Title: Beyond Greed and Fear Author(s): Hersh Shefrin. Publisher: Harvard Business School Press, 2000, 368 pages. Theory postulates that financial markets are perfect reflections of economic reality. Beyond Greed and Fear invites readers to reconsider this hypothesis, since observation effectively shows that markets often behave irrationally. The author focuses on the many psychological biases and interpretive errors that influence market players. Corporate executives and financial managers are encouraged to take a step back from the advice and forecasts of financial analysts, and carefully prepare financial communication in light of investor psychology. Main Theme [Finance and Cost Accounting]

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Critical commentary by Theo Wermaelen,
Professor of International Finance and Asset Management at INSEAD.
[Manageris 86b -- 10/2000]

Beyond Greed and Fear is the first comprehensive book on behavioral finance, that is behavioral psychology applied to financial decision making. The author uses the work of numerous researchers to illustrate various mechanisms such as :

• The propensity of investors to make biased decisions because they rely on crude rules of thumb rather than optimal statistical procedures ;
• The tendency of investors to allow their decisions to be influenced by not only the underlying fundamentals but how decisions are framed.

These mechanisms create inefficient markets where prices do not reflect fundamental economic value.

This book challenges the efficient market hypothesis (EMH) which postulates that stock prices are fair. According to this theory, it is impossible to generate abnormal returns on the basis of publicly available information. The book provides an excellent summary of some of the anomalies discovered by various academics in the past twenty years. Academics won’t find much new material here, but practitioners who have been taught that markets are absolutely efficient will find many new and provocative ideas here. Even non-financial specialists will recognize the described behavioral patterns, such as overreaction and under-reaction, reluctance to sell at a loss, etc.

Like many other academics in finance, I used to be a believer in the EMH. However, I must admit that my own work and that of my counterparts have made me change my mind. In collaborative research projects, we found in particular that the market systematically under-reacts to buyback announcements made by beaten-down "value stocks" at least in the short run. Investors extrapolate from the past excessively and underweight evidence that disconfirms their prior views. They are slow to adjust their opinion.

By explaining every anomaly within a behavioral finance framework, the author delivers a forceful message. However, if the book has one weakness, it is that it does not pay enough attention to alternative explanations for these phenomena. Many anomalies can potentially be explained by the fact that high-risk firms tend to have higher returns or by the fact that tradeoffs are often impossible. For example, in chapter 4, the author cites Robert Shiller, who argues that stock prices are less volatile than dividends. Nevertheless, this theory is contradicted by Miller and Modigliani, who received a Nobel Prize for showing that stock prices can’t be stabilized by stabilizing dividends.

In short, I recommend this book to anyone who wants to get up to date on the latest academic research findings on market efficiency, and to anyone who wants to acquire a more thorough understanding of his/her own behavior in various financial or non-financial contexts.

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Further readings:
• THE PSYCHOLOGY OF FINANCE,
Lars Tvede, John Wiley & Sons, 1999.
•  INEFFICIENT MARKETS,
Andrei Shleifer, Oxford University Press, 2000.