Behavioral Finance Definitions

1
Behavioral Finance 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.

2
Behavioral Finance 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.

3
Precursors to Behavioral Finance

• 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.

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 tomorrows 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

5
Werner De Bondt and Richard Thaler 1985 study

• De Bondt and Thaler extended Dremans 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 Kahnemans
  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.

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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.

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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.

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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.

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)

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Critics of De Bondt and Thaler 1985 study

• Reversion to the mean explanation offered by
  Malkeil consistent with efficient markets
  hypothesis
• Zsuzsanna Fluck, Richard Quandt, and Malkeil
  study
• Simulated an investment strategy of buying
  stocks which had poor recent two or three year
  performance.
• They found in the 1980s, 1990s, those stocks
  did enjoy improved returns in the next period of
  time, but they recovered only to the average
  stock market performance.
• It was a statistical pattern of return reversal,
  but to appropriate levels (they did not overshoot
  levels).
• Fama and French and Poterba and Summers studies
  

11
More Critics

• Two alternative Hypotheses to overreaction.
• 1. Risk Change Hypothesis overreaction is
  rational response to risk changes (short term
  earnings outlook changes) as measured by Betas
• 2. Firm size past loser portfolio made up of
  small firms
• Disturbing factors
• 1. Seasonal pattern of returns (January turn
  of the year effect)
• 2. The characteristics of the firms in the
  portfolios (Small size)
• 3. Co-relation is asymmetric
• De Bondt and Thalers response
• The data do not support either of these
  explanations. It is emotional shifts in mood of
  investorsbiased expectations of the future, not
  rational shifts in economic conditions
• see also, 1990 paper Do Security Analysts
  Overreact? yes

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But what about?

• Jegadeesh demonstrated shorter term reversals
  one week or one month
• though these results are transaction intense
• Grinblatt and Titman 1989, 1991 relative strength
  strategies they showed a tendency to buy stocks
  that have increased in price over the previous
  quarter, based on past relative strength

13
Integrating results

• Contrarian strategies work with
• 1. Very short periods (one week, one month)
• 2. Very long periods (3 to 5 years)
• Growth (relative strength strategies) work with
  three to 12 months
• Jegadeesh and Titman (1993) studied period
  1965-89 found
• three to 12 months earned average of 9.5 (six
  months earned 12)
• then reversals, 12-24 months lost 4.5
• for earnings announcements
• past winners earned positive returns for the
  first seven months
• past losers earned positive returns for 13 month
  period assessment

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Dremans research

• Sample of 1500 largest stocks, each over a
  billion in capitalization
• Develop a portfolio of stocks with low P/E ratio
• Portfolio established in 1970
• By 1997 portfolio grew from 10,000 to 909,000
  while the market benchmark was 326,000.
• Contrarian portfolios did better in down markets
• During down quarters over the years, market
  averaged down 7.5 Contrarian portfolio down 4
• Dreman emphasized the importance of reinforcing
  events and event triggers creating perceptual
  change
• Positive Surprises are very favorable for
  unpopular stocks (not so for popular stocks)
• Negative Surprises are very consequential for
  popular stocks (not so for unpopular stocks)

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What it means?

• Consistent with positive feedback traders
  hypothesis on market price
• Market under reacts to information about the
  short term prospects of firms but overreacts to
  information about their long term prospects
• This is plausible given that the nature of the
  information available about a firms short term
  prospects, such as earnings forecasts, is
  different form the nature of the more ambiguous
  information that is used by investors to assess a
  firms longer term prospects
• David Dreman Contrarian strategies do better
  than the market over time
• Importance of earnings surprises on popular and
  unpopular stocks reveals a market sentiment is
  significant

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Specific over and under market reactions

• Markets over react to IPOs
• Markets under react to earnings announcements,
  dividend announcements, open market share
  repurchases, brokerage recommendations
• Investors systematically under weight
  (conservative)
• abstract, statistical, and highly relevant
  information,
• while they over weight (representativeness
  heuristic)
• salient, anecdotal, and extreme information

17
Explanations/Theories for Under and Over reaction

• Kent Daniel, David Hirshleifer and Avanidhar
  Subrahmanyam
• Investor Overconfidence and biased self
  attribution
• Variations in investor confidence which is an
  over estimation of ability to value stocks and
  predict future prices arising from biased self
  attribution
• which is confirming information in the public
  arena encourages but disconfirming information
  does not discourage, (blames others) leads to
  market over and under reaction to information)

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Daniel, Hirshleifer and Subrahmanyan (cont)

• Shifts in investors confidence cause
• Negative long lag auto correlations (Contrarian
  strategies)
• Excess volatility relative to fundamentals
  (variance)
• Predictability about future prices
• Shifts in investors self attribution cause
• Short lag autocorrelation (momentum strategies)
• Short run earnings drift in the direction of
  earnings surprise
• Abnormal stock performance in the opposite
  direction of long term earnings changes.
  (Negative correlation between future returns and
  long term past stock market performance)

19
Daniel, Hirshleifer and Subrahmanyan (cont)

• Theory is based on investor overconfidence, and
  on changes in confidence resulting from biased
  self attribution of investment outcomes
• Investors will overreact to private information
  signals creates momentum in price (either absent
  public information to support price, or assuming
  public information confirm private signals, or.
• Investors will under react to public information
  signals (avoids correction in stock price until
  it goes to extreme)
• Unlike noise trader approach, this theory posits
  that investors misinterpret genuine new private
  information.

