Behavioral finance is a relatively new field that attempts to understand how people behave as opposed to how they think they behave or how they would be a in an ideal world. Classic economic theory is based on the assumption of rationalism, believing that individuals rationally consider all choices available and act to maximize their "utility." Put another way, they always act in their best interests.
The reality, as any individual knows, is quite different. Highly intelligent well educated people carry balances on high interest credit cards, keep large sums of money in low interest bearing accounts, fail to save for retirement, and if they do safe, tend to be overly conservative in their investments and overly confident in their assessments of their own judgment. It is not that these individuals are not aware of their behavior. If it is pointed out to them, they readily admit that they know that they should be behaving differently.
One of the basic assumptions of behavioral finance is that people systematically act in ways at odds with classical rational economic theory not because of simple misinformation but because they are hard-wired to act in a way that minimizes regret and maximizes pleasurable feelings about themselves even if their actions are not in their best long-term financial interests. Understanding behavioral finance is important because it we are aware of our tendencies, we can set up our financial life to take these tendencies into account. If we pretend that they do not exist then we will continue to act in a way that is financially self-defeating.
What follows is a summary of some of the major behavioral finance principles.
Heuristics: the process by which people find things out for themselves, usually by trial and error, leading to the development of rules of thumb. This process often leads to other errors; these errors can be systematic.
Representativeness: judgments based on stereotypes. People do not appreciate the extent to which there is progression to the mean.
Over confidence: people set overly narrow confidence bands. They set their low guess too high and their high guess too low. As a result, they are frequently surprised. In other words, they were too confident in their predictions. Self-attribution Bias: people attribute successful outcomes to their own skill but blame unsuccessful outcomes on bad luck. Having a financial adviser enables the investor to carry out a shifting of responsibility if things go wrong.
Anchoring-and-Adjustment, Conservatism: when presented with new information, analysts tend to be slow to change. For example, if a company reports the first of a series of improved earnings, the analyst is slow to change his projected earnings. In other words, he is anchored to the past earnings and is slow to change. Most people are conservative in incorporating new information. Perhaps analysts shift back and forth between two different mind-sets; following an unusual change, they believe that earnings will revert back to the prior trend. After a succession of surprises however the analysts a shift to a continuation mind-set (Nicholas Barberis, Andrei Shleifer, Robert Vishny, 1997).
Aversion to Ambiguity: people who prefer to gamble when the odds are even will play it safe when the odds are unknown. People prefer the familiar to the unfamiliar.
Frame Dependence:when a person has difficulty seeing through a frame (form) because it is opaque, he is exhibiting frame dependence. That is, he forgets that transferring a dollar from his left pocket to his right makes him no richer.
Loss Aversion: according to prospect theory, Daniel Kahneman and Amos Tversky (1979) provide evidence of frame dependence. Given a choice between a certain loss and a gamble, most people will take the gamble. For example, given a choice between losing $7,500 and having a 75% chance losing $10,000 with a 25% chance of losing nothing, they choose the gamble, although both are mathematically equivalent. In fact, the researchers found that a loss has about 2 1/2 times the impact of a gain of the same magnitude. Many investors will not sell anything at a loss. They don't want to give up the hope of making money. They have "get-evenitis."
Hedonic Editing: people are not uniform in their tolerance for risk. It depends on the situation. Someone will willing to tolerate risk in the face of a loss. People prefer some frames to others. They will shift frames to feel more comfortable about a loss. They will also mentally split up streams of income, for example spending dividends but not capital gains (which involves "dipping into capital"). They may do this to assert self control.
Cognitive And Emotional Aspects: the cognitive aspects concern the way people organize their information, while the emotional aspects deal with the way people feel as they register the information.
Regret: the emotion experienced for not having made the right decision. Regret is more than the pain of loss. It is the pain associated with feeling responsible for the loss.
Retirement Saving: in a December, 1997, Wall Street Journal poll of 2,013 people, 42% felt confident they will have enough money to live on in retirement, but 57% did not know how much they need the save in order to reach their retirement goal. Of the 55% who were saving, 26% had saved no more than $10,000 (Hart, Teeter, 1998). perhaps the major reason for insufficient savings is insufficient self control. Immediate demands are met whereas distant, deferred needs go unmet. Put another way, most people feel immediate needs but only think about future needs. (Shefrin, page 142).
Representativeness: DeBondt and Thaler, 1987: stocks that my in the bottom 10th percentile for the past three year return tend to outperform those that lie in the top 10th percentile. The cumulative returns for the losers are about 30% and about-10% for the winners over the subsequent sixty months. The authors contend that an investor who bought losers and sold winners short would have beaten the market by about risk 8% on a risk-adjusted basis. (Shefrin, page 34)
Conservatism: Victor Bernard and Jacob Thomas, 1989: stocks associated with recent positive earnings surprises experience higher returns than the overall market, while stocks associated with recent negative earnings surprises earn lower returns than the overall market. In the 60 days following an earnings announcement, the stocks with the highest earnings surprises outperformed the overall market my about 2%, while the stocks with the most negative earnings surprises underperformed the overall market by about 2%.
Frame Dependence: over the last two centuries, the real return to stocks has been about 7% more than risk free securities. A premium of 7% is enormous, and this differential has come to be called the equity premium puzzle.
Effect Of A Change In An Analyst Recommendation Of A Stock (Kent Womack, 1996): not only does the market price of the stock immediately react to the announcement, with the adjustment continues for a substantial period of time. This post-recommendation drift means to a 5% average additional gain following the first day of the buy recommendation and a subsequent 11% drop following a sell recommendation. Also, according to first call, the immediate average price increase to a buy recommendation is 3.6%. The immediate reaction to a sell recommendation is a 10.5% drop. Their reaction to a "removed from buy" recommendation is a 12.7% drop. Although investors responded to the change in recommendation, they actually under react. In the twelve months following the recommendation change, stocks with buy recommendations continued their upward march, whereas new sells and "removed from buys" continued their downward decline. After twelve months "removed from buys" fell about 15% whereas sells were down over 60%.
Studies of individual investors:
Barber, Brad and Terrance Odean, 1998. "The common stock investment performance of individual investors." Working paper, University of California, Davis.
Barberis, Nicholas, Andrei Shleifer, and Robert Vishny, 1997. "A model of investor sentiment." Journal Of Financial Economics 49, number 3: 307-344.
Benartzi, Shlomo and Richard Thaler, 1998. "Illusionary diversification and its implications for the United States and Chilean retirement systems." Working paper, University of California, Los Angeles.
Blume, Marshall, J. Crockett, and Irwin Friend, 1974. "Stock ownership in the United States: characteristics and trends." Survey Of Current Business 54 (November): 16-40.
Debondt, Werner, 1998. "A portrait of the individual investor." European Economic Review 42: 831-844.
Debondt, Werner, and Richard Thaler, 1987. "Further Evidence On Investor Overreaction And Stock Market Seasonality." Journal of Finance 42: 557-581.
French, Kenneth and James Poterba, 1993. "Investor diversification and international equity markets." In advances in behavioral finance, edited by Richard H. Thaler, 383-392. New York: Russell Sage Foundation.
Huberman, Gur, 1997. "Familiarity breeds investment." Working paper, Columbia University, New York, New York.
Kahneman, Daniel and Amos Tversky, 1979. "Prospect theory: and analysis of decision making under risk." Econometrica 47, number 2: 263-291.
Shefrin, Hersh, 2000. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press, 2000.
Womack, Kent, 1996. "Do brokerage analysts' recommendations have investment value?" Journal of Finance 51, number 1: 137-168.