Business Affairs

As we all know, business relationships do rarely resemble romantic affairs. The ever ongoing debate around shareholder vs. stakeholder value is one interesting aspect of this topic. Property is where law and economics meet, but it is not a simple concept. Property is not an object or a relation between people and objects, but a set of rights, relations among people over who is to control each of the many uses to which objects can be put. Different people may control different uses of an object, i.e have different property rights over its various uses – at the same time, or control the same use of the object at different times. When new uses create disputes, the law must define new property rights and allocate them initially to resolve the dispute – someone must be deemed to have won the dispute and be given initial ownership of the new rights. But once the former disputants are allowed to trade these rights among themselves, surprising results follow. But how do you tell whether you own something like an umbrella, let alone a company? Who owns a company?

An article I came across in the Financial Times had the title ‘Test of Possession’:
“I own my umbrella. And companies are owned by their shareholders. But what do we mean when we say that? What does, or could, the word own mean when applied, not to the relationship between me and my umbrella, but to that between hundreds of thousands of shareholders and the collection of people, assets, brands and customers that constitutes British Telecommunications (BT)?”

“The classic description of the nature of ownership was provided forty years ago by the distinguished legal theorist, AM Honoré. Concepts of ownership vary across countries and over time. But, Honoré argued, “there is indeed a substantial similarity in the position of one who “owns” an umbrella in England, France, Russia, China. In all these countries, the owner of an umbrella may use it, stop other using it, lend it, sell it, or leave it by will. Nowhere may he use it to poke his neighbour in the ribs or knock over his vase”.”

Honoré explained that ownership is neither a single nor a simple concept. Ownership, like friendship, or obligation, has many characteristics. If a relationship has sufficiently many of these, it is one we can describe as ownership: just as if an animal has enough elephant-like features, we say that what we see is an elephant.

Honoré went on to list eleven badges of ownership. Ownership typically confers the right to possess, the right to use, and the right to manage. Ownership entitles you to any income that is earned, and to claim the capital value of the asset. Ownership imposes an obligation to refrain from harmful use. What you own can be seized to satisfy your unpaid debts. Owners may claim security against expropriation. And owners can pass on any or all of their rights to someone else. There is no time limit on the rights of ownership. And owners have an ultimate right of residual control. All rights which you have not explicitly conceded to someone else belong to you.”

“That is what we mean when we say “I own my umbrella”. I can put it up, take it down, sell it, rent it, leave it in my will, throw it away. I can appeal to the police or the European Commission on Human Rights if a thief or the government takes my umbrella away. And I must accept responsibility for its misuse and admit the right of my creditors to take a lien on it.”

“When we run through these tests, we see immediately that shareholders own their shares in BT. All the criteria of ownership are met. But not at all obvious that they own BT itself. Their shareholding gives them no right of possession, no right of use. If they go to a telephone exchange, they will be turned away at the door. They have no more right to use BT services than any other customers. They are not responsible for BT’s harmful actions, and BT assets cannot be used to satisfy their debts. Shareholders do not have the right to manage, although they do have a – largely theoretical – right to appoint the people who do. They have a right to such part of the income as the directors declare as dividends. They have no right to the proceeds of the sale of BT assets, except in the wholly fanciful event of the liquidation of the entire company, in which case they will get what value is left, but not much.”

“The application of another of Honoré’s tests – the right of shareholders to contest the appropriation of the company’s assets – was the key issue in a leading case in corporate law, Short Vs Treasury Commissioners, and the shareholders cost. Their Lordships went on to say, in unequivocal terms, ’shareholders are not, in the eyes of the law, part owners of the company’.”

“And the House of Lords was right. Of the eleven tests put forward by Honoré, the relationship between BT and its shareholders satisfies only two, and these rather minor: three are satisfied in part: and six are not met at all. We could make a stronger case for asserting that BT is “owned” by its directors.”

“So who does own BT? The answer is that no one does, any more than anyone owns the River Thames, the National Gallery, the streets of London, or the air we breathe. There are many different kinds of claims, contracts and obligations in modern economies, and only occasionally are these well described by the term ownership.”

Characteristic Me and my umbrella Me and my BT share Me and BT
Right to manage Partial
Right of possession
Right of use
Right of income Partial
Right to capital Partial
Power to transfer
Security from expropriation
Must refrain from harmful use
Can satisfy debts
No limit of time
Right of residual control

“The differences between BT and my umbrella are so wide ranging that it is hardly likely that my relationship to them could be described in the same way. We have been made victims of an inappropriate analogy. As Charles Handy puts it, when we look at the modern corporation, ‘the myth of ownership gets in the way’.”

[Source: Kay, J. (1997) ‘Test of Possession’, Financial Times, 28. February.]

Comments (11)

  1. The Editor (Post author)


    Property is the single idea that ties together both the analysis of economists and the analysis of lawyers. So it makes sense to start at the beginning and ask exactly what property is. But as shown in the article above, it turns out that this is a harder question than it appears at first glance. From history, there are two views as to what property is, one older view and one newer. The older view held sway in the centuries before 1800, and it is derived from the ancient English Common Law, associated views from this period with the name of John Locke. It was replaced gradually after 1800 by a newer view, associated with the name of Jeremy Bentham.

    Locke’s View

    Bentham’s View

    John Locke by Godfrey Kneller – State Hermitage Museum, St. Petersburg, Russia, Public Domain

    Jeremy Bentham by Henry William Pickersgill (died 1875) – National Portrait Gallery
    Property as objects Property as right to control
    Relation between people and objects Relation between people and other people over objects
    Ownership as possession, use and disposition A different property right for every specific use
  2. The Editor

    The dispute between Locke and Bentham touches on the most fundamental questions of law and political philosophy and has never really been resolved.
    Locke wrote as a partisan in the great English Civil War of 1688 in “The Second Treatise of Government” (1690), as part of a war effort, that property comes from God. His purpose in writing The Second Treatise was to persuade ordinary Englishmen to participate in a revolution to overthrow James the Second and replace him by a two-headed monarchy, William and Mary. A problem for Locke and for the revolutionists during this period, was that James, supported by the Anglican Church, claimed to rule through what we now call the divine right of kings. Therefore, it was important for Locke to keep God in the theory of property. Locke illustrates a hypothetical thought experiment that people once lived in what he called the state of nature, living in a situation before any government existed. God gave every individual human being three distinct rights:

    1. The first of these rights is the right to personal liberty, or what Locke thought of as property in one’s own body.
    2. And at the very least, it means that we cannot be sold to another person as a slave might be sold and owned by another person. Indeed, Locke’s great disciple Thomas Jefferson called the right to personal liberty an inalienable right, therefore a right that could not be sold even if the individual wanted to sell the right. One concomitant of the right to personal liberty is that one’s speech emanate from one’s brain. And thus, if we own our own bodies we own our own brains and the product of those brains, speech and thought Locke said we have a right to them.

    3. A second right that Locke thought God gave every individual in the state of nature was a right to personal property.
    4. Personal property came to individuals out of the abundance of nature when people started to mix their own labor with those resources so as to produce something useful or valuable for human beings. God makes trees, but human beings produce apple orchards by working with the processes of nature and with the materials that nature provides. And that combination of labor and materials produces apples which can be enjoyed and which can be sold.

    5. Finally, Locke recognised that the first two rights did not have much meaning if there were individuals who were inclined to violate others’ rights, and that those people must be stopped from doing so. And so Locke argued, God gives every individual a third right, which is the right to punish those individuals who violate the first two rights.

    Notice that the state of nature is not a state of uncivil society. It is not a state of anarchy and not a state of chaos. As Locke concedes it, as long as everybody was reasonable, people would understand the benefits of the three rights and they would respect them of their own volition, because they recognise that forbearance would protect their own rights in situations that might arise in the future. But of course, in the real world are always people who won’t respect rights. In Plato’s tradition he called them unreasoning (not evil) because of their inability to accept the argument that he was making about natural rights. And these unreasoning few would not find it difficult to violate the property rights of people who are weaker than they were. But even the property rights of strong people were at the mercy of coalitions of weaker ones. Additionally, if people have the right to punish those who have victimised them, they may punish out of proportion to the harm that has been done to them. Locke said all of these were problems created by the difficulty of enforcing the third right in the state of nature. So he imagined that in the state of nature, people would recognise these dangers and therefore decide to force all. The way they did was to create Locke’s famous social contract.

    Individuals hold these property rights against the government. The government has no warrant to take these rights away from them without the consent of the individuals, no matter how compelling the public purpose might be that the government takes the property for. The State is a purposeless abstraction, created solely as an instrument of individuals to protect their individual liberty and property. It has no needs. It has no interests. It has no purposes of its own. And Locke would not recognise terms like national interest, or public welfare, or social good as appropriate justifications for governmental actions that violated either of the first two rights of individuals. This suggests that no person may be made the unwilling instrument of another’s welfare.

