least regarding earnings drift/momentum.

Regarding the overreaction/reversal effect, it also seems unlikely that standard EMH/EMT
retorts encompass the cause of the effect. Although, the original study by De Bondt and Thaler
(1985) formed ‗winner‘ and ‗loser‘ portfolios based only on past returns, other studies have used
more fundamentally based accounting values and achieved even greater excess returns. For
example, Ou and Penman (1989) form portfolios on the basis of a ―Pr measure‖ (i.e., a
probability measure based on fundamental analysis estimated using historical data). Bernard
(1992, pp. 20-21) notes that their measure ―represents an estimate of the probability of an annual
earnings increase in the coming year, based on a function of financial statement variables
identified and estimated using only historical data. A key factor contributing to the success of Pr
as a predictor of future earnings changes is mean reversion in earnings scaled by equity. Firms
with recent earnings declines have high Prs and subsequently increasing earnings; the opposite
earnings patterns for low Pr firms. In this sense, the high (low) Pr firms correspond to De Bondt
and Thaler‘s losers (winners).‖ In effect, both De Bondt and Thaler (1985) and Ou and Penman
(1989) end up with directionally similar results, but derived based on different sets of publically

which would mean they could offer below the risk-free rate in equilibrium). This is very, very unlikely, if not
impossible. The only realistic possibility is if the results were specific to this thirteen year time period, which is
unlikely and related to the macro events possibility.
Kihn / Behavioral Finance 101 / 380

available information. Regardless, normatively one should not be able to use either past returns
and/or past accounting information to generate excess returns years into the future.
314


It is difficult not to conclude that both overreaction and underreaction occur. For earnings,
underreaction with respect to the specific context of the event (i.e., the specific questions of
equity analysts, large companies, and accounting earnings announcements and the games
analysts play with claiming to forecast them). When the information is more complex,
overreaction may tend to rule. For example, if, regardless of earnings, complex and noisy
information comes out about IBM which is mostly negative and seemingly very salient, the stock
may be unjustifiably hammered (i.e., not based fully on fundamentals), and in some cases all
stocks associated might be affected to lesser degrees. The analyst case is amusing in that it is
easy to identify who is who, whereas in most other cases it tends to be much messier. In
summary, they are different things, one is well specified and the mechanism is clearer, in the
other it is more extreme and a less controlled environment.

Finally, and as noted by Block (1999), earnings are arguably the most watched and analyzed
number currently and in the history of the financial markets, yet they are not ―efficiently‖
imbedded into pricing (i.e., in the Fama (1970, 1991) sense). Therefore, if earnings are not
―efficiently‖ embedded into pricing, why would we expect other much less known and much less

314
Note that Holthausen and Larcker (1992) show the Ou & Penman (1989) strategy performs poorly after 1983, the
last year of the Ou & Penman results. Although, when they change the model to reflect predictions of stock returns,
the result comes back. In addition, Ou & Penman (1989) seem to capture a long-term risk shift vs. a transitory one
(i.e., compared to De Bondt & Thaler‘s (1985) results, which seem to be corrected by a return to more fundamental
pricing). Furthermore, their results work for up to six years without a reduction in effect (see Stober (1992)), while
the De Bondt & Thaler (1985) results generally decrease each January for three years.
Kihn / Behavioral Finance 101 / 381

commonly accepted information to be reflected into pricing in an ―efficient‖ manner? The likely
answer directly relates to information and pricing (i.e., in this case the most watched simple
information is not embedded into pricing in an ―efficient‖ manner). If this is true, what hope do
we have for less followed and/or more complex information? Given that earnings are arguably
the most researched, most followed (by both institutions and individuals), most speculated upon
(by both institutions and individuals), easiest information to obtain, etc. fundamental values in
finance, how couldn‘t they be ―fully reflected‖ in pricing?

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Kihn / Behavioral Finance 101 / 390





Kihn / Behavioral Finance 101 / 391

Chapter 11: Chapter 11
315


―Effectively, once a business has been born it is either acquired or liquidated. Most businesses
end their lives being liquidated. Regarding firm mortality, it is more a question of when, not
whether, a firm will die.‖
Kihn (1996b, pp. 21-22)

Again, effectively practically all firms end their existence by either going bankrupt or being
acquired, and most bankruptcies end in some form of liquidation.
316
Therefore, given this
common lifecycle of businesses where financial death of some form is almost inevitable, what
happens during and after bankruptcy and insolvency is critically important. If the agents in the
financial markets don‘t respond in a normatively efficient fashion during identifiable periods of
micro or macro financial distress, when would they be expected to respond in a normatively
correct fashion?

From a normative EMH/EMT perspective, odd things seem to happen before, during, and after
bankruptcy. Even though corporate bankruptcy, and even restructuring, can be considered a
corporate event (which are dealt with in another chapter, i.e., corporate events), I felt that the

315
As an aside, it should be noted that many traditional financial theories and models (e.g., Modigliani and Miller
(1958) on optimal capital structure) implicitely assume zero costs and/or zero probability of bankruptcy. Of course,
there are bankruptcies and costs associated with bankruptcy (both direct and indirect, and they can be substantial).
Therefore, according to traditional normative finance, this chapter (and some others) shouldn‘t even exist.
316
Most businesses that die don‘t formally file formal bankruptcy proceedings, they just close down. The intent of
the U.S. Bankruptcy Code (also known as the ―Code‖) is to either rehabilitate or liquidate. Even though
rehabilitation through, e.g., Chapter 11 proceeding in the case of corporations, is preferred, the norm is liquidation
(especially for individuals and smaller legal entities).
Kihn / Behavioral Finance 101 / 392

event of bankruptcy, or more generally insolvency, was of a nature as to be best dealt with on a
somewhat standalone basis. In addition, there is the issue of the type of state of the world under
which distress occurs. Namely, is there something unusual about recessionary or depressionary
environments, which in turn are directly related to elevated levels of bankruptcy and insolvency,
to cause us to question the standard stories of normative market efficiency? In fact, there is.

THE EVENT OF BANKRUPTCY OR RESTRUCTURING
In the U.S., there are three primary chapters of the Bankruptcy Code under which institutions and
individuals file:
1) Chapter 7: The ‗liquidation‘ chapter of the Bankruptcy Code that results in the sale of a
debtor's nonexempt property and the distribution of the resulting net proceeds to
creditors.
2) Chapter 11: Typically applying to incorporated legal entities, the ‗reorganization‘ chapter
of the bankruptcy code commonly results in a debtor proposing a plan of reorganization
Kihn / Behavioral Finance 101 / 393

(e.g., it is standard to specify, relative to pre-bankruptcy claims, reduced payments to
creditors over time).
317

3) Chapter 13: This typically applies to individuals with excessive debts yet regular income.
Under this chapter of the Bankruptcy Code, the debtor is allowed to keep their property
and pay their debts typically over a three to five year period.
4) Chapters 9, 12, & 15: Chapter 9 applies to municipalities (e.g., counties, cities, towns,
etc.). Chapter 12 applies to a ―family farmer‖ or ―family fisherman‖. Chapter 15 is a
relatively new chapter (i.e., as of the new 2005 code) that applies to cross-border
bankruptcies.
318

Therefore, and even though numerically Chapters 7 and 13 are the most common, because of the
focus on larger corporations with exchange listed common equity, for our purposes the focus will
be on Chapter 11. For better or worse, most of the empirical research on bankruptcy or
insolvency in finance has focused on Chapter 11. More specifically, most empirical work in
finance use the event of filing under Chapter 11 of the Bankruptcy Code as an event in order to
test one or more hypotheses concerning market efficiency.

The following graph is presented to give some notion of the volume of bankruptcy filings in the
U.S. over the recent past. Please note that spikes occuring around the year 2005 are the likely
result of mostly debtors responding strategically to the 2006 implementation of major changes

317
There are several forms of ―Chapter 11‖ for corporations and like legal entities. For example, a ―prepackaged
Chapter 11‖ is one form of Chapter 11 where the bankruptcy plan is submitted in such a way that the time the legal
entity is under ―bankruptcy protection‖ is typically limited and management retains full control. Often this form of
Chapter 11 is called a ―reorganization‖, which tends to result in some confusion as most non-liquidation
bankruptcies are also referred to as reorganizations.
318
In should be mentioned that there are also provisions/sections of the Bankruptcy Code, for example, covering
people in the military, brokers, etc. that I have chosen to ignore in order to better keep focused on that which has
been studied in some detail, namely Chapter 11 of the Bankruptcy Code.
Kihn / Behavioral Finance 101 / 394

the Bankruptcy Code (i.e., mostly people tried to decalre bankruptcy under what would have
been a less onerous bankruptcy code prior to the beginning of 2006).


Source: American Bankruptcy Institute (http://www.abiworld.org/).

Again, in particular, the ―non-businesses‖ spike occurs in 2005, even though economic
conditions are substantially worse after that spike in individual bankruptcy filings.
319


In terms of the major chapters under which most have filed:


319
It is expected that personal and corporate filings will show significant increases in 2009 and beyond.
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
B
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U.S. Bankruptcy Filings (1980 - 2008)
Non-Business Filings
Business Filings
Kihn / Behavioral Finance 101 / 395


Source: American Bankruptcy Institute (http://www.abiworld.org/).

Again, even though Chapter 11 filings are relatively numerically small, their economic impact is
well beyond their numbers. Regardless, what do we know about Chapter 11 bankruptcies with
respect to issues of normative efficiency?

Total Chapter 7 Chapter 11 Chapter 13
1980 287,564 213,983 460 73,121
1981 315,805 226,595 1,109 88,101
1982 310,942 212,657 2,187 96,098
1983 286,432 196,205 3,032 87,195
1984 284,507 195,826 2,472 86,209
1985 341,215 237,637 2,975 100,603
1986 449,188 324,073 3,372 121,743
1987 495,542 362,605 2,778 130,159
1988 549,599 399,128 2,138 148,333
1989 616,206 439,127 1,970 175,109
1990 718,093 506,931 2,498 208,664
1991 872,416 617,342 3,195 251,878
1992 900,831 643,512 3,197 254,122
1993 812,864 568,390 3,018 241,455
1994 780,417 537,533 2,265 240,619
1995 873,642 597,048 1,369 276,225
1996 1,125,202 779,719 1,173 342,991
1997 1,350,118 957,117 1,071 391,930
1998 1,398,182 1,007,922 862 389,398
1999 1,277,095 890,919 712 374,232
2000 1,220,062 838,885 687 378,400
2001 1,454,031 1,031,493 783 419,750
2002 1,558,871 1,102,397 986 453,477
2003 1,607,623 1,156,274 930 466,585
2004 1,562,343 1,115,048 959 456,636
2005 2,041,219 1,631,011 877 407,322
2006 599,971 349,012 519 238,430
2007 822,590 500,433 617 320,720
2008 1,074,225 714,380 888 358,947
Kihn / Behavioral Finance 101 / 396

BANKRUPTCY PREDICTION AND MARKET EFFICIENCY
As it turns out corporate bankruptcy is generally predictable (e.g., Altman (1968, p. 609) claims
a high degree of predictive accuracy).
320
Not only is it seemingly predictable (i.e., most are
predictable), but those predictions can be used to generate excess returns or the not so elusive
appearance of a normative ‗free lunch‘ (e.g., see Katz et al. (1985)).

Furthermore, it has been found that for large corporate bankruptcy filings investor reaction tends
not to be centered on the actual bankruptcy filing date but when the more popular media lists the
bankruptcy (see Dawkins and Bamber (1998)). Apparently, at least according to Dawkins and
Bamber (1998, p. 1149), ―most of the market reaction does not occur on the bankruptcy petition
filing date when the information becomes publicly available. Rather, most of the reaction occurs
when news of the bankruptcy filing is more widely disseminated via the Broadtape.‖ In other
words, most investors don‘t react to the public filing; they wait for the more public media
announcement.
321
Dawkins and Bamber (1998, p. 1162) suggest that the lack of basic
information efficiency ―is consistent with investors finding that it is not cost-effective to closely
monitor various jurisdictions for news of bankruptcy filings.‖ This excuse is absurd. Given the
size and value of at least their common stock at the time of filing, it is in fact economically
viable to search for such filings. The fact that most investors don‘t is an additional curiosity that
strongly contradicts the most basic notions of informational efficiency.


320
Note, bankruptcy prediction was not included explicitly in the ―the issue of predictability‖ list. Also, and though
not a focus for this chapter or the book more generally, individual bankruptcy is predictable. Essentially, once an
individual of firm reaches an insolvent state, its odds of formally declaring bankruptcy increase.
321
Of course, sometimes those two dates coincide.
Kihn / Behavioral Finance 101 / 397

Finally, I should note that by varying, for example, the periodicity of the data and filters used it
seems to be often or always possible to obtain a result superficially supportive of normative
market efficiency (see, e.g., Morse and Shaw (1988)).
322
Specifically, for example, by
introducing excess variance into the test you will tend to reject your null hypothesis, and
coporate bankruptcy is no exception to this general rule.

BEFORE, DURING AND AFTER BANKRUPTCY
Given the lack of concern for informational efficiency, how bad can ignoring the actual filing
date be? Clark and Weinstein (1983, p. 497) find that for their sample of common stocks, on
average and after controlling for risk, prices drop about 48% around the three day bankruptcy
announcement period (i.e., centered around the announcement date). That is, abnormal returns
are about -48% for three days. I would guess that most people would consider this is

322
Morse and Shaw (1988) use monthly data and throw out many firms due to their peculiar filtering technique or
approach. In addition, they find some evidence that the return generation process for the common equity of bankrupt
firms has changed after the Bankruptcy Reform Act of 1978. Thus by focusing on monthly returns and using a
sample skewed by post 1978 firms (i.e., in addition to their filtering approach and event study methodology), they
are able to reject their null hypothesis of market inefficiency. In particular, they dropped firms that lacked certain
accounting data (see Morse and Shaw (1988, pp. 1197-1201)).
Kihn / Behavioral Finance 101 / 398

economically significant. Clark and Weinstein (1983, p. 504) conclude by stating: ―Based upon
these findings, we conclude that bankruptcy filings convey important unanticipated information
to the market.‖

Given that bankruptcy can be predicted fairly well, what about the period preceeding
bankruptcy? In other words, based on normative notions of market efficiency, we shouldn‘t see
any abnormal returns well in advance of a bankruptcy filing. Aharony et al. (1980, p. 1014) find
that: ―a significant negative cumulative differential portfolio return starting roughly four years
before bankruptcy. The unexpected deterioration in the bankrupt group was high, with investors
having to continuously adjust for declining solvency over about a four year period.
Investors were apparently surprised up to the time of the bankruptcy.‖ Therefore, investors
were surprised well before bankruptcy, yet most large bankruptcies are clearly obvious well in
advance (i.e., they were predictable). Even more problematic for normative market efficiency is
that investors seem to adjust slowly. They appear to never quit catch on to the impending
bankruptcy.

Thus far we know common stock investors are surprised before and at the bankruptcy filing, but
what about after the bankruptcy filing? For the day after the filing, Dawkins and Bamber (1998,
p. 1151) find an abnormal return of about -16%.
323
Alright, so many investors are surprised by
the filing itself, but what about well after the filing date? It should be noted that it is rather
difficult to specifically define the period after a corporate entities‘ Chapter 11 filing. In fact,

323
For comparative purposes, Dawkins and Bamber (1998, p. 1158) find a significantly negative return of -12.24%
on the filing date and -15.97% the day after the filing. Therefore, there is a larger reaction after the filing.
Kihn / Behavioral Finance 101 / 399

many, if not most, eventually turn into some form of liquidation. Therefore, many cases (even
some larger ones) go from being classified as Chapter 11 to Chapter 7.
324
Thus, which are we
talking about, Chapter 11, Chapter 7, both, some combination, etc.? There is a relatively large
literature on the cost of bankruptcy (both 7s and 11s), but the costs associated with each are
highly contingent on things like the type of bankruptcy and general economic conditions.
Therefore, the sample of bankrupt firms most academics study tends to be a biased sample of
large firms that enter and emerge from bankruptcy relatively quickly, not those that either
emerge only to enter bankruptcy again or are converted to a liquidation (either before or after
emergence from Chapter 11 protection). Therefore, the sample itself tends to be skewed toward
positive results, especially after the bankruptcy filing.
325


In addition, historically financial academics have tended to imply that the ex ante and ex post
costs of bankruptcy are significant (e.g., see Altman (1984, pp. 1079 & 1082), he estimates
indirect costs alone, pre and post bankruptcy, to be around 20% and 17%, respectively). Thus,
and depending on method and significant characteristics & factors, bankruptcy is costly after the
filing (i.e., both direct and indirect costs).
326


324
See, for example, Kihn (1996b, pp. 38-43). Most of what begin as Chapter 11 filings don‘t end as clearcut
Chapter 11s. In fact, based on the actual experiences of most bankruptcy courts, the samples used by standard
finance studies are very skewed toward what would be considered ―successful‖ restructurings. In short, on one level
it is a wonder that negative abnormal returns are found.
325
Another issue is that earnings analysts typically avoid firms after they have declared bankruptcy (i.e., they tend to
drop coverage). In fact, few, if any, follow a firm once it has declared bankruptcy. Although, given their lack of
forecasting prowess, earnings analysts do not have sterling reputations with respect to providing useful information
for investors, their relative disappearance from providing bankrupt and distressed company information compounds
the already limited to nonexistent normative market efficiency for distressed firms.
326
Also, it is important to point out that it was, and probably is, common received wisdom for financial academics to
believe that there are economies of scale with respect to bankruptcy costs (see, e.g., Deis et al. (1995)). The original
article pushing this view was Warner (1977, p. 345): ―This evidence suggests that there are substantial fixed costs
associated with the railroad bankruptcy process, and hence economies of scale with respect to bankruptcy costs.
That is, the larger the firm the smaller the relative costs of bankruptcy.‖ In contrast, Kihn (1996b) and Bris et al.
Kihn / Behavioral Finance 101 / 400


In summary, with respect to large corporate bankruptcies, the following can be stated with some
confidence:
1) As a general rule, bankruptcy is costly to common equity holders and the firm in general
prior to bankruptcy.
327

2) Although largely predictable, many, if not most, investors are surprised both before and
during most bankruptcy filings.
3) The event of the bankruptcy filing itself tends to be costly to common equity
shareholders.
4) As a general rule, bankruptcy is costly to the firm itself after the bankruptcy filing.
5) Overall, and as a general rule, bankruptcy is costly to investors yet they seem consistently
surprised by it and its effects.
6) Bankruptcy is overall not supportive of normative notions of market efficiency.
Bankruptcy as documented by finance academics seems to puzzle those with a normative bent.
What about states of the world like recessions and depressions when bankruptcy and financial
distress generally rise? That is, is there anything normatively odd about more macro distress that
would cast suspicion on normative market efficiency? Yes.


(2006) do not find the commonly accepted economies of scale associated with bankruptcy. In fact, depending on
various characteristics and factors, diseconomies of scale may dominate.
327
Although not addressed here, it is also likely that, as a general rule, bondholders are also economically and
significantly harmed by bankruptcy (i.e., in addition to common stock shareholders). See e.g., Kihn (1996b).
Kihn / Behavioral Finance 101 / 401

PERIODS OF ECONOMIC DISTRESS – WHEN MANY FIRMS HIT THE SKIDS
(RECESSIONARY AND DEPRESSIONARY PERIODS)
Normative finance has seemingly continually modified theory to incorporate various ‗anomalies‘
over time and/or try to explain them away. For example, the original model used to control for
risk was of the form related to the CAPM (e.g., as used by Jensen (1968) and applied to a
portfolio). For example, it can be represented as:
328

-

=

+

(

-

)+

, where for time t:

= return on the portfolio being analyzed,

= return on the ‗risk-free‘ asset (typically some short-term Treasury or government rate is
used),

= return on the ―market portfolio‖ (typically the value weighted or equally weighted
portfolio of all, or most, stocks is used),

= the ‗beta‘ or sensitivity of the portfolio (or security) to ‗market‘ movements, and

= the random error term.
The alpha (

is intended to represent the difference between the realized mean return of the
time series and its risk-adjusted required return (i.e., as determined by the CAPM). Therefore, a
positive or negative and statistically significant alpha is considered to be evidence of normative
(i.e., based on roughly a CAPM view of finance) inefficiency. That is, from an EMH/EMT
perspective any statistically significant deviation from zero is considered to be evidence against

328
What now follows regarding ‗factor‘ representations of normative models used to adjust for risk is largely
repetitive of a part of a section in a previous chapter. My rationale for doing this is that I view this material as
sufficiently important as to largely repeat part of it, and add some nuance with respect to this section of this chapter.
Kihn / Behavioral Finance 101 / 402

market efficiency (i.e.,

<> 0). In addition, the ‗beta‘ or betas should tend toward unity (i.e.,
by normative definition

≈ 1).

More recently, the following two forms are commonly applied in the empirical finance literature
(Fama and French (1993) and Carhart (1997), respectively):

-

=

+

(

-

)+

(

-

)+

(

-

)+

, and

-

=

+

(

-

)+

(

-

)+

(

-

)
+

(

-

)+

, where

= return on small-cap (small capitalization) stocks,

= return on large-cap stocks,

= return on ‗value‘ stocks,

= reurn on ‗growth‘ stocks,

= ‗beta‘ or ‗factor sensitivity‘ of the portfolio to movements in excess returns associated
with firm size (typically proxied by common stock capitalization),

= ‗beta‘ or ‗factor sensitivity‘ of the portfolio to movements in excess returns associated
with ‗value‘ (typically proxied by the difference in returns associated with ‗value‘ stocks relative
to ‗growth‘ stocks; and often proxied by such things as ―book-to-market‖ ratio), and

= ‗beta‘ or ‗factor sensitivity‘ of the portfolio to momentum excess returns (typically
proxied by recent returns on the portfolio itself, and often expressed as a lagged variable, and
typically lagged no more than one year).
329


329
Of course, like the CAPM example the preceded these two, these are but one representation. In actual practice
what are often used are more purely statistical ―factor analysis‖ representations.
Kihn / Behavioral Finance 101 / 403


As you can see, over time as certain ‗anomalies‘ became empirically overwhelming, the models
changed to incorporate the ‗anomalous‘ returns.
330
Therefore, as can be seen from the above
form of ‗models‘ used in literally thousands of empirical studies in finance, over time certain
‗risk factors‘ were added. For example, given that smaller firms tended to provide excess returns,
by including a size ‗factor‘ you largely or totally circumscribe those excess returns to that
‗factor‘ (even if they have little or nothing to do with a ‗size factor‘). In effect, you can eliminate
that nasty ‗anomaly‘ (or associated anomalies) by defining it away and thus co-opting it, or any
related ones. Thus, by adding these ‗risk factors‘, whether or not being true ‗risk factors‘, one
can at least eliminate statistically significant alphas for such things as size, value, and momentum
(and any related ones). As stated previously, this type of activity does not settle the debate as to
whether the ‗anomaly‘ is truly anomalous, it merely hides it under the statistical rug, as it were,
but EMH/EMT proponents tend to act as if the case is settled.
331


With the issue of statistical misdirection duly noted, why bring these equations up? One reason is
to specify what is wrong with blithely assuming all is well just because the ‗3-factor‘ or ‗4-
factor‘ model implies it is. Not only would that be wrong according to normative theory, but
incorrect descriptively. The other reason is because normative theory would suggest that the ‗risk

330
Ex post identification of ‗risk factors‘ doesn‘t mean they are wrong, but it is suspicious.
331
As mentioned before, I would emphasize that there are more plausible explanations for such ‗anomalies‘ as size
and value. For example, limits to arbitrage and psychology (i.e., behavioral finance) could offer some insight that
seems to be lacking. For example, it is very likely that at times many investors value growth and value stocks
differently than at other times. What EMH/EMT proponents might call a ‗risk factor‘ for size or value might actually
be something more akin to a ‗characteristic‘ of the stock that investors might or might not value differently at
different times and under different circumstances, largely due to such things as the ―pillars of behavioral finance‖
(i.e., limits to arbitrage and psychology).
Kihn / Behavioral Finance 101 / 404

factors‘ should behave in certain ways during certain states of the world, yet in fact they tend not
to. Thus, both normative theory and descriptive reality are against such ‗modeling‘ of ‗risk‘.

