Behavioral Finance

1

• Behavioral Finance
• (see chapters 1 and 4 from Shefrin)

2
Behavioral Finance vs Standard Finance
Behavioral finance considers how various
psychological traits affect investors Behavioral
finance recognizes that the standard finance
model of rational behavior can be true within
specific boundaries but argues that this model
is incomplete since it does not consider the
individual behavior. Currently there is no
unified theory of behavioral finance, thus the
emphasis has been on identifying investment
anomalies that can be explained by various
psychological traits.
3
Aversion to a Sure Loss
First decision Choose between Choice 1 sure
gain of 85,000 Choice 2 85 chance of
receiving 100,000 and 15 chance of receiving
nothing Second decision Choose between Choice
1 sure loss of 85,000 Choice 2 85 chance of
losing 100,000 and 15 chance of losing
nothing

• Loss aversion psychologically, people experience
  a loss more
• acutely than a gain of the same magnitude

4
Seeking pride and avoiding regret
Rational individuals feel no greater
disappointment when they miss their plane by a
minute as when they miss it by an hour. What
about most of us? Most of the investors sell
winners too early, riding losers too long
(called the disposition effect) Individuals who
make decisions that turn out badly have more
regret when that decisions were more
unconventional
5
Regret Corporate finance implication
In the traditional agency theory the managers
make suboptimal decisions because incentive
system fail to align their interests with those
of shareholders. Behavioral influences lead to
suboptimal decisions, too. Some managers do not
want to close some failed projects earlier. This
behavior also depends not so much how much money
was involved but how visible the decision
was. Some managers will put more money into a
failure they feel responsible for than into a
successful project.
6
Overconfidence
Overconfidence people tend to overestimate
their ability More than 70 of drivers ranked
themselves as above the average
Overconfident investors trade more Overconfident
managers make poor decisions about both
investment and mergers and acquisitions, when
their firms are cash rich. Sun Microsystems
increased spending on research and development
in 2000 and its acquisition of Cobalt are cases
in point. (see text)
7
Excessively Optimistic Investors?

• During the stock market bubble between January
  1997 and June 2000, irrational exuberance drove
  up the prices of both the SP 500 and Suns
  stock.
• No firm the size of Sun has historically merited
  a price-to-earnings ratio (P/E) over 100.
• In March 2000, at the height of the bubble, Suns
  P/E reached 119.

Exhibit 1.2
8
Illusion of Control

• In 1997, Sun could purchase Intels chips for 30
  less than what it cost them to produce their own
  comparable chips.
• Despite the desire of some Sun executives to
  buy Intel chips instead of making their own,
  Scott McNealy felt that Suns chip design group
  exerted enough control to close the gap.
• In retrospect, McNealy describes his decision
  about using Intel chips as one of his biggest
  regrets.

9
Representativeness and the perceived Relationship
Between Risk and Return (or A good company is
not necessary a good stock)

• Traditional finance teaches that risk and return
  are positively related, that higher expected
  returns are associated with higher risk.
• Representativeness people make judgments based
  on stereotypical thinking
• Representativeness induces managers to view the
  relationship as going the other way, namely that
  less risky, larger and more well know firms will
  provide a higher return

10
Affect Heuristic Reinforces Representativeness

• Affect heuristic basing decisions primarily on
  intuition and instinct
• 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.
• For example some investors, employees and
  managers perceived the most admired firms as
  the best investments

11
Analysts

• 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,
  very often due to agency conflicts
• What agency conflicts? Most analysts work for
  investment banks that do or/and seek business
  with the covered companies

12
Extrapolation bias or hot-hand fallacy

• Is the market hotter if it's recently been hot?
• Based on data going back to 1926 when the SP 500
  index was formulated, the probability of an
  up-year is about 2/3.
• The probability is about the same after up-years
  as after down-years.
• Most individual investors extrapolate the past
  performance so, are momentum investors many
  institutional investors predict reversals (are
  contrarians) so suffer of gamblers fallacy
• Most value investors are contrarian, most growth
  investors are contrarian

13

• Learning outcomes
• Define, explain and provide a short example for
  the following behavioral flaws as applied to
  finance
• - Loss aversion
• - overconfidence
• Avoiding regret and the disposition effect
• Representativeness and the relation between risk
  and return (see slide 10)
• Affect heuristic (see slides 11 and 12)
• Extrapolation bias