The Behavioral Paradigm Shift

RAE-Revista de Administração de Empresas | FGV-EAESP 95

ESSAY Invited article

DOI: http://dx.doi.org/10.1590/S0034-759020150109 THE BEHAVIORAL PARADIGM SHIFT

In the last half decade, academic finance has experienced two revolutions, one neoclassical and one behavioral, which were jointly recognized in the awarding of the 2013 Nobel Prize in economics. Before 1960, academic finance was organized around a loose collection of anecdotes, puzzles, and investment philosophies. The neoclassical revolution changed all of this by importing the structure and rigor of rationality-based principles of microeconomics into finance. Three No- bel Prizes recognized its main contributors. The first, in 1990, was jointly awarded to Harry Mar- kowitz for mean-variance portfolio theory, to Merton Miller for corporate finance, and to William Sharpe for the capital asset pricing model (CAPM). The second prize, in 1997, was shared by My- ron-Scholes and Robert Merton for developing the Black-Scholes-Merton option pricing formula. Unfortunately, Fischer Black who co-developed the formula, died in 1995. The third prize, in 2013, was awarded to three economists, two of whom contributed to the neoclassical revolution - Eugene Fama, for his seminal work on market efficiency, and Lars Peter Hansen for his seminal work on asset pricing theory. The behavioral revolution imported ideas from behavioral psychology into finance, and replaced the rationality postulate with a more realistic alternative. Two of its main contributors were recognized with Nobel prizes. The first, in 2002, was awarded to Daniel Kahneman who shared the award with experimental economist Vernon Smith. The Nobel selection committee recognized Kahneman for his work with fellow psychologist Amos Tversky who died in 1996. The second prize, in 2013, was awarded to Robert Shiller for his work on asset pricing. Of course, this prize was shared by Shiller, Fama, and Hansen. Both of these revolutions created great intellectual value. The neoclassical revolution

HERSH SHEFRIN provided a first pass at introducing structure and rigor into the way academics think about fi- [email protected] nancial issues. The behavioral revolution has provided a second pass at modifying this struc- Professor at Santa Clara University, ture to reflect the fact that human beings are not perfectly rational, but are instead imperfectly Leavey School of Business – Santa Clara – California, United States of rational. Behavioral finance focuses on the structure and implications of people’s imperfect at- America tempts to match means and ends when making financial decisions.

