Lecture 7 Flashcards
Behavioural Finance
A relatively new school of thought, behavioural finance, argues that the sprawling literature on trading strategies has missed a larger and more important point by overlooking the first implication of efficient markets.
Whereas conventional theories presume that investors are rational, behavioural finance starts with the assumption that they are not.
Behavioural finance: investors suffer from behavioural biases that can have an impact on market prices.
The behavioural critique
Irrationalities that seem to characterise individuals making complicated decisions, are…
The premise of behavioural finance is that conventional financial theory ignores
how real people make decisions.
Investors are not always rational when making complicated decisions:
- Information processing
- Inconsistent/suboptimal decision making.
There are limits to arbitrage such that prices may deviate from the true asset values. When there are regulation based limitations, such as transaction costs , short selling being forbidden, occasions when it snot possible for arbitrage to eliminate mispricing. Then might show that there is alpha to be made, profit to be made. But this profit is still less than the transaction costs.
Remains exploited, cant make money of it. The limits for persistent mispricing is rational as it doesn’t require inefficiency or irrationality from the investors.
- Investors do not always process
information correctly and therefore infer incorrect probability distributions about future rates of return. - Even given a probability distribution of returns, they often make inconsistent or
If such irrationalities did affect prices, then sharp-eyed arbitrageurs taking advantage of profit opportunities might be expected to push prices back to their proper values.
Both the CAPM and the EMH assumes that investors are rational. (buy low, sell high)
Behavioural doesn’t contradict EMH but it complements it.
CAPM:
All investors hold the well diversified market portfolio. If the return on an asset i s not commensurate with systematic risk, arbitrageurs will exploit the mispricing and restore equilibrium.
- single explanation for the returns of risky assets, their systematic risk.
EMH:
Price reflects all information available to investors. As new information arrives, investors use the information to drive prices to their right level.
- EMH, just says that in equilibrium things will be priced correctly as rational behaviour will eliminate any mispricing.
-
-
-
-
Information Processing
Errors in information processing can lead investors to misestimate the true probabilities of possible events or associated rates of return.
Biases
- Forecasting Errors
- Overconfidence
- Conservatism
- Sample Size Neglect and Representativeness
- Forecasting Errors
indicate that people give too much weight to recent experience compared to prior beliefs when making forecasts (sometimes dubbed a memory bias ) and tend to make forecasts that are too extreme given the uncertainty inherent in their information.
Instead of taking the weight of every observation the same, it turns out this bias leads to forming an exceptions for the recent observations have higher weights.
when forecasts of a firm’s future earnings are high, perhaps due to favorable recent performance, they tend to be too high relative to the objective prospects of the firm. This results in a high initial P/E (due to the excessive optimism built into the stock price) and poor subsequent performance when investors recognise their error.
Thus, high P/E firms tend to be poor investments.
- Overconfidence
People tend to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities.
Our ability to summaries information is superior to others.
They find that men (in particular, single men) trade far more actively than women, consistent with the generally greater overconfidence among men well documented in the psychology literature.
For example, overconfident CEOs are more likely to overpay for target firms when making corporate acquisitions. Just as overconfidence can degrade portfolio investments, it also can lead such firms to make poor investments in real assets.
- Conservatism (Rise to Momentum)
A conservatism bias means that investors are too slow (too conservative) in updating their beliefs in response to new evidence
- might initially under-react to news
- prices will fully reflect new information
only gradually and not immediately.
Such a bias would give rise to momentum in stock market returns.
- Sample Size Neglect and Representativeness
The notion of representativeness bias holds that people commonly do not take into account the size of a sample, acting as if a small sample is just as representative of a population as a large one.
Infer a pattern too quickly based on a small sample and extrapolate apparent trends
too far into the future. Such a pattern would be consistent with overreaction and correction anomalies.
short-lived run of good earnings reports or high stock returns would lead such investors to revise their assessments of likely future performance, and thus generate buying pressure that exaggerates the price run-up. This is when we are hasty to uncover to uncover patterns, even when data are purely random. (Very common)
Eventually, the gap between price and intrinsic value becomes glaring and the market corrects its initial error.
Stocks with the best recent performance suffer reversals precisely in the few days surrounding earnings announcements, suggesting that the correction occurs just as investors learn that their initial beliefs were too extreme.
Behavioural Biases
Even if information processing were perfect, individuals would tend to make less-than-fully-rational decisions using that information.
These behavioural biases largely affect how investors frame questions of risk versus return, and therefore make risk–return trade-offs.
- Framing
- Mental Accounting
- Regret Avoidance
- Loss aversion
- Framing
Decisions seem to be affected by how choices are framed.
Example: Individual may reject a bet when it is posed in terms of the risk surrounding possible gains but may accept that same bet when described in terms of the risk surrounding potential losses
Example: Example: “If you quit smoking, you will not develop lung cancer” vs “if you continue to smoke, you will die of lung cancer”.
Example: ‘Annuity puzzle’ annuity is a great way to address the risk of outliving ones income, yet annuity contracts are extremely rare. You take your pension savings and give to investment company and they will pay you an annuity and they will pay you monthly until you live.- longer or short. People are not keen on giving up on savings, as they don’t like the prospect of dying. Find that participants find an annuity more attractive when framed as consumption rather than investment.
- Mental Accounting
Mental accounting is a specific form of framing in which people segregate certain decisions
Example: an investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education. Rationally, it might be better to view both accounts as part of the investor’s overall portfolio with the risk–return profiles of each integrated into a unified framework.
Example: Mental accounting effects also can help explain momentum in stock prices. The house money effect refers to gamblers’ greater willingness to accept new bets if they currently are ahead.
Example: after a stock market run-up, individuals may view investments as largely
funded out of a “capital gains account,” become more tolerant of risk, discount future cash flows at a lower rate, and thus further push up prices.
- Regret Avoidance
Investors regret poor returns more if they formed unconventional portfolios.
Example:
Buying a blue chip portfolio that turns down is not as painful as experiencing the same losses on an unknown start up firm. Investors may attribute losses on the blue chip stocks to bad luck, whereas those on the unknown start up firm to bad decision making.
The level of acknowledgement may vary between investors.
Higher book-to-market firms tend to have depressed stock prices. These firms are “out of favor” and more likely to be in a financially precarious position. Similarly, smaller, less well known firms are also less conventional investments.
Mental accounting can add to this effect. If investors focus on the gains or losses of individual stocks, rather than on broad portfolios, they can become more risk averse concerning stocks with recent poor performance, discount their cash flows at a higher rate, and thereby create a value-stock risk premium.
- Loss aversion
Investors exhibit risk seeking behaviour when faced with certain losses. We would take more risk to avoid losses. The shape of the utility function works with this theory.
Not framing, just frame of loss
Example:
Treatment 1: You are given £10 and faced with the following options:
1. A sure gain of £5. Expected Value = 5
2. Coin toss: no gain versus a gain of £10.
Expected value = 0.5 (10) + 0 (10) = 5
Treatment 2: You are given £20 and faced with the following options:
1. A safe loss of £5. Expected Value = -5
2. Coin toss: no loss versus a loss of £10.
Expected Value = -10
The majority of people who are subjected to treatment 1 (2) goes for the safe (risky) option, which implies risk aversion ( seeking)
Thus, people seem to act in a risk averse (seeking) way when faced with certain gains (losses). They are happy to take risks to avoid losses.
Prospect theory offers an explanation for this type of behaviour.
