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BEHAVIORAL FINANCE- AN INTRODUCTION
Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. Sewell (2005) "I think of behavioral finance as simply "open-minded finance"." Thaler (1993) 'This area of enquiry is sometimes referred to as "behavioral finance," but we call it "behavioral economics." Behavioral economics combines the twin disciplines of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they spend, invest, save, and borrow money.' Belsky and Gilovich (1999) "This paper examines the case for major changes in the behavioral assumptions underlying economic models, based on apparent anomalies in financial economics. Arguments for such changes based on claims of "excess volatility" in stock prices appear flawed for two main reasons: there are serious questions whether the phenomenon exists in the first place and, even if it did exist, whether radical change in behavioral assumptions is the best avenue for current research. The paper also examines other apparent anomalies and suggests conditions under which such behavioral changes are more or less likely to be adopted." Kleidon (1986) "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 stande ready to capitalize on the mistakes of the naive. (This process, which we camm poaching, includes but is not limited to arbitrage.) Yet financial markets have been subject to speculative fads, from Dutch tulip mania to junk bonds, and to occasional dramatic losses in value, such as occurred in October 1987, that are hard to interpret as rational. Descriptive decision theory, especially psychology (see D. Kahneman et al., 1982), can help to explain such aberrant macrophenomena. Here we propose some behavioral explanations of overall market outcomes—specifically of financial flows, that are of considerable practical consequence to both policymakers and finance practitioners. Patel, Zeckhauser and Hendricks (1991) "Because psychology systematically explores human judgment, behavior, and well-being, it can teach us important facts about how humans differ from traditional economic assumptions. In this essay I discuss a selection of psychological findings relevant to economics. Standard economics assumes that each person has stable, well-defined preferences, and that she rationally maximizes those preferences. Section 2 considers what psychological research teaches us about the true form of preferences, allowing us to make economics more realistic within the rationalchoice framework. Section 3 reviews research on biases in judgment under uncertainty; because those biases lead people to make systematic errors in their attempts to maximize their preferences, this research poses a more radical challenge to the economics model. The array of psychological findings reviewed in Section 4 points to an even more radical critique of the economics model: Even if we are willing to modify our familiar assumptions about preferences, or allow that people make systematic errors in their attempts to maximize those preferences, it is sometimes misleading to conceptualize people as attempting to maximize well-defined, coherent, or stable preferences." Rabin (1996)
"Market efficiency survives the challenge from the literature on long-term return anomalies. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction to information is about as common as under reaction, and post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal. Most important, consistent with the market efficiency prediction that apparent anomalies can be due to methodology, most long-term return anomalies tend to disappear with reasonable changes in technique." Fama (1998) "Recent literature in empirical finance is surveyed in its relation to underlying behavioral principles, principles which come primarily from psychology, sociology and anthropology. The behavioral principles discussed are: prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and under reaction, representativeness heuristic, the disjunction effect, gambling behavior and speculation, perceived irrelevance of history, magical thinking, quasimagical thinking, attention anomalies, the availability heuristic, culture and social contagion, and global culture." Shiller (1998) "The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, peoples 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." Barber and Odean (1999) "Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications. We begin with a preliminary question about relevance. Does some combination of market forces, learning and evolution render these human qualities irrelevant? No. Because of limits of arbitrage less than perfect agents survive and influence market outcomes. We then discuss three important ways in which humans deviate from the standard economic model. Bounded rationality reflects the limited cognitive abilities that constrain human problem solving. Bounded willpower captures the fact that people sometimes make choices that are not in their long-run interest. Bounded self-interest incorporates the comforting fact that humans are often willing to sacrifice their own interests to help others. We then illustrate how these concepts can be applied in two settings: finance and savings. Financial markets have greater arbitrage opportunities than other markets, so behavioral factors might be thought to be less important here, but we show that even here the limits of arbitrage create anomalies that the psychology of decision making helps explain. Since saving for retirement requires both complex calculations and willpower, behavioral factors are essential elements of any complete descriptive theory." Mullainathan and Thaler (2000) "Behavioral finance is a rapidly growing area that deals with the influence of psychology on the behavior of financial practitioners." Shefrin (2000) "Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners." Shefrin (2000) "Behavioral finance is the study of how psychology affects financial decision making and financial markets." Shefrin (2001)
EMH and other rational financial theories did a respectable job of predicting and explaining certain events. which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders. returns and the allocation of resources. including consumers. The field has two building blocks: limits to arbitrage. cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions. This survey sketches a framework for understanding decision biases." Barberis and Thaler (2001) "This essay provides a perspective on the trend towards integrating psychology into economics. and reviews recent models. such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). The fields are primarily concerned with the bounds of rationality (selfishness. While these theories could explain certain "idealized" events. We close by assessing progress in the field and speculating about its future course. see The Capital Asset Pricing Model: An Overview. evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices. Why is behavioral finance necessary? When using the labels "conventional" or "modern" to describe finance. behave rationally and predictably.) For a while. However. to individual trading behavior." Rabin (2001) "The basic paradigm of asset pricing is in vibrant flux. and then present a number of behavioral finance applications: to the aggregate stock market. and their effects on market prices. which describes another source of economic decisions with related biases towards promoting selfinterest. What Is Market Efficiency? and Working Through The Efficient Market Hypothesis. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. returns and the resource allocation. Some topics are discussed. and psychology. behavioral finance. the real world proved to be a very messy place in which market participants often behaved very . Behavioral models typically integrate insights from psychology with neo-classical economic theory. academics in both finance and economics started to find anomalies and behaviors that couldn't be explained by theories available at the time. We discuss these two topics. theoretical and empirical evidence suggested that CAPM." Hirshleifer (2001) "Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices. security expected returns are determined by both risk and mis-valuation. and to corporate finance."Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. for the most part." Behavioral economics and its related area of study. Behavioral analysts are not only concerned with the effects of market decisions but also with public choice. which catalogues the kinds of deviations from full rationality we might expect to see. (For more insight. In this approach. and arguments are provided for why movement towards greater psychological realism in economics will improve mainstream economics. borrowers and investors. use social. as time went on. to the cross-section of average returns. These theories assume that people. self-control) of economic agents. we are talking about the type of finance that is based on rational and logical theories.
The following section provides a brief introduction to three of the biggest names associated with the field. After reading a draft version of Kahneman and Tversky's work on prospect theory. Despite this. however. Daniel Kahneman and Amos Tversky Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the fathers of behavioral economics/finance. According to conventional economics. approaches to problem solving)that cause people to engage in unanticipated irrational behavior. Behavioral finance seeks to explain our actions. Consider how many people purchase lottery tickets in the hope of hitting the big jackpot.unpredictably.0000006849%. blending economics and finance with . Kahneman and Tversky have focused much of their research on the cognitive biases and heuristics (i. this duo has published about 200 works. Important Contributors Like every other branch of finance. Richard Thaler While Kahneman and Tversky provided the early psychological theories that would be the foundation for behavioral finance. psychological theory could account for the irrationality in behaviors. this field would not have evolved if it weren't for economist Richard Thaler. Their most popular and notable works include writings about prospect theory and loss aversion . whereas modern finance seeks to explain the actions of the "economic man" (Homo economicus). Thaler became more and more aware of the shortcomings in conventional economic theoryies as they relate to people's behaviors. or 0. this assumption doesn't reflect how people behave in the real world. Since their initial collaborations in the late 1960s.e. Thaler went on to collaborate with Kahneman and Tversky. From a purely logical standpoint. for the famous Powerball jackpot). During his studies. emotions and other extraneous factors do not influence people when it comes to making economic choices. Homo Economics One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational "wealth maximizers" who seek to increase their own well-being. Thaler realized that. it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder (roughly 1 in 146 million. most of which relate to psychological concepts with implications for behavioral finance. millions of people spend countless dollars on this activity. the field of behavioral finance has certain people that have provided major theoretical and empirical contributions. These anomalies prompted academics to look to cognitive psychology to account for the irrational and illogical behaviors that modern finance had failed to explain. In most cases. In 2002. unlike conventional economic theory.topics that we'll examine later. Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics. The fact is people frequently behave irrationally.
psychology to present concepts. In fact. In his 1998 paper. for example. Some supporters of the efficient market hypothesis. it is not without its critics. Fama argues that many of the findings in behavioral finance appear to contradict each other. entitled "Market Efficiency. the endowment effect and other biases. A BRIEF HISTORY . the founder of market efficiency theory. The efficient market hypothesis is considered one of the foundations of modern financial theory. The most notable critic of behavioral finance is Eugene Fama. Professor Fama suggests that even though there are some anomalies that cannot be explained by modern financial theory. However. Critics Although behavioral finance has been gaining support in recent years. he notes that many of the anomalies found in conventional theories could be considered shorterterm chance events that are eventually corrected over time. such as mental accounting. the hypothesis does not account for irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released. Long-Term Returns And Behavioral Finance". behavioral finance itself appears to be a collection of anomalies that can be explained by market efficiency. and that all in all. are vocal critics of behavioral finance. . market efficiency should not be totally abandoned in favor of behavioral finance.
There is a very interesting and rich history of Behavioral Finace rooted in Behavior Economics and psychology. Noted Author Adam Smith wrote meaningful words in his 1759 text The Theory of Moral Sentiments. During the Classical Period there was a very close link between economics and psychology. and today Behavioral Finance is a very important fundamental of finance and can be used to making financial decisions. social.Behavioral Finance is a subject closely related to Behavioral Economics. This was an important text in describing an individual's behavior based on psychological principles. The Theory of Moral Sentiments. returns and the allocation of resources. Scientific research on human. in particular market prices. Smith's first . Smith's views closely followed those of his mentor Francis Hutcheson. cognitive and emotional biases is used to better understand economic decisions and how they affect Finance.
 Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. This led to unintended and unforeseen errors. which proposed psychological explanations of individual behavior and Jeremy Bentham wrote extensively on the psychological underpinnings ofutility. They developed the concept of homo economicus. Smith argues that we naturally share emotion and to a certain extent the physical sensations we witness in other people. Sharing the sensations of our fellow people. microeconomics was closely linked to psychology. Kahneman and Tversky wrote Prospect theory: An Analysis of Decision Under Risk. such as Ward Edwards. 2000). Observed and repeatable anomalies eventually challenged those hypotheses. But society is not held together merely by neutral rules.and in his own mind most important work. Psychologists in this field. Irving Fisher and John Maynard Keynes. George Katona and Laszlo Garai. an important paper that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory. Inmathematical psychology. a decision problem he first presented in 1953 which contradicts the expected utility hypothesis. In the 1960s cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Adam Smith wrote The Theory of Moral Sentiments. during the development of neo-classical economics economists sought to reshape the discipline as a natural science. outlines his view of proper conduct and the institutions and sentiments that make men virtuous (Smith. 2000). including Francis Edgeworth. 2000). and further steps were taken by the Nobel prizewinner Maurice Allais. Smith believed people by nature pursue their own self-interest. there is a longstanding interest in the transitivity of preference and what kind of measurement scale utility constitutes (Luce. For example. instead society is held together by sympathy (Smith. This makes independence or self-command an instinctive good. we seek to maximize their pleasures and minimize their pains so that we may share in their joys and enjoy their expressions of affection and approval (Smith. And neutral rules are as difficult to craft as they are necessary. Expected utility and discounted utilitymodels began to gain acceptance. generating testable hypotheses about decision making given uncertainty and intertemporal consumption respectively. for example in setting out the Allais paradox. deducing economic behavior from assumptions about the nature of economic agents. Vilfredo Pareto. 2000) Here he develops his doctrine of the impartial spectator. . Economic psychology emerged in the 20th century in the works of Gabriel Tarde. many important neo-classical economists employed more sophisticated psychological explanations. However. However. whose hypothetical disinterested judgment we must use to distinguish right from wrong in any given situation (Smith. whose psychology was fundamentally rational. Prospect theory is an example of generalized expected utility theory. 2000). During the classical period. Prospect theory In 1979.
glucose levels. actually describes what people do when they make choices with future consequences. Other developments include a conference at the University of Chicago. and the effects of limited attention are now part of the theory. Some prominent researchers question whether discounting. but high at time t when t is the present and time t+1the near future. since the rate of discount between time t and t+1 will be low at time t-1. sign. Becker. Much of the recent work on intertemporal choice indicates that discounting is a constructed preference. as conventional economics presumed. a seminal work that factored psychological elements into economic decision making. Considering the variability of discount rates. Ted O'Donoghue. especially concerning human judgment and decision-making under uncertainty". focus. and therefore inconsistent with basic models of rational choice. Intertemporal choice Behavioral economics has also been applied to intertemporal choice. and the scales used to describe what is discounted. Maurice Allais produced "Allais Paradox". as exemplified by George Ainslie's hyperbolic discounting(1975) which is one of the prominently studied observations. Other areas of research Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in preferences. thought listings. framing. Armin Falk. instead of maximizing utility. however. In 1968 Nobel Laureate Gary Becker published Crime and Punishment: An Economic Approach. Nobelist Herbert Simon developed the theory of Bounded Rationality to explain how people irrationally seek satisfaction. The pattern can actually be explained though through models of subadditive discounting which distinguishes the delay and interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur. mood. generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory. the major parameter of intertemporal choice. Psychological traits such as overconfidence. "inequity aversion".Although not a conventional part of behavioral economics. Ernst Fehr. This pattern of discounting is dynamically inconsistent (or time-inconsistent). and "reciprocal altruism". Intertemporal choice behavior is largely inconsistent." This . when t is the near future. a special behavioral economics edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahneman's 2002 Nobel for having "integrated insights from psychological research into economic science. a crucial challenge to expected utility. weakening the neoclassical assumption of "perfect selfishness. and Matthew Rabin studied "fairness". further developed by David Laibson. Discounting is influenced greatly by expectations. Hyperbolic discounting describes the tendency to discount outcomes in near future more than for outcomes in the far future. and Matthew Rabin. maintained strict consistency of preferences. projection bias. this may be the case.
. Work on "intrinsic motivation" by Gneezy and Rustichini and on "identity" by Akerlof and Kranton assumes agents derive utility from adopting personal and social norms in addition to conditional expected utility. with the success of books like Dan Ariely's Predictably Irrational.work is particularly applicable to wage setting. Practitioners of the discipline have studied quasi-public policy topics such as broadband mapping. and calculates the probabilities of external events and hence utility as a function of their own action. Behavioral economics caught on among the general public. "Conditional expected utility" is a form of reasoning where the individual has an illusion of control. even when they have no causal ability to affect those external events.
this is not always so. our ideas and opinions should also be based on relevant and correct facts in order to be considered valid. solid foundation.KEY CONCEPTS Key Concept No. .1. The concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a reference point . Anchoring Similar to how a house should be built upon a good.even though it may have no logical relevance to the decision at hand. However.
academic studies have shown the anchoring effect to be so strong that it still occurs in situations where the anchor is absolutely random. Kahneman and Tversky conducted a study in which a wheel containing the numbers 1 though 100 was spun.even though the number had absolutely no correlation at all to the question. the "diamond anchor" will live up to its name.Although it may seem an unlikely phenomenon. In this case. it is true that the fickleness of the overall market can cause some stocks to drop substantially in value. Academic Evidence Admittedly. many go into debt in order to meet the "standard". While spending two months worth of salary can serve as a benchmark. many men illogically anchor their decision to the two-month standard. some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. stocks quite often also decline in value due to changes in their underlying fundamentals. the average estimate given by the subjects was 25%. when the wheel landed on 10.N. Although the amount spent on an engagement ring should be dictated by what a person can afford. In a 1974 paper entitled "Judgment Under Uncertainty: Heuristics And Biases". Then.term volatility. the two-month standard used in the previous example does sound relatively plausible. the average estimate was 45%. the subjects were asked to give an actual estimate. Believe it or not. Consequently. Afterward. pulling their estimates closer to the number they were just shown . However. membership accounted for by African countries was higher or lower than the number on the wheel. subjects were asked whether the percentage of U. For example. A Diamond Anchor Consider this classic example: Conventional wisdom dictates that a diamond engagement ring should cost around two months' worth of salary. . they are more likely to purchase something that is around the "standard". Because buying jewelry is a "novel" experience for many men. allowing investors to take advantage of this short. as investors base their decisions on irrelevant figures and statistics. whereas when the wheel landed on 60. the random number had an anchoring effect on the subjects' responses. While. Investment Anchoring Anchoring can also be a source of frustration in the financial world. anchoring is fairly prevalent in situations where people are dealing with concepts that are new and novel. As you can see. For example. it is a completely irrelevant reference point created by the jewelry industry to maximize profits. Tversky and Kahneman found that the seemingly random anchoring value of the number on which the wheel landed had a pronounced effect on the answer that the subjects gave. and not a valuation of love. the investor is anchoring on a recent "high" that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. This is the power of anchoring. However. Many men can't afford to devote two months of salary towards a ring while paying for living expenses. as the prospective groom struggles to keep his head above water in a sea of mounting debt. this "standard" is one of the most illogical examples of anchoring. In many cases. despite the expense.
even if doing so would provide added financial benefit. the investor has fallen prey to the dangers of anchoring. there's no substitute for rigorous critical thinking. they may not realize how illogical this line of thinking really is. Avoiding Anchoring When it comes to avoiding anchoring. while still carrying substantial credit card debt. In this example. Keep in mind that XYZ is not being sold at a discount. Although many people use mental accounting. Key Concept No.2: Mental Accounting Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria. . but why don't people behave this way? The answer lies with the personal value that people place on particular assets. causing its share price to shoot up from $25 to $80. rather than saving for a holiday. it's illogical (and detrimental) to have savings in a jar earning little to no interest while carrying credit-card debt accruing at 20% annually. despite the fact that diverting funds from debt repayment increases interest payments and reduces the person's net worth. individuals assign different functions to each asset group. Unfortunately. people may feel that money saved for a new house or their children's college fund is too "important" to relinquish. one of the company's major customers. Successful investors don't just base their decisions on one or two benchmarks. In this case.For instance. By anchoring to the previous high of $80 and the current price of $40. the investor erroneously believes that XYZ is undervalued. it's never a bad idea to seek out other perspectives. Be especially careful about which figures you use to evaluate a stock's potential. people often have a special "money jar" or fund set aside for a vacation or a new home. they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape. This seems simple enough. the most logical course of action would be to use the funds in the jar (and any other available monies) to pay off the expensive debt. money in the special fund is being treated differently from the money that the same person is using to pay down his or her debt. had decided not to renew its purchasing agreement with XYZ. like the source of the money and intent for each account. For instance. In this example. For novice investors especially. For example. As a result. suppose that XYZ stock had very strong revenue in the last year. According to the theory. This change of events causes a drop in XYZ's share price from $80 to $40. instead the drop in share value is attributed to a change to XYZ's fundamentals (loss of revenue from a big customer). Listening to a few "devil's advocates" could identify incorrect benchmarks that are causing your strategy to fail. Simply put. this "important" account may not be touched at all. who contributed to 50% of XYZ's revenue. which has an often irrational and detrimental effect on their consumption decisions and other behaviors.
Because of the mental accounting bias. such as from their paychecks. the interest on your debt will erode any interest . However. one of the following things occurs: 1) You find that you have a hole in your pocket and have lost $6. money should be interchangeable. Logically speaking. Different Purpose Another aspect of mental accounting is that people also treat money differently depending on its source. you stumble and your delicious sandwich ends up on the floor. realize that saving money in a low. The problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio. Where the money came from should not be a factor in how much of it you spend . Consequently. Different Source. the dilemma is whether you should spend $6 for a sandwich. consider this real-life example: You have recently subjected yourself to a weekly lunch budget and are going to purchase a $6 sandwich for lunch. the money had already been spent. In most cases. For example. Treating money differently because it comes from a different source violates that logical premise. most people in the first scenario wouldn't consider the lost money to be part of their lunch budget because the money had not yet been spent or allocated to that account. As you are waiting in line.regardless of the money's source. As an extension of money being fungible.or no-interest account is fruitless if you still have outstanding debt. spending it will represent a drop in your overall wealth. regardless of its origin. but as you plan to take a bite. whereas in the second scenario. would you buy another sandwich? Logically speaking. people tend to spend a lot more "found" money. this isn't so. Avoiding Mental Accounting The key point to consider for mental accounting is that money is fungible. by realizing that "found" money is no different than money that you earned by working. they'd be more likely to buy another sandwich. your answer in both scenarios should be the same. such as tax returns and work bonuses and gifts. This represents another instance of how mental accounting can cause illogical use of money. For example. regardless of its origins or intended use. because of the mental accounting bias. some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. or 2) You buy the sandwich. Mental Accounting In Investing The mental accounting bias also enters into investing. In either case (assuming you still have enough money). his net wealth will be no different than if he had held one larger portfolio.The Different Accounts Dilemma To illustrate the importance of different accounts as it relates to mental accounting. compared to a similar amount of money that is normally expected. all money is the same. You can cut down on frivolous spending of "found" money.
such as the Tulip bubble from the 1630s or the South Sea bubble of . Psychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable. Confirmation Bias It can be difficult to encounter something or someone without having a preconceived opinion. For example. Hindsight Bias Another common perception bias is hindsight bias. many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble from history. for example. Key Concept No. This is not to say that there is something wrong with your senses. the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. leaving them with an incomplete picture of the situation. this bias can often result in faulty decision making because one-sided information tends to skew an investor's frame of reference. While this sense of curiosity is useful in many cases (take science. As a result. whereas in fact. sometimes it makes more sense to forgo your savings in order to pay off debt. which tends to occur in situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious. In this section. while ignoring or rationalizing the rest. such as loss of critical customers or dwindling markets. but rather that our minds have a tendency to introduce biases in processing certain kinds of information and events. While having savings is important. This first impression can be hard to shake because people also tend to selectively filter and pay more attention to information that supports their opinions. finding erroneous links between the cause and effect of an event may result in incorrect oversimplifications. the event could not have been reasonably predicted. Many events seem obvious in hindsight.that you can earn in most savings accounts. an investor that hears about a hot stock from an unverified source and is intrigued by the potential returns. in certain situations what you perceive is not necessarily a true representation of reality. This type of selective thinking is often referred to as the confirmation bias. while glossing over financially disastrous red flags.3: Confirmation and Hindsight Biases It's often said that "seeing is believing". What ends up happening is that the investor finds all sorts of green flags about the investment (such as growing cash flow or a low debt/equity ratio). for example). In investing. While this is often the case. Consider. That investor might choose to research the stock in order to "prove" its touted potential is real. we'll discuss how confirmation and hindsight biases affect our perceptions and subsequent decisions.
investors or traders can easily fall prey to the gambler's fallacy. One solution to overcoming this bias would be finding someone to act as a "dissenting voice of reason". Gambler's Fallacy In Investing It's not hard to imagine that under certain circumstances. Conversely. Just because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session. Under the gambler's fallacy. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as "improbable". a lack of understanding can lead to incorrect assumptions and predictions about the onset of events. Another common example of the gambler's fallacy can be found with people's relationship with slot machines. For example. Each coin flip is an independent event. an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. the hindsight bias is a cause for one of the most potentially dangerous mindsets that an investor or trader can have: overconfidence. One of these incorrect assumptions is called the gambler's fallacy. so it doesn't matter if you play with a machine that just hit the jackpot or one that hasn't recently paid out. Avoiding Gambler's Fallacy . For investors and other participants in the financial world. In the gambler's fallacy. a person might predict that the next coin flip is more likely to land with the "tails" side up. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time. For example. Part of the problem with confirmation bias is that being aware of it isn't good enough to prevent you from doing it.1711) were very obvious. consider a series of 20 coin flips that have all landed with the "heads" side up. In this case. 4: Gambler's Fallacy When it comes to probability. some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don't believe that the position is likely to continue going up. That way you'll be confronted with a contrary viewpoint to examine. This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%. overconfidence refers to investors' or traders' unfounded belief that they possess superior stock-picking abilities. which means that any and all previous flips have no bearing on future flips. What these gamblers don't realize is that due to the way the machines are programmed. Key Concept No. We've all heard about people who situate themselves at a single machine for hours at a time. the odds of winning a jackpot from a slot machine are equal with every pull (just like flipping a coin). Most of these people believe that every losing pull will bring them that much closer to the jackpot. Avoiding Confirmation Bias Confirmation bias represents a tendency for us to focus on information that confirms some pre-existing thought. it probably wouldn't have escalated and eventually burst.
The ultimate goal of a money manager is to follow an investment strategy to maximize a client's invested wealth. With the amount of noise inherent in the stock market. The second reason is the common rationale that it's unlikely that such a large group could be wrong. Investors should instead base their decisions on fundamental and/or technical analysis before determining what will happen to a trend. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing. Therefore. . After all. Individually. believing they know something that you don't. After all. This is because most people are very sociable and have a natural desire to be accepted by a group. this wasn't the first time that events like this have happened in the markets. if the aforementioned gimmick pans out. which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. is usually not a very profitable investment strategy. his clients will be happy. There are a couple of reasons why herd behavior happens. The Costs of Being Led Astray Herd behavior. The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. the odds of any specific outcome happening on the next chance remains the same regardless of what preceded it. However. This is especially prevalent in situations in which an individual has very little experience. as the dotcom bubble illustrates. For example.It's important to understand that in the case of independent events. you might still follow the herd. the same logic applies: Buying a stock because you believe that the prolonged trend is likely to reverse at any second is irrational. A strong herd mentality can even affect financial professionals.5: Herd Behavior One of the most infamous financial events in recent memory would be the bursting of the internet bubble. it's tempting for a money manager to follow the herd of investment professionals. You probably know from experience that this can be a powerful force. that money manager can justify his poor decision by pointing out just how many others were led astray. even if you are convinced that a particular idea or course or action is irrational or incorrect. The first is the social pressure of conformity. following the group is an ideal way of becoming a member. In many cases. rather than be branded as an outcast. however. If it doesn't. Key Concept No. How could something so catastrophic be allowed to happen over and over again? The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior. a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy". The Dotcom Herd Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies. even though most of these dotcoms did not (at the time) have financially sound business models. most people would not necessarily make the same choice.
which can eat away at available profits. Furthermore.e. the soundest advice is to always do your homework before following any trend. most other investors have already taken advantage of this news. Price. if a herd investor hears that internet stocks are the best investments right now. the majority viewed themselves as average. overconfidence can be detrimental to your stock-picking ability in the long run. Of the remaining 26% surveyed. an investor is generally better off steering clear of the herd. Clearly. Overconfident Investing In terms of investing. and the strategy's wealth-maximizing potential has probably already peaked. As you can imagine. suggesting the irrationally high level of overconfidence these fund managers exhibited. overconfidence (i. By the time a herd investor knows about the newest trend. For example. Just remember that particular investments favored by the herd can easily become overvalued because the investment's high values are usually based on optimism and not on the underlying fundamentals. Just because everyone is jumping on a certain investment "bandwagon" doesn't necessarily mean the strategy is correct. perhaps before he has even experienced significant appreciation in his internet investments. . and Profit When All Traders Are Above Average". he'll probably move his money again. Volatility. Keep in mind that there's a fine line between confidence and overconfidence. overestimating or exaggerating one's ability to successfully perform a particular task) is not a trait that applies only to fund managers. researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance.. only 50% of the sample can be above average. Consider the number of times that you've participated in a competition or contest with the attitude that you have what it takes to win regardless of the number of competitors or the fact that there can only be one winner. almost 100% of the survey group believed that their job performance was average or better. If biotech stocks are all the rage six months later. Confidence implies realistically trusting in one's abilities. This means that many herdfollowing investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies. he will free up his investment capital and then dump it on internet stocks. Therefore. Incredibly. while overconfidence usually implies an overly optimistic assessment of one's knowledge or control over a situation.6: Overconfidence In a 2006 study entitled "Behaving Badly". Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction costs. it's extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting. In a 1998 study entitled "Volume. Key Concept No.Investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. Avoiding the Herd Mentality While it's tempting to follow the newest investment trends.
Odean also found that traders that conducted the most trades tended. on average. Just about every overconfident investor is only a trade away from a very humbling wake-up call. Oftentimes.7: Overreaction and the Availability Bias One consequence of having emotion in the stock market is the overreaction toward new information. investors overreacted to bad news. creating a larger-than-appropriate effect on a security's price.although the price change is usually sudden and sizable. the two examined returns on the New York Stock Exchange for a three-year period. and these losers began rebounding as investors came to the conclusion that the stock was underpriced. and that gain in share price should not decline if no new information has been released since. can still struggle at achieving market-beating returns. participants in the stock market predictably overreact to new information. Furthermore. it appears that the original "winners" would became "losers". it was found that the losers portfolio consistently beat the market index. investors essentially overreacted. good news should raise a business' share price accordingly. investors realized that their pessimism was not entirely justified. the surge erodes over time. the cumulative difference between the two portfolios was almost 25% during the three-year time span. De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years. however. Unfortunately. According to market efficiency. new information should more or less be reflected instantly in a security's price.researcher Terrence Odean found that overconfident investors generally conduct more trades than their less-confident counterparts. it also appears that this price surge is not a permanent trend . Key Concept No. who have access to the best investment/industry reports and computational models in the business. In total. The best fund managers know that each investment day presents a new set of challenges and that investment techniques constantly need refining. to receive significantly lower yields than the market. For example. Avoiding Overconfidence Keep in mind that professional fund managers. Winners and Losers In 1985. and vice versa. In the case of loser stocks. The . behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study. while the winners portfolio consistently underperformed. driving the stocks' share prices down disproportionately. tends to contradict this theory. From these stocks. In other words. So what happened? In both the winners and losers portfolios. they separated the best 35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". Surprisingly. After some time. Odean found that overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. Reality.
You have $1. suppose you see a car accident along a stretch of road that you regularly drive to work. According to the availability bias. Choice B: You have a 100% chance of gaining $500. research has found that we don't actually process information in such a rational way.exact opposite is true with the winners portfolio: investors eventually realized that their exuberance wasn't totally justified. the following questions were used in their study: 1. seeing the accident causes you to overreact. the end result is a net gain of $50. losses have more emotional impact than an equivalent amount of gains. Although the road might be no more dangerous than it has ever been. people would choose the former . According to prospect theory. despite the fact that you still end up with a $50 gain in either case. If you do a thorough job of researching your investments.000. and. most people view a single gain of $50 more favorably than gaining $100 and then losing $50. which contends that people value gains and losses differently. Remember to focus on the long-term picture. making any new opinion biased toward that latest news.even when they achieve the same economic end result. people tend to heavily weight their decisions toward more recent information. one expressed in terms of possible gains and the other in possible losses. Chances are. However. but you'll be back to your old driving habits by the following week. However. in a traditional way of thinking. it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. For example. While it's easy to get caught up in the latest news. Evidence for Irrational Behavior Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved making judgments between two monetary decisions that involved prospective losses and gains. For example. you'll better understand the true significance of recent news and will be able to act accordingly.8: Prospect Theory Traditionally. Academics tend to use "utility" to describe enjoyment and contend that we prefer instances that maximize our utility. Avoiding Availability Bias Perhaps the most important lesson to be learned here is to retain a sense of perspective.000 and you must pick one of the following choices: Choice A: You have a 50% chance of gaining $1. Thus. Key Concept No. Kahneman and Tversky presented an idea called prospect theory. you'll begin driving extra cautiously for the next week or so. if a person were given two equal choices. In 1979. For example. . will base decisions on perceived gains rather than perceived losses. as such. and a 50% chance of gaining $0. the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. short-term approaches don't usually yield the best investment results. In both situations. This happens in real life all the time.
(People choosing "B" would be more risk adverse than those choosing "A"). Consequently. but are willing to engage in risk-seeking behaviors where they can limit their losses. It is key to note that not everyone would have a value function that looks exactly like this. If the subjects had answered logically. For example. In other words. You have $2. and 50% of losing $0. according to the value function. The most evident feature is how a loss creates a greater feeling of pain compared to the joy created by an equivalent gain. However. this makes sense: it is a fair bet that you'd be kicking yourself over losing the $50 that you just found.2. each event is valued separately and then combined to create a cumulative feeling. For example.000 and you must pick one of the following choices: Choice A: You have a 50% chance of losing $1. this is the general trend. Financial Relevance . when multiple gain/loss events happen. but losing the $50 causes -50 points of utility (pain).000. the results of this study showed that an overwhelming majority of people chose "B" for question 1 and "A" for question 2. this would cause an overall effect of -40 units of utility (finding the $50 causes +10 points of utility (joy). losses are weighted more heavily than an equivalent amount of gains. but then lose it soon after. if you find $50. It is this line of thinking that created the asymmetric value function: This function is a representation of the difference in utility (amount of pain or joy) that is achieved as a result of a certain amount of gain or loss. To most of us. Choice B: You have a 100% chance of losing $500. they would pick either "A" or "B" in both situations. the absolute joy felt in finding $50 is a lot less than the absolute pain caused by losing $50. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more).
The most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses. Unfortunately. When it comes to selling winning stocks prematurely. with often disastrous results Avoiding the Disposition Effect It is possible to minimize the disposition effect by using a concept called hedonic framing to change your mental approach. Prospect theory also explains the occurrence of the disposition effect. versus +$45). framing the situation as one large loss would create less negative utility because the marginal difference between the amount of pain from combining the losses would be less than the total amount of pain from many smaller losses. Finally. versus -$45). and the losses incurred continued to mount. For example. Like the study's subjects.000 or $0. consider Kahneman and Tversky's study in which people were willing to settle for a lower guaranteed gain of $500 compared to choosing a riskier option that either yields a gain of $1. for situations where you have a choice of thinking as something as one large loss with a smaller gain or a situation where you have a smaller loss (-$100 and +$55. This explains why investors realize the gains of winning stocks too soon: in each situation. For situations where you have a choice of thinking as something as one large gain with a smaller loss or a situation where you net the two to create a smaller gain ($100 and -$55. there are people who do not wish to put their money in the bank to earn interest or who refuse to work overtime because they don't want to pay more taxes. For situations where you have a choice of thinking of something as one large loss or as a number of smaller losses (losing $100 versus losing $50 twice). it would be best to try to frame the situation as separate gains and losses.The prospect theory can be used to explain quite a few illogical financial behaviors. you would receive more positive utility from the sole smaller gain. investors are willing to assume a higher level of risk in order to avoid the negative utility of a prospective loss. it can help you minimize the dispositional effect. in situations where you have a choice of thinking of something as one large gain or as a number of smaller gains (such as finding $100 versus finding a $50 bill from two places). prospect theory suggests that the benefit (or utility gained) from the extra money is not enough to overcome the feelings of loss incurred by paying taxes. This represents typical risk-averse behavior. Although these people would benefit financially from the additional after-tax income. . which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. Trying these methods of framing your thoughts should make your experience more positive and if used properly. both the subjects in the study and investors seek to cash in on the amount of gains that have already been guaranteed. many of the losing stocks never recover. The flip side of the coin is investors that hold on to losing stocks for too long. thinking of the latter can maximize the amount of positive utility. For example.
called "Capital Market Seasonality: The Case of Stock Returns". Therefore. it does not account for the fact that the phenomenon still exists in places where capital gains taxes do not occur. some unconventional factor (other than the random-walk process) must be creating this regular pattern. This is at odds with the efficient market hypothesis. found that from 1904-74 the average amount of January returns for small firms was around 3. which is contrary to what is predicted by conventional financial theory. there are two primary factors that undermine the rational bidding process: the number of bidders and the aggressiveness of bidding. The Winner's Curse One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of some asset and will bid or pay accordingly. While the year-end tax selloff may explain some of the January effect. the more bidders involved in the process means that you have to bid more aggressively in order to dissuade others from bidding. Rational-based theories assume that all participants involved in the bidding process will have access to all relevant information and will all come to the same valuation.suggest that this is not the case. This anomaly sets the stage for the line of thinking that conventional theories do not and cannot account for everything that happens in the real world. which predicts that stocks should move at a "random walk". This suggests that the monthly performance of small stocks follows a relatively consistent pattern. According to Robert Thaler's 1988 article on winner's curse. and their continued existence. increasing your aggressiveness will also increase the likelihood in that your winning bid will exceed the value of the asset.5%. However. Rozeff and William R. anomalies such as the winner's curse . The following is a quick summary of some of the anomalies found in the financial literature BEHAVIORAL FINANCE ANOMALIES January Effect The January effect is named after the phenomenon in which the average monthly return for small firms is consistently higher in January than any other month of the year. Kinney. directly violate modern financial and economic theories. .The presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioral finance. when investors have less incentive to sell. However. Unfortunately. whereas returns for all other months was closer to 0.5%. Any differences in the pricing would suggest that some other factor not directly tied to the asset is affecting the bidding. causing returns to bounce back up in January. a 1976 study by Michael S. which assume rational and logical behavior. One explanation is that the surge in January returns is a result of investors selling loser stocks in December to lock in tax losses. These so-called anomalies. For example.a tendency for the winning bid in an auction setting to exceed the intrinsic value of the item purchased .
but now that buyer might have a difficult time securing financing. Conventional economic models have determined that this premium should be much lower. a myopic (i. academics believe that an equity premium of 6% is extremely large and would imply that stocks are considerably risky to hold over bonds. This lack of convergence between theoretical models and empirical results represents a stumbling block for academics to explain why the equity premium is so large. What happens is that investors are paying too much attention to the short-term volatility of their stock portfolios.Consider the example of prospective homebuyers bidding for a house.) Equity Premium Puzzle An anomaly that has left academics in finance and economics scratching their heads is the equity premium puzzle. the premium is seen as an incentive for market participants to invest in stocks instead of marginally safer government bonds.overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains . investors that hold riskier financial assets should be compensated with higher rates of returns. shortsighted) investor may not react too favorably to the downside changes. it is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss. According to the capital asset pricing model (CAPM). whereas bond real returns are 3%. Stock real returns are 10%.. However. Studies have shown that over a 70-year period. Behavioral finance's answer to the equity premium puzzle revolves around the tendency for people to have "myopic loss aversion". oftentimes driving up the sale price more than 25% above the home's true value. variables irrelevant to the asset (aggressive bidding and the amount of bidders) can cause valuation error. but rather that the addition of behavioral finance can further clarify how the financial markets work. stocks yield average returns that exceed government bond returns by 6-7%. .e. Therefore. However.. This is not to say that conventional theory is not valuable. Conventional financial theory does not account for all situations that happen in the real world.take a very short-term view on an investment. In this example. a situation in which investors . It's possible that all the parties involved are rational and know the home's true value from studying recent sales of comparative homes in the area. the curse aspect is twofold: not only has the winning bidder overpaid for the home. While it is not uncommon for an average stock to fluctuate a few percentage points in a very short period of time. Thus.
RESEARCH PAPERS .BEHAVIORAL FINANCE.
BEHAVIORAL FINANCE.D . Ph. THE MARKET CRISIS AND RETIREMENT SAVINGS SHLOMO BENARTZI.
the propensity of employees to invest in company stock is highly correlated with the past performance of company stock. preliminary data on recent activity in 401(k) plans indicates that the average participant moved money into company stock in September and early October. I am a Professor and co‐chair of the Behavioral Decision Making Group at the Anderson School of Management at UCLA. Buy High.. I am also co‐founder of the Behavioral Finance Forum (BeFi). We also saw individuals pulling money out of the stock market in 2002 right before the market started to go up. My name is Shlomo Benartzi. 1. many buy stock funds after they see a few years of positive returns. For example. Excessive extrapolation: Individual investors tend to place too much weight on past performance. we know that a portfolio invested 100 percent in cash is unlikely to provide the long‐term growth that many individuals need to fund their retirement. Myopic Loss Aversion: The term “myopic loss aversion” refers to the tendency of individuals to focus on short‐term losses. This probably includes many employees of financial institutions who invested in company stock and lost their savings and jobs at the same time. Interestingly. Similarly. I have spent the last 15 years researching participant behavior in 401(k) plans. There is a real concern that individuals will repeat the same mistake during this market crisis and sell at the bottom and perhaps even stop contributing to their retirement plan. Some of you might be familiar with the automatic savings increase program Richard Thaler of the University of Chicago and I designed about a decade ago. probably misjudging the risk of company stock. We saw this happen with the Internet bubble when individuals bought a lot of technology stocks at the end of 1999 and the beginning of 2000 right before the market crashed. And. even if they have 20 or 30 years until retirement. let me focus on just three behavioral principles that could weaken retirement security. with a particular focus on using behavioral economics to increase retirement savings and retirement security. To keep this report brief. 2. 3. Sell Low: Individuals have a tendency to buy at the peak. The unusual market volatility we have experienced over the past few weeks and months could magnify the degree of myopia and loss aversion individuals display. which we dubbed Save More Tomorrow (or SMarT). and then panic when markets drop and sell at the bottom. The myopic focus on short‐term losses could result in individuals chasing safety and placing all their retirement savings in cash. . I suspect that a lot of employees who were chasing performance and invested heavily in company stock a couple of years ago have recently suffered major losses. Let me begin my testimony by outlining the behavioral principles that guide retirement savers and how these behavioral tendencies could undermine the retirement security of 401(k) participants in the current environment.
Having highlighted “behavioral obstacles” that tend to undermine the retirement security of many people. however. In particular. Again. And. automatic enrollment and automatic increases made saving for retirement a lot easier for many Americans. And. I do believe some retirement savers will panic and bail out of the stock market at the wrong time. I also believe. then provide the recent quarter numbers on the second (or last) page. the real question is what can be done to help employees better plan for retirement? I believe Congress has already made significant contributions to the retirement security of Americans with the Pension Protection Act. deferral rates and investment elections into projected retirement income? Such projections would not be exact. I propose that the statements display longer‐term results on the first page. b. clarifying what constitutes a Qualified Default Investment Alternative made plan sponsors more comfortable choosing balanced portfolios on behalf of their plan participants. However. Since individuals are already obsessed with short‐term performance. Highlight Long‐Term Performance on First Page of Statements: Defined contribution plans are required to provide quarterly statements. Participant Information: a. even if it is caused by inertia and procrastination. especially in the current economic environment. why not use the quarterly statements as an opportunity to promote long‐term thinking? In particular. The goal of a retirement plan is to provide retirement income. For example. they would dampen the effects of volatile financial markets. a lot of plan providers interpret that requirement as having to highlight the most recent quarter’s performance on the first page of the statement. Below I list three key areas that I believe could be improved.The three behavioral principles outlined above highlight the risk of individuals mismanaging their retirement savings. our system should be improved to help individuals better plan for retirement. that inertia is extremely powerful and a lot of individuals are likely to procrastinate and never take any action. so why not translate account balances. Similarly. 1. but they would certainly be more informative for the average plan participant. rather than playing it safe with the most conservative option. someone who just experienced a 40 percent decline in his/her account balance might notice just a 10 percent decline in his projected retirement income once future contributions are taken into account. Provide Retirement Income Projections on Statements: I argue that most individuals are ill‐equipped to analyze rates of return. as they would incorporate both existing balances and future contributions. an . an endorsement of the idea might be all that is needed to get plan providers to design more sensible participant communications. sticking to one’s long‐ term plans and avoiding impulsive actions might actually be the best decision. In the current environment. Unfortunately. While this might be permissible under the current law.
In particular. I would like to clarify that I am not proposing to disallow company stock in defined contribution plans. comply with ERISA’s diversification requirement.endorsement might be all that is needed to get plan providers to add income projections to quarterly statements. Retirement Income Solutions: a. they do not know what to do about it. they could possibly be liable for selling the stock at the wrong time. I am just proposing that company stock pass the same fiduciary standards other investments must pass. then employees might wrongly believe that the company is in trouble. 3. if company stock is inherently undiversified and will fail basic fiduciary standards. Professor Richard Thaler and I promote the idea of offering employees the option to gradually sell their stock holdings. . Stop the Preferential Treatment of Company Stock: Company stock enjoys special treatment under ERISA. We saw thousands of Enron employees lose their jobs and retirement savings simultaneously. I view that as a good thing. Company Stock: a. that all investments offered to plan participants should be well‐diversified. Define “Qualified Retirement Income Solutions”: The Pension Protection Act has shed light on best practices for the accumulation stage. if they offer employees the option to gradually trim down their company stock exposure. We dubbed our proposed program. it endorsed automatically enrolling employees into retirement savings plans and automatically escalating their deferral rates over time. b. “Sell More Tomorrow. perhaps keeping a modest amount of say five percent of their savings in company stock. If they tell employees to diversify and sell the stock. and I predict the current crisis will result in many more employees losing their retirement savings due to concentrated positions in company stock. It is the only investment option offered to plan participants that is undiversified. We are already seeing that the mere endorsement of these best practices by Congress resulted in many plan sponsors adopting the proposed changes. Of course. However. Endorse Gradual Diversification Programs: Many plan sponsors are concerned about the financial security of employees investing in company stock. And.” Endorsing some type of a gradual diversification program could make plan sponsors more comfortable addressing the company stock problem before it is too late. that is. then plan sponsors will voluntarily stop offering it. exempting it from the diversification requirement. I believe. 2. however.
the risk that people will live much longer than was anticipated. The current financial crisis also highlights the need to rethink the type of retirement income solutions that would be prudent. it is not surprising that most plan sponsors do not offer any retirement income solution through the plan. In particular. I encourage regulators and legislators to shed light on best practices for the decumulation stage. plan sponsors will not offer any retirement income solutions. leading to the possibility that plan assets will run out. b. that is. enable insurance companies to better price and guarantee lifetime income streams. more importantly. they would. as medical advances in say the US will end up increasing longevity in all countries sooner or later. Retirees are given a lump sum of cash and sent out into their golden years searching for a solution on their own. especially in the current volatile environment. the Pension Protection Act did not spell out best practices for the decumulation phase. Again. and are similar in concept to TIPS (which allow the private sector hedge another systematic risk. The government could help facilitate the creation of a market for hedging systematic longevity risk by issuing longevity bonds. given that insurance companies have recently failed to properly manage risks? I do not necessarily have the answers. is an immediate annuity that pays monthly income for life prudent.to create and offer competitive retirement income solutions. namely inflation risk). For example. Furthermore.Unfortunately. As a result. These are bonds that pay more if people live longer and vice versa. the vast majority of plan sponsors are totally confused about: (a) whether or not making retirement income solutions available to retiring employees is part of their duties and responsibilities. And. Note that insurance companies do not presently have the financial instruments available to them to manage systematic increases in longevity where most people end up living longer than reserved for. I do know that retiring employees are ill‐equipped to set a sensible drawdown program on their own. This is because longevity . I believe an endorsement would encourage the industry . Evaluate Longevity Bonds: Both defined benefit and defined contribution plans face longevity risk. but I do know that without guidance from regulators and legislators. most individuals are ill‐equipped to handle such a complicated financial decision. Not only would longevity bonds enable retirement plans to better manage longevity risk. it is not diversifiable internationally.both plan sponsors and providers . and (b) what type of retirement income solutions would be prudent to offer. Systematic longevity risk is simply too large for insurance companies to handle. Given that. As we all know. it did not provide any guidance on what would constitute appropriate retirement income solutions for employees getting ready to retire.
