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Unformatted text preview: Behavioral Finance The 1990's bubble and 2000 crash in the stock market along with the Nobel Prize awarded to Kahneman and Smith has caused an increased interest in BEHAVIORAL FINANCE, which was already one of the hottest areas in business. Two studies are of particular relevance. First, Vernon smith was asked by the SEC to try to find a way to deal with the kind of market crash that occurred in 1987. The second study is by the behavioral economist, Robert Shiller, who published a book entitled Irrational Exuberance that explained the crash in 2000. We will go through his explanation and see if it works for the 2008 crash.
Professor Schulze AEM 414 Lecture 10 Behavioral Finance (cont.) Your labs on the asset market are slightly modified versions of the experiment that Vernon and others came up with. In particular , in the each lab the asset had a mean payoff of $.24 per round for 15 rounds so the expected value of a share in the first round is: EV = 15*$.24 = $3.60. The EV decreases linearly by $.24 per round until the last round when the asset share is worth only $.24, since share pay after the round is over. What Vernon found was that, more often than not, the trading price of shares failed to follow EV. Rather, prices were almost always above EV until a crash occurred in the latter half of the experiment.
Professor Schulze AEM 414 Lecture 10 Vernon Smith Experiment Results AEM 414 Professor Schulze Lecture 10 Vernon Smith Experiment These results are very anomalous because the efficient markets theory of finance predicts that the share prices should exactly follow EV. If price rises above EV any rational participant should sell all their shares. If price falls below EV you should buy all you can get. This should force Price=EV. But, if price stays at EV no trades should occur in the experiment at all!
Professor Schulze AEM 414 Lecture 10 Smith (cont.) Everything that Vernon tried to do to help such as suspending trading, cooling off periods, etc., did not help. The experiment was repeated- the only thing that worked was experience! The third time through the experiment the students got it right! When the students finally got it right, prices equaled EV and there was almost no volume, just as efficient market theory predicts.
Professor Schulze AEM 414 Lecture 10 Practical Example So, how many experienced traders were there in the market when the 2000 "disaster" occurred? I just happen to know the woman who writes the rules for the NYSE (a Princeton economics graduate). At a dinner party I drew the bubble crash experiment on a napkin six years ago and told her that I thought, given the high turnover of brokers and traders, that no experienced participants who went through the 1987 previous crash were left. AEM 414 Professor Schulze Lecture 10 Practical Example (cont.) Thus, the market bubble was irrational just like the ones in the lab and the bubble would burst. In my view all the stories about the "New Economy" were garbage.
She took serious umbrage at my remarks and said that she could find lots of experienced traders. She e-mailed me a couple of months later and admitted no one was still there who was around in 1987. I said kiss "your --- goodbye! This market is going to crash big time."
Professor Schulze AEM 414 Lecture 10 How Have Economists Explained this Phenomenon? First, they have not--this is psychology. But, second, they have pointed out that if other traders are not rational, then it does not pay for the rational trader to behave in the same way as efficient market theory predicts. Rather, as in your experiment, if the price stays the same or goes up (does not fall as it should) you should try to buy some additional shares and try to sell at the same price you bought at or above before the market crashes, earning dividends for free. In the actual markets, prices are rising during a bubble so you should definitely buy on the way up, assuming you can sell in time before the crash.
