Beyond Greed and Fear
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Beyond Greed and Fear
Understanding Behavioral Finance and the Psychology of Investing
Hersh Shefrin
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First published in 2000 by President and Fellows of Harvard College
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Library of Congress Cataloging-in-Publication Data
Shefrin, Hersh, 1948—
Beyond greed and fear: understanding behavioral finance and the psychology of investing /
Hersh Shefrin
p. cm.—(Financial Management Association survey and synthesis series)
Originally published: Boston: Harvard Business School Press © 2000.
ISBN 0-19-516121-1
1. Investments—Psychological aspects. 2. Stock exchanges—Psychological aspects.
3. Finance—Psychological aspects. I. Title. II. Series.
[HG4515.15. S53 2002]]
332.6′01′9—dc21 2002010047
For Arna
Contents
Preface
PART I What Is Behavioral Finance?
Chapter 1 Introduction
Chapter 2 Heuristic-Driven Bias: The First Theme
Chapter 3 Frame Dependence: The Second Theme
Chapter 4 Inefficient Markets: The Third Theme
PART II Prediction
Chapter 5 Trying to Predict the Market
Chapter 6 Sentimental Journey: The Illusion of Validity
Chapter 7 Picking Stocks to Beat the Market
Chapter 8 Biased Reactions to Earnings Announcements
PART III Individual Investors
Chapter 9 “Get-Evenitis”: Riding Losers Too Long
Chapter 10 Portfolios, Pyramids, Emotions, and Biases
Chapter 11 Retirement Saving: Myopia and Self-Control
PART IV Institutional Investors
Chapter 12 Open-Ended Mutual Funds: Misframing, “Hot Hands,” and Obfuscation Games
Chapter 13 Closed-End Funds: What Drives Discounts?
Chapter 14 Fixed Income Securities: The Full Measure of Behavioral Phenomena
Chapter 15 The Money Management Industry: Framing Effects, Style “Diversification,” and Regret
PART V The Interface between Corporate Finance and Investment
Chapter 16 Corporate Takeovers and the Winner’s Curse
Chapter 17 IPOs: Initial Underpricing, Long-term Underperformance, and “Hot-Issue” Markets
Chapter 18 Optimism in Analysts’ Earnings Predictions and Stock Recommendations
PART VI Options, Futures, and Foreign Exchange
Chapter 19 Options: How They’re Used, How They’re Priced, and How They Reflect Sentiment
Chapter 20 Commodity Futures: Orange Juice and Sentiment
Chapter 21 Excessive Speculation in Foreign Exchange Markets
Final Remarks
Notes
References
Credits
Index
Preface to the Oxford Edition
Behavioral finance is the study of how psychology affects finance. Psychology is the basis for human desires, goals, and motivations, and it is also the basis for a wide variety of human errors that stem from perceptual illusions, overconfidence, over-reliance on rules of thumb, and emotions. Errors and bias cut across the entire financial landscape, affecting individual investors, institutional investors, analysts, strategists, brokers, portfolio managers, options traders, currency traders, futures traders, plan sponsors, financial executives, and financial commentators in the media. This book is about recognizing the influence of psychology on oneself, on others, and on the financial environment at large.
I take some pride in the fact that Beyond Greed and Fear was the first comprehensive treatment of behavioral finance. However, the greatest satisfaction comes from witnessing the enormous growth that has occurred in the field since the book was first published in 1999.
As a field, behavioral finance is flourishing, not only in academia where financial issues are studied, but also in practice where behavioral concepts are coming to be routinely applied. One only need do a web-based search on “behavioral finance” to see how the field has virtually exploded.
Behavioral finance is now represented in almost every leading academic department of finance in the United States. Some universities, such as the University of Mannheim in Germany, have established institutes dedicated to the subject. The Social Science Research Network has a separate newsgroup devoted to behavioral and experimental finance. Behavioral papers are now routinely presented at every major academic finance meeting. Articles devoted to behavioral topics are winning Best Paper awards. Two notable instances are the Smith Breeden Prize and the William F. Sharpe Award. The Smith Breeden Prize was awarded to Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam for the best paper published in the Journal of Finance during 1999. They wro
te “Investor Psychology and Security Market Under and Overreactions.” The William F. Sharpe Award for Scholarship in Financial Research was awarded to Meir Statman and me for “Behavioral Portfolio Theory,” which appeared in the Journal of Financial and Quantitative Analysis in 2000.
The Review of Financial Studies and the Financial Analysts Journal have devoted entire issues to behavioral finance, and the Journal of Empirical Finance is planning a future issue, again dedicated to behavioral finance. The International Library of Critical Writings in Financial Economics is a compendium of edited collections in the various areas of finance. As a testament to its growing importance, a three-volume set on behavioral finance, which I was privileged to edit, appears in this collection, alongside more traditional areas such as corporate finance, futures markets, market efficiency, debt markets, options markets, and market microstructure.
Behavioral perspectives are routinely reported in major newspapers such as the Wall Street Journal. In January 2002, the New York Times profiled the work of Richard Thaler, one of behavioral finance’s leading figures. In June 2001, the Financial Times devoted an entire section to behavioral finance. In 2002, public television’s The Nightly Business Report devoted a whole program to behavioral finance. Well-known value manager and Forbes columnist David Dreman has organized the Institute of Psychology and Markets, along with a new journal, the Journal of Psychology and Financial Markets.
Many new papers and books are being written on behavioral topics. Shortly after Beyond Greed and Fear was published, two related behavioral books appeared, both by leading behaviorists. Irrational Exuberance by Robert Shiller is a highly acclaimed work, describing the psychological factors that produced a stock market bubble during the 1990s. Inefficient Markets by Andrei Shleifer contains a formal exposition of investor sentiment and its impact on security pricing.
Financial firms are increasingly applying behavioral concepts. At the forefront in basing their strategies explicitly on behavioral finance are Fuller & Thaler Asset Management, Dreman Value Management, Martingale Asset Management, and LSV Asset Management. In recent years the list of financial services firms that incorporate behavioral finance has grown to include American Skandia, Goldman Sachs, Merrill Lynch, Nuveen, Panagora, Putnam, Alliance Capital unit Sanford Bernstein, and Vanguard. A new mutual fund firm, Marketocracy, explicitly built its strategy on the concepts described in chapter 8. The use of behavioral concepts is not only confined to the United States; European financial institutions KBC Bank, ABN Ambro, J. P. Morgan Fleming Asset Management, and Robeco all run funds employing behavioral strategies.
Behavioral Finance: Key Message
People are imperfect processors of information and are frequently subject to bias, error, and perceptual illusions. The general lesson from Beyond Greed and Fear is that psychology permeates the entire financial landscape. Since this book was first published, I have learned that many people continue to misconstrue the main message of behavioral finance. Many think that the main lesson from behavioral finance is about how to beat the market. This is a dangerous misconception.
On page 89 I specifically caution investors not to “use behavioral finance to make a killing.” In chapter 1 and in my Final Remarks, I indicate that 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. Many investors only hear half the message about behavioral finance—the part about abnormal profit opportunities. They miss the part about additional sentiment-based risk, meaning risk that stems from psychologically induced errors.
That additional profit opportunities are accompanied by additional risk is the moral of the story about the hedge fund Long-term Capital Management (LTCM), described on pages 5–7, 33–34, and 41–42. The people running LTCM were exceedingly smart. However, the high level of intelligence at LTCM did not prevent disaster. Overconfidence can trump intelligence. In the case of LTCM, overconfidence did trump intelligence.
Roger Lowenstein in When Genius Failed details the events that brought down LTCM in 1998. The biggest surprises to LTCM’s traders did not come from unanticipated fundamental risk, but from unanticipated sentiment-based risk! On pages 50 and 51, I explain that overconfidence leads people to set confidence intervals that are too narrow, and as a result, overconfident people experience major surprises. Lowenstein tells us that LTCM calculated that on any single day its maximum loss was unlikely to exceed $35 million. On Friday, August 21, 1998, LTCM lost $553 million.
LTCM was built on the foundation of efficient market theory, where mispricing is small and quickly exploited by smart money, like them. Investors who are overconfident are inclined to take bigger risks than are prudent. Lowenstein reports that LTCM’s large positions and especially its heavy use of leverage turned what on August 21, 1998, might have been small losses into huge losses.
A year before LTCM’s collapse, behaviorists Andrei Shleifer and Robert Vishny published an article in 1997 in Journal of Finance entitled “The Limits of Arbitrage,” arguing that hedge fund strategies of the sort followed at LTCM were vulnerable to risks stemming from the errors and emotions of other traders. Shleifer and Vishny emphasized that liquidity constraints would force hedge funds to sell assets at prices that were not only inefficient, but at market lows. Lowenstein writes that Bob Merton had read an early version of the paper and “pooh-poohed the notion.” Ah, overconfidence.