In this second, behavioral, pass at they optimally balance expected return of extreme events are small, the aver- finance, behaviorists are modifying ev- against risk. Amazingly, in 1952 when age person is risk seeking in the domain ery nook and cranny of the discipline. Markowitz was developing mean-vari- of gains and risk averse in the domain of Mean-variance portfolio theory has its ance portfolio theory, he was also laying losses. counterpart in behavioral portfolio theo- the groundwork for behavioral portfolio The insights offered by prospect ry. Corporate finance has its counterpart in theory. In consecutive months he pub- theory motivated Meir Statman and me behavioral corporate finance. The CAPM, lished two seminal papers, one neoclas- to introduce “the disposition effect” into which neoclassical asset pricing theorists sical and the other behavioral. Kahneman finance literature. The disposition effect such as Hansen generalized to pricing ker- and Tversky built prospect theory with holds that investors are predisposed to nel theory, has its counterpart in behavior- Markowitz’s behavioral piece constitut- sell winners too quickly and hold losers al pricing kernel theory; a special case is ing one of its core elements. Psychologist too long, except in the month of December the behavioral Black-Scholes option pric- Lola Lopes also built SP/A theory with when the disposition will either weaken ing formula. Finally, the concept of effi- Markowitz’s behavioral insights as a core or reverse. Prospect theory was our start- cient markets based upon the idea of ar- element. ing point; however we pointed out that ex- bitrage has its counterpart in inefficient Prospect theory, applied to port- plaining the disposition effect required markets based upon the idea that there folio selection, tells us that investors other psychological elements such as re- are limits to arbitrage. will think about their portfolios as a col- gret and self-control. The behavioral revolution in finance lection of separate components (called Statman and I developed the psy- and economics came fast on the heels of a mental accounts), rather than as a single chological underpinnings for the dispo- similar behavioral revolution in psycholo- integrated entity. Kahneman and Tversky sition effect against the results of a ma- gy which gave us coherent frameworks to told us that this lack of integration will jor study of individual investors by Lease, study how people make choices among make people vulnerable to making choic- Lewellen, and Schlarbaurm who found ev- risky prospects, how they rely on heuris- es that violate first order stochastic dom- idence of disposition effect behavior, but tics to form judgments, and how their im- inance, meaning they will act as if they argued that it did not stem from psycho- perfections leave them vulnerable to par- throw away money. logical sources. Several years later, Ter- ticular biases. The set of psychological A key aspect of the explanation ry Odean built a rich database of U.S. in- frameworks and concepts from which be- for why investors behave in this fashion dividual investors and tested the main havioral economists draw includes pros- is that they evaluate these components hypotheses Meir and I had developed. pect theory, SP/A theory, regret theory, in terms of gains and losses, rather than Subsequently, the disposition effect has change of process theory, excessive opti- net asset position. Moreover, they exhib- become one of the most studied features mism, overconfidence, confirmation bias, it loss aversion in the sense of experienc- of investor behavior. Researchers have in- anchoring-and-adjustment bias, illusion ing losses more acutely than gains. Loss vestigated the disposition effect in differ- of control, representativeness, and the aversion will induce people to be risk ent countries, different time periods, and affect heuristic. Behavioral economists averse when facing situations in which different markets. They have also extend- have been applying these frameworks and they might experience gains if fortunate, ed the analysis to professional investors, concepts to investigate issues across the but might also experience losses if unfor- and studied its impact on asset prices. entire landscape of finance. tunate. However, at the same time, peo- The work of Lease, Lewellen, and In the remainder of these intro- ple will be averse to sure losses, and Schlarbaum told us that investors trade ductory remarks, I will offer a short per- prone to exhibiting risk-seeking behavior too much, and that the portfolios of those sonal perspective on how these develop- when dealing with the prospect of a re- who trade the most, the so-called “high ments from psychology impact aspects alized loss. Among Kahneman and Tver- rollers”, experience the worst perfor- of finance, effectively my impressions of sky’s key lessons is the fourfold pattern mance. Using transaction data that was how the behavioral approach adds in- in which people’s risk appetite is circum- more recent and more extensive, Brad sights and value to the major subfields stance dependent. When outcome prob- Barber and Terry Odean documented the of finance: portfolio theory, asset pricing, abilities are in the midrange, the aver- degree to which turnover hurts perfor- and corporate finance. age person is risk averse in the domain mance, and attributed excessive trading Mean-variance theory tells us how of gains and risk seeking in the domain to overconfidence. Lease, Lewellen, and investors can choose portfolios in which of losses. When outcome probabilities Schlarbaum also reported that high roll-

