Behavioural Finance: Insights into Irrational Minds and Markets

by James Montier

A concrete guide that links the theory of behavioral finance with applications in financial products
Behavioral finance is a rapidly expanding field, with major implications for the way in which the investment process is conducted. Behavioural Finance links the concepts of behavioral finance to measurable variables and smarter investment decision making. Comprehensive coverage relating theory to practical investment analysis provides a usable, practical guide for real-world situations.

Genres: Economics, Finance, Business, Psychology, Nonfiction, Money

212 pages, Hardcover

First published October 15, 2002

About the author

James Montier is an expert in behavioral finance, argues that investors would have a greater chance of spotting the formation of bubbles if they could only brush up on their history and have a greater awareness of human psychology. He has been a top-rated strategist in the annual Thomson Reuters Extel survey for the last five years. When not reading, writing, or speaking, Montier can usually be found swimming with sharks and blowing bubbles at fishes.

Reviews

[wetdog778 · Rating 4 out of 5]

1. Psychological foundations
- biases of judgement/perception: over-optimism, over-confidence, cognitive dissonance, confirmation bias, conservatism bias, anchoring, representative heuristics, availability, ambiguity aversion
- apply such biases to modelling, forecasting, valuation, portfolio construction, under-diversification
- artificial framing locks value, cash flow or earnings? (check earnings quality cash vs accruals), difference between pro forma and GAAP? (exclusions > earnings surprise),
- non-linear weights (overweight extremes and underweight intermediate probabilities), value function (weighted towards losses), myopic behaviour = short-term equity risk premium, disposition effect (holding onto losses and quickly selling off winners)
- how risk fluctuates with recent wins/losses
2. imperfect markets and limited arbitrage: arbitrage is far from costless/riskless
- LOOP fails in twin securities, equity carve outs, parent company puzzle
- because of noisy trader risk (destabilise the spread for long periods, pressures from margin calls), limited arbitrage (fundamental risk, noise trader [horizon, margin, short covering], debt timing x costs)
- positive feedback noise traders mimic bubbles, noise traders survive through moderate over-confidence
3. style investing (growth vs value)
- investors gravitate to styles that have performed well recently -> propping it up
- fundamentalists vs switchers -> investment style lifecycle
- over-pessimism/optimism during economic downturns/upswings
- long-run outperformance of value stocks is driven by growth stocks falling short of expectations
- very few firms experience persistence in operating performance (more persistence higher up the income statement = dubious accounting?),
- under-react to reliable information and over-react to unreliable/low-visibility information
- momentum lifecycle [winners, losers, under-reaction, over-reaction, early-stage, late-stage, P/B, volume, earnings surprise] where momentum (3-6 months) and contrarian (3-5 years)
- quantitative screens via Piotroski (2000): ROA, CFO, ΔLever, ΔLiquid, ΔMargin, ΔTurnover, look in book for more detail
- implied ERP drops = investors extend their time horizon (value vs growth or dividends vs capital gains)
4. stock valuation: involves anchoring and framing
- Nash equilibrium (steps of player thinking), 0-3 steps before bubble pops
- speculative bubbles emerge when uncertainty around fundamental value, lottery characteristics, inexperienced population, short-selling difficulty, are all high
- analysts biases: agency, familiarity, forecast errors for 2 months+
- relative valuations assume industry P/E is 'fair value', DCFs are anchored to market price and analysts constantly revise to price changes not actual value/new info.
- cash flow not earnings (high accruals tend to underperform), don't blindly follow heuristics like mean reversion/5 year median
- idiosyncratic (company-specific) risk has been rising due to death of conglomerates, fastening company life cycles, rise in growth stocks, more thought should be paid to liquidity too
- you need balance between fundamentalists vs market prices
- what prices should be vs what they are, CAPM beta is used by firms with strong balance sheets/debt availability vs multifactor models for firms that need to approach the market
5. portfolio construction
- only that goes up in a bear market is correlation (downside co-movements are statistically significant), variance fails to capture all outliers/crashes so need behavioural to predict
6. asset allocation (stocks vs bonds)
- low dividend yield implies future returns will be low (dividends either grow faster or returns will be lower)
corporate finance: managers are subject to the same biases
- year-end pessimism, otherwise confidence from proximity/control
- asymmetry in capital structure preferences (dislike external)
- cash flows correlated to investment, managers overestimate future cash flows from investments/acquisitions = value destruction
-Carve-outs, convertible debt, SEOs, IPOs, stock-financed M&A follow initial underpricing, hot markets, long-run underperformance
- explained by underpricing compensates for investor risk, bandwagon, signalling, optimists set the price (short-selling is restricted for IPOs), timing is set by underwriters during optimum economic conditions
- unified theory uncovered points: investor optimism triggers IPO market trend triggers low quality IPOs, ownership transfers from institutional -> retail
- repurchases are the only positive signal, all above is the firm realising the market is overpricing the stock
- value stocks do it better as differing motivation from growth
8. indicators
- liquidity measures: bid-ask spread, turnover, absolute price change/trading volume
- sentiment: surveys (Merrill Lynch, II, AAII), ratio of analysts upgrades/downgrades (optimism), uncertainty (standard deviation of analyst forecasts), put/call ratios, implied ERP
- earnings measures: accruals and cash flows, income smoothing (variability of operating earnings to variability of cash flows, take the ratio, low value = cooking the books), discretion in reporters earnings (incidence of small profits against small losses, high ratio = greater loss avoidance = greater earnings management)

[Mimmy · Rating 5 out of 5]

Definitely one of the best financial books I have read so far!