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1. Behavioral finance and anomalies of conventional economic theory 1.1. What is meant by behavioral finance? 1.2. Anomalies in behavioral finance 2. How to interpret the behavioral finance anomalies? The discovery of preferences hypothesis 2.1. The discovery of preferences hypothesis 2.2. Re-interpreting the anomalies
A lecture in Greifswald University, June 9, 2011. Timo Tammi University of Eastern Finland
Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps to explain why and how markets might be inefficient
Hypothesis: if prices equal fundamental value, the market value of Royal Dutch equity should be 1.5 times the market value of Shell equity. Data shows that the hypothesisi is false ->
Data from Froot and Dabora (1999; also Barberis and Thaler 2003) shows the ratio of Royal Dutch share value to Shell share value. The efficient market hypothesis ratio is 1,5 the figure shows deviations from this benchmark. Deviations ar large and inefficieny strong and persistent.
There are limits to arbitrage! One explanation is the existence of noisy traders.
Some psychology
If noisy traders cause deviations from fundamental value, rational traders remain often powerless psychological models are needed to model many phenomena New ideas and insights on beliefs and preferences
How agents form expectations? Do agents have stable and consistent preferences that can be successfully modeled on the basis of EUT?
Beliefs
Overconfidence
"The investors take bad bets because they fail to realize that they are at an informational disadvantage. Or they trade more frequently than is prudent, which leads to excessive trading volume. Shefrin (2000)
Representativeness
looking at an event and making a judgment as to how closely it corresponds to other events as found in the general population. Shefrin (2000)
Beliefs
Conservatism
tendency to cling tenaciously to a view or a forecast. When movement does occur it is only very slow (this creates under-reaction to events).Montier (2002)
Standard model
Expected utility theory/model
A psychological model
Prospect theory
Preferences
Both EUT and PT model preferences but use very different strategies
EUT is axiomatic/deductivistic PT is inductivistic For EUT preferences are given, stable and consistent For PT preferences are constructed EUT is a normative theory; PT is a descriptive theory
The value function is defined for the changes in wealth and the function is steeper in losses than in gains. Sometime we use terms loss function and gain function. Below is a typical value function.
losses
gains
The loss function is convex, gain function is concave. Diminishing marginal sensitivity: The effect of a loss or a gain to ones subjective valuing decreases as the magnitude of the loss or gain increases.
The shape of the weighting function shows that small objective probabilities are overestimated and large objective probabilities are underestimated.
Weight (p)
1
Probability, p
Many anomalies bother EUT, but EUT is adhered to. This is since (1) EUT is a good general theory of decision-making and since (2) EUT is, for the time being, the best normative theory of decision-making. However: the prospect theory is a multifaceted descriptive theory of decision-making
Anomalies are systematic observations or findings that are not predicted/explained by the conventional economic theory (EUT) A list:
January effect Winners curse Equity premium puzzle And others
Example
Yoy are Company A (the acquirer) which is currently considering acquiring Company T (the target) by means of a tender offer. You plan to tender in cash for 100% of Company T's shares but are unsure how high a price to offer. The main complication is this: the value of the company depends directly on the outcome of a major oil exploration project it is currently undertaking.
In the worst case (if the exploration fails completely), the company under current management will be worth nothing$O/share. In the best case (a complete success), the value under current management could be as high as $100/share. All share values between $0 and $100 per share are considered equally likely. By all estimates the company will be worth considerably more in the hands of Company A than under current management. Whatever the value under current management, the company will be worth 50 percent more under the management of Company A than under Company T. How much to offer?
The problem:
Thus, you (Company A) will not know the results of the exploration project when submitting your offer, but Company T will know the results when deciding whether or not to accept your offer. In addition, Company T is expected to accept any offer by Company A that is greater than or equal to the (per share) value of the company under its own management. As the representative of Company A, you are deliberating over price offers in the range $O/share to $150/share. What offer per share would you tender?
A typical reasoning: The firm has an expected value of $50 to Company T, which makes it worth $75 to Company A. Therefore if I suggest a bid somewhere between $50 and $75, Company A should make some money. This analysis fails to take into consideration the asymmetricinformation that is built into the problem.
The correct reasoning A correct analysis must calculate the expected value of the firm conditioned on the bid being accepted. If a bid B is accepted, then the company must be worth no more than B under current management for an average of B/2. Under the new management, the average is 150 percent of this, or 3B/4, which is still less than B, so it is best not to bid at all. extreme form of the winner's curse in which any positive bid yields an expected loss to the bidder. See the next slide for the results of an experiment
In both conditions over 90 percent of the subjects make positive bids, and a majority are in the range between $50 and $75.
Treasury bill : A security issued by a government (or firms trade bill). Bills carry no explicite interest: the interest on bills is provided by issuing them at a discount to their redemption value. Bond: A security issued by a firm, financial institution or government. May carry a fixed interest or an interest linked to some financial index. Government bods are regarded as very safe (no risk).
General utility-based theories of asset prices have difficulty explaining (or fitting, empirically) the difference, not only in the U.S. but in other countries too (ibid.)
Puzzled theories
The theories against which the evidence constitute a "puzzle" tend to have these aspects in common: Standard preferences described by standard utility functions Contractually complete asset markets (against possible time- and state-of-the-world contingencies) Costless asset trading (in terms of taxes, trading fees, and presumably information).
Puzzling puzzle: Academics dispute on the origin, measurig and the meaning of the puzzle. Some almost totally ignored questions from Kocherlakota, 1996: (1)Why not ask from citizens why they invest so little on stocks? (2)As participating stock markets becomes more familiar and easier (through web, for example) , will the puzzle disappear in the future?
Only if these conditions hold, we may expect that individuals find their true preferences
Then you have stable preferences prior to entering into a decisionmaking situation. But these preferences may be hidden.
Then you have stable preferences prior to entering into a decisionmaking situation. But these preferences may be hidden.
Then you have no clear and consistent preferences prior to entering to a decision-making situation.
You discover them when you are in the situation repeatedly, get feedback and able to learn.
You discover them when you are in the situation repeatedly, get feedback and able to learn.
Common arguments Traditional economist : if empirical evidence is inconsistent with the theory, the conditions 1-3 are not fullfilled; that is, people have not yet found their true preferences. Therefore the inconsistency is harmless to economics Reformist economists: The itmes 1-3 in DPH have to be tested empirically; its seems that the traditional theory has a narrower area of applicability than has been assumed. Note: Researhers in behavioral economics can be found in both camps.
This reminds us of the cognitive dissonance theory. Accordingly, people feel uncomfortably if the have conflicting ideas simultaneously. They try to reduce the dissonance by changing their attitudes, beliefs and behaviour. There is an article by George Akerlof: The Economic Consequences of Cognitive Dissonance A book by Jon Elster Sour grapes An many others more recent ones See also Applied Behavioral Finance blog: http://behavioralfinances.com/category/cognitive-dissonance/
Anticipated outcomes
Subjective probabilities
Cognitive evaluation
Decision
Feelings
Utility framework is as simple as possible. The decision-maker may have feelings but feelings do not influence on decisionmaking.
Anticipated outcomes
Subjective probabilities
Cognitive evaluation
Decision
Feelings
Some features of the real-world decision-making and the idea that the perception of risk may result from feeling or emotion, are incorporated in utility framework.
Conclusions
In behavioral finance some anomalies are persistent This means that it is difficult to get people to behave correctly (sic!), that is, according to the traditional theory Winners curse can be corrected by institutions Equity premium puzzle can disappear (maybe) by making it easier for citizens to participate financial markets