th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4Profiting from Irrationality
Behavioral Finance in the Philippines
Francisco L. Roman Jr., DBAFrancisco L. Roman Jr., DBA
?
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 1
Table of Contents I. “Is Behavioral Finance a Growth Industry?”• What is Behavioral Finance?• Behavioral AND Traditional Finance• Examples of Terms
II. Behavioral Finance in the Philippines• FINEX Survey Findings• Analysis and Preliminary Conclusions
III. Wrap-Up• Usefulness for Corporate Finance• Words of Caution
/45
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4
Part I:Behavioral Finance
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4Behavioral AND Traditional 1/2BEHAVIORAL FINANCEThe idea is simple: Investors are not as rational as traditional theory has assumed, and so biases in their decision-making can have a cumulative effect on asset prices.
TRADITIONAL FINANCEIn efficient market theory, assets are correctly priced because supply and demand reflect aggregate public knowledge about those assets, and that the movement of stock prices can not be reliably predicted based on past results.
2
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 3
Traditional AND Behavioral 2/2
Fundamental Heuristic(& Technical) BeliefsAnalyses (Biases)
Efficient Market BehavioralHypothesis Finance
Rational IrrationalMarkets Markets
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4Behavioral Finance models will NOTreplace the theory ofEfficient Markets.
The idea that investors and managers are NOT uniformly rational makes intuitive sense.
Two Points of View
4
Basic Market “Psychology”: Buy out of Greed. Sell out of Fear.
Behavioral Finance goes Beyond Greed and Fear.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4The “Traditionalists” Critique
• Overemphasis • On (Unrepresentative) Anomalies • On (“Before & After”) Events
• Ambiguity: Over/Under Reaction
• Not Scholarly Enough • An excuse to evade economic theory • Behavioral Finance has NOT shown that the tendencies of individuals, when aggregated, have an impact on world prices.
5
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 6
Behaviorial Finance Response
In finance, you are playing against people, who value assets on the basis of their expectations about the future. These expectations are ephemeral, or at best unstable.
• Valuing shares is an ART (not a science):• Globalization creates info. lags.• Many critical assets are intangible.
• Brands & patents, learning organizations• Trust is still critical (Enron et al.).
• And ephemeral
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 “RECONCILIATION 1/3”
Efficient market models of rational behavior
are not BAD descriptions of reality. They’re
just NOT going to capture everything. Since
bubbles and other anomalies have real
economic effects, and occur often enough,
it is worth devoting time and effort trying to
understand what drives them and whether
their impact can be contained.
7
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 “RECONCILIATION 2/3”From the Traditionalists:
There’s a big demand for behavioral finance
among the practitioners because nobody wants
to believe the markets are efficient, but if there’s
so much money on the table, how is it that
professional managers can’t do any better than
index funds?
8
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 “RECONCILIATION 3/3”From the Behaviorists:
BF doesn’t say “There’s easy money. Go after it.” It says that psychology causes market prices and fundamental values to part company for a long time.
9
Potential profit opportunities come packaged together with additional risk, and “smart money” can’t or won’t take a large enough bet to eradicate the anomalies, and won’t be able to arbitrage away the anomalies and return the market to equilibrium.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4Examples of Terms 1/3
HEURISTIC BELIEFS= “Rules of Thumb” = “Biases”
* Disposition Effect* Herd Mentality * Overconfidence * Regret Minimization* Representativeness
10
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 11
Examples of Terms 2/3HERD MENTALITY• Start: Investors depend on “buzz”/rumors.• The Herd: Other investors join the “crowd”.• Reversal: Initial “pull-outs” accelerate
• REPRESENTATIVENESS• “Recall”– of past performance.• “Persistence”– winners are winners & v.v.• Tendency to use media-based info.
• OVERCONFIDENCE: “Analysts are 80% confident but only 60% accurate.”
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 12
Examples of Terms 3/3REGRET MINIMIZATION• Dependence of the analyst• Share the credit for good performance.• Blame the analyst for poor performance.
DISPOSITION EFFECT• “Loss Averse”: hold losers too long.• Ego-driven• Uneven expectation
(of recovery & breaking-even)• “Risk Averse”: sell winners too early.• Fear of price reversal.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Findings From DC Markets1/4
• Professional traders can be loss averse.• Herd mentality will raise stock prices
(Irrational Exuberance).• “The Greenspan Put”:
13
Just as an investor can can set a floor for the price of a security by buying a put option, so Mr. Greenspan will provide a floor for the stock market by cutting interest rates when it gets too low for his liking.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 14
Findings From DC Markets 2/4• Bubbles/Anomalies exist & persist.
