Académique Documents
Professionnel Documents
Culture Documents
22
May 2000.
managers.
Master the ability to solve problems in this chapter
by using a spreadsheet. Access Excel Master on the
student Web site www.mhhe.com/rwj.
PA RT 8
BEHAVIORAL
FINANCE:
IMPLICATIONS
FOR FINANCIAL
MANAGEMENT
709
ros46128_ch22.indd 709
1/16/09 10:47:17 AM
710
PA RT 8
behavioral nance
The area of finance dealing
with the implications of
reasoning errors on
financial decisions.
Sooner or later, you are going to make a financial decision that winds up costing you (and
possibly your employer and/or stockholders) a lot of money. Why is this going to happen?
You already know the answer. Sometimes, you make sound decisions, but you get unlucky
in the sense that something happens that you could not have reasonably anticipated. Other
times (however painful to admit), you just make a bad decision, one that could have (and
should have) been avoided. The beginning of business wisdom is to recognize the circumstances that lead to poor decisions and thereby cut down on the damage done by financial
blunders.
As we have previously noted, the area of research known as behavioral finance attempts
to understand and explain how reasoning errors influence financial decisions. Much of the
research done in the behavioral finance area stems from work in cognitive psychology,
which is the study of how people, including financial managers, think, reason, and make
decisions. Errors in reasoning are often called cognitive errors. In the next several subsections, we will review three main categories of such errors: (1) biases, (2) framing effects,
and (3) heuristics.
22.2 Biases
If your decisions exhibit systematic biases, then you will make systematic errors in judgment. The type of error depends on the type of bias. In this section, we discuss three particularly relevant biases: (1) overconfidence, (2) overoptimism, and (3) confirmation bias.
OVERCONFIDENCE
overcondence
The belief that your abilities
are better than they really
are.
ros46128_ch22.indd 710
Serious errors in judgment occur in the business world due to overconfidence. We are all
overconfident about our abilities in at least some areas (recall our question about driving
ability at the beginning of the chapter). Here is another example that we see a lot: Ask
yourself what grade you will receive in this course (in spite of the arbitrary and capricious
nature of the professor). In our experience, almost everyone will either say A or, at worst,
B. Sadly, when this happens, we are always confident (but not overconfident) that at least
some of our students are going to be disappointed.
In general, you are overconfident when you overestimate your ability to make the correct choice or decision. For example, most business decisions require judgments about the
unknown future. The belief that you can forecast the future with precision is a common
form of overconfidence.
Another good example of overconfidence comes from studies of stock investors.
Researchers have examined large numbers of actual brokerage accounts to see how investors fare when they choose stocks. Overconfidence by investors would cause them to overestimate their ability to pick the best stocks, leading to excessive trading. The evidence
supports this view. First, investors hurt themselves by trading. The accounts that have the
most trading significantly underperform the accounts with the least trading, primarily
because of the costs associated with trades.
A second finding is equally interesting. Accounts registered to men underperform those
registered to women. The reason is that men trade more on average. This extra trading is
consistent with evidence from psychology that men have greater degrees of overconfidence
than women.
1/16/09 10:47:18 AM
CHAPTER 22
711
OVEROPTIMISM
Overoptimism leads to overestimating the likelihood of a good outcome and underestimating the likelihood of a bad outcome. Overoptimism and overconfidence are related, but
they are not the same thing. An overconfident individual could (overconfidently) forecast a
bad outcome, for example.
Optimism is usually thought of as a good thing. Optimistic people have upbeat personalities and sunny dispositions. However, excessive optimism leads to bad decisions. In
a capital budgeting context, overly optimistic analysts will consistently overestimate cash
flows and underestimate the probability of failure. Doing so leads to upward-biased estimates of project NPVs, a common occurrence in the business world.
overoptimism
Taking an overly optimistic
view of potential outcomes.
CONFIRMATION BIAS
When you are evaluating a decision, you collect information and opinions. A common bias
in this regard is to focus more on information that agrees with your opinion and to downplay or ignore information that doesnt agree with or support your position. This phenomenon is known as confirmation bias, and people who suffer from it tend to spend too much
time trying to prove themselves correct rather than searching for information that might
prove them wrong.
Here is a classic example from psychology. Below are four cards. Notice that the cards
are labeled a, b, 2, and 3. You are asked to evaluate the following statement: Any card
with a vowel on one side has an even number on the other. You are asked which of the four
cards has to be turned over to decide if the statement is true or false. It costs $100 to turn
over a card, so you want to be economical as possible. What do you do?
conrmation bias
Searching for (and giving
more weight to) information
and opinion that confirms
what you believe rather
than information and
opinion to the contrary.