The bottom line issue revolves around the following question(s): Are these so called ‗factors‘
really risk factors in the true normative sense of the term, or are they mispricings, or both? That
is, even more specifically, are

,

,

, and

really ‗risk factors‘ at all? To refresh
our collective memory, remember EMH/EMT proponents began the debate claiming that

was the only normative ‗risk‘ worth taking account of. It was expected that this ‗market risk‘ was
all that should be controlled for in order to test for normative market efficiency. Then after the
evidence piled up, other ‗risk factors‘ were added in the mid-1990s, but with little or no even
normative justification (i.e.,

,

, and optionally

). This alone is suggestive that
normative theory stuggles to fit the pieces together ex post. The analogy could be akin to
theorizing that all the planets and the sun revolve around the Earth, only to discover a few more
planets. It isn‘t that one cannot reconcile these new discoveries; it‘s just that doing so within the
context of an earthcentric theory becomes more difficult. In my opinion it would probably be far
easier to scrap the original theory and apply something more nuanced than the original theory but
simpler and more stable than the current evolving one (e.g., behavioral finance would be my
suggestion); but alas we know that humans are predisposed to denial. In my opinion ―Occam‘s
Razor‖ is no longer the guiding heuristic in finance, rather the need not to falsify the EMH or
EMT.

Kihn / Behavioral Finance 101 / 405

As stated by Daniel et al. (2002, p. 156-157): ―There is a factor associated with book/market, but
there is no clear evidence as to whether this factor earns a risk premium.‖ In other words, sure
investors seem to respond to book-to-market values (recall book/mkt), but what does that mean?
Therefore, for example, think of

(because book-to-market can be a proxy for value with
high book-to-market value firms possessing more ―value‖ than low book-to-market value ones)
as measuring or at least proxying the extent to which investors value value. The problem isn‘t
that investors don‘t value value, it is that value itself may be more of a ‗characteristic‘ than a
‗risk‘, or it may change from being more of a characteristic then at other times more of a risk. If
it does that, then it cannot be a purely ‗risk factor‘ (i.e., as per the more recent evolving
normative theory). For behavioral finance, whether it‘s more of a ‗characteristic‘ or ‗risk‘
doesn‘t really matter, but for normative finance it‘s seems to be life or death (i.e., at least with
this seeming iteration of the normative theory). In short, it seems normative finance ala
EMH/EMT has backed itself into a kind of corner over its more recent explanations of what is or
is not ‗risk‘ and how those risks should behave over time; whereas behavioral finance hasn‘t, and
is compatible with the ‗risk factor‘ explanation, yet finds that explanation descriptively lacking.

Also, what is, for example, a book-to-market ‗risk factor‘ anyway? That is, I might buy into the
notion that ‗market risk‘ (e.g.,

) should be priced, but what about book-to-market or the
month of January, etc.? At some point the notion that something like overreaction, underreaction,
S.A.D., etc. should be viewed as some purely normative ‗risk factor‘ approaches the absurd. Of
course, most finance academics don‘t even believe this view of the normative theory they teach
(see Welch (2000)). Thus, on the one hand textbooks and lectures teach about ‗risk factors‘ but
Kihn / Behavioral Finance 101 / 406

most academics, at least as of 1999, don‘t even accept that normative version of finance but
rather feel that these are types of things are best described as ‗characteristics‘.
332


Furthermore, and as mentioned previously, it has been normatively theorized that these types of
‗factors‘ represent hedges against shifts in the investment opportunity set, particularly financial
distress. But, for example, if this was true why do so many that can invest in their own
company‘s stock do so (i.e., when normative diversification theory would advise them not to;
and it is doubtful they are hedging future distress risk, quit the contrary)?

The point of contention in academic finance is that as it has become more and more difficult, if
not impossible, to reconcile the 1970 version of EMT with empirical reality, a new and evolving
view has emerged in parallel with all perceived threats to its view (and related agenda). Once
again, note the following:
- Patterns of return predictability can have alternative explanations, and not all
explanations are equally plausible (specifically, strictly ‗rational‘ vs. behavioral).
- The behavioral approach is consistent with risk based factor premia (i.e., people do price
various forms of risk, but there are other psychologically based things going on,
specifically, psychological biases influence pricing). Actually, it was the original
EMT/EMH and the CAPM that lead the majority of academics and practitioners to
believe that there was only one risk worth taking account of, whereas the behavioral

332
Interestingly, yet the majority felt the markets were ‗efficient‘ and arbitrage free (see Welch (2000, p. 523)).
Fortunately, psychology can help explain how and why humans can keep contradictory notions at the same time.
Kihn / Behavioral Finance 101 / 407

approach has always maintained that explaining what motivates investors is more
nuanced.
- The mispricing of factors is consistent with those factors identified as new additions to
the evolving EMT asset pricing model (i.e., the ‗3-factor‘ model of Fama and French
(1993) or the ‗4-factor‘ model of Carhart (1997)). Therefore, the ex post identification
and subsequent addition of new risk factors to the evolving EMT asset pricing model
doesn‘t mean those factors are anything more than the mispriced factors they were
identified as being in the first place.
- In particular, the cross-section of securities returns is very difficult to rationalize based
upon ‗rational‘ risk measures (e.g., size, value (again, e.g., book-to-market being its
proxy), and momentum). Again, the Fama and French (1993) and Carhart (1997) asset
pricing models may help to ‗explain‘ away a great deal of the mispricing or ‗anomaly‘,
but that doesn‘t mean it isn‘t caused by mispricing and/or is in fact mispricing. The
seemingly important question has been largely ignored. That is, are those factors true risk
factors?
- Ignoring for a moment that they were added after the fact (ex post identification, which is
a type of theoretical specification search, ironically a claim made against others) and they
have no real theoretical grounding in economics, what is a momentum, value, or size risk
anyways? If those factors were truly risk factors then the factor realizations should
strongly covary with investors‟ marginal utility across states. Specifically, rational
asset pricing models would suggest that low marginal utility states (e.g., economic
booms) should be associated with high relative returns for ‗value‘ stocks and high
Kihn / Behavioral Finance 101 / 408

marginal utility states (e.g., recessions/depressions) should be associated with low
relative returns for ‗value‘ stocks. In fact, they either don‘t seem to move much or move
in the opposite direction as that expected by the newly evolved theory. Therefore, there is
little or no evidence to support the ‗insurance‘ theory proposed by the evolving theory
(see Cochrane (1999) on an outline of what is predicted by this type of theory).
- The bottom line is that, short of extreme preferences not accepted by or incorporated into
any ‗rational‘ model, it is very difficult to explain the very high Sharpe ratios achieved by
forming portfolios based on size, value, and/or momentum. This is true no matter how
high the correlations between the returns of portfolios based on these ‗factors‘ and
innovations in macroeconomic variables (see Daniel et al. (2002, p. 152-153)), that is,
those studies with signs in the ‗right‘ direction.
- In addition to there being little evidence to suggest these returns are correlated with
macroeconomic variables that might proxy for marginal utility, there is very little
evidence of size, value, and momentum returns being correlated across countries.
Therefore, forming these types of portfolios internationally would result in even higher
risk-adjusted returns with even more problems for the evolving theory.
- Therefore, stay tuned for the next adjustment(s) to the theory.
―Taken together, this evidence seems to imply that a frictionless, rational model which would
explain this evidence would have to have very unusual (and perhaps implausible) preferences to
accommodate very large variability in marginal utility across states.‖
Daniel et al. (2002, p. 153)

Kihn / Behavioral Finance 101 / 409

In short, it is not plausible to explain asset returns (especially stock returns) across economic
booms and busts with the current version of EMT. It isn‘t just that viewing such things as

,

,

, and

as ‗risk-factors‘ makes little or no logical sense, it‘s that even viewing
them as such doesn‘t make much descriptive sense across time as economies boom and bust.
―Value stocks‖, for example, at least according to the recent normative EMT should not behave
the way they appear to descriptively behave.
333
The critical point is that if ‗value‘ stocks return
more than ‗growth‘,
334
then in a ‗rational world‘ this extra return is due to extra risk, and this
extra risk will become more clearly visible in the extreme negative states of the world (for
example, recessions). Furthermore, most of these types of risk are a kind of ‗insurance‘ against
bad states that people are rationally worried about when pricing assets (again, think recessions).
Therefore, during recessions ‗value‘ stocks should return significantly less than ‗growth‘ stocks.
In fact, they tend to return significantly more than ‗growth‘ stocks. Actually, this type of result
tends to be generally true of most of the ‗anomalies‘.
335
Thus, not only are the ‗risk factors‘ such
as size, value, and momentum suspicious, but their actual behavior during economic downturns
is normatively contradictory toward EMT.


333
One study in partial support of the evolved EMT is Liew and Vassalou (2000) on ten countries and using book-
to-market to predict economic growth (‗most‘ countries support the view that returns of a portfolio based on book-
to-market and size are positively associated with GDP growth). In my view the key is recession, not growth; and, in
addition, this is only the sign that superficially appears to contradict the contradiction, but not magnitude. Also, the
Liew and Vassalou (2000) study funds contradictory evidence in Japan. Therefore, on a market weighted basis, there
is no support. Therefore, in summary, there are the following issues: (1) only growth is focused on and not
recessionary or depressionary periods (when it should be the reverse), (2) only the sign is the issue not magnitude
(i.e., when magnitude should be critical), and (3) on a weighted basis there is no supposedly supportive evidence.
334
Which may be part of the ‗good stock/good company‘ effect.
335
Also, note, much of this comes down to consumption risk (see Daniel et al. (2002, p. 152)). Lakonishok et al.
(1994) present evidence in strong support of the behavioral view (i.e., they look at recessions).

Kihn / Behavioral Finance 101 / 410

FINAL TWO COMMENTS FOR CHAPTER 11
First, I caution that the reader should not take away from the discussion on bankruptcy the notion
that bankruptcy is either unusual as an event or generally supportive of normative notions of
market efficiency. Descriptively the reality is that, at least with respect to mostly empirical
equity research, the bulk of research is either damning of normative EMT or could be interpreted
within a behavioral framework. Regarding EMT, the reverse could be said, namely, the research
is mostly and typically strongly unsupportive and it is almost impossible to interpret that research
from an EMT viewpoint.

Second, and even though it could be its own chapter, we haven‘t discussed research on debt
during financial distress. Suffice it to say empirical research in that area is small relative to
equity research, yet the complexity is increased. This is typical in academically inclined finance
research. Equity data tends to be far easier to come by, and the bond or debt results tend to be
some version of the equity results. In fact, and viewed from an embedded option perspective,
bonds can be much more complex. For example, and ignoring liquidity, conceptually the
following is a simplified contingent claims or option view of the general equations of the five
types of securities commonly encountered in financial research (see Kihn (1996a)):
(1)

=

, where

is the value of Treasury bond i and

is the value of ‗risk-
free‘ bond i;
(2)

=

, where

is the value of high-grade corporate bond i and

is the
value of interest rate call option i;
Kihn / Behavioral Finance 101 / 411

(3)

=

, where

is the value of low-grade corporate bond i and

is the value of default or put option i;
(4)

=

, where

is the value of convertible
corporate bond i and

is the value of equity call option i; and
(5)

=

, where

is the value of equity security i.
Clearly from this perspective alone (and even ignoring cross-products or other interaction terms),
convertible bonds are potentially the most complex of the five security types just listed.
Furthermore, other debt securities can be more complex than convertible bonds (for example,
common tax-exempt or ―municipal bonds‖ – see, for example, Kihn (1996c)). On this basis
alone, equities are relatively simple. To avoid relatively limited empirical research and needless
complexity, distressed debt was ignored in favor of the more popular and numerous equity
research. Therefore, I have chosen to keep the focus on that evidence which is more plentiful,
accepted by EMH/EMT proponents, and simpler. Finally, like most, if not all, of descriptive
finance, regardless of including debt in the analysis on bankruptcy, the evidence would still be
most plausibly explained by behavioral finance in comparison to standard normative EMT.

Kihn / Behavioral Finance 101 / 412

REFERENCES
Aharony, C., Jones, C., and I. Swary, ―An Analysis of Risk and Return Characteristics of
Corporate Bankruptcy Using Capital Market Data‖, Journal of Finance, Volume 35, Number 4,
September 1980, 1001-1016.

Altman, E., ―Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy‖, Journal of Finance, Volume 23, Number 4, September 1968, 589-609.

Altman, E., ―A Further Empirical Investigation of the Bankruptcy Cost Question‖, Journal of
Finance, Volume 39, Number 4, September 1984, 1067-1089.

Bris, A., Welch, I., and N. Zhu, ―The Costs of Bankruptcy: Chapter 7 Liquidation versus Chapter
11 Reorganization‖, Journal of Finance, Volume 61, Number 3, Jne 2006, 1253-1303.

Carhart, M., ―On Persistence in Mutual Fund Performance‖, Journal of Finance, Volume 52,
Issue 1, March 1997, 57-82.

Clark, T., and M. Weinstein, ―The Behavior of the Common Stock of Bankrupt Firms‖, Journal
of Finance, Papers and Proceedings Forty-First Annual Meeting American Finance Association
New York, N.Y., December 28-30, 1982, Volume 38, Number 2, May 1983, 489-504.

Kihn / Behavioral Finance 101 / 413

Daniel, K., Hirshleifer, D., and S. Teoh, ―Investor psychology in capital markets: evidence and
policy implications‖, Journal of Monetary Economics, Volume 49, Issue 1, January 2002, 139-
209.

Dawkins, M., and L. Bamber, ―Does the Medium Matter? The Relations among Bankruptcy
Petition Filings, Broadtape Disclosure, and the Timing of Price Reactions‖, Journal of Finance,
Volume 53, Number 3, June 1998, 1149-1163.

Deis, D., Guffey, D., and W. Moore, ―Further Evidence on the Relationship Between Bankruptcy
Costs and Firm Size‖, Quarterly Journal of Business & Economics, Volume 34, Issue 1, Winter
1995, 69-79.

Fama, E., and K. French, ―Common risk factors in the returns on bonds and stocks‖, Journal of
Financial Economics, Volume 33, Issue 1, February 1993, 3-53.

Jensen, M., ―The Performance of Mutual Funds in the Period 1945-1964‖, Journal of Finance,
Volume 23, Issue 2, Papers and Proceedings of the Twenty-Sixth Annual Meeting of the
American Finance Association Washington, D.C., December 28-30, 1967 (May 1968), 389-416.

Katz, S., Lilien, S., and B. Melson, ―Stock Market Behavior Around Bankruptcy Model Distress
and Recovery Predictions‖, Financial Analysts Journal, Volume 41, Issue 1, January/February
1985, 70-74.
Kihn / Behavioral Finance 101 / 414


Kihn, J., ―The Effect of Embedded Options on the Financial Performance of Convertible Bond
Funds‖, Financial Analysts Journal, Volume 52, Issue 1, January/February 1996a, 15-26.

Kihn, John, Distress & Low-Grade Securities: Issues in Distress & Illiquidity, Dissertation,
London School of Economics amd Political Science, University of London, London, England,
1996b.

Kihn, J., ―The Financial Performance of Low-Grade Municipal Bond Funds‖, Journal of
Financial Management, Volume 25, Issue 2, Summer 1996c, 52-73.

Lakonishok, J., Shleifer, A., and R. Vishny, ―Contrarian Investment, Extrapolation, and Risk‖,
Journal of Finance, Volume 49, Issue 5, December 1994, 1541-1578.

Liew, J., and M. Vassalou, ―Can Book-to-Market, Size and Momentum Be Risk Factors That
Predict Economic Growth‖, Journal o Financial Economics, Volume 57, Number 2, August
2000, 221-245.

Modigliani, F., and M. Miller, ―The Cost of Capital, Corporation Finance and the Theory of
Investment‖, American Economic Review, Papers and Proceedings of the Seventieth Annual
Meeting of the American Economic Association, May, 1958, Volume 48, Number 3, June 1958,
261-297.
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Morse, D., and W. Shaw, ―Investing in Bankrupt Firms‖, Journal of Finance, Volume 43,
Number 5, December 1988, 1193-1206.

Warner, J., ―Bankruptcy Costs: Some Evidence‖, Journal of Finance, Papers and Proceedings of
the Thirty-Fifth Annual Meeting of the American Finance Association, Atlantic City, New
Jersey, September 16-18, 1976, Volume 32, Number 2, May 1977, 337-347.

Welch, I., ―Views of Financial Economists on the Equity Premium and on Professional
Controversies‖, Journal of Business, Volume 73, Number 4, October 2000, 501-537.




Kihn / Behavioral Finance 101 / 416

Chapter 12: Illusions

Illusions are one area where psychology and finance can meet head on. The classic illusion that
has the potential to affect all financial markets is something known as the ―inflation illusion‖.
Given that normative finance and economics assumes people can distinguish been nominal and
real values, to the extent they tend not to can have significant valuation implications. That is,
minimally through its impact on discount rates.

Normative theory typically suggests that something, for example, like stock prices should be
inflation neutral. More specifically related to finance, to the extent that agents in the financial
markets are normatively supposed to discount nominal cash flows with nominal discount rates
and real cash flows with real discount rates, yet do not, then we have a large problem indeed
(i.e., from a normative perspective). In fact, for example, in the case of stocks (and probably real
estate), they seem to skew toward discounting real cash flows with nominal rates.

The easiest way to break down the inflation illusion is to group by the two forces and four main
asset classes it seems to affect: (1) stocks & real estate, and (2) bonds & currency exchange
rates.
336
Although, I would classify bonds and exchange rates are more of an indirect effect likely
working through ‗biased expectations‘. With stocks and real estate, the evidence points to
investors generally discounting earnings (real cash flows, or claims on real cash flows) with

336
Clearly these two are related, and not so coincidently short interest rates drive both the ―expectations hypothesis‖
and actual fita currency based exchange rates and their forward rates (in one case they are hypothesized to directly
affect long rates and in the other they actually seem to impact them more or less directly, although they impact both
directly).
Kihn / Behavioral Finance 101 / 417

nominal rates. This tends to cause stocks and real estate to be undervalued during inflationary
times and overvalued during other times. With bonds, the EH suggests that a steeply upward
sloping term structure of interest rates implies that bond investors expect that nominal rates will
be rising in the future. To the extent the term structure represents an unbaised forecast of future
nominal rates, then, according to a normative theory like the EH, no predictable pattern should
be revealed, yet there appears to be a pattern that suggests that the term structure is a relatively
consistent biased forecast of nominal rates (especially at extremes). Specifically, when nominal
rates are high and the term structure is steeply sloped, rates tend to go down, not up; conversely,
when nominal rates are low and the term structure is flat to downward sloping, rates tend to go
up, not down. Traditional or textbook normative theory would suggest the opposite of what we
observe in the actual markets. Finally, exchange rates essentially give us the case of the bond
effect in two countries at the same time. The short term to medium term driver of an exchange
rate between any two countries tends to be primarily driven through the relative yields of the two
countries. Normative theory would suggest that investors should be able to adjust two sets of
nominal rates (i.e., two countries nominal term structures) for the impact of relative inflation and
expected unbiased appreciation or depreciation of one currency relative to another. In fact,
currency investors/traders seem to hold relatively predictable biased expectations that indicate
they have systematic trouble accounting in an unbiased way for what the real difference between
any two currencies is. For example, it seems that high real yields in one country relative to
another tend to drive the relevant exchange rate in a relatively predictable way. If currency
investors were unbiased, such a simple differential shouldn‘t be predictive, yet it seems to be.

Kihn / Behavioral Finance 101 / 418

They all seem to have in common cognitive errors when trying to adjust for inflation and
inflation expectations, either in one market or two. Essentially the common thread isn‘t the lack
of the ability to adjust nominal values, it‘s more the tendency to make nominal evaluations of
financial securities (and even real estate), when the optimal normative evaluation would be real.

‘MONEY ILLUSION‘ – A BRIEF EXPLANATION OF THE BIAS OR NOMINAL VS. REAL
EVALUATIONS
Shafir et al. (1997, p. 241) explain that ‗money illusion‘ is ―a tendency to think in terms of
nominal rather than real monetary terms. Money illusion has significant implications for
economic theory, yet it implies a lack of rationality that is alien to economists.‖ Essentially,
Shafir et al. (1997) explain that money illusion is a problem rooted in framing. We tend to frame
most things nominally, and that leads to our normative undoing. That is, our natural tendency is
to ―bias toward a nominal evaluation.‖

Kihn / Behavioral Finance 101 / 419

One example of money illusion and framing by Shafir et al. (1997, pp. 351-353) is Ann and
Barbara, with the same college, same publishing jobs, but one year apart. Based on their two
hypothetical individuals, they asked three questions: (1) who is happier, (2) doing better in
economic terms, and (3) more likely to leave her position? Assume that both have $30,000
starting salaries. Ann begins her job first with 0% inflation and a 2% raise at end of year ($600
increase from $30,000 to $30,600), then Barbara begins with 4% inflation and 5% raise at end of
her first year ($1,500 increase from $30,000 to $31,500). As they enter their second year, who is
better off economically? Most people said that Ann was better off. When asked who is happier,
most thought Barbara was happiest. When asked who will look for a job and likely to take it,
most said Ann. The last question answer seems odd given the other two. Regardless, here are the
results:
Economic terms (N = 150):
As they enter their second year on the job, who is doing better in economic terms?
Ann: 71% Barbara: 29%
Happiness (N = 69):
As they enter their second year on the job, who do you think was happier?
Ann: 36% Barbara: 64%
Job attractiveness (N = 139):
As they enter their second year on the job, each received a job offer from another firm. Who do
you think was more likely to leave her present position for another job?
Ann: 65% Barbara: 35%

Kihn / Behavioral Finance 101 / 420

When asked to evaluate in real terms most correctly answered in real not nominal terms (71%
answered correctly), yet when asked about happiness they tended to associate happiness with a
nominal evaluation (64%). In addition, when framed in terms of job attractiveness, most used a
nominal evaluation (65%) and thought that Ann would leave. Therefore, it seems that people can
distinguish between real vs. nominal, but context is critical. The key is that even though people
can adjust for inflation with training/learning it is not natural to think that way. People think in
nominal terms and adjusting for inflation takes training and/or thought.

INFLATION ILLUSION – STOCKS (ACCEPTING THE MODIGLIANI-COHN
HYPOTHESIS) & REAL ESTATE
In an article published in 1979, Modigliani and Cohn (1979) hypothesized (call it the MC
Hypothesis or the ―MCH‖) that investors might irrationally discount real cash flows
(specifically, company earnings) using nominal interest rates. This sort of psychological bias
would tend to lead to inflation-induced valuation errors. If true, during periods when inflation is
expected to be high, stocks would tend to be undervalued; which would be in contrast to periods
Kihn / Behavioral Finance 101 / 421

when inflation is expected to be low, during such periods stocks would tend to be overvalued.
Therefore, if true, and contrary to normative theory, we should expect the current major
overvaluation of the U.S. stock market to shift to undervaluation as we will eventually shift from
low expected inflation to high expected inflation.

More recently, some have linked what is commonly referred to as the ‖Fed model‖ to the MCH.
The ‗Fed model‘ is usually based on the following: the earnings yield (i.e., the ratio of equity
earnings to price) should be approximately equal to nominal rates. If nominal rates are higher,
then stocks are considered overvalued, if nominal rates are lower then stocks are considered
undervalued. Asness (2003, p. 22) correctly points out that: ―The very popular Fed model has the
appearance but not the reality of common sense. Its lure has captured many a Wall Street
strategist and media pundit. However, the common sense is largely misguided, most likely due to
a confusion of real and nominal (money illusion). ... Now, as opposed to its failure for
forecasting long-term stock returns, the Fed model seems to be a success at describing how
investors actually set current market P/Es. There is strong evidence that investors set stock
market E/Ps lower (P/Es higher) when nominal interest rates are lower (and vice versa).‖ In fact,
if you track, for example, for the U.S. stock market earnings yield relative to the generic 10-year
Treasury bond yield over time the reader will see Asness‘ point quite clearly.

Kihn / Behavioral Finance 101 / 422



Certainly since the U.S. broke with original Brettan Woods exchange rate agreement (that is,
after the world became an exchange rate regime based soley on fiat currencies), the relationship
between nominal Treasury rates and the earnings to price ratio (also known as the ―earnings
yield‖) on the S&P 500 (which represents the majority of the U.S. equity markets capitalization)
has been close. Therefore, as a general rule, as nominal rates have risen or decreased so has the
earnings to price ratio. Again, and with respect to this graph, the heuristic or rule of thumb for
the ―Fed model‖ is that if the red line in the above graph is above the blue line then the S&P 500
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S&P 500 Earnings Yield vs. 10-year Treasury Yield
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Kihn / Behavioral Finance 101 / 423

is considered overvalued, and if the red line is below the blue line then the S&P 500 is
considered undervalued. At the time of this writing, the red line is well above the blue line. In
fact, the earnings yield of the S&P 500 is the lowest it has ever been (yet Treasury rates are very
low).

There have been a number of studies on the MCH or related to it, and overwhelming support for
it.
337
For example, Fama and Schwert (1977, p. 115) was one of the first academic pieces to
identify a ―most anomalous result is that common stock returns were negatively related to the
expected component of the inflation rate‖ over their study period (1953 – 1971). In other words,
even if stock investors expected inflation to increase they tended to ignore this and possibly
penalize firm real cash flow with nominal discounting. Combined, Ritter and Warr (2002) and
Campbell and Vuolteenaho (2004) largely rule out alternative explanations as well as strongly
support the MCH.
338
In addition, these types of studies directly and indirectly suggest profitable
trading strategies based on this valuation bias (e.g., see Ritter and Warr (2002, pp. 47-49)).
339



337
Of course, as with almost any empirical evidence in finance and economics, if you specify a special time period
or include or exclude a critical period, significantly alter your model and/or assumptions, you can often fail to notive
a result or even reverse results.
338
This, of course, hasn‘t stopped EMH/EMT proponents from developing ‗rational‘ models that seek to contain this
irrational response within the normative paradigm (see, e.g., Bekaert and Engstrom (2008)). It never ceases to amaze
this author how deeply ingrained the need to mathematically operationalize even relatively clear irrationality into
some kind of rational model (as always the terms rational and irrational are used in the EMH/EMT sense of the
terms). To me this response is just crazy.
339
Also, see, for example, Boucher (2006, p. 211) where he states: ―Our results are rather in line with behavioral
finance that has identified a number of cognitive errors to which investors are susceptible. However, the reasons for
which inflation makes investors more risk averse remains to be explained.‖ In short, he also finds significant excess
returns that are apparently available to anyone willing to key on this illusion, yet correctly points out that the
mechanics of what is causing it aren‘t exactly specified. But we strongly suspect it is wrapped up in humans‘
susceptibility to inflation illusion.
Kihn / Behavioral Finance 101 / 424

Regarding real estate, the same forces that apply to stocks seem to apply to real estate (see, e.g.,
Feinman (2005)). The price of a home or just a raw piece of land should be equal to the present
value of the future cash flows derived from it. For residential real estate, that is typically
represented by the discounted net actual or theoretically possible rental income stream expected
to be derived from the residence. Therefore, the rent/price ratio is analogous to the earnings/price
ratio or earnings yield. In fact, there is a tendency for rent to price ratios, much like earnings to
price ratios for stocks, to vary with nominal rates and the level of inflation itself. Of course, this
is not in line with standard normative theory.

BIASED INTEREST RATE EXPECTATIONS OR NOT – BONDS
―If the attractiveness of an economic hypothesis is measured by the number of papers which
statistically reject it, the expectations theory of the term structure is a knockout. Most tests
beginning with Macaulay (1938) find no evidence supporting the expectations hypothesis. Many
cannot even reject statistically the alternative hypothesis that the spread between long and short
rates contains no information about future interest-rate changes. To make matters worse, in
Kihn / Behavioral Finance 101 / 425

U.S. postwar data, future long rates tend to rise when short rates are above long rates. Since the
expectations hypothesis would predict that long rates tend to fall, the theory often does worse
than even the naive model that future interest rate changes are always zero.‖
Froot (1989, p. 283)

As it relates to bills, notes, and bonds (i.e., across the term structure), the EH is the notion that
forward prices are unbiased estimates of expected future spot prices. Its original specification (as
laid out by Lutz (1940, p. 37), who in turn referenced Hicks (1939) and Fisher (1896) before
him) implies that ―the long-term rate as a sort of average of the future short-term rates.‖
Minimally, the risk-free or government spot rate curve is shaped by risk-free or government
bond market expectations about future nominal interest rates. Therefore, an upward sloping
curve generally suggests that that particular bond market expects that rates will be increasing, vs.
a flat curve where the market generally expects rates to stay the same, vs. a downward sloping
curve where the market generally expects rates to be declining.
340


So why have a theory when very little evidence seems to support it? Because, in the land of
normative theory, if you torture the data and/or theory enough something good will come of it, or
at least it seems to warrant publishing. Chance and Rich (2001) correctly point out that two
issues/arguments render the theory incorrect: (1) if bond investors are risk-averse (i.e., not risk-

340
We could also call this the Pure Expectations Hypothesis or Theory of interest rates (―PEH‖ or ―PET‖, also
known as the Unbiased Expectations Hypothesis – ―UEH‖), but I find it more useful to stay focused on the more
general point concerning biased expectations rather than making refined mathematical or tautological points.
Therefore, let‘s just stick with the EH and the more general notion of the shape of a term structure or yield curve
generally reflecting expectations about future rates and the arbitrage argument contained therein.
Kihn / Behavioral Finance 101 / 426

neutral as per the theory)
341
, and (2) the theory should incorporate a storage and/or cost of carry
component.
342
They correctly note that (Chance and Rich (2001, p. 84)): ―Arbitrage provides the
linkage between spot and forward prices so that there is no more information in forward prices
than in spot prices. Indeed, ..., there is precisely the same information in spot prices as in forward
prices. Therefore, why would anyone look to the forward market any more than the spot market
for a prediction of future spot prices?‖ To that I say, indeed. Thus, why concern ourselves with
biased forward rates when spot rates show approximately the same thing? Therefore, I‘ll take it
one small step further and state, that for our purposes it is sufficient to show that the yield curve
itself is a biased predictor.
343


Therefore, ultimately the EH comes down to the basic question of whether government yield
curves display bias in such a way as to suggest that bond market participants err in a systematic
way, if at all. There are many fine details and the evidence can be mixed, largely due to various
statistical methods, datasets, etc., yet the vast majority empirically reject the EH. Here is a partial
list of those generally rejecting the EH: Frankel and Froot (1987), Fama and Bliss (1987),
Campbell and Shiller (1991), Bekaert et al. (1997), Bekaert and Hodrick (2001), Clarida et al.
(2006), Sarno et al. (2007), and Della Corte et al. (2008). There is one notable exception to

341
Campbell (1986, p. 183) notes ―that differences among expectations theories are second-order effects of bond
yield variability.‖
342
For me, for example, I am most worried about things like equating ‗risk-free‘ rates with government securities
that can be defaulted upon. I never cease to be amazed at academic focus on what seem to me to be ‗academic‘
issues, while the fundamental driver(s) is/are largely ignored.
343
Actually, Longstaff (2000a) makes it simple. Longstaff (2000a, p. 989) ―shows that all traditional forms of the
expectations hypothesis can be consistent with the absence of arbitrage if markets are incomplete. A key implication
is that the validity of the expectations hypothesis is purely an empirical issue; the expectations hypothesis cannot be
ruled out on a priori theoretical grounds.‖ In other words, it isn‘t theoretical and/or mathematical issues that matter,
it is the extent to which empirically/descriptively yields of different maturities are related, and if so, in what way(s).
Thus, the other arguments are probably ―much ado about nothing‖.
Kihn / Behavioral Finance 101 / 427

rejection, Longstaff (2000b) finds that repo rates from overnight to three months do not reject the
EH
344
; although, based on the same updated dataset and using a different method, Della Corte et
al. (2008) reject the EH. All in all, the EH has been rejected across the term structure, in many
different countries, and with many different tests. One could say it has been one of the most
rejected hypotheses in finance.

Therefore, the question isn‘t so much as to whether it is rejected, but why? Whenever an EMT
proponent feels threatened he or she will often respond that rejection of a favored hypothesis
must be due to ‗time-varying-risk-premiums‘. With respect to the EH this seems an unlikely
explanation and is not supported empirically (e.g., see Frankel and Froot (1987)). My guess is
that it may have something to do with limits to arbitrage and/or psychology, and what evidence
there is seems to support that notion.

For example, according to the EMH there should be no excess returns available, not for any
maturity. Froot (1989) finds support for the notion that the expectational bias is at least in part
due to underreaction of future expected long rates to changes in the short rate. These prediction
errors at least suggest profit making opportunities. Again, and as stressed by Shafir et al. (1997),
it isn‘t that people don‘t understand real vs. nominal, but framing in nominal terms is more
natural. Furthermore, it is not that people don‘t learn, it‘s that they may learn very slowly. The
fact that there is a strong tendency for the forecast error to be predictable doesn‘t necessarily
connect it directly to the failure of the EH, but it is suggestive.

344
Actually, Longstaff (2000b, p. 397) states they are ―almost unbiased‖. Regardless, the results are in contrast to
the many studies before it.
Kihn / Behavioral Finance 101 / 428


De Bondt and Bange (1992) made a study of the yield curve and expectations about inflation.
They found that the forecast error has a ―strong predictable component‖ that tends to be during
periods of increasing inflation and during periods of decreasing inflation. This is supported by
other studies showing forecastable inflation that is largely not accounted for (see Barsky and De
Long (1988)). That is, De Bondt and Bange found an ―underreaction phenomenon.‖ It appears
investors put too much weight on historical rates, possibly excessively anchoring on them. This
seems to be a primary driver of the cause of the EH failure. Thus, what seems to be causing the
EH failure is at least in part due to inflation forecasting bias, which in turn is likely driven by
inflation illusion. Specifically, here are some of the key findings:
- Confirming past research, there isn‘t a one for one change in nominal rates relative to
changes in expected inflation as normative theory would suggest.
- There is a tendency for inflation forecasts to be predictably too high during periods of
declining inflation, and too low during periods of increasing inflation.
- The slope of the yield curve is predictive of the error/bias. Therefore, by historical
standards, when the slope is steep investors tend to make too high an inflation forecast vs.
when the slope is relatively flat the tendency is to make too low an inflation forecast.
- When the twelve-month-ahead inflation forecast exceeded the six-month-ahead forecast,
investors subsequently earned positive abnormal returns by holding long-term bonds.
Therefore, excess returns are forecastable off inflation misjudgment.
- ―The surveys give too much weight to inflation in the distant past, relative to recent past
inflation.‖ De Bondt and Bange (1992, p. 485) It appears to be excessive anchoring.
Kihn / Behavioral Finance 101 / 429

- ―Expectations are insufficiently adaptive: if the economists paid more attention to recent
inflation, and interpreted the prevailing rate as less of a surprise, they would not make the
same error repeatedly.‖ De Bondt and Bange (1992, p. 485)
- ―The expectations theory and investor rationality imply that, when long-term rates are
above short-term rates, long rates ought to rise. Correcting for the term premia, the
resulting capital loss equates expected holding period returns across assets. Similarly,
when long rates are below short rates, long rates ought to fall. However, in practice, the
opposite tends to happen. As seen in Table 5 (Panel A), the more the term structure is
upward-sloping, the more long-duration instruments outperform bills.‖ De Bondt and
Bange (1992, p. 489)
- ―The third and perhaps most noteworthy implication is that past survey errors—which get
repeated and predict the spread—also predict ex post term premia.‖ De Bondt and Bange
(1992, p. 491)
- ―This result suggests potentially profitable bond trading strategies.‖ De Bondt and Bange
(1992, p. 492)
- ―From the above discussion, we conclude that movements in term premia are partly
driven by inflation forecast errors. Interestingly, however, the yield spread does not lose
all its predictive power if past inflation forecast errors are taken into account.‖ De Bondt
and Bange (1992, p. 493)
- ―Thus, contrary to intuition, if the yield spread is a risk proxy, it would appear that long-
term instruments are less risky when inflation uncertainty is high.‖ De Bondt and Bange
(1992, p. 493)
Kihn / Behavioral Finance 101 / 430

- ―As with bonds, the stock market risk premium is not explained by inflation uncertainty.‖
De Bondt and Bange (1992, p. 494)
- ―Apparently, past inflation forecast errors predict future forecast errors in surveys, predict
future movements in real rates, and predict term premia on U.S. Government Bonds.
Even though the inflation forecasts fail standard rationality tests, movements in the yield
spread strongly reflect their variation through time.‖ De Bondt and Bange (1992, p. 494)
Overall, the results paint a picture of underreaction and forecastability. For example, when the
term structure is sloped more steeply than average, inflation forecasts are too high. In addition,
past inflation forecasting errors are positively correlated with future excess returns. Thus,
overall, the actual government yield curve and/or term structure over time doesn‘t represent the
world of efficient markets in the textbook sense.

Kihn / Behavioral Finance 101 / 431

BIASED EXCHANGE RATE EXPECTATIONS OR NOT – EXCHANGE RATES & THE
FORWARD DISCOUNT BIAS (OR TWO WRONGS DON‘T MAKE IT RIGHT)
Many of the tests of the EH are also tests of unbiased currency expectations (e.g., Frankel and
Froot (1987)). There is a clear linkage between the bond markets and exchange rate market both
theoretically and in practice. For example, there is a strong link (i.e., post Brettan Woods
dissolution during the early 1970s) between the relative real short rates between two countries
and their respective exchange rate (i.e., the short interest rates of two currency areas at least in
part seem to determine the exchange rate between them).

Although not reviewed here, I encourage the reader to read up on the background material for
exchange rate determination, both normative and descriptive. For example, the interest parity
condition emanates from the observation that the domestic interest rate must equal the foreign
interest rate plus (minus) the expected appreciation (depreciation) in the foreign currency (i.e.,
based on basic arbitrage conditions holding). Interest parity in turn is contingent on the
Purchasing Power Parity theory (―PPP‖) that states that exchange rates between any two
countries will adjust to reflect changes in the price levels of the two countries, which is simply an
application of the LOOP. Even though some goods are not traded across borders, LOOP rests on
the assumption that all good are identical in both countries and that transportation costs and trade
barriers are not significant. Forward discounts for an exchange rate between two currencies are
normatively supposed to represent unbiased forecasts of future exchange rate changes.
Descriptively they seem not to be (e.g., Froot and Frankel (1989)).

Kihn / Behavioral Finance 101 / 432

The equivalent of tests of the EH for exchange rates are tests of the ‗forward discount bias‘.
Specifically, is the forward discount an ―unbiased‖ predictor of the future changes in the spot
exchange rate? Given PPP, relative inflation is the expected and likely driver of exchange rates
and furthermore the likely driver of any bias. Much like the tests of the EH, most empirical tests
of the unbiasedness hypothesis reject it. This has left the more refined question of whether this
bias is evidence of a risk premium or a violation of rational expectations (or both, or neither)?

One of the most popular tests of forward market unbiasedness is a regression of the future
change in the spot rate (i.e., the actual realized change) on the forward discount (i.e., today‘s
forecast, of sorts). It seems that there descriptively is a bias in the systematic component of
exchange rate changes in excess of the forward discount. Essentially, if you assume risk
neutrality, then the empirical evidence violates rational expectations. The essential questions
reduce down to: Which is it, expectational errors or the EMH/EMT standby excuse of a time-
varying risk premium being responsible for repeatedly biased forecasts of the forward discount,
let alone the issue of whether the risk premium is more variable than expected depreciation?

Froot and Frankel (1989, p. 151) provide a helful visual into some key issues associated with the
forward disocunt bias.

Kihn / Behavioral Finance 101 / 433


Source: Froot and Frankel (1989, p. 151).

The focus here is on the so called ―risk premium‖ being able to explain the forward rate error. It
doesn‘t. As you can see, as the error moves the risk premium doesn‘t seem to change much. This
should be especially disconcerting normatively because the forward rate errors are smoothed.
Therefore, relative to the errors, the risk premium is a relative constant. Some highlighted Froot
and Frankel (1989) results are:
1. Primary finding: ―the systematic portion of forward discount prediction errors does not
capture time-varying risk premium.‖
Kihn / Behavioral Finance 101 / 434

2. Reject the hypothesis that none of the bias is due to systematic expectational errors.
3. Cannot reject the hypothesis that all of the bias is due to systematic expectational errors,
or the hypothesis that none is due to a time-varying risk premium.
4. (2) + (3) imply that changes in the forward discount reflect changes in expected
depreciation (on a one-for-one basis).
5. Reject the hypothesis that the variance of the risk premium is greater than the variance of
expected depreciation (seems to be vise versa).
6. The risk premium does not vary with the forward discount (i.e., it doesn‘t vary much at
all, and cannot reject the hypothesis that it is constant).
Since the risk-premium isn‘t the driver (i.e., causality doesn‘t run through it), and the risk-
premium plus depreciation equals the forward discount, then changes in depreciation translate
one-for-one into changes of the forward discount. Given that the forward discount is biased, this
implies that whatever drives the expected discount is driving the bias. Overall, the findings imply
that currency traders have a tendency to underreact. Much like the a domestic bond market, when
it comes to currency exchange rates we likely have inflation illusion induced underreaction
except that for exchange rates the bias is compounded by the fact we are dealing with two
markets not one (or one set of markets), with similar bias dynamics likely happening in each one.
Again, as with individual bond markets, excessive anchoring may be the culprit or possibly a
piece of the puzzle.

Kihn / Behavioral Finance 101 / 435

A FEW FINAL THOUGHTS ON INFLATION AND FINANCE ILLUSIONS
An alternative title for this chapter could have been ―probable underreaction to changes in the
rate of inflation‖. Stocks, real estate, bonds, and exchange rates all seem to show some normative
underreaction. The cause of the underreaction is uncertain, but then again what is certain? It is
plausible, if not likely, that biased expectations and inflation are driving forces.

Oddly, that is from a normative perspective, all can be traced to an inflation illusion of some
kind. This should not be descriptively surprising. Given that finance is fundamentally concerned
with discounted present values, and discount rates are influenced by the ‗risk-free‘ rate; then, it
should be of some normative concern if inflation is not quickly and correctly being incorporated
into the discount rate. For stocks and real estate, the fact that their values tend to move as biased
inflation expectations underreact. For bonds, to the extent the yield curve or term structure of
interest rates is relatively steeply sloped foreshadows a higher likelihood of nominal rates
moving down, not up as expected. For exchange rates, the implied discount of the expected
depreciating currency tends not to show up, or show up to the extent expected. In each case the
biased expectations can at least in part be traced to or influenced by actual and/or expected
inflation.

Why do agents in the financial markets tend toward an inflation illusion? I began the chapter
with a brief discussion on the ‗money illusion‘, and that is as good an explanation as any. In
short, it‘s not that we cannot think in real and nominal terms, it‘s just that it‘s not typically
framed that way, and we may have a strong tendency to anchor as well. Also, and especially
Kihn / Behavioral Finance 101 / 436

among non-economists, we do not like inflation and tend to associate it with a lower standard of
living, loss of morale, damage to national prestige, etc. (see Shiller (1996)). Therefore, there is a
visceral dislike of inflation among many that may, at least in part, explain investors‘ tendency to
discount most values nominally, even those real values that do not deserve it.

Finally, much like overreaction and underreaction, illusions is a classic topic for this book
because it demonstrates the following principals:
(1) The markets are ‗inefficient‘ in the traditional finance textbook sense of the term.
(2) Market participants almost assuredly are acting in ‗irrational‘ ways in order to
cause these types of effects. That is, the psychology piece of behavioral finance
seems obvious in these cases, although hard to prove.
(3) Although there appears to be a ‗free lunches‘ (i.e., as defined traditionally by
normative textbook finance), because textbook finance doesn‘t account for: (A)
realistic costs (e.g., transaction costs, taxes, brokerage costs, etc.), and (B)
realistic risk and/or characteristics, there may not be a ‗free lunch‘ after all. That
is, the limits to arbitrage part of behavioral finance seems obvious in these cases.
(4) It is also relatively clear that you can have inefficiency, yet little or no, for
example, ‗cancelation‘ (e.g., exchange rates).
Again, those are four common themes of this book and they all come together in this chapter.

Kihn / Behavioral Finance 101 / 437

REFERENCES
Asness, C., ―Fight the Fed Model‖, Journal of Portfolio Management, Volume 30, Issue 1, Fall
2003, 11-24.

Barsky, R., and B. De Long, ―Forecasting Pre-World War I Inflation: The Fisher Effect
Revisited‖, NBER Working Paper Series, Working Paper No. 2784, December 1988, 1-44.

Bekaert, G., and E. Engstrom, ―Inflation and the Stock Market: Understanding the ‗Fed Model‘‖,
Working Paper, September 2008, 1-35.

Bekaert, G., and R. Hodrick, ―Expectations Hypothesis Tests‖, Journal of Finance, Papers and
Proceedings of the Sixty-First Annual Meeting of the American Finance Association, New
Orleans, Louisiana, January 5-7, 2001, Volume 56, Number 4, August 2001, 1357-1394.

Bekaert, G., Hodrick, R., and D. Marshall, ―On biases in tests of the expectations hypothesis of
the term structure of interest rates‖, Journal of Financial Economics, Volume 44, Issue 3, June
1997, 309-348.

Boucher, C., ―Stock prices-inflation puzzle and the predictability of stock market returns‖,
Economic Letters, Volume 90, Issue 2, February 2006, 205-212.

Kihn / Behavioral Finance 101 / 438

Campbell, J., ―A Defense of Traditional Hypotheses about the Term Structure of Interest Rates‖,
Journal of Finance, Volume 41, Number 1, March 1986, 183-193.

Campbell, J., and R. Shiller, ―Yield Spreads and Interest Rate Movements: A Bird‘s Eye View‖,
Review of Economic Studies Ltd., Special Issue: The Econometrics of Financial Markets,
Volume 58, Number 3, May 1991, 495-514.

Campbell, J., and T. Vuolteenaho, ―Inflation Illusion and Stock Prices‖, American Economic
Review, Volume 94, Issue 2, May 2004, 19-23.

Chance, D., and D. Rich, ―The False Teachings of the Unbiased Expectations Hypothesis‖,
Journal of Portfolio Management, Volume 27, Issue 4, Summer 2001, 83-95.

Clarida, R., Sarno, L., Taylor, M., and G. Valente, ―The Role of Asymmetries and Regime Shifts
in the Term Structure of Interest Rates‖, Journa of Business, Volume 79, Issue 3, May 2006,
1193-1224.

De Bondt, W., and M. Bange, ―Inflation Forecast Errors and Time Variation in Term Premia‖,
Journal of Financial and Quantitative Analysis, Volume 27, Issue 4, December 1992, 479-496.

Kihn / Behavioral Finance 101 / 439

Della Corte, P., Sano, L., and D. Thornton, ―The expectations hypothesis of the term structure of
very-short term rates: Statistical tests and economic value‖, Journal of Financial Economics,
Volume 89, Issue 1, July 2008, 158-174.

Fama, E., and R. Bliss, ―The Information in Long-Maturity Forward Rates‖, American Economic
Review, Volume 77, Number 4, September 1987, 680-692.

Fama, E., and G. Schwert, ―Asset Returns and Inflation‖, Journal of Financial Economics,
Volume 5, Issue 2, November 1977, 115-146.

Feinman, J., ―Inflation Illusion and the (Mis)Pricing of Assets and Liabilities‖, Journal of
Investing, Volume 14, Issue 2, Summer 2005, 29-36.

Fisher, Irving, Appreciation and Interest, Macmillian, New York, New York, 1896.