To the extent that the proposed changes make sense. Again. improving participant information. in the same way that TIPS help to establish the inflation risk premium. . some of the changes I propose could also address behavioral obstacles such as myopic loss aversion and excessive extrapolation. Keeping in mind the regulatory burden employers already face by offering a retirement plan. In summary. And. I believe mere endorsement by regulators and legislators might be sufficient to make a difference.bonds would help to establish the market price of longevity risk. but there are experts who have studied these issues extensively. I think establishing a committee to evaluate the merits of longevity bonds is appropriate. Professors David Blake and Robert Shiller would be superb candidates to serve on such a committee. thank you Chairman Miller and members of the committee for the opportunity to share my views. I must admit I am not an expert on launching new markets. my proposals focus on endorsing better practices without necessarily forcing or requiring plan sponsors and plan providers to implement new or expensive options. addressing the company stock problem and incorporating retirement income solutions into defined contribution plans could enhance the retirement security of millions of people.
.email@example.com (352) 846-2837 Published. Box 117168 Gainesville FL 32611-7168 http://bear. Abstract This article provides a brief introduction to behavioral finance.Behavioral Finance Jay R. and the U. The growth of behavioral finance research has been fueled by the inability of the traditional framework to explain many empirical patterns. 4. (September 2003) pp. No. Ritter Cordell Professor of Finance University of Florida P.O.S. The two building blocks of behavioral finance are cognitive psychology (how people think) and the limits to arbitrage (when markets will be inefficient). with minor modifications.ufl.cba. including stock market bubbles in Japan. Behavioral finance encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets. in the Pacific-Basin Finance Journal Vol. 429-437.edu/ritter jay. Taiwan.ufl. 11.
For example. There is a huge psychology literature documenting that people make systematic errors in the way that they think: they are overconfident. This extra demand drove up the price by over 50% in a week and over 100% in a month. The EMH does not assume that markets can foresee the future. An example of an assumption about preferences is that people are loss averse . etc. Modern finance has as a building block the Efficient Markets Hypothesis (EMH). behavioral finance assumes that. but it does assume that markets are rational. the stock price was down by over 90% from where it was shortly after being added to the S&P. Specifically. Their preferences may also create distortions.Behavioral Finance 1. the tyranny of indexing can lead to demand shifts that are unrelated to the future cash flows of the firm. behavioral finance has two building blocks: cognitive psychology and the limits to arbitrage. Mistaken beliefs arise because people are bad Bayesians. Eighteen months later. Introduction Behavioral finance is the paradigm where financial markets are studied using models that are less narrow than those based on Von Neumann-Morgenstern expected utility theory and arbitrage assumptions. . The EMH does not assume that all investors are rational. Some are just due to temporary supply and demand imbalances. In contrast. however. they put too much weight on recent experience. The EMH argues that competition between investors seeking abnormal profits drives prices to their “correct” value. Behavioral finance uses models in which some agents are not fully rational.a $2 gain might make people feel better by as much as a $1 loss makes them feel worse. in some circumstances. but it does assume that markets make unbiased forecasts of the future. Not all misvaluations are caused by psychological biases. When Yahoo was added to the S&P 500 in December 1999. either because of preferences or because of mistaken beliefs. financial markets are informationally inefficient. rather than taking the arrogant approach that it should be ignored. Limits to arbitrage refers to predicting in what circumstances arbitrage forces will be effective. Behavioral finance uses this body of knowledge. and when they won't be. Cognitive refers to how people think. index fund managers had to buy the stock even though it had a limited public float.
If it is easy to take positions (shorting overvalued stocks or buying undervalued stocks) and these misvaluations are certain to be corrected over a short period, then “arbitrageurs” will take positions and eliminate these mispricings before they become large. But if it is difficult to take these positions, due to short sales constraints, for instance, or if there is no guarantee that the mispricing will be corrected within a reasonable timeframe, then arbitrage will fail to correct the mispricing.1 Indeed, arbitrageurs may even choose to avoid the markets where the mispricing is most severe, because the risks are too great. This is especially true when one is dealing with a large market, such as the Japanese stock market in the late 1980s or the U.S. market for technology stocks in the late 1990s. Arbitrageurs that attempted to short Japanese stocks in mid1987 and hedge by going long in U.S. stocks were right in the long run, but they lost huge amounts of money in October 1987 when the U.S. market crashed by more than the Japanese market (because of Japanese government intervention). If the arbitrageurs have limited funds, they would be forced to cover their positions just when the relative misvaluations were greatest, resulting in additional buying pressure for Japanese stocks just when they were most overvalued! 2. Cognitive Biases Cognitive psychologists have documented many patterns regarding how people behave. Some of these patterns are as follows: Heuristics Heuristics, or rules of thumb, make decision-making easier. But they can sometimes lead to biases, especially when things change. These can lead to suboptimal investment decisions. When faced with N choices for how to invest retirement money, many people allocate using the 1/N rule. If there are three funds, one-third goes into each. If two are stock funds, two-thirds goes into equities. If one of the three is a stock fund, one-third goes into equities. Recently, Benartzi and Thaler (2001) have documented that many people follow the 1/N rule. Overconfidence People are overconfident about their abilities. Entrepreneurs are especially likely to be overconfident. Overconfidence manifests itself in a number of ways. One example is too little diversification, because of a tendency to invest too much in what one is familiar with. Thus,
Technically, an arbitrage opportunity exists when one can guarantee a profit by, for example, going long in an undervalued asset and shorting an overvalued asset. In practice, almost all arbitrage activity is risk arbitrage— making trades where the expected profit is high relative to the risk involved.
people invest in local companies, even though this is bad from a diversification viewpoint because their real estate (the house they own) is tied to the company’s fortunes. Think of auto industry employees in Detroit, construction industry employees in Hong Kong or Tokyo, or computer hardware engineers in Silicon Valley. People invest way too much in the stock of the company that they work for. Men tend to be more overconfident than women. This manifests itself in many ways, including trading behavior. Barber and Odean (2001) recently analyzed the trading activities of people with discount brokerage accounts. They found that the more people traded, the worse they did, on average. And men traded more, and did worse than, women investors. Mental Accounting People sometimes separate decisions that should, in principle, be combined. For example, many people have a household budget for food, and a household budget for entertaining. At home, where the food budget is present, they will not eat lobster or shrimp because they are much more expensive than a fish casserole. But in a restaurant, they will order lobster and shrimp even though the cost is much higher than a simple fish dinner. If they instead ate lobster and shrimp at home, and the simple fish in a restaurant, they could save money. But because they are thinking separately about restaurant meals and food at home, they choose to limit their food at home. Framing Framing is the notion that how a concept is presented to individuals matters. For example, restaurants may advertise “early-bird” specials or “after-theatre” discounts, but they never use peak-period “surcharges.” They get more business if people feel they are getting a discount at off-peak times rather than paying a surcharge at peak periods, even if the prices are identical. Cognitive psychologists have documented that doctors make different recommendations if they see evidence that is presented as “survival probabilities” rather than “mortality rates,” even though survival probabilities plus mortality rates add up to 100%. Representativeness People underweight long-term averages. People tend to put too much weight on recent experience. This is sometimes known as the “law of small numbers.” As an example, when equity returns have been high for many years (such as 1982-2000 in the U.S. and western Europe), many people begin to believe that high equity returns are “normal.”
Conservatism When things change, people tend to be slow to pick up on the changes. In other words, they anchor on the ways things have normally been. The conservatism bias is at war with the representativeness bias. When things change, people might underreact because of the conservatism bias. But if there is a long enough pattern, then they will adjust to it and possibly overreact, underweighting the long-term average. Disposition effect The disposition effect refers to the pattern that people avoid realizing paper losses and seek to realize paper gains. For example, if someone buys a stock at $30 that then drops to $22 before rising to $28, most people do not want to sell until the stock gets to above $30. The disposition effect manifests itself in lots of small gains being realized, and few small losses. In fact, people act as if they are trying to maximize their taxes! The disposition effect shows up in aggregate stock trading volume. During a bull market, trading volume tends to grow. If the market then turns south, trading volume tends to fall. As an example, trading volume in the Japanese stock market fell by over 80% from the late 1980s to the mid 1990s. The fact that volume tends to fall in bear markets results in the commission business of brokerage firms having a high level of systematic risk.2 One of the major criticisms of behavioral finance is that by choosing which bias to emphasize, one can predict either underreaction or overreaction. This criticism of behavioral finance might be called "model dredging." In other words, one can find a story to fit the facts to ex post explain some puzzling phenomenon. But how does one make ex ante predictions about which biases will dominate? There are two excellent articles that address this issue: Barberis and Thaler (2002), and Hirshliefer (2001). Hirshliefer (p. 1547) in particular addresses the issue of when we would expect one behavioral bias to dominate others. He emphasizes that there is a tendency for people to excessively rely on the strength of information signals and under-rely on the weight of information signals. This is sometimes described as the salience effect.
During the bear market beginning in April 2000 in the U.S., aggregate stock market volume has not dropped. This is apparently due to increased trading by institutions, since stock trading by individuals has in fact declined. The significant drop in transaction costs associated with the move to decimalization and technological advances partly accounts for this. Another reason is that many firms split their shares in late 1999 and the first half of 2000, which, ceteris paribus, would have resulted in higher trading volume. The drop in commission revenue from individuals (predicted by the disposition effect) has resulted in revenue declines for retail-oriented brokerage firms such as Charles Schwab & Co.
and keep them from ever getting too big. But they were right in the long run! LTCM mainly traded in fixed income and derivative markets. Royal Dutch of the Netherlands and Shell of the UK agreed to merge their interests on a 60-40 basis. For their first three or four years. the efforts of arbitrageurs to make money will make some markets more efficient. John Meriwether. buying undervalued securities and then finding highly correlated securities that are overvalued. Even worse. the market is pretty efficient for these assets. it is impossible in real time to identify the peaks and troughs until they have passed. Long Term Capital Management. they had one bad quarter in which they lost $4 billion. How well do efforts by arbitrageurs to make money work in practice at making markets more efficient? As Shleifer and Vishny argue in their 1997 "Limits to Arbitrage" article. Because of this. such as shorting Nasdaq during the last two years. but they won't have any effect on other markets. A relative value hedge fund takes long and short positions. and shorting them. Let's look at an example. Just who are these investors who make markets efficient? Well. they were spectacularly successful. at least on a relative basis. In 1907.3. hedge funds and others zero in on these. and others. A macro hedge fund. and those that are nonrepeating and long-term in nature. It is easy to show that whenever the stock prices are not in a 60-40 ratio. But then. LTCM was founded about nine years ago by Myron Scholes. The limits to arbitrage Misvaluations of financial assets are common. if limited partners or other investors are supplying funds. takes speculative positions that cannot be easily hedged. Why? Misvaluations are of two types: those that are recurrent or arbitrageable. nonrepeating misvaluations. but it is not easy to reliably make abnormal profits off of these misvaluations. But one of the ways that they lost money was on the Royal Dutch/Shell equity arbitrage trade. Finance theory . withdrawals of capital after a losing streak may actually result in buying or selling pressure that exacerbates the inefficiency. on the other hand. there is an arbitrage profit opportunity. that of a giant hedge fund. For the long-term. wiping out their equity capital and forcing the firm to liquidate. Robert Merton. and pay dividends on the same basis. four years ago. Thus. Getting in too early risks losses that wipe out capital. one obvious class of investors who are trying to make money by identifying misvaluations are hedge funds. trading strategies can reliably make money. For the recurrent misvaluations.
Furthermore. Royal Dutch was in the S & P 500.has a clear prediction. How well does this prediction work? . these are large companies. Until July 2002. and Shell is in the FTSE.
as computed by Froot and Dabora (1999) and updated by Ken Froot.2 -0.2 0.1 -0. .Royal Dutch / Shell Deviation 0.3 Figure 1—Deviations from Royal Dutch/Shell parity from January 1980 to December 2001.1 0 -0.
The data plotted in figure 1 end in December 2001. and this selling pressure made markets more inefficient. 2) The Japanese stock price and land price bubble of the 1980s. In 1998. from 1980 to 2001. rather than more efficient. they lost money when prices diverged further from their theoretical values during the third quarter of 1998. media. 4) The October 1987 stock market crash.For the last 22 years. LTCM and other hedge funds were forced to sell out their positions. The first application concerns inflation and the stock market. Applications of behavioral finance I would now like to talk about some specific applications of behavioral finance.high-frequency events. I am going to briefly discuss two of my recent publications. 5) The technology. however. does not support market efficiency. And mutual funds have difficulty beating their benchmarks. While I could choose from many applications. although there is no suggestion that the present value of dividends changed. which occur often. To meet liquidity needs. Did they make money? No. I list some specific assumptions about a hypothetical firm. figure 1 demonstrates that there have been large deviations from the theoretical relation. 3) The Taiwanese stock price bubble that peaked in February 1990. LTCM shorted the expensive stock and bought the cheap one. Standard and Poors announced that Royal Dutch would be dropped from the S&P 500 because they were deleting non-American companies. which occur only infrequently. Examples of enormous misvaluations include: 1) The undervaluation of world-wide stock markets from 1974-1982. Royal Dutch dropped by 17% in the week of the announcement. Has it stayed there? In July 2002. So the forces of arbitrage failed. I’m going to start out with a simple valuation question. The low-frequency evidence. with the price ratio close to its theoretical value. So what is the bottom line on market efficiency? It is useful to divide events into two categories . The high-frequency evidence supports market efficiency. It is hard to find a trading strategy that is reliably profitable. Below. and telecom (TMT) bubble of 1999-2000. and low-frequency events. and may take a long time to recover from. 4. “How much is the equity of this firm worth?” . and the question is.
g) with r = 10% and g = 6%. because they fall more . ask yourself “how many finance professors with PhDs get the valuation correct?” If the market makes this mistake. There is no real growth. the true economic earnings are higher than the accounting earnings. but not the benefit to equityholders. The decrease in the real value of nominal liabilities due to inflation does not appear on the income statement. P = $12/(0. or $300 per share. and all free cash flow (if any) is paid out in dividends.000 more debt next year to keep the real value of its debt constant. Because it doesn’t appear. but they don't treat the inflation-induced decrease in the real value of debt as a benefit to equity holders. because accountants measure the cost.000 $400. This cash can be used to pay dividends.10 . and the equity risk premium is zero. Nominal interest expense appears on the income statement.000 $0 $0 $2.06) = $300 per share.500. So the equity is worth $3 million. of debt financing when there is inflation.000 $1. then stocks become riskier. so it must increase the nominal amount of debt by 6% each year.Assumptions: The inflation rate is 6%. This is $12 per share.000 10.000 $600.000.000 $200.0.200. and hence undervalue equities when inflation is high. Revenue Cost of Goods Sold Administrative Expenses Interest Expense Taxes After-tax profits Debt Book Equity Shares outstanding Interest rate on debt $1. The firm wants to keep the real value of its debt unchanged. I would argue that investors don’t take it into account. the firm must issue $120. and using the growing perpetuity formula P = Div1/(r . so the nominal cost of capital is 10% (a real cost of capital of 4%).000 10% With inflation at 6% and $2 million in debt. This is an example of where framing makes a difference. In other words. Earnings are zero because the accountants treat nominal interest expense as a cost. If you find this implausible.
winning one and losing one. This is because the person integrates the good . these two effects balance out. Prospect theory is a descriptive theory of choice under uncertainty. This is in contrast to expected utility theory. Fortunately. which is why stocks are less risky in the long run than they are in the short run (Siegel (1998). We argue that part of the bull market of the 1980s was attributable to a recovery from the undervaluation. and focusing on this makes the bettor happy. given the high inflation that existed then. which is normative rather than descriptive. and they rise more than they should when inflation decreases. Chapter 2). Prospect theory focuses on changes in wealth. These have been the bestperforming asset class. if a person goes to the racetrack and makes two bets. the person may integrate the outcome and focus on the net payoff. If an IPO is underpriced.S.than they should when inflation increases. pre-issue stockholders are worse off because their wealth has been diluted. For example. and I've had much of my retirement assets in inflation-indexed bonds the last three years. conduct an out-of-sample test of the ModiglianiCohn hypothesis. an individual has a choice of treating them as separate events (segregation) or as one (integration). but happy once.the stock market became overvalued . Over a full inflation cycle. the entrepreneur doesn't bargain as hard for an even higher offer price. If the net payoff is positive. Gains and losses are measured relative to a reference point. a gain has occurred. stock market was grossly undervalued in the mid and late 1970s because investors had irrational beliefs about earnings. in our March 2002 JFQA article on the decline of inflation and the bull market of 1982-1999. We argue that if an entrepreneur receives the good news that he or she is suddenly unexpectedly wealthy because of a higher than expected IPO price. segregating the two bets allows the bettor to feel disappointed once. We also argue that the continued stock market rise in the 1990s was an overshooting . whereas expected utility theory focuses on the level of wealth. I believe in my research. Modigliani and Cohn (1979) argued that the U. Richard Warr and I. If there is a net loss. Prospect theory also incorporates framing—if two related events occur. The second application of behavioral finance that I would like to briefly discuss concerns the underpricing of IPOs. Tim Loughran and I use prospect theory in our 2002 RFS paper "Why Don't Issuers Get Upset About Leaving Money on the Table in IPOs?" to explain the severe underpricing of some IPOs.and we predicted that 20002002 would have low stock returns. Prospect theory also assumes loss aversion.
Most of these shortsellers. or Taiwanese stocks in early 1989 when they were substantially overvalued. This does not imply that financial markets are informationally efficient. who were right in the long run. and Shiller (2000). relatively speaking. individuals or institutions who shorted Japanese stocks in 1987-1988 when they were substantially overvalued. which work well for high frequency events. Low frequency misvaluations may be large.news of a wealth increase with the bad news of excessive dilution. all lost enormous amounts of money as these stocks became even more overvalued. It is very difficult to find trading strategies that reliably make money. Hirshliefer (2001). without presenting any opportunity to reliably make money. the forces of arbitrage. or TMT stocks in the U.. however. Underwriters take advantage of this mental accounting and severely underprice these deals. As an example. Behavioral finance is. It is not a separate discipline. Conclusions This brief introduction to behavioral finance has only touched on a few points. 5. in its infancy. The individual is better off on net. Thus. Shefrin (2000). Europe. were wiped out before the misvaluations started to disappear. work very poorly for low frequency events. and Hong Kong in early 1999 when they were substantially overvalued.S. but instead will increasingly be part of mainstream finance. It is these IPOs where the offer price has been raised (a little) that leave a lot of money on the table when the market price goes up a lot. More extensive analysis can be found in Barberis and Thaler (2003). .
although the long run might be very long. even though the probability of tossing a tail is 50 percent because tails occur roughly half the time in any long stretch of coin tosses.” Representativeness refers to overrelying on stereotypes and is a principle that underlies particular rules of thumb that are used to arrive at judgments. it is worth keeping a few postulates in mind. The coin is fair. they think the odds favor a tail because they have not seen a tail for a while. B ehavioral finance can shed light on many areas of investing. before it narrows. its risk premium reflects the extent to which its return co-varies with the return of a risky behavioral meanvariance portfolio. Therefore. One only needs to go to Las Vegas or Reno. In that respect. New Jersey. of course. I will discuss some of the key behavioral phenomena and how they relate to particular issues associated with analyst perceptions about returns (namely. Behavioral finance also postulates that market values eventually revert to intrinsic values. California Behavioral finance examines the biases that investors (individual and professional) incorporate in their investment decision-making process. The question is. Instead. Nevada. to see this phenomenon in place at any gambling table. What are the odds of my tossing a tail on the sixth toss? The answer. This illusion is called “gambler’s fallacy”—the tendency to overpredict reversals in situations of this sort. Behavioral finance researchers believe that gambler’s fallacy is a product of a psychological phenomenon called “representativeness. For an individual security. These biases lead to inefficiencies in market pricing that are reflected in behavioral mean-variance portfolios. and in some cases is likely to widen. I will then compare returns for what I call “behavioral meanvariance portfolios ” with those of traditional mean-variance-efficient portfolios. including valuation. representativeness and affect). But some people intuit a greater probability of a tail after so many heads in a row.) The stereotypical pattern for coin flips involving a fair coin is that heads appear half the time and tails appear half the time. MeanVariance Returns. (The term “heuristic” is a fancy name for a rule of thumb. Therefore. Representativeness and Affect Heuristic Imagine that I flip a fair coin five times and the result is five heads. is 50 percent. investors need to be careful about looking at a stock that is overvalued and thinking that its price will quickly move to fundamental value. if a coin that is known to be fair is tossed several times in succession and a head has not appeared for a while. 1 Behavioral finance postulates that in the short run. I will trace the importance of a concept known as “sentiment” and describe its impact on risk premiums in the market. intuition . and Risk Premiums Hersh Shefrin Mario L. Because behavioral finance is complicated. Belotti Professor of Finance Santa Clara University Santa Clara. In this presentation. or Atlantic City.Behavioral Finance: Biases. the stock price can move the other way: The mispricing can widen. markets are inefficient and the potential exists for misvaluation. Therefore.
. whether a particular player seems to be consecutively making or missing. In basketball. We are no longer observing a sequence of heads/tails. and retained earnings. say. in essence. So. . This is why representativeness-based thinking leads some of us to succumb to gambler’s fallacy when the odds are known. thereby predisposing them to gambler’s fallacy. The implication is that investors see risk and return as being negatively related—not positively related as is taught in traditional finance. That is the statistical fact of life in basketball. The information provided about these two stocks most likely would lead an investor to conclude that Intel has been a better company than Unisys for this period. we are observing success rates for. representativeness leads us to extrapolate recent performance. the slope would be fairly close to zero. streaks. and players. If I were to graph the relationship between actual year-overyear returns to the S& P 500. the question becomes. but the point is that they have no predictive power! The idea that streaks have predictive power is an illusion. but they also would view Intel as being a safer stock than Unisys. the hot-hand fallacy involves predictions of unwarranted continuation when observing processes that are unknown. The positive relationship between risk and return is a cornerstone of modern finance. as a species. humans have very poor intuition about random processes. market cap.e. The concept of streaks (i. they get the relationship upside down. The regression line for Panel A would be positively sloped. The biases just discussed are not restricted to gambling and sports. we are watching a basketball game. Figure 1 shows two charts. What does this mean? It means that when forecasting market returns. consider two stocks—Unisys and Intel. they would end up viewing Intel as featuring a higher expected return than Unisys. Suppose that investors form their judgments about risk and return by relying on representativeness. The person. individual investors are prone to the hot-hand fallacy and that investment professionals are prone to gambler’s fallacy. This is not to say that we do not see streaks. particularly based on the past five-year sales. representativeness involves overreliance on stereotypical thinking. and slumps. The cornerstone principle of modern finance is not accepted at a gut level. For most investment professionals. But when most investors form judgments in practice. How likely is Player X to make his next shot given that he has recently been hot (meaning that he has recently been successful in his three-point attempts)? The answer is that he is just as likely to make his next shot when he has been hot as he is when he has been cold. predisposing them to the hot-hand fallacy. They also show up in the investment world. In this case. they associate safe stocks with the stocks of financially sound companies. begins to ask. most of whom believe in hot hands. consider what happens when the odds are not known. but representativeness leads both investment professionals and individual investors to attach too much predictability to the previous year’s returns. So. and thinking that it is due is succumbing to gambler’s fallacy. But in reality. To understand how representativeness works at the level of individual securities. In addition to representativeness. “recency bias” is also at work in the hot-hand fallacy. and the regression line for Panel B would be negatively sloped. there is no such thing as a hot hand. three-point attempts. in this case. representativeness-based thinking leads a person to try to uncover the process through observation. Next. They would tend to judge Intel as a better stock than Unisys because they would think Intel is a better company than Unisys. The fact is. experience with stock market history leads them to be familiar with the process generating the market returns. We do see them. In particular. For most individual investors. whether the process is coin tossing or whether it is three-point attempts in basketball. but it runs counter to the intuition of many—coaches. a head is not due. and the stereotype for heads/tails is that 50 percent probabilities lead to half heads/half tails in terms of realization. More generally. There is very little predictive power in last year’s return to the S&P 500. Recency bias is the tendency to overweight the importance of more recent events relative to less recent events. for what process is the observed sequence representative? Suppose now that instead of flipping coins. In summary. But statistically. fans. described in Table 1.might suggest that a head is due. the hot-hand fallacy leads to predicting that a player will continue to be hot because his recent performance has been hot. One does not need to display the regression lines to see the patterns. the process generating the market returns is unknown. They thus believe that better stocks feature higher expected returns. Panel B is based on Livingston Survey data and represents the same type of relationship but for investment professionals. In addition. three-point attempts) is well established among sports followers. Panel A is based on a UBS/Gallup survey and represents individual investors’ expectations about returns on the S&P 500 Index for the next year (graphed on the y-axis) against what the S&P 500 return was the previous year (graphed on the x-axis).
Figure 1. adding dot-com after the name of a company in the second half of the 1990s made a profound difference in the market value of the company because it affected investors’ immediate emotional response to those companies.” which is another way of saying that decisions are made based on gut instincts. and concepts. pp. The affect heuristic serves to reinforce representativeness by allowing snap intuitive judgments based on emo- tion. imagery is important. Individual Investors: Mean Expected Return vs. The above is also an example illustrating the “affect heuristic. objects. The basis for these judgments is a set of affective or emotional tags that are mentally attached to images. . In this regard. And interestingly. Lagged Return for the S&P 500 Expected Return (%) 18 16 14 12 10 8 6 4 2 0 40 30 20 10 0 10 20 30 40 50 Lagged One-Year Return (%) B. Expected Return vs. 66 and 78) with permission of Elsevier. For example. 19902003 Forecasted Change (%) 25 20 15 10 5 0 5 30 20 10 0 10 20 30 40 Change in S&P 500 Prior Year (%) Source: Reprinted from Shefrin (2005a. Lagged One-Year Return A. I have found this pattern to be the case whether I am looking at investment professionals or individual investors. Prior Change in the S&P 500. Investment Professionals: Forecasted Change vs.
well-documented momentum effect exists in returns.33 $8. small market caps. Risk and Return Perceptions The traditional view is that expected return on a stock is determined by a four-factor model (return on the market. The distribution in Figure 2 is multimodal.6% 92. For horizons up to a year. analysts treat the relationship between risk and expected return as being positive. In 1998. Thus.8 60. Some people may talk about the sentiment of individual investors.2 0. investors view stocks with low betas.04 $441.Table 1. return differential between small-cap and large-cap stocks. it pertains to what the aggregate market error is. not momentum.” We know as a practical matter that benefits are associated with positive affect and that risks are associated with negative affect—and not just for stocks: When psychologists are looking at affect. This left-hand tail gets smaller over the sample period as the right-hand tail grows larger. Finally. In addition. The question then becomes. is that this general propensity carries over to stocks when there is a cornerstone academic principle that says the relationship should go the other way. opinions will differ with respect to such key variables as EPS and target prices. which. Market sentiment can be thought of as aggregate market error. about 23 percent expected a 5 percent return. analysts’ target prices tend to be excessively optimistic. extreme past losers tend to outperform extreme past winners. the distribution shows a fat tail on the left.22 215. If I like something. this belief in short-term reversals means that analysts are prone to exhibit gambler’s fallacy. Parenthetically. is reasonable.6% 222.8 Intel 1. the distribution shifted over time. Investor Sentiment In any view of the markets. it is how they handle momentum. Unisys and Intel: Comparative Data from April 2000 Item Beta Market value of equity (billions) Book value of equity (billions) Book-to-market equity Balance sheet retained earnings (billions) Prior six-month return Prior one-year return Prior three-year return Past five-year growth rate of sales Unisys 1. for example. persistent. Holding beta constant. Furthermore. Individual investors associate low book-to-market value and high market capitalization with both good stocks and good companies. and high book-tomarket values. I see these data as being the basis for market sentiment.2 Source: Reprinted from Shefrin (2005b. larger-cap stocks. investors have a good sense of what makes up risk. Historically. Instead. risk and benefits tend to be negatively related. analysts expect smaller-cap stocks to earn higher returns than . but they have a poor sense of how to connect that risk to expected returns. At the same time. Therefore. So.62 -67. A clear.860 $ 36. What is interesting. If you want to know what distinguishes outperformers from underperformers among money managers. approximately 33 percent of investors expected a 10 percent return in that year. strong. and then gets fat again in 2001. Unlike individual investors. one can see clusters of optimism and pessimism at very high and very low returns. shrinks. analysts view the relationship as positive but nowhere nearly as strongly positive as academic textbooks suggest.088 0. But analysts establish target prices as if they believed in shortterm reversals.08 $ 25. Given the strong evidence for momentum.26 -$1. the expected returns were quite variable. And a small right tail in 1998 gets fat in 1999. But for horizons as long as three years. but when sentiment is talked about in any meaningful sense. for the year 2000. or are they instead self-canceling? Figure 2 shows the results of a survey of expected returns for the period from 1998 to 2001. this is not the case. The affect heuristic is a mental shortcut that people often use to judge benefits and risks. 58) with permission of McGraw-Hill/Irwin. the target-price time horizon is an issue here. I do not buy it or I short it. Do these differences of opinion affect security prices. and momentum). however. I buy it. if I do not like it. Using beta as a measure of risk. What drives this behavior is a subconscious coding system in our brains called “affective labeling. p.3 56. Note that it is an aggregate of individual and professional investor expectations. and low book-tomarket values as being less risky than stocks with high betas. It has thick tails with clusters of beliefs on the extremes. return differential between value and growth stocks. Expected returns in the data are not all in the middle. large market caps. short-term winners tend to outperform short-term losers. But analysts also expect growth stocks to earn higher returns than value stocks.003 $2. in view of the historical record.2 21.103 0.
. suggesting that the market contains a great many underconfident pessimists. 360) with permission of Elsevier. p. consider Figure 3 . The number of survey participants who answered “yes” was astonishingly high. Evidence shows clustering by investors—both a cluster of overconfident optimists and a cluster of underconfident pessimists. These bets manifest themselves through options prices and have a significant impact on mean-variance-efficient returns. 1998-2001 Relative Frequency (%) 35 30 25 20 15 10 5 0 <0 0 5 10 15 20 25 30 Expected Return (%) 1998 1999 2000 2001 Source: Reprinted from Shefrin (2005a. traded options play an important role because options permit investors to bet on particular ranges of returns. Thus. To demonstrate the impact that sentiment can have in contrast to a traditional mean-variance portfolio return pattern. Shiller’s survey asked investors whether they believed the chance of a stock market crash in the next year exceeded 10 percent. p. gross Figure 3. 218) with permission of Elsevier. which are the basis for risk premiums. which represents the results of a survey conducted by Robert Shiller. investors have more flexibility than they would have if they were simply holding or shorting individual securities or market indices. In this regard.Figure 2. 1989-2001 Portion (%) 90 80 70 60 50 89 90 91 92 93 94 95 96 97 98 99 00 01 Individual Investors Institutional Investors Source: Reprinted from Shefrin (2005a. In this regard. Time Series of Percentage of Investors Expecting a Crash Based on Shiller Crash Confidence Index. consider Figure 4. Here. Mean-Variance Returns The nature of investor sentiment has profound implications for how security prices and risk premi- ums are determined. Distribution of Average of Survey Expected Returns. This figure depicts how the gross return (per quarter) to a meanvariance portfolio varies with the growth rate of the underlying economic fundamentals.
including bullish investors who underestimate upper-tail volatility.5 101.8 96.00 Efficient Portfolio Return 0. simply compute the covariance between the return to the security and the return to a behavioral mean-variance-efficient portfolio. But despite the differences between the composition of traditional and behavioral mean-variance portfolios.6 103.1 97. Expected return for an individual security can be found by adding the equilibrium risk-free rate to the product of behavioral beta and the risk premium on the behavioral mean-varianceefficient portfolio. This particular mean-variance portfolio is quite conservative. it is possible to compute a behavioral beta for a security.9 102.5 99.2 101.95 0. a gross return of 1. Gross Return to a Mean-Variance Portfolio: Behavioral Mean-Variance Return vs. with behavioral mean-variance returns being more volatile than those associated with the traditional mean-variance portfolio.) The peaks and the valleys in a behavioral meanvariance. with the weight associated with the risk-free security being heavy.05 1.10 represents a 10 percent return.7 105.8 98. 245) with permission of Elsevier. For example.10 1.2 99. Thus. %) Source: Reprinted from Shefrin (2005a.75 95.8 100. The solid line represents the traditional mean-variance return pattern. it is possible to apply traditional meanvariance concepts in a behavioral world.3 104. oscillating. it is an easy step to get to a behavioral capital asset pricing model (B-CAPM).5 106. From a behavioral beta. But the return pattern for a behavioral mean-variance portfolio is very different at the extremes.efficient portfolios will seek to exploit these inefficiencies by shorting out-of-themoney index puts and going long out-of-the-money index calls. (The choice of a conservative traditional mean-variance portfolio is intended to highlight the nature of the incremental behavioral mean-variance volatility. The very low returns at the left of Figure 4 occur because bearish investors who overestimate volatility bid the price of out-of-the-money index put options above their efficient levels.80 0. Efficient Mean-Variance Return MeanVariance Return 1. a mean-variance-efficient portfolio that is attempting to exploit these inefficiencies will perform badly if a lower-tail event occurs and perform well if an upper-tail event occurs.Figure 4. return is 1 + net return.efficient portfolio actually represent opportunities to exploit mispricing. . Its return pattern is relatively conservative in the middle portion and is not “too different” from its traditional counterpart. bid the price of out-of-the money index call options below their efficient levels. p.85 0. lumpy and bumpy curve (the dotted line) displays the return pattern associated with a behavioral mean-variance portfolio. The high returns at the right of Fig- ure 4 occur because all investors. g (gross. The strange. divide by the return variance of the behavioral mean-variance-efficient portfolio to obtain a behavioral beta.2 Consumption Growth Rate. It can be thought of as representing the return pattern of a portfolio that is a mix of the risk-free security and the market portfolio in a market that is free of sentiment.0 104. To do so. For example. Then. Investors who hold true mean-variance.5 97.90 Behavioral Portfolio Return 0.
not mean-variance portfolios. because of its negative skew. the behavioral portfolios that individual investors select are not behavioral mean-variance portfolios—in fact. Much of what is known about the pricing of skewness comes from Harvey and Siddique (2000). In other words. a large positive risk premium must be expected. Therefore. the addition of coskewness brings that up to 68. the net returns associated with growth rates lower than those displayed on the x-axis of the graph can fall below 100 percent. They are symmetrical—a situation called “zero skewness. Individual investors form behavioral portfolios. and momentum may derive from co-skewness—an explanation that is consistent with the behavioral approach. The co-skewness of a stock measures the impact its return distribution has on the already negative skewness of a behavioral mean-variance portfolio. The distribution for the lottery payoff is said to be positively skewed because the right tail is longer than the left tail. According to the shape of Figure 4. Within the Fama -French framework. It is not even attractive for many investment professionals who can afford to do it. Thus. In contrast. although the option will expire unexercised most of the time. I remind you. The reason for measuring co-skewness is to adjust for the quadratic-like pattern in the left and right extremes of the mean-variance pattern depicted in Figure 4. To induce investors to invest in situations with negative skew. They found that the correlation between coskewness and mean returns of portfolios sorted by size. the length of the right tail of the payoff distribution is long: $100 million . In the CAPM. Think of it this way: The potential for large losses (negative skew) represents an unattractive feature to investors. Suppose you hold a lottery ticket that will pay you $100 million with a probability of 1 in 50 million if you win or $0 if you lose. That is one reason why a positive risk premium is associated with shorting index puts and a negative risk premium is associated with lottery-like stocks (whose return patterns feature positive skewness). They meet their needs for upside potential by seeking securities that offer positively skewed returns.71.$2. the risk premium for a stock will include a component whose magnitude depends on the extent to which the stock’s return mimics the negatively skewed return pattern from shorting index puts. you will want to measure its co-skewness because the co-skewness indicates how much of the mean-variance left-tail exposure displayed in Figure 4 you will add to a portfolio when you include the stock in that portfolio. The measure of how much market risk a stock adds is beta. Moreover. book-to-market equity. The expected payoff for the ticket is $2. The point of the discussion is that the risk premium for a security actually has a component that reflects the degree to which the stock mimics the return pattern from shorting index puts.8 percent. The reason that risk premiums reflect coskewness is analogous to the reasoning used to explain risk premiums by using the CAPM.1 percent. The problem is that individual investors do not find the idea of shorting index puts very attractive. the distribution for shorting an out-of-the-money index put option is negatively skewed because. just shy of what the regular linear three-factor Fama-French model explains—that being 71. As far as analysts are concerned. and for that. The length of the left tail of the payoff distribution is a mere $2 (the difference between the expected value and the leftside payoff). the risk premium for a stock is determined by how much market risk the stock adds to a welldiversified portfolio. Therefore.5 percent of crosssectional returns . But we also want to measure how much mean-variance skewness the stock adds to a properly diversified portfolio. the correlation . The CAPM explains only 3. By the same token. much of the explanatory power of size. like those associated with the payoff of lottery tickets. In a behavioral portfolio. just the opposite. do not have this payoff pattern. Co-skewness has a beta-like formula that involves the squared market return instead of the market return.” But some distributions. a positive premium must be associated with the risk of shorting out-of-the-money index put options. which. book to market. co-skewness alone can explain a portion of excess returns that the Fama-French model cannot. Thus. a small probability of a crash exists. Behavioral portfolios reflect the needs for downside protection and upside potential (again indicating the importance of the co-skewness statistic).If you think about a bell-shaped distribution. individuals protect their downsides by avoiding negatively skewed returns. in Figure 4. if you are trying to understand what determines the risk premium for a security. we measure co-skewness . the right tail and the left tail are mirror images of each other. the key issue in this discussion is estimating risk premiums for securities. and momentum is a remarkable and surprising -0. has a beta-like formula. Notably. not constructing portfolios. in which case the investor who shorted the put will lose a lot of money— more than the premium received from shorting the option.
In particular. . Consistent with the behavioral approach. The above findings. Behavioral mean-variance portfolios embody investor errors and feature negatively skewed return patterns. But the historical evidence shows that value stocks outperform growth stocks and recent winners outperform recent losers. Therefore. provide strong support for a behavioral asset-pricing theory in which the basis for risk premiums is the behavioral mean-variance frontier. analysts appear to make some errors in judgment when setting target prices. the higher the stock’s risk premium will be. In contrast. Conclusion Many investors form judgments that suggest that they mistakenly believe that risk and return are negatively related. taken together.between unexplained return and co-skewness is 0. analysts establish target prices as if they expected growth stocks to outperform value stocks and recent losers to outperform recent winners.” The more negative the co-skewness is.53. the risk premium for a stock features a component that reflects how much “mean-variance skewness” the stock contributes to a well-diversified portfolio. . At the same time. Recent winners feature lower co-skewness than recent losers. the momentum effect also has an explanation in terms of co-skewness. the judgments underlying analysts’ target prices are consistent with risk and return being positively related. The measure of a stock’s contribution to mean-variance skewness is called its “co-skewness. which is large.
a Martin Webera.de .BWL. firstname.lastname@example.org to appear in: Derek J.uni-mannheim.de. 2 68131 Mannheim Germany p: +49-621-181 1532 f: +49-621-181 1534 email: email@example.com.Chapter 26 Lehrstuhl für Bankbetriebslehre UniversitätMannheim L 5.BWL.uni-mannheim.Behavioral Finance Markus Glaser. firstname.lastname@example.org Markus Nöth. Koehler and Nigel Harvey (eds.BWL.). Blackwell Handbook of Judgment and Decision Making .
methodology. From a market perspective. Traditional Finance and Empirical Evidence Traditional finance theory assumes that agents are rational and the law of one price holds. Then. In the second section.m.1. Traditional and Behavioral Finance Behavioral finance as a subdiscipline of behavioral economics is finance incorporating findings from psychology and sociology into its theories. During these 4. Behavioral finance models are usually developed to explain investor behavior or market anomalies when rational models provide no sufficient explanations. for example. 1. and 6:00 p. we will show how modifications (e. If these adjusted prices are different from each other. UTC. and contributions. the shares of DaimlerChrysler AG.5 hours.m. Whether the market can . finance researchers would not care. The key question is whether agents’ irrationalities affect market outcomes . To understand the research agenda. incorporated into traditional finance theories. traditional finance theory rests on the law of one price which states that securities with the same payoff have the same price. it may be possible that the market absorbs (at least to some degree) these individual irrationalities and thus prevent their impact on prices and allocation. an arbitrageur would sell shares at the higher price at one exchange and would buy the same number of shares at the other exchange and would thus realize a risk-less profit (see Shleifer and Vishny (1997) for another example of arbitrage). the overconfidence literature. we will explain the behavioral finance research methodology -how biases are modeled. Important aspects of agents' rationality are maximization of expected utility and Bayesian learning (see chapter 2). Arbitrageurs eliminate instantaneously any violations of the law of one price by simultaneously buying and selling these securities at advantageously different prices. incorporating market frictions) can rationally explain observed individual or market behavior. that choices are time-consistent (see chapter 21). it is necessary to review traditional finance theory first.g. and tested empirically and experimentally. for example. shares should trade for the same prices on both exchanges adjusted for the current EUR-USD exchange rate.otherwise. They are traded simultaneously on the New York Stock Exchange (NYSE) and in Frankfurt (Xetra) between 1:30 p. This implies. Even if some or even all market participants are irrational. Consider.using one specific subset of the behavioral finance literature.1.
1. “Weak-form” “semi-strong form” efficient. As a consequence. Finally. p. If the current price contains only the information consisting of past prices. Several studies document positive autocorrelation of short-term stock returns. the market is efficient. market efficiency may exist.average out irrationalities depends on the structure of the observed behavior: unsystematic irrationalities can be absorbed more easily than systematic deviations from rational behavior. for example. One explanation for this inefficiency is the existence of noise traders who trade randomly and not based on information. It is unlikely that market prices contain all private information. Fama (1991) surveys studies on the above mentioned time-series predictability of returns. including all insider information). earnings “strong-form” announcements).1. However. it is no longer possible to identify private information completely based on buying or selling activity by observing market prices because noise traders' orders jam the trading signal generated by insiders. 83). In addition. But even the original “weak-form” efficiency did not survive empirical tests. Fama (1970) defines an efficient market as a “market in which prices always ‘fully reflect’ available information” (Fama (1970). which are based on past returns and which earn statistically significant profits. If prices reflect all publicly available information (historical prices and.e. empirical studies over the last 25 years demonstrated that future returns are predictable to some extent. Studies as discussed in Fama (1970) show that stock returns are typically unpredictable based on past returns. the current dividend yield predicts subsequent returns. as well as and negative autocorrelation of short-term returns separated by long lags. Market Efficiency and Security Return Patterns If agents are rational and the law of one price holds.1. Different forms of market efficiency exist due to the amount of information which is assumed to be “available”. if prices reflect all private information (i. they trade to match their own liquidity requirements because of inherited money (=buy stocks) or because they want to buy a new car or house (=sell stocks). the market is “weak-form” efficient. trading strategies exist. For example. the market is market efficiency in connection with the assumption of constant expected returns had long been successful in explaining security return patterns. Furthermore. One specific example is the momentum strategy in which stocks with high returns over the last three to 12 months (“winner”) are bought and stocks .
1. As the above presented empirical evidence is still inconclusive due to this reason. One example are security prices of “Siamese twin” shares. This violation is so severe that prices are inconsistent with all valuation models. a high price/earnings ratio and/or a low book-to-market ratio (see.e. specific events may predict subsequent security returns Daniel.e. a security market anomaly can either result from market inefficiency or from the wrong asset pricing model. we will show in the next subsection that some securities are obviously mispriced. Jegadeesh and Titman (1993. for example. Other researchers argue that securities are mispriced (see. Returns of stocks with low market capitalization have been on average higher than returns of stocks with high market capitalization(=size effect. earnings announcements or stock splits (see (see Rouwenhorst (1998. i. Moreover. some puzzles have been discovered proving that the law of one price is violated. Banz (1981) and Dimson and Marsh (2000)). such as Royal Dutch Petroleum and Shell (event-based return predictability). The short-selling of “losers” finances the buying of “winners”. Fama and French (1992) and Lakonishok. stocks with a low dividend yield. 1999) as well as Glaser and Weber (2003a) for international evidence on the . for example.S. and Vishny (1994)).e. 2001) showed for U. the “losers” are bought back and the “winners” are sold. and Vishny (1994)). Shleifer. Hirshleifer. Shleifer. see. and Subrahmanyam (1998) and Fama (1991. Such events are. Some researchers argue that the observed security return regularities are rational and can be explained by time-varying expected returns (Fama (1991)). a low price/earnings ratio and/or a high book-to-market ratio have been on average higher than returns of growth stocks. i. there is no need to invest your own money. i.1. Law of One Price Recently. Resolving this conflict is at least difficult if not impossible because market efficiency can only be tested using a specific asset pricing model. 1998)). Returns of value stocks.with low returns over the same period (“loser”) are sold.e. Closely related are the following cross-sectional return patterns. Thus. a test of market efficiency is always a joint test of market efficiency and the assumed correctness of the asset pricing model. After a holding period of up to 12 months. i. for example.2. stocks that this strategy results in significant positive profits. The question is now whether these findings are real profit opportunities and thus a violation of market efficiency or just a proper reward for risk. stocks with a high dividend yield. Lakonishok. This strategy has been successful in other stock markets as well profitability of momentum strategies). for example.
