Behavioral Finance

Alok Kumar Yale School of Management 8 December 1999

Agenda
Efficient Market Hypothesis (EMH) Expected Utility; Rational Expectations Few Examples Prospect Theory (Kahneman and Tversky) Behavioral Heuristics and Biases in Decision Making Implications for Financial Markets

Market Efficiency
Fama: The market price at any time instant
reflects all available information in the market. Cannot make money using stale information.

Three forms
Weak form: past prices and returns. Semi-strong form: all public information. Strong form: all public AND private information.

Michael Jensen: there is no other proposition in

economics which has more empirical support than the EMH.

Challenges to EMH
Investors are not fully rational. They exhibit biases and use simple heuristics (rules of thumb) in making decisions. Empirical Evidence on investor behavior:
investors fail to diversify. investors trade actively (Odean). Investors may sell winning stocks and hold onto losing stocks (Odean). extrapolative and contrarian forecasts.

Expected Utility Theory

A theory of choice under uncertainty for a single decision-maker. Expected Utility = p1*u1 + p2*u2 + + pn*un.
p: probability of an event u: utility derived from the event

Based on several strong assumptions about preferences. Example: transitivity, cancellation.

Rational Expectations Paradigm

All investors are identical. All investors are utility maximizers. All investors use Bayes rule to form new beliefs as new information becomes available. All investor predictions are accurate. Expected Utility + Rational Expectations => Market Efficiency

Are Financial Markets Efficient?

Weak form of market efficiency supported to a certain extent. 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. Size and B/M ratio (stale information) may help predict returns.

Stock Price Reaction to Non-Information

Crash of 1987: 22.6% decline without any apparent news. 50 largest one-day stock price movements: occurred on days of no major announcements. Inclusion of a stock in the S&P500 index results in significant share price reactions.
Example: AOL rose 18% on the news of its inclusion in the index.

Role of Investor Behavior

Bounded Rationality: satisficing behavior. Information processing limitations. Example: memory limitations. Investor Sentiment: beliefs based on heuristics rather than Bayesian rationality. Investors may react to irrelevant information and hence may trade on noise rather than information.

Irrational Behavior of Professional Money Managers

May choose a portfolio very close to the benchmark against which they are evaluated (for example: S&P500 index). Herding: may select stocks that other managers select to avoid falling behind and looking bad. Window-dressing: add to the portfolio stocks that
have done well in the recent past and sell stocks that have recently done poorly.

An Example
Initial endowment: $300. Consider a choice between:
a sure gain of $100 a 50% chance to gain $200, a 50% chance to gain $0.

Initial endowment: $500. Consider a choice between:

a sure loss of $100 a 50% chance to lose $200, a 50% chance to lose $0.

Reversal in Choice
Case 1: 72% chose option 1, 28% chose option 2. Case 2: 36% chose option 1, 64% chose option 2. => A reversal in Choice

Problem framed as a gain: decision maker is risk averse. Problem framed as a loss: decision maker is risk seeking.

Allais Paradox
Case 1: consider a choice between:
$1 million with certainty. $5 million with prob 0.1, $1m with prob 0.89 and $0 with prob 0.01

Case 2: consider a choice between:

$1m with prob 0.11, $0 with prob 0.89. $5m with prob 0.10 and $0 with prob 0.90.

Allais Paradox: Explanation

u(1m) > 0.10*u(5m) + 0.89*u(1m) + 0.01*u(0m) Add 0.89*u(0m) - 0.89*u(1m) to both sides.
0.11*u(1m) + 0.89*u(0m) > 0.10*u(5m) + 0.90*u(0m) Violates Expected Utility Theorem!

Prospect Theory
Proposed by two psychologists: Daniel Kahneman and Amos Tversky. Gambles are evaluated relative to a reference point. Decision maker analyzes gains and losses differently. Incremental value of a loss is larger than that of a loss.
the hurt of a $1000 loss is more painful than the benefit of a $1000 gain.

Behavioral Heuristics and Decision-Making Biases

What strategies do decision makers use when faced with difficult decisions, especially ones that involve uncertainty? Commonly Used Heuristics
Availability: familiarity breeds investment. Representativeness: judgement based on similarity. Patterns in random sequences. Reliance on the judgement of other people (Keynes beauty contest analogy).

Gamblers Fallacy
Investors may apply law of large numbers to small sequences.
Example: fair coin tossing.
THTHTHHHHHH -> P(T) = ?, P(H) = ?.

Which of the 2 sequences is more likely to occur in a fair coin tossing experiment?
HHHHHHTTTTTTHHHHHH HHTHTHHTHTTHTHHTTH

Some more Heuristics

Overconfidence: people overestimate the reliability of
their knowledge. Excessive trading

Framing Effect Regret Aversion: anticipation of a future regret can

influence current decision.

Disposition Effect: sell winners, hold on to the losers. Anchoring and adjustment: can create under-reaction.

Fashions and Fads

People are influenced by each other. There is a social pressure to conform. Herding behavior: safety-in-numbers. Informational Cascades Positive Feedback Example: excessive demand for internet IPOs.
Extremely high opening day returns.

Can arbitrage opportunities exist?

Yes!
Real-world arbitrage is always risky. No riskless hedge for the arbitrageur. Arbitrageur facesnoise trader risk: mispricing can become worse before it disappears. Close substitutes (needed for arbitrage positions) may not be available. Fundamentally identical assets may NOT sell at identical prices.

Behavioral Finance: Two Major Foundations

Investor Sentiment: creates disturbances to efficient prices. Limited arbitrage: arbitrage is never riskfree, hence it does not counter irrational disturbances.
Prices may not react to information by the right amount. Prices may react to non-information. Markets may remain efficient.

Summary
Investor behavior does have an impact on the behavior of financial markets. How much? Not clear! Both social and psychological must be taken into account in explaining the behavior of financial markets. Market anomalies may be widespread. Behavioral Finance: does not replace but complements traditional models in Finance.