Behavioral Finance

Investors, Corporations, and Markets

H. Kent Baker, John R. Nofsinger

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470769683
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A definitive guide to the growing field of behavioral finance

This reliable resource provides a comprehensive view of behavioral finance and its psychological foundations, as well as its applications to finance. Comprising contributed chapters written by distinguished authors from some of the most influential firms and universities in the world, Behavioral Finance provides a synthesis of the most essential elements of this discipline, including psychological concepts and behavioral biases, the behavioral aspects of asset pricing, asset allocation, and market prices, as well as investor behavior, corporate managerial behavior, and social influences.

• Uses a structured approach to put behavioral finance in perspective
• Relies on recent research findings to provide guidance through the maze of theories and concepts
• Discusses the impact of sub-optimal financial decisions on the efficiency of capital markets, personal wealth, and the performance of corporations

Behavioral finance has quickly become part of mainstream finance. If you need to gain a better understanding of this topic, look no further than this book.

PART I

Foundation and Key Concepts

CHAPTER 1

Behavioral Finance: An Overview

H. KENT BAKER

University Professor of Finance and Kogod Research Professor, American University

JOHN R. NOFSINGER

Associate Professor of Finance and Nihoul Finance Faculty Fellow, Washington State University

INTRODUCTION

Behavioral finance is a relatively new but quickly expanding field that seeks to provide explanations for people’s economic decisions by combining behavioral and cognitive psychological theory with conventional economics and finance. Fueling the growth of behavioral finance research has been the inability of the traditional expected utility maximization of rational investors within the efficient markets framework to explain many empirical patterns. Behavioral finance attempts to resolve these inconsistencies through explanations based on human behavior, both individually and in groups. For example, behavioral finance helps explain why and how markets might be inefficient. After initial resistance from traditionalists, behavioral finance is increasingly becoming part of mainstream finance.

An underlying assumption of behavioral finance is that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes. The thinking process does not work like a computer. Instead, the human brain often processes information using shortcuts and emotional filters. These processes influence financial decision makers such that people often act in a seemingly irrational manner, routinely violate traditional concepts of risk aversion, and make predictable errors in their forecasts. These problems are pervasive in investor decisions, financial markets, and corporate managerial behavior. The impact of these suboptimal financial decisions has ramifications for the efficiency of capital markets, personal wealth, and the performance of corporations.

The purpose of this book is to provide a comprehensive view of the psychological foundations and their applications to finance as determined by the current state of behavioral financial research. The book is unique in that it surveys all facets of the literature and thus offers unprecedented breadth and depth. The targeted audience includes academics, practitioners, regulators, students, and others interested in behavioral finance. For example, researchers and practitioners who are interested in behavioral finance should find this book to be useful given the scope of the work. This book is appropriate as a stand-alone or supplementary book for undergraduate or graduate-level courses in behavioral finance.

This chapter begins in the next section with a brief discussion of behavioral finance from the context of its evolution from standard finance. Four key themes of behavioral finance (heuristics, framing, emotions, and market impact) are delineated next. These themes are then applied to the behavior of investors, corporations, markets, regulation and policy, and education. Lastly, the structure of this book is outlined, followed by an abstract for each of the remaining 35 chapters.

BEHAVIORAL FINANCE

Before the evolution of behavioral finance, there was standard or traditional finance. This section discusses some of the key concepts underlying standard finance and the need for behavioral finance.

Standard (Traditional) Finance

At its foundation, standard finance assumes that finance participants, institutions, and even markets are rational. On average, these people make unbiased decisions and maximize their self-interests. Any individual who makes suboptimal decisions would be punished through poor outcomes. Over time, people would either learn to make better decisions or leave the marketplace. Also, any errors that market participants make are not correlated with each other; thus the errors do not have the strength to affect market prices.

This rationality of market participants feeds into one of the classic theories of standard finance, the efficient market hypothesis (EMH). The rational market participants have impounded all known information and probabilities concerning uncertainty about the future into current prices. Therefore, market prices are generally right. Changes in prices are therefore due to the short-term realization of information. In the long term, these price changes, or returns, reflect compensation for taking risk. Another fundamental and traditional concept is the relationship between expected risk and return. Risk-averse rational market participants demand higher expected returns for higher risk investments. For decades, finance scholars have tried to characterize this risk-return relationship with asset pricing models, beginning with the capital asset pricing model (CAPM). The paradigms of traditional finance are explained in more detail in Chapter 2. Chapter 8 summarizes the behavioral finance view of risk aversion.

Evolution of Behavioral Finance

Although the traditional finance paradigm is appealing from a market-level perspective, it entails an unrealistic burden on human behavior. After all, psychologists had been studying decision heuristics for decades and found many biases and limits to cognitive resources. In the 1960s and 1970s, several psychologists began examining economic decisions. Slovic (1969, 1972) studied stock brokers and investors. Tversky and Kahneman (1974) detailed the heuristics and biases that occur when making decisions under uncertainty. Their later work (see Kahneman and Tversky, 1979) on prospect theory eventually earned Daniel Kahneman the Nobel Prize in Economics in 2002. (See Chapters 11 and 12 for discussion about prospect theory and cumulative prospect theory, respectively.)

In his book, Shefrin (2000) describes how these early psychology papers influenced the field of finance. The American Finance Association held its first behavioral finance session at its 1984 annual meeting. The next year, DeBondt and Thaler (1985) published a behaviorally based paper on investors’ overreaction to news and Shefrin and Statman (1985) published their famous disposition effect paper. Chapter 10 provides a detailed discussion of the disposition effect.