Frankel, J., and K. Froot, ―Using Survey Data to Test Standard Propositions Regarding Exchange
Rate Expectations‖, American Economic Review, Volume 77, Number 1, March 1987, 133-153.

Froot, K., ―New Hope for the Expectation Hypothesis of the Term Structure of Interest Rates‖,
Journal of Finance, Volume 44, Number 2, June 1989, 283-305.

Kihn / Behavioral Finance 101 / 440

Froot, K., and J. Frankel, ―Forward Discount Bias: Is it an Exchange Rate Premium?‖, Quarterly
Journal of Economics, Volume 104, Number 1, February 1989, 139-161.

Hicks, John, Value and Capital, Oxford University Press, London, England, 1939.

Longstaff, F., ―Arbitrage and the Expectations Hypothesis‖, Journal of Finance, Volume 55,
Number 2, April 2000a, 989-994.

Longstaff, F., ―The term structure of very short-term rates: New evidence for the expectations
hypothesis‖, Journal of Financial Economics, Volume 58, Issue 3, December 2000b, 397-415.

Lutz, F., ―The Structure of Interest Rates‖, Quarterly Journal of Economics, Volume 55, Number
1, November 1940, 36-63.

Modigliani, F., and R. Cohn, ―Inflation, Rational Valuation and the Market‖, Financial Analysts
Journal, Volume 35, Number 2, March/April 1979, 24-44.

Ritter, J., and R. Warr, ―The Decline of Inflation and the Bull Market of 1982-1999‖, Journal of
Financial and Quantitative Analysis, Volume 37, Issue 1, March 2002, 29-61.

Kihn / Behavioral Finance 101 / 441

Sarno, L., Thornton, D., and G. Valente, ―The Empirical Failure of the Expectations Hypothesis
of the Term Structure of Bond Yields‖, Journal of Financial and Quantitative Analysis, Volume
42, Number 1, March 2007, 81-100.

Shafir, E., Diamond, P., and A. Tversky, ―Money Illusion‖, Quarterly Journal of Economics,
Volume 112, Issue 2, In Memory of Amos Tversky (1937-1996), May 1997, 341-372.

Shiller, R., ―Why Do People Dislike Inflation?‖, NBER Working Paper Series, Working Paper
5539, Cambridge, Massachusetts, April 1996, 1-75.





Kihn / Behavioral Finance 101 / 442

Chapter 13: Descriptive theories in finance

Up to this point, we have discussed at least two descriptive finance theories and their associated
hypotheses, namely one-half of the MCH (the other part relates to leverage) and SAD. Besides
those two, there are others. Some of the notable ones are:
1. Lee et al. (1991) on CEFs. and
2. Kahneman and Tversky‘s (1979) prospect theory (―PT‖).
These are good examples of analyzing what actually happens in the financial markets, and then
based on that hopefully objective analysis
345
backing out a theory and/or hypotheses from what is
the descriptive reality of one or more financial markets. These descriptive theories are in direct
contrast to most textbook theories in finance and economics (e.g., the CAPM and Modigliani-
Miller), that is at least until recently.

Thus, I will review four solid descriptive finance theories on:
1. ‗inflation illusion‘ and stock prices,
2. expected utility theory (i.e., a behavioral alternative to),
3. CEFs, and
4. SAD and stock prices.
I find it a useful exercise to review some theories and associated hypotheses that seem to provide
a superior alternative to the largely normative theories and unfalsifiable hypotheses that occupy
most textbooks on the subject of finance. Of course, this is not a complete list, but at the time of

345
Remember, the EMH and EMT could be considered a descriptive theory that was not based on an objective
analysis of the facts (e.g., counter evidence was ignored, or worse, purposely hidden).
Kihn / Behavioral Finance 101 / 443

this book‘s writing they represent some of the better theories and associated testable hypotheses.
In short, and unlike the EMH/EMT, they are falsifiable and have not been rejected at the time of
this writing.

A TEMPLATE FOR DESCRIPTIVE FINANCIAL MARKETS HYPOTHESES
Although no template exists for descriptive financial market theories it seems rather likely that
there is a critical path, of sorts, that one would go through to develop such theories and related
hypotheses. That template might take the form:
1
st
Identify the seeming unusual pricing behavior to be explained; and identify the market or
markets it seems to impact, and any timing issues associated with the phenomena.
2
nd
Propose a theory that parsimoniously addresses as many of the phenomena as possible (ala
Occam‘s razor), hopefully all. Obviously, try not to make any unrealistic assumptions.
3
rd
Create one or more testable hypothesis; and test (i.e., apply standard western scientific
methods).
Kihn / Behavioral Finance 101 / 444

There is nothing special about such a path toward developing a theory and/or hypotheses, but it
seems at least somewhat incongruously unusual for ‗modern finance‘ and economics, at least as
of today.

MODIGLIANI-COHN THEORY & RELATED HYPOTHESES
In the chapter mostly concerned with inflation illusion, the Modigliani-Cohn (1979) Hypothesis
(―MCH‖) was introduced as an explanation for the seemingly odd way equities are valued as
inflation has waxed and wanned, in the U.S. in particular. Normative theory demands that real
returns should be unaffected by inflation, yet they appear to be affected by inflation. Again, it
was recognized that equity valuation seemed to be affected by ‗money illusion‘ when it should
not be affected by it. That is, it was this possibility of ‗money illusion‘ affecting pricing and its
impact on the equity markets that was of interest to the authors who wrote the article. One
combined quote from them is telling:
―The reader may ask: ‗Is it credible that investors have systematically undervalued equity values
for at least a decade, and are still undervaluing them by as much as 50 per cent, solely as the
Kihn / Behavioral Finance 101 / 445

result of the mistakes suggested by your analysis?‘ ... we readily admit that our conclusion is
indeed hard to swallow – and especially hard for those of us who have been preaching the gospel
of efficient markets. ... when the hypothesis first crossed the mind of the senior author some four
years ago, it was lightly dismissed as too preposterous to be entertained seriously. But over the
ensuing three years that hypothesis continued to provide the only seemingly useful clue to
market performance, and we finally succumbed to the temptation of undertaking the systematic
tests reported in this article.‖
―Confronted with overwhelming statistical evidence consistent with our error hypothesis, and no
direct evidence inconsistent with it, our original skepticism turned into a degree of confidence
approaching belief – and certainly high enough to justify placing our findings before the public.‖
Modigliani and Cohn (1979, p. 35, p. 36)

In other words, even they didn‘t believe their own basic conclusion as to causation, largely
because it went against the efficient market doctrine. Also, remember this was back in the mid-
1970s when they were kicking this theory around. Therefore, given the timing, and probably
unbeknownst to them, they may have developed one of the first truely descriptive behavioral
finance theories.

Regarding the theory itself, MC hypothesize that inflation causes investors to make two major
errors in pricing common stocks (Modigliani and Cohn (1979, p. 24)):
Kihn / Behavioral Finance 101 / 446

1. ―First, in inflationary periods, investors capitalize equity earnings at a rate that parallels
the nominal interest rate, rather than the economically correct real rate – the nominal rate
less the inflation premium.‖
2. ―Second, investors fail to allow for the gain to shareholders accruing from depreciation in
the real value of nominal corporate liabilities.‖
In other words, investors are hypothesized to: (1) discount real equity earnings by nominal rates,
and (2) largely ignore the impact of leverage. We have thus far focused on the first error.
Regarding the possibility of error related to improperly (i.e., from a normative perspective), for
example, accounting for inflation‘s impact on debt, Ritter and Warr (2002) do indeed find strong
support for the second hypothesis. They find that levered stocks are more undervalued than less
levered stocks during inflationary times and more overvalued during less inflationary times.
Therefore, both hypotheses receive strong support and continue to reflect what is observed in the
actual financial markets. Unlike the EMH or even the CAPM, this is a theory that has seemed to
grow stronger with testing over time.

Kihn / Behavioral Finance 101 / 447


Source of data: Federal Reserve Bank of St, Louis (FRED) – September 27, 2009 download, and Pinnacle Data for
the S&P 500 return series.

The above graph plots the rolling three-year covariance of two discount scenario series (real and
nominal) against S&P 500 quarterly returns (3-month returns). The values being discounted are
derived from a series that comes from the government called ―CPATAX‖ or ―Corporate Profits
After Tax with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment
(CCAdj)‖. In other words, these values are supposed to represent a version of all corporate cash
flows after taxes and adjusting for most non-cash depreciation. What I have done is to discount
CPATAX by my approximate version of a real and nominal rate with a duration derived from the
dividend yield of the S&P 500 index itself. The nominal rate is the ‗generic‘ 10-year Treasury
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Do Stock Investors Tend to use Nominal or Real Discount Rates for Real Cash Flows?
March-1957 through June-2008
CPATAX/Real
CPATAX/Nominal
10yrTrs
Kihn / Behavioral Finance 101 / 448

yield, while the real rate is the generic 10-year Treasury yield less the realized one year SGS CPI
inflation rate. Therefore, to arrive at a real rate of +5% would require that, for example, a
nominal 10-year rate of 10% is netted against actual measured CPI inflation of +5% for that date.
The nominal 10-year Treasury yields are shown by the blue line and are plotted against the right
side vertical axis. The other two lines represent the rolling three-year covariance of the CPATAX
discounted by the real rate (shown by the red line) and the CPATAX discounted by the nominal
rate (shown by the light green line). The important part to visualize is that any significant
movement away from zero by either the green or blue lines shows significant implied valuation
of the U.S. stock market (i.e., in this case proxied by the S&P 500) as either driven by real (i.e.,
the red line) or nominal discounting (i.e., the green line). What the reader will note is that only
the green line really shows any of these types of periods, and predominantly during very high or
very low nominal interest rate periods. In fact, the actual correlation (and yes, correlation, or in
this case covariance, does not mean causation, but here it is certainly suggestive) between the
S&P 500 return and the CPATAX real and CPATAX nominal is about -4% and +38%,
respectively. In other words, given the methodology, real discounting is statistically insignificant
but nominal discounting is highly significant. Therefore, at least in this example, even though
investors are normatively supposed to use a real discount rate, they instead seem to wrongly use
a nominal one (again, wrongly from a normative perspective).

Also, in addition, and although not directly intended to address real estate valuation or bonds,
this theory seems to apply directly or indirectly to those asset classes as well. Again, as
mentioned, Feinman (2005, p. 35) notes that at least one could argue that the first hypothesis
Kihn / Behavioral Finance 101 / 449

could be applied analogously to real estate where rental income can be imputed. In addition,
Miller and Shulman (1999, p. 45) state: ―in the presence of ‗money illusion‘ the correlation
between stock and bond returns will be abnormally high during periods of high inflation.‖
Therefore, another possible asset class affected via a potentially similar inflation illusion
mechanism, bond prices are likely more directly linked to stock prices as inflation increases.
346

Overall, any theory like the MCH that is largely explained by ‗money illusion‘ will likely go
beyond normative mistakes in just equity valuation.

CLOSED-END FUNDS (―CEFS‖), AND IPO SIMILARITIES
Up until around the early 1990s, CEFs had puzzled normative finance academics. Specifically,
and not all being equally as important, there are roughly four factual parts of the ―closed-end
puzzle‖ and their related questions:
1. At IPO they are sold with a large commission (about 7%) at a premium (of about 5%),
then they under-perform over the short-run (by about 5% over the next 20 days), after

346
Although, one could argue that biased interest rate expectations already covers this likelihood.
Kihn / Behavioral Finance 101 / 450

which they then under-perform more (by a total of about 10% over the 120 days
following the offering – all toll, a grand total under-performance of about 25%) (see
Weiss (1989) on stock funds). Why do people buy them, and who are these people?
2. CEFs tend to trade at substantial discounts to their NAVs (e.g., around 10% or more
historically for many stock funds).
347
Why aren‘t prices equal to their NAVs?
3. Discounts fluctuate greatly (even among groupings of funds), but they tend to co-vary
with other CEFs, and tend to shrink in January, but not for the stocks they own (see
Brauer and Chang (1990)). Why do they vary so much, and why don‘t they vary so
much?
4. When ―opened‖ the discount goes away. Why aren‘t they opened more often; and why do
some argue NAVs are mispriced, or aren‘t even the correct pricing formula?
Overall, CEFs seem to be a normative mess. There may be four general issues related to them,
but more than four questions associated with those general issues.

As a reminder, I selected a relatively recent ―hot‖ CEF in the energy area as a backdrop to basic
CEFs issues:


347
Pontiff (1995, p. 341) states: ―fund premia are negatively correlated with future returns. Funds with 20%
discounts have expected twelve-month returns that are 6% greater than nondiscounted funds. ... Economically
motivated explanations do not account for this effect.‖ In short, basic mean-reversion with little or no economic
basis drives significant excess returns.
Kihn / Behavioral Finance 101 / 451


Source: Data from www.etfconnect.com/.

As the reader can see, this energy stock CEF began at a premium of about 7%, then quickly went
toward discount, then several times crossed over to premium territory, then more recently to end
this graph at a discount of about 30% (i.e., an approximate average daily discount of 30% for the
month of September 2009). Again, normatively it is never supposed to deviate from the zero line.

In 1991 an article was published by Lee et al. (1991) that suggested there might be a reason for
the four ‗puzzles‘ surrounding CEFs. Their theory was called ‗investor sentiment‘, and they
posited that the underlying cause of all of these puzzles was individual investor sentiment. One
could call it a form of ‗noise trader‘ or irrational trader risk. In general, when individual investors
were excited about an asset class they tended to overdo it; one could even say they overreacted.
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Kihn / Behavioral Finance 101 / 452

For example, say if individual investors are excited about technology stocks, then the theory
would expect to see more technology share related CEFs be issued at premiums, and as that
positive sentiment eventually ebbed, then overall premiums would turn to discounts, etc.
Additionally, as more or fewer individual investors increased their holdings relative to
institutional investors you would expect discounts to shrink or expand accordingly. Thus, NAVs
are the correct pricing model, but investor ‗sentiment‘ will drive prices above and below NAV as
sentiment waxes and wanes, or until the CEF is opened and values converge to the NAV.
Consider this theory to emphasize irrational traders (often called ‗noise‘ traders), but in this case
the irrational traders are primarily individual investors.

Lee et al. (1991) actually checked to see if their theory fit the facts. Regarding CEF IPOs, they
found that CEF IPOs tend to happen when CEFs are generally selling at a premium
348
(i.e., a
strong negative relationship between discounts and CEF IPO activity), especially based on
historical standards. Also, and as Weiss (1989) found, about 3/4
ths
of equity CEF IPOs are
purchased by individuals, with the remainder held by institutions at the offering. Regarding their
primary thesis (i.e., small investor sentiment drives the premiums and discounts), indeed they
found evidence consistent with the investor sentiment theory. Specifically, discounts on closed-
end stock funds narrow when small stocks do well, which is in contrast to the largest stocks. As
Lee et al. (1991, p. 75) summarize the basic conclusion of the study: ―The evidence supports
these predictions. In particular, we find that both closed-end funds and small stocks tend to be

348
Specific types of CEFs clearly have periods when IPOs are high and correspondingly their premiums are at
historic highs.
Kihn / Behavioral Finance 101 / 453

held by individual investors, and that the discounts on closed-end funds narrow when small
stocks do well.‖

Lee et al. (1991) results can be summarized as:
- With respect to the discount, individual investor sentiment matters. That is, discounts are
high when investors are pessimistic and low (or even negative) when they are optimistic.
- Sentiment risk is connected with holding CEFs. This same sentiment is widespread
enough to affect small stocks primarily held by individual investors as well.
- By extension, discounts can be considered a proxy for the small stock premium
associated with small stocks and/or stocks held primarily by individual investors.
- Findings imply relatively risk-free arbitrage opportunities (e.g., also see Brauer (1988)).
Overall, there is strong support for the theory that has probably grown since it was first proposed.

How did the theory do, or did it explain the four general issues? Regarding the first
Three issues, the answers are yes, yes, and yes. Lee et al. (1991) didn‘t directly address issue #4
on opening CEFs, but see Brauer (1984) or Brickley and Schallheim (1985) for any doubts on
that issue (i.e., CEF market prices converge to NAV when opened, actually they begin to
converge well before formal opening). In fact, the Lee et al. (1991) investor sentiment theory did
such a good job, that it seems that their overall results are accepted as true. Therefore, at the
time, it would seem that it is largely accepted as explaining most of what were viewed as
puzzles.

Kihn / Behavioral Finance 101 / 454

Additionally, from research on CEFs flow several pieces of prescriptive advice:
1. Don‘t buy CEF IPOs.
2. Wait until they are selling at a discount, then make sure they are selling at a historically
low discount to NAV (or else just avoid them, i.e., especially if they are trading at a
premium).
3. When buying or selling, try to find the lowest brokerage commissions (although, this is
generally true).
4. Avoid purchases around January (especially for small stock funds).
5. Avoid trendy asset classes (i.e., unless you are shorting them).
6. If you can, try to buy at a deep discount and open the fund up.
Normative finance theory doesn‘t have much to say about CEFs, but descriptive evidence and
theory can.

Finally, and I would be remiss without acknowledging the similarity between IPOs and CEFs.
CEFs and equity IPOs are directly related. CEFs have an equity IPO which mirrors traditional
IPOs (i.e., initial underpricing and longer term overpricing). This is the key and they are very
much alike with respect to two of the puzzles (i.e., apparent initial overreaction and longer-run
underperfromance/underreaction), but in the case of standard equity IPOs there isn‘t an explicit
premium or discount to look at. This is too bad and due to the lack of an agreed upon pricing
formula for regular IPOs descriptive theoretical work has been relatively slow and messy.
Therefore, with IPOs we must assume a pricing model applies when we don‘t have one that
Kihn / Behavioral Finance 101 / 455

applies (i.e., that academics can agree on). But after that assumption we generally come up with
two implicit issues/puzzles (and one based on the first two) vs. four explicit puzzles for CEFs.

Essentially there are two or three phenomena associated with IPOs:
1. short-term initial under-pricing and/or outperformance/overreaction (and in many cases a
‗hot-issue‘ market), followed by
2. long-term underperformance or implied overpricing with longer term underreaction
349
,
and possibly
3. the time varying, and possibly other characteristics, nature of #1 and #2 (i.e., the degree
of initial underpricing and eventual underperformance can vary greatly from time to time
and group to group of IPOs). Therefore, choice of sample period and sample group can
greatly impact how much, how long, and how strong the effects for #1 & #2 occur or
are.
350

Therefore, the initial price is generally set too low, then subsequently goes too high, and finally
over what typically takes several years drifts back down in relative price.

In addition, it should be mentioned that there are three principal actors or agents involved (which
are the same as that for CEF IPOs): (1) the issuing firm, (2) the underwriter or underwriters, and
(3) investors. Also, remember, CEFs begin life as equity IPOs, hence a direct link between the
two. Traditionally, for example, Loughran and Ritter (1995) find that in the long-run U.S. equity

349
This is unusual in that underreaction tends to be a more short-term proposition. Although maybe not so unusual
in that all misspricings, whether large or small, have to start somewhere.
350
Of course, this could also be noted for CEF IPOs and most other types as well. Actually, it‘s very true of many
phenomoena in finance.
Kihn / Behavioral Finance 101 / 456

IPOs underperform their comparison group on non-IPOs by about 6% per year for five years
after issuing (using a market-cap control, but no other controls).
351
In contrast, Brav and
Gompers (1997) indicate that long-run underperformance is more complicated than generally
indicated by most IPO studies. Specifically, by also matching on market-to-book (i.e., as well as
market-cap) they find that underperformance only occurs in small firms not backed by venture
capitalists.
352
Regardless of exact long-term underperformance mechanics, in effect short-term
investors tend to initially overreact, and then underreact on a more macro basis. Shiller (1988)
suggests that market for IPOs is subject to fads (there is strong evidence for hot markets in
IPOs)
353
, and enhanced by underwriters creating the impression of doing the investor a favor. In
essence, all the actors see and seize a window of opportunity that is cyclical in nature, as well as
possessing a tendency to build over time. Overall, it would seem that the three principal agents
each seem to have shifting motivations (e.g., the regret of missing the ‗hot‘ market). Investors
will bet on trends, overweight the recent past, and are overly optimistic. Issuing firms see a
window of opportunity and appear, at times, almost desperate to find an underwriter and time the
market. Underwriters also see a window of opportunity, but are in a position to play investors off
against issuing firms.


351
Based on U.S. data covering 1970 through 1990, about 5% for new IPOs and about 7% for SEOs, according to
Loughran and Ritter (1995). Note that although a bit different in their initial overpricing characteristics, seasoned
equity offerings are similar in their long-run underperformance characteristics compared to new IPOs.
352
In effect, they pick up on the fact that big underwriters tend to pushing marginal companies at opportune times in
the IPO market cycle. That is, underwriters tend to key on high market-to-book firms that have shown short-run
success, but predictably lack long-term performance.
353
For example, Ritter (1991, p. 3) finds ―substantial variation in the underperformance year-to-year and across
industries.‖ Indeed, certain industries do seem to have ‗hot‘ IPO markets at certain times, then fad away into virtual
obscurity again.
Kihn / Behavioral Finance 101 / 457

Generally, the IPO evidence and theory (normative and descriptive) can be summarized as
follows (see Ritter and Welch (2002)):
- Most IPO empirical results are not stationary (e.g., the degree to which the IPO is initially
underpriced), that is, they vary greatly over time. For example, in the U.S. equity markets
during 1980s the average first-day return was about 7%, then roughly doubled to about
15% during 1990 through 1998, then went to about 65% during the final bubble years of
1999 through 2000 (see Loughran and Ritter (2004))! Also, at different times and places,
there seem to be windows of opportunity for some types of firms but not for others (see,
e.g., Ritter (1991)).
- While initial underpricing of the IPO is a persistent empirical feature of IPOs generally,
the cause is not so clear. The more normative rationale has been asymmetric information.
I tend to agree with the Ritter and Welch (2002, p. 1816) that: ―it is not so much a matter
of which model is right, but more a matter of the relative importance of different models.
Furthermore, one reason can be of more importance for some firms and/or at some
times.‖ Thus, at different times and for different markets the specific cause(s) may be
very different (i.e., as one would expect in behavioral finance).
- While long-run underperformance of IPOs is a persistent feature of IPOs generally, a
primary complicating feature is that most IPOs tend to occur among sets of firms that
tend to have poor long-run performance. Thus, using ‗control‘ non-IPO firms to match
against IPO firms tends to make the effect diminish or go away statistically, yet says little
or nothing about why those types of firms generally tend to underperform after the IPOs
occur for that group of firms possessing similar characteristics (e.g., Internet company
Kihn / Behavioral Finance 101 / 458

IPOs that were issued during 1999 had horrible relative performance over 2000 through
2003).
354

From a behavioral perspective, one of the more interesting issues is the cause for initial
underpricing. For example, Loughran and Ritter (2004, p. 5) find that: ―We attribute much of the
higher underpricing during the bubble period to a changing issuer objective function. We argue
that in the later periods there was less focus on maximizing IPO proceeds due to an increased
emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage
accounts of issuing firm executives created an incentive to seek rather than avoid underwriters
with a reputation for severe underpricing.‖ Thus, at least in the U.S. more recently, a primary
reason for initial underpricing of about one order of magnitude higher than previously (i.e., about
65% vs. 7%) is corruption and/or fraud at least in part seemingly tied to the changing of
incentives and/or incentive structure.


354
This seems to be a fairly common approach of EMH/EMT promoters. It is as if they forget that by pointing out
that one ‗anomaly‘ is subsumed by another larger ‗anomaly‘ that the first somehow will go away. What seems to be
forgotten in apparent rush to discredit one ‗anomaly‘ is that they just showed that the issue is much more widely
distributed that first realized. Thus, not only hasn‘t the ‗anomaly‘ gone way, but it has grown. This issue with
general long-run underperformance of IPOs is just such an example; overreaction being mostly a January
phenomena is probably another.
Kihn / Behavioral Finance 101 / 459


Source: Loughran and Ritter (2004, p. 14).

