Behavioral Finance Lecture(1)
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Transcript of Behavioral Finance Lecture(1)
8/2/2019 Behavioral Finance Lecture(1)
http://slidepdf.com/reader/full/behavioral-finance-lecture1 1/13
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Behavioral Finance
Behavioral Finance is the study of how human psychology emotionimpacts investment decisions
Behaviorists argue that the EMH puts an unfair burden on human
behavior The EFM assumes that all investment decisions are rational
It also assumes that if a arbitrage opportunity arises, thearbitrageurs will move in to close it assuring market efficiency
These are the two fundamental assumptions of the EMH
It is for this reason that arbitrage trading is also called convergencetrading
The trick remains to see if behavioral trading is persistent and canbe exploited
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Key Themes
Heuristics or Rules of Thumb – reduce the need forcognitive behavior Affect – Environment impacts decisions. Buy roofing stock when raining
Representativeness -The inability to select a complete and unbiased
sample. People that look like criminals are criminals
Availability – Using data which is available because it comes to mindeasily. Newsworthy vs. non-newsworthy
Anchoring – Inability to move off of an initial starting point. PNC stock is $57 per share. Value from this point
Familiarity – People tend to pick stocks that they know Overconfidence – For example most people think they are better than
average drivers. Failure to allow for regression to the mean
Status Quo – A belief that things will stay the same rather than change
Loss Aversion – People are averse to taking a loss and admit mistake
Conservatism – People tend to be conservative with forecasts
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Key Themes
When heuristics result in non-rational behavior they giverise to a bias
Framing Bias – How is the question asked? What examples of
framing can you think of?
Emotional Bias – Mood impacts investment decision.
Weather
Sporting Events
Market Impact – At times investors have an incentive to trade withthe trend that caused the missed pricing if they don’t feel themarket will correct, for example the real estate market of 2005-2007
Market Impact – Institutional investors have an incentive to
influence prices in a positive direction
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Behavioral Finance
Investors deviate from standard (rational and unbiased)decision making in at least three ways:
First is their attitude toward risk
Investors simply do not look at gains and losses the same way.Take gains and avoid losses
Second is non-bayesian expectation formation
Decisions are made with limited information
Investors use heuristics to guide decisions
Third decisions are greatly influenced by the framing of the question
For example bonds may look good when looking at short term
returns on the market and look bad when compared with longterm returns
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Overreaction and Underreaction
Behaviorists point to over and under reaction to eventsas evidence of inefficiency related to psychologicalfactors
How do EMH proponents respond?
Under and Over reaction are consistent with EMH if they eachoccur with similar frequency
How does Underreaction occur?
Investors are inclined to believe that past trends are likely torepeat and move slowly to accept new information
People are slow to update models with new information
Biased self-attribution causes people to ignore public signals
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Overreaction and Underreaction (cont)
How does overreacton occur?
Bias to exaggerate private signals about a company and ignorethe public signals
Sequential episodes of good news result in securities beingoverpriced
Sequential episodes of bad news result in securities beingundervalued
Past winners tend to be future losers and past losers tend to befuture winners – Is this behavioral or managerial?
The grandfather of all underreaction studies is the factthat stocks with positive earnings news outperform evenafter the announcements with the corollary also true.
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Other Biases
Familiarity Bias People tend to favor investments in companies they are familiar with
Relative Wealth Bias A desire to hold stocks which are perceived as being successful for peers
leads to undiversified portfolios
Sensation Seeking Bias Studies have shown that speeders trade more than non speeders which is
attributed to sensation seeking
Disposition Bias Investors are slow to sell losers and quick to sell winners
There is a reluctance to admit a mistake
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Other Biases (cont)
Informational Bias People tend to overestimate information of others while underestimating their
own
Cognitive Bias Underinformed investors tend to overestimate their ability to find value and trade
too much. Tends to occur more with men than women and more with singleinvestors vs. married investors
Framing Bias For example people are less likely to select a loss of $750 vs a 75% chance of a
loss of $1000 (also known as Prospect Theory) Hindsight bias
We tend to remember winners more than losers.
We tend to blame losers on unpredictable events
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Herding
Herd Behavior
People tend to favor investments favored by others
This goes for portfolio managers as well
Examples are numerous but include the Tulip Bulb craze of the1600s and the internet bubble of 2000s
Generally groups make better decisions than individualsand this encourages herd behavior
The Delphi teaching method
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Limits to Arbitriage
What is arbitriage?
Taking a riskless position by buying and selling an asset whichgives rise to a gain. The purchase and sale position is called a
hedge
Are hedges perfect? Hardly
If the hedge involves different underlying assets, an unexpectedchange in one would defeat the hedge
Shorts are one sided hedges. Given what we know about herdbehavior – are one sided hedges reliable?
You might not be able to borrow the stock necessary to short it
Tax posture of investor will impact arbitrage decisions – not truefor a tax exempt investor
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Limits to Arbitriage
At times you are forced to select similar securities andthe hedge will not be perfect.
For example there is no market for unleaded fuel but there is
for diesel
The Royal Dutch / Shell example
Despite the fact that these are virtually identical securities, therehave been times when deviations from the 60/40 earnings
sharing ratio have ranged from -30% to positive 10% - Why?? The most advanced reason is that they trade in two different
markets and that each stock covaries with its respective market
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Sums it all up
Richard Thaler – the father of BehaviorialFinance summed it all up when he said to
a “traditionalist”, Robert Barro at anacademic conference
He said “The difference between us is that
you assume people are as smart as youare, while I assume people are as dumbas I am”