AN INTRODUCTION AN INTRODUCTION TO TO

BEHAVIORAL FINANCEBEHAVIORAL FINANCE

Definition: Behavioral Finance is an approach Definition: Behavioral Finance is an approach that attempts to explain anomalous behaviour that attempts to explain anomalous behaviour of security prices (i.e. deviations from efficient of security prices (i.e. deviations from efficient markets theory and asset pricing models) by markets theory and asset pricing models) by the psychological biases and/or behavioral the psychological biases and/or behavioral

regularities of market participants. regularities of market participants.

A Reminder of TheoryA Reminder of Theory

Finance Theory basically suggests that the return of Finance Theory basically suggests that the return of a a financial financial asset in period t asset in period t should beshould be the sum of expected return (i.e. the the sum of expected return (i.e. the compensation for holding the asset) and a random error term compensation for holding the asset) and a random error term (reflecting information su(reflecting information surrprises and any temporary deviations). prises and any temporary deviations). R Rtt = E(R = E(Rtt) + e) + ett

E(RE(Rtt) is practically the sum of the protection against inflation, ) is practically the sum of the protection against inflation, reward for postponing consumption, and reward for taking the risk reward for postponing consumption, and reward for taking the risk associated with the assetassociated with the asset

A sufficiently long term average of RA sufficiently long term average of Rtt (realized returns) should (realized returns) should converge toconverge to E(R E(Rtt), such that ), such that E(RE(RABNABN)=0)=0. .

Further, efficient markets theory predicts that abnormal returns Further, efficient markets theory predicts that abnormal returns

(e(eii’s) should be unpredictable (follow a random walk), so that it is ’s) should be unpredictable (follow a random walk), so that it is impossible to persistently earn positive abnormal returns.impossible to persistently earn positive abnormal returns. RRABNABN

tt ~~ iid(0, iid(0,σσii))

These examples do not constitute a violation of the theory, although These examples do not constitute a violation of the theory, although abnormal returns are not compensation for risk.abnormal returns are not compensation for risk. But, they do suggest that But, they do suggest that

unexpected returns can be much larger than expected returns.unexpected returns can be much larger than expected returns.

1.Chart: short period, unpredictable, should rather be assigned to the 1.Chart: short period, unpredictable, should rather be assigned to the error term. (manipulation in a small-cap stock in Turkish stock market).error term. (manipulation in a small-cap stock in Turkish stock market).

2.Chart: The process of incorporation of new fundamental information into 2.Chart: The process of incorporation of new fundamental information into price may seem like an anomaly, but does not necessarily violate theory. price may seem like an anomaly, but does not necessarily violate theory.

(the rise of Crude Oil since 2002).(the rise of Crude Oil since 2002). It is possible to obtain positive abnormal returns by exploiting superior It is possible to obtain positive abnormal returns by exploiting superior

private information private information (theory should allow for t(theory should allow for the effect of information surpriseshe effect of information surprises). ).

Maybe, the theory is to be revised as such: Maybe, the theory is to be revised as such: RRtt = E(R = E(Rtt) + I) + Itt + e + ett (Elton, 1999) (Elton, 1999)

A true violation needs to be predictable cases of statistically and A true violation needs to be predictable cases of statistically and economically significantly positive or negative average abnormal returns economically significantly positive or negative average abnormal returns

over sufficiently long periods such that E(Iover sufficiently long periods such that E(Itt)=0.)=0.

VIOLATIONS OF THE THEORY THAT GIVE RISE TO VIOLATIONS OF THE THEORY THAT GIVE RISE TO BEHAVIOURAL APPROACHESBEHAVIOURAL APPROACHES

* * Momentum Rules (Short-lag Positive Autocorrelation in ReturnsMomentum Rules (Short-lag Positive Autocorrelation in Returns): ): Create zero-cost arbitrage portfolios by buying most winners and Create zero-cost arbitrage portfolios by buying most winners and selling (short) most losers of the past 3-12 months, hold them for selling (short) most losers of the past 3-12 months, hold them for the next 3-12 months.the next 3-12 months.

Jegadeesh and Titman (1993) and Rauwenhorst (1998) report Jegadeesh and Titman (1993) and Rauwenhorst (1998) report around 1% monthly average excess returns to this strategy.around 1% monthly average excess returns to this strategy.

* * Contrarian Rules (Long-lag Negative Autocorrelation in ReturnsContrarian Rules (Long-lag Negative Autocorrelation in Returns): ): Buy most losers and sell most winners of the past 3-5 years, Buy most losers and sell most winners of the past 3-5 years, hold the portfolio for the next 3-5 years. hold the portfolio for the next 3-5 years.

DeBondt and Thaler (1985) report significantly positive returns to DeBondt and Thaler (1985) report significantly positive returns to this strategy, however more recent studies suggest less this strategy, however more recent studies suggest less profitability (while profitability of momentum rules turns out to be profitability (while profitability of momentum rules turns out to be more robust over time). more robust over time).

* * Excessive VolatilityExcessive Volatility: Shiller (1981) finds that stocks are more : Shiller (1981) finds that stocks are more volatile than fundamentals require. Lo and MacKinlay (1990) find volatile than fundamentals require. Lo and MacKinlay (1990) find that excessive volatility violates random walk.that excessive volatility violates random walk.

