behavior finance mm101026

8/8/2019 Behavior Finance Mm101026

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Behavior Finance


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Behavioral review divisionThe review is divided into three parts;1. Anomalous evidence on stock returns

i. The cross section of average stock returnsii. Theoretical literatureiii. Investor moods

iv. Limits to arbitrage & survival of irrational traders2. How investor trade

i. Patterns in tradesii. Evidence from derivative marketiii. Portfolio choice

3. Research in corporate financei. Corporate eventsii. Ongoing corporate financial decisionsiii. Mergers and acquisitionsiv. Other applications


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Cross section of average stock return

Fama & MacBeth Significant positive relationship

between cross section securitybeta and expected return.

Support CAPMonly risk that is priced by rational (risk averse) investorsis the systematic risk, in other words the risk correlated to thewhole market risk The CAPM is supposed todescribe how asset marketsbring optimal prices

Fama & French No significant relation between

return and market beta

Does CAPM reflect marketrealities?

Is beta good predictor of futurereturns? the future beta might diverge from the past beta,which makes that past one a

poor predictor. Behavioral finance find flaws in

this concept. M easurable dataand objective events, are not the only market pricing factors.

Investor perceptions aredecisive also. exclusively focused on the

monetary risk / reward criterion. It does not take intoaccount that, in the real world,investors have a range of other

motivations


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Expected Return vs. Required Return

Expected return weighted average of all

probable outcomes for thatinvestment. Its the most likely

return you wouldexpect/anticipate from aninvestment based on its risk.But its not guaranteed.

Comparing the two tells youwhether or not you will meetyour goal. If the expectedreturn is equal to or morethan your required returnthen you would invest .

Required return the amount that you would

need in order to get you toput your money into that

investment. Its anopportunity cost.


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Consumption CAPM

Expansion of the capital asset pricing model(CAPM). The CCAPM factors in consumption asa means of understanding and calculating an

expected return on investment.Periods when investments are consideredriskier (bear market)vs. Periods when they areconsidered less risky (bull market...). Riskpremium is variable


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Structural Change

A structural change can alter past trends ortheories regarding stock returns. For example,the futures market oil today is more valued

than oil in the future. If political instability andfears of scarce reserves arise, the oil marketmay undergo a structural change. Demand forfuture oil may increase, as people would fearlower supply levels for that period.Consequently, the market may shift to abackwards market, where the oil today is lessvaluable than future oil.


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Book to Market Ratio

A ratio used to find the value of a companyby comparing the book value of a firm to itsmarket value.

The book-to-market ratio attempts to identifyundervalued or overvalued securities.


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Limit to Arbitrage and the Survival of Irrational Investor

Efficient MarketHypothesis

Prices reflect value Mispricing corrected by

arbitragers

Limits of Arbitrage Strategies may not be

arbitrage Correction leads to

imbalances

Can arbitrageopportunities exist?

Real-world arbitrage is

always risky. Arbitrageur faces noise

trader risk: mispricingcan become worse

before it disappears. Fundamentally identical

assets may NOT sell atidentical prices.


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Behavioral Finance:Two Major Foundations

Investor Sentiment: creates disturbances toefficient prices.

Limited arbitrage: arbitrage is never riskfree,hence it does not counter irrationaldisturbances.

Prices may not react to information by the right amount. Prices may react to non-information. Markets may remain efficient.


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Are Financial Markets Efficient?

Weak form of market efficiency supported to acertain extent.Challenges:

Excess market volatility Stock price over-reaction: long time trends (1-3

years) reverse themselves. Momentum in stock prices: short-term trends (6-

12 months) continue. Size and B/M ratio (past information) may help

predict returns.


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Irrational Behavior

May choose a portfolio very close to thebenchmark against which they are evaluated

Herding: may select stocks that othermanagers select to avoid falling behind andlooking bad .

Window-dressing: add to the portfolio stocks that havedone well in the recent past and sell stocks that have recentlydone poorly.


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An Example

A. Initial Investment: Rs.300. Consider a choicebetween:A. a sure gain of Rs.100

B. a 50% chance to gain Rs.200, a 50% chance to gain Rs.0.

B. Initial Investment : Rs.500. Consider a choicebetween:A. a sure loss of Rs.100B. a 50% chance to lose Rs.200, a 50% chance to lose Rs.0.


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Reversal in Choice

Chose option A, chose option B.=> A reversal in Choice

Problem framed as a gain: decision maker isrisk averse.Problem framed as a loss: decision maker isrisk seeking.


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Behavioral Heuristics and Decision-Making Biases

Commonly Used Heuristics Availability: familiarity raises investment . R epresentativeness: judgment based on similarity.

Patterns in random sequences . Reliance on the judgement of other people


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Some more Heuristics

Overconfidence: people overestimate the reliability of their knowledge.

Excessive trading

Framing EffectRegret Aversion: anticipation of a future regret caninfluence current decision.

Disposition Effect: sell winners, hold on to the losers.Anchoring and adjustment: can create under-reaction.

behavior finance mm101026

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