BEHAVIORAL

FINANCE
 Behavioral Finance
People are rational in “standard
finance.”
People are normal in Behavioral
finance.
Normal people:
commit cognitive errors
Affected by frames
Know the pain of regret
Are both risk averse and risk seeking
Cause bubbles in Markets
Behavioral finance research focuses on
 how investors make decisions to buy and
sell securities, and
 how they choose between alternatives.
 Market Efficiency
Two meanings
• Price equals (fundamental) value.
• You cannot beat the market (so buy and
hold).
“The bubble of the late 1990s proves that
the market is not efficient.”
In the sense that price equals value
But, can you predict when the bubble will
burst? It is very difficult.
Errors in Information Processing
Overconfidence
• Investors view themselves as more able to
value securities than they actually are.
• Investors tend to over-weight their
forecasts relative to those of others.
Overconfidence in Info. Processing
• People tend to believe things that are
easier to understand more readily than
things that are more complicated.
 Representativeness Heuristic
• The representativeness heuristic takes
one characteristic of a company and
extends it to other aspects of the firm.
• In particular, many investors believe a
well-run company represents a good
investment.
• Mental Short-cuts used to solve complex
problems.
 Behavioral Biases:
Loss Aversion

• Investors do not like losses and often

engage in mental gymnastics to reduce
their psychological impact.
• Their tendency to sell a winning stock
rather than a losing stock is called the
disposition effect in some of the behavioral
finance literature
 Myopic Loss Aversion

• Investors have a tendency to assign too

much importance to routine daily
fluctuations in the market.
• Abandoning a long-term investment
program because of normal market
behavior is sub optimal behavior.
 Anchoring
• Our decisions can be influenced by
extraneous information contained in the
problem statement.
• For example, investors tend to remember
the price they paid for a stock, and this
information influences their subsequent
decisions about what to do with it.
Anchoring—Earnings Estimates

• Analysts may be anchored to old EPS estimates.

• “Cockroach” theory of earnings surprises. When
good (or bad) announcements are made, other
good (or bad) surprises follow.
• Analysts may be anchored and not understand
the series of surprises to follow.
 Prospect Theory

• Risk averse investors get increasing utility

from higher levels of wealth, but at a
decreasing rate.
• Research shows that while risk aversion
may accurately describe investor behavior
with gains, investors often show risk
seeking behavior when they face a loss
 Mental Accounting
• Mental accounting refers to our tendency
to “put things in boxes” and track them
individually.
• For example, investors tend to
differentiate between dividend and capital
dollars, and between realized and
unrealized gains
 Availability Heuristic

• The availability heuristic is the contention

that things that are easier to remember
are thought to be more common.
 Empirical Evidence:
Value v Growth
• Investors naively extrapolate a continuation of
fast growth for growth firms and slow growth ….
• Slow growers tend to improve and fast growers
slow their growth in the future
• Errors by investors overprice growth firms and
under-price value firms.
• Value stocks out-perform growth stocks in LT
studies.
• Source: Broussard, Neely, et al JABR 2004.
 Conclusions
The Markets are not as Efficient as we once
thought
• Investors should recognize the
psychological, non-rational nature of
people.
• We need to guard against the over-
reactions of markets caused by mental
shortcuts, etc.
Warren Buffett, etc.
• Need to Understand the Business
• Mr. Market is sometimes give high quotes
and sometimes gives low quotes.
Choose the price that is lower than your
idea of “Intrinsic Value” (with a margin of
safety because you are apt to make a
mistake from time to time)
• More than a “EMH Anomaly”
 What should investors do?
• The market is still a very difficult “boggy”
to beat
• Buy and hold and resist psychological
factors
• It still pays to invest for the long-term.
• It still pays to Diversify