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Behavioral finance is the academic discipline which examines how psychological factors affect financial decisions.

Since non-rational factors form the basis for human desires, goals and motivations, behavioral finance is based on the premise that these factors are also the reason for a variety of errors in decision making. Errors typically stem from illusions in perception, overconfidence, free reign to emotions and an over-reliance on rules of thumb. Such errors and the biases that underlie them also influence the financial landscape and all actors who participate in it, because people are imperfect processors of information.

This is the essential premise and gist of behavioral finance. Shefrin (2002), a noted advocate of behavioral finance, states that the way to understand financial decisions is to look beyond the explanation that market psychology is about greed and fear. He asserts that the primary emotions that determine risk-taking are hope and fear. The emotion of hope brings a whole new gamut of non-rational and incalculable factors into consideration, which cannot be sufficiently explained by greed. An equally important discovery is that although it is human to make mistakes, financial practitioners (even sophisticated ones) make the same mistakes repeatedly (Shefrin, 2002:3). The way in which applications of these insights (a) lead to a different view of financial decisionmaking compared to that offered by rational finance, and (b) offer an alternative explanation for a conundrum like the value premium, are themes explored in this chapter.

The chapter commences with a prcis of the assumptions on which behavioral finance is based. It continues with an explanation of how these assumptions give rise to financial decision-making based on imperfect data processing. The outcome of such decisions is then demonstrated as a misplaced reaction to historic occurrences, the latter which is protracted into the future as extrapolation. Extrapolation is proposed as the most plausible explanation for the value

premium, and forms the theoretical hypothesis which is empirically tested with South African data in later chapters. The last part of this chapter provides an overview of South African research findings, which deal with the value premium and extrapolation on the JSE.

3.1 Basic assumptions In their endeavors to construct frameworks which enable them to study financial markets, behavioral finance theorists like rational finance theorists have to make assumptions about the judgments, preferences and decisions of market participants. Most of the fundamental principles employed by behavioral finance had been imported from other social sciences, because most of the work to understand less-than-perfectly-rational human behavior had been done by practitioners of social sciences other than economics. Scholars applying psychological insights (in combination with economic theory) such as Kahneman and Tversky (1973), Benartzi and Thaler (1995), Rabin (1998) and Odean (1998a) produced substantial evidence that people do not base their preferences purely on the information they have to hand about expected utility (as argued by Von Neumann and Morgenstern), nor do they form judgments by applying Bayesian statistical reasoning to work out their chances of success. Instead, humans systematically behave in a manner contrary to both of these precepts. Shleifer called behavioral finance a study of human fallibility in competitive markets (2000: 24). It is this human fallibility, and the tendency to base decisions on non-rational motivations, which underlie the basic point of departure used in this study. 3.1.1 Market participants Behavioral finance shifts the focus from the mechanical working of efficient markets to human decision-making. The following most salient assumptions are made about the characteristics of market participants. Participants are: 1. Imperfectly rational;

2. Not reliant on statistical procedures to make investment decisions, but instead rely on crude heuristics, i.e. simple and general rules; 3. Greatly influenced in decision-making by the way problems are framed, i.e. worded and presented; and 4. Overconfident of their ability to judge.

Statman (1999) further summarizes the essential difference between rational and behavioral finance by stating that in rational finance people (participants) are always rational, care about utilitarian considerations (as opposed to value ones), never make cognitive errors, have perfect self-control, are always risk averse, and never regret a decision. In stark contrast, in behavioral finance people are regarded as normal, and they do not obey any of these patterns.

3.1.2 Utility maximizing Behavioral finance supporters do not deny the role which the maximize benefit and minimize cost maxim plays in the financial decision-making process, but they differ from the rational finance interpretation about how gains and losses are perceived when outcomes are uncertain.

Rational finance assumes that individuals undertake financial decisions to maximize their consumption (and the utility derived from it). Such a position assumes that investment decisions are made strictly with an eye on final outcomes, as financial success is the basis on which increased consumption rests. In contrast, behavioral finance assumes that individuals undertake financial decisions in order to maximize consumption, as well as for financial well-being and the latter is seen as valuable in its own right. These broader dimensions of value connected to financial decisions have implications for utility maximizing decisions. Rational finance theory holds that the only factor which people take into account when choosing investments, is the utility (or satisfaction) which the consumption of their wealth is anticipated to bring. Behavioral

finance proposes that investors are as concerned about changes in the level of their financial wealth as they are about consumption. Consequently, they take both consumption utility and changes in financial well-being into consideration.

Rational finance relies on Von Neumann and Morgensterns (1944) expected utility theory to explain utility maximization. Expected utility theory assumes that investors give the same weight to gains and losses. In the presence of uncertain outcomes, rational decision-makers choose between two investments based on the higher expected utility, which is calculated by deducting the negative value of the loss from the positive value of the gain, taking into consideration the probability of each outcome coming to fruition. The higher expected utility investment is the preferred one, because rational individuals maximize expected utility and minimize loss. The behavioral finance counterpart to expected utility theory is prospect theory, the brainchild of Kahneman and Tversky (1979). In prospect theory, gains and losses are considered very differently, because value is assigned to gains and losses, not only to final outcomes. Probabilities are also replaced by decision weights. This means that people tend to think of possible outcomes relative to a reference point usually the status quo or, in the case of stock purchases, the purchasing price. Instead of a utility calculation (as in rational finance) Kahneman and Tversky suggested that decision-makers construct a value function. This is the difference between a possible outcome (x) and a reference point (), expressed as (x - ). Decision-makers choose between two investments by ranking them according to their value (x ); where the reference point is as important as the final outcome x.

Graphically, the prospect theorys value function is concave for gains after passing through the reference point, and convex with a steeper curve for losses. This change of slope at the origin is due to the tendency of investors to be more sensitive to possible reductions in levels of wellbeing (points on the loss side of the graph) than to increases in wellbeing (points on the gains

side of the graph). Empirical estimates of loss aversion converge around the number 2, which means that the disutility of giving something up is twice as great as the utility of acquiring it (Tversky and Kahneman, 1991; Kahneman, Knetsch and Thaler, 1990). Value

Outcome Losses Gains

Purchase price

Figure 2: Prospect theory value function

Prospect theory, like expected utility theory, focuses on the way people choose among alternative investments, but it comes to a different conclusion about what they will choose. To test this, Shefrin and Statman (1985) applied the concepts of aversion to loss and purchase price as reference point, and found that it explains the tendency to sell winning stocks too soon and hang on to losing stocks for too long.

In summary, while expected utility in rational finance is linear in its probabilities, value in behavioral finance is not. Secondly, where utility is dependent on final wealth, value is defined in terms of gains and losses to financial well-being (Shiller, 2003). This difference in perception is borne out in possible explanations for the value premium a matter that will be elaborated on later in this chapter.

3.1.3 Approach towards risk Garland (2002) observed that when individuals focus on risk, it has both an objective and subjective component. Objective risk the only kind rational finance considers refers to risk which can be confirmed scientifically by applying statistical analyses to the best obtainable knowledge and data. Subjective risk the more important component of risk according to behavioral finance refers to perceived risk that is rooted in subjective factors such as recent personal experience. Frankfurter, McGoun and Allen (2004) called this the difference between rational and actual decision-making.

Kahneman and Tversky (1979) found that people do not treat risk objectively (i.e. by its scientifically calculated probabilities) but that they instead place a disproportionate amount of weight on small probabilities. This may lead people to be risk-seekers if the potential outcome is hugely profitable (e.g. by buying lottery tickets) and risk-averse when facing substantial losses. The way in which weight is assigned is therefore not in accordance with Bayesian thinking, but instead it gives zero weight to extremely low probabilities, and 100% weight to extremely high probabilities. This means that people behave as if they regard extremely improbable events as impossible, and extremely probable events as certain. Prospect theory is not clear on what constitutes an extremely low probability or an extremely high probability, because this assessment is determined by individuals subjective impressions. However, differences in approach to risk have profound implications for portfolio construction. Kahneman and Tversky found that people do not choose well-diversified portfolios. In particular, people ignore covariance among security returns and choose portfolios that lie below the efficient frontier.

