Efficient Market
Hypothesis and
Behavioral Finance
Where we began and where
we are heading
Group Member: Savita Krautheim
Can we predict risk
tolerance from
investor behavior?
• Black Monday –On Monday October 19th 1987,
stock markets around the world crashed, shredding a
huge value in a short time. The crash began in Hong
Kong, spread to Europe then the United States. The
Dow Jones Industrial Average (DJIA) dropped by 508
points to 1738.74 (22.61)%.
Most investors sold their investments because they saw the
prices declining as opposed to selling based on information!!
Eugene Fama wrote The Efficient Market
Hypothesis theory in the 1960’s.
Three forms of EMH
Weak Form –Stock prices reflect all past information in the
prices.
Semi-Strong Form-stock prices reflect all past and current
publicly available information.
Strong Form-stock prices reflect all relevant information,
including information that is not disclosed to the pubic i.e.
insider information.
Is The Market Rational?
No, say the experts. But neither
are you. -Justin Fox
"If the efficient markets
hypothesis was a publicly
traded security, its price
would be enormously
volatile.”
-Andrei Shleifer and Lawrence Summers (1990)
Two types of Investors
• Rational Speculators or Arbitrageurs- trade on
the basis of information.
Greed is Good!–Gordon Gekko
• “Be Fearful When Others Are Greedy
And Greedy When Others Are Fearful”
——Warren Buffett
Noise traders-trade on the basis of imperfect information.
Arbitrage is Limited by two types of
risk
• Fundamental Risk – e.g stocks are selling above
expected value of future dividends and arbitrageur is selling
them short. The arbitrageur then bares the risk that the
realization of dividends-or of the new about dividends-is
better than expected, in which case he loses on his trade.
• Unpredictability of future resale price- future
mispricing is more extreme than when the arbitrage trade is
put on, the arbitrageur suffers a loss in his position.
Psychology has shown
individuals have limited information processing
capabilities.
exhibit systematic bias in processing information.
are prone to making mistakes.
often tend to rely on the opinion of others.
• Kahneman and Tversky's prospect theory, is
very important in economics and especially in
financial economics. In 2002 Daniel
Kahneman shared the Nobel Prize in
Economics but unfortunately Amos Tversky
had died by that time and did not get his
share of the fame.
Mental
Accounting
Group member :
Sarah Khosroshahi
The Behavioral Shift
Conventional finance->rationality (e.g. EMH, expected
utility hypothesis)
But conventional finance had its problems:
• Certainty effect
• Isolation effect To watch or not to watch!!
Behavioral finance -> acceptance of human irrationality
• Using a value function instead of utility function of expected utility
theory to factor in human subjectivity
Mental Accounting
Financial behavior
• Reference price ( reflected by
transaction value)
• Transaction utility
• Fungibility
• Coding Gains and losses
Integration and Stagnation (2)
• So investors sometimes consider their portfolio as a
whole, and sometimes as a collection of separate
components
– Integration: evaluating the whole
– Stagnation: evaluating the parts
• How does the investor choose between the two
options?
Integration v Stagnation (1)
Multiple gain : v(x) +v(Y) >v(x+y) segregation (christmas gifts!)
Multiple Loss :v(-X) + v(-Y)<V[-(x+y)] integration why desirable
credit cards!
Mix gain: v(X) + V(-Y) <V(x-y) integration cancel loss against larger
gain : because the loss is more steeper so may v(x) +v(-Y)<0
Mix losses: silver lining principle : keeping in mind separately a
small gain and a loss and forget about the sum
Khaneman
Prospect Theory
and Some
Financial
Applications
Describing Decision-Making
under Uncertainty
Group Member: Rachel Jiang
The Value Function (1)
Loss/gain perspective
• value function defined by deviations from reference point and
thus looks at relative changes, not absolute wealth in the final
state.
Concave/convex value function
• Concave for gains
• Convex for losses
• Steeper for losses than for gains (loss aversion)——Thus
whether an investor frames alternatives as gains or losses
strongly impacts risk-attitude.
The Value Function (2)
Probabilities are weighed subjectively, not objectively
• Weights measure impact of events on desirability of prospects, not
just the perceived likelihood of the event
• Lower probability scenarios are overweighted
Fourfold pattern of risk attitudes results from
overweighing small probabilities and concavity/convexity
•
•
•
•
Risk aversion for gains of moderate or high probability
Risk aversion for losses of low probability
Risk seeking for gains of low probability
Risk seeking for losses of moderate to high probability
Illustrations
The Game:
A=sure gain of €2400
[E(A)=2400]
B=25% chance of gaining
€ 10000 and 75% chance
of nothing [E(B)=2500]
C=sure loss of € 7500
[E(C)= -7500]
D=75% chance to lose
€ 10000 and 25% to lose
nothing [E(D)= -7500]
Prospect Theory in Action (1)
Disposition Effect: traders often hold on to their losing
investments for too long and “cash in” their winners too early.
• Loss aversion: agents become risk-seeking in the face of loss,
risk-averse in the face of gain (see time value)
• Greater investor appetite for large losers than small ones
• Similar reasoning leads to difficulty relinquishing sunk cost and
Bowman’s risk-return paradox
• Hedonic framing may help avoid the disposition effect
• An investor can use his awareness of psychology rules to
frame situations in a way that maximizes his decision-making
abilities.
Prospect Theory in Action (2)
Why are portfolios often not well diversified?
• Framing leads to 1) separating “downside protection layer” from “upside
potential layer” so that their weights diverge 2) ignoring security-returns
covariance
• Loss aversion leads to 1) focus on loss avoidance rather than benefiting from
diversification 2) excess cash holdings to avoid losses due to liquidity problems
Other applications include explanations of the equity premium
puzzle and the volatility puzzle.
References

