Beh Finance

BEHAVIORAL FINANCE Introduction behavioral nance is an alternative to the EMH this material taken mostly from the 2000 book by Andrei Shleifer of Harvard: Inecient Markets: An Introduction To Behavioral Finance EMH has been the central tenet of nance for almost 30 years power of the EMH assumption is remarkable

Beh Finance

EMH started in the 1960s immediate success in theory and empirically early empircal work gave overwhelming support to EMH EMH invented at Chicago and Chicago became a world center of research in nance Jensen (1978) no other proposition in economics . . . has more solid empirical support

Beh Finance

verdict is changing eciency of arbitrage is much weaker than expected true arbitrage possibilities are rare near arbitrage is riskier than expected Markets can remain irrational longer than you can remain solvent John Maynard Keyes quoted by Roger Lowenstein in When Genius Failed: The Rise and Fall of Long-Term Capital Management

Beh Finance

Defense of EMH three lines of defense of the EMH: investors are rational trading of irrational investors is random and their trades cancel each other even if a herd of irrational investors trade in similar ways, rational arbitrageurs will eliminate their inuence on market price each of these defenses is weaker that had been thought

Beh Finance

rational investing = value a security by its fundamental value fundamental value = net present worth of all future cash ows rational investing prices are (geometric) random walks but prices being random walks (or nearly so) does not imply rational investing there is good evidence that irrational trading is correlated look at the Internet stock bubble

Beh Finance

initial tests of the semi-strong form of eciency supported that theory event studies showed that the market did react immediately to news and then stopping reactin so reaction to news, as EMH predictos also no reaction to stale news, again as EMH predicts Scholes (1972) found little reaction to non news block sales had little eect on prices

Beh Finance

Challenges to the EMH it is dicult to maintain that all investors are rational. many investors react to irrelevant information Black calls them noise traders investors act irrationally when they fail to diversify purchase actively and expensively managed mutual funds churn their portfolios investors do not look at nal levels of wealth when assessing risky situations (prospect theory)

Beh Finance

there is a serious loss aversion people do not follow Bayes rule for evaluating new information too much attention is paid to recent history overreaction is commonplace these deviations from fully rational behavior are not random moreover, noise traders will follow each others mistakes thus, noise trading will be correlated across investors

Beh Finance

managers of funds are themselves human and will make these errors too managers also have their own types of errors buying portfolios excessively close to a benchmark buying the same stocks as other fund managers (so as not to look bad) window dressing adding stocks to the portfolio that have been performing well recently on average, pension and mutual fund managers underperform passive investment strategies these managers might be noise traders too

Beh Finance

10

Can arbitrageurs save the day? the last defense of the EMH depends on arbitrage even if investor sentiment is correlated and noise traders create incorrectly priced assets arbitrageurs are expected to take the other side of these traders and drive prices back to fundamental values a fundamental assumption of behavioral nance is that real-world arbitrage is risky and limited

Beh Finance

11

arbitrage depends on the existence of close substitutes for assets whose prices have been driven to incorrect levels by noise traders many securities do not have true substitutes often there are no risk-less hedges for arbitrageurs mispricing can get even worse, as the managers of LTCM learned this is called noise trader risk

Beh Finance

12

What do the data say? Shiller (1981), Do stock prices move too much to be justied by subsequent changes in dividends: market prices are too volatile more volatile than explained by a model where prices are expected net present values this work has been criticized by Merton who said that Shiller did not correctly specify fundamental value

Beh Finance

13

De Bondt and Thaler (1985), Does the stock market overreact?: frequently cited and reprinted paper work done at Cornell compare extreme winners and losers nd strong evidence of overreaction for every year starting at 1933 they formed portfolios of the best performing stocks over the previous three years winner portfolios they also formed portfolios of the worse performing stocks loser portfolios

Beh Finance

14

then examined returns on these portfolios over the next ve years losers consistently outperformed winners dierence is dicult to explain as due to dierences in risk, at least according to standard models such as CAPM De Bondt and Thaler claim that investors overreact extreme losers are too cheap so they bounce back the opposite is true of extreme winners

