Perhaps for some, trading is like consumption and they trade for the sheer pleasure of it


By AVANIDHAR SUBRAHMANYAM

IN the real world of finance, there are a number of puzzles which remain unexplained by theory. Students of finance traditionally learn, for instance, that portfolios should be allocated based on a trade-off between risk and return and that the desire for higher returns necessitates taking on more risk.



Learning from history: Recent research in behavioural finance has quite a lot to teach investors. One of its insights is that the best predictors of future returns are past returns, trading volumes as well as accounting ratios
The celebrated Black Scholes formula explains the formation of prices of derivatives, such as options.

These ideas are all based on the notion that the individual is a rational, calculating investor, making decisions to maximise wealth. The proponents of some of these ideas were awarded Nobel Prizes.

However when it comes to the real world of finance, the theories fall short of explaining why certain things happen. Why do investors trade, and do so frequently? How do they decide upon the composition of their portfolios? Why are there stock market bubbles, like the tech stock overvaluation of the early 2000s? Why has trading volume on stock exchanges increased at a pace that is not explained by returns earned by investors?

Despite awareness of the benefits of diversification, why do many investors only hold a handful of stocks in their portfolios?

Then again, research shows that variation in returns across stocks is due to factors other than risk. In the arena of corporate finance, recent evidence indicates that finance managers' decisions to raise capital appear to be a result of 'market timing' to exploit equity market mispricing and rather than conform to what theories predict about rational managers.

In spite of these shortcomings, the 'Neoclassical' theories have maintained a virtual stranglehold on how finance is taught in MBA programmes across the world.

But some of the unanswered questions are being increasingly addressed by behavioural Finance', a new school of thought that has emerged over the past decade.

Finance education in general can be more useful if it sheds specific light on active investing by addressing aspects such as:


What mistakes to avoid while investing, and


What strategies in financial markets are likely to work in terms of earning supernormal returns.

Those are the main goals of behavioural finance, which allows for explanations of financial phenomena based on 'nonrational' behaviour amongst investors. Of late, behavioural finance has also been applied to corporate finance - for example, by linking behavioural characteristics of top executives (such as their level of confidence) to their decision-making.

So what does recent research in behavioural finance tell us? One of its insights is that the best predictors of future returns are past returns, trading volumes and accounting ratios.

Momentum effect

Specifically, returns are negatively related to market capitalisation and volume, and positively to the book-to-price ratio of a stock. There is also evidence of a momentum effect', observed in many countries, that is, that stocks that have gone up in the past six to twelve months continue to go up in the next few months, and vice versa.

There is little evidence, however, that risk measures such as systematic or total volatility are material for predicting equity returns.

Recent work in behavioural finance also helps us understand the trading activities of individual investors. First, there appears to be a 'disposition effect' among individual investors, which can be termed as a tendency to sell winners too soon and hold on to losers too long.

Thus, it is not uncommon for investors to avoid selling the stock of a well-known company even if its fundamentals point in a negative direction. On the flip side, a winning stock will be sold off too soon in the eagerness to realise profits even if there is upward momentum in the stock.

This behaviour is consistent with the notion that realising profits allows one to maintain self-esteem but realising losses causes one to implicitly admit an erroneous investment decision, and hence is avoided.

Interestingly, past winners do better than losers following the date of sale of stock by an individual investor, suggesting a perverse outcome to trades by individual investors. There also is evidence that women outperform men in their individual stock investments.

This can be attributed to the notion that men tend to be more overconfident than women. The rationale for this explanation derives from evolution: it was believed that men, as hunter-gatherers, are required to be overconfident to take risks for the purposes of hunting in order to acquire food.

We also know that investors who invest online perform better than investors who invest offline. However, once those offline investors switch to investing online, they perform better than the investors who were online earlier.

The reason is that the more time investors spend investing online, the more they tend to trade excessively, which dissipates their profits. There is also survey evidence that stock market participation is influenced by social interaction: people who are more social, in the sense of interacting more with peers at collective gatherings such as at church, are more likely to invest in the stock market than those who are not so social.

And why do individuals trade so much? Perhaps for some investors, trading is like a consumption good - that is, they trade for the sheer pleasure that trading provides in a manner similar to watching a sport or a film, or gambling in Las Vegas or Macau. Nonetheless, it appears that making investors aware of some of their common biases would be useful.

Nascent field

In sum, behavioural finance research has expanded considerably in recent years though much work needs to be done, including the development of comprehensive theories and cross-cultural studies of stock market behaviour.

The fact that behavioural finance is a nascent field, however, should not detract from the point that students in business programmes should be exposed to the available research.

Results so far established can go a long way in ensuring that MBAs are prepared on what goes on in the real world of investing and have an understanding of which strategies actually work in the financial markets.

This article is an abridged version of the keynote address given by Professor Avanidhar Subrahmanyam, Goldyne and Irwin Hearsh Chair in Money and Banking at the University of California at Los Angeles (UCLA), at the 1st Singapore International Conference on Finance, hosted by the Saw Centre for Financial Studies at the NUS Business School.