ec7092 investment management behavioral financea new paradigm: behavioural nance cognitive biases...

EC7092 Investment ManagementBehavioral Finance

Suresh Mutuswami

December 4, 2011

Suresh Mutuswami EC7092 Investment Management Behavioral Finance

Road map and readings

The Efficient Markets Hypothesis (EMH): a retrospectivereview

Challenges to the EMH

A new paradigm: behavioural finance

Cognitive biases

Limits to speculationReadings

BKM, Chapter 12.Other readings:

Shleifer (2000), Chapter 1Barberis and Thaler (2003), “A Survey of BehaviouralFinance” in Constantinides, G.M., Harris, M. and Stulz, R.(eds) Handbook of Economics of Finance.Shiller, R.J. (1999), “Human behaviour and the Efficiency ofFinancial Markets”, in Handbook of Macroeconomics, Vol. 1,130-540.Shefrin and Statman (2000), “Behavioural Portfolio Theory,”Journal of Quantitative Financial Analysis, 35, 127-151.


Are financial markets efficient?

Fama (1970): the Efficient Market Hypothesis (EMH) statesthat in an efficient market prices always fully reflect theavailable information.

Trading strategies based upon past and current informationcannot consistently beat the market.

Evidence:

1960: theoretical and empirical support at first. Later, keyforces that are supposed to create efficiency (i.e. arbitrage) arefound to be weak.1990: efficiency is limited and significant persistent deviationsfrom equilibrium conditions are observed.


Theoretical foundations of the EMH

Investors are rational and value assets rationally on the basisof the NPV of assets’ future cash flows.

Irrational investors (if any) trade randomly without affectingprices.

When there are many similar irrational traders, interactionsbetween rational and irrational traders offset the effect ofirrational trading on prices.

In competitive markets and risk-neutral agents

Returns are unpredictable, prices follow a random walk (RW).

When investors are risk-averse

Prices do not follow a RW but rationality implies theimpossibility of earning higher risk-adjusted returns.


Theoretical foundations of the EMH (contd)

EMH does not require rationality.

There are cases where some investors are not fully rational butmarkets are still predicted to be efficient.

EMH depends on arbitrage (the simultaneous purchase andsale of similar securities in two different markets atadvantageously different prices).

Smart investors note mispricing (induced by irrational or noisetraders) and trade to exploit it. This will reduce the mispricingtowards the fundamental value.Prices should stay close to fundamentals even if irrationaltraders are correlated.


Empirical foundations of the EMH

1960-1970: empirical evidence supporting EMHQuick and accurate response to news (stale information is ofno value in making money). However, difficulties in defining

’making money’ (higher return adjusted for risk). How is riskmeasured? CAPM? EMH would be model dependent.’stale information.’ Public as opposed to private information(weak, semi-strong and strong form of the EMH).

No under- or over-reaction to news.

No price trends or price reversals.

Prices do not react to non-information (arbitrage in action).


Empirical foundations of the EMH (contd)



It is difficult to believe that investors are fully rational.

People react to irrelevant information, trade on noise ratherthan information.

Investors deviate from economic rationality in persistent andsystematic ways.

Attitudes toward risk (they do not look at the level of finalwealth but at the gains and losses relative to a referenceperiod).Non-bayesian expectation formation (investors deviate fromBayes rule in their prediction of uncertain events. Use shorthistory of data. Example: overreaction to glamourous stocks,dotcoms etc.)



Previous biases are amplified by the fact that investors oftenact in the market by means of professional managers whomdecisions are subject to similar biases.

Delegation introduce further distortions.Herding behaviour (managers tend to adopt strategies thatother managers tend to adopt. Example: Window-dressing)

Arbitrage, which should bring prices to their fundamentalvalues, is risky and therefore limited.

Without exact substitute assets, there is no riskless hedge forarbitrageurs.With a finite risk-bearing capacity, the ability of arbitrageurs tobring prices to fundamentals is limited as well.


Behavioral finance

This is a newly introduced paradigm where financial marketsare studied using models with less restrictive assumptions thanthose based on expected utility and arbitrage theory.

Building blocks

Cognitive psychology (how investors think)Limits to arbitrage (in what circumstances arbitrage forces areeffective).


Cognitive biases

Heuristics, or rules of thumb, make decision-making easier.They can lead to suboptimal investment decisions (example:the 1/N rule).

Overconfidence about own investment abilities.Overconfidence generally results in too little diversification.

Mental Accounting. Investors sometimes separate decisionsthat should be combined. (example: separate budgets forfood and entertaining, currency overlay portfolios).

Framing, or the notion that how a concept is presented toindividuals matters. (Examples: ’after-theatre discounts’rather than ’peak-time extra-charges’; ’survival probability’rather than ’mortality rate.’)


Cognitive biases (contd)

Representativeness: Investors underweight long-term averagesor differently investors put too much weight on recentexperience: ’law of small numbers.’ (example: high equityreturns as ’normal.’)

