I N T R O D U C T I O N

T O

B EHAV I O RAL F I N AN CE
People invest to make money. Though their motivations- a bigger house, a better education for their children
or a better retirement for themselves - may differ, theirobjectives do not.
Many great minds have examined the financial markets in hopes of finding investment strategies that yield
the best results. And nearly all have based their theories on one assumption - that investors always act in amanner that maximizes their returns. Yet volumes ofresearch show that investors aren’t always so rational.
Psychological studies, for example, have repeatedly
demonstrated that the pain of losing money frominvestments is nearly three times greater than the joy ofearning money. Small market corrections have often
disintegrated into full-scale crashes as a result, fueledby panicked investors who made rash decisions to
avoid losing money in the short-term rather than focusing on an investment’s long-term potential.
Clearly, not every choice investors make is in their bestinterests. While emotions such as fear and greed often
play a pivotal role in poor decisions, there are othercauses of irrational behavior. Common mental mistakes sometimes lead people to incorrectly process
new information about a company and, in turn, misjudge a stock’s true value.
Behavioral Finance is the study of how these emotions
and mental errors can cause stocks and bonds to beovervalued or undervalued. It has led to the creation ofinvestment strategies that capitalize on this irrational
investor behavior.
While investment strategies that exploit emotions haveexisted for centuries, the newest and most promisingarea of Behavioral Finance focuses on identifying
mental mistakes regularly made by investors. Thesestrategies do more than just examine the fundamentals
of companies or the feelings of investors. They incorporate how the brain solves problems and, in certain
instances, might be most prone to making a mistake.
MENTAL SHORTCUTS - POWERFUL BUT
IMPERFECT TOOLS USED BY THE BRAIN
Psychological research has shown that the humanbrain often uses shortcuts to solve complex problems.
Rather than fully digesting all information before producing an exact answer, the brain sometimes uses tools
to quickly generate an estimate. These estimates, however, aren’t always accurate.
Optical illusions are good examples of how the useof shortcuts can lead to mental mistakes. Vision is avery complex problem that requires the brain toprocess colors, depths and shapes. A set of tools
enables the brain to make rapid estimates so thatpeople do not collide with objects around them. Whilethese estimates are usually accurate, there are occasions when these tools cause the brain to incorrectly

undiscovered
managersTMINTRODUCTION TO

BEHAVIORAL FINANCE
Optical Illusions and Mental Shortcuts
Which of the straight-line segments appears to be longer?

process information and produce an
optical illusion.
The picture to the left is a good exampleof how shortcuts can cause the brain to betricked. Although the lines are identical inlength, the line on the right appears to belonger because the brain uses a shortcut
that leads it to believe it is solving a threedimensional problem. The brain is tricked
into believing that the line on the right isfarther away. And in a three-dimensional
problem, items that are farther away
appear longer than items that are closer.
MENTAL MISTAKES CAN ALSOCAUSE ERRORS IN THE
FINANCIAL MARKETS

Vision is not the only complex problem
that the brain solves by using shortcuts.
Studies in Behavioral Finance have shownthat the brain has similar tools for processing financial data and producing estimates when making investment decisions. And, similar to optical illusions, there are certain instances when these tools
can cause mistakes.
The primary mental mistakes made by investors are overreacting or underreacting to new information about a company.
Research has shown that the longer investors have studied a company, the harder it is for them to quickly evaluate newdata and properly adjust their view because their brains rely on shortcuts to make decisions.
REPRESENTATIVENESS - ONE TOOL THAT CAUSES OVERREACTION
There are dozens of mental shortcuts that make it hard for investors to correctly analyze new information. One example is representativeness, a tool that the brain uses to classify things rapidly. The brain assumes that items - plants, people, stocks, etc. - with a few similar traits are likely to be identical even though they may be quite different in reality.
While representativeness helps the brain organize and quickly process large amounts of data, it is a shortcut that cancause investors overreact to old information.
The following test shows how easy it is for anyone to make a mistake because of representativeness.

Representativeness
A Brief Quiz
You are given the following information:
Mary is quiet, studious, and very concerned with social issues.
While an undergraduate at Berkeley, she majored in English
Literature and Environmental Studies.
Given this information, indicate which of the following threecases is most probable:
A. Mary is a librarian
B. Mary is a librarian and a member of the Sierra Club
C. Mary works in the banking industry

