BEHAVIORAL FINANCE

FNCE 455Class Session #8Lloyd KurtzSanta Clara University

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Topics

• What is Behavioral Finance?

• People Make Mistakes• Processing - The Monty Hall Problem• Decisions - The Disposition Effect

• Markets Make Mistakes• Shiller Study #1• Shiller Study #2• Shiller Study #3

• The Graham View

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What Is Behavioral Finance?

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What is behavioral finance?

“The application of psychology to financial behavior – the behavior of practitioners.”

- Shefrin

“The study of how cognitive biases and other psychological factors impact human behavior in markets.”

- Bodie, Kane, and Marcus

"The study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets."

-Sewell

Even professors are human

“When we started our work together, we didn’t say we wanted to deviate from neoclassical finance. [But] we always found it really ridiculous that finance academics kept two selves: a rational self they presented in their research and teaching, and a personal self where they did what they described as irrational in their classes... No one was asking about the disconnect.” - Statman

Meir Statman and Hersh Shefrin

The optimal car

Suboptimal cars

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Utilitarian sales pitch

• I am well-educated, have had extensive professional training, and hold all appropriate professional certifications.

• I have specialized diagnostic tools and software that will help me match your portfolio’s risk to your needs and objectives.

• I monitor your portfolios and rebalance them so that you can spend your time on other things.

• I have particular expertise in _____.

• Empirical studies suggest you’ll almost certainly do better hiring me than you would on your own.

Value-expressive sales pitch

Because you’re

not the kind of

person who

thinks ‘good’ is

good enough.

Predictably irrational

“These irrationalities fall into two broad categories:

first, that investors do not always process

information correctly and therefore infer incorrect

probability distributions about future rates of return;

and second…they often make inconsistent or

systematically sub-optimal decisions...”

- Bodie, Kane, and Marcus

People Make Mistakes

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Processing

The Monty Hall Problem

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A thoroughly honest game-show host has placed a car behind one of three doors. There is a goat behind each of the other doors. You have no prior knowledge that allows you to distinguish among the doors. "First you point toward a door," he says. "Then I'll open one of the other doors to reveal a goat. After I've shown you the goat, you make your final choice whether to stick with your initial choice of doors, or to switch to the remaining door. You win whatever is behind the door." You begin by pointing to door number 1. The host shows you that door number 3 has a goat.

Source: Wikipedia

OK, now...

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Should you stay with Door #1 or SWITCH to Door #2?

Source: Wikipedia

Counterintuitive

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“A restated version of [the Monty Hall problem] appeared in Marilyn vos Savant's Ask Marilyn question-and-answer column of Parade in September 1990. Though vos Savant gave the correct answer, … [she] estimates 10,000 readers including several hundred mathematics professors wrote in to declare that her solution was wrong. ”

Source: Wikipedia

How Monty Gets Your Goat

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Source: Wikipedia

Decision Tree

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Source: Wikipedia

DECISIONS

Disposition Effect: prediction

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“The disposition effect is a behavioral finance theory that predicts individuals will hold their losing investments too long and sell their winning investments too soon to optimize profits.”

- Garvey and Murphy

Disposition Effect: evidence

Studies finding evidence of the disposition effect:

• Shefrin and Statman (1985)• Makhija (1988)• Heisler (1994)• Odean (1998)• Locke and Mann (2000)• Coval and Shumway (2001)

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Why would people do that?

• The purchase price is a reference point.

• People like gains, but they hate losses.

• People don’t like to admit they’ve made a bad decision. A sale ‘ratifies’ the loss.

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Garvey and Murphy

• 15 professional equity traders

• “Generated $1.4 mm in intraday trading profits” over 68 trading days, in a “downward-trending market” (3/8/2000-6/13/2000).

• 96,323 trades

• Median duration of a winning roundtrip: 64 seconds

• Median duration of a losing roundtrip: 102 seconds

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Disposition effect in Taiwan

• Individual Investors: Very Strong• Dealers: Strong• Corporate: Strong• Foreigners: No disposition effect• Mutual funds: No disposition effect• All Investors: Very Strong

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Source: Bard Barber, Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean. “Is the Aggregate Investor Reluctant to Realize Losses? Evidence from Taiwan.”

Markets Make Mistakes

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Robert Shiller

• Yale economist• Pioneer in behavioral finance

• Recent research has focused on valuations in the equity and housing markets.

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Source: Newsweek, 1/27/2005

Shiller on volatility

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“There will always be bubbles.”

Source: Newsweek, 1/27/2005

Shiller’s three shots

#1 – S&P 500 Dividends and Prices

#2 – S&P 500 Cyclically-Adjusted P/E Ratio

#3 – Home Prices

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#1 – The market is too volatile

• Shiller (1981) argues the market is too volatile when compared with economic fundamentals.

• With 20-20 hindsight, Shiller was able to compute ‘rational’ prices for stocks using a dividend discount model for the 1871-1979 time period.

• Real prices were more than 5x times as volatile as ‘rational’ prices.

• BD&K: “If true, this finding would be an outright refutation of the Efficient Market Hypothesis (EMH) and must result from irrational investment behavior.”

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#1 – The market is too volatile

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BK&M on Shiller (1981)

“Since earnings are far more volatile than dividends, the volatility of rational prices will be much larger in [an earnings-based model]...[and therefore] will indicate that actual prices do not exhibit excess volatility.”

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#2 – Stock market bubbles

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Long-Term Interest Rates

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Originally created for the 2000 book Irrational Exuberance

#3 – Home prices (1880 – 2010)

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Source: Robert Shiller

The Graham View

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Graham’s critique

• Prices are more volatile than intrinsic valuations [e.g., dividends and book values are relatively stable].

• Much of this volatility is the product of irrational behavior on the part of other investors.

• An unjustified fall in price increases expected return.

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Buffett explains Mr. Market

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“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his...”

Warren Buffett, 1987 Chairman’s Letter

Mr. Market: happy

“...at times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains...”

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Mr. Market: sad

“...at other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him...”

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The best thing about Mr. Market

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“He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.”

Therefore...

“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely turning his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.” -Graham

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Graham and theorists agreeMarkets are pretty efficient

• EMH Theorists: yes• Graham: yes

Most people would be better off in an index fund• EMH Theorists: yes• Graham: yes

Markets may move because of human emotions • EMH Theorists: yes, appetite for risk can change over time• Graham: yes, fear creates undervalued securities

Short-term market-timing is likely to be fruitless• EMH Theorists: yes, because markets are so efficient• Graham: yes, because it encourages a speculative mindset

A sucessful investor needs discipline and willpower• EMH Theorists: yes – to pursue an indexing strategy• Graham: yes – to purchase undervalued securities when others are afraid

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DisagreementsThere is such a thing as an ‘unjustified’ move in the price of a stock

• EMH Theorists: no• Graham: yes

Buying stocks that appear inexpensive is a lower-risk activity than buying stocks that appear expensive

• EMH Theorists: no• Graham: yes

There are reasonably simple techniques that could offer superior investment results over time:

• EMH Theorists: no• Graham: yes

Adjusting stock market exposure based on an awareness of valuations could be the basis for good investment decisions over time.

• EMH Theorists: no• Graham: yes

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