Amsterdam, The Netherlands October 2013 Werner De Bondt. The Behavioral Revolution In Finance: What Does It Mean for Money Management?

Transcription

1 Amsterdam, The Netherlands October 2013 Werner De Bondt The Behavioral Revolution In Finance: What Does It Mean for Money Management?

2 Overview The crisis in economics and economic thought. What is behavioral finance? Behavioral macroeconomics. Behavioral asset pricing and money management.

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5 The financial services sector has been dramatically transformed.. Technology has enabled creditors to achieve significant efficiencies.. Where once moremarginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending. Alan Greenspan April 8, 2005

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8 30 Long-term interest rates in the Eurozone AT BE DE ES FI FR GR IE IT NL PT

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10 The crisis and economic thought [The crisis] exposed the shortcomings of [economics.] More than a year after the event, there is no consensus on what caused [it]... One gets the sense.. that the intellectual energy is no longer with economists who construct abstract.. models. The field [is] moving in a humanistic direction... The.. yearnings of.. human beings are not reducible to universal laws.. Once this is accepted.. economists will be able to draw out some suggestive lessons to keep in mind while thinking about other people and other contexts, just like historians, psychologists and novelists do. David Brooks, New York Times, March 26, 2010.

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13 "A full understanding of human limitations will ultimately benefit the decision-maker more than will naïve faith in the infallibility of his intellect." Paul Slovic Journal of Finance 1972

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16 The logic of behavioral finance and economics Starting points: Dual processing, intentionality, bounded rationality. Mechanisms: Mental frames (simple conceptual models); heuristics; psychophysics. Decision traps, e.g., Loss aversion, regret, mental accounting, wishful thinking, etc. Biases in financial judgment and choice, e.g., past trend extrapolation, inertia or underdiversification. Distortions in financial markets and the macroeconomy, e.g., bubbles, unemployment.

17 Sources of bias Cognition Emotion, affect, feelings Social pressure The need to justify decisions Widely-shared self-reinforcing misconceptions Trading practices based on deceptive illusions

18 How attractive is a gamble? Gamble Mean and variance A (.95, 5K;.05, 105K) 10K 475K B (.50, 5K;.50, 15K) 10K 25K H (.50, -5K;.50, 25K) 10K 225K W (.50, -85K;.50, 105K) 10K 9,025K The ideal gamble: Little fear and much hope?

19 Linda Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and she also participated in the antinuclear movement. What is most likely? What is least likely? 1. Linda works in a bookstore and takes Yoga classes. 2. Linda is a bank teller. 3. Linda is a bank teller and is active in the feminist movement.

20 Opinions and social pressure Unpredictability, yet highly unequal outcomes in business success. Are we confusing quality with success? A study of musical taste. Subjects are invited to listen to 48 songs by unknown bands and to rate the songs. They have the option to download the songs they like. >14,000 participants. See Salganik et al.

21 Independent group (20%) (no download history) Social world 1 (10%) Social world 2 (10%) Social world 3 (10%) subject enters website musiclab.columbia.edu Social world 4 (10%) Social world 5 (10%) Social world 6 (10%) Social world 7 (10%) Social world 8 (10%)

22 Insights? Implications? Investor autonomy. Financial intuition is fragile. (Basic investment principles are not learned from everyday experience.) Choice architecture. (Decision outcomes, and errors, are a function of decision process.) Asset price bubbles. (Other people s decision errors are an opportunity for profit even if these errors create risk.)

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24 Behavioral macroeconomists? J.M. Keynes (consumption; investment; cash hoarding + liquidity trap) Irving Fisher (debt deflation; money illusion) George Katona (economic psychology; sentiment) Charles Kindleberger (manias and panics) Hyman Minsky (financial instability) George Akerlof + Robert Shiller

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26 Core concepts Confidence (sentiment) and its multipliers Trust (vs. bad faith or corruption) Stories Fairness. A capitalist economy is not inherently stable. The invisible hand vs. animal spirits. Multiple equilibria. Vicious circles. Government should set the stage and contain the excesses of free market capitalism.

