Behavioural Finance

Preface xv

Acknowledgements xvii

1 Introduction 1

1.1 Illustration and Structure 2

1.2 Finance Theory as an Engine not a Camera 3

1.2.1 Rational Fools or Folly of Wisdom? 5

1.3 Rebuilding on New Foundations 7

1.3.1 Reasoned Emotion: The Case of Phineas Gage 8

1.3.2 What Can Psychologists Bring to Finance? 9

1.4 Challenging the Classical Assumptions of Finance 9

1.5 Modelling Behavioural Aspects of Finance 11

1.6 The Structure of the Book 12

Appendix: A Financial Tsunami 14

Notes 14

References 14

Part I Foundations 17

2 Financial Decision Making 19

2.1 Illustration and Structure 19

2.2 The Expected Utility Rule 20

2.2.1 An Illustration of Expected Utility 21

2.2.2 Attitudes to Risk 22

2.2.3 Diversification as Risk Reduction Strategy 23

2.2.4 How Best To Bear Risk 24

2.3 Expected Utility Theory: Simple But Untrue? 26

2.3.1 Paradoxes and Problems in Early Understanding of Expected Utility Theory 27

2.3.2 Gambling Insurance and Aspiration 29

2.4 Frames for Actions, Contingencies and Outcomes 31

2.4.1 The Decision Process 31

2.4.2 Inferring Big Ideas from Small Samples 32

2.4.3 Stars with Feet of Clay 33

2.4.4 Is There More to Life Than (Maximizing) Utility? 34

2.4.5 Happiness, Well-Being and the Emotional Basis of Utility 34

2.5 Conclusion and Summary 35

Questions 35

Notes 36

References 36

3 Discounting 39

3.1 Illustration and Structure 40

3.2 The Discounted Utility Model 40

3.2.1 Some Problems with the Discounted Utility Model 41

3.2.2 Evaluating Reallocations of Consumption by Equivalent Gains or Compensating Losses of Present Consumption 42

3.2.3 Delays and Speed-Ups of Utility 44

3.3 How and Why Discount Rates Vary 44

3.3.1 Discounting Single Outcomes Compared to Sequences of Outcomes 46

3.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’ 47

3.5 Hyperbolic Discount Factors 49

3.6 Valuation by Using the Matching Law 51

3.6.1 On Pigeons and Men: Comparing Hyperbolic and Exponential Discounting 53

3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54

3.7.1 A Simple Example of a Sub-Game Perfect Equilibrium 55

3.7.2 The Properties of a Sub-Game Perfect Investment Strategy Equilibrium 57

3.7.3 How Do Declining Discount Rates Affect Investment Behaviour? 58

3.8 Conclusion and Summary 59

Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal Choice 60

Questions 61

Notes 62

References 62

4 Learning 65

4.1 Illustration and Structure 65

4.2 Rational Learning 66

4.2.1 Bayes’ Rule 66

4.2.2 Elements of Bayesian Revision 68

4.2.3 The Value of Stock Recommendations 70

4.3 Do We Learn the Bayesian Way? 72

4.3.1 Representativeness 74

4.3.2 Representation Bias in the Market: Analysts’ Overreaction to Earnings 74

4.3.3 A Once and For All Lesson? 75

4.4 Over Inference and the Law of Small Numbers 76

4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77

4.6 Conclusion and Summary 79

Appendix: Case Study – Baseball the Bayesian Way 80

Questions 87

Notes 88

References 88

5 Bubbles 89

5.1 Illustration and Structure 90

5.2 Tulipmania and the Didactic Value of Bubbles 91

5.3 The Regulatory Origins of the Most Recent Bubble 92

5.3.1 Long-Term Capital Management 92

5.3.2 The Federal Reserve and Market Restraint 95

5.4 Bubbles: Past, Present and Future 101

5.4.1 Financial Bubbles and Infrastructure Technology 102

5.4.2 Are Bubbles Just Part of the Market Process? 103

5.5 The 1929 Stock-Market Crash 104

5.5.1 Early Signs 104

5.5.2 The Boom is On 105

5.5.3 Innovation and Speculation 106

5.5.4 Investment Trusts in the Boom’s Growth 106

5.5.5 The Final Implosion 107

5.6 Should Government Burst the Bubble? 108

5.7 Conclusion and Summary 109

Appendix: Tulips as Assets and Art 110

Questions 114

Notes 114

References 114

Part II Asset Pricing 117

6 Noise Traders 119

6.1 Illustration and Structure 120

6.2 The De Long, Shleifer, Summers and Waldmann Model 121

6.2.1 The Basic Set Up 122

6.2.2 Modelling Mispricing 122

6.2.3 What Investors Want 123

6.2.4 Choosing Optimal Asset Allocations Across the Safe and Risky Asset 124

6.2.5 The Pricing Equation 125

6.2.6 Will Noise Traders Die Out? 128

6.2.7 Decomposing Noise Traders’ Profits 130

6.3 Can Investors Get Emotional? 133

6.3.1 Feeling the Risk 134

6.3.2 The Affect Heuristic 135

6.3.3 Panic and Feedback Trading During the 1987 Stock-Market Crash 136

6.3.4 The Diminishing Roar of Noise 137

6.4 Conclusion and Summary 138

Questions 138

Notes 139

References 139

7 Overconfidence and Optimism 141

7.1 Illustration and Structure 142

7.2 A Model of Trading Amongst Optimistic Investors 142

7.2.1 The Model 143

7.2.2 Price Setting 143

7.2.3 Conditions for Overconfident Pricing of the Risky Asset 144

7.2.4 Pricing in Odean’s Model 147

7.2.5 The Implications of Odean’s Model for Financial Markets 150

7.3 Do Investors Trade Too Much? 150

7.3.1 Optimism in Corporate Finance 151

7.3.2 Facing Failure 151

7.3.3 Who Dares Loses? 153

7.3.4 The Hubris Theory of Takeovers 153

7.4 Conclusion and Summary 154

Appendix A: Hubris at Work: The AOL–Time Warner Merger 155

Appendix B: Derivation of Results in Odean’s Model 161

Questions 163

Notes 163

References 163

8 Asset Pricing under Prospect Theory 165

8.1 Illustration and Structure 165

8.2 The Basics of Prospect Theory 166

8.2.1 Prospect Theory’s Application to Finance 167

8.2.2 Benchmarks, Gains and Losses and the Dynamics of Utility under Prospect Theory 168

8.2.3 Integration or Segregation of Losses and Gains in the Presence of Loss Aversion 169

8.2.4 The Evolution of Investor Benchmarks 170

8.2.5 Price Formation in a Market Populated By Investors With Prospect Theory Utility Functions 171

8.2.6 Pricing in the Standard Inter-Temporal Consumption-Based Asset-Pricing Model or Economy I 171

8.3 Does Prospect Theory Work? 172

8.3.1 Can Prospect Theory Explain the Internet Bubble? 172

8.3.2 Can Prospect Theory Explain IPO Underpricing? 174

8.3.3 Prospect Theory Here, There and Everywhere 176

8.4 The Cumulative Probability Version of Prospect Theory 176

8.5 Does Cumulative Prospect Theory Work? 177

8.5.1 Cumulative Prospect Theory and Asset Pricing 179

8.6 Conclusion and Summary 181

Appendix: CARA Utility 181

Questions 182

Note 182

References 183

9 Overreaction and/or Underreaction 185

9.1 Illustration and Structure 185

9.2 The DHS Model 186

9.2.1 Reversals of Fortune 188

9.2.2 Pricing When Confidence Levels Depend on the Relation Between the Public and Private Signals 189

9.2.3 Investor Extrapolation and Reversals of Fortune 192

9.2.4 Many Theories in Search of a Decisive Verification 192

9.2.5 Momentum and Underreaction: Two Stock-Market Anomalies or One? 194

9.3 No News Is . . .? 194

9.3.1 The Jackson and Johnson (JJ) Model’s Message 195

9.3.2 How the JJ Model Works 196

9.3.3 Stock-Market Responses to News and No News 199

9.4 Conclusion and Summary 199

Questions 199

Note 199

References 200

10 Momentum 201

10.1 Illustration and Structure 201

10.2 Grinblatt and Han’s (2005) Model 203

10.2.1 Modelling Asset Demand in the GH Model 204

10.2.2 Investor Returns and the Evolution of the Reference Point 207

10.3 What Drives Stock-Market Momentum? 208

10.3.1 Evidence of PEAD 209

10.4 What Causes PEAD? 212

10.4.1 Is PEAD Due to Changes in Risk? 212

10.4.2 Are Prices Following Themselves or Following Earnings? 213

10.4.3 Is PEAD in the Market or in the Eye of the Researcher? 215

10.4.4 Show Me the Money 216

10.5 Conclusion and Summary 217

Questions 217

Note 218

References 218

11 Herding 221

11.1 Illustration and Structure 221

11.2 The FSS Model 222

11.2.1 The Basic Set Up 222

11.2.2 The Price-Setting Mechanism Used by Market-Makers 223

11.2.3 Informed Speculators’ Demands 224

11.3 Conformity as a Force for Social Good and Evil 228

11.3.1 Evidence on Herding and its Effect 229

11.3.2 Herding in Investment Advice 230

11.3.3 Words which Cannot be Spoken 230

11.3.4 Private Truths and Public Lies 231

11.3.5 The Herd in History 233

11.4 Conclusion and Summary 233

Appendix: The United States vs. Microsoft 234

Questions 236

Note 237

References 237

12 Insider Trading 239

12.1 Illustration and Structure 240

12.2 Insider Trading Here for Better or Worse 241

12.2.1 The Distributional Impact of Insider Trading 242

12.2.2 When does Trading become Insider Trading? 243

12.2.3 Insiders on Trial: Proof of Guilt or Innocence? 244

12.3 The Hirshleifer, Subrahmanyam and Titman Model 245

12.3.1 Asset Demands and the Determination of Investor’s Terminal Wealth in the HST Model 246

12.3.2 Pricing in Equilibrium 250

12.3.3 Trading Behaviour in Equilibrium 251

12.4 Insider Trading, Stock Options and the Construction of Earnings 255

12.4.1 Psychological Factors Determining the Exercise of Stock Options 256

12.5 Insider Trading and its Consequence for Outsiders 257

12.6 Conclusion and Summary 258

Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model? 258

Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262

Questions 265

Notes 265

References 266

13 Equity Premium Puzzle 269

13.1 Illustration and Structure 269

13.2 The Puzzle 270

13.2.1 The Mehra and Prescott Statement of the Equity Premium Puzzle 271

13.2.2 Explaining the Risk Premium by Myopic Loss Aversion 272

13.2.3 Can Loss Aversion Explain the Puzzle? 274

13.3 Loss Aversion in a Reference-Dependent Utility Model 276

13.3.1 A Reference-Dependent Model of Investor Choice 277

13.3.2 Loss Aversion in a Reference-Dependent Model of Choice 277

13.3.3 Diminishing Sensitivity to Losses and Gains 278

13.3.4 Constant Risk Aversion and the Benartzi and Thaler (1995) Model 279

13.3.5 Is Loss Aversion Irrational? 280

13.4 Conclusion and Summary 280

Questions 281

References 281

Part III Corporate Finance 283

14 Incorporation 285

14.1 Illustration and Structure 285

14.2 Companies: Where did They Come from and Where will They Go? 286

14.2.1 Limited Liability: its Value and its Role in the Emergence of the Corporate Form 288

14.2.2 The Economic Rationale for Granting Limited Liability 288

14.3 Agency, Monitoring and Incorporation 289

14.3.1 Are Managers Agents or Team Members? 291

14.3.2 Psychological Barriers to Arm’s Length Contracting 294

14.3.3 Group Psychology on the Board, Building Consensus and its Dissimulation 294

14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 296

14.4.1 Clearing Out the ‘Inside View’ 297

14.4.2 Come On Down: the Satisfaction of Recognition 298

14.4.3 Facing Glory and Defeat: Managers’ Resistance to Recognizing Failure 298

14.4.4 Governance in the Long and Short Run 299

14.5 Conclusion and Summary 300

Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a Corporation 300

Questions 313

Notes 313

References 314

15 The Market for Information, Noise and Deception 317

15.1 Illustration and Structure 318

15.2 The Boundaries of the Market for Corporate Information 318

15.2.1 The Conduct of the Market for Corporate Information 319

15.3 What Do Analysts Do? 321

