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Behavioral Finance Definitions

Behavioral Finance, a study of investor market behavior that

derives from psychological principles of decision making, to

explain why people buy or sell the stocks they do.

The linkage of behavioral cognitive psychology, which studies

human decision making, and financial market economics.

Behavioral Finance focuses upon how investors interpret and act on

information to make informed investment decisions. Investors do

not always behave in a rational, predictable and an unbiased

manner indicated by the uantitative models. Behavioral finance places an emphasis upon investor behavior leading to various

market anomalies.

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Behavioral Finance !romise

Behavioral Finance promises to make economic models better at explaining

systematic "non#idiosyncratic$ investor decisions, taking into consideration

their emotions and cognitive errors and how these influence decision making.

Behavioral Finance is not a branch of standard finance% it is its replacement,

offering a better model of humanity.

&reate a long term advantage by understanding the role of investor psychology

'uman flaws pointed out by the analysis of investor psychology are consistent

and predictable, and that they offer investment opportunities.

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!recursors to Behavioral Finance

(alue investors proposed that markets over reacted to negative news.

Ben)amin *raham and David Dodd in their classic book, +ecurity nalysis,

asserted that over reaction was the basis for a value investing style.

David Dreman in -/0 argued that stocks with low !12 ratios were undervalued,coining the phrase overreaction hypothesis to explain why investors tend to be

pessimistic about low !12 stocks.

Tversky and Daniel 3ahneman published two articles in -/4 in +cience. They

showed heuristic driven errors, and in -/ in 2conometrica, they focused on

representativeness heuristic and frame dependence.

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Two Important +tudies

5 re euity valuation errors are systematic and therefore predictable6 7 2fficient markets view8 prices follow a random walk, though prices fluctuate to extremes, they

are brought back "regression to the mean$ to euilibrium in time.

7 Behavioral finance view8 prices are pushed by investors to unsustainable levels in bothdirections. Investor optimists are disappointed and pessimists are surprised. +tock prices are

future estimates, a forecast of what investors expect tomorrow9s price to be, rather than anestimate of the present value of future payments streams.

7 2arly studies focused on relative strength strategies that buy past winners and sell past losers

5 :erner De Bondt and ;ichard Thaler -0< 7 Investor =verreaction 'ypothesis opposes 2fficient >arkets 'ypothesis

7 ;e)ection of ;egression to the >ean which says prices operating in the context of extremehighs and lows balance each other

5 +hefrin and +tatman -0< 7 Disposition 2ffect suggests investors relate to past winners differently "they keep winners in

their portfolio$ than past losers "they sell past losers$

7 =dean applied the Disposition 2ffect in vivo context

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:erner De Bondt and ;ichard Thaler -0< study

De Bondt and Thaler extended Dreman9s reasoning to predict a new anomaly.

They refer to representativeness, that investors become overly optimistic about

recent winners and overly pessimistic about recent losers.

5 They applied Tversky and 3ahneman9s representativeness to market pricing

7 =verweight salient information such as recent news

7 ?nderweight salient data about long term averages

5 Investors overreact to both bad news and good news.

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De Bondt and Thaler +tudy

;obert +hiller proposed prices show excess volatility.

That is, dividends do not vary enough to rationally )ustify observed aggregate

price movements

In spite of dividends, investors seem to attach disproportionate importance toshort run economic developments.

Two 'ypotheses8 2ach a violation of weak form market efficiency.

-. 2xtreme movements in stock prices will be followed by subseuent price

movements in the opposite direction.

@. The more extreme the initial price movement, the greater will be the

subseuent ad)ustment.

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De Bondt and Thaler -0< study "cont$

=verreaction leads past losers to become under priced and past winners to become

overpriced.

De Bondt and Thaler propose a strategy of buying recent losers and selling recentwinners. Investors become too pessimistic about past losers and overly

optimistic about past winners.

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De Bondt and Thaler -0< study "cont$

De Bondt and Thaler studied two portfolios of A< stocks

=ne consisting of past extreme winners over the prior three years

=ne consisting of past extreme losers over the prior three years

!ast losers subseuently outperformed winners over the next four years.!ast losers were up -. percent relative to the market in general.

!ast winners were down five percent relative to the market in general.

difference of @4. percent between the two portfolios.

+tudy suggests that investors cause market prices to deviate from fundamentalvalues creating inefficient markets8 due to representativeness heuristic

markets9 treatment of past winners and losers is not efficient.

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De Bondt and Thaler study

=ther Findings8

-. The overreaction effect is asymmetric8 it is much larger for losers than

winners.

@. >ost of the excess returns are realiCed in anuary. "-.E of the @4.E$A. The overreaction phenomenon mostly occurs during the second and third

year of the test period. "By the end of the first year the difference in the two

portfolios is a mere <.4E$

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&ritics of De Bondt and Thaler -0< study

;eversion to the mean explanation offered by >alkeil consistent with efficient

markets hypothesis

suCsanna Fluck, ;ichard Guandt, and >alkeil study

+imulated an investment strategy of buying stocks which had poor recent twoor three year performance.