Beh Finance

15

historically, small stocks have earned higher returns than large stocks no evidence that the dierence is due to higher risk superior returns of small stocks have been concentrated in January small rm eect and January eect seem to have disappeared over the last 15 years market to book value is a measure of cheapness high market to book value rms are growth stock they tend to underperform also they tend to be riskier, especially in severe down markets

Beh Finance

16

October 19, 1987 Dow Jones index dropped 22.6% there was no apparent news that day Cutler et al (1991): looked at 50 largest one-day market changes many came on days with no major news announcements

Beh Finance

17

Roll (1988) tried to predict the share of return variation that could be explained by economic inuences returns on other stocks in the same industry public rm-specic news Rolls ndings: R2 = .35 for monthly data R2 = .2 for daily data

Beh Finance

18

Rolls study also shows that there are no close substitutes for stocks this lack of close substitutes limits arbitrage stocks rise if the company is put on the S&P 500 index this is reaction to non news America Online rose 18% when included on the S&P In summary, there is now considerable evidence against the EMH This evidence was not found during early testing of the EMH Researchers needed to know what to look for

Beh Finance

19

Market Volatility and Irrational Exuberance Two books by Robert J. Shiller: 1989 Market Volatility 2000 Irrational Exuberance

Beh Finance

20

What is a stock worth? Let Vt be intrinsic value at time t. By denition Ct+1 Ct+2 Vt = + + = 2 1 + k (1 + k) Ck is the cash ow at time k k is the discount rate A little bit of algebra shows that
T

i=1

Ct+i . i (1 + k)

Vt =
i=1

VT Ct+i + . i T (1 + k) (1 + k)

(exercise: check)

Beh Finance

21

From previous page:

T

Vt =
i=1

Ct+i VT + . i T (1 + k) (1 + k)

(1)

Shillers idea: T = now t < T is the past Use past data to compute Vt as an approximation use PT in place of VT then all quantities in (1) are known at time T compare Vt with Pt = actual stock price EMH says that Pt is the optimal forecast at time t of Vt .

Beh Finance

22

How do Vt and Pt compare?

Rough freehand sketch of Shillers plot.

Beh Finance

23

We see that Pt is more volatile than Vt . Does this agree with the hypothesis that Pt is the optimal forecast of Vt ? NO!

Beh Finance

24

Best prediction If X is the best predictor of X, then X and X X are uncorrelated Var(X) = Var(X) + E(X X)2 . Var(X) Var(X). (Exercise: prove these results if X is the best linear predictor of X.) An optimal predictor is less variable than the quantity being predicted.

Beh Finance

25

Example: random walk Suppose that Wt = N (, 2 ).

1

+ + t , where

1, . . .

are IID

at time t, 0 t < T , the best predictor of WT is WT = Wt + (T t) In other words, at time t WT = {

1

+ + t} + {

t+1

+ +

T}

is predicted by WT = {
1

+ + t } + { + + }

Beh Finance

26

From last page: WT = {

1

+ + t} + {

t+1

+ +

T}

is predicted by WT = {
1

+ + t } + { + + }

Var(WT ) = T 2 Var(WT ) = Var(Wt ) = t 2 . WT WT = (

t+1

) + + (

Var(WT WT ) = (T t) 2 . Therefore, in this example, Var(WT ) = Var(WT ) + Var(WT WT )

Beh Finance

27

As t T we cumulate more information about WT and Var(WT ) = Var(Wt ) = t 2 increases Var(WT WT ) = (T t) 2 decreases Var(WT ) = T 2 stays the same (of course) The main point, however, is simply that an optimal forecast is less variable that what is being forecasted. stock prices are more variable that the present values of future discounted dividends. Therefore, price cannot be optimal forecasts of the present value of discounted future dividends.

Beh Finance

28

At least, this is Shillers argument.

Beh Finance

29

Irrational Exuberance is a very interesting discussion of market psychology, bubbles, naturally occurring Ponzi schemes, and other possible explanations of why the market seemed overpriced in 2000. Shillers analysis suggests that the market may be still overpriced in 2002, despite two years of declining prices. Shiller presents fascinating evidence that periods where the market is either over or under priced have occurred, often several times, in many countries.