ASSEE 2009 - Behavioral Finance

The topic of the 4th Advanced Summer School was on “Behavioral Finance“.

Professor Hersh Shefrin (Santa Clara UniversityLeavey School of Business) was the Distinguished Guest Professor.

The lectures of the Summer School provided an up-to-date coverage of the main methods and models used in behavioral finance.  The course examined familiar, basic methods and frontier developments in the field.

Course Description

At the conclusion of this course, students will be able to describe the key psychological concepts that underlie the study of behavioural finance. These concepts roughly fall into two categories: (1) framing effects and (2) heuristics and biases. Students will learn to apply these concepts to the behaviour of investors, the behaviour of corporate managers, and the character of asset prices. The course teaches students to identify and explain how psychological elements influence the manner in which investors construct portfolios, how corporate managers make decisions about capital budgeting and capital structure, and how market prices reflect investor sentiment.

Lecture topics covered

  • Asset pricing with heterogeneous beliefs and preferences
  • Psychological contributions of Kahneman and Tversky
  • Behavioral portfolio selection
  • Behavioral asset pricing: sentiment, overreaction, and under reaction
  • Behavioral corporate finance

Workshop topics covered

  • Psychology experiments (mainly from the work of Kahneman & Tversky)
  • Experiments involving choice among risky alternatives
  • Stock selection experiment
  • Simulation game experiment
  • Simulation game experiment replay

Course Outline

Day 1 introduces a theoretical framework for analyzing equilibrium in the presence of heterogeneous agents. A key issue is to identify conditions under which markets can be efficient in the presence of heterogeneous agents, both in the short-run and in the long-run. The workshop on Day 1 is intended as a prelude to the lecture on Day 2.

Day 2 focuses on the psychological concepts that underlie behavioral finance. Behavioral finance is the study of how psychology impacts financial decision making and financial markets. The purpose of this lecture is to provide a structured approach to behavioral finance in respect to underlying psychological concepts, formal framework, empirical hypotheses and implications, and empirical findings.� Among the psychological concepts discussed in this lecture are unrealistic optimism, overconfidence, representativeness, salience, prospect theory, and regret. The workshop on Day 2 is intended as a prelude to the lecture on Day 3.

Day 3 is dedicated to behavioral portfolio selection. Both preferences and beliefs are impacted by human psychology. Preferences pertain to the manner in which investors evaluate cash flow representations. Beliefs pertain to the manner in which investors� judgments about risk and return reflect bias. Preferences lead many investors to adopt a piecemeal approach to portfolio selection, in which purchasing decisions are influenced by salience or attention, and realization decisions are influenced by the disposition effect. The disposition effect is the tendency to sell winners too early and ride losers too long in all months of the year except December. Behavioral preferences also explain how investors segment their portfolios into risk layers, and exhibit a taste for skewness. Behavioral beliefs involve a series of biases such as hot hand fallacy, gambler�s fallacy, and home bias. This lecture describes a series of hypotheses that stem from the behavioral finance literature, and surveys the literature that tested these hypotheses. The workshop on Day 3 is intended as a prelude to the lecture on Day 4.

Day 4 focuses on how behavioral portfolio choices impacts asset pricing. Behavioral asset pricing theory is eclectic, and features a wide variety of models, centered on the concept of sentiment. Many of the models in the behavioral asset pricing literature were developed to analyze overreaction and under reaction in financial markets. This lecture briefly discusses some of these models. The lecture also describes a behavioral SDF-based approach. The behavioral SDF-based approach brings together the powerful asset pricing tools favored by neoclassical asset pricing theorists and the realistic assumptions favored by behavioral asset pricing theorists. The behavioral SDF-based approach offers a unified treatment of behavioral beliefs and behavioral preferences, showing how these features combine to impact the mean-variance frontier, option prices, equity prices, and the term structure of interest rates. The workshop on Day 4 is intended as a prelude to the lecture on Day 5.

Day 5 discusses behavioral corporate finance. Behavioral corporate finance is concerned with the manner in which behavioral beliefs, behavioral preferences, and inefficient prices impact the corporate financial decisions made by managers. Among the topics discussed in this lecture are capital budgeting, capital structure, corporate governance, and mergers and acquisitions. The workshop on Day 5 is intended as an opportunity to reinforce the issues discussed in the lecture on Day 5.

Texts

The main material for the lectures will be drawn from three of the author�s texts.

  • Beyond Greed and Fear, 2002, Oxford University Press:� New York.
  • A Behavioral Approach to Asset Pricing, 2008, Academic Press: Burlington, MA.
  • Behavioral Corporate Finance, 2005, McGRaw Hill.

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