They found8 in the -0Hs, -Hs, those stocks did en)oy improved returns in

the next period of time, but they recovered only to the average stock market

performance.

It was a statistical pattern of return reversal, but to appropriate levels "they did

not overshoot levels$.

Fama and French% and !oterba and +ummers studies8

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>ore &ritics

Two alternative 'ypotheses8 to overreaction.

-. ;isk &hange 'ypothesis8 overreaction is rational response to risk changes"short term earnings outlook changes$ as measured by Betas

@. Firm siCe8 past loser portfolio made up of small firms

Disturbing factors-. +easonal pattern of returns "anuary turn of the yearJ effect$

@. The characteristics of the firms in the portfolios "+mall siCe$

A. &o#relation is asymmetric

De Bondt and Thaler9s response

The data do not support either of these explanations. It is emotional shifts inmood of investorsKbiased expectations of the future, not rational shifts ineconomic conditions

see also, -H paper8 Do +ecurity nalysts =verreact6 yes

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But what about6

egadeesh demonstrated shorter term reversals8 one week or one month

though these results are transaction intenseJ

*rinblatt and Titman -0, -- relative strength strategies8 they showed a

tendency to buy stocks that have increased in price over the previous uarter,

based on past relative strength

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Integrating results

&ontrarian strategies work with

-. (ery short periods "one week, one month$

@. (ery long periods "A to < years$

*rowth "relative strength strategies$ work with three to -@ months

egadeesh and Titman "-A$ studied period -<#0 found8

three to -@ months earned average of .<E "six months earned -@E$

then reversals, -@#@4 months lost 4.<E

for earnings announcements8

past winners earned positive returns for the first seven months

past losers earned positive returns for -A month period assessment

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Dreman9s research

5 +ample of -<HH largest stocks, each over a billion in capitaliCation

5 Develop a portfolio of stocks with low !12 ratio

5 !ortfolio established in -/H

5 By -/ portfolio grew from L-H,HHH to LH,HHH while the market benchmark was

LA@,HHH.

&ontrarian portfolios did better in down markets

During down uarters over the years, market averaged down /.<E% &ontrarian portfolio

down 4E

Dreman emphasiCed the importance of reinforcing events and event triggersJ creating

perceptual change

5 !ositive +urprises are very favorable for unpopular stocks "not so for popular stocks$

5 Megative +urprises are very conseuential for popular stocks "not so for unpopular

stocks$

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:hat it means6

&onsistent with positive feedback tradersJ hypothesis on market price

>arket under reacts to information about the short term prospects of firms but

overreacts to information about their long term prospects

This is plausible given that the nature of the information available abouta firm9s short term prospects, such as earnings forecasts, is different form the

nature of the more ambiguous information that is used by investors to assess a

firm9s longer term prospects

David Dreman8 &ontrarian strategies do better than the market over time

Importance of earnings surprises on popular and unpopular stocks

reveals a market sentiment is significant

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+pecific over and under market reactions

>arkets over react to I!=s

>arkets under react to8 earnings announcements, dividend announcements, open

market share repurchases, brokerage recommendations

Investors systematically under weight "conservative$8 abstract, statistical, and highly relevant information,

while they over weight "representativeness heuristic$

salient, anecdotal, and extreme information

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2xplanations1Theories for ?nder and =ver reaction

3ent Daniel, David 'irshleifer and vanidhar +ubrahmanyam

Investor =verconfidence and biased self attributionJ

(ariations in investor confidence which is an over estimation of ability to

value stocks and predict future prices arising from biased self attributionwhich is confirming information in the public arena encourages but

disconfirming information does not discourage, "blames others$ leads to

market over and under reaction to information$

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Daniel, 'irshleifer and +ubrahmanyan "cont$

5 +hifts in investors9 confidence cause

7 Megative long lag auto correlations "&ontrarian strategies$

7 2xcess volatility relative to fundamentals "variance$

7 !redictability about future prices

5 +hifts in investors9 self attribution cause

7 +hort lag autocorrelation "momentum strategies$

7 +hort run earnings drift in the direction of earnings surprise

7 bnormal stock performance in the opposite direction of long term earnings

changes. "Megative correlation between future returns and long term past stock

market performance$

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Daniel, 'irshleifer and +ubrahmanyan "cont$

Theory is based on investor overconfidence, and on changes in confidence

resulting from biased self attribution of investment outcomes

5 Investors will overreact to private information signals creates momentum in

price "either absent public information to support price, or assuming public

information confirm private signals, orN.

5 Investors will under react to public information signals "avoids correction in

stock price until it goes to extreme$

?nlike noise trader approach, this theory posits that investors misinterpret genuine

new private information.