So, there may be a human element adding to volatility.So, there may be a human element adding to volatility.

* * Trends, Trend ReversalsTrends, Trend Reversals and The Profitability of Technical and The Profitability of Technical Analysis: It may be possible to make money by following trendsAnalysis: It may be possible to make money by following trends

• In sum, short-lag positive and long-lag negative autocorrelation In sum, short-lag positive and long-lag negative autocorrelation in Rin Rtt series, which is a violation of weak form of efficiency. series, which is a violation of weak form of efficiency.

* Sentiment Anomalies, Calendar Effects, etc.* Sentiment Anomalies, Calendar Effects, etc.

MAJOR BEHAVIOURAL THEORIESMAJOR BEHAVIOURAL THEORIES

• Underreaction due to Conservatism BiasUnderreaction due to Conservatism Bias: : Human tend to be slow Human tend to be slow in adapting to new information. Consequently, new information is in adapting to new information. Consequently, new information is pricepriced-ind-in gradually gradually (stepwise) (stepwise) rather than at a single rather than at a single stepstep.. This spurs This spurs positive autocorrelation in returns and renders momentum rules positive autocorrelation in returns and renders momentum rules profitable.profitable.

However, some of the profitability of momentum rules may result from However, some of the profitability of momentum rules may result from gradual diffusion of private information, and it’s difficult to distinguishgradual diffusion of private information, and it’s difficult to distinguish (semi-strong form of efficiency)(semi-strong form of efficiency). Earnings. Earnings momentum. momentum.

* * Overreaction due to Representativeness BiasOverreaction due to Representativeness Bias: : A tendency to A tendency to overemphasize the most recent and the most salient overemphasize the most recent and the most salient may cause may cause overreaction, creating excessive volatility (continuing trends, then overreaction, creating excessive volatility (continuing trends, then reversals)reversals)..

* * Overconfidence with Self-AttributionOverconfidence with Self-Attribution: : Daniel et al. (1998) suggest it Daniel et al. (1998) suggest it may cause overreaction and subsequent reversals.may cause overreaction and subsequent reversals.

• Interaction between informed and momentum tradersInteraction between informed and momentum traders (Hong and (Hong and Stein, 1999)Stein, 1999):: One of the most promising theories: The insuffic One of the most promising theories: The insufficiient ent number of informed traders results in underreaction, which creates number of informed traders results in underreaction, which creates room for profitability for momentum tradersroom for profitability for momentum traders, the existence of which , the existence of which creates the potential for an overreaction and subsequent reversal.creates the potential for an overreaction and subsequent reversal.

• Herd BehavioHerd Behaviouurr: Herding : Herding is is an instinctual defenan instinctual defencce mechanism e mechanism against unknown external danger.against unknown external danger. It may be rational as it ensures It may be rational as it ensures to be not far worse than average. There is evidence that some fund to be not far worse than average. There is evidence that some fund managers, analysts and even CEO’s mimic each other. This may managers, analysts and even CEO’s mimic each other. This may enhance existing trends. enhance existing trends.

• Disposition EffectDisposition Effect: : TTendency to hold losing stocks too long and sell endency to hold losing stocks too long and sell gaining stocks too earlygaining stocks too early;; may harm individual traders may harm individual traders;; has little has little impact onimpact on market prices as informed traders dominate the pricing. market prices as informed traders dominate the pricing.

DEBATE BETWEEN EFFICIENT MARKETS AND DEBATE BETWEEN EFFICIENT MARKETS AND BEHAVIOURAL APPROACHESBEHAVIOURAL APPROACHES

Statistical and economic significance of reported abnormal returns are not robust to Statistical and economic significance of reported abnormal returns are not robust to methodological issues (Fama, 1998).methodological issues (Fama, 1998).

Behaviourists:Behaviourists: Especially momentum rules are robust.Especially momentum rules are robust.

Behavioural Factors are difficult to identify ex ante, and backward evaluations do Behavioural Factors are difficult to identify ex ante, and backward evaluations do not constitute robust evidence against efficient markets (one may attach one of not constitute robust evidence against efficient markets (one may attach one of a large number of behavioural theories to any anomaly).a large number of behavioural theories to any anomaly).

Behaviourists: produced testaBehaviourists: produced testabble predictions and general models. Real-time testle predictions and general models. Real-time testss may overcome this problem.may overcome this problem.

SophisticSophisticaated market participants can learn not to commit behavioural biases. As ted market participants can learn not to commit behavioural biases. As markets will be dominated by sophisticated traders as a result of “natural markets will be dominated by sophisticated traders as a result of “natural selection”, markets may evolve toward efficient market conditions. Hence, selection”, markets may evolve toward efficient market conditions. Hence, behavioural factors, even if they exist today, will be a temporary phenomenon.behavioural factors, even if they exist today, will be a temporary phenomenon.

Behaviourists: The causes of behavioural biases are instinctual, they are inherent Behaviourists: The causes of behavioural biases are instinctual, they are inherent in human psychology, likely to repeat over next generations.in human psychology, likely to repeat over next generations.