Prior evidence showing that high testosterone CEOs deliver better firm performance (Wong et al., 2011). Poorly informed and unsophisticated investors might lead financial market to be inefficient. Behavioural finance studies investor decision processes which in turn shed light on anomalies which depart from neoclassical finance theory (DeBondt et al., 2008). Implications and Applications of behavioural finance in many corporate events such as M&A, splits, portfolio choices (Subrahmanyam, 2007).
Overconfidence is one of the important behavioral determinant in finance. There are three distinct ways to define overconfidence: 1) Overestimation, 2) Overprecision, 3) Overplacement (Moore and Healy, 2008). For example, analyst recommendation, investor beat market, takeover failure hubris, corporate collapse. There are illusion of knowledge and control. The bias includes over optimism bias and self-serving attribution bias e.g. ‘lucky fool’ syndrome among market traders, attributing randomness to skill. Overconfidence also relates to confirmation bias means we see what we want to see. We can draw a concentration and motivation curve to explain the diffidence, optimal confidence and overconfidence. And negative linearity for anxiety graph. What is overconfidence positive side, impact and how to deal with? It is difficult due to hard wired, should know where is on spectrum and humility exercise. Measures of overconfidence in finance such as excessive trading activity reduce returns (Barber and Odean, 2001, Odean, 1999), late exercise of managerial options (Malmendier and Tate, 2005) and active share (Choi and Lou, 2010). The link between the overconfidence and trading relate to disposition effect when investors tend to sell securities that rising in recent week, hold if declining. Men take more risk and trade more than women (Barber and Odean, 2001). To calculate using Proportion of Gains Realized divided by Proportion of Losses Realized. Disposition effect has negative impact on portfolio returns, and it explain stock momentum (Grinblatt and Han, 2005) and under reaction to news (Frazzini, 2006). To debiase it, we need strong sell discipline, take gain and stop loss limits and frequency of looking at the screen. There is also overconfidence among fund managers, turnover impacts negatively on fund performance (Carhart, 1997). Tracking error vs Active share was proposed to measure overconfidence (Cremers and Petajisto, 2009, Petajisto, 2013). The critics for Active share such as difficult to measure, can be misleading, sensitive to benchmark definition, prone to data mining. To sum up, the proxy for overconfidence is fund manager private info through noisy and delayed feedback, place to much weight and overestimate private info, press coverage. Domain specific risk taking or DOSPERT psychometric test 2.
Behavioural also finance deal with loss aversion that is psychoanalysis like pain of losing not just due to the financial loss but also the associated emotions of guilt, regret and shame. I often unconscious mental defences against loss such as denial, blame and projection, rationalisation and hope. Generally faced with gain, people prefer less risk, but in lottery it runs differently. Expected utility theory vs prospect theory. Prospect theory suggest that investors think in terms of gains or losses relative to some reference point such as the status quo or what the investors expects based on other people’s experience. See the prospect theory value function that loss graph is steeper than gain due to loss aversion (Barberis, 2013; Kahneman and Tversky, 1979). Then, disposition effect (Frazzini, 2006) explain that investors generally tend to sell their winner to soon but hold on to their losers too long, it is the result of prospect theory and loss aversion. This loss become sunk cost which irrelevant for current decision making but in fact it influence, this is called sunk cost fallacy. Endowment effect refers to the fact that people require more to sell because they have feeling as owner rather than they are willing to pay for goods. The endowment effect is inconsistent with standard economic theory because willingness to pay and willingness to accept is different which underlies consumer theory or indifference curves. Then, discussing about the survival frame and mortality frame that is similar kind by giving two different questions that substantially providing similar choices. Traditional finance assume framing bias can see through different ways, or framing is transparent. Behavioural finance sees framing differently as frame dependent that perceptions are highly influenced by framing. Framing practice is opaque, actual behaviour and change in form could change in substances. Presentation in different format can alter people’s decisions such as The Shepard tables illusion. The mitigation of framing bias use familiarity and use thinking than intuition. Framing can be linked to prediction such as presenting return 20% vs presenting increase price from 5000 to 6000. It will be seen by investor differently to predict future, return forecast will continue and price forecast will be reversed. Nudge improving decisions about health, wealth and happiness (Sunstein and Thaler, 2008). Central idea design choice environment or architecture that make it easier for people to choose, give freedom of choices, libertarian paternalism, the implications many to financial regulations and products. Behavioural intervention, opt in opt out (changes to the default of policy, lead people to opt out rather opt in), status quo bias (investor tend to hold investment they currently have, the bias longer if experience lost, another explanation of disposition effect). Hindsight bias tell us that we are unable to go back in time once the result of event is known or inevitable. Debiasing hindsight because it is very pervasive and damaging, keeping formal record of predictions and investment diary. Choices of architectures called nudges. Easy, attractive, social, timely. Can successful fund manager be identified in advance, but did we know of warrant buffet ability of foresight.
In order to manage financial asset, people usually have mental accounting is the process by which people code, categorize and evaluate economic outcomes. People mentally frame assets as belonging to either current income, current wealth or future income. The accounts are largely non-fungible. Separate mental account between open or close to manage physiological pain. The feeling of discomfort due to conflicting cognitions called cognitive dissonance. Alpha is the amount by which the market is beaten, after adjusting for risk. Common sources of alpha are value, small cap and momentum. There are 10 financial bubbles. Common feature of crisis: asset market collapse, decline in employment and output. There also inflation crisis experiences, German sample. Sovereign debt crisis, banking crisis (random deposit withdrawals). Who is to blame with bank crisis. High frequency trading, market anomalies, value anomalies, different faces of value investors, passive screeners and activist value investors, post earnings announcement drift. Market anomaly is an empirical result involving asset returns that is inconsistent with market efficiency and the maintained asset pricing model, resulted in abnormal return. Value investor is one who invest in low price to book or low price to earnings stocks. Behavioural explanation for value anomaly: overreaction, extrapolation, overreaction, extrapolation, representativeness, shying away.
Heuristic is mental shortcut to simplify complex judgments or decision. It leads to decision errors due to less than rational decisions. For example: Availability, Ambiguity Aversion, Diversification, Representativeness. Real example shark attack vs deer hit. Heuristic make people overestimate. Heuristic caused by the easiness to remember something then we assume. The frequency of media exposure influences the formation of heuristic. The fact that each analyst also have their own experience that form their own heuristic (Malmendier et al., 2011). Heuristic create different forms of bias such as a familiarity bias, home country bias (Bekaert and Wang, 2009), attention bias “noise trading” (Barber and Odean, 2008). Attention grabbing stocks include abnormal trading volume, extreme one day return, new stories. Retail investor are attention driven while institutional are not. Let’s see Ellsberg Paradox. There is ambiguity aversion that lead to prefer risk of uncertainty. The risk is probability distribution known while uncertainty unknown. Known unknown vs unknown unknown. This ambiguity aversion closely related to diversification heuristic. Conjunction fallacy is the combination of two events is more likely than one on its own. Remember winning lottery and being happy ven diagram. This is special form of representativeness heuristic: stereotypes, similarity, Other factor influence judgment. Representativeness example is dotcom and fund style name changes, company name changes (Cooper et al., 2001). Dotcom produce 74% abnormal returns of 10 days surrounding the announcement day, positive reaction. A more recent example is blockchain. Heuristic could lead to stock recommendation bias based on company attractiveness and blindly trusting fund managers also affinity fraud. Biases related to representativeness include insensitivity to sample size, and ignoring base rate frequencies (base rate fallacy, base rate neglect). Gambler fallacy, Anchoring and Adjustment, Anchoring in Auction and Finance. Move to heuristic and human brain or neuro finance using brain imaging fMRI, human brain tested using Cognitive Reflection test. Cognitive burden (Shiv and Fedorikhin, 1999), having subject to remember and giving choice to eat. Time discounting results from combined influence of two neural systems: emotional system is impatient and analytic frontal system is patient. Emotional brain responds little to delayed rewards and create taste for instant gratification.
Public opinion only exists when there are no ideas (Wilde, 1894). Herding exist due to social pressure of conformity, sociable human nature, common rationale, less regret. Herding explained with FSS model where asset trade v (value of asset) = a + b (two distinct attributes to value). There are three types of traders such as informed speculators, uninformed traders and a competing set of market makers.
Behavioral Finance also deal with behavioural Biases and Capital Structure and Budgeting Hot hand fallacy, perception about market premium, extrapolation bias, market timing and catering approach, affect heuristic, overconfidence, reluctant to terminate losing project. Capital structure include behavioural APV. Market timing, debt puzzle, project hurdle rate, cash poor, cash limited. Three key variables, financing constraints, degree of perceived mispricing, impact of the firms repurchase. Proxies for CEO overconfidence: trading behaviour through net purchase ratio, net buyer, photograph, press release.
