Behavioral Economics Dr. D. Kuebler, SS2003 Behavioral Finance – A Challenge to Market Efficiency Henry Fiebelkorn Structure I Introduction Behavioral Finance and Overview II Market Phenomena - Anomalies III Financial Asset Pricing Theory – Behavioral Models IV Applying Behavioral Finance V Summary and Outlook Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 2 Introduction „Modern BF:is the finance application theorists ofhave psychology turned finance to financial into behavior a science, – but they the forgot behavior that it of is apractioners. social science!“ Aim: recognize, understand and avoid mistakes. State of Modern Finance: Perfect Markets & Perfect People Current State: Imperfect Markets & Perfect People Behavioral Finance: Imperfect Markets & Imperfect People Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 3 Classification Behavioral Finance Framing Aspects Heuristics Self-Concept Mental Accounting Representativeness Overconfidence Prospect Theory Availability Self-Attribution Anchoring Cognitive Dissonanz Ambiguity Aversion Self-Control Confirmation Bias Underlying Concepts: Herding 1. 2. Bounded Rationality Emotions Seminar Behavioral Economics SS 2003 Conservatism 04-07-03 Behavioral Finance | 4 Structure I Introduction Behavioral Finance and Overview II Market Phenomena - Anomalies III Financial Asset Pricing Theory – Behavioral Models IV Applying Behavioral Finance V Summary and Outlook Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 5 Anomalies Volume Volatility Dividends 1. Anomalies are consistent 2. Violate the Efficient Market Hypothesis Equity Premium Puzzle Book-to-Market Ratio Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 6 Structure I Introduction Behavioral Finance and Overview II Market Phenomena - Anomalies III Financial Asset Pricing Theory – Behavioral Models IV Applying Behavioral Finance V Summary and Outlook Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 7 Existing Approaches Model of Investor Sentiment Information Trader Noise Trader Abitrageurs: • • • Follow Standard CAPM: No cognitive errors Utility expressed motives Try to exploit Noise Trader Outside CAPM (BAPM): • • Cognitive errors: listen to gurus, follow rumors Value expressed motives = Investor Sentiment “Inefficient Markets” by Shleifer (2000) Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 8 Existing Approaches Model of Investor Sentiment Abitrage is limited because: 1. Securities don´t have obvious substitutes 2. Abitrage is risky (Risk Aversion) 3. Noise Trader Risk Price changes in absence of fundamental news! Belief about Noise Trader determines price Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 9 Existing Approaches Model of Investor Sentiment Price Determination: Two Earning Regimes: News News • Prior views • give up old model • No revaluation due to •Attach to new model due to Conservatism Representativeness Underreaction Seminar Behavioral Economics SS 2003 Overreaction 04-07-03 Behavioral Finance | 10 Existing Approaches BSV - Model Captures 2 Judgement Biases: Investors: 2 Earning Regimes: (+) Representativeness Bias Conservatism Firms´ earnings are trending Long-termChange Earnings are meanreverting Change temporarely (-) Barberis, Shleifer, Vishny (1998) Barberis, Shleifer, Vishny (1998) Overreaction of Stock Prices Underreaction of Stock Prices Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 11 Existing Approaches DHS - Model Captures 2 Judgement Biases: Overconfidence Self-Attribution (-) (+) Exaggerate Privat Information Downweight Public Information Daniel, Hirshleifer, Subramanyam (1997) Special Prediction: Selective Items Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 12 Existing Approaches Behavioral Asset Pricing Model (BAPM) Enable user to identify value of products Rational Utility Strong: Jewelry Less: Automobiles Absent: Laundry Risk: Automobiles : Laundry “Behavioral Asset Pricing Theory” by Shefrin, Statmen (1994) Utilitarian characteristics vs. Value expressed characteristics (Timex /Rolex example) Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 13 16 Model Requirements Identification of preferences of the buyers/sellers Characteristics capturing value expressive (VEC) & utilitarian preferences (UC) Behavioral Asset Pricing Model: Should include: 1. 2. 3. 4. Conclude with equilibrium prices What investors think How they asses risk How they forecast growth What rules they follow Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 14 Structure I Introduction Behavioral Finance and Overview II Market Phenomena - Anomalies III Financial Asset Pricing Theory – Behavioral Models IV Applying Behavioral Finance V Summary and Outlook Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 15 Applying Behavioral Finance Investors Limitations External Internal • • • • • Mental Accounts Heuristics Self-Deception Seminar Behavioral Economics SS 2003 • 04-07-03 Biases information Limitation of time &resources Practical restrictions Behavioral Finance | 16 Applying Behavioral Finance Emotional Feelings Performance Pressure Overload of Information Biased Information Time & Resource Constraints Seminar Behavioral Economics SS 2003 Investor Uncertainty 04-07-03 Heuristics Practical Restrictions Behavioral Finance | 17 Applying Behavioral Finance Coping with Limited Rationality „People are intendedly rational but limited to do so!“ 1. Identify / Framing 2. Editing 3. Decomposition 4. Heuristics Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 18 Applying Behavioral Finance Investment Strategies Behavior: • Overreaction • Underreaction • Extrapolation • Herd Behavior Seminar Behavioral Economics SS 2003 04-07-03 • Value Investing • Mean Reversion Strategy • Momentum Strategy • Event Studies • Earning Revision Strategies • Combination Studies Behavioral Finance | 19 Applying Behavioral Finance Behavioral Finance leads to product development • Guaranteed products Loss Aversion • RenteMaXX • Best of World Garant Fund • Daytrading Overconfidence • Hedge Funds: Absolute Return • Event driven • Opportunistic • Relative value Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 20 Structure I Introduction Behavioral Finance and Overview II Market Phenomena - Anomalies III Financial Asset Pricing Theory – Behavioral Models IV Applying Behavioral Finance V Summary and Outlook Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 21 Summary What lessons does Behavioral Finance teach us? ll Investor 1. Be aware of information biases: seek and screen information actively Market 1. Market and people are imperfect 2. There are systematic and recurring market inefficiencies 2. Avoid narrow framing, anchoring, overconfidence 3. Follow rules of decision making under uncertainty Thanks for are yourconsistent attention! and Anomalies can´t be ignored 3. Sensible implementation of irrational human behavior into asset pricing models necessary • Seminar Behavioral Economics SS 2003 04-07-03 VEC as well as UC must be included Behavioral Finance | 22