intro to behavioral finance Flashcards
What is an efficient market?
An efficient market is one that cannot be beaten and therefore implies holding the market index
Efficiency assumptions - Prices are efficient because
Investors are rational, evaluating information probabilistically.
Prices settle at equilibrium.
Instantaneous price change only when new information arrives.
Prices follow a random walk and are non-random, do not trend
Random price movement
Implies stocks should move in a step fashion
Non-random price movement
trend can be viewed as a gradual adjustment to new equilibrium (rational) price level
This implies that prices move in waves. This looks more like price charts
What does EMH imply?
It should rule out the possibility of trading systems.
No one should be able to consistently beat the market.
No payoff for information gathering and processing.
With no new information prices should oscillate in random and unbiased fashion
False notions of Market Efficiency
Price movements are random and at rational values at all times.
No one can beat the market: Practitioners (traders & portfolio managers) have known otherwise and offer us examples that this is not always the case. Ex: Warren Buffett
Semi-strong form efficiency
Prices should neither overreact or under react to news, a security’s price adjusts quickly and accurately to news
Prices only change when news arrives
Weak form efficiency
Stale, past information already public should have no predictive power – TA fails and does not generate superior risk adjusted returns
“Investors are rational” significance
Prices adjust instantaneously, quickly to new information.
Pricing errors are unbiased.
Mistakes of individual investors are uncorrelated.
problems with the “Investors are rational” rationale
Investors are not as rational as they appear.
Price adjustment to equilibrium can be gradual, can under or over react – The main disagreement point between FA & TA!
Investor departures from rationality:
–> inaccurate risk assessments
–> they make behavioral mistakes
–> commit poor probability judgments, irrational decision framing.
“Investor errors are uncorrelated” significance
Prices follow a RW & returns are normally distributed
Valuation mistakes are uncorrelated, errors cancel off.
If on investor erroneously values a security too high this will be offset by another investor valuing the same security too low.
These actions cancel out and leave prices at equilibrium levels
problems with the “Investor errors are uncorrelated” rationale
This assumption is contradicted by psychological research showing that investors tend to make similar errors and do not deviate from rationality randomly.
Errors can be correlated:
–> A bad buy often times leads to a bad sell
–> herding
–> follow the leader
–> “window dressing,”
–> retail clients act irrationally.
“Arbitrage forces are possible” assumption of EMH
If valuations of irrational investors turn out to be biased, then arbitrage forces prices back to equilibrium
problems with the “Arbitrage forces are possible” assumption of EMH
Arbitrage activities are more limited then it seems.
Does a “Free lunch” really exist? Is arbitrage riskier then it seems?
Improper use of leverage, i.e. hedge funds can get wiped out by using too much (Long Term Capital Management).
Lack of perfect substitutes to hedge.
Limited use of short proceeds and freedom to pursue opportunities.
Cannot always borrow securities at will for short sells.
Therefore, the assumption that arbitrage can always eliminate price inefficiencies is oversimplified and unrealistic.
Empirical challenges to EMH
- Excessive price volatility
- Predictability studies with stale/ past information
- Predictability studies with excess risk-adjusted returns
Excessive price volatility in EMH
Prices are more volatile than fundamentals warrant.
Some price movements cannot be explained by financial analysis:
–> Bubbles.
–> Excessive price movements with no news.
Predictability studies with stale/ past information in EMH
Contradict weak-form EMH, which implies that no excess returns are possible on past price information
ex:
Momentum studies: Strong past price momentum over 6-12 months predicts strong future 6-12 momentum
Momentum reversals: strong trends in momentum over prior 3 -5 years tends to reverse
Non reversing momentum: strong momentum persists for stocks near their 52-week highs, despite their fundamentals
Momentum confirmed by volume: strong profits can be earned with combining price/volume with momentum, that’s a great trading system idea!
Predictability studies with excess risk-adjusted returns in EMH
Contradict semi-strong form EMH, which implies that no abnormal returns can be made by acting on publicly available technical and fundamental information.
However, many studies have shown that excess risk adjusted returns are possible using past fundamental information:
- Small cap effect, January effect
- P/E ratio effect: low P/E stocks outperform high P/E ones
- P/B effect: low P/B stocks outperform high P/B
- Earnings surprise with technical confirmation; better/worse than expected earnings with strong/weak price and volume, another trading system idea!
All these above studies validate TA!
Behavioral Finance (Analysis) or BA
The study of how psychology affects finance and investment decisions.
Explains why investors depart from full rationality using elements of cognitive psychology, economics, and sociology
BA says some departures are systematic and last long enough to be exploited by strategies and explains why excess returns can result from stale strategies.
Investors vary in their rationality example: noise traders versus rational arbitrageurs.
Where prices likely diverge from rational levels we are likely to experience systematic predictable movements
Pillars of Behavioral finance
Limits of arbitrage: lack of perfect substitutes.
Limits of rationality: inefficiencies will occur but under what circumstances?
-> human judgment errors.
Conservatism bias
too little weight given to new information
Your prior beliefs are not modified as much as new information warrants. You conserve prior beliefs.
i.e. despite signs that the economy starts to emerge from recession you remain pessimistic and underinvested in equities
Confirmation Bias
an investor’s beliefs become more extreme over time.
Confirmatory information is given more credence, contradictory info not believed.
i.e. any negative news validates your negative bias
Anchoring
an individual’s inability to sway from initial estimates, forecasts, opinion, personal biases (an anchor) even if they are irrelevant and not evidenced based, sizing a prediction based on numbers previously given.
Anchoring examples
Anchoring to compelling emotional stories, numbers (your break even price, initial account balance, price targets set by analysts, prior highs, your account values)
Optimism / Overconfidence
Investors are generally overconfident about the quality and precision of their knowledge.
i.e. analysts, portfolio managers, and traders.
Crime of small numbers
using too small of a sample size to draw a conclusion resulting in two judgment errors:
Gambler’s fallacy
Clustering illusion
Gambler’s fallacy
occurrence of a positive streak does not alter the probability of the next event
Clustering illusion
Misperception of order, when the outcomes are truly random, a few events in an ordinary streak in a random walk get interpreted for a trend change
i.e.: a trend of black numbers being drawn in roulette.
Imitative behavior / herding
looking at behavior of others for cues
People look at the behavior of others for cues and imitate their actions.
Investors making the same mistakes result in prices that systematically diverge from rational levels
i.e.: buy stocks that Warren Buffet and Carl Ichan buy.
Information cascades
Random behavior can trigger imitative behavior resulting in long duration price swings. This is caused by a feedback loop
Information cascades
chain of imitative behavior initiated by the (random) action of a few.
Feedback loops and systems
Feedback plays an integral role in price systems
Feedback can be positive or negative
Feedback refers to channeling of a system’s output back into the system as input that forms a circuit or feedback loop leading to a self regulating system
Positive feedback
system output multiplied by a positive number.
This amplifies, snowballs, a system’s behavior.
ex. Speaker screech, momentum or imitative behavior.
Positive stock gains lead to more positive gains as positive news feeds on itself, price declines lead to more price declines because of immititaive effects. They build on each other. Trends go far above or below rational levels.
Negative feedback
system output multiplied by a negative number.
This has a dampening effect it drives output back to equilibrium,
ex. A heating or cooling system, arbitrage. Positive/negative moves come back to their original price.
Mental accounting
contributes to positive feedback
Thinking of money as if it belonged in separate accounts – which should be treated differently.
Ex: Speculative account/money is for more speculation. Investment account is for long term. Treat speculative gains differently
Ponzi schemes / Bubbles
Robert Shiller contends that bubbles are naturally occurring Ponzi schemes, and also the stock market is a naturally occurring Ponzi (fraud) scheme.
This confirms feedback theory.
Self attribution
attributing successful results to our own ability (we take credit for positive outcomes), unsuccessful results attributed to “bad luck”.
Prospect theory
How investors value gains and losses differently.
The decisions they make under uncertainty explains how investors hold on to losers but sell profitable positions to avoid the pain of realizing a loss.
Psychological factors, judgment and cognitive errors all investors make
- Conservatism bias
- Confirmation Bias
- Anchoring
- Optimism / Overconfidence
- Crime of small numbers
- Imitative behavior / herding
- Mental accounting
- Ponzi schemes / Bubbles
- Self attribution
- Prospect theory
How can systematic price movement arise in markets that are not fully efficient?
Behavioral finance contentions
Price departures are systematic and last long enough to be exploited by certain investment strategies.
Can be formulated as mathematical models that generate testable predictions of how markets would behave if the hypothesis is correct making behavioral finance scientifically meaningful
How can systematic price movement arise in markets that are not fully efficient?
conclusion
EMH predicts that systematic price motion should not be observed
behavioral finance hypotheses do predict the occurrence of systematic price motion and tries to offer an explanation why, good news for TA!
Possibility of price prediction does or does not necessarily imply that markets are inefficient?
does not necessarily imply that markets are inefficient
why do different risk tolerances exist?
because participants are compensated the following kinds of risk premium:
Equity risk premium
Hedge risk transfer premium
Liquidity premium
Information or price discovery premium
Equity risk premium
returns above the risk free rate.
Hedge risk transfer premium
compensation of speculators versus commercial hedger (users) for price risk.
i.e. commodity /currency
Liquidity premium
higher returns for holding illiquid securities or providing liquidity to markets
Information or price discovery premium
compensates investors for making buy and sell decisions that move prices to rational level
i.e. holding a position overnight
Systematic price motion co-existing with Efficiency?
Efficient markets and price predictability can co-exist.
Markets can be at times efficient and prices random and at other times be inefficient with predictable prices dependent on investor behavior and cognitive errors.
Behavioral finance offers empirical basis for TA, giving proof to what TA practitioners have already suspected and known but didn’t initially test
Finance Disciplines
Behavioral Analysis
Fundamental Analysis
Technical Analysis
Quantitative Analysis
how are Equity exchanges referred to as?
describe them
“auction markets”
Provide an organized and regulated environment for participants to trade securities.
This includes both traditional floor trading and electronic trading.
All trading activity is overseen by IIROC (Investment Industry Regulatory Organization of Canada).
Stock exchanges in Canada: (TMX Group)
Toronto Stock Exchange (TSX) Trading in senior securities
Venture Exchange (TSXV) Trading in junior securities
Montreal Exchange (MX) Options trading
Main market participants
Agency (Broker)
Principal
Market Maker
Arbitrager
Market Structure
An auction market always displays the “best available price” at any given time.
displayed as the BID and ASK prices at any given time
–> BID is the highest price people are willing to pay.
–> ASK is the lowest price people are willing to sell at.
“Market size”
Indicates how many shares are available at the BID and ASK prices
“Market depth” (Also called level 2 quotes)
Indicates how many shares are available at each and every price that is inferior to the BID and superior to the ASK.
market order
An order for immediate execution at the best available price. No price is specified
limit order
An order to buy or sell a security at a specific price
A better price may be obtained than the limit specified
Stop Sell (Stop Loss)
Order with Stop limit**
An order to sell which becomes effective as a market order when the price trades at or below* the “trigger” or stop loss price.
Stop loss orders must be set at a stop price below the current market price.
A stop limit MUST now be used to set a lower boundary.
Stop Buy (Buy Stop)
Order with Stop Limit**
An order to buy which becomes effective as a market order when the price trades at or above* the “trigger” or stop buy price.
Stop buy orders must always be above the current market price.
A stop limit MUST now be used to set a upper boundary maximum price.
Trailing stop order**
An stop order that adjusts and follows a stock price by a fixed dollar or percentage amount.
Day order
An order that is valid for that day only.
Good till cancelled
An order that is valid until a pre-specified date
All or None**
An order that can be filled for the specific number of shares at a specific price. No partial fills
Market on Close (MOC)
An order entered before the close of the exchange (before 3:40 pm for the TSX) to trade at the closing price
This order becomes unmodifiable after this time.
