Behavioral Finance by blue123


									Meir Statman
Professor, Deparlment of Finance
Leavey School of Business
Santa Clara University

Finance practitioners and academicsare, or should             thatthe rationality-basedmarketequilibrium mod-
be, interested in the following questions:                                  in       and
                                                             elsin finance general of dividendsin particu-
     .Why     do investors like dividends?                   lar arealiveand well-or at leastin no worseshape
     .Why     do investors hate to realize losses?            thanothercomparable          in            at
                                                                                    models economics their
                                                             level of aggregation. The framework is not so
     .Why      do investors prefer stocks of "good"          weigheddown with anomalies      that a completere-
         companies?                                                        (on
                                                             construction behavioral/    cognitiveor otherlines)
     .How     are expected returns determined?                                 or
                                                             is eitherneeded likely to occurin the nearfuture.
     .What      kjnds of securities do investors like?       (p. 5466)
     .What     arethe forces that shapefinancial regu-    I argue that, today, ten years after Miller spoke,
        lations?                                          standard finance is indeed so weighted down with
The range of questionsis wide. It includes investor       anomalies that it makes much senseto continue the
behavior; the interaction of investors in markets,        reconstructionof financial theory on behavioral lines.
which determines security prices; and the interaction          Standardfinance is constructed with a few com-
of citizens in public policy arenas,which determines      mon componentsthat have many uses. So is behav-
financial regulations.                                    ioral finance. But the componentsof standard finance
      Standard finance-the body of knowledge that         and behavioral finance, reflecting different models of
is built on such pillars as the arbitrage principles of   human behavior, aredifferent. This presentation pro-
Merton Miller and Franco Modigliani, the portfolio        vides examples of the construction of behavioral fi-
construction principles of Harry Markowitz, the           nanceasa framework that builds on standard finance
capital asset pricing theory of John Lintner and          and replacesit.
William Sharpe, and the option-pricing theory of                Proponents of standard finance often concede
Fischer Black, Myron Scholes, and Robert Mer-              that their financial theory does poorly as a descrip-
ton-is so compelling because it uses only a few           tive, or positive, theory of the behavior of individu-
basic components to build a unified theory, a the-        als. They retreat to a second line of defense: that
 ory that should provide answers to all the ques-         standard finance does well as a descriptive theory of
tions of finance.                                         the equilibrium that results from the interaction of
      Few theories,however, are fully consistent with      individuals in markets. For example, Miller (1986)
 all the available empirical evidence, and standard       wrote that, for individual investors,
 finance is no exception. For example, Miller (1986)                 are
                                                              stocks usuallymorethan just the abstract    "bun-
 readily acknowledges that the observed preference            dlesofreturns"of oureconomic  models.  Behindeach
 for cash dividends is one of the "soft spots in the          holding maybe a story of family business,family
 current body of theory" (p. 5451). Miller goes on to         quarrels, legacies        divorcesettlements,
                                                                                received,                    and
 argue, however:                                              a hostof otherconsiderations  almosttotally irrele-
  vant to our theories of portfolio selection. That we       nore covariances and assessthe risk of an asset in
  abstract from all thesestories in building our models      isolation from the overall portfolio. By that rule, the
  is not becausethe stories are uninteresting but be-        options position is more risky, but by the rules of
  cause they may be too interesting and thereby dis-         Markowitz, the cashposition is the more risky one.
  tract us from the pervasive market forces that should
                                                                 Peoplein standard finance are rational. Peoplein
  be our principal concern. (p. 5467)
                                                             behavioral finance arenormal. When offered a choice
Even the second line of defense, however, does not           between a $10 bill and a $20 bill, both rational and
hold. Evidence is mounting that the capital asset            normal people choosethe $20 bill. Rational people,
pricing model (CAPM), the market equilibrium the-            however, are never confused by frames that make
ory by which risk and expected returns are deter-            that $10 bill look like a $100 bill, whereas as Amos
mined in standard finance, is not a good description         Tversky shows, normal people are often confused by
of reality. Moreover, contrary to Miller's view, I think     frames.1
that financial decisions by individuals and institu-                The effect of frames on choice is one part of
tions are the proper domain of finance, not merely           Kahneman and Tversky's (1979) prospect theory,
stories that "distract us from the pervasive market          and prospect theory is one of the components of
forces that should be our principal concern." Indeed,        behavioral finance. Susceptibility to cognitive errors
a good theory of the financial behavior of individuals       is a second component of behavioral finance (see
is crucial for a good theory of the equilibrium that         Kahneman, Slovic, and Tversky 1982).For example,
 results from the interactions of individuals in the         standard investors are never fooled by the "law of
marketplace. To understand the differences between           small numbers." They know that five years of return
the components from which standard finance and               data on a mutual fund provide little information
behavioral finance are constructed, consider the ar-         about the investment skills of the fund's manager.
bitrage principle.                                           Standard investors also know that, as they assess   the
      People in standard finance are not confused by          ability of the manager of a particular fund--say, the
frames. The pricing of a call option in the Black-           Magellan Fund-they should take into consideration
Scholes model is a good example. The price of a call         the evidence on the ability of the average fund man-
option is determined by substance: the knowledge              ager to beat the market. Behavioral investors tend to
that the cash flows of an option can be replicated by a      conclude that a five-year record of a fund is plenty of
particular dynamic combination of a bond and the             evidence about the skills of its manager and that the
underlying stock. The fact that in one case the cash         performance of the average fund manager is irrele-
flows are framed in terms of options and in the second                               of
                                                              vant in the assessment the skill of a particular fund
case flows are framed in terms of bonds and stocks
does not matter to standard finance investors. If the             Standard-finance people are immune to prob-
 option cash flows exceed the cash flows of the stocks       lems of self-control. They stick to their diet plans and
and bonds, "standard investors" engage in arbitrage,         find it easyto turn down tempting desserts.They also
make arbitrage profits, and move prices to equilib-          stick to their savings plans and never engage in im-
 rium levels where arbitrage is no longer profitable.        pulse buying. Behavioral investors are subject to
       Whereas standard investors are never affected         temptation and, as Thaler and Shefrin (1981)noted,
 by frames, "behavioral investors" are often affected        they look for ways to improve their self-control.
 by frames. Moreover, behavioral investors are af-                Standard-finance investors are also immune to
 fected by frames in a normal, predictable way. Con-         the pain of regret (seeKahneman and Tversky 1982).
 sider the following question: Which investment              Standard-finance people feel no greater disappoint-
 position is more risky?                                      ment when they miss their plane by a minute as when
       1. a $1,000 long position in U.S. T-bills or           they miss it by an hour. Behavioral investors know
       2. a $1,000 short position in naked call options      the joy of pride and the pain of regret as they kick
           on the S&P 500 Index.                             themselvesharder when they miss the plane by only
 Most people choose the options position as the more         a minute.
  risky one. Someone whose overall portfolio is posi-             The following sectionsdescribe how the compo-
  tively correlated with the S&P SOO    and who has cho-      nentsof prospecttheory, cognitive errors, self-control,
 sen the options position as the more risky position is       and regretcan help makesenseof the world of finance
  probably a behavioral investor-one       who has been       and answer the questionsposed at the beginning of
  fooled by the frame. The options position is nega-          this presentation. I begin with dividends, the issue
  tively correlated with this investor's portfolio; thus,     discussedby Miller (1986).
  it provides a hedge and lowers overall portfolio risk.
  In contrast, the T -bill position has only a zero corre-
  lation with the portfolio and reduces its risk by less
                                                                  lSee ProfessorTversky's presentation,pp. 2-5.
  than the options position. Normal behavior is to ig-
         Investor Preferences for Cash Dividends                          savings, but behavioral investors have to combat the
                                                                          desire for dessert even when they know that vegeta-
            During the energy crisis of the early 1970s, Con              bles are better for their long-term welfare. Rules are
            Edison, the power company in New York City, de-               a good tool for self-control. "No dessertbefore vege-
            cided to eliminate its dividend. At Con Edison's 1974         tables" is one such rule. "Consume from dividends
            annual meeting, shareholders revolted; some cried,            but don't dip into capital" is another. Recall that the
            some had to be restrained from doing physical harm            person who spoke for the woman at the Con Edison
            to the company's chairman. Here is a typical share-           meeting did not even consider the possibility of dip-
            holder reaction, quoted from the transcript of the            ping into capital to createhomemade dividends.
            1974 meeting:                                                     Indeed, following standard finance theory can
              A lady came over to me a minute ago,and she said            get people into deep trouble. One person in the
              to me, "Please say a word for the senior citizens."         audience at the Con Edison meeting asked why
              And she had tears in her eyes. And I really know            stock dividends were not paid in place of cash divi-
              what she means by that. She simply means that now           dends "so at least the blow to stockholders by the
              she will get only one check a month, and that will be       omission of dividends would have been much less."
              her Social Security, and she's not going to make it         The chairman, in an explanation that would have
              becauseyou have denied her that dividend.
                                                                          made Miller and Modigliani proud, explained that
                  Standard-finance shareholders of Con Edison             stock dividends are no more than pieces of paper
            would have been upset by the energy crisis and its            and that shareholders can create homemade divi-
            impact on the value of Con Edison's stock, but they           dends by selling a few shares.The chairman missed
            would not have been angry about the decision to               the point entirely. Naming the piecesof paper "divi-
            eliminate the dividend. The Con Edison shareholders           dends" moves them from the capital mental account
            must have been behavioral investors.                          to a dividend mental account and allows consump-
                  Standard investors follow the arbitrage princi-         tion without violating the rule of "don't dip into
            ple of Miller and Modigliani and know that in a               capital."
            world without taxes and transaction costs, they                    In short, contrary to the precepts of standard
            should be indifferent between a dollar in dividends           finance, investors make important distinctions be-
            and a dollar in capital. Standard investors are indif-        tween dividends and capital. The distinctions are
            ferent between dividends and capital because they             rooted in the way they frame money in mental ac-
            do not rely on company decisions to create divi-              counts and the rules by which they use these frames
            dends. They can create "homemade dividends" by                to control savings and consumption. One cannot
            selling shares. Moreover, in a world where divi-              solve the dividend puzzle while ignoring the pat-
            dends are taxed more heavily than capital gains,              terns of normal investor behavior.
            investors are actually better off when companies
            refrain from paying dividends. So, why do investors
            like dividends? This is the puzzle to standard fi- ~              Winners Too Early, Riding Losers Too
            nance about which Black (1976) wrote. Hersh She-
            frin and I have used the components of behavioral
            finance to explain why investors like dividends               Underlying the arbitrage principle of Miller and
             (Shefrin and Statman 1984).                                  Modigliani is the mechanismof arbitrage. An investor
                   A central element of prospect theory is that people    who sellsa share at $100in one market and simulta-
             segment their money into mental accounts. A dividend         neouslybuys a share of the samecompany in another
            dollar is identical to a capital dividend in standard         market for $95engagesin arbitrage, with a risk-free
            finance, but a dollar dividend is different from a capital    gain of $5. Of course, standard-finance investors
             dollar in prospect theory because the two dollars be-        never leave arbitrage opportunities unexploited.
             long to separate mental accounts and mental account-              The tax law, especiallyas it stood before the 1986
             ing is done account by account. The decline in the price     changes,provided investors with the "timing" arbi-
             per share of Con Edison is a loss in the capital mental      trage opportunity described by Constantinides
             account, and the elimination of the dividend is a loss in    (1983,1984).  The opportunity arises from differences
             the dividend mental account. Paying the dividend             in the tax rates on long-term and short-term gains
             would have provided a "silver lining" lessening the          and losses.Here is how it works: Imagine that you
             pain even if the dividend payment had resulted in a          have $10,000and you have decided to invest it in a
              further decline in the price of the stock.                  no-load mutual fund, Fund A. You also identify Mu-
                    Segregating monies into mental accounts is espe-       tual Fund H, whose returns are perfectly correlated
              cially beneficial for people who have difficulty with        with the returns on Fund A. Imagine also that the
              self-control. As noted earlier, standard finance inves-      "short term" is classified by the Internal Revenue
              tors have no self-control difficulties in either diets or   Serviceasone year, so gain and loss realizations after