The Value Function (1):


The Value Function (2):


Han, Bing and Jason Hsu. “Prospect Theory and Its Applications in
Finance.” Research Affiliates. (Dec. 2004).
<http://www.researchaffiliates.com/ideas/pdf/Prospect_Theory_and_It
s_Applications_in_Finance.pdf>.
Prospect Theory in Action (1):


Kahneman, Daniel and Amos Tversky. “Prospect Theory: An Analysis of
Decision under Risk.” Econometrica. Vol. 27, No. 2. (Mar., 1979). p. 263292.
Illustrations:


Kahneman, Daniel and Amos Tversky. “Prospect Theory: An Analysis of
Decision under Risk.” Econometrica. Vol. 27, No. 2. (Mar., 1979). p. 263292.
Fiegenbaum, Avi and Howard Thomas. “Attitudes Toward Risk and the
Risk-Return Paradox: Prospect Theory Explanations.” The Academy of
Management Journal, Vol. 31, No. 1 (Mar. 1988), p. 85-106.
<http://www.jstor.org/stable/256499>.
Prospect Theory in Action (2):


Barberis, Nicholas et al. “Prospect Theory and Asset Prices.” Journal of
Economic Literature G12. (Jul. 1999).
Han, Bing and Jason Hsu. “Prospect Theory and Its Applications in
Finance.” Research Affiliates. (Dec. 2004).
<http://www.researchaffiliates.com/ideas/pdf
/Prospect_Theory_and_Its_Applications_in_Finance.pdf>.
Anchoring
and Framing
Group Member:
Alberto Banchetti
Anchoring
Cognitive bias that describes the common human
tendency to rely too heavily (anchor) on one piece
of information while taking decisions
Frequently it occurs when:
• people are dealing with concepts that are new for them
• a single value is taken in consideration in an overestimated way
In the Financial World
Most of the people take decisions for their investments analyzing
specific figures and considering them the leading factors of their
choice.
In the economic field most of the times the anchor is represented
by a precise number, a value or a price. In investments the
reference can be:
a previous peak stock ( or index ) price, a previous price trend or a
previous estimate.
• This process can lead to wrong evaluations in predicting the utility of a future
outcome.
Examples
Tendency of investing in the stocks of companies that have fallen
perceptibly in a very short amount of time. The investor may be
anchored to the idea that the drop in prices is not a relevant
message but it’s just a great opportunity to buy the stock at a
discount.
Tendency of being anchored to the investments that you have
done and accepting the possibility to wait for subpar investments
for several years looking for the break even point instead of
dumping them.
The most balanced and correct
strategy seems to be the one that
avoids the anchoring process and
tend to evaluate plenty of
perspectives in order to derive the
truest picture of the investments
landscape.
So Why Does Anchoring Still Exist?
“Human limits”
1)People usually feel committed to the choice
they’ve done so they prefer to rationalize and
find good reasons for what is happening
instead of changing their belief.
2)People usually balk at the complex cognitive
task required to re-analyze and adjust their
prior estimate of prospects and risks.
Consequences
Investors, at least in the first moment, tend to under-react
by keeping, more or less, the same behavior that has
become demonstrably inadequate.
The inner problem is that mind is anchored on a reference
that tends to solidify into a tunnel vision and to be blind
to signals that may contradict this reference.
It neglects facts and ideas that do not confirm this prior,
also if often it has no logical and objective bases.
FRAMING
A selective and excessively narrow
way by which a question or a
piece of information used to take
a decision is described and
processed.
SCIENTIFIC EXPLANATION
• According to Taylor and Fiske human beings are by nature
“cognitive misers” thus meaning that they prefer to do as
little thinking as possible.
• Frames provide a quick and simple way to process an
information; using these mental filters people manage to
make sense easily of the incoming messages coming from
the external world.
INNER PROBLEMS
• The framing bias becomes easily dangerous because it
distorts the perception of an issue and the whole decision
making process. It gives a selective ( framed ) and simplistic
picture of reality that may lead to flawed decisions with
unwanted effects.
PRACTICAL EXAMPLES
1)Companies usually focus their perception on
the immediate future, they are full interested
in the short term position and, by doing so,
