What drives investor behavior - INVESTOR PSYCHOLOGY

What drives investor behavior?
We would all like to think we always behaverationally while at the same time assuming that others often do not. But as investment manager Arnold Wood of Martingale Asset Management says, “if you sit down at a poker table and can’t spot the sucker who will be taken that night, get up—it’s you.”
Most financial theory is based on the idea that everyone takes careful account of all available information before making investment decisions. But there is much evidence that this is not the case. Behavioral finance, a study of the markets that draws on psychology, is throwing more light on why people buy or sell the stocks they do—and even why they do not buy stocks at all. This research on investor behavior helps to explain the various market anomalies that challenge standard theory. It is emerging from the academic world and beginning to be used in money management.
An article by Yale finance professor Robert Shiller that is available on his website surveys some of the key ideas in behavioral finance, including:
• Prospect theory
• Regret theory
• Anchoring
• Over- and underreaction
Prospect theory suggests that people respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain. Typically, they become considerably more distressed at the prospect of losses than they are made happy by equivalent gains. This loss aversion means that people are willing to take more risks to avoid losses than to realize gains: Even faced with sure gain, most investors are risk-averse; but faced with sure loss, they become risk takers. According to the related endowment effect, people set a higher price on something they own than they would be prepared to pay to acquire it.
Regret theory is about people’s emotional reaction to having made an error of judgment, whether buying a stock that has gone down or not buying one they considered and that has subsequently gone up. Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a bad investment and the embarrassment of reporting the loss. They may also find it easier to follow the crowd and buy a popular stock: If it subsequently goes down, it can be rationalized as everyone else owned it. Going against conventional wisdom is harder since it raises the possibility of feeling regret if decisions prove incorrect (see “Contrarian Investing”).
Anchoring is a phenomenon in which, in the absence of better information, investors assume current prices are about right. In a bull market, for example, each new high is anchored by its closeness to the last record, and more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with longrun averages and probabilities.
The consequence of investors putting too much weight on recent news at the expense of other data is market over- or underreaction. People show overconfidence. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. And in certain circumstances, this can lead to extreme events Two psychological theories underpin these views of investor behavior. The
first is what Daniel Kahneman and the late Amos Tversky (coauthors of prospect
theory) call the representativeness heuristic—where people tend to see patterns in
random sequences, for example, in financial data. The second, conservatism, is
where people chase what they see as a trend but remain slow to change their
opinions in the face of new evidence that runs counter to their current view of
the world.
The ideas of behavioral finance apply as much to financial analysts as they do to individual investors. For example, research indicates that professional an-
alysts are remarkably bad at forecasting the earnings growth of individual com-
panies. Indeed, it seems that forecasts for a particular company can be made more accurately by ignoring analysts’ forecasts and forecasting earnings growth at the same rate as the average company. The underlying reasons for the abject failure of the professionals are classic behavioral finance: They like to stay close to the crowd, and their forecasts tend to extrapolate from recent past performance, which is very often a poor guide to the future There is evidence that institutional investors behave differently from individuals, in part because they are agents acting on behalf of the ultimate investors. Compensation devices like profit-splitting schemes seek to align the interests of principals with their agents—portfolio managers and other advisers—but still differences persist. For example, agents may be reluctant to take risks—even when probabilities strongly suggest they should for their clients’ interests—when the risks are small but real that they might be fired.
Similarly, agents tend to favor well-known and popular companies because they are less likely to be fired if they underperform. Stock analysts as a group en-
gage in herd behavior in part because they are constantly evaluated against their peers (see “Performance Measurement”), though research does suggest that when forecasting earnings, young analysts try to fit in with the crowd, even if the crowd is wrong, more than older ones. This is probably because a few notable failures can destroy reputations. When analysts are older and more established, it is possible that they face less risk in pursuing an independent line of thought.
Santa Clara finance professor Meir Statman makes the case for behavioral finance when he writes:
Standard finance is so weighted down with anomalies that it makes much sense to continue the reconstruction of financial theory on behavioral lines. Proponents of standard finance often concede that their financial theory does poorly as a descriptive or positive theory of the behavior of individu-
als. They retreat to a second line of defense: that standard finance does well as a descriptive theory of the equilibrium that results from the interaction of individuals in the markets. But even the second line of defense does not hold. Evidence is mounting that even the capital asset pricing model (CAPM), the market equilibrium theory by which risk and expected returns are determined in standard finance, is not a good description of reality.
Investor Psychology Gurus: Richard Thaler and Robert Vishny
Considering the widespread popular acceptance of the ideas emanating from behavioral finance, it is unusual to observe the relatively small amount of academic research, though what has been done is of good quality. Experts in the field besides Kahneman, Tversky, Shiller, and Statman include Richard Thaler and Robert Vishny. Practitioners include David Dreman, who describes his investment strategies as being “totally based on behavioral finance,” Bill Miller at Legg, Mason , and Russell Fuller.
Behavioral finance still remains at the fringes of portfolio management
and modern financial theory, perhaps because there is still no behavioral equiv-
alent of the CAPM, a technique developed in academia but widely used in prac-
tice. Yet many believe that the human flaws pointed out by the analysis of
investor psychology are consistent and predictable, and that they offer invest-
ment opportunities. In his satirical novel A Tenured Professor, John Kenneth Gal-
braith describes a Harvard academic who pursues just such a scheme, developing
a technique called the “index of irrational expectations” based on the idea that
investors have a tendency to get carried away by optimism. Can such a concept
work in reality?
In a sense, Chicago finance professor Robert Vishny believes so. His firm
LSV Asset Management, which he set up with fellow scholars Josef Lakonishok
and Andre Shleifer, aims to exploit behavioral inconsistencies through the value
investing approach of buying losers and selling winners (see “Value Investing”).
Vishny believes that market anomalies and investor behavior are uniform around
the world—in both developed and emerging countries—and that value is a be-
havioral phenomenon of underreaction. What happens is that investors under-
price out-of-favor stocks while at the same time being irrationally overconfident
about exciting growth companies. Not only do they like to follow the crowd, but
they also get pleasure and pride from owning growth stocks (see “Growth In-
vesting”).
Vishny believes that investors can also exploit underreaction in momentum investing. For example, his research suggests that stocks with high past six- or twelve-month returns tend to have high future six- to twelve-month returns, perhaps because of an underreaction to information such as dividend changes or stock splits. Conservatism suggests that in response to objective information, people usually recognize it but move slowly.
Richard Thaler, professor of behavioral science and economics at the Uni-
versity of Chicago’s business school and a pioneer of research on quasi-rational
economics, is another scholar trying to apply his ideas in investment practice. In
1998, he cofounded with Russell Fuller, Fuller and Thaler Asset Management,
a firm offering a broad line of behavioral-based investment strategies to pension
funds and other institutions. Thaler describes his firm’s investment approach
thus:
We capitalize on systematic mental mistakes that are caused by behavioral biases. These mental mistakes by investors result in the market developing biased expectations of future profitability and earnings of companies which, in turn, cause the securities of these companies to be mispriced. Because human behavior changes slowly, past market inefficiencies due to behavioral biases are likely to persist.