ers are overly prone to focus on short-term having data on investors’ expectations of acquisition activity, and corporate gov- capital gains and use technical analysis, returns, meaning ex ante judgments, as ernance. Although some of these issues and in recent work with Arvid Hoffmann, opposed to relying on ex post realized re- pertain to the impact of psychological im- which uses data from Dutch investors, we turns, can serve to distinguish whether or perfections on corporate managers, oth- find that this continues to be so. not prices are fully rational. This statement ers involve how corporate managers react In the last decade, research has applies both to the cross-section of secu- to market inefficiencies. shown that entertainment, gambling, and rity returns and to the time series. In re- I am going to close these remarks thrill seeking are important aspects in spect to the cross-section, Statman points by going back in time, first a few decades, portfolio decisions, not just risk and ex- out that investors’ need for value expres- and then a few centuries. My first work pected returns. Markowitz’s behavioral siveness, which applies for example to so- as a behavioral economist began in the work dealt with people’s tendency to hold cially responsible companies, will be man- 1970s with Richard Thaler, and involved both very safe and very risky securities si- ifest in their portfolio choices and also in the study of self-control. Thaler and I de- multaneously, a pattern that attracted the the factor structure that explains returns. veloped a dual system theory, in which a attention of psychologists Kahneman, My work has emphasized the im- decision maker’s choices emanate from Tversky, and Lopes, and which subse- portance of building behavioral pricing the interaction between a subconscious quently made its way back into finance. kernel models. These models extend the automatic system involving emotions The “behavioral portfolio theory” put for- neoclassical models to incorporate sen- (“the doer”) and a deliberative system ward by Meir Statman and me emphasiz- timent, and in so doing generate a set of involving conscious thought (“the plan- es that investors build layered portfolios results about the impact of sentiment on ner”). Statman and I first applied this to provide both downside protection and the pricing of bonds, stocks, and all man- framework to the study of dividends, in upside potential. Alok Kumar documents ner of derivatives. This approach empha- our first behavioral work together. the degree to which investors overweight sizes the importance of investor heteroge- With the publication of Kahneman’s “lottery stocks” in their portfolios: Lottery neity, and focuses on the manner in which book Thinking, Fast and Slow, the System stocks are stocks that share some of the markets aggregate the judgments of het- 1/System 2 framework is now recognized key traits exhibited by lotteries. erogeneous investors. One of the main well outside the confines of academia. The 2013 Economics Nobel has theoretical results is a decomposition the- Kahneman identifies System 1 with intu- highlighted the difference in neoclassi- orem establishing how the pricing kernel ition and System 2 with reason, which he cal and behavioral perspectives about as- decomposes into a neoclassical compo- links to the doer/planner dichotomy that set pricing. Fama tells us that it is not pos- nent and sentiment. In recent co-authored Thaler and I developed. Although a few ac- sible to distinguish whether asset prices work with Giovanni Barone-Adesi and Lo- ademics have pursued a formal two sys- are fully rational or whether they reflect riano Mancini, we apply this theorem to tem approach to human decision making, behavioral biases instead. Shiller tells us estimate sentiment, which we find to be my sense is that there is much untapped that some asset prices are associated with closely linked to independent measures of potential in applying this framework to pricing bubbles, and notes that he called sentiment such as the Baker-Wurgler sen- study financial issues. both the dot.com bubble of the 1990s and timent variable SENT and Shiller’s crash Behavioral economics did not be- the real estate bubble underlying the glob- confidence index. gin in the 1970s. John Maynard Keynes al financial crisis that erupted in 2008. In 2000, I introduced the term “be- was already writing extensively about The financial crisis spurred legis- havioral corporate finance” into finance the role of psychology in the 1930s. His lation to establish new regulatory prac- literature. Before 2000, there were scat- famous treatise The General Theory of tices. Although Statman and I have been tered applications of behavioral ideas to Employment, Interest, and Money uses writing about the behavioral dimension issues in corporate finance, but no gen- the word “psychology” many times, and of financial market regulation since 1992, eral framework for understanding how makes many references to “optimism,” this is an area that although ripe for study behavioral elements impact the entire “confidence,” and “sentiment.” He is has not proven to be especially popular subfield. Now, almost fifteen years later, very clear about corporate managers fail- among academics. there is a rich literature documenting how ing to base decisions on computations of Over the years, Statman and I have psychological elements impact valuation, discounted cash flow, let alone probabili- written about asset pricing issues, both capital budgeting, capital structure, cor- ty assessments of alternative cash flows. together and separately. We point out that porate incentive structures, merger and Likewise, he emphasizes the role of sen-

timent in driving the market prices of se- place. Earlier this year, I wrote that Adam between neuroscientists and econo- curities. Without question, Keynes was a Smith would not have been surprised by mists. Future work will study the roles behavioral economist. the recent Libor fixing scandal. What has of brain structure, hormonal balance, The dual system perspective of changed in the course of almost two and a and genetic traits on financial deci- decision making is centuries old. Adam half centuries is that behaviorally minded sions and market outcomes. There is Smith termed System 2 a person’s “im- academics are developing psychological- much to which we can look forward. It partial spectator” and System 1 a per- ly-based insights into why people cheat. is an exciting time for those with a pas- son’s “passion.” Smith’s focus was on A rich new line of inquiry has sion to understand how psychology im- moral behavior, especially in the market- just begun involving collaborations pacts finance.