2011 Vol. 1

Does Investor Psychology Rules the Markets?

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments

In financial models, investors are assumed to be rational in their decision-making. In reality, humans are subject to a variety of emotions, or cognitive biases, that can influence their investing decisions. Some researchers attribute the discovery and persistence of financial anomalies, or market inefficiencies, to irrational behavior in the markets. The belief is that irrational behavior, such as overconfidence and fear of regret, leads to errors in judgment and thereby results in arbitrage opportunities. Well-documented market anomalies in the last several decades include the predictability of stock returns based on momentum strategies, firm characteristics such as size and book-to-market, and earnings indicators, to name just a few.

In this issue of the Bulletin, we examine some of the psycho- logical biases to which investors fall prey. New technological advances and institutional changes have increased the ease with which rational investors can perform arbitrage. What has been the effect on the persistence of market anomalies and the efficiency of the markets? Have arbitrage opportuni- ties vanished? Thus, we seek to better our understanding of investor psychology, its effect on return predictability, as well as the aggregate behavior of the market after accounting for changes that have developed over time.

Howard Marks, Chairman of Oaktree Capital, shares with us valuable insights that he has accumulated from many successful years in the investment management industry. He discusses emotions such as greed and tendency towards herding behavior, amongst others, that lead to costly and recurring investing mistakes. Howard argues that the greatest investing errors stem from psychological, rather than informational or analytical factors, and warns us of six emotional pitfalls. The article is an excerpt from his forthcoming book, "The Most Important Thing; Uncommon Sense for the Thoughtful Investor" due out in May 2011.

Avanidhar Subrahmanyam, Goldyne and Irwin Hearsh Chair in Money and Banking at UCLA Anderson, is a leading ex- pert on behavioral finance and discusses the findings of his recent study. The paper's hypothesis is that market efficiency may be impeded by frictions such as trading costs; since trading costs have diminished over time, there has been greater activity and arbitrage opportunities have been taken advantage of, resulting in less return predictability in stock returns. Their results indicate that indeed, the predictability of returns has generally decreased in recent years, and in par- ticular, the profitability of momentum strategies.


Industry Perspective

Howard Marks
Chairman, Oaktree Capital Management.

Market inefficiencies-mispricings, misperceptions, mistakes that other people make-provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.

Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor psychology includes many separate elements, but the key thing to remember is that they consistently lead to incorrect decisions. Much of this falls under the heading of "human nature."

The first emotion that serves to under- mine investors' efforts is the desire for money, especially as it morphs into greed.

Most people invest to make money. (Some participate as an intellectual exercise or because it's a good field in which to vent their competitiveness, but even they keep score in terms of money. Money may not be everyone's goal for its own sake, but it is everyone's unit of account. People who don't care about money generally don't go into investing.)

There's nothing wrong with trying to make money. Indeed, the desire for gain is one of the most important elements in the workings of the market and the overall economy. The danger comes when it moves on further to greed, which Merriam-Webster's defines as an "inordinate or all-consuming and usually reprehensible acquisitiveness especially for wealth or gain."

Greed is an extremely powerful force. It's strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble. Instead, from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price.



Academic Perspective

Avanidhar Subrahmanyam (Bio)
Goldyne and Irwin Hearsh Chair in Money and Banking, UCLA Anderson

Recent years have witnessed a sea of change in the costs of trading on financial markets. For example, institutional commissions and bid-ask spreads have declined substantially over time. Further, technology has allowed institutions to conduct algorithmic trading and online brokerage accounts have facilitated trading by individual investors. Another trend in financial markets is the proliferation of hedge funds, possibly stimulated by the exogenous decreases in trading costs. The decrease in trading costs is dramatic and quite unprecedented from an historical perspective.

