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SSRN Id256754
SSRN Id256754
Abstract
While conventional academic finance emphasizes theories such as modern portfolio theory and the efficient market hypothesis, the emerging field of behavioral finance investigates the psychological and sociological issues that impact the decision-making process of individuals, groups, and organizations. This paper will discuss some general principles of behavioral finance including the following: overconfidence, financial cognitive dissonance, the theory of regret, and prospect theory. In conclusion, the paper will provide strategies to assist individuals to resolve these mental mistakes and errors by recommending some important investment strategies for those who invest in stocks and mutual funds.
Introduction
During the 1990s, a new field known as behavioral finance began to emerge in many academic journals, business publications, and even local newspapers. The foundations of behavioral finance, however, can be traced back over 150 years. Several original books written in the 1800s and early 1900s marked the beginning of the behavioral finance school. Originally published in 1841, MacKays Extraordinary Popular Delusions And The Madness Of Crowds presents a chronological timeline of the various panics and schemes throughout history. This work shows how group behavior applies to the financial markets of today. Le Bons important work, The Crowd: A Study Of The Popular Mind, discusses the role of crowds (also known as crowd psychology) and group behavior as they apply to the fields of behavioral finance, social psychology, sociology, and history. Seldens 1912 book Psychology Of The Stock Market was one of the first to apply the field of psychology directly to the stock market. This classic discusses the emotional and psychological forces at work on investors and traders in the financial markets. These three works along with several others form the foundation of applying psychology and sociology to the field of finance. Today, there is an abundant supply of literature including the phrases psychology of investing and psychology of finance so it is evident that the search continues to find the proper balance of traditional finance, behavioral finance, behavioral economics, psychology, and sociology. The uniqueness of behavioral finance is its integration and foundation of many different schools of thought and fields. Scholars, theorists, and practitioners of behavioral finance have backgrounds from a wide range of disciplines. The foundation of behavioral finance is an area based on an interdisciplinary
approach including scholars from the social sciences and business schools. From the liberal arts perspective, this includes the fields of psychology, sociology, anthropology, economics and behavioral economics. On the business administration side, this covers areas such as management, marketing, finance, technology and accounting. This paper will provide a general overview of the area of behavioral finance along with some major themes and concepts. In addition, this paper will make a preliminary attempt to assist individuals to answer the following two questions: How Can Investors Take Into Account the Biases Inherent in the Rules of Thumb They Often Find Themselves Using? How Can Investors know themselves better so They Can Develop Better Rules of Thumb? In effect, the main purpose of these two questions is to provide a starting point to assist investors to develop their own tools (trading strategy and investment philosophy) by using the concepts of behavioral finance.
mum (highest) expected return given the amount of risk assumed, or, on the contrary, contains the lowest possible risk for a given expected return. Another main theme in standard finance is known as the Efficient Market Hypothesis (EMH). The efficient market hypothesis states the premise that all information has already been reflected in a securitys price or market value, and that the current price the stock or bond is trading for today is its fair value. Since stocks are considered to be at their fair value, proponents argue that active traders or portfolio managers cannot produce superior returns over time that beat the market. Therefore, they believe investors should just own the entire market rather attempting to outperform the market. This premise is supported by the fact that the S&P 500 stock index beats the overall market approximately 60% to 80% of the time. Even with the preeminence and success of these theories, behavioral finance has begun to emerge as an alternative to the theories of standard finance.
Figure 2.
Figure 1.
Figure 1 demonstrates the important interdisciplinary relationships that integrate behavioral finance. When studying concepts of behavioral finance, traditional finance is still the centerpiece; however, the behavioral aspects of psychology and sociology are integral catalysts within this field of study. Therefore, the person studying behavioral finance must have a basic understanding of the concepts of psychology, sociology, and finance (discussed in Figure 2) to become acquainted with overall concepts of behavioral finance.
Figure 3.
In reviewing the literature written on behavioral finance, our search revealed many different interpretations and meanings of the term. The selection process for discussing the specific viewpoints and definitions of behavioral finance is based on the professional background of the scholar. The discussion within this paper was taken from academic scholars from the behavioral finance school as well as from investment professionals.
when they invest their money. As a portfolio manager or as an individual investor, recognizing the mental mistakes of others (a mis-priced security such as a stock or bond) may present an opportunity to make a superior investment return (chance to arbitrage). Arnold Wood of Martingale Asset Management described behavioral finance this way: Evidence is prolific that money managers rarely live up to expectations. In the search for reasons, academics and practitioners alike are turning to behavioral finance for clues. It is the study of us. After all, we are human, and we are not always rational in the way equilibrium models would like us to be. Rather we play games that indulge self-interest. Financial markets are a real game. They are the arena of fear and greed. Our apprehensions and aspirations are acted out every day in the marketplace. So, perhaps prices are not always rational and efficiency may be a textbook hoax. (Wood 1995, p. 1) Now that you have been introduced to the general definition and viewpoints of behavioral finance, we will now discuss four themes of behavioral finance: overconfidence, financial cognitive dissonance, regret theory, and prospect theory.
What is Overconfidence?
Research scholars from the fields of psychology and behavioral finance have studied the topic of overconfidence. As human beings, we have a tendency to overestimate our own skills and predictions for success. Mahajan (1992, p. 330) defines overconfidence as an overestimation of the probabilities for a set of events. Operationally, it is reflected by comparing whether the specific probability assigned is greater than the portion that is correct for all assessments assigned that given probability. To illustrate: The explosion of the space shuttle Challenger should have not surprised anyone familiar with the history of booster rockets 1 failure in every 57 attempts. Yet less than a year before the disaster, NASA set the chances of an accident at 1 in 100,000. That optimism is far from unusual: all kinds of experts, from nuclear engineers to physicians to be overconfident. (Rubin, 1989, p. 11) Academic research on overconfidence has been a recurrent theme in psychology. Take for instance the work in experimental psychology of Fishchhoff,
Slovic, and Lichtenstein (1977). This piece studied a group of people by asking them general knowledge questions. Each of the participants in study had to respond to a set of standard questions in which the answers were definitive. However, the subjects of the study did not necessarily know the answers to the questions. Along with each answer, a person was expected to assign a score or percentage of confidence as to whether or not they thought their answer was correct. The results of this study demonstrated a widespread and consistent tendency of overconfidence. For instance, people who gave incorrect answers to10 percent of the questions (thus the individual should have rated themselves at 90 percent) instead predicted with 100 percent degree of confidence their answers were correct. In addition, for a sample of incorrect answers, the participants rated the likelihood of their responses being incorrect at 1:1000, 1:10,000 and even 1:1,000,000. The difference between the reliability of the replies and the degree of overconfidence was consistent throughout the study. In both the areas of psychology and behavioral finance the subject matter of overconfidence continues to have a substantial presence. As investors, we have an inherent ability of forgetting or failing to learn from our past errors (known as financial cognitive dissonance, which will be discussed in the next section), such as a bad investment or financial decision. This failure to learn from our past investment decisions further adds to our overconfidence dilemma. In the area of gender bias, the work of Barber and Odean (2000) has produced very interesting findings. The study of differences in trading habits according to an investors gender covered 35,000 households over six years. The study found that men were more overconfident than women regarding their investing skills and that men trade more frequently. As a result, males not only sell their investments at the wrong time but also experience higher trading costs than their female counterparts. Females trade less (buy and hold their securities), at the same time sustaining lower transaction costs. The study found that men trade 45 percent more than women and, even more astounding, single men trade 67 percent more than single women. The trading costs reduced mens net returns by 2.5 percent per year compared with 1.72 percent for women. This difference in portfolio return over time could result in women having greater net wealth because of the power of compounding interest over a 10 to 20 year time horizon (known as the time value of money).
longer apply. This is usually the point in the economic cycle in which the stock market reaches its peak. The second action that displays cognitive dissonance is ignoring traditional forms of investing, and buying these Internet stocks simply based on price momentum. Purchasing stocks based on price momentum while ignoring basic economic principles of supply and demand is known in the behavioral finance arena as herd behavior. In essence, these Internet investors contributed to the financial speculative bubble that burst in March 2000 in Internet stocks, especially the retail sector, which has declined dramatically from the highs of 1999; many of these stocks have decreased up to 70% off their all time highs.
