Cards Flashcards
Framing in Finance
Asian disease Problem,+ Price group forecasts show lower average return than return group
Metntal Accounting
Theatre Ticket
Traditional Finance conclusions
Agents are rational (Bayes), Agents Make normatively Acceptable Choices (Utility Function), irrational investors don’t matter – rational eliminate mispricing
Certainty Equivalent
u(CE)=EU(x)
Risk Premium
RP=E(a)-CE(a)
Expected utility 3 axioms
- Complete ordering (Completeness – lotteries can be compared; transitivity– a>b and b>c then a>c);
- Continiuty (there is some p, prob which in combination with a and c is as good as b (a>b>c)
- Independance (preference should not change if both connected to same lottery)
Arrow absolute risk aversion
r(x) = -(u’‘/u’) then r’ and r’<0– agent increases amount of risky asset
Arrow relative risk aversion
r(x)=-(u’‘/u’)*x, r’ <0, agent increases fraction of risky asset
Sensitivity
Positive is defined as positive
Specificity
Negative is defined as negative, much more important in very low base rate
Gambler’s Fallacy examples
BGGB GGGBBB, Weber 98 “The disposition effect in securities trading, lab experiment where they had virtual money and invested in 6 assets– subjects knew that the asset is not winning but still bought it.
Overconfidence
- excessive optimism (marriage)
- illusion of control (game with Dapper- confident or Schnook- shy)
- miscalibration (70% sure that Jakarta is Capital of Indonesia)
- Above average (driving safety skills)
Example from paper : Barber, 2001 “Boys will be boys” where there appeared to be a strong link between overconfidence and excessive trading, especially in men, + “Odean,99 “Do investors trade too much?” rational vs overconfident investors, where overconfident overestimate their trading profits and precision of information signal
Disposition effect
Selling winners too soon and holding losers too long
2 experimental papers (Shefrin and Weber)+ Odean who describes the OPPORTUNITY TO SELL
Potential Survivorship bias
Successful investors are overreplaced at the end of the sample hence investors sell winners (-don’t have losers)
Paper of Odean 98 “Are investors reluctant to realize their losses?” - he also uses excess return in paper (excess return= raw return- value weighted CRSP like S&P500)
Why do we compute excess return? (Odean 98, “Are investors reluctant to realize their losses?”)
Idea: Investors select the stocks to sell based on their future performance, i.e. they keep (sell) the stocks that will perform best (worst)?
Excessive trading, do investors trade rationally? Do trading profits cover trading costs?
“Do investors trade too much?” Odean 99, no they don’t they misinterpret info and overestimate the presicion of this info
Where do investors misinterpret info and overestimate the presicion of info?
While trading too much, Odean 99, they don;t even cover their trading costs
Odean’s 99 “Do investors trade too much?” motivation?
Odean’s motivation is based on the traditional framework.
The traditional finance framework assumes that investors will only trade if they have different beliefs about an asset’s fundamental value.
In this traditional setting, taxes, liquidity needs, and other factors that would cause trading activity are ignored
Describe where authors used calendar time PORTFOLIOS and why
- Odean 99 “Do inv trade too much?”
use CALENDAR time portfolios to check systematic risk (sell stocks with high beta and buy with low beta) - Engelberg “Market Madness” calendar-time portfolois - = months (or whatever time unit the study uses) are weighted equally
- Ang, et al - calendar time appr using total vol and idiosyncratic vol to show that vol is negatively priced
- Bali et al. use calendar time approach for Max return calculation (to show thta stocks with max 1 day returns underperform)
Describe Event-time approach
Odean 99, “Do investors trade too much”
The return calculations are in event time. The individual returns (𝑅𝑗,𝑡+𝜏)of the stocks (=1 to N) are calculated from one to 40/252/504 days (=T) after the event (=transaction).
•Time periods with many transactions get higher weight than periods with few trades.
Event-time = each event is weighted equally
Which attention proxies do u know
- News (stock featured in media)
- Abormal trade volumes
- Abnormal returns (either high or low)
Investor attention proxies positively related to trading activity
Conjunction fallacy
Specific conditions are more probable than general ones, Linda’s problem
Statisticical or casual base rate is usually underweighted?
Cab accident, statistical, as it is treated as info about individual case and is combined with other case-specific info
4 explanations of disposition effect in Shefrin, “The disposition of sell winners too early and hold losers too long”
- Prospect theory (gains- risk averse, losses- risk prone)
- Mental accounting
- Regret aversion (pride to sell winner, regret to sell loserr)
- Self- control (System 1 feels pride and regret, System 2 knows optimal strategy but not successful sometimes to persuade S1)
3 explanations of Disposition effect in Weber, “The disposition effct in securities trading”
- Self-control
- Pride and regret
- Gambler’s Fallacy!
Where do investors forego tax benefits?
In disposition effect
1. Shefrin 85, “The disposition to sell winners” , lost tax benefits while selling winners and holding losers
- Odean 98, “Are investors relctant to realize losses?” - when they may not have opport to sell loser,
How to solve disposition effect?
a. Strickt rules (loss of 10% means sell)
b. Stop-loss orders
c. Unexpected circumstances that cause liquidity needs as add motivator
d. Reminder/ deadline of tax loss selling
Where do we find impact-reversal pattern?
IR pattern: firstly prices go up but with the time they go down
Attention matters
Where?
- Barber and Odean “All that glitters” -stock will be affected if the retail investors’ oders have price impact (=create demand)
- Engelberg “ Market Madness” -long term reccomendation returns for stocks with high o/n return
- Da et Al. :In search of attention”-GSV- post ipo performance: investors negatively predict med-long-term returns, prices return to fundamentals
Why distinguish between stocks with and without news?
(1) Cramer could select stocks that had some important event (positive earnings etc)
(2) Positive returns are caused by these unobserved events (and not Crammers’ recomm)
Self-attribution bias
Good outcomes- own ability
Bad outcomes - bad luck
What is mitigating representativeness?
Heart attack example (from conjunction fallacy topic) when from what % to how many the answes differ.
What is subproportionality?
This is the violation of independance axiom , if one lowers the positive outcoe for both lotteries by same factor the preferences change
What is subadditivity?
Small prob are overweighted (holds for small p)
6000;0.01>3000;0.02
people find it more attractive to have two 5% chances to win an amount than to have a 10% chance to win, i.e. pi(5) + pi (5) > pi (10) pi(0.05) > 0.5 * pi(0.1) pi (0.5 * 0.1) > 0.5 * pi (0.1)
Weightning Function Shape
Subproportionality
Subadditivity
Subcertainty
Overweight of small prob
Does experimental evidence contradicts EUT?
Yes, because of: •certainty effect •reflection effect •isolation effect •assessment of probabilities does not seem to be objective
What is isolation effect?
Isolation effect: the bonus is not taken into account because common to both options., individuals cancel out similar information when making a decision
How to define lottery-type stock?
- Above-median idiosyncratic vol
- Above median idiosyncr SKew
- Below-median Price
Charactristics of lottery-type stocks
- Owned by retail investors
- Have higher systematic risk
- Are young
- Rarely pay dividends
5 .Are hard to value
They underperform!
Showing past prices mean
People have higher expectations
Showing past returns results
In lower expectations
T stat formula
((Mean sample- mean hypothet)/ stnd dev) *sqrt(n)
Fundamental risk reduction
Hedge position in market
Hedge position in same industry
Hedge position in close substitutes
Noise trade risk
Risk that mispricing exploited by arb. worsens in short run
If there’s no free lunch then prices are right?
No! due to arb being costly
How can long-run IPO underpricing can be explained?
The returns there are highly positively skewed and investors prefer assets with positive skewness even if assets earn negative excess return.
In addition, a situation of overweighning of small prob- the investors believe each IPO to be next Google
Why distressed stocks have low average return?
Overweight of small p of success
Retail vs institutional investors and lottery stocks
Retail overweight, institutional underweight
Is volatility priced correctly ? Shall one buy high vol stock to get high return?
No, risk is nit priced correctly, High vol stocks get lower return (Ang et al.), low beta stocks yiled higher returns than high beta stocks (Baker), stocks with largest 1 day return subsequently underperform (Bali et al.)
Proxy for positive skewness and idiosyncr volatility
Max return
3 properties of utility function
- Money’s marginal utility is positive (u’>0, having more money is desirable)
- Marginal utility decreases with increased amount of money (u’‘<0 - icrease from 1000 to 2000 counts more than from 1 mio)
- Absolute risk-aversion is not increasing if people become richer, i.e. they don’t decrease absolute amount in the risky asset than before.
Risk attitude in PT
In positive domain- risk-averse, in negative- risk-seeking
How do you consider changes in PT
From a REFERENCE POINT, don’t evaluate prospects in absolute lvls
Is # of transaction a good measure in paper?
The number of transactions is not a good measure as it does not take into account the number of winners and losers in an investor’s portfolio. For example, if the overall stock market significantly increases (decreases) in value investors hold, on average, more (fewer) winners in their portfolios. So, selling more winners than losers does not necessarily indicate evidence for the disposition effect
What for do we calculate abnormal return or turnover?
To show that this is an attention- grabbing stock
Does selling more winners than losers necessarily indicates evidence for the disposition effect?
No, as if the overall stock market significantly increases (decreases) in value investors hold, on average, more (fewer) winners in their portfolios. Paper of Odean 98 “Are investors reluctant to realize their losses?” shows that. (Calculate PGR and PLR)
Describe arbitrage risks
- Fundamental : revaluation if new info arrives
- Noice trader: if the price drops lower than you bought
- Implementation costs: lending fees, comissions.
Hot hand phenomenon. Generally and in finance
If a basketball player scores several times in a row she is assigned a temporary higher probability to score –> she has a hot hand, – Cognitive illusion
In finance: Skill of fund managers, e.g., outperform the fund’s benchmark in three consecutive years.
Is Buying behavior of retail investors is more heavily influenced by attention than is the buying behavior of institutional investors
Yes, proof: Barber et Odean “All that glitters”
Is retail investor’s buying beh is more influenced by attention than their selling behavior?
Yes, proof: Barber et Odean “All that glitters”
What attracts retail investor?
- Lottery type stocks (Kumar)– above mormal vol, abover meidan idiosyncr. skewness and below median price
- Attention- grabbing stocks (news stocks, unusual trading vol, extreme returns)
- Alphabetic bias?
What types of stocks did Cramer recommend?
- Growth stocks (low B/M ratio)
2. Past winners (highest past-year returns)- momentum strategy
Expected utility BASIC PROCEDURE
- assign a utility level to each possible outcome.
- weight utility by associated probability.
- choose the option with the highest expected utility.
three forms of market efficiency
- Weak :Historical trading info
- Semi-strong: Market info
- Strong: All info
Editing phase 2 tasks
1) Decision-makers do not evaluate prospects in absolute levels but consider changes from a reference point. Thus, they will transform absolute outcomes to changes, i.e. gains and losses.
2) Simplification: rounding of probabilities and outcomes as well as deletion of extremely unlikely outcomes.
Evaluation phase
Case 1: Regular prospects, i.e. 𝑥≥0≥𝑦or 𝑥≤0≤𝑦.
•Value function: 𝑉𝑥,𝑝;𝑦,𝑞=𝜋𝑝𝑣𝑥+𝜋𝑞𝑣𝑦, where 𝜋0=0,𝜋1=1, and 𝑣0=0
probabilities 𝑝 are transformed to decision weights 𝜋𝑝
Typically: 𝜋𝑝+𝜋1−𝑝<1
Case 2: Strictly positive (negative) prospects, i.e. 𝑥>𝑦>0(𝑥
In efficient markets, prices equal fundamental value
Yes, as Stock price is the discounted sum of expected future cash flows / dividends
The positive abnormal returns prove that markets are inefficient
False, due to Joint Hypothesis Problem- we don’t know the true asset pricing model investors use;
Finding that there an investment strategy yields positive abnormal returns implies:
- markets are not efficient (and the asset pricing model is right) or
- the asset pricing model is wrong (and markets are efficient) or
- markets are not efficient and the asset pricing model is wrong
Two biases related to the perception of randomness
Gambler’s Fallacy and Hot hand Phenomenon