3Com announced that its shareholders would eventually receive 1. Accordingly. different liquidity due to the market microstructure. Possible rational explanations such as exchange rate risks. Rational explanations of why arbitrage is not sufficient to avoid violations of the law of one price. we know that the market value of Royal Dutch has to be 1. They study equity carve-outs by analyzing the spin-off of Palm which was owned by 3Com. 3Com sold 5% of its Palm shares in an initial public offering and kept the remaining 95% of the shares. and in the Netherlands whereas Shell is primarily traded in the UK.Transport and Trading. Even if we do not know the correct fundamental value of Royal Dutch and Shell. Shares of Royal Dutch are primarily traded in the U. the stock price of 3Com has to be at least 1. bubbles and crashes occur from time to time and seem to reject the notion of efficient markets and the positive effect of arbitrage.5 times as high as the stock price of Palm. Future cash flows are split in the proportion of 60:40 in favor of Royal Dutch. market prices are clearly wrong and this mispricing persists for several years. However. Limits of Arbitrage In addition to the evidence presented in the previous subsection.S.1. the stock price of Palm was far above the stock price of 3Com implying a value of -22 billion U. as long as the value of the whole 3Com company is positive. Froot and Dabora (1999) find that Royal Dutch is sometimes more than 40% underpriced and sometimes 10% overpriced relative to the share prices of Shell. In Germany. For example. Another example of non-rational market prices which are not compatible with the law of one price is presented by Lamont and Thaler (2003). 1.5 shares of Palm for every 3Com share they owned. Thus. the New Market index (Nemax50) rose to more than 9000 (March 2000) and stands at about 310 (three hundred and ten !) by the end of March 2003.3. However. Twin shares trade at different places or in different countries and the division of current and future cash flows is fixed to each twin. In March 2000.5 times as large as the market value of Shell if prices reflect fundamental value. and asynchronous trading as a result of different trading hours are not sufficient to account for the apparent mispricing.S. dollars of 3Com's non-Palm business. These huge changes of market indices are . the NASDAQ Index rose from about 1000 in late 1997 to more than 4500 in March 2000 before declining to 1000 in March 2003. are looked at in the next subsection. too.
This additional risk is priced by the market. Summers. the question arises why arbitrage cannot dampen these swings which are. Summers. However.difficult to explain using a standard finance model. other market frictions such as short-sale constraints or non-tradable future labor income may limit arbitrage. recently a wide range of studies deal with another central pillar of standard finance. as common sense suggests. Moreover. they can earn higher returns than rational investors (DeLong. noise trader risk will prevent them from exploiting this mispricing.e. If these noise traders take this additional risk. Moreover. all kinds deviations from rationality of judgment and .1. and Waldmann (1990a) and Shleifer and Vishny (1997) show that noise trader risk can worsen the mispricing in the short run. Shleifer. severe mispricing will not necessarily be eliminated by arbitrage (Dow and Gorton (1994)). In other words. Several models within the rational framework were developed to explain limits of arbitrage. DeLong. Ross. irrational investors are not necessarily eliminated from the market due to their losses. Kogan. not only due to new information. and Westerfield (2003) show that survival and price impact of irrational traders are two independent concepts: They find that the price impact of irrational traders does not rely on their survival in the long-run and that they can even influence prices when their wealth becomes negligible. i. 1. If arbitrageurs have short investment horizons. and Waldmann (1990b)). Finally. mispricing can occur because of noise traders who create additional risk by trading randomly.4. In this handbook. This research usually demonstrates investor behavior that is difficult to reconcile with rationality or predictions of standard finance models. Shleifer. Agents' Rationality So far. Wang.actually behave. we have discussed theoretical and empirical issues concerning market outcomes. too. limits of arbitrage exist and may lead to severe mispricing even with fully rational market participants and unsystematic irrational behavior of noise traders. These studies try to examine how agents in financial markets -professional and individual investors. If the investment horizon is shorter than the time until the fundamental value of an asset is reached with certainty. agents' rationality. Summing up.
the behavior of market participants changes as Weber. a finding that is difficult to reconcile with agents' rationality. market trading volume. and to a particular manifestation of the representative heuristic. One example is naïve diversification or the 1/n heuristic. Both approaches have the same goal. In this subsection we present a few examples from the finance literature which deal with some of these problems. i. there are two different approaches towards behavioral finance. the tendency of people to expect even short sequences of realizations of a random variable to reflect the properties of the parent population from which the realizations are drawn. The higher the number of stock funds. As a consequence. However. the higher the allocation to equities. Another aspect of non-rational behavior is that market behavior of investors is influenced by framing. and individual behavior better than traditional finance models. Each savings plan offers a fixed number of investment options that varies across firms. Keppe. Benartzi and Thaler (2001) analyze 401 (k) retirement savings plans. the starting points are . Shleifer. trading is driven by loss aversion whereas in the second case diversification is the main reason for trading. and Vishny (1998) model investors who make systematic errors when evaluating public information. the underweighting of new evidence when updating probabilities.e. Investors are prone to a conservatism bias. Barberis. Furthermore. and Meyer-Delius (2000) have demonstrated in an experimental asset market. In the first case. 1. to explain observed prices.decision making are surveyed. Traders are willing to pay more for assets if they have a short position at the beginning of a trading period compared to situations with a long position even though the expected value of both portfolios is the same. Benartzi and Thaler (2001) find that some individuals spread their savings evenly across the investment alternatives and do not take into account the riskiness of the investment options. the asset allocation of individuals is influenced by the percentage of stock funds offered. if investors use specific heuristics which put too much weight on recent information. Depending on the framing of gains and losses.2. agents' rationality requires that all available information is evaluated using Bayes' Law. this systematic bias has an impact not only on the price reaction to new information but also on the price reaction afterwards when this error becomes obvious. In the first approach. Behavioral Finance and Remaining Puzzles In principle.
One important puzzle is the high trading volume in all capital markets. Then. Why do rational investors trade at all? Rational investors only trade when they are heterogeneous. accidents or unexpected bequests). or index funds. So why should we buy this security? Therefore.e. about the value of a . it is possible that even differences in private information do not lead to trading volume (no trade theorem.. Recent theoretical work in finance suggests that different beliefs or different opinions across people (e. implies that every available share is traded more than once per year. it is not possible to make an investor better off without making another investor worse off by changing the allocation (=trading). psychological results of individual behavior are screened to find an explanation for the observed market phenomena. These results are used to build new models to explain market observations. or information. If these investors receive different pieces of private information about the uncertain value of the risky asset. when they differ with regard to tastes (such as the degree of risk aversion).g. i. Consider investors who have common prior beliefs about the value of an asset and the initial allocation of the risky asset is pareto-optimal. endowments (such as liquidity shocks due to. In the second approach. empirical deviations from predictions based on traditional finance theory are observed.results from psychology describing human behavior in certain economic circumstances. when an investor wants to sell us a security. i. see Milgrom and Stokey (1982)). we can conclude that he has received a bad signal about the value of this security. Given that a significant number of shares is owned by long-term oriented institutional investors like pension funds. However. for example. Pagano and Röell (1992) provide further details about rational motives for trading. large mutual funds.S. Common sense suggests that these rational motives for trade are not sufficient to explain the high trading volume observed in financial markets. But even differences in information do not necessarily lead to trading. This trading volume appears to be high. as observed in the U.e. a turnover of 100%. there is heterogeneity between investors and thus a potential for trade.
Loss aversion is captured by a piecewise linear function that is steeper for losses than for gains relative to a reference point. Before we concentrate on the overconfidence literature. The equity premium puzzle. stocks have a higher risk-adjusted return than bonds (see Mehra and Prescott (1985)). and Santos (2001) thus incorporate central ideas of prospect theory (Kahneman and Tversky (1979)). But why do people have differing beliefs or opinions? Are their expectations biased? Are differences of opinion a result of overconfidence? Insights from psychology may provide answers to these questions. psychological results are needed to explain interactions between investors. gamblers’ increased willingness to bet after gains. Huang. may be another problem requiring a behavioral explanation. They study asset prices in an economy with investors deriving utility not only from consumption but also from the value of their financial wealth. they assume investors are loss averse over these changes. he faces a high probability of observing losses and thus requests a higher risk premium compared to the fully rational investor who is not influenced by short-term fluctuations. Furthermore. In addition. Thus. Losses are less painful after gains whereas they are more painful after losses.g. Barberis and Huang (2001) extend this model by additionally incorporating a further form of mental accounting (besides the house money effect): Investors either care about the value of their whole stock portfolio or about the value of each single security in their portfolio and thus ignore correlations. Barberis. This assumption is consistent with the house money effect (Thaler and Johnson (1990)). the model does not capture the feature of the original version of prospect theory with risk aversion in the domain of gains and risk seeking in the domain of losses. Huang. Barberis. it is important to stress that behavioral finance research is either focused on individual behavior (e. . In the second case.risky asset in the future or about how to interpret public news) may explain high levels of trading volume (see the next section and Glaser and Weber (2003b)). it is assumed that prior outcomes affect the degree of loss aversion. i. and Santos (2001) provide a refined explanation for the equity premium puzzle. Note however that there is some doubt that the equity premium puzzle is (still) existing given the burst of the stock market bubble in recent years and the performance of stocks in Japan over the last 20 years. Benartzi and Thaler (1995) provide a behavioral explanation based on (myopic) loss aversion: If an investor is loss averse and evaluates his portfolio at least every year. asset allocation within a 401(k) plan) or on the implications for financial market outcomes. Risk aversion is not sufficient to explain the empirical findings.e. In the first case it is obvious that psychological research has to be adapted to a different context.
1. stated equivalently. Hirshleifer. Overconfidence is modeled as overestimation of the precision of information or. Even though we focus on one particular research area within behavioral finance. Behavioral Finance Models In this subsection. Rather. study how overconfident investors affect market outcomes. financial contracting. or banking. we will briefly survey recent theoretical behavioral finance literature. and Teoh (2002) and Shiller (1999)). or investor behavior. Other applications are. corporate finance. the aim is to present a representative selection of recent behavioral finance theories to show which and how findings of psychology research are incorporated into standard finance models. asset pricing. Most of the models. we will focus on the overconfidence literature in finance to demonstrate the behavioral finance research methodology. The goal is not to discuss every model that has been published in recent years.3. . research is not restricted to the aggregate stock market. for example. We restrict our focus on the theoretical behavioral finance literature as recent behavioral finance surveys offer an in-depth discussion of various empirical findings (see Daniel. Some dynamic models assume that the degree of overconfidence changes over time in the way that it increases as a function of past investment success due to biased self-attribution. underestimation of the variance of information signals. As overconfidence is the most studied bias in the theoretical and empirical behavioral finance literature.
Psychological studies show that people are miscalibrated in the way that their probability distributions or confidence intervals for uncertain quantities are too tight (Lichtenstein. Some or all investors receive private s v information signals s . If the parameter k is in the interval [0. The discussion of the theoretical overconfidence literature in finance in the second subsection will point out the most important results of these models. i. and Phillips (1982) and chapter 9). an . v . stated equivalently. We do not attempt to provide a comprehensive overview of the psychological overconfidence literature.e. their confidence intervals are too tight. especially the implicit assumptions behind the particular way of modeling overconfidence. we present various endeavors to empirically and experimentally test these theories.s e ) are independent. In the last subsection. In the first subsection. 2. or stated equivalently.e. k 0 . If investor even believes that he knows the value of the risky asset with certainty.2.1. i. Assume. i. underestimates the variance of the error term). and the distribution of the error term. ~ N( o. an investor underestimates the variance of the signal s (or. we will discuss recent behavioral finance theories more deeply that incorporate overconfident investors. underestimate the variance of signals or the uncertain liquidation value of an asset. the uncertain liquidation value of a risky asset is modeled as a realization of a random variable. s v ) . Chapter 9 surveys psychological literature on subjective probability calibration. The parameter k captures the finding of overconfidence. Fischhoff.1). Modeling and Motivating Overconfidence in Theoretical Finance Overconfidence is usually modeled as overestimation of the precision of private information.s v k ×s e) .e. the signal s is usually written as a realization of the random variable ~ . Overconfidence In this section. this way of modeling overconfidence captures the idea that people overestimate the precision of their knowledge.e. ( k × ) ~ N(0 . v 2 ~ N ( 0 . we describe the way overconfidence is modeled and motivated in finance. they ~ contain a random error e as well. These signals contain information but the signals are noisy. the liquidation value v is a realization of a normal distribution with mean 0 and variance 2. i. Assuming that random variables (the distribution of the 2 e liquidation value. Thus. In finance models. We only mention the main psychological findings that are discussed in the finance literature. which is the sum of the s v e 2 2 2 random variables ~ and e .
is by no means clear. overconfidence and biased self-attribution are sometimes regarded as static and dynamic counterparts (Hirshleifer (2001)). and Till (1973). for example. Langer and Roth (1975). in the following forms: People believe that their abilities are above average (better than average effect. Sherman. However. Odean (1998). p. underestimate risks. is a function of past investment success. Although overconfidence is almost exclusively modeled as overestimation of the precision of private information. other models assume that overconfidence dynamically changes over time.. the above way of modeling overconfidence is justified in the following way: “The foremost reason is that people usually are overconfident.” (Odean (1998). Some models assume that the degree of overconfidence. Schneider. This is a difficult task and it is precisely in such difficult tasks that people exhibit the greatest overconfidence. Some argue that these manifestations are related (see. Under this view. they think that they can control random tasks.. Hastorf. the degree of overestimation of the precision of private information. Kahneman and Riepe (1998.e. besides various findings subsumed as miscalibration. (. This assumption is motivated by psychological studies that find biased self-attribution (Wolosin.) Most of those who buy and sell financial assets try to choose assets that will have higher returns than similar assets. overconfidence can manifest itself. p. the degree of overconfidence. 1892). summarize this motivation of overconfidence as follows.. Miller and Ross (1975).Although other psychological research results concerning (mis)calibration (see chapter 9) are not ignored in the finance literature. which causes people to overestimate their knowledge. Langer and Roth (1975). Taylor and Brown . for example.” However. Svenson (1981). p. Langer (1975). and Weinstein (1980)). whether the above mentioned facets of overconfidence are related. and they are excessively optimistic about the future (illusion of control and unrealistic optimism. Taylor and Brown (1988)). and exaggerate their ability to control events. as can be seen in several introductions of finance articles (see.. “The combination of overconfidence and optimism is a potent brew. i. is a stable individual trait and is thus constant over time. (. overconfidence models are usually motivated by a richer set of findings that are often summarized as overconfidence in the finance literature (although psychologists treat these as distinct concepts). 54).e. In a finance journal. In overconfidence models with biased self-attribution. In the finance literature. the degree of the underestimation of the variance of signals.) Learning is fastest when feedback is quick and clear. 1896). but in securities markets the feedback is often slow and noisy. i. and Ellsworth (1979)): People overestimate the degree to which they are responsible for their own success.
