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Investment Management

Behavioural Finance

Road Map

The Efficient Markets Hypothesis (EMH): a retrospective review

Challenges to the EMH

A new paradigm: behavioural finance

Cognitive biases

Limits to speculation

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Course outline (recall)

Introduction √Market instruments and portfolio diversification √Passive asset allocation √Evaluation of portfolio performance √Equities √Interest rate theory and pricing of bonds √Managing equities and bond portfolios √Forwards and futures √Behavioural finance and investment management

Are financial markets efficient?

Fama (1970): the Efficient Market Hypothesis(EMH) states that in an efficient market prices always fully reflect the available information

− Trading strategies based upon past and current information cannot consistently beat the market

Evidence:

− 1960: theoretical and empirical support at first. Later, key forces that are supposed to create efficiency (i.e. arbitrage) are found to be weak

− 1990: efficiency is limited and significant persistent deviations from equilibrium conditions are observed

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Theoretical foundations of the EMH

Investors are rational and value assets rationally on the basis of the NPV of assets’ future cash flows

Irrational investors (if any) trade randomly without affecting prices

When there are many similar irrational traders, interactions between rational and irrational traders offset the effect of irrational trading on prices

In competitive markets and risk-neutral agents

− Returns are unpredictable, prices follow a random walk (RW)

When investors are risk-averse

− Prices do not follow a RW but rationality implies the impossibility of earning higher risk-adjusted returns

Theoretical foundations of the EMH (cont’d)

EMH does not require rationality

− There are cases where some investors are not fully rational but markets are still predicted to be efficient

EMH depends on arbitrage (= the simultaneous purchase and sale of similar securities in two different markets at advantageously different prices)

− Smart investors note mispricing (induced by irrational or noise traders) and trade to exploit it. This will reduce the mispricing towards the fundamental value

− Prices should stay close to fundamentals even if irrational traders are correlated

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Empirical foundations of the EMH

1960-1970: empirical evidence supporting EMH

− Quick and accurate response to news (= stale information is of no value in making money). Difficulties in defining

° ‘making money’ (= higher return adjusted for risk). How is risk measured? CAPM? EMH would be model dependent.

° ‘stale information’. Public as opposed to private information (weak, semi-strong and strong form of the EMH).

− No under- or over-reaction to news

− No price trends or price reversals

− Prices do not react to non-information (= arbitrage in action)

Empirical foundations of the EMH (cont’d)

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Challenges to the EMH

It is difficult to believe that investors are fully rational

− People react to irrelevant information, trade on noise rather than information

Investors deviate from economic rationality in a persistent and systematic way

− Attitudes toward risk (they do not look at the level of final wealth but at the gains and losses relative to a reference period)

− Non-bayesian expectation formation (investors deviate from Bayes rule in their prediction of uncertain events. Use short history of data. Example: overreaction to glamourousstocks, dot coms etc.)

Challenges to the EMH

Previous biases are amplified by the fact that investors often act in the market by means of professional managers whom decisions are subject to similar biases

− Delegation introduce further distortions

− Herding behaviour (managers tend to adopt strategies that other managers tend to adopt. Example: Window-dressing)

Arbitrage, which should bring prices to their fundamental values, is risky and therefore limited

− Without exact substitute assets, there is no riskless hedge for arbitrageurs

− With a finite risk-bearing capacity, the ability of arbitrageurs to bring prices to fundamentals is limited as well

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Behavioural finance

Is a newly introduced paradigm where financial markets are studied using models with less restrictive assumptions than those based on expected utility and arbitrage theory

Building blocks

− Cognitive psychology (= how investors think)

− Limits to arbitrage (= in what circumstances arbitrage forces are effective)

Cognitive biases

Heuristics, or rules of thumb, make decision-making easier. They can lead to suboptimal investment decisions (example: the 1/N rule)

Overconfidence about own investment abilities. Overconfidence generally results in too little diversification

Mental Accounting. Investors sometimes separate decisions that should be combined. (example: separate budgets for food and entertaining, currency overlay portfolios)

Framing, or the notion that how a concept is presented to individuals matters. (example: ‘after-theatre discounts’rather than ‘peak-time extra-charges’ or ‘survival probability’ rather than ‘mortality rate’)

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Cognitive biases (cont’d)

Representativeness, investors underweight long-term averages or differently investors put too much weight on recent experience: ‘law of small numbers’. (example: high equity returns as ‘normal’)Conservatism and belief perseverance, when things change, investors tend to be slow to pick up the changes. They anchor on the way things have been normal. Investors rarely search for evidence against their beliefs and if found they are skeptical (for example, confirmation bias). Representativeness bias may offset the conservative bias

Optimism and wishful thinking, many investors display unrealistically rosy views of their abilities and prospects

Cognitive biases (cont’d)

Criticisms:

− By choosing which cognitive bias to emphasiseone can predict either overreaction or underreaction!

− One could find a story to fit the facts and ex postexplaining some puzzling phenomena (model dredging)

It would be appropriate to have a model able to make ex ante predictions about which bias will dominate.

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Limits to arbitrage

In the traditional framework with rational agents and no frictions asset prices equal their fundamental values (that is the discounted value of expected future cash flows based on all available information).

Behavioural finance argues that some features of asset prices can be interpreted as deviations from fundamental value brought by the presence of traders who are not fully rational.

− arbitrage opportunities are risky (costly) and limited

Limits to arbitrage (cont’d)

Arbitrageurs’ risks and costs:

− Fundamental risk, associated with a bad news relative to assets fundamental values (imperfect substitutability)

− Noise trader risk, is the risk that the mispricing being exploited by arbitrageurs worsens in the short run (pessimistic investors may drive mispricing even lower (higher) then expected). Arbitrageurs may be forced to liquidate positions in order to avoid steeper losses

− Implementation costs

° Transaction costs

° Short-sales constraints

° Learning about mispricing

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Limits to arbitrage (cont’d)

In essence: in contrast to straightforward textbook arbitrage, real-word arbitrage entail both costs and risks which under some conditions will limit arbitrage and allow deviations from fundamental value to persist.

The case of LTCM

In February 1994 Myron Scholes, Robert Merton and others founded the Long Term Capital Management group (LTCM)

For their first 3-4 years of life they have performed spectacularly (on average 30.2%, outperforming the market by nearly 7%)

33.4%17.1%1997

23.8%30.2%average

23.1%40.8%1996

37.4%42.8%1995

1.3%19.9%1994

S&P 500LTCM

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The case of LTCM (cont’d)

In August 1998 after a bad quarter when they lost US$ 4 millions, LTCM collapsed. Paradoxically they were right in the long-run!

LTCM mainly traded in fixed income and derivatives but one of the ways they lost money was on the Royal Dutch/Shell equity arbitrage trade.

Twin shares

In 1907 Royal Dutch (the Netherlands) and Shell Transport (UK) agreed to merge on a 60:40 basis remaining separate entities

− Shares of Royal Dutch (mainly traded in the US and in the Netherlands) are claim to 60% of the total cash flow

− Shares of Shell (mainly traded in the UK) are claim to the remaining 40%

If prices = fundamental values PRD = 1.5 PS

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Twin shares (cont’d)

Twin shares

If PRD ≠ 1.5 PS there is an arbitrage profit opportunity.

The data show evidence of persistence inefficiencies

− Deviations from fundamental value are large in magnitude

− Royal Dutch is sometimes 35% underpriced relative to parity, and sometimes 15% overpriced

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Twin shares

Did LTCM make money out of it?

− in 1998 LTCM sold the expensive stock and bought the cheap one.

− They lost money when prices diverged further later at the end of 1998.

− To meet liquidity needs, LTCM was forced to sell out positions driving the market towards a more inefficient situation.

− The forces of arbitrage failed.

Application: Home biasLarge evidence suggests that investors internationally diversifytheir portfolios much less than recommended by conventional models of portfolio choice

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Application: Home bias (cont’d)

Home bias: Ambiguity and familiarity

Ambiguity offers a simple way to understand insufficient diversification (home bias)

Investor may find

− their national stock markets more familiar (therefore less ambiguous) then foreign stock indices

− Firms situated closed to them geographically more familiar than others located further away

Familiar assets are attractive and investors allocate their wealth in them because less ambiguous

Portfolios appear undiversified because conventional models of portfolio choice do not consider the investor’s degree of confidence in the probability distribution of a gamble

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Home bias: behavioural portfolio theory

Sherfin and Statman (JFQA, 2000) propose a behavioural portfolio theory

Investors divide their wealth in layers of a portfolio pyramid:

− Lower layers are designed to protect them from poverty

− Upper layers are designed to make them rich

− Different progressive layers correspond to different goals and levels of aspiration (example: investors buy bondsfor protection, mutual funds in the hope of moderate riches and individual stocks and lottery in the hope of

great riches)

Home bias: behavioural portfolio theory (cont’d)

Investors prefer

− Low risk in the lower layers of their portfolios

− High risk in the uppermost layers of their portfolios

Risk-aversion gives way to risk-seeking at the uppermost layers as they desire to avoid poverty give way to the desire for riches

Some investors fill the uppermost layers with few (international or domestic) stocks of an undiversified portfolio while others fill them with lottery tickets

Few stocks, like few lottery tickets, provide a chance for great riches while well-diversified portfolios or many lottery tickets guarantees mediocrity

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Readings

BKM, Chapter 12Other readings− Shleifer (2000), Chapter 1− Barberis and Thaler (2003), “A Survey of

Behavioural Finance” in Constantinides, G.M., Harris, M. and Stulz, R. (eds) Handbook of Economics of Finance

− Shiller, R.J. (1999), “Human behaviour and the Efficiency of Financial Markets”, in Handbook of Macroeconomics, Vol. 1, 130-540

− Shefrin and Statman (2000), “Behavioural Portfolio Theory”, Journal of Quantitative Financial Analsys,35, 127-151