EMH anomalies, fundamental

analysis, alternatives, and manager

and investor sentiment
Presenter: Dr Gizelle Willows
 Manager and investor sentiment
• The three themes of behavioural finance:
1. Heuristic-driven bias
o Cognitive bias
2. Frame dependence
3. Inefficient markets

• Role of irrational behaviour

 Heuristic-driven bias
• Representativeness
• Overconfidence
• Confirmation bias
• Cognitive dissonance
• Aversion to ambiguity
• Regret avoidance
• Disposition effect
• Mental accounting
• Recency bias
• Anchoring
• Endowment effect
 Frame dependence
• Loss aversion
– Risk aversion
– Prospect theory
• Present bias
– Hyperbolic discounting
• Self-control
– Default options
• Money illusion
 Frame dependence
• People make decisions that are influenced by
the manner in which information is presented

• View each individual purchase or sale in terms

of that transaction only = “narrow framing”
• Generally, the wider your frame, the more
diversified your portfolio will be, but with
greater volatility attached thereto.
 Loss Aversion
• Risk averse
– Value gains and losses equally

• Loss averse
– Value losses more than gains
– Risk-averse over gains, risk-seeking over losses
 Prospect theory
• Alternative model of decision-making to expected
utility theory and rational choice theory
• More realistic behavioural assumptions
• Decision-making in situations involving decisions
between alternatives that involve risk, e.g. in
financial decisions
• People value gains and losses differently
– Financial decision-making is driven by loss-
aversion
Traditional Utility Function
 Prospect Theory Value Function
1) Loss averse
2) Risk-averse over gains, risk-seeking
over losses
3) Centred at reference point
4) Diminishing sensitivity
 Prospect theory
• Prospective losses bother investors much more than
prospective gains
• The choices people make are based on their subjective
version of the situation, not on some objective reality

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 How do we maximise utility?
• Good news, bad news

• What are some of the implications of this

observation for managers
– Break up good news announcements
• Earnings management…
– Clump bad news announcements
• Earnings management…
– Divide up bonuses into smaller chunks (a few
times a year)?
 Present bias
• How much do people want to consume today relative to
tomorrow
– Directly related to savings decisions

• In standard models, investors are assumed to discount at a

constant rate
• Trade-off between today and tomorrow is always the same:
– Answer to “do I want to save more today to consume more
tomorrow” should be the same today or 1 year from now.
– Coherence of choices between selves of different times
– No self-control problem.
 Present bias
• Discounting steeper in immediate future
– “Present bias” higher in drug and alcohol addicts,
gamblers, less cognitively talented, younger
people (Chabris et al. 2008)
• To model these self-control problems, Laibson
(1997) uses hyperbolic discounting.
 Hyperbolic discounting
• Hyperbolic discounting captures time-
inconsistent preferences:
– Short run impatience / long run patience
• Applications:
– Saving: consuming 1 less today, 2 more tomorrow;
I’ll save tomorrow; procrastination
– Smoking: I’ll quit tomorrow
 The Marshmallow Experiment
• Explores willpower/ability for delaying
gratification
• Correlation with future academic performance
 Self-control
• In exercise decisions…

• How many of you plan to exercise at least twice

in the next 7 days?

• How many of you

have exercised at
least twice in the
past 7 days?
 Health clubs
• Scenario 1. You are thinking of going to a gym
• The gym offers two options:
– Monthly membership for R800/month
– Pay per visit card: R100/visit

• How would you choose between these two?

• What do you think people would do?
 Health clubs
• Data (DellaVigna and Malmendier, 2006)
• Three health clubs in Boston
– Choice as above ($80/month or $10/visit)
– For monthly members
• Observe number of visit per month
• Compute cost per visit and compare to $10
• Results:
– Month 1: 3.4 visits/mo.→ $16.0/visit (pro-rated)
– Month 2: 5.5 visits/mo.→ $14.8/visit
– Month 3 : 4.9 visits/mo.→ $14.4/visit
– Month 4: 4.5 visits/mo.→ $17.9/visit
– Month 5: 4.4 visits/mo.→ $18.5/visit
– Month 6: 4.3 visits/mo.→ $18.9/visit
Health clubs
 Health clubs
• It may be only a small number of people making mistakes…
– 80% of users pay more than $10/visit
– 25% pay more than $60/visit
– 10% pay more than $120/visit

• Interpretation: Self-control problems

– I want to go to the gym next week
– I sign up expecting to go frequently (naiveté)
– But today, I do not feel like going

– Decision-making insight: Tension plans vs. actions

 Health clubs
• Reason 1. It matters for consumers
– $700 average loss from picking wrong plan

