Behavioral Finance – A Challenge to Market Efficiency

Behavioral Finance –

A Challenge to Market Efficiency

Henry Fiebelkorn

Behavioral Economics

Dr. D. Kuebler, SS2003

Seminar Behavioral Economics SS 2003 04-07-03 Behavioral Finance | 2

Structure

Introduction Behavioral Finance and Overview

Summary and Outlook

Market Phenomena - Anomalies

I

V

II

Financial Asset Pricing Theory – Behavioral ModelsIII

Applying Behavioral FinanceIV


Introduction

„Modern finance theorists have turned finance into a science,

but they forgot that it is a social science!“

State of Modern Finance:

Current State:

Behavioral Finance:

PerfectPerfect Markets & PerfectPerfect People

ImperfectImperfect Markets & PerfectPerfect People

ImperfectImperfect Markets & Imperfectmperfect People

BF:is the application of psychology to financial behavior –

the behavior of practioners.

Aim: recognize, understand and avoid mistakes.


Behavioral Finance

Classification

Framing Aspects

Heuristics Self-Concept

Mental Accounting

Prospect Theory

Representativeness

Availability

Anchoring

Ambiguity Aversion

Overconfidence

Self-Attribution

Cognitive Dissonanz

Self-Control

Confirmation Bias

Herding

Conservatism

Underlying Concepts:

1. Bounded Rationality2. Emotions


Structure


Summary and Outlook

II

V



Introduction Behavioral Finance and OverviewI


Anomalies

Volume

Volatility

Dividends

Equity Premium Puzzle

Book-to-Market Ratio

1. Anomalies are consistent

2. Violate the Efficient Market Hypothesis


Structure


Summary and Outlook


I

V

II




Model of Investor Sentiment

Existing Approaches

“Inefficient Markets” by Shleifer (2000)

Abitrageurs:

• Follow Standard CAPM: No cognitive errors

• Utility expressed motives• Try to exploit Noise Trader

Information Trader Noise Trader

Outside CAPM (BAPM):

• Cognitive errors: listen to gurus, follow rumors

• Value expressed motives

= Investor Sentiment



Existing Approaches

Abitrage is limited because:

1. Securities don´t have obvious substitutes

2. Abitrage is risky (Risk Aversion)

3. Noise Trader Risk

Price changes in absence of fundamental news!

Belief about Noise Trader determines price



Existing Approaches

Price Determination: Two Earning Regimes:

• Prior views

• No revaluation due to

News News

Conservatism Representativeness

• give up old model

•Attach to new model due to

Underreaction Overreaction


BSV - Model

Existing Approaches

Captures 2 Judgement Biases:

Barberis, Shleifer, Vishny (1998)

Representative-ness Bias

Conservatism

Underreaction of Stock Prices

Overreaction of Stock Prices

Investors: 2 Earning Regimes:

Barberis, Shleifer, Vishny (1998)

Earnings are meanreverting

Firms´ earnings are trending

(+)

(-)Change

temporarely

Long-term-Change


DHS - Model

Existing Approaches

Captures 2 Judgement Biases:

Daniel, Hirshleifer, Subramanyam (1997)

Overconfidence Self-Attribution

Exaggerate Privat

Information

Downweight Public

Information

(+) (-)

Special Prediction: Selective Items


Behavioral Asset Pricing Model (BAPM)

Existing Approaches

16

Strong: JewelryLess: AutomobilesAbsent: Laundry

valu

e ex

pre

ssed

ch

arac

teri

stic

sEnable user to identify value of products

Risk: Automobiles: Laundry

Uti

litia

n

char

acte

rist

ics Rational Utility

Utilitarian characteristics vs. Value expressed characteristics (Timex /Rolex example)

“Behavioral Asset Pricing Theory” by Shefrin, Statmen (1994)

BA

PM


Model Requirements

Identification of preferences of the

buyers/sellers

Characteristics capturing value expressive (VEC) & utilitarian preferences (UC)

Conclude with equilibrium

prices

Behavioral Asset Pricing Model:

Should include:

1. What investors think2. How they asses risk3. How they forecast growth4. What rules they follow


Structure


Summary and Outlook


I

V

II




Applying Behavioral Finance

Investors

Limitations

Internal

• Mental Accounts• Heuristics• Self-Deception

External

• Biases information• Limitation of time

&resources• Practical restrictions



Emotional

Feelings

Investor

Performance Pressure

Time & Resource Constraints Uncertainty

Overload of

Information

Heuristics

Practical Restrictions

Biased

Information


Coping with Limited Rationality


4. Heuristics

1. Identify / Framing

2. Editing

3. Decomposition

„People are

intendedly rational but limited to do so!“



Behavior:

• Overreaction

• Underreaction

• Extrapolation

• Herd Behavior

Investment Strategies

• Value Investing

• Mean Reversion Strategy

• Momentum Strategy

• Event Studies

• Earning Revision Strategies

• Combination Studies


Loss Aversion

Behavioral Finance leads to product development


• Guaranteed products

• RenteMaXX

• Best of World Garant Fund

Overconfidence

Absolute Return

• Daytrading

• Hedge Funds:

• Event driven

• Opportunistic

• Relative value


Structure


Summary and Outlook


I

V

II




ll

1. Be aware of information biases:

seek and screen information actively

2. Avoid narrow framing, anchoring, overconfidence

3. Follow rules of decision making under uncertainty

Investor Market

1. Market and people are imperfect

2. There are systematic and recurring market inefficiencies

Anomalies are consistent and can´t be ignored

3. Sensible implementation of irrational human behavior into asset pricing models necessary

• VEC as well as UC must be included

Summary

What lessons does Behavioral Finance teach us?

Thanks for your attention!

Behavioral Finance – A Challenge to Market Efficiency

Documents

Transcript of Behavioral Finance – A Challenge to Market Efficiency