CHAPTER TEN: BEHAVIORIAL FINANCE potx

CHAPTER TEN: BEHAVIORIAL FINANCE 06/08/2011 1 DEFINITIONS Behavioral Finance, a study of investor market behavior that derives from psychological principles of decision making, to explain why people buy or sell the stocks they do. The linkage of behavioral cognitive psychology, which studies human decision making, and financial market economics. Behavioral Finance focuses upon how investors interpret and act on information to make informed investment decisions. Investors do not always behave in a rational, predictable and an unbiased manner indicated by the quantitative models. Behavioral finance places an emphasis upon investor behavior leading to various market anomalies. 06/08/2011 2 PROMISE Behavioral Finance promises to make economic models better at explaining systematic (non-idiosyncratic) investor decisions, taking into consideration their emotions and cognitive errors and how these influence decision making. Behavioral Finance is not a branch of standard finance; it is its replacement, offering a better model of humanity. Create a long term advantage by understanding the role of investor psychology Human flaws pointed out by the analysis of investor psychology are consistent and predictable, and that they offer investment opportunities. 06/08/2011 3 PRECUSORS Value investors proposed that markets over reacted to negative news. Benjamin Graham and David Dodd in their classic book, Security Analysis, asserted that over reaction was the basis for a value investing style. David Dreman in 1978 argued that stocks with low P/E ratios were undervalued, coining the phrase overreaction hypothesis to explain why investors tend to be pessimistic about low P/E stocks. Tversky and Daniel Kahneman published two articles in 1974 in Science. They showed heuristic driven errors, and in 1979 in Econometrica, they focused on representativeness heuristic and frame dependence. 06/08/2011 4 Two Important Studies • Are equity valuation errors are systematic and therefore predictable? – Efficient markets view: prices follow a random walk, though prices fluctuate to extremes, they are brought back (regression to the mean) to equilibrium in time. – Behavioral finance view: prices are pushed by investors to unsustainable levels in both directions. Investor optimists are disappointed and pessimists are surprised. Stock prices are future estimates, a forecast of what investors expect tomorrow’s price to be, rather than an estimate of the present value of future payments streams. – Early studies focused on relative strength strategies that buy past winners and sell past losers • Werner De Bondt and Richard Thaler 1985 – Investor Overreaction Hypothesis opposes Efficient Markets Hypothesis – Rejection of Regression to the Mean which says prices operating in the context of extreme highs and lows balance each other • Shefrin and Statman 1985 – Disposition Effect suggests investors relate to past winners differently (they keep winners in their portfolio) than past losers (they sell past losers) – Odean applied the Disposition Effect in vivo context 06/08/2011 5 Werner De Bondt and Richard Thaler 1985 study De Bondt and Thaler extended Dreman’s reasoning to predict a new anomaly. They refer to representativeness, that investors become overly optimistic about recent winners and overly pessimistic about recent losers. • They applied Tversky and Kahneman’s representativeness to market pricing – Overweight salient information such as recent news – Underweight salient data about long term averages • Investors overreact to both bad news and good news. 06/08/2011 6 De Bondt and Thaler Study Robert Shiller proposed prices show excess volatility. That is, dividends do not vary enough to rationally justify observed aggregate price movements. In spite of dividends, investors seem to attach disproportionate importance to short run economic developments. Two Hypotheses: Each a violation of weak form market efficiency. 1. Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction. 2. The more extreme the initial price movement, the greater will be the subsequent adjustment. 06/08/2011 7 De Bondt and Thaler 1985 study (cont) Overreaction leads past losers to become under priced and past winners to become overpriced. De Bondt and Thaler propose a strategy of buying recent losers and selling recent winners. Investors become too pessimistic about past losers and overly optimistic about past winners. 06/08/2011 8 De Bondt and Thaler 1985 study (cont) De Bondt and Thaler studied two portfolios of 35 stocks: One consisting of past extreme winners over the prior three years One consisting of past extreme losers over the prior three years Past losers subsequently outperformed winners over the next four years. Past losers were up 19.6 percent relative to the market in general. Past winners were down five percent relative to the market in general. A difference of 24.6 percent between the two portfolios. Study suggests that investors cause market prices to deviate from fundamental values creating inefficient markets: due to representativeness heuristic markets’ treatment of past winners and losers is not efficient. 06/08/2011 9 De Bondt and Thaler study Other Findings: 1. The overreaction effect is asymmetric: it is much larger for losers than winners. 2. Most of the excess returns are realized in January. (16.6% of the 24.6%) 3. The overreaction phenomenon mostly occurs during the second and third year of the test period. (By the end of the first year the difference in the two portfolios is a mere 5.4%) 06/08/2011 10 . CHAPTER TEN: BEHAVIORIAL FINANCE 06/08/2011 1 DEFINITIONS Behavioral Finance, a study of investor market behavior that derives from. the quantitative models. Behavioral finance places an emphasis upon investor behavior leading to various market anomalies. 06/08/2011 2 PROMISE Behavioral Finance promises to make economic models. emotions and cognitive errors and how these influence decision making. Behavioral Finance is not a branch of standard finance; it is its replacement, offering a better model of humanity. Create a