近日，《Asia Asset Management》在其10周年特刊中刊登我院副院长朱宁教授的文章《Same subject, different angle——Challenging the fundamental assumptions》。文中，朱宁教授从诺奖得主导师席勒谈起，围绕着行为金融阐释了自己的观点。

Same subject, different angle——Challenging the fundamental assumptions

Professor Robert Shiller, Sterling Professor of Economics at Yale University and the author’s dissertation advisor back at Yale, won the Nobel Prize in Economics this year for his contribution to‘The Empirical Analysis of Asset Prices’ (in conjunction with Professor Eugene Fama and Professor Lars Hanssen, both from University of Chicago).

This is an unusual award for the Nobel Prize in Economics, not least because it marks the first time two scholars with starkly contrasting views have shared the same spotlight. Professor Eugene Fama proposed ‘The Efficient Market Hypothesis’ some 50 years ago and this has had a heavy influence on academic research in the field of finance over the better part of that period. By contrast,

Professor Robert Shiller presented the field of ‘behavioural finance’, which challenged the fundamental assumptions underpinning the efficient market hypothesis, buttressed with much supporting empirical evidence.

What may be more important is that, this is an unusual prize for behavioural finance. Finance in general has long been thought to have been built upon rational behaviour plus perfect optimization and computation processes.

However, with advances in psychological research plus the availability of enhanced financial data and more intensive computational capacities, the limitation in the efficient market hypothesis have now been clearly demonstrated.

In economics and finance, rationality means two things: first, when they receive new information, agents update their beliefs correctly; second, given their beliefs, agents make choices that are normatively acceptable.

In contrast, there is increasing evidence in behavioural economics that shows that investors can neither collect all meaningful and available information, nor can they properly process such information even when it is available. Rather investors have been shown to focus on information that attracts their attention, and tend to downplay or completely ignore relevant but less salient
information.

A classic example of this investor failure to process information is EntreMed, a bio-medical company listed on the Nasdaq. When the company released encouraging news about the breakthrough in its cancer drug, the market barely moved. However, after the New York Times weekend edition featured the same story, the company’s stock soared by more than 100% the following Monday. Such an anecdote supports behavioural finance research in its belief that investors are not that rational.

Another strand of research in behavioural finance, including many of the author’s studies, shows that investors often make what are apparently bad investment decisions. Investors, and especially retail investors worldwide, tend to hold severely under-diversified portfolios, and to trade too frequently even though doing so sometimes doesn’t even cover the incurred transaction costs. They are also inclined to invest in stocks which they believe they know well even though these may fail to outperform the market index. In one study, the author showed that 0.6% of all warrants contracts in

China were wrongly exercised, i.e. in-the-money warrants were left unexercised and even more perversely, out-of-money warrants were exercised by investors.

Such retail investors not only make less than rational decisions, they also lean toward making them in alarmingly systematic ways. Studies have shown that small investors tend to concentrate their purchase and sales of certain stocks during the same period, as opposed to being noisy traders cancelling off each other’s trades.

Based on such findings, behavioural finance has reached a not-so-surprising conclusion. Instead of the lack of predictability advocated by the efficient market hypothesis, there are indeed many occasions when asset prices are predictable, due to a systematic shift in investors’ sentiment – and mistakes – and likewise investors’ failure to properly update their information.

For example, behavioural finance literature shows that even with publicly available information on past performance and company valuations, one can form profitable zero-cost trading strategies that can generate abnormal returns in excess of 10% per annum. Buying stocks that did very well over the past six months and short selling stocks that did very poorly over the same period (commonly known as the momentum strategy, can generate sizeable trading profits in many markets around the world. In addition, buying stocks that did very poorly for the past three years, and short selling stocks that did very well for the past three years (commonly known as the reversal strategy) can also produce attractive risk-adjusted returns.

Once one moves beyond basic information on asset prices and volume, there are even more information inputs that can be used to predict future asset movement. For example, behavioural finance studies find that many macro economic factors can reliably predict future stock market performance. As well these studies have found that marketwide sentiment measures have reliable predictive power over mid-term stock returns. Finally, information inferred from corporate executives’ beliefs about their own businesses and prospects have also shown promising potential as to predicting future market returns.

As to why such seemingly attractive profitable strategies exist and persist, behavioural finance differs from the efficient market hypothesis in arguing that even if institutional investors are very smart and can indeed forecast market performance (which itself is a very strong assumption), their concerns about their own career safety, their asymmetric compensation schemes between gains and losses, and their inability to predict the irrational decisions made by retail investors, all render them not very helpful in trading against the irrational investors and so ensuring efficiency in the market. Put in the parlance of behavioural finance, the limits to arbitrage make it much harder to ‘arbitrage’ than originally thought. Without arbitrage, it is then easy to understand why pricing inefficiencies and market anomalies can persist for a very long period of time.

Precisely because of this investor irrationality and the ‘limits to arbitrage’, securities markets are accompanied by excessive volatility and their familiar boom and bust cycles. These bubbles and their busts not only waste a lot of economic resources; they also mislead the expectations of the entire economy. Consequently, a better understanding of investor behaviour and social norms and expectations in behavioural finance research helps not only the field of finance itself; it also provides important lessons for other areas of economics.

Partly because of its research thrust, behavioural finance has paid close attention to new research areas that can address the ‘inefficiencies’ in the markets. In the field of real estate research, for example, Robert Shiller developed the Case – Shiller index to track U.S. housing market movement, successfully predicting the 2008 global financial crisis. Many researchers in behavioural finance, myself included, have tried to implement trading strategies based on their academic research. Additionally, with the spread of behavioural finance’s influence, more and more practitioners and money managers apply ideas, consciously or not, that were initially
inspired by behavioural finance.

Moving beyond the field of trading strategies, the development of behavioural finance has important implications for other areas of asset management as well.

To regulators, the increasing evidence of the lack of rationality in many investors’ investment decisions underscores the need for better investor education and protection. As it becomes evident that many investors lack the basic knowledge and skills in assessing the returns, and in particular risks, of financial products and financial services providers, regulators around the world have to take a more active role in helping to promote knowledge of finance and awareness of the various risks it entails.

To product designers, behavioural finance not only means new products, but also new return distributions that can help investors better diversify from traditional strategies. For example, JP Morgan

Asset Management rolled out a JP Morgan Behavioural Finance Fund some time ago, to take advantage of the research ideas coming from this quarter.

Seen another way, a better understanding of investor behaviour can create more opportunities for marketers of financial services to better understand their clients, and so find better ways to access them, and pro-actively help them navigate a course that steers away from well-known behavioural pitfalls.

Behavioural finance, as a new and promising field of finance, has probably asked more questions than it has answered. But maybe this is the essence of its beauty. As Albert Einstein once said, “The ability to ask the right question is more than half the battle in finding the answer.”Through asking more relevant questions, behavioural finance can probably provide an integration of better investment performance, greater investor sophistication and risk awareness, improved design of financial products, and therefore better services for clients.

With the burgeoning development of behavioural finance over the past few decades, actual financial market practitioners have embraced it far more willingly than some academics. One point that is frequently cited is that behavioural finance lacks a centrally unifying theory and does not posit all-encompassing predictions. Although this may seem to be a shortcoming from the perspective of the field of economics, it is important to point out that this is not a problem in many other scientific fields. After all, economics and finance come under the grouping of social sciences and applied disciplines. Finding the right questions and answering them accurately should be the first and foremost priority, whether these are founded on a unifying theory or not.