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Behavioral Finance

Behavioral Finance is the study of how human psychology emotion impacts investment decisions Behaviorists argue that the EMH puts an unfair burden on human behavior The EFM assumes that all investment decisions are rational It also assumes that if a arbitrage opportunity arises, the arbitrageurs will move in to close it assuring market efficiency These are the two fundamental assumptions of the EMH It is for this reason that arbitrage trading is also called convergence trading The trick remains to see if behavioral trading is persistent and can be exploited
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Key Themes

Heuristics or Rules of Thumb reduce the need for cognitive behavior


Affect Environment impacts decisions. Buy roofing stock when raining Representativeness -The inability to select a complete and unbiased sample. People that look like criminals are criminals Availability Using data which is available because it comes to mind easily. Newsworthy vs. non-newsworthy Anchoring Inability to move off of an initial starting point. PNC stock is $57 per share. Value from this point Familiarity People tend to pick stocks that they know Overconfidence For example most people think they are better than average drivers. Failure to allow for regression to the mean Status Quo A belief that things will stay the same rather than change Loss Aversion People are averse to taking a loss and admit mistake Conservatism People tend to be conservative with forecasts
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Key Themes

When heuristics result in non-rational behavior they give rise to a bias


Framing Bias How is the question asked? What examples of framing can you think of? Emotional Bias Mood impacts investment decision. Weather Sporting Events Market Impact At times investors have an incentive to trade with the trend that caused the missed pricing if they dont feel the market will correct, for example the real estate market of 20052007 Market Impact Institutional investors have an incentive to influence prices in a positive direction
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Behavioral Finance

Investors deviate from standard (rational and unbiased) decision making in at least three ways: First is their attitude toward risk

Investors simply do not look at gains and losses the same way. Take gains and avoid losses Decisions are made with limited information Investors use heuristics to guide decisions

Second is non-bayesian expectation formation


Third decisions are greatly influenced by the framing of the question

For example bonds may look good when looking at short term returns on the market and look bad when compared with long term returns

Overreaction and Underreaction

Behaviorists point to over and under reaction to events as evidence of inefficiency related to psychological factors How do EMH proponents respond?

Under and Over reaction are consistent with EMH if they each occur with similar frequency
Investors are inclined to believe that past trends are likely to repeat and move slowly to accept new information People are slow to update models with new information Biased self-attribution causes people to ignore public signals
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How does Underreaction occur?

Overreaction and Underreaction (cont)

How does overreacton occur?

Bias to exaggerate private signals about a company and ignore the public signals Sequential episodes of good news result in securities being overpriced Sequential episodes of bad news result in securities being undervalued Past winners tend to be future losers and past losers tend to be future winners Is this behavioral or managerial?

The grandfather of all underreaction studies is the fact that stocks with positive earnings news outperform even after the announcements with the corollary also true.
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Other Biases

Familiarity Bias

People tend to favor investments in companies they are familiar with A desire to hold stocks which are perceived as being successful for peers leads to undiversified portfolios Studies have shown that speeders trade more than non speeders which is attributed to sensation seeking Investors are slow to sell losers and quick to sell winners There is a reluctance to admit a mistake

Relative Wealth Bias

Sensation Seeking Bias

Disposition Bias

Other Biases (cont)

Informational Bias

People tend to overestimate information of others while underestimating their own Underinformed investors tend to overestimate their ability to find value and trade too much. Tends to occur more with men than women and more with single investors vs. married investors For example people are less likely to select a loss of $750 vs a 75% chance of a loss of $1000 (also known as Prospect Theory) We tend to remember winners more than losers. We tend to blame losers on unpredictable events

Cognitive Bias

Framing Bias

Hindsight bias

Herding

Herd Behavior

People tend to favor investments favored by others This goes for portfolio managers as well Examples are numerous but include the Tulip Bulb craze of the 1600s and the internet bubble of 2000s

Generally groups make better decisions than individuals and this encourages herd behavior The Delphi teaching method

Limits to Arbitriage

What is arbitriage?

Taking a riskless position by buying and selling an asset which gives rise to a gain. The purchase and sale position is called a hedge If the hedge involves different underlying assets, an unexpected change in one would defeat the hedge Shorts are one sided hedges. Given what we know about herd behavior are one sided hedges reliable? You might not be able to borrow the stock necessary to short it Tax posture of investor will impact arbitrage decisions not true for a tax exempt investor
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Are hedges perfect? Hardly

Limits to Arbitriage

At times you are forced to select similar securities and the hedge will not be perfect.

For example there is no market for unleaded fuel but there is for diesel Despite the fact that these are virtually identical securities, there have been times when deviations from the 60/40 earnings sharing ratio have ranged from -30% to positive 10% - Why?? The most advanced reason is that they trade in two different markets and that each stock covaries with its respective market

The Royal Dutch / Shell example

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Sums it all up

Richard Thaler the father of Behaviorial Finance summed it all up when he said to a traditionalist, Robert Barro at an academic conference He said The difference between us is that you assume people are as smart as you are, while I assume people are as dumb as I am
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The Bottom Line

Show me the money(after adjusting for risk) !!! Backtests rarely fail !!!

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