You would probably begin by turning over the card with an a on it, which is correct. If
we find an odd number, then we are done because the statement is not correct.
Suppose we find an even number. What next? Most people will turn over the card with
a 2. Is that the right choice? If we find a vowel, then we confirm the statement, but if we
find a consonant, we dont learn anything. In other words, this card cant prove that the
statement is wrong; it can only confirm it, so selecting this card is an example of confirmation bias.
Continuing, there is no point in turning over the card labeled b because the statement
doesnt say anything about consonants, which leaves us with the last card. Do we have to
turn it over? The answer is yes because it might have a vowel on the other side, which
would disprove the statement, but most people will chose the 2 card over the 3 card.
Concept Questions
22.2a What is overconfidence? How is it likely to be costly?
22.2b What is overoptimism? How is it likely to be costly?
22.2c What is confirmation bias? How is it likely to be costly?
ros46128_ch22.indd 711
1/16/09 10:47:19 AM
712
PA RT 8
Option A:
Option B:
Which would you choose? There is no necessarily right answer, but most people will
choose Option A. Now suppose your choices are as follows:
SCENARIO 2
Option C:
Option D:
frame dependence
The tendency of individuals
to make different (and
potentially inconsistent)
decisions depending on
how a question or problem
is framed.
LOSS AVERSION
Here is another example that illustrates a particular type of frame dependence:
SCENARIO 1:
Option A:
Option B:
SCENARIO 2:
Option C:
Option D:
What were your answers? Did you choose option A in the first scenario and option D in the
second? If thats what you did, you are guilty of just focusing on gains and losses, and not
paying attention to what really matters, namely, the impact on your wealth. However, you
are not alone. About 85 percent of the people who are presented with the first scenario
choose option A, and about 70 percent of the people who are presented with the second
scenario choose option D.
If you look closely at the two scenarios, you will see that they are actually identical. You
end up with $1,500 for sure if you pick option A or C, or else you end up with a 50-50
chance of either $1,000 or $2,000 if you pick option B or D. So, you should pick the same
option in both scenarios. Which option you prefer is up to you, but the point is that you
should never pick option A in our first scenario and option D in our second one.
This example illustrates an important aspect of financial decision making. Focusing on
gains and losses instead of overall wealth is an example of narrow framing, and it leads to
ros46128_ch22.indd 712
1/16/09 10:47:19 AM
CHAPTER 22
713
a phenomenon known as loss aversion. In fact, the reason that most people avoid option C
in scenario 2 in our example is that it is expressed as a sure loss of $500. In general,
researchers have found that individuals are reluctant to realize losses and will, for example,
gamble at unfavorable odds to avoid doing so.
Loss aversion is also known as get-evenitus or the break-even effect because it frequently
shows up as individuals and companies hang on to bad investments and projects (and perhaps even invest more) hoping that something will happen that will allow them to break
even and thereby escape without a loss. For example, we discussed the irrelevance of sunk
costs in the context of capital budgeting, and the idea of a sunk cost seems clear. Nonetheless,
we constantly see companies (and individuals) throw good money after bad rather than just
recognize a loss in the face of sunk costs.
How destructive is get-evenitus? Perhaps the most famous case occurred in 1995, when
28-year-old Nicholas Leeson caused the collapse of his employer, the 233-year-old Barings
Bank. At the end of 1992, Mr. Leeson had lost about 2 million, which he hid in a secret
account. By the end of 1993, his losses were about 23 million, and they mushroomed to
208 million at the end of 1994 (at the time, this was $512 million).
Instead of admitting to these losses, Mr. Leeson gambled more of the banks money in
an attempt to double-up and catch-up. On February 23, 1995, Mr. Leesons losses were
about 827 million ($1.3 billion), and his trading irregularities were uncovered. Although
he attempted to flee from prosecution, he was caught, arrested, tried, convicted, and imprisoned. Also, his wife divorced him.
Do you suffer from get-evenitus? Maybe so. Consider the following scenario: You just
lost $78 dollars somehow. You can just live with the loss, or you can make a bet. If you make
the bet, there is an 80 percent chance that your loss will grow to $100 (from $78) and a
20 percent chance that your loss will be nothing. Do you take the loss or take the bet? We
bet you choose the bet. If you do, you have get-evenitus because the bet is a bad one. Instead
of a sure loss of $78, your expected loss from the bet is .80 $100 .20 $0 $80.
