Behavioral finance

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BEHAVIORAL FINANCE H.Kent Baker and John R. Nofsinger, Editors Investors, Corporations, and Markets KOLB SERIES IN FINANCE Essential Perspectives Baker Nofsinger BEHAVIORAL FINANCE The Robert W. Kolb Series in Finance is an unparalleled source of informa- tion dedicated to the most important issues in modern fi nance. Each book focuses on a specifi c topic in the fi eld of fi nance and contains contributed chapters from both respected academics and experienced fi nancial profes- sionals. As part of the Robert W. Kolb Series in Finance, Behavioral Finance aims to provide a comprehensive understanding of the key themes associated with this growing fi eld and how they can be applied to investments, corpora- tions, markets, regulations, and education. Behavioral fi nance has the potential to explain not only how people make fi nancial decisions and how markets function, but also how to improve them. This book provides invaluable insights into behavioral fi nance, its psychological foundations, and its applications to fi nance. Comprising contributed chapters by a distinguished group of academics and practitioners, Behavioral Finance provides a synthesis of the most essential elements of this discipline. It puts behavioral fi nance in perspective by detailing the current state of research in this area and offers practical guidance on applying the information found here to real-world situations. Behavioral fi nance has increasingly become part of mainstream fi nance. If you intend on gaining a better understanding of this discipline, look no further than this book. KOLB SERIES IN FINANCE Essential Perspectives (continued from front flap) EAN: 9780470499115 ISBN 978-0-470-49911-5 (continued on back flap) $95.00 USA/$114.00 CAN B ehavioral fi nance has increasingly become part of mainstream fi nance—helping to provide explanations for our economic decisions by combining behavioral and cognitive psychological theory with conventional economics and fi nance. Filled with in-depth insights and practical advice, this reliable resource—part of the Robert W. Kolb Series in Finance—provides a comprehensive view of behavioral fi nance by discussing the current state of research in this area and detailing its poten- tial impact on investors, corporations, and markets. Comprising contributed chapters by distinguished experts from some of the most infl uential fi rms and universities in the world, Behavioral Finance provides a synthesis of the essential elements of this discipline including psychological concepts and behavioral biases; the behavioral aspects of asset pricing, asset allocation, and market prices; investor behavior, corporate managerial behavior, and social infl uences. Divided into six comprehensive parts, it skillfully: • Describes the fundamental heuristics, cognitive errors, and psychological biases that affect fi nancial decisions • Discusses market ineffi ciency and behavioral- based pricing models • Explores corporate and executive behavioral fi nance and examines the behavioral infl uences involving their investment and fi nancing decisions • Addresses how behavioral fi nance applies to individual and institutional investors’ holdings and their trading endeavors • Shows how cultural factors and societal attitudes affect markets BEHAVIORAL FINANCE Behavioral Finance contains the latest information from some of the leading practitioners and academics in this fi eld. Engaging and accessible, this book provides a clear understanding of how people make fi nancial decisions and their effects on today’s markets. H. KENT BAKER, P HD, CFA, CMA, is University Professor of Finance and Kogod Research Professor at the Kogod School of Business, American University. He has published extensively in leading academic and professional fi nance journals including the Journal of Finance, Journal of Financial and Quantitative Analysis, Financial Management, Financial Analysts Journal, Journal of Portfolio Management, and Harvard Business Review. Professor Baker is recognized as one of the most prolifi c authors in fi nance during the past fi fty years. He has consulting and training experience with more than 100 organizations and has been listed in fi fteen biographies. JOHN R. NOFSINGER is an Associate Professor of Finance and Nihoul Faculty Fellow at Washington State University. He is one of the world’s leading experts in behavioral fi nance and is a frequent speaker on this topic at investment management conferences, universities, and academic conferences. Nofsinger has often been quoted or appeared in the financial media, including the Wall Street Journal, Financial Times, Fortune, BusinessWeek, Bloomberg, and CNBC. He writes a blog called “Mind on My Money” at psychologytoday.com. Jacket Design: Leiva-Sposato Jacket Illustration: © ImageClick, Inc./Alamy P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton BEHAVIORAL FINANCE P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton The Robert W. Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately 65 volumes covering all major topics and specializations in finance, ranging from investments, to corporate finance, to financial institutions. Each vol- ume in the Kolb Series in Finance consists of new articles especially written for the volume. Each Kolb Series volume is edited by a specialist in a particular area of finance, who develops the volume outline and commissions articles by the world’s experts in that particular field of finance. Each volume includes an editor’s introduction and approximately thirty articles to fully describe the current state of financial research and practice in a particular area of finance. The essays in each volume are intended for practicing finance professionals, grad- uate students, and advanced undergraduate students. The goal of each volume is to encapsulate the current state of knowledge in a particular area of finance so that the reader can quickly achieve a mastery of that special area of finance. P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton BEHAVIORAL FINANCE Investors, Corporations, and Markets Editors H. Kent Baker John R. Nofsinger The Robert W. Kolb Series in Finance John Wiley & Sons, Inc. P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton Copyright c  2010 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. 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Investments–Psychological aspects. 2. Investments–Decision making. 3. Finance–Psychological aspects. I. Baker, H. Kent (Harold Kent), 1944– II. Nofsinger, John R. HG4515.15.B4384 2010 336.201'9–dc22 2010010865 Printed in the United States of America 10987654321 P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton Contents Acknowledgments ix PART I Foundation and Key Concepts 1 1 Behavioral Finance: An Overview 3 H. Kent Baker, John R. Nofsinger 2 Traditional versus Behavioral Finance 23 Robert Bloomfield 3 Behavioral Finance: Application and Pedagogy in Business Education and Training 39 Rassoul Yazdipour, James A. Howard 4 Heuristics or Rules of Thumb 57 Hugh Schwartz 5 Neuroeconomics and Neurofinance 73 Richard L. Peterson 6 Emotional Finance: The Role of the Unconscious in Financial Decisions 95 Richard J. Taffler, David A. Tuckett 7 Experimental Finance 113 Robert Bloomfield, Alyssa Anderson 8 The Psychology of Risk 131 Victor Ricciardi 9 Psychological Influences on Financial Regulation and Policy 151 David Hirshleifer, Siew Hong Teoh v P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton vi Contents PART II Psychological Concepts and Behavioral Biases 169 10 Disposition Effect 171 Markku Kaustia 11 Prospect Theory and Behavioral Finance 191 Morris Altman 12 Cumulative Prospect Theory: Tests Using the Stochastic Dominance Approach 211 Haim Levy 13 Overconfidence 241 Markus Glaser, Martin Weber 14 The Representativeness Heuristic 259 Richard J. Taffler 15 Familiarity Bias 277 Hisham Foad 16 Limited Attention 295 Sonya S. Lim, Siew Hong Teoh 17 Other Behavioral Biases 313 Michael Dowling, Brian Lucey PART III Behavioral Aspects of Asset Pricing 331 18 Market Inefficiency 333 Raghavendra Rau 19 Belief- and Preference-Based Models 351 Adam Szyszka PART IV Behavioral Corporate Finance 373 20 Enterprise Decision Making as Explained in Interview-Based Studies 375 Hugh Schwartz 21 Financing Decisions 393 Jasmin Gider, Dirk Hackbarth P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton CONTENTS vii 22 Capital Budgeting and Other Investment Decisions 413 Simon Gervais 23 Dividend Policy Decisions 435 Itzhak Ben-David 24 Loyalty, Agency Conflicts, and Corporate Governance 453 Randall Morck 25 Initial Public Offerings 475 Franc¸ois Derrien 26 Mergers and Acquisitions 491 Ming Dong PART V Investor Behavior 511 27 Trust Behavior: The Essential Foundation of Financial Markets 513 Lynn A. Stout 28 Individual Investor Trading 523 Ning Zhu 29 Individual Investor Portfolios 539 Valery Polkovnichenko 30 Cognitive Abilities and Financial Decisions 559 George M. Korniotis, Alok Kumar 31 Pension Participant Behavior 577 Julie Richardson Agnew 32 Institutional Investors 595 Tarun Ramadorai 33 Derivative Markets 613 Peter Locke PART VI Social Influences 629 34 The Role of Culture in Finance 631 Rohan Williamson P1: OTA/XYZ P2: ABC fm JWBT306-Baker July 10, 2010 13:53 Printer Name: Hamilton viii Contents 35 Social Interactions and Investing 647 Mark S. Seasholes 36 Mood 671 Tyler Shumway PART VII Answers to Chapter Discussion Questions 681 Index 727 [...]