Preface xv
Acknowledgements xvii
1 Introduction 1
1.1 Illustration and Structure 2
1.2 Finance Theory as an Engine not a Camera 3
1.2.1 Rational Fools or Folly of Wisdom? 5
1.3 Rebuilding on New Foundations 7
1.3.1 Reasoned Emotion: The Case of Phineas Gage 8
1.3.2 What Can Psychologists Bring to Finance? 9
1.4 Challenging the Classical Assumptions of Finance 9
1.5 Modelling Behavioural Aspects of Finance 11
1.6 The Structure of the Book 12
Appendix: A Financial Tsunami 14
Notes 14
References 14
Part I Foundations 17
2 Financial Decision Making 19
2.1 Illustration and Structure 19
2.2 The Expected Utility Rule 20
2.2.1 An Illustration of Expected Utility 21
2.2.2 Attitudes to Risk 22
2.2.3 Diversification as Risk Reduction Strategy 23
2.2.4 How Best To Bear Risk 24
2.3 Expected Utility Theory: Simple But Untrue? 26
2.3.1 Paradoxes and Problems in Early Understanding of Expected Utility Theory 27
2.3.2 Gambling Insurance and Aspiration 29
2.4 Frames for Actions, Contingencies and Outcomes 31
2.4.1 The Decision Process 31
2.4.2 Inferring Big Ideas from Small Samples 32
2.4.3 Stars with Feet of Clay 33
2.4.4 Is There More to Life Than (Maximizing) Utility? 34
2.4.5 Happiness, Well-Being and the Emotional Basis of Utility 34
2.5 Conclusion and Summary 35
Questions 35
Notes 36
References 36
3 Discounting 39
3.1 Illustration and Structure 40
3.2 The Discounted Utility Model 40
3.2.1 Some Problems with the Discounted Utility Model 41
3.2.2 Evaluating Reallocations of Consumption by Equivalent Gains or Compensating Losses of Present Consumption 42
3.2.3 Delays and Speed-Ups of Utility 44
3.3 How and Why Discount Rates Vary 44
3.3.1 Discounting Single Outcomes Compared to Sequences of Outcomes 46
3.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’ 47
3.5 Hyperbolic Discount Factors 49
3.6 Valuation by Using the Matching Law 51
3.6.1 On Pigeons and Men: Comparing Hyperbolic and Exponential Discounting 53
3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54
3.7.1 A Simple Example of a Sub-Game Perfect Equilibrium 55
3.7.2 The Properties of a Sub-Game Perfect Investment Strategy Equilibrium 57
3.7.3 How Do Declining Discount Rates Affect Investment Behaviour? 58
3.8 Conclusion and Summary 59
Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal Choice 60
Questions 61
Notes 62
References 62
4 Learning 65
4.1 Illustration and Structure 65
4.2 Rational Learning 66
4.2.1 Bayes’ Rule 66
4.2.2 Elements of Bayesian Revision 68
4.2.3 The Value of Stock Recommendations 70
4.3 Do We Learn the Bayesian Way? 72
4.3.1 Representativeness 74
4.3.2 Representation Bias in the Market: Analysts’ Overreaction to Earnings 74
4.3.3 A Once and For All Lesson? 75
4.4 Over Inference and the Law of Small Numbers 76
4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77
4.6 Conclusion and Summary 79
Appendix: Case Study – Baseball the Bayesian Way 80
Questions 87
Notes 88
References 88
5 Bubbles 89
5.1 Illustration and Structure 90
5.2 Tulipmania and the Didactic Value of Bubbles 91
5.3 The Regulatory Origins of the Most Recent Bubble 92
5.3.1 Long-Term Capital Management 92
5.3.2 The Federal Reserve and Market Restraint 95
5.4 Bubbles: Past, Present and Future 101
5.4.1 Financial Bubbles and Infrastructure Technology 102
5.4.2 Are Bubbles Just Part of the Market Process? 103
5.5 The 1929 Stock-Market Crash 104
5.5.1 Early Signs 104
5.5.2 The Boom is On 105
5.5.3 Innovation and Speculation 106
5.5.4 Investment Trusts in the Boom’s Growth 106
5.5.5 The Final Implosion 107
5.6 Should Government Burst the Bubble? 108
5.7 Conclusion and Summary 109
Appendix: Tulips as Assets and Art 110
Questions 114
Notes 114
References 114
Part II Asset Pricing 117
6 Noise Traders 119
6.1 Illustration and Structure 120
6.2 The De Long, Shleifer, Summers and Waldmann Model 121
6.2.1 The Basic Set Up 122
6.2.2 Modelling Mispricing 122
6.2.3 What Investors Want 123
6.2.4 Choosing Optimal Asset Allocations Across the Safe and Risky Asset 124
6.2.5 The Pricing Equation 125
6.2.6 Will Noise Traders Die Out? 128
6.2.7 Decomposing Noise Traders’ Profits 130
6.3 Can Investors Get Emotional? 133
6.3.1 Feeling the Risk 134
6.3.2 The Affect Heuristic 135
6.3.3 Panic and Feedback Trading During the 1987 Stock-Market Crash 136
6.3.4 The Diminishing Roar of Noise 137
6.4 Conclusion and Summary 138
Questions 138
Notes 139
References 139
7 Overconfidence and Optimism 141
7.1 Illustration and Structure 142
7.2 A Model of Trading Amongst Optimistic Investors 142
7.2.1 The Model 143
7.2.2 Price Setting 143
7.2.3 Conditions for Overconfident Pricing of the Risky Asset 144
7.2.4 Pricing in Odean’s Model 147
7.2.5 The Implications of Odean’s Model for Financial Markets 150
7.3 Do Investors Trade Too Much? 150
7.3.1 Optimism in Corporate Finance 151
7.3.2 Facing Failure 151
7.3.3 Who Dares Loses? 153
7.3.4 The Hubris Theory of Takeovers 153
7.4 Conclusion and Summary 154
Appendix A: Hubris at Work: The AOL–Time Warner Merger 155
Appendix B: Derivation of Results in Odean’s Model 161
Questions 163
Notes 163
References 163
8 Asset Pricing under Prospect Theory 165
8.1 Illustration and Structure 165
8.2 The Basics of Prospect Theory 166
8.2.1 Prospect Theory’s Application to Finance 167
8.2.2 Benchmarks, Gains and Losses and the Dynamics of Utility under Prospect Theory 168
8.2.3 Integration or Segregation of Losses and Gains in the Presence of Loss Aversion 169
8.2.4 The Evolution of Investor Benchmarks 170
8.2.5 Price Formation in a Market Populated By Investors With Prospect Theory Utility Functions 171
8.2.6 Pricing in the Standard Inter-Temporal Consumption-Based Asset-Pricing Model or Economy I 171
8.3 Does Prospect Theory Work? 172
8.3.1 Can Prospect Theory Explain the Internet Bubble? 172
8.3.2 Can Prospect Theory Explain IPO Underpricing? 174
8.3.3 Prospect Theory Here, There and Everywhere 176
8.4 The Cumulative Probability Version of Prospect Theory 176
8.5 Does Cumulative Prospect Theory Work? 177
8.5.1 Cumulative Prospect Theory and Asset Pricing 179
8.6 Conclusion and Summary 181
Appendix: CARA Utility 181
Questions 182
Note 182
References 183
9 Overreaction and/or Underreaction 185
9.1 Illustration and Structure 185
9.2 The DHS Model 186
9.2.1 Reversals of Fortune 188
9.2.2 Pricing When Confidence Levels Depend on the Relation Between the Public and Private Signals 189
9.2.3 Investor Extrapolation and Reversals of Fortune 192
9.2.4 Many Theories in Search of a Decisive Verification 192
9.2.5 Momentum and Underreaction: Two Stock-Market Anomalies or One? 194
9.3 No News Is . . .? 194
9.3.1 The Jackson and Johnson (JJ) Model’s Message 195
9.3.2 How the JJ Model Works 196
9.3.3 Stock-Market Responses to News and No News 199
9.4 Conclusion and Summary 199
Questions 199
Note 199
References 200
10 Momentum 201
10.1 Illustration and Structure 201
10.2 Grinblatt and Han’s (2005) Model 203
10.2.1 Modelling Asset Demand in the GH Model 204
10.2.2 Investor Returns and the Evolution of the Reference Point 207
10.3 What Drives Stock-Market Momentum? 208
10.3.1 Evidence of PEAD 209
10.4 What Causes PEAD? 212
10.4.1 Is PEAD Due to Changes in Risk? 212
10.4.2 Are Prices Following Themselves or Following Earnings? 213