Social Interaction and Emotion also played in Finance. Investor become interested in stock market because other mentioned it (Shiller and Pound, 1989). Information about investing influenced by neighbourhood. When neighbour increase their investment in industry by 10%, the household will improve the ownership by 2% (Ivkovi et al., 2007). Word of mouth is influential. Interaction make people are more interesting to invest (Hong et al., 2004). Survey of 7,500 households in Health and Retirement study of households finds that social households are more likely to invest in the stock market, this is called peer effects. The informal opinions, norms of the social group influence your investment decision. Study on pension plan participation is influenced by the work location (Duflo and Saez, 2002). Therefore, the speed of communication is also important, it is like disease that infectious and contagion. The evidence from the year after M&A completion, target investors double their trading activity, neighbours within 3 miles radius follow the trends (Huang et.al., 2016). His research using VAR to account for speed of communication, regress trading activity by household i. Google Search volume index can be used to measure investor attention to the media (Da et al., 2011). The language and words also matter because some words create vivid imagery. Vivid words influence the performance forecast of the company (Hales et al., 2011). Then we move to emotions in finance that includes feeling, misattribution bias, sentiment, excitement and entertainment. Investor mood can be influenced by misattribution of sunshine. The sunny days outperformed the miserable weather days (Hirshleifer and Shumway, 2003). Sentiment, investing for fun, local sports, moonstruck.
Behavioural Bias, Dividend and M&A. Basic premise of MM is investor are immune to framing effects. Mental accounting and hedonic editing feature framing effects that lead individual investors to find dividends especially attractive. Older view dividends as a replacement for wage and salary (Shefrin and Statman, 1984). Mental accounting is mentally separating info into manageable pieces, by maintaining separate accounts. Investor over age 65 concentrate their stock holdings in firms that pay high dividends, reason for individual prefer dividend are mental accounting, hedonic editing, tax effect (Graham and Kumar, 2006). For younger investor, hedonic editing applied means people prefer to experience gains separately than together e.g. gain+gain (segregated), loss+loss, large gain+small loss (cancellation effect), small gain+large loss (silver lining effect, segregated)(Thaler, 1985). Who make acquisitions (Malmendier and Tate, 2005). Managers developed heuristic to set dividend policy that cater to investor’ psychological needs. The survey evidence shows manager establish long run target payout ratios, concern for dividend increase rescind (Lintner, 1956). The market reacts positively to dividend, asymmetry. Managers appear catering to investors preference for dividends, it has price affects. During the bear market, investors who engage in hedonic editing might favour stable divs, then how about during bull market (investors’ perception of risk and return change). Moving to M&A, it relates to CEO overconfidence indicated by press coverage and option excising behaviour-based measures (Longholder, Holder 67) (Malmendier and Tate, 2005, Malmendier and Tate, 2008). The finding is strong relation between OC and probs undertaking mergers (Malmendier and Tate, 2008). Tendency compounded when firm is generating positive cash flow but mitigated when board size less than 12. In M&A, winner’s curse and hubris are frequently happen. Optimistic Executives in M&As usually have likelihood of conducting a deal, overpayment, more negative market reaction, cash payment, overconfident happen for ample internal sources. Rational manager calculates value of combined firm as market value company A plus market value company B plus synergy and minus cash paid. Overestimate will perceive dilution cost and pay as much as possible in cash, will perceive the firm to be overvalued with reversed pecking order. OC acquirer, OC target: premium is common and could be very large. Asymmetric info says that target firm only accept in which the acquiring firms overpays.
During the financial crisis, property price increase and then dramatically fall, subprime mortgages, securitisation. The participants are mortgage lenders, real estate appraisers, financial institutions. Physiological of borrowers is that people have difficulty processing complex contracts, often underestimate future costs, and optimistic about their future. Predatory lending targets are people who are most susceptible to these manipulated frames. Cross subsidy from the less wealthy to the wealthier. Underwater households and social norms. Biases of other participants such as insurance firms, credit rating agency and regulator. General biases during the crisis are greed, underestimation of risk, herding, fear and panic phase.
References
Barber, B. and Odean, T. (2001) ‘Boys will be boys: gender, overconfidence, and common stock investment’, Quarterly journal of economics,cxvi(1), pp. 261-292.
