BEHAVIORAL FINANCE

Behavioral finance is the study of how humans interpret and act on information to make informed investment decisions. Its findings suggest that investors do not always behave in a rational, predictable and an unbiased manner indicated by the quantitative models.

In fact, investors make mistakes. People often see order where it does not exist and interpret accidental success to be the result of skill. Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Be careful in making predictions. When it comes to the financial markets, there are no shortages of predictions. Everyone cannot be right.

In particular, some believe that the outperformance of value investing results from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks. Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit. This is the mantra of contrarian investors.

Using Behavioral Finance in Your Investments

Here's how you can use the Theories of Behavioral Finance to make better investments.

1. Remember that increasing levels of confidence frequently show no correlation with greater success.

2. Many investors believe that they can consistently time the financial markets when there exists an overwhelming amount of evidence to the contrary.

3. People typically give too much weight to recent experience.

4. People often see other people's decisions as the result of disposition but they see their own choices as rational.

5. There is a growing body of research that indicates financial markets often fail to behave as they should if trading were truly dominated by the fully rational investors assumed financial theories. In other words, markets are not completely efficient.

A New Buzz Word

Behavioral finance has recently become a buzzword in the investment community. Numerous articles have appeared in the financial press, and there has been an increasing number of seminars on the subject. Even Harvard Medical School has held a congress on the psychology of investing. Despite its recent attention, however, the study of behavioral finance is not a new phenomenon. Two books written in the 1800's, The Crowd by Gustave Le Bon and Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, are still considered by many investors as classics in the field of group behavior with application to the investment markets.

Behavioral Finance has evolved from attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. As outlined above, researchers believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes.

Behavioral finance might be the more enduring of the recent theoretical descriptions of the market, replacing chaos theory and its fractals and the fanfare over neural networks. Studying humans - from works in psychology to biography - is more fascinating than studying multipatterned blots of fractal images. But Professor Miller may be right about behavioral finance's beguiling nature. Professional investors have long cited ``psychology'' as a convenient way to dismiss market crises, as manias and herd instincts. But it probably was bad psychology. The behavioral economists probably will better understand psychology, if it has any application to markets. According to Professor Miller, ``(S)tocks are usually more than just the abstract `bundles of returns' of our economic models. Behind each holding may be a story of family business, family quarrels, legacies received, divorce settlements, and a host of other considerations almost totally irrelevant to our theories of portfolio selection. That we abstract from all these stories in building our models is not because the stories are uninteresting but because they may be too interesting and thereby distract us from the pervasive market forces that should be our principal concern.''

Classical economic theory assumes that people make good use of the information that is available to them and that they act in an unbiased manner. Professor Tversky's research showed, however, that people were commonly biased in several regards. They were optimistic; they overestimated the chances of their success, and they overestimated their degree of knowledge in the sense that their confidence far exceeded their success rates. Tversky pointed to a key implication of overconfidence. Textbooks tell you that investors and markets in theory behave rationally. Nevertheless, as the increasingly exquisite and detailed financial data demonstrate, financial markets often fail to behave as they should if trading were truly dominated by the fully rational investors that populate financial theories.

* Traditional economic theory assumes that money is fungible, that is the notion that one dollar is capable of being used in place of another dollar. However, when individual behavior is studied, money can become less than completely fungible.

* Investors (including professional and amateur investors) are susceptible to "cognitive illusions," because they relate to perceptions that are often tempting even in error. These illusions occur in three areas:

1. Risk attitudes
2. Mental accounting
3. Overconfidence.

An example of mental accounting involves people who invest monies on one hand and borrow money on the other hand at a rate which far exceeds that which the monies in the investment account are likely to earn (particularly on a risk-adjusted basis). Most people rate themselves as being above average in their abilities to get along with others. Have you ever met an investment manager who considers himself below average in this regard? In a recent study, security analysts were asked to estimate the probability that the price of a given stock would exceed a particular value on a given date. The analystswere 80% confident but only 60% accurate. Many researchers believe that analysts who visit a company develop more confidence in their stock picking skill, although there is no evidence to support this confidence.

Increasing levels of confidence frequently show no correlation with greater success. People are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge. For instance, studies show that men consistently overestimate their own abilities in many areas including athletic skills, abilities as a leader, and ability to get along with others. Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Unfortunately, the majority fail to do so.

Many investors believe that they can consistently time the financial markets when there exists an overwhelming amount of evidence to the contrary. The same can be true in attempting to select above-average investment managers. By just focusing on recent investment performance, investors may be setting themselves up for problems. People often see order where it does not exist and interpret accidental success to be the result of skill. Tversky is well known for having demonstrated statistically that many occurrences are the result of luck and odds. One of the most cited examples is Tversky and Thomas Gilovich's proof that a basketball player with a "hot hand" was no more likely to make his next shot than at any other time. Many people have a hard time accepting some facts despite mathematical proof.

People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. As an example, Professor Shiller found that at the peak of the Japanese market, 14% of Japanese investors expected a crash, but after it did crash, 32% expected a crash (Source: WSJ 6/13/97). Many believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur (the classical contrarian approach).

People often see other people's decisions as the result of disposition but they see their own choices as rational. Investors frequently trade on information they believe to be superior and relevant, when in fact it is not and is fully discounted by the market. This results in frequent trading and consistently high volumes in financial markets that many researchers find puzzling. On one side of each speculative trade is a participant who believes he or she has superior information and on the other side is another participant who believes his/her information is superior. Yet they can't both be right.

More Efficient, But Not Perfect

Increasingly exquisite and detailed financial data demonstrate, financial markets often fail to behave as they should if trading were truly dominated by the fully rational investors that populate financial theories. This is despite the fact that modern financial markets offer the real world's best approximation to the idealized price auction market envisioned in economic theory. Telecommunications spread price information around the world at the speed of light. Armies of analysts pour over data relevant to underlying asset values. And most investment decisions are now made by well-informed professionals.

Werner De Bondt and Thaler find an explanation for superior price performance of firms with poor recent earnings histories in the tendencies of investors to overreact to recent information. Richard Roll traces the negative effects of corporate takeovers on the stock prices of the acquiring firms to the overconfidence of managers, who fail to recognize the contributions of chance to their past successes. Charles Lee, Andrei Shleifer and Thaler show how the persistently puzzling discount built into the price of closed end mutual funds might be explained by the large holdings of small investors, whose unpredictable investment behavior leads rational investors to demand a premium. Shleifer and Robert Vishny show how the difficulty of establishing a reliable reputation for correctly assessing the value of long term capital projects can lead investment analysts, and hence corporate managers, to focus myopically on short term returns. These and many other analyses in this wide-ranging collection demonstrate the growing success of behavioral approaches to understanding the puzzling behavior of financial markets. As a testing ground for assessing the empirical accuracy of behavioral theories, these successful studies of the stock market reach beyond the world of finance to suggest, very powerfully, the importance of pursuing behavioral approaches to other areas of economics.

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