10.4.3 Is PEAD in the Market or in the Eye of the Researcher? 215
10.4.4 Show Me the Money 216
10.5 Conclusion and Summary 217
Questions 217
Note 218
References 218
11 Herding 221
11.1 Illustration and Structure 221
11.2 The FSS Model 222
11.2.1 The Basic Set Up 222
11.2.2 The Price-Setting Mechanism Used by Market-Makers 223
11.2.3 Informed Speculators’ Demands 224
11.3 Conformity as a Force for Social Good and Evil 228
11.3.1 Evidence on Herding and its Effect 229
11.3.2 Herding in Investment Advice 230
11.3.3 Words which Cannot be Spoken 230
11.3.4 Private Truths and Public Lies 231
11.3.5 The Herd in History 233
11.4 Conclusion and Summary 233
Appendix: The United States vs. Microsoft 234
Questions 236
Note 237
References 237
12 Insider Trading 239
12.1 Illustration and Structure 240
12.2 Insider Trading Here for Better or Worse 241
12.2.1 The Distributional Impact of Insider Trading 242
12.2.2 When does Trading become Insider Trading? 243
12.2.3 Insiders on Trial: Proof of Guilt or Innocence? 244
12.3 The Hirshleifer, Subrahmanyam and Titman Model 245
12.3.1 Asset Demands and the Determination of Investor’s Terminal Wealth in the HST Model 246
12.3.2 Pricing in Equilibrium 250
12.3.3 Trading Behaviour in Equilibrium 251
12.4 Insider Trading, Stock Options and the Construction of Earnings 255
12.4.1 Psychological Factors Determining the Exercise of Stock Options 256
12.5 Insider Trading and its Consequence for Outsiders 257
12.6 Conclusion and Summary 258
Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model? 258
Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262
Questions 265
Notes 265
References 266
13 Equity Premium Puzzle 269
13.1 Illustration and Structure 269
13.2 The Puzzle 270
13.2.1 The Mehra and Prescott Statement of the Equity Premium Puzzle 271
13.2.2 Explaining the Risk Premium by Myopic Loss Aversion 272
13.2.3 Can Loss Aversion Explain the Puzzle? 274
13.3 Loss Aversion in a Reference-Dependent Utility Model 276
13.3.1 A Reference-Dependent Model of Investor Choice 277
13.3.2 Loss Aversion in a Reference-Dependent Model of Choice 277
13.3.3 Diminishing Sensitivity to Losses and Gains 278
13.3.4 Constant Risk Aversion and the Benartzi and Thaler (1995) Model 279
13.3.5 Is Loss Aversion Irrational? 280
13.4 Conclusion and Summary 280
Questions 281
References 281
Part III Corporate Finance 283
14 Incorporation 285
14.1 Illustration and Structure 285
14.2 Companies: Where did They Come from and Where will They Go? 286
14.2.1 Limited Liability: its Value and its Role in the Emergence of the Corporate Form 288
14.2.2 The Economic Rationale for Granting Limited Liability 288
14.3 Agency, Monitoring and Incorporation 289
14.3.1 Are Managers Agents or Team Members? 291
14.3.2 Psychological Barriers to Arm’s Length Contracting 294
14.3.3 Group Psychology on the Board, Building Consensus and its Dissimulation 294
14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 296
14.4.1 Clearing Out the ‘Inside View’ 297
14.4.2 Come On Down: the Satisfaction of Recognition 298
14.4.3 Facing Glory and Defeat: Managers’ Resistance to Recognizing Failure 298
14.4.4 Governance in the Long and Short Run 299
14.5 Conclusion and Summary 300
Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a Corporation 300
Questions 313
Notes 313
References 314
15 The Market for Information, Noise and Deception 317
15.1 Illustration and Structure 318
15.2 The Boundaries of the Market for Corporate Information 318
15.2.1 The Conduct of the Market for Corporate Information 319
15.3 What Do Analysts Do? 321