    one year are classified by the IRSas "long term."
          You hold Fund A for a month, and as it happens, Why !Investors Prefer Stocks of GOOd
    the stock market declines and your sharesare now          Companies
    worth $9,000,a paper loss of $1,000.Now the arbi-
                                                             Everyone has heard that beta is dead. Some say it is
   trage game at the expense of the IRS begins. You
                                                             coming back; others say it is dead for good. The life
   realize the $1,000paper loss by selling your sharesin     or death of beta is so important becausebeta is the
   Fund A and using the $9,000 in proceeds to buy            center of the CAPM and the CAPM is the standard-
   sharesof Fund B. The $1,000loss,asa short-term loss,      finance way of understanding risk, expectedreturns,
   can be offset against your regular income taxed at,       and the relationship between the two.
   say, 30 percent. Your "rebate" from the IRS is 30              The current state of the CAPM illustrates the
   percent of $1,000, or $300. Now, imagine that you         danger in the tendency of standard finance to down-
  hold the $9,000in Fund B for a year and a day, and         play an understanding of human behavior and con-
   the value of the shares appreciates from $9,000 to       centrate instead on the resulting equilibrium in
  $10,000. You realize your $1,000 paper gain as a          financial markets. The assumptions about human
   long-term gain. You pay, say, 20percent, or $200,as      behavior that underlie the CAPM are not simplified
  a long-term tax to the IRS and buy $10,000 shares         versions of observed behavior. Rather, they contra-
  of Fund A.                                                dict observedbehavior. For example,investors in the
         Compare your situation to the situation of an      world of the CAPM are assumed to agree on the
  investor who held Fund A for the entire period. That      expected returns of all assets. Of course, nobody
  investor begins with $10,000   and ends with $10,000-     believes that this assumption comeseven close to a
  no gains, no losses. You, however, have $10,100      be-  description of human behavior.
  cause your initial $300tax rebate is $100higher than           Assumptions about individual behavior might
  the later $200 tax payment. This kind of arbitrage is     not matter when a theory works, but the CAPM does
 easy.It involves only the exploitation of a quirk in the   not work. Now that Fama and French (1992)have
 tax law. And, of course, standard-finance investors        brought the sorry state of the CAPM to the headlines,
 have no difficulty recognizing or exploiting arbitrage     standard finance offers no fallback theory for ex-
 opportunities.                                             pected returns and risk. Instead, the result is data
         Behavioral investors have a problem with the       mining in the form of size and book-to-marketeffects.
 arbitrage prescription; it requires the realization of a        Shefrin and I have also observed the choices of
 $1,000"paper loss" as they sell Fund A and buy Fund       investors, rather than stock prices, and offered in-
B. Behavioral investors hate to realize losses.Behav-       sights into the process by which investors form ex-
 ioral investors think of money within mental ac-           pectations about stock returns (Shefrin and Statman
 counts and distinguish paper losses from "realized        1995b). An analysis of investor expectations might
 losses." A stock with a paper loss might rise in price,   well be the best route to understanding the equilib-
 so the chance exists that the mental accountcontain-                                                as
                                                           rium levels of expected returns because, everyone
ing the stock will break even, but a realized loss         agrees,realized-return data, upon which virtually all
means kissing the hope of breaking even goodbye.           current analyses are based, are very noisy. In com-
 Behavioral investors are reluctant to realize losses,     parison, the noise level in expectationaldata is low.
despite the tax advantagesof doing so, because the  of           For example, Fortunemagazine collects data on
pain of regret that comes with kissing hope goodbye.       expectationsthrough surveys it conductsof a group
        Gross (1982)described the reluctance of inves-     of respondents who are commonly regarded as s0-
 tors to realize lossesthis way:                           phisticated investors-executives,       members of
      Many clients,however,will not sell anything at a     boards of directors, and financial analysts. Thou-
      loss.Theydo not wantto give up thehopeofmaking       sands of respondents are asked each year to rank
      moneyon a particular investment, perhaps    they     companies on eight attributes, including quality of
      wantto getevenbeforetheygetout. The"geteveni-        management, quality of products and services,and
      tis" disease probablywroughtmore destruction         value as a long-term investment. The top three com-
      on investment                            (p.
                    portfoliosthananythingelse. 150)       panies, asjudged by the average quality scorein the
SheErinand I have analyzed transactionsin mutual           survey published in the February 1993issue of For-
funds and stocks and found evidence against the            tune,are Merck & Company, Rubbermaid, and Wal-
standard finance hypothesis that people engagein the       Mart. The bottom three companies are Wang
tax arbitrage that Constantinides described (Shefrin       Laboratories, Continental Airlines, and Glenfed.
and Statman 1985).Ignoring arbitrage opportunities              Consider the relationship between the rating of
and leaving $100 (or much more) in the pocket of the       a given company on quality of managementand on
IRS may not be rational, but it is hard for behavioral     value as a long-term investment. Quality of manage-
investors to bring themselvesto realize losses.                                                In
                                                           ment is an attribute of the company. contrast, value