In corporate finance, loss aversion can be quite damaging. We already mentioned the
pursuit of sunk costs. We also might see managers bypassing positive NPV projects because
they have the possibility of large losses (perhaps with low probability). Another phenomenon that we see is debt avoidance. As we discuss in our coverage of capital structure, debt
financing generates valuable tax shields for profitable companies. Even so, there are hundreds of profitable companies listed on major stock exchanges that completely (or almost
completely) avoid debt financing. Because debt financing increases the likelihood of losses
and even bankruptcy, this potentially costly behavior could be due to loss aversion.
HOUSE MONEY
Las Vegas casinos know all about a concept called playing with house money. The casinos
have found that gamblers are far more likely to take big risks with money that they have
won from the casino (i.e., house money). Also casinos have found that gamblers are not as
upset about losing house money as they are about losing the money they brought with them
to gamble.
It may seem natural for you to feel that some money is precious because you earned it
through hard work, sweat, and sacrifice, while other money is less precious because it came
to you as a windfall. But these feelings are plainly irrational because any dollar you have
buys the same amount of goods and services no matter how you obtained that dollar.
Lets consider another common situation to illustrate several of the ideas we have
explored thus far. Consider the following two investments:
Investment 1: You bought 100 shares in Moore Enterprises for $35 per share. The
shares immediately fell to $20 each.
ros46128_ch22.indd 713
1/16/09 10:47:19 AM
714
PA RT 8
Investment 2: At the same time, you bought 100 shares in Miller Co. for $5 per share.
The shares immediately jumped to $20 each.
How would you feel about your investments?
You would probably feel pretty good about your Miller investment and be unhappy with
your Moore investment. Here are some other things that might occur:
1. You might tell yourself that your Miller investment was a great idea on your part;
youre a stock-picking genius. The drop in value on the Moore shares wasnt your
faultit was just bad luck. This is a form a confirmation bias, and it also illustrates
self-attribution bias, which is taking credit for good outcomes that occur for reasons
beyond your control, while attributing bad outcomes to bad luck or misfortune.
2. You might be unhappy that your big winner was essentially nullified by your loser, but
notice in our example that your overall wealth did not change. Suppose instead that
shares in both companies didnt change in price at all, so that your overall wealth was
unchanged. Would you feel the same way?
3. You might be inclined to sell your Miller stock to realize the gain, but hold on to
your Moore stock in hopes of avoiding the loss (which is, of course, loss aversion).
The tendency to sell winners and hold losers is known as the disposition effect. Plainly,
the rational thing to do is to decide if the stocks are attractive investments at their new
prices and react accordingly.
Suppose you decide to keep both stocks a little longer. Once you do, both decline to $15.
You might now feel very differently about the decline depending on which stock you
looked at. With Moore, the decline makes a bad situation even worse. Now you are down
$20 per share on your investment. On the other hand, with Miller you only give back
some of your paper profit. You are still way ahead. This kind of thinking is playing with
house money. Whether you lose from your original investment or from your investment
gains is irrelevant.
Our Moore and Miller example illustrates what can happen when you become emotionally invested in decisions such as stock purchases. When you add a new stock to your portfolio, it is human nature for you to associate the stock with its purchase price. As the price
of the stock changes through time, you will have unrealized gains or losses when you compare the current price to the purchase price. Through time, you will mentally account for
these gains and losses, and how you feel about the investment depends on whether you are
ahead or behind. This behavior is known as mental accounting.
When you engage in mental accounting, you unknowingly have a personal relationship
with each of your stocks. As a result, it becomes harder to sell one of them. It is as if you
have to break up with this stock, or fire it from your portfolio. As with personal relationships, these stock relationships can be complicated and, believe it or not, make selling
stocks difficult at times. What can you do about mental accounting? Legendary investor
Warren Buffet offers the following advice: The stock doesnt know you own it. You have
feelings about it, but it has no feelings about you. The stock doesnt know what you paid.
People shouldnt get emotionally involved with their stocks.
Loss aversion, mental accounting, and the house money effect are important examples
of how narrow framing leads to poor decisions. Other, related types of judgment errors
have been documented. Here are a few examples:
Myopic loss aversion. This behavior is the tendency to focus on avoiding short-term
losses, even at the expense of long-term gains. For example, you might fail to invest
in stocks for long-term retirement purposes because you have a fear of loss in the near
term.
ros46128_ch22.indd 714
1/16/09 10:47:20 AM
CHAPTER 22
715
Regret aversion. This aversion is the tendency to avoid making a decision because
you fear that, in hindsight, the decision would have been less than optimal. Regret
aversion relates to myopic loss aversion.
Endowment effect. This effect is the tendency to consider something that you own
to be worth more than it would be if you did not own it. Because of the endowment
effect, people sometimes demand more money to give up something than they would
be willing to pay to acquire it.
Money illusion. If you suffer from a money illusion, you are confused between real buying
power and nominal buying power (i.e., you do not account for the effects of inflation).
