McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 PERCEPTIONS ABOUT RISK AND RETURN Behavioral Corporate Finance by Hersh Shefrin

1 Representativeness Risk and Return  In practice, managers appear to rely on representativeness when forming judgments about risk and return.  They are prone to view the stocks of good companies as representative of good stocks.  As a result, they come to judge that risk and return are negatively related.

2 Unisys and Intel Comparative Data  Unisys just reported a decline in sales, year- over-year.  Analysts were predicting that Intel sales would grow by 10%.

3 Rate Intel and Unisys  Quality of company  Financial soundness  Long-term investment value  Expected return over next 12 months  Perceived risk  Intel is a better company than Unisys. Past 5 year sales Market cap Retained earnings component of book equity Similarly Intel does better on the other variables.

4 Risk and Return  Managers who rely on representativeness judge Intel stock to be a better stock than Unisys stock.  Managers who rely on representativeness view the stocks of financially sound companies as safe stocks, and the stocks of companies that are not financially sound as risky stocks.  Managers who rely on representativeness view Intel as a safer stock than Unisys.

5 Perceived Relationship Between Risk and Return  Traditional finance teaches that risk and return are positively related, that higher expected returns are associated with higher risk.  Representativeness induces managers to view the relationship as going the other way. Exhibit 4-2 Scatter plot displaying assessments of investment professionals.

6 Affect Heuristic Reinforces Representativeness  People assign affective labels or tags to images, objects, and concepts.  Imagery is important, e.g. adding “dot.com” to name of firm in second half of 1990s.  The affect heuristic is a mental shortcut that people use to search for benefits and avoid risks. Benefits are associated with positive affect, whereas risks are associated with negative affect.

7 Perceived Risk and Firm Characteristics  Executives associate low book-to-market equity and high market capitalization to both good stocks and good companies.  Executives view stocks associated with low betas, large market capitalization, and low book-to-market equity to be less risky than stocks associated with high betas, small market capitalization and high book-to-market equity.

8 Analysts  Unlike executives, analysts treat the relationship between beta and expected return as being positive.  Holding beta constant, analysts expect smaller capitalization stocks to earn higher returns than larger capitalization stocks.  Analysts expect growth stocks to earn higher returns than value stocks.  Analyst target prices are excessively optimistic.

9 Financial Executives and the Market Premium  Financial executives appear to believe that at the level of the market, expected returns and risk are negatively related.  The higher the market return has been in the prior quarter, the higher their forecasts of the equity premium over the subsequent year.  The higher the market return has been in the prior quarter, the lower are their forecasts of market volatility over the subsequent year.

10 S&P 500 Rolling Dice?  Is the market hotter if it's recently been hot?  Is the market colder if it's recently been cold?  Based on data going back to 1926 when the S&P 500 index was formulated, the probability of an up-year is about 2/3.  The probability is about the same after up- years as after down-years.  It's almost like rolling dice.

11 Two Fallacies Individual investors exhibit the hot hand fallacy. Investment professionals exhibit gambler's fallacy.

12 Wall Street Analysts and Executives  For individual stocks, analysts believe in short-term reversals, not momentum.  Given the evidence for momentum, analysts appear to exhibit gambler's fallacy.  Executives engaging in legal insider trading exhibit gambler's fallacy. This leads them to sell growth stocks and buy or hold value stocks.

13 Project Discount Rates  In theory, managers discount project cash flows at a rate that reflects the systematic risk of those flows. If those flows comprise a series of components, all featuring different levels of risk, then in theory managers should discount each component separately, using its own discount rate.  Survey evidence from FEI indicates that in practice, most managers use a “one size fits all” heuristic.

14 Debiasing  Carefully identify both the base rate information and the singular information.  Use statistical forecasting techniques, and contrast the outcomes with forecasts based on intuitive judgments.  Based on the contrast, ascertain whether the intuitive judgments fail to make appropriate use of either base rate information or singular information.