    as a long-term investment is an attribute of the stock      tial properties to its parent population and (2)reflects
    of the company. If respondeI\tsto the Fortune survey        the salient features by which it is generated. In other
    believe in market efficiency, they will conclude that       words, an event A is judged more probable than an
    the price of a stock fully reflects the quality of the      event B when A appearsmore representative than B.
    company. m efficient markets, the wonderful growth          Kahneman and Tversky (1972)have supported the
    opportunities of good companies are fully reflected         hypothesis that subjectsjudge the probability of an
    in the prices of their stocks, and therefore, the stocks    event by its representativenesswith a series of ex-
    offer no special value as a long-term investment.           periments.
    Similarly, the lousy growth opportunities of bad                  Consider this experiment (Kahneman and Tver-
    companies are fully reflected in the prices of their        sky 1982).Subjectswere presented with a brief per-
    stocks. Neither stocks of good companies nor stocks         sonality sketch of Linda: Linda is 31 yearsold, single,
    of bad companiesare bargains in an efficient market.        outspoken, and very bright. She majored in philoso-
    If so, we should find a zero correlation between the        phy. As a student, she was deeply concerned with
    Fortune ratings on quality of management and the            issues of discrimination and social justice and also
    Fortune ratings on value as a long-term investment.         participated in antinuclear demonstrations.
          Now col"\Sider, contrast,what might be expected            Subjectswere then asked which event is more
    if the FortuI'\erespondeI\ts standard-financeinves-         probable:
     torswho properly incorporatethe knowledge reflected             .Linda       is a bank teller (T).
    m findi11gson size and ratio of book value to market              .Linda       is a bank teller and is active in the
    value (BVIMV) by Famaand French (1992) others.and                      feminist movement (T & F).
    Shefrin and I have fOUI\dthat, in geI\eral,companies             The description of Linda was constructed to be
     thatFortuI'\erespondeI\ts highly by quality of man-
                               rate                             similar to or representative of the profile of an active
     agemeI\t  have high marketvalues of equity (large size)    feminist and unrepresentative of that of a bank teller.
    and low BVIMVs. Thesecharacteristics, course,ap-
                                               of               Now/the rules of probability state that the com-
     ply to companieswhose stocks provide low returns,          pound event T & F cannotbe more probable than the
    accordi11g Fama and FreI'\ch.If respondeI\tsto the
                to                                              simple eventT. Yet, 87 percent of all subjectsjudged
    FortuI'\e survey are aware of the Fama and French           the probability of the compound event that Linda is
    results, explicitly or implicitly, they should produce a    a bank teller and is active in the feminist movement
    negative correlation betweel\ the rating of a company       ashigher than the probability of the simple event that
     on quality of managementand the rating of the stock        Linda is a bank teller.
     of the company on value as a long-term mvestment.               The outcome of this experiment is consistent
    m fact,Shemn and I foUI\d neither the zero correlation      with the hypothesis that subjects judge the prob-
     between quality of managementand value as a long-           ability of an event by its similarity or repre-
     term investment, which would be expected if the            sentativeness. Specifically/because a feminist
     Fortunerespondentsbelieve stockprices are efficient,       attitude seems    more representativeof Linda than the
     nor the negative correlation expected if the Fortune       bank teller occupation, subjectsconcluded that Linda
     respondents follow Fama and French. lI1Stead,        we    is more probably a bank teller and feminist than a
     fOUI\da strong positive correlation. A regressionof        bank teller.
     value as a long-term investment on quality of man-               In interviews following the experiment, Kahne-
      agement produces not oIlly a positive coefficient         man and Tversky asked 36 subjects to explain their
     with a rare sigrlificant t-statistic, 43.95, but also an   choices. More than two-thirds of subjects who se-
     adjusted R2of 0.86.m other words, people as sophis-        lected the compound event gave some version of a
     ticated as the Fortune respondents think that good          similarity or typicality argument as their reasonbut
      stocksare the stocksof good companiesalthough the         agreed, after some reflection, that the responsewas
     evidence indicates that the opposite is true.               wrong becauseeveryone who is both a bank teller
          Why do people think that stocks of companies           and a feminist must also be a bank teller. Only two
      such as Merck, Rubbermaid, and Wal-Mart offer              of the subjectsmaintained that the probability order
      higher values as long-term investments than stocks        need not agree with class inclusion, and only one
      of companies such as Wang, Continental Airlines,           claimed that he had misinterpreted the question.
      and Gle11fed?   Michael Solt and I have argued that              In relation to good companies and good stocks,
      mvestors tend to believe that good stocksare stocks        Saltand I argue that investors overestimate the prob-
      of good comparnes because they fall prey to the            ability that the stock of a good company is a good
      representativeness heuristic (Solt and Statman 1989).      stock because they rely on the representativeness
          A person who follows the representativeness            heuristic. They overestimate the probability that a
      heuristic evaluates the probability of an UI\certain       good stock is stock of a good company because a
      event by the degreeto which it (1)is similar in essen-     good stock is similar to a good company.

