Behavioural Finance

Annotations:

• Real people make decisions that are different from what EMH expects

1. Prices do not match intrinsic value

   Annotations:

   • EMH says prices reflect all info
   1. Investors behave irrationally
      1. Information Processing Errors - Predict future returns wrong
         1. Representative/Memory bias/forecasting errors - Kahn & Tversky (1973)

            Annotations:

            • Too much weight given to recent experience Make forecasts that are too extreme given uncertainty
            1. P/E effect explained - DeBont & Thaler (1990)

               Annotations:

               • Effect: High P/E is bad investment (low return)
               • Explanation: when forecasts of E are high due to good performance, they are too high.  Excessive optimism built into P.  Poor subsequent performance (E) and high P gives high P/E.
         2. Overconfidence

            Annotations:

            • People overestimate: the precision of their forecasts their own abilities
            1. Trading activity predictive of poor investment performance - Barber & Ocean (2001)

               Annotations:

               • The top 20% of accounts ranked by portfolio turnover had 7% worse returns than the bottom 20%
            2. Only 10-15% of equity in mutual fund industry is held in indexed (passive) accounts
            3. New Issue Effect

               Annotations:

               • After initial rush on stock issue, price rises short term, but long term - 3.8% worse return than comparable stocks.  Could be B2M in disguise
         3. Conservatism

            Annotations:

            • Investors are too slow to update their beliefs after new info.  Leads to momentum
            1. Earnings Announcement Puzzle

               Annotations:

               • Investors underreact to earnings announcement.  Top 10% in earnings outperform the with worst by just 1% per month
      2. Behavioural Biases - suboptimal decisions given information (even if info proc is correct)
         1. Framing

            Annotations:

            • Decision affected by how situation is posed.  May reject if posed in terms of risk around gains, but accept if around losses
         2. Mental Accounting

            Annotations:

            • People mentally frame assets as belonging to either current income, current wealth or future income More likely to bet with credit card than with cash
            • Explains momentum - house money effect - gamblers accept bets if they are ahead ("winnings account") Same with "capital gains account" after success --> risk tolerance
            1. Preference for high cash dividend stocks even though they have same overall return as others (Statman, 1997)
            2. People ride out losing positions for too long (Statman, 1997)
         3. Regret Avoidance

            Annotations:

            • Investors require more courage and a higher return on unconventional shares because they see any losses made as their fault (regret) as opposed to bad luck. This drives up the price
            1. Size and B2M effects explained by this - DeBont & Thaler (1987)

               Annotations:

               • High B2M have depressed stock prices.  Are in financially precarious position.  Small firms are less conventional.  These firms require courage - so required return is higher.
         4. Prospect Theory

            Annotations:

            • Investors are risk seeking rather than risk averse when it comes to losses - see diagram http://upload.wikimedia.org/wikipedia/commons/4/4e/Valuefun.jpg
         5. Herding
         6. Calendar effects

            Annotations:

            • Jan, Monday - cannot make returns here because of transaction costs
2. It is still difficult to outperform a passive investment strategy

   Annotations:

   • EMH says this is true too - but this does not prove that EMH is true
   1. Limits to arbitrage

      Annotations:

      • Investors cannot take advantage of difference between price and intrinsic value. No arbitrage.  Prices stay false
      1. Fundamental Risk

         Annotations:

         • "markets can remain irrational longer than you can remain solvent"
         1. The Law of One, price violations - where arbitrage should have worked

            Annotations:

            • LO1P = identical assets should have identical price
            1. Siamese Twins - 1907 Royal Dutch Petroleum and Shell Transport merged and had all same assets. but the prices differed between 93 & 99 = Fundamental risk

               Annotations:

               • prices differed and did not converge for ages
         2. NASDAQ was overpriced @3500 in 1999, but INCREASED to 5000 before finally falling. Shorting in @3500 would have been a disaster
      2. Implementation Costs

         Annotations:

         • Shorting entails costs/fees. May have to return security at very short notice.
      3. Model Risk

         Annotations:

         • Is the model giving your intrinsic value faulty?
3. Bubbles
   1. Investors increasingly confident with their investment prowess = OVERCONFIDENCE BIAS
   2. Extrapolating short term patterns into future - REPRESENTATIVE BIAS
   3. Examples
      1. dotcom
      2. Japan 1980s
      3. Housing 2005+
      4. Bitcoin 2014
   4. Other causes
      1. Excessive liquidity leading to lax screening by banks
      2. Moral Hazard
   5. Herding
4. Critique
   1. Does not explain how to exploit irrationality/mispricing
      1. BUT - it does highlight that misleading price signals as to where to allocate resources
   2. Too unstructured - can explain irrationality using a laundry list. No unified theory to explain a range of anomalies
   3. Support of one type of rationality over another is inconsistent. Some papers use overreaction, some use undereaction for same phenomenon Fama (1998)
   4. Poor statistical significance of studies (Fama, 1998)
   5. BF highlights biases in individuals and committees and not competitive markets
      1. "Hyperbolic discounting by individuals invites arbitrage"
      2. "diversification, derivatives and hedging eliminate mispricings"