Asset Management

Lecture 19

Agenda

• Behavioral finance (Chapter 12)• Challenges to market efficiency

• Limits to arbitrage

• Irrational investors

Market Efficiency

• Fama: “The market price at any time instant reflects all available information in the market”.

• Cannot “make money” using “stale information”.

• Three forms

• Weak form: past prices and returns.

• Semi-strong form: all public information.

• Strong form: all public AND private information.

• Michael Jensen: “there is no other proposition in economics which has more empirical support than the EMH”.

Are Financial Markets Efficient?

• Weak form of market efficiency supported to a certain extent.

• Challenges:

• Excess market volatility

• Stock price over-reaction: long time trends (1-3 years) reverse themselves.

• Momentum in stock prices: short-term trends (6-12 months) continue.

• Size and B/M ratio (stale information) may help predict returns.

What Makes Markets Efficient?

• Competition among information providers

• Arbitrage traders

• Critical Factors Behind Efficient Markets• Investor Rationality

• Irrational Behavior is Not Systematic

• Rational Arbitrage Traders

Behavioral Finance

Irrational Investors Limits to Arbitrage

Investor Irrationality

• Empirical Evidence on investor behavior:

• investors fail to diversify.

• investors trade actively

• Investors may sell winning stocks and hold onto losing stocks

• extrapolative and contrarian forecasts.

• Systematically irrational trading by investors

• Information processing

• Suboptimal decisions

Psychology

• Beliefs

• Overconfidence

• Optimism / Wishful Thinking

• Miscalibration

• Better-than-average-effect

• 90% of Drivers Claim Above Average Skill

• 99% of Freshman Claim Superior Intelligence

• Illusion of control• Rolling dice in craps

Psychology

• Beliefs

• Representativeness

• Base Rates are Under-Emphasized Relative to Evidence

• “Law of Small Numbers” – gambler’s fallacy

Example: fair coin tossing.

T H T H T H H H H H H

P(T) = ?, P(H) = ?.

Psychology

• Beliefs

• Conservatism

• Base Rates are Over-Emphasized Relative to Evidence

• Belief Perseverance

• Anchoring

• Availability Biases

Psychology

• Behavioral biases• Framing• Mental accounting

• Preference for dividends• Holding on to loser stocks for too long• “house money effect”

• Regret avoidance• Prospect Theory

• Utility Defined over Gains and Loses• Concave over Gains, Convex over Losses

“Irrational” Behavior of Professional Money Managers

• Herding:

• may select stocks that other managers select to avoid “falling behind” and “looking bad”.

• Window-dressing:

• add to the portfolio stocks that have done well in the recent past and sell stocks that have recently done poorly.

Limits to Arbitrage

• Fundamental Risk • Horizon Risk• Model Risk• Lack of Substitutes • Limited Capital • Legal Constraints • Implementation Costs

Limits to Arbitrage

• Implementation Costs

• Commission

• Bid/Ask Spread

• Price Impact

• Short Sell Costs

• Fees

• Volume Constraints

• Legal Restraints

Limits to Arbitrage

• Twin Shares: Royal Dutch (60%) and Shell (40%)• Only Risk is Noise Traders• PriceRD = 1.5*PriceS

Limits to Arbitrage

• Nick Leeson • Jan 16, 1995, Short Straddle on Tokyo stock exchange• Jan 17, 1995, Kobe Earthquake• Riskier tools to bet on recovery of Nikkei Stock Average• Losses reached £827 million, twice the bank's available trading

capital. • Feb 26, 1995, Barings Bank filed bankruptcy.

Summary

• Investor behavior does have an impact on the behavior of financial markets.

• Both “social” and “psychological” must be taken into account in explaining the behavior of financial markets.

• Market “anomalies” may be widespread.

• Behavioral Finance: does not replace but complements traditional models in Finance.