Conservatism and belief perseverance: When things change,investors tend to be slow to pick up the changes. They anchoron the way things have been normal. Investors rarely searchfor evidence against their beliefs and if found they aresceptical (for example, confirmation bias). Representativenessbias may offset the conservative bias.

Optimism and wishful thinking: Many investors displayunrealistically rosy views of their abilities and prospects.


Criticisms

By choosing which cognitive bias to emphasise one canpredict either overreaction or underreaction!

One could find a story to fit the facts and ex post explainingsome puzzling phenomena (model dredging).

It would be appropriate to have a model able to make ex antepredictions about which bias will dominate.


Limits to arbitrage

In the traditional framework with rational agents and nofrictions asset prices equal their fundamental values (that isthe discounted value of expected future cash flows based onall available information).

Behavioural finance argues that some features of asset pricescan be interpreted as deviations from fundamental valuebrought by the presence of traders who are not fully rational.

arbitrage opportunities are risky (costly) and limited.


Limits to arbitrage (contd)

Arbitrageurs’ risks and costs:

Fundamental risk, associated with a bad news relative toassets fundamental values (imperfect substitutability)Noise trader risk, is the risk that the mispricing being exploitedby arbitrageurs worsens in the short run (pessimistic investorsmay drive mispricing even lower (higher) then expected).Arbitrageurs may be forced to liquidate positions in order toavoid steeper losses.Implementation costs

Transaction costsShort-sales constraintsLearning about mispricing


Limits to arbitrage (contd)

In essence: in contrast to straightforward textbook arbitrage,real-word arbitrage entail both costs and risks which undersome conditions will limit arbitrage and allow deviations fromfundamental value to persist.


The case of LTCM

In February 1994 Myron Scholes, Robert Merton and othersfounded the Long Term Capital Management group (LTCM).

For their first 3-4 years of life they have performedspectacularly (on average 30.2%, outperforming the market bynearly 7%).

LTCM S & P 500

1994 19.9% 1.3%

1995 42.8% 37.4%

1996 40.8% 23.1%

1997 17.1% 33.4%

Average 30.2% 23.8%


The case of LTCM

In August 1998 after a bad quarter when they lost US $4millions, LTCM collapsed. Paradoxically they were right in thelong-run!

LTCM mainly traded in fixed income and derivatives but oneof the ways they lost money was on the Royal Dutch/Shellequity arbitrage trade.


Twin shares

In 1907 Royal Dutch (the Netherlands) and Shell Transport(UK) agreed to merge on a 60:40 basis while remainingseparate entities.

Shares of Royal Dutch (mainly traded in the US and in theNetherlands) are claim to 60% of the total cash flow.Shares of Shell (mainly traded in the UK) are claim to theremaining 40%

If prices reflect fundamental values, then PRD = 1.5PS .


Twin shares (contd)


Twin shares (contd)

If PRD 6= 1.5PS , there is an arbitrage profit opportunity.

The data show evidence of persistence inefficiencies.

Deviations from fundamental value are large in magnitudeRoyal Dutch is sometimes 35% underpriced relative to parity,and sometimes 15% overpriced.


Twin shares (contd)

Did LTCM make money out of it?

In 1998 LTCM sold the expensive stock and bought the cheapone.They lost money when prices diverged further later at the endof 1998.To meet liquidity needs, LTCM was forced to sell out positionsdriving the market towards a more inefficient situation.The forces of arbitrage failed.


Application: Home bias

Large evidence suggests that investors internationally diversifytheir portfolios much less than recommended by conventionalmodels of portfolio choice.


Application: Home bias (contd)


Home bias: Ambiguity and familiarity

Ambiguity offers a simple way to understand insufficientdiversification (home bias).

Investor may find

their national stock markets more familiar (therefore lessambiguous) then foreign stock indices.Firms situated closed to them geographically more familiarthan others located further away.

Familiar assets are attractive and investors allocate theirwealth in them because less ambiguous.

Portfolios appear undiversified because conventional models ofportfolio choice do not consider the investor’s degree ofconfidence in the probability distribution of a gamble.


Home bias: Behavioral portfolio theory

Sherfin and Statman (JFQA, 2000) propose a behaviouralportfolio theory.

Investors divide their wealth in layers of a portfolio pyramid:

Lower layers are designed to protect them from poverty.Upper layers are designed to make them rich.Different progressive layers correspond to different goals andlevels of aspiration. (example: investors buy bonds forprotection, mutual funds in the hope of moderate riches andindividual stocks and lottery in the hope of great riches.)


Home bias: Behavioral portfolio theory

Investors prefer

Low risk in the lower layers of their portfolios.High risk in the uppermost layers of their portfolios.

Risk-aversion gives way to risk-seeking at the uppermostlayers as they desire to avoid poverty give way to the desirefor riches.

Some investors fill the uppermost layers with few(international or domestic) stocks of an undiversified portfoliowhile others fill them with lottery tickets.

Few stocks, like few lottery tickets, provide a chance for greatriches while well-diversified portfolios or many lottery ticketsguarantees mediocrity.


ec7092 investment management behavioral financea new paradigm: behavioural nance cognitive biases...

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