CFA 4 - 6

EMH anomalies, fundamental analysis, alternatives, and manager and

investor sentiment

EMH Anomalies and Fundamental Analysis

- Efficient Capital Markets
o From Fama (1970)
 A market in which prices always fully reflects available information
is called efficient
o From Malkiel
 Formally the market is efficient with respect to some information
set If security prices would be unaffected by revealing that
information to all participants
 Moreover, efficiency with respect to an information set implies
that it is impossible to make economic profits by trading on the
basis of that information set
- Forms of efficiency
o Fama:
 The market price at any time instantly reflects all available
information in the market
 Less information = Weaker EMH
 More information = Stronger EMH
o Three forms (information set)
 Weak form: Past prices and returns
 Semi-strong form: All public information
 Strong form: All public and private information
o Michael Jensen:
 There is no other proposition in economics which has more
empirical support that the EMH
- Theoretical Underpinning
o What’s the economic behind the EMH
 There is a right price, P*
 P* incorporates all information in relevant information set
 P* results from competitive equilibrium
 P* equates supply and demand
o Normal Goods Market
P Dem a n d
Supply
 Aggregate demand curve simply aggregates investors demand at
hypothetical price P
 Negative relationship:
P*  The higher the price of the good, the lower the demand.
 Positive Relationship
Q  The higher the price, the higher the quantity sold

o Efficient Capital Markets

  Supply is typically fixed in the short term
 Flat demand curve
 Rational investors know the right price (P*)
 Every rational investor demands a lot more if:
 P<P* and a lot less if
 P>P*
 Aggregate demand curve is flat P=P*
 Some investors are irrational
 But their uncorrelated misperceptions cancel out
P Supply o If some optimist think that P<P* and an equal
number of pessimists think that P>P*, they don’t
affect the aggregate demand curve
o Assuming P=P* to start with, P=P* remains
 Even if some investors are systematically irrational,
P* arbitrageurs enforce efficiency
Demand
o Arbitrage
 The simultaneous purchase and sale if the
same or essentially similar, security in two
different markets at advantageously different
Q prices.
- Capital Markets Theory
o EMH
o CAPM
o Arbitrage Pricing Theory (APT)
o Options Theory
o Black-Scholes (B-S) Options Pricing Model

An analysis of alternatives to EMH

- Challenges to EMH
o Investors are not fully rational. They exhibit biases and use simple
heuristics (rules of thumb) in making decisions.
o Empirical evidence on investor behaviour
 Investors fail to diversify
 Investors trade actively
 Investors may sell winning stocks and hold onto losing stocks
 Extrapolative and contrarian forecasts
o Expected Utility Theory + Rational Choice Theory = Market Efficiency
 A theory of choice under certainty for a single decision-maker
 Expected Utility = p1*u1+p2*u2+…+pn*un
 P= Probability of event
 U= Utility derived from the event
 All investors are identical
 All investors are utility maximises
 All investors predictions are accurate
o Bounded Rationality
 In decision making, rationality of individuals is limited by the
  Information they have
 Cognitive limitations of their minds
 Finite amount of time they have to make a decision
o System 1 and System 2
o Weak form of market efficiency supported to a certain extent
o Challenges
 Excess market volatility
 Stock price over reaction: long time trends (1-3 years) reverse
themselves
 Momentum in stock prices: short-term trends (6-12 months)
continue
 Crash of 1987: 22.67% decline without any apparent news
 50 largest one-day stock price movements: occurred on days of no
major announcements

