Behavioral finance summary

By: Mohamed Ismail MegahedDBA, Finance

Behavioral Finance

Definition of Behavioral Finance

A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.

Investors

Are rational beingsConsider all information

and accurately assess its meaning

Some individuals/agents may behave irrationally or against predictions, but in the aggregate they become irrelevant.

Markets

Quickly incorporate all known information

Represent the true value of all securities

May be difficult to beat in the long term

Standard Theory of Finance

Investors

Are not totally rational

Often act based on imperfect information

Markets

In the short term, there are anomalies and excesses

Standard Theory of Finance

Conventional Finance

• Prices are correct; equal to intrinsic value.

• Resources are allocated efficiently.

• Consistent with Efficient Market Hypothesis

Behavioral Finance

• What if investors don’t behave rationally?

Behavioral Finance & Conventional Finance

The Behavioral Critique

There are two categories of irrationalities:1. Investors do not always process information

correctly. Result: Incorrect probability

distributions of future returns.2. Even when given a probability distribution of

returns, investors may make inconsistent or suboptimal decisions.

Result: They have behavioral biases.

Information Processing Critique

1. Forecasting Errors: Too much weight is placed on recent experiences.

2. Overconfidence: Investors overestimate their abilities and the precision of their forecasts.

3. Conservatism: Investors are slow to update their beliefs and under react to new information.

4. Sample Size Neglect and Representativeness: Investors are too quick to infer a pattern or trend from a small sample.

Behavioral Characteristics

1. Loss aversion2. Anchoring3. Diversification4. Disposition effect 5. Herding6. Media response7. Optimism


Loss aversionDevote significant attention to assessing riskAssess risk tolerance at least once per year

possibly using a risk tolerance questionnaireAssess gains and losses less frequently


Anchoring: describes the common human tendency to rely

too heavily on the first piece of information offered (the "anchor") when making decisions.

Be aware of investment anchorsUse relevant benchmarks in comparing the

investment portfolioBe cognizant of long-term goals, not short-term

fluctuations


DiversificationMake sure you are properly diversifiedDon’t let investment options dictate the asset

allocationWork with the financial advisor to determine

asset classes that will maximize return and reduce risk


Disposition effect The disposition effect refers to people’s

tendency to: Hang on to losers too long Sell the winners too soon

This allows them to enjoy the feeling of winning faster and defer the pain of loss


HerdingInvestors have a tendency toward “herd

behavior”“Line” study on the effects of herd behaviorDisproportionate flow of money into four and

five-star rated mutual fundsRatings have a lack of predictive value


Media responseStudy of the effects of news on investment

decisions: Two groups: one received news and one did not The group with no news outperformed

the group that received newsPeople often feel the need to react to new

informationNews is often irrelevant to long-term

performance and is often misinterpretedInformation overload can cause stress


OptimismPeople believe it is likely that:

Good things will happen to them Bad things will happen to others

They believe others are more likely to: Have a heart attack Develop cancer

They believe others are less likely to: Become rich Become famous

Behavioral Biases

1. Narrow Framing2. Mental accounting3. Regret avoidance4. Prospect theory

Behavioral Biases

Narrow Framing How the risk is described, “risky losses” vs. “risky

gains”, can affect investor decisions Investing is a series of “propositions,” not a single

event Performance should always be viewed within the

context of the total net worth Look at long-term goals, not short-term results

Mental accounting Investors may segregate accounts or monies and

take risks with their gains that they would not take with their principal.

Behavioral Biases

Regret avoidance Investors blame themselves more when an

unconventional or risky bet turns out badly.

Prospect theoryConventional view: Utility depends on level of

wealth. Behavioral view: Utility depends on changes in

current wealth.

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.

Limits to Arbitrage

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?

Limits to Arbitrage and the Law of One Price

Siamese Twin CompaniesRoyal Dutch should sell for 1.5 times ShellHave deviated from parity ratio for extended

periodsExample of fundamental risk

Equity Carve-outs3Com and PalmArbitrage limited by availability of shares for

shorting

Limits to Arbitrage and the Law of One Price

Closed-End FundsMay sell at premium or discount to NAVCan also be explained by rational return

expectations

Bubbles and Behavioral Economics

As the dot-com boom developed, it seemed to feed on itself

Investors were increasingly confident of their investment prowess

Bubbles are easier to spot after they end.Dot-com bubbleHousing bubble

Technical Analysis and Behavioral Finance

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 to losing investments.Demand for shares depends on price historyCan lead to momentum in stock prices

Trends and Corrections: The Search for Momentum

Dow Theory1.Primary trend : Long-term movement of prices,

lasting from several months to several years.2.Secondary or intermediate trend: short-term

deviations of prices from the underlying trend line and are eliminated by corrections.

3.Tertiary or minor trends: Daily fluctuations of little importance.

Sentiment Indicators

Trin Statistics:

Relative strengthMeasures the extent to which a security has

outperformed or underperformed either the market or its industry

advancingnumberadvancingvolume

decliningnumberdecliningvolume

trin

..

..


Confidence indexRatio of the average yield on 10 top-rated

corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds

Put/call ratioCall options give investors the right to buy at a

fixed exercise price and a put is the right to sell at a fixed exercise price

Change in ratio can be given a bullish or bearish interpretation


Short Interest - total number of shares that are sold shortWhen short sales are high a signal occursBullish interpretationBearish interpretation

A Warning

Although the ability to discern apparent patterns with stock market prices is irresistible—it is also possible to perceive patterns that may not exist

Thanks

Behavioral finance summary

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