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Textbook
Behavioural FinanceDecember 2009, ©2009
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Acknowledgements.
1 Introduction.
1.1 Illustration and Structure.
1.2 Finance Theory as an Engine not a Camera.
1.3 Rebuilding on New Foundations.
1.4 Challenging the Classical Assumptions of Finance.
1.5 Modelling Behavioural Aspects of Finance.
1.6 The Structure of the Book.
Appendix: A Financial Tsunami.
Notes.
References.
Part I FOUNDATIONS.
2 Financial Decision Making.
2.1 Illustration and Structure.
2.2 The Expected Utility Rule.
2.3 Expected Utility Theory: Simple But Untrue?
2.4 Frames for Actions, Contingencies and Outcomes.
2.5 Conclusion and Summary.
Questions.
Notes.
References.
3 Discounting.
3.1 Illustration and Structure.
3.2 The Discounted Utility Model.
3.3 How and Why Discount Rates Vary.
3.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’.
3.5 Hyperbolic Discount Factors.
3.6 Valuation by Using the Matching Law.
3.7 How Investment Decisions are Made When Discount Factors Decline Over Time.
3.8 Conclusion and Summary.
Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal Choice.
Questions.
Notes.
References.
4 Learning.
4.1 Illustration and Structure.
4.2 Rational Learning.
4.3 Do We Learn the Bayesian Way?
4.4 Over Inference and the Law of Small Numbers.
4.5 Disagreement, Tastes and the Capital Asset Pricing Model.
4.6 Conclusion and Summary.
Appendix: Case Study – Baseball the Bayesian Way.
Questions.
Notes.
References.
5 Bubbles.
5.1 Illustration and Structure.
5.2 Tulipmania and the Didactic Value of Bubbles.
5.3 The Regulatory Origins of the Most Recent Bubble.
5.4 Bubbles: Past, Present and Future.
5.5 The 1929 Stock-Market Crash.
5.6 Should Government Burst the Bubble?
5.7 Conclusion and Summary.
Appendix: Tulips as Assets and Art.
Questions.
Notes.
References.
Part II ASSET PRICING.
6 Noise Traders.
6.1 Illustration and Structure.
6.2 The De Long, Shleifer, Summers and Waldmann Model.
6.3 Can Investors Get Emotional?
6.4 Conclusion and Summary.
Questions.
Notes.
References.
7 Overconfidence and Optimism.
7.1 Illustration and Structure.
7.2 A Model of Trading Amongst Optimistic Investors.
7.3 Do Investors Trade Too Much?
7.4 Conclusion and Summary.
Appendix A: Hubris at Work: The AOL–Time Warner Merger.
Appendix B: Derivation of Results in Odean’s Model.
Questions.
Notes.
References.
8 Asset Pricing under Prospect Theory.
8.1 Illustration and Structure.
8.2 The Basics of Prospect Theory.
8.3 Does Prospect Theory Work?
8.4 The Cumulative Probability Version of Prospect Theory.
8.5 Does Cumulative Prospect Theory Work?
8.6 Conclusion and Summary.
Appendix: CARA Utility.
Questions.
Note.
References.
9 Overreaction and/or Underreaction.
9.1 Illustration and Structure.
9.2 The DHS Model.
9.3 No News Is . . .?
9.4 Conclusion and Summary.
Questions.
Note.
References.
10 Momentum.
10.1 Illustration and Structure.
10.2 Grinblatt and Han’s (2005) Model.
10.3 What Drives Stock-Market Momentum?
10.4 What Causes PEAD?
10.5 Conclusion and Summary.
Questions.
Note.
References.
11 Herding.
11.1 Illustration and Structure.
11.2 The FSS Model.
11.3 Conformity as a Force for Social Good and Evil.
11.4 Conclusion and Summary.
Appendix: The United States vs. Microsoft.
Questions.
Note.
References.
12 Insider Trading.
12.1 Illustration and Structure.
12.2 Insider Trading Here for Better or Worse.
12.3 The Hirshleifer, Subrahmanyam and Titman Model.
12.4 Insider Trading, Stock Options and the Construction of Earnings.
12.5 Insider Trading and its Consequence for Outsiders.
12.6 Conclusion and Summary.
Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model?
Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model.
Questions.
Notes.
References.
13 Equity Premium Puzzle.
13.1 Illustration and Structure.
13.2 The Puzzle.
13.3 Loss Aversion in a Reference-Dependent Utility Model.
13.4 Conclusion and Summary.
Questions.
References.
Part III CORPORATE FINANCE.
14 Incorporation.
14.1 Illustration and Structure.
14.2 Companies: Where did They Come from and Where will They Go?
14.3 Agency, Monitoring and Incorporation.
14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making.
14.5 Conclusion and Summary.
Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a Corporation.
Questions.
Notes.
References.
15 The Market for Information, Noise and Deception.
15.1 Illustration and Structure.
15.2 The Boundaries of the Market for Corporate Information.
15.3 What Do Analysts Do?
15.4 Valuing Investment Advice.
15.5 Conclusion and Summary.
Questions.
Notes.
References.
16 Dividends.
16.1 Illustration and Structure.
16.2 The Irrelevance of Dividends to Value.
16.3 A Prospect Theory Explanation of Dividend Payments.
16.4 Who Pays Dividends and Why?
16.5 Conclusion and Summary.
Questions.
Note.
References.
17 Entrepreneurship.
17.1 Illustration and Structure.
17.2 The BT Model.
17.3 Is Deluding Yourself Worth it?
17.4 Conclusion and Summary.
Appendix: Entrepreneurs and the BT Model – Some Case Studies.
Questions.
Notes.
References.
Part IV THE PROFESSIONS.
18 Analysts’ Conflicts of Interest.
18.1 Illustration and Structure.
18.2 Evidence of Conflicts of Interest from Empirical Studies.
18.3 Regulating Conflicts of Interest.
18.4 Conclusion and Summary.
Questions.
Notes.
References.
19 Accounting Reform.
19.1 Illustration and Structure.
19.2 The Onward March of ‘Fair-Value’ Accounting.
19.3 An Accounting-Based Valuation Model.
19.4 Behavioural Bias in Estimates of the Ohlson Model.
19.5 Conclusion and Summary.
Appendix A: Mark-to-Market Accounting at Enron – A Case Study.
Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting Information only (Equation (19.7)).
Questions.
Notes.
References .
20 Conclusion.
Index.
- ‘Behavioural Finance’ meets the growing demand for an introductory level textbook that can be used by students on advanced undergraduate and postgraduate courses.
- Provides a range of UK and European examples, whereas most of the existing books include primarily examples from North America.
- Integrates a series of key papers into a coherent theoretical framework capable of application to a wide range of problems in finance.
- Examples of FTSE 100 companies provide the reader with an appreciation of everyday problems faced by finance professionals.
The book itself is comprised of an introduction and four parts. The first part, 'Foundations', introduces basic intertemporal utility theory and Bayesian learning. .... Moreover, new features of utility theory are introduced throughout the book. In the chapter on Bayesian learning, the author presents Bayes Law and relates it to empirical findings on how information is processed in practice.
In the second part of the book the author deals with asset pricing. Noise trader models and prospect theory serve as the workhorses of this section and each receives a separate chapter. Noise trader models include informed and uninformed agents and these agents may differ in how they process information. This model is the subject of much scholarly work, which is cited in subsequent chapters. A similar model is that of Odean, which the author uses to discuss overconfidence of investors. Prospect theory is at the very core of behavioral finance and Forbes discusses several variations on the theory, including those of its founders, Kahnemann and Tversky, as well as the work of Barberis and Huang. The subsequent chapters in this part deal with applied problems, namely, overreaction, momentum, and herding. Professor Forbes describes each phenomenon with a detailed research model and provides insights into what behavior the models are able to reproduce. The final chapter of Part 2 covers how behavioral finance deals with the equity premium puzzle.
Part 3 elaborates on the corporate finance aspects of behavioral finance. This section of the book relies less on scholarly models than the other sections and more on stylized facts generated from, eg, prospect theory. It starts with arguments for the existence of companies and a general discussion of corporate governance and the principal-agent problem. One chapter explains how market participants process information. Behavioral finance approaches to explaining dividend policies are discussed separately. The last chapter is especially notable for covering self-control versus self-confidence from the perspective of an entrepreneur, an aspect of behavioral finance rarely found in textbooks.
In the fourth and final part of the book on 'The Professions', the author returns to principal-agent problems, this time looking at them from an accounting and regulation perspective. This part of the book includes many instructional cases, some drawn from the recent credit crisis.
...nearly every statement is backed with citations, if not from scholarly research then from other sources of literature. .... The book excels when it discusses how scholarly models are applied to capture observed human behavior. In summary, William Forbes's Behavioural Finance is an accessible textbook with a focus on stylized facts encompassed within selected reference models of behavioral finance research.
Evert Wipplinger, Swiss Institute of Banking and Finance, University of St Gallen, St Gallen, Switzerland
