Behavioural Finance

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.

• Preface xvAcknowledgements xvii1 Introduction 11.1 Illustration and Structure 21.2 Finance Theory as an Engine not a Camera 31.2.1 Rational Fools or Folly of Wisdom? 51.3 Rebuilding on New Foundations 71.3.1 Reasoned Emotion: The Case of Phineas Gage 81.3.2 What Can Psychologists Bring to Finance? 91.4 Challenging the Classical Assumptions of Finance 91.5 Modelling Behavioural Aspects of Finance 111.6 The Structure of the Book 12Appendix: A Financial Tsunami 14Notes 14References 14Part I Foundations 172 Financial Decision Making 192.1 Illustration and Structure 192.2 The Expected Utility Rule 202.2.1 An Illustration of Expected Utility 212.2.2 Attitudes to Risk 222.2.3 Diversification as Risk Reduction Strategy 232.2.4 How Best To Bear Risk 242.3 Expected Utility Theory: Simple But Untrue? 262.3.1 Paradoxes and Problems in Early Understanding of Expected Utility Theory 272.3.2 Gambling Insurance and Aspiration 292.4 Frames for Actions, Contingencies and Outcomes 312.4.1 The Decision Process 312.4.2 Inferring Big Ideas from Small Samples 322.4.3 Stars with Feet of Clay 332.4.4 Is There More to Life Than (Maximizing) Utility? 342.4.5 Happiness, Well-Being and the Emotional Basis of Utility 342.5 Conclusion and Summary 35Questions 35Notes 36References 363 Discounting 393.1 Illustration and Structure 403.2 The Discounted Utility Model 403.2.1 Some Problems with the Discounted Utility Model 413.2.2 Evaluating Reallocations of Consumption by Equivalent Gains or Compensating Losses of Present Consumption 423.2.3 Delays and Speed-Ups of Utility 443.3 How and Why Discount Rates Vary 443.3.1 Discounting Single Outcomes Compared to Sequences of Outcomes 463.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’ 473.5 Hyperbolic Discount Factors 493.6 Valuation by Using the Matching Law 513.6.1 On Pigeons and Men: Comparing Hyperbolic and Exponential Discounting 533.7 How Investment Decisions are Made When Discount Factors Decline Over Time 543.7.1 A Simple Example of a Sub-Game Perfect Equilibrium 553.7.2 The Properties of a Sub-Game Perfect Investment Strategy Equilibrium 573.7.3 How Do Declining Discount Rates Affect Investment Behaviour? 583.8 Conclusion and Summary 59Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal Choice 60Questions 61Notes 62References 624 Learning 654.1 Illustration and Structure 654.2 Rational Learning 664.2.1 Bayes’ Rule 664.2.2 Elements of Bayesian Revision 684.2.3 The Value of Stock Recommendations 704.3 Do We Learn the Bayesian Way? 724.3.1 Representativeness 744.3.2 Representation Bias in the Market: Analysts’ Overreaction to Earnings 744.3.3 A Once and For All Lesson? 754.4 Over Inference and the Law of Small Numbers 764.5 Disagreement, Tastes and the Capital Asset Pricing Model 774.6 Conclusion and Summary 79Appendix: Case Study – Baseball the Bayesian Way 80Questions 87Notes 88References 885 Bubbles 895.1 Illustration and Structure 905.2 Tulipmania and the Didactic Value of Bubbles 915.3 The Regulatory Origins of the Most Recent Bubble 925.3.1 Long-Term Capital Management 925.3.2 The Federal Reserve and Market Restraint 955.4 Bubbles: Past, Present and Future 1015.4.1 Financial Bubbles and Infrastructure Technology 1025.4.2 Are Bubbles Just Part of the Market Process? 1035.5 The 1929 Stock-Market Crash 1045.5.1 Early Signs 1045.5.2 The Boom is On 1055.5.3 Innovation and Speculation 1065.5.4 Investment Trusts in the Boom’s Growth 1065.5.5 The Final Implosion 1075.6 Should Government Burst the Bubble? 