- Behavioural accounting/Finance theories

- Definition and scope

o The study of the behaviour of accountants or the behaviour of non-
accountants as they are influenced by accounting functions and reports
o Positive (rather than normative theories)
 In the sense that it involves explaining and predicting human
behaviour in relation to the use of accounting information (rather
than prescribing how people should act)
 Preparers of financial statements and corporate reports
 Auditors
 Users of financial statements and corporate reports
o E.g. Investors and creditors
 Behavioural accounting theories focus on the impact of
psychological processes on financial decision making
 How preparers, users, and auditors use and process accounting
information
 Particular focus on user of accounting information
 Alternative to capital market research
- Capital Market Research vs Behavioural Research
o Capital Market Research
 Theories from financial and economics
 Assumptions of human behaviour
 Users are rational
 Users seek optimal outcomes
 Capital market is efficient
 How capital markets react to release of accounting information
 Share price movements = proxy of investor behaviour
 Based on concepts of market efficiency to explain pricing
mechanisms of security markets
 Focuses on aggregate behaviour of investors
 Economic view of human behaviour
  Home economicus
 Based on expected utility theory and rational choice theory
 Based on assumptions of investor rationality and utility
maximisation
 Solutions are found by means of applying mathematical
models
 Assumes market efficiency
 Decision making process is treated as a black box
 Does not investigate how information is processed by
market participants
o Behavioural Theories
 Theories from psychology
 Assumptions of human behaviour
 Users are not rational
 Users seek satisfactory outcomes
 Capital market is not efficient
 Focusses on actual behaviour and decision processes
 Focussed on design-making at an individual level (rather than
aggregate) level
 Does not assume market efficiency
 Psychological views on human behaviour
 Homo heuristics
 Based on assumptions of bounded rationality/irrationality
and satisfactory rather than optimal solutions
 Portrays investors as active processors of information
 Focus on biases relating to decision making and probability and
belief
- Cognitive Psychology
o Concerned with how knowledge is acquired, stored, correlated and
retrieved
 By studying the mental processes underlying attention, information
processing and memory
o Focus on why people faced with investment and other financial decisions,
make the choices they do
- Social Psychology
o Concerned with how a persons thoughts and behaviour are affected by
others
 E.g. Herding or bandwagon effect
 People moving as a group in one direction or another
 Helps to explain market bubbles, in part because of the
emphasis on social consensus, rather than analysis
- Why Behavioural research is important
o Economic -> Finance -> Accounting
Why behavioural accounting is important
o Potentially provide useful information to accounting regulators
 Objective of accounting is to provide decision-useful information
  Researchers report to standard setters which accounting methods
and disclosures improve decisions
o Findings from behavioural accounting can be used to improve quality of
decision-making
 Leads to efficiencies in work practices of accountants and other
professionals. Eg. Auditors, loan officers or financial analysts
o Alternatively, findings from behavioural accounting can be used to explain
how firms deliberately reduce the quality of decision making by exploiting
investors cognitive and social biases by means of impression management
 E.g. ordering of information, using graphical rather than numerical
info
Why behavioural finance is important
o Behavioural finance is an important (perhaps the most important) aspect
of the determinants affecting corporate finance
 Ignoring them in the real world is problematic so you should be
prepared if you end up in a CFO job, or in a job that puts you close
to a CFO
o Behavioural finance has wide ranging implications for consumer finance as
well – understanding how psychology biases affects peoples credit and
portfolio decisions can help you think about new business ideas
o Even if you do not want to work in finance or the finance-related industry,
you might be interested in how financial markets actually work.
 Behavioural finance is the recognition that standard theories are
not enough to make sense of real world – and that institutional
friction as well as investors are needed to understand financial
markets

- Historical Background
o Developed concurrently with capital markets research in the late 1960s
early 1970s
o Gained prominence in 1980s due to
 Empirical evidence highlighting flaws of finance theories (capital
markets research)
 Development of prospect theory (kahneman and Tversky)
 Joint noble prize in economics in 2002
CFA 5
Manager and Investor Sentiment

