Behavioural Finance

William Forbes is Professor of Accounting and Finance in the Business School at Loughborough University, UK. He has previously held positions at University of Glasgow, University of Manchester, University College of North Wales in Bangor and the University of Exeter.

Preface xv Acknowledgements xvii 1 Introduction 1 1.1 Illustration and Structure 2 1.2 Finance Theory as an Engine not a Camera 3 1.2.1 Rational Fools or Folly of Wisdom? 5 1.3 Rebuilding on New Foundations 7 1.3.1 Reasoned Emotion: The Case of Phineas Gage 8 1.3.2 What Can Psychologists Bring to Finance? 9 1.4 Challenging the Classical Assumptions of Finance 9 1.5 Modelling Behavioural Aspects of Finance 11 1.6 The Structure of the Book 12 Appendix: A Financial Tsunami 14 Notes 14 References 14 Part I Foundations 17 2 Financial Decision Making 19 2.1 Illustration and Structure 19 2.2 The Expected Utility Rule 20 2.2.1 An Illustration of Expected Utility 21 2.2.2 Attitudes to Risk 22 2.2.3 Diversification as Risk Reduction Strategy 23 2.2.4 How Best To Bear Risk 24 2.3 Expected Utility Theory: Simple But Untrue? 26 2.3.1 Paradoxes and Problems in Early Understanding of Expected Utility Theory 27 2.3.2 Gambling Insurance and Aspiration 29 2.4 Frames for Actions, Contingencies and Outcomes 31 2.4.1 The Decision Process 31 2.4.2 Inferring Big Ideas from Small Samples 32 2.4.3 Stars with Feet of Clay 33 2.4.4 Is There More to Life Than (Maximizing) Utility? 34 2.4.5 Happiness, Well-Being and the Emotional Basis of Utility 34 2.5 Conclusion and Summary 35 Questions 35 Notes 36 References 36 3 Discounting 39 3.1 Illustration and Structure 40 3.2 The Discounted Utility Model 40 3.2.1 Some Problems with the Discounted Utility Model 41 3.2.2 Evaluating Reallocations of Consumption by Equivalent Gains or Compensating Losses of Present Consumption 42 3.2.3 Delays and Speed-Ups of Utility 44 3.3 How and Why Discount Rates Vary 44 3.3.1 Discounting Single Outcomes Compared to Sequences of Outcomes 46 3.4 Investment Behaviour When Discount Rates are Declining: Investing in a Golden Egg 47 3.5 Hyperbolic Discount Factors 49 3.6 Valuation by Using the Matching Law 51 3.6.1 On Pigeons and Men: Comparing Hyperbolic and Exponential Discounting 53 3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54 3.7.1 A Simple Example of a Sub-Game Perfect Equilibrium 55 3.7.2 The Properties of a Sub-Game Perfect Investment Strategy Equilibrium 57 3.7.3 How Do Declining Discount Rates Affect Investment Behaviour? 58 3.8 Conclusion and Summary 59 Appendix: Timely Choice: Euler Equations Dynamics and Inter-Temporal Choice 60 Questions 61 Notes 62 References 62 4 Learning 65 4.1 Illustration and Structure 65 4.2 Rational Learning 66 4.2.1 Bayes Rule 66 4.2.2 Elements of Bayesian Revision 68 4.2.3 The Value of Stock Recommendations 70 4.3 Do We Learn the Bayesian Way? 72 4.3.1 Representativeness 74 4.3.2 Representation Bias in the Market: Analysts Overreaction to Earnings 74 4.3.3 A Once and For All Lesson? 75 4.4 Over Inference and the Law of Small Numbers 76 4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77 4.6 Conclusion and Summary 79 Appendix: Case Study Baseball the Bayesian Way 80 Questions 87 Notes 88 References 88 5 Bubbles 89 5.1 Illustration and Structure 90 5.2 Tulipmania and the Didactic Value of Bubbles 91 5.3 The Regulatory Origins of the Most Recent Bubble 92 5.3.1 Long-Term Capital Management 92 5.3.2 The Federal Reserve and Market Restraint 95 5.4 Bubbles: Past, Present and Future 101 5.4.1 Financial Bubbles and Infrastructure Technology 102 5.4.2 Are Bubbles Just Part of the Market Process? 103 5.5 The 1929 Stock-Market Crash 104 5.5.1 Early Signs 104 5.5.2 The Boom is On 105 5.5.3 Innovation and Speculation 106 5.5.4 Investment Trusts in the Booms Growth 106 5.5.5 The Final Implosion 107 5.6 Should Government Burst the Bubble? 108 5.7 Conclusion and Summary 109 Appendix: Tulips as Assets and Art 110 Questions 114 Notes 114 References 114 Part II Asset Pricing 117 6 Noise Traders 119 6.1 Il