The preceding graph shows issuance as bars (i.e., ―number of IPOs‖) and average first-day
returns as a line of connected dots. As the above graph shows, there was a special spike in first-
day returns to IPOs issued during 1999 that is rather unique. My guess is that the why of this
spike is certainly not increased competency and more likely linked to increased corruption and
fraud.
355



355
Loughran and Ritter (2002) find that the amount of money ―left on the table‖ during 1990-1998 is, for example,
more than the amount of underwriting fees, or about three years of operating profits. This would seem not only
irrational, but highly odd (i.e., at least from a normative perspective), especially if one cannot assume that a root
cause is at least some form of corruption or fraud. That is, it is hard to imagine the issuer and especially the
underwriter, since it is their primary job to raise funds, could be that incompetent. Loughran and Ritter (2002)
theorize that wrapped up in the initial underpricing is at least in part due to unanticipated wealth increases,
especially for ‗hot IPOs‘. For them, it is a kind of temporary insanity that takes over. I find that a credible link, but
not necessarily the driving cause.
Kihn / Behavioral Finance 101 / 460

PROSPECT THEORY
In 1979 an article was published by Kahneman and Tversky (1979) (or ―KT‖) that may be the
first formal descriptive based theory in economics. The theory was called prospect theory (―PT‖)
and was submitted as a more realistic theory in place of standard expected utility theory
(―EUT‖). EUT was designed to directly address decision making under uncertainty as first
formulated by Bernoulli in 1738 and respecified formally some 200 or more years later by von
Neumann and Morgenstern. Tversky and Kahneman (1992) later followed PT with cumulative
PT or ―CPT‖. For this section I will focus on PT, as CPT is messier and I believe most of the
analytic benefit can be found in PT itself.
356


Compared to the descriptive theories detailed thus far in this chapter (i.e., the MCH and the
‗investor sentiment‘ theory of CEFs), PT is more mathematical. Thus, unlike the others that
provide a general outline of what to expect, this is more detailed in its specification yet injects a
large part of the descriptive reality that is required of any realistic finance theory or hypothesis.
Economics historically has assumed away psychology as a relevant variable in decision making
in general, and decision making under uncertainty specifically. In effect, decision making was
largely ignored in favor of a normative ―black box‖. But we know, for example, that decision
makers (see Olsen (1998, p. 11):
1. Preferences‘ ―tend to be multifaceted, open to change, and often formed only
during the decision process.‖

356
This review is intended to be brief. That is, I am not going to do a full scale proof of PT or CPT. Therefore,
detailed mathematical proofs can be had by reading Kahneman & Tversky (1979) and Tversky & Kahneman (1992).
In addition, because it is not a normative theory and is primarily based on actual evidence, pay attention to the
explicit assumptions behind the theory and contrast them to EUT.
Kihn / Behavioral Finance 101 / 461

2. Appear to adapt their decisions to the environment the decision was made in (e.g.,
framing matters).
3. Tend to ―seek satisfactory, rather than optimal solutions.‖
Decision making reality it turns out to be very different than normative theory. In general,
simplicity and mathematical tractability have been chosen over empirical reality (e.g., rational
expectations). In PT several EUT assumptions are relaxed or modified to reflect known human
biases.

Driving the basic model of the evaluation of risky prospects/gambles are the assumptions behind
investor preferences. The majority of models assume that investors evaluate risky
prospects/gambles according to the EUT of Von Neumann and Morgenstern (1947). They show
that if preferences satisfy a series of axioms (completeness, transitivity, continuity, and
independence), then preferences can be represented by the expectation of a utility function.
Unfortunately, life is messier and people systematically violate EUT (e.g., Allais (1953)). There
have been a number of substitutes proposed, of which Prospect Theory (KT (1979), and Tversky
and Kahneman (1992)) are a promising alternative, for financial market applications in
particular.

As noted by KT, traditionally economic decision making under risk is usually viewed in strictly
normative probability terms, but it can also be viewed as a choice between prospects or gambles
(which is actually how most humans tend to view it). That is, the overall utility of a prospect,
Kihn / Behavioral Finance 101 / 462

denoted by U, can be viewed as the expected utility of its outcomes, but those outcomes may not
possess a purely strictly normative rationality form, unlike traditional EUT.

More formally, based on KT‘s PT, more traditional EUT can be placed in PT notation as follows:
A prospect ) , ;...; , (
1 1 n n
p x p x is a contract that yields outcome
i
x with probability
i
p , where
1 ...
2 1
= + + +
n
p p p .
To simplify, ) , ( p x denotes the prospect ) 1 , 0 ; , ( p p x ÷ that yields x with probability p and 0 with
probability 1 - p (i.e., two outcomes).
The (riskless) prospect that yields x with certainty is denoted by (x). The application of expected
utility theory to choices between prospects is based on the following three tenets:
(i) Expectation: ) ( ... ) ( ) , ;...; , (
1 1 1 1 n n n n
x u p x u p p x p x U + + = .
(ii) Asset Integration: ) , ;...; , (
1 1 n n
p x p x is acceptable at asset position w iff
) ( ) , ;...; , (
1 1
w u p x w p x w U
n n
> + + .
(iii) Risk Aversion: u is concave (u‖<0).
Thus, with standard EUT all probabilities add to unity, expectations are linearly additive, etc.
(i.e., the EUT world with risk/uncertainty is normatively is so well behaved, that virtually
nothing behavioral is possible). KT (1979, p. 264) state: ‖a prospect is acceptable if the utility
resulting from integrating the prospect with one‘s assets exceeds the utility of those assets alone.
Thus, the domain of the utility function is final states (which includes one‘s asset position) rather
than gains or losses. ... most applications of the theory have been concerned with monetary
outcomes. … A person is risk averse if he prefers the certain prospect (x) to any risky prospect
with expected value x. In EUT, risk aversion is equivalent to the concavity of the utility
Kihn / Behavioral Finance 101 / 463

function‖. Most of these properties of EUT will now be dropped for PT in favor of several more
realistic assumptions. This was done largely in response to behavioral experiments that showed
most people violate basic ‗axioms‘ underpinning traditional EUT.

For example, Allais (1953) performed the following experiment that showed a clear violation of
EUT:

Problem 1: Choose between
A: 2,500 with probability .33, B: 2,400 with certainty.
2,400 with probability .66,
0 with probability .01.

N = 72 [18] [82]*

Problem 2: Choose between
C: 2,500 with probability .33, D: 2,400 with probability .34,
0 with probability .66, 0 with probability .66.

N = 72 [83]* [17]*

EUT implies u(2,400) > .33u(2,500) + .66u(2,400) or .34u(2,400) > .33u(2,500)

In this example, 82% of the subjects chose B in Problem 1, and 83% of the subjects chose C (i.e.,
effectively answer A from Problem 1) in Problem 2 (each is significant at the 1% level of
statistical significance). First preference of EUT implied that there should be no change, yet there
was an actual flip-flop. Problem 2 is obtained from Problem 1 by eliminating a .66 chance of
winning 2,400 from both prospects under consideration. The substitution axiom of utility theory
asserts that if B is preferred to A, then any (probability) mixture (B, p) must be preferred to the
mixture (A, p). The subjects did not obey this axiom. Eliminating a .66 chance of winning 2,400
Kihn / Behavioral Finance 101 / 464

from both prospects under consideration had a big effect (altered the character of the prospect
from a sure gain to a probable one).

PT, which is an alternative account of individual decision making under risk, attempts to avoid
such violations of EUT. KT note that many ‗anomalies‘ of preference result from the editing of
prospects (i.e., context and framing – see, e.g., Tversky and Thaler (1990) on preference
reversals, and Tversky and Kahneman (1986) on framing of decisions). KT delineate two phases
in the choice process: (1) an early editing phase, and (2) a subsequent evaluation phase. ‖The
function of the editing phase is to organize and reformulate the options so as to simplify
subsequent evaluation and choice.‖ Major editing operations are:
1. Coding: place into gains and losses (rather than as final states of wealth or welfare as
with EUT) relative to some reference point (typically a neutral point, like their current
asset position, but can be affected by the formulation of the offered prospects). The
critical point is that coding is done relative to some reference point.
2. Combination: prospects can sometimes be simplified by combining the probabilities
associated with identical outcomes.
3. Segregation: some prospects contain a riskless component that is segregated from the
risky component in the editing phase (e.g., (300, .8; 200, .2) becomes a sure gain of 200).
The preceding operations are applied to each prospect separately, while the following
operation is applied to a set of two or more prospects.
Kihn / Behavioral Finance 101 / 465

4. Cancellation: Discarding of components that are shared by the offered prospects (e.g.,
discarding the first step in a two-step sequential game because the stage was common to
both options).
357

5. Simplification: Simplification of prospects by rounding probabilities or outcomes (e.g.,
the prospect (101, .49) becomes an even chance to win 100). Another important form of
simplification involves the discarding of extremely unlikely outcomes.
6. Detection of dominance: Scanning of offered prospects to detect dominated
alternatives, which are rejected without further evaluation.
Note, some editing operations either permit or prevent the application of others (e.g., (500, .20;
101, .49) will appear to dominate (500, .15; 99, .51) if the second constituents of both prospects
are simplified to (100, .50)). Therefore, the final edited prospects could depend on the sequence
of the editing operations, which will likely depend on the structure of the offered set and the
format of the display (as in the real world). PT assumes no room for further editing or no
ambiguity for the edited prospects. These six steps are intended to reflect a version of what
people actually do in reality applied to decision making under risk.

Following the editing phase, assume the decision maker will evaluate each of the edited
prospects, and choose the prospect of highest value. The overall value of an edited prospect is
denoted V, and is expressed in terms of two scales, t and v. t associates with each probability p
a decision weight ) ( p t , which reflects the impact of p on the overall value of the prospect.

357
This is a version of what is called the ‗isolation effect‘. It is a form of framing that ―leads to inconsistent
preferences when the same choice is presented in different forms.‖ People can decompose distinctive and common
components in more than one way, and different decompositions sometimes lead to different preferences (e.g., a
two-stage game).
Kihn / Behavioral Finance 101 / 466

However, t is not a probability measure (e.g., ) 1 ( ) ( p p ÷ +t t is typically less than unity). The
second scale, v, assigns to each outcome x a number v(x), which reflects the subjective value of
that outcome. Remember, outcomes are defined relative to a reference point, which serves as a
zero point of the value scale. Hence, v measures the value of deviations from that reference point
(i.e., gains and losses). This reference point is a critical distinction between PT and EUT, and
reflects how most people actually measure value.

KT consider only simple prospects of the form ) , ; , ( q y p x which have at most two non-zero
outcomes. In such a prospect, one receives x with probability p, y with probability q, and nothing
with probability 1 – p – q, where p + q 1 s . An offered prospect is strictly positive if its
outcomes are all positive (i.e., if x, y > 0 and p + q = 1); it is strictly negative if its outcomes are
all negative. A prospect is regular if it is neither strictly positive nor strictly negative.

The basic equation is as follows (it describes the manner in which t and v are combined to
determine the overall value of regular prospects):
If (x, p; y, q) is a regular prospect (i.e., either p + q < 1, or y x > > 0 , or y x s s 0 ), then
) ( ) ( ) ( ) ( ) , ; , ( y v q x v p q y p x V t t + = (1) for ‖regular prospects‖
where v(0) = 0, 0 ) 0 ( = t , and 1 ) 1 ( = t .
As in utility theory, V is defined on prospects, while v is defined on outcomes. The two scales
coincide for sure prospects, where V(x, 1.0) = V(x) = v(x). Equation (1) generalizes EUT by
relaxing the expectation principle.

Kihn / Behavioral Finance 101 / 467

The evaluation of strictly positive and strictly negative prospects follows a different rule. In the
editing phase such prospects are segregated into two components: (1) the riskless component
(i.e., the gain or loss which is certain to be obtained or paid); and (2) the risky component (i.e.,
the additional gain or loss which is at stake).
If p + q = 1 and either x > y > 0 or x < y < 0, then
)] ( ) ( )[ ( ) ( ) , ; , ( y v x v p y v q y p x V ÷ + = t . (2) for ‖+ and - prospects‖
That is, the value of a strictly positive or negative prospect equals the value of the riskless
component plus the value-difference between the outcomes, multiplied by the weight associated
with the more extreme outcome (e.g., V(400, .25; 100, .75) = v(100) + t (.25)[v(400) –
v(100)]).
358


It is critical to note that PT introduces a subjective value and a reference point; this is not the
case in EUT. Key features of PT are:
- It is not a normative theory (indeed, Tversky and Kahneman (1986) argue ―that
normative approaches are doomed to failure, because people routinely make choices that
are simply impossible to justify on normative grounds, in that they violate dominance or
invariance.‖ (Barberis and Thaler (2002, p. 16))
- ―Utility is defined over gains and losses rather than final wealth positions, an idea first
proposed by Markowitz (1952).‖ (Barberis and Thaler (2002, p. 16)) Therefore, wealth is
defined as something relative, not absolute (most people define their lives, and such

358
Note, the RHS of (2) = ) ( )] ( 1 [ ) ( ) ( y v p x v p t t ÷ + . Hence, equation (2) reduces to equation (1) if
1 ) 1 ( ) ( = ÷ + p p t t .
Kihn / Behavioral Finance 101 / 468

things as light, loudness, and temperature based on earlier levels, rather than in absolute
terms).
- Shape of the value function v is unique (it is concave in the domain of gains, and convex
in the domain of losses). This implies that people are risk-averse to gains and risk-
seeking over losses.
- The v function has a kink at the origin (which indicates a greater sensitivity to gains than
to losses, also known as loss aversion).
359

- Nonlinear probability transformation (i.e., small probabilities are overweighted, so that
π(p) > p).
- Higher sensitivity to differences in probabilities at higher probability levels (related to the
‗certainty effect‘, where people place higher weights on certain prospects).
- As a bonus, it also explains preferences for insurance and lottery tickets (for example,
although v is concave in the region of gains (indicating risk aversion), for lotteries which
offer a very small chance of a large gain, the overweighting of small probabilities
dominates, leading to risk-seeking in the domain of gains).

Note, PT does not establish where the reference point
360
is (but it is likely to be around a
person‘s current wealth level), nor does it establish where the weighting function reverses at

359
The ‗reflection effect‘ picks up a dramatic shift of risk aversion to risk. Especially true when moving from
positive prospects to negative prospects. Risk aversion in the domain of gains and risk seeking in the domain of
losses. The aversion to uncertainty is also picked up here. Actually, ‖certainty increases the aversiveness of losses as
well as the desirability of gains.‖ Therefore, three effects:
(1) Risk aversion in the positive domain is replaced by risk seeking in the negative domain.
(2) Preferences between the positive prospects are inconsistent with EUT.
(3) The reflection effect eliminates aversion for uncertainty or variability as an explanation of the certainty
effect.
Kihn / Behavioral Finance 101 / 469

extremely high and low points (e.g., deep out-of-the-money lottery tickets/options).
361
Thus, it
presents a general form of the shape of a person‘s weighting function. Again, people tend not to
follow strict rules, but may display a general pattern of behavior that may be well described by
such functional forms. The essential feature of equation (2) is that a decision weight is applied to
the value-difference v(x) – v(y), which represents the risky component of the prospect, but not to
v(y), which represents the riskless component. Also note that the conditions that need to be
satisfied for the right hand side (―RHS‖) of equation (2) to equal that described, which reduces to
equation (1) are generally not satisfied.
362


The two keys to this theory are: (1) PT assumes that values are attached to changes rather than to
final states, and (2) that decision weights do not coincide with stated probabilities (i.e., decision
weights are not probabilities, and therefore do not obey probability axioms). Both are departures
from EUT, which leads to inconsistencies, intransitivities, and violation of dominance (which
EUT does not allow, but actually happen). Such anomalies of preference are normally corrected
by the decision maker when he or she realizes that his or her preferences are inconsistent,
intransitive, or inadmissible; but in most cases the decision maker is never made aware (or made

360
This notion of the reference point is also related to ―get-evenitis‖ (which in turn is related to the ―disposition
effect‖), which is more applicable to the accounting of gains and losses relative to the original price paid for a
specific asset. Overall wealth has been emphasized, yet it is important to add this aspect about the reference point
(which was originally noted and motivated by Markowitz (1952)).
361
The PT of Tversky and Kahneman (1992 - CPT) is a generalized PT which can be applied to gambles with more
than two outcomes, and they incorporate a loss aversion coefficient (which is estimated to be about two to 2.25, i.e.,
based on empirical research).
362
As an aside, note that Markowitz (1952) was the first to propose that utility be defined on gains and losses rather
than on final asset positions. Also, Markowitz noted the presence of risk seeking in preferences among positive and
negative prospects, and proposed a utility function which has convex and concave regions in both the positive and
negative domains (although, he retained the expectations principle).
Kihn / Behavioral Finance 101 / 470

aware only after the fact). Again, decision weights are not probabilities, and therefore do not
obey probability axioms; PT does not ignore this reality.

PT produces the following general form of ―value function‖
363
:


This contrasts and compares with the following utility functions:

363
Please note that what is missing from this diagram are reversals at the extreme regions of gains and losses.
Therefore, the lines of the curve at the both ends reverse themselves.
Kihn / Behavioral Finance 101 / 471


From: Lopes, L., ―Between hope and fear: The psychology of risk‖, in Goldstein, W., and R. Hogarth, (editors)
Research on Judgment and Decision Making: Currents, Connections, and Controversies, Cambridge Series on
Judgment and Decision Making, Cambridge University Press, New York, N.Y., 1997, p. 683.

I do not want to give the reader the idea these (except for the upper left one) are standard utility
functions in economics or finance. Note, with the exception of the upper left utility function, the
others are not standard and not well received by theoretical microeconomists. The Bernoullian
function (upper left) is uniformly risk averse (i.e., negatively accelerated). The Friedman and
Savage (1948) function in the upper right. The Markowitz (1952) function in the lower left. The
KT (1979) function in the lower right (i.e., the utility version of PT‘s value function). All but the
Bernoullian have regions of both risk aversion (i.e., negative acceleration) and risk seeking
(positive acceleration). Note, risk seeking behavior is contrary to normative economics, but
Kihn / Behavioral Finance 101 / 472

observed under certain conditions in the real world. The upper two functions range from zero
assets to large positive assets. The lower two functions range about a customary asset level (e.g.,
the status quo). Both risk seeking behavior and the reference point kink are not traditional
normative finance or economics assumptions. They are shown here in contrast to the traditional
normative Bernoullian utility function that has neither of these features.

A few final comments on PT are in order. First, the math is substantially messier than standard
EUT for a reason. It better reflects reality and thus is accordingly mathematically messier.
Second, it is more realistic, but not perfect. The reader should now be more comfortable with the
thought that human behavior is tricky to forecast. Therefore, more realistic assumptions help PT,
but more could be made at the likely cost of more mathematical messiness and/or tractability.
Finally, it is an improvement, yet it is still wrong.

Kihn / Behavioral Finance 101 / 473

SAD AND STOCK EXCHANGE DISTANCE FROM THE EQUATOR
I will end this chapter with a psychology based descriptive theory applied directly to pricing in
equity markets, namely SAD and regional stock exchange pricing effects. This theory was
already discussed in the chapter on psychology (again, see Kamstra et al. (2002)). I mention it
again because I find it an excellent example of a descriptive behavioral finance theory. In effect,
the SAD theory has it all, and then some. There is at least the appearance of the two pillars of
behavioral finance, yet there are still some seemingly odd things going on. That is, there seems
to be both limits to arbitrage (e.g., large multinationals are typically traded outside of their home
country yet seem to be affected by their home distance from the equator, even when few, if any,
limits to arbitrage seem apparent) and psychology (i.e., a seeming direct link from clinical
psychology running through depression caused by the diminution of daylight hours during one
part of the year the further we move away from the equator). What else could a behavioral
finance person look for?

With SAD there is a very likely direct observable link between human behavior and the financial
markets. What is especially unusual is that a clear minority of people is clinically depressed, yet
it seems to affect the pricing equities in a predictable way. In addition, it would seem that it
affects large-cap and small-cap stocks roughly equally. This is unique and seemingly
arbitrageable, yet it still happens. It is likely, as mentioned before, that other foreign investors
seem to generally follow the local lead, yet it is still seems a bit odd.

Kihn / Behavioral Finance 101 / 474

Regardless, daylight hours/distance from the equator, clinical depression, and equity prices, who
would have believed such a theory? My guess is that before reading this book most would have
brushed such a theory off as absurd. Again, from Modigliani and Cohn (1979, p. 36):
―Confronted with overwhelming statistical evidence consistent with our error hypothesis, and no
direct evidence inconsistent with it, our original skepticism turned into a degree of confidence
approaching belief – and certainly high enough to justify placing our findings before the public.‖
I imagine that Kamstra et al. (2002) felt the same way; and I now hope the reader will begin to
entertain such thoughts concerning descriptive behavioral finance theories, to do otherwise is not
in their economic interest.

REFERENCES
Allais, M., ―Le Comportement de l'Homme Rationnel devant le Risque: Critique des Postulats et
Axiomes de l'Ecole Americaine‖, Econometrica, Volume 21, Number 4, October 1953, 503-
546.

Kihn / Behavioral Finance 101 / 475

Barberis, N., and R. Thaler, ―A Survey of Behavioral Finance‖, NBER Working Paper #9222,
Addison-Wesley Publishing Company, Inc., September 2002, 1-78.

Brauer, G., ―‘Open-ending‘ closed-end funds‖, Journal of Financial Economics, Volume 13,
Issue 2, December 1984, 491-507.

Brauer, G., ―Closed-End Fund Shares‘ Abnormal Returns and the Information Content of
Discounts and Premiums‖, Journal of Finance, Volume 43, Issue 1, March 1988, 113-127.

Brauer, G., an E. Chang, ―Return Seasonality in Stocks and Their Underlying Assets: Tax-Loss
Selling versus Information Explanations‖, Review of Financial Studies, Volume 3, Number 2,
1990, 255-280.

Brav, A., and P. Gompers, ―Myth or Reality? The Long-Run Underperformance of Initial Public
Offerings: Evidence from Venture and Nonventure Capital-Backed Companies‖, Journal of
Finance, Volume 52, Issue 5, December 1997, 1791-1821.

Brickley, J., and J. Schallheim, ―Lifting the Lid on Closed-End Investment Companies: A Case
of Abnormal Returns‖, Journal of Financial and Economic Analysis, Volume 20, Number 1,
March 1985, 107-117.

Kihn / Behavioral Finance 101 / 476

Feinman, J., ―Infaltion Illusion and the (Mis)Pricing of Assets and Liabilities‖, Journal of
Investing, Volume 14, Issue 2, Summer 2005, 29-36.

Friedman, M., and L. Savage, ―The Utility Analysis of Choices Involving Risk‖, Journal of
Political Economy, Volume 56, Number 4, August 1948, 279-304.

Kahneman, D., and A. Tversky, ―Prospect Theory: An Analysis of Decision under Risk‖,
Econometrica, Volume 47, Issue 2, March 1979, 263-292.

Kamstra, M., Kramer, L., and M. Levi, ―Winter Blues: A SAD Stock Market Cycle‖, Federal
Reserve Bank of Atlanta, Working Paper 2002-13, July 2002, 1-36.

Lee, C., Shleifer, A., and R. Thaler, ―Investor Sentiment and the Closed-End Fund Puzzle‖,
Journal of Finance, Volume 46, Issue 1, March 1991, 75-109.

Loughran, T., and J. Ritter, ―The New Issue Puzzle‖, Journal of Finance, Volume 50, Number 1,
March 1995, 23-51.

Loughran, T., and J. Ritter, ―Why Don‘t Issuers Get Upset about Leaving Money on the Table in
IPOs?‖, Review of Financial Studies, Special Issue: Conference on Market Frictions and
Behavioral Finance, Volume 15, Number 2, Special Edition 2002, 413-443.

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Loughran, T., and J. Ritter, ―Why Has IPO Underpricing Changed Over Time?‖, Financial
Management, Volume 33, Issue 3, Autumn 2004, 5-37.

Markowitz, H., ―The Utility of Wealth‖, Journal of Political Economy, Cowles Foundation paper
57, Volume LX, Number 2, April 1952, 151-158.

