Behavioral finance and the psychology of investing
By Hersh Shefrin; Abstract: This book provides a comprehensive treatment of behavioural finance. With the use of the latest psychological research. Behavioral finance combines psychology and finance to analyze and explain why and how people make financial decisions. It attempts to explain the. Daniel Kahneman: Psychology for Behavioral Finance to buy or sell securities, and even how to optimally organize an investment firm. BLACK SCHOLES FORMULA INVESTOPEDIA FOREX
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To an impulsive spender, the perceived cost of waiting increases the internally calculated cost of the purchase. Thus, an impulsive spender places a higher cost on spending in or saving for the future and is less likely to do so. Credit card companies take advantage of impulsiveness. When you pay with a credit card, your monthly costs are summed up into one number that can be easily detached from the spending. No emotional attachment to that spending means the pain of waiting to spend is numbed.
And with automatic payments, or digital payments i. The pain-free spending is now brain-free, too. This is a problem because it is the pain of spending is that actually helps people control their spending. To counteract impulsive spending and focus more on saving for the future, spenders can try tricks like mental imagery and psychological distance.
Future Concept One way to oppose impulsiveness is through future concept. The future is hard to grasp for many, especially when it comes to finances. With future concept, you envision and understand your future self by mentally shortening the distance between right now and the future. Making the future a little more tangible can make it carry more importance, which leads to more rational money decisions.
The power in visualizing your child graduating from college, buying a vacation home or building your business can keep you focused on saving over spending. Other critics cite the fact that behavioral finance has not produced much data to support its arguments. Fama tells Institutional Investor he still believes behavioral investing is really just another name for choosing value stocks that have a higher cost of capital, which gives them higher expected returns.
When Russell Fuller and Richard Thaler set up their asset management firm in , Fuller, who had been chairman of the finance department at Washington State University, had already been in business five years. As an academic, Thaler had written a classic paper on why the stock market overreacts to new information, but he says he was still dubious about using behavioral finance actually to invest. Fuller says his firm is able to identify these companies in four out of five cases.
So how does it work? The small-cap growth strategy begins with an earnings surprise. The trick, according to Thaler, is to determine whether the source of the surprise is permanent. The opposite effect is overreaction. If their book value total assets minus liabilities, preferred stock and intangible assets remains constant, these equities become low price-to-book stocks, which investors normally term value stocks. Many money managers that have embraced behavioral finance use this value strategy.
This is based on psychological studies that show when people suffer a long string of losses, their relative risk aversion changes. When the market thinks a stock is a dog, has always been a dog and always will be a dog, that is representativeness. But Thaler and DePaul University finance professor Werner De Bondt showed in an academic paper in that long-term losers often become future winners.
Charles Lee, a professor of accounting at Stanford Graduate School of Business and a former adviser to Barclays Global Investors, says that even with a behavioral approach you need to look at fundamentals to determine the difference between price and value.
With large-cap stocks, Thaler says, his firm has to go both long and short and use both underreaction and overreaction to make any money, because of the increased competition in that sector. In fact, the firm is about to roll out a new large-cap strategy. The small-cap value strategy, started in , has earned annualized returns of While Thaler was honing his theories about cognitive biases, three other academics with a clear behavioral bias also decided to get into money management.
For example, the firm has identified mathematical proxies for extrapolation by processing data about analyst recommendations and analyst forecasts. Its large-cap fund, which began in December , has generated annualized returns of Its international large-cap fund, which was started in , has produced annualized returns of 9. According to Fuller, Fama was instrumental in getting Thaler his job there in Although their friendship thrives on the court, the philosophic divide between Fama and Thaler is as great as ever.
But Thaler shrugs off the lack of a unifying principle. It just happens to be wrong. If cognitive biases were the explanation, he insists, they would be a short-term phenomenon because arbitrageurs would learn about them and they would soon cease to work. Of course, behavioral finance adherents argue that investors are hardwired to make the same mistakes over and over again.
It is such disputes that have led some academics to question the accuracy of both efficient market theory and behavioral finance. Andrew Lo, a finance professor at the Massachusetts Institute of Technology Sloan School of Management, says the biggest contradiction of the EMH is the claim that there are no excess profits to be made, while investors such as hedge fund manager John Paulson and a number of others have been successful in beating the market.
Lo has proposed another theory, which he calls the Adaptive Markets Hypothesis, in which markets are neither efficient nor irrational, but some combination of both. That is something that can be measured. The more capital deployed in a given market, the more efficient it will be and the smaller the alpha each manager can earn.
In the early s, J. Morgan Asset Management began experimenting with behavioral finance in the U. The strategies proved successful and were adopted in the U. At first, J. But in late , Christopher Blum was chosen to begin managing a small-cap behavioral fund for J. Blum had been working as an analyst valuing private equity for alternative asset manager Pomona Capital in New York.
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