One of the major lessons from behavioral finance is that investors should guard against overconfidence, and not poohpooh the magnitude of sentiment-based risk! That is why, on page 89, I state: “I think most investors would be better off holding a well-diversified set of securities, mainly in index funds, than they would be trying to beat the market.” I say this not because I believe that skilled investors are incapable of beating the market. Instead, I think that most investors are overconfident about their vulnerability to psychologically induced errors, and although intelligent, not as intelligent as they believe themselves to be.
The Collapse of the Bubble: An Update
Behavioral analyses involves terms such as framing, transparency, optimism, and overconfidence. Psychology is ubiquitous and germane. In order to drive home this point, I would like to update some of the key events described in the book against the backdrop of events that have occurred since the book was first published. The events that have occurred since that time comprise an informal out-of-sample test and underscore the power of behavioral forces in financial decisions.
Beyond Greed and Fear went to press in August 1999, as the level of irrational exuberance in the market was approaching its peak. In chapter 4 (page 39 and the footnotes on pages 313–314), I mention that in December 1996, Federal Reserve chairman Alan Greenspan first used the phrase “irrational exuberance” when expressing his concern that excess optimism among U.S. investors would eventually lead to a prolonged bear market along the lines that the Japanese stock market had experienced since 1990. Behaviorist Robert Shiller chose the term “irrational exuberance” for the title of his book, and in so doing made the phrase a “familiar refrain.” On pages 38–41, I use Shiller’s analysis to explain why the U.S. stock market was in the midst of a major bubble. Figure 4-3 on page 39 depicts the point in graphic fashion.
As far as technology stocks are concerned, in chapter 10, page 133, I state: “On the strength of investors’ imagination, and little else, Internet stock prices were propelled into orbit. According to Lipper Analytical Services, the best-performing mutual fund in 1998 was the Internet Fund, managed by Kinetics Asset Management.” The fund manager was Ryan Jacob, whose story I return to below.
As Beyond Greed and Fear went to press, technology stocks began a dramatic advance. At the time, the technology-heavy Nasdaq Composite Index stood at about 2800. Yet, in the space of eight months, the Nasdaq soared above 5048. This rise amounted to an 80 percent increase, 142 percent when measured on an annual basis.
How did the sto
ry play out? The Nasdaq bubble burst in March 2000. The figure below plots the time path of the Nasdaq Composite, together with the S&P 500 and the Dow Jones Industrial Average. To facilitate the comparison, $100 is invested in each of the three indexes, beginning in January 1988, barely two months after the stock market crash of 1987. Was there a tech-stock bubble? The figure speaks for itself. Outside the period 1999 through 2002 the three indexes are quite close to one another. But within the eight-month period (August 1999 through March 2000), the technology stock bubble evolved and then burst.
As for Internet fund manager Ryan Jacob, mentioned above for being the best performing mutual fund manager in 1998, his experience essentially reflects the evolution and collapse of the bubble. In December 1999, Jacob left Kinetics Asset Management to launch the Jacob Internet fund. In August 2000 Lipper reported that year-to-date, the Jacob Internet was down 40 percent, and ranked last among 184 science and technology funds.
Scholars will study the late 1990s for some time to come. Here are two examples of issues already being investigated. The first involves pricing. In a working paper entitled “DotCom Mania: The Rise and Fall of Internet Stock Prices,” Eli Ofek and Matthew Richardson analyze the role of short sale restrictions in respect to the overvaluation of Internet stock prices during the period January 1998 to November 2000. The second example examines the relationship between message posting on the Internet and trading volume and volatility. Werner Antweiler and Murray Frank at the University of British Columbia have written a working paper entitled “Is All That Talk Just Noise? The Information Content of Internet Message Boards.” They report a strong relationship between the degree of message posting and the degree of both trading volume and volatility. Other studies on message board activity include “News or Noise? Internet Message Board Activity and Stock Prices” by Robert Tumarkin and Robert Whitelaw (Financial Analysts Journal, 2001), and “Yahoo for Amazon: Opinion Extraction from Small Talk on the Web” by Sanjiv Das and Mike Chen.
Beyond Greed and Fear Page 1