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The Future of Behavioral Finance Research

November 4, 2012 Leave a comment

Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case. Dozens of examples of irrational behavior and repeated errors in judgment have been documented in academic studies. The late Peter L. Bernstein wrote in Against The Gods that the evidence “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”

A field known as “behavioral finance” has evolved that attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. Many 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 manystock market anomalies, market bubbles, and crashes. As an example, 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 humans flaws are consistent, predictable, and can be exploited for profit.

Some Professors recognized as experts in the field include Daniel Kahneman (Princeton), Meir Statman (Santa Clara), Richard Thaler (University of Chicago), Robert J. Shiller(Yale), and Amos TverskyTversky passed away in 1996 and is frequently cited as the forefather of the field. LSV Asset ManagementFuller & Thaler Asset ManagementDavid Dreman and Ken Fisher are some money managers that invest based on behavioral finance theories.

Among the many books with discussions about Behavioral Finance are What Investors Really Want from Meir StatmanPredictably Irrational (2009) by Dan ArielyThe Myth of the Rational Market (2009) by Justin FoxCapital Ideas Evolving (2009) by Peter Bernstein, Your Money & Your Brain (2008) by Jason ZweigBehavioral Finance and Wealth Management (2006) by Michael M. Pompian and Why Smart People Make Big Money Mistakes And How To Correct Them (2000) by Gary Belsky and Thomas Gilovich. Common examples of irrational behavior (some interrelated) that researchers have documented include the following.

Tversky and Kahneman originally described Prospect Theory in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Here is an example from Tversky and Kahneman’s 1979 article. Researchers have also found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.

Professor Statman is an expert in the behavior known as the “fear of regret.” People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the IRS, accountants, and others may also contribute to the tendency not to sell losing investments. Some researchers theorize that investors follow the crowd and conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down. Additionally, many believe that money managers and advisors favor well known and popular companies because they are less likely to be fired if they underperform. See also Terrance Odean‘s Are Investors Reluctant to Realize Their Losses? in the October 1998 issue of the Journal of Finance.

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.

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 are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge. However, increasing levels of confidence frequently show no correlation with greater success. 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, however, most fail to do so. Gur Huberman of Columbia University recently found that investors strongly favor investing in local companies that they are familiar with. Specifically investors are far more likely to own their local regional Bell company than the other regional Bells. The study provides evidence that investors prefer local or familiar stocks even though there may be no rational reason to prefer the local stock over other comparable stocks that the investor is unfamiliar with. See The Perils of Investing Too Close to Home in BusinessWeek (9/29/97).

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. See Why Do Investors Trade Too Much? from Brad Barber and Terrance Odean.

Many researchers theorize that the tendency to gamble and assume unnecessary risks is a basic human trait. Entertainment and ego appear to be some of the motivations for people’s tendency to speculate. People also tend to remember successes, but not their failures, thereby unjustifiably increasing their confidence. As John Allen Paulos states in his book Innumeracy, “There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful.”

People’s decisions are often affected by how problems are “framed” and by irrelevant but comparable options. In one frequently cited example, an individual is offered a set amount of cash or a cross pen, in which case most choose the cash. However, if offered the pen, the cash, or an inferior pen, more will choose the cross pen. Sales professionals typically attempt to capitalize on this behavior by offering an inferior option simply to make the primary option appear more attractive.

Arnold S. Wood of Martingale Asset Management describes the “touchy-feely syndrome” as the tendency for people to overvalue things they’ve actually “touched” or selected personally. In one experiment, participants where either handed a card or asked to select one. Those that selected a card were less interested in selling the card back and required more than four times the price to sell the card as compared with the participants who were handed a card. Similarly, 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.