How Should Investors Take Into Account the Biases Inherent in the Rules of Thumb They Often Find Themselves Using and How Should They Develop Better Rules of Thumb?
As investors, we are obviously influenced by various behavioral and psychological factors. Individuals who invest in stocks and mutual funds should implement several safeguards that can help control mental errors and psychological roadblocks. A key approach to controlling these mental roadblocks is for all types of investors to implement a disciplined trading strategy. In the case of stock investments: the best way for investors to control their mental mistakes is to focus on a specific investment strategy over the long-term. Investors should keep detailed records outlining such matters as why a specific stock was purchased for their portfolio. Also, investors should decide upon specific criteria for making an investment decision to buy, sell, or hold. For example, an investor should create an investment checklist that discusses questions such as these: Why did an investor purchase the stock? What is their investment time horizon? What is the expected return from this investment one year from now? What if a year from now the stock has under-performed or over-performed your expectations? Do you plan on buying, selling, or holding your position? How risky is this stock within your overall portfolio? The purpose of developing and maintaining an investment record is that over time it will assist an investor in evaluating investment decisions. With this type of strategy, investors will have an easier time admitting their mental mistakes, and it will support them in controlling their emotional impulses. Ultimately, the way to avoid these mental mistakes is to trade less and implement a simple buy and hold strategy. A long-term buy and hold investment strategy usually outperforms a short-term trading strategy with high portfolio turnover. Year after year it has been documented that a passive investment strategy beats an active investment philosophy approximately 60 to 80 percent of the time. In the case of mutual fund investments: in terms of mutual funds, its recommended that investors apply
a similar checklist for individual stocks. Tomic and Ricciardi (2000) recommend that investors select mutual funds with a simple 4-step process which includes the following criteria: Invest in only no-load mutual funds with low operating expenses; Look for funds with a strong historical track record over 5 to 10 years; Invest with tenured portfolio managers with a strong investment philosophy; and Understand the specific risk associated with each mutual fund. Essentially, these are good starting point criteria for mutual fund investors. The key to successful investing is recognizing the type of investor you are along with implementing a solid investment strategy. Ultimately, for most investors, the best way to maximize their investment returns is to control their mental errors with a long-term mutual fund philosophy. In November 1999, there was a conference entitled Recent Advances in Behavioral Finance: A Critical Analysis(hosted by the Berkeley Program in Finance). The conference featured a debate on the validity of behavioral finance between advocates for the traditional finance and behavioral finance schools of thought. There was no clear winner in this contest; however, having such an event demonstrates the gradual acceptance of behavioral finance. Both schools seemed to agree that the best trading strategy is a long-term buy and hold investment in a passive stock mutual fund such as S&P 500 index. For example, Terrance Odean, a behavioral finance expert, says in a recent interview that he invests primarily in index funds. As a young man, Odean said, I traded too actively, traded too speculatively and clung to my losses. I violated all the advice I now give (Feldman, 1999, p. 174).
Closing Remarks
Over the last forty years, standard finance has been the dominant theory within the academic community. However, scholars and investment professionals have started to investigate an alternative theory of finance known as behavioral finance. Behavioral finance makes an attempt to explain and improve peoples awareness regarding the emotional factors and psychological processes of individuals and entities that invest in financial markets. Behavioral finance scholars and investment professionals are developing an appreciation for the interdisciplinary research that is the underlying foundation of this evolving discipline. We believe that the behaviors described in this
paper are exhibited within the stock market by many different types of individual investors, groups of investors, and entire organizations. This paper has discussed four themes within the arena of behavioral finance, which are overconfidence, cognitive dissonance, regret theory, and prospect theory. These four topics are an introductory representation of the many different themes that have started to occur over the last few years within the field (see checklist of behavioral finance topics after this section). The validity of all of these topics will be tested over time as the behavioral finance scholars eventually research and implement concepts, or as other practices start to fad or are rejected. This article has also discussed some trading approaches for investors in stocks and bonds to assist them in manifesting and controlling their psychological roadblocks. These rules of thumb are a starting point for investors that encourage them to keep an investment track record and checklist regarding each stock or mutual fund within their overall portfolio. Hopefully, these behavioral finance-driven structured guidelines for making investment choices will aid individuals by drawing attention to potential mental mistakes, hopefully leading to increased investment returns. In closing, we believe that the real debate between the two schools of finance should address which behavioral finance themes are relevant enough today to be taught in the classroom and published in new editions of finance textbooks. A concept such as prospect theory deserves mention by finance academics and practitioners, to offer students, faculty, and investment professionals an alternative viewpoint of finance.
