behavioral finance lecture(1)

8/2/2019 Behavioral Finance Lecture(1)

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Behavioral Finance

Behavioral Finance is the study of how human psychology emotionimpacts investment decisions

Behaviorists argue that the EMH puts an unfair burden on human

behavior The EFM assumes that all investment decisions are rational

It also assumes that if a arbitrage opportunity arises, thearbitrageurs will move in to close it assuring market efficiency

These are the two fundamental assumptions of the EMH

It is for this reason that arbitrage trading is also called convergencetrading

The trick remains to see if behavioral trading is persistent and canbe exploited



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Key Themes

Heuristics or Rules of Thumb – reduce the need forcognitive behavior Affect – Environment impacts decisions. Buy roofing stock when raining

Representativeness -The inability to select a complete and unbiased

sample. People that look like criminals are criminals

Availability – Using data which is available because it comes to mindeasily. Newsworthy vs. non-newsworthy

Anchoring – Inability to move off of an initial starting point. PNC stock is $57 per share. Value from this point

Familiarity – People tend to pick stocks that they know Overconfidence – For example most people think they are better than

average drivers. Failure to allow for regression to the mean

Status Quo – A belief that things will stay the same rather than change

Loss Aversion – People are averse to taking a loss and admit mistake

Conservatism – People tend to be conservative with forecasts



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Key Themes

When heuristics result in non-rational behavior they giverise to a bias

Framing Bias – How is the question asked? What examples of

framing can you think of?

Emotional Bias – Mood impacts investment decision.

Weather

Sporting Events

Market Impact – At times investors have an incentive to trade withthe trend that caused the missed pricing if they don’t feel themarket will correct, for example the real estate market of 2005-2007

Market Impact – Institutional investors have an incentive to

influence prices in a positive direction



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Behavioral Finance

Investors deviate from standard (rational and unbiased)decision making in at least three ways:

First is their attitude toward risk

Investors simply do not look at gains and losses the same way.Take gains and avoid losses

Second is non-bayesian expectation formation

Decisions are made with limited information

Investors use heuristics to guide decisions

Third decisions are greatly influenced by the framing of the question

For example bonds may look good when looking at short term

returns on the market and look bad when compared with longterm returns



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Overreaction and Underreaction

Behaviorists point to over and under reaction to eventsas evidence of inefficiency related to psychologicalfactors

How do EMH proponents respond?

Under and Over reaction are consistent with EMH if they eachoccur with similar frequency

How does Underreaction occur?

Investors are inclined to believe that past trends are likely torepeat and move slowly to accept new information

People are slow to update models with new information

Biased self-attribution causes people to ignore public signals



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Overreaction and Underreaction (cont)

How does overreacton occur?

Bias to exaggerate private signals about a company and ignorethe public signals

Sequential episodes of good news result in securities beingoverpriced

Sequential episodes of bad news result in securities beingundervalued

Past winners tend to be future losers and past losers tend to befuture winners – Is this behavioral or managerial?

The grandfather of all underreaction studies is the factthat stocks with positive earnings news outperform evenafter the announcements with the corollary also true.



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Other Biases

Familiarity Bias People tend to favor investments in companies they are familiar with

Relative Wealth Bias A desire to hold stocks which are perceived as being successful for peers

leads to undiversified portfolios

Sensation Seeking Bias Studies have shown that speeders trade more than non speeders which is

attributed to sensation seeking

Disposition Bias Investors are slow to sell losers and quick to sell winners

There is a reluctance to admit a mistake



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Other Biases (cont)

Informational Bias People tend to overestimate information of others while underestimating their

own

Cognitive Bias Underinformed investors tend to overestimate their ability to find value and trade

too much. Tends to occur more with men than women and more with singleinvestors vs. married investors

Framing Bias For example people are less likely to select a loss of $750 vs a 75% chance of a

loss of $1000 (also known as Prospect Theory) Hindsight bias

We tend to remember winners more than losers.

We tend to blame losers on unpredictable events



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Herding

Herd Behavior

People tend to favor investments favored by others

This goes for portfolio managers as well

Examples are numerous but include the Tulip Bulb craze of the1600s and the internet bubble of 2000s

Generally groups make better decisions than individualsand this encourages herd behavior

The Delphi teaching method



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Limits to Arbitriage

What is arbitriage?

Taking a riskless position by buying and selling an asset whichgives rise to a gain. The purchase and sale position is called a

hedge

Are hedges perfect? Hardly

If the hedge involves different underlying assets, an unexpectedchange in one would defeat the hedge

Shorts are one sided hedges. Given what we know about herdbehavior – are one sided hedges reliable?

You might not be able to borrow the stock necessary to short it

Tax posture of investor will impact arbitrage decisions – not truefor a tax exempt investor



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Limits to Arbitriage

At times you are forced to select similar securities andthe hedge will not be perfect.

For example there is no market for unleaded fuel but there is

for diesel

The Royal Dutch / Shell example

Despite the fact that these are virtually identical securities, therehave been times when deviations from the 60/40 earnings

sharing ratio have ranged from -30% to positive 10% - Why?? The most advanced reason is that they trade in two different

markets and that each stock covaries with its respective market



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Sums it all up

Richard Thaler – the father of BehaviorialFinance summed it all up when he said to

a “traditionalist”, Robert Barro at anacademic conference

He said “The difference between us is that

you assume people are as smart as youare, while I assume people are as dumbas I am”



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The Bottom Line

Show me the money(after adjusting forrisk) !!!

Backtests rarely fail !!!

behavioral finance lecture(1)

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