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