Behavioralfinance and anomalies

7/30/2019 Behavioralfinance and anomalies

1/46

Behavioral finance and

anomalies what do they mean?

1. Behavioral finance and anomalies of conventional economictheory

1.1. What is meant by behavioral finance?1.2. Anomalies in behavioral finance

2. How to interpret the behavioral finance anomalies? Thediscovery 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


2/46

1. What is behavioral finance?

Traditional finance theory sees agents as rational Agents update their beliefs immediately after

receiving new information (-> Bayes law)

Agents make choices that are normatively acceptable

Behavioural finance is the study of the influenceof psychology on the behaviour of financialpractitioners and the subsequent effect onmarkets.

Behavioural finance is of interest because it helpsto explain why and how markets might beinefficient


3/46

Two major topics

Limits to arbitrage issue

although there are rational and non-rational agents in

markets, the former one prevent the latter ones from

influencing prices in the long run through a process of

arbitrage (= purchase and sale of an asset in order to profit

from a difference in the price)

Bringing some psychology into economics

People deviate from full rationality by making mistakes in

updating their beliefs and in consulting their preferences

Therefore, psychology is needed: how beliefs are formed,

are preferences consistent etc.


4/46

Rational traders, noise traders and some price

phenomena

If arbitrage works, there is no long-rung underpricing oroverpricing; that is, an asset price equals its fundamental

value

If there are limits to arbitrage, price does not equal

fundamental value Assume the fundamental value of a share of Ford is $20 but

some noisy traders become too pessimistic and sell their

shares. Consequently, the price is pushed to $15. Then

rational traders buy Ford until the price is back to

fundamental value.

Does this happen in real markets?


5/46

Froot and Daboras 1999 study

The case ofRoyal Dutch Petroleum and Shell 1907alliance

The alliance produced a twin-company Interest merged on 60:40 basis; cash flows split in the

proportion of 60:40

However, Royal Dutch and Shell remained as separateentities

Royal Ducth and Shell trades on nine exchanges in Europeand USA; Royal Dutch, however primarily in theNetherlands and USA and Shell in the UK

Hypothesis: if prices equal fundamental value, themarket value ofRoyal Dutch equity should be 1.5times the market value ofShell equity.

Data shows that the hypothesisi is false ->


6/46

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.


7/46

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 thatcan be successfully modeled on the basis of EUT?


8/46

Beliefs

Overconfidence

"The investors take bad bets because they fail torealize that they are at an informational disadvantage.

Or they trade more frequently than is prudent, which

leads to excessive trading volume. Shefrin (2000)

Optimism and wishful thinking

People tend to exaggerate their own abilities.

Representativeness

looking at an event and making a judgment as to howclosely it corresponds to other events as found in the

general population.

Shefrin (2000)


9/46

Beliefs

Conservatism

tendency to cling tenaciously to a view or aforecast. When movement does occur it is only veryslow (this creates under-reaction to events).Montier(2002)

Staus quo bias individuals have a strong tendency to remain at the

status quo, because the disadvantages of leaving itloom larger than the advantages.Thaler (1992) p. 68

Anchoring & Availability bias The initial value, or starting point, may be suggested

by the formulation of the problem, That is, differentstarting points yield different estimates, which arebiased toward the initial values."

Tversky and Kahneman (1974)


10/46

Preferences

The basic questions How do investors evaluate risky gambles?

How to understand (with a model) asset prices or

trading behaviour? Standard model

Expected utility theory/model

A psychological model Prospect theory


11/46

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


12/46

The expected utility theory (very shortly)

The EUT consists of axioms about preferences and probability

calculations

Predictions of EUT are logically drawn from the axioms

Predictions can be tested against observational data

EUT states that the decision maker chooses between

uncertain prospects by comparing their expected utility

values, i.e., the weighted sums obtained by adding the utility

values of outcomes multiplied by their respective

probabilities.

The expected utility hypothesis asserts that when people are

faced with making choices under uncertainty, they do so by

maximizing their expected utility.


13/46

1. Prospect theory

1.1. Standard rational choice theory in a nutshell

Some shortcomings of the theory, however

1) Why average returns to stocks > average returns to bonds?

2) Why do sellers value their goods and assets higher than

buyers?

3) Why are people willing to drive accross town to save 5 in

buying a calculator but not in buying a 125jacket?

4) Why do you delight to hear you are going to have 10% raise in

salary but are furious to see you colleague will get 15%?

5) Why do people so often make firm decisions to have a diet or

to quit smoking only to give in later?

6) Why are people willing to bet long odds on the last race of the

day but not on the previouos races (horse race)?


