Chapter 2

Overview of Psychology & Behavioral Finance

Much of economic and financial theory is based on the notion that individuals act
rationally and consider all available information in the decision-making process. However,
researchers have uncovered a surprisingly large amount of evidence that this is frequently
not the case. Dozens of examples of irrational behavior and repeated errors in judgement
have been documented in academic studies. Peter L. Bernstein in Against The Gods states
that the evidence "reveals repeated patterns of irrationality, inconsistency, and
incompetence in the ways human beings arrive at decisions and choices when faced with
uncertainty."

A field known as "behavioral finance" has evolved that attempts to better understand and
explain how emotions and cognitive errors influence investors and the decision-making
process. Many researchers believe that the study of psychology and other social sciences
can shed considerable light on the efficiency of financial markets as well as explain
many stock market anomalies, market bubbles, and crashes. As an example, some believe
that the outperformance of value investingresults from investor's irrational overconfidence in
exciting growth companies and from the fact that investors generate pleasure and pride
from owning growth stocks. Many researchers (not all) believe that these humans flaws are
consistent, predictable, and can be exploited for profit.

Some Professors recognized as experts in the field include Daniel

Kahneman (Princeton), Meir Statman (Santa Clara), Richard Thaler (University of
Chicago), Robert J. Shiller (Yale), and Amos Tversky. Tversky passed away in 1996 and is
frequently cited as the forefather of the field (See Roger Lowenstein's tributes to Tversky in
the Wall Street Journal on 6/6/96 and 6/13/96). LSV Asset Management, Fuller & Thaler
Asset Management, David Dreman and Ken Fisher are some money managers that invest
based on behavioral finance theories. Common examples of irrational behavior (many
interrelated) that researchers have documented include the following.

Tversky and Kahneman originally described "Prospect Theory" in 1979. They found that
contrary to expected utility theory, people placed different weights on gains and losses and
on different ranges of probability. They found that individuals are much more distressed by
prospective losses than they are happy by equivalent gains. Some economists have
concluded that investors typically consider the loss of $1 dollar twice as painful as the
pleasure received from a $1 gain. They also found that individuals will respond differently to
equivalent situations depending on whether it is presented in the context of losses or
gains. Here is an example from Tversky and Kahneman's 1979 article. Researchers have
also found that people are willing to take more risks to avoid losses than to realize gains.
Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors
become risk-takers.

Professor Statman is an expert in the behavior known as the "fear of regret." People tend
to feel sorrow and grief after having made an error in judgement. Investors deciding whether
to sell a security are typically emotionally affected by whether the security was bought for
more or less than the current price. One theory is that investors avoid selling stocks that
have gone down in order to avoid the pain and regret of having made a bad investment.

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The embarrassment of having to report the loss to the IRS, accountants, and others may
also contribute to the tendency not to sell losing investments. Some researchers theorize
that investors follow the crowd and conventional wisdom to avoid the possibility of feeling
regret in the event that their decisions prove to be incorrect. Many investors find it easier to
buy a popular stock and rationalize it going down since everyone else owned it and thought
so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down.
Additionally, many believe that money managers and advisors favor well known and popular
companies because they are less likely to be fired if they underperform. See also Terrance
Odean's Are Investors Reluctant to Realize Their Losses?.

People typically give too much weight to recent experience and extrapolate recent trends
that are at odds with long-run averages and statistical odds. They tend to become more
optimistic when the market goes up and more pessimistic when the market goes down. As
an example, Professor Shiller found that at the peak of the Japanese market, 14% of
Japanese investors expected a crash, but after it did crash, 32% expected a crash (Source:
WSJ 6/13/97). Many believe that when high percentages of participants become overly
optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.
See Bull & Bears.

People often see order where it does not exist and interpret accidental success to be the
result of skill. Tversky is well known for having demonstrated statistically that many
occurrences are the result of luck and odds. One of the most cited examples is Tversky and
Thomas Gilovich's proof that a basketball player with a "hot hand" was no more likely to
make his next shot than at any other time. Many people have a hard time accepting some
facts despite mathematical proof.