p. number of trading periods. for example. 2. Hoffrage. Zuslin. Hilton. illusion of control. They find that most of the correlations are insignificant. miscalibration. Due to the page constraints in this survey. Evidence on this issue is important. whereas the motivation of this use is based on a variety of possibly unrelated findings and it is unclear which manifestation of overconfidence actually drives economic behavior. Some correlation coefficients are even negative.(1988). and unrealistic optimism for a group of individual investors. some models are static in the way that there is . and Budescu (1994)) or if there are stable individual differences in reasoning or decision making competence (see Parker and Fischhoff (2001). and Pouget (2002). the following details: market environment. we discuss the most important results of models that incorporate overconfident market participants. Mazurier. Important Results and Predictions of Overconfidence Models In this subsection. Gigerenzer. Erev. and Olson (2000). Winman. for example. 9). there is a large debate in the psychological literature over whether miscalibration is domain or task dependent or even a statistical illusion (see. Moreover.2. for example. At this point of the survey. or even deny a logical link (see. as theoretical models often incorporate only one facet of overconfidence. and Barlas (1999). the better than average effect. and Stanovich and West (2000)). 194). miscalibration. Hvide (2002). Stanovich and West (1998). Empirical evidence on this issue is still limited. we omit a comprehensive presentation of the precise mechanism of how overconfidence affects the model predictions. The results of this study cast doubt on whether overconfidence. Biais. Gonzáles-Vallejo. we want to stress the following explicit and implicit assumptions of the way overconfidence is modeled in theoretical finance. Wallsten. 19). for example. is a stable concept or a general valid phenomenon and that the above mentioned manifestations of overconfidence are related. others argue that this need not to be the case (see. But these are preliminary results that need further investigation. p. Soll. or number of assets traded. p.e. In contrast to these explicit and implicit assumptions. Static models or models with constant overconfidence over time assume that there are stable individual differences in the degree of overconfidence. Investors in a competitive market environment do not influence the price of assets whereas other investors in a strategic market environment take into account that their trading behavior might influence the market price. and Kleinbölting (1991). Glaser and Weber (2003b) correlate scores that measure individual differences in the degree of miscalibration. Klayman. i. Such a presentation would require a discussion of. as it is used as a motivation in the finance literature.
and Wang (1998) make further predictions as well. overconfident investors will trade more aggressively: The higher the degree of overconfidence of an investor. Kyle and Wang (1997). Hirshleifer. In contrast.2 shows that most of the overconfidence models predict high trading volume in the market in the presence of overconfident traders. Wang (2001) show that overconfident traders may survive in security markets. the fluctuation of asset prices is higher than the fluctuation of the fundamental value. Apart from the ability to explain high levels of trading volume. Odean (1998) finds that overconfident traders have lower expected utility than rational traders and hold underdiversified portfolios. the effect of overconfidence on expected utility). Kyle and Wang (1997). the higher her or his trading volume. the models of Benos (1998). Moreover . Kyle and Wang (1997) find that overconfident traders might earn higher expected profits or have higher expected utility than rational traders as overconfidence works like a commitment device to aggressive trading. at the individual level. However. Caballé and Sákovics (2003). Gervais and Odean (2001) analyze how overconfidence dynamically changes through time as a function of past investment success due to a self-attribution bias. Benos (1998). and Odean (1998) show that the presence of overconfident traders helps explain excess volatility of asset prices. Furthermore. Odean (1998) calls this finding “the most robust effect of overconfidence”.e. Daniel.only one trading round whereas dynamic models analyze several periods. Benos (1998) finds similar results. The interested reader will find a presentation of various overconfidence models and other behavioral finance models in the survey of Hirshleifer (2001). Hirshleifer and Luo (2001). DeBondt and Thaler (1995) note that the high trading volume observed in financial markets standard finance paradigm” and that “is perhaps the single most embarrassing fact to the “the key behavioral factor needed to understand the trading puzzle is overconfidence”. Hirshleifer. Odean (1998). Table 26.g. This presentation shows that some predictions are common results of all models (the effect of overconfidence on trading volume) whereas other predictions depend on further assumptions (e. i. higher profits of overconfident investors are a result of a first mover advantage in his model. and Subrahmanyam (1998) show that overconfidence might present an explanation for the momentum effect and for long-run reversals of returns whereas the model of Daniel. Caballé and Sákovics (2003). models have either one or multiple risky assets that are traded. . and Subrahmanyam (2001) is able to generate the value/growth effect and the size effect.
Chief Financial Officers underestimate the variance of stock returns and are thus very confident in their assessments. They study expectations of stock market risk premium as well as their volatility estimates in a panel survey.S. the above mentioned studies show that it is a reasonable modeling assumption that investors are miscalibrated by underestimating stock variances or equivalently by . overconfidence was measured via subjective confidence intervals and via the comparison of objective accuracy and subjective certainty. Empirical and Experimental Tests of Model Assumptions Model assumptions can be evaluated by experiments and questionnaire studies which analyze whether individual and institutional investors do underestimate the variance of stock returns.3. Before each period. Hilton (2001) surveys questionnaire studies which analyze exchange rate and stock price predictions. Graham and Harvey (2002) find that. In this subsection we present a few studies which show that investors are miscalibrated in the context of financial markets. or how they react to releases of private or public information. 2. Chief Financial Officers of U. These studies find too narrow confidence intervals. Empirical and Experimental Tests of Overconfidence Models There are two points of departure to test the empirical validity of an overconfidence model: model assumptions and model predictions. They experimentally investigate individual overconfidence in the context of an experimental asset market with several trading periods.2. Another example of a questionnaire study that analyzes whether financial markets participants or financial professionals underestimate the variance of stock returns is by Graham and Harvey (2002). overestimate the precision of their knowledge. In the following two subsections we will discuss empirical and experimental tests of model assumptions and model predictions in turn.1. Summing up. Kirchler and Maciejovsky (2002) is an example of an experiment which analyzes whether investors overestimate the precision of their knowledge or give too tight confidence intervals in a market environment. Subjects' confidence intervals were too tight indicating overconfidence whereas according to the comparison of objective accuracy and subjective certainty the same people can sometimes even be classified as underconfident. On a quarterly basis. corporations are asked to provide their estimates of the market risk premium as well as upper and lower bounds of 90 percent confidence intervals of this premium. compared to historical standard deviations of one-year stock returns.3.
Statman. trade more subsequently. Kim and Nofsinger (2002) confirm these findings using Japanese market level data. b) Analysis of trading behavior of investors. They find that high current stock trading volume is associated with high stock returns in the previous weeks. Empirical and Experimental Tests of Model Predictions Model predictions can be tested in several ways. such as returns and trading volume. Thorley. We will discuss these three possibilities in turn while focusing on the above mentioned hypothesis concerning overconfidence and trading volume. We structure these various endeavors as follows: 1 Predictions concerning trading behavior and investment performance of and institutional) investors. and Vorkink (2003) argue that this finding supports the hypothesis as high returns make investors overconfident and they will. 2.S. Statman.overestimating the precision of their knowledge. They identify stocks with varying degrees of individual ownership to test the hypothesis and discover higher monthly turnover in stocks . market data to test the hypothesis that overconfidence leads to high trading volume. Statman. They test dynamic models predicting that after high returns subsequent trading volume will be higher as investment success increases the degree of overconfidence.2. 2 Predictions concerning market outcomes. and Vorkink (2003) and Kim and Nofsinger (2002) are examples of group a). Thorley. as a consequence. Note that this is the way how overconfidence is modeled in the finance literature.3. c) Correlation of proxies or measures of overconfidence on the one hand and economic variables such as trading volume on the other hand. and Vorkink (2003) use U. Thorley. Predictions Concerning Behavior and Performance of Investors The most important prediction in category 1 is that trading volume increases with an (individual increasing degree of overconfidence. The above mentioned predictions can be tested by analyzing the following data from the field or from experiments: a) Analysis of market level data.
unrealistic optimism). In the following. He finds that these investors reduce their returns by trading and thus concludes that trading volume is excessive . These investors were asked to answer an internet questionnaire which was designed to measure various facets of overconfidence (miscalibration. They test the hypothesis by correlating individual overconfidence scores with several measures of trading volume of these individual investors (number of trades. illusion of control.a finding which is consistent with overconfidence models and thus indirect evidence in favor of the above mentioned hypothesis. Odean (1999) is an example of group b). or uses only crude proxies for overconfidence (past returns.held by individual investors during the bull market in Japan.000 households from a large discount brokerage house on gender and find that men trade more than women which is consistent with overconfidence models. Glaser and Weber (2003b) find that investors trade more if they believe that they are above average in terms of investment skills or past performance. This result is striking as theoretical models that incorporate overconfident investors model overconfidence as . contrary to theory. The Barber and Odean (2001) study is a further example of group c). they partition their data set which consist of 35. The measures of trading volume were calculated by the trades of 215 individual investors who answered the questionnaire. gender). A direct test of the hypothesis that a higher degree of overconfidence leads to higher trading volume is the correlation of measures of overconfidence and measures of trading volume as mentioned in c). investors overestimate their relative position within the group of investors. the better-than-average effect. The evidence in favor of overconfidence models is either indirect. He analyzes the trades of 10. they summarize psychological studies that find a higher degree of overconfidence among men than among women. high past returns in both studies might be interpreted as a proxy of overconfidence as stated in group c).000 individuals with discount brokerage accounts. we will discuss two recent studies that use this approach Glaser and Weber (2003b) directly test the hypothesis that overconfidence leads to high trading volume by analyzing trades of individual investors who have online broker accounts. Their proxy for overconfidence is gender. When realized returns are used as a proxy for investment skills. Measures of miscalibration are. unrelated to measures of trading volume. Consequently. as in Odean (1999). Moreover. turnover). All the above mentioned studies share the shortcoming that overconfidence is never directly observed. In the paper.
and Pouget (2002) find that overconfident subjects have a greater tendency to place unprofitable orders. and Subrahmanyam Contrary to . there is a debate over whether miscalibration is domain or task dependent or even a statistical illusion (see chapter 9). The results hold even when several other determinants of trading volume are controlled for in a cross-sectional regression analysis. there are other reasons that might explain the failure of miscalibration scores in explaining volume.e. Mazurier. Hirshleifer. Furthermore. The subjects also participated in an experimental asset market afterwards. their overconfidence measure -the degree of miscalibration . Biais. we discuss how predictions of overconfidence models in group 2 can be tested. predictions of overconfidence models. among other psychological traits. and Pouget (2002) analyze experimentally if psychological traits and cognitive biases affect trading. But there might be other biases that are able to explain the same empirical findings when implemented in a theoretical model. Overconfidence models are motivated by psychological studies which show that people are generally miscalibrated or by empirical findings that are consistent with miscalibrated investors. overconfident subjects do not place more orders. such as high trading volume. Hilton. Mazurier. Hilton. Predictions Concerning Market Outcomes In the remainder of this section. i. Why is miscalibration not positively related to trading volume. the degree of overconfidence via calibration tasks. In the psychological literature.underestimation of the variance of signals. miscalibration. in the model of Daniel. However. Biais. Glaser and Weber (2003b) contains an enlarged discussion of these points and further possible explanations and interpretations of the result that miscalibration scores are unrelated to measures of trading volume. This shows the importance of analyzing the link or correlation between judgment biases and economic variables such as trading volume as the only way to test which bias actually influences economic behavior. as predicted by overconfidence models ? One important point to remember is that the link between miscalibration and trading volume has never been shown or even analyzed empirically or experimentally. If miscalibration is not a stable individual trait or if the degree of miscalibration depends on a specific task then it is no surprise that the above mentioned studies are unable to empirically confirm the hypothesis that a higher degree of miscalibration leads to higher trading volume.is unrelated to trading volume. For example. Based on the answers of 184 subjects (students) to a psychological questionnaire they measured.
In other words. and looks as if it may never be.” Thaler (1999. . Naturally.. behavioral finance has never been. are marginalizing themselves by clinging to the underlying tenets. Behavioral finance tries to improve existing models via more realistic assumptions. 375-376): “Even the supposed proponents of behavioral finance.. Daniel and Titman (1999) confirm this implication. The question should be: Does the new model produce rejectable predictions that capture the menu of anomalies better than market efficiency? For existing behavioral models. as a measure of trading volume: momentum is stronger among high-turnover stocks. 16) predicts the end of behavioral finance as all financial theorists will sooner or later incorporate realistic assumptions: “I predict that in the not-too-distant future. or asymmetric information on the one hand or observed traits of individuals such as risk aversion on the other hand into finance models. behavioral finance has drawn some criticism: “My view is that any new model should be judged (…) on how it explains the big picture. taxes. however. pp.(1998) the momentum effect is a result of the trading activity of overconfident traders. my answer to this question (perhaps predictably) is an emphatic no. 3. p. (. 291). One reason for this conclusion is given by Frankfurter and McGoun (2002. p. the number of shares traded divided by the number of shares outstanding. It is neither a minor subdiscipline nor a new paradigm of finance. One example for such stocks are growth stocks with hard-to-value growth options in the future. Hirshleifer. This finding is confirmed by Lee and Swaminathan (2000) and Glaser and Weber (2003a) using turnover. behavioral finance follows the traditional way of financial modeling that incorporates real world imperfections such as transaction costs. and Subrahmanyam (1998) model is a stronger momentum effect among high-volume stocks. and methods of the dominant paradigm. One implication of their model is that momentum is strongest among stocks that are difficult to evaluate by investors. They find that momentum is stronger for growth stocks. either.” (Fama (1998). behavioral finance models are currently not able to replace traditional finance theory. If disagreement of investors about the future performance is stronger among hard-to-value stocks and if trading volume is a measure of this disagreement then a further implication of the Daniel. forms. Summary and Open Questions Behavioral finance has become widely accepted among finance academics. Thus.) Although ‘behavioral finance’ sounds as if it would be a new methodology or even a significant new paradigm for research in financial economics.
it will be necessary to develop financial models which are based on alternative.the term ‘behavioral finance’ will be correctly viewed as a redundant phrase. behavioral assumptions of decision making. To make further progress. What other kind of finance is there? In their enlightenment. we have quite a large amount of knowledge. As we demonstrated in the case of overconfidence. individual or professional investors' behavior. we know less.g. it would be helpful to extend the research program beyond individual decision making by investigating problems or open questions which are central to a financial (or economic) context. behavioral finance will have to prove its usefulness here as well. On the level of individual decision making in markets. For research in finance. Examples are. it would be best to join forces from both disciplines to further enhance behavioral finance which after all is an interdisciplinary field of research. like market prices or trading volume. ultimately. The challenge will be to show that these new models come up with predictions different from standard financial models and that these alternative predictions win over predictions from standard theory. e. As these variables are central for research in finance. because otherwise financial models get too complex. On the level of aggregate variables. decision making in organizations or principle-agents situations. Clearly. to do otherwise would be irrational. . After all.” Behavioral finance as a field is a rather young enterprise which has proved its usefulness by first results but which still has some way to go. From the perspective of psychology. strategic and dynamic interaction of economic agents in markets. A large part of this knowledge stems from psychological research which tries to answer similar questions. it would be helpful to read more carefully what psychologist have found. economists will routinely incorporate as much ‘behavior’ into their models as they observe in the real world. By studying the psychological literature. researchers in finance want truths from psychologists which are as simple as possible. The truths have to be simple. We conclude with some thoughts on how research in behavioral finance might become even more successful. researchers in finance have to extract those findings which are robust as well as useful for modeling purposes.