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What is Behavioral Finance?
Meir StatmanGlenn Klimek Professor of Finance
Santa Clara Universityand Visiting Professor
Tilburg University – The Netherlands
What is Behavioral Finance?
Standard Finance
Finance with rationalpeople in it
Computer-like people
Behavioral Finance
Finance with normalpeople in it
Sometimes normal-smart
sometimes normal-stupid
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What is Behavioral Finance?
Mr. Osborne, may I be excused? My brain is full
The brains of rational investors
are never full
The brains of normal investors
are often full
We commit cognitive errors
and are misled by emotions
What is Behavioral Finance?
Behavioral Finance version 1
Because we are irrational
Behavioral Finance version 2
Because we are normal, pursuing what normal investors want
We fall victim to cognitive errors and misleading
emotions on our way
to what we want
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A (short) History of FinanceMeir Statman - Financial Analysts Journal - 2005
From Proto Behavioral Finance to Finance
Proto Behavioral Finance: Before the 1960s - (Obese)
Anecdotal but realistic about human behavior
A (short) History of Finance
From Proto Behavioral Finance to Finance
Standard Finance: 1960s - (Anorexic)
Introduced the scientific method into finance but narrowed its boundaries
and based it on unrealistic human behavior
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A (short) history of Finance
From Proto Behavioral Finance to Finance
Behavioral Finance: 1980s - (Fit)
Keeping the scientific method in finance but broadening its boundaries and basing it on
realistic human behavior
Standard finance and behavioral finance
are joined into Finance
A (short) history of Finance Foundation blocks of standard finance
1. Investors are rational
2. Investors should construct portfolios by the rules of mean-variance portfolio theory (and actually do so)
3. Markets are efficient
4. Expected returns are determined only by risk (measured by beta)
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A (short) history of Finance Foundation blocks of behavioral finance
1. Investors are normal
2. Investors construct portfolios by the rules of behavioral portfolio theory (and it is pretty wise to do so)
3. Markets are not efficient (but are not as easy to beat as many normal investors think)
4. Expected returns are determined by more than risk
A (short) history of Finance
Standard Finance1. Investors are rational
Merton Miller and Franco Modigliani in their 1961
article on dividends:
a. Rational investors always prefer more wealth to less
b. Rational investors are never confused by the form of wealth
Rational investors are indifferent between company-paid dividends and homemade dividends
Normal investors are not indifferent
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A (short) history of FinanceBehavioral Finance
1. Investors are normal
Normal investors have normal wants
Normal investors: commit cognitive errors and are misled by emotions on the way to what they want
Framing errors:Investors are often confused by the form of wealth
Statman – Journal of Investment Consulting, 2004
Normal investorsWants, cognitive errors and emotions
Martha lied about her sale
of ImClone stocks based
on inside information.
She served 6 months in jail
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Normal investorsWants, cognitive errors and emotions
Just took lots of huge losses to offset some gainsMade my stomach turn
Martha’s wants:
Not to face losses
Not to realize losses
Wants, cognitive errors and emotionsIs Martha Stewart rational?
Rational investors always prefer more wealth to less
Rational investors are never confused by the form of wealth
The stomach of rational investors turn when stocks go down
and they incur “paper losses”
But rational investors are happy when they realize paper losses
Because loss realization reduces taxes and increases wealth
Rational investors are never confused by framing losses as
“paper losses” or “realized losses”
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Wants, cognitive biases and emotionsMartha Stewart wanted to avoid the pain of regret
that comes with realizing losses
Framing - Mental accountingRealizing “paper losses”
The stock mental account is closed at a lossThere is no more hope of a recovery
HindsightWasn’t it clear in foresight that the stock would decline?
Why did I buy the stock?
RegretI was stupid to buy this stock
Now my stomach turns because of my stupidity
Proto Behavioral FinanceHoward Snyder (1957)
“How to take a loss and like it”“Human nature being what it is, we are loath to take
a loss until we are forced into it.”
Anecdotal but realistic about human behavior
Behavioral FinanceHersh Shefrin and Meir Statman (1985)
Disposition EffectRealistic human behavior with theory,
hypotheses and empirical evidence
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A (short) history of FinanceStandard Finance
2. Investors should construct portfolios by the rules of mean-variance theory (Markowitz, 1959)
and actually do so (Sharpe, 1964)
Question
If you could increase your chances of having a more comfortable retirement by taking more risk, would you:
a. Be wiling to take a little more risk with
all your money?
b. Be willing to take a lot more risk with
some of your money?
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Mean-variance portfolio theory
If you could increase you chances of improving your returns by taking more risk, would you:
Risk Money
=xA lot more
riskSome of
your money
Addition to
portfolio risk
=xAll of your
moneyA little
more risk
Addition to
portfolio riska.
b.
Mean-variance portfolio theory
It all mixes in the stomachRational investors are never confused by
the form of wealth
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Behavioral Portfolio Theory
Downside
Protection
Upside
Potential
A lotmore risk
with some of
your money
Behavioral FinanceBehavioral Portfolio Theory (Hersh Shefrin and Meir Statman, 2000)
Upside potential and downside protection
Lottery tickets and insurance
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What do investors want?Freedom from fear – Downside protection
Hope – Upside potential
Goal-based portfolios
We want to be rich
(20% chance to be rich)
We don’t want to be poor
(Almost 100% chance not to be poor)
Mean-variance portfolio theory
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Behavioral portfolio theory
Combining elements of mean-variance portfolio theory
and behavioral portfolio theory into a mental-accounting portfolio framework
Portfolio Optimization With Mental Accounts, Journal of Financial and Quantitative Analysis, 2010
Portfolios for investors who want to reach their goals while staying on the mean-variance efficient frontier
Journal of Wealth management, 2011
Sanjiv Das, Harry Markowitz, Jonathan Scheid, and Meir Statman
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The overall portfolio and mental account (goals) sub-portfolios are all on the mean variance efficient frontier
Options and Structured Products in Behavioral Portfolios
Sanjiv Das and Meir Statman
Working paper 2011
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Market efficiency (Fama 1966)
Two main definitions of efficient markets:
Rational markets - where securities' prices always equal their intrinsic values
Unbeatable markets - where investors are unable to generate consistent excess returns
Bubbles cannot exist in rational markets
Bubbles can exist in unbeatable markets
Market efficiencyEfficient markets as rational markets
Price = Intrinsic value
Intrinsic value is determined by:
Reasonably expected cash flows
Risk of these cash flows
Market cap does not matter
Book-to-market does not matter
Momentum does not matter
Social responsibility does not matter
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Efficient Markets
Unbeatable markets - where investors are unable to generate consistent excess returns (alpha)
Bubbles can exist in unbeatable markets
But investors are unable to beat the market by generating consistent excess returns (alpha)
Market efficiency and asset pricing modelsThe market efficiency hypothesis is a joint hypothesis of market
efficiency and an asset pricing model.
Example: Two loaves of bread cost $2 each
Perhaps the second loaf is really heavier than the first
The market is not efficient
You get a one ounce alpha when you buy the second loaf
OrL
Perhaps the two loaves have equal weight but the scale is faulty
The asset pricing model is faulty
Weight = 16 ounces
Weight = 17 ounces
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Market efficiency and asset pricing models
If the CAPM is the right asset pricing model then the market is not efficient
Anomalies:
The returns of small cap stocks exceed CAPM expected returns.
The returns of value stocks exceed CAPM expected returns.
Should we give up market efficiency or the CAPM as the asset pricing model?
Standard FinanceMarket efficiency and asset pricing models
Fama and French (1992) gave up the CAPM
rather than market efficiency
They introduced the 3 –factor model
1. Market (beta)
2. Size
3. Book-to-market Measure Risk
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Standard Finance
Market efficiency and asset pricing models
The number of factors keeps growing
1. Market
2. Size
3. Book-to-market
4. Momentum
5. Liquidity
6. Skewness of returns
Measure Risk
Behavioral Finance
Market efficiency and asset pricing models
What is the automobile pricing model?
What determines the demand for an automobile?
What determines the supply?
Think about a BMW 330i
Price of BMW 330i
Quantity of BMW 330i
Demand
Supply
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Why does the BMW 330i cost more than the Acura TL?
• Is the market for automobiles inefficient?
• Is the automobile pricing model mis-specified?
Behavioral FinanceStocks are like automobiles
The automobile pricing model has:Utilitarian factors:
Gas mileage
Safety
Physical comfort
Expressive factors:Beauty
Status
Emotional factors:Exhilaration
Emotional comfort
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What watch-buyers really wantWhy do I pay $10,000 for an IWC watch?
Utilitarian benefitsWhat does it do for me and my pocketbook?
It tells time and never breaks down
Expressive benefits What does it say about me (to me and to others)?
I am a successful man with high status and refined tastes
Emotional benefitsHow does it make me feel?
Accomplished and masculine
Swatch also makes Longines, Omega, Tissot and Breguet
“Demand from Asians who want to communicate their wealth and taste overcomes the worldwide economic downturn and
the strong franc” NYT December 10, 2011
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What Investors Really WantWe want to stay true to our values
Socially responsible investments
Utilitarian benefits
I’ll get high returns
Expressive benefits
I am socially responsible
Emotional benefits
I have peace of mind because my
finances are true to my values
What Investors Really WantWe want high status and proper respect
Hedge funds
Fifty million, sadly, leaves one flying commercial. Hedge-fund money can put you into exhilarating conversations about the virtues of Gulfstreams versus Falcons
Utilitarian benefits
I will have high returns with low risk
Expressive benefits
I have high status
Emotional benefit
I feel proud as a member of an exclusive club
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What Investors Really WantWe want great beauty and high status
Kenneth Griffin of Citadel bought Jasper Jones’ “False Start” for $80 million
Richard Fuld of Lehman sold Arshile Gorky’s “Study for Agony I” after Lehman’s collapse
Behavioral FinanceMarket efficiency and asset pricing models
Utilitarian, expressive and emotional factorsStatman, Fisher, and Anginer (FAJ 2008)
“Affect in a Behavioral Asset Pricing Model”
1. Market
2. Size
3. Book-to-market
4. Momentum
5. Liquidity
6. Skewness of returns
7. Social responsibility
8. Status
Measures utilitarian risk?
Measures affect?
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An Asset Pricing Model with Social Responsibility FactorsJan 1992 – June 2011
Statman and Glushkov (2011)
DS 400 S&P 500
Alpha (Annualized) 1.02% 0.36% 0.31% 0.13%
Market 0.99*** 0.98*** 0.98*** 0.98***
Small-Large -0.18*** -0.20*** -0.19*** -0.19***
Value-Growth -0.04** 0.02 0.02* 0.03**
Momentum High-Low -0.01 -0.02 -0.02*** -0.02**
SR Top-Bottom 0.13*** 0.02*
SR Accepted-Shunned 0.11*** -0.03*
N (months) 243 231 243 231
Adj R-sq 0.95 0.96 0.99 0.99
Average Top-Bottom Score 0.17 0.07
Average Accepted-Shunned Score 0.93 0.67
An Asset Pricing Model with Social Responsibility FactorsFund introduction through March 2011
Vanguard FTSE
Social Index Inv
Calvert Social
Index A Fund
Calvert Social
Investment
Equity A
Ave Maria
Catholic ValuesVice Fund
Alpha (Annualized) -3.24% -3.26% -2.87% -3.12% -0.33% -0.25% 0.27% 1.40 1.14% 0.67%
Market 1.03*** 1.04*** 0.99*** 1.01*** 0.91*** 0.91*** 0.85*** 0.82*** 0.86*** 0.84***
Small-Large -0.01 -0.06* -0.03 -0.07** -0.05 -0.05 0.39*** 0.41*** 0.05 0.18
Value-Growth -0.02 0.02 -0.06** -0.01 0.01 0.02 0.29*** 0.22*** 0.01 -0.09
Momentum High-Low -0.08*** -0.08*** -0.06*** -0.06*** -0.05** -0.06** -0.07** -0.09*** 0.10** 0.11**
SR Top-Bottom 0.06* 0.09*** 0.01 -0.19*** -0.05
SR Accepted-Shunned 0.19*** 0.15*** 0.06 0.03 -0.44***
N (months) 130 130 129 129 231 231 118 118 103 103
Adj R-sq 0.97 0.97 0.97 0.97 0.87 0.87 0.9 0.91 0.73 0.74
Average Top-Bottom
Score0.10 0.12 0.10 -0.05 0.00
Average Accepted-
Shunned Score0.90 0.89 0.79 0.70 -0.47
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A (short) history of Finance
Foundation blocks of behavioral finance
1. Investors are normal
2. Investors construct portfolios by the rules of behavioral portfolio theory (and it is pretty wise to do so)
3. Markets are not efficient (but are not as easy to beat as many normal investors think)
4. Expected returns are determined by more than risk