– Important to make realistic exercise choices for

health

– Thoughts on health issues? Obesity, diabetes…

 Health clubs
• Reason 2. It matters for company pricing
– Companies learn to offer contracts targeted to consumer
behavior
– 1970s: Mostly pay per visit or lifetime memberships
– 1980s: Annual contracts
– Early 1990s: Month contracts, renewed month-to-month
– Late 1990s: Annual contracts, renewed month-to-month

– Automatic renewal caters to self-control

– In the data, on average 2+ months between last visit and
contract cancellation
 Health clubs
• Reason 3. It provides evidence of self-control
problems at play in other decision-making
contexts:
– Smoking
– Alcohol
– Savings
– Credit card borrowing
 Self-control
• In credit decisions…

• Scenario. Credit card company sends credit card offers

to households with FICO score of, say, 700

• How would you set the interest rate on balances?

• Complicated problem; Higher interest rate leads to

– Higher return → Profit
– Lower response rate → Profit
– Higher default rate → Profit
 Credit cards
• Back to self-control problems
– I like to consume more today → Borrow on credit card
– I wish to save in near future →Intend to pay back debt
– But in future continue to borrow

• Two cards:
– Card A: Constant 16%
– Card B: 6% for 6 month, 22% thereafter

• Which card does person with self-control problems prefer?

• Which card accrues more interest?
– (Bad for borrower, good for company)
 Credit cards
• Why?
• Self-control problems
– I expect to borrow only for a short-time
– Instead half of balance is still there two years later

• Important implications for credit card market

and clothing retailers
– Higher profit margin on ‘teaser-rate’ offers
 Lessons for consumers
• Two very different settings
– Exercise at a gym
– Borrowing on credit card

• Yet, similar decision-making issue: self-control

– We’d like to exercise more
– We’d like to borrow less on high-interest debt
– We fall short of our expectations

• Helps understand consumer decisions

– Consumers sign up for too many gym memberships
– Consumers take up too much ‘teaser-rate’ debt
 Lessons for companies
• Helps understand company decisions
– Gyms offer automatically-renewed contracts
– Credit cards / retailers offer ‘teaser-rates’

• Take-away 1: It matters to apply consumer

psychology to market decisions
– Self-control
– Overconfidence, etc.

• Take-away 2: It is critical to collect data, guided

by behavioral principles
– Run experiments to get evidence if you can
 Self control and default options
• In frictionless/non-behavioral world, default
options are irrelevant
– However, behavioural models implies
procrastination and role for default options
 Libertarian Paternalism
• Nudge (Sunstein-Thaler)
• Rational agents are free to
elect to opt-out
• Behavioral agents enrolled
into default
Default options and saving
 Money illusion
• Belief that money has a fixed value in terms of its
purchasing power i.e. changes in the prices
represent real gains and losses
• Inflation, time value of money, “exponential
growth bias”
• (Lusardi & Mitchell, 2007):
 Inefficient markets
• Effects stemming from representativeness,
frame dependence, overconfidence…
• Herding
– Investors react to information about the
behaviour of other investors rather than the
behaviour of the market, and the fundamental
transactions.
 Role of irrational behaviour
• Investor behaviour
• Professional managers behaviour
 Role of investor behaviour
• Investment decisions characterised by high uncertainty
• Human beings have cognitive limitations (bounded
rationality, “satisficing” behavior, information
processing limitations)
• Investor Sentiment: beliefs based on heuristics rather
than rationality.
• Human beings have an intuitive, less quantitative,
emotionally-driven perception of risk than implied by
finance models
• Future performance must be estimated from a set of
noisy and vague variables
 Therefore…
• People make systematic errors in the way they
think
• They use heuristics (mental shortcuts or rules
of thumb) to simplify decision-making
• Decision-makers seek satisfactory, rather than
optimal solutions
• This results in biases and sub-optimal
investment decisions
Role of professional fund managers
• May choose a portfolio very close to the
benchmark against which they are evaluated (for
example: index fund or ETF).
• Herding: may select stocks that other managers
select to avoid “falling behind” and “looking bad”.
• Window-dressing: add shares that have done well
to the portfolio and sell shares that have not
done well.
 Summary
• How do users of financial statements make decisions?
• To invest in a company
• To grant a loan to a company
• To work for a particular company
a) Capital market theories b) Behavioural theories
• Theories from finance & • Theories from psychology
economics • Assumptions of human
• Assumptions of human behaviour:
behaviour: – Users are irrational
– Users are rational – Users seek satisfactory
– Users seek optimal outcomes outcomes
– Capital market is efficient – Capital market is inefficient
• Methodology • Methodology
– CAPM – Experiment