Concept Questions
22.3a What is frame dependence? How is it likely to be costly?
22.3b What is loss aversion? How is it likely to be costly?
22.3c What is the house money effect? Why is it irrational?
Heuristics
22.4
Financial managers (and managers in general) often rely on rules of thumb, or heuristics,
in making decisions. For example, a manager might decide that any project with a payback
period less than two years is acceptable and therefore not bother with additional analysis.
As a practical matter, this mental shortcut might be just fine for most circumstances, but we
know that sooner or later, it will lead to the acceptance of a negative NPV project.
heuristics
Shortcuts or rules of
thumb used to make
decisions.
affect heuristic
The reliance on instinct
instead of analysis in
making decisions.
ros46128_ch22.indd 715
representativeness
heuristic
The reliance on
stereotypes, analogies, or
limited samples to form
opinions about an entire
class.
1/16/09 10:47:20 AM
716
PA RT 8
History of Previous
Attempts
46%
50
51
52
54
53
56
Detailed analysis of shooting data failed to show that players make or miss shots more
or less frequently than what would be expected by chance. That is, statistically speaking,
all the shooting percentages listed here are the same.
From the shooting percentages, it may appear that teams will try harder to stop a shooter
who has made the last two or three shots. To take this into account, researchers also studied
free-throw percentages. Researchers told fans that a certain player was a 70 percent freethrow shooter and was shooting two foul shots. They asked fans to predict what would
happen on the second shot if the player
1. Made the first free throw.
2. Missed the first free throw.
Fans thought that this 70 percent free-throw shooter would make 74 percent of the second free throws after making the first free throw but would only make 66 percent of the
second free throws after missing the first free throw. Researchers studied free-throw data
from a professional basketball team over two seasons. They found that the result of the first
free throw does not matter when it comes to making or missing the second free throw. On
average, the shooting percentage on the second free throw was 75 percent when the player
made the first free throw. On average, the shooting percentage on the second free throw
was also 75 percent when the player missed the first free throw.
It is true that basketball players shoot in streaks. But these streaks are within the bounds
of long-run shooting percentages. So, it is an illusion that players are either hot or cold.
If you are a believer in the hot hand, however, you are likely to reject these facts because
ros46128_ch22.indd 716
1/16/09 10:47:20 AM
CHAPTER 22
717
you know better from watching your favorite teams over the years. If you do, you are
being fooled by randomness.
The clustering illusion is our human belief that random events that occur in clusters are
not really random. For example, it strikes most people as very unusual if heads comes up
four times in a row during a series of coin flips. However, if a fair coin is flipped 20 times,
there is about a 50 percent chance of getting four heads in a row. Ask yourself, if you flip
four heads in a row, do you think you have a hot hand at coin flipping?
ros46128_ch22.indd 717
1/16/09 10:47:21 AM
718
PA RT 8
Visit www.
behaviouralfinance.net for
many other terms and
concepts of behavioral
finance.
the possibility that the odds might really be in their favor. That is, there could be more
than 50 blue balls in the bin.
False consensus. This is the tendency to think that other people are thinking the
same thing you are thinking (with no real evidence). False consensus relates to
overconfidence and confirmation bias.
Availability bias. You suffer from availability bias when you put too much weight on
information that is easily available and place too little weight on information that is
hard to obtain. Your financial decisions will suffer if you only consider information
that is easy to obtain.
Concept Questions
22.4a What is the affect heuristic? How is it likely to be costly?
22.4b What is the representativeness heuristic? How is it likely to be costly?
22.4c What is the gamblers fallacy?
LIMITS TO ARBITRAGE
limits to arbitrage
The notion that the price of
an asset may not equal its
correct value because of
barriers to arbitrage.
Investors who buy and sell to exploit mispricings are engaging in a form of arbitrage and
are known as arbitrageurs (or just arbs for short). Sometimes, however, a problem arises
in this context. The term limits to arbitrage refers to the notion that, under certain circumstances, it may not be possible for rational, well-capitalized traders to correct a mispricing,
at least not quickly. The reason is that strategies designed to eliminate mispricings are often
risky, costly, or somehow restricted. Three important such problems are:
1. Firm-specific risk. This issue is the most obvious risk facing a would-be arbitrageur.
Suppose that you believe that the observed price on General Motors stock is too low,
ros46128_ch22.indd 718
1/16/09 10:47:21 AM
CHAPTER 22
719
so you purchase many, many shares. Then, there is some unanticipated negative news
that drives the price of General Motors stock even lower. Of course, you could try to
hedge some of the firm-specific risk, but any hedge you create is likely to be either
imperfect and/or costly.