Miller, R., and E. Schulman, ―Money Illusion Revisited‖, Journal of Portfolio Management,
Volume 25, Issue 3, Spring 1999, 45-54.

Modigliani, F., and R. Cohn, ―Inflation, Rational Valuation and the Market‖, Financial Analysts
Journal, Volume 35, Number 2, March/April 1979, 24-44.

Olsen, R., ―Behavioral Finance and Its Implications for Stock-Price Volatility‖, Financial
Analysts Journal, Volume 54, Number 2, March/April 1998, 10-18.

Pontiff, J., ―Closed-end fund premia and returns: Implications for financial market equilibrium‖,
Journal of Financial Economics, Volume 37, Issue 3, March 1995, 341-370.

Ritter, J., ―The Long-Run Performance of Initial Public Offerings‖, Journal of Finance, Volume
46, Number 1, March 1991, 3-27.

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Ritter, J., and R. Warr, ―The Decline of Inflation and the Bull Market of 1982-1999‖, Journal of
Financial and Quantitative Analysis, Volume 37, Issue 1, March 2002, 29-61.

Ritter, J., and I. Welch, ―A Review of IPO Activity, Pricing, and Allocations‖, Journal of
Finance, Volume 57, Issue 4, August 2002, 1795-1828.

Shiller, R., ―Initial Public Offerings: Investor Behavior and Underpricing‖, National Bureau of
Economic Research, Working Paper No. 2806, Cambridge, Massachusetts, December 1988, 1-
23.

Tversky, A., and D. Kahneman, ―Rational Choice and the Framing of Decisions‖, Journal of
Business, Volume 59, Issue 4, Part 2: Behavioral Foundations of Economic Theory, October
1986, S251-S278.

Tversky, A., and D. Kahneman, ―Advances in Prospect Theory: Cumulative Representation of
Uncertainty‖, Journal of Risk and Uncertainty, Volume 5, Issue 4, October 1992, 297-323.

Tversky, A., and R. Thaler, ―Anomalies: Preference Reversals‖, Journal of Economic
Perspectives, Volume 4, Issue 2, Spring 1990, 201-211.

Kihn / Behavioral Finance 101 / 479

Von Neumann, John and Oscar Morgenstern, Theory of Games and Economic Behavior (second
edition with appendix containing axioms of expected utility), Princeton University Press,
Princeton, N.J., 1947.

Weiss, K., ―The Post-Offering Price Performance of Closed-End Funds‖, Financial Management,
Volume 18, Issue 3, Autumn 1989, 57-67.













Kihn / Behavioral Finance 101 / 480

Chapter 14: Volatility & volume (V & V) – or why so much trading?

―Noise makes trading in financial markets possible, and thus allows us to observe prices for
financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from
taking advantage of inefficiencies. ... Most generally, noise makes it very difficult to test either
practical or academic theories about the way that financial or economic markets work. We are
forced to act largely in the dark.‖
Black (1986, p. 529)

Normative finance models have historically assumed homogenous expectations (e.g., the
CAPM). If all investors have the same expectations it is difficult, if not illogical, to generate any
trading in a normative model, and if there is no trading it is difficult, if not impossible, to
generate any volume. Yet, in the actual financial markets all kinds of trading/volume and
volatility goes on. Why? Specifically, if we all think the same and agree that, for example, the
price of IBM should be $10 a share, then there should be little or no trading and little no
volatility, yet there is. As suggested by Black (1986), would we essentially have no trading
without ‗noise‘? In short, why do we have all the volume and volatility that we seem to have?

Kihn / Behavioral Finance 101 / 481

VOLATILITY
In 1981 two articles were published directly examining the question of whether stock price
variability was justified by changes in cash flow (see Shiller (1981a) for dividends, and LeRoy
and Porter (1981) for earnings). As noted early in the book, actual finance is principally
concerned with present values or discounted cash flows. Shiller (1981a) essentially makes his
case based on the fact that the primary periodic cash flows of equities are their dividends.
Therefore, stock price variability should be approximately equal to the variability of their cash
flows (i.e., dividends). Shiller (1981a) calls this the ―simple efficient markets model‖. Based on
such a model, Shiller (1981a, p. 422) graphs the model derived volatility against actual market
volatility for the S&P and Dow Jones indices.


Kihn / Behavioral Finance 101 / 482

From: Shiller, R., ―Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?‖,
American Economic Review, Vol. 71, Issue 3, June 1981, p. 422.

The dotted lines represent the expected price series based on Shiller‘s discounted cash flow
model (i.e., discounted dividend cash flow model) for each U.S. stock index. Left to right, the
solid lines are the S&P Composite and Dow Jones indices, respectively. As the reader can clearly
see, in both cases the actual variation is many times the theoretical expectation. In fact, the actual
variation is somewhere between five to thirteen times too high!

It is difficult to imagine that looking at these graphs would make one a big supporter of the
notion that economic fundamentals are the primary drivers of the equity markets. Again, stock
price volatility has been five to thirteen times too high over the last century or so, as measured by
future real dividend uncertainty (depending on the level of confidence; and remember, this is
market volatility, therefore individual stocks or groupings of stocks can be much worse).

It seems that this result cannot be attributed to tax law changes, price index problems, or data
errors. Some arguments against Shiller‘s result are (1) that he should have used earnings, and/or
(2) factored in a time-varying real interest rate. Unfortunately for detractors, this doesn‘t really
change the results; in addition, it isn‘t clear what detractors mean by earnings and the real
interest rate. That is, it is hard to argue against something when you don‘t define what you are
arguing in support of. As usual in finance, one must expose oneself to some sort of pricing model
or it is difficult, by definition, if not impossible, to establish much of anything empirically. In
addition, actual nominal movements are less than the real rates would have had to move (i.e., it is
likely physically impossible to rationalize the counter argument by varying ‗real‘ rates alone).
Kihn / Behavioral Finance 101 / 483

Another counter argument has been whether there is a systematic underestimating the level of
uncertainty surrounding future dividends? Again, we cannot observe that, and it would have had
to be so big, that it is hard to imagine. Finally, for example, a well known attack against Shiller
(1981a) was by Marsh and Merton (1986) where they argued that by assuming nonstationarity
(vs. Shiller (1981a) assuming stationarity) the Shiller (1981a) result is no longer clear.
364
As
always in normative finance and economics assumptions can trump evidence and basic logic.
365

But on balance, in summary the general result has held and it has been and seems to be very
disconcerting to EMH/EMT promoters.
366


Using adjusted earnings (because earnings are typically not cash flows), a different present value
model, and different tests, LeRoy and Porter (1981, p. 573) came to a similar conclusion as
Shiller (1981a) and concluded by stating: ―we are not able to resolve this difference between our
results in which market efficiency is rejected with the standard results in which the opposite
conclusion is reached.‖
367
By ―standard results‖ they mean Fama (1970). In other words, their
results are so far away from standard textbook market efficiency at the time that they really
didn‘t know what to write.

364
That is, by changing a basic assumption underlying the variance bounds tests, the results of those tests themselves
are no longer clearly interpretable. Obviously, for example, if you assume the moon is made of cheese any proof that
it is not made of cheese would not be convincing. Also, see, e.g., Mankiw et al. (1991) for another version of the
Marsh and Merton (1986) result.
365
Essentially, given that it is a present value formula, you can either attack the dividend part or the discount rates.
As Barberis and Thaler (2002, p. 30) point out: ―Some rational approaches try to introduce variation in the P/D ratio
through the third term on the right in equation (14). Since this requires investors to expect explosive growth in P/D
ratios forever, they are known as models of rational bubbles.‖ Alternatively, one can attack the rates part, but, note,
actually interest rates only weaken the EMT case (e.g., typically, interest rates are lowest when the stock market is
most volatile, e.g., 1929). Also, see Shiller (2002, p. 9-10).
366
Also, see, e.g., Shiller (1981b) for a review of the general statistical and/or econometric issues and his general
inference that it is more likely that ―markets are irrational and subject to fads‖ than, for example, ―ex ante real
interest rates show very large movements‖.
367
Similar results for exchange rates as well (e.g., Huang (1981)). That is, basic market efficiency with respect to
volatility is violated not just for stocks.
Kihn / Behavioral Finance 101 / 484


These results and Shiller‘s (1981a) are a kind of basic efficiency tests that were not really
formally accounted for in the original EMH/EMT, yet they are conceptually devasting to
standard notions of market efficiency. Using Shiller‘s (1981a) lower bound of five times too
much volatility as can be justified by present value changes in cash flows, how could one accept
these results alone and still have faith in textbook market efficiency?

Finally, on the question of what or who might be causing excess volatility (i.e., from an efficient
market viewpoint), Sias (1996, p. 18) concludes with the following comment: ―Our empirical
results are consistent with the hypothesis that an increase in institutional investor interest induces
an increase in volatility.‖ In other words, institutional ownership seems to cause some volatility.
If this is true, then, like retail PMs ‗portfolio pumping‘, we have another area where supposed
‗smart money‘ is causing an inefficiency (in this case likely pushing prices around too much
from an efficiency standpoint as opposed to the prices being too high or too low per say),
although possibly not breaking rules or laws. Thus, you can get a kind of ‗cancelation‘ but
volatility is way too high and on that basis alone market efficiency is lacking.

Regarding behavioral rationales for the volatility puzzle, they can be grouped into two
overlapping areas: (1) beliefs, and (2) preferences. Some examples of each are:
Beliefs:
• ‗Law of small numbers‘ version of representativeness – People expect small samples to
reflect the parent population (e.g., extrapolating recent past into the long-term future).
Kihn / Behavioral Finance 101 / 485

• Overconfidence about perceived private information.
• ‗Money illusion‘ with respect to the P/D ratio (i.e., prices and cash flows will tend to
increase due to inflation, but people interpret this as a real, not a nominal, effect).
Preferences:
• Loss aversion is not constant, but depends on circumstances (e.g., prior losses or gains).
• The ‗house money effect‘ or willingness to take on risk after experiencing a sequence of
gains can change (therefore, the approximately 2.25 risk aversion coefficient found by
Tversky and Kahneman (1991) is not a constant).
Beliefs and preferences can impact both the cash flows and discount rates. In addition, it may at
least in part just reflect the nature of financial market tasks. For example, Olsen (1998) notes that
psychology has documented that complex problems combined with heterogeneous beliefs tend to
lead to a: ―unless arbitrage opportunities are complete, larger divergence of opinion will lead not
only to greater price volatility but also higher prices.‖
368
Therefore, the nature of most financial
problems can cause volatility and higher prices (even possibly price bubbles). In summary, the
causes can be speculated upon, but are not well established. All that can be stated with
confidence is that it is very likely there is normatively too much volatility; but we do not know
why.


368
See Olsen (1998, pp. 16-17): ―Ex post, the performance of few ‗experts‘ on complex, ill-structured tasks
surpasses naïve strategies, and when experts do outperform, the margin of superior performance is small and
inconsistent. … Complex, ill-structured tasks or decisions give rise to great variability in decision outcomes because
they tend to lie more toward the experience or intuitive end of the decision spectrum than the objective end and
make greater use of idiosyncratic information and procedures that are personal, concrete, holistic, affective
(emotional), and based on such associative conventions as the use of analogies and stereotypes (Forgas 1991,
Epstein 1994, Hammond 1996, and Busemeyer 1995). … unless arbitrage opportunities are complete, larger
divergence of opinion will lead not only to greater price volatility but also higher prices.‖
Kihn / Behavioral Finance 101 / 486

VOLUME
―Trading volume on the world‘s markets seems high, perhaps higher than can be explained by
models of rational markets. ... we lack economic models that predict what trading volume in
these markets should be. In theoretical models trading volume ranges from zero (e.g., in rational
expectation models without noise) to infinite (e.g., when traders dynamically hedge in the
absence of trading costs). But without a model which predicts what trading volume should be in
real markets, it is difficult to test whether observed volume is too high.‖
Odean (1999, p. 1279)

Therefore, normative models can give you no trading or infinite trading. Of course, the most
‗rational‘ ones tend toward zero. Clearly, and contrary to one of the most relied upon
assumptions in traditional finance models, investors possess heterogeneous beliefs and
expectations, not homogenous ones, as often assumed in models such as the CAPM, or trading
wouldn‘t be so active and voluminous. In addition, often ‗noise traders‘ are introduced to force
trading into a normative model. Given that trading is the main activity of the financial markets,
then most activity in the financial markets has the larger part of its cause motivated by
psychology, not purely economics (remember, without trading these markets wouldn‘t exist).
Barber and Odean (1999, p. 51) point out that ‗rational‘ models ―provide little insight into why
people trade as much as they do. In some models, investors seldom trade or do not trade at all
(e.g., Grossman 1976). Other models simply stipulate a class of investors – noise or liquidity
traders – who are required to trade (e.g., Kyle 1985). Harris and Raviv (1993) and Varian (1989),
however, pointed out that heterogeneous beliefs are needed to generate significant trading. And
Kihn / Behavioral Finance 101 / 487

behavioral finance throws light on why and when investors form heterogeneous beliefs.‖
Descriptive models of trading that directly incorporate psychological biases such as
overconfidence tend to produce excessive volume (e.g., Odean (1998)). Regardless of theoretical
model assumptions, how much volume, if any, is enough? Rephrased, how much trading is
efficient? We don‘t know, but common sense is rather pressed to find actual levels are
normatively rational. As De Bondt and Thaler (1995, p. 392) noted concerning trading volume:
―the high trading volume observed in financial markets is perhaps the single most embarrassing
fact to the standard finance paradigm.‖

Without a normative answer, we should at least look at empirical reality. According to the
NYSE, their highest recorded annual turnover was 319% during 1901.
369
Therefore, during 1901
institutions and individuals investing in U.S. common stocks on average held NYSE shares for
less than four months (i.e., less than 1/3
rd
of a year). More recently, average annualized turnover
on the NYSE through the end of September 2009 it was running at about 139% and about 138%
for 2008.
370
Is it possible that annual turnover of even 100% makes economic sense?
Furthermore, could it be that the normatively optimal level of trading varies from one year to the
next by multiples (e.g., 319% one year, then less than 100% in another)? Specifically, it doesn‘t
seem likely that, for example, hedging requirements in 1901 were more than twice as great as in
2008, or more than 35 times as great as 1942 (see the next graph). Regardless of the seeming
absurdity of the absolute levels, is it even possible that the magnitude of changes from one year
to the next could be viewed as normatively rational?

369
See http://www.nyse.com/about/history/timeline_1900_1919_index.html.
370
See http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3084&category=3.
Kihn / Behavioral Finance 101 / 488



Source for data: http://www.nyxdata.com/nysedata/asp/factbook/ on November 3, 2009.

Besides the apparent irrational waxing and waning of trading levels, additionally there is the cost
issue of turnover, and not just transaction costs. For example, Odean finds that discount
brokerage investors don‘t just lose money trading more than they should, but lose money by
purchasing securities that perform more poorly than those they sell.
371
Again, the quote is:
―The surprising finding is that not only do the securities that these investors buy not outperform
the securities they sell by enough to cover trading costs, but on average the securities they buy
underperform those they sell. This is the case even when trading is not apparently motivated by
liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk securities.

371
Other countries also seem to exhibit this tendency or worse (e.g., see Barber et al. (2006) on Taiwan).
0%
25%
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100%
125%
150%
175%
200%
225%
250%
275%
300%
325%
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8
NYSE Annual Turnover - 1900 through 2008
Kihn / Behavioral Finance 101 / 489

While investors‘ overconfidence in the precision of their information may contribute to this
finding, it is not sufficient to explain it. These investors must be systematically misinterpreting
information available to them. They do not simply misconstrue the precision of their
information, but its very meaning.‖
Odean (1999, p. 1280)
In other words, in general, people trade too much and generally do not have sound economic
motivation for so doing (i.e., trading is clearly economically excessive). In essence, much or
even most of financial market trading represents sheer normative irrationality. Overconfidence
alone is not even sufficient to explain the results.

Descriptively, overconfidence has been proposed as one primary cause of excessive trading or
volume in the financial markets.
372
In addition, for example, self-attribution bias and the
disposition affect may have significant impacts on trading, especially under certain market
environments (e.g., see Statman et al. (2003)). During the front side of a financial bubble such
psychological biases inspired trading based on self-attribution bias can feed overconfidence.
Additionally, the disposition affect can affect trading both on the front and back sides of a bubble
(again, see Statman et al. (2003)). Therefore, shocks, especially large ones, to financial market
prices will provoke trading and empirically seem to be the case. Statman et al. (2003, p. 27):
―turnover levels are responsive to past market returns even when past security returns are
included in the model. In fact, past market returns are statistically and economically more

372
Also, Daniel et al. (1998) theorize that underreaction and overreaction are based on two biases: (1)
overconfidence about the precision of their information, and (2) biased self-attribution.
Kihn / Behavioral Finance 101 / 490

important than past security returns in explaining individual stock turnover‖.
373
Therefore,
empirically, it seems that large up market moves inspire overconfident self-attribution biased
traders to trade more, while large down market moves tend to limit trading activity via the
disposition affect and the need to displace responsibility onto the mad market.

Finally with respect to the issue of overconfidence, I should note that there is some evidence that
standard psychological measures of overconfidence, namely calibration may not turn out to be
well correlated with excessive trading. Based on combining investor surveys with trading data,
Glaser and Weber (2003, p. 1) summarize their findings as: ―We find that investors who think
that they are above average in terms of investment skills or past performance trade more.
Measures of miscalibration are, contrary to theory, unrelated to measures of trading volume. This
result is striking as theoretical models that incorporate overconfident investors mainly motivate
this assumption by the calibration literature and model overconfidence as underestimation of the
variance of signals.‖ Therefore, overconfident traders trade more, but with the critical caveat that
it seems to be more an issue of overly inflated self-perception with respect to trading skills,
illusion of control, etc. than miscalibration per say.

As background for what can go wrong with excessive trading (i.e., based on basic normative
standards), Barber and Odean (2000) have interesting findings. They find that households that

373
Glaser and Weber (2009) support this interpretation. In addition to a positive relationship between trading
volume and past market and portfolio returns, Glaser and Weber (2009, p. 1) find that: ―After high portfolio returns,
investors buy high risk stocks and reduce the number of stocks in their portfolio.‖
Kihn / Behavioral Finance 101 / 491

trade the most (i.e., the top quintile or top 20%) in their 78,000 sample
374
turnover their stock
portfolios about 250% per year vs. an average of about 75% (over a sample period of
encompassing approximately 1991 through 1996 or around six years).
375
More importantly,
those households that trade the most earn a net annual return of about 11.4% vs. those that trade
infrequently earn a net annual return of about 18.5%. Therefore, based on that comparison alone
the ‗traders‘ forego roughly 7% annually due to what appears to be unnecessary trading activity.
Even ignoring top to bottom trading quintile group comparisons, underperformance for the most
frequent traders varies between about 5.5% to 10.3% annually, depending on how one controls
for risk or what index returns are measured against (Barber and Odean (2000, pp. 793 & 797)).
Keep in mind, although gross returns were around measures of general index returns (i.e., before
transactions costs, taxes, etc.), the average household consistently underperformed the market on
a normative risk-adjusted basis.
376
Therefore, even the average household broke the normative
economic trading rule that states that the marginal benefit of trading must be equal to or exceed
its marginal cost (e.g., see Grossman and Stiglitz (1980)), and the most aggressive traders were
seemingly on another planet altogether. Overall, it can be said that trading is a consistent source
of negative return for most investors most of the time. The question remains, why so much
trading when it clearly is harmful to your wealth?

374
Of those households, 66,465 have positions in common stocks (Barber and Odean (2000, p. 778)). Furthermore,
―Roughly 60 percent of the market value in the accounts is held in common stocks. In these households, more than 3
million trades are made in all securities during the sample period, with common stocks accounting for slightly more
than 60 percent of all trades. On average during our sample period, the mean household holds 4.3 stocks worth
$47,334, though each of these figures is positively skewed. The median household holds 2.61 stocks worth $16,210.
In December 1996, these households held more than $4.5 billion in common stock.‖
375
Given that the NYSE is routinely over 100% annual turnover and in the Barber and Odean (2000) sample
investors average 75% turnover, therefore, it is likely that institutional investors turn over their portfolios more than
households. If true, which is likely, this is not prima facie helpful for the view that institutions are more efficient
than individual investors with respect to trading efficiency.
376
As confirmed by CEF research, individual investors, and households, tend to hold smaller-cap stocks with higher
Betas than institutional investors (and high book-to-market).
Kihn / Behavioral Finance 101 / 492


In terms of overall cost to society from trading that appears to be generally a money losing
proposition, how much does it cost? Barber et al. (2006) got hold of all equity trades on the
Taiwan Stock Exchange (―TSE‖) and estimated that the costs: ―Using a complete trading history
of all investors in Taiwan, we document that the aggregate portfolio of individual investors
suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are
equivalent to 2.2 percent of Taiwan‘s GDP or 2.8 percent of total personal income – nearly as
much as the total private expenditure on clothing and footwear in Taiwan.‖ Think about that for
a moment, based on equity trades on the TSE only (i.e., excluding bond trading, outright
gambling, trading on other stock exchanges, etc.) the average Taiwanese spends at least as much
transacting money losing stock trades as he or she does on clothes and shoes. To date, this is the
only study that I know of that takes a stab at such an estimate. Also, note that the turnover on the
TSE during the study period was substantially greater than say on the NYSE (about two to three
times as great).

If trading is generally a money losing proposition for individual investors, what about
institutional trading? That is, does the negative relationship between returns and transactions for
individuals hold for institutions? For example, institutions tend to have lower transaction costs,
so they may not suffer as poorly. In the case of mutual funds, Carhart (1997, p. 69) finds: ―that
transaction costs describe most of the unexplained mutual fund performance.‖ In short, they are
important and can be a significant drag on performance. In addition, he found about 77%
turnover in his sample covering mutual fund monthly returns from 1962 through 1993
Kihn / Behavioral Finance 101 / 493

(inclusive), which is roughly comparable to individual investor turnover. In addition, regarding
costs of transacting Carhart (1997, p. 69) estimates it to be about 95 BPs per round-trip
transaction vs. Barber and Odean‘s (2000, p. 779) value of about 245 to 303 BPs for individual
discount brokerage clients (median and mean round-trip trading costs, respectively). Thus, it has
been roughly 1/3
rd
cheaper to transact for mutual funds vs. discount brokerage clients.
Nevertheless, it is costly and the transactions generally do not justify the trades made whether
individual or institutional investor.

As Barber and Odean (2000, p. 799) noted: ―It is unlikely that mutual fund managers buy and
sell stocks for the pure joys of trading despite the fact that this trading lowers the expected
returns of their shareholders.‖ This is related to one reason often given for individual investor
losses associated with excessive trading, namely a gambling rationale. It has been proposed that
individual investors may derive some satisfaction, as with gambling, from the mere ability to
gamble and thus set aside money they will knowingly have a strong tendency to be on the losing
side of most transactions. Barber and Odean (2000) looked into this for individuals and did not
find this to be a credible explanation. Regarding institutional investors like mutual funds, they
found the argument unconvincing based at least in part on empirical evidence like Carhart
(1997), Jensen (1969), and Malkeil (1995).
377
Trading tends to hurt performance for both, but
because transaction costs tend to be higher for individuals, it just hurts individual returns more.

377
Although generally the average mutual fund underperforms basic market indices, there is one possibly
contradictory piece of evidence that could be interpreted to suggest trading enhances performance under certain
specific circumstances. For example, Grinblatt and Titman (1994, pp. 435-437) identify excess returns attributable
to a subset of 279 equity mutual funds under study (December 1974 through December 1984); but they attribute
their unexpected significant statistic to the differential between their set of high turnover funds and low turnover
funds. In fact, the cause seems to largely come from negative returns caused by their low turnover funds doing
Kihn / Behavioral Finance 101 / 494


REFERENCES
Barber, B., Lee, Y., Liu, Y., T. Odean, ―Just How Much Do Individuals Investors Lose by
Trading?‖, Working Paper, October 2006, 1-28.

Barber, B., and T. Odean, ―Trading is Hazardous to Your Wealth: The Common Stock
Investment Performance of Individual Investors‖, Journal of Finance, Volume LV, Number 2,
April 2000, 773-806.

Barberis, N., and R. Thaler, ―A Survey of Behavioral Finance‖, NBER Working Paper #9222,
Addison-Wesley Publishing Company, Inc., September 2002, 1-78.

Black, F., ―Noise‖, Journal fo Finance, Volume 41, Issue 3, July 1986, 529-543.

relatively poorly (0.8 percent per year vs. -1.3 percent per year). This somewhat truely anomolous result may be due
to: (1) their sample, and/or (2) the power of their tests.
Kihn / Behavioral Finance 101 / 495


Carhart, M., ―On Persistence in Mutual Fund Performance‖, Journal of Finance, Volume 52,
Issue 1, March 1997, 57-82.

Daniel, K., Hirshleifer, D., and A. Subrahmanyam, ―Investor Psychology and Security Market
Under- and Overreactions‖, Journal of Finance, Volume LIII, Number 6, December 1998, 1839-
1885.

De Bondt, W., and R. Thaler, ―Financial decision making in markets and firms: A behavioral
perspective‖, in R. Jarrow, V. Maksimovic, and W. Ziemba (Editors), Handbooks in Operations
Research and Management Science, Finance, Volume 9, Elsier, Amsterdam, 1995, 385−410.

Fama, E., ―Efficient Capital Markets: A Review of Theory and Empirical Work‖, Journal of
Finance, Volume 25, Issue 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of
the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), 383-
417.

Glaser, M., and M. Weber, ―Overconfidence and Trading Volume‖, Working Paper, April 14,
2003, 1-55.

Glaser, M., and M. Weber, ―Which past returns affect trading volume?‖, Journal of Financial
Markets, Volume 12, Issue 1, February 2009, 1-31.
Kihn / Behavioral Finance 101 / 496


Grinblatt, M., and S. Titman, ―A Study of Monthly Mutual Fund Returns and Performance
Evaluation Techniques‖, Journal of Financial and Quantitative Analysis, Volume 29, Issue 3,
September 1994, 419-444.

Grossman, S., and J. Stiglitz, ―On the Impossibility of Informationally Efficient Markets‖,
American Economic Review, Volume 70, Number 3, June 1980, 393-408.

Huang, R., ―The Monetary Approach to Exchange Rate in an Efficient Foreign Exchange
Market: Tests Based on Volatility‖, Journal of Finance, Volume 36, Issue 1, March 1981, 31-41.

Jensen, M., ―Risk, The Pricing of Capital Assets, and The Evaluation of Investment Portfolios‖,
Journal of Business, Volume 42, Isue 2, April 1969, 167-247.

LeRoy, S., and R. Porter, ―The Present-Value Relation: Tests Based on Implied Variance
Bounds‖, Econometrica, Volume 49, Issue 3, May 1981, 555-574.

Malkiel, B., ―Returns from Investing in Equity Mutual Funds 1971 to 1991‖, Journal of Finance,
Volume 50, Issue 2, June 1995, 549-572.

Kihn / Behavioral Finance 101 / 497

Mankiw, N., Romer, D., and M. Shapiro, ―Stock Market Forecastability and Volatility: A
Statistical Appraisal‖, Review of Economic Studies, Volume 58, Number 3, Special Issue: The
Economics of Financial Markets, May 1991, 455-477.

Marsh, T., and R. Merton, ―Dividend Variability and Variance Bounds Tests for the Rationality
of Stock Market Prices‖, American Economic Review, Volume 76, Issue 3, June 1986, 483-498.

Odean, T., ―Volume, Volatility, Price, and Profit When All Traders Are Above Average‖,
Journal of Finance, Volume 53, Issue 6, December 1998, 1887-1934.

Odean, T., ―Do Investors Trade Too Much?‖, American Economic Review, Volume 89, Issue 5,
December 1999, 1279-1298.

Olsen, R., ―Behavioral Finance and Its Implications for Stock-Price Volatility‖, Financial
Analysts Journal, Volume 54, Number 2, March/April 1998, 10-18.

Shiller, R., ―Do Stock Prices Move Too Much to be Justified by Subsequent Changes in
Dividends?‖, American Economic Review, Volume 71, Issue 3, June 1981a, 421-436.

Shiller, R., ―The Use of Volatility Measures in Assessing Market Efficiency‖, Journal of
Finance, Volume 36, Number 2, May 1981b, 291-304.

Kihn / Behavioral Finance 101 / 498

Shiller, R., ―From Efficient Markets Theory to Behavioral Finance‖, Cowles Foundation
Discussion Paper No. 1385, October 2002, 1-42.

Sias, R., ―Volatility and the Institutional Investor‖, Financial Analysts Journal, Volume 52,
Number 2, March/April 1996, 13-20.

Statman, M., Thorley, S., and K. Vorkink, ―Investor Overconfidence and Trading Volume‖,
Working Paper, March 2003, 1-52.

Tversky, A., and D. Kahneman, ―Loss Aversion in Riskless Choice: A Reference Dependent
Model‖, Quarterly Journal of Economics, Volume 106, Issue 4, November 1991, 1039-1061.









Kihn / Behavioral Finance 101 / 499


Kihn / Behavioral Finance 101 / 500

Chapter 15: Corporate events

Under the original textbook definition of market efficiency, information, and especially public
information, is supposed to be embedded into pricing as it becomes available to ―the market‖. In
short, no ―excess returns‖ or ‗free lunch‘ should be available to investors trading on such
information.
378
For example, and as mentioned in the chapter on overreaction and underreaction,
earnings announcements are arguably the most available and researched of all ‗publically‘
available financial information, yet they don‘t appear to be incorporated into pricing in a
normatively efficient manner. Specifically and as previously mentioned, Bernard and Thomas
(1989) reported extensive underreaction that resulted in risk-adjusted excess returns or a ‗free
lunch‘ of about 18% on an annual basis, which could be enhanced by focusing on small- vs.
large-cap stocks (Bernard and Thomas (1990)). How can this be? Furthermore, if this occurs for
earnings, what about pricing ―efficiency‖ for other less public and popular announcements?
Apparently, although there are questions as to statistical power, among other things, earnings
announcements not being ―efficiently‖ embedded into pricing are not alone.

In fact, according to financial market research, essentially every measurable corporate event has
at least some evidence of being ‗anomalous‘. Overall, as a general statement it seems that
extensive underreaction to most documented corporate events is the norm. The real substantive
debates concerning much of the descriptive corporate event literature typically revolve around
the statistical confidence of the ‗free lunch‘ and whether one can even be defined or tested.

378
Typically, any statistically systematic deviation of equity returns from zero is considered evidence of normative
market inefficiency.
Kihn / Behavioral Finance 101 / 501


Of course, if an ‗anomaly‘ is the norm, it is not an anomaly, it is normal. Therefore, like so much
in finance, when actually examined, the balance of the evidence on corporate events is: (1) not
supportive of the EMH/EMT, and (2) even ignoring that evidence, it tends not to actually fit
normative theory very well, if at all. Also, like ‗earnings drift‘ much of the evidence is based on
‗event studies‘ that attempt to identify excess returns by: (1) identification of an announcement
date, and (2) assuming some asset pricing model is appropriate for controlling for risk. Although
announcement dates are less debatable (i.e., outside of such events as corporate bankruptcy),
there is considerable debate about the asset model used to control for risk. In effect, the old
standby problem of testing both normative market efficiency and an asset pricing model (i.e.,
essentially two hypotheses) applies to event studies looking to support or reject market efficiency
with respect to accepted corporate events.

In addition, of course, there is considerable counter evidence, but the most plausible explanation
is not EMH/EMT based. Therefore, while there is a long, and growing, list of empirical work in
the area of corporate events one cannot say, at this time, we have conclusively identified the
cause or causes of what appears to be the general rule of underreaction. That noted, what we can
normatively say, either generally or specifically, they all seem to be ‗anomalous‘ or have some
‗anomalous‘ component to them.

Thus, in this chapter I will not attempt to review the hundreds or thousands of more descriptive
studies in the area of corporate events, but rather try to present a brief outline of the area as it
Kihn / Behavioral Finance 101 / 502

relates to behavioral finance. First, a list of the common documented corporate events and then a
list of some evidence whether there appears to be normative ‗free lunch‘ for each will be
presented. Second, some discussion of the arguments of whether we can even say anything about
corporate events, especially as it relates to the ―power‖ of the statistical tests employed. Finally,
a few comments/summary as events studies of corporate events relate to behavioral finance.

A LIST OF CORPORATE EVENTS
Regarding the events themselves, here is my own attempt at a list (and ignoring corporate
bankruptcy):


Kihn / Behavioral Finance 101 / 503

Common Corporate Events
Event Description Evidence
Unambiguously
Supportive of
EMH/EMT?
Event
Studies
Offerings:
Initial Public Offerings (IPOs) No Yes
Seasoned equity offerings No Yes
Debt offerings No Yes

Cash flow related announcements:
Earnings No Yes
Dividends No Yes

Repurchases/stock buybacks No Yes
Stock and cash financed mergers & tender offers/M&A

No Yes
Stock splits No Yes


Arguably the one major set of events that are missing are bankruptcies and restructurings
(covered in a previous chapter). As mentioned, those types of events are also generally not
supportive of normative market efficiency. Regarding examples of event studies and
approximate excess returns/‘free lunches‘ for the events listed:


Kihn / Behavioral Finance 101 / 504

Common Corporate Events – some excess return examples
Event Description Examples of approximate
excess returns found
Time
Period
Event Study
Offerings:
Initial Public Offerings (IPOs) Timing and time matters:
e.g., during the Internet
bubble +65%
-23.4%


1
st
day
3 yr. avg.
Ritter & Welch
(2002, pp. 1822,
1817)
Seasoned equity offerings -44%
(note, same finding for IPOs)
5 yrs. Loughran & Ritter
(1995, p. 46)
Debt offerings (debt IPOs) Exchange matters: For
example OTC +4.66% vs.
NYSE/AMEX -1.78%
Bond rating matters: Low
grade +1.86% vs. high grade
-2.88%
Average equity move of -
6.35%

1
st
day


1
st
day

2 day avg.
Datta et al. (1996,
p. 391)




Data et al. (2000, p.
731)

Cash flow related announcements:
Earnings Size matters: e.g., medium-
cap 10% vs. large-cap 4%
3 quarters Bernard & Thomas
(1990, p. 323)
Dividend reductions &
omissions
-6.85% to -11.04%
(depending on model)
1 year Liu et al. (2008, p.
996)

Repurchases/stock buybacks +12.1%
Value matters: e.g., ‘value’
stocks +45.3%
+3.5%
3 years

3 years
5 days
Ikenberry et al.
(1995, p. 181)
Ikenberry et al.
(1995, p. 206)
Stock and cash financed mergers
& tender offers/M&A

+0.59% to 0.86% (about +7%
to +10% annualized)
1 month Baker & Savasoglu
(2002, p. 103)
Stock splits & reverse splits Splits: +7.05% & +11.87 splits
Reverse splits: -10.76% & -
33.90%
1 year &
3 years
Desai & Jain (1997,
p. 409)

Source: Various.

Kihn / Behavioral Finance 101 / 505

Again, as previously noted, every corporate event listed has at least some strong evidence of
abnormal returns (i.e., according to normative conventions and models at the time the studies
were made). Therefore, what are often called ‗anomalies‘ are in fact not anomalous at all; rather,
they are the norm.

What is interesting is that in some cases, for example IPOs, you can get an initial relatively
short-run overshooting then a relatively long-run underreaction. But, again, as a general rule,
most corporate events seem to support underreaction. Thus, pricing isn‘t fully reflecting basic
information and it seems to take in many cases up to one year, and in some cases beyond one
year, to do so.

In addition, for cash flow related variables (i.e., earnings and dividends) it has been stated, and
seems quit plausible that that which is driving earnings underreaction (also called ―Post Earnings
Announcement Drift‖ or ―PEAD‖) is also driving dividend announcements (e.g., see Liu et al.
(2008)). For students of behavioral finance, and even most who have studied accounting, this
should not be too surprising. It should not be shocking that the largely unknown mechanism
driving earnings to be reflected in stock prices over about three quarters works according to
about the same process for dividend surprises. Remember, finance is about discounted cash
flows or present values. In this case you have the basic periodic cash flow for equities (i.e.,
dividends) and what is often an accounting accruals adjusted proxy for cash flow available for
dividends (i.e., earnings after accounting and/or tax adjustments) behaving in similar ways. Of
course, they should behave in similar ways over large samples of firms because they should and
Kihn / Behavioral Finance 101 / 506

often do reflect similar cash flow dynamics. In short, dividends should move as earnings move,
because they are largely the same things. Thus, there really is no mystery here; but alas much
like attributing overeaction to the January effect, it doesn‘t explain what is so ‗efficient‘ about
basic cash flow changes (i.e., whether represented by dividends or earnings) taking up to about
one year to get incorporated into common stock prices. Therefore, explaining a normative
mystery with a normative mystery does not explain the normative mystery (i.e., either one of
them).

CONCERNING THE ―POWER‖ OF THE EVENT STUDY TESTS AND RELATED
ISSUES
379

Even if the ‗model‘ is EMT inspired and rationalized and/or the test EMT sanctioned, a common
EMH/EMT supporter retort to events study results not supportive of ‗market efficiency‘ is that

379
See e.g. Campbell et al. (1997 pp. 149-180) for a thorough treatment of event studies and related issues.
Kihn / Behavioral Finance 101 / 507

the model is wrong or misspecified and therefore the test is misapplied.
380
This is commonly
called the ―joint hypothesis problem.‖ In short, any test of market efficiency (e.g., event studies
tests) is a ―joint test‖ of efficiency and the asset pricing model used. The logic is that if the asset
model applied is not the true model, then we cannot really say anything about the efficiency (or
inefficiency) of the market (i.e., the efficiency test is not valid). Therefore, given that ―all models
are wrong‖, all empirical tests of market efficiency (which includes all event studies of corporate
events) are misapplied and meaningless (i.e., according to this line of argument).

While the ―joint hypothesis problem‖ seems truly to be a problem, and potentially invalidates
most, if not all, normatively based descriptive research in finance, the arguably most important
issue is likely the ―power‖ of the tests themselves. That is, given a null hypothesis of the public
announcement of the event has no impact on security returns (typically common equity returns)
after the announcement, what is the probability of incorrectly rejecting such a hypothesis?
Apparently, the answer is that the probability is and has been typically quite high (see, e.g.,
Khotari and Warner (2006, pp. 14-20)). Therefore, it isn‘t just that the model is wrong (i.e., one
or more assumptions are descriptively incorrect, which they are), but that in addition one or more
of the assumptions of the statistical test is wrong. For example, most event studies tests assume
that the cross-sectional distribution of security returns is normally distributed. Strictly speaking,
it rarely is (for that matter, if they even can be). It‘s not just the distribution of returns that may
be problematic, other related issues include the following (see Khotari and Warner (2006) for a
more detailed review):

380
Of course, EMH/EMT supporters originally felt the models and tests were fine as long as the results were
generally interpreted as supportive of market efficiency. Again, by my reckoning, the most important issue is that
these studies focus on returns and not whether the price levels themselves are efficient.
Kihn / Behavioral Finance 101 / 508

- Particularly problematic are long horizon event studies (long horizon is typically
regarded as one year or more). In general, the ―joint hypothesis‖ problem is more
problematic for longer horizon studies, and the power of the test(s) is/are lower. Thus,
short horizon studies are less reliant on the model employed to determine efficiency or
lack thereof.
- In addition to the minimally implicit assumption of using the correct model (which is
unlikely, if not impossible), different models have different properties. Therefore, not
only is the model ―wrong‖, but it may not be very useful to prove or disprove efficiency.
The precision and bias of each model will likely differ; therefore, minimally, it is difficult
to compare event studies.
- In addition to the likely problematic assumption concerning the normality of returns
across the cross-section of returns, there is the assumption of returns being independently
distributed across time.
381
This is unlikely as event-time clustering is, by design and
definition, not conducive to the independence requirement. Therefore, due to the nature
of the event study methodology, this assumption is wrong and the resulting inferences
incorrect. Unless a correction is made, the estimated standard deviation is biased
downward, and the resulting test statistic is therefore biased upward.
- As with the previous issue, the nature of events themselves may preclude unbiased tests.
For example, and assuming some leakage of information before the event announcement
date (which is likely in many, if not most, cases) and/or managers are timing the market
(i.e., systemic misvaluation), the returns surrounding an event, and most importantly

381
Therefore, returns are normatively assumed to be independent through time and in the cross-section. Both are
dubious assumptions.
Kihn / Behavioral Finance 101 / 509

before the event, are anything but representative of the normal distribution of returns for
that security. Therefore, unless the prior event date data is clean or not impacted by the
upcoming event (i.e., given the underlying statistical assumptions), then the test cannot be
unbiased.
382
For example, price volatility tends to increase around a corporate event
announcement (even before the announcement, which is normatively not supposed to
happen). Clearly, many events are at least partially anticipated which largely defeats one
critical basic assumption made by event studies.
383

- The descriptive reality of nonrandom size and industry characteristics works against the
notion that increased noise decreases power.
384
Furthermore, even ignoring more specific
sample characteristics, volatility varies through time. This alone would tend to introduce
diminished power for event study tests. Therefore, firm characteristics and even the
calendar can dramatically impact the power of event studies.
- One time events (e.g., a single merger) are more difficult to adequately measure than
repeat periodic events (e.g., earnings announcements). For example, mergers
announcements tend to be smaller sample studies than earnings announcements.
- For all the mentioned reasons alone, it can be generally hard to resolve whether
something is a mispricing and/or mismeasurement. We may conclude that there is
mispricing when none exists or conclude there is no mispricing when in fact there is.

382
Otherwise, it might be possible to compare to pre-event periods and adjust the bias accordingly, but then that
would assume that the observable pre-event period(s) is/are unbiased. In a sense, in almost any statistical endeavor
in economics one must rely on assumptions that are almost invariably wrong.
383
Even more damming is the fact that, for example, managers clearly try to time stock and/or debt issuance, yet
event studies ignore this fact. As pointed out by Khotari and Warner (2006, p. 31) this will tend to result in findings
of market efficiency, particularly for the Jensen‘s alpha approach, when in fact it doesn‘t exist.
384
In addition, value characteristics can have significant effects (e.g., samples strongly biased toward low or high
book-to-market ratio firms).
Kihn / Behavioral Finance 101 / 510

- ―However, absent a sound economic rationale motivating the inclusion of the size, book-
to-market, and momentum factors, whether these factors represent equilibrium
compensation for risk or they are an indication of market inefficiency has not been
satisfactorily resolved in the literature (see, e.g., Brav and Gompers, 1997).‖ Khotari and
Warner (2006, p. 27) In other words, not just is the model a problem, but there is an issue
of whether the ‗risk factors‘ associated with models used in event studies are really that.
For example, what exactly is the justification for a size ‗risk factor‘? Again, are we just
measuring the size ‗anomaly‘ and calling it a ‗risk‘, even if it isn‘t, or is it something
else? Behavioral finance types would tend to say that size, value, momentum, etc.
‗factors‘ are not really purely ‗risk factors‘ but something more akin to ‗characteristics‘.
Therefore, effectively, the ‗model‘ is not controlling for various ‗risks‘ but actually
confounding risk with something beyond risk. Therefore, the ‗model‘ is not just ―wrong‖,
but misspecified.
In summary, almost regardless of the particular event study method, it is difficult, if not
impossible, to confidently state, especially concerning long horizon studies, that a study supports
or rejects market efficiency. Especially more recently for long horizon event studies, there are
suggested methods for correcting such things as skewness, non-normality, cross-correlation,
specification bias, lack of independence of returns, industry and other dimensions of
overrepresentativeness, etc., but none to my knowledge corrects all problems all the time.
Therefore, event studies, particularly beyond one year horizons typically infer a degree of
statistical accuracy that just doesn‘t exist. Actually nonrandom samples, such as those found in
event studies (actually most studies purportedly examining market efficiency) tend to reject the
Kihn / Behavioral Finance 101 / 511

null hypothesis of no abnormal performance more often than the studies infer from their stated
statistical values (see, e.g., Jegadeesh and Karceski (2004)).
385


SO, WHAT CAN WE SAY ABOUT CORPORATE EVENT STUDIES?
Even if we cannot infer too much from long horizon studies, in the final analysis we can say the
following:
1. Corporate events can have significant impacts on stock prices.
2. All major researched corporate events show some signs of market inefficiency (i.e., as
normatively defined), especially at horizons under one year.
3. Given that all models and methodologies are wrong, especially at horizons of more than
one year, we should be somewhat circumscribed in our declarations.
In short, event studies are much like most of current finance, right, wrong, and messy.


385
Is it merely coincidental that most journals that publish such studies have a clear bias to reject such hypotheses?
Kihn / Behavioral Finance 101 / 512

REFERENCES
Baker, M., and S. Savasoglu, ―Limited arbitrage in mergers and acquisitions‖, Journal of
Financial Economics, Volume 64, Issue 1, April 2002, 91-115.

Bernard, V., and J. Thomas, ―Post-Earnings-Announcement Drift: Delayed Price Response of
Risk Premium?‖, Journal of Accounting Research, 1989 Supplement – Current Studies on the
Information Content of Accounting Earnings, Volume 27, Number 3, Autumn 1989, 1-36.

Bernard, V., and J. Thomas, ―Evidence that Stock Prices Do Not Fully Reflect the Implications
of Current Earnings for Future Earnings‖, Journal of Accounting and Economics, Volume 13,
Issue 4, December 1990, 305-340.

Campbell, John, Lo, Andrew, and A. MacKinlay, The Econometrics of Financial Markets,
Princeton University Press, Princeton, New Jersey, 1997.

Datta, S., Iskandar-Datta, M., and A. Patel, ―The Pricing of Initial Public Offers of Corporate
Straight Debt‖, Journal of Finance, Volume 52, Number 1, March 1997, 379-396.

Desai, H., and P. Jain, ―Long-Run Common Stock Returns following Stock Splits and Reverse
Splits‖, Journal of Business, Volume 70, Issue 3, July 1997, 409-433.

Kihn / Behavioral Finance 101 / 513

Ikenberry, D., Lakonishok, J., and T. Vermaelen, ―Market underreaction to open market share
repurchases‖, Journal of Financial Economics, Volume 39, Issues 2-3, October 1995, 181-208.

Jegadeesh, N., and J. Karceski, ―Long-Run Performance Evaluation: Correlation and
Heteroskedasticity-Consistent Tests‖, Working Paper, April 2004, 1-40.

Khotari, S., and J. Warner, ―Econometrics of Event Studies‖, Center for Corporate Governance –
Working Paper, May 2006, 1-53.

Liu, Y., Szewczyk, S., and Z. Zantout, ―Underreaction to Dividend Reductions and Omissions?‖
Journal of Finance, Volume 63, Number 2, April 2008, 987-1020.

Loughran, T., and J. Ritter, ―The New Issue Puzzle‖, Journal of Finance, Volume 50, Number 1,
March 1995, 23-51.

Ritter, J., and I. Welch, ―A Review of IPO Activity, Pricing, and Allocations‖, Journal of
Finance, Volume 57, Issue 4, August 2002, 1795-1828.




