2. Definition of Behavioral Finance A field of finance that
proposes psychology-based theories to explain stock market
anomalies. Within behavioral finance, it is assumed that the
information structure and the characteristics of market
participants systematically influence individuals' investment
decisions as well as market outcomes. 3. Investors Are rational
beings Consider all information and accurately assess its meaning
Some individuals/agents may behave irrationally or against
predictions, but in the aggregate they become irrelevant. Markets
Quickly incorporate all known information Represent the true value
of all securities May be difficult to beat in the long term
Standard Theory of Finance 4. Investors Are not totally rational
Often act based on imperfect information Markets In the short term,
there are anomalies and excesses Standard Theory of Finance 5.
Conventional Finance Prices are correct; equal to intrinsic value.
Resources are allocated efficiently. Consistent with Efficient
Market Hypothesis Behavioral Finance What if investors dont behave
rationally? Behavioral Finance & Conventional Finance 6. The
Behavioral Critique There are 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. 7. Information Processing Critique 1. Forecasting Errors:
Too much weight is placed on recent experiences. 2. Overconfidence:
Investors overestimate their abilities and the precision of their
forecasts. 3. Conservatism: Investors are slow to update their
beliefs and under react to new information. 4. Sample Size Neglect
and Representativeness: Investors are too quick to infer a pattern
or trend from a small sample. 8. Behavioral Characteristics 1. Loss
aversion 2. Anchoring 3. Diversification 4. Disposition effect 5.
Herding 6. Media response 7. Optimism 9. Behavioral Characteristics
Loss aversion Devote significant attention to assessing risk Assess
risk tolerance at least once per year possibly using a risk
tolerance questionnaire Assess gains and losses less frequently 10.
Behavioral Characteristics Anchoring: describes the common human
tendency to rely too heavily on the first piece of information
offered (the "anchor") when making decisions. Be aware of
investment anchors Use relevant benchmarks in comparing the
investment portfolio Be cognizant of long-term goals, not
short-term fluctuations 11. Behavioral Characteristics
Diversification Make sure you are properly diversified Dont let
investment options dictate the asset allocation Work with the
financial advisor to determine asset classes that will maximize
return and reduce risk 12. Behavioral Characteristics Disposition
effect The disposition effect refers to peoples tendency to: Hang
on to losers too long Sell the winners too soon This allows them to
enjoy the feeling of winning faster and defer the pain of loss 13.
Behavioral Characteristics Herding Investors have a tendency toward
herd behavior Line study on the effects of herd behavior
Disproportionate flow of money into four and five-star rated mutual
funds Ratings have a lack of predictive value 14. Behavioral
Characteristics Media response Study of the effects of news on
investment decisions: Two groups: one received news and one did not
The group with no news outperformed the group that received news
People often feel the need to react to new information News is
often irrelevant to long-term performance and is often
misinterpreted Information overload can cause stress 15. Behavioral
Characteristics Optimism People believe it is likely that: Good
things will happen to them Bad things will happen to others They
believe others are more likely to: Have a heart attack Develop
cancer They believe others are less likely to: Become rich Become
famous 16. Behavioral Biases 1. Narrow Framing 2. Mental accounting
3. Regret avoidance 4. Prospect theory 17. Behavioral Biases Narrow
Framing How the risk is described, risky losses vs. risky gains,
can affect investor decisions Investing is a series of
propositions, not a single event Performance should always be
viewed within the context of the total net worth Look at long-term
goals, not short-term results Mental accounting Investors may
segregate accounts or monies and take risks with their gains that
they would not take with their principal. 18. Behavioral Biases
Regret avoidance Investors blame themselves more when an
unconventional or risky bet turns out badly. Prospect theory
Conventional view: Utility depends on level of wealth. Behavioral
view: Utility depends on changes in current wealth. 19. Limits to
Arbitrage Behavioral biases would not matter if rational
arbitrageurs could fully exploit the mistakes of behavioral
investors. Fundamental Risk: Markets can remain irrational longer
than you can remain solvent. Intrinsic value and market value may
take too long to converge. 20. Limits to Arbitrage Implementation
Costs: Transactions costs and restrictions on short selling can
limit arbitrage activity. Model Risk: What if you have a bad model
and the market value is actually correct? 21. Limits to Arbitrage
and the Law of One Price Siamese Twin Companies Royal Dutch should
sell for 1.5 times Shell Have deviated from parity ratio for
extended periods Example of fundamental risk Equity Carve-outs 3Com
and Palm Arbitrage limited by availability of shares for shorting
22. Limits to Arbitrage and the Law of One Price Closed-End Funds
May sell at premium or discount to NAV Can also be explained by
rational return expectations 23. Bubbles and Behavioral Economics
As the dot-com boom developed, it seemed to feed on itself
Investors were increasingly confident of their investment prowess
Bubbles are easier to spot after they end. Dot-com bubble Housing
bubble 24. Technical Analysis and Behavioral Finance Technical
analysis attempts to exploit recurring and predictable patterns in
stock prices. Prices adjust gradually to a new equilibrium. Market
values and intrinsic values converge slowly. Disposition effect:
The tendency of investors to hold on to losing investments. Demand
for shares depends on price history Can lead to momentum in stock
prices 25. Trends and Corrections: The Search for Momentum Dow
Theory 1. Primary trend : Long-term movement of prices, lasting
from several months to several years. 2. Secondary or intermediate
trend: short-term deviations of prices from the underlying trend
line and are eliminated by corrections. 3. Tertiary or minor
trends: Daily fluctuations of little importance. 26. Sentiment
Indicators Trin Statistics: Relative strength Measures the extent
to which a security has outperformed or underperformed either the
market or its industry advancingnumber advancingvolume
decliningnumber decliningvolume trin . . . . 27. Sentiment
Indicators Confidence index Ratio of the average yield on 10
top-rated corporate bonds divided by the average yield on 10
intermediate- grade corporate bonds Put/call ratio Call options
give investors the right to buy at a fixed exercise price and a put
is the right to sell at a fixed exercise price Change in ratio can
be given a bullish or bearish interpretation 28. Sentiment
Indicators Short Interest - total number of shares that are sold
short When short sales are high a signal occurs Bullish
interpretation Bearish interpretation 29. A Warning Although the
ability to discern apparent patterns with stock market prices is
irresistibleit is also possible to perceive patterns that may not
exist
