2018, Study Session # 3, Reading # “THE BEHAVIORAL FINANCE PERSPECTIVE” REM = Rational Economic Man INTRODUCTION BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES Traditional VS Behavioral Finance Traditional Finance Behavioral Finance Grounded in neoclassical economics Individuals are assumed to be rational, risk averse & utility maximizers Traditional finance believes in EMH Grounded in psychology Based on observed financial behavior rather than idealized financial behavior Classification Behavioral Finance Micro Describe decision making process of individuals Cognitive errors & emotional biases Behavioral Finance Macro Consider anomalies that distinguish market from efficient markets 2.1 Traditional Finance Perspectives on Individual Behavior Traditional finance assumes: Investors are risk averse & self interested Investors make decisions based on utility theory & revise expectations consistent with Bayes’ formula Efficient Markets 2.1.1 Utility Theory and Bayes’ Formula People maximize the PV of expected utility subject to their budget constraints Expected utility = weighted sum of the utility values of outcomes × Probabilities A rational investor make decision based on following axioms of utility theory: Completeness ⇒ an individual has well defined preferences & can decide b/w two alternatives Transitivity ⇒ as an individual decides according to completeness axiom, an individual decides consistently Independence⇒ assumes preference order of two choices combined with third choice maintains the same preference order Continuity ⇒Indifferent curves (IC) are smooth & unbroken (continuous) Bayes’ formula: New information is assumed to update beliefs about probabilities according to Bayes’ formula Application of conditional probability Assumes that events are mutually exclusive & exhaustive with known probabilities ܲ ሺܣ⁄ܤሻ = ቂ ሺ⁄ሻ ሺሻ ቃ ܲሺܣሻ Where P (A/B) & (P (B/A)) = conditional probability of event A, (B) given B, (A) P (B) = prior probability of event B P (A) = prior probability of event A Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # 2.1.2 Rational Economic Man REM: Maximize utility given budget constraints & available information Selfishly seek the personal utility maximizing decision Tries to minimize economic cost Govern by perfect rationality, perfect self-interest & perfect information principles 2.1.3 Perfect Rationality, Self-Interest, & Information Prefect rationality ⇒ REM is a rational thinker (ability to reason & make beneficial judgments) Prefect self interest ⇒ REM is perfectly selfish Perfect information ⇒ REM has perfect knowledge of every subject 2.1.4 Risk Aversion Risk Attitudes Risk Averse Risk Neutral Investors who prefer a certain alternative over an uncertain one (same expected value) Diminishing marginal utility of wealth (concave utility function) Investors are indifferent b/w a certain & uncertain alternative Constant marginal utility of wealth Linear utility function Risk Seeking Investors who prefer to invest in uncertain alternatives Increasing marginal utility of wealth (convex function) Expected utility theory assumes that investors are risk averse (utility functions are concave & diminishing marginal utility of wealth) Certainty equivalent ⇒ max sum of money a person would pay to participate or minimum amount of money a person would accept to not participate in an event with uncertain outcome 2.2 Behavioral Finance Perspectives on Individual Behavior Behavioral finance challenges assumptions of traditional finance on the following grounds: Investors may be unable to make decisions based on utility theory & revise expectations consistent with the Bayes’ formula Perfect rationality, self interest & prefect information principles’ violation 2.2.1 Challenges to Rational Economic Man Bounded rationality ⇒ individual’s choices are subject to knowledge & cognitive limitations REM ignores the fact that people can have difficulty prioritizing short term v/s long term goals Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # 2.2.2 Utility Maximization and Counterpoint An IC depicts all possible combination of two goods amongst which an individual is indifferent For perfect substitutes (complements), the IC is a line with constant slope (L-shaped) IC analysis fails to consider exogenous factors (e.g risk aversion, individual’s circumstances etc) 2.2.3 Attitudes toward Risk Risk evaluation depends on the: Wealth level Circumstances of the decision maker Double inflection utility function ⇒ utility function that changes based on level of wealth Investors are risk averse at & income levels Investors are risk seeking at moderate income levels Prospect theory ⇒ Shape of a decision maker’s value function differs for G&L Value function is normally concave for gains, convex for losses & steeper for losses than for gains 2.3 Neuro-economics Explain how humans make economic decisions under uncertainty Neuro-economics explains: Overconfidence & market overreaction A panicked rather than analytical response after falling market DECISION MAKING Prospect theory & bounded rationality are based on how people behave & make decisions(behavioral finance based) Expected utility & decision theories are based on how people should& make decisions (traditional finance based) 3.1 Decision Theory Indentify values, probabilities & other uncertainties relevant to a decision & using that information to arrive at a theoretically optimal decision Based on expected value & traditional finance assumptions Expected utility can vary from person to person (based on the worth assigned by the decision maker) Expected value is same for every one (based on price) 3.2 Bounded Rationality Subjective expected utility theory ⇒ probability distributions of all relevant variables can be provided by the decision makers Bounded rationality & satisfice ⇒ situation where people gather some available information, use heuristics to analyze the information & stop at a satisfactory decision Satisficing ⇒ finding an acceptable solution as opposed to optimizing Investor takes steps to achieve intermediate goals, as long as they advance the investor towards the desired goals Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # 3.3 Prospect Theory Investors analyze risk relative to possible gains & losses rather than relative to expected return Investors are more concerned with the change in wealth & place greater value