Posts Tagged ‘behavioral finance’

I’d rather die than pay taxes

August 30, 2010 Leave a comment

“Well, Mr. Big Brother I.R.S. man, let’s try something different, take my pound of flesh and sleep well,” wrote Andrew Joseph Stack III before flying his plane into an I.R.S. office building, killing an I.R.S. employee and himself.

Anger over taxation by a foreign government was the cry of the 1773 Boston Tea Party where American colonists, animated by anger, tossed into the Boston harbor a shipload of tea taxed by the British government. Still, we do not like taxes even when imposed by our own governments. “I drive to work,” wrote one taxpayer. “I paid tax on the car I drive, the gas it uses, and on the maintenance to keep it up. At work, I earn money. This money is taxed by the state and federal government…I go out for lunch and guess what, it’s taxed as well…Should I die, taxed again…”
My mechanic sent a postcard offering “Tax Break Specials,” saving me the cost of sale tax. He must know that his typical customers prefer small savings in the form of a tax break to more substantial savings in the form of a cash discount. We dislike taxes so much that we are willing to pay $5,000 to save $4,000 in taxes. Imagine that you earn an annual salary of $50,000 before taxes at an American company. Now you are offered a position at one of two European branches at a $75,000 salary. The good thing about Country A is that your daily commute will be 60 minutes shorter than in Country B. The bad thing about Country A is that food would cost you $5,000 more than in Country B. Which country would you choose? Now imagine identical circumstances except that the bad thing about Country A is that you would pay $4,000 more in taxes than in Country B. Which country would you choose? Abigail Sussman and Christopher Olivola presented the first of the two circumstances to one group of people and the second to another group. It turned out that more people in the United States and Britain chose country B when they could save $4,000 in taxes than when they could save $5,000 in taxes. Sussman and Olivola asked people in their survey for political affiliations, placing Democrats, Communists and Socialists in the pro-tax group, and Republicans and Libertarians into the anti-tax group. They found that aversion to taxes characterized the anti-tax group but not the pro-tax one. Indeed, Democrats, Communists and Socialists were willing to endure a longer commute to avoid higher food costs than to avoid higher taxes.

Further reading

  1. Brick, Michael (2010).  “Man Crashes Plane Into Texas I.R.S. Office.”  New York Times, 19 February.
  2. Comments to an article by Laura Sanders, “Rich Cling to Live to Beat Tax Many.” Wall Street Journal 30 December, 2009.
  3. Axe the Tax: Taxes are Disliked More than Equal Costs Abigail B. Sussman Princeton University Christopher Y. Olivola University College London Working paper 2010.

What Is Behavioral Finance

August 16, 2010 Leave a comment

Behavioral finance is a framework that augments some parts of standard finance and replaces other parts. It describes the behavior of investors and managers; it describes the outcomes of interactions between investors and managers in financial and capital markets; and it prescribes more effective behavior for investors and managers.

Continue reading.

Investor sentiment toward stocks

August 11, 2010 Leave a comment

I discussed some aspects of behavioral finance recently at a seminar for the investment professionals of a large investment company. In preparation, I presented to half of them the names and industries of several dozen companies and asked them to rate the future return of the stock of each company on a 10-point scale ranging from low to high. I presented the same list of companies to the other half and asked them to rate the risk of each stock on the same scale.

Standard financial theory predicts a positive correlation between expected returns and risk. The theory predicts that stocks rated high in expected returns would be rated high in risk. Yet this is not what I have found. Instead, I found a negative correlation.  The investment professionals rated some stocks high in expected returns and low in risk, while they rated other companies as low in expected returns but high in risk. The perceptions of theses investment professionals are identical to perceptions of individual investors, as I found in a study with Kenneth Fisher and Deniz Anginer.

The perception of a negative relation between expected returns and risk is likely due to the ‘affect heuristic,’ described by Paul Slovic and his colleagues. We know affect in the finance literature as sentiment, where we speak about positive affect as positive sentiment and about negative affect as negative sentiment. Company names elicit sentiment, positive or negative. The names Google and Apple elicit positive sentiment, which attracts investors, whereas the names of Citigroup and Bank of America elicit negative sentiment, which repels investors. Companies with relatively positive sentiment tend to be growth companies with characteristics such as relatively low book-to-market ratios and relatively high market capitalizations. Companies with relatively negative sentiment tend to be value companies. Yet investor perceptions are driven by sentiment rather than by consideration of characteristics.

Companies which elicit positive sentiment are admired companies. Companies which elicit negative sentiment are spurned companies. Fortune magazine surveys executives and analysts each year and classifies companies along the admired-spurned line. Stocks of the admired companies in the Fortune surveys yielded lower returns, on average, than stocks of spurned companies. Investors who want high returns are wise to buy stocks of spurned companies. But I would offer no such advice to investors who know that facts of returns yet tilt their portfolios toward stocks of admired companies because they enjoy their glow. Enjoy!

Further reading
Slovic, Paul, Melissa Finucane, Ellen Peters and Donald G. MacGregor (2002).  “The affect heuristic,” Heuristics and Biases, Gilovich, Griffin and Kahneman eds.  New York: Cambridge University Press.

Statman, Meir, Kenneth Fisher and Deniz Anginer (2008). “Affect in behavioral asset-pricing model,“ Financial Analysts Journal, vol. 64, no. 2 (March/April): 20 – 29.

Statman, Meir, “Investor sentiment, stock characteristics, and returns,” forthcoming in the Journal of Portfolio Management.