Behavioral finance and anomalies – what do they mean?

1. Behavioral finance and anomalies of conventional economic theory

1.1. What is meant by behavioral finance?1.2. Anomalies in behavioral finance

2. How to interpret the ‘behavioral finance anomalies’? The discovery of preferences hypothesis

2.1. The discovery of preferences hypothesis2.2. Re-interpreting the anomalies

A lecture in Greifswald University, June 9, 2011.Timo Tammi

University of Eastern Finland

1. What is behavioral finance?• Traditional finance theory sees agents as rational

– Agents update their beliefs immediately afterreceiving new information (-> Bayes’ law)

– Agents make choices that are normatively acceptable

• Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets.

• Behavioural finance is of interest because it helps to explain why and how markets might be inefficient

Two major topics• Limits to arbitrage issue

– although there are rational and non-rational agents in markets, the former one prevent the latter ones frominfluencing prices in the long run through a process of arbitrage (= purchase and sale of an asset in order to profit from a difference in the price)

• Bringing some psychology into economics

– People deviate from ’full rationality’ by making mistakes in updating their beliefs and in consulting their preferences

– Therefore, psychology is needed: how beliefs are formed, are preferences consistent etc.

Rational traders, noise traders and some pricephenomena

• If arbitrage works, there is no long-rung underpricing oroverpricing; that is, an asset price equals its fundamentalvalue

• If there are limits to arbitrage, price does not equalfundamental value

• Assume the fundamental value of a share of Ford is $20 butsome noisy traders become too pessimistic and sell theirshares. Consequently, the price is pushed to $15. Thenrational traders buy Ford until the price is back to fundamental value.

• Does this happen in real markets?

Froot and Dabora’s 1999 study

• The case of Royal Dutch Petroleum and Shell ’1907’ alliance

• The alliance produced a twin-company– Interest merged on 60:40 basis; cash flows split in the

proportion of 60:40– However, Royal Dutch and Shell remained as separate

entities– Royal Ducth and Shell trades on nine exchanges in Europe

and USA; Royal Dutch, however primarily in the Netherlands and USA and Shell in the UK

• Hypothesis: if prices equal fundamental value, the market value of Royal Dutch equity should be 1.5 times the market value of Shell equity.

• Data shows that the hypothesisi is false ->

Data from Froot and Dabora (1999; also Barberis and Thaler 2003) shows the ratio of Royal Dutch share value to Shell share value. The efficient market hypothesis ratio is 1,5 – the figure shows deviations from this benchmark. Deviations ar large and inefficienystrong and persistent.

There are limits to arbitrage! One explanation is the existence of noisy traders.

Some psychology

• If noisy traders cause deviations fromfundamental value, rational traders remain oftenpowerless psychological models are needed to model many phenomena

• New ideas and insights on beliefs and preferences

– How agents form expectations?

– Do agents have stable and consistent preferences thatcan be successfully modeled on the basis of EUT?

Beliefs

• Overconfidence

– "The… investors take bad bets because they fail to realize that they are at an informational disadvantage. Or … they trade more frequently than is prudent, which leads to excessive trading volume.“ Shefrin (2000)

• Optimism and wishful thinking

– People tend to exaggerate their own abilities.

• Representativeness

– looking at an event and making a judgment as to how closely it corresponds to other events as found in the general population. Shefrin (2000)

Beliefs

• Conservatism– “… tendency to cling tenaciously to a view or a

forecast. When movement does occur it is only very slow (this creates under-reaction to events).Montier(2002)

• Staus quo –bias– “…individuals have a strong tendency to remain at the

status quo, because the disadvantages of leaving it loom larger than the advantages. Thaler (1992) p. 68

• Anchoring & Availability bias– The initial value, or starting point, may be suggested

by the formulation of the problem,… That is, different starting points yield different estimates, which are biased toward the initial values."Tversky and Kahneman (1974)

Preferences

• The basic questions

– How do investors evaluate risky gambles?

– How to understand (with a model) asset prices ortrading behaviour?

• Standard model

– Expected utility theory/model

• A psychological model

– Prospect theory

Preferences

• Both EUT and PT model preferences but usevery different strategies

– EUT is axiomatic/deductivistic

– PT is inductivistic

– For EUT preferences are given, stable and consistent

– For PT preferences are constructed

– EUT is a normative theory; PT is a descriptivetheory

The expected utility theory (very shortly)

• The EUT consists of axioms about preferences and probabilitycalculations

• Predictions of EUT are logically drawn from the axioms

• Predictions can be tested against observational data

• EUT states that the decision maker chooses between uncertain prospects by comparing their expected utility values, i.e., the weighted sums obtained by adding the utility values of outcomes multiplied by their respective probabilities.

• The expected utility hypothesis asserts that when people are faced with making choices under uncertainty, they do so by maximizing their expected utility.

1. Prospect theory1.1. Standard rational choice theory in a nutshell

Some shortcomings of the theory, however

1) Why average returns to stocks > average returns to bonds?

2) Why do sellers value their goods and assets higher thanbuyers?

3) Why are people willing to drive accross town to save 5€ in buying a calculator but not in buying a 125€ jacket?

4) Why do you delight to hear you are going to have 10% raise in salary but are furious to see you colleague will get 15%?

5) Why do people so often make firm decisions to have a diet orto quit smoking – only to give in later?

6) Why are people willing to bet long odds on the last race of the day but not on the previouos races (horse race)?

The value function is defined for the changes in wealth and the function is steeper in losses than in gains. Sometime we useterms loss function and gain function. Below is a typical valuefunction.

gainslosses

The subjective value of the outcome

The loss function is convex, gain function is concave.

Diminishing marginal sensitivity: The effect of a loss or a gain to one’s subjectivevaluing decreases as the magnitude of the loss or gain increases.

The shape of the weighting function shows that small objectiveprobabilities are overestimated and large objective probabilitiesare underestimated.

0

0.5

1

0.5 1

Probability, p

Weight π(p)

π(0,25) > 0,25 = p

π(0,75) < 0,75 = p

Some conclusions (for part 1)

• Prospect theory accommodates many phenomena in labs and in real life

– What does this mean? What’s the weight of the evidence?

– Is prospect theory better?

• Many anomalies bother EUT, but EUT is adhered to. This is since (1) EUT is a good general theory of decision-making and since (2) EUT is, for the timebeing, the best normative theory of decision-making.

• However: the prospect theory is a multifaceteddescriptive theory of decision-making

1.2. Anomalies in behavioural finance

• Anomalies are systematic observations orfindings that are not predicted/explained bythe conventional economic theory (EUT)

• A list:

– January effect

– Winner’s curse

– Equity premium puzzle

– And others…

The winner’s curse

• Originally the winner’s curse was found to happen in auctions where the drilling licenses in the Gulf of Mexico were auctioned

• It was found that those who won the auction veryoften ended up with making bad profit or evenloss

• Definition– A tendency for the winning bid in an auction to exceed

the intrinsic value of the item purchased. – Caused generally by the difficulty in estimating the

value of the auctioned item– Difficulties in estimating come from incomplete

information, emotions, or other such things

Example

• Yoy are Company A (the acquirer) which is

• currently considering acquiring Company T (the target) by means of a tender offer.

• You plan to tender in cash for 100% of Company T's shares but are unsure how high a price to offer.

• The main complication is this: the value of the company depends directly on the outcome of a major oil exploration project it is currently undertaking.

• In the worst case (if the exploration fails completely), the company under current management will be worth nothing-$O/share.

• In the best case (a complete success), the value under current management could be as high as $100/share.

• All share values between $0 and $100 per share are considered equally likely.

• By all estimates the company will be worth considerably more in the hands of Company A than under current management. Whatever the value under current management, the company will be worth 50 percent more under the management of Company A than under Company T.

• How much to offer?

• The problem:

• Thus, you (Company A) will not know the results of the exploration project when submitting your offer, but Company T will know the results when deciding whether or not to accept your offer.

• In addition, Company T is expected to accept any offer by Company A that is greater than or equal to the (per share) value of the company under its own management.

• As the representative of Company A, you are deliberating over price offers in the range $O/share to $150/share. What offer per share would you tender?

• A typical reasoning:

• The firm has an expected value of $50 to Company T, which makes it worth $75 to Company A.

