Behavioural Finance Flashcards
What are the ‘Elements of a rational man/woman’?
1) Well-defined stable preferences
2) Preferences based on expected outcomes resulting from their choice
3) Investors maximise their own well-being/utility
4) Investors discount expected payoffs exponentially
What are the assumptions behind behavioural finance?
1) Presence of bias in investors decision making e.g. optimism/conservatism etc
2) Usage of ‘mental frames’ to simplify complex decisions, learning ‘heuristics’ to characterise data
3) Time inconsistency with choice
What is the efficient market hypothesis (EMH)? (Samuelson 1965, Fama 1970)
Stock prices should follow a random walk if rational investors require a fixed rate of return. Efficient market prices reflect all there is to know about a capital asset, only new information can change the price.
What does the EMH predict?
1) Stock price should change when news of it’s value hits the market
2) Stock price should not change if there is no news about it’s fundamental value
3) Old news has no value in predicting future returns
What is the empirical evidence behind EMH?
1) Early positive evidence
2) Excess volatility not all explained by change in dividends
3) Short-run momentum
4) Long-run Reversion
What was the methodology behind the long-run reversion discovery?
For every year since 1933, they formed portfolios of the best and worst performing stocks of the previous 3 years, then looked at average performance over the next 3 years. The ‘losers’ outperformed the ‘winners’ significantly. (EMH says they will be equal).
What are the possible causes of the long-run reversion?
1) Excessive optimism on past good news leading to high market-to-book ratios (lower returns)
2) Environmental factors - cloud cover, daylight saving time
3) Small Firm/January effect - CAPM understates return on low market value firms and overstates high market value firms - especially in January
4) Turn of the month - higher at end/beginning
5) Lunar effect - lower around full moon
What events contradict EMH?
1) October 19th, 1987 - S&P 500 falls by 22.6%, no news to explain it
2) Cutler et al. (1991) show how many of the 50 biggest one-day drops in US weren’t due to any news
3) Roll (1984) saw how weather explained only a small fraction of the price change in orange juice futures
What are the criticisms of behavioural finance? (Fama 1998)
1) Markets under-react and over-react so cancels on average
2) The findings disappear with greater methodology and data