Kihn / Behavioral Finance 101 / 514

Chapter 16: Can we learn our way to normative market efficiency?
386


―Economists usually contend that in natural settings people either learn from personal experience
or are surrounded by institutions – such as advice of relatives or consultants – that provide advice
in unfamiliar situations. How well people learn from personal experience, and from the
experience of others, is therefore a central question in the debate about the behavioral
foundations of economics.
Our research suggests grounds for pessimism about both kinds of learning.‖
Camerer et al. (1989, p. 1246)

The above quote is from an experimental study showing that ‗experts‘ display the ‗curse of
knowledge‘. As opposed to providing a ―steady hand‖ to the ignorant investor, professional
investors and traders actually often display more bias than the ignorant. Haigh and List (2005, p.
523) found something similar when they checked for myopic loss aversion (―MLA‖ – the
combination of mental accounting and loss aversion) among a group of ―professional‖ CBOT
traders and compared them to a control group of students: ―Yet, much like certain anomalies in
the realm of riskless decision-making, these behavioral tendencies may be attenuated among
professionals. Using traders recruited from the CBOT, we do indeed find behavioral differences

386
This chapter could have been the most involved and far reaching of those in this book; it is not. I have decided to
cut it short for various reasons. First, I am not an expert, but have done some reading and applied some common
sense. Second, I wanted to keep as focused on the financial markets and pricing therein as much as possible. Third,
even though I think this is a critical topic, I want it to be as conceptually focused as possible, which is very difficult
given that the subject needs to be focused on financial market pricing. Therefore, I choose to pick and choose what I
thought would be helpful for a reader trying to come to grips with behavioral finance and open to learning how to
learn the subject matter.
Kihn / Behavioral Finance 101 / 515

between professionals and students, but rather than discovering that the anomaly is muted, we
find that traders exhibit behavior consistent with MLA to a greater extent than students.‖ In other
words, student suck, but the traders are worse. Therefore, much like our search for the mythical
rational arbitrageur, when we begin to look for a correcting influence we often find agents who
are as bad or worse than the agents they are mythically supposed to help and/or correct (i.e., from
a normative perspective).

Again, can we learn our way to traditional market efficiency? Answer: Of course, but it is
unlikely. Remember there is the issue of the strict economic definition (which is based currently
on specific mathematical definitions) of rationality. As humans we just don‘t adhere to the
normative coherence and invariance economics demands. Therefore, the mathematical
specification of normative choice under uncertainty just cannot hold, that is, unless we learn to
be strictly economically rational (i.e., in the current normative sense). Is that possible? Answer:
Possibly for some, but probably not for all, minimally because of something called the ‗dual
burden‘ (which is related to overconfidence). If we at least had a strictly rational group of
economic agents, then we get back to the rational arbitrageur argument of this group correcting
mispricing in all markets all the time, but, of course, they would also need to have sufficient
capital to impact pricing sufficiently. If we at least had a group ready to correct mispricing, how
likely would it be that they would and/or could? Answer: It depends (minimally, it depends on
who is strictly rational and how much relative capital they possess at any given time).

Kihn / Behavioral Finance 101 / 516

―Economists presume that experimental subjects do not work for free and work harder, more
persistently, and more effectively, if they earn more money for better performance. …
In the kinds of tasks economists are most interested in, like trading in markets, bargaining in
games and choosing among gambles, the overwhelming finding is that increased incentives
do not change average behavior substantially (although the variance of responses often
decreases).‖ Camerer and Hogarth (1999, p. 1) Much like the ‗professional‘ vs. amateur
canard/normative myth, we have the normative myth that monetarily incentivized ‗professionals‘
will correct pricing, because they will make more money by so doing. As mentioned elsewhere
in this book, there certainly are some more rational arbitrageur types for which this is true, but it
presupposes that money will flow overwhelmingly to them, when in fact it often doesn‘t (e.g.,
during the front leg of a bubble).

Furthermore, many economists believe people will ‗learn their way out‘ of their irrational biases
(i.e., irrational from a normative economics perspective). Is there hope of this? Given current
incentives and associated financial market structure, it is unlikely. Although, some effects that
cause violations of economic axioms can be diminished by incentives and structure. Pointedly,
Camerer and Hogarth (1999, p.7) note that: ―no replicated study has made rationality violations
disappear by raising incentives‖.

Also, it is important to remember that even the so called professionals (e.g., WSSs, earnings
analysts, etc.) not only get it wrong, but they can be systematically wrong. This is somewhat akin
to a professional soccer player scoring for the opposing side more than they score for their own
Kihn / Behavioral Finance 101 / 517

team. If this sort of systematic bias (which you do not systematically see in professional sports)
toward pushing prices away from fundamental value occurs among ‗professionals‘ in the
financial markets, then why would we think the incentives are there to train the unwashed masses
(i.e., amateurs) to push prices toward their fundamental values? Well, you wouldn‘t.

In addition to diverging from the strict normative economic definition of rationality and the fact
that even many finance ‗professionals‘ are systematically biased, there is the issue of the
―exactingness‖ of the task(s) itself/themselves. Exactingness is the cost of failure to learn. For
example, what is the cost of not being able to learn to properly price a T-bill, or for a WSS to
forecast the stock market?

Furthermore, many, or even most, of us just may not be able to do what it would take to move
prices toward their fundamental values. Think of what tasks one would need to be able to
perform and the degree of precision required for the tasks required, and under what conditions it
would be required. Therefore, not only would a group of relatively well capitalized economic
agents have to exist, but they would have to perform cognitive tasks that are likely beyond the
majority of the population under conditions that don‘t seem to exist today. What are the odds of
this happening? If the current state of finance and the financial markets are any indication, it is
―not bloody likely.‖
387




387
In the movie he was answering a rhetorical question about whether a soldier would die for ―King and country‖ if
they knew what they were getting into.
Kihn / Behavioral Finance 101 / 518

And if that wasn‘t enough, there is the issue of the ‗dual burden‘. I‘m confident there are other
problems, but this alone should give one pause.

THE ‗DUAL BURDEN‘
―We argue that when people are incompetent in the strategies they adopt to achieve success and
satisfaction, they suffer a dual burden: Not only do they reach erroneous conclusions and make
unfortunate choices, but their incompetence robs them of the ability to realize it. … three points.
The first two are noncontroversial.
1. First, in many domains in life, success and satisfaction depend on knowledge, wisdom, or
savvy in knowing which rules to follow and which strategies to pursue. … .
2. Second, people differ widely in the knowledge and strategies they apply in these domains
(Dunning, Meyerowitz, & Holzberg, 1989; Dunning, Perie, & Story, 1991; Story &
Dunning, 1998), with varying levels of success. Some of the knowledge and theories that
people apply to their actions are sound and meet with favorable results. Others, … are
imperfect at best and wrong-headed, incompetent, or dysfunctional at worst.‖
Kihn / Behavioral Finance 101 / 519

3. The ‗dual burden‘ issue.
(Kruger and Dunning (1999, p. 1121))

The ‗dual burden‘ issue seems likely related to overconfidence. Essentially, whenever I am
ignorant of some area, for example financial market pricing, I suffer two burdens. First, because
I don‘t know financial market pricing models I cannot value financial market securities. Second,
because I don‘t know about financial market pricing models or even say basic finance (i.e., the
first burden), I find it impossible, or at least difficult, to find an ‗expert‘ to help me learn them, or
to entrust to value securities for me. The second part is a practical circularity that can be broken
by learning, that is, to the extent I am capable of learning about financial market pricing, which I
may or may not be.
388
The fact that most people, for example, invest in securities for which they
haven‘t the slightest idea whether they are priced ―correctly‖ or not, would clearly indicate they
must have some exaggerated level of confidence in themselves and/or others.

Kruger and Dunning (1999) analyzed three areas of ―metacognitive skills‖: (1) humor, (2) logical
reasoning, and (3) grammar. The results were similar in all three. They found:
1. ―Competence begets calibration‖ (hence, the ‗dual burden‘ without competency).

388
There is a clear difference between most tasks in the physical domain (e.g., shooting a basketball) and most in the
cognitive domains (e.g., learning particle physics). Most tasks in the physical domain can be performed and/or
evaluated by most people, yet in the cognitive domains this is typically far from true (e.g., financial market pricing).
Kihn / Behavioral Finance 101 / 520

2. ―The burden of expertise‖
389
(competent people tend to underestimate their abilities
almost as systematically as the least competent systematically overestimate their
abilities), but there are far fewer of them (roughly 1/10
th
seem to be underconfident).
Based on the results of the first three tests, they also examined the extent to which learning was
possible (a fourth test). They found that learning may be possible under stringent feedback
and self-assessment, otherwise calibration could get worse (i.e., based on the fourth tests‘
results). The people in the lower quartile overestimated their competence by, on average, about
50% (i.e., they were in the 12
th
percentile and estimated themselves to be in the 62
nd

percentile).
390
It is interesting that the competent have a burden of overestimating the ability of
their peers (and/or underestimating their own abilities).

When viewing the next three graphs, note that if people were well calibrated (i.e., had an
accurate and unbiased opinion of themselves), then people‘s ―perceived ability‖ (the dark line)
would approximately overlap the light line (i.e., the 45 degree line). If the black line is above the
light line, that is a measure of overconfidence; conversely, if the light line is above the black line,
that is a measure of underconfidence (which is relatively rare among humans, regardless of the

389
Obviously, this ―burden of expertise‖ differs from the one documented where ‗experts‘ showed more inefficient
bias than nonexperts.
390
The tests were based on 65 Cornell University undergraduates for the humor test, 45 for the logical reasoning
test, and 84 for the grammar test. The humor test was based on 30 jokes from Woody Allen, Al Frankin, and a book
of ―really silly‖ pet jokes by Jeff Rovin, which were sent out to individual professional comedians which rated them
on a scale of 1 to 11 (not funny to very funny). The experts were in very strong agreement on the ratings. The logical
reasoning test was a set of 20 questions from the LSAT. The grammar test was based on the worth they assigned to
American Standard Written English (ASWE) from a 20 question test based on questions taken from a National
Teacher Examination preparation guide. Also, a fourth test was given to 140 Cornell undergraduates from a single
human development course that was given extra credit for participating. Completed tests then went over their
results, the asked to re-estimate their results.
Kihn / Behavioral Finance 101 / 521

subject matter, as you will see). The first graph is on humor, then logical reasoning, and finally
grammar.

Humor
Figure 1. Perceived ability to recognize humor as a function of actual test performance (Study 1).
From: Kruger, J., and D. Dunning, ―Unskilled and Unaware of It: How Difficulties in Recognizing One‘s Own
Incompetence Lead to Inflated Self-Assessments‖, Journal of Personality and Social Psychology, 1999, Vol. 77, No.
6, p. 1124.

Kihn / Behavioral Finance 101 / 522


Logical reasoning
Figure 2. Perceived logical reasoning ability and test performance as a function of actual test performance (Study 2).
From: Kruger, J., and D. Dunning, ―Unskilled and Unaware of It: How Difficulties in Recognizing One‘s Own
Incompetence Lead to Inflated Self-Assessments‖, Journal of Personality and Social Psychology, 1999, Vol. 77, No.
6, p. 1125.

Kihn / Behavioral Finance 101 / 523


Grammar
Figure 3. Perceived grammar ability and test performance as a function of actual test performance (Study 3).
From: Kruger, J., and D. Dunning, ―Unskilled and Unaware of It: How Difficulties in Recognizing One‘s Own
Incompetence Lead to Inflated Self-Assessments‖, Journal of Personality and Social Psychology, 1999, Vol. 77, No.
6, p. 1126.

Regardless of test, again, the bottom quartile people overestimated their competence by, on
average, about 50%. There are several things to note:
1. There was systematic overconfidence at the bottom and underconfidence at the top, in all
three tests.
2. Overall, overconfidence is generally pronounced in all three (by a great deal).
Kihn / Behavioral Finance 101 / 524

3. With respect to logical reasoning, people in the middle show relatively good calibration,
whereas those at the bottom are worst (i.e., in terms of difference between actual and
perceived ability).
Even after repeated feedback (i.e., the fourth study), there was only slight improvement with
respect to logical reasoning and learning (i.e., the perceived and actual test scores begin to
steepen like the perceived ability line), not for humor or grammar.

But why? (See Kruger and Dunning (1999, p. 1131-1132))
1. ―People seldom receive negative feedback about their skills and abilities from others
in everyday life.‖
2. ―Some tasks and settings preclude people from receiving self-correcting information
that would reveal the suboptimal nature of their decisions.‖ This is espcially true, for
example, of WSSs.
3. ―The problem with failure is that it is subject to more attributional ambiguity than
success. For success to occur, many things must go right: The person must be skilled,
apply effort, and perhaps be a bit lucky. For failure to occur, the lack of any one of these
components is sufficient.‖
4. ―Incompetent individuals may be unable to take full advantage of one particular kind of
feedback: social comparison.‖ Again, the ‗dual burden‘ issue impedes progress or even
the ability to learn.
Think of the extreme counter-example, say professional athletes in an individual sport or in a
team sport where copious statistics on individual performance are kept. Do the best professional
Kihn / Behavioral Finance 101 / 525

players overestimate their ability in their sport by 50%? That is highly unlikely, not just because
feedback tends to be fast and blunt, but it is also typically physical. For example, if you miss a
penalty kick at the end of regulation play, it is not only physically obvious who missed, but your
team will tend to lose. Therefore, there is a clear difference between the physical domain and, for
example, most areas of finance (which are cognitive in nature).

Also, the authors mention other issues involved with feedback:
1. ―Self-serving trait definitions‖, such as ―selective recall of past behavior‖ and ―the
tendency to ignore proficiency in others‖.
2. ―Incompetent are likely to be unaware of their lack of skill.‖
3. ―In other domains, however, competence is not wholly dependent on wisdom, but
depends on other factors, such as physical skill.‖ However, coaches may be skilled in the
strategies and tactics of the sport, but couldn‘t, for example, dunk a ball if their life
depended on it.
4. ―Finally, in order for the competent to overestimate themselves, they must satisfy a
minimal threshold of knowledge, theory, or experience that suggests that they can
generate correct answers. In some domains, there are clear and unavoidable reality
constraints that prohibit this notion. For example, most people have no trouble identifying
their own inability to translate Slovenian proverbs, reconstruct an 8-cylinder engine, ... .
In these domains, without even an intuition of how to respond, people do not
overestimate their ability. Instead, if people show any bias at all, it is to rate themselves
as worse than their peers (Kruger, 1999).‖
Kihn / Behavioral Finance 101 / 526

5. ―People are more miscalibrated when they face difficult tasks, ones for which they fail to
possess the requisite knowledge, than they are for easy tasks, ones for which they possess
that knowledge (Lichtenstein & Fischhoff, 1977). … the end result is a large degree of
overconfidence.‖
In essence, failure is fairly easy to achieve, but well deserved success in the more cognitive
realms requires not only skill and knowledge, but a level of self awareness that most of us are not
programmed with (and probably some luck).

It isn‘t that people don‘t want to succeed, but, for several reasons, they may just be unable to.
Specifically, people tend to have ―overly optimistic and miscalibrated views‖ of themselves.
Therefore, if it wasn‘t bad enough that many might not even be able to act like perfect economic
creatures, those that might want to and even be able to might decide they don‘t need to. Blame it
on the ‗dual burden‘.

The obvious problem of the ‗dual burden‘ can obviously be applied to finance. What if I am
unaware of what constitutes ―good performance‖, but I want above average risk-adjusted
returns? Then I would have at least two problems: (1) I cannot generate good performance (i.e.,
ignoring ―luck‖), and (2) I cannot be trusted with selecting a person or firm to generate ―good
performance‖. How can I hope to evaluate others if I am not even aware of the fact I don‘t know
how to evaluate what would constitute ―good performance‖ in the first place? Therefore, the dual
burden issue permeates organizations and the very existence of the inefficiencies themselves.
Then again, there is the issue of learning itself. The only way it seems most people can learn is
Kihn / Behavioral Finance 101 / 527

under tightly controlled conditions, which are almost the opposite of those encountered in the
‗real world‘ of finance (e.g., monetary tiebacks to errors that are systematic). Combining the
‗dual burden‘ with learning issues makes it rather difficult to be optimistic concerning learning
our way out.

Now pause for a moment and consider an individual and how he or she would evaluate an
investment, particularly after the investment has either gained or lost value (i.e., after controlling
for risk). Consider a simple world where there are only two possible outcomes, a gain or a loss.
In addition, consider that one can either be right or wrong in their assessment of the investment.


The 4 possible outcomes of the investment process
Loss Gain
W
r
o
n
g
Clearly bad (abandon all
hope, since likely due to
'dual burden') - Type II
error analogy
Could be worst outcome
(likely result is a false
sense of confidence)
R
i
g
h
t
Not time to panic, if
recognized, this can be
good (need to work IP
towards lower right box)
Ideal, but remain paranoid
R
e
a
s
o
n
Outcome
Kihn / Behavioral Finance 101 / 528

Keep this 2 x 2 grid in mind. Obviously, two quadrants or boxes are akin to ‗Type I error‘ (also
called a ‗false positive‘)
391
and ‗Type II error‘ (also called a ‗false negative‘)
392
. The ideal is to
gain for the right reason, but imagine you don‘t really understand why an investment gains or
losses, but erroneously think you do. The problem is that there can be cases where we gain but
for an erroneous reason. Now imagine that you indeed experienced a gain, but for the wrong
reason and do not know it because of overconfidence and/or the dual burden. This is potentially
dangerous and normal for most people in finance. Consider the Internet stock and Dot.com ―day
traders‖ during the mid- to late-1990s NASDAQ bubble. Didn‘t they think they knew why they
were making money? Most convinced themselves that they were savvy ―traders‖ with keen
insight. Few admitted to themselves, let alone others, that they were mostly tagging along with a
fundamentally unjustified ‗bubble‘. The proof of this was that most rode the bubble up and back
down after the spring of 2000 (i.e., around when the market peaked). If they really knew what
was going on (and if that was even possible) for the right reason(s), they would have sold
sometime in late 1999 or around the spring of 2000, and knew why they were doing it. In short,
most ―day traders‖ found themselves in the gain box for the wrong reason(s) and then after the
spring of 2000 found themselves in the loss box also for the wrong reason.
393
That is normal, and
human psychology is a key component of the process.

Now take it a step further and imagine you are a finance ‗professional‘ advising other people and
you lose their money consistently but are handsomely rewarded for this (e.g., WSSs and earnings

391
Formally, it is rejecting the null hypothesis when the null hypothesis is true. This would be analogous to the gain
for the wrong reason.
392
Formally, it is failure to reject the null hypothesis when the null hypothesis is false.
393
See Linnainmaa (2003).
Kihn / Behavioral Finance 101 / 529

analysts). Furthermore, suppose you didn‘t really understand why your firm‘s clients lost or
made money, just that you were rewarded. What would you think? Most think they understand
what is happening and why because why else would they be paid so well? Aren‘t the finance
related labor markets efficient after all? As long as you are paid well you probably don‘t obsess
on the why. Clearly, given their lack of professional prowess, current and past WSSs and earning
analysts don‘t, and one can only surmise the incentives haven‘t been there to correct it.
394


This brings us to the very basic issue of exactly how we make a decisions and learn from them,
or don‘t. As De Bondt (2002, p. 607) noted: ―Decision processes are often crucial to decision
outcomes.‖ Implicitly or explicitly economics and finance has not felt compelled to deal with the
actual decision making process that humans go through, including their capacity and/or ability to
learn from their mistakes in the markets. As it turns out, it is important.


394
My assumption is that given current turmoil in the finance industry things have a chance to change, but as of the
writing of this footnote, they haven‘t significantly changed.
Kihn / Behavioral Finance 101 / 530

HOW DO WE LEARN?
For what follows see, for example, Hogarth et al. (1991). First, a big caveat, the following
applies to repetitive tasks only. Therefore, non-repetitive tasks (e.g., the kind often found in
financial decision making) do not apply, but to the extent learning in general is useful in the
financial realm, I expect some basic lessons will still apply. This is largely why structured
training is focused on repetitive tasks (think military and large public & private bureaucracies),
because it works.

Learning from feedback (again, the following applies only to repetitive tasks):
1 There is a tradeoff between incentives and ―exactingness‖ (exactingness refers to
―severity‖ with which performance is evaluated, for example in a normal teaching
situation it is the grade).
2 Feedback is often ambiguous. It has an inferential component (e.g., a grade on a paper
informs the student of how to write a good paper) as well as an evaluative component
(e.g., the grade tells the student whether the effort was good, bad, or indifferent).
Therefore, confounding things is the extent to which the grade reflects student ability or
instructor grading policy.
3 Specifically, exactingness reflects the severity of penalties imposed for errors.
4 In addition, the outcome may or may not be perceived as consequential. That is, it may or
may not be motivating (e.g., rightly or wrongly, the grade may not be perceived to affect
job prospects).
Kihn / Behavioral Finance 101 / 531

5 Therefore, motivation is critical to learning, but due to cognitive limitations (e.g., the
―dual burden‖) and/or factual limitations (e.g., it actually may not matter) motivation may
be completely lacking.
6 For example, regardless of actual importance of a task or not but its perceived
importance, the extent to which the individual learning a task has an incentive to learn
the task can vary greatly.
7 Generally, there are two types of incentives: internal (i.e., intrinsic motivations – e.g.,
pride of mastery) and external (e.g., monetary or other explicit rewards based on
performance).
8 There is an interaction between exactingness and incentives that suggests the
following: there is a tradeoff. Therefore, Incentives can help up to point and
exactingness can matter up to a point (i.e., assuming the task is perceived to matter, etc.),
but at the margin too much of either tends to cancel the other out.
9 Intermediate exactingness was found best (i.e., not too lenient and not too exacting) with
no incentives to limited incentives. In lenient environments incentives can improve
performance, while in exacting environments they have deleterious effects.
10 In general, it is also helpful to reveal the evaluation function to the learners (e.g., explain
generally what will be on the test and what you are looking for as a teacher).

Now equate this to the financial markets and try to apply these concepts. In short, most financial
firms (actually most bureaucracies) are poor places to apply learning concepts. In addition, if we
Kihn / Behavioral Finance 101 / 532

overlay adverse selection and the economic incentives associated with it in the finance industry
we have some real issues to surmount to achieve efficiency, let alone learning.

But of course, in the final analysis it all depends on the individual and the learning task (e.g.,
under some circumstances incentives can be detrimental – see e.g., Greene and Lepper (1974)).
There appear to be tradeoffs between incentives and exactingness, but it all depends. It is clear
that exactingness can be overused. For example, think of the extreme, death or life as feedback
(genetic selection). If someone is pointing a loaded gun at you and asking you to perform brain
surgery, surely the motivation is there but the level of exactingness may have gone too far. Now
think finance, it should be profits or loss, but it isn‘t very often at the institutional level. That is,
most institutional investors are not risking their own capital. Does that influence motivation
and/or exactingness? Obviously, it does, and matters, for example, for hedge funds‘ structure vs.
that of mutual funds.

The key seems to be the nature of the task. For tasks that are more creative and/or complex,
incentives can ―divert needed attention from inference to evaluation, that is, from a concern
about how to do the task to how well one is doing. In tasks that are understood, however,
attention can be more profitably allocated to executing known strategies.‖ (Hogarth et al. (1991,
pp. 735-736) In financial portfolio management, for example, PMs and the annual bonus cycle
seem to mess up the IP. Many are so completely fixated on gaming their bonuses that they are
not trying to improve the IP.

Kihn / Behavioral Finance 101 / 533

Note that the penalty function in the aforementioned study was symmetric and the task was a
single task (Hogarth et al. (1991)). Additionally, because different evaluation functions induce
different rates of learning, it may not always be a good idea to reveal the evaluation function.
How often in realms like finance is the evaluation function well known? For say a hedge fund
PM it might be established. But contrast the general task of a teacher with that of a businessman
or businesswoman. In academics it‘s superficially easy, that is, the teachers job is to teach you
and make sure you learn (as a student your job is to learn); and in business it‘s also superficially
easy, that is, you are suppose to maximize profit, and maximize excess returns in finance (i.e.,
controlling for risk). Now contrast that with the military with academics or business. The
military is potentially the most exacting environment (e.g., front line soldiering). But even in
cases where the penalty and/or reward are well known it may not be so clear how to get there. In
some sense, that is the dificulty of the job itself. Alas, typically in finance the penalty function is
neither symmetric nor the task singular.

I feel it is important to again mention overconfidence as a legitimate issue for not only finance,
but almost any realm where brutal and constant feedback may be lacking. Barberis and Thaler
(2002, p. 12 footnote #10) suggest that it may be due to at least two other biases: self-attribution
bias (where people see their