introduction to business behavior finance
- 1. BEHAVIORAL FINANCE - INTRODUCTION
- 2. INTRODUCTION ¡ Subfield of Behavioral economics ¡ Study of the psychological influences and biases which affects the financial behaviors of investors ¡ Area of study focused on how psychological influences can affect market outcomes ¡ This might explain different types of market anomalies in the stock market
- 3. INTRODUCTION ¡ It seeks to provide explanations for people’s economic decisions by combining behavioral and cognitive psychological theory with conventional economics and finance. ¡ Classical financial theories assume efficient market (EMH-Efficient Market Hypothesis) where investors are rational decision maker ¡ Key assumption: Financial decision makers are not perfectly rational and self- controlled but rather psychologically influential with somewhat normal & self- controlling tendencies
- 4. TRADITIONAL FINANCIAL THEORY ¡ Classical/Traditional financial theory assumes following beliefs: ¡ Both the market and investors are perfectly rational ¡ Market participants makes unbiased decisions & maximize their self-interests ¡ Investors have perfect self-control ¡ They are not confused by cognitive errors or information processing errors ¡ Any individual who makes suboptimal decisions would be punished through poor outcomes ¡ Errors of any market participants are not correlated with each other thus, these individual errors don’t affect market prices
- 5. EFFICIENT MARKET HYPOTHESIS (EMH) What is it? Why it is assumed?
- 6. EFFICIENT MARKET HYPOTHESIS (EMH) ¡ According to EMH, any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information ¡ But, In reality different emperical data has documented the contradictions of EMH
- 7. EVOLUTION OF BEHABIORAL FINANCE ¡ 1960s & 1970s – Psychologists began examining economic decisions ¡ Slovic (1969, 1972) – studied stock brokers & investors ¡ Tversky and Kahneman (1974) detailed heuristics and biases that occur when making decisions under uncertainty ¡ Kahneman &Tversky (1979) published prospect theory ¡ DeBondt &Thaler (1985) – studied investor’s overreaction to news ¡ Shefrin & Statman (1985) – published disposition effect paper ¡ Shefrin (2000) describes how these psychology papers influenced the field of finance ¡ Odean (2000) find individual investors are loss averse, exhibit disposition effect & trade too much.
- 8. BEHAVIORAL FINANCE THEORY ¡ Traits of behavioral finance are: ¡ Investors are treated as “normal” not “rational” ¡ They actually have limits to their self-control ¡ Investors are influenced by their own biases ¡ Investors make cognitive errors that can lead to wrong decision “Human thinking process does not work like a computer. Instead, it often processes information using shortcuts and emotional filters-Heuristics”
- 9. “Change in Psychology” And “Change in Fundamentals”
- 10. “Is it greed and fear” https://www.forbes.com/2010/06/17/guide-financial-bubbles-personal-finance-bubble.html
- 11. Initially,Yes.“it is greed and fear” But, psychologists discovered that primary emotions that determine risk-taking behavior are “hope & fear”
- 12. ¡ Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners. ¡ Practitioners mean: portfolio managers, financial planners & advisers, investors, brokers, strategists, financial analysts, investment bankers etc. ¡ Practitioners need to know that because of human nature, they make particular types of mistakes. Mistakes can be very costly. This course will help practitioners learn : ¡ recognize their own mistakes and those of others; ¡ understand the reasons for mistakes; and ¡ avoid mistakes.
- 13. KEY THEMES IN BEHAVIORAL FINANCE 1) Heuristics 2) Framing 3) Emotions 4) Market Impact
- 14. 1) HEURISTICS ¡ Heuristics (Rules of thumb) are means of reducing the cognitive resources necessary to find a solution to a problem. ¡ They are mental shortcuts that simplify the complex methods ordinarily required to make judgments. ¡ Decision makers frequently confront a set of choices with vast uncertainty and limited ability to quantify the likelihood of the results. ¡ Scholars are continuing to identify, reconcile, and understand all the heuristics that might affect financial decision making. ¡ Some familiar heuristic terms are affect, representativeness, availability, anchoring and adjustment, familiarity, overconfidence etc.
- 15. HEURISTICS
- 17. 2) FRAMING ¡ People’s perceptions of the choices they have are strongly influenced by how these choices are framed. In other words, people often make different choices when the question is framed in a different way, even though the objective facts remain constant. Psychologists refer to this behavior as frame dependence. ¡ For example, Glaser, Langer, Reynders, and Weber (2007) show that investor forecasts of the stock market vary depending on whether they are given and asked to forecast future prices or future returns. ¡ Choi, Laibson, Madrian, and Metrick (2004) show that pension fund choices are heavily dependent on how the choices and processes are framed. ¡ Thaler and Sunstein’s (2008) book, Nudge, is largely about framing important decisions in such a way to as “nudge” people toward better choices.
- 18. GLASER, LANGER, REYNDERS,AND WEBER (2007) ¡ They analyzed existing studies on return expectations that usually ask for either future price levels or future returns. ¡ They found that studies which ask for future price levels document mean reverting expectations whereas studies asking for future returns document a belief in trend continuation ¡ For upward sloping time series, the return forecasts given by investors who are asked directly for returns are significantly higher than those stated by investors who are asked for prices. For downward sloping time series, the return forecasts given by investors who are asked directly for returns are significantly lower than those stated by investors who are asked for prices.