Professor Schulze AEM 414 Lecture 10 Psychological Explanation Do psychologists have an explanation for why the market behaves the way it does? The answer is they have many of the pieces, but not the whole story, figured out. Much of what follows is drawn from Shiller's book on behavioral finance. The first point that Shiller makes is that the Clinton boom was far and away the biggest bubble in world history, dwarfing 1929. AEM 414 Professor Schulze Lecture 10 Shiller Book Data: Prices and Earnings Compare the 1929 crash to the 2000 bubble! Stock prices should follow earnings! If we look at the ratio of prices to earnings (the P-E ratio) it logically should stay constant--next slide. AEM 414 Professor Schulze Lecture 10 Shiller Book Data: PriceEarnings Ratio
Oops! The P-E ratio is insane! Stock prices do not follow earnings! AEM 414 Professor Schulze Lecture 10 P/E Ratio We measure the true value of stocks (fundamental value) by examining the price earnings (P/E) ratio. Note that the price earnings ratio which should absolutely never get above 20 (comparable to a 5% pretax rate of return) and should really not get above 15, if stockholders are getting a reasonable rate of return on their investments. Yet, in 1929 the P/E ratio hit 33 and approached 45 in 2000! The problem is, how can buyers suspend their disbelief? Is this the result of a mass hallucination? Let's look at the class results for an experiment structured almost exactly like Smith's early experiment, EV = $3.60 on round one decaying to EV = $.24 on round 15.
Professor Schulze AEM 414 Lecture 10 Your Experiment Design Initial Cash Endowment: $12.60 Initial Assets: 2 Payoff Values (equal probability) : $0, $.08, $.24, $.28, $.60 Expected (average) payoff per round for 1 asset: $.24 Present EV of holding asset for 15 rounds: $3.60 Present EV of initial assets: $7.20 EV of base portfolio: $12.60 + $7.20 = $19.80
Professor Schulze AEM 414 Lecture 10 Class Results Week 1: Bubble with crash at very end AEM 414 Professor Schulze Lecture 10 Class Results Week 2: Bubble but crash comes earlier AEM 414 Professor Schulze Lecture 10 Class Results Week 3: Smaller or no bubble AEM 414 Professor Schulze Lecture 10 What anomalies are important in the stock market? Loss Aversion: Richard Thaler who developed behavioral finance here at Cornell argues that loss aversion keeps people from selling when they should during a real crash. Investors are reluctant to accept the loss of selling an asset that they paid a high price for at a lower price, hoping the market will get better (which it does not!). Now lets look at bids (WTP) and offers (WTA) by round, noting that the WTA/WTP ratio should be equal to unity and that if it approached or exceeds two, that is a sure sign of loss aversion.
Professor Schulze AEM 414 Lecture 10 WTA/WTP Results Lab 1 AEM 414 Professor Schulze Lecture 10 WTA/WTP Results Lab 2 AEM 414 Professor Schulze Lecture 10 WTA/WTP Results Lab 3 AEM 414 Professor Schulze Lecture 10 Avoiding Loss Aversion Wow. WTA/WTP stays between 1 and 2 for most rounds but approaches 5 or 6 in the last rounds and during the crash starting in rounds 11-13. We have proven Thaler to be very correct! Lesson, if the market tanks, sell everything now! DO NOT SUFFER FROM LOSS AVERSION --SELL, SELL, SELL (AND GIVE SOME TO CORNELL). AEM 414 Professor Schulze Lecture 10 Most Important Thing Given that the most important thing to figure out is when to bail, what explains the biggest bubble of all time that started in 1982 and crashed in 2000. It is impossible to pick the exact high and low. Use P-E ratios. If stocks are cheap, buy. If stocks are expensive, sell. Many investors do exactly the opposite. AEM 414 Professor Schulze Lecture 10 Schiller lists 12 precipitating factors that contributed but are not causal:
1) The internet arrived on top of solid real growth earnings growth. 2) Foreign economic rivals like Japan tanked. 3) Culture changed to favor business including stock participation by managers and unions tanked. 4) Republican Congress and Capital Gains Tax cuts. 5) Baby Boomers. First Consume like crazy and get away with it by retiring on fantastic stock market gains. (DREAM ON.) 6) Media reports and the development of stupid talking heads hyping the boom. 7) Optimistic forecasts by analysts with the brain power of pumpkins.