One weakness of the efficient market theory is the assumption that arbitrage by the informed (rational investor) against the uninformed (e.g., biased) is riskless and costless.
LTCMAssume a relatively small volume of shares in circulation that can not meet the demand by would-be shorters. Peoples with imperfect valuations can set prices that are out of line.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Findings From DC Markets 3/4
• Computer models imply that price patterns are created by the collective actions of market traders themselves– e.g., a trend in rising prices can be interpreted as a buy or a sell signal.
• The more orderly a market appears (e.g., regularly rising P & Q), the less stable it is–• The Domino Effect
15
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Findings From DC Markets 4/4
• Economists have a problem with self-control.• We think it is not a problem.• Homo Economicus is always rational.• But “time-inconsistent” behavior persists.• The Doughnut Dilemma (& the Borrower)
Other Heuristics• Instant Amnesia• Arbitrary Obsessions• Fatal Optimism• Compulsive Monitoring
16
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Findings From LDC Markets 1/217
• In general RoE works better than P/E Multiples.• DCF projections are “guesses”.• The past becomes a good predictor
• In South Korea, the prices of the worst firmsin the last 6 months did better in the next 6.• Government bail-outs = “implied put”
• In Taiwan, it is the ratio of R&D to Sales.• In China & RP, it is debt– CA/CL, etc.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Findings From LDC Markets 1/218
• Dividends are the GOOD NEWS:• In HK, China, Singapore & Malaysia• 50% give > bank deposit interest rates• In USA, only 7%
• Since 1991, two-thirds of investment returns came from dividends (not capital gains).
• A “wasteful” use of scarce capital?
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4
Part II:The FINEX Survey
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Survey Items
HEURISTIC BELIEFS> “Rules of Thumb” = “Biases”
> Disposition Effect> Herd Mentality > Overconfidence > Regret Minimization> Representativeness
19
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Case Examples 1/2
DISPOSITION EFFECT
Hold losers
Sell winners early
HERD MENTALITY
20
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Case Examples 2/2
OVERCONFIDENCE
REPRESENTATITIVENESS
REGRET MINIMIZATION
21
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 22
Survey Sample 1/3
Methodology• Two “Runs”: July 4 & Aug 28
• Phone & E-mail Follow Up
• All Finex Members• Excluding errors in addresses
• 75 Responses as of September 19
• 6 Point Rating Scale (most of the time)
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Survey Sample 2/323
Banks25%
Other Fin.30%
Mfg.19%
Commercial13%
Others13%
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Survey Sample 3/324
CFO37%
Others 11%
CEO25%
Senior Mgt. 27%
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 The FrameworkOverconfidence
Herd Mentality
Represent.
GreedDisposition
Regret
Fear Factor
25
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 26
On the Two Paradigms 1/2• Ranking Factors in Investing• Fundamental Analysis (25/27 respondents)• Technical, Risk-Return, Earning’s Report (11)
• Time-Based Investing• Short Term 60-90%• Medium 15-30• Long 0-100
• Use of ChartsAs CFO As IndividualOften (6/14) Once in a While
& Sometimes (7&8/22)
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 27
On the Two Paradigms 2/2
• Use of “Rules-of-Thumb” from Experience• Significant & More Significant (20/25)
• Ranking Reasons for Losses• Market & Stock Price (15/21)• Interest Rate (6), Time(8), Luck (11)
Investors combine both paradigms.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 28
Disposition Effect 1/4• To What Extent Does a “Paper Loss”• Affect your future investments• Significant 15/24
• Your evaluation as a CFO• Significant & More & Extremely (14/23)• Less Significant & Insignificant (9/23)
• Holding on to LOSING Stocks• 23/23• Up to what point?• 11-20% Decline (18/23)
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 29
Disposition Effect 2/4 • Compensating for the Loss• Sometimes & Often (15/24)• Once in a while & Hardly (9/24)
• And how often did the losing stock return to its original price?
• Sometimes & Often (16/23)
• And Your Response (multiple answers)?• Buy Other Equity (15)• Buy Non-Equity (14)
•
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 30
Disposition Effect 3/4
012
3456
78
N H O S O A
Legend:NeverHardlyOnce in a whileSometimesOftenAlways
Meantime, do you make other investments?
• Selling WINNING Stocks• Not based on time but % rise• Between 11-20% (12/23)• Between 21-40% (10//23
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 31
Disposition Effect 4/4
Investors “respond” to paper losses/gains.
Floor: Hold losers up to a 20% decline.Ceiling: Sell winners after a 20% rise.
