Efficiency vs. Behavioral Finance
Efficiency vs. Behavioral Finance
Efficiency vs. Behavioral Finance
Efficient Markets
Behavioral Finance
Inputs: information
Price Changes
Past price changes do not predict future
price changes
Cov(et, et+1) = 0
Why?
Financial markets
Types of Information
Historical
trading info
private info
All info
Forms of EMH
Weak - prices reflect only historical
trading information
Semi-strong - prices reflect all publicly
available information
Strong - prices reflect all information
Fundamental Analysis
Event studies
Event studies
Return from trading strategies using historical
trading info
Returns from trading strategies using publicly
available info
Insider trading returns
Performance of professional money managers
January Effect
October Effect
Day of the week effects
Speculative bubbles
Historical perspective
Conclusion
The market for US large-cap liquid stocks is
approximately semi-strong form efficient
No reason to believe that other markets are
It is not easy to outperform the market on a
risk-adjusted basis
Around 1 p.m.
End of day
Behavioral Finance
Relaxes one of the most important set
of assumptions in classic finance
theory:
Investor Rationality
Investor Rationality
Consistent and homogeneous beliefs
Consistent preferences
Real Investors
Triunal Brain
Cognitive biases
Time-inconsistent preferences
Influenced by hot states
Triunal Brain
The human brain can be decomposed in
three parts
Neocortex reason
Limbic system emotions
Reptilian brain actions
Cognitive Biases
Biases of Judgment
Overconfidence/Optimism
Hindsight bias
Quick Judgments
Anchoring
Representativeness
Overconfidence
Misjudge probability of downside risk
Place large weight on personal ability
Consequences
Frequent trading
Large positions
Undiversification
Cognitive Biases
Heuristics for reducing complexity
Mental Accounts
Example
Selective Perception
Bruner&Postman Experiment
Selective Perception
You can see 6 different cards.
Think on one.
Just think on it.
Are you thinking intently?
I will find the card on your mind.
Selective Perception
Now, look straight into my eyes
and think about your card
I cant see the card you have
chosen
but I know exactly the card
that is on your mind
Selective Perception
Look!
Your card is gone!
Do it again?
You can see 6 different cards.
Think on one.
Just think on it.
Are you thinking intently?
I will find the card on your mind.
Selective Perception
Now, look straight into my eyes
and think about your card
I cant see the card you have
chosen
but I know exactly the card
that is on your mind
Selective Perception
Look!
Your card is gone!
Cognitive Biases
Errors of preferences (Kahneman &
Tversky)
Prospect Theory
Consequences
Disposition effect
Framing bias
Prospect Theory
Choose one option
Prospect Theory
Choose one option
Disposition Effect
Investors are reluctant to sell losers
Consequences
Sell winners
Keep losers
Documented both in individual accounts (Barber and Odean)
and in some mutual funds (Cici and Gibson)
Suboptimal strategy
Tax losses
Does not take advantage of short-term momentum
Wall St. Rule Cut your losses and let your winners ride
Cognitive Biases
Evaluating Consequences of Decisions
Regret of Commission or
Omission
State your biggest mistake in past
investments
Time-Inconsistent Preferences
Large weight placed on current benefits
or costs compared to all future ones
Consequences
Procrastination
Nave investors
Projection bias
Behavioral Trading
Professional investors are also subject
to biases like individuals
Biases may lead to suboptimal
performance
Disposition bias
Paralysis
Explosive risk taking
Procrastination/Paralysis
Market Sentiment
Sentiment Indicators
Technical
Consumer Sentiment
Market Participant Sentiment
Technical Indicators
Odd-lot trading
Put/Call Ratio
Short interest
VIX/VXN
Since 1952
University of Michigan
Phone survey of 500-800 households
Preliminary results, the second Friday of each
month
Since 1967
5000 households
Last Thursday of the month
Market Vane
Daily sentiment
Polls of brokerage houses, tip hotlines
Used by commodity traders
References
Dorsey, W., 2004, Behavioral Trading,
Thomson/Texere
Goldberg, J., and R. von Nitzsch, 2001, Behavioral
Finance, Wiley & Sons
Kahneman, D., and M. Riepe, 1998, Aspects of
Investor Psychology, JPM, Summer, 52-65
Kiev, A., 2002, Trading in the Zone, Wiley & Sons
Mahoney, P., and H. Mulherin, 2002, The Stock Price
Reaction to the Challenger Crash: Information
Disclosure in an Efficient Market, Journal of
Corporate Finance,