Lecture 3: Ch. 5 & 6 Flashcards
How executives perceive risk and return between good stocks and between bad stocks? What behavioral explanations is behind that?
They perceive stocks of good companies [with good products and good management] to be good stocks [i.e. good for investment purposes]: Representativeness Heuristic
Free lunch: high returns, low risk (does not match with the theory)
- “Good-feeling stocks” are associated with higher expected returns and lower risk compared to “bad-feeling stocks”.
- This perception relies on the Affect Heuristic
- Thus, Affect and Representativeness reinforce each other here
What Shefrin and Statman [1995] and Statman et al. [2008], relate “good stocks” and “ good-feeling stocks” to?
› Shefrin and Statman [1995] and Statman et al. [2008],
relate “good stocks” and “ good-feeling stocks” to:
SIZE and VALUE PREMIA.
• “good [feeling] stocks” are large growth firms that are expected to outperform [which contradicts empirical evidence]
• Note that this apparent bias of executives is also very much present among security market investors in general.
How do CFO’s determine cost of capital? Is it a good measure?
70% of CFOs use CAPM to determine the cost of capital (aka simple models are chosen over sophisticated ones).
If the value and size [and momentum] premia reflect mispricing rather than a compensation for fundamental risk, then firms may better stick to the CAPM.
What discount rate do CFO’s use for project evaluation? Is it a good measure to use?
58% of CFO’s use one company-wide discount rate.
The use of a company-wide discount rate [such as the WACC] favors risky projects over safer projects. That is, a simple ‘One Single Discount Rate Heuristic’ creates ‘biases’ in the firm’s capital budgeting decisions
SML and cost of capital:
Error type 1: Accept More-Risky Projects with Negative NPV
Error type 2: Reject Less-Risky Projects with Positive NPV
What is an efficient market? Name 3 types of efficiencies and describe what kind of information is reflected in each.
The market in which prices reflect all relevant information.
Depending on “relevant information”:
• weak form efficiency [based on Random Walk hypothesis] -> no information that could predict future prices is reflected in the past prices
• semi-strong form efficiency-> cannot predict by studying annual reports (as the information is already reflected in the prices)
• strong form efficiency -> even information that is private (inside) is reflected in the prices
What are three finance-theoretical arguments in support of Market Efficiency?
How behavioral finance questions these arguments?
› Finance-Theoretical arguments in support of Market Efficiency:
• Investors are rational
• Deviations from rationality are independent (non-systematic way)
• ‘Disciplining’ role of arbitrage
› Behavioral Finance questions these arguments:
• Investor behavior often deviates from rationality. In general, people are subject to bounded rationality, to self-deceptive and emotion-based influences, and to social interactions.
• Deviations from investor rationality can be (and often are) systematic. For example, investors are subject to common psychological heuristics, which may result in under- or overreactions in stock-price patterns -> Prices may contain Sentiment.
• Power of arbitrage is limited, even in stock markets. The main reason for this limitation is that stock-market arbitrage is risky
• And: Evidence from Empirical Research that questions the validity of market efficiency as a ‘well-established regularity’
Why arbitrage may be limited?
› Short sale constraints
• Sometimes short selling is not possible or not allowed
› Noise trader risk (not that smart people who trade based on non-information)
• Mispricing may get worse
• Related are Agency issues: clients of money managers cannot distinguish between skill and luck. Money Managers then face time constraints (if you are right (think that something is overpriced/underpriced) it doesn’t mean that you are profiting from that (mispricing might continue))
› Fundamental risk
• Impact of unexpected news that affects only 1 side of the trade
› Costs
• Transaction, search and information costs
Limited arbitrage is at the core of the behavioral
argument why mispricing may persist.
What is The winner-losser effect? What is the behavioral explanation behind it?
› Mean-reverting patterns in cumulative returns of selected stock portfolios: previous losers outperform previous winners in a 3-5 year period
› Behavioral Explanation:
• Representativeness heuristic: extrapolation bias regarding prior earnings and returns, leads investors to Overreact to past-loser stocks -> losers become undervalued -> increased future returns
• Similarly, past-winner stocks become overvalued -> decreased future return
Winner-loser effect is inconsistent with weak-form market efficiency
What is Momentum effect? What are the three behavioral explanations behind it?
A portfolio formed by holding past-6-months winners & shorting past-6-months losers earn abnormal positive returns in the short run (more than 10% per year)
› Three behavioral explanations:
• Analysts and investors tend to underreact to new information [‘conservatism’, based on heuristic of Anchoring & Adjustment] -> price then adjusts slowly
• Subsequent to initial market reaction to news, overconfident investors overreact to later news -> price then “overshoots”
• Result from so-called disposition effect among investors: from their stocks, they tend to “sell winners too early and ride losers too long” [primarily based on
Prospect Theory] -> causes retardation of price increases / price decreases
Momentum effect is inconsistent with weak-form efficiency
What is pos-earnings-announcement-drift? What is the behavioral explanation behind it?
› Often, stock prices appear not to adjust to earnings-news surprises immediately: prices adjust slowly over time, exhibiting drift in the same direction as the surprise for a prolonged period. [link to
momentum]
› EMH (not consistent)
• prices should change instantly when new information becomes available.
› Behavioral Explanation:
• financial analysts underreact to ‘surprising’ news [from heuristic of Anchoring & Adjustment]
This phenomenon is inconsistent with semi-strong market efficiency
What are three aspects of IPO? Explain them.
• Hot Issue Market ( explained by rational managers exploiting sentiment driven markets [so: market timing], or the need for external financing during good economic times)
• Initial Underpricing (Rationally explained by [info. assym. induced] risk, agency issues [e.g. reducing ligitation risk], and truncation by underwriters.
Behavioral issues: anchoring to bookbuilding price range, framing aspect of opportunity loss, hedonic editing [loss is small compared to gain], price is set by optimistic investors given short sale constraints.)
• Long-term Underperformance (new issues earn lower returns compared to stocks with comparable characteristics (size and book-to-market equity).
