Behavioural Finance

behavioural finance repository

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	Title	Authors	Abstract/Summary

	A quick and easy introduction	Daniel Kahneman, Mark Riepe	An excellent and succinct introduction to the topic from one of its leading exponents. The examples are both fun and instructive in establishing just how flawed your investment thinking may be and the paper offers some pragmatic recommendations to market practitioners on how to deal with these traits in oneself and one's clients.

	Behavioural finance and the sources of alpha	Russell Fuller	Behavioral finance is a new field in economics that has recently become a subject of significant interest to investors. This article provides a general discussion of behavioral finance and presents some insights from this field that apply to the problems plan sponsors face when evaluating and selecting active equity managers.

	Why women are better traders than men...	Brad Barber, Terrance Odean	Theoretical models predict that overconfident investors trade excessively. We test this prediction by partitioning investors on gender. Psychological research demonstrates that, in areas such as finance, men are more overconfident than women. Thus, theory predicts that men will trade more excessively than women. Using account data for over 35,000 households from a large discount brokerage, we analyse the common stock investments of men and women from February 1991 through January 1997. We document that men trade 45 percent more than women. Trading reduces men’s net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women.

	Are strategists reliable contrary indicators?	Kenneth Fisher, Meir Statman	Investors are not all alike and neither is their sentiment. The sentiment of Wall Street strategists is unrelated to the sentiment of individual investors or that of newsletter writers although the sentiment of the last two groups is closely related. Sentiment can be useful for tactical asset allocation. There is a negative relationship between the sentiment of each of the three groups and future stock returns and that relationship is statistically significant for Wall Street strategists and individual investors.

	Behavioural portfolio construction	Hersh Shefrin, Meir Statman	We develop a positive behavioral portfolio theory and explore its implications for portfolio construction and security design. Portfolios within the behavioral framework resemble layered pyramids. Layers are associated with distinct goals and covariances between layers are overlooked. We explore a simple two-layer portfolio. The downside protection layer is designed to prevent financial disaster. The upside potential layer is designed for a shot at becoming rich. Behavioral portfolio theory has predictions that are distinct from those of mean-variance portfolio theory. In particular, behavioral portfolio theory is consistent with the reluctance to have short and margined positions, an inverse relation between the bond/stock ratio and portfolio riskiness, the existence of the home bias, the use of labels such as “growth” and “income,” the preference for securities with floors on returns, and the purchase of lottery tickets.

	The frailties of forecasting	Kenneth Fisher, Meir Statman	Tactical asset allocation practitioners emphasise quantitative tools, while traditional market timing practitioners emphasise qualitative ones. Each forecasting method is subject to biases and each calls for remedies.This paper discusses five cognitive biases that underlie the illusion of validity: overconfidence, confirmation, representativeness, anchoring and hindsight. In this short, very readable document the authors use forecasts based on p/e ratios and dividend yields to illustrate these biases and offer remedies.

	Learning to let go	Terrance Odean	This paper examines the so-called disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon. They may (rationally or irrationally) believe that their current losers will in future outperform their current winners. Unfortunately, the winning investments that they choose to sell continue in subsequent months to outperform the losers they keep. This results in poor returns, particularly in taxable situations. The paper does not, however, suggest methods of counteracting this aberrant behaviour. Clearly, rigorous internal investment processes, which include profit-taking and loss-taking rules, are required.

	Why so many earnings surprises?	David Dreman	This paper presents typical analyst forecast errors by industry and shows that these errors are large and related to behavioural tendencies towards extrapolation from the past, being misled by expert opinion and consensus as well as peer and institutional pressures. He examines the different types of earnings surprises, their impact, size and frequency and finds that there is post-surprise reversion towards the mean. Analysts and fund managers typically display the behavioural phenomenon of unjustified confidence. When this is betrayed by a surprise the result is overreaction, which results in the long-term success of contrarian strategies.

	Can investors profit from the prophets?	Brad Barber, Reuven Lehavy, Maureen McNichols, Brett Trueman	In this paper we document that stocks highly recommended by analysts outperform the market, while those that are unfavourably recommended underperform. Our findings are based on an extensive analysis of over 360,000 analyst recommendations from 269 brokerage houses over the period 1986-1996. We show that strategies of purchasing the stocks with the most favourable consensus (average) recommendations or selling short those with the least favourable recommendations, in conjunction with daily portfolio rebalancing and a quick investor response to changes in consensus recommendations, yielded an annual abnormal gross return of more than 4 percent. Less frequent portfolio rebalancing or a delay in reacting to consensus recommendation changes diminished the abnormal returns; however, they did remain significant for the least favourably rated stocks. We also show that quite high trading levels are required to capture the excess returns generated by the strategies we analyse, entailing substantial transactions costs and leading to abnormal net returns that were not reliably greater than zero.