The dynamics of the investment process, culture, and the relationship between investors and their advisors can also significantly impact the decision-making process and resulting investment performance. Full service brokers and advisors are often hired despite the likelihood that they will underperform the market. Researchers theorize that an explanation for this behavior is that they play the role of scapegoat. In Fortune and Folly: The Wealth and Power of Institutional Investing, William M. O’Barr and John M. Conley concluded that officers of large pension plans hired investment managers for no other reason than to provide someone else to take the blame and that the officers were motivated by culture, diffusion of responsibility, and blame deflection in forming and implementing their investment strategy. The theory is that they can protect their own jobs by risking the managers account. If the account underperforms, it is the managers fault and they can be fired, but if they overperform they can both take credit.

Psychographics” describe psychological characteristics of people and are particularly relevant to each individual investor’s strategy and risk tolerance. An investors background and past experiences can play a significant role in the decisions an individual makes during the investment process. For instance, women tend to be more risk averse than men and passive investors have typically became wealthy without much risk while active investors have typically become wealthy by earning it themselves. The Bailard, Biehl & Kaiser Five-Way Model divides investors into five categories. “Adventurers” are risk takers and are particularly difficult to advise. “Celebrities” like to be where the action is and make easy prey for fast-talking brokers. “Individualists” tend to avoid extreme risk, do their own research, and act rationally. “Guardians” are typically older, more careful, and more risk averse. “Straight Arrows” fall in between the other four personalities and are typically very balanced.

Investors Errors Repeatedly Make in Choice of Investment and Timing

November 4, 2012 Leave a comment

Applying a strategy is more than just deciding when to buy and when to sell according to some predetermined notion. Most importantly, it’s about having the right mental approach. From a psychonomic perspective, two sides of the coin, financial criteria and approach, need to be integrated for you to be an effective investor. Hence, the strategies that are the most profitable are a result of successful investors being able to accept any behavioral tendencies they have and trade accordingly. And this is where it can all go to pieces. You may start out using a strategy with the best of intentions, but irrational motives, misperceptions and beliefs can lead to poor decisions. Here, therefore, is a summary from the findings of investment psychology and behavioral finance of systematic errors to learn to avoid.

Watching out for systematic errors

  • Investors may overestimate their skills; attributing success to ability they don’t possess and seeing order in information or data where it doesn’t exist.
  • Having expressed a preference for an investment, people often distort any other information in order to add weight to their decision.
  • Investors are often unable to alter long-held beliefs, even when confronted with overwhelming evidence that they should. – they fall in love with their investments, rationalize losses, or hang on too long to sell.
  • People tend to remember their successes and minimize or forget their failures.
  • Most investors will avoid risk when there is the chance of a certain gain. But faced with a certain loss, they become risk takers
  • Investors are often impatient to sell a good stock
  • Investors often make a distinction between money easily made from investments, savings or tax refunds and hard-earned money – found money is more readily spent or wasted
  • People tend to think in extremes – the highly probable news is considered certain, while the improbable is considered impossible.
  • People feel the loss of a dollar to a far greater extent than they enjoy gaining a dollar.
  • Investors often take a short-term viewpoint. Recent market losses lead to suspicion and caution, while recent gains lead to action.
  • Investors often assume that lack of market or price movement represents stability, while volatility represents instability –stability misperception.
  • Investors follow the crowd, and are heavily influenced by other investors or compelling news; they fail to check out the real facts
  • Investors make predictions based on limited information as if they had special foreknowledge.
  • Investments are often thought of as pieces of paper rather than part ownership of a company.
  • Investors become obsessed with prices and trend-watching, rather than solid information.

Overall, these errors really have only one effect: that is, you take a financial decision that lacks accuracy. And these errors are strongest when uncertainty, inexperience, attitudes and market pressures come together to undermine your decision-making ability. The way to get round this problem is to implement a good strategy – because good strategy is about taking the right decision, in the right way, at the right time.

Can you use contrarianism to overcome errors?

To be contrarian just for the sake of it is like the guy who always wears a scarf whether the climate is cold or hot; it smacks of obstinacy. To go against accepted wisdom, and implement an active strategy – such as a particular type of value strategy – there must be some good evidence that your decisions are valid.