3.3 Different assumptions of rational and behavioral finance

The assumptions that indicate the fundamental differences between rational and behavioral finance can be contrasted as follows. Rational finance assumes that: (1) investors are rational, (2) markets are efficient; (3) investors design their portfolios according to the rules of mean-variance portfolio theory; (4) expected returns are a function of risk and risk alone; and (5) when making financial decisions, investors are oriented to the future. This is done by performing statistically sophisticated calculations of what future cash flows are likely to be, followed by discounting these to bring them to present values for cost comparison.

Behavioral finance, on the other hand, assumes that: (1) investors are normal, not rational; (2) markets are not efficient, even if they are difficult to beat; (3) investors design portfolios according to rules of behavioral portfolio thinking (i.e. subjective impressions), not mean-variance portfolio theory; (4) expected returns follow a path in which risk is not measured by beta, and returns are determined by more than risk; and (5) when making financial decisions, investors are essentially oriented towards the past. This is done by looking at a reference point such as returns generated by an asset in the past, and basing expectations for future returns on that.

The behavioral finance assumptions above are fundamental insights required for understanding information processing in financial markets. This gives rise to a plausible explanation for the value premium anomaly.

3.9.2 Market practitioners and the value premium

The debate about whether value companies are more risky (the traditional approach) or mispriced (the behavioral finance approach) has reached practitioners in a haphazard manner. Practitioners of finance, such as investment bankers, fund managers and analysts, are the market participants whose opinions and impressions move the market.

Bloomfield and Michaely (2002) collected data from market practitioners such as sell-side analysts, investment bankers and traders, on their views and beliefs. The study was a controlled experiment rather than a survey because Bloomfield and Michaely manipulated the variables of interest (beta, BV/MV and firm size), and examined how those manipulations led to differences in beliefs among investment professionals. They found that practitioners view high BV/MV as an indicator of mispricing, but generally did not expect mispricing to correct itself within one year. They also found no evidence that practitioners viewed BV/MV as an indicator of risk which, within the CAPM model, would explain higher returns. However, practitioners expected high beta firms to earn significantly higher returns than low beta firms a belief that is no longer borne out by empirical evidence.

Analysts also divulged to Bloomfield and Michaely that the BV/MV ratio is the most important factor in assessing wrong evaluation, and that beta is the most important in assessing risk. Bloomfield and Michaely concluded that market participants have been more influenced by earlier literature, which puts a heavy emphasis on the central role of beta in asset pricing, than by later literature, which questions betas role. Practitioners have also been more swayed by the behavioral finance literature, which argues that the BV/MV ratio is an indicator of mispricing (or value measure), than by rational finance theory, which argues that the BV/MV ratio is an indicator of risk factors.

3.9.3 The current status of this debate and where this study fits in

In 1986, when Fama and French presented their test results for New York Stock Exchange index data, in which they found strong evidence of mean-reversal (as discussed in section 3.6), they did not concede that the behavioral finance explanation is correct. In fact, they came to the following conclusion:

[T]he tendency toward reversal may reflect time-varying expected returns generated by rational investor behavior and the dynamics of common macroeconomic driving variables. On the other hand, reversals generated by a stationary component of prices may reflect market-wide waves of over-reaction of the kind assumed in the models of an inefficient market. Whether predictability reflects market inefficiency or time-varying expected returns generated by rational investor behavior, is and will remain an open issue. (1986: 23)

This open issue, as Fama and French called it here, begs the question: Does erroneous thinking (such as heuristics, representativeness and conservatism) and extrapolation which results from it, explain the value premium, or does risk provide the explanation? For the risk argument to be convincing, the still poorly understood risk measure which Fama and French (1986) called time varying, will have to be demonstrated to be real. In order for extrapolation to be accepted as a viable explanation, the drumbeat of empirical evidence will have to become so resounding that it will be impossible to ignore which is what this study aims to contribute to.