Putting Investors on the Couch

Unless you’re into economics, you might be surprised to learn that traditional finance theories — from investor decisions to the rules of arbitrage — rest on the assumption that the marketplace is efficient and rational. That view seems to contradict the less-than-rational, downright messy world of modern finance that we see in the news. It’s precisely this confounding world that captivates Fatma Sonmez.

Fatma is an up-and-coming QSB professor who specializes in behavioural finance, a hot field for both scholars and investment professionals alike. During a time of chaos and confusion in financial markets, behavioural finance offers fresh perspectives by studying the influence of cognitive psychology on the behaviour of investors and the subsequent effects on markets.

“Especially as the financial crisis continues to unfold, people are saying that the rational finance view has to be questioned,” says Fatma, Assistant Professor of Finance and founding force behind QSB’s Behavioural Finance Conference, the only academic gathering of its kind in Canada. “Market efficiency has to be questioned. We have to find different explanations, and behavioural finance offers different views.”

Behavioural finance offers possible explanations for nagging questions: Why do investors overreact to glamour stocks or bad news? Why do some investors hold bonds over the long term when equities offer much higher yield? Does an optimistic bias skew forecasting and expectations? What is the role of overconfidence in trading behaviour? Some researchers are even studying the link between testosterone levels and risk-taking behaviour in investors.

Research in this field started in earnest only in the late 1980s, although some of the major themes were suggested in John Maynard Keynes’s 1936 classic, The General Theory of Employment, Interest and Money. “Keynes outlined all sorts of investor behaviour, investor biases, and how investors form their beliefs,” says Fatma. But during the 45 years that followed, finance and economic thought centred on rational finance and market efficiency, which seemed to preclude any need to study the behaviour of the actors within the system.

The tide began to turn when early behavioural finance researchers started questioning the traditional theory that fundamental value is accurately reflected in the market. Traditional theory could not offer convincing explanations for obvious mispricing, and those in the behavioural camp looked for alternate explanations. As their papers began to be published in academic journals, researchers branched out to explore investor trading behaviour — investors’ belief systems or expectations and how these expectations are formed.

They also studied the role of behaviour in financing and investment decisions in the corporate sphere, such as those impacting mergers and acquisitions. “When you’re a manager, there are two important questions,” says Fatma. “First, how to find money, and second, how to invest that money. Behavioural finance says there are behavioural biases that we have to understand in order to understand financing and investment decisions.”

Some researchers are going a step further, delving into the field of neuroscience to study how biases can be predicted by studying the workings of the brain.

Like other researchers in the field, Fatma comes to behavioural finance with a hardcore mathematics and finance background. Because she and most of her colleagues do not have formal education in psychology, they turn to extensive experimental evidence in cognitive psychology and behavioural biases to better understand finance anomalies.

"We are really fascinated by this idea of understanding human behaviour," she says. "We know that mathematics is just a tool, and it’s not a complete picture of what we see in real life. What makes finance different from other areas, like physics, is the human interaction. Once there's a human aspect, you have to understand behaviour."

In the early 2000s, Fatma pursued dual graduate degrees, in pure mathematics and in engineering management, at Middle East Technical University in her native Turkey. She got her first taste of finance at an international conference she had attended out of curiosity, and decided then and there to pursue a PhD in finance.

She was turned onto behavioural finance during her doctoral studies at the University of Toronto. A workshop by Cornell scholar Ming Huang, who discussed new approaches to financial theories, was a turning point. “I started to look at the same questions from a different perspective,” says Fatma. “It was like rereading the same book from a totally different angle.”

Another chance encounter years later would give Fatma the opportunity to pursue this interest. Shortly after joining the QSB faculty in August 2009, she attended a mathematics seminar, where she met Frank Milne, a finance professor in Queen’s Economics Department. They talked about the financial crisis and behavioural finance, and mused that it would be great to invite the top researchers in the field to a conference at Queen’s.

Although she was a junior faculty member with no published papers to her credit, Fatma quickly drew up a list of possible speakers and started calling. By the next day, she had five speakers lined up and within ten days, the conference was officially on. “I have a very determined personality,” says Fatma. “After all, I did my PhD in just four years.”

The Queen’s Behavioural Finance Conference has run for three years, with Fatma sharing Chair duties with Frank Milne in the first year and finance professor Fabio Moneta in the subsequent two. The event has developed a reputation for attracting leading and emerging researchers from some of the top universities in the world (the Wharton School, Purdue University, and Boston College were among those represented at the 2012 conference). The next conference is scheduled for Spring 2014.

Meanwhile, Fatma continues to pursue a number of her own research projects. She has written three papers (in various stages of publication) examining the behaviour of investors in ‘lottery stocks’—inexpensive and wildly speculative stocks favoured by those looking for the next Facebook. She wants to explore how investors value firm-specific risk as opposed to market risk that is inherent in an industry or type of business.

She is collaborating with fellow QSB scholars, as well. Fatma has teamed up with Lynnette Purda, RBC Fellow of Finance, to examine whether investors view companies with AAA credit ratings in the same way across different industries. The answer seems to be that they do not; AAA-rated financial service companies are deemed more risky than similarly rated manufacturing firms.

Fatma and Sean Cleary, Bank of Montreal Professor of Finance, are studying how investors view firms engaged in building up their cash reserves. Policymakers have decried such corporate strategies and have implored firms to put “dead money” to use. But the markets like these cash hoarders just fine. According to research by the QSB professors, a strategy of buying stocks from “high cash” firms and selling those of “low cash” ones would have generated abnormally high returns of approximately seven per cent per year.

These research subjects are diverse, reflecting a strategy Fatma has consciously adopted.

“There are costs and benefits of focusing,” she says. “If you’re focused on one area, you’ll publish many papers and be the expert in that area. But I like to learn more about different areas. Being innately curious is who I am.

” Fatma’s behavioural finance focus, shared by a number of QSB colleagues, “is an important and emerging area of business research,” says Jay Handelman, Associate Dean of Research and MSc/PhD Programs. “Queen’s is well positioned to create new knowledge for both scholars and anyone interested in investing and investor behaviour.

” So when a financial advisor suggests purchasing a specific stock, in addition to asking about its performance history, the canny investor may also want to ask what kind of a day the advisor is having. If he or she just got a speeding ticket on the way to work, or had words with a colleague who drank the last of the communal coffee, Fatma cautions: “Let the buyer beware.”

This article originally appeared on the QSB Insight website at www.qsbinsight.ca. Check out the site for more articles, whitepapers on faculty research, webinars, videos and more.