on a loss than on a gain of same amount Phases to Making a Choice Editing Phase 3.3.1 Evaluation Phase Prospects are framed as gains or losses using heuristics Steps in Editing Codification Investors identify & code outcomes as gains or losses & assign a probability to each People compute a value function based on potential outcomes & their probabilities ܷ = ܹሺܲଵሻ ܸ ሺܺଵ ሻ + ܹሺܲଶሻ ܸሺܺଶ ሻ Where ܺଵ , ܺଶ = Potential outcomes ܲଵ, ܲଶ = Probabilities W = Probability weighting function V = Function that assigns a value to an outcome The value function states: People overreact (underreact) small (mid-sized & large) probabilities events People are loss averse Preferences are determined by attitudes towards gains & losses Combination Investor combines those outcomes with identical value Segregation The riskless component of any prospect is separated from its risky component Cancellation Identical outcomes b/w choices can be eliminated Simplification Investors will tend not to think in precise numbers (rounded off the prospects) Detection of Dominance Investor will eliminate any choice that is strictly dominated by another Isolation effect⇒ investors focus on one factor or outcome while eliminating or ignoring others Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # PERSPECTIVES ON MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION 4.1 Traditional Perspectives on Market Behavior Traditional finance assumes EMH 4.1.1 Review of the Efficient Market Hypothesis EMH assumes: Market participants are REM Population updates its expectations as new relevant information appears Relevant information is freely available to all participants Forms of Market Efficiency Weak Form Semi-Strong Form Consistently excess return is not possible using technical analysis Reflect all historical price &volume data Strong Form All publically available information is fully reflected in securities prices Excess return on continuous basis is not possible using technical & fundamental analysis All public & private information is fully reflected in securities prices Even insiders are unable to generate excess return on consistent basis Grossman-Stiglitz paradox ⇒prices must offer returns to information acquisition otherwise the market can’t be efficient 4.1.2 Studies in Support of the EMH 4.1.2.1 Support for the Weak Form of the EMH Test whether security prices are serially correlated or whether they are random Studies conclude that security prices are random, (support weak form of the EMH) 4.1.2.2 Support for the Semi-Strong Form of the EMH Event studies Announcement of the event (not event itself) appear to be reflected in prices 4.1.3 Studies Challenging the EMH: Anomalies 4.1.3.1 Fundamental Anomalies Investor generates excess return based on some fundamental characteristics of the firm Small cap firms appear to outperform large cap firms Value stocks appear to outperform growth stocks 4.1.3.2 Technical Moving average ⇒ if the short (long) moving avg prices rise above the long (short) avg prices, this is an indication of strength (weakness) Resistance level ⇒ price will climb to the resistance level & then reverse direction (act like a ceiling) Support level ⇒ floor price (price will move upward after support level reached) Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # 4.1.3 Studies Challenging the EMH: Anomalies 4.1.3.3 Calendar Anomalies 4.1.3.4 Anomalies: Conclusion January effect ⇒ stocks deliver abnormally returns during the month of January Turn-of-the month effect ⇒ stocks earn returns on the last day & 1st four days of each month Markets are neither perfectly efficient not completely anomalous 4.1.3.5 Limits to Arbitrage Uncertain need for liquidity limits the ability of arbitrage to force prices to their intrinsic values Implicit in the limit to the arbitrage idea is that the EMH does not hold 4.2 Traditional Perspectives on Portfolio Construction Rational portfolio: Meets investor’s objective & constraints Choose from mean-variance efficient portfolios 4.3 Alternative Models of Market Behaviorand Portfolio Construction 4.3.1 A Behavioral Approach to Consumption and Savings Behavioral life-cycle theory incorporates: Self control bias ⇒ short-term satisfaction to the detriment of long-term goals Mental accounting ⇒ people ignore the fact that wealth is fungible (interchangeable) & assign different portions of their wealth to meet different goals Framing bias ⇒results in different responses based on how questions are asked (framed) 4.3.2 A Behavioral Approach toAsset Pricing Behavioral assets pricing model adds a sentiment premium (stochastic discount factor) to discount rate Required return on an asset = Rf + fundamental risk premium + sentiment premium Sentiment premium ⇒ based on analysts’ forecasts The dispersion of analysts’ forecasts, the sentiment premium, the discount rate & the perceived value of the assets 4.3.3 Behavioral PortfolioTheory Uses of probability-weighting function rather than the real probability distribution Investor’s structure their portfolio in layers & composition of each layer is determined by interaction of following five factors The importance of the goals Required return The investor’s utility function Access to information Loss aversion Optimal portfolio ⇒combination of riskless & highly speculative assets (may not be mean-variance efficient) Copyright © FinQuiz.com All rights reserved 2018, Study Session # 3, Reading # 4.3.4 Adaptive Markets Hypothesis Revised version of the EMH that considers bounded rationality, Satisficing& evolutionary principles The competition & adaptable the participants, the likelihood of not surviving Five implications: Risk premiums change over time Active management can add value Consistent outperformance is impossible Investors must adapt to survive Survival is the essential objective Copyright © FinQuiz.com All rights reserved ... difficulty prioritizing short term v/s long term goals Copyright © FinQuiz. com All rights reserved 20 18, Study Session # 3, Reading # 2. 2 .2 Utility Maximization and Counterpoint An IC depicts all possible... they advance the investor towards the desired goals Copyright © FinQuiz. com All rights reserved 20 18, Study Session # 3, Reading # 3. 3 Prospect Theory Investors analyze risk relative to possible.. .20 18, Study Session # 3, Reading # 2. 1 .2 Rational Economic Man REM: Maximize utility given budget constraints & available