Behavioral Finance Summary

Behavioral Finance

Behavioral finance is a relatively new field that attempts to understand how people behave as opposed to how they think they behave or how they would be a in an ideal world. Classic economic theory is based on the assumption of rationalism, believing that individuals rationally consider all choices available and act to maximize their "utility." Put another way, they always act in their best interests.

The reality, as any individual knows, is quite different. Highly intelligent well educated people carry balances on high interest credit cards, keep large sums of money in low interest bearing accounts, fail to save for retirement, and if they do safe, tend to be overly conservative in their investments and overly confident in their assessments of their own judgment. It is not that these individuals are not aware of their behavior. If it is pointed out to them, they readily admit that they know that they should be behaving differently.

One of the basic assumptions of behavioral finance is that people systematically act in ways at odds with classical rational economic theory not because of simple misinformation but because they are hard-wired to act in a way that minimizes regret and maximizes pleasurable feelings about themselves even if their actions are not in their best long-term financial interests. Understanding behavioral finance is important because it we are aware of our tendencies, we can set up our financial life to take these tendencies into account. If we pretend that they do not exist then we will continue to act in a way that is financially self-defeating.

What follows is a summary of some of the major behavioral finance principles.

Heuristics: the process by which people find things out for themselves, usually by trial and error, leading to the development of rules of thumb. This process often leads to other errors; these errors can be systematic.

Representativeness: judgments based on stereotypes. People do not appreciate the extent to which there is progression to the mean.

• Stocks that have been extreme past losers in the preceding three years do much better than extreme past winners over the subsequent three years (DeBondt and Thaler, 1987).
• analysts are biased in the direction of recent success or failure in their earnings forecasts (DeBondt, 1992).
• Regression to the mean suggests that future returns will be closer to a historical average, not necessarily below a historical average.
• Gambler's fallacy: the idea that after a series of wins, a loss is inevitable or vice versa. Also known as the law of small numbers.
• Myopic Loss Aversion: people tend to frame every gamble they face in isolation from all others. Yet people face small gambles of one sort or another all the time. But such gambles are independent of one another. But they don't frame that experience in an integrated way. Instead they frame every gamble as a one-shot deal rather than as one in a series of gambles. As a result, investors hold too little in equities and too much in fixed income securities in their portfolios (Benartzi and Thaler, in press). Since 1926, stocks have made money 62% of the time in a given month, of 90% of the time in 5-year segments. (Shefrin, page 147). Of note, however, optimistic investors may select portfolios that are too aggressive, especially if they have never experienced a bear market.
• Hedonic Framing: people tend to divide their money into mental accounts, for example spending dividends instead of capital gains. The objective of this division is to maximize psychological pleasure and minimize pain (regret).

Over confidence: people set overly narrow confidence bands. They set their low guess too high and their high guess too low. As a result, they are frequently surprised. In other words, they were too confident in their predictions. Self-attribution Bias: people attribute successful outcomes to their own skill but blame unsuccessful outcomes on bad luck. Having a financial adviser enables the investor to carry out a shifting of responsibility if things go wrong.

Anchoring-and-Adjustment, Conservatism: when presented with new information, analysts tend to be slow to change. For example, if a company reports the first of a series of improved earnings, the analyst is slow to change his projected earnings. In other words, he is anchored to the past earnings and is slow to change. Most people are conservative in incorporating new information. Perhaps analysts shift back and forth between two different mind-sets; following an unusual change, they believe that earnings will revert back to the prior trend. After a succession of surprises however the analysts a shift to a continuation mind-set (Nicholas Barberis, Andrei Shleifer, Robert Vishny, 1997).

Aversion to Ambiguity: people who prefer to gamble when the odds are even will play it safe when the odds are unknown. People prefer the familiar to the unfamiliar.

Frame Dependence: when a person has difficulty seeing through a frame (form) because it is opaque, he is exhibiting frame dependence. That is, he forgets that transferring a dollar from his left pocket to his right makes him no richer.

