Lecture 10. Behavioral Finance Prepared by Prof. Chanyoung Eom Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Behavioral Finance Conventional Finance Prices are correct and equal to intrinsic value. Resources are allocated efficiently. Consistent with EMH Behavioral Finance What if investors don’t behave rationally? Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Irrationalities Investors do not always process information correctly, so that they have incorrect probability distributions of future returns. Even when given a correct probability distribution of returns, investors may make inconsistent or suboptimal decisions. They have behavioral biases. Biases result in less than rational decisions, even with perfect information. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Errors in Information Processing Overconfidence: Investors overestimate their abilities and the precision of their forecasts. Conservatism: Investors are slow to update their beliefs and under-react to new information. Representativeness: Investors are too quick to infer a pattern or trend from a small sample. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Overconfidence: Boys Will Be Boys Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Behavioral Biases Framing effect How the risk is described, risky losses vs. risky gains, can affect investor decisions. People tend to avoid risk when a positive frame is presented but seek risk when a negative frame is presented. Mental accounting Investors may segregate accounts or monies and take risk with their gains that they would not take with their principal. For instance, supermarket shoppers spend less money at the market when paying with cash than with their debit cards (and credit cards), even though both cash and debit cards draw on the same economic resource. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Regret avoidance Investors blame themselves more when an unconventional or risky bet turns out badly. Regret avoidance causes investors to not correct bad decisions, which can make those decisions worse. Prospect theory Conventional view: Utility depends on level of wealth. Behavioral view: Utility depends on changes in current wealth. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Prospect Theory Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Limits to Arbitrage Behavioral biases would not matter if rational arbitrageurs could fully exploit the mistakes of behavioral investors. Fundamental Risk Markets can remain irrational longer than you can remain solvent. Intrinsic value and market value may take too long to converge. Implementation Costs Transactions costs and restrictions on short selling can limit arbitrage activity. Model Risk What if you have a bad model and the market value is actually correct? Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Technical Analysis and Disposition Effect Technical analysis attempts to exploit recurring and predictable patterns in stock prices. Prices adjust gradually to a new equilibrium. Market values and intrinsic values converge slowly. Disposition effect The tendency of investors to hold on losing investments Demand for shares depends on price history. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Trends and Corrections: The Search for Momentum Dow Theory 1 2 3 Primary trend : Long-term movement of prices, lasting from several months to several years. Secondary or intermediate trend: short-term deviations of prices from the underlying trend line and are eliminated by corrections. Tertiary or minor trends: Daily fluctuations of little importance. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Graphical Illustration: The Search for Momentum Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Trends and Corrections: Moving Averages The moving average is the average level of prices over a given interval of time. Bullish signal Market price breaks through the moving average line from below. Time to buy Bearish signal When prices fall below the moving average. Time to sell Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Moving Average for Hewlett-Packard Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Warning! It is possible to perceive patterns that really don’t exist. Panel A is based on real data. Panel B is generated using returns created by a random-number generator. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Empirical Challenges Earnings surprises Stock prices adjust slowly to earnings announcements. Behavioralists claim that investors exhibit conservatism. Size Small cap stocks seem to outperform large cap stocks. Value versus growth High book value-to-stock price stocks and/or high E/P stocks outperform growth stocks. Turn-of-the-Year Effect Much of the abnormal return to small firms occurs during the first two weeks in January. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Weekend effect The average return to the S&P composite portfolio was reliably negative over weekends in the period 1953 - 1977. Contrarian effect Stocks with low returns in the past three to five years have higher average returns than stocks with high returns in the past three to five years. Momentum effect Recent past winners (portfolios formed on the last year of past returns) outperform recent past losers. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Crashes On October 19, 1987, the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released. A drop of this magnitude for no apparent reason is inconsistent with market efficiency. Bubbles Consider the tech stock bubble of the late 1990s. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Investor Sentiment Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance Reviewing the Differences Financial Economists have sorted themselves into three camps: Market efficiency Behavioral finance Those that admit that they do not know This is perhaps the most contentious area in the field. Prepared by Prof. Chanyoung Eom Lecture 10. Behavioral Finance