Counterpoint
The primary critics of behavioral finance and its use of psychology for investment management are the progenitors of the efficient market hypothesis (EMH). For example, Chicago finance professor Eugene Fama, one of our gurus for “Market Efficiency,” argues that:
... the empirical evidence is weak, they don’t have a coherent theory and without that, there is no behavioral finance. Until you find something that can replace the theory of efficient markets with a systematic alternative theory, you don’t have anything.
Peter Bernstein who devotes two chapters of his best-selling book (1996) on risk to the gurus of behavioral finance—whom he calls the theory police—is less dismissive though still critical:
While it is important to understand that the market doesn’t work the way
classical models think—there is a lot of evidence of herding, the behavioral
finance concept of investors irrationally following the same course of ac-
tion—but I don’t know what you can do with that information to manage
money. I remain unconvinced anyone is consistently making money out
of it.
MIT finance professor Andrew Lo concurs:
... taking advantage of individual irrationality cannot be a recipe for longterm success.
Certainly, it is true that there is no behavioral equivalent of the CAPM, and while markets obviously do not work as the strong versions of the EMH suggest, it can be difficult to see how a behavioral approach can be used to manage money. Perhaps behavioral finance is more of an attitude than an investment sys-
tem: a helpful check at potential turning points but not an everyday guide.
Guru Response
Richard Thaler comments:
Regarding the absence of a behavioral CAPM, I think the two camps are
equally at a loss. We know from the work of Fama and his colleague Ken-
neth French that the rational CAPM is false, so neither side has a complete
theory. Several recent papers have tried to develop behaviorally based theo-
ries of asset pricing and while they are not the final word, they are better
than nothing.
As to whether one can make money using investor irrationality, I
would ask a similar question: What else can you do? The only investment
strategy consistent with rational efficient markets is indexing, and we know
that if everyone indexes, the markets are no longer efficient. To me, any ac-
tive management strategy that has a chance of being successful must rely ei-
ther on better information or on an understanding of why other investors
are producing mispriced securities. The one strategy that everyone seems to
agree has worked well for a very long period of time is value—buying low
price-to-earnings (P/E) or price-to-book (P/B) stocks. As Fama and French
have shown, this strategy does well all around the world. I view this as a clas-
sic behavioral strategy first advocated by Benjamin Graham in the 1930s.
Time will tell as to whether other behaviorally motivated strategies yield su-
perior long-term returns.