              The                Fortune                              r~spo~den~                                         rate                 st~ks                           as        if         they               like                  The        Design                               and                    Marketing                                                     of            Financial                                        Products

stocks                     of         companIes                                         WIth              high-quality                                                  management,
with                  high                   market                               values                          of             equity,                           and                        with                    low                         In            t~a~g                                     students                                      the                 basics                           of          options,                                  I      draw

BV        /MVs.                         Do                   they                 care                 about                        beta?                        No.                 Regression                                                   pro~t                     di~~ams,                                            as.shown                                           in             Figure                            1,         of            the                four

results                         show                    that                    there                is          no              statistically                                          significant                                               basIc                   POSItiOns:                                  buymg                                    a        call,                  selling                        a       call,               buying                             a

relationship                                           between                                 value                         as           a            long-term                                        invest-                                   put,                and                      selling                         a          put.                     I        ask                the                students,                                    "Which

                t                db                t                                                                                                                                                                                              positions                                 do             you                  like?"                           They                      like                 the               idea               of         buying

men                   an.                    e         a.                                                                                                                                           ..calls                                                           and                  puts,                     but                    they                     hate                 the                 idea                  of         selling                          (na-

               TypICal            ..c             Fortune                               respondents                                                are             behavIoral                                               m-                    ked)                     alls                and             pu.             ts           Th           eyexp                          I am.                 that              b uymgac       .                              all           .IS

vestors,                          mvestors                                      who                 .believe                             that                ~ood                            stocks                     are                       attractive                                    because                                the                position                                  has                 a         floor                   on            losses

stocks                      of        good                        companIes.                                      Standard                                       mvestors                                      know                               but             unlimited                                        potential                                             for            gains.                           "The                       maximum

what                  Fama                        and                    Fren~                         know,                             ~at                 g~od                            stocks                     are                       that                I    can                     lose            is              the                 premium,"                                               they                   say.                  Selling                          a

stocks                      of         bad                  companIes.                                           BehavIoral                                         mvestors                                       load                            (naked)                              call          involves                                     a      ceiling                            on          gains                        but            unlimited

up            on          stocks                       of             good                   companies.                                           Standard                                     investors                                          potential                                 for            losses.

 tilt         their               portfolios                                      toward                          stocks                           of        bad                   companies,                                                                     Next,                        I     show                       them                      a            profit                     diagram                                 of        a       covered-

but           being                     fully                     rational,                           they               are              mindful                                  of         the              nega-                              call            option                             (shown                               in            Figure                            2),            a        position                              that                 com-

tive             effect                   that                        concentration                                              has              on             portfolio                                    diver-                              bines                   buying                            a      share                           of          stock                      for,               say,               $21             and                    selling

sification.                             Thus,                           standard                             investors                                      moderate                                      the               tilt                  a      call             option                          on         the                  stock                         with                 an          exercise                              price                     of          $25

toward                           stocks                           of       bad                companies,                                               and                the                 force                    that                        for          $1.             My                 stud~nts                                  like                th~              idea                   of           covered                               calls,                   but

 they                  exert                      on                  stock                  prices                          may                       not                    therefore                                      be                    they                   are               surprised                                        to               realize                             that                  the              shape                          of            the

 sufficient                              to                 counter                            fully                   the                effect'                        of             behavi~ral                                                 ~ro~t                    ~agr~                                    of              the                covered-call                                                  posi~on                               that                they