An unrelated paradigm shift in academic finance has been the suggestion that the cross-section of stock returns may be driven by behavioral as opposed to rational considerations. In a well-known study, Fama and French (1992) find that size and the book/market ratio strongly predict future returns. Returns are negatively related to size and positively to book/market. Fama and French (1993) provide evidence that a three-factor model based on factors formed on the size and book-market characteristics explains average returns, and argue that the factors compensate for distress risk. But Daniel and Titman (1997) argue that, after controlling for size and book/market ratios, returns are not strongly related to betas calculated based on the Fama and French (1993) factors. More recently, Daniel and Titman (2006) argue that the book/market effect is driven by overreaction to the intangible part of the book/market ratio - in other words, to that part unrelated to accounting fundamentals. The part of this ratio that is related to fundamentals does not appear to forecast returns, thus raising questions about the distress-risk explanation.

In addition to the value effect, two anomalies that have largely defied rational perspectives are (i) the momentum effect i.e., the positive abnormal returns to buying winners and selling losers at three to twelve month horizons, and (ii) the accruals anomaly, wherein stocks with greater non-cash components of earnings earn lower abnormal returns. Other cross-sectional predictors that also have proved difficult to explain using neoclassical theories include post-earnings announcement drift and the phenomenon where stock with high dispersion of analysts' forecasts earn low average returns.

We examine how the cross-sectional predictability of stock returns has changed in recent years. Our simple hypothesis is that frictions may impede efficiency, so that if predictability arises due to market inefficiencies, it should have diminished in recent years due to the steep declines in trading costs and the resulting increase in arbitrage activity. Further, we expect the diminution of predictability to be the strongest for the most liquid stocks, which should have higher levels of arbitrage, stimulated by lower trading costs.



Faculty Highlights

Mark Grinblatt is Keynote Speaker at Helsinki Finance Summit and Recipient of Honorary Degree from Aalto University

Mark Grinblatt

Professor Mark Grinblatt will be the keynote speaker at the Helsinki Finance Summit on Investor Behavior this spring. The conference is organized by the finance department at Aalto University and will be held May 17-19, 2011 in Helsinki, Finland. The objective of this conference is to present state-of-the-art academic research on topics related to investor behavior from empirical and theoretical as well as experimental standpoints.

Mark will also be receiving an honorary degree from Aalto University. This degree is awarded only once every five years.

Peter Carr is 2011 IAFE/SunGard Financial Engineer of the Year

Peter Carr UCLA Anderson has done it again! The International Association of Financial Engineers (IAFE) and SunGard named Dr. Peter Carr the 2010 IAFE/ SunGard Financial Engineer of the Year. The award was presented to Peter on February 10, 2011, at the New York Stock Exchange in New York City, during the IAFE/SunGard Financial Engineer of the Year Award Gala Dinner.

Commenting on his 2010 FEOY award, Peter said, "As the world economy regenerates, it becomes increasingly important for financial engineers to connect with each other, as well as to build bridges to the rest of the financial community. The annual event surrounding the IAFE/SunGard award has emerged as a crucial spoke in that developing social network. As such, I'm deeply honored to be this year's recipient."

Peter is managing director and global head of market modeling for Morgan Stanley in New York. He is also the executive director of the Masters in Math Finance program at NYU's Courant Institute. Prior to his current positions, he headed quantitative research groups at Bloomberg LP and at Banc of America Securities. His prior academic positions include four years as an adjunct professor at Columbia University and eight years as a finance professor at Cornell University. Since receiving his Ph.D. in Finance from UCLA Anderson in 1989, he has published extensively in both academic and industry-oriented journals.

Peter joins a prestigious list of recipients of the IAFE/SunGard Financial Engineer of the Year Award. They include: Richard Roll, Bob Litterman, Jack Treynor, Jim Simons, Phelim Boyle, Oldrich Alfons Vasicek, Darrell Duffie, Jonathan Ingersoll, Andrew Lo, Emanuel Derman, John Hull, John Cox, Robert Merton, Fischer Black, Mark Rubinstein, Stephen Ross, and Robert Jarrow. Myron Scholes received a lifetime achievement award in 2001.


Upcoming Events

ASAM Speaker Series

This speaker series is held regularly on Monday evenings starting at 7:00 p.m. Leading investment managers are invited to speak to a select group of MBA students interested in pursuing a career in investment management. The students are members of ASAM, who manage an investment fund that aims to provide a competitive rate of risk-adjusted return to its investors, and engage in experiential learning through firm visits and guest speakers. The Winter quarter speakers appear below.

Date Speaker Firm Topic
January 24 Lou Caballero Partner, Bison Capital Private Equity vs. Public Equity
January 31 Antonio Bernardo Professor, UCLA Anderson Leverage and the Pricing of Illiquid Assets
February 7 Suzanne Trepp Senior High Yield Analyst, Western Asset Research Process: A Case Study High Yield Credit
February 14 Howard Marks Chairman, Oaktree Capital The Outlook
March 7 Ram Willner Portfolio Manager, Analytic Investor Quantitative Investment Strategies

Join the UCLA Anderson finance faculty, ranked #1 in intellectual capital by BusinessWeek, for a weekly seminar given by renowned academics visiting from leading universities all over the world. Seminars are open to the public and held at UCLA Anderson from 11:00 a.m.- 12:15 p.m.




February 11


Peter Koudijis


Pompeu Fabra
Title of paper: "The boats that did not sail. News, trading and asset price volatility in a natural experiment." 

February 18


David Hirshleifer

UC Irvine

Title of paper: "Self-Enhancing Transmission Bias and Active Investing

February 25

Jan Brueckner

UC Irvine

March 4

Amir Yaron

The Wharton School

March 11


Dean Yang

University of Michigan

Title of paper: "Identification Strategy: A Field Experiment on Dynamic Incentives in Rural Credit Markets"

March 18

Jeremy Stein

Harvard University

April 1

Dean Karlan

Yale University

April 8

Fernando Ferreira

The Wharton School

April 15

Steve Ross


May 6

Adriano Rampini


May 13 Vojislav Maksimovic University of Maryland
May 20 Christine Parlour UC Berkeley
June 3 Anil Shivdasani University of North Carolina, Chapel Hill


2011 Investment Banking Fellows

Congratulations to the 2011 Fink Center Investment Banking Fellows!

After a rigorous selection process, we'd like to introduce this year's IB Fellows: Todd Holman (JD/MBA 2012), Guillaume Hotelin (MBA 2012) and Nathan True-Daniels (MBA 2012).


Todd Holman Todd Holman is pursuing his JD MBA at UCLA. He spent the last two summers at the Department of Justice in the Office of the US Trustee, and at a corporate law firm, Shartsis Friese, in San Francisco where he mainly focused on M&A deals and its hedge fund practice. At UCLA he is an editor of a journal at the law school, a TA for accounting courses, the president of the Surf Club, as well as the captain of the rugby team.

Todd attended UCSD for college, where he majored in economics. Upon graduation he took a role as an analyst at a nascent hedge fund as their first full-time hire. He then went on to work for Capital One in Richmond, VA and Washington D.C. as a Business Analyst, and later as a Senior Analyst.

Todd will be working at RBC Capital Markets in San Francisco this summer.

Guillaume Hotelin Guillaume Hotelin is a member of the class of 2012 at UCLA Anderson. Previously, he worked for Fordham Financial Management in New York City as a sales trader where he covered institutional sales and also provided strategic guidance to high net worth clients focusing on emerging growth companies. Earlier in his career, he was the business development manager of Comarbois, a lumber retail company, in Morocco. Guillaume holds a M.S in Mechanical & Electrical Engineering from the ESTP (Paris) and a M.S. in Civil & Environmental Engineering from UCLA. He is also FINRA Series 7 and 63 registered.

Guillaume has received an offer to work this summer at BNP Paribas in New York.

Nathan True-Daniels Nathan True-Daniels is a member of the class of 2012 at UCLA Anderson. Prior to UCLA Anderson, Nathan worked in investment management at Goldman Sachs and UBS where he conducted analyses on a variety of different financial products including debt, equity, futures and options. While working in Dallas, he was also an active volunteer at the Texas Scottish Rites Hospital for Children and was the founder of the "Crawfish for Kids" charity event. Nathan graduated cum laude with a Bachelors in Science from Vanderbilt University in 2005.

Nathan will be working at Barclays Capital in Los Angeles this summer.

The Fink Center for Finance & Investments
UCLA Anderson School of Management
110 Westwood Plaza, Los Angeles, CA 90095