• Therefore if I suggest a bid somewhere between $50 and $75, Company A should make some money.

• This analysis fails to take into consideration the asymmetricinformation that is built into the problem.

• The correct reasoning• A correct analysis must calculate the expected

value of the firm conditioned on the bid being accepted.

• If a bid B is accepted, then the company must be worth no more than B under current management for an average of B/2.

• Under the new management, the average is 150 percent of this, or 3B/4, which is still less than B, so it is best not to bid at all.

• extreme form of the winner's curse in which any positive bid yields an expected loss to the bidder.

• See the next slide for the results of an experiment

In both conditions over 90 percent of the subjects make positive bids, and a majority are in the range between $50 and $75.

Can you avoid?

• The winner’s curse is a difficult ‘thing’

• It happens, if you want to win an auction, but it may lead you to pay more than is the value of the auctioned item

• How to avoid?

– Not to make high offers (and, not to win)

– Tell to your competitors that there is a danger of the winner’s curse

• Would these work? – Hardly….

Eguity premium puzzle: some terms

• Equity: 1. The ordinary shares (UK) or common stocks (US) of companies. (2. The concept of distributive justice used in welfare economics.)

• Premium: 1. A share price higher than the issue price. (2. The price paid for an insurance policy. 3. An addition to interest rates required to compensatelenders for risk.)

• Treasury bill : A security issued by a government (or firms trade bill). Billscarry no explicite interest: the interest on bills is provided by issuing them at a discount to their redemption value.

• Bond: A security issued by a firm, financial institution or government. Maycarry a fixed interest or an interest linked to some financial index. Governmentbods are regarded as very safe (no risk).

The equity premium puzzle

• A short definition: Returns to stocks are higher than returns to bonds, which is inconsistent with the conventional finance theories

• A longer definition: Real returns to investors from the purchases of U.S. government bonds have been estimated at one percent per year, while real returns from stock ("equity") in U.S. companies have been estimated at seven percent per year (Kocherlakota, 1996)

• General utility-based theories of asset prices have difficulty explaining (or fitting, empirically) the difference, not only in the U.S. but in other countries too (ibid.)

Puzzled theories

• The theories against which the evidence constitute a "puzzle" tend to have these aspects in common:

• Standard preferences described by standard utility functions

• Contractually complete asset markets (against possible time- and state-of-the-world contingencies)

• Costless asset trading (in terms of taxes, trading fees, and presumably information).

Puzzling puzzle: Academics dispute on the origin, measurig and the meaning of the puzzle. Some almost totally ignored questionsfrom Kocherlakota, 1996:

(1)Why not ask from citizens why they invest so little on stocks?(2)As participating stock markets becomes more familiar and easier

(through web, for example) , will the puzzle disappear in the future?

Source: Dimson et al. 2006

Source: Dimson et al. 2006

Does prospect theory explain the puzzle?

• There are promising attempts based on lossaversion and mental accounting

– Loss aversion: investors feel losing more strongly thanwinning

– Mental accounting: investors put gains and losses in separate ’pots’, which are reviewed at regular set intervals

Myopic loss aversion: investors are very loss averseand evaluate the performance of their investments eachyear eplanation of Equity premium puzzle?

2. How to interprete the ’behavioral finance anomalies’?

2.1. The discovery of preferences hypothesis

• Plott (1996): preferences revealed in choicesconverge to the same underlying preferences…

• In addition (ibid.):– The underlying preferences are discovered after

agents repeatedly take decisions, receive feedback, and are given incentives to discover which actionsbest satisfy their prefernces

– Anomalies to standard theory are results of untutoreddecisions by agents; after repetition and feedback agents discover their true preferences and anomaliesdisappear

2. How to interprete the ’behavioral finance anomalies’?

2.1. The discovery of preferences hypoblethesis

• According to the DPH traditional economic theory(EUT) is applicable to situations where:– (1) Individuals are driven (motivated) by clear

incentives and individuals perceive the incentives ’in a right way’

– (2) Individuals have learned to behave in the situation; they are experienced enough

– (3) Individual repeatedly face the situations so thatlearning is possible

• Only if these conditions hold, we may expect thatindividuals find their ’true preferences’

PREFERENCES --

DISCOVERED or CONSTRUCTED?

