Behavioural Finance

<p>Preface xv</p>
<p>Acknowledgements xvii</p>
<p>1 Introduction 1</p>
<p>1.1 Illustration and Structure 2</p>
<p>1.2 Finance Theory as an Engine not a Camera 3</p>
<p>1.3 Rebuilding on New Foundations 7</p>
<p>1.4 Challenging the Classical Assumptions of Finance 9</p>
<p>1.5 Modelling Behavioural Aspects of Finance 11</p>
<p>1.6 The Structure of the Book 12</p>
<p>Appendix: A Financial Tsunami 14</p>
<p>Notes 14</p>
<p>References 14</p>
<p>Part I FOUNDATIONS 17</p>
<p>2 Financial Decision Making 19</p>
<p>2.1 Illustration and Structure 19</p>
<p>2.2 The Expected Utility Rule 20</p>
<p>2.3 Expected Utility Theory: Simple But Untrue? 26</p>
<p>2.4 Frames for Actions, Contingencies and Outcomes 31</p>
<p>2.5 Conclusion and Summary 35</p>
<p>Questions 35</p>
<p>Notes 36</p>
<p>References 36</p>
<p>3 Discounting 39</p>
<p>3.1 Illustration and Structure 40</p>
<p>3.2 The Discounted Utility Model 40</p>
<p>3.3 How and Why Discount Rates Vary 44</p>
<p>3.4 Investment Behaviour When Discount Rates are Declining: Investing in a Golden Egg 47</p>
<p>3.5 Hyperbolic Discount Factors 49</p>
<p>3.6 Valuation by Using the Matching Law 51</p>
<p>3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54</p>
<p>3.8 Conclusion and Summary 59</p>
<p>Appendix: Timely Choice: Euler Equations Dynamics and Inter–Temporal</p>
<p>Choice 60</p>
<p>Questions 61</p>
<p>Notes 62</p>
<p>References 62</p>
<p>4 Learning 65</p>
<p>4.1 Illustration and Structure 65</p>
<p>4.2 Rational Learning 66</p>
<p>4.3 Do We Learn the Bayesian Way? 72</p>
<p>4.4 Over Inference and the Law of Small Numbers 76</p>
<p>4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77</p>
<p>4.6 Conclusion and Summary 79</p>
<p>Appendix: Case Study Baseball the Bayesian Way 80</p>
<p>Questions 87</p>
<p>Notes 88</p>
<p>References 88</p>
<p>5 Bubbles 89</p>
<p>5.1 Illustration and Structure 90</p>
<p>5.2 Tulipmania and the Didactic Value of Bubbles 91</p>
<p>5.3 The Regulatory Origins of the Most Recent Bubble 92</p>
<p>5.4 Bubbles: Past, Present and Future 101</p>
<p>5.5 The 1929 Stock–Market Crash 104</p>
<p>5.6 Should Government Burst the Bubble? 108</p>
<p>5.7 Conclusion and Summary 109</p>
<p>Appendix: Tulips as Assets and Art 110</p>
<p>Questions 114</p>
<p>Notes 114</p>
<p>References 114</p>
<p>Part II ASSET PRICING 117</p>
<p>6 Noise Traders 119</p>
<p>6.1 Illustration and Structure 120</p>
<p>6.2 The De Long, Shleifer, Summers and Waldmann Model 121</p>
<p>6.3 Can Investors Get Emotional? 133</p>
<p>6.4 Conclusion and Summary 138</p>
<p>Questions 138</p>
<p>Notes 139</p>
<p>References 139</p>
<p>7 Overconfidence and Optimism 141</p>
<p>7.1 Illustration and Structure 142</p>
<p>7.2 A Model of Trading Amongst Optimistic Investors 142</p>
<p>7.3 Do Investors Trade Too Much? 150</p>
<p>7.4 Conclusion and Summary 154</p>
<p>Appendix A: Hubris at Work: The AOL Time Warner Merger 155</p>
<p>Appendix B: Derivation of Results in Odean s Model 161</p>
<p>Questions 163</p>
<p>Notes 163</p>
<p>References 163</p>
<p>8 Asset Pricing under Prospect Theory 165</p>
<p>8.1 Illustration and Structure 165</p>
<p>8.2 The Basics of Prospect Theory 166</p>
<p>8.3 Does Prospect Theory Work? 172</p>
<p>8.4 The Cumulative Probability Version of Prospect Theory 176</p>
<p>8.5 Does Cumulative Prospect Theory Work? 177</p>
<p>8.6 Conclusion and Summary 181</p>
<p>Appendix: CARA Utility 181</p>
<p>Questions 182</p>
<p>Note 182</p>
<p>References 183</p>
<p>9 Overreaction and/or Underreaction 185</p>
<p>9.1 Illustration and Structure 185</p>
<p>9.2 The DHS Model 186</p>
<p>9.3 No News Is . . .? 194</p>
<p>9.4 Conclusion and Summary 199</p>
<p>Questions 199</p>
<p>Note 199</p>
<p>References 200</p>
<p>10 Momentum 201</p>
<p>10.1 Illustration and Structure 201</p>
<p>10.2 Grinblatt and Han s (2005) Model 203</p>
<p>10.3 What Drives Stock–Market Momentum? 208</p>
<p>10.4 What Causes PEAD? 212</p>
<p>10.5 Conclusion and Summary 217</p>
<p>Questions 217</p>
<p>Note 218</p>
<p>References 218</p>
<p>11 Herding 221</p>
<p>11.1 Illustration and Structure 221</p>
<p>11.2 The FSS Model 222</p>
<p>11.3 Conformity as a Force for Social Good and Evil 228</p>
<p>11.4 Conclusion and Summary 233</p>
<p>Appendix: The United States vs. Microsoft 234</p>
<p>Questions 236</p>
<p>Note 237</p>
<p>References 237</p>
<p>12 Insider Trading 239</p>
<p>12.1 Illustration and Structure 240</p>
<p>12.2 Insider Trading Here for Better or Worse 241</p>
<p>12.3 The Hirshleifer, Subrahmanyam and Titman Model 245</p>
<p>12.4 Insider Trading, Stock Options and the Construction of Earnings 255</p>
<p>12.5 Insider Trading and its Consequence for Outsiders 257</p>
<p>12.6 Conclusion and Summary 258</p>
<p>Appendix A: Why Don t Later Informed Traders Trade in Period 1 in the HST Model? 258</p>
<p>Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262</p>
<p>Questions 265</p>
<p>Notes 265</p>
<p>References 266</p>
<p>13 Equity Premium Puzzle 269</p>
<p>13.1 Illustration and Structure 269</p>
<p>13.2 The Puzzle 270</p>
<p>13.3 Loss Aversion in a Reference–Dependent Utility Model 276</p>
<p>13.4 Conclusion and Summary 280</p>
<p>Questions 281</p>
<p>References 281</p>
<p>Part III CORPORATE FINANCE 283</p>
<p>14 Incorporation 285</p>
<p>14.1 Illustration and Structure 285</p>
<p>14.2 Companies: Where did They Come from and Where will They Go? 286</p>
<p>14.3 Agency, Monitoring and Incorporation 289</p>
<p>14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 296</p>
<p>14.5 Conclusion and Summary 300</p>
<p>Appendix: Emperor Eisner A Case Study in the Power of Personal Control in a</p>
<p>Corporation 300</p>
<p>Questions 313</p>
<p>Notes 313</p>
<p>References 314</p>
<p>15 The Market for Information, Noise and Deception 317</p>
<p>15.1 Illustration and Structure 318</p>
<p>15.2 The Boundaries of the Market for Corporate Information 318</p>
<p>15.3 What Do Analysts Do? 321</p>
<p>15.4 Valuing Investment Advice 325</p>
<p>15.5 Conclusion and Summary 333</p>
<p>Questions 334</p>
<p>Notes 334</p>
<p>References 334</p>
<p>16 Dividends 337</p>
<p>16.1 Illustration and Structure 337</p>
<p>16.2 The Irrelevance of Dividends to Value 338</p>
<p>16.3 A Prospect Theory Explanation of Dividend Payments 340</p>
<p>16.4 Who Pays Dividends and Why? 346</p>
<p>16.5 Conclusion and Summary 350</p>
<p>Questions 350</p>
<p>Note 351</p>
<p>References 351</p>
<p>17 Entrepreneurship 353</p>
<p>17.1 Illustration and Structure 354</p>
<p>17.2 The BT Model 355</p>
<p>17.3 Is Deluding Yourself Worth it? 362</p>
<p>17.4 Conclusion and Summary 364</p>
<p>Appendix: Entrepreneurs and the BT Model Some Case Studies 364</p>
<p>Questions 370</p>
<p>Notes 370</p>
<p>References 371</p>
<p>Part IV THE PROFESSIONS 373</p>
<p>18 Analysts Conflicts of Interest 375</p>
<p>18.1 Illustration and Structure 376</p>
<p>18.2 Evidence of Conflicts of Interest from Empirical Studies 377</p>
<p>18.3 Regulating Conflicts of Interest 380</p>
<p>18.4 Conclusion and Summary 385</p>
<p>Questions 386</p>
<p>Notes 386</p>
<p>References 386</p>
<p>19 Accounting Reform 389</p>
<p>19.1 Illustration and Structure 389</p>
<p>19.2 The Onward March of Fair–Value Accounting 390</p>
<p>19.3 An Accounting–Based Valuation Model 392</p>
<p>19.4 Behavioural Bias in Estimates of the Ohlson Model 404</p>
<p>19.5 Conclusion and Summary 407</p>
<p>Appendix A: Mark–to–Market Accounting at Enron A Case Study 407</p>
<p>Appendix B: Solving for Price in Terms of Abnormal Earnings and Non–Accounting</p>
<p>Information only (Equation (19.7)) 423</p>
<p>Questions 425</p>
<p>Notes 425</p>
<p>References 426</p>
<p>20 Conclusion 427</p>
<p>Index 431</p>