The best answer is “C” (Mary works in the banking industry). There are so many more
people employed by banks than by libraries that it is far more likely someone is abanker than a librarian. If you chose answer “A” (Mary is a librarian) your brain isprobably making a “representativeness” mistake. You have assumed that because
Mary demonstrates a few traits of librarians (quiet and studious), she is one. In reality, it is statistically much more likely that she is a banker.
The worst and most common answer is “B” (Mary is a librarian and a member of theSierra Club). This is a pure error in probabilities because the joint probability of being
both a librarian and a member of the Sierra Club has to be smaller than the simple probability of being a librarian.
Representativeness can also cause investors to make errors in financial markets. Forexample, if a company has repeatedly delivered poor results, investors will sometimes
become disillusioned with it. In their minds, the company has the traits of a lousy company and, like most lousy companies, it will continue to deliver poor results in thefuture. Investors in these instances overreact to the past, negative information andignore valid signs of improvement. Although it may be poised to deliver good results,
the company is overlooked and its stock undervalued.
This is not to say investors won’t ever change their view. If the company continues its
improvement over time, investors will eventually overcome their representativenesserror. And the company will start to look like a potentially attractive investment.
ANCHORING - A TOOL THAT CAUSES UNDERREACTION
Mental mistakes can also cause investors to underreact to new, positive information
about a company. One shortcut that causes this is anchoring - a tool the brain uses
to solve complex problems by selecting an initial reference point and slowly adjusting to the correct answer as it receives additional information.

Case Study:
RepresentativenessFingerhut Companies, Inc.
Fingerhut was trading at approximately $30 a share in 1994
before embarking on a two-year
slide that dropped its stock priceinto the mid-teens. Despite an economic boom, sales and margins
for the mail-order catalog company decreased. And the company
became known in the investmentcommunity as one to avoid.
In early 1999, however, the company announced it was developing an on-line trading departmentthat could potentially expand its
audience and boost its earnings
by several times. Company insiders, including a senior vice-president and four directors, started
buying stock. Increased sales andother fundamental signals ofimprovement also started toappear.
But the company’s stock price did
not rise much initially despite thenew information. Investors overreacted to the old information andremained convinced that the company would continue to perform
poorly, much like it had over the
past two years - creating an
opportunity for rational investors toexploit the market’s bias against
the stock. Between July 1996 andApril 1999, the stock rose from$15 to $25. The company also
spun off Metris Companies, Inc.
during this period, adding an
additional $18 per share to shareholder return. The company wasacquired in April 1999 byFederated Department Stores, Inc.

undiscoveredmanagersTMCase Study:

Bargaining is a good example of how anchoring works. A well-trained car salesman
negotiates with potential customers by starting at a high price and slowly reducing theprice over time. His goal is to anchor the customer to the high price (regardless of theactual value of the car) and let the customer feel he negotiated a good deal by getting a lower price.

Anchoring
Jabil Circuit, Inc.

Anchoring also can cause securities to be mispriced. For example, should a company suddenly report substantially higher earnings, the market will on occasion underreact to this change. Although the company is making more money, its stock pricedoes not rise because investors assume that the change in earnings is only temporary.
They remain anchored to their previous view of the company’s potential profitability
because they have underreacted to the new, positive information.

The movement of Jabil Circuit’s
stock price is an excellent exampleof investors being anchored andonly slowly adjusting their expectations of future performance overtime. The electronic outsourcing
company was trading at approximately $7 in June 1996 when it
lost a substantial account withQuantum Corporation. The company more than made up for thisloss by attracting other clients,
however, and surprised the market
by reporting a more than 300-percent increase in earnings over theprevious year.

This does not mean that investors will never move away from their initial reference
point, or anchor. Similar to representativeness, as investors get better information
about the company over time, they will eventually overcome mental mistakes causedby anchoring. They will realize that the company is likely to continue to be more profitable in the future and that its stock is probably an attractive potential investment.
THE GOAL OF BEHAVIORAL FINANCE STRATEGIES TO INVEST BEFORE INVESTORS RECOGNIZE THEIR MISTAKES
Behavioral Finance seeks to identify market conditions in which investors are likely tooverreact or underreact to new information. These mistakes can cause mispriced securities. And the goal of Behavioral Finance strategies is to invest in these securities
before most investors recognize their error - and to benefit from the subsequent jumpin price once they do.

But the company’s stock price rose
only slightly at first. Even though
the company reported significant
increases in sales and margins
and operating income, the market
underreacted to the new information. Most investors were convinced the company couldn’t possibly sustain its increase in earnings.

BEHAVIORAL FINANCE INVESTMENT STRATEGIES MORE SUSTAINABLE IN THE LONG RUN?
A particularly attractive feature of Behavioral Finance investment strategies is that they
have an advantage over most traditional approaches to investing. Most investors use
information-based strategies. They try to generate good returns by acquiring better
information about companies or by processing information better than their peers
through a unique, quantitative (black box) strategy.

However, Jabil Circuit continued toreport significantly higher earnings
over the next year, and as
investors became less anchored totheir view of the company, its stockrose dramatically. By October
1997, it traded for $60 per shareon a split-adjusted basis.

But gaining advantages through these methods is becoming increasingly difficult. A
combination of the Internet and the increasing power of microprocessors is making
information more readily available and easier to process for all investors.
Behavioral Finance strategies, however, take advantage of human behavior - andhuman behavior changes very slowly. The brain has evolved over centuries. Its
approach to solving complex problems, and the tools it uses to solve them, are unlikely to change in the near future. And Behavioral Finance investors will be waiting totake advantage when mistakes are made.

© Copyright Undiscovered Managers, LLC, 1999
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