INTERVIEW
The Biases Of Traders
Hersh Shefrin On Behavioral Finance
by John Sweeney
Technicians became interested in behavioral finance because it could explain behaviors that previously they had tried to capture in the forms of charts, indicators, and trading rules. Academic studies rigorously defined anecdotal phenomena that technicians had tried to capture using empirical tools, with varying success. In addition, it helped that the behavioralists challenged the efficient markets hypothesis anathema to technicians.
Hersh Shefrin was in the field of behaviorial finance from the beginning when he and economist Richard Thaler first applied behavioral ideas to economics while both were teaching at the University of Rochester in the late 1970s. Later, Shefrin and Meir Statman took the same ideas to the field of finance at Santa Clara University in the early 1980s. Amplifying and confirming work by many other researchers has brought behavioral finance to the point where it is now the main contender to modify the efficient markets hypothesis. Summarizing for practitioners such results with examples and research, Shefrin explains, was the purpose of writing Beyond Greed And Fear, his latest book, available from Harvard Business School Press.
Hersh Shefrin is the Mario Belotti Professor of Finance at the Leavey School of Business, Santa Clara University. His research is in the application of behavioral decision making to finance and economics, an area in which he has worked since 1975. STOCKS & COMMODITIES spoke with Shefrin on January 3, 2000, to find out firsthand how the field's work affects technical analysts in their day-to-day work.
ILLUSTRATION BY CARL GREEN
How did you first become aware of the findings from psychology that became a key part of behavioral finance?
For me, it happened when Dick Thaler, my colleague at the University of Rochester, told me that all the misgivings I was having about what I had learned in graduate school was being actively investigated by psychologists. Dick had met some of the key psychologists working in the field. He started to look at the psychology literature, and a chance encounter with a psychologist who is now at Carnegie-Mellon brought him into the group of behavioral psychologists. And the thing about academics is, we tend to work in our own specialties, without interacting with those in other specialties, so all that was a surprise.
You don't even talk to each other intradepartmentally?
That's it. You could have been talking to psychologists, but you had to be talking to the right psychologists, because even in economics departments, urban economists only talk to other urban economists, econometricans only talk to other econometricians, historians to other historians. There was an article in 1972 in the Journal of Finance, which is the leading journal that financial academics read, that was written by a psychologist, Paul Slovic. It laid out about 50% of the theory of behaviorial finance.
So that was the start.
It took more than a decade for those ideas to start to germinate, but it's now 50% of the behavioral ballgame in terms of what is happening in finance. It was a prophetic piece. I sat next to him at a conference a couple of weeks ago, and I told him just how incredible it was, that he wrote what he wrote way back then.
What did he write?
He said that analysts, individual investors, and brokers are vulnerable to committing huge mistakes because of the way they try to predict values and financial outcomes. But it is not just the fact that they are prone to error, but why they are prone to error. They are likely to be very overconfident in the accuracy of their judgment.
Later studies have shown, for example, that if you provide people with a little information and ask them to predict, you can gauge their accuracy, but you can also ask them how confident they are in their assessments. Then you can give them another similar exercise, but this time you give them more information. You test their accuracy again, and you ask them again how confident they are in the accuracy of their prediction. You keep on doing this, adding more and more information. As you add information, accuracy improves and the degree of confidence improves. After just a little more information, accuracy starts to peak. But confidence soars.
So in our modern world of information overload --
A little more information helps us predict more accurately, but then we become wildly overconfident in our sense of how accurate we are. That is a terribly important point, given the information age explosion.
What other kinds of investor errors have cropped up? There have been a lot.
Yes, there have been. Anchoring and adjustment [Editor's note: See sidebar, "Behavioral finance definitions"]. You know the story of Goldilocks? One bowl of porridge is too hot, another bowl of porridge is too cold. It takes her a while to find one with just the right temperature. Well, for most people, when it comes to how you react to information, most of us don't find the porridge that is just right.
Or it takes us a very long time to figure it out.
A lifetime. So what you have in financial markets, in terms of the way that prices react to information -- and this is probably quite germane for technical analysts -- is you tend to get one of two reactions. You get either underreaction in some kinds of circumstances or overreaction in others. Now, when you get underreaction, it usually afflicts whoever is looking at the fundamental information. They are not fully absorbing the impact of the data.
As a group?
Yes. So when you look at prices, what you see is momentum stemming from underreaction. This is what makes a relative strength strategy work. You get drift in the prices, either positive or negative, depending on whether the news is good or bad.
Now, why does that happen? Why does the information not get fully absorbed? Is it -- and this is particularly critical in the information age -- because the information is trickling out too slowly? Nah.
Then why?
It takes people a long time to figure out how to incorporate the information they get into what they already know. It takes people a long time to figure out how the new information ought to change their views. Most people get anchored on old news, so they don't fully adjust. That is why the heuristic is referred to as anchoring and adjustment. The adjustment is really partial adjustment because folks get anchored on their previous beliefs.
It is really behavioral finance that ultimately will tell you why a particular trading rule is likely to work, because technical trading does, for the most part, exploit market inefficiencies. Otherwise, you might as well just buy and hold, but if you are looking for abnormal returns, then you have to be using the right technical trading strategies. -- Hersh Shefrin
Excerpted from an article originally published in the March 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.