Lecture 2 Behavioural Finance and Anomalies

 

** Behavioural Finance and Anomalies **

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studies do find evidence that appears to be or is inconsistent with the EMH.

 If

such market anomalies persist, those market ets. s. anom an omal alie ies s argu argue e fo for  r    inefficiency   of mark Several different forms of anomalies have been identified.

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Market Behaviour  In an efficient market, one  should not be able to consistently generate excess returns using returns  using any form of information. Once information is known and fully fully incorp incorpora orate ted d into into to inve invest stor ors, s, it shou should ld be   instantaneously   and prices. price s. But this this does not mean that all apparent apparent pricing exceptions exceptions to the efficient market hypothesis are anomalies.   An   exce excess ss ret return urn   befo before re fees fees and and expe expens nses es that that   disappears   after  properly reflecting all costs required to exploit it is not an anomaly anomaly..

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  Some Some apparent apparent   anomalies   are   simply a reflection of an inadequate

pricing model. model. If another model with an additional risk factor removes the excess return, it may not be an anomaly. anomaly.

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Market Behaviour  size. Just because  Apparent anomalies can just be small sample size. flipping a coin three times generates three heads, does heads,  does not not make  make the odds on the next flip anything more than 50/50. •

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 An anomaly may exist for only the short-run and short-run  and disappear once it becomes known and exploited.

  Some   apparent apparent anomalies anomalies   are a   rational rational refle reflectio ction n   of relev relevant ant econ ec onom omic ic fact factor ors. s. Year ear end end tr trad adin ing g anom anomal alie ies s ma may y just just re refl flec ectt •

rational behavior to reduce taxes.

But other deviations from the EMH and rationality do persist and behavioral finance can offer insight into these.

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Momentum Effect •

  should All for forms ms thevalue. EMH Yet asse assert rt tec techni hnical cal-pr -priceice-bas ed tra tradin ding g rul rules es notofadd studies continue tobased show evidence of  correlation in price movement. movement. A pattern of returns that is correlated with wi th th the e re rece cent nt pa past st   wou would be cl cla ass ssif ifie ied d as a  momentum

effect. •

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  This effect can last can last up to two years, years, after which it generally reverses itself and becomes negatively correlated, with returns reverting to the mean. This mean.  This effect is caused by investors following the lead of  others,, which at first is not considered to be irrationa others be irrational. l.   The The collective sum of those investors trading in the same direction  collective sum of results in irrational behavior, however. There are several forms of  mome mo ment ntum um tha that ca can n take take pl plac ace e, which hich are are discu iscuss ssed ed in th the e following

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Herding •

  Herding Herding is  is when investors the   same direction or in they the same securities, securities , and possibly eventrade tradeincontrary to the information have ing g so some meti time mes s ma make kes s in inve vesto stors rs fe feel el mo more re avai av aila labl ble e to them them..   Herd Herdin comfortable because comfortable  because they are trading with the consensus the consensus of a group group.. •

  Two behavi behavioral oral biases associated associated with herding are the  the   availability bias

(a.k.a. the   recency bias or recency effect) effect) and   fear of regret regret.. In the availabili avail ability ty bias, recent information information is given more importance importance because it is most vividly remembered. •

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  It is also referre referred d to as the avai availabili lability ty bias because it is based on data that are readily are  readily available available,, including small data samples or data that do not provide a complete picture.   In the conte context xt of herdin herding, g, the recent recent dat data a or tre trend nd is  extrapolated by

investors into a forecast.

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Regret

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  Regret is Regret  is the feeling that an that  an opportunity has passed by and is a hindsight bias. The bias.  The investor  looks   looks back thinking they thinking  they should  should have bought or sold a sold  a particular  inve in vest stme ment nt (not (note e that that in the the avai availa labi bili lity ty bias bias,, the the investor most easily recalls the recent positive performance).

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  Regret can lead investorswhich to buy investments they wish they had purchased, in turn fuels turn  fuels a trendchasing effect. Chasing effect.  Chasing trends can lead to excessive to  excessive trading,, which in turn creates trading turn creates short-term trends trends..

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Financial Bubbles

In the Mind of the Market: Theory of Mind Biases Value Computation during Financial Bubbles (Benedetto De Martino)

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Financial Bubbles and Crashes •

  Financial bubbles and bubbles  and subsequent crashes are periods returns caused  caused by panic by panic of   unusual unusual positive or negative returns buying   and   selling,   ne neither of which is based on economic fundamentals. The buying The  buying (selling (selling)) is driven by investors believing the price of the asset will up (  (down down). ). continue to go to go up

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  A bubble   or  crash  crash   is defined as an extended extended period of  deviations from the mean the mean.. prices that are two are two standard deviations from   A  crash   can also be characterized as a   fall in asset prices of 30% or more over more over a period of several months, whereas bubbles usually take much longer to form.

