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Behavioral FinanceBehavioral Finance“from “from LeftLeft to to RightRight””

Behavioral FinanceBehavioral Finance“from “from LeftLeft to to RightRight””

Prof. Felixberto U. Bustos, Jr., DBA, CFAExecutive Director, Gov. Jose B. Fernandez, Jr.,

Center for Banking and Financing

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Outline

Traditional Finance (Left Brain) Efficient Market Hypothesis (EMH) Capital Asset Pricing Model (CAPM) Portfolio Theory

Behavioral Finance (Right Brain) Definition Phenomena/Examples

Applications

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EMH

“Stock prices already reflect all available information”

Competition is the source of “efficiency” Three “forms” of EMH

weak - past information semi-strong - public information strong - both public and private information

Originated from Alfred Cowles’s 1944 random walk theory of stock prices

Left Brain

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CAPM

“A model that predicts the expected

return on each risky asset.”

CAPM estimate can be compared to

the required rate of return to

determine properly valued assets.

Developed by William Sharpe in 1964.

Left Brain

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CAPM

Ri = Rf + ß( Rm - Rf)

Left Brain

CML

ME (rM)

σM

Efficient Frontier

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Portfolio Theory

Assumptions on investor behavior each investment alternative is captured by

the probability distribution of expected returns risk estimation is based on variability of

expected returns preference for high return and less risk

Investor is rational; decisions depend on only (1) expected return and (2) risk measure

Originated by Harry Markowitz in the 1950s

Left Brain

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Right Brain Finance

Studies finance through the eyes of a

psychologist, more than a nuclear scientist

Recognizes that investors do not behave

completely rationally when making

decisions

Combines finance theory and psychological

theory to explain market behavior

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Believed to have originated in 1951 with Burrell’s article entitled “Possibility of an Experimental Approach in Investment Studies”, but was ignored by the academe as the fascination with quantitative methods prevented its growth

Right Brain Finance

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Preliminary Example

Imagine that you have paid $20 for a play ticket. When you get to the theater you discover that you have lost the ticket, the seat was not marked, and the ticket cannot be recovered.

Would you pay $20 for another ticket?

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Now consider this...

Imagine that you have decided to see a play that costs $20 per ticket. As you arrive at the theater to buy the ticket, you discover that you have lost a $20 bill.

Would you pay $20 for a ticket to the play?

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In a survey...

46% of the respondents in the first question said they would pay for another ticket

88% of the respondents in the second question said they would pay for another ticket

Is this behavior rational?

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Mental Accounting

Preliminary Example is a case of

mental accounting

Evaluation of gains and losses

separately in different mentally

created accounts.

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Mental Accounting Another Example ...

Investors of Con Ed, the electric utility company

of New York City, shed tears when the company

announced that it cannot issue dividends

during the energy crisis of 1974

Dividend “account” vs. capital gains “account”

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Other Concepts Relatedto Behavioral Finance

Loss Aversion Reference Dependence Asset Segregation Biased Expectations Herd Behavior Consistent Investor Above-

Average Performance

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Loss Aversion

Gambles on losses preferred over

sure losses.

Example: Choice between ... sure loss of $85,000, or

85% chance of losing $100,000 and 15%

chance of losing $0.

Most people choose the second option

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Reference Dependence

Alternatives are evaluated based on a

certain reference point

Example …

Sell AOL.com as soon as they rise up to

original cost

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Reference Dependence

Boughthere

Sell now?

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Asset Segregation

Options are evaluated one at a time

Example: Choose between A & B ...

A. A sure gain of $240

B. A 25% chance of gaining $1,000

84% chose A over B

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Choose between C & D ...

C. A sure loss of $740

D. A 75% chance of losing $1,000

Asset Segregation

87% chose D over C

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Asset Segregation

Aggregated Decisions ...

A&D : A sure gain of $240 and 75% of

chance of losing $1,000

B&C: A 25% chance of gaining $1,000

and a sure loss of $740

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Asset Segregation

Expected Value Responses

A & D -510 73%

B & C -490 2%

A & C -500 11%

D & B -500 14%

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Biased Expectations

Tendency to generalize based on

limited satisfactory experience

Example:

A Microsoft investor assumes that all

software companies will do well

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Herd behavior

The tendency of investors to follow fads that

leads to large movements in the markets

Example:

Asian foreign exchange crisis in 1997 that

started with the “fall” of the Thai baht

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Investor Above-Average Performance

Some analysts are able to

consistently outperform the market

Warren Buffet Up 27% a year, 1957 to 1998, 20%

over last 32 years

Benjamin Graham Up 17% a year, 1929-56

Peter Lynch Up 29% per year, 1977 to 1990

George Soros Up 34% per year since 1969

Michael Steinhart Up 21% per year since 1968

John Templeton Up 18% a year, 1954-1987

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Disposition Effect

Tendency to sell winners too early

and ride losers too long

Value Value Function

Losses Gains

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JBF Center Research on Behavioral Finance : Preview

Survey respondents are financial executives from the Philippines

Pre-test observations loss aversion - hold on to losing stocks to “get-even”

disposition effect - sell early

overconfidence on analysts

herd mentality - tend to go with the crowd

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How to Use Right-Brain Finance

Recognize the “disposition effect”

Choose fund managers well

Ensure that decision sets are indeed

consistent with objectives

Profile critical investors, and anticipate

the role of sentiment

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Recognize Disposition Effect

Set sell orders on a price floor and a price cap

Value Value Function

Losses Gains

Target

Return

Maximum

Loss

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Choose your fund managers

Pick winners, and stick with them

Consistent over-performance is

possible

Remember: Warren Buffet has had an

over 20% return over the last 32 years!

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Ensure Decision Sets Are Consistent with Objectives

Forget the purchase price, how does the

price look now?

Do not be afraid to take certain losses, if

a more lucrative opportunity arises

Example: Lose 10% for a possible gain of

30% if your long-term target return is 20%

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Profile Critical Investors

Article by Coyne and Witter, The

McKinsey Quarterly, 2002 No. 2, “What

makes your stock price go up and

down?”

Maximum of only 100 investors

significantly influence the share prices of

large companies

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Profile critical investors

Rationale:

The company’s stock price affects cost of

capital, employee morale, and potential

mergers

Buying and selling activities of critical

investors are influential enough to affect

price

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Who are critical investors?

Some of the company’s largest

investors, but not necessarily all. Some

of the largest investors have no desire or

intention of trading their holdings.

Portfolio managers and traders that have

an interest in your industry

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Steps in Anticipating Investor Sentiment

Identify critical investors (include

potential investors)

common characteristics may be observable

of investors in the industry, and similar

companies

e.g., conservative investors tend to invest

in utilities

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Steps in Anticipating Investor Sentiment

Profile critical investors

watch how they react

Create a model

Test the model by observing their reactions

to economic, industry and management

announcements

Refine the model

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Thank you.

Presentation of the complete results of

the JBF Center research on Behavioral

Finance is on

September 25, 2002.

JBF Center website:

www.jbf.aim.edu.ph