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                                                                                                                                                                                                                                        t         like             15           Identical

                                                                                                                                                                                                                                                                                                                          to           the               shape                            of         the                selling                         a       (naked)

 Sh            frin                      d         I                                           .f                                                       b          h                 .al.                                                          put             posItion                                 that                     they                     hate.                     My                   students                               are                hardly

          e                      an                         see               cons~ts                        ~               many                            e            avlor                               mves-                                unique;                               the               attraction                                           of              covered                                 calls                  has                 been                       a

  tors              who                 hol~                      portfolios                                 tilted                      t~ward                                the              stocks                             of              puzzle                        to            standard                                   finance                                 for            years.                         But            Shefrin                               and

 good                     companIes,                                          a    few               standard                                   mvestors                                      who                  hold                            I     have                   attempted                                            to            explain                              that                   attraction                                      (Shefrin

 portfolios                              tilted                        toward                        stocks                         of     bad                   companies,                                            and                         and             Statman                                  1993a).

 an           expected-returns                                                          equilibrium                                           where                            stocks                         of       bad                                        Covered                                   calls                     are               promoted                                         by             investment                                           advi-

  companies-low                                                                 market                       values                               of         equity                            and                 high                            sors               as          positions                                    that                 contain                               free                 lunches.                                 Here                    is      an

  BV          /MVs-have                                                   high                 returns.                                                                                                                                            example                                     from                   the                    Research                                          Institute                                  of         America's

                                                                            Profit Diagram for Call and Put Options
                                                                  Figure 1. Buya Call
                                                                  -.~_.                                                                                                                                                                                                                                                               Buy a Put

                                                                                                                             I            "" :"

                                                                          Maximum                                                                                                                                                                                                                                                                                                 Maximum
                                                                                   Loss                                                                                                                                                                                                                                                                                             Loss

                                                                                                          Sella Call                                                                                                                                                                                                                      Sella Put
                                                                  Maximum                                                                                                                                                                                                                                                                                                       Maximum
                                                                          Gain                                                                                                                                                                                                                                                                                                          Gain

                                                                                                                                                                                                                                                                                                                     .'         .'                       'I

                                                                  Note:The solid horizontal line in each diagram is the stockprice at option expiration date. The tick marks
                                                                  on this line indicate the point at which the strike price equals the stock price at expiration.

                                                                        Meir Statman.