PREFERENCES --

DISCOVERED or CONSTRUCTED?

Then you have stable preferencesprior to entering into a decision-making situation. But thesepreferences may be hidden.

PREFERENCES --

DISCOVERED or CONSTRUCTED?

Then you have stable preferencesprior to entering into a decision-making situation. But thesepreferences may be hidden.

Then you have no clear and consistentpreferences prior to entering to a decision-making situation.

PREFERENCES --

DISCOVERED or CONSTRUCTED?

You discover them when you are in the situation repeatedly, get feedback and able to learn.

PREFERENCES --

DISCOVERED or CONSTRUCTED?

You construct them when you are in the situation.

You discover them when you are in the situation repeatedly, get feedback and able to learn.

Common arguments

• ’Traditional economist’: if empirical evidenceis inconsistent with the theory, the conditions1-3 are not fullfilled; that is, people have notyet found their true preferences. Thereforethe inconsistency is harmless to economics

• ’Reformist economists’: The itmes 1-3 in DPH have to be tested empirically; its seems thatthe traditional theory has a narrower area of applicability than has been assumed.

• Note: Researhers in behavioral economics canbe found in both camps.

DPH and finance anomalies

• Does DPH save the standard economic theory(EUT) from financial anomalies such as the winner’s curse and equity premium puzzle?

2.2. Re-interpreting the anomalies?A reinterpretation: sour grapes

• Economists typically see themselves merely as advisors of the government

• Could they also advise citizens and entrepreneurs?

– They would like to know is it rational to invest in stocksand/or bonds?

• A household survey? Webb-technology?

– Are there spontaneous solutions (conventions) thatprevent the realization of the winner’s curse

• Construction industry conventions (investigated in Texas by Kagel et al)

– Think of the Fox and Grapes fabel in the next slide

Der Fuchs und die Trauben

In dieser Fabel zeigt sich ein Fuchs verächtlich über die Trauben, die er nicht erreichen kann:

„Der Fuchs biss die Zähne zusammen, rümpfte die Nase und meinte hochmütig: "Sie sind mir noch nicht reif genug, ich mag keine sauren Trauben." Mit erhobenem Haupt stolzierte er in den Wald zurück.“

Die Moral ist: "Es ist leicht etwas zu verachten, was man nicht erreichen kann..."

This reminds us of the cognitive dissonance theory. Accordingly, people feel uncomfortably if the have conflicting ideas simultaneously. They try to reduce the dissonance by changing their attitudes, beliefs and behaviour. There is • an article by George Akerlof: The Economic Consequences of Cognitive Dissonance• A book by Jon Elster Sour grapes…• An many others more recent ones• See also Applied Behavioral Finance blog:

http://behavioralfinances.com/category/cognitive-dissonance/

2.2. Re-interpreting the anomalies?Another re-interpretation: new theory

• Recall the discovered preferences hypothesis– Some anomalies may disappear through repetition,

feedback and adequate incentives– Others will not

• These and many other anomalies call forth– More and more empirical investigation (traditional

and experimental)– New theory or theories: maybe economics will

develop towards theoretical diversity

• What would a new theoretical framework look like?

Anticipatedoutcomes

Subjectiveprobabilities

Cognitiveevaluation

Decision

Feelings

Outcomes(includingemotions)

The consequentialist perspective on decision-making (Loewenstein et al. (2001)

Utility framework is as simple as possible. The decision-makermay have ’feelings’ but ’feelings’ do not influence on decision-making.

Anticipatedoutcomes

Subjectiveprobabilities

Other factors- Vividness

- Immediacy- Social context

Cognitiveevaluation

Decision

Feelings

Outcomes(includingemotions)

The ’risk-as-feeling’ perspective on risk (Loewenstein et al. (2001)

Some features of the real-world decision-making and the idea that the perception of risk may result from ’feeling’ or’emotion’, are incorporated in utility framework.

Conclusions

• In behavioral finance some anomalies arepersistent

• This means that it is difficult to get people to behave ’correctly’ (sic!), that is, according to the traditional theory

• Winner’s curse can be corrected by institutions

• Equity premium puzzle can disappear (maybe) bymaking it easier for citizens to participatefinancial markets