The beginning of this psychologically based financial analysis coincided with the start of many empirical findings (starting with the small firm effect) that raised doubts about some of the key foundations in standard finance: EMH and CAPM. Chapter 18 provides a discussion about these anomalies and market inefficiency. The early anomaly studies examined security prices and found that either markets were not as efficient as once purported or that the asset pricing models were inadequate (the joint test problem). However, later studies cut to the potential root of the problem and examined the behavior and decisions of market participants. For example, Odean (1998, 1999) and Barber and Odean (2000) find that individual investors are loss averse, exhibit the disposition effect, and trade too much. Researchers also discovered that employees making their pension fund decisions about participation (Madrian and Shea, 2001), asset allocation (Benartzi, 2001; Benartzi and Thaler, 2001), and trading (Choi, Laibson, and Metrick, 2002) are largely influenced by psychological biases and cognitive errors. Evidence also shows that even professionals such as analysts behave in ways consistent with psychologists’ view of human behavior (DeBondt and Thaler, 1990; Easterwood and Nutt, 1999; Hilary and Menzly, 2006).

Today, the amount of research and publishing being done in behavioral finance seems staggering. Though psychology scholars have been examining economic and financial decision making for decades, psychology research is conducted in a fundamentally different manner than finance research. Psychology research involves setting up elaborate surveys or experiments in order to vary the behavior in which researchers are interested in observing and controlling. The advantage of this approach is that researchers can isolate the heuristic they are testing. Several disadvantages include doubt that people might make the same choice in a real life setting and using college students as the most common subjects. Finance scholars, on the other hand, use data of actual decisions made in real economic settings. While using this method is more convincing that people would actually behave in the manner identified, isolating that behavior in tests is difficult. Chapter 7 provides a discussion on experimental finance.

KEY THEMES IN BEHAVIORAL FINANCE

To help organize the vast and growing field of behavioral finance, it can be characterized by four key themes: heuristics, framing, emotions, and market impact.

Heuristics

Heuristics, often referred to as 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. However, some familiar heuristic terms are affect, representativeness, availability, anchoring and adjustment, familiarity, overconfidence, status quo, loss and regret aversion, ambiguity aversion, conservatism, and mental accounting. Heuristics are well suited to help the brain make a decision in this environment. Chapter 4 discusses heuristics in general, while many other chapters focus on a specific heuristic. These heuristics may actually be hardwired into the brain. Chapter 5 explores the growing field of neuroeconomics and neurofinance, where scholars examine the physical characteristics of the brain in relation to financial and economic decision making.

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. Lastly, Thaler and Sunstein’s (2008) book, Nudge, is largely about framing important decisions in such a way to as “nudge” people toward better choices. Chapter 31 describes in detail how poor framing has adversely affected many people’s pension plan choices.

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? This aspect of behavioral finance recognizes the role Keynes’s “animal spirits” play in explaining investor choices, and thus shaping financial markets (Akerlof and Shiller, 2009). 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. Chapter 6 describes the role of emotional attachment in investing activities and the consequences of engaging in a necessarily ambivalent relationship with something that can disappoint an investor. Chapter 36 examines the relationship between investor mood and investment decisions through sunshine, weather, and sporting events.

Market Impact

Do the cognitive errors and biases of individuals and groups of people affect markets and market prices? Indeed, part of the original attraction for a fledgling behavioral finance field was that market prices did not appear to be fair. In other words, market anomalies fed an interest in the 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. But who are these arbitrageurs who would keep the markets efficient? Chapter 32 discusses the institutional class of investors. They are the best candidates for keeping markets efficient because they have the knowledge and wealth needed. However, they often have incentives to trade with the trend that causes mispricing. Thus, institutional investors often exacerbate the inefficiency. Other limits to arbitrage (Shleifer and Vishny, 1997; Barberis and Thaler, 2003) are that most arbitrage involves: (1) fundamental risk because the long and short positions are not perfectly matched; (2) noise trader risk because mispricing can get larger and bankrupt an arbitrageur before the mispricing closes; and (3) 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. Chapter 35 examines the degree of correlated trading across investors, and Chapter 19 describes models that attempt to accommodate these influences in asset pricing.

APPLICATIONS

The early behavioral finance research focused on finding, understanding, and documenting the behaviors of investors and managers, and their effect on markets. Can these cognitive errors be overcome? Can people learn to make better decisions? Some of the more recent scholarship in behavioral finance is addressing these questions. Knowing these biases goes a long way to understanding how to avoid them.

Investors

A considerable amount of research has documented the biases and associated problems with individual investor trading and portfolio allocations (see Chapters 28 and 29). How can individual investors improve their financial decisions? Some of the problems are a result of investor cognitive abilities, experience, and learning. Chapter 30 discusses learning and the role of cognitive aging in financial decisions. This chapter provides recommendations for dealing with the limitations of aging investors. Other problems arise from the decision frames faced by employees making investment decisions. The reframing of pension choices helps employees make better choices. This topic is addressed in Chapter 31.

Corporations

Traditional finance argues that arbitrageurs will trade away investor mistakes and thus those errors will not affect market prices. Limits to arbitrage put in doubt any real ability of arbitrageurs to correct mispricing. However, the arbitrage argument may be even less convincing in a corporate setting. 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. Therefore, behavioral finance is likely to be even more important to corporate finance than it is to investments and markets. 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 (Chapter 21), capital budgeting (Chapter 22), dividend policy (Chapter 23), corporate governance (Chapter 24), initial public offerings (Chapter 25), and merge...

Table of contents

• Title Page
• Copyright Page
• Acknowledgments
• PART I - Foundation and Key Concepts
• PART II - Psychological Concepts and Behavioral Biases
• PART III - Behavioral Aspects of Asset Pricing
• PART IV - Behavioral Corporate Finance
• PART V - Investor Behavior
• PART VI - Social Influences
• PART VII - Answers to Chapter Discussion Questions
• Index