Value strategies

One of the strongest findings of behavioral finance is that, in a three to five-year period, there is a tendency – remember this is not an absolute – for previous poor performers to begin to do well and for previous good performers to begin to perform less well.

In other words, value stocks turn into glamour stocks, and glamour stocks turn into value stocks. The value stocks are those that have low ratings; for example, low price to earnings ratios – the market price of a company’s stock divided by its earnings – while glamour stocks, or growth stocks as they’re also known, have high ratings because they’re sought after by investors.

Equating ‘winners’ with glamour stocks and ‘losers’ with value stocks, this idea was tested by Werner De Bondt of the University of Wisconsin and Richard Thaler of the University of Chicago Business School, who formed a portfolio of ‘winner’ and ‘loser’ stocks. They found that the thirty-five ‘loser’ stocks in their portfolio subsequently outperformed the ‘winner’ stocks, during the next three-year period, by twenty-five percent.

What this means is that investors who specialize in buying ‘loser’ stocks may profit. Essentially, because these are good quality stocks but their price is dependent on misperception, they move up and down in a cyclical manner.

Nevertheless, you don’t know at what stage in the cycle you’re at, so buying what you believe to be a value or ‘loser’ stock with great potential may mean you have to sit on it for a long time – and that’s hard, especially when you see opportunities that you’re missing. If you mistime it, could you really wait five years on just a hope?

In the same way, investors believe the stories and the market hype surrounding glamour stocks. They buy and keep buying; again overreacting. Eventually, the price rises to a level above what is financially realistic and investors finally see that it has become too expensive.

The fact that investors are slow to come round to a true assessment of stocks is what drives prices up or down to the extent of overreaction or underreaction. It is a result of the difficulty many people have in giving up a firmly held belief. Often too, they have a vested interest in maintaining their holding. Their thinking is dictated by a failure to admit that a changed situation necessitates a change of action. As a result, they wait too long to trade. So, for example, they keep revising their trading limits. ‘I’ll sell when it rises another 15c.’ or ‘It can’t drop much more, I’ll hang in there.’ Many people also hate to sell a stock if it falls below the level they bought it. This is sometimes referred to as the disposition effect. So, investors don’t cut their loss until later when the price has dropped even further. The strategy of these investors is unformed and they are buffeted around the market by the actions of the herd, never truly making their own systematic investment decisions.

Though initially there may have been a good reason for the downward price re-rating, as time passes and the company puts its affairs in order, the real outlook changes. But, real facts are overlooked. Once investors have perceived the stock as a bad bet, the price falls. With minimal news hitting the market – it’s no darling of the analysts and rarely focused upon – investors become discouraged and keep trading out, pushing the price ever lower. Investors have again overreacted by being slow to respond to changed conditions. This provides the opportunity. Using a value strategy, clued-in investors buy stocks that are weak in the hope they’ll eventually become strong. It’s a long-term view. But, when the price begins to rise, their approach is proven correct.

Momentum stocks

If you’ve ever pulled up sharply in a car and felt the seat belt cut into your shoulder then you’ve experienced momentum. In a physical sense, it is the tendency for objects to keep moving when they’ve been previously moving but the force that propelled them has stopped.

If XYZ Industries has recently been a poor performer, investors believe it will remain a poor performer until there is a weight of evidence to convince them otherwise. Similarly, if XYZ Industries has performed exceedingly well in recent months, investors often believe it will continue to do so. Their thinking is by momentum. All this may fly in the face of sound evidence to the contrary. For example the PE ratio may be way above the sector average and the projected earnings may not justify the high price investors are paying. Momentum strategies that take advantage of this systematic error have become more popular in the last ten years.