People are overconfident in their own abilities, and investors and analysts are particularly
overconfident in areas where they have some knowledge. However, increasing levels of
confidence frequently show no correlation with greater success. For instance, studies show
that men consistently overestimate their own abilities in many areas including athletic skills,
abilities as a leader, and ability to get along with others. Money managers, advisors, and
investors are consistently overconfident in their ability to outperform the market, however,
most fail to do so. Gur Huberman of Columbia University recently found that investors
strongly favor investing in local companies that they are familiar with. Specifically investors
are far more likely to own their local regional Bell company than the other regional Bells.
The study provides evidence that investors prefer local or familiar stocks even though there
may be no rational reason to prefer the local stock over other comparable stocks that the
investor is unfamiliar with. See The Perils of Investing Too Close to
Home in BusinessWeek (9/29/97). See also Smart people, stupid money moves in Money
Magazine (4/18/97).

People often see other people's decisions as the result of disposition but they see their
own choices as rational. Investors frequently trade on information they believe to be
superior and relevant, when in fact it is not and is fully discounted by the market. This
results in frequent trading and consistently high volumes in financial markets that many
researchers find puzzling. On one side of each speculative trade is a participant who
believes he or she has superior information and on the other side is another participant who

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believes his/her information is superior. Yet they can't both be right. See also Terrance
Odean's Why Do Investors Trade Too Much?

Many researchers theorize that the tendency to gamble and assume unnecessary risks
is a basic human trait. Entertainment and ego appear to be some of the motivations for
people's tendency to speculate. People also tend to remember successes, but not their
failures, thereby unjustifiably increasing their confidence. As John Allen Paulos states in his
book Innumeracy, "There is a strong general tendency to filter out the bad and the failed
and to focus on the good and the successful."

People's decisions are often affected by how problems are "framed" and by irrelevant but
comparable options. In one frequently cited example, an individual is offered a set amount
of cash or a cross pen, in which case most choose the cash. However, if offered the pen,
the cash, or an inferior pen, more will choose the cross pen. Sales professionals typically attempt to
capitalize on this behavior by offering an inferior option simply to make the primary option appear
more attractive.

Arnold S. Wood of Martingale Asset Management describes the "touchy-feely syndrome" as the
tendency for people to overvalue things they've actually "touched" or selected personally. In one
experiment, participants where either handed a card or asked to select one. Those that selected a
card were less interested in selling the card back and required more than four times the price to sell
the card as compared with the participants who were handed a card. Similarly, many researchers
believe thatanalysts who visit a company develop more confidence in their stock picking skill,
although there is no evidence to support this confidence.

The dynamics of the investment process, culture, and the relationship between investors and
their advisors can also significantly impact the decision-making process and resulting investment
performance. Full service brokers and advisors are often hired despite the likelihood that they will
underperform the market. Researchers theorize that an explanation for this behavior is that they play
the role of scapegoat. In Fortune and Folly: The Wealth and Power of Institutional Investing, William
M. O'Barr and John M. Conley concluded that officers of large pension plans hired investment
managers for no other reason than to provide someone else to take the blame and that the officers
were motivated by culture, diffusion of responsibility, and blame deflection in forming and
implementing their investment strategy. The theory is that they can protect their own jobs by risking
the managers account. If the account underperforms, it is the managers fault and they can be fired,
but if they over perform they can both take credit.

"Psychographics" describe psychological characteristics of people and are particularly relevant to

each individual investor's strategy and risk tolerance. An investors background and past experiences
can play a significant role in the decisions an individual makes during the investment process. For
instance, women tend to be more risk averse than men and passive investors have typically became
wealthy without much risk while active investors have typically become wealthy by earning it
themselves. The Bailard, Biehl & Kaiser Five-Way Model divides investors into five categories.
"Adventurers" are risk takers and are particularly difficult to advise. "Celebrities" like to be where the
action is and make easy prey for fast-talking brokers. "Individualists" tend to avoid extreme risk, do
their own research, and act rationally. "Guardians" are typically older, more careful, and more risk
averse."Straight Arrows" fall in between the other four personalities and are typically very balanced.