Behavioural Finance

Behavioural Finance builds on the knowledge and skills that students have already gained on an introductory finance or corporate finance course. The primary focus of the book is on how behavioural approaches extend what students already know. At each stage the theory is developed by application to the FTSE 100 companies and their valuation and strategy. This approach helps the reader understand how behavioural models can be applied to everyday problems faced by practitioners at both a market and individual company level. The book develops simple formal expositions of existing attempts to model the impact of behavioural bias on investor/managers' decisions. Where possible this is done grounding the discussion in practical, numerical, examples from the financial press and business life.

Table of Contents:
Preface xv Acknowledgements xvii 1 Introduction 1 1.1 Illustration and Structure 2 1.2 Finance Theory as an Engine not a Camera 3 1.2.1 Rational Fools or Folly of Wisdom? 5 1.3 Rebuilding on New Foundations 7 1.3.1 Reasoned Emotion: The Case of Phineas Gage 8 1.3.2 What Can Psychologists Bring to Finance? 9 1.4 Challenging the Classical Assumptions of Finance 9 1.5 Modelling Behavioural Aspects of Finance 11 1.6 The Structure of the Book 12 Appendix: A Financial Tsunami 14 Notes 14 References 14 Part I Foundations 17 2 Financial Decision Making 19 2.1 Illustration and Structure 19 2.2 The Expected Utility Rule 20 2.2.1 An Illustration of Expected Utility 21 2.2.2 Attitudes to Risk 22 2.2.3 Diversification as Risk Reduction Strategy 23 2.2.4 How Best To Bear Risk 24 2.3 Expected Utility Theory: Simple But Untrue? 26 2.3.1 Paradoxes and Problems in Early Understanding of Expected Utility Theory 27 2.3.2 Gambling Insurance and Aspiration 29 2.4 Frames for Actions, Contingencies and Outcomes 31 2.4.1 The Decision Process 31 2.4.2 Inferring Big Ideas from Small Samples 32 2.4.3 Stars with Feet of Clay 33 2.4.4 Is There More to Life Than (Maximizing) Utility? 34 2.4.5 Happiness, Well-Being and the Emotional Basis of Utility 34 2.5 Conclusion and Summary 35 Questions 35 Notes 36 References 36 3 Discounting 39 3.1 Illustration and Structure 40 3.2 The Discounted Utility Model 40 3.2.1 Some Problems with the Discounted Utility Model 41 3.2.2 Evaluating Reallocations of Consumption by Equivalent Gains or Compensating Losses of Present Consumption 42 3.2.3 Delays and Speed-Ups of Utility 44 3.3 How and Why Discount Rates Vary 44 3.3.1 Discounting Single Outcomes Compared to Sequences of Outcomes 46 3.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’ 47 3.5 Hyperbolic Discount Factors 49 3.6 Valuation by Using the Matching Law 51 3.6.1 On Pigeons and Men: Comparing Hyperbolic and Exponential Discounting 53 3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54 3.7.1 A Simple Example of a Sub-Game Perfect Equilibrium 55 3.7.2 The Properties of a Sub-Game Perfect Investment Strategy Equilibrium 57 3.7.3 How Do Declining Discount Rates Affect Investment Behaviour? 58 3.8 Conclusion and Summary 59 Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal Choice 60 Questions 61 Notes 62 References 62 4 Learning 65 4.1 Illustration and Structure 65 4.2 Rational Learning 66 4.2.1 Bayes’ Rule 66 4.2.2 Elements of Bayesian Revision 68 4.2.3 The Value of Stock Recommendations 70 4.3 Do We Learn the Bayesian Way? 72 4.3.1 Representativeness 74 4.3.2 Representation Bias in the Market: Analysts’ Overreaction to Earnings 74 4.3.3 A Once and For All Lesson? 75 4.4 Over Inference and the Law of Small Numbers 76 4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77 4.6 Conclusion and Summary 79 Appendix: Case Study – Baseball the Bayesian Way 80 Questions 87 Notes 88 References 88 5 Bubbles 89 5.1 Illustration and Structure 90 5.2 Tulipmania and the Didactic Value of Bubbles 91 5.3 The Regulatory Origins of the Most Recent Bubble 92 5.3.1 Long-Term Capital Management 92 5.3.2 The Federal Reserve and Market Restraint 95 5.4 Bubbles: Past, Present and Future 101 5.4.1 Financial Bubbles and Infrastructure Technology 102 5.4.2 Are Bubbles Just Part of the Market Process? 