Thaler goes on to explain the practical application of his ideas:

Behavioral biases that affect security pricing can be divided into two classes: noneconomic behavior, for example, when agents do not maximize the ex-

pected value of their portfolio because they are maximizing other behavioral
factors; and heuristic biases. Heuristics are mental shortcuts or rules of
thumb that people use to solve complex problems. But in some instances,
reliance on heuristics can result in biased or mistaken judgments. Such bi-
ases can cause investors to make systematic mental mistakes in evaluating
new information and forming expectations about the future prospects
of firms.
By focusing on behavioral factors that cause the market’s expectations to be biased, we have successfully identified mispriced securities and generated above normal returns for our clients. We have developed strategies for exploiting the heuristic biases that cause over- and underreaction to information. Because the heuristics are different, these strategies identify different types of stocks and, as a result, different portfolio characteristics. But both strategies tend to focus on small to mid-cap size companies.
For example, our growth portfolios capitalize on anchoring bias that, under certain circumstances, causes investors to underreact to new, positive information. As a result, the market’s expectations are biased concerning the future profitability of these companies and their stocks tend to be under-
priced. This strategy typically selects stocks that have growth characteristics. For example, these stocks generally have above average betas, P/E ratios, and P/B ratios. Portfolio turnover for this strategy tends to be higher than average.
Our value portfolios capitalize on heuristic biases associated with representativeness and saliency. Reliance on these heuristics causes investors to overreact to bad, but temporary, information concerning the profitability of companies. In such cases, the market naively extrapolates the recent temporary negative news concerning a company, resulting in biased expectations of the company’s future prospects, and these stocks tend to be underpriced. This strategy typically selects stocks with value characteristics. For example, these stocks generally have below average betas, P/E ratios, and P/B ratios. Portfolio turnover for this strategy tends to be below average.

Where Next?
The analysis of investor psychology is having a growing impact on both invest-
ment research and practice as it seeks to expose and explain the shortcomings of modern financial theory: problems in the models used to price stocks and the difficulties of making sense of market anomalies like calendar effects. It is an im-
portant dimension of investment and almost all investors consciously or uncon-
sciously take it into account though they call it different things. George Soros’s
concept of reflexivity (see “Hedge Funds”), momentum investing, and agency theory all point to the ultimate insufficiency of traditional tools of analysis in economics and investment.
The new directions of behavioral finance are being pushed toward biological metaphors by researchers like Andrew Lo, our guru for “Financial Engineering.” If purely mechanical number computation fails to give us useful models, perhaps the complex biological functions will. Early evidence is strongly suggestive of success.