... 1 Behavioral Finance: An Overview H KENT BAKER University Professor of Finance and Kogod Research Professor, American University JOHN R NOFSINGER Associate Professor of Finance and Nihoul Finance Faculty Fellow, Washington State University INTRODUCTION Behavioral finance is a relatively new but quickly expanding field that seeks to provide explanations for people’s economic decisions by combining behavioral. .. 40 articles in scholarly and practitioner journals, including the Journal of Finance, Journal of Business, Journal of Financial and Quantitative Analysis, Journal of Corporate Finance, Journal of Banking and Finance, Financial Management, Financial Analysts Journal, Journal of Behavioral Decision Making, Journal of Behavioral Finance, and many others P1: OTA/XYZ P2: ABC c01 JWBT306-Baker July 19, 2010... chapters in the other five sections Chapter 2 Traditional versus Behavioral Finance (Robert Bloomfield) This chapter examines the tension between traditional and behavioral finance, which differ only in that the latter incorporates behavioral forces into the otherwisetraditional assumption that people behave as expected utility maximizers Behavioralists typically argue their approach can account for market... idiosyncrasies Such research will establish common ground between traditionalists and behavioralists, while also identifying settings in which behavioral research is likely to have the most predictive power Chapter 3 Behavioral Finance: Applications and Pedagogy in Business Education and Training (Rassoul Yazdipour and James A Howard) While behavioral finance had its beginnings in the early 1970s, it has not yet... this book is outlined, followed by an abstract for each of the remaining 35 chapters BEHAVIORAL FINANCE Before the evolution of behavioral finance, there was standard or traditional finance This section discusses some of the key concepts underlying standard finance and the need for behavioral finance Standard (Traditional) Finance At its foundation, standard finance assumes that finance participants, institutions,... new paradigm on the grounds that it is too complex and incapable of refutation A history of behavioral research in financial reporting shows the importance of sociological factors in building acceptance for behavioral finance Behavioral researchers should redouble their efforts to demonstrate that the influence of behavioral factors is mediated by the ability of institutions (such as competitive markets)... common subjects Finance scholars, on the other hand, use data of actual decisions made in real economic settings While using this method is more convincing that people would actually behave in the manner identified, isolating that behavior in tests is difficult Chapter 7 provides a discussion on experimental finance KEY THEMES IN BEHAVIORAL FINANCE To help organize the vast and growing field of behavioral finance,... Name: Hamilton BEHAVIORAL FINANCE: AN OVERVIEW 21 ABOUT THE AUTHORS H Kent Baker is a University Professor of Finance and Kogod Research Professor at the Kogod School of Business, American University He has held faculty and administrative positions at Georgetown University and the University of Maryland Professor Baker has written or edited 10 books, including Survey Research in Corporate Finance: Bridging... Professor of Finance and Nihoul Faculty Finance Fellow at Washington State University He is one of the world’s leading experts in behavioral finance and is a frequent speaker on this topic His book The Psychology of Investing (4th edition, 2010) is popular in the investment industry and academics Other books include Investments: Analysis and Behavior (with Mark Hirschey, 2nd edition), Finance: Applications... are interested in behavioral finance should find this book to be useful given the scope of the work This book is appropriate as a stand-alone or supplementary book for undergraduate or graduate-level courses in behavioral finance This chapter begins in the next section with a brief discussion of behavioral finance from the context of its evolution from standard finance Four key themes of behavioral finance . Foundation and Key Concepts 1 1 Behavioral Finance: An Overview 3 H. Kent Baker, John R. Nofsinger 2 Traditional versus Behavioral Finance 23 Robert Bloomfield 3 Behavioral Finance: Application and Pedagogy. BEHAVIORAL FINANCE H.Kent Baker and John R. Nofsinger, Editors Investors, Corporations, and Markets KOLB SERIES IN FINANCE Essential Perspectives Baker Nofsinger BEHAVIORAL FINANCE The. 1 Behavioral Finance: An Overview H. KENT BAKER University Professor of Finance and Kogod Research Professor, American University JOHN R. NOFSINGER Associate Professor of Finance and Nihoul Finance