- The three themes of behavioural finance

o Heuristic-driven bias
 Cognitive bias
 Mental Shortcuts or rule of thumb
o A rough and ready procedure or rule of thumb for
making decisions, forming a judgement or solving a
problem
 Without the application of an algorithm or an
exhaustive comparison of all available options
 Hence without any guarantee of
obtaining correct or optimal results
o Biases are due to
 Memory limitations
 Information overload
 Time constraints
 Human nature
 Representativeness
 Judgement based on stereotypes
o Discriminatory
 Gambler fallacy
 Overconfidence
 Over-optimism
 Overestimate one’s own skills and chances of success
o Leads to overly positive self-evaluations
 Which are often unrealistic
 Resulting in over-confidence
 Confirmation Bias
 Seeks out evidence that confirms the opinion we already
hold
o Tend to avoid any evidence that may be
contradictory to our opinion
 Cognitive Dissonance
 To seek consistency amongst your cognition
o Beliefs and opinions
 When there is inconsistency between attitudes or
behaviours (dissonance) something must change to
eliminate dissonance
 Aversion to Ambiguity
 Fear of the unknown
 Willing to gable when the odds are even
o But play it safe when the odds are unkown
 Regret Avoidance
 Avoids, as far as possible any regrettable decisions
 Pushes us to conform to social norms or the status quo
 o Status-quo bias
 Disposition Effect
 Key questions: how often is stock performance
experienced?
o Every minute, every day or every month
o Sell winners, hold onto losers
 Mental Accounting
 Process whereby we segregate money into different
accounts and the apply different sets of rules to these
accounts
o Money is meant to be fungible, used interchangeable
 Money is money is money
 Recency Bias
 Putting too much emphasis on current experiences or
situations and not enough on long term historical patterns
o The result may be a tendency to sell assets in a
downturn or overbuy in a bubble
 Anchoring
 The tendency to focus on a single factor as the primary
reason for a decision or central explanation of an event
 The factor may or may not be relevant, but it is never
sufficient by itself
 Anchored to a reference point
 Endowment Effect
 The classic mug experiments
 Experimental design
o 50% of participants randomly given a mug
 Asked the minimum price for which they
would sell their mug
o 50% given nothing
 Asked what the maximum price for which they
would want to buy the mug
o Standard economics predicts that the average WTP
should equal the average WTA
 People will pay more to retain something they
own that to obtain something owned by
someone else
 Even when there is no cause for
attachment
 Even when the item was obtained
moments ago
 Once you have it, foregoing It feels like a loss
(and we are loss averse)
 Frame Dependence
 People make decisions that are influence by the manner in
which information is presented
 View each individual purchase or sale in terms of that
transaction only = narrow framing
 Generally, the wider your frame, the more diversified your
portfolio will be, but with greater volatility attached thereto
o Loss aversion
 Risk aversion
 Value gains and losses equally
 Loss aversion
 Value gains and losses equally
 Risk averse over gains, risk seeking
over losses
o Prospect theory
 Alternative model of decision-making to
expected utility theory and rational choice
theory
 More realistic behavioural assumptions
 Decision making between situations involving
decisions between alternatives that involve
risk
 i.e. in financial decisions
 People value gains and losses differently
 Financial decision making is driven by
loss aversion
 Prospective losses bother investors much
more than prospective gains
 The choices people make are based on their
subjective version of the situation, not on
some objective reality
 How do we maximise utility?
 Good news, bad news
o break up good news announces
 earning management
o clump bad news announcement
 earnings management
o Divide bonuses into smaller
chunk
 A few times a year
o Present bias
 How much do people want to consume today
relative to tomorrow
 Directly related to savings decisions
 In standard model, investors are assumed to
discount at a constant rate
 Trade off between today and tomorrow is
always the same
 Answers to “do I want to save more
today to consume more
 tomorrow”should be the same today
or 1 year from now
 Coherence of choices between selves
of different times
 No self-control problem
 Discounting steeper in immediate future
 Present bias higher in drug and alcohol
addicts, gamblers, less cognitively
talented and younger people
 To model these self-control problems uses
hyperbolic discounting
o Hyperbolic discounting
 Captures time inconsistent preferences
 Short run impatience/long run
patience
 Applications
 Saving: consuming 1 less today, 2 more
tomorrow, ill save tomorrow,
procrastination
 Smoking: ill quit tomorrow
 The marshmallow experiment
 Explores will power/ability for delaying
gratification
 Correlation with future academic
performance
o Self-control
 Default options
 In frictional/non-behavioural world,
default options are irrelevant
o However behavioural models
implies procrastination and role
for default options
 Libertarian Paternalism
o Nudge
o Rational agents are free to elect
or opt out
o Behavioural agents enrolled
into default
 In exercise decision
 How many days did you plan on
exercising
o How many days have you
actually exercised
 Health clubs
 Two gyp options
o Monthly at 800
o Pay per visit at R100 a visit
  How would you choose?
o Evidence that self-control plays
a role in decision-making
contexts
 Smoking
 Alcohol
 Savings
 Credit cards borrowing
 Credit cards
o Money illusion
 Belief that money has a fixed value in terms of
its purchasing power
 i.e. changes in the prices represent
real gains and losses
 Inflation, time value of money, exponential
growth bias (lusardi and Mitchell)
 Inefficient Markets
 Effects stemming from representativeness, frame
dependence and over-confidence
 Herding
o Investors react to information about the behaviour
of other investors rather than the behaviour of the
market, and the fundamental transactions