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28 I accuse the classical economic theory of being.. one of these pretty.. techniques which tries to deal with the present by abstracting from the fact that we know very little about the future... By uncertain knowledge, I do not merely distinguish what is known for certain from what is only probable. The game of roulette is not subject.. to uncertainty... [T]he prospect of a European war is uncertain or the price of copper.. 20 years hence. About these matters there is no scientific basis on which to formulate any calculable probability whatsoever. We simply do not know. John Maynard Keynes

29 18 U.S. Treasury 10-year constant maturity rate, April 1953-September

30 18 U.S. Treasury 10-year constant maturity rate, September 1981-March

31 .. Individual initiative [is] only adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers.. is put aside. This means.. not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a[n] atmosphere which is congenial to the average business man. John Maynard Keynes

32 Our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. John Maynard Keynes

33 Charles Kindleberger An economic shock that justifies higher prices. Extrapolation bias. Rising investor confidence. Use of leverage and speculative instruments. Herding. Positive feedback trading. Unrealistic hopes and overconfidence draw many newcomers into the market. Panic and crash.

34 Bubbles are often precipitated by perceptions of real improvements in the productivity and underlying profitability of the corporate economy. But as history attests, investors then too often exaggerate the extent of the improvement in economic fundamentals. Alan Greenspan August 30, 2002

35 VALUE SUPPLY PRICE ESTIMATED VALUE # SHARES

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37 The price-earnings and price-dividend ratio of the S&P-index,

38 The price-earnings ratio of the S&P-index and returns over the next 10 years,

39 Behavioral asset pricing Two essential assumptions Investor beliefs about future cash flows and risk perception. Changing risk attitudes. Herding behavior and contagion. All three sentiment factors may cause mispricing. Betting against market sentiment is costly and risky.

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41 Disaster myopia In an expanding economy, growing confidence associated with the absence of major shocks strengthens the tendency for subjective shock probabilities to decline merely through the passage of time (p. 1366). Guttentag and Herring (Journal of Finance, 1984) link disaster myopia, rising instability, credit rationing, and financial disorder.

42 World financial markets Four stylized facts Misvaluation: False beliefs. Contagion: Bonanza s followed by sudden stops. High price volatility and trading volume Predictability Illustrations based on (i) De Bondt and Thaler (1985) and (ii) world equity markets since 1969.

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44 100 x (country/u.s.)-index The US$ performance of the French, German, Japanese, and U.K. stock markets relative to the U.S. since Japan Germany 400 France U.K

45 The stock index performance of Germany, Japan, the UK and the US, in US dollars since January 1, Germany Japan UK US

46 The stock index performance of Brazil, China, India and Russia, in US dollars since January 1, Brazil China India Russia

47 G7 and Switzerland: Fraction of last 260 trading days with index fluctuations >abs(2%), since January 1, % price drops <-2% % all daily returns >abs(2%)

48 BRIC-countries: Fraction of last 260 trading days with index fluctuations >abs(2%), since January 1, % price drops <-2% % all daily returns >abs(2%)

49 Predictability in asset returns 1. Study countries that are subject to similar economic forces. Two types of variables matter: Business fundamentals and investor sentiment. 2. Rank countries by past price movements. Euphoria and hysteria may be identifiable in the cross-section if the same global economic forces affect all industrialized countries. 3. Find subsequent average returns and test for differences.

50 Cumulative excess returns. How profitable are contrarian portfolios? Market-adjusted returns after 6, 12, 18, and 24 months WINNERS LOSERS

51 Cumulative excess returns. How profitable are momentum portfolios? Market-adjusted returns after 6, 12, 18, and 24 months WINNERS LOSERS

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53 There are no whole truths; all truths are half-truths. It is trying to treat them as whole truths that plays the devil. Alfred North Whitehead English philosopher and mathematician

54 As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing. William Stanley Jevons

55 What is important in market fluctuations are not the events themselves, but the human reactions to those events. Bernard Baruch