Lecture 14

1. Lecture 14 Behavioral Finance

2. The primary source of this lecture is from the book by Hersh Shefrin, “Beyond Greed and Fear; Understanding Behavioral Finance and the Psychology of Investing,” Harvard Business School Press, 2000.

3. Behavioral Finance • Financial practitioners commit errors because: 1. They use rules of thumb or heuristics. 2. They are influenced by form as well as substance. • These errors cause market prices to deviate from fundamental values.

4. Heuristic-Driven Bias • Heuristic refers to the process by which people find things out for themselves, usually by trial and error. • Trial and error leads people to develop rules of thumb which often causes errors.

5. Heuristic-Driven Bias • Representativeness > Refers to judgments based on stereotypes. > People believe that a small sample is representative of the entire population.

6. Heuristic-Driven Bias • Gambler’s fallacy > In a coin toss, what is the probability of a tail after five straight heads? > The law of large numbers. If x is a random variable with E[x]=m, then the sample mean of x approaches m as the sample size increases.

7. Heuristic-Driven Bias • Overconfidence > People set overly narrow confidence intervals. > They get surprised more frequently than they anticipate.

8. Heuristic-Driven Bias • Anchoring-and-Adjustment > People do not adjust their expectations sufficiently in response to new information. > They are anchored to their initial expectations.

9. Predictions • DeBondt’s study “Betting on Trends.” • People tend to naively project trends that they perceive in the charts. • They are overconfident about their ability to predict accurately. • Their confidence intervals are skewed.

10. Heuristic Diversity • Those that bet on trends extrapolate. • Those who commit gambler’s fallacy predict reversal. • Both predictions stem from representativeness. • They differ because of different perspectives.

11. Heuristic-Driven Bias • Confirmation bias—the illusion of validity. > Most people have difficulty assessing the validity of statements like “if X, then Y”. > They look for confirming evidence (X and Y hold) instead of disconfirming evidence (where X and not-Y hold.)

12. Bullish Sentiment Index • The Bullish Sentiment Index measures the percent of newsletter writers that are bullish. • The indicator is viewed as a contrarian indicator. • “Since most advisory services are trend followers, they are most bearish at market bottoms and least bearish at market tops.”

13. Heuristic-Driven Bias • The fear of regret leads to loss aversion. • Regret is more than the pain of a loss. It is the pain associated with feeling responsible for the loss. • Hindsight bias—events are viewed as far more likely than they looked before the fact.

14. Heuristic-Driven Bias • Loss aversion—regret makes losses very painful. • Faced with a loss, which choice would you make. A. A sure loss of $7,500. B. A 25% chance of losing $0 and a 75% chance of losing $10,000.

15. Heuristic-Driven Bias • “My intention was to minimize my future regret. So I split my contribution fifty-fifty between bonds and stocks.” Harry Markowitz

16. Heuristic-Driven Bias • Aversion to ambiguity—There is a fear of the unknown. • The bailout of Long-Term Capital Management. “It was a very large unknown. It wasn’t worth a jump into the abyss to find out how deep it was.”Herbert Allison, Merrill Lynch President.

17. Frame Dependency • The form used to describe a decision problem is called its frame. • Traditional finance assumes that frames are transparent. • Non-transparent frames can affect decisions, thereby making behavior frame dependent.

18. Frame Dependency • First decision: Choose A. A sure gain of $2,400, or B. A 25% chance to gain $10,000 and a 75% chance to gain nothing. • Second decision: Choose C. A sure loss of $7,500, or D. A 75% chance to lose $10,000 and a 25% chance to lose nothing.

19. Frame Dependency • People separate choices into mental accounts in order to help maintain self control. • The dividend puzzle. • For some investors dividends are a way to maintain self control. • Don’t dip into capital is a self control mechanism.

20. Frame Dependency • People split dividends and capital gains into separate mental accounts to protect funds designated for other goals. • Selling assets to satisfy current consumption can cause regret if the security price increases after it is sold.

21. Frame Dependence • Money illusion. > People naturally think in terms of nominal values. > Emotional reaction is driven by nominal values even though people know the affect of inflation.

