The key question that investors want to know is how to use behavioral finance to pick stocks in order to beat the market. As I reminded readers at the beginning of this preface, the task is not easy. Louis Chan, Narasimhan Jegadeesh, and Josef Lakonishok, in “The Profitability of Momentum Strategies” (Financial Analysts Journal, 1999), point out that chasing momentum can generate high turnover and requires a strategy that focuses on managing trading costs.
On page 99 in chapter 8 I described the performance of Fuller & Thaler’s Behavioral Growth fund. This fund effectively seeks to exploit momentum associated with delayed reactions to earnings surprises. Figure 8-2 shows the strong performance the strategy experienced since its inception in 1992. What has happened in the subsequent three years, since this book went to press?
For the full year of 1999, the return to Behavioral Growth was 65 percent, a full 10 percent above its benchmark index, the Russell 2500
Growth Index. The years 2000 and 2001 were very different, and Behavioral Growth underperformed its benchmark by about 10 percent in both of those years. From inception through March 31, 2002, Behavioral Growth has returned 6.6 percent per year, with the Russell 2500 having returned 3.9 percent over the same period.
According to proponents of behavioral finance, long-term reversals are a reflection of investor overreaction. In 1998 Fuller & Thaler began the Behavioral Value fund, to exploit long-term reversals. This fund is benchmarked against the Russell 2000 Value Index. From inception through March 31, 2002, the fund has returned 21.8 percent annually, and its benchmark has returned 14.7 percent. Notably, Behavioral Value underperformed its benchmark in both 2000 and 2001, as had Behavioral Growth.
On pages 70 and 81, I mention David Dreman, one of the most prominent spokesman for value investing. For the ten-year period ending in April 30, 2002, Dreman’s largest fund, the Scudder-Dreman High Return Equity Fund, earned 15.94 percent. Notably in 1999, during the evolution of the Nasdaq bubble, the fund lost 13 percent of its value. In 2000, when the bubble collapsed, the fund gained 41 percent, and in 2001 it gained 1 percent. Over the most recent three-year period, the cumulative return has been 7.26 percent.
On pages 86 and 87, I discuss work by Josef Lakonishok, Andrei Shleifer, and Robert Vishny, work that has come to be known by the initials of the three authors—LSV. The three run a money management firm, LSV Asset Management. Their Large-Cap Value Fund is benchmarked against the Russell 1000. Since inception in 1994, the fund has returned 18.5 percent on an annual basis, before fees. In contrast, during this period, the Russell 1000 returned 14.8 percent, and the S&P 500 returned 14.6 percent. Except for 1998 and 1999, the LSV Large-Cap Value Fund has outperformed both indexes every year. In the three-year period ending March 31, 2002, the fund outperformed the S&P 500 by 13.7 percent. For the prior twelve-month period, the fund outperformed the S&P 500 by 14.9 percent.
In July 1998, Theo Vermaelen began to manage a fund for Belgian bank KBC, based on a behavioral strategy. The fund is called KBC Equity Buyback. Together with David Ikenberry and Josef Lakonishok, he wrote an article entitled “Market Underreaction to Open Market Share Repurchases” (Journal of Financial Economics, 1995), in which the authors argue that investors underreact when companies repurchase shares. Interestingly, corporate managers often announce that they are repurchasing shares because they think the shares of their firms are undervalued. The authors quote the chairman of Midland Resources, Inc, an American-based oil and gas concern, who said: “If you look at the amount of our reserves, we think (our stock) should be trading for about twice its current value. What it boils down to is, if you can buy a dollar for 50 cents, why not buy it?”
Ikenberry, Lakonishok, and Vermaelen found that when a company announced a share repurchase, on average it saw its stock go up by an average of 3.5 percent. However, the market underreacted in that the 3.5 percent run-up was too small, especially if the stock was a value stock. Over the next four years value stocks rose by 45.3 percent more than comparable firms that had not repurchased shares.
Vermaelen’s buyback fund invests in value stocks, taking a position when managers announce share buybacks, claiming their stock is undervalued. At year-end 2001, the KBC Equity Buyback fund was up 36.7 percent. Theo Vermaelen tells me that in its first two years, his fund beat the S&P 500 by 35 percent and the Russell 2000 by more that 45 percent.
