P. 1
Application Report

Application Report

|Views: 33|Likes:
Published by Deepak_Agarwal_1889

More info:

Published by: Deepak_Agarwal_1889 on Oct 10, 2010
Copyright:Attribution Non-commercial


Read on Scribd mobile: iPhone, iPad and Android.
download as DOCX, PDF, TXT or read online from Scribd
See more
See less





Understanding Investor Behavior – Biases and Trading Strategies

Behavioral Judgment and Decision Making
STUDENT ID - 19031977835

1. Introduction Behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns and the resource allocation. For this application report I have chosen to understand two widespread phenomenon of over-reaction and under-reaction in stock market through the prospective of behavioral decision-making. 2. Behavioral phenomenon Stock markets are often time govern by sentiments rather than underlying fundamentals. This often leads to irregularities that cannot be explained from rational prospective. The pervasive irregularities are under-reaction and over-reaction. Under-reaction - Under-reaction is a phenomenon where the good news such as good earning news, share buybacks or dividend payouts are slowly incorporated into the stock price. As a result the stock price does not truly reflect the price of the stock. A related way to look this point is to argue that current good news has power in predicting positive returns in the future. As per research from behavioral scientists shows that over the horizons of perhaps one to twelve months, security prices under-react to good news. Over-reaction - Over-reaction is a phenomenon where the stocks get over-priced after they had a long record of good news. Put differently, securities with strings of good performance received extremely high valuations and these valuations. These high valuations suggest that future returns will be low. This also works the other way i.e., the stocks get cheap after series of bad news such as negative earning surprises. 3. Explanation of Phenomenon - Cognition Prospective The human judgment process is governed by heuristics and biases under uncertainty. From the physiological prospective, there are certain biases that can explain the underreaction and over-reaction.

Representative bias - Representative bias is defined as the tendency to view events as typical or representative of some specific class. When considering representative heuristics human judgment tend to ignore the laws of probability and tend to rely on similarity of the current event with the past events that subject has witnessed. In the stock market, investors might consider some stocks as growth stocks based on history of consistent earnings growth, ignoring the fact that there are very few companies that just keep growing. An important manifestation of the representative heuristic is that people tend to see patterns in truly random sequences. Representativeness heuristic explains the phenomenon of over-reaction. When a company has consistent history of earning growth over several years accompanied by salient and enthusiastic descriptions of its products and management, investors might conclude that the past history is representative of a future earning growth potential. While a consistent pattern of high growth may be nothing more than random draw of few lucky firms, investors see order among chaos and infer that the firms profit continue to grow in future. As a consequence investors might disregard the reality that earnings growth is unlikely to repeat itself. They will overvalue the company and be disappointed in the future when the forecasted earnings fail to materialize. Conservatism bias - Conservatism bias is the tendency where person beliefs are slow to change in the face of new evidence. Person under grip of conservatism bias tends to update his belief in the right direction. However, the magnitude is too small compared from the rational prospective- Bayesian benchmark. Conservatism explains the phenomenon of under-reaction. Individuals subject to conservatism might disregard the full information contents of the good news such as good earning announcement, share buybacks or dividend announcements because they belief that numbers contained in good news contains large temporary components. With this belief they continue to support their prior estimates of earnings. Conservatism bias is typically reflected in value stocks. In spite of consistent earnings growth and good dividend payouts over the past few years, these stocks does tend to appreciate slowly as compared to glamour stocks.

Mental Models - Wrong mental models also shape investors behavior. Stocks tend to follow random walk. However, investors tend to ignore this fact. This ignorance is rooted on human desire to find pattern in random sequences. Investor believes that the firms earning does not move randomly but rather moves between two regimes (or states). These false patterns give hope to the investors that they have found formula to beat the market. There are two states that are described below: Mean reverting state – In this state the earnings always trend around the mean value (average value to company’s normal earning). This state implies that positive earning shocks are more likely to be followed by negative earning shocks and vice-versa. Conservatism bias can be explained by this state. An investor using this state to forecast the earnings reacts too little to good news announcement leading to under-reaction phenomenon. Trending state – In this state positive earning shock is more likely followed by another positive earning shock. Similarly negative earning shocks are more likely to be followed by another negative shock. In this state the earning tend to follow the past trend. Representative bias can be explained by this state. After the series of good news, an investor uses this state to forecast future earnings. Since investor belief that stock is in trending state they overprice the stock, leading to over-reaction phenomenon. These mental models led investors to falsely belief that by seeing the patterns they can beat the overall market. If the market just moves randomly then there is good chance that these types of pattern appears often in different stocks from time to times. By falsely believing that these stocks are following some patterns, investors are falling prey to their flawed judgment and decision-making process. In summary the under-reaction and over-reaction can be summarized by the following table: Table 1. