1 Behavioural Finance. 2 Financial markets are studied using models that are less narrow than those based on Von Neumann-Morgenstern utility theory and.

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Behavioural Finance

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Behavioural Finance

‘Financial markets are studied using models that are less narrow than those based on Von Neumann-Morgenstern utility theory and arbitrage assumptions’

Jay Ritter. Pacific-Basin Finance Journal Vol 11 No 4 Sept 2003, Pgs 429-437

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Behavioural Finance

• Two building blocks

- Cognitive Psychology or how people think

(systematic errors in the way people think, overconfidence, weighting recent experience etc

and

- Limits to Arbitrage in what circumstances arbitrage forces will be effective and when not

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Behavioural Finance

• Agents are not fully rational

- Preferences e.g. people are loss averse $2 gain versus $1 loss

- Mistaken beliefsPeople are bad Bayesians

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Behavioural Finance

Bayesian inference is statistical inference in which evidence or observations are used to update or to newly infer the probability that a hypothesis may be true. The name "Bayesian" comes from the frequent use of Bayes' theorem in the inference process. Bayes' theorem was derived from the work of the Reverend Thomas Bayes.[1]

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Behavioural Finance (BF)

• Efficient Markets Hypothesis (EMH)

Competition between investors seeking abnormal profits will drive prices to their ‘correct’ value.

Markets are rational

Unbiased forecasts of the future

• BF financial markets maybe ‘informationally inefficient’

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Behavioural Finance

• Supply and Demand Imbalances

- Tyranny of indexing e.g. Yahoo

- Shorting markets

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Behavioural Finance

Cognitive Biases

• Heuristics (rules of thumb)

1/N rule

• Overconfidence

Too little diversification

e.g. local companies

Men more overconfident than women!

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Behavioural Finance

Cognitive Biases

• Mental accounting

E.g. food budget and entertaining

• Framing

E.g ‘pre theatre’ not surcharges

• Representativeness

e.g. high equity returns ‘normal’

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Behavioural Finance

Cognitive Biases

• Conservatism

slow to change but Vs representativeness

• Disposition effect

Avoid realising paper losses but realise paper gains.

Bull market trading volumes grow

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Behavioural Finance

• Major criticism

Depending on the bias can use to predict either over reaction or under reaction

• Salience effect

Tendency to over rely on the strength of signals and ignore the weight

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Behavioural Finance

Limits to Arbitrage• Misvaluations which are recurrent and

may be arbitraged and those which are non repeatable and long term in nature

• High frequency• Low frequency e.g. Japanese stock and land bubble of

1980s, October 1987 stock market crash, Technology bubble of 1999-2000

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Behavioural Corporate Finance

• Examines the effects of managerial and investor psychological biases on a firm’s corporate finance decisions.

• Dr Richard Fairchild (2007).

• ‘Behavioural finance is an integrated approach that combines traditional finance, psychology and sociology’

Ricciardy and Simon (2000)

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Behavioural Corporate Finance

• Irrational Investor

• Managers juggle

- Maximise long term value

- Maximise short tem value

- Take advantage of short term mispricing to transfer wealth to existing shareholders

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Behavioural Corporate Finance

• Looked at using two main models

- Catering and

- Timing• Investors divide firms into Dividend paying or not

paying and pay a premium for dividend paying• Managers may use free cash flow to pay a

dividend (i.e. cater) and max current price or not pay and reinvest in growth (i.e. not cater)

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• Market timing looks at stock mispricing

- Graham and Harvey (2001) found that 2/3 of CFO s believe that mispricing is important in decision to issue new stock

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Behavioural Corporate Finance

• Managers’ Irrationality• Managers more optimistic about outcomes - That they believe they can control and- To which they are highly committed

• Areas to be looked at - Capital budgeting

- Capital structure

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Behavioural Corporate Finance

• Capital Budgeting and Investment Appraisal

- Malmendier and Tate (2002) argue that ‘overconfident managers overestimate the quality of their projects and see external finance as costly as outside financiers undervalue the company’

So expected a positive correlation between internal cash flow and investment

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Behavioural Corporate Finance

• They found that investment is significantly responsive to cash flow if the CEO is overconfident (defined as not exercising in the money options or buy stock of company)

• Gervais et al (2003) looked at the combined effects of managerial risk aversion and overconfidence arguing that one offsets the other

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Behavioural Corporate Finance

• Heaton (2002) overconfidence leads to overestimates of NPV

• Malmendier and Tate (2004) argue that managers overinvest when there is plenty of internally generated funds

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Behavioural Corporate Finance

• Capital structure• Hackbarth (2002) found a positive relationship

between overconfidence and debt• Fairchild (2005) demonstrates that

overconfidence can lead to greater managerial effort which may counterbalance the negative effects of overconfidence leading to more debt and greater chance of financial distress.

• Malmendier and Tate (2005), Oliver (2005), Barros and Silveira (2007) all find a positive relationship between overconfidence and debt

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Behavioural Corporate Finance

• Managerial overconfidence and Firm Value

Ambiguous!

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Behavioural Corporate Finance

• Other Biases Statman and Caldwell (1987)Managerial entrapment, sunk costs and

reluctance to abandon losing projects.Prospect theory, framing and mental

accounting, regret aversion and self control.

2,000 spent, abandon and make 1,000 or continue and 50/50 make 2,000 or 0?

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Behavioural Corporate Finance

• Managers shift into the ‘negative domain’ when they create a ‘mental account’ in which they include the sunk cost.

• Kahnemann and Tversky (1979) Managers are risk avers in the positive domain but risk takers when in the negative domain and here, where there is a choice between a certain loss and a gamble, they are likely to gamble.