Beyond Greed and Fear Financial Management Association Survey and Synthesis Series The Search for Value: Measuring the Company's Cost of Capital Michael C. Ehrhardt Managing Pension Plans: A Comprehensive Guide to Improving Plan Performance Dennis E. Logue and Jack S. Rader Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation Richard O. Michaud Real Options: Managing Strategic Investment in an Uncertain World Martha Amram and Nalin Kulatilaka Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin Dividend Policy: Its Impact on Form Value Ronald C. Lease, Kose John, Avner Kalay, Uri Loewenstein, and Oded H. Sarig Value Based Management: The Corporate Response to Shareholder Revolution John D. Martin and J. William Petty Debt Management: A Practitioner's Guide John D. Finnerty and Douglas R. Emery Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities Su Han Chan, John Erickson, and Ko Wang Trading and Exchanges: Market Microstructure for Practitioners Larry Harris Beyond Greed and Fear Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin 2002 198 Madison Avenue, New York, New York 10016 Oxford University Press is a department of the University of Oxford It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Bangkok Buenos Aires Cape Town Chennai Dar es Salaam Delhi Hong Kong Istanbul Karachi Kolkata Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi São Paulo Shanghai Taipei Tokyo Toronto Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Copyright © 2002 by Oxford University Press, Inc. The moral rights ofthe authors have been asserted Database right Oxford University Press (maker) First published in 2000 by President and Fellows ofHarvard College All rights reserved. No part ofthis publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing ofOxfordUniversity Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope ofthe above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose this same condition on any acquirer Library ofCongress Cataloging-in-Publication Data Shefrin, Hersh, 1948— Beyond greed and fear : understanding behavioral finance and the psychology ofinvesting / Hersh Shefrin p. cm.—(Financial Management Association survey and synthesis series) Originally published: Boston: Harvard Business School Press © 2000. ISBN 0-19-516121-1 1. Investments—Psychological aspects. 2. Stock exchanges—Psychological aspects. 3. Finance—Psychological aspects. I. Title. II. Series. [HG4515.15. S53 2002]] 332.6′01′9—dc21 2002010047 For Arna This page intentionally left blank Contents Preface ix PART I What Is Behavioral Finance? 1 Chapter 1 Introduction 3 Chapter 2 Heuristic-Driven Bias: The First Theme 13 Chapter 3 Frame Dependence: The Second Theme 23 Chapter 4 Inefficient Markets: The Third Theme 33 PART II Prediction 43 Chapter 5 Trying to Predict the Market 45 Chapter 6 Sentimental Journey: The Illusion of Validity 59 Chapter 7 Picking Stocks to Beat the Market 69 Chapter 8 Biased Reactions to Earnings Announcements 91 PART III Individual Investors 105 Chapter 9 “Get-Evenitis”: Riding Losers Too Long 107 Chapter 10 Portfolios, Pyramids, Emotions, and Biases 119 Chapter 11 Retirement Saving: Myopia and Self-Control 139 PART IV Institutional Investors 157 Chapter 12 Open-Ended MutualFunds: Misframing, “Hot Hands,” and Obfuscation Games 159 Chapter 13 Closed-End Funds: What Drives Discounts? 175 viii Contents Chapter 14 Fixed Income Securities: The Full Measure of Behavioral Phenomena 193 Chapter 15 The Money Management Industry: Framing Effects, Style “Diversification,” and Regret 213 PART V The Interface between Corporate Finance and Investment 225 Chapter 16 Corporate Takeovers and the Winner's Curse 227 Chapter 17 IPOs: InitialUnderpricing, Long-term Underperformance, and “Hot-Issue” Markets 239 Chapter 18 Optimism in Analysts' Earnings Predictions and Stock Recommendations 257 PART VI Options, Futures, and Foreign Exchange 271 Chapter 19 Options: How They're Used, How They're Priced, and How They Reflect Sentiment 273 Chapter 20 Commodity Futures: Orange Juice and Sentiment 289 Chapter 21 Excessive Speculation in Foreign Exchange Markets 299 FinalRemarks 309 Notes 311 References 333 Credits 351 Index 359 Preface to the Oxford Edition Behavioral finance is the study of how psychology affects finance. Psychology is the basis for human desires, goals, and motivations, and it is also the basis for a wide variety of human errors that stem from perceptual illusions, overconfidence, over-reliance on rules ofthumb, and emotions. Errors