22. Picking Stocks • Investors are consistent in the mistakes that they make. • They believe that: 1. Growth stocks outperform value stocks. 2. Winners continue to be winners and losers continue to be losers. 3. Strong revenue growth will continue.

23. Picking Stocks • Analysts recommend stocks of past winners more often than stocks of past losers. • Investors believe that good stocks and the stocks of good companies. • The DeBondt and Thaler study.

24. Picking Stocks • It is difficult to arbitrage away these heuristic-driven biases. • Some losers will continue to be losers. • The strategy may not work in any given year. • Hindsight bias will set in and the investor will feel like a fool.

25. Picking Stocks • Long Term Capital Management example. • Royal Dutch Petroleum and Shell Transport and Trading jointly own Royal Dutch/Shell. • All cash flow of Royal Dutch/Shell are divided on a 60/40 basis. • The market value of Royal Dutch should be 1.5 times that of Shell.

26. Picking Stocks • Shell Transport has traditionally traded at an 18% discount relative to Royal Dutch. • When the discount widened, LTCM bought Shell Transport and sold Royal Dutch short. • Unfortunately, the discount widened.

27. Analysts’ Earnings Predictions • Positive (negative) earning surprises are followed by positive (negative) earning surprises for up to three quarters. • Trading strategies based on post-earnings-announcement drift generate abnormal returns.

28. Analysts’ Earnings Predictions • Analysts and investors remain overconfidently anchored to their prior view of the company’s prospects. • They underweight evidence that disconfirms their prior views and overweight confirming evidence.

29. Analysts’ Earnings Predictions • Analysts and investors place little weight on changes in earnings unless there is salient news associated with the announcement. • They tend to overreact to salient information.

30. Analysts’ Earnings Predictions • Analysts long-term forecasts are overly optimistic. • Analysts are highly dependent on executives of companies they follow for their information. • Analysts are rewarded for bringing business to their company.

31. Analysts’ Earnings Predictions • Analysts’ short-term forecasts tend to be pessimistic. • Companies try to encourage pessimism just prior to earning announcements. • Stock prices jump when earnings beat the forecasts.

32. Earnings Manipulation • People have a tendency to evaluate outcomes relative to some benchmark. • Three thresholds. 1. Zero earnings. 2. The previous periods earnings. 3. Analysts’ consensus forecast.

33. “Get-Evenitis” • Most people exhibit loss aversion. • Consequently, they tend to hold their loses too long and sell their winners too early. • Realizing a loss is painful, despite the possible tax advantage.

34. “Get-Evenitis” • Most people exhibit loss aversion. • Consequently, they tend to hold their loses too long and sell their winners too early. • Realizing a loss is painful, despite the possible tax advantage.

35. “Get-Evenitis” • Collapse of Barings Bank. • Apple Computer’s Newton project. • “The definition of a good trader is a guy who takes loses.” Alan Greenberg, Bear Stearns Company chairman

36. Portfolio Decisions • Investor’s decisions are driven by fear, hope and goal aspirations. • Most investors think about portfolios in layers. > Bottom layer for security. > Middle layers for specific goals. > Top layer earmarked for potential. • Each layer is treated separately.

37. Portfolio Decisions • Investors are overconfident about their abilities to pick winners. • They take bad bets because they fail to realize that they are at an informational disadvantage.

38. Portfolio Decisions • Investors trade more frequently than prudent because of over-confidence and a false sense of control. • Individual’s fail to diversify. > The rule of five. > Naive diversification—place an equal amount across all funds available in their 401(k) plan.

39. Security Design • Financial markets are beginning to provide securities that appeal to both hope and fear. • British premium bonds—safe principal plus lottery tickets in lieu of interest. • Life USA’s Annu-a-dex—guaranteed 45% return over 7 years plus 50% of the market’s return over 45%.

40. Security Design • Dean Witter’s Principle Guaranteed Portfolio—$50,000 investment in a zero-coupon bond with face value of $50,000 and risky stocks. • A home made version—buy money market funds and use the interest to purchase call options.

41. Financial Advisors • Having a financial advisor is like holding a psychological call option. • Self-attribution bias—the investor attributes good outcomes to skill and bad outcomes to someone else or bad luck.