AEM 414 Professor Schulze Lecture 10 Schiller lists 12 precipitating factors that contributed but are not causal:
8) 401k pension plans and move to stocks for retirement plans. 9) Advertising and mutual funds focused people on overall market rather than individual stocks. 10) People reacted to decreasing interest rates (due to decreasing inflation) by putting more money into stocks, not realizing that only the real rate of return is relevant (money illusion). 11) Volume of trade has increased because of online trading, day trading, etc. From 1982-1999 volume rose from 42% to 78% of all shares trading per year on the NYSE and from 88% in 1990 to 221% in 1999 on the NASDAQ. Given that stocks should be long term investments, this implies that everyone now is a day trader! 12) Gambling in the US increased dramatically over this interval of time and became more legitimate with increased use of State lotteries.
AEM 414 Professor Schulze Lecture 10 Conclusion These precipitating factors created a psychologically devastating environment that both encouraged and allowed anomalous behavior to flourish in the stock market to a degree never experienced before the perfect storm. AEM 414 Professor Schulze Lecture 10 Causal Factors Schiller places great confidence in confidence as a measure that contributes to an amplification process. First, Schiller argues that stock market bubbles are a kind of Ponzi Scheme or process perpetrated on witless investors. The key element in a Ponzi Scheme is that you must have a believable story that convinces people to participate because they will absolutely make money for sure by participating.
Professor Schulze AEM 414 Lecture 10 Causal Factors (cont.) Shiller describes one version of the story as follows: In his 1999 book, DOW 40,000, David Elias quotes one person's argument in favor of investing as follows: "An example of what can happen when an individual waits for the Dow to indicate a perfect time is the saga of Joe, a friend of mine. Joe started calling me in 1982 waiting for the perfect time to get into [stocks]. Over the years he continued to seek....his perfect moment. Today at 62 Joe still has his money parked in bank CDs. He has missed the entire bull market... Even now he does not realize that there is never a perfect time. When the market recovers from a pullback it generally goes to new highs." (Shiller p 49.)
Professor Schulze AEM 414 Lecture 10 Causal Factors (cont.) Note that the story utilizes loss aversion! Joe could be rich (the reference point) but he regrets that he is poor. Don't end up regretting your mistake too and be a schmuck. Get into the market now! (At high prices.) AEM 414 Professor Schulze Lecture 10 Causal Factors (cont.) The popularity of this Ponzi approach is reflected in books and magazine articles with titles like: "Everybody Ought to be Rich," Ladies Home Journal (1929) The Millionaire Next Door NYTimes Best Seller (1996) The Road to Financial Freedom: A Millionaire in Seven Years best seller in Germany (1999) The Nine Steps to Financial Freedom (1999) The Courage to be Rich (1999), etc.
Professor Schulze AEM 414 Lecture 10 How Does The Ponzi Scheme Work Assuming You Can Find Suckers? Feedback theory uses adaptive expectations to explain both the Ponzi scheme and bubbles. In the case of bubbles, price increases lead people to believe that there will be more price increases for stocks. However, the price increases cannot continue indefinitely because eventually people run out of money to invest or there are no suckers left. Because prices are supported only by the expectations of further price increases (not earnings), when people run out of money to buy high priced stocks, the bubble collapses and values return to those based on earnings alone (or below).
Professor Schulze AEM 414 Lecture 10 Ponzi Scheme A Ponzi scheme works the same way in that is you sell franchises for a worthless business venture to 5 people (and pay your earnings from sales of franchises to the person who sold you the franchise) and they pay you half of the money the make selling franchises to 5 more people each, and so on, the losers are the last people to buy who run out of schmucks to sell the franchise. The real anomaly issue is, how can people believe in a story that promotes such nonsense. The answer is that each bubble that has occurred over history is sold on some version of the "new economy" story that explains why the present is different from the past.
Professor Schulze AEM 414 Lecture 10 Beyond Shiller's Book: Does What He Said About the 2000 Crash predict the 2008 Crash?
S&P 500 P-E Ratio: The Long Run View AEM 414 Professor Schulze Lecture 10 Beyond Shiller's Book: Does What He Said About the 2000 Crash predict the 2008 Crash?
S&P 500 P-E Ratio: The Short Run View AEM 414 Professor Schulze Lecture 10 Beyond Shiller's Book: Does What He Said About the 2000 Crash predict the 2008 Crash?
DOW: The Short Run View AEM 414 Professor Schulze Red shows DOW price index. Yellow shows earnings. Blue shows P-E Ratio. White shows what Dow price index should be at a constant P-E of 14. So, just before the current crash the DOW was rationally priced at 11,500!!! So, why the CRASH? Lecture 10 Shiller fails because the crash had nothing to do with the stock market itself where nothing was wrong. The panic came about because of a collapse in the financial/banking/housing sector that caused an emotion based panic.
Most Recent DOW Price Index P-E Ratio is now just above 10. Stocks are incredibly cheap. Panic caused by the emotion of fear which is located deep in the inner brain, the amygdala. Use your cerebral cortex and buy stock now or do not sell. Neuroeconomics studies the conflict between the cerebral cortex (rational calculator) and the amygdala (irrational emotion) when facing risk. Never let your amygdala get you to buy high and sell low! AEM 414 Professor Schulze Lecture 10 What happened in the financial markets? Starting with Senator Phil Gramm under Reagan, banks were steadily deregulated. This continued under Bush 1, Clinton, and Bush 2. Banks had been heavily regulated because bank failures were a major cause of the Great Depression. Only Wall Street crashed first leading to bank failure. This time it was the other way around! Banks started approving high risk mortgages and used tricks like balloon payments, etc. These mortgages were not held but were bundled and "securitized" and sold at high prices with hidden risk. When home prices stopped going up (partly pushed up by all the high risk mortgages) people could not make their balloon payments or afford the increased payments and defaulted.
Professor Schulze AEM 414 Lecture 10 What is a Toxic Mortgage? "AMY GOODMAN: Lionel Ouellette, you organize homeowners, tell us some of their stories. LIONEL OUELLETTE: One of our members, a Latina first-time home buyer, 760 credit score, which should make her eligible for the best loan products out there, got a subprime of 2/28, which is a loan that was fixed for two years, adjustable for twenty-eight, and with a balloon payment. 760 credit score should have the best product available...... she's hoping to refinance, to do something before it adjusts in 2008. JUAN GONZALEZ: And when you say a 2/28, can you explain? These interest rates jump phenomenally, right? Could you talk, the difference, what it means in terms of an actual payment suddenly after two years? LIONEL OUELLETTE: It can go from $2,300 up to $3,400 to $3,800 to $4,100. It can double. JUAN GONZALEZ: $4,100 a month. AMY GOODMAN: A month. LIONEL OUELLETTE: $4,100 a month, yeah." AEM 414 Professor Schulze Lecture 10 What happens when somebody defaults on a mortgage? Imagine that one principal payment of $1000 is not made. The bank would have kept 20% and loaned out the other $800. The other $800 dollars would have been lent out. The $800 would have been deposited in another bank and that bank would have to keep 20% on reserve and lent out $640 and so on. So the one payment of $1000 would have led to $5000 in new loans after 6 months. This is why money for lending dried up along with foreigners who were no longer willing to put money into American banks. A credit crunch--no car loans, business loans, home loans, etc., and the economy was starting to collapse and Wall Street tanked.
Professor Schulze AEM 414 Lecture 10 Your Class Paper Will Explain How Behavioral Anomalies Help Explain the Disaster in the Financial Sector--What did various managers do that was stupid that led to this mess and the failure of many firms? Go through the lectures and list all the behavioral anomalies. Go to the internet and look at the history of a number of failed financial sector firms and figure out how anomalies played a role in bad decisions including consumers and business managers. This is much like an Easter egg hunt. Aha, this moron was suffering from hyperbolic discounting. Or this manger was dismissing risk "it can't happen to me." Or this firm suffered a loss and in trying to recoup took extra risks because managers became risk seeking in losses. Less than or equal to 10 pages double spaced 12 pt font. AEM 414 Professor Schulze Lecture 10 ...
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This note was uploaded on 02/20/2009 for the course AEM 4140 taught by Professor Schulze,w. during the Fall '08 term at Cornell University (Engineering School).
- Fall '08