Lecture 7: Behavioural Finance & Technical Analysis

Question 1

Summary

Answer 1

Behavioural finance: investors suffer from behavioural biases that can have an impact on market prices.

Limits to arbitrage can limit exploitation of irrational behaviours in markets.

It is easier to identify consequences of irrational behavior, such as bubbles, ex post.

Technical analysis is based on analysing trends in stock prices and predicting
future price movements based on these trends.

Humans can have a tendency to discern patterns when there is none. So,
one has to be careful about inferring too much from data patterns

Question 2

Both the CAPM and the EMH assumes that investors are rational. (buy low, sell high)

Answer 2

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.

Question 3

History

Answer 3

These predictions are predicted by market efficiency and assumptions of CAPM.

Up until the mid 1980’s, our view about asset prices was almost conclusive

• Asset returns are unpredictable, same as prices being random walks.
• Returns are explained by the market beta, systematic risk.

Implications

• It is very difficult to earn abnormal returns, the same as coming up with trading strategy and consistently outperforming the market portfolio in the long run. (hard)
• Active strategy is not likely to be better than passive strategy. Active strategy could be same as trading strategy.

However, new evidence began to emerge, predictability of returns is possible and it is consistent with efficiency.

Question 4

Example: Momentum strategy
(Predictability)

Explain why momentum doesn’t have to be an anomaly.

Answer 4

Proposed by Jegadeesh and Titman (1993).

If you observed stocks that performed well in the past (yesterday, months, years), and you follow a trading strategy where you buy today. These types of assets had high returns in the past. Vice versa, you short.

• This strategy results in abnormal returns (about 1% per month) in the short term.
• The momentum strategy still works today
• This momentum effect is one of the many anomalies we see in security markets
• There are many explanations for the momentum effect. (see Moskowitz paper)

Question 5

Capital IQ: Alpha Factors

Answer 5

Basic Momentum Strategy: past winners keep winning and past losers keep loosing. Passive strategy of following the portfolio outperforms all other strategies.

The momentum portfolio didn’t get hit by COVID that much. Since Market it has been overperfomlng relative to the other strategies. - Now 10% over 1 year horizon

Question 6

Anomaly with efficiency explanation 1

Answer 6

If I run a regression, and we see that there is statistically significantly coefficient. It is telling me that if you follow this strategy on average, you will make money.

Which is what everyone will do, by longing this. Then everyone will push the price up today and therefore the return tomorrow will not be as high. So a lower return tomorrow is more logical (rational investor).
It seems like an anomaly.

You catch up with the reaction later.

One group of explanations is based on the idea that investors are not rational

• underreaction
• limited attention
• delayed overreaction
• herding, disposition.

heuristics: A decision-making procedure resulting from limited time and attention

Question 7

Anomaly with efficiency explanation 2

Answer 7

Group of explanations is risk based we mean consistent with efficient and consistent with asset pricing theory. They are stating that if something carries risk, it must compensate with return.

Consistent with rationality/ efficiency economic risks affect firm investment and growth rates that impact their long term cash flows

Past over performance can be linked with company becoming riskier as it grows faster, engages with riskier investments. This is what the investors are compensated for.

Question 8

Momentum Type 1: Time series

Answer 8

Is good return today associated with good return tomorrow? known as momentum effect

Is good return today associated with mean reversal tomorrow? also called “profit taking”

Are returns predictable? Not perfectly, but somewhat?

What should we get for the coefficients a and b if there is momentum vs mean reversal?

1. If we run the regression: 𝑅𝑡+1=𝑎+𝑏𝑅𝑡+𝜀𝑡+1
2. Based on CAPM & EMH, then there shouldn’t be any predictability as returns are not predictable. This coefficient should not be statistically significantly different from 0.
3. Positive coefficient, is statistical evidence for time series momentum. It states that there is predictability inside the asset itself. It is able to predict its results.

Question 9

Mean reversion

Answer 9

If coefficient is statistically significantly negative, - call it mean reversion

Negative beta tells us that the return will be lower so we are going back to the mean

This is also called profit taking. - means selling your asset. This can lead to a negative result in the next day. If this was the case then investors would develop a strategy to short the stocks that are gaining today, to make money of selling tomorrow.

Rational: predict that we should observe any beta, it should not be statistically different from 0.

Question 10

Regression Results

Answer 10

• all in annual
• regress over themselves
• Beta is never statistically significant for market portfolio, whether in raw or excess form. Whether for short term or long term .
• At least at annual frequency there is no evidence of time series momentum in data.

Question 11

Difference between a long term and short term bond yield. (Fixed income instruments)

Answer 11

Longer maturity bond has a higher average yield.

Question 12

Market Risk Premium Explanation

Answer 12

In CAPM returns is explained by market risk premium X beta.
- Beta- systemic risk

MRP

• MRP is the market price of risk.
• MRP is return on market - RfR. This is a long short portfolio, where you invest in long MP and short Rfr.
• MRP is a long-short strategy. This premium is the price of unit of systematic risk.

Question 13

Momentum Type 2: Cross Sectional

Answer 13

Think of momentum as a risk factor like the market risk factor, i.e. MRP; notation: * for
excess returns;

We are looking at all assets yesterday, sorting by performance yesterday and then picking the top (10% or 20%) of the highest possible returns yesterday and the one that lost the most yesterday and then we form a long- short strategy. (year/monthly)

On the short one we owe the return, on long we receive the return. The difference is the net position. This can be a positive or negative market risk premium.

Similar to market price of momentum risk.

MOM the momentum factor; 𝜇𝑗 the sensitivity of 𝐸∗𝑅𝑗 to MOM

𝐸∗𝑅𝑗=𝛼𝑗+𝛽𝑗𝑀𝑅𝑃+𝜇𝑗𝑀𝑂𝑀+𝜀𝑗

• : excess returns
  BjMRP: is long-short portfolio
  UjMOM: is corresponding long-short portfolio on the longing of high return stocks and shorting low performing return stocks.
  Uj : sensitivity of asset j to momentum j factor, this is what we see in capital IQ.

Momentum strategy is the one with the highest transaction costs as the long and short positions of the stock in the distribution is constantly changing.

Question 14

The main aim of today

Answer 14

Some behavioural biases that may affect investment decisions.

Some reasons why rational arbitrageurs may not be able to exploit the mispricing and restore prices to the ‘true’ values.

Question 15

The behavioural critique

Answer 15

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.

Question 16

Example: Momentum strategy

Answer 16

The momentum strategy can be explained by conservatism and representativeness

Conservatism: investors at first respond too slowly to new information, leading to trends in price. - This means that if you act now you can still make money in the next period as information is reflected gradually. Typical example of inefficient processing of information.

Representativeness: investors extrapolate trends too far into the future and overshoot intrinsic value. As investors work on expectations, they bid the prices up. You believe in momentum which then creates momentum.

Pricing error is eventually corrected, leading to a reversal.

Question 17

Example 4: Bubbles and behavioural economics

Answer 17

Bubbles happen when asset prices are ‘too high’. These are bubbles of market inefficiency and then it is restored, through correction of the market.

Eugene Fama : Bubbles are special cases of market inefficiency where cumulative returns differ predictably from equilibrium expected returns for sustained periods

Price = present value of all FCF

• Returns are discount factor
• But prices are more volatile than the change in cash flows.
• Then changes in price must come from the change in discount rate (risk free rate + risk
  premium) .
• dividends are smooth, therefore volatile in prices come from volatile returns.

EMH: “Prices are high, risk aversion must have fallen”

Behavioural:“Prices are high, there must be a wave of irrational optimism”

Shiller (2000) argues that the NASDAQ bubble was driven by “fads”.

• Firms experienced increase in stock prices after adding “.com” to their names
• Overconfidence bias, representativeness bias. Companies with Dotcom in name saw increase by bids of irrational bidders.
• The NASDAQ index fell to less than ¼ of its peak value in October 2002.

Question 18

Paper 1: Culture and R^2

• Eun, Wang and Xiao (2015).
• Journal of Financial Economics 115(2):
  283 303.

Answer 18

Stock prices co move with market index

• more in culturally tight countries and less in culturally loose countries.
• Tightness vs looseness the strength of country’s social norms and the society’s tolerance for deviant behaviour.

Stock prices co move (R^2 is higher)

• more in collectivistic countries and less in individualistic countries. - overconfidence
• Individualism vs collectivism the confidence in their ability to acquire and analyse information and the confidence in having different opinions from others.
• returns are only explained by the market portfolio and there are less returns that are unexplained, thus meaning R^2 is higher.

Implication on the information environment incorporation of firm specific information into stock prices (means less R^2), means that there is more richness in the information or enviromemt. This is debatable whether the magnitude of R^2 can be used to understand the richness of the enviromemt.

Question 19

Paper 2: Explaining behaviour of investors.
Where are we?

Cronqvist, Previtero , Siegel and White (2015). The fetal origins hypothesis in finance ”. Review of Financial Studies 29 (3): 739 786.

Answer 19

Prenatal environment can explain the observed differences in investment behaviours. Use Swedish Twin Registry (to control for upbringing etc.)

Twin Testosterone Transfer Hypothesis:
Pre natal exposure to testosterone: female with a male co twin takes significantly more risk later in life compared with a female with a dizygotic female co twin.

Birthweight is positively associated with ‘better’ financial decisions:
Investors with low birth weight are less likely to hold risky assets, but when they do they prefer more volatile portfolios and more individual stocks.

Cognitive ability / ‘gambling for resurrection’

Question 20

3. Breadth

Answer 20

The breadth of a market is a measure of the extent to which movement in a market index is reflected widely in the movements of all the stocks in the market.

If most of the stocks are going up, Brett
1. Calculate the number of stocks that advanced in a particular day A
2. Calculate the number of stocks that declined in a particular day D
The difference is a way of measuring the breadth: A − D . This is difference between positive and negative returns in the market.

If A − D is large;
The market is viewed as being stronger because the rally is widespread.

You can form the cumulative breath and see how the breadth was increased or decreased as the day changes.

Question 21

Sentiment indicators

Answer 21

There are various indicators of market
sentiment (general optimism among investors):

1. Trin statistic
2. Confidence index
3. Put/Call ratio

Question 22

1. Trin statistic

Answer 22

Market volume is sometimes used to measure the strength of a market
rise or fall. The confidence of investors, the rate of participation captures market confidence. This combines confidence measure and the breath measure allows the following derivation.

Increased investor participation in a market advance or retreat is a measure of the significance of the movement.

The trin statistic is defined as follows:
Volume declining/Number declining divided by Volume advancing/Number advancing
- It can also be a product of ratios

Less than 1: bullish
More than 1: bearish, bearish signal, falling stocks have larger average volume, indicating selling pressure. Tells us the numerator is higher (bearish stocks), then overall the market is more bearish than bullish.

Question 23

2. Confidence index

Answer 23

The confidence index is the ratio of the average yield on 10 top rated corporate bonds divided by the average yield on 10 intermediate grade corporate bonds:

• The ratio is always less than 100
• It gets closer to 100% when bond traders are more optimistic.
• Increases in this index send bullish signals.

It still captures riskiness of the corporate as compared to government bonds.

Less than 1:
Highly rated means lower yield as you don’t need to compensated for lower risk. Closer to 1, the risk premium on bonds are shrinking as the intermediate rated bonds are getting closer to higher rated bonds. This shows that investors are more optimistic, therefore this is a bullish signal.

Question 24

2. Put/Call ratio -

bets on prices increase or decrease

Answer 24

Put: is right to sell. Put options protect investors from stock price decreases. This is a bearish bet, inherently.

Call: is right to buy. Call options are a way of betting on stock price increases . This is inherently a bullish bet as you are reserving a right to buy.

The ratio of outstanding put options to outstanding call options is called the put/call ratio. In equilibrium these individual prices should be the same as the exercise price, but in reality they don’t have to be. If you take out all outstanding put options and call options and you take the premiums, then you know which bets are more than others.

Normally, an increase (decrease) in the ratio is seen as a signal to sell

However, some argue that investors should buy when the ratio is high as the prices are depressed due to pessimism.

Put/Call ratio.
This ratio typically hovers around 65%.

The put/call ratio is computed as the number of outstanding put options divided by outstanding call options, and higher values are considered bullish or bearish signals

Question 25

Short Interest

Answer 25

This can be an indication of bearish sentiment among sophisticated investors.

Question 26

The anomalies literature

Answer 26

suggests that several strategies would have provided superior returns.

Question 27

value-versus-growth

Answer 27

Overconfidence about the precision of one’s value-relevant information is consistent with this anomaly