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Behavioural Finance
Efficient Market Hypothesis Behavioral Finance Behavioral Biases: Examples Versions of the EMH The Behavioral Critique Limits to Arbitrage Types of Stock Analysis Errors in Information Processing Technical Analysis Efficient market hypothesis is A. Resources are allocated efficiently B. Prices react fast and without bias C. I don’t know what EMH is D. Prices react fast but with bias Efficient Market Hypothesis (EMH) • EMH says stock prices already reflect all available information • A forecast about favorable future performance leads to favorable current performance, as market participants rush to trade on new information. Result: Prices change until expected returns are exactly commensurate with risk. Efficient Market Hypothesis (EMH) • New information is unpredictable; if it could be predicted, then the prediction would be part of today’s information. • Stock prices that change in response to new (unpredictable) information also must move unpredictably. • Stock price changes follow a random walk. Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies Figure 11.2 Stock Price Reaction to CNBC Reports Versions of the EMH • Weak • Semi-strong • Strong • All versions assert that prices should reflect available information Types of Stock Analysis • Technical Analysis - using prices and volume information to predict future prices - Success depends on a sluggish response of stock prices to fundamental supply-and-demand factors. - Weak form efficiency • Relative strength • Resistance levels The difference between a martingale (random walk) and a submartingale is the expected price change in a martingale (random walk) is____, and the expected price change for a submartingale is____. A. Positive; zero B. Positive; positive C. Positive; negative D. Zero; positive E. Zero; zero Types of Stock Analysis • Fundamental Analysis - using economic and accounting information to predict stock prices - Try to find firms that are better than everyone else’s estimate. - Try to find poorly run firms that are not as bad as the market thinks. - Semi strong form efficiency and fundamental analysis Behavioral Finance Conventional Finance Behavioral Finance • Prices are correct and equal to intrinsic value • Resources are allocated efficiently • Consistent with EMH • What if investors don’t behave rationally? The Behavioral Critique Two categories of irrationalities: 1. Investors do not always process information correctly • Result: Incorrect probability distributions of future returns 2. Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions • Result: They have behavioral biases Which of the following do you prefer? A. $1m with chance of winning of 100% B. $1m with 89% chance; $0 with 1% chance and $5m with 10% chance Which of the following do you prefer? A. $1m with 11% probability and $0 with 89% probability or B. $5m with 10% probability and $0 with 90% probability. Rational decision CHOICE 1 A. $1m with chance of winning of 100% $1M x 100% = $1M B. $1m with 89% chance; nothing with 1% chance and $5m with 10% chance $1M x 89% + $0 x1% +$5M X 10% = $1.39M CHOICE 2 A. $1m with 11% probability and $0 with 89% probability $1M x 11% + $0 x 89% = $110,000 B. $5m with 10% probability and nothing with 90% probability. $5M x 10% + $0 x 90% = $500,000 Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which is more probable? A. Linda is a bank teller B. Linda is a bank teller and is active in the feminist movement Conjunction fallacy Choosing a very low probability of Linda being a bank teller, say Pr(Linda is a bank teller) = 0.05 and a high probability that she would be a feminist, say Pr(Linda is a feminist) = 0.95, then, assuming independence, Pr(Linda is a bank teller and Linda is a feminist) = 0.05 × 0.95 or 0.0475, lower than Pr(Linda is a bank teller). Proponents of EMH typically advocate A. An active trading strategy. B. Investing in an index fund C. A passive investment strategy D. An active trading strategy and investing in an index fund E. Investing in an index fund and a passive investment strategy Errors in Information Processing: Misestimating True Probabilities 1. Forecasting Errors: Too much weight is placed on recent experiences 2. Overconfidence: Investors overestimate their abilities and the precision of their forecasts 3. Conservatism: Investors are slow to update their beliefs and under react to new information 4. Sample Size Neglect and Representativeness: Investors are too quick to infer a pattern or trend from a small sample Behavioral Biases: Examples 1. Framing • How the risk is described, “risky losses” vs. “risky gains,” can affect investor decisions 2. Mental Accounting • Investors may segregate accounts or monies and take risks with their gains that they would not take with their principal If you are faced with the following choice, which alternative would you chose? A. A sure gain of AUD 240 B. A 25% chance to gain AUD 250 and a 75% chance to gain nothing. If you are faced with the following choice, which alternative would you chose? A. A sure loss of AUD 750 B. A 75% chance to lose AUD 1000 and 25% chance to lose nothing Imagine you have bought a AUD 50 ticket to a concert. When you show up at the door and realise you have lost your ticket, do you buy another? A. Yes B. No Now imagine say you hadn’t bought the ticket yet, and you show up at the door of the concert hall to buy your ticket. Unfortunately, you realised you have lost AUD 50 in cash since you walked from your car. LUCKILY, you still have enough in your wallet though to cover the cost of the ticket. Do you buy the ticket? A. Yes B. No Behavioral Biases: Examples 3. Regret Avoidance • Investors blame themselves more when an unconventional or risky bet turns out badly 4. Prospect Theory • Conventional view: Utility depends on level of wealth • Behavioral view: Utility depends on changes in current wealth Traditional finance presumes that investors_____, and behavioral finance presumes that they______. A. Are irrational; are irrational B. Are rational; may not be rational C. Are rational; are rational D. May not be rational; may not be rational E. May not be rational; are rational Limits to Arbitrage • Behavioral biases would not matter if rational arbitrageurs could fully exploit the mistakes of behavioral investors • Fundamental Risk: -“Markets can remain irrational longer than you can remain solvent” - Intrinsic value and market value may take too long to converge Limits to Arbitrage • Implementation Costs: - Transactions costs and restrictions on short selling can limit arbitrage activity • Model Risk: - What if you have a bad model and the market value is actually correct? Technical Analysis:Trends and Corrections • Momentum and moving averages - The moving average is the average level of prices over a given interval of time, where the interval is updated as time passes • Bullish signal: Market price breaks through the moving average line from below, it is time to buy • Bearish signal: When prices fall below the moving average, it is time to sell Figure 12.3 Moving Average for INTC Technical Analysis: Relative Strength • Relative strength - Measures the extent to which a security has out- or underperformed either the market as a whole or its particular industry