While waiting, will NOT buy the same stock.Instead, buy OTHER stock or asset.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 32
Analysts’ Rate Themselves 1/2
• In predicting turning points (28 responses):
• Fair 6• Satisfactory 17• More than 5• 6-point scale (Poor, Very Good, Excellent)
• Investment GainsBefore 1997 Post-199741%& > (21/24) 11-30% (14/24)
<10% (5/24)
Overconfidence?
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Analysts’ Rate Themselves 2/233
• Performance Over Time/Administrations
Aquino Ramos Estrada ArroyoPoor 0 0 6 4Fair 3 1 7 4Satisfactory 2 6 5 11Very Good 9 12 0 0Excellent 0 1 0 0
Let the Viewer decide.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 34
Non-CFOs Rate Analysts• 17/46 Firms use investment analyst or team• Often (6) & Always (9) follow the advise.• But get contrary results Once in a While (6)
& Sometimes (10)• But when accurate, the rise in price is:• 21-30% 4/16• 31-40% 2• 41-50% 3• >50% 7
When they’re right, they deliver.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4Herd Mentality, Representativeness
& Regret Minimization 1/6
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 35
Herd Mentality, Regret Minimization & Representativeness 1/6
• Pick 1 & 2 “best” & 1 “worst” stocks in 4 sectors:• PSE listed companies• Telecoms, Food, Banking, Real Estate
• Criteria: Company Image, Fundamentals, Management
• Answers were tested against actual stock performance, over a 12-month period.• Returns include appreciation (or not) + any
dividends.
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Herd et al. 2/6: Reasons forCompany’s Profile/Image
BEST WORST• Stable * Political in Nature• Conservative * Bad Reputation• Strong Franchise * Too Speculative• Blur Chip * No New Developments• Dominant * Unclear Business Model• Diversified * Unclear Plans
36
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Herd et al. 3/6: Reasons for37
Fundamentals (Ratios)
BEST WORST• Liquid * Not Liquid• Low Debt * Shareholders’ Reputation• Strong P&L & BS * Speculative• Good/High RoE * No New Developments• Large Share Base * Poor transparency• Cash-Rich * Weak Cash Flows
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Herd et al. 4/6: Reasons for38
Management
BEST WORST• Transparent/Prof’l * Past “Baggage” (Old Mgt.)• Market Leader * Poor Credibility/Governance• Foreign Backing * Speculative• Prudent * Secretive• Clear Focus * No Long Terms Strategy• Good Track Record * Heavy Debts
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 39
Herd et al. 5/6: Reasons forReturns of the Best Choices
• with other comparisons *• if data available
PROPERTY RETURN %ALI +45.4
BANKS RETURN %BPI (17.9)RCBC (52.9)
*EBC +1.2
*MFC +11.8
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 40
Herd et al. 6/6: Reasons for
TELECOMS RETURN %Globe + 5.2PLDT (28.9)
*Digital 100
FOOD RETURN %SMC +16.4Jolllibee + 4.9
*RFM +95.1 Some Herd et al.Some Bad Calls
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4
Part III:Wrap-Up
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Wrap-Up 1/5
For the Retail Investors
Research does show that these people tend to hold on to a losing investment and to sell a winning investment too quickly relative to their opportunity costs.
Retail investors who think they’re clever enough to beat the market probably don’t even understand traditional finance ideas and should simply follow a passive long-term strategy.
41
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Wrap-Up 2/5
For the Field of Corporate Finance:
• Decision biases can have a significant impact on how the firm fares. (The + & - of Enron)
• IBM altered its menu of pension funds offered to its employees because alternative program can overcome biases and enable investors to make more rational decisions.
42
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Wrap-Up 3/5
Assuming “Imperfectly Rational” Managers, Issues for Future Research:
• Why do “bad” capital structure decisions occur?
• What about discrepancies between market & CFO valuation of a firm?
• How do imperfectly rational CFOs decide?
43
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Wrap-Up 4/5
• Rating Investors in the Philippines (54)
Aquino Ramos Estrada ArroyoStill at Basics 16 3 7 4Moving Up 13 14 20 11Improved 4 14 11 26Excellent 1 4 1 1
44
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4 Wrap-Up 5/5• Profiting from Irrationality???• Not for the retail investor
• Inevitable• Low trading volume (even pre-1997)• Easy to be a “big” player
• Information lags (even legally)• “Pre-buying” IPOs
• Order lags (both buying & selling)• Some are more equal than others
• Improving processes (internally)
45
th
KEEPING THE FAITH IN THE FINANCIAL KEEPING THE FAITH IN THE FINANCIAL SYSTEMS SYSTEMS
SERIESLE
CTUR
E
26 September 200226 September 2002
4
To get a copy of the To get a copy of the presentation, please visit …presentation, please visit …
www.jbf.aim.edu.phwww.jbf.aim.edu.ph