Behavioral Finance

The Age of Reason: Financial Decisions Over the Lifecycle, Sumit Agarwal, John C. Driscoll, Xavier Gabaix, David Laibson, Chicago Fed, June 7, 2007

Key elements:

• Performance tends to rise and then fall with age.
• Baseball players peak in their late 20s
• Theoretical physicists, and lyric poets make their most important contributions around age 30.
• Chess players achieve their highest ranking in their mid-30s
• Autocratic rulers are maximally effective in their early 40s
• Authors write their most influential novels around age 50

Linked paper studies personal financial decision making:

• Many financial products are complex and difficult to understand.
• Fees are sometimes shrouded and the true costs of financial services are not always easily calculated.
• Researchers find that younger adults and older adults borrow at higher interest rates and pay more fees than middle-aged adults controlling for all observable characteristics, including measures of risk.

Imagining recession by Robert J. Shiller: "The world’s housing, oil, and stock markets have been plunged into turmoil in recent months. Yet consumer confidence, capital expenditure, and hiring have yet to take a sharp hit. Why? Ultimately, consumer and business confidence are mostly irrational. The psychology of the markets is dominated by the public images that we have in mind from day to day, and that form the basis of our imaginations and of the stories we tell each other. Popular images of past disasters are part of our folklore, often buried in the dim reaches of our memory, but re-emerging to trouble us from time to time. Like traditional myths, such graphic, shared images embody fears that are deeply entrenched in our psyche. The images that have accompanied past episodes of market turmoil are largely absent today..."

Banks without Parachutes — Competitive Effects of Government Bail-out Policies, Hendrik Hakenes, Isabel Schnabel, Max Planck Institute for Research on Collective Goods, Bonn, 2004

Paper Abstract:

"The explicit or implicit protection of banks through government bail-out policies is a universal phenomenon. We analyze the competitive effects of such policies in two models with different degrees of transparency in the banking sector. Our main result is that the bail-out policy unambiguously leads to higher risk-taking at those banks that do not enjoy a bail-out guarantee. The reason is that the prospect of a bail-out induces the protected bank to expand, thereby intensifying competition in the deposit market and depressing other banks’ margins. In contrast, the effects on the protected bank’s risk-taking and on welfare depend on the transparency of the banking sector."

Bonus payments are ahead in many banks. This year distributing bonuses might be a particularly difficult task for top management in banks with various business segments such as wealth management and investment banking under one roof. Let us assume that investment bankers have lost a lot of money in the subprime crisis and that their division consequently generated losses whereas the bankers in the wealth management division have created big profits.

Bank`s top management has to give a clear signal that it is well positioned to solve the crisis caused by the investment bankers. "Giving clear signal" means a.o. measures to cut bonuses. What happens if you substantially cut the bonus of a New York or London based investment banker (even if he was part of a team that has created huge losses)? - he probably leaves. If the bank sticks to both wealth management and investment banking, allocating bonuses to the various divisions becomes more a political than a reward oriented task.

What`s the sense of organizational structures which incorporate completely different businesses under one roof?

Organizational research gives essentially technological reasons for its existence. Examples are information processing, supervision, task assignment and the coordination of interactions across activities.

The activities between wealth management and investment banking might be rather minor..

Organizational structures should be developed in order to maximize the organization`s effectiveness and ressource allocation. Ressources should mainly be allocated to divisions with exzellent risk adjusted returns and the biggest growth projects. Within a bank with wealth management and investment banking this would most likely be the wealth management division.

In times of bonus allocation, as mentioned above, top management might realize that structures could become the battle ground for political contest. The structural position of management plays an important role in such political contest. As long as the bank intends to keep its loss making investment banking business, the management of this division will have a quite strong negotiation power. They will argue that the market for investment bankers is very efficient and that people will leave if they do not get a substantial bonus.

That is no meritocracy anymore! Such problems could be overcome with structures which make a clear separation between investment banking and the rest of the businesses. "Clear" includes also a (partial) separation of shareholders. Investors who like investment banking type of businesses might have a completely different risk profile than investors who choose to invest in long-term oriented wealth management type of businesses.

City bonuses: after the long feast, time for some famine, Guardian unlimited, Dec. 2, 2007

In previous posts either in the behavioral finance or the stock market sector we have dealt with the herding phenomena of investors and consequently with information cascades. Information cascades are a situation where individuals, based on observations of others, make the same choices ignoring their private signals. The individual for its own is still a rational decision maker. However, when a cascade occurs the cascade effect is so overwhelming that every individual might take the wrong action even if it would be able to make the right choice individually.

An information cascade can be interrupted by certain public information or unusual signals. This might for example be information released by the Fed.

As mentioned, information cascades have become an important topic in the discipline of behavioral finance. In financial markets such cascades can create excessive price movements in certain segements or the market as a whole.

Information cascades are not only an economic phenomena but are also of importance in politics and sociology. In this respect the Cato Institute published an excellent article by Pierre Lemieux, University of Quebec:

"Following the Herd", P. Lemieux, University of Québec, Winter 2003-2004

Key elements of the article are:

• Cascade theory explains, within a rational-choice framework, why large numbers of people think and behave in the same way.
• When incorrect cascades develop, bad public policy will follow.
• False cascades are often fragile. However, even if they are false, reputational concerns may make them more resilient and may tip a social system into inertia or into revolution.
• Special interests also make cascades more resilient to the extent that they can manipulate them.
• One way interest groups manipulate public opinion is by rewarding certain types of opinion or behavior
• Cascades are only one of the factors that influence what people think and how they behave, and which public policies follow.
• Long-term ideology and political and bureaucratic processes interact with cascades.

"THERE ARE GOOD REASONS TO BELIEVE THAT FALSE CASCADES, EVEN SUPPORTED BY SPECIAL INTEREST, CAN BE REVERSED BY FREE SPEECH, INDIVIDUAL LIBERTY AND THE DISPERSION OF POWER IN SOCIETY."

...so much to the excursion and the wonderful article of P. Lemieux. Have a nice weekend!

We have heard lately about hedge funds and mortgage vehicles getting into troubles or even bankruptcy due to overexposure in the subprime loan market. From a retrospective view financial economists might be surprised why the managers of such vehicles could not foresee the risk involved with such instruments.

Many economists over the years studying markets started to realize that traditional economic explanations and efficient market theory do not account for all of the market behaviour. This might also be the case for the investment behavior in the subprime loan segment. Economists are trying to offer explanations through what is called `behavioural finance'. Conventional economic theory assumes rational behaviour of market participants. However, the behavior of various players in the subprime loan markets is evidence of the fact that investors are definitely not always rational.

Behavioral finance offers explanations for the volatile market activity through psychological theories, information cascades, herd behaviour, over-confidence and so on. When looking at market participant’s behavior one has to take into account following observations:

• Public memory is short: Today's world is so dynamic that the details of past negative economic events such as crashes and bankruptcies are easily forgotten. People are also sometimes overly enthusiastic for some kind of assets and might easily get greedy.
• Social and political movements: Social and political movements can play a vital role in investment behavior. For example globalization: it is definitely an engine for growth. However, it might not be the reason for a paradigm shift towards much longer growth cycles as many might believe.
• Group pressure: People are often heavily influenced by others rather than by their own thinking. This was for example demonstrated in the way investors reacted to share price movements of software companies during the new economy hype.
• Information cascades: Many events in the stock markets are based on little information. If decisions are made on the basis of very limited information by more and more investors an information cascade is created.

Behavioral finance is one of the most complex fields in economics. Much more research has to be done in order to better understand how masses react in specific environments.

As learnt from other posts, behavioral finance deals with the topic how people's emotions affect their investment decisions and finally their performance.

Many studies have shown that a lot of human beings are amazingly irrational about money and their investment decisions. In many situations of life people who go with the crowd (herding behavior) tended to survive better than those standing out of the crowd.
However, herding behavior might not be the optimal strategy when investing - at least in the medium and long term.

Mistakes people often make when investing include:

- Herding behavior, driven by a desire to be part of the crowd
- treating windfall profits(e.g. gains from venture investments which
are based on pure luck) differently than other money
- Excessive aversion to loss
- Fear of change, resulting in an excessive bias for the status quo
- Fear of making an incorrect decision and feeling stupid
- Drawing conclusions from a limited sample size
- Underestimation of the impact of rising markets and overestimation
of its own analytical skills
- Neglection of the cyclical nature of many businesses
- Forgetting the powerful tendency of regression to the mean
- Confusing of familiarity with knowledge
- Lack of diversification due to overconfidence in its decisions

Quotes of Benjamin Graham:

"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed."

"The individual investor should act consistently as an investor and not as a speculator. This means.. that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase."

Herding among analysts is a behavioral finance subject. There are various comprehensive studies about this subject leading to a variety of results. Most of these studies use US data as the availability of relevant data is the highest in the US.

Sofia Darmstadt has analyzed the forecast behavior of US fixed income analysts (using 227 test persons) and comes to the conclusion that analysts influence each other significantly and that only 10% of test persons are able to make deductions about predecessors’ private signals from their actions.

Rationales Herdenverhalten bei US-amerikanischen Rentenmarkt-Analysten

In behavioral finance - more so than classical finance theory - computers play an important role in the practical implementation of trading strategies.

In this "game" it's not about an analyst's unprecedented ability to identify an undervalued title by extracting a better understanding of company fundamentals through interviewing corporate managers and analyzing economic market drivers in the respective industry. It's about analyzing the financial market per se. Given that the finance industry is a market of numbers and figures, it's no wonder that one can only grasp the underlying dynamics from analysing them, comparing ratios, moves and momentum, trading volumes and market participants' (mainly brokers) expectations, amongst various other trends.

Ergo, you better are capable of processing thousands/millions of data items at any point in time, and apply the vigorousness to trading (buy/sell) discipline, if you want to out-perform in the long run. Behavioral Finance is not about short-term profits, also not about trying to predict when it is the best time to enter or exit a stock market. We look at the stock market as a system and not at the world (other alternative investment opportunities outside of the stock market).

But why do computers outperform in the long-run against a "gifted" individual investor? It's like in chess: Deep Blue did not win against Kasparov because "he" was more creative or had better intuition. As a matter of fact, he was dumb and could only learn from the past. But he could process by far more strategic outcomes than a human brain at the same time can do, and he was not affected by "human stress" (to perform) and therefore a culprit of "irrational behavior" himself. As long as he had "power" (I mean electricity), he did his job with a discipline like no human being could do. Steven J. Milloy in 1997 wrote about this show-down as follows: "The creation of Deep Blue, in short, is a marvelous human achievement. Its creators deserve our admiration. That it took so many of them so long to combine such awesome computing power in a way that could stand up to one human genius is reason on all sides for humility-an occasionally useful virtue in times such as these."

This virtue doesn't help when things are changing fundamentally. But except for 09/11, things "usually" don't change over night fundamentally. There are signs available from market participants, that the avid "computer trader" can exploit in advance. That's why behavioral finance-related investment strategies cannot make money from "insider trading" or may lose money in the short-term, but by and large the robustness and discipline of the models exploit the weaknesses of the human trading counterparts in the same market.

So, if you are thrilled by this discipline, let me advise you on two prerequisites to "survive" in it: (a) Don't think you're a smart investor, but have the computer make decisions for you. You cannot grasp this discipline without it! (b) Be in it for the long-term. Don't get cold feet, because you lose money in one month of trading or even within a quarter. This is not about day-trading or should I be in the market or not. It's about outperforming other players in the market in the longer-term.

Good luck, enjoy, and endure!

Today NZZ am Sonntag published various articles and one opinion on the lax Swiss regulation regarding position build-up strategies in public stocks for takeover bids. One such article is available at our sister blog "Stock Market".

In the opinion column - page 23, NZZ am Sonntag, 21.01.2007 - (jac) states that the rules related to stock option trading as currently in place for Switzerland are a sign of joy for all those who like to operate in the dark and don't want to publish their intentions. He/she continues that it is not that takeovers per se are bad, but the way they are constructed today. In the old days interested parties were publicly presenting a takeover bid that in most cases was sweetened by a surcharge to the current share price offered to the existing shareholders to tender their stock. Today, as per this opinion, raiders control such activities via options, that do not need to be published in Switzerland, as well as through banks that purchase shares on their behalf. This way he/she concludes that majorities can be construed that do not exist in reality.

Let's analyze this from a behavioral finance background:

Trying to buy a stock position in the intention to gain control without telling from the outset - Is it "bad behavior" from an economic or ethical point of view?

a) From an economic point of view, it is definitely not a bad intention. If a party wants to gain control in order to fundamentally change how a company (for that sake a "public" company) is managed, then she acts with a future view in mind, that may or may not work given the readiness of current owners to trade their stock. From a DCF-valuation perspective, this party envisions future returns from fundamental changes in operations, she would implement if given power. But that only makes sense, if today she does not need to pay an "exorbitant" sweetener (as mentioned above) to existing shareholders just to be given the chance to implement that change. Takeover scenarios that tend to be "published" too early only stir the expectations of current shareholders that their company is worth more today, than what the stock market "tells them" with its current share price. So, shareholders tend to have higher expectations from what is an often not communicable strategy at times, when a potential buyer is not in a position to control and therefore risks to be perceived as manipulative and simply dreaming, if she was given the chance to drastically change something. From a fundamental DCF-valuation point of view, such high risk strategies require a huge discount and therefore in the end will only work, if a buyer does not need to pay too high a price for an acquisition.

b) From an ethical point of view, it's a mixed situation. If takeover prices turn out to be high just because a buyer was willing to "neglect" that higher risk to some degree by leveraging a takeover price too high to make her DCF-model work, it is also not a reasonable outcome. As is commonly known, financial leverage - although in current liquid markets for mezzanine money and bank financing possible - adds additional risk besides the inherent risk of an operating change in an organisation. If in the end the whole transformation strategy fails, the new investors lost their money, some people may have lost their jobs, and previous shareholders who were provided with the equity sweetener may have a somewhat mixed feeling about their "prepayment" for a future value, that still needed to be created and partly may not have worked due to their "unfair" early cash-in. So, from the perspective of someone who sees and wants change in how things are operated at an organisation, one would not necessarily agree with a statement of Johann Schneider-Ammann, President of Swissmem (Swiss machinery, electro, and metal industries), that "we risk, that our best companies are now sold too fast and too cheap." First of all who is "we" (the Swiss general public?) and then what is too cheap in view of the above mentioned? Where he is right though from an ethical point of view, is when in such situations companies become a trading product for speculators, who don't have the strategic view of fundamental change in mind, but simply a short-term profit from riding a band waggon based on "irrational behavior" (from a classical finance point of view) by stock market participants.

c) Pablo Spinnler in his speech "Die drei Goldenen Pflichten: Corporate Responsibility im 21. Jahrhundert" at the 35. ISC-Symposium at the university of St. Gall, 19.-21. May 2005 said the following: The company from an ethical point of view is responsible vis-à-vis its shareholders based on the value contribution of their capital, vis-à-vis its employees based on the value contribution of their human capital, vis-à-vis society based on the value contribution of its "capital of trust", vis-à-vis its customers based on the trust in its products and subjective quality, and finally vis-à-vis itself based on its sustainability. In other words, different stakeholder may have different perceptions as to what their respective value contribution of a company should be worth. In a knowledge society, it's no longer the financial capital that generates "highest" value add, but the human capital. If we acknowledge that we more and more live in such a society, it's nothing than "normal" that those who drive change and implement it, demand a higher return. In this respect, an acquisition strategy that tries to keep share prices low in view of future changes to be implemented is an incarnation of a value contribution discussion of human capital against financial capital. I'm aware that such a conclusion per se is over-simplified. But there is definitely some truth in it...

Link: http://www.iew.unizh.ch/study/courses/downloads/bfexam0506.pdf

...how would they have answered the BF-test linked in the title? One thing seems evitable: Both of them pursued trains of thought that, each from his respective background have profoundly contributed to what BF is today:

1. Perception precedes action (Aristotle)
2. Facts are facts, but perception is reality (Albert Einstein)

Link: http://lsb.scu.edu/finance/faculty/Statman/articles/what%20is%20bf%20IMCA.pdf

For the novice and interested reader this article linked in the title shows the principles that are pursued and build the basis for behavioral finance. It is recommended to everybody as an 'entry point' to this topic.