Behavioral Finance:

An Introduction

劉玉珍 政大財管系

壹、 Background of BF

BF takes into consideration some of the psychological biases and decision-making processes of people.

貳、 Introduction

Part I. Some Debates!! Traditional

1.makes decisions according to the axioms of expected utility theory and

2.Makes unbiased forecasts about the future. BF

1.Even if prices were set only by rational investors in the aggregate, knowing what individual investors are doing might still be of interest.

2.limits of arbitrage, costless short selling.

Rather than assuming that all people or most people will behave optimally, randomly and rationally, BF takes into consideration some of the psychological biases and decision-making processes of people.

Part II. Nobel Prizes in 2002

Foundations of Behavioral and Experimental Economics: Daniel Kahneman and Vernon Smith

A large and growing body of scientific work : unbounded rationality, pure self-interest, and complete self-control.

This recent research has its roots in two distinct, but converging, traditions: theoretical and empirical studies of human decision-making in cognitive psychology, and tests of predictions from economic theory by way of laboratory experiments.

Dainel Kahneman has used insights from cognitive psychology regarding the mental processes of answering questions, forming judgments, and making choices, to help us better understand how people make economic decisions.

Vernon Smith is the most influential figure in launching experiments as an empirical methodology in economics.

A current wave of research draws on the combined traditions of psychology and experimental economics. This new research is potentially significant for all areas of economics and finance. Experimental evidence indicates that certain psychological phenomena-such as bounded rationality, limited self-interest, and imperfect self-control- are important factors behind a range of market outcomes.

A challenging task in financial economics is to consider the extent to which the effects of systematic irrationality on asset prices will be weeded out by market arbitrage.

Part III. Two building blocks Economists have tried to understand

financial markets using models in which all market participants-investors, managers and others- are rational.

Perhaps the best-known prediction of this approach is the Efficient Markets Hypothesis(EMH)

Limits to Arbitrage One of the biggest successes of behavioral

finance to date is a series of theoretical advances showing that Friedman’s critique, while initially compelling, is actually seriously flawed, and hat irrational traders can have a substantial and long-lived impact on prices.

This research is often referred to as the literature on “limits to arbitrage”.

Psychology Experts on decision-making and cognitive

psychology on the systematic errors that people make when they form beliefs.

For example, in general, people significantly overestimate the accuracy of their forecasts. Overconfidence may be due, at least in part, to and error known as self-attribution bias. People tend to ascribe any success they have in some activity to their own insight and any disasters to bad luck.

參 . Applications in Finance

understanding aggregate stock market behavior

understanding investor behavior

understanding managerial behavior

Part I: understanding aggregate stock market behavior

One of the most enduring puzzles about financial markets is that the valuations of national stock markets are excessively volatile which are simply too large to rationalize.

The simplest rationalization of a high price-earnings ratio, namely that investors expect future earnings to be high and are therefore willing to pay top dollar for a claim to those earnings.

If investors’ expectations are rational, then it must be the case that times of high price-earnings ratios are indeed, on average, followed by times of high earnings growth.

Rober Shiller’s recent best-seller, Irrational Exuberance, in price-earnings ratios show remarkably little predictive power for future earnings.

Why then, do price-earnings ratios fluctuate so much in the first place, if their fluctuations have nothing to do with rationally forecasted earnings?

BF: People overreact to past earnings growth if a country’s economic sector delivers several quarters of rising earnings.

Investors may be too quick to believe that the true underlying growth rate of earning has increased, thereby leading them to push prices up too far, contributing to excessive price volatility.

Part II: understanding investor behavior Explaining how certain groups of

investors behave, and in particular, what kinds of portfolios they choose to hold and how they trade over time.

Two factors make this type of research increasingly important. First, more and more individuals are

investing in equities. Second, the world-wide trend toward

defined contribution retirement savings plans.

Investors are very under-diversified: There is a pronounced “home bias”

Investors in the U.S., Japan and the U.K. allocated over 80 percent of their overall equity investment, respectively, to domestic equities

Investors are heavily tilted towards companies located in their local province or city defined contribution pension plans.

Investors allocated heavily to their own company stock, leaving themselves dangerously under-diversified, as the recent experience of Enron employees has made all too clear.

Research have tried to find rational explanations for these facts, but with little success(ambiguity aversion, preference for the familiar)

Investors may find their national markets more familiar-or less ambiguous-than foreign stock indices(geographically more familiar than those located further away; and they may find their employer’s stock)

High level of trading volume on the world’s stock exchanges individual investors in particular, see to trade too much.

Brad barber and Terrance Odean find these investors would have been better off if they had traded less.

Interpretation investors are overconfident about the value of the information they uncover:they believe they have information worth trading on, whereas in fact, they do not.

Disposition effect--When individual investors sell stocks, they typically sell stocks that have gone up in value relative to their purchase price, rather than stocks which have gone down.

Narrow framing-- Individuals prefer to hold on to the losing stock, in the hope that at some point down the line, it will bread even, they can sell it without experiencing any regret.

Part III. Understanding managerial behavior An alert manager will then engage in “

timing”, issuing shares when they are overvalued, and repurchasing them when they are undervalued.

Price relative to book value are good predictors of share issuance with high valuations associated with greater issuance.

The long-term returns of shares whose firms have just announced a share repurchase are good, outperforming a control group of stocks.

It is less clear whether they also influence firms’ investment decisions. To some, this is one of the most critical questions in behavioral finance.

