th KEEPING THE FAITH IN THE FINANCIAL SYSTEMS KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SERIES LECTUR E 26 September 2002 26 September 2002 4 Profiting from Irrationality Behavioral Finance in the Philippines Francisco L. Roman Jr., Francisco L. Roman Jr., DBA DBA ?
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KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
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26 September 200226 September 2002
4Profiting from Irrationality
Behavioral Finance in the Philippines
Francisco L. Roman Jr., DBAFrancisco L. Roman Jr., DBA
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Table of Contents I. “Is Behavioral Finance a Growth Industry?”• What is Behavioral Finance?• Behavioral AND Traditional Finance• Examples of Terms
II. Behavioral Finance in the Philippines• FINEX Survey Findings• Analysis and Preliminary Conclusions
III. Wrap-Up• Usefulness for Corporate Finance• Words of Caution
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Part I:Behavioral Finance
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4Behavioral AND Traditional 1/2BEHAVIORAL FINANCEThe idea is simple: Investors are not as rational as traditional theory has assumed, and so biases in their decision-making can have a cumulative effect on asset prices.
TRADITIONAL FINANCEIn efficient market theory, assets are correctly priced because supply and demand reflect aggregate public knowledge about those assets, and that the movement of stock prices can not be reliably predicted based on past results.
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Traditional AND Behavioral 2/2
Fundamental Heuristic(& Technical) BeliefsAnalyses (Biases)
Efficient Market BehavioralHypothesis Finance
Rational IrrationalMarkets Markets
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4Behavioral Finance models will NOTreplace the theory ofEfficient Markets.
The idea that investors and managers are NOT uniformly rational makes intuitive sense.
Two Points of View
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Basic Market “Psychology”: Buy out of Greed. Sell out of Fear.
Behavioral Finance goes Beyond Greed and Fear.
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4The “Traditionalists” Critique
• Overemphasis • On (Unrepresentative) Anomalies • On (“Before & After”) Events
• Ambiguity: Over/Under Reaction
• Not Scholarly Enough • An excuse to evade economic theory • Behavioral Finance has NOT shown that the tendencies of individuals, when aggregated, have an impact on world prices.
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Behaviorial Finance Response
In finance, you are playing against people, who value assets on the basis of their expectations about the future. These expectations are ephemeral, or at best unstable.
• Valuing shares is an ART (not a science):• Globalization creates info. lags.• Many critical assets are intangible.
• Brands & patents, learning organizations• Trust is still critical (Enron et al.).
• And ephemeral
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4 “RECONCILIATION 1/3”
Efficient market models of rational behavior
are not BAD descriptions of reality. They’re
just NOT going to capture everything. Since
bubbles and other anomalies have real
economic effects, and occur often enough,
it is worth devoting time and effort trying to
understand what drives them and whether
their impact can be contained.
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4 “RECONCILIATION 2/3”From the Traditionalists:
There’s a big demand for behavioral finance
among the practitioners because nobody wants
to believe the markets are efficient, but if there’s
so much money on the table, how is it that
professional managers can’t do any better than
index funds?
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4 “RECONCILIATION 3/3”From the Behaviorists:
BF doesn’t say “There’s easy money. Go after it.” It says that psychology causes market prices and fundamental values to part company for a long time.
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Potential profit opportunities come packaged together with additional risk, and “smart money” can’t or won’t take a large enough bet to eradicate the anomalies, and won’t be able to arbitrage away the anomalies and return the market to equilibrium.
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Examples of Terms 2/3HERD MENTALITY• Start: Investors depend on “buzz”/rumors.• The Herd: Other investors join the “crowd”.• Reversal: Initial “pull-outs” accelerate
• REPRESENTATIVENESS• “Recall”– of past performance.• “Persistence”– winners are winners & v.v.• Tendency to use media-based info.
• OVERCONFIDENCE: “Analysts are 80% confident but only 60% accurate.”
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Examples of Terms 3/3REGRET MINIMIZATION• Dependence of the analyst• Share the credit for good performance.• Blame the analyst for poor performance.
DISPOSITION EFFECT• “Loss Averse”: hold losers too long.• Ego-driven• Uneven expectation
(of recovery & breaking-even)• “Risk Averse”: sell winners too early.• Fear of price reversal.
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4 Findings From DC Markets1/4
• Professional traders can be loss averse.• Herd mentality will raise stock prices
(Irrational Exuberance).• “The Greenspan Put”:
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Just as an investor can can set a floor for the price of a security by buying a put option, so Mr. Greenspan will provide a floor for the stock market by cutting interest rates when it gets too low for his liking.
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Findings From DC Markets 2/4• Bubbles/Anomalies exist & persist.
