Behavioural finance Flashcards
(74 cards)
Representativeness Heuristic
A person who relies on the Representativeness Heuristic evaluates the probability of an uncertain event by the degree to which sample evidence is
(i) is similar in essential properties to its parent population.
(ii) reflects the salient features of the process by which it is generated
Myopic loss aversion and equity premium puzzle
Myopic loss aversion combines loss aversion and mental accounting to explain investor behavior. Loss aversion, central to prospect theory, means people feel the pain of losses more than the joy of equivalent gains. Mental accounting refers to how individuals divide their money into separate mental “accounts” and evaluate gains and losses within each one. If investors frequently check their portfolios, they are more likely to notice losses due to short-term volatility, intensifying their loss aversion. This short-term sensitivity may cause them to avoid equities, even though stocks offer higher long-term returns. As a result, they demand a higher equity premium, contributing to the equity premium puzzle. If investors evaluated their portfolios less frequently or were less loss-averse, the demand for this risk premium might decrease, potentially resolving the puzzle.
Disposition effect
(1) Disposition effect: Investors have a greater propensity to sell stocks that have risen in value since purchase, rather than stocks that have fallen in value.
(2) Intuition: Take the purchase price as reference point. When price of the asset falls below this reference point, people are in the “loss domain”, where they tend to be risk-seeking. Hence, they tend to keep the risky asset. When the price of the asset raises above this reference point, people are in the “gain domain”, where they tend to be risk-averse. Hence, they tend to sell the risky asset.
The law of small numbers
The law of small numbers is the exaggeration of likelihood that a small sample resembles the parent population from which it is drawn.
Which study showed Excess volatility
Shiller (1981) Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?. Excess volatility
Which studies showed Negative autocorrelation over 3-5 years
De Bondt and Thaler (1985) analyze the predictability of stock prices using an overshooting hypothesis
Which study was about siamese twin companies and what companies?
Froot and Dabora (1999) How Are Stock Prices Affected by the Location of Trade? – Siamese Twin companies
Royal Dutch and Shell
Which study was about the close end fund puzzle and what company
Lee et al “Investor Sentiment and the Closed-End Fund Puzzle.”. (1991) Closed end funds puzzle
Tricontinental company
Which study showed that most large gains in the market followed no news? Which companies have showed this?
Cutler et al. (1989) “What Moves Stock Prices?”.
Zoom Video (real) - Zoom Technology (fake)
Which study showed noise trader risk can lead to noise trader risk and noise traders making profits?
De Long/Shleifer/Summers/Waldmann (1990). Noise trader risk in financial markets
The Efficient Market Hypothesis
The Efficient Market Hypothesis stresses that, at any instant in time, the price of a security equals its fundamental value i.e. the discounted value of all future income flows associated with the security. Further that all publicly available information is immediately incorporated into security prices
How can Myopic loss aversion lead to deviations from The Efficient Market Hypothesis
- Less demand for equities pushing prices below fundamental values
- Overreaction to bad news leading to momentum based on previous prices
- Limit arbitrage
- To high trading volume when frequently evaluating stocks
How can Disposition effect lead to deviations from The Efficient Market Hypothesis
- past price changes are indicative of future price trends due to people selling in the gains and keeping loosers. This would make stock prices of firms with positive earnings shocks be below fundamental value.
Can the diposition effect be rational?
Yes if they believe in short term mean reversion. However, even in experimental markets where selling winners is a very bad strategy people still do so and keep losers. Also stock markets show 6-12 months of momentum (Odean) which is within the average holding period of investors. here selling winners would also be bad
Which study show that the skewness of a stock matters?
Barberis & Huang (2008) Stocks as lotteries: The implications of probability weighting for security prices.
Properties of Prospect Theory?
“Reflection Effect”
“Certainty effect”
“Isolation Effect”
“Loss aversion”
Diminishing sensitivity -“Concavity of gains” and “Convexity of losses”
Probability weighting function”
“Editing phase”
What are the problems with stochastic dominance in Propect Theory?
There are stochastic dominance problems due to π(0,5)u(100)+π(0,5)u(100)<u(100) such that an incremental increase i utility would making the forsure gain of a smaller utility greater than a for sure gain of a larger utility.
What is subadditivity?
Underweighting of differences between small probabilities π(rp)>rπ(p),0<r<1
What is subcertainty?
Decision weights of complementary risky events do not add up to 1! π(0,34)+π(0,66)<1
What is the equity premium puzzle?
Equity Premium Puzzle is the observation that the average return of the US stock market has historically exceeded the average return of Treasury bills by a much greater margin than predicted by CAPM.
What is important to know about studies of disposition effect?
How can experimental markets hel?
Any empirical test for disposition effects tests joint hypothesis that prospect theory is correct and a particular specification of how investors choose reference points
Experimental markets can help control investors expectations and measure original purchase prices or previous periods purchase prices
Which study show disposition effect in the housing market and what result?
Genesove & Mayer (2001). Loss aversion and Seller Behavior: Evidence From The Housing Market.
Research question: Does whether the sale of the house is predicted to have a nominal loss at current market prices predict the sales strategy?
a 10% predicted loss led to a 3.5% increase in asking price. Also more houses sold in upmarkets than down markets. Less effect for investors.
Which study showed in market data that disposition effect is true and what results?
Terrance O’dean (1998) Are investors reluctant to Realize Their Losses?
data: 100.000 transaction in the 1980’s
PGR>PLR, but opposite in december
reference point: average price
Is it rational? No due to momentum and investors holding stock for on average 104-124 days
Which study showed in experimental markets that disposition effect is true and what results?
Weber & Camerer (1998). The disposition effect in securities trading.
H1: More shares are sold when the current price is above the purchase price than when it’s below it. (here the purchase price is seen as the reference point). The null is no difference for selling depending on purchase price.
H2: More shares are sold when the current price is above the last period’s price than when it’s below it. (here last periods price is seen as the reference point). The null is no difference for selling depending on last periods price.
Also H3: no disposition effect in markets with automatic selling
A-f stocks (++,+,0,0,-,–)
People sell winner stocks 59% of time. sell losing stock 36% of time in direct contradiction to the optimal bayesian strategy. Profits from sold stocks was 1 and profits from held stocks was only 0.4-0.7
