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Baker & Nofsinger, eds., Behavioral Finance

Behavioral Finance: Investors, Corporations, and Markets, edited by H. Kent Baker and John R. Nofsinger (Wiley, 2010) is a must-have book for anyone who wants a comprehensive review of the literature on behavioral finance. In thirty-six chapters academics from around the world write about the key concepts of behavioral finance, behavioral biases, behavioral aspects of asset pricing, behavioral corporate finance, investor behavior, and social influences. The book is hefty (757 pages of typographically dense text), and each contribution includes an extensive bibliography. But this is not simply a reference book; it reads surprisingly well.

Why should we study behavioral finance? “Anyone with a spouse, child, boss, or modicum of self-insight knows that the assumption of Homo economicus is false.” (p. 23) In our investing and trading—indeed, in all the financial decisions we make, we are prone to behavioral biases; we are often inconsistent in our choices. Only if we understand the kinds of emotional pulls that negatively affect our financial decisions can we begin to address them as problems. Some of the authors offer suggestions for overcoming these problems.

Here are a few takeaways from the book that give a sense of its tone and breadth.

First, I am happy to report that the literature shows that “high-IQ investors have better stock-picking abilities” than low-IQ investors and they “also appear more skillful because they incur lower transaction costs.” (p. 571) I figure that everyone reading this review falls into the Lake Wobegon category.

Second, individual investors can form powerful herds. “[T]rading by individuals is highly correlated and surprisingly persistent. …[I]ndividual investors tend to commit the same kind of behavioral biases at or around the same time [and hence] have the potential of aggregating. If this is the case, individual investors cannot be treated merely as noise traders but more like a giant institution in terms of their potential impact on the markets.” (p. 531)

Third, what are some of the behavioral factors affecting perceived risk? Although the author lists eleven factors, I’ll share just two. “Benefit: The more individuals perceive a benefit from a potential risky activity, the more accepting and less anxiety (fear) they feel…. Controllability: People undertake more risk when they perceive they are personally in control because they are more likely to trust their own abilities and skills….” (p. 139)

And finally, investors’ attitude toward risk is not fixed. They care about fluctuations in their wealth, not simply the total level. “[T]hey are much more sensitive to reductions in their wealth than to increases,” and “people are less risk averse after prior gains and more risk averse after prior losses.” (p. 355) Interestingly, CBOT traders tend to exhibit a different pattern, reducing risk in the afternoon if they’ve had a profitable morning.

As should be expected in this kind of volume, there is a fair amount of repetition. The same studies are quoted by several authors. We read about such topics as overconfidence and the disposition effect multiple times. The context is different, the principles are the same. But through repetition we come to appreciate the scope of behavioral finance (and often its limitations as well).

Although this book is certainly no primer, the reader needs only a passing familiarity with behavioral finance to profit from it. And for those who are better acquainted with the field, it is a useful compendium and an excellent research tool. It has earned a place in my library.

The Inanity Of Asking Questions On Blue Channels

Last week I was watching a investor query an analyst on a television show , the analyst in his most humble opinion on a particular stock said “Fundamentally it is good , technically it is not looking so good ” . What should I do asked the investor ? , the analyst replied ” I think you should hold on ” . the investor prompted “can I buy more , should I sell some ” . up came the analyst in his humble opinion ” buy on a fall , and sell on a rise ” and in wisdom he added “it is a volatile stock anything can happen “.. I failed to understand what the investor achieved of this conversation . the conversation had incorporated everything viz. . buy ,sell , hold and the standard disclaimer , “anything can happen ” . Investors are bombarded with packets of irreconcilable data which cause their little hard drives to collapse under pressure and confusion . Partly to blame for this are investors themselves , who ,in the quest for more information buy themselves a box of contradictions . !
What an investor needs is a modicum of authenticated information and to be phlegmatic .. however most investors these days are contrarian’s and hence , they follow up with every pink paper , and investment magazine , add to it the daily dose of ‘analysis’ on television … Those Score’s of analyst reciting their pedantic verses and the numerous phone calls by altruists souls that ring in to tell you ‘what’s hot on the street’ .! What do we have at the end of all this ? Ans.: An agglomeration of profligate et irreconcilable information and a confused individual — who can barely find his way in the heap of ‘ information ‘.
Serpents In the financial Eden :
All the information an investor has access to is at most sciolism , what lies beneath is above the reach of the common man on dalal street .Distortion and dilution are the two most plaintive facets of information today . Mostly intentional , distortion and dilution is carried out by interested quarters and the fodder is fed to the people , the public domain as we are all aware has the ability to Xerox information at the speed of light , and before you know it a distorted Piece of information has taken the shape of a ‘hot news’ on the street. (more…)