2. Noise trader risk. A noise trader is someone whose trades are not based on information or financially meaningful analysis. Noise traders could, in principle, act together
to worsen a mispricing in the short run. Noise trader risk is important because the
worsening of a mispricing could force the arbitrageur to liquidate early and sustain
steep losses. As Keynes once famously observed, Markets can remain irrational longer than you can remain solvent.1
Noise trader risk is also called sentiment-based risk, meaning the risk that an
assets price is being influenced by sentiment (or irrational belief) rather than factbased financial analysis. If sentiment-based risk exists, then it is another source of risk
beyond the systematic and unsystematic risks we discussed in an earlier chapter.
3. Implementation costs. All trades cost money. In some cases, the cost of correcting a
mispricing may exceed the potential gains. For example, suppose you believe a small,
thinly-traded stock is significantly undervalued. You want to buy a large quantity. The
problem is that as soon as you try to place a huge order, the price would jump because
the stock isnt heavily traded.
noise trader
A trader whose trades are
not based on information or
meaningful financial
analysis.
sentiment-based risk
A source of risk to investors
above and beyond firmspecific risk and overall
market risk.
When these or other risks and costs are present, a mispricing may persist because arbitrage is too risky or too costly. Collectively, these risks and costs create barriers or limits to
arbitrage. How important these limits are is difficult to say, but we do know that mispricings
occur, at least on occasion. To illustrate, we next consider two well-known examples.
This remark is generally attributed to Keynes, but whether he actually said it is not known.
In other words, as we discuss in our chapter on mergers and acquisitions, 3Com did an equity carveout and
planned to subsequently spin off the remaining shares.
2
ros46128_ch22.indd 719
1/16/09 10:47:22 AM
720
PA RT 8
FIGURE 22.1
40
Percentage deviation
30
20
10
0
10
20
30
40
3/
2
3/
9
3/
16
3/
23
3/
30
4/
6
4/
13
4/
20
4/
27
5/
4
5/
11
5/
18
5/
25
6/
1
6/
8
6/
15
6/
22
6/
29
7/
6
7/
13
7/
20
7/
27
50
Date
This means, then, that the price of Palm relative to 3Com was much too high, and investors
should have bought and sold such that the negative value was instantly eliminated.
What happened? As you can see in Figure 22.1, the market valued 3Com and Palm
shares in such a way that the non-Palm part of 3Com had a negative value for about two
months, from March 2, 2000, until May 8, 2000. Even then, it took approval by the IRS for
3Com to proceed with the planned distribution of Palm shares before the non-Palm part of
3Com once again had a positive value.
The Royal Dutch/Shell Price Ratio Another fairly well-known example of an apparent mispricing involves two large oil companies. In 1907, Royal Dutch of the Netherlands
and Shell of the UK agreed to merge their business enterprises and split operating profits
on a 6040 basis. So, whenever the stock prices of Royal Dutch and Shell are not in a
6040 ratio, there is a potential opportunity to make an arbitrage profit.
Figure 22.2 contains a plot of the daily deviations from the 6040 ratio of the Royal
Dutch price to the Shell price. If the prices of Royal Dutch and Shell are in a 6040 ratio,
there is a zero percentage deviation. If the price of Royal Dutch is too high compared to the
Shell price, there is a positive deviation. If the price of Royal Dutch is too low compared
to the price of Shell, there is a negative deviation. As you can see in Figure 22.2, there have
been large and persistent deviations from the 6040 ratio. In fact, the ratio is seldom at
6040 for most of the time from 1962 through mid-2005 (when the companies merged).
ros46128_ch22.indd 720
Lyrics from Godzilla, by Donald Buck Dharma Roeser (as performed by Blue Oyster Cult).
1/16/09 10:47:22 AM
721
FIGURE 22.2
50
40
30
20
10
0
10
20
30
40
04
20
01
20
98
95
19
92
19
19
89
19
86
19
83
80
19
77
19
19
74
19
71
68
19
65
19
19
62
50
19
CHAPTER 22
Date
A bubble occurs when market prices soar far in excess of what normal and rational
analysis would suggest. Investment bubbles eventually pop because they are not based on
fundamental values. When a bubble does pop, investors find themselves holding assets
with plummeting values.
A crash is a significant and sudden drop in marketwide values. Crashes are generally
associated with a bubble. Typically, a bubble lasts much longer than a crash. A bubble can
form over weeks, months, or even years. Crashes, on the other hand, are sudden, generally
lasting less than a week. However, the disastrous financial aftermath of a crash can last for
years.
bubble
A situation where observed
prices soar far higher than
fundamentals and rational
analysis would suggest.
crash
A situation where market
prices collapse significantly
and suddenly.
