Behavioural Finance and Financial Markets Micro, Macro, and Corporate ( PDFDrive ) PDF

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UNIVERSITÀ POLITECNICA DELLE MARCHEFACOLTÀ DI ECONOMIA____________________________________________________________________________________Dottorato di Ricerca in Mercati Finanziari e Assicurativi XI° CicloPhD in Financial and Insurance MarketsTesi di DottoratoBehavioural Finance and Financial Market...

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UNIVERSITÀ POLITECNICA DELLE MARCHE FACOLTÀ DI ECONOMIA ____________________________________________________________________________________

Dottorato di Ricerca in Mercati Finanziari e Assicurativi XI° Ciclo PhD in Financial and Insurance Markets

Tesi di Dottorato

Behavioural Finance and Financial Markets: Micro, Macro, and Corporate

Coordinatore:

Dottorando:

Prof. GianMario Raggetti

Fergus McGuckian

Anno Accademico 2012/2013

Abstract This thesis consists of four chapters that explore different aspects of the relationship between behavioural finance, financial decisions and financial markets. Behavioural finance has emerged as a multidisciplinary research approach which addresses the impact of psychology on individual choice behaviour and financial decisions, and the subsequent implications for financial markets. The behavioural models posited build upon classical economic theories to develop alternative approaches to financial problems, by applying concepts from psychology to create an open-minded line of scientific enquiry that is more flexible in its assumptions. The conceptualisation of homo oeconomicus, i.e. the always rational economic man, is refuted in behavioural finance: people are thought to often behave irrationally, due to the fact that when confronted with a range of alternatives, they do not always select the choice associated with the optimum payoff, and secondly, because they regularly fail to make utility maximising decisions in reality. Indeed, behavioural finance has emerged to be much more than a peripheral way to deliberate financial markets. Over last two decades, the discipline has provided many fascinating insights about economic agents, and these new notions have aided the advancement of understanding of both individual level financial decisions, and of macro level financial market dynamics. The thesis is structured as follows. The introductory chapter discusses the development of the academic area, and outlines the context of the thesis. The foundations of both traditional and behavioural finance are compared and contrasted. Chapter two investigates the micro-level foundations of behavioural finance, with specific regard to the individual investor. Of particular interest is research about cognitive heuristics and behavioural biases in financial decision making, and whether or not measures can be taken to reduce mental errors of this nature. The professional application of behavioural finance findings to modern portfolio theory, to consumer finance, and also within the financial advisor/retail investor relationship about decisions pertaining to asset allocation, buying, selling, borrowing, and saving is deliberated, and a framework for testing and categorising investors according to their personality is proposed. The research in chapter 3 investigates financial anomalies, macro behavioural finance, and market efficiency. The study adds to the theoretical debate and examines whether financial markets are affected by mood variables, and if so, if this is reflected in asset prices. The final essay discusses a focal corporate finance area, the Initial Public Offering, in the institutional context of the Italian Stock Exchange from a uniquely behavioural perspective. It is contended that the primary influence on security prices is emotion, not reason, in that market sentiment rather than fundamental factors is the biggest explanatory factor in IPO share price performance.

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Table of Contents Chapter 1. Introduction to Behavioural Finance 1. Origins and Evolution ........................................................................................................................ 1 1.1. Theoretical Pillars of Traditional Finance ............................................................................... 2 1.2. Theoretical Pillars of Behavioural Finance ............................................................................. 7 1.2.1. Psychology and Finance: Social Science Divisions .......................................................... 9 1.2.2. Prospect Theory as a Foundation ....................................................................................10 2. Shifting Paradigm and the Philosophy of Science ........................................................................... 13 3. Discussion........................................................................................................................................ 16 4. Bibliography .................................................................................................................................... 18 Chapter 2. BF Micro: Individual level 1. Introduction ..................................................................................................................................... 21 2. The Behavioural Biases which affect Financial Decisions ............................................................. 22 2.1. Financial decision making ..................................................................................................... 22 2.2. Decision heuristics and Cognitive Biases..............................................................................24 2.3. Investment Heuristics and Biases ......................................................................................... 27 2.3.1. The Dual System Perspective.......................................................................................... 31 2.3.2. Cognitive Load, Capacity and Overload ......................................................................... 34 3. Applied Micro BF............................................................................................................................ 36 3.1. The Integration of BF into Financial Advice ........................................................................... 37 3.1.1. Bias Blind Spot ............................................................................................................... 38 3.1.2. Caveat Emptor: Let the Buyer Beware ........................................................................... 39 3.2. Practical Steps: can biases be debiased? ................................................................................. 40 3.3. Behavioural Finance and Portfolio Management ................................................................... 49 3.3.1. Behaviouralised Portfolio Theories................................................................................. 52 3.3.2. How to Measure Risk...................................................................................................... 54 3.3.3. Risk Tolerance Profiling ................................................................................................. 55 4. Financial Personality ....................................................................................................................... 57 4.1. Personality Profiling ............................................................................................................... 58 4.1.1. Psychological Tests ......................................................................................................... 60 4.1.2. Investor Categorisation Framework ................................................................................ 61 5. Discussion........................................................................................................................................ 65 6. Bibliography ................................................................................................................................... 67

