Behavioral Finance Definitions
Behavioral Finance, a study of investor market behavior that
derives from psychological principles of decision making, to
explain why people buy or sell the stocks they do.
The linkage of behavioral cognitive psychology, which studies
human decision making, and financial market economics.
Behavioral Finance focuses upon how investors interpret and act on
information to make informed investment decisions. Investors do
not always behave in a rational, predictable and an unbiased
manner indicated by the quantitative models. Behavioral finance
places an emphasis upon investor behavior leading to various
market anomalies.
Behavioral Finance Promise
Behavioral Finance promises to make economic models better at explaining
systematic (non-idiosyncratic) investor decisions, taking into consideration
their emotions and cognitive errors and how these influence decision making.
Behavioral Finance is not a branch of standard finance; it is its replacement,
offering a better model of humanity.
Create a long term advantage by understanding the role of investor psychology
Human flaws pointed out by the analysis of investor psychology are consistent and
predictable, and that they offer investment opportunities.
Precursors to Behavioral Finance
Value investors proposed that markets over reacted to negative news.
Benjamin Graham and David Dodd in their classic book, Security Analysis,
asserted that over reaction was the basis for a value investing style.
David Dreman in 1978 argued that stocks with low P/E ratios were undervalued,
coining the phrase overreaction hypothesis to explain why investors tend to be
pessimistic about low P/E stocks.
Tversky and Daniel Kahneman published two articles in 1974 in Science. They
showed heuristic driven errors, and in 1979 in Econometrica, they focused on
representativeness heuristic and frame dependence.
Two Important Studies
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Are equity valuation errors are systematic and therefore predictable?
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Werner De Bondt and Richard Thaler 1985
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Efficient markets view: prices follow a random walk, though prices fluctuate to extremes, they
are brought back (regression to the mean) to equilibrium in time.
Behavioral finance view: prices are pushed by investors to unsustainable levels in both
directions. Investor optimists are disappointed and pessimists are surprised. Stock prices are
future estimates, a forecast of what investors expect tomorrow’s price to be, rather than an
estimate of the present value of future payments streams.
Early studies focused on relative strength strategies that buy past winners and sell past losers
Investor Overreaction Hypothesis opposes Efficient Markets Hypothesis
Rejection of Regression to the Mean which says prices operating in the context of extreme
highs and lows balance each other
Shefrin and Statman 1985
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Disposition Effect suggests investors relate to past winners differently (they keep winners in
their portfolio) than past losers (they sell past losers)
Odean applied the Disposition Effect in vivo context
Werner De Bondt and Richard Thaler 1985 study
De Bondt and Thaler extended Dreman’s reasoning to predict a new anomaly.
They refer to representativeness, that investors become overly optimistic about
recent winners and overly pessimistic about recent losers.
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They applied Tversky and Kahneman’s representativeness to market
pricing
– Overweight salient information such as recent news
– Underweight salient data about long term averages
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Investors overreact to both bad news and good news.
De Bondt and Thaler Study
Robert Shiller proposed prices show excess volatility.
That is, dividends do not vary enough to rationally justify observed aggregate
price movements
In spite of dividends, investors seem to attach disproportionate importance to
short run economic developments.
Two Hypotheses: Each a violation of weak form market efficiency.
1. Extreme movements in stock prices will be followed by subsequent price
movements in the opposite direction.
2. The more extreme the initial price movement, the greater will be the
subsequent adjustment.
De Bondt and Thaler 1985 study (cont)
Overreaction leads past losers to become under priced and past winners to become
overpriced.
De Bondt and Thaler propose a strategy of buying recent losers and selling recent
winners. Investors become too pessimistic about past losers and overly
optimistic about past winners.
De Bondt and Thaler 1985 study (cont)
De Bondt and Thaler studied two portfolios of 35 stocks
One consisting of past extreme winners over the prior three years
One consisting of past extreme losers over the prior three years
Past losers subsequently outperformed winners over the next four years.
Past losers were up 19.6 percent relative to the market in general.
Past winners were down five percent relative to the market in general.
A difference of 24.6 percent between the two portfolios.
Study suggests that investors cause market prices to deviate from fundamental
values creating inefficient markets: due to representativeness heuristic
markets’ treatment of past winners and losers is not efficient.
De Bondt and Thaler study
Other Findings:
1. The overreaction effect is asymmetric: it is much larger for losers than
winners.