The Crash of 1929 During the Roaring Twenties, the stock market was supposed to be
the place where everyone could get rich. The market was widely believed to be a no-risk
situation. Many people invested their life savings without learning about the potential pitfalls of investing. At the time, investors could purchase stocks by putting up 10 percent of
the purchase price and borrowing the remainder from a broker. This level of leverage was
one factor that led to the sudden market downdraft in October 1929.
As you can see in Figure 22.3, on Friday, October 25, the Dow Jones Industrial Average
closed up about a point, at 301.22. On Monday, October 28, it closed at 260.64, down
13.5 percent. On Tuesday, October 29, the Dow closed at 230.07, with an intraday low of
212.33, which was about 30 percent lower than the closing level on the previous Friday. On
this day, known as Black Tuesday, NYSE volume of 16.4 million shares was more than
four times normal levels.
Although the Crash of 1929 was a large decline, it pales with respect to the ensuing bear
market. As shown in Figure 22.4, the DJIA rebounded about 20 percent following the
October 1929 crash. However, the DJIA then began a protracted fall, reaching the bottom
at 40.56 on July 8, 1932. This level represents about a 90 percent decline from the record
high level of 386.10 on September 3, 1929. By the way, the DJIA did not surpass its previous high level until November 24, 1954, more than 25 years later.
ros46128_ch22.indd 721
1/16/09 10:47:23 AM
722
PA RT 8
FIGURE 22.3
340
320
DJIA
300
280
260
240
220
21-Oct
FIGURE 22.4
22-Oct
23-Oct
24-Oct
25-Oct
Date
28-Oct
29-Oct
30-Oct
31-Oct
390
340
DJIA level
290
240
190
140
90
40
Oct-28 Apr-29 Oct-29 Apr-30 Oct-30 Apr-31 Oct-31 Apr-32 Oct-32
Date
The Crash of October 1987 Once, when we spoke of the Crash, we meant October 29,
1929. That was until October 1987. The Crash of 1987 began on Friday, October 16. On huge
volume (at the time) of about 338 million shares, the DJIA fell 108 points to close at 2,246.73.
It was the first time in history that the DJIA fell by more than 100 points in one day.
October 19, 1987, now wears the mantle of Black Monday, and this day was indeed a
dark and stormy one on Wall Street; the market lost about 22.6 percent of its value on a new
record volume of about 600 million shares traded. The DJIA plummeted 508.32 points to
close at 1,738.74.
ros46128_ch22.indd 722
1/16/09 10:47:24 AM
CHAPTER 22
723
3,000
2,750
FIGURE 22.5
Dow Jones Industrial
Average, October 1986 to
October 1990
DJIA level
2,500
2,250
2,000
1,750
1,500
1,250
Oct-86 Apr-87 Oct-87 Apr-88 Oct-88 Apr-89 Oct-89 Apr-90 Oct-90
Date
During the day on Tuesday, October 20, the DJIA continued to plunge in value, reaching
an intraday low of 1,616.21. But the market rallied and closed at 1,841.01, up 102 points.
From the then market high on August 25, 1987, of 2,746.65 to the intraday low on
October 20, 1987, the market had fallen over 40 percent.
After the Crash of 1987, however, there was no protracted depression. In fact, as you
can see in Figure 22.5, the DJIA took only two years to surpass its previous market high
made in August 1987.
What happened? Its not exactly ancient history, but, here again, debate rages. One faction says that irrational investors had bid up stock prices to ridiculous levels until Black
Monday, when the bubble burst, leading to panic selling as investors dumped their stocks.
The other faction says that before Black Monday, markets were volatile, volume was heavy,
and some ominous signs about the economy were filtering in. From the close on October
13 to the close on October 16, 1987, for example, the market fell by over 10 percent, the
largest three-day drop since May 1940 (when German troops broke through French lines
near the start of World War II). To top it all off, market values had risen sharply because of
a dramatic increase in takeover activity, but Congress was in session and was actively considering antitakeover legislation.
Another factor is that beginning a few years before the Crash of 1987, large investors
had developed techniques known as program trading designed for very rapid selling of
enormous quantities of shares of stock following a market decline. These techniques were
still largely untested because the market had been strong for years. However, following the
huge sell-off on October 16, 1987, sell orders came pouring in on Monday at a pace never
before seen. In fact, these program trades were (and are) blamed by some for much of what
happened.
One of the few things we know for certain about the Crash of 1987 is that the stock
exchanges suffered a meltdown. The NYSE simply could not handle the volume. Posting
of prices was delayed by hours, so investors had no idea what their positions were worth.
The specialists couldnt handle the flow of orders, and some specialists actually began
ros46128_ch22.indd 723
1/16/09 10:47:25 AM
724
PA RT 8
selling. NASDAQ went off-line when it became impossible to get through to market
makers.
On the two days following the crash, prices rose by about 14 percent, one of the biggest
short-term gains ever. Prices remained volatile for some time, but as antitakeover talk in
Congress died down, the market recovered.
The Asian Crash The crash of the Nikkei Index, which began in 1990, lengthened into a
particularly long bear market. It is quite like the Crash of 1929 in that respect.
The Asian crash started with a booming bull market in the 1980s. Japan and emerging
Asian economies seemed to be forming a powerful economic force. The Asian economy
became an investor outlet for those wary of the U.S. market after the Crash of 1987.
To give you some idea of the bubble that was forming in Japan between 1955 and
1989, real estate prices in Japan increased by 70 times, and stock prices increased
100 times over. In 1989, price-earnings ratios of Japanese stocks climbed to unheard of
levels as the Nikkei Index soared past 39,000. In retrospect, there were numerous warning signals about the Japanese market. At the time, however, optimism about the continued growth in the Japanese market remained high. Crashes never seem to occur when
the outlook is poor, so, as with other crashes, many people did not see the impending
Nikkei crash.
As you can see in Figure 22.6, in three years from December 1986 to the peak in December
1989, the Nikkei 225 Index rose 115 percent. Over the next three years, the index lost 57 percent of its value. In April 2003, the Nikkei Index stood at a level that was 80 percent off its
peak in December 1989.
The growth
of the World Wide
Web is documented at
www.zakon.org/robert/
internet/timeline.
The Dot-Com Bubble and Crash How many Web sites do you think existed at the end
of 1994? Would you believe only about 10,000? By the end of 1999, the number of active
Web sites stood at about 9,500,000 and at the end of 2007, there were about 70,000,000
active Web sites.
FIGURE 22.6
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
8
/0
01
/0
4
01
/0
01
/0
2
01
/0
01
/9
8
01
/9
6
01
/9
01
/9
01
/9
01
/8
01
/8
01
01
/8
Date
ros46128_ch22.indd 724
1/16/09 10:47:25 AM
CHAPTER 22
725
By the mid-1990s, the rise in Internet use and its international growth potential fueled
widespread excitement over the new economy. Investors did not seem to care about
solid business plansonly big ideas. Investor euphoria led to a surge in Internet IPOs,
which were commonly referred to as dot-coms because so many of their names ended in
.com. Of course, the lack of solid business models doomed many of the newly formed
companies. Many of them suffered huge losses and some folded relatively shortly after
their IPOs.
The extent of the dot-com bubble and subsequent crash is presented in Table 22.1 and
Figure 22.7, which compare the Amex Internet Index and the S&P 500 Index. As shown in
Table 22.1, the Amex Internet Index soared from a level of 114.68 on October 1, 1998, to
its peak of 688.52 in late March 2000, an increase of 500 percent. The Amex Internet Index
then fell to a level of 58.59 in early October 2002, a drop of 91 percent. By contrast, the
S&P 500 Index rallied about 31 percent in the same 19982000 time period and fell
40 percent during the 20002002 time period.
TABLE 22.1 Values of the Amex Internet Index and the S&P 500 Index
Amex Internet
Index Value
Date
October 1, 1998
Gain to Peak
from Oct. 1,
1998 (%)
Loss from
Peak to
Trough (%)
S&P 500
Index Value
114.68
Loss from
Peak to
Trough (%)
986.39
688.52
Gain to Peak
from Oct. 1,
1998 (%)
500%
1,293.72
91%
58.59
31%
40%
776.76
800
1,800
700
1,600
600
1,400
1,200
500
1,000
400
800
300
600
200
400
100
200
06
/0
10
10
/
/0
10
04
10
/
03
10
/
/0
2
10
01
10
/
10
/0
0
99
10
/
98
97
10
/
10
/
96
0
10
/
95
0
10
/
FIGURE 22.7 Values of the AMEX Internet Index and the S&P 500 Index, October 1995 through December, 2007
Date
AMEX Internet Index
ros46128_ch22.indd 725
1/16/09 10:47:27 AM
726
PA RT 8
By now, youre probably wondering how anyone could sensibly think that financial
markets are in any way efficient. Before you make up your mind, however, be sure to
carefully read our next section. As you will see, there is a powerful argument in favor of
market efficiency.
Concept Questions
22.5a What is meant by the term limits to arbitrage?