15.3.1 The Ivkovic and Jegadeesh (IJ) Model 322
15.4 Valuing Investment Advice 325
15.4.1 The Market for Corporate Information 326
15.4.2 What Type of Valuation Models do Analysts Use? 328
15.4.3 The Fragility of Valuation Models 330
15.4.4 A Dynamic Model of the Market for Financial Information 332
15.4.5 From Inside and Out: Isolation Bias and Risk Taking 333
15.5 Conclusion and Summary 333
Questions 334
Notes 334
References 334
16 Dividends 337
16.1 Illustration and Structure 337
16.2 The Irrelevance of Dividends to Value 338
16.2.1 The Puzzle of Dividend Policy 339
16.3 A Prospect Theory Explanation of Dividend Payments 340
16.3.1 Coding of Prospects: Combination, Segregation 341
16.3.2 Shop Until You Should Stop 341
16.3.3 Calculating the Dividend Yield Premium/Discount 342
16.4 Who Pays Dividends and Why? 346
16.4.1 Are Dividends Signals of Future Earnings Prospects? 346
16.4.2 Dividend Omissions, Initiations and Drift 347
16.4.3 What Reasons do Managers Give for Paying Dividends? 348
16.4.4 Does Pay-out Policy Matter? 349
16.5 Conclusion and Summary 350
Questions 350
Note 351
References 351
17 Entrepreneurship 353
17.1 Illustration and Structure 354
17.1.1 The Problem of Self-Control 354
17.2 The BT Model 355
17.2.1 The Demand for Self-Confidence in the BT Model 355
17.2.2 Always Wrong but Never in Doubt 359
17.2.3 The Supply of Self-Confidence in the BT Model 359
17.2.4 Numerical Illustration of the BT Model 361
17.3 Is Deluding Yourself Worth it? 362
17.3.1 Optimism, Self-Control and Society 363
17.3.2 The Social Benefits of the Maverick Entrepreneur 363
17.4 Conclusion and Summary 364
Appendix: Entrepreneurs and the BT Model – Some Case Studies 364
Questions 370
Notes 370
References 371
Part IV The Professions 373
18 Analysts’ Conflicts of Interest 375
18.1 Illustration and Structure 376
18.2 Evidence of Conflicts of Interest from Empirical Studies 377
18.2.1 No Conflict, No Interest 378
18.2.2 Is Disclosure of a Conflict of Interest Sufficient Protection for Investors? 379
18.2.3 Conflicts in the Laboratory 379
18.3 Regulating Conflicts of Interest 380
18.3.1 UK Policy on Conflicts of Interest 380
18.3.2 EU Policy on Conflicts of Interest 382
18.3.3 US Policy on Conflicts of Interest 383
18.3.4 The Common Law of Conflicts of Interest 383
18.3.5 The Dura Pharmaceuticals Case 384
18.3.6 Market Efficiency, Conflicts of Interest and the Courts 385
18.4 Conclusion and Summary 385
Questions 386
Notes 386
References 386
19 Accounting Reform 389
19.1 Illustration and Structure 389
19.2 The Onward March of ‘Fair-Value’ Accounting 390
19.2.1 Historic Cost versus Fair Value 390
19.2.2 A Return to Fundamental Valuation 392
19.3 An Accounting-Based Valuation Model 392
19.3.1 Are All Reported Earnings Additions to Shareholder Value? 394
19.3.2 The Dynamics of Abnormal Earnings Valuation 395
19.3.3 Some Examples of the Ohlson Model in Action 396
19.3.4 Implications for Price 398
19.3.5 Implications for Returns 400
19.3.6 Does the Ohlson Model Work? 400
19.3.7 Earnings Persistence in the Ohlson Model 403
19.3.8 Other Information in the Ohlson Model 403
19.4 Behavioural Bias in Estimates of the Ohlson Model 404
19.4.1 Inferring Value from Accounting Data: Fair Values versus Historic Costs 405
19.4.2 The Three Levels of Fair Value 406
19.4.3 Some Implicit Trade-Offs in Fair-Value Accounting 406
19.5 Conclusion and Summary 407
Appendix A: Mark-to-Market Accounting at Enron – A Case Study 407
Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting Information only (Equation (19.7)) 423
Questions 425
Notes 425
References 426
20 Conclusion 427
Index 431