Irrational trader sentiment need not necessarily have any impact on firms’ investment decisions.

Even if he knows that the projects investors are excited about do not make any sense, the manager may feel pressured to do them anyway.

Even if the manager knows that certain investments are not good for the firm, he will do them anyway so as to stoke investors’ frenzy, leading to still higher stock prices, at which time he can exercise his stock options or unload his large equity stake for personal gain.

More formal research on this topic is still I its early stages, however, and the overall magnitude of these effects is still unclear.

Another potential application is to understanding the apparently excessive volume of takeover activity. Just as overconfidence may lead to excessive trading, so it may also lead to excessive merger activity.

肆 . Is BF a growth industry?

It is accepted as a field in finance, whereas 5-6 years ago it wasn’t. (Gervais)

How individuals make investment decisions. The implication of those decisions for price

s. The behavioral biases that affect decision- making in corporate finance.

Fama’s criticism(1998, 2001) Data-mining techniques make it possible

to locate patterns whose significance is nonetheless questionable.

BF hasn’t shown that the tendencies of individuals, when aggregated, have an impact on world prices.

BF models frequently contradict one another.

Some proponents are listening to Fama Gervais: Some people don’t try to see if the

biases are the result of underlying economic forces.

Shefrin: It’s a misconception that behavioral finance means people can beat the market.

Hirshleifer: psychology-based finance is currently a growth discipline and not yet a mature one, there’s a lot of disagreement.

Metrick: it is too mainstream to be called a revolution. In some guise, this has been around since the beginning of finance research. It is just hasn’t been codified and married to psychology quite so formally before.

Odean: Systematic biases in the decisions of investors make a difference and can add to our understanding of how markets work.

Benartzi: prices can be right yet every single investor cold be making the wrong choice.

It’s just that in the aggregate the mistakes are washed out.

Some other skeptical thoughts: While they concede that many facts are

not easy to understand in the rational paradigm.

There are so many different examples of systematic biases in the psychology literature that a researcher can explain any existing finding he wants to by searching through a list of biases until be finds one that “fits”.

Possible responses to these critiques:

While there are indeed many biases to choose from, most research in behavioral finance has made use only of those listed earlier in this article, which are among the most robus and well-documented of all biases.

While behavioral finance faces the risk of being undisciplined, the rational paradigm does too.

Though, it is to note that the only way to test any model, whether rational or behavioral, is to check its previously untested predictions. Researchers on both sides of the debate are hard at work on this.

If behavioral finance comes through this process successfully, its place in financial economics will be secure.

E、

伍 . A Wish List

I. Popular Topics: Investment

Disposition effect, prospect theory Mental accounting Overconfidence Diversification Exercise stock options

II. BF corporate finance is appealing If managers are imperfectly rational, perhaps t

hey are not evaluating investments correctly.

Shefrin: how managers really make decisions Hirshleifer: Do firms exploit investor biases? (I

nternet firms) Do firms try to mislead investors? Gervais: why corporations hire overconfident e

mployees.

II-A. Who makes acquisitions? CEO overconfidence and the market’s reaction Malmendier and Tate(2003) analyze the imp

act of CEO overconfidence on mergers and acquisitions. Overconfident CEOs over-estimate their ability to generate returns.

The impact of overconfidence is strongest when CEOs can finance mergers internally.

The classify CEOs as overconfident when they hold company options until expiration.

The market reacts negatively to takeover bids and this effect is significantly stronger for overconfident managers.

II-B Hot markets, investor sentiment, and IPO pricing

Ljungqvist, Nanda and Singh(2001) relate hot IPO markets to the presence of a class of investors who are “irrational” in the sense of having exuberant expectations regarding future performance.

Underpricing and long-run underperformance emerge as underwriters attempt to maximize profits from the sale of equity, at the expense of these exuberant investors.

III. Other markets: Are investors credulous? Some preliminary evidence from art auctions

Mei and Moses(2002) constructs a new data set from auctions that include auctioneer presale price estimates to examine the credulity of art investors.

They have a natural experiment to observe changes in price behavior under the influence of auctioneer estimates.

They use high- and low-price estimates for all artworks and find the price estimates tend to have an upward bias for expensive paintings.

Investors do not discount fully the strategic incentives of auctioneers.

IV. Law: Blinded by the Light: Information Overload and Its Consequences for Securities Regulations

Paredes(2003) tried to provide a framework for thinking about information overload and how it fits within the overall structure of securities regulation.

Information overload raises doubts about the effectiveness of the disclosure philosophy at the core of the federal securities laws.

Investors will actually make less accurate decisions in the face of more information as they adopt less complicated decision strategies in an effort to simplify their investment decisions.

A number of concerns, what disclosure items should be deleted?

Regulators and policy makers need to focus on how users process information and make decisions.

V. Some behaviorists look at the big picture.

The market has not digested imminent threats of inflation and energy shocks.

F、

陸 . What’s the Next?

The debate is far from over

Researchers in behavioral finance continue to develop advanced models of the interplay of psychology and finance, proponents of efficient markets will continue to probe the relationships between risk and return.

The End of Behavioral Finance

In a not-too-distant future, the term “behavior finance” will be correctly viewed as a redundant phrase.

In their enlightenment, economists will routinely incorporate as much “behavior” into their model as they observe in the real world.

(Richard Thaler)

Some References

Barberis (2002) Fama (1998, 2002) Kahneman and Tversky(1979) Kahneman (1999) Shleifer(2000) Smith(2000) Thaler (2003)

Thank You!