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Chapter 3. BF Macro: Market Level 1. Anomalies in Finance ...................................................................................................................... 73 1.1. What determines Asset Prices? ................................................................................................ 75 1.2. Financial Anomalies ................................................................................................................ 76 1.2.1. Fundamental Anomalies ................................................................................................. 76 1.2.2. Technical Anomalies....................................................................................................... 78 1.2.3. Calendar Anomalies ........................................................................................................ 78 1.2.4. Mood Variables ............................................................................................................... 79 1.3. Anomaly Explanations ............................................................................................................. 81 2. Friday the 17th .................................................................................................................................. 82 2.1. Data and Research Hypothesis ................................................................................................ 84 2.2. Results...................................................................................................................................... 85 3. Discussion and Concluding Remarks .............................................................................................. 92 4. Appendices ...................................................................................................................................... 96 5. Bibliography ................................................................................................................................. 100 Chapter 4. BF Corporate: Italian IPO Market 2000-2010 1. Introduction and Paper Scope ........................................................................................................ 105 2. Italian Institutional Context and Background ................................................................................ 108 2.1. Going Public in Italy .............................................................................................................. 110 3. Literature Review of the Main IPO Puzzles .................................................................................. 115 3.1. Positive Initial Returns and Under-Pricing ............................................................................ 115 3.2. IPOs and Market Timing ....................................................................................................... 120 3.3. Long-run underperformance of IPOs ..................................................................................... 121 3.4. Book-building and Price Range ............................................................................................. 123 3.5. Behavioural Explanations ...................................................................................................... 125 3.6. Market Sentiment ................................................................................................................... 128 4. Hypothesis Development ............................................................................................................... 132 5. Research Design ............................................................................................................................ 134 5.1. Data Sample ........................................................................................................................... 134 5.2. Empirical analysis .................................................................................................................. 135 6. Model Set-Up ................................................................................................................................ 158 6.1. Regression Analysis ............................................................................................................... 158 6.2. Market Survey Data Indices vs. IPO Performance ................................................................ 168 7. Discussion of Results..................................................................................................................... 172 8. Final Remarks ................................................................................................................................ 178 9. Appendices .................................................................................................................................... 181 10. Bibliography .................................................................................................................................. 183

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Chapter 1. Introduction to Behavioural Finance 1. Origins and Evolution Financial economics, the dynamics of international markets, and the operation of agents therein (individuals as well as firms), are topics which are ultimately scrutinised differently by various people. Over the past 20 years or so an important debate has been on-going between ‘rationalists’ who assume that economic agents behave rationally, against ‘behaviourists’, who assume that they behave in systematically irrational ways. There is a certainly plethora of alternative views, with many of these advocating a more psychologically realistic stance in economics and currently we are in a transition phase between two paradigms (Stiglitz, 2010). Theories developed by researchers in traditional or classical finance tend to accept as valid that decisions are a maximisation of objective functions subject to individual budgetary constraints, and that investors only evaluate risk and expected returns when making investment decisions. Indeed, standard approaches in financial economics make few assumptions about agents’ psychology, and typically this has been considered as a great strength. To supporters of behavioural finance, the role of human conduct in modelling markets is of fundamental importance, and there is thought to be an innate relationship between the two. It is felt that contemporary economics seriously under-values and ignores, the importance of emotions, whereas it holds in high esteem the orderly mathematical models which emphasise the full rationality of decision makers. The behaviourists consider the rational model to be an unrealistic precept for human judgment. These people believe that the phrase behavioural finance – the most widely made definition of which, is that it is fundamentally the application of psychology to understand human behaviour in finance or investing – itself is a pleonastic expression; finance is inherently behavioural in nature (pleonasm: “the use of more words than are necessary to express an idea”, Oxford English Dictionary).1 As of late, and in an ever increasing manner, other disciplines such as psychology have become more included into economics in pursuit of new and more realistic theories.2 A wider range of factors and subjective elements, which are important to the financial decision making process of households and the aggregate dynamics of financial markets, are taken into account by these people (such as psychological, social, and emotional factors, beliefs, demographic traits, internal factors such as neural processes, cognitive ability, mood states, and environmental factors like information sources, fashions/fads, social networks, crowd psychology herding, information cascades, person-to-person, social learning and media contagion of sentiment/behaviour).

1 Behavioural finance is analogous to the phrase ‘wet water’ – it is implicitly known that the water is wet. 2 This has mostly occurred because it is thought by many that evaluating real world economic behaviour without including the findings of psychology is like dealing with quantitative relationships without using readily available techniques of mathematics (Schwartz, 2007).

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These factors lead economic agents to depart from the rational behaviour that is presumed by traditional economists and that many of the economic decisions and responses which happen in daily life are not accurately depicted or accounted for in traditional economic models. A main contention is that economics has become too theoretical and is not descriptive enough of the world around us. Subsequently it is thought that theoretical models in finance should be verified against the actual experimental evidence, i.e. financial data; this necessitates that economists employ more of a bottom up approach, whereby cognitive and emotional states are taken into consideration when developing models of human behaviour and decision models for individuals in the real world. This perspective develops a fundamentally new and important way to understand financial markets and the behaviour seen in them. Behavioural finance models argue that there are more intrinsically important factors in the decision making process, pertaining to how we should invest, value assets and adjust for risk. Psychologically based assumptions, which emanate from individual/collective psychology and decision making research, are more descriptive and it is thought that a larger variety of factors introduce distortions and prevent rational financial decision making from taking place on an aggregate scale. In short, behavioural finance is the study of the influence of psychology on the behaviour of economic agents and the subsequent effects of this behaviour on financial markets (Sewell, 2007). To make any comparisons and to understand what behavioural finance is, we should first discuss the main concepts of classical finance

1.1. Theoretical Pillars of Traditional Finance “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest”, (Adam Smith, 1776; Book One, Chapter Two)

From the very beginning of modern economic writing by the likes of Adam Smith and David Ricardo in the 1700s and to later work by John Stuart Mill in the 1800s, the concept of the rational economic agent or homo oeconomicus, he who is motivated by self-interest and seeks to maximise his own utility (wealth) in decisions for the lowest possible expenditure of work/labour, has been a central tenet to understanding the economic system in which we live in. The rational economic man is the theoretical backbone or according to the economist F.Y. Edgeworth “the first principle of economics is that every agent is actuated only by self-interest” (1881; p.16). In addition to this however, as a formal discipline since the 1940s economics has been mostly free of psychological notions; economic agents are considered to be utility optimisers. Influential economists trained in mathematics such as Paul Samuelson (1938) John Hicks (1939) and Lionel Robbins (1952) where advocates of this approach for the simple reason that for the discipline to be initially accepted, it needed to supply empirical evidence without the 2

complications of actual human action.3 Perhaps the main reason for this early development was that traditional models, with rational and unemotional economic agents, were easier to build (Thaler, 2000). In truth economics has always attempted to explain economic behaviour and how people choose under scarcity and at the centre of the traditional mainstream paradigm – and also by association modern financial economics – lays this assumption of rationality and the belief that agents manage any quantity of information they receive according to Bayes rule.4 Finance studies decision making under uncertainty and asks the question of how an individual should choose when faced with uncertain outcomes. To examine the financial decision making process traditional models have utilised concepts such as conditional probabilities and the goal of optimisation. When confronted with a choice, the rational agent assesses the probability and determines the utility payoff of each potential outcome; the option chosen has the optimal combination of these two factors. In addition, people are thought to be selfish and only interested in their own welfare (utility function maximisation), to have complete access to all available information, to be well informed and to possess sufficient reasoning ability to solve complex problems...