103 5.5 The 1929 Stock-Market Crash 104 5.5.1 Early Signs 104 5.5.2 The Boom is On 105 5.5.3 Innovation and Speculation 106 5.5.4 Investment Trusts in the Boom’s Growth 106 5.5.5 The Final Implosion 107 5.6 Should Government Burst the Bubble? 108 5.7 Conclusion and Summary 109 Appendix: Tulips as Assets and Art 110 Questions 114 Notes 114 References 114 Part II Asset Pricing 117 6 Noise Traders 119 6.1 Illustration and Structure 120 6.2 The De Long, Shleifer, Summers and Waldmann Model 121 6.2.1 The Basic Set Up 122 6.2.2 Modelling Mispricing 122 6.2.3 What Investors Want 123 6.2.4 Choosing Optimal Asset Allocations Across the Safe and Risky Asset 124 6.2.5 The Pricing Equation 125 6.2.6 Will Noise Traders Die Out? 128 6.2.7 Decomposing Noise Traders’ Profits 130 6.3 Can Investors Get Emotional? 133 6.3.1 Feeling the Risk 134 6.3.2 The Affect Heuristic 135 6.3.3 Panic and Feedback Trading During the 1987 Stock-Market Crash 136 6.3.4 The Diminishing Roar of Noise 137 6.4 Conclusion and Summary 138 Questions 138 Notes 139 References 139 7 Overconfidence and Optimism 141 7.1 Illustration and Structure 142 7.2 A Model of Trading Amongst Optimistic Investors 142 7.2.1 The Model 143 7.2.2 Price Setting 143 7.2.3 Conditions for Overconfident Pricing of the Risky Asset 144 7.2.4 Pricing in Odean’s Model 147 7.2.5 The Implications of Odean’s Model for Financial Markets 150 7.3 Do Investors Trade Too Much? 150 7.3.1 Optimism in Corporate Finance 151 7.3.2 Facing Failure 151 7.3.3 Who Dares Loses? 153 7.3.4 The Hubris Theory of Takeovers 153 7.4 Conclusion and Summary 154 Appendix A: Hubris at Work: The AOL–Time Warner Merger 155 Appendix B: Derivation of Results in Odean’s Model 161 Questions 163 Notes 163 References 163 8 Asset Pricing under Prospect Theory 165 8.1 Illustration and Structure 165 8.2 The Basics of Prospect Theory 166 8.2.1 Prospect Theory’s Application to Finance 167 8.2.2 Benchmarks, Gains and Losses and the Dynamics of Utility under Prospect Theory 168 8.2.3 Integration or Segregation of Losses and Gains in the Presence of Loss Aversion 169 8.2.4 The Evolution of Investor Benchmarks 170 8.2.5 Price Formation in a Market Populated By Investors With Prospect Theory Utility Functions 171 8.2.6 Pricing in the Standard Inter-Temporal Consumption-Based Asset-Pricing Model or Economy I 171 8.3 Does Prospect Theory Work? 172 8.3.1 Can Prospect Theory Explain the Internet Bubble? 172 8.3.2 Can Prospect Theory Explain IPO Underpricing? 174 8.3.3 Prospect Theory Here, There and Everywhere 176 8.4 The Cumulative Probability Version of Prospect Theory 176 8.5 Does Cumulative Prospect Theory Work? 177 8.5.1 Cumulative Prospect Theory and Asset Pricing 179 8.6 Conclusion and Summary 181 Appendix: CARA Utility 181 Questions 182 Note 182 References 183 9 Overreaction and/or Underreaction 185 9.1 Illustration and Structure 185 9.2 The DHS Model 186 9.2.1 Reversals of Fortune 188 9.2.2 Pricing When Confidence Levels Depend on the Relation Between the Public and Private Signals 189 9.2.3 Investor Extrapolation and Reversals of Fortune 192 9.2.4 Many Theories in Search of a Decisive Verification 192 9.2.5 Momentum and Underreaction: Two Stock-Market Anomalies or One? 194 9.3 No News Is . . .? 194 9.3.1 The Jackson and Johnson (JJ) Model’s Message 195 9.3.2 How the JJ Model Works 196 9.3.3 Stock-Market Responses to News and No News 199 9.4 Conclusion and Summary 199 Questions 199 Note 199 References 200 10 Momentum 201 10.1 Illustration and Structure 201 10.2 Grinblatt and Han’s (2005) Model 203 10.2.1 Modelling Asset Demand in the GH Model 204 10.2.2 Investor Returns and the Evolution of the Reference Point 207 10.3 What Drives Stock-Market Momentum? 