	The need for behavioural finance	Werner De Bondt	The paper outlines how behavioural finance is needed to address the problem of Keynes' "animal spirits" (i.e. sentiment), which distorts modern finance theory as a result of aberrations such as "bounded rationality" (i.e. people are silly sometimes), the fact that mistakes are repeated (by many people at the same time or the same people at different times), that false beliefs do matter and that information is not always asymmetrical (i.e. silly people may not be aware that they are being silly). It discusses the concepts of framing, heuristics and the dynamics of security prices, including analyst forecasts, the winner/loser effect and evidence of market underreaction.

	All the phenomena of behavioural finance	Robert Shiller	Recent literature in empirical finance is surveyed in its relation to underlying behavioral principles, principles which come primarily from psychology, sociology and anthropology. The behavioral principles discussed are: prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and underreaction, representativeness heuristic, the disjunction effect, gambling behavior and speculation, perceived irrelevance of history, magical thinking, quasi-magical thinking, attention anomalies, the availability heuristic, culture and social contagion, and global culture.

	People are normal, not rational!	Meir Statman	the attached article compares behavioural finance with standard finance. Standard finance is a poor descriptive theory of finance. Investors regularly overlook the arbitrage principles of Miller and Modigliani, fail to use Markowitz in constructing their portfolios and don't drive stock returns to levels predicted by Sharpe’s CAPM. People in standard finance are rational whereas people in behavioural finance are not always rational, but are always normal. Normal people are often confused by frames, are affected by cognitive errors, know the pain of regret and the struggle with self-control. Statman discusses the puzzles of investor's preference for cash dividends, the phenomena of selling winners too early and riding losers too long, the pursuit of "popular" stocks, the role of marketing financial products and the behavioural forces that shape financial regulations.

	Homo Economicus flawed	Sendhil Mullainathan, Richard Thaler	Some of the interesting anomalies discussed include: There are important limits to arbitrage - it may often pay “smart money” to follow “dumb money” rather than to lean against it. There are limits to learning – the opportunity costs of learning or experimenting can result in us becoming stuck in nonoptimal equilibrium, simply because the cost of trying something else is too high. A rapidly-changing environment exacerbates this, and learning opportunities can be limited to start with - for example, the number of times we get to learn from our retirement decisions is low, and possibly zero. The three tenets of the so-called “standard economic model” of human behaviour: unbounded rationality, unbounded willpower and unbounded selfishness are all called into question, as are core economic principles such as the law of one price. The article illustrates some of these aspects in a field we have not touched on before: savings. For example, the life cycle model of savings and consumption is patently untrue, as illustrated by the frightening fact that most people cannot afford to retire.

	The best value strategies	Lakonishok, Schleifer, Vishny	The paper shows that a wide range of value strategies do indeed produce higher returns, and then tackles the two potential explanations. It shows that the pattern of returns and the structure of past, expected and actual growth rates is consistent with the contrarian model, and that there is little, if any, support for the view that value strategies are fundamentally riskier. The resulting implication is that the market has a predilection for naive growth strategies. Reasons for this could be the placing of excessive weight on recent history, "glamour" factors, the overestimation of good but expensive companies and the very pertinent fact that most investors have shorter time horizons than are required for value strategies to pay off consistently.

	Why do we do it?	Richard Thaler	The article examines the reasons that lead to the rise of behavioural finance. These were generally anomalies inexplicable by conventional financial economics theory, such as excessive trading, excessive volatility, the dividend puzzle, the equity premium puzzle and the predictability of returns. He then summarises the progress and discoveries made by the behavioural approach and suggests further areas of investigation. These include large-cap stocks, corporate finance and the behaviour of individual investors.

	The unbearable asymmetry of newsflow	Jennifer Conrad, Bradford Cornell, Wayne R. Landsman	We examine whether the asymmetrical price response to bad and good earnings shocks changes as the relative level of the market changes. The study is based on a sample of 24,108 announcements of firms’ annual earnings during the period 1988 to 1998. The level of the market is a relative measure based on the difference between the market P/E at the end of the announcement month and the average market P/E over the prior 12 months. Predictions based on behavioral finance models and extended regime-shifting models suggest that stock prices should respond more strongly to negative news as the relative market level rises. Similarly, prices should respond more strongly to good news in bad times, although the effect should be somewhat attenuated if the regime-shifting models are descriptively valid. The findings generally support these predictions.

	The assimilation of behavioural finance	George Frankfurter, Elton McGoun	In this paper we compare and contrast modern finance (the de facto ruling paradigm of financial economics) with what is being called (most of the time) behavioral finance, and some time “the anomalies literature.” The faithful of the ruling paradigm have marginalised behavioral finance by making it the “anomalies literature.” But even the supposed proponents of behavioral finance are marginalising themselves by clinging to the underlying tenets, forms, and methods of what is now called modern finance. They have allowed it to set the terms of the debate and made it the benchmark against all finance is not only judged, but also labelled “finance.” But finance research is subject to the same “mistakes” that behavioral finance attributes to practitioners, and it is these same “mistakes,” perhaps more than the fierce attacks of the supporters of the ruling doctrine that are preventing behavioral finance from emerging as a new paradigm. In effect, the mere failure of behavioral finance is proof of its veracity and legitimacy.

	Investor Psychology in Capital Markets	Kent Daniel, David Hirshleifer, Siew Hong Teoh	We review evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules and procedures ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially, government should avoid actions that exacerbate investor biases.

	Trading Places	Lawrence Harris	The paper introduces the topic by stating that on any given transaction, the chances of winning or losing may be near even. However, in the long term winners profit from trading because they have some persistent advantage which allows them to win slightly more often, or slightly bigger, than the losers. Winners choose better portfolios than losers, they time their trades better than they negotiate their trades better. The paper examines the economics that determine the winners and losers in trading, the types of traders and how their trading styles lead to profits or losses as well as how access to information of various types creates trading advantages and why many losing traders continue to trade.

	An Unflattering Portrait	Werner De Bondt	The article offers a brief survey of prior research and produces new survey evidence of actual investor behaviour, offering a list of widely-acknowledged anomalies in behaviour as well as some interpretations. Four classes of anomalies are discussed: Investors' perceptions of the stochastic process of asset prices, investors' perceptions of value, the management of risk and return and trading practices. The portrait of investors which develops is unflattering.

	Contrarian and Momentum Strategies	Dirk Schiereck, Werner de Bondt, Martin Weber	The research analysed the profitability of these two strategies on the Frankfurt Stock Exchange over 31 years. It found that both strategies were profitable and examined some possible reasons, including the size effect and various risk measures, including the macroeconomic environment. Interestingly, the momentum strategies performed well irrespective of the state of the economy, while the contrarian strategies performed poorly when the discount rate was low and when long-term interest rates greatly exceeded short-term rates.

	Investor Sentiment and Asset Valuation	Gregory W Brown, Michael T Cliff	The attached paper tests two main hypotheses. The first is that excessive optimism leads to periods of market overvaluation. This would then lead to the second hypothesis, that high current sentiment is followed by low cumulative long-run returns as the market price reverts to its intrinsic value. If the price correction were quick and predictable, there would be a potentially profitable trading strategy. It is found that after a bullish shock to sentiment there is an economically significant positive effect on prices in the first few months, which is then nearly completely reversed over the next three years. This effect is concentrated in the large-cap growth stocks.

	Herd Behaviour and Cascading in Capital Markets	David Hirshleifer, Siew Hong Teoh	The attached paper reviews both fully rational and imperfectly rational theories of behavioural convergence; their implications for investor trading, managerial investment and financing choices, analyst following and forecasts, market prices, market regulation and welfare; and associated empirical evidence. Some of the more interesting sections deal with herd behaviour in research and trading, herding by stock analysts and other forecasters and cascading effects in securities trading, creditor runs, bank runs, financial contagion and crashes.

	Brain Hemispheric Consensus	Michael Boyd	Are you primarily left-brained or right-brained? And will this have any effect on your investment performance? In this rather fun paper Michael Boyd reports on the result of an experiment he carried out on his MBA students. The experiment seemed to support the view that hemispheric consensus may lead to better stock selection, but not necessarily to the extent of outperforming an unmanaged index. Moreover, it appears likely that the technique’s benefits quickly dissipate with the passage of time. It may therefore follow that hemispheric consensus building is better applied to active portfolio management or even short-term trading than to buy-and-hold strategies.