Figure2. ProfIt Diagramfor a Covered.caII                             dividends due you as the owner of the stock.
                                                                      The third source of profit would be in the in-
                                                                      creasein price of the shares,from what you
                                                                      paid, to the agreed selling price.
                                                                     By agreeing to sell at a higher price than you
                                                               bought, all you are giving up is the unknown, un-
                                                               knowable profit possibility above the agreed price.
                                                               In return, for relinquishing some of the profit poten-
                                            Stock Price        tial, you collect a handsome amount of cash that you
                                             at Option
                                                               can immediately spend or reinvest, as you choose.(p.
                                                                    Note the way Gross frames the cash flows into
                                                               three "sources of profit" rather than integrating the
Source: Meir Statman.                                          three into an overall net cashflow. Of course, stand-
                                                               ard investors have no difficulty in integrating the
Personal Money Guide:                                          cashflows, and they understand that covered calls
                                                               provide no free lunch. But not all investors can dis-
   An investment strategy that can make you extra
                                                               entangle the cash flows from their frame, and cov-
   money is writing calls on securities you already own.
   ...When you sell a call on a stock you own, you             ered calls remain popular.
   receive a premium. Think of these premiums as extra               As Ross (1989) wrote, when standard finance
   dividends. By careful selection of stocks and timing        scholars are asked to explain the proliferation of
   of writing calls, you have the opportunity to earn          financial products and the features of their designs,
   annual rates of returns of 11 percent to 19 percent:        they tend to " fall back on old canards such as span-
   regular dividends of 4 percent to 9 percent and pre-        ning." Rossemphasizedthe role of marketing in the
   mium "dividends" of 7 percent to 10 percent.                world of financial products. SheErin and I (1993a)
And here is an example of the exasperated response             have shown that an understanding of the behavior of
of standard finance:                                           individuals and institutions explains the design of
   Even for long-term investors who plan "never" to
                                                               covered calls, money market funds, and many other
   sell their stocks,the premiums received from writing        securities.
   options against these stocks cannot be treated as
   simply extra income to be added to the normal return
                                                            Behavioral Forces That Shape Financial
   of the stocks, as some advertising in the options
   industry seems to suggest. (Merton, Scholes, and            Regulations
   Gladstein 1978)
                                                               "Do you know what the concept of suitability means
     Why do investors continue to ignore the good              in the context of investments?" I ask financial econo-
advice of standard finance? One part of the answer is          mists. Few know, and few investment textbooks
that behavioral investors frame the cash flows of              mention suitability. In contrast, suitability regula-
covered calls into separate mental accounts rather              tions are well known to securities brokers. Perhaps
than integrate them as standard finance suggests.              financial economistswithin standard finance ignore
Consider the way Gross (1982) frames covered calls              suitability regulations because they are not impor-
in his manual for brokers:                                     tant, or perhaps they ignore them becausesuitability
    JoeSalesman:You have told me that you have not             is difficult to fit into standard finance.
        beentoo pleased with the results of your                     Suitability regulations revolve around the re-
        stock market investments.                              sponsibilities of brokers to their customers. Brokers
    John Prospect:That's right. I am dissatisfied with
                                                                are required to ascertain that the securities they rec-
        the return, or lack of it, on my stock portfolio.
    JoeSalesman:Starting tomorrow, how would you                ommend aresuitable for their customersbased on the
        like to have three sources of profit every time         customers' financial conditions and needs. Consider
         you buy a common stock?                                the experienceof Charles Schwab& Company. Char-
    John Prospect:Three profit sources?What are                 les Schwabis, of course,a discount. broker that pro-
         they?                                                  vides no investment advice. An investor was trading
     JoeSalesman:First, you could collect a lot of dol-          options through Schwab and lost $500,000.Then,
         lars-maybe hundreds, sometimes thou-                    claiming that those investments were unsuitable for
         sands-for simply agreeing to sell your                  his financial condition and needs, he sued Schwab.
         just-bought stock at a higher price than you
                                                                Schwab'sargument in its defensewas that it does not
         paid. This agreementmoney is paid to you
          right away, on the very next business day-
                                                                give advice; it merely trades what the investor wants
          money that's yours to keep forever. Your sec-          traded. The arbitration panel said that Schwab's ar-
         ond source of profit could be the cash                  gument is irrelevant, the option trades were not suit-
              able for that investor, and the fact that Schwab is a       pay for IPOs. Should merit regulations be abolished
              discount broker does not exempt it from suitability         or, given the evidence on the returns IPas provide,
              regulations.                                                should the regulations be tightened?
                    The typical reaction of financial economistswhen           Suitability and merit regulations are not the only
              they are told about suitability regulations is that these   tools designedto help behavioral investors cope with
              regulations are senselessand should be abolished.           their shortcomings. Shefrin and I have analyzed suit-
              Suitability regulations prevent investors from using        ability, merit, and such other regulations as those
               their investor sovereigntyto choosethe securitiesthey      pertaining to insider trading and mandatory disclo-
              want and construct the portfolios that are, in their        sure (Shefrinand Statman 1992,1993b).
              judgments, optimal. The role of a theory is to explain
              the evidence,however, not argue with it.
                    Suitability regulations make no sensein stand-
              ard finance because,in standard finance, people are         Standard finance is well built on the arbitrage princi-
               assumed to be free of cognitive errors and problems        ples of Miller and Modigliani, the portfolio construc-
               of self-control. Suitability regulations are important,    tion principles of Markowitz, and the CAPM of
              however, for behavioral investors. Indeed, suitability      Linmer and Sharpe. Standard finance does not do
               regulations can be understood as tools that help be-       well, however, as a descriptive theory of finance.
               havioral investors control the effects of their cogni-     Investors regularly overlook arbitrage opportunities,
               tive errors and self-control problems. In that sense,      fail to use Markowitz's principles in constructing
                suitability regulations are analogous to "cooling-off"    their portfolios, and fail to drive stock returns to
                                                                          levels commensurate with the CAPM.
                    Considerthe door-to-door salesof vacuum clean-              Peoplein standard finance are rational. They are
              ers. By law, a customerhas three days after making a        not confusedby frames, they are not affected by cog-
              purchase, a cooling-off period, to cancelthe transac-       nitive errors, they do not know the pain of regret, and
              tion. The existenceof this law implies that people have      they have no lapsesof self-control. People in behav-
              realized that sometimes they get too "hot" for their        ioral finance may not always be rational, but they are
               own good; they need time to cool off, think clearly,       always normal. Normal people are often confused by
              and regain their self-control. So, through the legisla-     frames, affected by cognitive errors, and know the
              tive process, people created a law that helps them          pain of regretand the difficulty of self-control. I argue
               control their cognitive errors and imperfect self-con-      that behavioral finance is built on a better model of
              trol. The same argument applies to securities.People        human behavior than standard finance and the better
               understand that cognitive errors and imperfect self-        model allows it to deal effectively with many puzzles
               control interfere with good decisions.So, through the       that plague standard finance, among them, the puz-
               law, they appoint a broker or investment advisor to         zles discussed here-investor preference for cash
               do for them what parents do for children--say no to         dividends, investor reluctance to realize losses, the
               choices that parentsjudge irresponsible.                     determination of expectedreturns, the design of secu-
                     Or consider state merit, or blue-sky, regulations.    rities, and the nature of financial regulations.
                Under them, a bureaucrat in, for example, Sacra-                 Finance offers many other puzzles. Some are
               mento decides whether a particular security can or           small-for example, why the practice of dollar-cost
                cannot be sold to residents of California. The ration-      averaging persists despite its inconsistency with
                ale behind merit regulations is that people are sus-        standard finance (Statman 1995). Some are large-
                ceptible to cognitive errors and, left to their own         for example,why investors ignore Markowitz's rules
                devices, will overpay for securities. As in the caseof      of portfolio construction (Shefrin and Statman
                suitability regulations, merit regulations are de-          1995b).  Thesepuzzles might be solved within behav-
                signed to protect investors from themselves,protec-         ioral finance.
                tion that makes no sensein standard finance.                     Financial professionals who understand behav-
                      Consider merit regulations in light of the evi-       ioral finance will understand their own behavior and
                dence on the returns from initial public offerings.         improve their decisions.Institutional investors who
                Mounting evideI:lceindicates that investors who buy         understand behavioral finance will understand the
                IPOs in the public market, on average,lose substan-         beliefs and motives of their clients and will be better
                tially. Left to their own devices,IPO investors over-        at serving and educating them.


Question and Answer Session
Meir Statman
Question:    What is "quality of         Question: With all theinforma-          replacement for standard finance
management," how do we                   tion availableaboutthe benefits         as a descriptive theory. The re-
measure or quantify it?                  of indexing-costs are low and           turn anomalies are the pebbles in
                                         managers  havedifficulty outper-        the shoe that make one say,
Statman: Quality of manage-              formingthe indexes-why aren't          "Enough! Standard finance does
ment is the rating of quality of         morepeopleindexing?                     not work." When standard theo-
management by respondentsto                                                     ries of portfolio selectionare in-
Fortune's survey of companies.Re-        Statman: Indexing does not cor-         consistent with the evidence and
spondents give each company a            respond to investors' intuition         when market forces are inconsis-
score on quality of management           about the way the market works.
                                                                                 tent with the predictions of the
ranging from zero (absolutely aw-        I ask my students, "When you
                                                                                CAPM, the wise move is to go
ful) to ten (glorious). The correla-     buy a stock becauseyou are confi-
tions cited in the presentation are      dent that it is a bargain, who do      back to an examination of the fi-
based on the averagesof those            you think is the idiot who is on       nancial decisions of individuals.
rankings from all the Fortunere-         the other end of the transaction?/l         Moreover, the activities of in-
spondents. We do not know the            Most have never thought about          dividuals and institutions are a le-
respondents' thought processes     in    this question. Most people do not      gitimate concern of the field of
assigning the ratings.                   think about the stock market as a      finance even if they do not affect
                                         zero-sum game relative to index        prices. When corporations fail to
Question: Did you examine the            funds. They do not consider the        deploy their assetsefficiently,
relationship between past stock          likelihood that the trader on the      welfare declines.Agency theory
performance and managementrat-           other side of the trade might be       focuseson the issues that pertain
ings from the Fortunesurvey?             an insider and that they, in fact,     to welfare lossesand mechanisms
                                         are the patsy.                         for alleviating such losses(seeJen-
Statman: Yes, and the answer is                                                 sen and Meckling 1976).Welfare
in a paper that Roger Clarke and I       Question: Some of the findings         lossesalso exist when individuals
wrote (Clarke and Stabnan1994).          of decision theory suggestthat in-     fail to construct efficient portfo-
One of the characteristics of high-      dividuals overpay for volatility /     lios; a description of such losses
quality companies is that their          whereas your researchsuggests          and mechanismsfor the allevia-
past stock returns are high.             that individuals overpay for sta-
                                                                                tion of such lossesare a concern
                                         bility / or good companies. How
                                                                                of finance practitioners and
                                         do we reconcile theseviews?
Question: As a matter of com-                                                   should be a concern of finance
munication, can we educateour-                                                  academics.
selvesand our clients to look at         Stabnan: People frame their                 As behavioral finance devel-
portfolios rather than segments?         money into those different pock-
                                                                                ops, we ought to keep in mind
If so, how?                              ets. So,there is no unified attitude
                                                                                that we need theory that contains
                                         toward risk. Many people who
                                         buy insurance also buy lottery         testablehypotheses, not stories. I
Statrnan: It is possible to edu-                                                take delight when somebody
                                         tickets. Are they risk averse or
cate people, but we need more                                                   finds evidence contrary to hy-
than education. I begin my talk          risk seeking?Investors divide
                                         their money into "safe" money          pothesesof behavioral finance. At
about portfolios in my invest-
                                         and "risky" money (She£rin    and      least nobody can say that our the-
ments class by telling students
                                         Statrnan1995a).                        ory is a just-so theory that cannot
that their intuition is likely to mis-
                                                                                be refuted by evidence.
lead them. What is really needed
                                         Question: A so-called new fi-               Moreover, explaining the ex-
are structures that prevent us
from acting on wrong intuition-          nance is driven heavily by market      isting anomalies is not enough.
 for example, a work sheetwith           inefficiency. Where does behav-        Behavioral finance will be tested
boxes that must be filled in-a           ioral finance fit in this approach-    in its ability to explain phenom-
 framework that forcesus to con-         as a subsetor as the keystone?         ena that are not even recognized
 sider factors that, acting on intui-                                            today as anomalous within stand-
 tion alone, we are likely to miss.      Statman: Behavioral finance is a       ard finance.

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