15.3.1 The Ivkovic and Jegadeesh (IJ) Model 322

15.4 Valuing Investment Advice 325

15.4.1 The Market for Corporate Information 326

15.4.2 What Type of Valuation Models do Analysts Use? 328

15.4.3 The Fragility of Valuation Models 330

15.4.4 A Dynamic Model of the Market for Financial Information 332

15.4.5 From Inside and Out: Isolation Bias and Risk Taking 333

15.5 Conclusion and Summary 333

Questions 334

Notes 334

References 334

16 Dividends 337

16.1 Illustration and Structure 337

16.2 The Irrelevance of Dividends to Value 338

16.2.1 The Puzzle of Dividend Policy 339

16.3 A Prospect Theory Explanation of Dividend Payments 340

16.3.1 Coding of Prospects: Combination, Segregation 341

16.3.2 Shop Until You Should Stop 341

16.3.3 Calculating the Dividend Yield Premium/Discount 342

16.4 Who Pays Dividends and Why? 346

16.4.1 Are Dividends Signals of Future Earnings Prospects? 346

16.4.2 Dividend Omissions, Initiations and Drift 347

16.4.3 What Reasons do Managers Give for Paying Dividends? 348

16.4.4 Does Pay-out Policy Matter? 349

16.5 Conclusion and Summary 350

Questions 350

Note 351

References 351

17 Entrepreneurship 353

17.1 Illustration and Structure 354

17.1.1 The Problem of Self-Control 354

17.2 The BT Model 355

17.2.1 The Demand for Self-Confidence in the BT Model 355

17.2.2 Always Wrong but Never in Doubt 359

17.2.3 The Supply of Self-Confidence in the BT Model 359

17.2.4 Numerical Illustration of the BT Model 361

17.3 Is Deluding Yourself Worth it? 362

17.3.1 Optimism, Self-Control and Society 363

17.3.2 The Social Benefits of the Maverick Entrepreneur 363

17.4 Conclusion and Summary 364

Appendix: Entrepreneurs and the BT Model – Some Case Studies 364

Questions 370

Notes 370

References 371

Part IV The Professions 373

18 Analysts’ Conflicts of Interest 375

18.1 Illustration and Structure 376

18.2 Evidence of Conflicts of Interest from Empirical Studies 377

18.2.1 No Conflict, No Interest 378

18.2.2 Is Disclosure of a Conflict of Interest Sufficient Protection for Investors? 379

18.2.3 Conflicts in the Laboratory 379

18.3 Regulating Conflicts of Interest 380

18.3.1 UK Policy on Conflicts of Interest 380

18.3.2 EU Policy on Conflicts of Interest 382

18.3.3 US Policy on Conflicts of Interest 383

18.3.4 The Common Law of Conflicts of Interest 383

18.3.5 The Dura Pharmaceuticals Case 384

18.3.6 Market Efficiency, Conflicts of Interest and the Courts 385

18.4 Conclusion and Summary 385

Questions 386

Notes 386

References 386

19 Accounting Reform 389

19.1 Illustration and Structure 389

19.2 The Onward March of ‘Fair-Value’ Accounting 390

19.2.1 Historic Cost versus Fair Value 390

19.2.2 A Return to Fundamental Valuation 392

19.3 An Accounting-Based Valuation Model 392

19.3.1 Are All Reported Earnings Additions to Shareholder Value? 394

19.3.2 The Dynamics of Abnormal Earnings Valuation 395

19.3.3 Some Examples of the Ohlson Model in Action 396

19.3.4 Implications for Price 398

19.3.5 Implications for Returns 400

19.3.6 Does the Ohlson Model Work? 400

19.3.7 Earnings Persistence in the Ohlson Model 403

19.3.8 Other Information in the Ohlson Model 403

19.4 Behavioural Bias in Estimates of the Ohlson Model 404

19.4.1 Inferring Value from Accounting Data: Fair Values versus Historic Costs 405

19.4.2 The Three Levels of Fair Value 406

19.4.3 Some Implicit Trade-Offs in Fair-Value Accounting 406

19.5 Conclusion and Summary 407

Appendix A: Mark-to-Market Accounting at Enron – A Case Study 407

Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting Information only (Equation (19.7)) 423

Questions 425

Notes 425

References 426

20 Conclusion 427

Index 431