14/46

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 valuefunction.

gainslosses

The subjective value of the outcome

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.


15/46

The shape of the weighting function shows that small objective

probabilities are overestimated and large objective probabilities

are underestimated.

0

0.5

1

0.5 1

Probability, p

Weight (p)

(0,25) > 0,25 = p

(0,75) < 0,75 = p


16/46

Some conclusions (for part 1)

Prospect theory accommodates many phenomena inlabs and in real life

What does this mean? Whats the weight of the evidence?

Is prospect theory better?

Many anomalies bother EUT, but EUT is adhered to.This is since (1) EUT is a good general theory ofdecision-making and since (2) EUT is, for the time

being, the best normative theory of decision-making.

However: the prospect theory is a multifaceteddescriptive theory of decision-making


17/46

1.2. Anomalies in behavioural finance

Anomalies are systematic observations orfindings that are not predicted/explained by

the conventional economic theory (EUT)

A list: January effect

Winners curse

Equity premium puzzle

And others


18/46

The winners curse

Originally the winners curse was found tohappen in auctions where the drilling licenses inthe Gulf of Mexico were auctioned

It was found that those who won the auction veryoften ended up with making bad profit or even

loss Definition

A tendency for the winning bid in an auction to exceedthe intrinsic value of the item purchased.

Caused generally by the difficulty in estimating thevalue of the auctioned item

Difficulties in estimating come from incompleteinformation, emotions, or other such things


19/46

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 CompanyT's shares but are unsure how high a price tooffer.

The main complication is this: the value of the

company depends directly on the outcome of amajor oil exploration project it is currentlyundertaking.


20/46

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 ofCompany A than under Company T.

How much to offer?


21/46

The problem:

Thus, you (Company A) will not know the resultsof the exploration project when submitting youroffer, but Company T will know the results whendeciding whether or not to accept your offer.

In addition, Company T is expected to accept anyoffer by Company A that is greater than or equalto the (per share) value of the company under itsown management.

As the representative of Company A, you aredeliberating over price offers in the range$O/share to $150/share. What offer per sharewould you tender?


22/46

A typical reasoning:

The firm has an expected value of $50 toCompany T, which makes it worth $75 toCompany A.

Therefore if I suggest a bid somewhere between

$50 and $75, Company A should make somemoney.

This analysis fails to take into consideration theasymmetricinformation that is built into theproblem.


23/46

The correct reasoning

A correct analysis must calculate the expected

value of the firm conditioned on the bid beingaccepted.

If a bid B is accepted, then the company must beworth 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 whichany positive bid yields an expected loss to thebidder.

See the next slide for the results of an experiment


24/46

In both conditions over 90 percent of the subjects make positive

bids, and a majority are in the range between $50 and $75.


25/46

Can you avoid?

The winners curse is a difficult thing

It happens, if you want to win an auction, but

it may lead you to pay more than is the value

of the auctioned item

How to avoid?

Not to make high offers (and, not to win)

Tell to your competitors that there is a danger of

the winners curse

Would these work? Hardly.


26/46

Eguity premium puzzle: some terms

Equity: 1. The ordinary shares (UK) or common stocks (US) of companies. (2.

The concept of distributive justice used in welfare economics.)

Premium: 1. A share price higher than the issue price. (2. The price paid for an

insurance policy. 3. An addition to interest rates required to compensate

lenders for risk.)

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. Maycarry a fixed interest or an interest linked to some financial index. Government

bods are regarded as very safe (no risk).


27/46

The equity premium puzzle

A short definition: Returns to stocks are higher

than returns to bonds, which is inconsistent withthe conventional finance theories

A longer definition: Real returns to investors from the purchases of U.S.government bonds have been estimated at one percent per year, while

real returns from stock ("equity") in U.S. companies have been estimated

at seven percent per year (Kocherlakota, 1996)

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.)


28/46

Puzzled theories

The theories against which the evidenceconstitute a "puzzle" tend to have these aspectsin common:

Standard preferences described by standardutility functions

Contractually complete asset markets (againstpossible time- and state-of-the-world

contingencies) Costless asset trading (in terms of taxes, trading

fees, and presumably information).


29/46

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?

Source: Dimson et al. 2006


30/46

Source: Dimson et al. 2006


31/46

Does prospect theory explain the puzzle?

There are promising attempts based on lossaversion and mental accounting

Loss aversion: investors feel losing more strongly than

winning

Mental accounting: investors put gains and losses in

separate pots, which are reviewed at regular set

intervals

Myopic loss aversion: investors are very loss averseand evaluate the performance of their investments each

year eplanation of Equity premium puzzle?