22.5b What is noise trader risk?
ros46128_ch22.indd 726
1/16/09 10:47:28 AM
CHAPTER 22
FIGURE 22.8
3,500
3,000
2,500
Number
727
2,000
1,500
1,000
500
06
20
04
20
02
20
00
20
98
19
96
19
94
19
92
19
90
19
88
19
19
86
Year
Total funds
Funds beating Vanguard 500 over past one year
Funds existing for 10 years
Funds beating Vanguard 500 over past 10 years
FIGURE 22.9
80
The Percentage of
Managed Equity Funds
Beating the Vanguard 500
Index Fund, One-Year
Returns
70
60
Percent
50
40
30
20
10
19
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
06
Year
ros46128_ch22.indd 727
1/16/09 10:47:29 AM
728
PA RT 8
FIGURE 22.10
80
Percentage of Managed
Equity Funds Beating the
Vanguard 500 Index Fund,
10-Year Returns
70
60
Percent
50
40
30
20
10
19
8
19 6
87
19
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
94
19
9
19 5
96
19
9
19 7
9
19 8
99
20
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
06
Year
TABLE 22.2 The Performance of Professional Money Managers versus the Vanguard 500 Index Fund
Length of Each
Investment
Period (Years)
Span
Number of
Investment
Periods
Number of Investment
Periods Half the
Funds Beat Vanguard
Percent
Number of Investment
Periods Three-Fourths of
the Funds Beat Vanguard
Percent
19772006
30
14
46.7%
6.7%
19792006
19812006
28
13
46.4
7.1
26
34.6
7.7
10
19862006
21
9.5
0.0
only, while Figure 22.10 uses return data for the previous 10 years. As you can see from
Figure 22.9, in only 9 of the 21 years spanning 1986 through 2006 did more than half the
professional money managers beat the Vanguard 500 Index Fund. The performance is
worse when it comes to 10-year investment periods (19771986 through 19972006). As
shown in Figure 22.10, in only 2 of these 21 investment periods did more than half the professional money managers beat the Vanguard 500 Index Fund.
Table 22.2 presents more evidence concerning the performance of professional money
managers. Using data from 1977 through 2006, we divide this time period into 1-year
investment periods, rolling 3-year investment periods, rolling 5-year investment periods,
and rolling 10-year investment periods. Then, after we calculate the number of investment
periods, we ask two questions: (1) what percentage of the time did half the professionally
managed funds beat the Vanguard 500 Index Fund? and (2) what percentage of the time did
three-fourths of the professionally managed funds beat the Vanguard 500 Index Fund?
As you see in Table 22.2, the performance of professional money managers is generally
quite poor relative to the Vanguard 500 Index Fund. In addition, the performance of professional money managers declines the longer the investment period.
The figures and table in this section raise some difficult and uncomfortable questions for
security analysts and other investment professionals. If markets are inefficient, and tools
like fundamental analysis are valuable, why dont mutual fund managers do better? Why
cant mutual fund managers even beat a broad market index?
ros46128_ch22.indd 728
1/16/09 10:47:29 AM
Concept Questions
22.6a How does an index fund differ from an actively managed mutual fund?
22.6b What do we learn from studying the historical performance of actively
managed general equity funds?
ros46128_ch22.indd 729
1/16/09 10:47:31 AM
730
PA RT 8
Visit us at www.mhhe.com/rwj
2.
3.
4.
5.
6.
ros46128_ch22.indd 730
1/16/09 10:47:32 AM
7.
8.
9.
10.
731
underperformed a passively managed index fund. How does this fact bear on the
issue of market efficiency?
Efficient Market Hypothesis [LO4] The efficient market hypothesis implies
that all mutual funds should obtain the same expected risk-adjusted returns.
Therefore, we can simply pick mutual funds at random. Is this statement true or
false? Explain.
Evidence on Market Efficiency [LO4] Some people argue that the efficient
market hypothesis cannot explain the 1987 market crash or the high price-toearnings ratio of Internet stocks during the late 1990s. What alternative hypothesis
is currently used for these two phenomena?
Behavioral Finance and Efficient Markets [LO4] Proponents of behavioral
finance use three concepts to argue that markets are not efficient. What are these
arguments?
Frame Dependence [LO2] In the chapter, we presented an example where you
had lost $78 and were given the opportunity to make a wager in which your loss
would increase to $100 80 percent of the time and decrease to $0 20 percent of the
time. Using the stand-alone principal from capital budgeting, explain how your
decision to accept or reject the proposal could have been affected by frame
dependence. In other words, reframe the question in a way in which most people
are likely to analyze the proposal correctly.
MINICASE
ros46128_ch22.indd 731
Visit us at www.mhhe.com/rwj
CHAPTER 22
QUESTIONS
1.
2.
3.
1/16/09 10:47:32 AM