1. ANOMALIES

Summary:Stock prices volatility is greater than can be justified by fundamentals (i.e. a new info about change in dividends)

Purpose:What accounts for movements in stock prices? there may be a human element adding to volatility

Excessive VolatilityRobert J. Shiller (1981) The American Economic ReviewDo stock prices move too much to be justified by subsequent changes in dividends?

High volatility of stock market prices compared to fundamental prices

Short-term momentum

Positive short-term (6-12 months) autocorrelation in stock returns (underreaction) – news is incorporated slowly into prices

Momentum Strategies:(To exploit short lags)

• Create zero-cost arbitrage portfolios by buying most winners and selling most losers of the past 3-12 months, hold them for the next 3-12 months.

• Jegadeesh and Titman (1993) and Rauwenhorst (1998): report around 1% monthly average excess returns to this strategy.

Long-term reversal

Negative long-term (3-5 years) autocorrelation in stock returns

Contrarian Strategies:(To exploit long lags)

Buy most losers and sell most winners of the past 3-5 years, hold the portfolio for the next 3-5 years. DeBondt and Thaler (1985) report significantly positive returns to this strategy

Yesterday's top performers become tomorrow's underperformers, and vice versa.

Short-lag positive and long-lag negative autocorrelation in Rt series are a violation of weak form of efficiency.

The Profitability of Technical Analysis(Trends, Trend Reversals): It may be possible to

make money by following trends.

IPO Stocks’ UnderperformanceRitter (1991): IPO stocks yield below normal returns in the 36 months following the IPO.

Investors become too optimistic about IPO firms, inflating the initial IPO return (buy at a high price, stocks later underperform)

Facebook IPO

2. Behavioral Theories Designed to Explain These

Anomalies…

Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment

• Underreaction due to Conservatism bias: Individuals are slow to change their beliefs in the

face of new evidence Information is reflected step-by-step in prices rather

than in a single step Stock prices underreact to earnings

announcementsThis creates positive short-term autocorrelation in

returns and explains the profitability of momentum rule

• Overreaction due to Representativeness Bias: Tendency of people to underweight statistical

properties of population/see patterns in random sequences/reemphasize the most recent and salient

Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment

Representativeness Bias

Investor might think that high earnings growth of a company is trending (when it is not) and overvalues the company

Stock prices overreact to consistent patterns of good/bad news, creating excessive volatility (continuing trends, then reversals)

This explains negative long-term autocorrelation in returns and profitability of contrarian strategy

Effect on the market

• Conservatism + Representativeness Bias:Short-run momentum (continuation)Long-run reversal

Daniel, Hirshleifer, Subrahmanyam The Journal of Finance (1998)DHS model

Overconfidence: An investor tends to be overconfident about the information he has generated but NOT about public signals.

Biased self-attribution:When confirming public information is received – investor’s confidence rises.When disconfirming public information is received – investor’s confidence falls only modestly, if at all.

OVERREACTION to private informationAnd UNDERREACTION to public information

Q: HOW DO THESE BIASES AFFECT MARKET BEHAVIOR? Tend to produce:- Short-run momentum- Long-run reversals

E.g. Bubbles

3. DEBATE

Shleifer and Summers Journal of Economic Perspective(1990)The Noise Trader Approach to Finance

Efficient markets approach: Random trades SHOULD cancel out.

Noise Trader approach: Random trades DO NOT cancel out.

Movements in investor sentiment are an important determinant of prices

Fama’s critique of behavioral theoriesMarket efficiency, long-term returns, and behavioral finance (1998), Journal of Financial Economics

• Long-term return anomalies – NO EVIDENCE AGAINST EFFICIENT MARKET THEORY

anomalies are chance results, underreactions are equally likely as overreactions, so they cancel each other out

unpredictability of behavioral factsmethodology problem temporarity of behavioral facts

Thaler (1999)The End of Behavior Finance“After all, to do otherwise would be irrational “

• Evidence that should worry the efficient market advocates– Volume– Volatility– Predictability Fama 1970/1991– Dividents (MM - 1958)

• Why do most large companies pay cash dividends?• And why do stock prices rise when dividends are initiated or increased?

• “Behavioral finance" will be correctly viewed as a redundant phrase

• “After all, to do otherwise [not include the human factor in trading ] would be irrational “

Summary of Behavioral Finance Theories in ONE formula: