Behavioural Finance Topic 4 Flashcards
Random walk
Price changes are random and unpredictable, new information causes them to change
Random walk is a result of prices that always reflect current knowledge
Efficient market hypothesisq
Stocks already reflect all available information
3 degrees of efficiency
- Weak form efficiency
- Semi strong form efficiency
- Strong form efficiency
Weak form efficiency
The only information set is market trading data, eg prices, volumes,reported short interest
Semi strong form efficiency
Prices impound both past prices and all other public information. Eg financial reports, other financial information released by firms, macroeconomic information, anything else publicly available that is relevant to the stock
Strong form efficiency
This incorporates information from weak and semi strong forms, as well as an element of private or insider information. The insid with knowledge signals as soon as attempt to trade on it is made, so no abnormal profit results.w
Implications of efficient market hypothesis
- Technical analysis
- Fundamental analysis
- Technical analysis: bAsed on the idea that it is possible to discover patterns in price data which convey clear trading signals
- Fundamental analysis: analysis of economic data about a firm and its environment in order to assess whether that firms stock is currently overpriced or underpriced.
Active portfolio management
- The attempt to earn abnormal returns on the basis of forecasts a out the future
- Attempt to identify mispriced stocks and/or practice market timing or sector selection
- If EMH is true for all stocks at all times any attempt at active management would fail
Event study
Describes a technique of empirical financial research that enables the observer to assess the impact of a particular event on a stocks price. A technique for examining market reactions to and abnormal returns around specific information releases which may be value-relevant, eg macroeconomic announcements or firm specific announcements
Measure the impact of an event by…
Estimating the abnormal return of the asset at the time the event becomes known to the market.
This can be impacted by leakage
Cumulative abnormal return
The sum of all abnormal returns over the time period of interest. An attempt to cover leakage
Issues in testing for market efficiency
- Te magnitude of market efficiencies may be so small in terms of return (although large in terms of cashflows) that it may not be easy to observe.
- The investment processes selected to be published may not include those that are profitable (and therefore retained as proprietary)
- The publication of lucky events as skill can disguise the true level of efficiency
Weak form tests
- Momentum effect: good or bad recent performance of stocks or markets continues over an intermediate horizon.
- Reversal effect: over long horizons the best performing stocks subsequently underperform, the reversal effect. The market overreacts to news. Should give rise to the contrarian investor.
Weak form tests: Turn of year effect
January returns higher than December due to firms selling stocks in December to realize tax losses, then repurchase in January.
In Australia research suggests that’s
1. There is a pronounced January effect
2. It is driven by smaller firms
3. There is no overall July effect
Therefore tax loss selling is only a partial explanation of the turn of the year phenomenon
Weak form tests: Weekend effect
Mondays tend to be a wearer return, though perhaps firms with bad news to report do so on a Friday, and mondaybis a response to the announcement
Semi strong form test: P/E effect
Low PE stocks earn higher returns than higher PE stocks
Positive serial correlation is…
Positive returns follow positive returns
Negative serial correlation is…
Positive returns tend to follow negative returns
Semi strong form tests also known as ……. Literature
Anomalies literature
Tests of semi strong form of the EMH
Semi strong form test: small firm effect
Portfolios of small firms outperformed portfolios of large firms (Keim, 1983)
High excess return related to portfolio size rather than beta. Could be explained by:
1. Small firms are “neglected”, relatively little information about them, therefore risk is higher than that indicated by beta
2. Small firms tend to be low priced firms, so a small movement on the exchange can represent a large change for the firms
3. Short trading history, meaning market cannot yet accurately assess risk
4 excess returns on a small firm occur over the early part of January
Strong form tests: inside information
Stock prices rise when insiders intensively buy, and stock prices fall when insiders intensively sell.
In the US trades by insiders are a matter of unlicensed record
In a strong form efficient market, any attempt to trade n the basis of inside information immediately communicates that information to the market preventing insiders from profiting from their private information
Empirical evidence suggests strong form does not hold - else insiders would not achieve abnormal returns
Irrationalities: information processing
- Forecasting errors (eg too much weight to recent events when forecasting)
- Overconfidence
- Conservatism (being slow in responding to news)
- Representativeness (inferring a pattern from a small sample as if it is representative of the population
Irrationalities: behavioral biases
- Framing (choices are affected by the context in which the question is posed)
- Mental accounting (considered a sub part of framing where we compartmentalise total portfolio and make decisions regarding separate components
- Regret avoidance (unconventional decisions cause greater regret than more common investment choices)
- Prospect theory, adds to the regular convex shape the utility models the possibility that there is also a decreasing impact on utility from incremental losses
Technical Analysis and EMH
Technical analysis: involves search for recurrent and predicatable patterns in stock prices in order to enhance returns.
EMH suggests this is of no value because any information that was ever available forn analysing prices has already been reflected in the marekt price.
Fundamental analysis and EMH
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates and risk evaluation of the firm to determine proper stock prices.
EMH: no investor can earn excess returns from trading rules based on publicly available information. Only analysts with superior insight can achieve the highest returns.
ole/responsibilities of portfolio managers in efficient market environment
- identify risk/return objectives given investor constraints
- tailoring portfolio to client needs - understand return requirements and risk tolerance
- examine investors constraints, inluding liquidity, time horizon, laws and regulations, taxes and unique preferences and circumstances such as age and employment
