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.