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  Ty Typically pically,, in a bubble, the the initial rational   as  initial behavior is thought to be rational  investors trade according to economic changes or expectations. doub ubtt th the e fu fund ndam amen enta tall va valu lue e   of of the the   Lat Later er,, the investo investors rs   start start to do underlying asset, at which point the behavior becomes irrational.   Recent  bubbles   were seen in the   technology bubble of 1999-2000 and   increased   resident residential ial hou housin sing g pri prices ces   in the the Un Unit ited ed King Kingdo dom, m,  Australia, and and the United States.

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 rational behavior-they  behavior-they know   In bubble bubbles, s, investors investors sometimes exhibit exhibit rational they are in a bubble but don't but  don't know where know  where the peak of the bubble is. bubble  is. Or, there are no suitable alternative investments to get into, making it difficult to get out of the current investment.   Fo Forr in inve vestm stmen entt ma mana nage gers rs,, the there re co coul uld d be   perfor performan mance ce or car career  eer  incentives encouraging encouraging them to stay invested in the inflated asset class.

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  There are several are  several different types  of behavior that are evident duri du ring ng bubb bubble les. s. Inve Inves stor tors usual sually ly exhi exhibi bitt   overconfidence, overconfidence, leadin lead ing g to ex exce cess ssiv ive e tr trad adin ing g an and d un unde dere rest stim imat atin ing g th the e ri risk sk involved. Portfolios become concentrated, and investors reject information. contradictory information.

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  Overconfidence   is linked to the   conf confirmat irmation ion bias bias,, in which investors look for evidence that confirms their beliefs and ignore evidence that contradicts their beliefs.

  Self-attribution bias bias is  is also present when investors when investors take personal credit for the success of their trades  (they make no attempt to link ex post performance to strategy) .

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  Hindsight bias is bias  is present when the investor  looks  looks back at what happened and says, "I says, "I knew it all along." Regret aversion is aversion  is present when an investor does not want to regret missing out on all the gains everyone else seems to be enjoying.   The   disposition effect   is prevalent when investors are losers , leading more willing to sell winners and hold onto losers, to the excessive trading of winning stocks.

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  As the bubble unwinds in   th the e ea earl rly y sta tage ges s, investors are anchored to their beliefs, causing  because they are unwilling them to under-react to  under-react because to accept losses.   As As the   unwi unwindi nding ng con contin tinues ues,,   the di dispo sposit sition ion effect dominates   as investors hold onto losing stocks in an effort to postpone

regret.

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Value vs. Growth •

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and d Fr Fren ench ch   are associ associate ated d wi with th   Two anomal anomalies ies dis discuss cussed ed by   Fama Fama an value and growth stocks.   Value stocks   have   low   price-to-earnings price-to-earnings ratios,  high   book-to-market values, and  and   low low   price-to-dividend ratios, ratios, with growth with  growth stocks having the opposite characteristics.   In thei theirr 1998 1998 study study,, Fa Fama ma an and d Fr Fren ench ch found found that that   valu value e sto stock cks s historically outperformed growth stocks in 12 of 13 markets over a 20year period from 1975 to 1995.   They also found that small-capitalization that small-capitalization stocks outperformed large-caps in 11 of 16 markets. Additionally, Additionally, they contend that in their   three three factor  mode mo del, l, co comp mpri rise sed d of si size ze,, va valu lue, e, an and d ma mark rket et be beta ta,, th the e va valu lue e sto stock ck mispricing anomaly disappears and disappears  and is instead due to risk exposures of  companies with a particular size and book-to-market value being more vulnerable during economic downturns.

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  Other Other studies have offered offered behavioral behavioral explanations, explanations, identifying identifying the value and growth anomalies as a mispricing rather than an adjustment for risk.   For example, in the   hal o halo

the inve invest stor or tran transf sfer ers s effe ef fect ct,   the

favorable company attributes into thinking that the stock is a good buy. buy. A company with a good record of growth and share price performance is seen as a good investment with continued high expected returns.

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  This is a form of      representativeness   in in whic which h inve invest stor ors s extr apol olat ate e pa past st pe perf rfor orma manc nce e in into to fu futu ture re ex expe pect cted ed re retu turn rns s, extrap leading growth leading stocks to become overvalued.  growth stocks to

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Uncertainty

Risk 

Fear Gain