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Lecture Week12 Behavior Finance

It provides an overview of efficient market hypothesis, which posits that stock prices fully reflect all available information and follow a random walk. It also discusses behavioral finance and how human irrationality and biases may lead to market inefficiencies. Specifically, it explores how errors in information processing and behavioral biases could impact investors' decisions. Finally, the document covers some technical analysis strategies used by traders, such as analyzing trends, momentum, and sentiment indicators, but notes these may find nonexistent patterns in random data.

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Yaonik Himmatramka
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50 views26 pages

Lecture Week12 Behavior Finance

It provides an overview of efficient market hypothesis, which posits that stock prices fully reflect all available information and follow a random walk. It also discusses behavioral finance and how human irrationality and biases may lead to market inefficiencies. Specifically, it explores how errors in information processing and behavioral biases could impact investors' decisions. Finally, the document covers some technical analysis strategies used by traders, such as analyzing trends, momentum, and sentiment indicators, but notes these may find nonexistent patterns in random data.

Uploaded by

Yaonik Himmatramka
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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LEARNING MODULE 9:

MARKET EFFICIENCY &


BEHAVIOURAL FINANCE
Portfolio Management
Overview
◦ Efficient Market Hypothesis

◦ Conventional vs. behavioral finance


◦ Information processing and behavioral irrationalities
◦ Limits to arbitrage and bubbles in behavioral economics
◦ Technical analysis and strategies
THE EFFICIENT
MARKET
HYPOTHESIS
Efficient Market Hypothesis (EMH)
◦ Maurice Kendall (1953) found no predictable pattern in stock price changes
◦ Prices are as likely to go up as to go down on any particular day
◦ How do we explain random stock price changes?

◦ EMH: some set-ups


◦ A forecast about favorable future performance 
◦ Market participants trade on new information
◦ Generates favorable current performance 
◦ Prices change until expected returns are commensurate with risk

◦ New information is unpredictable


◦ Stock prices that change in response to new (unpredictable) information also must move unpredictably
◦ Stock price changes follow a random walk if the market is efficient
EMH: Some Evidence?
EMH and Competition
◦ Information:
◦ The most precious financial commodity
◦ Strong competition assures prices reflect information
◦ Higher investment returns motivates information-gathering
Versions of the EMH
◦ Weak: Market prices already reflect all information that can be derived from market trading data (e.g.
history of past prices, trading volume, or short interest

◦ Semi-strong: Market prices already reflect all publicly available information regarding the prospects of
a firm must be reflected in the stock price (e.g. fundamental data on firm)

◦ Strong: Market prices already reflect all information relevant to the firm, even including information
available only to company insiders

◦ All versions assert that prices should reflect available information


Implications of the EMH
◦ Technical Analysis: charts….
◦ Success depends on a sluggish response of stock prices to supply-and-demand factors
◦ If market is efficient, then technical analysis will be fruitless

◦ Fundamental Analysis: get information of earnings and dividend prospects, expectations of future
interest rates, risk evaluation…
◦ Seek firms that are mispriced
◦ Find poorly run firms that are not as bad as the market thinks
◦ Again, if market is efficient, then fundamental analysis will be fruitless
Active versus Passive Management
◦ Active Management
◦ An expensive strategy
◦ Suitable for very large portfolios
◦ Passive Management
◦ No attempt to outsmart the market
◦ Accept EMH
◦ Index Funds and ETFs
◦ Very low cost
◦ Even if the market is efficient a role exists for portfolio management:
◦ Diversification to reduce the unsystematic risk
◦ Appropriate risk level: fail of Lehman brothers makes employees loss their shares
◦ Tax considerations: instead of investing in some interest-income generating assets only, people with a high salary could
consider investing in capital gain assets to avoid tax, such as real estate.
Why is market efficiency important?
◦ Resource Allocation
◦ Inefficient markets  systematic resource misallocation
◦ Overvalued securities can raise capital too cheaply
◦ Undervalued securities may give up profitable opportunities because cost of capital is too high
◦ Efficient market does not mean perfect foresight market
So, Are Markets Efficient?
◦ Professional manager performance is broadly consistent
with market efficiency
◦ Most managers do not do better than the passive
strategy
◦ Some analysts may add value, but:
◦ Difficult to separate effects of new information from
changes in investor demand
◦ Findings may lead to investing strategies that are too
expensive to exploit

◦ There are, however, some notable superstars:


◦ Peter Lynch, Warren Buffett, John Templeton, Mario
Gabelli
BEHAVIOURAL FINANCE
& TECHNICAL ANALYSIS
Behavioral Finance
Conventional Finance Behavioral Finance
◦ Prices are correct and equal ◦ What if investors don’t
to intrinsic value behave rationally?
◦ Resources are allocated
efficiently
◦ Consistent with EMH
The Behavioral Critique
Two categories of irrationalities:
1. Investors do not always process information correctly
◦ Result: Incorrect probability distributions of future returns
2. Even when given a probability distribution of returns, investors may make inconsistent or
suboptimal decisions
◦ Result: They have behavioral biases
Errors in Information Processing
1. Forecasting Errors
◦ People give too much weight to recent experience compared to prior beliefs when making forecasts
◦ People tend to make forecasts that are too extreme given the uncertainty inherent in their information

2. Overconfidence
◦ People tend to overestimate the precision of their beliefs or forecasts
◦ People tend to overestimate their own abilities (e.g. drivers)

3. Conservatism
◦ Investors are too slow (too conservative) to update their beliefs in response to new evidence (e.g. earnings drift)

4. Sample Size Neglect and Representativeness


◦ People 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. Therefore, infer a pattern too quickly and extrapolate apparent trends into the future
(e.g. overreaction and correction)
Behavioral Biases: Examples
1. Framing
◦ How the risk is described, “risky losses” vs. “risky gains” can affect investor decisions
2. Mental Accounting
◦ Investors may segregate accounts or monies and take risks with their gains that they would not take with their
principal
3. Regret Avoidance
◦ Investors blame themselves more when an unconventional or risky bet turns out badly
4. Prospect Theory
◦ Conventional view: Utility depends on level of wealth
◦ Behavioral view: Utility depends on changes in current wealth
Bubbles and Behavioral Economics
◦ Bubbles are easier to spot after they end
◦ Dot-com bubble (a period of extreme growth in the use and adoption of the Internet)
◦ Housing bubble
◦ Bitcoin?

Those bubbles could also lead investors to make irrational decisions.


Disposition effect

◦ Disposition effect:
◦ Tendency of investors to hold on to losing investors
◦ Behavioral investors seem reluctant to realize losses.
◦ Demand for shares depends on price history
◦ Can lead to momentum in stock prices , even if fundamental values follow a random walk
Research on Behavior finance and
personality
◦ Rosa and Durand (2008):
◦ “Investors rely on the availability heuristic: salience (the number of stories in the national press about a
stock
in the month before the portfolios are formed) captures over 50% of the variation in our dependent
variable.”

◦ “We utilize a unique dataset to provide further evidence of how investors choose stocks for their
portfolios. The data allows us to hold the information opportunity set constant for each investor and, as
such, provides a strong control for the analysis of the use of information in forming portfolios. We find
strong support for the hypothesis that investors utilize the availability heuristic when selecting shares.”
◦ “We find that the salience of a company, proxied by the number of stories in the national press about that
company in the month before portfolios had to be chosen (July 24, 2003 to August 24, 2003), is the
predominant influence in determining the likelihood of inclusion of a company in an investor's
portfolio.”

◦ Salience, as we have noted previously, is proxied by the number of stories in the national press about that
company in the month before portfolios had to be chosen. We hypothesize that the greater the salience of
a company, the more likely it is that the company will be included in an investor's portfolio.
Technical Analysis: Trends and
Corrections
◦ Momentum and moving averages
◦ The moving average is the average level of prices over a given time interval, interval updates as time
passes
◦ Bullish signal: prices breaking through the moving average from below (shift from falling trend to
a rising trend)
◦ Bearish signal: prices breaking through the moving average from above (shift from rising trend to
a falling trend)
Technical Analysis: Relative Strength
◦  Relative strength

◦ Measures if a security has out- or underperformed either


the market or its particular industry
◦ Pricing ratio implies outperformance

◦ Breadth
◦ Often measured as the spread between the number of
stocks that advance and decline in price during a given
period
Technical Analysis: Sentiment Indicators
◦  Trin Statistic
share volume and stock no.
Ratios above 1.0 are bearish

◦ Confidence Index
◦ The ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10
intermediate-grade corporate bonds
◦ Higher values are bullish

◦ Put/Call Ratio
◦ Calls are the right to buy (bet on rising prices) and puts are the right to sell (bet on falling prices)
◦ A rising ratio may signal investor pessimism and a coming market decline
◦ Contrarian investors see a rising ratio as a buying opportunity
What happened next?
Technical Analysis: A Warning
◦ It is possible to perceive patterns that really don’t exist
◦ Figure 12.6A is based on the real data
◦ The graph in panel B was generated using “returns” created by a random-number generator
◦ Figure 12.7 shows obvious randomness in the weekly price changes behind the two panels in Figure 12.6

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