Professional Documents
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STUDENT ID - 19031977835
1. Introduction
Behavioral finance, use social, cognitive and emotional factors in understanding the
economic decisions of individuals and institutions performing economic functions,
including consumers, borrowers and investors, and their effects on market prices, returns
and the resource allocation. For this application report I have chosen to understand two
widespread phenomenon of over-reaction and under-reaction in stock market through the
prospective of behavioral decision-making.
2. Behavioral phenomenon
Stock markets are often time govern by sentiments rather than underlying fundamentals.
This often leads to irregularities that cannot be explained from rational prospective. The
pervasive irregularities are under-reaction and over-reaction.
These mental models led investors to falsely belief that by seeing the patterns they can
beat the overall market. If the market just moves randomly then there is good chance that
these types of pattern appears often in different stocks from time to times. By falsely
believing that these stocks are following some patterns, investors are falling prey to their
flawed judgment and decision-making process.
In summary the under-reaction and over-reaction can be summarized by the following
table:
Table 1. Under-reaction and Over-reaction- biases and mental models
Behavioral Phenomenon Biases Investor Mental models
Under-reaction Conservatism Mean-reverting state
Over-reaction Representative Trending state
Prior probability is the investor’s belief that particular stock will not do well in future
and likelihood is conditional on this fact in the face of new evidence. Prior probability
can also be referred as weight because it determines the prior beliefs of how a particular
stock is going to perform in the market. Similarly likelihood can also be thought of as
strength of the new evidence i.e. how reliable is the new evidence.
Under-reaction happens when the individual is slow to change their belief when the new
evidence comes. This means they people put more emphasis on weight (base rate) rather
than on the strength of the new evidence (good earning announcement). Unimpressed by
the new evidence investors tend to assign low value to the strength and hence they react
mildly to the good news. So in under-reaction people do not sufficiently update their
beliefs about the new information.
Overreaction, on the other hand, occurs when individual put more value to strength (good
earning announcement) and low value to weight (base rate). People tend to belief that
past winning streak will continue in the future forever. Moreover, they also forget that
stock performance will regress to mean i.e. stock will perform poorly in future. This is a
typical case of base rate neglect because investors in their enthusiasm forget that very few
stocks will keep outperforming the market for long time.
4. Normative approach
Human abilities are not good at judging probabilities. Analytical tools can be used to de-
bias the probability assessment task and improve the decision making process. Two such
tools that can be used are: Bayesian decision-making and decision trees. Bayesian
approach has been discussed in previous section. By assigning subjective probability we
overweight or underweight the probability of an event. Instead that more objective
probabilities can be assigned to new information depending on how useful the
information is. These new probabilities combined with base rate can be used to figure the
correct probability of event happening.
The second analytical tool is a decision tree. A decision tree is a decision
support tool that uses a tree-like graph or model of decisions and their
possible consequences, including chance event outcomes, resource
costs, and utility. Decision trees will reduce the influences of biases in decision-
making. The decision trees can also help to account all the factors that can affect the
market prices of the stocks.
Figure 1: data showing opening and closing price of Apple stock during earning
month for last 6 years.
To show how this trading strategy can be used, I collected some data on Apple stock
price of last 5 years. The data is collected only for the month when the earnings should be
announced (see DATA 1 in Appendix). There are only 6 quarters in last 24 quarters (6
years) when the monthly return is not positive. It was found that average return during
earning month is around 6.7%. So this implies that if investors buy the stock on first
trading day of earning month and sell the stock on last trading day of the same month,
they can earn on average 6.7% on their investment.
This data shows the typical under-reaction because moving into earning month the
investors does not update their estimate correctly (insufficient updating), sending the
price higher after good earning announcement i.e. investors tend to underestimate the
upcoming earning announcement. It is only after the good news they update their beliefs.
Contrarian strategies - The second category is contrarian type strategies, reflecting
mispricing that persist for many months or years. The contrarian effect is the fact that
over long periods of time, contrarian stocks (measured by price/book or some other
valuation ratio) outperform growth stocks. It reflects the fact that sentiment causes some
stocks to be overpriced (growth stocks) and some to be underpriced (contrarian stocks).
These types of strategies exploit the market over-reaction because betting against the
market optimism or pessimism; investors hope that future returns will be in their favor.
These types of strategies exploit the market over-reaction.
Contrarian opportunities often appear in stocks of good companies. One of the
opportunities arises during the height of recent financial crisis in Chevron stock. The
stock was trading at 100$ (Jul 08) when it drop to 60$ (Oct 08) along with other
commodities stock. The contrarian would have bought the stock then and enjoyed a
decent return till now when the prices are trading at 84$. The stock lost its appeal during
the crisis because everyone feared that global economy would go into deep recession,
leading to demand slowdown for oil companies.
Figure 2: Data showing opening and closing price of Chevron stock for last three
years.
6. Conclusions
Efficient market assumes that markets are rational and all agents take into account all the
available information before taking any decisions. However, as learned in this course, lot
of biases and heuristics play a critical role in human judgment process. Investors
make systematic errors in evaluating information. They may over-react
to dramatic news and under-react to mundane news. The under-
reaction is caused by conservatism bias and when investors failed to
update their beliefs after the good news. Similarly, over-reaction is
caused by representativeness bias and when investors belief that good
news will continue in the future, neglecting the base rate in the
process.