    One final implication of Locke’s theory is that it justifies revolution. This was the point of his writing it, and this was the point of Thomas Jefferson’s implicit references to it in the Declaration of Independence. Locke argues that when the government itself violates the first two property rights, then government becomes the agent, the robber. Locke’s view was that when government broke the social contract, that they had rescinded the contract itself just as in an ordinary contract.

    Locke’s theory was challenged 1791 by Jeremy Bentham who made the obvious observation that no property can be enforced, no claim to use objects, or control the use of objects as against other people can be enforced without proper consent of the State. Property was simply those claims to the use of objects that the State was willing to throw its enforcement power behind. In this sense, property originates in the State’s decision as to what rights to honor and what property rights to ignore. And in that case it is hard to say that we have a property right at all.

    For Bentham, the State has a particular purpose in mind assigning property rights. That is Bentham’s famous formula of the greatest happiness for the greatest number of people. Bentham was the originator of the philosophy of utilitarianism, and the way that we now typically express his philosophy is that all social policy, all law, ought to be made so as to maximise the sum of individual utilities. Like Locke’s theory, Bentham’s has important implications for the relationship between property and the State, and through it on the relationship between individuals and the State:

    1. There is no property until the State creates (acknowledges) it. This means that individuals have no right to property as against the State. And the State ultimately is the final arbiter and chooser of exactly what property rights are and exactly who is going to hold property rights, at least initially, before people are allowed to trade those rights in commercial life.
    2. Since the State is assigning property rights, it ought to have a purpose when it assigns property rights. And for Bentham, that purpose was the utilitarian purpose. To produce the greatest possible happiness amongst people, to maximize the sum of individual utlilities.
    3. This public purpose was superior to the private interests of any individual, including that individual’s interest in personal liberty and in personal property. For Bentham, the State was the instrument of public welfare. It was the instrument by which social utility was to be maximised. And the State may take the liberty and property of any individual in pursuit of its proper purposes.
  3. The Editor (Post author)

    Corporate Governance

    Traditionally, the UK and US companies have raised capital through equity and debt markets. The anglo-saxon economies are dominated by corporate businesses mostly listed on the stock market, with a vast range of investors involved. For example, stocks represent one of the most important instruments for individual and institutional pension plans. The French and German systems have been dominated by the banks as a major source of finance. These differences have a significant impact on corporate governance. The anglo-saxon view is that corporate governance should be understood specifically in the light of ‘corporate objectives’, whereas the continental European approach can be more holistic.

    Accordingly, there are two ‘families’ of financial reporting worldwide: the anglo-saxon and the continental European, also referred to as commercial code accounting. Modern notions of ‘imperialism’ include the idea of economic domination, e. g. Canada and Mexico using accounting modelled on US rules, or Switzerland’s use of European rules. The two families represent the cultural variables, the objecitves of financial reporting, and also the underlying legal systems: there are the common law and the Roman law models.

    Under common law, a great deal of interpretation is left to the courts in determining how the law is applied (case law). The law says what its objectives are, people try to meet these, and the courts decide whether they have acted within the boundaries or not. Under Roman law, there are procedures that have to be followed in order to meet the legislator’s objectives. In Roman law countries, standard setting is usually in government hands.

    It follows that it is hard to make a general rule what is the best corporate governance mechanism. The structure depends on ownership patterns, the development and maturity of financial markets, regulatory systems, and the legacy from past models adopted. Take for example Romania, one of the transition economies of Eastern Europe. It may not be appropriate to simply adopt any of the anglo-saxon or Western European corporate governance mechanisms when its economy has not yet seen the development of efficient financial markets, an investing culture, customer service awareness, or a society’s willingness for excellence.

  4. The Editor


    One of the problems in developing markets is that there is often an informal economy, i.e. outside the regulatory and tax systems. Reasons being:

    • to circumvent taxes
    • corruption
    • avoiding regulations and potential inefficiencies that come with it (bureaucracy)
    • a high inflation rate
    • barter transactions
    • simply local customs

    The level of corruption may interfere with the principles of a free market, making financial reporting – based on the idea of some minimal ethical behaviour – a difficult task and of questionable benefit. Additionally there could be strict rules imposed by religious groups which might be more important than in developed countries. For example, the elimination of interest in the Islamic financial system, and Shariah goes much further in its efforts to eliminate exploitation. Also the Christian tradition had an ambiguous relationship towards money lenders: Usurers, people who lent money at interest, had been excommunicated by the Third Lateran Council in 1179. Even arguing that usury was not a sin had been condemned as heresy by the Council of Vienna in 1312. This taboo is the reason why Jews were providing commercial credit. In Venice, they did their business in front of the building once known as the “banco rosso”, sitting behind their tables (“tavule”) on their benches, the “banci”.

    Developing economies exhibit a number of characteristics that resemble the time prior to the Industrial Revolution in the developed world. They have a limited need for detailed financial statements. Nevertheless, these countries will only be able to grow and overcome their dependence through FDI (as contradictory as it sounds). But foreign investors have their expectations of accountability (the capital market function of financial reporting) that may lead to a clash of cultures, which in turn undermines the success of development – a vicious circle.

  5. The Editor (Post author)


    There is an additional issue regarding “ownership” of a company. One of the features of a public limited company is the separation of ownership and control. The inherent conflict of interest has been dealt with by agency theory: that is, a potential conflict of interest between owners and managers. Agency problems can be found in all types of organisation where the owners delegate responsibility and powers to oversee its operation.
    One aspect is the dilemma between shareholders’ objective to maximise wealth (although shareholders don’t “own” a company, as highlighted above) and the interest of managers. Following high-profile corporate failures, such as Enron, WorldCom, and Parmalat, the issue of accountability has attracted a lot of attention.
    Corporate Governance
    Corporate governance: external and internal views (Source: Open University 2010, B821)

    On one side, management has responsibility to ensure that the business leads to value creation in a most efficient way. On the other side, what is reported externally to shareholders should conform to good reporting practice. This is the anglo-saxon model, where corporate governance mechanisms emphasise the relationship between shareholder and management. The issue was pointed out by Berle and Means in their 1932 book ‘The Modern Corporation and Private Property’, but Adam Smith also alluded to this possibility 1776 in his pioneering work on economics (‘An Enquiry into the Nature and Causes of the Wealth of Nations’). In Continental European countries, such as Germany and France, the mechanisms take a stakeholders’ approach to governance, trying to balance between all major stakeholders (e.g. shareholders, managers, employees, creditors, the public). Which approach is better?

  6. The Editor


    Viney (2007, p. 21) writes about purpose:

    “In not-for-profit organisations, there is usually a significant purpose of trust (or ‘benefit for others’) either made explicit in purpose statements or implicit in their operating relationships. Legally, public sector and voluntary organisations exist to fulfil the objectives set out in legislation or the founding documents (e.g. deeds of trust, constitution, charters etc.) in respect of some designated purpose or activity. Providers of resources, such as taxpayers, funding agencies, and other donors, obtain a basic return through the organisation’s pursuit of the objectives they have subscribed to. Hence, the return involves ‘personal fulfilment’ rather than a direct economic reward, such as a dividend. Primary purposes and objectives for such organisations might be the implementation of social or public policy, such as the provision of healthcare.”

    “These seem fairly obvious explicit purposes for voluntary and public-sector organisations, but managers in such organisations must also be alert to the implicit wishes of donors and resource providers when establishing such trusts, for instance: A senior manager in a health department or a quasi-autonomous regulatory body would be na?ve not to recognise that elected politicians who set public and social policy and vote tax revenues have political purposes related to public opinion.”

    “In considering such organisations, however, it is also important to emphasise the essential similarities with managing commercial organisations: the senior managers of the organisation must still secure scarce resources from providers, commit these to its activities, ensure an adequate return (i.e. the fulfilment of objectives) to the resource providers, and, last but not least, be accountable for the efficient use of all resources. Purpose, therefore, is achieved if these objectives are delivered. Additionally, government and voluntary organisations are not above the ‘shareholder’ versus ‘stakeholder’ debate, as different stakeholder groups may have different perspectives.”

  7. The Editor (Post author)

    Ownership (revisited)

    Freeman (1984) suggests a model called “Stakeholder Strategy Formulation Process” and that four generic strategies can result out of it: offensive, defensive, hold the current position, and change the rules. Freeman emphasizes past behaviour in order to predict future behaviour. However, a critique about Freeman’s (ibid.) model comes from Mintzberg et al. (1998, p. 251) who find it difficult to see how this approach can help responding to stakeholder pressures in an orderly and timely fashion.

  8. The Editor


    Social scientists often view empathy and perspective taking as fraternal twins – closely related, but not identical. Perspective taking is a cognitive capacity, while empathy is an emotional response. But both are crucial.

    According to the interviews I conducted in medical settings empathy is associated with fewer medical errors, fewer malpractice, better patient outcome, and more satisfied clinical personnel.

    Galinsky et al. (2008) found that perspective taking is highly effective when it comes to securing resources and moving others: “Taking the perspective of one’s opponent produced both, greater joint gains and more profitable individual outcomes […] Perspective takers achieved the highest level of economic efficiency, without sacrificing their own material gains.” Empathy was effective, but less so, “and was, at times, a detriment to both, discovering creative solutions and self-interest”.

    Research by Dacher Keltner of the University of California at Berkeley and others show that people with lower status and power are keener perspective takers. When you have fever resources, Keltner explaines in an interview, “you are going to be more attuned with the context around you”.

    Pink (2012) concludes that traditional sales and non-sales selling often involve what look like competing imperatives – cooperation versus competition, group gain versus individual advantage, and that perspective taking enables the proper calibration between the two poles.

  9. The Editor (Post author)

    Agency Theory

    “The directors […] being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.”
    (Adam Smith, 1776)

    The separation of the ownership of a firm from its management has continued to yield interesting insights ever since. In their influential work ‘The Modern Corporation and Private Property’, Berle and Means (1932, p. 300) describe this separation as follows:

    “Where such a separation is complete one group of individuals, the security holders and in particular the stockholders, performs the function of risk-takers and suppliers of capital, while a separate group exercises control and ultimate management.”

    They argue that the type of firm that had existed in the early years of the 20th century is not the same as after the ascent of the public corporation. It has seen a shift in power from the individual entrepreneur to depersonalised ownership. Berle and Means conclude that the new type of corporation should serve not “alone the owners or the control but all society” (p. 312). This was the foundation for the subsequent idea that multiple stakeholder groups possess a legitimate claim in a corporation’s activities. Handy (1993, p.16) sees the corporation as an entity “owned by no-one. It is in charge of its own destiny, and it is immortal or would like to be. It is not a piece of property, inhabited by humans, it is not a community, which itself has porperty.”

    In a classic paper, Jensen and Meckling (1976) develop a theory of ownership structure of the corporation based upon agency, property rights, and financial theory. In a corporate context, the principal is the investor in shares and the agent is the manager engaged by the investor to act on their behalf. Decision-making authority is delegated by the principal to the agent. A key premise is that both the agent and the principal are maximisers of utility:

    “In economics, an individual’s consumption of goods and services satisfies human wants and, thus, yields utility […] Within certain assumptions of rationality, utility is considered as a measure of an individual’s preference for different patterns of consumption […] The assumption that individuals make decisions upon consumption in accordance with their preferences is equivalent to assuming that individuals maximise their utility, i.e. they are rational.”
    (Bullock and Trombley 2000, p. 901)

    Agents are maximisers of utility (monetary advantage, prestige, office environment, interpersonal relationships) and present significant risks to the principal’s utility. The agency relationship involves agency costs:

    • Monitoring costs by the principal (e.g. incentives, bonuses, golden parachutes)
    • Bonding expenditures by the agent (e.g. financial statements, contracts)
    • Residual loss (intrinsic divergence of interests in monetary equivalents)

    The agency theoretical view of the corporation is that it is a “nexus of contracts, written and unwritten, among owners of factors of production and customers” (Fama and Jensen 1983, p. 302). The corporation is simply a legal fiction, and therefore cannot itself hold rights and responsibilities.

    There are two inherent elements in agency theory:

    “At the heart of agency theory, as expounded in accounting, finance and economics, is the assumption that people act unreservedly in their own narrow defined self-interest with, if necessary, guile and deceit. The other necessary ingredient in agency theory is the recognition that both parties to a contract often do not have the same information”
    (Noreen 1988, p. 359)

    The weaknesses of agency theory can be summarised as follows:

    • Agency theory tends to ignore the role of markets in mitigating agency costs (Watts and Zimmerman, 1986; Fama, 1980). However, it is questionable if markets are efficient – as discussed in the next section.
    • Agency theory does not, for example, point to an environmental stewardship role for the corporation.
    • Noreen (1988) finds that agency theory is not a sufficient explanation for the complexities of the agent/principal relationship. It ignores important aspects of human behaviour.
    • One of the principal underpinnings of agency theory, and of classical economics generally, is that people behave rationally in their own self-interest. There are some striking examples of individual and corporate greed in recent history which reinforce these assumptions. However, there are also many examples of people doing good in the world through their businesses. Kahneman et al. (1986) report a series of resource-allocation experiments in which they demonstrate that people not only make fair allocations, but are also willing “to enforce fairness at some cost to themselves” – at least under experimental conditions.
    • Finally, people are prone to all kind of personal biases (Fenton-O’Creevy 2010, p. 36) and therefore not very effective at making rational judgements. While the more pessimistic depict us as cognitive misers, prone to a wide range of systematic failings of judgement and biases (Nisbett and Ross, 1980), there is increasing evidence that we move between both extremes – switching from simple heuristics to more complex cognitive strategies in response to the importance of the situation and desired outcomes (Fiske and Taylor, 1991).
    • People make judgements based on experiences of the past and the present and cannot see into the future.
  10. The Editor

    Efficient Markets Hypothesis

    A market in which prices always fully reflect available information is efficient (Fama, 1970). In an efficient capital market, the price of a share reflects its underlying value. Three potential levels of efficiency in capital markets are identified in the efficient markets hypothesis (EMH):

    1. Weak efficiency
    2. Weak-form efficiency arises where share prices move independently of previous fluctuations, as in the random walk. Prices respond only where new information is made available or where economic events influence the share or the market.
      ‘Random walk’: The observation of a random pattern in price movements had in the 1950s and 1960s important implications for investment strategy. Many investors at the time used charts of historical price movements for predictive purposes. If price movements really did follow a random walk – and there were many studies that appeared to prove the point – the so-called ‘chartists’ were wasting their time. Chartists seek to predict the future price movements by interpreting past patterns – on the assumption that ‘history tends to repeat itself’.

    3. Semi-strong efficiency
    4. Occurs if share prices immediately respond to new, publicly available information. It is therefore impossible to identify under-valued stocks by analysing published data.
      Whaley and Cheung (1982) observed the effects of quarterly earnings announcements, and concluded that the market they examined (the Chicago Board Options Exchange) was efficient, with market prices fully reflecting the information content of earnings disclosures within a very short period of time.
      Ball and Brown (1968) concluded that 85 to 90 percent of the information value relating to annual income is already absorbed in the securities prices by the time an annual report is released (the so-called ‘fait accompli’).

    5. Strong efficiency
    6. A market displays strong efficiency if its prices not only reflect the publicly available information but also all relevant information.
      Pope et al. (1990) studied share price movements following insider trading announcements in the UK, and found that there was a sharp market reaction, confirming previous US results.

    The implications of EMH for investors are that, where strong or semi-strong efficiencies exist, it is fruitless to spend time trying to beat the market. Also, where real world conditions such as transaction costs are taken into account, the results of such attempts are likely to be negative. As a consequence, EMH is probably responsible for the growth in index funds.

    Objections to EMH

    Hines (1982) documents that investor surveys indicate that investors do use annual reports, even though EMH indicates that there is no point in doing so.

    • Investors may be using some of the qualitative information in annual reports to make risk assessments.
    • EMH ignores important aspects of human behaviour. Glickman (1994) argues that:
    • “[…] financial information has an essentially dual nature in that financial ‘events’ are characteristically open to interpretation at two levels: as potentially relevant to our understanding of real underlying conditions and as suggestive of possible changes in the behaviour of market participants.”

    • Efficiency in markets assumes investor rationality. There is a substantial body of behaviouralist literature exploring the psychological ‘framing’ of decisions (Tversky and Kahneman, 1986). A trader once told me that I should always account for human greed.
    • A related, and rather obvious objection to EMH, lies in the observation of ‘bubbles’ in the market.
    • Signaling theory. E.g. Elliott and Jacobson (1994) predicted increases in the level of disclosures made by companies, so long as this would give competitive advantage and reduce the cost of capital.
    • Warren Buffett, the celebrated American investor, has had exceptional success in investment on the stock market over a long period. He suggests that stock market movement is attributable to a combination of economic and psychological factors, and it would appear that his own success is attributable to his ability to take contrarian actions that would not be contemplated by the majority of investors (Buffett, 2001). Buffett appears to achieve better than average outcomes by taking a long-term view and by working against ‘herd mentality’.
    • It also seems plausible that some individuals are able to discern information from companies’ financial reports that is not accessible to all. The fundamental analyst studies corporate financial reports and other relevant information to try and gain insight into the ‘real worth’ of the shares, in the hope of identifying one that the market has over- or under-valued.
    • The insider dealer seeks to acquire information not yet publicly available for the purposes of exploiting it before it is transmitted to the markets.
    • Finally, not all capital markets display the same level of efficiency (Brown, 1988). Furthermore, capital markets are not perfectly efficient, and it is therefore possible for some investors to earn abnormal returns.
  11. The Editor

    Behavioural Finance

    Behavioural Finance is about the underlying human behaviour of the financial world. Behavioural finance, or behavioural economics more broadly, is a kind of revolution that has occurred in finance and economics over the last 20 or 30 years – and remains somewhat controversial. The real problem is that people are complex. Our financial institutions are designed for real people, and their functioning depends on the behaviour of real people. It is not tat economists have liked to invoke the principle of rationality.

