Behavioral Finance

1
Behavioral Finance

• Part Two

2
Behavioral Phenomenon in Finance

• Representativeness
• Judgments based on stereotypes
• There are several market anomalies that may be
  explained by this behavior
• Stocks that outperform earnings expectations tend
  to exhibit post-announcement drift.
• There is strong evidence that stocks exhibit
  momentum in the short-run (6-12 months). Those
  stocks that did better than average this quarter
  also do better than average next quarter
• Stocks that have been extreme past losers in the
  preceding three years do better than stocks that
  have been extreme winners in the preceding three
  years.

3
Behavioral Phenomenon in Finance

• Gamblers Fallacy
• This refers to an overemphasis on mean-reverting
  behavior
• If I flip a coin and get heads 3 times in a row,
  what is the probability that the next flip will
  result in heads?
• Financial Gravity and the comeback
• May be a partial explanation to why investors are
  more willing to sell stocks that have increased
  in value rather than stocks that have declined in
  value
• Overconfidence
• Most people tend to be overconfident.
• A recent survey had over 70 of people classify
  themselves as better than average drivers.
• Overconfidence is most likely after a series of
  successes and can lead to excessive risk
  taking.
• May explain excessive trading
• Combined with restrictions on short-selling can
  lead to overvaluation

4
Behavioral Phenomenon in Finance

• Anchoring
• Anchoring refers to the tendency to place too
  much emphasis on information (even irrelevant
  information) that we are exposed to
• Many people can be slow to adjust to new
  information.
• One study asked subjects to (a) estimate whether
  the of UN countries that are in Africa is
  greater or less than a randomly selected number
  and then (b) what the correct is. The answer
  to b is highly correlated to the random number.

5
Behavioral Phenomenon in Finance

• Prospect Theory
• One component of prospect theory is that
  investors are loss averse instead of risk averse
• Most investors feel the pain of loss far more
  than they feel the joy of gain.
• One study estimates that losses are felt 2.5
  times as much as gains of the same magnitude
• A second component of prospect theory is that we
  tend to overweight very small probabilities
• May explain popularity of lotteries
• May explain why actual option prices for deep
  out-of-the-money options are higher than
  suggested by the BS model.

6
Behavioral Phenomenon in Finance

• Herd Behavior
• Many investors make buy/sell decisions not based
  on rational decision making but because everyone
  else is doing it.
• Selective Perception
• People have a tendency to recognize evidence that
  reinforces their beliefs and ignore evidence that
  contradicts their beliefs
• May explain why investor overconfidence persists

7
Behavioral Phenomenon in Finance

• Risk/Return inversion
• Many investors expect to earn higher returns on
  stocks that are less risky. For example, which
  stock do you feel will have a higher return over
  the next 5 years? Home Depot or Sketchers. Now,
  which stock do you feel is riskier?
• Get Even-itis
• Most investors will go to great lengths to avoid
  selling for a loss and are quick to sell for a
  profit.
• From January to November, investors are 1.68
  times more likely to sell a stock that has gone
  up than one that has gone down.
• This same phenomenon has been documented in
  futures traders by showing that they hold losing
  positions longer than winning positions.

8
Behavioral Phenomenon in Finance

• Mental Accounts
• Many investors place profits into a separate
  category than their initial principal. This
  house money can be lost with much less mental
  pain than the original capital.
• Dividends, as income, are easier to spend than
  original capital.

9
Behavioral Phenomenon in Finance

• Problems with Numbers
• Many investors think greater percentage increases
  are possible with low priced stocks and greater
  percentage decreases are possible with high
  priced stocks.
• Possible reason why stock splits are attractive.

10
Homework

• Knowing about behavioral finance, defend the
  traditional finance view.
• Knowing about behavioral finance, attack the
  traditional finance view.
• If investors are not rational, does stock
  valuation matter? Explain
• Explain each of the behavioral biases in this
  chapter and discuss why they are relevant from a
  financial perspective.
• Proponents of market efficiency will argue that
  in order for behavioral finance to impact market
  efficiency, not only must their be behavioral
  biases, but these biases must be consistent and
  either be pervasive (impact everyone) or if they
  are not pervasive, then there must be market
  frictions that prevent arbitrage. Discuss this.