Behavioral Finance “from Left to Right ”

Behavioral Finance“from Left to Right” Prof. Felixberto U. Bustos, Jr., DBA, CFA Executive Director, Gov. Jose B. Fernandez, Jr., Center for Banking and Financing

Outline • Traditional Finance (Left Brain) • Efficient Market Hypothesis (EMH) • Capital Asset Pricing Model (CAPM) • Portfolio Theory • Behavioral Finance (Right Brain) • Definition • Phenomena/Examples • Applications

EMH Left Brain • “Stock prices already reflect all available information” • Competition is the source of “efficiency” • Three “forms” of EMH • weak - past information • semi-strong - public information • strong - both public and private information • Originated from Alfred Cowles’s 1944 random walk theory of stock prices

CAPM Left Brain • “A model that predicts the expected return on each risky asset.” • CAPM estimate can be compared to the required rate of return to determine properly valued assets. • Developed by William Sharpe in 1964.

CAPM Left Brain CML M E (rM) Efficient Frontier σM Ri = Rf + ß( Rm - Rf)

Portfolio Theory Left Brain • Assumptions on investor behavior • each investment alternative is captured by the probability distribution of expected returns • risk estimation is based on variability of expected returns • preference for high return and less risk • Investor is rational; decisions depend on only (1) expected return and (2) risk measure • Originated by Harry Markowitz in the 1950s

Right Brain Finance • Studies finance through the eyes of a psychologist, more than a nuclear scientist • Recognizes that investors do not behave completely rationally when making decisions • Combines finance theory and psychological theory to explain market behavior

Right Brain Finance • Believed to have originated in 1951 with Burrell’s article entitled “Possibility of an Experimental Approach in Investment Studies”, but was ignored by the academe as the fascination with quantitative methods prevented its growth

Preliminary Example • Imagine that you have paid $20 for a play ticket. When you get to the theater you discover that you have lost the ticket, the seat was not marked, and the ticket cannot be recovered. • Would you pay $20 for another ticket?

Now consider this... • Imagine that you have decided to see a play that costs $20 per ticket. As you arrive at the theater to buy the ticket, you discover that you have lost a $20 bill. • Would you pay $20 for a ticket to the play?

In a survey... • 46% of the respondents in the first question said they would pay for another ticket • 88% of the respondents in the second question said they would pay for another ticket • Is this behavior rational?

Mental Accounting • Preliminary Example is a case of mental accounting • Evaluation of gains and losses separately in different mentally created accounts.

Mental Accounting • Another Example ... • Investors of Con Ed, the electric utility company of New York City, shed tears when the company announced that it cannot issue dividends during the energy crisis of 1974 • Dividend “account” vs. capital gains “account”

Other Concepts Relatedto Behavioral Finance • Loss Aversion • Reference Dependence • Asset Segregation • Biased Expectations • Herd Behavior • Consistent Investor Above-Average Performance

Loss Aversion • Gambles on losses preferred over sure losses. • Example: Choice between ... • sure loss of $85,000, or • 85% chance of losing $100,000 and 15% chance of losing $0. Most people choose the second option

Reference Dependence • Alternatives are evaluated based on a certain reference point • Example … • Sell AOL.com as soon as they rise up to original cost

Reference Dependence Bought here Sell now?

Asset Segregation • Options are evaluated one at a time • Example: Choose between A & B ... A. A sure gain of $240 B. A 25% chance of gaining $1,000 84% chose A over B

Asset Segregation • Choose between C & D ... C. A sure loss of $740 D. A 75% chance of losing $1,000 87% chose D over C

Asset Segregation • Aggregated Decisions ... • A&D : A sure gain of $240 and 75% of chance of losing $1,000 • B&C: A 25% chance of gaining $1,000 and a sure loss of $740

Asset Segregation

Biased Expectations • Tendency to generalize based on limited satisfactory experience • Example: • A Microsoft investor assumes that all software companies will do well

Herd behavior • The tendency of investors to follow fads that leads to large movements in the markets • Example: • Asian foreign exchange crisis in 1997 that started with the “fall” of the Thai baht

Investor Above-Average Performance • Some analysts are able to consistently outperform the market Warren Buffet Up 27% a year, 1957 to 1998, 20% over last 32 years Benjamin Graham Up 17% a year, 1929-56 Peter Lynch Up 29% per year, 1977 to 1990 George Soros Up 34% per year since 1969 Michael Steinhart Up 21% per year since 1968 John Templeton Up 18% a year, 1954-1987

Disposition Effect • Tendency to sell winners too early and ride losers too long Value Function Value Losses Gains

JBF Center Research on Behavioral Finance : Preview • Survey respondents are financial executives from the Philippines • Pre-test observations • loss aversion - hold on to losing stocks to “get-even” • disposition effect - sell early • overconfidence on analysts • herd mentality - tend to go with the crowd

How to Use Right-Brain Finance • Recognize the “disposition effect” • Choose fund managers well • Ensure that decision sets are indeed consistent with objectives • Profile critical investors, and anticipate the role of sentiment

Recognize Disposition Effect • Set sell orders on a price floor and a price cap Value Function Value Target Return Losses Gains Maximum Loss

Choose your fund managers • Pick winners, and stick with them • Consistent over-performance is possible • Remember: Warren Buffet has had an over 20% return over the last 32 years!

Ensure Decision Sets Are Consistent with Objectives • Forget the purchase price, how does the price look now? • Do not be afraid to take certain losses, if a more lucrative opportunity arises • Example: Lose 10% for a possible gain of 30% if your long-term target return is 20%

Profile Critical Investors • Article by Coyne and Witter, The McKinsey Quarterly, 2002 No. 2, “What makes your stock price go up and down?” • Maximum of only 100 investors significantly influence the share prices of large companies

Profile critical investors Rationale: • The company’s stock price affects cost of capital, employee morale, and potential mergers • Buying and selling activities of critical investors are influential enough to affect price

Who are critical investors? • Some of the company’s largest investors, but not necessarily all. Some of the largest investors have no desire or intention of trading their holdings. • Portfolio managers and traders that have an interest in your industry

Steps in Anticipating Investor Sentiment • Identify critical investors (include potential investors) • common characteristics may be observable of investors in the industry, and similar companies • e.g., conservative investors tend to invest in utilities

Steps in Anticipating Investor Sentiment • Profile critical investors • watch how they react • Create a model • Test the model by observing their reactions to economic, industry and management announcements • Refine the model

Thank you. Presentation of the complete results of the JBF Center research on Behavioral Finance is on September 25, 2002. JBF Center website: www.jbf.aim.edu.ph

Behavioral Finance “from Left to Right ”