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2xplanations1Theories "cont$

Barberis, +hlieifer and (ishny -0

Oearning model explanation

ctual earnings follow a random walk, but individual s believe that

earnings follow either a steady growth trend, or else

earnings are mean reverting.

;epresentativeness heuristic "finds patterns in data too readily, tends to over react to

information$ and conservatism "clings to prior beliefs, under reacts to information$.

Interaction of representativeness heuristic and conservatism8 explains short term under

reaction and long term over reaction

Investor9s reaction to current information condition on past information. Investor tends

to under react to information that is preceded by a small uantity of similar information

and to over react to information that is preceded by a large uantity of similar

information.

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'ong and +tein -/

?nder and =ver reactions arise from the interaction of momentum traders and

news watchers

>omentum traders make partial use of the information continued in recent price

trends, and ignore fundamental news

Fundamental traders rationally use fundamental news but ignore prices.

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Bloomfiled, Oibby and Melson

Traders in experimental markets undervalue the information of others

!eople with evidence that is favorable but unrealiCable tend to overreact toinformation, whereas people with evidence that is somewhat favorable but

reliable under react

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=ptimism, =verconfidence, and =dean9s ;esearch

!eople are overly optimistic

5 !eople believe that they are less likely to get hit by a bus or be robbed than

their neighbors

!eople are overconfident in their own abilities

5 Driving skills and social skills are better

5 Mew business owners believe their business has a /HE chance of success, but

only AHE succeed

5 'elps soldiers cope with war

=verconfidence and the stock market

5 =verconfidence can lead to substantial losses when investors overestimate their

ability to identify the next >icrosoft or maCon

5 +ecurities that investors purchase under perform those they sell

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BenartCi, 3ahneman and Thaler survey on

=verconfidence

+urvey of >orningstar -H<A subscribers

5 04E male, average age is 4<, annual in come LA,HHH

5 verage allocation to stocks is /E

5 =ptimism uestion8 7 Thinking about financial decisions, do you spend more time thinking about the

potential return or the possible loss6

7 :hat do you think is the likelihood of stocks outperforming bonds in the long run6

5 =verconfidence and =ptimism decided by

7 nswer to the uestion about likelihood of stocks outperforming bonds

7 sset allocation of retirement contributions of stocks vs. bonds

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=dean9s study of overconfidence in the marketplace

:hat happens in financial markets when people are overconfident6

5 Trading volume increases8 overconfidence generates trading. Those who trade

more freuently fare worse than those who trade less

5 =verconfident traders hold under#diversified portfolios% riskier portfolios

though they have the same degree of risk aversion

5 =verconfident insiders improve price uality% overconfident noise traders

worsen it

5 >en are more overconfident than women% men trade more freuently "4<E

more$ than women, men earn less returns than women "one percent less$.

5 +ingle men and single women the results are larger "/E more trading, -.4E

less$

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Trading Behavior and ;eturns

Individual investors who hold common stock directly pay a tremendous

performance penalty for active trading

5 =dean study trading can be haCardous to your wealthJ

7 +tudied ,4< households from -- to -

7 >ost freuent traders earn --.4E "turn over /<E of portfolio$

7 verage household earned -.4E

7 >arket benchmark was -/.E

5 =dean study on =n line traders

7 +tudied -H/ traders on line, compared with -H/ telephone traders

7 =n line traders experienced strong performance prior to going on line

7 fter on line, less profitable, lagging the market by three points

7 2xplained by overconfidence, self attribution bias, illusion of knowledge, and

illusion of control

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=verconfidence and the Disposition 2ffect

Investors weight recent observations too heavily "representativeness heuristic$

Investors under weight prior information

Investors commit the gambler9s fallacy8 expecting recent events "downturns in

stock prices$ to reverse

Disposition effect8 Investors hold on to losers in their portfolio "because they can9t

be wrong$, and sell winners.

Investors )udge their decision on the basis of the returns realiCed not paper money

returns, then holding losers will avoid confronting their true abilities.

Investors won9t learn from mistakes, continue as overconfident.

=dean9s research confirms Disposition 2ffect

=dean looks at trading decisions of investors at discount brokerage

+tocks traders buy under perform those that they sell

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Oevel of =ver#confidence changes dynamically

Depending upon the success of failure, level of overconfidence changes

5 trader is not overconfident when he begins to trade

5 =verconfidence increase over his first several trading periods early in his

career

7 These overconfident traders survive the threat of arbitrage, that is, they are not the

poorest traders

7 Initial success increases overconfidence

5 =verconfidence declines thereafter

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'omework ssignment8 Disposition 2ffect and De

Bondt and Thaler9s study

'omework assignment8 'ow do you suare the Disposition 2ffect with the !rice

;eversals Oiterature "see De Bondt and Thaler -0< study$6

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