208 10.3.1 Evidence of PEAD 209 10.4 What Causes PEAD? 212 10.4.1 Is PEAD Due to Changes in Risk? 212 10.4.2 Are Prices Following Themselves or Following Earnings? 213 10.4.3 Is PEAD in the Market or in the Eye of the Researcher? 215 10.4.4 Show Me the Money 216 10.5 Conclusion and Summary 217 Questions 217 Note 218 References 218 11 Herding 221 11.1 Illustration and Structure 221 11.2 The FSS Model 222 11.2.1 The Basic Set Up 222 11.2.2 The Price-Setting Mechanism Used by Market-Makers 223 11.2.3 Informed Speculators’ Demands 224 11.3 Conformity as a Force for Social Good and Evil 228 11.3.1 Evidence on Herding and its Effect 229 11.3.2 Herding in Investment Advice 230 11.3.3 Words which Cannot be Spoken 230 11.3.4 Private Truths and Public Lies 231 11.3.5 The Herd in History 233 11.4 Conclusion and Summary 233 Appendix: The United States vs. Microsoft 234 Questions 236 Note 237 References 237 12 Insider Trading 239 12.1 Illustration and Structure 240 12.2 Insider Trading Here for Better or Worse 241 12.2.1 The Distributional Impact of Insider Trading 242 12.2.2 When does Trading become Insider Trading? 243 12.2.3 Insiders on Trial: Proof of Guilt or Innocence? 244 12.3 The Hirshleifer, Subrahmanyam and Titman Model 245 12.3.1 Asset Demands and the Determination of Investor’s Terminal Wealth in the HST Model 246 12.3.2 Pricing in Equilibrium 250 12.3.3 Trading Behaviour in Equilibrium 251 12.4 Insider Trading, Stock Options and the Construction of Earnings 255 12.4.1 Psychological Factors Determining the Exercise of Stock Options 256 12.5 Insider Trading and its Consequence for Outsiders 257 12.6 Conclusion and Summary 258 Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model? 258 Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262 Questions 265 Notes 265 References 266 13 Equity Premium Puzzle 269 13.1 Illustration and Structure 269 13.2 The Puzzle 270 13.2.1 The Mehra and Prescott Statement of the Equity Premium Puzzle 271 13.2.2 Explaining the Risk Premium by Myopic Loss Aversion 272 13.2.3 Can Loss Aversion Explain the Puzzle? 274 13.3 Loss Aversion in a Reference-Dependent Utility Model 276 13.3.1 A Reference-Dependent Model of Investor Choice 277 13.3.2 Loss Aversion in a Reference-Dependent Model of Choice 277 13.3.3 Diminishing Sensitivity to Losses and Gains 278 13.3.4 Constant Risk Aversion and the Benartzi and Thaler (1995) Model 279 13.3.5 Is Loss Aversion Irrational? 280 13.4 Conclusion and Summary 280 Questions 281 References 281 Part III Corporate Finance 283 14 Incorporation 285 14.1 Illustration and Structure 285 14.2 Companies: Where did They Come from and Where will They Go? 286 14.2.1 Limited Liability: its Value and its Role in the Emergence of the Corporate Form 288 14.2.2 The Economic Rationale for Granting Limited Liability 288 14.3 Agency, Monitoring and Incorporation 289 14.3.1 Are Managers Agents or Team Members? 291 14.3.2 Psychological Barriers to Arm’s Length Contracting 294 14.3.3 Group Psychology on the Board, Building Consensus and its Dissimulation 294 14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 296 14.4.1 Clearing Out the ‘Inside View’ 297 14.4.2 Come On Down: the Satisfaction of Recognition 298 14.4.3 Facing Glory and Defeat: Managers’ Resistance to Recognizing Failure 298 14.4.4 Governance in the Long and Short Run 299 14.5 Conclusion and Summary 300 Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a Corporation 300 Questions 313 Notes 313 References 314 15 The Market for Information, Noise and Deception 317 15.1 Illustration and Structure 318 15.2 The Boundaries of the Market for Corporate Information 318 15.2.1 The Conduct of the Market for Corporate Information 319 15.3 What Do Analysts Do? 321 15.3.1 The Ivkovic and Jegadeesh (IJ) Model 322 15.4 Valuing Investment Advice 325 15.4.1 The Market for Corporate Information 326 15.4.2 What Type of Valuation Models do Analysts Use? 328 15.4.3 The Fragility of Valuation Models 330 15.4.4 A Dynamic Model of the Market for Financial Information 332 15.4.5 From Inside and Out: Isolation Bias and Risk Taking 333 15.5 Conclusion and Summary 333 Questions 334 Notes 334 References 334 16 Dividends 337 16.1 Illustration and Structure 337 16.2 The Irrelevance of Dividends to Value 338 16.2.1 The Puzzle of Dividend Policy 339 16.3 A Prospect Theory Explanation of Dividend Payments 340 16.3.1 Coding of Prospects: Combination, Segregation 341 16.3.2 Shop Until You Should Stop 341 16.3.3 Calculating the Dividend Yield Premium/Discount 342 16.4 Who Pays Dividends and Why? 346 16.4.1 Are Dividends Signals of Future Earnings Prospects? 346 16.4.2 Dividend Omissions, Initiations and Drift 347 16.4.3 What Reasons do Managers Give for Paying Dividends? 348 16.4.4 Does Pay-out Policy Matter? 349 16.5 Conclusion and Summary 350 Questions 350 Note 351 References 351 17 Entrepreneurship 353 17.1 Illustration and Structure 354 17.1.1 The Problem of Self-Control 354 17.2 The BT Model 355 17.2.1 The Demand for Self-Confidence in the BT Model 355 17.2.2 Always Wrong but Never in Doubt 359 17.2.3 The Supply of Self-Confidence in the BT Model 359 17.2.4 Numerical Illustration of the BT Model 361 17.3 Is Deluding Yourself Worth it? 362 17.3.1 Optimism, Self-Control and Society 363 17.3.2 The Social Benefits of the Maverick Entrepreneur 363 17.4 Conclusion and Summary 364 Appendix: Entrepreneurs and the BT Model – Some Case Studies 364 Questions 370 Notes 370 References 371 Part IV The Professions 373 18 Analysts’ Conflicts of Interest 375 18.1 Illustration and Structure 376 18.2 Evidence of Conflicts of Interest from Empirical Studies 377 18.2.1 No Conflict, No Interest 378 18.2.2 Is Disclosure of a Conflict of Interest Sufficient Protection for Investors? 379 18.2.3 Conflicts in the Laboratory 379 18.3 Regulating Conflicts of Interest 380 18.3.1 UK Policy on Conflicts of Interest 380 18.3.2 EU Policy on Conflicts of Interest 382 18.3.3 US Policy on Conflicts of Interest 383 18.3.4 The Common Law of Conflicts of Interest 383 18.3.5 The Dura Pharmaceuticals Case 384 18.3.6 Market Efficiency, Conflicts of Interest and the Courts 385 18.4 Conclusion and Summary 385 Questions 386 Notes 386 References 386 19 Accounting Reform 389 19.1 Illustration and Structure 389 19.2 The Onward March of ‘Fair-Value’ Accounting 390 19.2.1 Historic Cost versus Fair Value 390 19.2.2 A Return to Fundamental Valuation 392 19.3 An Accounting-Based Valuation Model 392 19.3.1 Are All Reported Earnings Additions to Shareholder Value? 394 19.3.2 The Dynamics of Abnormal Earnings Valuation 395 19.3.3 Some Examples of the Ohlson Model in Action 396 19.3.4 Implications for Price 398 19.3.5 Implications for Returns 400 19.3.6 Does the Ohlson Model Work? 400 19.3.7 Earnings Persistence in the Ohlson Model 403 19.3.8 Other Information in the Ohlson Model 403 19.4 Behavioural Bias in Estimates of the Ohlson Model 404 19.4.1 Inferring Value from Accounting Data: Fair Values versus Historic Costs 405 19.4.2 The Three Levels of Fair Value 406 19.4.3 Some Implicit Trade-Offs in Fair-Value Accounting 406 19.5 Conclusion and Summary 407 Appendix A: Mark-to-Market Accounting at Enron – A Case Study 407 Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting Information only (Equation (19.7)) 423 Questions 425 Notes 425 References 426 20 Conclusion 427 Index 431

About the Author :
William Forbes is Professor of Accounting and Finance in the Business School at Loughborough University, UK.  He has previously held positions at University of Glasgow, University of Manchester, University College of North Wales in Bangor and the University of Exeter.