they run the risk of facing difficulties in the
long term.
2)Investors usually put overemphasis on the
short term risk so they prefer assets with low
return ( seen as safer ) even when they save
for the long term.
REASON OF FRAMING EXISTANCE
1) Outside reason: a representation is deliberately reductive, manipulative and non
neutral in order to achieve positive effects on the audience. It can be due to the
incompetence of the author ( in this case is done involuntarily ) or it can be
launched voluntarily by the informer to manipulate the massage.
2) Inner reason: it can be occasional ( due to lack of attention, tunnel vision but also
emotional situations that block analytic mind ) or the result of the habit to look
at information from a single angle. In this case the prior beliefs and choice criteria
may result too much selective and framed.
CONSEQUENCES
- Possibility to narrow the situation by focusing only on one aspect.
- Possibility to take a narrow approach that lead to different conclusions if
the objectives and criteria at stake in the issue change ( an investment decision
can be different if the analysis is focused on the loss prospect or on the contrary
on the gain prospect ).
RESULTS
- Thwart the ensuing reasoning, conclusions and decisions in an investment decision
making process
- Usually creates in the investor’s mind a too favorable or too unfavorable impression
and this aspect usually bring to dubious and anomalous practical effects
PARTICULARITY
There are also some positive effects that can be attributed to the framing process.
The most important one is the “wealth frame” for investments decision: it means you
have to take on account your present and expected wealth in order to choose the
right investment for yourself considering this important “personal” perspective.
Overreaction,
Overconfidenc
e, and the
Availability Bias
Group Member: Neo Zhou
Uncle
•Failure
•Too sensitive
Father
•Failure
•Too confident
OVERREACTION
VS
OVERCONFIDENCE
OVERREACTION !
A study by Behavioral Finance
academics
35 Best Performing Stocks
•Winners portfolio
35 Worst Performing Stocks
•Losers portfolio
How did it turn out?
……………………………………………………………
Winners
Portfolio
Losers Portfolio
Why does
it
happen ? ? ?
investors in the previous year overreact to
news favoring certain stocks and speaking
against the value of others
This leads to a divergence between the
fundamental fair price of these stocks and
the market price.
the information of this overreaction fades
away and the market price of the stock
converges back toward the fair price
Availability Bias
"if you can think of it,
it must be important."
Try to recall your driving behavior after
you heard that there was a car accident
happening on your daily way to school/work
Value investing
Securities
shares
underpriced
Make a gain
Stock price
converges to
the fair price
Fundamental
analysis
Investment in
these stocks
DOGS OF A DOW
Value investing
Focus on Fundamental Analysis
•
•
•
•
•
-Company Assets
-Financial Statements
-Brand Names
-Patented Technology
-Management Team
Fundamental Analysis Includes
•
•
•
•
•
-Earnings per Share
-Sales Revenue
-Asset Values
-Profit Margins
-Return on Equity
Further Practice
Warren Buffett has taken
the value investing concept
even further with a focus on
"finding an outstanding
company at a sensible price"
rather than generic
companies at a bargain price.
OVERCONFIDENCE !
People in the market,
especially men,
have overly optimistic
assessments of their
own knowledge or control
over a situation.
MERGER
PERSONAL COMPUTER
MINI COMPUTER
NETWORK STORAGE
“Risk management issue should
not only be addressed on a
corporation’s financial level.
Management should also be
involved, thus integrating it into a
daily management practice.”
--Prof. Mantovani
How do we avoid overconfidence?
We need to recognize that we’re not
as smart as we think we are. In fact,
the smartest investors (and frankly
the smartest financial advisers) are
the ones that acknowledge that
they’re dumb.
A paradigm shift has occurred since the
days of rational theories and EMH. In
the modern day, theorists recognize the
existence and importance of
psychological and cognitive factors upon
investor decisions. People are not
completely rational creatures; there is
no true “economic man.”
Investors, as humans, are all subject to
emotions, biases, and a whole host of
mental factors and make decision
making a complex but fascinating field
of study.
THE
END