In academia debates about momentum and reversals continue. For example, in “Momentum and Autocorrelation in Stock Returns,” Jonathan Lewellen argues that the momentum effect does not stem from underreaction (Review of Financial Studies, 2002), although the discussants of his paper, Joseph Chen and Harrison Hong claim to be unconvinced. Alon Brav and J.B. Heaton, in “Competing Theories of Financial Anomalies” (Review of Financial Studies, 2002), argue that it is difficult to discriminate between behaviorally based theories such as the De Bondt-Thaler overreaction effect, and rationality-based theories that account for the risk of structural change. Their discussant, Werner De Bondt, challenges their test, and counters that there is overwhelming evidence that many investors fail to infer the most basic investing principles, even after years of experience. In this respect, he cites his own work, which I discuss on pages 131–132.
Werner De Bondt has a point. One of the fundamental principles of finance is that risk and return are positively correlated, that if investors are to accept more risk, they will insist on higher expected returns. This principle is manifest in the core concepts of the capital market line and the security market line. The capital market line indicates the maximum expected return associated with any given return standard deviation, while the security market line indicates how the expected return to a security varies with its beta. Both of these graphs feature a positive slope, meaning that the higher the risk the higher the expected return.
On page 84, I report that even though investors may state that in principle, risk and expected return are positively related, in practice they form judgments in which the two are negatively related. In my editorial comment “Do Investors Expect Higher Returns from Safer Stocks than from Riskier Stocks?” (Journal of Psychology and Financial Markets, 2001), I provide additional evidence for this claim, based on surveys conducted with portfolio managers and analysts.
My survey results also show that investors attribute high expected returns and low perceived risk to the stocks of firms that are high in both market cap (size) and price-to-book (growth). In this regard, work by Gregory Brown and Michael Cliff provides evidence that stocks associated with high degrees of investor sentiment subsequently earn low returns at horizons of two to three years. Their paper is entitled “Investor Sentiment and Asset Prices.”
After my editorial appeared on the Social Science Research Network (FEN), I received several messages from economists who also noted the negative correlation between expected returns and perceived risk. John Graham emailed me in connection with his own recent paper, written with Campbell Harvey, entitled “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective.” Graham and Harvey conducted a large survey of chief financial officers and found that the relationship between the CFOs’ one-year expected risk premiums and their perceptions of expected risk is negative, not positive as traditional theory indicates.
Scott Smart, who teaches behavioral finance at Indiana University emailed with the following message: “I saw your paper arguing that people believe there is a negative relationship between risk and return on FEN recently. I thought you might like to hear a related story. Each year in my behavioral finance class, teams of students have to come up with a project to test some idea from behavioral finance. Last year a team did a survey of professors in different schools (business, law, music, and A&S) asking them various questions about their investments. One unexpected (to me) finding was that across every school in the university, the correlation between how risky people thought an investment was and how high they thought the return on the investment would be was negative. That
relationship was true even in the business school, except for faculty in two departments … accounting and finance.” On the basis of Scott Smart’s observations, it is safe to conclude that finance and accounting faculty are adept at modeling their own judgments. As for modeling the judgments of others, that is a different matter.
Behavioral finance appears to be exploding. Academics will continue to write survey papers describing the evolution of behavioral finance. Indeed, in the last three years, several excellent surveys have actually appeared. Meir Statman wrote a thought-provoking piece entitled “Behavioral Finance: Past Battles, Future Engagements” (Financial Analysts Journal, 1999). David Hirshleifer surveyed the psychology literature that he judges to be especially relevant for financial economists; his article is entitled “Investor Psychology and Asset Pricing” (Journal of Finance, 2001). Nicholas Barberis and Richard Thaler wrote “A Survey of Behavioral Finance,” which was commissioned for the Handbook of the Economics of Finance. Finally, let me mention an editorial that argues the case for the traditional perspective. Its author is Mark Rubinstein, and his editorial is entitled “Rational Markets: Yes or No? The Affirmative Case” (Financial Analysts Journal, 2001). Rubinstein’s editorial is based on a debate between himself and Richard Thaler that took place at a Berkeley Program in Finance Symposium in November 2000.
Future Directions
What comes next? At the moment, great strides are being made in the application of behavioral concepts to corporate finance. I described some of the key issues in a recent article “Behavioral Corporate Finance (Journal of Applied Corporate Finance, 2001). John Graham and Campbell Harvey have begun a research program that will prove to be of immense value. They are conducting widespread surveys of chief financial officers (CFOs) in order to determine the factors that the CFOs take into account when making decisions about capital budgeting, capital structure, the cost of capital, dividend policy, and the equity premium. Some of their findings are published in “The Theory and Practice of Corporate Finance: Evidence from the Field” (Journal of Financial Economics, 2001). Graham and Harvey report additional findings in their working paper, mentioned earlier, “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective.”
Chapter 17, on IPO pricing, is based on insights from the work of Tim Loughran and Jay Ritter. In “Why Don’t Issuers Get Upset About Leaving Money on the Table in IPOs?” (Review of Financial Studies, 2002), Loughran and Ritter continue their research program on equity offerings. In their article, they provide a formal analysis to explain why corporate executives are willing to accept initial underpricing. The issue is one that I have treated informally on page 249, and deals with the difference between “in-the-pocket gains” and “opportunity losses.”
Jeremy Stein laid the groundwork for a behavioral framework of corporate financial decisions, in “Rational Capital Budgeting in an Irrational World” (Journal of Business, 1996). Building on the Stein framework, Malcolm Baker and Jeffrey Wurgler have written “Market Timing and Capital Structure” (Journal of Finance, 2002). Baker and Wurgler report that firms tend to issue new equity when their existing equity is most likely to be overpriced. Moreover, they find that temporary fluctuations in market valuations lead to permanent changes in capital structure.
Malcom Baker, Jeremy Stein, and Jeff Wurgler wrote a paper entitled “When Does the Market Matter? Stock Prices and the Investment of Equity-Dependent Firms.” The three authors document that stock prices will have a stronger impact on the investment of firms that need external equity to finance their marginal investments, than those that do not.
Baker and Wurgler have also studied dividend policy. In their paper “A Catering Theory of Dividends,” they suggest that firms cater to investors by initiating or increasing dividends when behavioral factors increase the attractiveness of cash dividends in the eyes of investors.
There are additional papers in behavioral finance that I have not mentioned that are part of the rapidly growing debate. Below are some examples to indicate the direction of future research. Michael Cooper, Roberto C. Gutierrez Jr., and Allaudeen Hameed report that that momentum profits exclusively follow market gains and that contrarian profits are stronger following market losses. Their working paper is entitled “Market States and the Profits to Momentum and Contrarian Strategies.” David Hirshleifer, James Myers, Linda Myers, and Siew Hong Teoh ask: “Do individual investors drive post-earnings announcement drift?” The question forms the title of their paper, and the answer they provide is no.
Where is the behavioral finance headed? Richard Thaler suggests that the end point is for behavioral elements simply to become part and parcel of regular financial analysis. He calls this state of affairs the end of behavioral finance (Financial Analysts Journal, 1999). Judging by the volume of work described above, the end of behavioral finance may be fast approaching.
Acknowledgments
I would like to express my gratitude to many people for their help on this book. I especially thank Richard Thaler and Meir Statman, from whom I have gained a great deal over the years. In the mid-1970s, Dick Thaler introduced me to behavioral heuristics, biases, errors, and framing. In the early 1980s, Meir Statman joined me in a collaborative effort to apply behavioral concepts to finance. Both Dick and Meir provided very useful comments on earlier drafts of this book. I am also indebted to Phil Cooley, who suggested the idea behind this book, Kirsten Sandberg, my editor at Harvard Business Press who first published the book; Paul Donnelly, my editor at Oxford University Press, the current publisher; my colleagues at Santa Clara University, Mario Belotti, Alex Field, Harry Fong, Atulya Sarin, Jerry Shapiro, Barbara Stewart, Robert Warren; and my academic colleagues at other institutions, Mark Carhart, Werner De Bondt, Ken Froot, William Goetzmann, Robert Hansen, Daniel Kahneman, Charles Lee, Lola Lopes, Terry Odean, Jay Ritter, Richard Roll, Robert Shiller, Jon Skinner, Paul Slovic, Bhaskaran Swaminathan, Jacob Thomas, and Kent Womack. I thank as well a host of practitioners, including John Watson (Financial Engines); Cadmus Hicks, William Kehr, Steve Peterson, Andrew Schell, and Brad Shaw (Nuveen); Rick Chrabaszewski (Zacks); Georgette Jasen (Wall Street Journal); Rick Dubroff and Martha Gosnay, (Wall $treet Week with Louis Rukeyser); Louis Radovic and Kim Rupert (MMS); Bob Saltmarsh (Silicon Graphics, Inc.); Frank Tesoriero (New York Cotton Exchange); Rick Angell, Chris Bernard, Sheldon Natenberg, and Al Wilkinson (Chicago Board of Trade); Russ Fuller and Fred Stanske (Fuller and Thaler Asset Management); Doug Carlson (Cambridge Associates, Inc.); Yakoub Billawalla, Ken Kam, and Kevin Landis (First-hand Funds); Stan Levine (First Call); Tisha Findeisen and Patricia Sendgsen (Vanguard); Diana MacDonald (Bridge Information Systems); James Davidson (Hambrecht & Quist); Florence Eng (I/B/E/S); John Ronstadt (PaineWebber); Allan Eustis (National Weather Service); the Dean Witter Foundation, especially Sal Gutierrez and Kip Witter. I am grateful to individuals Ira Scharfglass, Jayne Scharfglass, and my tireless research assistant Chitra Suriyanarayanan. I am indebted to Bridge Information Systems, I/B/E/S International, MMS, and Zacks for data used in this book.
My biggest debt of gratitude goes to my dear wife, Arna, who provided editorial advice along with years of encouragement, support, and examples that illustrate behavioral phenomena.
Part I What Is Behavioral Finance
Chapter 1 Introduction
Wall $treet Week with Louis Rukeyser panelist Frank Cappiello once explained that because of a “change in psychology,” but “no change in fundamentals,” he altered his stance on the market from positive to neutral.1 Cappiello has plenty of company. The popular financial press regularly quotes experts and gurus on market psychology. But what do these experts and gurus mean? The stock answer is, “greed and fear.” Well, is that it? Is that all there is to market psychology?
Hardly. Our knowledge of market psychology now extends well beyond greed and fear. Over the last twenty-five years, psychologists have discovered two important facts. First, the primary emotions that determine risk-takin
g behavior are not greed and fear, but hope and fear, as psychologist Lola Lopes pointed out in 1987. Second, although to err is indeed human, financial practitioners of all types, from portfolio managers to corporate executives, make the same mistakes repeatedly. The cause of these errors is documented in an important collection edited by psychologists Daniel Kahneman, Paul Slovic, and the late Amos Tversky that was published in 1982.
Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners. I have written this book about practitioners, for practitioners. Practitioners need to know that because of human nature, they make particular types of mistakes. Mistakes can be very costly. By reading this book, practitioners will learn to
• recognize their own mistakes and those of others;
• understand the reasons for mistakes; and
• avoid mistakes.
For many reasons, practitioners need to recognize others’ mistakes as well as their own. For example, financial advisers will be more effective at helping investors if they have a better grasp of investor psychology. There are deeper issues too. One investor’s mistakes can become another investor’s profits. But one investor’s mistakes can also become another investor’s risk! Thus, an investor ignores the mistakes of others at his or her own peril.
Who are practitioners? The term covers a wide range of people: portfolio managers, financial planners and advisers, investors, brokers, strategists, financial analysts, investment bankers, traders, and corporate executives. They all share the same psychological traits.
The Three Themes of Behavioral Finance
The proponents of behavioral finance, myself included, argue that a few psychological phenomena pervade the entire landscape of finance. To bring this point out clearly, I have organized these phenomena around three themes. What are the three themes? And how does behavioral finance treat them differently than traditional finance does?2 The answers are arranged by theme. I begin the discussion of each theme with a defining question.
Beyond Greed and Fear Page 4