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values, this question is really: What is the expected value of the item given that you win the
auction, i.e., that the maximum of N independent bids is your bid of $8? Surely, this expected
value depends on the number of estimates. The larger the number of estimates, the lower is the
expected value given that you win the auction with a bid of $8. Thus, if you hold your bid
at your expected value while the number of bidders grows, the probability that if you win,
you have overbid grows and so does your expected loss. This is the winner™s curse: if you
win the auction, everyone else must think the asset is worth less than you do, so you likely
have overpaid.
Armed with this insight, you must bid less than your estimate of the expected value; in
game-theory parlance you must “shave your bid.” The optimal bid depends on the distribution
of the true value, the number of bidders, and the degree of independence of their estimates.
If everyone bids optimally, the winner can expect to pay a fair value and, more generally,
assets traded in auctions would fetch a fair price. Can we assume this to be the case? Eco-
nomic theorists would answer in the affirmative. Faced with the observation that most bidders
do not have the knowledge required to derive the optimal bid, they would argue that rules of
thumb derived from experience eventually lead traders to avoid the winner™s curse.
Experiments appear to contradict this assertion, however. Findings suggest that the learn-
ing curve of participants in auctions is flat. Moreover, even managers in the construction in-
dustry, where bidding is the normal way of lending contracts, did not show savvy in avoiding
the winner™s curse. This leaves open the question of whether assets priced in auctions fetch a
fair value.


The Endowment Effect, the Status Quo Bias, and Loss Aversion
What is the value of an item, say a Harley Davidson, to an individual? Economic theory takes
this value to be unambiguous given the individual™s tastes and resources. It turns out this isn™t
so. When asked to bid on the item, an individual may bid $5,000. Once in possession of an
item, however, that same individual may not be willing to sell it for less than $6,000. This am-
biguous preference is called the endowment effect, whereby an individual™s preference for a
good increases by virtue of ownership. This ambiguity is part of a broader phenomenon called
the status quo bias. Individuals appear to prefer the status quo over a new position even if, a
priori, the new position would have been preferred to the current position.
Researchers explain the endowment effect and the status quo bias by a type of preference
called loss aversion, shown in Figure 19.1. In any given position, potential losses are given
more weight than gains as conventional utility theory would predict. But the slope and origin
of the preference function will abruptly change with a change in wealth, that is, preferences
continuously vary as fortunes change, leading to decisions that are inconsistent with predictions
from economic theory. One result is that opportunity costs are not equal to out-of-pocket costs.
That is, forgone opportunities are valued less than perceived losses and investors will not up-
date portfolios to account for changes in security values in the manner predicted from mean-
variance considerations.
Observed inconsistent behavior also manifests itself in intertemporal choices, producing
ambiguity in the time value of money. For example, it has been estimated that individuals con-
sistently assign excessive discount rates (from 25% to as high as 300%) to savings on energy
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
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Fifth Edition




654 Part SIX Active Investment Management




F I G U R E 19.1 Value
Loss aversion
preference function




Losses Gains




cost when they can invest in items such as insulation or energy-efficient appliances. But, re-
searchers also find that individuals implicitly assign too low, even negative, time value when
they choose the timing of a lottery prize. Studies of individual choices show significant in-
consistency in assigning discount rates for consumption that changes with the timing and mag-
nitude of future cash flows. More generally, refuting the theory of life-cycle consumption, it
appears that young and old people consume too little and middle-aged people consume too
much relative to predictions of conventional theory. Moreover, consumption appears to be too
highly correlated with income and too little correlated with various forms of wealth such as
home equity and pension accumulation.