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Explanations/Theories (cont)

• Barberis, Shlieifer and Vishny 1998
• Learning model explanation
• Actual earnings follow a random walk, but
  individual s believe that
• earnings follow either a steady growth trend,
  or else
• earnings are mean reverting.
• Representativeness heuristic (finds patterns in
  data too readily, tends to over react to
  information) and conservatism (clings to prior
  beliefs, under reacts to information).
• Interaction of representativeness heuristic and
  conservatism explains short term under reaction
  and long term over reaction
• Investors reaction to current information
  condition on past information. Investor tends to
  under react to information that is preceded by a
  small quantity of similar information and to over
  react to information that is preceded by a large
  quantity of similar information.

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Explanations/Theories (cont)

• Hong and Stein 1997
• Under and Over reactions arise from the
  interaction of momentum traders and news watchers
• Momentum traders make partial use of the
  information continued in recent price trends, and
  ignore fundamental news
• Fundamental traders rationally use fundamental
  news but ignore prices.

22
Explanations/Theories (cont)

• Bloomfiled, Libby and Nelson
• Traders in experimental markets undervalue the
  information of others
• People with evidence that is favorable but
  unrealizable tend to overreact to information,
  whereas people with evidence that is somewhat
  favorable but reliable under react

23
Optimism, Overconfidence, and Odeans Research

• People are overly optimistic
• People believe that they are less likely to get
  hit by a bus or be robbed than their neighbors
• People are overconfident in their own abilities
• Driving skills and social skills are better
• New business owners believe their business has a
  70 chance of success, but only 30 succeed
• Helps soldiers cope with war
• Overconfidence and the stock market
• Overconfidence can lead to substantial losses
  when investors overestimate their ability to
  identify the next Microsoft or Amazon
• Securities that investors purchase under perform
  those they sell

24
Benartzi, Kahneman and Thaler survey on
Overconfidence

• Survey of Morningstar 1053 subscribers
• 84 male, average age is 45, annual in come
  93,000
• Average allocation to stocks is 79
• Optimism question
• Thinking about financial decisions, do you spend
  more time thinking about the potential return or
  the possible loss?
• What do you think is the likelihood of stocks
  outperforming bonds in the long run?
• Overconfidence and Optimism decided by
• Answer to the question about likelihood of stocks
  outperforming bonds
• Asset allocation of retirement contributions of
  stocks vs. bonds

25
Odeans study of overconfidence in the marketplace

• What happens in financial markets when people are
  overconfident?
• Trading volume increases overconfidence
  generates trading. Those who trade more
  frequently fare worse than those who trade less
• Overconfident traders hold under-diversified
  portfolios riskier portfolios though they have
  the same degree of risk aversion
• Overconfident insiders improve price quality
  overconfident noise traders worsen it
• Men are more overconfident than women men trade
  more frequently (45 more) than women, men earn
  less returns than women (one percent less).
• Single men and single women the results are
  larger (67 more trading, 1.4 less)

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Trading Behavior and Returns

• Individual investors who hold common stock
  directly pay a tremendous performance penalty for
  active trading
• Odean study trading can be hazardous to your
  wealth
• Studied 66,465 households from 1991 to 1996
• Most frequent traders earn 11.4 (turn over 75
  of portfolio)
• Average household earned 16.4
• Market benchmark was 17.9
• Odean study on On line traders
• Studied 1607 traders on line, compared with 1607
  telephone traders
• On line traders experienced strong performance
  prior to going on line
• After on line, less profitable, lagging the
  market by three points
• Explained by overconfidence, self attribution
  bias, illusion of knowledge, and illusion of
  control

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Overconfidence and the Disposition Effect

• Investors weight recent observations too heavily
  (representativeness heuristic)
• Investors under weight prior information
• Investors commit the gamblers fallacy
  expecting recent events (downturns in stock
  prices) to reverse
• Disposition effect Investors hold on to losers
  in their portfolio (because they cant be wrong),
  and sell winners.
• Investors judge their decision on the basis of
  the returns realized not paper money returns,
  then holding losers will avoid confronting their
  true abilities.
• Investors wont learn from mistakes, continue as
  overconfident.
• Odeans research confirms Disposition Effect
• Odean looks at trading decisions of investors at
  discount brokerage
• Stocks traders buy under perform those that they
  sell

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Level of Over-confidence changes dynamically

• Depending upon the success of failure, level of
  overconfidence changes
• A trader is not overconfident when he begins to
  trade
• Overconfidence increase over his first several
  trading periods early in his career
• These overconfident traders survive the threat of
  arbitrage, that is, they are not the poorest
  traders
• Initial success increases overconfidence
• Overconfidence declines thereafter

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Homework Assignment Disposition Effect and De
Bondt and Thalers study

• Homework assignment How do you square the
  Disposition Effect with the Price Reversals
  Literature (see De Bondt and Thaler 1985 study)?