Heuristics vs Cognitive Biases

- Heuristic = Mental shortcut used to sole a particular problem
o Helpful when assists in making quick sense of a complex environment, but
times when they fail at making the correct decision
o When that happens, it results in a cognitive bias
 Tendency to draw an incorrect conclusion in certain circumstances
based on cognitive factors
o Cognitive biases can also result from social cognition
 An individual trying to feel better about oneself

Functional Fixedness
- Investors fixate on the information reported to them, due to information
processing biases
- Limits investors ability to under earnings
o Cannot see through earning management

Belief adjustment Model

- Einhorn and Hogarth
o Investors start with an initial belief and revise that belief upward or
downward
 Ordering if information (primacy/recency effect)
 Elections/Polls
o Complexity of information
 o Length of information

Format and presentation of AFS

- Humans prefer information in graphical rather than financial format
- Libby:
o Changing presentation and amount of information
o Investors can make better decisions based on Chernoff faces that financial
rations
 Companies exploit this by using impression management
 Visual and structural manipulation of information in
corporate narratives
o Primacy effect
 People focus on information presented first
 Present good news before bad news
 Choice of earning number (EBITDA earnings vs Headline
earnings)
o Functional fixedness
 Cognitive bias that limits investors ability to
undo earnings

- Role of irrational behaviour
o Investor behaviour
 Investment decisions characterised by high uncertainty
 Human beings have cognitive limitation (bounded rationality,
satisficing behaviour, information processing limitations)
 Investor sentiment: beliefs based on heuristic rather that
rationality
 Human beings have an intuitive, less quantitative, emotionally-
driven perception of risk than implied by finance models
 Future performance must be estimated from a set of noisy and
vague variables
 Therefore
 People make systematic errors in the way they think
 They use heuristics
o Mental shortcuts or rules of thumb to simplify
decision making
 Decision makers seek satisfactory, rather than optimal
solutions
 This results in biases and sub-optimal investment decisions
o Professional fund managers behaviour
 May choose a portfolio very close to the benchmark against which
they are evaluated
 i.e. index fund or etf
 Herding
 May select stocks that other managers select to avoid falling
behind and looking bad
 Window Dressing
  Add shares that have done well to the portfolio and sell
shares that have not done well

Summary
- How do users of financial statements make decisions
o To invest in a company
o To grant a loan to a company
o To work for a particular company
- Capital market theories
o Theories from finance and economic
o Assumptions of human behaviour
 Users a rational
 Users seek optimal outcomes
 Capital market is efficient
o Methodology
 CAPM
- Behavioural theories
o Theories from psychology
o Assumptions of human behaviour
 Users are irrational
 Users seek satisfactory outcomes
 Capital markets is inefficient
o Methodology
 experiment