behav finance notes

1 Behavioral Finance – Exercise Course IV Dr. Heiko Jacobs

Behavioral Finance – FSS 2012 Exercise Course IV


Linking individual behavior and market outcomes

Should we care about individual investor behavior if we are primarily

interested in economic aggregates?

Yes!

We will study implications of

Overconfidence (very briefly)

Disposition effect

Limited Attention

Agenda


• Investors overestimate the precision of their knowledge or underestimate

the variance of stock returns.

• Incorporating overconfidence in different types of models (e.g. Diamond

and Verrecchia (1981), Kyle (1985)) leads to the following conclusion:

Overconfident traders trade more than rational traders.

The higher the degree of overconfidence, the higher trading volume.

Overconfidence and differences of opinion are not mutually exclusive

“Excessive” trading volume as a result of overconfidence

Exercise 1


Seller Buyer Seller Buyer

no overconfidence overconfidence

trading activity

no opportunity for trading

90

100

110

120

130

140

150

Overconfident traders base their decision on confidence intervals, which are “too narrow”

Trade more

aggressively

Higher trading

volume

The intuition behind the result

Exercise 1


Does the purchase price (or any other reference from the past)

affect the willingness to sell?

past future Price

today

What is the disposition effect?

Exercise 2a)


Yes, the purchase price / reference point effects the willingness to sell!

Investors have the tendency to sell shares whose price is increasing,

while keeping assets that have dropped in value,

so they tend to ''sell winners too early and ride losers too long“

Exercise 2a)

„Investors tend to • sell winners too early

• and ride losers too long“

Disposition effect


Why is prospect theory one possible explanation for the disposition effect?

Past prices serve as a reference point,

Different risk attitude for gains and losses:

Risk seeking in the loss domain, risk averse in the gain domain

Gain Loss

convex =>

risk seeking

Gain Loss

concave =>

risk averse

Gains

Losses

Sell!

Hold!

Exercise 2b)


Exercise 2


=> Yes, investors may also believe that winners and losers will mean revert

Fundamental misunderstanding of random processes and stock market

efficiency:

• If stock prices follow a random walk, past price movements say nothing

about future price movements

• Similar to “Gambler’s fallacy”: people are likely to predict reversal

Exercise 2b)

Can you think of another possible explanation for the disposition effect?


Exercise 2c)

From a welfare-point of view what is the problem if investors are disposed to

selling winners and holding losers?

Problems associated with the Disposition effect:

• The behavior is tax-inefficient: Optimal tax-behavior predicts holding

profitable investments to postpone taxable gains and selling

investments with paper losses to receive a tax rebate

• Losing stocks held underperform winning stocks sold!

• Possible explanation: momentum in stock returns

Winning stocks sold Paper losses not sold

Average excess return after

252 trading days: 2.35%.

Average excess return after

252 trading days: -1.06%.


Data:

• American discount broker

• 10,000 accounts

• 1987-1993

How does Odean (1998) measure the disposition effect?

Exercise 2d)

Terrance Odean, "Are Investors Reluctant to Realize Their

Losses?", Journal of Finance, Vol. LIII, No. 5, October 1998,

1775-1798.

(From his homepage):

“MEDIA: Over 1,000 Television, Radio,

and Print interviews and discussions

of research”



Methodology:

• he looks at the frequency with which investors sell winners and losers relative to their

opportunities to sell

• each day a sale takes place in a portfolio of two or more stocks, he compares the

selling price for each stock sold to its average purchase price to determine whether

that stock is sold for a gain or a loss

• each stock in the portfolio at the beginning of the day, that is not sold, is considered to

be a paper (unrealized) gain or loss (or neither) by comparing its high and low price for

that day to its average purchase price

• other reference points: highest purchase price, first purchase price, most recent

purchase price

Exercise 2d)



Two hypothesis to be tested:

• Hypothesis 1:

Investors tend to sell their winners and hold their losers:PGR > PLR (for entire year)

• Hypothesis 2:

In December investors are more willing to sell losers and less willing to sell winners

than during the rest of the year: PLR - PGR in December > PLR - PGR in January-

November

Proportion of gains realized: PGR =

Proportion of losses realized: PLR =

Realized gains

Realized gains + unrealized gains

Realized losses

Realized losses + unrealized losses

Exercise 2d)


Odean (1998), Results:

14.8%

9.8%

0%

5%

10%

15%

20%

PGR PLR

10.8% 12.8%

0%

5%

10%

15%

20%

PGR PLR

Entire year, H1: December, H2:

Exercise 2d)


Realized Gains: A + B + H Realized Losses: C

Paper Gains: D + I Paper Losses: E + F + G + J

Portfolio X Portfolio Y

Stock Gain/ Stock Gain/

Loss Loss

A + G -

B + H +

C - I +

D + J -

E -

F -

A + B + C are sold H is sold

Exercise 2e)


5

1

41

1

J,G,F,EC

CPLR

5

3

23

3

I,DH,B,A

H,B,APGR

Proportion of gains realized: PGR =

Proportion of losses realized: PLR =

Realized gains

Realized gains + unrealized gains

Realized losses

Realized losses + unrealized losses

Realized Gains: A + B + H Realized Losses: C

Paper Gains: D + I Paper Losses: E + F + G + J

Exercise 2e)


• Experimental validation of the disposition effect, instead of empirical analysis

• Stock exchange in the laboratory, controlled environment:

- six assets (A-F), different probabilities of price increases/decreases

- probabilities known + fix, but unknown which probability refers to which asset

- prices are not determined by supply and demand but by a chance process

• Notional investment amount: 10,000 DM

What do Weber and Camerer (1998) do to test the existence of the disposition

effect? What is different to the analysis of Odean (1998)?

Exercise 2f)


Asset prices

• Price increase or decrease, assets independent

• Probability for an price increase:

• Price change 1, 3, or 5 DM, assets independent

++ : 65%

+ : 55%

0 : 50% (2 assets)

- : 45%

-- : 35%

Why is it rational to buy winners and sell losers?

Exercise 2g)


Participants have to look at the price paths to calculate which asset is of the type ++ , + , 0 , 0 , - , - -

Example:

Rational expecta-

tions after period 5

Exercise 2g)


Rational:

probability of a price increase is fixed over time

the stock that has risen most frequently is most likely to be the ++ stock,

the stock that has fallen most frequently is most likely to be the - - stock,

...

strategy: sell losers, buy winners

Example: Rational expectations after period 5

Exercise 2g)


But: actual behavior

%

Exercise 2g)


How can the disposition effect be reduced? (Weber / Camerer)

Trading phase

• new prices

• purchases/sales

Automatic selling

of holdings

Possibility of redemption

at the old price

Trading phase

• new prices

• purchases/sales

Alternative design • 2 different designs:

– Experiment I:

voluntary selling of holdings

after each period

– Experiment II:

automatic selling of all holdings

but possibility of redemption of

the assets at the old prices

Exercise 2h)


How can the disposition effect be reduced?

Possible counteractions:

• do not look at the purchase price, only current price is important

• ask yourself the question: “By now would I buy the stock again?“

• use stop-loss prices

• keep distance to your investments

Exercise 2h)


Explain how the disposition effect might influence stock returns.

Exercise 2i)

The Disposition effect may affect the supply of stocks:

• If stock prices rise above the reference point: Investors will be more willing

to sell thereby increasing the supply of stocks temporary downward

pressure on current stock prices positive drift in stock returns

• If stock prices fall below the reference point: Investors will be averse to sell

thereby restricting supply temporary upward pressure on current stock

prices negative drift in stock returns

However:

• Every investor may have a different reference point Is there an effect in

aggregate?

• Rational investors may “step in” to assure that prices reflect the

fundamental value


Frazzini’s research design (The Disposition Effect and Underreaction

to News, Journal of Finance, 2006)

Exercise 2j)

Methodology:

• he looks at the holdings of mutual funds which constitute a large fraction of the market

• For each individual stock he constructs an individual reference point =average

purchase price of the funds which hold the particular stock in a particular quarter

• Example: 3 funds A, B, and C which hold Microsoft shares

• If Microsoft stocks currently trade above (below) $32.86, most current stock holders of

Microsoft have a paper gain (paper loss) in their books capital gains (loss)

overhang

Fund No. Microsoft shares Purchase Price Total trading amount

A 20 $25 $500

B 70 $30 $2,100

C 50 $40 $2,000

Total 140 $4,600

Average purchase

price=$4,600/140=

$32.86


Frazzini’s research design (The Disposition Effect and Underreaction


Exercise 2j)

Methodology:

• Frazzini then looks at major corporate news announcements (e.g. Microsoft

announcing a delay of the launch of a new operating system)

• In the absence of frictions the news should be immediately incorporated into prices

and there will be no predictable price trend afterwards

• However, if the Disposition effect has an impact on stock prices there will be a

(stronger) post-event announcement drift

Negative news Positive news


Frazzini’s results (The Disposition Effect and Underreaction


Exercise 2j)

1,11%

0,35%

-0,98%

-0,43%

-1,50%

-1,00%

-0,50%

0,00%

0,50%

1,00%

1,50%

"Overhang" Stocks Other Stocks

Good News

Bad News

Large return drift if price

is far away from the

average purchase price

Smaller (and insignificant)

return drift if price is close

to average purchase price

Methodology:

• Frazzini looks at the abnormal

return in the month after the

corporate announcement

• In fact, he finds a large price

drift for “overhang” stocks

• Stocks with good news have a

1.11% higher return in the next

month if most current stock

holders have a capital gain,

stocks with bad news have a

0.98% lower return if most

current stock holders have a

capital loss

• Disposition effect influences

stock prices


Linking individual behavior and market anomalies: Attention constraints

Exercise 3

a) Briefly summarize the main findings of Barber/Odean (2008, RFS) with regard to

their empirical analysis of individual investors’ buying patterns. Why do individual

investors behave in that way?

b) Illustrate how investors’ attention constraints might affect market outcomes by

sketching the idea and main results in Hirshleifer et al. (2009, JF) and

DellaVigna/Pollet (2009, JF)


Large sample of US individual investors

66.000 investors of a large discount broker

14.000 investors of a small discount broker

647.000 investors of a retail broker (with investment advice)

Brad Barber and Terrance Odean (2008): "All that Glitters: The Effect of

Attention and News on the Buying Behavior of Individual and Institutional

Investors“, Review of Financial Studies, 21, 785-818.

What prompts individual investors to buy a certain stock? Empirical analysis



Main result:

Individual investors buy

Stocks with abnormal trading volume

Stocks with an extreme (positive or negative) one day price movement

Stocks that are in the news

Proxies for attention-grabbing stocks:

„Attention-grabbing stocks“



Number of listed companies in 2008

(World Federation of Exchanges)

America: 11,790

Asia Pacific: 20,819

Europa/Africa/Middle East: 14,097

=> Total: 46,706

Attention-grabbing stock simplify the search problem Explanation

“Attention is a major factor determining the stocks

individual investors buy.“ Conclusion


vs


“Attention is a scarce cognitive resource and attention to

one task necessarily requires a substitution of cognitive

resources from other tasks”

(Kahneman (1973))

Psychological

research

Should we care about investors’ attention constraints? Asset

Pricing Implications

„Attention grabbing events“ (Barber/Odean (2008, RFS)

excessive attention (too much?)

„Investor distraction events“

limited attention (not enough?)



Market anomaly: Post earnings announcement drift (PEAD)

Returns continue to drift up for firms with “good earnings

news” and down for "bad earnings news" firms. Post earnings

announcement drift

Empirical challenge: How to measure „good/bad earnings news“

One of several commonly used approaches:

Actual earnings per share – Median analyst forecast

Share Price

Sort firms into „earnings surprise“ deciles based on that measure


Market anomaly: Post earnings announcement drift (PEAD)

Bernard/Thomas (1989)

"unexpectedly good

earnings announcements"

"unexpectedly bad

earnings announcements"

Returns continue to drift up for firms with “good earnings

news” and down for "bad earnings news" firms. Post earnings

announcement drift

Earnings announcements at day 0

Cumulative

abnormal

returns


Limited Attention: PEAD

Does limited attention play a role? Possible explanation

At least in some situations, investors might not pay adaquate attention to the

information incorporated in the earnings announcement

=> At least a portion of the price response to new information will be delayed.

Paper Limited Attention Proxy Motivation

DellaVigna/Pollet (2009, JF) („Investor Inattention and Friday Earnings

Announcements“)

Fridays Investors might be

distracted by the

upcoming weekend

Hirshleifer/Lim/Teoh (2009, JF) (Driven to Distraction: Extraneous Events and

Underreaction to Earnings News)

Number of same day

earnings announcements

The number of

competing stimuli

increases

Peress (2008, WP) (Media Coverage and Investors‘ Attention to Earnings

Announcements)

(Lack of) media coverage Media disseminate

information to a

broad audience



DellaVigna/Pollet

(2009, JF)

...the initial response for earnings announcements on Friday is weaker



And the post-earnings-announcement drift stronger

=> Consistent with the limited attention hypothesis

DellaVigna/Pollet

(2009, JF)



Similar results in Hirshleifer et al. (2009, JF)

Immediate response Post-earnings-announcement drift

=> Attention constraints do matter for market outcomes!

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