and bias cut across the entire financial landscape, affecting individual investors, institutional investors, analysts, strategists, brokers, portfolio managers, options traders, currency traders, futures traders, plan sponsors, financial executives, and financial commentators in the media. This book is about recognizing the influence ofpsychology on oneself,on others, and on the financial environment at large. I take some pride in the fact that Beyond Greed and Fear was the first comprehensive treatment ofbehavioral finance. However, the greatest satisfaction comes from witnessing the enormous growth that has occurred in the field since the book was first published in 1999. As a field, behavioral finance is flourishing, not only in academia where financial issues are studied, but also in practice where behavioral concepts are coming to be routinely applied. One only need do a web-based search on “behavioral finance” to see how the field has virtually exploded. Behavioral finance is now represented in almost every leading academic department of finance in the United States. Some universities, such as the University ofMannheim in Germany, have established institutes dedicated to the subject. The Social Science Research Network has a separate newsgroup devoted to behavioral and experimental finance. Behavioral papers are now routinely presented at every major academic finance meeting. Articles devoted to behavioral topics are winning Best Paper awards. Two notable instances are the Smith Breeden Prize and the William F. Sharpe Award. The Smith Breeden Prize was awarded to Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam for the best paper published in the Journal of Finance during 1999. They wrote “Investor Psychology and Security Market Under and Overreactions.” The William F. Sharpe Award for Scholarship in Financial Research was awarded to Meir Statman and me for “Behavioral Portfolio Theory,” which appeared in the Journal of Financial and Quantitative Analysis in 2000. The Review of Financial Studies and the Financial Analysts Journal have devoted entire issues to behavioral finance, and the Journal of x Preface Empirical Finance is planning a future issue, again dedicated to behavioral finance. The International Library of Critical Writings in Financial Economics is a compendium ofedited collections in the various areas of finance. As a testament to its growing importance, a three-volume set on behavioral finance, which I was privileged to edit, appears in this collection, alongside more traditional areas such as corporate finance, futures markets, market efficiency, debt markets, options markets, and market microstructure. Behavioral perspectives are routinely reported in major newspapers such as the Wall Street Journal. In January 2002, the New York Times profiled the work ofRichard Thaler, one ofbehavioral finance's leading figures. In June 2001, the Financial Times devoted an entire section to behavioral finance. In 2002, public television's The Nightly Business Report devoted a whole program to behavioral finance. Well-known value manager and Forbes columnist David Dreman has organized the Institute ofPsychology and Markets, along with a new journal, the Journal of Psychology and Financial Markets. Many new papers and books are being written on behavioral topics. Shortly after Beyond Greed and Fear was published, two related behavioral books appeared, both by leading behaviorists. Irrational Exuberance by Robert Shiller is a highly acclaimed work, describing the psychological factors that produced a stock market bubble during the 1990s. Inefficient Markets by Andrei Shleifer contains a formal exposition of investor sentiment and its impact on security pricing. Financial firms are increasingly applying behavioral concepts. At the forefront in basing their strategies explicitly on behavioral finance are Fuller & Thaler Asset Management, Dreman Value Management, Martingale Asset Management, and LSV Asset Management. In recent years the list of financial services firms that incorporate behavioral finance has grown to include American Skandia, Goldman Sachs, Merrill Lynch, Nuveen, Panagora, Putnam, Alliance Capital unit Sanford Bernstein, and Vanguard. A new mutual fund firm, Marketocracy, explicitly built its strategy on the concepts described in chapter 8. The use ofbehavioral concepts is not only con fined to the United States; European financial institutions KBC Bank, ABN Ambro, J. P. Morgan Fleming Asset Management, and Robeco