anomalies- behavioral finance
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Discussion of Behavioral Finance AnomaliesTRANSCRIPT
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1. ANOMALIES
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Summary:Stock prices volatility is greater than can be justified by fundamentals (i.e. a new info about change in dividends)
Purpose:What accounts for movements in stock prices? there may be a human element adding to volatility
Excessive VolatilityRobert J. Shiller (1981) The American Economic ReviewDo stock prices move too much to be justified by subsequent changes in dividends?
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High volatility of stock market prices compared to fundamental prices
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Short-term momentum
Positive short-term (6-12 months) autocorrelation in stock returns (underreaction) – news is incorporated slowly into prices
Momentum Strategies:(To exploit short lags)
• Create zero-cost arbitrage portfolios by buying most winners and selling most losers of the past 3-12 months, hold them for the next 3-12 months.
• Jegadeesh and Titman (1993) and Rauwenhorst (1998): report around 1% monthly average excess returns to this strategy.
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Long-term reversal
Negative long-term (3-5 years) autocorrelation in stock returns
Contrarian Strategies:(To exploit long lags)
Buy most losers and sell most winners of the past 3-5 years, hold the portfolio for the next 3-5 years. DeBondt and Thaler (1985) report significantly positive returns to this strategy
Yesterday's top performers become tomorrow's underperformers, and vice versa.
Short-lag positive and long-lag negative autocorrelation in Rt series are a violation of weak form of efficiency.
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The Profitability of Technical Analysis(Trends, Trend Reversals): It may be possible to
make money by following trends.
IPO Stocks’ UnderperformanceRitter (1991): IPO stocks yield below normal returns in the 36 months following the IPO.
Investors become too optimistic about IPO firms, inflating the initial IPO return (buy at a high price, stocks later underperform)
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Facebook IPO
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2. Behavioral Theories Designed to Explain These
Anomalies…
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Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment
• Underreaction due to Conservatism bias: Individuals are slow to change their beliefs in the
face of new evidence Information is reflected step-by-step in prices rather
than in a single step Stock prices underreact to earnings
announcementsThis creates positive short-term autocorrelation in
returns and explains the profitability of momentum rule
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• Overreaction due to Representativeness Bias: Tendency of people to underweight statistical
properties of population/see patterns in random sequences/reemphasize the most recent and salient
Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment
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Representativeness Bias
Investor might think that high earnings growth of a company is trending (when it is not) and overvalues the company
Stock prices overreact to consistent patterns of good/bad news, creating excessive volatility (continuing trends, then reversals)
This explains negative long-term autocorrelation in returns and profitability of contrarian strategy
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Effect on the market
• Conservatism + Representativeness Bias:Short-run momentum (continuation)Long-run reversal
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Daniel, Hirshleifer, Subrahmanyam The Journal of Finance (1998)DHS model
Overconfidence: An investor tends to be overconfident about the information he has generated but NOT about public signals.
Biased self-attribution:When confirming public information is received – investor’s confidence rises.When disconfirming public information is received – investor’s confidence falls only modestly, if at all.
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OVERREACTION to private informationAnd UNDERREACTION to public information
Q: HOW DO THESE BIASES AFFECT MARKET BEHAVIOR? Tend to produce:- Short-run momentum- Long-run reversals
E.g. Bubbles
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3. DEBATE
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Shleifer and Summers Journal of Economic Perspective(1990)The Noise Trader Approach to Finance
Efficient markets approach: Random trades SHOULD cancel out.
Noise Trader approach: Random trades DO NOT cancel out.
Movements in investor sentiment are an important determinant of prices
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Fama’s critique of behavioral theoriesMarket efficiency, long-term returns, and behavioral finance (1998), Journal of Financial Economics
• Long-term return anomalies – NO EVIDENCE AGAINST EFFICIENT MARKET THEORY
anomalies are chance results, underreactions are equally likely as overreactions, so they cancel each other out
unpredictability of behavioral factsmethodology problem temporarity of behavioral facts
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Thaler (1999)The End of Behavior Finance“After all, to do otherwise would be irrational “
• Evidence that should worry the efficient market advocates– Volume– Volatility– Predictability Fama 1970/1991– Dividents (MM - 1958)
• Why do most large companies pay cash dividends?• And why do stock prices rise when dividends are initiated or increased?
• “Behavioral finance" will be correctly viewed as a redundant phrase
• “After all, to do otherwise [not include the human factor in trading ] would be irrational “
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Summary of Behavioral Finance Theories in ONE formula: