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Studying the Psychology of Finance

November 12, 2012

Oliver Bunn (Economics) has a lot on his plate right now. He’s wrapping up three studies on behavioral finance for his dissertation, looking for a job, and helping his wife Michela with their brand new baby Helena, born October 1.

Oliver completed two master’s degree-level programs called “Diploms,” one in mathematics and the second in economics at the University of Bonn in Germany, where he was born. Midway through these studies, he realized that he wanted to use math for “something that applied to the real world,” he says. A year as an exchange student in the Economics Department at the University of California, Berkeley, convinced him to pursue a PhD in economics in the U.S.

At Yale, a course on behavioral finance taught by Nicholas Barberis hooked him on behavioral economics – a field that incorporates insights from psychology and sociology into the analysis of economic theory. His dissertation, “The Impact of Valuation Measures and Confidence Indices on the U.S. Stock Market,” includes three related studies, all advised by Robert Shiller. Barberis is also on his committee.

One study, “Changing Times, Changing Values: A Historical Analysis of Sectors within the U.S. Stock Market 1872-2012,” coauthored with Shiller, focuses on “valuation measures.” According to classic economic theory, every stock should be priced based on accurate knowledge of its true value and every investor should be in possession of complete information, rendering it impossible for people to make money in the stock market, since all investors would move rationally and in unison. Clearly, this “Efficient Markets Hypothesis” doesn’t reflect reality. Using data from the 1870s to today, this paper considers what’s known as the cyclically-adjusted price/earnings ratio (CAPE), also called the “Campbell-Shiller PE10,” to establish return predictability over the years.

We’ve found encouraging results,” Oliver says. “Of course, back in 1870, they didn’t have all the stock market sectors we have today. We studied the industrial, utilities, and railroad sectors. I tried to trace the history of these sectors through time, to understand if the CAPE ratio can generate a signal of miss-pricing. If the ratio is low, it’s a sign of undervaluation. If the ratio is high, it’s a sign of high or overvaluation.”

A second study, “Survey-Based Confidence Indices and Stock Market Data,” uses a data set compiled by the Yale International Center for Finance. Since 1989, the center has surveyed institutional and individual investors about their confidence in the stock market. The surveys focus on what investors were thinking as they made their choices, and Oliver used that information to analyze how changes in the market influenced investors’ thinking, and how their thinking, in turn, impacted the market.

The third study, “The Interaction of Value- and Momentum-Based Investing,” deals with two standard investment styles. In “value investing,” potential buyers try to determine a stock’s worth by comparing the balance sheet information and financial market variables of a company. In the second style, “momentum investing,” buyers make decisions based on the trending price of a stock: if it’s been going up, they assume (rightly or wrongly) that it will continue to rise, and vice versa. Oliver explores combining these approaches: “First use value measures to assess what a portfolio should look like. Then use momentum as a corrective device. Lead with one; follow with the other,” he says. “I take the two styles and apply them in a nonlinear way.”

In addition to his academic research, Oliver was invited to help produce a family of new investment products for Barclays PLC. He collaborated for twelve months on these new financial instruments, working full time on the project during the summer. “These financial products have now been launched. It’s really satisfying to be part of creating something like this,” he says. Based on this experience, he has decided to work in the financial industry after graduation in May, creating systematic investment strategies.

While at Yale, Oliver has also been active in graduate student life, serving last year as of the Graduate Student Assembly (GSA) and chairing the GSA’s committee on Academics and Professional Development. His wife Michela is awaiting publication of her dissertation on Italian philology, submitted to the University of Bonn, and teaches Italian and German at Aux Trois Pommes in Guilford and New Haven.