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 • Are equity valuation errors are systematic and therefore predictable? – – – • Werner De Bondt and Richard Thaler 1985 – – • 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 – – 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. • They applied Tversky and Kahneman’s representativeness to market pricing – Overweight salient information such as recent news – Underweight salient data about long term averages • 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 • • • • 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) • Shifts in investors’ confidence cause – Negative long lag auto correlations (Contrarian strategies) – Excess volatility relative to fundamentals (variance) – Predictability about future prices • 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? • 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” – – – – • 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 – – – – 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 • 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)?