2. Most of the excess returns are realized in January. (16.6% of the 24.6%)
3. The overreaction phenomenon mostly occurs during the second and third
year of the test period. (By the end of the first year the difference in the two
portfolios is a mere 5.4%)
Critics of De Bondt and Thaler 1985 study
Reversion to the mean explanation offered by Malkeil consistent with efficient
markets hypothesis
Zsuzsanna Fluck, Richard Quandt, and Malkeil study
Simulated an investment strategy of buying stocks which had poor recent two
or three year performance.
They found: in the 1980s, 1990s, those stocks did enjoy improved returns in
the next period of time, but they recovered only to the average stock market
performance.
It was a statistical pattern of return reversal, but to appropriate levels (they did
not overshoot levels).
Fama and French; and Poterba and Summers studies:
More Critics
Two alternative Hypotheses: to overreaction.
1. Risk Change Hypothesis: overreaction is rational response to risk changes
(short term earnings outlook changes) as measured by Betas
2. Firm size: past loser portfolio made up of small firms
Disturbing factors
1. Seasonal pattern of returns (January “turn of the year” effect)
2. The characteristics of the firms in the portfolios (Small size)
3. Co-relation is asymmetric
De Bondt and Thaler’s response
The data do not support either of these explanations. It is emotional shifts in
mood of investors—biased expectations of the future, not rational shifts in
economic conditions
see also, 1990 paper: Do Security Analysts Overreact? yes
But what about?
Jegadeesh demonstrated shorter term reversals: one week or one month
though these results are “transaction intense”
Grinblatt and Titman 1989, 1991 relative strength strategies: they showed a
tendency to buy stocks that have increased in price over the previous quarter,
based on past relative strength
Integrating results
Contrarian strategies work with
1. Very short periods (one week, one month)
2. Very long periods (3 to 5 years)
Growth (relative strength strategies) work with three to 12 months
Jegadeesh and Titman (1993) studied period 1965-89 found:
three to 12 months earned average of 9.5% (six months earned 12%)
then reversals, 12-24 months lost 4.5%
for earnings announcements:
past winners earned positive returns for the first seven months
past losers earned positive returns for 13 month period assessment
Dreman’s research
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Sample of 1500 largest stocks, each over a billion in capitalization
Develop a portfolio of stocks with low P/E ratio
Portfolio established in 1970
By 1997 portfolio grew from $10,000 to $909,000 while the market benchmark was
$326,000.
Contrarian portfolios did better in down markets
During down quarters over the years, market averaged down 7.5%; Contrarian portfolio
down 4%
Dreman emphasized the importance of reinforcing events and “event triggers” creating
perceptual change
• Positive Surprises are very favorable for unpopular stocks (not so for popular stocks)
• Negative Surprises are very consequential for popular stocks (not so for unpopular
stocks)
What it means?
Consistent with “positive feedback traders” hypothesis on market price
Market under reacts to information about the short term prospects of firms but
overreacts to information about their long term prospects
This is plausible given that the nature of the information available about
a firm’s short term prospects, such as earnings forecasts, is different form the
nature of the more ambiguous information that is used by investors to assess a
firm’s longer term prospects
David Dreman: Contrarian strategies do better than the market over time
Importance of earnings surprises on popular and unpopular stocks
reveals a market sentiment is significant
Specific over and under market reactions
Markets over react to IPOs
Markets under react to: earnings announcements, dividend announcements, open
market share repurchases, brokerage recommendations
Investors systematically under weight (conservative):
abstract, statistical, and highly relevant information,
while they over weight (representativeness heuristic)
salient, anecdotal, and extreme information
Explanations/Theories for Under and Over reaction
Kent Daniel, David Hirshleifer and Avanidhar Subrahmanyam
“Investor Overconfidence and biased self attribution”
Variations in investor confidence which is an over estimation of ability to
value stocks and predict future prices arising from biased self attribution
which is confirming information in the public arena encourages but
disconfirming information does not discourage, (blames others) leads to
market over and under reaction to information)
Daniel, Hirshleifer and Subrahmanyan (cont)
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Shifts in investors’ confidence cause
– Negative long lag auto correlations (Contrarian strategies)
– Excess volatility relative to fundamentals (variance)
– Predictability about future prices
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Shifts in investors’ self attribution cause
– Short lag autocorrelation (momentum strategies)
– Short run earnings drift in the direction of earnings surprise
– Abnormal stock performance in the opposite direction of long term earnings
changes. (Negative correlation between future returns and long term past stock
market performance)
Daniel, Hirshleifer and Subrahmanyan (cont)
Theory is based on investor overconfidence, and on changes in confidence
resulting from biased self attribution of investment outcomes
• Investors will overreact to private information signals creates momentum in
price (either absent public information to support price, or assuming public
information confirm private signals, or….
• Investors will under react to public information signals (avoids correction in
stock price until it goes to extreme)
Unlike noise trader approach, this theory posits that investors misinterpret genuine
new private information.
Explanations/Theories (cont)
Barberis, Shlieifer and Vishny 1998
Learning model explanation
Actual earnings follow a random walk, but individual s believe that
earnings follow either a steady growth trend, or else
earnings are mean reverting.
Representativeness heuristic (finds patterns in data too readily, tends to over react to
information) and conservatism (clings to prior beliefs, under reacts to information).
Interaction of representativeness heuristic and conservatism: explains short term under
reaction and long term over reaction
Investor’s reaction to current information condition on past information. Investor tends
to under react to information that is preceded by a small quantity of similar information
and to over react to information that is preceded by a large quantity of similar
information.
Explanations/Theories (cont)
Hong and Stein 1997
Under and Over reactions arise from the interaction of momentum traders and
news watchers
Momentum traders make partial use of the information continued in recent price
trends, and ignore fundamental news
Fundamental traders rationally use fundamental news but ignore prices.
Explanations/Theories (cont)
Bloomfiled, Libby and Nelson
Traders in experimental markets undervalue the information of others
People with evidence that is favorable but unrealizable tend to overreact to
information, whereas people with evidence that is somewhat favorable but
reliable under react
Optimism, Overconfidence, and Odean’s Research
People are overly optimistic
• People believe that they are less likely to get hit by a bus or be robbed than
their neighbors
People are overconfident in their own abilities
• Driving skills and social skills are better
• New business owners believe their business has a 70% chance of success, but
only 30% succeed
• Helps soldiers cope with war
Overconfidence and the stock market
• Overconfidence can lead to substantial losses when investors overestimate
their ability to identify the next Microsoft or Amazon
• Securities that investors purchase under perform those they sell
Benartzi, Kahneman and Thaler survey on
Overconfidence
Survey of Morningstar 1053 subscribers
• 84% male, average age is 45, annual in come $93,000
• Average allocation to stocks is 79%
• Optimism question:
– Thinking about financial decisions, do you spend more time thinking about the
potential return or the possible loss?
– What do you think is the likelihood of stocks outperforming bonds in the long run?
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Overconfidence and Optimism decided by
– Answer to the question about likelihood of stocks outperforming bonds
– Asset allocation of retirement contributions of stocks vs. bonds
Odean’s study of overconfidence in the marketplace
What happens in financial markets when people are overconfident?
• Trading volume increases: overconfidence generates trading. Those who trade
more frequently fare worse than those who trade less
• Overconfident traders hold under-diversified portfolios; riskier portfolios
though they have the same degree of risk aversion
• Overconfident insiders improve price quality; overconfident noise traders
worsen it
• Men are more overconfident than women; men trade more frequently (45%
more) than women, men earn less returns than women (one percent less).
• Single men and single women the results are larger (67% more trading, 1.4%
less)
Trading Behavior and Returns
Individual investors who hold common stock directly pay a tremendous
performance penalty for active trading
• Odean study “trading can be hazardous to your wealth”
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Studied 66,465 households from 1991 to 1996
Most frequent traders earn 11.4% (turn over 75% of portfolio)
Average household earned 16.4%
Market benchmark was 17.9%
Odean study on On line traders
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Studied 1607 traders on line, compared with 1607 telephone traders
On line traders experienced strong performance prior to going on line
After on line, less profitable, lagging the market by three points
Explained by overconfidence, self attribution bias, illusion of knowledge, and
illusion of control
Overconfidence and the Disposition Effect
Investors weight recent observations too heavily (representativeness heuristic)
Investors under weight prior information
Investors commit the gambler’s fallacy: expecting recent events (downturns in
stock prices) to reverse
Disposition effect: Investors hold on to losers in their portfolio (because they can’t
be wrong), and sell winners.
Investors judge their decision on the basis of the returns realized not paper money
returns, then holding losers will avoid confronting their true abilities.
Investors won’t learn from mistakes, continue as overconfident.
Odean’s research confirms Disposition Effect
Odean looks at trading decisions of investors at discount brokerage
Stocks traders buy under perform those that they sell
Level of Over-confidence changes dynamically
Depending upon the success of failure, level of overconfidence changes
• A trader is not overconfident when he begins to trade
• Overconfidence increase over his first several trading periods early in his
career
– These overconfident traders survive the threat of arbitrage, that is, they are not the
poorest traders
– Initial success increases overconfidence
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Overconfidence declines thereafter
Homework Assignment: Disposition Effect and De
Bondt and Thaler’s study
Homework assignment: How do you square the Disposition Effect with the Price
Reversals Literature (see De Bondt and Thaler 1985 study)?