    One thing about the human species is that we are aware of other people’s weaknesses – and have an impulse to exploit them. So when we see other people behaving stupidly, sometimes we are tempted to turn this to our advantage, and that becomes a problem. “The history of human kind is a history of exploitation of one person by another, not entirely, but I’m saying it has that as an important element” (Shiller, 2011).

    Evolutionary biologists think that morality evolved along with our other traits, that we have an impulse to be moral. Adam Smith is probably the most important figure in the history of economic thought. In 1759 he wrote his “Theory of Moral Sentiments”. And in 1776 he wrote the more famous book, “The Wealth of Nations”. The Wealth of Nations is considered the first real treatise on economics, and is still very readable today. His Theory of Moral Sentiment is not so widely read. He emphasized right at the beginning of the book that people inherently love praise. We crave the approval of other people. And so praise is a fundamental human desire. But then he reflected on it. He said, do people really want praise itself or is it something else that they want? Thinking of undeserved praise, Smith said adults make a transition from a desire for praise to a desire for praise worthiness: I want to know that I am the kind of person who will be praised and I don’t need to get the praise. He said it is that tendency, ultimately, which makes an economy work. A successful society promotes people up who have the praiseworthiness desire. We try to recognise them, and we try to put people of character into important positions – with limited, not complete success.

    One of the most famous elements of behavioural economics is Prospect Theory, invented by two psychologists Daniel Kahneman and Amos Tversky in the late 20th century. They called it Prospect Theory because it was a theory of how people form decisions about prospects. And a prospect is a gamble. It’s about peoples decisions under uncertainty. And in very simple terms, prospect theory says that there is something called a value function, which represents how people value things, and there is a weighting function. These are the two parts which show how people infer or how to deal with probabilities.

    If you put on the horizontal axis wealth or money, and on the vertical axis value – which is something like utility. What they found is that people’s value has a funny shape. We don’t weigh gains and losses linearly.

    When we have positive gains there is diminishing value like diminishing marginal utility in Economic Theory. But for losses, it is concave up. You note that the value function has a kink at the origin. So what does this mean?

    First of all, from what point do I estimate gains and losses? That is called the reference point; it is psychological and subject to manipulation. The reference point is the zero, from which I measure things. The kink, the reference point is probably today’s wealth. But it can be something else if people are manipulated. For example by the way something is presented to them. Framing, according to Convin, is presentation. So I can give the same prospect to people, but word it in different ways that suggests a different reference point. And that will change people’s behaviour. So you can manipulate people by describing something in different terms by suggesting a different reference point.

    The kink means that people are very conscious of little changes in their wealth and that they are spooked by them. They are really afraid, because the value drops very rapidly, even for a small loss. And less encouraged by small gains. This kind of thing allows business people to exploit people if they want to. If people are so focused on these little changes, then you are encouraged in business to try to pick things out that people are paying attention to. Like sell insurance policies on just those things and make it something little, so that it doesn’t require people to spend so much money. The classic example of that is funeral insurance. They go around telling people if for some reason this sales pitch works – and it has worked for thousands of years because it was sold in Ancient Rome – they tell people if someone in the family dies you can have an expense of getting a proper burial for this person, it costs money. And so they would insure that one little thing. Another example of that is airline flight insurance. You are insured for this specific flight on the airplane.

    The other aspect of Kahneman and Tversky is the weighting function. It is how people psychologically think about probabilities. A probability is a number between zero and one. We can tell someone the probability of something but they can’t accept it psychologically. Errors that people make are described by the Weighting Function, which means psychological impact. What Kahneman and Tversky say is that for either very low probabilities, people may round them to zero. And for very high probabilities they may round them to one. But if they decide not to round them to zero or one they exaggerate the difference between zero and one. People just cannot think in terms of a continuum of probabilities. So that means if you are getting on an airplane and think about the probability of this airplane crashing (its probably is something like one in ten million), most of us just say it is zero and I’m done. I’m not going to worry about it. But some people don’t round it to zero, they just blow it out of all proportion in their minds, and it becomes exaggerated. And then ultimately, if the probability gets really high, then it is one.

    Regret Theory is related to Kahneman and Tversky. It says that people fear the pain of regret. There is an old expression, “I was kicking myself because I made some bad decisions”. That can be a painful experience. This is represented by the kink in the value function of Prospect Theory. But Regret Theory says that there is actually a painful emotion – that you are wired not to like to have made a mistake. And so then you end up designing your life around that, and trying to avoid doing anything that you might regret later. Of course this creates problems. You may make bad decisions because you were overly worried about regret.

    Gambling behaviour: Anthropologists have recorded that gambling occurs in every human society. 1.1% of men are compulsive gamblers. And 0.5% of women. It is usually not a pathology but an aspect of human sensation seeking of various aspects of our psychology that drive us. What the stock market is in some sense is a way of channeling this kind of behaviour into something productive instead of just a game – or exploit human behaviour as mentioned above. Underlie traits that work out well.

    Over Confidence: Psychologists have found that there’s a human tenancy to over estimate one’s own abilities. Most of us think we are above average. Some of us think we are way above average. This tendency has been revealed in a number of experiments. Psychologists have tried to describe what it is that goes on into people’s minds that produces answers. One of them is that people seem to have a sense that they understand the world more then they actually do – it is an illusion. The world is infinitely complicated and there are so many surprises. When you think about a question like this, there are many different perspectives you can take. You cannot think of all the perspectives at once. And so you tend to gravitate to the first one that comes to mind. For example, Khurana wrote in Harvard Business Review that in search for the charismatic CEO there is a tendency for people to think that CEOs are geniuses. Or at least the one they found was a genius. And companies then try to seek out genius CEOs in order to put them in charge of their company. As a kind of a manipulation of the stock market. They think if they get some guy who has run other companies successfully in the past, he must be a genius. Put him in our company, and our stock price will go up. Then we can sell our executive, we can exercise our options, and make a lot of money by putting in this fake genius. Khurana says there are some people who may be geniuses at management, but most of the time they are just lucky and we tend to develop over confidence. And then what happens according to Khurana, is you put in some guy who turned around some company spectacularly. You bring him in to run a new company. And he doesn’t know anything about this new company. But he has to justify himself. So he lays off a lot of people to shuffle things around. And he just destroys everything in the company and ruins things.

    Cognitive dissonance: This is another psychological principle. The term was coined by sociologist Leon Festinger in 1962. It is a judgmental bias that people tend to make because they don’t want to admit that they are wrong. It is painful to think that I believed something, and it was wrong. So people will cling to old beliefs and try to find evidence that supports their belief because they have an ego involvement with the belief. And and so it will be biased. Goetzmann and a couple of his coauthors found that mutual fund investors, when a mutual fund does very badly in its investment performance, sell the stock and get out of it – but some of them hang on. And they thought that was due perhaps to cognitive dissonance So they interviewed these people and they found out that these people didn’t even know how badly the fund has done. They had blocked it out and had an exaggerated impression, which is characteristic of cognitive dissonance. You just forget the evidence that is contrary to your theory, and you keep assembling evidence that supports your theory.

    Social Contagion is very important. Social psychology reflects on the fact that people are interdependent. What I think is affected by what other think. Sometimes it is also referred to as Herd Behaviour, which is a popular term. It refers to the tendency for people to move with the herd, not consciously. People don’t think that they are moving with the herd. One of the founders of the discipline of sociology was the French scholar Emile Durkheim at the late 19th, early 20th century. He used the word collective consciousness. That our opinions about what is happening are formed by a collective understanding of what is going on. We have a tendency to think of ourselves as rational, and common sense, all of our views come from common sense processing of facts. But we underappreciate the extent to which our views are a little bit arbitrary and shared by millions of other people. You live at a certain point in time in history, and there are certain kinds of facts and ideas and anecdotes that are circulating. There is another term called Zeitgeist. So what Durkheim and other sociologists allowed us to understand is that the Zeitgeist is determined by a collective memory, a collective set of facts that we operate on. This herd behaviour creates big swings in the stock market, among other things. It has a huge financial impact.

    So these are a number of behavioural finance principles that really come from psychology. There is a lot of manipulation and exploitation going on. Some are active, some are just related to our conditio humana. But it links back the question asked above, if markets are efficient.

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