These behavioral patterns often result in mispricing of stocks that can
be exploited by various trading strategies. Some these strategies are
discussed in this paper. These strategies can be classified in two forms.
Momentum strategies assume that investor places the directional bet
that stock will continue to go down after bad news or it will continue to
go up after good news. These are short-term bets. The other trading
strategy is contrarian strategy in which investor take the contrarian
long-term view and buy the under-price securities and sell the
overprice securities. Different behavioral phenomenon and
corresponding biases, mental models and trading strategies are
summarized below:
Percentage
earning
change
(compared
Average from past
Month's Month's return for Earning prev. year
Date Open Close the month data quarter)
7/1/10 254.3 257.25 1.160047188 3.51 74.62686567
4/1/10 237.41 261.09 9.974306053 3.33 46.24624625
-
1/4/10 213.43 192.06 10.01265052 3.67 31.88010899
10/1/09 185.35 188.5 1.699487456 2.77 54.51263538
7/1/09 143.5 163.39 13.86062718 2.01 40.7960199
4/1/09 104.09 125.83 20.88577193 1.79 35.19553073
1/2/09 85.88 90.13 4.94876572 2.5 29.6
-
10/1/08 111.92 107.59 3.868834882 1.26 19.84126984
-
7/1/08 164.23 158.95 3.215003349 1.19 22.68907563
4/1/08 146.3 173.95 18.89952153 1.16 25
-
1/2/08 199.27 135.36 32.07206303 1.76 35.22727273
10/1/07 154.63 189.95 22.84162194 1.01 38.61386139
7/2/07 121.05 131.76 8.847583643 0.92 41.30434783
4/2/07 94.14 99.8 6.012322074 0.87 45.97701149
-
1/3/07 86.29 85.73 0.648974389 1.14 42.98245614
10/2/06 75.1 81.08 7.962716378 0.62 19.35483871
7/3/06 57.52 67.96 18.15020862 0.54 31.48148148
4/3/06 63.67 70.39 10.55442123 0.47 27.65957447
1/3/06 72.38 75.51 4.324399005 0.65 46.15384615
10/3/05 54.16 57.59 6.333087149 0.5
7/1/05 36.83 42.65 15.80233505 0.37
-
4/1/05 42.09 36.06 14.32644334 0.34
1/3/05 64.78 76.9 18.70947823 0.35
10/1/04 39.12 52.4 33.94683027
DATA 2: Stock price data for Coca-Cola from 2004-2010
Percentage
earning change
Average (compared from
Month's Month's return for Earning past prev. year
Date Open Close the month data quarter)
10/1/10 59.04 59.12 0.135501355
7/1/10 50.3 55.11 9.562624254 1.02 13.7254902
-
4/1/10 55.36 53.45 3.450144509 0.69 18.96551724
-
1/4/10 57.16 54.25 5.090972708 0.66 53.48837209
-
10/1/09 53.4 53.31 0.168539326 0.81 0
7/1/09 48.48 49.84 2.805280528 0.88 44.26229508
-
4/1/09 43.76 43.05 1.622486289 0.58 -9.375
1/2/09 45.4 42.72 -5.9030837 0.43 -17.30769231
-
10/1/08 52.62 44.06 16.26757887 0.81 14.08450704
-
7/1/08 51.92 51.5 0.808936826 0.61 -23.75
-
4/1/08 61.01 58.87 3.507621701 0.64 18.51851852
-
1/2/08 61.45 59 3.986981286 0.52 79.31034483
10/1/07 57.61 61.76 7.203610484 0.71 14.51612903
-
7/2/07 52.65 52.11 1.025641026 0.8 2.564102564
4/2/07 48.2 52.19 8.278008299 0.54 14.89361702
-
1/3/07 48.36 47.88 0.992555831 0.29 -19.44444444
10/2/06 44.9 46.72 4.053452116 0.62 14.81481481
7/3/06 43.2 44.5 3.009259259 0.78 8.333333333
-
4/3/06 42.1 41.96 0.332541568 0.47 11.9047619
1/3/06 40.79 41.38 1.446432949 0.36
-
10/3/05 43.21 42.78 0.995140014 0.54
7/1/05 41.96 43.76 4.289799809 0.72
4/1/05 41.83 43.44 3.848912264 0.42
-
1/3/05 41.9 41.49 0.978520286
10/1/04 40.48 40.66 0.444664032
-
7/1/04 50.51 43.86 13.16570976
4/1/04 50.48 50.57 0.178288431
1/2/04 50.8 49.24 -
3.070866142
REFERENCES
1) A model of investor sentiment – Nicholas Barberis, Andrei Shleifer and Robert
Vishny (1998)
2) Investor psychology and asset pricing – David Hirshleifer (2001)
3) Behavioral Finance and Wealth Management Michael Pompian – John Wiley and
Sons
4) Data from Yahoo finance