One weakness of the efficient market theory is the assumption that arbitrage by the informed (rational investor) against the uninformed (e.g., biased) is riskless and costless.
LTCMAssume a relatively small volume of shares in circulation that can not meet the demand by would-be shorters. Peoples with imperfect valuations can set prices that are out of line.
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4 Findings From DC Markets 3/4
• Computer models imply that price patterns are created by the collective actions of market traders themselves– e.g., a trend in rising prices can be interpreted as a buy or a sell signal.
• The more orderly a market appears (e.g., regularly rising P & Q), the less stable it is–• The Domino Effect
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4 Findings From DC Markets 4/4
• Economists have a problem with self-control.• We think it is not a problem.• Homo Economicus is always rational.• But “time-inconsistent” behavior persists.• The Doughnut Dilemma (& the Borrower)
Other Heuristics• Instant Amnesia• Arbitrary Obsessions• Fatal Optimism• Compulsive Monitoring
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4 Findings From LDC Markets 1/217
• In general RoE works better than P/E Multiples.• DCF projections are “guesses”.• The past becomes a good predictor
• In South Korea, the prices of the worst firmsin the last 6 months did better in the next 6.• Government bail-outs = “implied put”
• In Taiwan, it is the ratio of R&D to Sales.• In China & RP, it is debt– CA/CL, etc.
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4 Findings From LDC Markets 1/218
• Dividends are the GOOD NEWS:• In HK, China, Singapore & Malaysia• 50% give > bank deposit interest rates• In USA, only 7%
• Since 1991, two-thirds of investment returns came from dividends (not capital gains).
• A “wasteful” use of scarce capital?
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Part II:The FINEX Survey
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Non-CFOs Rate Analysts• 17/46 Firms use investment analyst or team• Often (6) & Always (9) follow the advise.• But get contrary results Once in a While (6)
& Sometimes (10)• But when accurate, the rise in price is:• 21-30% 4/16• 31-40% 2• 41-50% 3• >50% 7
When they’re right, they deliver.
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4Herd Mentality, Representativeness
& Regret Minimization 1/6
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• Pick 1 & 2 “best” & 1 “worst” stocks in 4 sectors:• PSE listed companies• Telecoms, Food, Banking, Real Estate
• Criteria: Company Image, Fundamentals, Management
• Answers were tested against actual stock performance, over a 12-month period.• Returns include appreciation (or not) + any
dividends.
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4 Herd et al. 2/6: Reasons forCompany’s Profile/Image
BEST WORST• Stable * Political in Nature• Conservative * Bad Reputation• Strong Franchise * Too Speculative• Blur Chip * No New Developments• Dominant * Unclear Business Model• Diversified * Unclear Plans
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4 Herd et al. 3/6: Reasons for37
Fundamentals (Ratios)
BEST WORST• Liquid * Not Liquid• Low Debt * Shareholders’ Reputation• Strong P&L & BS * Speculative• Good/High RoE * No New Developments• Large Share Base * Poor transparency• Cash-Rich * Weak Cash Flows
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4 Herd et al. 4/6: Reasons for38
Management
BEST WORST• Transparent/Prof’l * Past “Baggage” (Old Mgt.)• Market Leader * Poor Credibility/Governance• Foreign Backing * Speculative• Prudent * Secretive• Clear Focus * No Long Terms Strategy• Good Track Record * Heavy Debts
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Herd et al. 5/6: Reasons forReturns of the Best Choices
• with other comparisons *• if data available
PROPERTY RETURN %ALI +45.4
BANKS RETURN %BPI (17.9)RCBC (52.9)
*EBC +1.2
*MFC +11.8
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Herd et al. 6/6: Reasons for
TELECOMS RETURN %Globe + 5.2PLDT (28.9)
*Digital 100
FOOD RETURN %SMC +16.4Jolllibee + 4.9
*RFM +95.1 Some Herd et al.Some Bad Calls
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Part III:Wrap-Up
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4 Wrap-Up 1/5
For the Retail Investors
Research does show that these people tend to hold on to a losing investment and to sell a winning investment too quickly relative to their opportunity costs.
Retail investors who think they’re clever enough to beat the market probably don’t even understand traditional finance ideas and should simply follow a passive long-term strategy.
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4 Wrap-Up 2/5
For the Field of Corporate Finance:
• Decision biases can have a significant impact on how the firm fares. (The + & - of Enron)
• IBM altered its menu of pension funds offered to its employees because alternative program can overcome biases and enable investors to make more rational decisions.
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4 Wrap-Up 3/5
Assuming “Imperfectly Rational” Managers, Issues for Future Research:
• Why do “bad” capital structure decisions occur?
• What about discrepancies between market & CFO valuation of a firm?
• How do imperfectly rational CFOs decide?
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