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
Behavioral Characteristics
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
Behavioral Characteristics
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
Behavioral Characteristics
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
Behavioral Characteristics
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
Behavioral Characteristics
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
Behavioral Characteristics
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
Behavioral Characteristics
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
..
..
Sentiment Indicators
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
Sentiment Indicators
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
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