A Behavioral Approach to Asset Pricing
Simons, Howard L
A Behavioral Approach to Asset Pricing By Hersh Shefrin Elsevier Academic Press (2005) $84.95, 456 pages
In addressing this complex material, Shefrin takes the reader on a review of the experimental evidence, followed by critical discussion of investor expectations. Then he offers some heavy quantitative analysis of utility functions better turning to risk tolerance and time discounting mechanisms, market sentiment and the creation of a behavioral-based stochastic discount factor (SDF).
Shefrin says the SDF underlies all asset prices; it and it alone can account for the impact of market sentiment in the search processes at the heart of all auctions. Finally, Shefrin explains prospect theory, the development of decisions under both risk and uncertainty. Behavioralists contend investors hold un-diversified portfolios combining very safe and very risky securities.
The risk in writing about quantitative analysis and psychological arguments is you can lose the social scientists with the first, lose the quants with the second and fail to resonate with experienced traders with the entire package. Shefrin does an excellent job of buttressing behavioral arguments with real data and of using his quantitative analysis to shed light on the problem rather than displaying his mathematical prowess.
Any economic theory has to explain asset pricing and this is Shefrin’s goal. The first message to those relying on conventional pricing models is that investors are not uniformly risk-averse; our biases can and do drive us to be risk seeking in predictable ways. The implications for investor preferences for stocks over other asset classes, for the shape of the yield curve and for option smiles are profound.
The second message to the traditionalists concerns the notion of a representative investor. Behavioralists note how the distribution of investor behavior creates a distribution of investors at the margin, where all prices are set, and time-varying preferences.
A third message is on a topic that occupies much of the book, the creation of an SDF. Market sentiment -and the study of market sentiment and contrarian investment philosophies has taken on a life of its own – must be added to the fundamental factors underlying discount rates to assess investor preferences for stochastic cash flows over time. Finally, a method for estimating SDFs from observed market prices is offered.
Behavioral finance is hardly new. The Nobel Prize in economics was awarded to behavior finance pioneers Daniel Kahneman and Vernon Smith in 2002 for their work in decisionmaking under uncertainty and empirical economic analysis.
As much as behavioral finance appeals to anyone familiar with some of its basic tenets – overconfidence, underestimation of the impact of lowprobability events, anchoring to the most recent wealth state, risk-aversion in the domain of profits and risk-seeking in the domain of losses – it has suffered from a lack of theoretical coherence. The late Merton Miller, another Nobel Laureate, derided the whole discipline as a collection of anecdotes in search of a theory.
Nothing here will end the argument on behavioral finance’s role in market analysis. But it continues behavioralism’s march into the center of the debate. Anyone wishing to place their own trading into a more refined perspective is well-advised to pay attention to behavioral finance and its implications.
Howard L. Simons is president of Rosewood Trading. E-mail: firstname.lastname@example.org.
Copyright Futures Magazine Group Sep 2005
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