1085.7 Conclusion and Summary 109Appendix: Tulips as Assets and Art 110Questions 114Notes 114References 114Part II Asset Pricing 1176 Noise Traders 1196.1 Illustration and Structure 1206.2 The De Long, Shleifer, Summers and Waldmann Model 1216.2.1 The Basic Set Up 1226.2.2 Modelling Mispricing 1226.2.3 What Investors Want 1236.2.4 Choosing Optimal Asset Allocations Across the Safe and Risky Asset 1246.2.5 The Pricing Equation 1256.2.6 Will Noise Traders Die Out? 1286.2.7 Decomposing Noise Traders’ Profits 1306.3 Can Investors Get Emotional? 1336.3.1 Feeling the Risk 1346.3.2 The Affect Heuristic 1356.3.3 Panic and Feedback Trading During the 1987 Stock-Market Crash 1366.3.4 The Diminishing Roar of Noise 1376.4 Conclusion and Summary 138Questions 138Notes 139References 1397 Overconfidence and Optimism 1417.1 Illustration and Structure 1427.2 A Model of Trading Amongst Optimistic Investors 1427.2.1 The Model 1437.2.2 Price Setting 1437.2.3 Conditions for Overconfident Pricing of the Risky Asset 1447.2.4 Pricing in Odean’s Model 1477.2.5 The Implications of Odean’s Model for Financial Markets 1507.3 Do Investors Trade Too Much? 1507.3.1 Optimism in Corporate Finance 1517.3.2 Facing Failure 1517.3.3 Who Dares Loses? 1537.3.4 The Hubris Theory of Takeovers 1537.4 Conclusion and Summary 154Appendix A: Hubris at Work: The AOL–Time Warner Merger 155Appendix B: Derivation of Results in Odean’s Model 161Questions 163Notes 163References 1638 Asset Pricing under Prospect Theory 1658.1 Illustration and Structure 1658.2 The Basics of Prospect Theory 1668.2.1 Prospect Theory’s Application to Finance 1678.2.2 Benchmarks, Gains and Losses and the Dynamics of Utility under Prospect Theory 1688.2.3 Integration or Segregation of Losses and Gains in the Presence of Loss Aversion 1698.2.4 The Evolution of Investor Benchmarks 1708.2.5 Price Formation in a Market Populated By Investors With Prospect Theory Utility Functions 1718.2.6 Pricing in the Standard Inter-Temporal Consumption-Based Asset-Pricing Model or Economy I 1718.3 Does Prospect Theory Work? 1728.3.1 Can Prospect Theory Explain the Internet Bubble? 1728.3.2 Can Prospect Theory Explain IPO Underpricing? 1748.3.3 Prospect Theory Here, There and Everywhere 1768.4 The Cumulative Probability Version of Prospect Theory 1768.5 Does Cumulative Prospect Theory Work? 1778.5.1 Cumulative Prospect Theory and Asset Pricing 1798.6 Conclusion and Summary 181Appendix: CARA Utility 181Questions 182Note 182References 1839 Overreaction and/or Underreaction 1859.1 Illustration and Structure 1859.2 The DHS Model 1869.2.1 Reversals of Fortune 1889.2.2 Pricing When Confidence Levels Depend on the Relation Between the Public and Private Signals 1899.2.3 Investor Extrapolation and Reversals of Fortune 1929.2.4 Many Theories in Search of a Decisive Verification 1929.2.5 Momentum and Underreaction: Two Stock-Market Anomalies or One? 1949.3 No News Is . . .? 1949.3.1 The Jackson and Johnson (JJ) Model’s Message 1959.3.2 How the JJ Model Works 1969.3.3 Stock-Market Responses to News and No News 1999.4 Conclusion and Summary 199Questions 199Note 199References 20010 Momentum 20110.1 Illustration and Structure 20110.2 Grinblatt and Han’s (2005) Model 20310.2.1 Modelling Asset Demand in the GH Model 20410.2.2 Investor Returns and the Evolution of the Reference Point 20710.3 What Drives Stock-Market Momentum? 20810.3.1 Evidence of PEAD 20910.4 What Causes PEAD? 21210.4.1 Is PEAD Due to Changes in Risk? 21210.4.2 Are Prices Following Themselves or Following Earnings? 