- 19. 3) EMOTIONS ¡ People’s emotions and associated universal human unconscious needs, fantasies, and fears drive many of their decisions. ¡ How much do these needs, fantasies, and fears influence financial decisions? ¡ The underlying premise is that the subtle and complex way our feelings determine psychic reality affect investment judgments and may explain how markets periodically break down. ¡ Example: Role of emotional attachment during investment & the consequences of engaging in a necessarily ambivalent relationship with something that can disappoint an investor; Examines the relationship between investor mood and investment decisions through sunshine, weather, and sporting events.
- 20. (AKERLOF AND SHILLER, 2009) ¡ This aspect of behavioral finance recognizes the role Keynes’s “animal spirits” play in explaining investor choices, and thus shaping financial markets ¡ Animal spirits is a term used by John Maynard Keynes in his 1936 book The GeneralTheory of Employment, Interest and Money to describe the instincts, proclivities and emotions that ostensibly influence and guide human behavior, and which can be measured in terms of, for example, consumer confidence ¡ The global financial crisis has made it painfully clear that powerful psychological forces are imperiling the wealth of nations today. From blind faith in ever-rising housing prices to plummeting confidence in capital markets, "animal spirits" are driving financial events worldwide.
- 21. 4) MARKET IMPACT Do the cognitive errors and biases of individuals and groups of people affect markets and market prices? ¡ Part of the original attraction in behavioral finance field was that market prices did not appear to be fair which opens up an possibility that they could be explained by psychology. ¡ Standard finance argues that investor mistakes would not affect market prices because when prices deviate from fundamental value, rational traders would exploit the mispricing for their own profit. ¡ These rational traders are arbitrageurs who would keep the markets efficient. E.g. Institutional class of investors. But, they often have incentives to trade with the trend that causes mispricing.
- 22. 4) MARKET IMPACT ¡ Institutional investors often exacerbate the inefficiency as they also play the trend. Other limits to arbitrage as per (Barberis and Thaler, 2003) are: ¡ fundamental risk because the long and short positions are not perfectly matched ¡ noise trader risk because mispricing can get larger and bankrupt an arbitrageur before the mispricing closes; and ¡ implementation costs. ¡ Hence, the limits of arbitrage may prevent rational investors from correcting price deviations from fundamental value.This leaves open the possibility that correlated cognitive errors of investors could affect market prices.
- 23. PICK-A-NUMBER GAME ¡ April 1997, Financial Times ran a contest suggested by economist “Richard Thaler” ¡ Winner get: 2 British Airwards round-trip “Club Class” tickets between london & Chicago/NewYork ¡ Choose a whole number between 0 & 100.The winning entry would be the one closest to two-thirds of the average entry ¡ E.g. Suppose 5 people enter the contest and choose: 10, 20, 30, 40 & 50. In this case, average is 30, two-thirds of which is 20. If any of 5 people has chosen 20 to enter the contest would be the winner
- 24. PICK-A-NUMBER GAME ¡ Point of this game is that if you are playing to win, you need to understand how the other players are thinking. ¡ Suppose you think everyone who enters the contest will choose 20, since that is the winning choice in the example. In that case, you should choose the integer closest to two-thirds of 20, or 14. ¡ But you might reflect on this for a moment, and wonder whether most other entrants would also be thinking along these lines, and therefore all be planning to choose 14. In that case, your best choice would be 10. ¡ And if you kept rethinking your choice, you would eventually come down to choosing 1.And, if everyone thinks along these lines, the winning entry will indeed be 1.
- 25. PICK-A-NUMBER GAME ¡ But in a group of normal, even well-educated, people, the winning entry will not be 1. In the Financial Times contest, with two transatlantic round-trip tickets at stake, the winning choice was13. If everyone chose a1, then nobody would have made a mistake in his or her choice. But if 13 is the winning choice, then most people are making mistakes.The real point of this game is that playing sensibly requires you to have a sense of the magnitude of the other players' errors. ¡ The pick-a-number game illustrates two of the three themes of behavioral finance. People commit errors in the course of making decisions; and these errors cause the prices of securities to be different from what they would have been in an error-free environment.
- 26. APPLICATIONS ¡ The early behavioral finance research focused on finding, understanding, and documenting the behaviors of investors and managers, and their effect on markets. ¡ Recent research are more directed towards: ¡ Can these cognitive errors be overcome? ¡ Can people learn to make better decisions? ¡ Knowing these biases goes a long way to understanding how to avoid them.
- 27. APPLICATIONS 1) For Investors: biases and associated problems with individual investor trading and portfolio allocations. How can individual investors improve their financial decisions? 2) For Corporations: In companies, one or a few people make decisions involving millions (even billions) of dollars.Thus, their biases can have a direct impact on corporate behavior that may not be susceptible to arbitrage corrections. Shefrin (2007, p. 3) states that “Like agency costs, behavioral phenomena also cause managers to take actions that are detrimental to the interests of shareholders.” Knowledgeable managers can avoid these mistakes in financing, capital budgeting, dividend policy.
- 28. APPLICATIONS 1) For Markets:The manner in which cognitive errors of market participants affects markets is a key theme of behavioral finance scholarship. Markets are the critical mechanism for distributing financing in a capitalistic society.Therefore, their functioning directly affects the health of the economy. 2) For Regulations: The heuristics that impact investors and managers also influence the politicians who make law and policy. New regulation and policy tends to overreact to financial events. Second, well-designed policy can help peo- ple overcome their biases to make better choices.
- 29. Case Discussion