Heuristics Manias Panics Disposition Effect Loss Aversion Prospect Theory Regret Theory Groupthink Theory Anomalies Market Inefficiency Behavioral Economics Overreaction Under-reaction Overconfidence Mental Accounting Irrational Behavior Economic Psychology Risk Perception Gender Bias Irrational Exuberance
cognitions (i.e., beliefs, viewpoints). When there is a discrepancy between feelings or behaviors (dissonance), something must transform to eliminate the dissonance. Correlation: a concept from probability (statistics). It is a measure of the degree to which two random variables track one another, such as stock prices (stock market) and interest rates (bond market). Crash: a steep and abrupt drop in security market prices. Efficient Frontier: the line on a risk-reward graph representing a set of all efficient portfolios that maximize expected return at each level of risk. Efficient Market Hypothesis (EMH): the theory that prices of securities fully reflect all available information and that all market participants receive and act on all relevant information as soon as it becomes available. Efficient Portfolio: a portfolio that provides the greatest expected return for a given level of risk. Expected return: the return expected on a risky asset based on a normal probability distribution for all the possible rates of return. Finance: a discipline concerned with determining value and making decisions. The finance function allocates capital, including acquiring, investing, and managing resources. Herding or Herd Behavior: herding transpires when a group of investors make investment decisions on a specific piece of information while ignoring other pertinent information such as news or financial reports. January Effect: the January effect is generally thought to be among the most frequent of the stock markets anomalies. Investors each January expect above average gains for the month, which are most likely caused by the result of a flood of new money (supply) from retirement contributions, combined with optimism for the New Year. Loss Aversion: The idea that investors assign more significance to losses than they assign to gains. Loss aversion occurs when investors are less inclined to sell stocks at a loss than they are to sell stocks that have gained in value (even if expected returns are the identical). Modern Portfolio Theory: An inclusive investment approach that assumes that all investors are risk averse and seeks to create an optimal portfolio in consideration of the relationship between risk and reward as measured by alpha, beta and R-squared. Overconfidence: The findings that people usually have too much confidence in the accuracy of their judgments; peoples judgments are usually not as correct as they think they are.
Panics: Sudden, widespread fear of an economic of market collapse, which usually leads to falling stock prices. Prospect Theory: can be defined as how investors assess and calculate the chance of a profit or loss in comparison to the perceptible risk of the specific stock or mutual fund. Psychology: is the scientific study of behavior and mental processes, along with how these processes are affected by a human beings physical, mental state, and external environment. Regret Theory: The theory of regret states that individuals evaluate their expected reactions to a future event or situation Sociology: is the systematic study of human social behavior and groups. This field focuses primarily on the influence of social relationships on peoples attitudes and behavior. Standard Deviation: within finance, this statistic is a very important variable for assessing the risk of stocks, bonds, and other types of financial securities. Time Value of Money: is the process of calculating the value of an asset in the past, present or future. It is based on the notion that the original principal will increase in value over time by interest. This means that a dollar invested today is going to be worth more tomorrow.
Acknowledgements
The authors would like to thank the following for their insightful comments and support: Robert Fulkerth, Steve Hawkey, Robert Olsen, Tom Powers, Hank Pruden, Hugh Schwartz, Igor Tomic, and Mike Troutman. An earlier version of this paper was presented by Victor Ricciardi at the Annual Colloquium on Research in Economic Psychology July 2000 in Vienna, Austria. The sponsors of this conference were the International Association for Research in Economic Psychology (IAREP) and The Society for the Advancement of Behavioral Economics (SABE) in affiliation with the University of Vienna.
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