Barber, B. M. and Odean, T. (2000) ‘Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’, Journal of Finance,55(2), pp. 773-806.
Barber, B. M. and Odean, T. (2008) ‘All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors’, The Review of Financial Studies,21(2), pp. 785-818.
Barberis, N. C. (2013) ‘Thirty Years of Prospect Theory in Economics: A Review and Assessment’, Journal of Economic Perspectives,27(1), pp. 173-196.
Bekaert, G. and Wang, X. S. (2009) ‘Home bias revisited’.
Carhart, M. M. (1997) ‘On Persistence in Mutual Fund Performance’, Journal of Finance,52(1), pp. 57-82.
Choi, D. and Lou, D. (2010) ‘A test of the self-serving attribution bias: evidence from mutual funds’.
Cooper, M. J., Dimitrov, O. and Rau, P. R. (2001) ‘A Rose.com by Any Other Name’, Journal of Finance,56(6), pp. 2371-2388.
Cremers, K. M. and Petajisto, A. (2009) ‘How active is your fund manager? A new measure that predicts performance’, The Review of Financial Studies,22(9), pp. 3329-3365.
Da, Z., Engelberg, J. and Gao, P. (2011) ‘In Search of Attention’, Journal of Finance,66(5), pp. 1461-1499.
Duflo, E. and Saez, E. (2002) ‘Participation and investment decisions in a retirement plan: the influence of colleagues’ choices’, Journal of Public Economics,85(1), pp. 121-148.
Frazzini, A. (2006) ‘The Disposition Effect and Underreaction to News’, Journal of Finance,61(4), pp. 2017-2046.
Graham, J. R. and Kumar, A. (2006) ‘Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Investors’, Journal of Finance,61(3), pp. 1305-1336.
Grinblatt, M. and Han, B. (2005) ‘Prospect theory, mental accounting, and momentum’, Journal of Financial Economics,78(2), pp. 311-339.
Hales, J., Kuang, X. and Venkataraman, S. (2011) ‘Who Believes the Hype? An Experimental Examination of How Language Affects Investor Judgments.(Report)’, Journal of Accounting Research,49(1), pp. 223.
Hirshleifer, D. and Shumway, T. (2003) ‘Good Day Sunshine: Stock Returns and the Weather’, Journal of Finance,58(3), pp. 1009-1032.
Hong, H., Kubik, J. D. and Stein, J. C. (2004) ‘Social Interaction and Stock‐Market Participation’, Journal of Finance,59(1), pp. 137-163.
Ivkovi, amp, x, Zoran and Weisbenner, S. (2007) ‘Information Diffusion Effects in Individual Investors' Common Stock Purchases: Covet Thy Neighbors' Investment Choices’, The Review of Financial Studies,20(4), pp. 1327-1357.
Lintner, J. (1956) ‘Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes’, The American Economic Review,46(2), pp. 97-113.
Malmendier, U. and Tate, G. (2005) ‘CEO Overconfidence and Corporate Investment’, Journal of Finance,60(6), pp. 2661-2700.
Malmendier, U. and Tate, G. (2008) ‘Who makes acquisitions? CEO overconfidence and the market’s reaction’, Journal of Financial Economics,89(1), pp. 20-43.
Malmendier, U., Tate, G. and Yan, J. (2011) ‘Overconfidence and Early‐Life Experiences: The Effect of Managerial Traits on Corporate Financial Policies’, Journal of Finance,66(5), pp. 1687-1733.
Moore, D. A. and Healy, P. J. (2008) ‘The Trouble with Overconfidence’, Psychological Review,115(2), pp. 502-517.
Odean, T. (1999) ‘Do Investors Trade Too Much?’, American Economic Review,89(5), pp. 1279-1298.
Petajisto, A. (2013) ‘Active share and mutual fund performance’, Financial Analysts Journal,69(4), pp. 73-93.
Shefrin, H. M. and Statman, M. (1984) ‘Explaining investor preference for cash dividends’, Journal of Financial Economics,13(2), pp. 253-282.
Shiller, R. J. and Pound, J. (1989) ‘Survey evidence on diffusion of interest and information among investors’, Journal of Economic Behavior and Organization,12(1), pp. 47-66.
Thaler, R. (1985) ‘Mental accounting and consumer choice’, Marketing science,4(3), pp. 199-214.