Chapter 4

1. Chapter 4 PERCEPTIONS ABOUT RISK AND RETURN Behavioral Corporate Finance by Hersh Shefrin

2. Traditional treatment of risk and return • The typical starting point for the analysis of risk and return is the capital asset pricing model (CAPM), which provides a theory for determining the expected return that investors require in order to hold a security.

3. Cont… • Underlying the CAPM is the notion that investors are risk averse and require compensation in the form of a risk premium for bearing risk. • The beta of an individual stock measures the amount of risk that justifies compensation in the form of a higher expected return.

4. Cont… • The main tenet of the CAPM is that the risk premium on a stock is the product of beta and the market risk premium. • For individual stocks, this tenet can be expressed in terms of a graph known as the security market line.

5. Cont… • The CAPM provides one theory for determining required returns. The CAPM features a single factor to measure risk, the market premium.

6. Cont… • A more general theory uses several factors to determine required returns. Other examples of factors besides the market premium relate to market capitalization (size) , the ratio of book-to-market equity, and momentum.

7. Risk and Return for Individual Stocks • In practice, managers rely on a variety of techniques that include the traditional approach but also include heuristic techniques that leave them vulnerable to bias.

8. Rate Intel and Unisys • Quality of company • Financial soundness • Long-term investment value • Expected return over next 12 months • Perceived risk • Intel is a better company than Unisys. • Past 5 year sales • Market cap • Retained earnings component of book equity • Similarly Intel does better on the other variables.

9. Risk, Representativeness, and Bias • A manager who relied on representativeness would judge that Intel is a better company than Unisys. Why? Because Intel’s products are everywhere, changing the world in ways that are obvious.

10. Cont… • Managers who rely on representativeness to judge stock would judge the stock of Intel to be a better stock than that of Unisys. This means that managers would say that Intel’s stock offered better long-term investment value than Unisys’ stock. • What does better value mean?

11. Cont.. • In practice, managers appear to rely on representativeness when forming judgments about risk and return. • They are prone to view the stocks of good companies as representative of good stocks. • As a result, they come to judge that risk and return are negatively related.

12. Cont… • Presumably better value means either higher expected returns, or low risk, or both. • Managers who rely on representativeness will be inclined to expect higher returns from better stocks.

13. Cont… • Traditional finance teaches that risk and return are positively related, that higher expected returns are associated with higher risk. Representativeness induces managers to view the relationship as going the other way.

14. Sign of Relationship between Risk and Return • We learn that managers judge the relationship between risk and return to be negative. They expect higher returns from safer stocks. • A cornerstone principle of the CAPM is that expected return is positively related to risk, where risk is measured by beta.

15. Risk and Return • Managers who rely on representativeness judge Intel stock to be a better stock than Unisys stock. • Managers who rely on representativeness view the stocks of financially sound companies as safe stocks, and the stocks of companies that are not financially sound as risky stocks. • Managers who rely on representativeness view Intel as a safer stock than Unisys.

16. Perceived Relationship Between Risk and Return • Traditional finance teaches that risk and return are positively related, that higher expected returns are associated with higher risk. • Representativeness induces managers to view the relationship as going the other way. Exhibit 4-2 Scatter plot displaying assessments of investment professionals.

17. Cont… • On average, all respondents judged that Intel was a better firm than Unisys, and that relative to Unisys stock, Intel stock offered higher long-term investment value, a higher expected return, and low risk.

18. The Affect Heuristic • Psychologists have found that the tendency to view risk and reward as being opposite is a general phenomenon. • People form emotional impressions of activities, where impression reflects degree of goodness, or affect.

19. Cont… • Managers form opinions of companies. • In terms of affect, the most admired company has the highest positive affect.

20. Cont… • Having a positive affect connotes something that is good, whereas having a negative affect connotes something that is bad. • Evidence suggests that in their minds, people assign affective labels or tags to images, objects, and concepts. These tags exert a strong influence on their decisions.

21. Affect Heuristic Reinforces Representativeness • People assign affective labels or tags to images, objects, and concepts. • Imagery is important, e.g. adding “dot.com” to name of firm in second half of 1990s. • The affect heuristic is a mental shortcut that people use to search for benefits and avoid risks. • Benefits are associated with positive affect, whereas risks are associated with negative affect.

22. Perceived Risk and Firm Characteristics • Executives associate low book-to-market equity and high market capitalization to both good stocks and good companies. • Executives view stocks associated with • low betas, • large market capitalization, and • low book-to-market equity to be less risky than stocks associated with • high betas, • small market capitalization and • high book-to-market equity.

23. Heuristics, Biases, and Factors • The heuristics rely on a combination of representativeness and affect and predispose executives to bias. • Affect and representativeness reinforce each other when it comes to risk and return.

24. Cont… • Survey reveals that executives associate low book-to-market equity and high market capitalization to both good stocks and good companies.

25. Cont… • Executives expect stocks associated with low betas, large market capitalization, and low book-to-market equity to earn higher returns than stocks associated with high betas, small market capitalization and high book-to-market equity.

26. Cont… • Yet the evidence suggests that the empirical relationships go the other way. That is, executives perceptions display bias.

27. Cont… • Interestingly, evidence from the supplemental survey does suggest that executives view stocks associated with low betas, large market capitalization, and low book-to-market equity to be less risky than stocks associated with high betas, small market capitalization, and high book-to-market equity. These associations are in accordance with traditional theory.

28. Analysts’ Return Expectations • Unlike executives, analysts treat the relationship between beta and expected return as being positive. • Holding beta constant, analysts expect smaller capitalization stocks to earn higher returns than larger capitalization stocks. • Analysts expect growth stocks to earn higher returns than value stocks. • Analyst target prices are excessively optimistic.

29. Financial Executives and the Market Premium • Financial executives appear to believe that at the level of the market, expected returns and risk are negatively related. • The higher the market return has been in the prior quarter, the higher their forecasts of the equity premium over the subsequent year. • The higher the market return has been in the prior quarter, the lower are their forecasts of market volatility over the subsequent year.

30. Excessive Optimism and Agency Conflicts • Companies like favorable coverage, analysts have an incentive to produce favorable reports. • In addition, analysts depend on the managers of firms they cover to provide information. • In sum, analysts have an incentive to provide favorable coverage, in order to curry favor with corporate managers.

31. Die-Rolling • The occurrence of up- and down- years for the S&P 500 is akin to die-rolling. • The past outcomes offers no guidance to future performance.

32. Extrapolation Bias: The Hot-Hand Fallacy • Base Rate Information: Information pertaining to the general environment. • Most people do not think of S&P 500 annual returns as being analogous to rolling a die. Most people are unaware of the historical statistics.

33. Cont… • Historical statistics constitute examples of what psychologists call base rate information. Base rate information is typically abstract and not readily available.

34. Cont… • Singular Information: Unique information directly related to a situation or object. • Most people base their judgments about risk and return on information that is more available, such as recent events. Psychologists call this type of information singular information.

35. Cont… • Extrapolation bias, or the hot-hand fallacy: Unwarranted extrapolation of past trends in forming forecasts. • Psychologists suggest that people who overweight recent events are prone to extrapolating recent trends when forming forecasts

36. Cont… • Therefore, during a bull market such people will expect high returns from stocks. During a bear market, they will expect low returns from stocks. • If such extrapolation is unwarranted, the resulting bias is called extrapolation bias. Another name for extrapolation bias is the hot-hand fallacy.

37. Cont… • People who are prone to extrapolation bias will be excessively optimistic during bull markets and excessively pessimistic during bear markets.

38. Biased Financial Executives’ Estimates • Financial executives succumb to extrapolation bias when estimating the market risk premium. • Overconfidence leads financial executives to underestimate market risk.

39. Cont… • Representativeness also affects the manner in which financial executives form their forecasts of future volatility. The higher the market return has been in the prior quarter, the lower are their forecasts of market volatility over the subsequent year.

40. Cont… • Overconfidence leads people to establish confidence intervals that are too narrow. • In regard to optimism, the average financial executive estimated the equity premium to be between 1 and 3 percent.

41. Investor Biases in Estimating the Market Risk Premium • Individual Investors and the Hot Hand Fallacy • Professional Investors and Gambler’s Fallacy

42. Individual Investors and the Hot-Hand Fallacy • Individual investors exhibit the same type of bias as financial executives when it comes to the market risk premium. • Individual investors succumb to extrapolation bias. After the market has gone up, they become increasingly optimistic. After the market has gone down, they become less optimistic or even pessimistic.

43. Professional Investors and Gambler’s Fallacy • Like individual investors, professional investors’ return expectations are biased. • However, the biases of professional investors differ from those of individual investors. While individual investors have very little knowledge of base rate information, professional investors are well acquainted with key base rate information pertaining to market returns.

44. Cont… • Gamblers’ fallacy: The tendency to overweight the probability of an event because it has not recently occurred at a frequency that reflects its probability.

45. Wall Street Strategists • Wall Street strategists’ estimates of the market risk premium exhibit gambler’s fallacy.

46. Wall Street Analysts • Wall Street Security analysts succumb to gambler’s fallacy when forecasting the future prices of individual stocks. • Short-term winners are likely to continue as short-term winners, and vice versa. This phenomenon has been called the momentum effect.

47. Executives, Insider Trading, and Gambler’s Fallacy • Like security analysts, financial executives appear to be guided by gambler’s fallacy in their insider trading activity. • Financial executives tend to sell the stocks of their own firms when those stocks have featured high positive appreciation in the previous year.

48. Cont… • Executives hold, or even purchase, the stocks of their firms when those stocks have featured low price appreciation in the previous year. • Growth stocks have experienced high price appreciation in the previous year and value stocks have experienced low price appreciation.

49. Cont… • That is, price appreciation in the previous year is negatively correlated with book-to-market equity. • Therefore, executives appear to engage in insider selling when the stocks of their firms are growth stocks and engage in holding or insider buying when the stocks of their firms are value stocks.

50. Cont… • Representativeness and the affect heuristic lead executives to attain higher expected returns and lower risk to growth stocks than to value stocks. • People routinely display preference reversal, where their value judgments and choices go in opposite directions.