Behavioural Decision and Behavioural Finance

Speaker: Professor Richard Zeckhauser- Frank P. Ramsey Professor of Political Economy

Date: Thursday, 19th March 2008

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Lecture Synopsis

by Panos Vrahiotis

Professor Richard Zeckhauser’s lecture focused on decision making theory and its application to critical choices in the sphere of economics and finance. By using examples ranging from individual savings behaviour, to financial market volatility, he discussed how highly reputed investors can even go wrong after deploying unsuccessful investment strategies. “We are all severely handicapped in decision making theory, the very structure of our brains leads us to make decision errors.” said Mr Zeckhauser. Financial crises and plummeting stocks are not only a sight of the past, but also of the future. “The behaviour of the financial markets and the participants within them illustrate that people have difficulties making rational decisions.” he added.

The Professor, illustrated his first point by using the example of the recent US subprime crisis. Bear Stearns, one of the most important investment banking houses in the US saw the value of its stock plummet by 97.5% over a period of less than 2 months. The decision to leverage $9 billion USD in borrowings into $29.7 billion securities linked to the housing-market drove the investment bank to bankruptcy following the meltdown of the subprime mortgage market, and the rise of interest rates.

“Some people will make very good guesses and some people will make very bad guesses. Individuals and companies want to avoid the possibility of being blamed.” JP Morgan bought Bear Stearns and its liabilities at 10 USD per share when it had been selling at an excess of 80 USD a share earlier this year. “They were taking on the potential for blame and their stock has risen 15% within a week of the acquisition.” said Mr. Zeckhauser.

Such examples, suggest that people should have a much broader subjective probability distributions on what might happen than what they do have. “Everybody is much too confident with his or her estimates of what’s going to happen. Rule processes reinforce this. Groups tend to become more certain on beliefs.”

On a day to day basis, most of the decisions people make don’t involve uncertainty but repeated types of processes. However, to make decisions about investment is much harder. Uncertainty influences and preferences make these decisions difficult. “People make systematic errors in their decisions. Preferences are strongly inconsistent. People are very biased in their calibration of probabilities and updating and these errors persist in relatively easy financial decision” said Mr. Zeckhauser

The example of stock ownership plans illustrates how employees mistakenly invest, thinking that their employer’s stock is safer than a mutual fund.“This happens because it is comforting for the investor.” However, according to Zeckhauser, there are two reasons why an employer stock is riskier than a mutual fund. “The one reason is that your mutual fund may hold 100 securities and your employer stock 1 security. You have no diversification. The second reason why this is risky is that you are heavily invested in your employer’s stock. Company value fluctuates. Maybe your company is a better investment for me and mine is for you”. He added.

There are various behavioural propensities which may influence decision-making. Examples of behavioural finance can be noticed by observing the preference between value and glamour (high potential) stocks, as well as the difference in demand between equities and bonds are such examples. “Value stocks consistently outperform glamour stocks. Value stocks rise considerably when the earnings do well. Glamour stocks indicate increase in earnings of 15% percent when doing well, but plummet when the earnings disappoint.” Similarly, equity premium can be seen to pay substantially more in premium than bonds. “People demand too much to invest in equities. Stocks may offer profit but people do not want to see stocks go up and down as the losses count more for them than the gains” said Professor Zeckhauser.

In the world of finance, market and security prices may often move dramatically beyond fundamentals. The rise of NASDAQ after September 11th is one such example. Wise investors have earned extraordinary returns by investing in the unknown and the unknowable. As Professor Zeckhauser said “Currencies swing widely unrelated to interest rate differentials or other traditional causative factors. This is because big industries capitalise on investor errors such as mutual fund success, despite poor performance and through commissions from excess trading on market.”

Behaviour in the context of firms and markets relies on a rational utitility-maximising framework, disagreeable with assertions of non-rational behaviour. In spite of this, many empirical investigations have led to a discovery of anomalies. “On the 1st September 2001, Dow Jones had a stock market level of 9,480, today it is 12,000.” However, the issues of Global Warming, Terrorism, the Iraq war with a cost of 3 trillion dollars, the subprime crisis, and the recession looming over the US are not indicative of prosperous times. “Everything is worse, but the value and level of the stock market is 20% higher” added Zeckhauser.

Such examples suggest that psychology is equally important as economics in the field of behavioural finance. By reviewing existing human, social and emotional biases, it is possible to acquire a better understanding of economic decisions and how market prices, returns and the allocation of resources can be affected.

Emotional structures in the brain play an important role. The part of the brain used when thinking of immediate rewards, overpowers the other portion brain. This results in people making systematic errors.” Emotional structures are impatient whereas, front-parietal analytic systems of the brain are patient. The emotional brain does not respond to delayed rewards” said Zeckhauser “It creates a drive for instant gratification.” In fact individuals assess probabilities in a manner influenced by their values as well as their emotions. “There is a positive correlation between preference and belief” he said. Group processes exacerbate behavioural propensities “An agreement on why your candidate in the Presidential Elections will win or common reinforcing beliefs on why a business deal makes sense suggest a strong correlation between preference and belief.”

Professor Zeckhauser highlighted the important lessons that can be taught from the field of behavioural decision and finance. “One should think systematically and independently about preferences and probabilities.” But how can this be done? By improving decisions, by using knowledge as the first step and reflecting on biases whilst being aware of overconfidence and certainty of own estimates. Professor Zeckhaurser advised all members of the audience to; ‘Heal thyself’; by de-biasing or re-biasing and invest in understanding the behavioural biases of others” and concluded by quoting French novelist, Anatole France: “Of all the ways of defining man the worst is the one which makes him out to be a rational animal.”