Read the text and explain all concept discussed in the text below: (This subject is Behavioral Finance)

Representativeness Bias and Good Companies. The representativeness heuristic involves individuals assessing situations based on superficial characteristics rather than underlying probabilities. One possible manifestation of this inclination is the assumption that the shares of a good company will be a good investment. Shefrin and Statman (1995) show that survey respondents believe that the shares of companies that do well in the annual Fortune magazine survey of corporate reputation will prove to be good investments. Their findings indicate that these companies tend to be large companies (past winners) with low book-to-market ratios, which are characteristics linked empirically to poor subsequent returns. More recent work is somewhat mixed. Anderson and Smith (2006) find that the shares of the Fortune surveys most admired companies outperform the S&P 500 Index in the periods following publication of the survey results, whereas Statman, Fisher, and Anginer (2008) use a longer sample and find results consistent with Shefrin and Statman (1995).

Cooper, Dimitrov, and Rau (2001) show that investors can be influenced also by the name a company adopts, again consistent with the representativeness heuristic. Their analysis of 95 companies that changed to dot-com (.com) names during 1998 and 1999 finds that these companies earned statistically significant and sizably positive abnormal returns that did not appear to reverse in the following 120 trading days. They note that adoption of the dot-com name appears to lead to investor mania. Not all of the companies that changed names had substantial involvement with the internet, but the extent to which they did was not related to the share price response.

The Equity Risk Premium. The relatively high level of the equity risk premiumthat is, the excess return of equities over bonds or T-billsis another empirical finding regarded by some authors in the traditional finance literature as a puzzle. Behavioral theories may offer some solution to the puzzle. Benartzi and Thaler (1995) argue that loss-averse investors who evaluate their portfolio on a regularat least annualbasis will require a high risk premium to be induced to invest in equities. For these investors, losses are weighed more heavily than comparable-sized gains, and given the distribution of gains and losses at short horizons, investors who regularly evaluate their portfolios will often be confronted with painful losses.

Asness (2000) presents an explanation for time variation in the equity risk premium based on the idea that the relative yield on stocks versus bonds will reflect the experience of each generation of investors with each asset class, particularly in terms of volatility. The risk premium at any point in time is argued to be determined by the relative volatility of stocks and bonds over the past 20 years (i.e., the personal experience of the majority of current investors). The results are shown to be robust when changing the horizon to between 10 and 30 years. The results can explain why stocks previously yielded more than bonds but in the more recent past have had the opposite relationship. (See also Zhiyi Songs literature review on the Equity Risk Premium: www.cfapubs.org/toc/rflr/2007/2/1.)

Behavioral Corporate Finance

Behavioral finance also has applications in analysis of corporate finance decisions. As Baker, Ruback, and Wurgler (2007) note, the extension of behavioral ideas to corporate finance has taken two distinct paths. The first path, which takes the view that investors are less than fully rational, analyzes the corporate financing decisions made by management in response to the behavior of investorsthat is, the rational managers make decisions in response to the mispricing of securities by behaviorally biased investors. The second path holds that corporate managers can be subject to behavioral biases and that some of the corporate finance transactions they undertake are the result of those biases. For example, managers may make certain decisions because they are overconfident about their abilities or the prospects for their firm or because they are loss averse. Baker et al. (2007) note that the second, irrational managers, path is somewhat less developed than the first path, which focuses on managerial responses to market mispricing.

Rational Managers and Irrational Investors. The rational managers/irrational investors school of thought has its main implications in terms of corporate financial structure and the timing of securities issues. For example, Baker and Wurgler (2000) find that the share of equity issues relative to total equity and debt issues is high before periods of low equity market returns, suggesting that companies time their equity issues to take advantage of positive investor sentiment and market mispricing. These results suggest also that corporate capital structure often reflects the cumulative outcome of past attempts to time the equity market rather than some target capital structure (Baker and Wurgler 2002).

Baker and Wurgler (2004) argue that dividend policy may be influenced by managers catering to the demands of investors. According to the authors, managers rationally cater to investor demand by paying dividends when investors put higher prices on payers and not paying when investors prefer nonpayers. The authors show that the lagged dividend premiumthe difference between the average market-to-book ratio for dividend payers relative to the average for nonpayersis positively related to dividend initiations. The authors argue also that investors time-varying demand for dividends is related to sentiment. When the dividend premium is high, investors are seeking companies that exhibit characteristics of safety, and when it is low, investors are seeking maximum capital growth.

Shleifer and Vishny (2003) present a model that seeks to explain merger and acquisition (M&A) deals in behavioral terms. In the model, stocks are mispriced and management perceives and responds to the mispricing. The authors argue that M&A decisions and decisions about methods of financing deals are driven by misvaluations of the participating companies; for example, acquisitions will involve payment in stock when valuations are high. The model suggests that acquisitions for stock are made by overvalued companies and target companies tend to be less overvalued. The model is able to explain many of the observed characteristics of the M&A market.

Behavioral finance also has implications for the market for IPOs. These offerings are widely documented as showing high first-day returns, usually taken to imply that the issues are underpriced at the offering price. One puzzle is why issuers and pre-IPO shareholders are prepared to tolerate this money left on the table phenomenon. Loughran and Ritter (2002) propose a model based on prospect theory in which issuers are likely to net the amount of money left on the table by an underpriced offering together with the gain in their wealth that comes from the rise in the price of the shares that they retain in the company. The net amount will often be a positive sum

with the increase in value of the retained holdings exceeding the difference between the offer price and the market price for the shares sold in the offering. Furthermore, the most underpriced offerings tend to be those in which the offer price has been revised up in the face of strong demand from the price set out in the prospectus. Therefore, the original pre-IPO shareholders can offset the loss of the underpricing with the good news that their total wealth is higher than was previously expected. Ljungqvist and Wilhelm (2005) provide some support for this hypothesis in that issuers of underpriced offerings often use the IPO underwriter for subsequent equity issues, suggesting they are not unhappy with the service received.

Irrational Managers. Despite the suggestion by Baker and Wurgler (2004) that the irrational managers school of behavioral corporate finance is currently underdeveloped, the theory can be regarded as having a relatively long history. For example, Rolls (1986) hubris hypothesis of takeovers is based on the idea of overconfidence among managers, which leads them to overestimate the gains to be made from corporate activity. More recently, Doukas and Petmezas (2007) calculate a measure of management overconfidence and find overconfident managers companies earn lower merger announcement returns and have poorer long-term share price performance. Self-attribution bias also appears to be at play, in that returns are lower for serial acquirers (five or more deals in three years) than for first-time deals.

Another example of the managerial overconfidence idea relates to project appraisal and internal investment decisions. Malmendier and Tate (2005) argue that overconfident management overestimates the returns on investment projects and views external funds as too costly. They tend to overinvest when internal funds are abundant but refrain from investing when external funds are required. The authors use managements personal financial exposure to company-specific risk as a proxy for overconfidence and find that investment by overconfident CEOs is closely related to cash flow.

Investor Behavior and Behavioral Portfolio Theory

In this section, we look at the trading and portfolio construction behavior of investors without regard to whether or not that behavior has a lasting impact on market prices. We consider the evidence for professional investors, fiduciaries (such as pension fund trustees), and individual investors.