Mental Accounts
The behaviorists™ explanation of various inconsistencies in consumption and investment
behavior is based on a system of “mental accounts” in which individuals mentally segregate
assets into independent accounts rather than viewing them as part of a unified portfolio. One
such set of accounts is equity in assets, current income, and future income. With this break-
down, the marginal propensity to consume (MPC) out of wealth, that is, the amount consumed
from an increase of $1 in wealth depends on the “account” where the extra dollar appears.
MPC from current income is close to 1.0, MPC from future income is close to zero, and MPC
from equity is in-between. As discussed in the nearby box, this separation of mental accounts
serves to impose discipline on consumption behavior despite impatience to consume”future
income and equity in assets accounts are preserved while consumption binges are limited to
current income.
The “disposition effect,” another outcome of mental accounts and loss aversion, refers
to the tendency to sell winners too early in order to increase cash accounts and to hang on to
losers for too long to avoid realizing losses. The fact that the demand of “disposition in-
vestors” for a stock depends too heavily on the price history of the stock means that prices
may close in on fundamentals only over time, imparting momentum to price evolution. Grin-
blatt and Han (2001) show that disposition effects can lead to momentum in stock prices even
if fundamentals follow a random walk.
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We All Make Irrational Decisions,
But That May Not Be a Bad Thing
The perfect is the enemy of the good. oversight gives us added confidence in our strategy and
I write a lot about rational investing. But none of us makes us more tenacious during rough markets.
is completely rational. We trade too much. We chase To be sure, all this is likely to cost us, with the price
hot funds. We take a flier on dubious stocks. And, more paid in market-lagging performance. But when we suf-
often than not, we end up hurting our performance. fer this performance penalty, maybe we are getting our
But I am unwilling to dismiss this behavior as mere money™s worth.
foolishness. Why not? Seemingly foolish behavior can
Seeking Solace
help us with our struggle.
Studies suggest you won™t beat the market by following
the advice of newsletter writers and stock analysts.
Saving Ourselves
Yet, as we try to summon the nerve necessary to buy
When saving for financial goals, we are supposed to
individual stocks, we often latch onto the recommen-
figure out how much each goal will cost, make a rea-
dations of these experts.
sonable estimate of what return we are likely to earn
Are we misguided? Maybe not. “Even if the stocks
and then diligently save the appropriate sum every
don™t turn out to be better than other stocks, at least it
month.
gives us the courage to get started,” Prof. Nofsinger
Sound like the way you go about saving money? Me
notes.
neither. Saving is a messy business, because of the con-
stant temptation to spend. Injecting Fun
To compensate for our lack of self-control, we of-
While many investors struggle to find the courage to
ten fall back on mental games. For instance, we might
buy stocks, some folks have too much confidence.
have a chunk of cash sitting in a money-market fund
These investment junkies buy and sell stocks like crazy,
earning 1%, which we have earmarked for our tod-
thereby incurring exorbitant trading costs and taking
dler™s college education. But right now, we need a
unnecessary risks.
new car.
Still, such enthusiasm isn™t all bad. After all, if we
Financially, it would make sense to “borrow” from
are enthused about investing, we are probably more
the college fund and then pay the money back. But in-
keenly aware of how much money we need for retire-
stead, we take out a car loan, even though the loan will
ment and thus we are more likely to save enough.
likely cost us far more than we are earning on the
The trick is to make sure our enthusiasm for trading
money-market fund.
doesn™t do too much damage.
Why do we go this route? Mentally, we have ear-
“If you must trade and invest in foolish stocks, allo-
marked the money-market fund for the kid™s college
cate $10,000 or 5% of your money, whichever is
education, and we don™t trust ourselves to replenish the
smaller, to a fun-money account,” suggests Meir Stat-
account if we dip into it.
man, a finance professor at Santa Clara University in
“Lots of us know that we won™t make those payments
California. “And then, very much like in Vegas, try to
to ourselves,” says John Nofsinger, author of “Invest-
make the money last as long as possible.”
ment Madness” and a finance professor at Washington
State University in Pullman, Wash. “Mental accounting Playing the Percentages
helps us stay disciplined.”
We should all decide what portion of our portfolio we
want in stocks and then stick with this percentage
Winning by Losing through thick and thin. But as many folks have discov-
The evidence is undeniable: Market-tracking index ered, this advice can be tough to follow.
funds outperform actively managed stock funds. De- Inevitably, some investors get skittish, and start danc-
spite this lackluster performance, actively managed ing in and out of the stock market. This isn™t a smart
funds still account for 91% of all stock-fund assets. strategy. But it will probably lead to better results than
Why do we continue to bank so heavily on a losing simply leaving everything in a money-market fund.
proposition?
It seems we like having the chance, however slim, to
beat the market. In fact, it makes us more inclined to SOURCE: Jonathan Clements, “We All Make Irrational Decisions,
invest in stocks. We also find it comforting when But That May Not Be a Bad Thing.” Abridged from The Wall Street
Journal online, March 26, 2002.
professional stock pickers watch over our money. Their




655
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Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




656 Part SIX Active Investment Management


In sum, while economic theory relies on rational expectations and rational behavior, be-
haviorists have documented evidence and explanations of fundamentals of behavior that are
inconsistent with this theory. However, the test of success of the efforts of the behaviorists
is in explaining deviations of assets prices from predictions of classic theory. In the next
section we provide an assessment of these efforts.


19.3 ASSET RETURNS AND BEHAVIORAL
EXPL ANATIONS
It is natural for behaviorists to concentrate on documented anomalies in asset prices and at-
tempt to explain them by behavior that is excluded by economic theory. Here are the main-
stream of these anomalies and offered explanations.


Calendar Effects
Calendar effects are prominent among the anomalies documented in Chapter 8 on market ef-
ficiency. An extraordinary pattern of abnormal returns occurs around the turn of the year and
turn of months. Behaviorists point to the following explanations:
1. The timing of the flow of funds into the market is derived, at least in part, by the flow of
funds to individual and institutional investors. These tend to be concentrated around
calendar turns.
2. “Window dressing” by institutional investors refers to trades timed to load quarterly
balance sheets with stocks of recently successful firms and rid them of stocks that have
recently stumbled.
3. The publication of good and bad news under the control of the proprietors is mostly
issued around calendar turns.


Cash Dividends
Dividend irrelevance in the absence of taxes and transaction costs is a fundamental tenet
of financial theory. Tax-code discrimination against dividend income should, if anything,
punish high-yield stocks. Finally, the clientele effect predicts that, if investors exhibited
preference for dividends over capital gains, supply of dividends by corporations would
materialize so as to eliminate risk-adjusted differentials in expected returns. Nevertheless,
high dividends seem to endow stocks with a price premium.
Preference for cash dividends can be justified by mental accounts, since dividends increase
current income at the expense of the “higher self control” equity account. As evidence for such
bias in the population, Lease, Lewellen, and Schlarbaum (1976) compiled Table 19.1, which
shows that older and retired investors, those with the most funds to invest, value dividends
more highly and concentrate their (better diversified!) portfolios in high income securities.


Overraction and Mean Reversion
Perhaps the most notable influence of behavioral finance in explaining as set returns can be
found in the literature of overreaction and mean reversion. Investors assign a probability dis-
tribution to future asset returns based on a relevant history of previous returns. Appropriate
reaction to an unexpected event (return) is to update one™s prior probability distribution by
assigning a weight to the most recent event. Overreaction results when investors assign too
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657
19 Behavioral Finance and Technical Analysis


(1) (2) (3) (4) (5)
TA B L E 19.1 Highly
Importance of Educated Young Older
alternative
Young Unmarried Males, Females,
investment goals to
Professional Professionals Still at Mostly Retired
various demographic
Men & Managers Work Retired Males
groups as measured
by average rating Investment Goal Rating:
(4 very important Short term capital gains 2.19 2.00 1.86 1.50 1.53

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