Loss Aversion: according to prospect theory, Daniel Kahneman and Amos Tversky (1979) provide evidence of frame dependence. Given a choice between a certain loss and a gamble, most people will take the gamble. For example, given a choice between losing $7,500 and having a 75% chance losing $10,000 with a 25% chance of losing nothing, they choose the gamble, although both are mathematically equivalent. In fact, the researchers found that a loss has about 2 1/2 times the impact of a gain of the same magnitude. Many investors will not sell anything at a loss. They don't want to give up the hope of making money. They have "get-evenitis."

Hedonic Editing: people are not uniform in their tolerance for risk. It depends on the situation. Someone will willing to tolerate risk in the face of a loss. People prefer some frames to others. They will shift frames to feel more comfortable about a loss. They will also mentally split up streams of income, for example spending dividends but not capital gains (which involves "dipping into capital"). They may do this to assert self control.

Cognitive And Emotional Aspects: the cognitive aspects concern the way people organize their information, while the emotional aspects deal with the way people feel as they register the information.

Regret: the emotion experienced for not having made the right decision. Regret is more than the pain of loss. It is the pain associated with feeling responsible for the loss.

Retirement Saving: in a December, 1997, Wall Street Journal poll of 2,013 people, 42% felt confident they will have enough money to live on in retirement, but 57% did not know how much they need the save in order to reach their retirement goal. Of the 55% who were saving, 26% had saved no more than $10,000 (Hart, Teeter, 1998). perhaps the major reason for insufficient savings is insufficient self control. Immediate demands are met whereas distant, deferred needs go unmet. Put another way, most people feel immediate needs but only think about future needs. (Shefrin, page 142).

• To overcome this bias, investors must be systematic about their saving. According to the Survey of Income and Program Participation used to track household assets between 1984 and 1991, families with a 401(k) but no IRA experienced a median increase in value of their total financial assets from $8,566.00 to 9,808 from 1987 to 1991. those families that contributed both to a 401 k plan and an IRA saw their financial assets rise from $20,686 to $27,094 but most of this increase occurred in their IRA accounts. (Shefrin, 142)
• Mental accounting: most people treat the same amount of money in a different light depending on its source. If a bonus is given to them in their paycheck, they tend to treat it as part of their current income account and is spent. If it is to arrive in the future, 90% of the sample will save the entire amount.
• Time diversification: people are more likely to engage in gambling if they are allowed to play multiple times instead of one time. People feel that the law of averages is on their side.

Research:

Representativeness: DeBondt and Thaler, 1987: stocks that my in the bottom 10^th percentile for the past three year return tend to outperform those that lie in the top 10^th percentile. The cumulative returns for the losers are about 30% and about-10% for the winners over the subsequent sixty months. The authors contend that an investor who bought losers and sold winners short would have beaten the market by about risk 8% on a risk-adjusted basis. (Shefrin, page 34)

Conservatism: Victor Bernard and Jacob Thomas, 1989: stocks associated with recent positive earnings surprises experience higher returns than the overall market, while stocks associated with recent negative earnings surprises earn lower returns than the overall market. In the 60 days following an earnings announcement, the stocks with the highest earnings surprises outperformed the overall market my about 2%, while the stocks with the most negative earnings surprises underperformed the overall market by about 2%.

Frame Dependence: over the last two centuries, the real return to stocks has been about 7% more than risk free securities. A premium of 7% is enormous, and this differential has come to be called the equity premium puzzle.

Effect Of A Change In An Analyst Recommendation Of A Stock (Kent Womack, 1996): not only does the market price of the stock immediately react to the announcement, with the adjustment continues for a substantial period of time. This post-recommendation drift means to a 5% average additional gain following the first day of the buy recommendation and a subsequent 11% drop following a sell recommendation. Also, according to first call, the immediate average price increase to a buy recommendation is 3.6%. The immediate reaction to a sell recommendation is a 10.5% drop. Their reaction to a "removed from buy" recommendation is a 12.7% drop. Although investors responded to the change in recommendation, they actually under react. In the twelve months following the recommendation change, stocks with buy recommendations continued their upward march, whereas new sells and "removed from buys" continued their downward decline. After twelve months "removed from buys" fell about 15% whereas sells were down over 60%.