32/46

2. How to interprete the behavioral finance anomalies?

2.1. The discovery of preferences hypothesis

Plott (1996): preferences revealed in choicesconverge to the same underlying preferences

In addition (ibid.):

The underlying preferences are discovered afteragents repeatedly take decisions, receive feedback,and are given incentives to discover which actionsbest satisfy their prefernces

Anomalies to standard theory are results of untutoreddecisions by agents; after repetition and feedbackagents discover their true preferences and anomaliesdisappear


33/46

2. How to interprete the behavioral finance anomalies?

2.1. The discovery of preferences hypoblethesis

According to the DPH traditional economic theory(EUT) is applicable to situations where: (1) Individuals are driven (motivated) by clear

incentives and individuals perceive the incentives in a

right way (2) Individuals have learned to behave in the situation;

they are experienced enough

(3) Individual repeatedly face the situations so thatlearning is possible

Only if these conditions hold, we may expect thatindividuals find their true preferences


34/46

PREFERENCES --

DISCOVERED or CONSTRUCTED?


35/46

PREFERENCES --


Then you have stable preferences

prior to entering into a decision-

making situation. But these

preferences may be hidden.


36/46

PREFERENCES --


Then you have stable preferences

prior to entering into a decision-

making situation. But these

preferences may be hidden.

Then you have no clear and consistent

preferences prior to entering to a

decision-making situation.


37/46

PREFERENCES --


You discover them when you are in

the situation repeatedly, get feedback

and able to learn.


38/46

PREFERENCES --


You construct them when you are in

the situation.

You discover them when you are in

the situation repeatedly, get feedback

and able to learn.


39/46

Common arguments

Traditional economist: if empirical evidence

is inconsistent with the theory, the conditions1-3 are not fullfilled; that is, people have notyet 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 thatthe traditional theory has a narrower area of

applicability than has been assumed. Note: Researhers in behavioral economics can

be found in both camps.


40/46

DPH and finance anomalies

Does DPH save the standard economic theory

(EUT) from financial anomalies such as the

winners curse and equity premium puzzle?

2 2 i i h li ?


41/46

2.2. Re-interpreting the anomalies?

A reinterpretation: sour grapes

Economists typically see themselves merely as advisors of

the government

Could they also advise citizens and entrepreneurs?

They would like to know is it rational to invest in stocks

and/or bonds?

A household survey? Webb-technology?

Are there spontaneous solutions (conventions) that

prevent the realization of the winners curse

Construction industry conventions (investigated in

Texas by Kagel et al)

Think of the Fox and Grapes fabel in the next slide


42/46

Der Fuchs und die Trauben

In dieser Fabel zeigt sich ein Fuchs verchtlich ber die

Trauben, die er nicht erreichen kann:

Der Fuchs biss die Zhne zusammen, rmpfte die Naseund meinte hochmtig: "Sie sind mir noch nicht reifgenug, ich mag keine sauren Trauben." Mit erhobenemHaupt stolzierte er in den Wald zurck.

Die Moral ist: "Es ist leicht etwas zu verachten, was mannicht erreichen kann..."

This reminds us of the cognitive dissonance theory. Accordingly, people feel

uncomfortably if the have conflicting ideas simultaneously. They try to reduce thedissonance 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/


43/46

2.2. Re-interpreting the anomalies?

Another re-interpretation: new theory

Recall the discovered preferences hypothesis Some anomalies may disappear through repetition,

feedback and adequate incentives

Others will not

These and many other anomalies call forth More and more empirical investigation (traditional

and experimental)

New theory or theories: maybe economics willdevelop towards theoretical diversity

What would a new theoretical framework looklike?


44/46

Anticipated

outcomes

Subjective

probabilities

Cognitive

evaluationDecision

Feelings

Outcomes

(including

emotions)

The consequentialist perspective on decision-making (Loewenstein et al. (2001)

Utility framework is as simple as possible. The decision-maker

may have feelings but feelings do not influence on decision-

making.


45/46

Anticipated

outcomes

Subjective

probabilities

Other factors- Vividness

- Immediacy

- Social context

Cognitive

evaluationDecision

Feelings

Outcomes

(including

emotions)

The risk-as-feeling perspective on risk (Loewenstein et al. (2001)

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.


46/46

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 thetraditional theory

Winners curse can be corrected by institutions

Equity premium puzzle can disappear (maybe) bymaking it easier for citizens to participate

financial markets

Documents

Behavioralfinance and anomalies