21310.4.3 Is PEAD in the Market or in the Eye of the Researcher? 21510.4.4 Show Me the Money 21610.5 Conclusion and Summary 217Questions 217Note 218References 21811 Herding 22111.1 Illustration and Structure 22111.2 The FSS Model 22211.2.1 The Basic Set Up 22211.2.2 The Price-Setting Mechanism Used by Market-Makers 22311.2.3 Informed Speculators’ Demands 22411.3 Conformity as a Force for Social Good and Evil 22811.3.1 Evidence on Herding and its Effect 22911.3.2 Herding in Investment Advice 23011.3.3 Words which Cannot be Spoken 23011.3.4 Private Truths and Public Lies 23111.3.5 The Herd in History 23311.4 Conclusion and Summary 233Appendix: The United States vs. Microsoft 234Questions 236Note 237References 23712 Insider Trading 23912.1 Illustration and Structure 24012.2 Insider Trading Here for Better or Worse 24112.2.1 The Distributional Impact of Insider Trading 24212.2.2 When does Trading become Insider Trading? 24312.2.3 Insiders on Trial: Proof of Guilt or Innocence? 24412.3 The Hirshleifer, Subrahmanyam and Titman Model 24512.3.1 Asset Demands and the Determination of Investor’s Terminal Wealth in the HST Model 24612.3.2 Pricing in Equilibrium 25012.3.3 Trading Behaviour in Equilibrium 25112.4 Insider Trading, Stock Options and the Construction of Earnings 25512.4.1 Psychological Factors Determining the Exercise of Stock Options 25612.5 Insider Trading and its Consequence for Outsiders 25712.6 Conclusion and Summary 258Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model? 258Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262Questions 265Notes 265References 26613 Equity Premium Puzzle 26913.1 Illustration and Structure 26913.2 The Puzzle 27013.2.1 The Mehra and Prescott Statement of the Equity Premium Puzzle 27113.2.2 Explaining the Risk Premium by Myopic Loss Aversion 27213.2.3 Can Loss Aversion Explain the Puzzle? 27413.3 Loss Aversion in a Reference-Dependent Utility Model 27613.3.1 A Reference-Dependent Model of Investor Choice 27713.3.2 Loss Aversion in a Reference-Dependent Model of Choice 27713.3.3 Diminishing Sensitivity to Losses and Gains 27813.3.4 Constant Risk Aversion and the Benartzi and Thaler (1995) Model 27913.3.5 Is Loss Aversion Irrational? 28013.4 Conclusion and Summary 280Questions 281References 281Part III Corporate Finance 28314 Incorporation 28514.1 Illustration and Structure 28514.2 Companies: Where did They Come from and Where will They Go? 28614.2.1 Limited Liability: its Value and its Role in the Emergence of the Corporate Form 28814.2.2 The Economic Rationale for Granting Limited Liability 28814.3 Agency, Monitoring and Incorporation 28914.3.1 Are Managers Agents or Team Members? 29114.3.2 Psychological Barriers to Arm’s Length Contracting 29414.3.3 Group Psychology on the Board, Building Consensus and its Dissimulation 29414.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 29614.4.1 Clearing Out the ‘Inside View’ 29714.4.2 Come On Down: the Satisfaction of Recognition 29814.4.3 Facing Glory and Defeat: Managers’ Resistance to Recognizing Failure 29814.4.4 Governance in the Long and Short Run 29914.5 Conclusion and Summary 300Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a Corporation 300Questions 313Notes 313References 31415 The Market for Information, Noise and Deception 31715.1 Illustration and Structure 31815.2 The Boundaries of the Market for Corporate Information 31815.2.1 The Conduct of the Market for Corporate Information 31915.3 What Do Analysts Do? 32115.3.1 The Ivkovic and Jegadeesh (IJ) Model 32215.4 Valuing Investment Advice 32515.4.1 The Market for Corporate Information 32615.4.2 What Type of Valuation Models do Analysts Use? 32815.4.3 The Fragility of Valuation Models 33015.4.4 A Dynamic Model of the Market for Financial Information 33215.4.5 From Inside and Out: Isolation Bias and Risk Taking 33315.5 Conclusion and Summary 333Questions 334Notes 334References 33416 Dividends 33716.1 Illustration and Structure 33716.2 The Irrelevance of Dividends to Value 33816.2.1 The Puzzle of Dividend Policy 33916.3 A Prospect Theory Explanation of Dividend Payments 34016.3.1 Coding of Prospects: Combination, Segregation 34116.3.2 Shop Until You Should Stop 34116.3.3 Calculating the Dividend Yield Premium/Discount 34216.4 Who Pays Dividends and Why? 34616.4.1 Are Dividends Signals of Future Earnings Prospects? 34616.4.2 Dividend Omissions, Initiations and Drift 34716.4.3 What Reasons do Managers Give for Paying Dividends? 34816.4.4 Does Pay-out Policy Matter? 34916.5 Conclusion and Summary 350Questions 350Note 351References 35117 Entrepreneurship 35317.1 Illustration and Structure 35417.1.1 The Problem of Self-Control 35417.2 The BT Model 35517.2.1 The Demand for Self-Confidence in the BT Model 35517.2.2 Always Wrong but Never in Doubt 35917.2.3 The Supply of Self-Confidence in the BT Model 35917.2.4 Numerical Illustration of the BT Model 36117.3 Is Deluding Yourself Worth it? 36217.3.1 Optimism, Self-Control and Society 36317.3.2 The Social Benefits of the Maverick Entrepreneur 36317.4 Conclusion and Summary 364Appendix: Entrepreneurs and the BT Model – Some Case Studies 364Questions 370Notes 370References 371Part IV The Professions 37318 Analysts’ Conflicts of Interest 37518.1 Illustration and Structure 37618.2 Evidence of Conflicts of Interest from Empirical Studies 37718.2.1 No Conflict, No Interest 37818.2.2 Is Disclosure of a Conflict of Interest Sufficient Protection for Investors? 37918.2.3 Conflicts in the Laboratory 37918.3 Regulating Conflicts of Interest 38018.3.1 UK Policy on Conflicts of Interest 38018.3.2 EU Policy on Conflicts of Interest 38218.3.3 US Policy on Conflicts of Interest 38318.3.4 The Common Law of Conflicts of Interest 38318.3.5 The Dura Pharmaceuticals Case 38418.3.6 Market Efficiency, Conflicts of Interest and the Courts 38518.4 Conclusion and Summary 385Questions 386Notes 386References 38619 Accounting Reform 38919.1 Illustration and Structure 38919.2 The Onward March of ‘Fair-Value’ Accounting 39019.2.1 Historic Cost versus Fair Value 39019.2.2 A Return to Fundamental Valuation 39219.3 An Accounting-Based Valuation Model 39219.3.1 Are All Reported Earnings Additions to Shareholder Value? 39419.3.2 The Dynamics of Abnormal Earnings Valuation 39519.3.3 Some Examples of the Ohlson Model in Action 39619.3.4 Implications for Price 39819.3.5 Implications for Returns 40019.3.6 Does the Ohlson Model Work? 40019.3.7 Earnings Persistence in the Ohlson Model 40319.3.8 Other Information in the Ohlson Model 40319.4 Behavioural Bias in Estimates of the Ohlson Model 40419.4.1 Inferring Value from Accounting Data: Fair Values versus Historic Costs 40519.4.2 The Three Levels of Fair Value 40619.4.3 Some Implicit Trade-Offs in Fair-Value Accounting 40619.5 Conclusion and Summary 407Appendix A: Mark-to-Market Accounting at Enron – A Case Study 407Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting Information only (Equation (19.7)) 423Questions 425Notes 425References 42620 Conclusion 427Index 431

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