Behavioral Finance: Biases, Mean– Variance Returns, and Risk Premiums

ehavioral finance can shed light on many areas of investing, including valuation. In this presentation, I will discuss some of the key behavioral phenomena and how they relate to particular issues associated with analyst perceptions about returns (namely, representativeness and affect). I will then compare returns for what I call “behavioral mean– variance portfolios” with those of traditional mean–variance-efficient portfolios. In that respect, I will trace the importance of a concept known as “sentiment” and describe its impact on risk premiums in the market. Because behavioral finance is complicated, it is worth keeping a few postulates in mind.1 Behavioral finance postulates that in the short run, markets are inefficient and the potential exists for misvaluation. Behavioral finance also postulates that market values eventually revert to intrinsic values, although the long run might be very long. Therefore, investors need to be careful about looking at a stock that is overvalued and thinking that its price will quickly move to fundamental value. Instead, the stock price can move the other way: The mispricing can widen, and in some cases is likely to widen, before it narrows. Representativeness and Affect Heuristic Imagine that I flip a fair coin five times and the result is five heads. The question is, What are the odds of my tossing a tail on the sixth toss? The answer, of course, is 50 percent. The coin is fair. But some people intuit a greater probability of a tail after so many heads in a row, even though the probability of tossing a tail is 50 percent because tails occur roughly half the time in any long stretch of coin tosses. Therefore, they think the odds favor a tail because they have not seen a tail for a while. One only needs to go to Las Vegas or Reno, Nevada, or Atlantic City, New Jersey, to see this phenomenon in place at any gambling table. This illusion is called “gambler’s fallacy”—the tendency to overpredict reversals in situations of this sort. Behavioral finance researchers believe that gambler’s fallacy is a product of a psychological phenomenon called “representativeness.” Representativeness refers to overrelying on stereotypes and is a principle that underlies particular rules of thumb that are used to arrive at judgments. (The term “heuristic” is a fancy name for a rule of thumb.) The stereotypical pattern for coin flips involving a fair coin is that heads appear half the time and tails appear half the time. Therefore, if a coin that is known to be fair is tossed several times in succession and a head has not appeared for a while, intuition Behavioral finance examines the biases that investors (individual and professional) incorporate in their investment decision-making process. These biases lead to inefficiencies in market pricing that are reflected in behavioral mean–variance portfolios. For an individual security, its risk premium reflects the extent to which its return co-varies with the return of a risky behavioral mean–variance portfolio.