Behavioral Finance,Introduction,“Only two things are infinite, the universe and human stupidity, and Im not sure about the former.“ Albert Einstein,What is behavioral finance,Behavioral finance (BF) is the study of how psychology affects finance. BF argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. BF acknowledges that investors are not perfectly rational BF allows for psychological factors of behavior BF argues that behavioral biases affect prices established in the market,The first theme of BF,Traditional finance (TF) seeks to understand financial markets using models in which agents are “rational”. First, when agents receive new information, they update their beliefs correctly, in the manner described by Bayes law. Second, given their beliefs, agents make choices that are normatively acceptable, in the sense that they are consistent with Savages notion of Subjective Expected Utility (SEU).,The first theme of BF,Are financial investors really rational? Do investors commit errors? BF answers YES, TF answers NO Why do we make mistakes? Incapability of processing unlimited information Relying on rule of thumb called “heuristics” Back-of-the-envelope calculation is imperfect,The first theme of BF,Investors commit heuristic-driven biases e.g., representativeness bias, anchoring effect, loss-aversion bias, etc. Investors commit frame-dependence baises Investor decision-make is influenced by how problems are framed (presented). “If you transfer a dollar from your right pocket to your left pocket, you are not wealthier. Franco and I proved that rigorously.” Merton Miller TF assumes frame independence,The second theme of BF,Do behavioral biases systematically affect financial markets? TR argues that errors presented unsystematically will be cancelled-out in the market. BF disagrees Do we all commit to same errors and simultaneously? Do we all buy winners and sell losers? Are average investors stupid? Are marginal investors whose actions affect the market stupid? What if Im smart, though you are stupid?,The second theme of BF,Case study: in April 1997, Financial Times ran a contest Readers chose a whole number between 0 and 100. The winning entry would be the one closest to two-thirds of the average entry. Suppose five people enter the contest and they choose 10,20,30,40 and 50. In this case, the average is 30, two-thirds of which is 20. The person who chose to enter 20 would be the winner. What is the winning number?,The second theme of BF,You are playing to win, you need to understand how the other players are thinking. If everyone is smart and bias-free, the winning entry is 1. In reality, the winning choice is _. If you are smart, but the others are not, you are not the winner. What is the point of this pick-a-number game? People commit errors in the course of making decisions These errors cause asset prices to be different from what they would have been in an error-free environment.,The third theme of BF,Are markets efficient? TR says yes. All information is incorporated into prices in an unbiased and immediate fashion. Any mispricing due to behavioral biases provides profitable opportunities for smart people (arbitrageurs) and will be corrected by the market force. Is it true? BF says no - limit of arbitrage is substantial enough to prevent risk-free arbitrage Smart money is vulnerable to risks stemming from the errors and emotions of other traders.,The third theme of BF,Case study: Long Term Capital Management (LTCM) A hedge fund headed by fixed-income arbitrage pioneer John Meriwether, Nobel laureates Myron Scholes and Robert Merton Building on the foundation of efficient market theory, LTCM believes the existence of mispricing, which can be quickly exploited by smart money. LTCM held more than $7 billion of capital at year-end 1997, shrinking to $4 billion in 1998. The FRB of NY was forced to implement a rescue plan.,The third theme of BF,LTCM had taken large positions in two companies, Royal Dutch Petroleum (RD) and Shell Transport and Trading (ST), that jointly owned the entity Royal Dutch/Shell A corporate charter linking these two companies divides the joint cash flow of Royal Dutch/Shell between them on a 60/40 basis. In theory, the market value of RD should be 1.5 times as large as that of ST(only in a error-free environment). The shares of ST have traditionally traded at an 18% discount relative to RD.,The third theme of BF,When the discount widened beyond 18%, LTCM did a “pairs” trade, taking a long position in ST and a short position in RD. LTCM would make a profit if the discount reverted to its traditional value. But LTCM encountered the same fate as someone who chose a 1 in the pick-a-number game. The discount widened rather than narrowed.,The key message of BF,BF is not about how to beat the market Although behavioral errors do create abnormal profit opportunities for the smart money, these errors also introduce an additional source of risk, above and beyond fundamental risk. Caution on “use BF to make a killing” The collapse of LTCM The biggest surprise to LTCM did not come from unanticipated fundamental risk, but from unanticipated sentiment-based risk!,