Investors, it appears, can be overly cautious when confronted with situations that call for clear thinking. Hence, they wait too long to act and miss the best opportunities for profit. And, in the same way, once the investment is on the move, they plough in. It’s the Barn door closing effect, where investors are saying to themselves: Hey. Wait a minute, this is a good opportunity. I’ve got to be quick though, otherwise everybody else will get in and I’ll miss the chance to make any money. An example of this is in mutual funds when performance improves above around ten percent and is publicized. Suddenly, new money entering the fund increases. But, projections about the fund’s future performance don’t have this effect. Furthermore, once in the fund, investors are slow to react to information suggesting poor performance is just around the corner. At the extreme, they fudge the information, misinterpreting the facts, and again failing to act. They do this because they don’t want to admit to themselves that they could’ve chosen a bad mutual fund. Overall, investors delay taking action.

 

  Market Activity Investor Response
Stock undervalued with a static price –forgotten by the market Investors wait
Stock on the move – past its lowest and cheapest price – but increasingly active Investors slow to trade
Stock soaring – a rising glamour stock – now trading at a heavy premium Investors waited too long

 

You Have to be Alert to Catch the Best Momentum Stocks

 Within this behavior lies opportunity, as the interesting finding by Josef Lakonishok, professor of finance at the University of Illinois and partner in LSV Asset Management, has shown. High momentum stocks – based on their previous six months gains or by dazzling earnings surprises – outperform low momentum stocks by eight to nine-percent in the following year. In other words, the momentum behavior of investors, coupled with a swift appraisal of new information, is used to signal which stocks are starting the upward phase of their cycle.

The longer you wait, however, the more other people will have spotted the opportunity and the more expensive the stock will become. Very soon it isn’t a momentum stock anymore but a growth stock. As investors catch on though, the higher premiums paid for momentum stocks are justified because they don’t have to wait so long for improvements compared to highly underrated value stocks.

Nevertheless, for many of these stocks, it still isn’t easy to identify which ones are on the move but undervalued by the market. Besides using financial yardsticks, like performance ratios or relative strength, which are discussed in the next chapter, spotting these types of undervalued stocks can be done using published forecasts, such as the consensus earnings forecasts of the S&P 500 Index. You then need to figure in where you believe this stock is going to go. If, however, the forecast is more than thirty percent above what it was a year ago, then it may have already peaked – but then again, you don’t know for sure. This is where an informed guess based on instinct, experience, and psychonomic rationality comes in.

Strategies that look for value stocks on the basis of momentum rely on the fact that out-of-favor stocks have begun to turn around, as other investors have spotted their potential. Investors are buying stocks when they are already moving in the hope they will move even more. In the medium term it can be a highly profitable approach if you trade at the right times. But it’s important to remember that this strategy is not dependent on the stock itself but on investor’s perception of the stock’s future value. To paraphrase Finance Professor Robert Vishny, You don’t necessarily make money by buying the best stocks in the market this way but by buying stocks everyone thinks are going to be the best.

A Profitable Momentum Edge

Momentum effects also work on combinations of stocks. Research on portfolio returns by Andrew Lo and Craig Mackinlay, showed there was a correlation between one weeks return and the next, where about four- percent of the price change of next weeks return could be predicted from this weeks return. When the constituents of the portfolio were altered to contain small capitalization companies, rather than an equal amount invested in each stock of the New York Stock Exchange, the effect was enhanced to around ten- percent. Though the effect only works for portfolios, not for individual stocks, and only in the short-term – that is, daily and weekly returns – there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, a contrarian investment approach where investors buy second line stocks – mid caps and small caps – in a sector believed to be ready for a re-rating sometime in the near future, and then sit on their investments patiently, can work very well. Though money can be made from momentum, my preference here is for a portfolio that’s financially sound and less likely to be buffeted around by volatility once it moves. In other words, you’re pitting your wits against market sentiment, where investor perception alone has decided these stocks are unfashionable, not against fundamental financial determinants and economic realities.

Categories: Result and Research Tags: ,

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