Studies of individual investors:

• DeBondt, 1998: study a group of 45 investors who were members of the National Association of Indivestment Clubs; two-thirds were men, the average age was 58, with a portfolio worth an average $310,000, 72% invested in stocks. they displayed excessive optimism, over confidence, discounted diversification, and rejected the idea that there was a trade of between risk and return.
• Barber and Odean, 1998: 60,000 investors over a six year period ending in 1996 beat a value-weighted market index by 60 basis points, although this was gross of trading costs. Trading costs consumed 240 basis points, translating to and under performance of 1.8% per year. Those who traded most fared worst, under performing the index 500 basis points. Women outperformed men by 1.4% on a risk adjusted basis; men traded 45% more than women..
• Blume, Crockett, and Friend, 1974: under diversification: 34.1% of a sample of 17,056 held only one dividend paying stock. 50% held no more than two stocks and only 10.7% held more than ten stocks. The average number of stocks in the portfolio was 3.41.
• Shlomo Benartzi and Richard Thaler, 1998: naive diversification: will tend to diversify their money evenly among all choices in their 401 k plan. In other words, if a plan offers a stock fund and a bond fund, they will split their money up 50:50 between the two. If three stock funds and one bond fund is offered, they tend to have 75% of their money in stock funds.
• Ken French and James Poterba, 1993: home bias: although United States stocks account for only 45% of global market value, United States investors tend to concentrate their holdings in United States stocks. Only 7% of their portfolios of Americans are in foreign securities. Europeans tend to concentrate their portfolios in European stocks and Japanese tend to concentrate in Japanese stocks.
• Gur Huberman, 1997: United States investors concentrate their holdings in the Baby Bells of their own region.

Sources

Barber, Brad and Terrance Odean, 1998. "The common stock investment performance of individual investors." Working paper, University of California, Davis.

Barberis, Nicholas, Andrei Shleifer, and Robert Vishny, 1997. "A model of investor sentiment." Journal Of Financial Economics 49, number 3: 307-344.

Benartzi, Shlomo and Richard Thaler, 1998. "Illusionary diversification and its implications for the United States and Chilean retirement systems." Working paper, University of California, Los Angeles.

Blume, Marshall, J. Crockett, and Irwin Friend, 1974. "Stock ownership in the United States: characteristics and trends." Survey Of Current Business 54 (November): 16-40.

Debondt, Werner, 1998. "A portrait of the individual investor." European Economic Review 42: 831-844.

Debondt, Werner, and Richard Thaler, 1987. "Further Evidence On Investor Overreaction And Stock Market Seasonality." Journal of Finance 42: 557-581.

French, Kenneth and James Poterba, 1993. "Investor diversification and international equity markets." In advances in behavioral finance, edited by Richard H. Thaler, 383-392. New York: Russell Sage Foundation.

Huberman, Gur, 1997. "Familiarity breeds investment." Working paper, Columbia University, New York, New York.

Kahneman, Daniel and Amos Tversky, 1979. "Prospect theory: and analysis of decision making under risk." Econometrica 47, number 2: 263-291.

Shefrin, Hersh, 2000. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press, 2000.

Womack, Kent, 1996. "Do brokerage analysts' recommendations have investment value?" Journal of Finance 51, number 1: 137-168.

Behavioral Finance Resources

Belskey, Gary & Thomas Gilovich. Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons From the New Science of Behavioral Science. Fireside, 1999.

Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. John Wiley & Sons, 1996.

Shefrin, Hersh. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press, 2000.

Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life. Texere, 2001.

Thaler, Richard H. The Winner's Curse: Paradoxes and Anomalies of Economic Life. Princeton University Press, 1992.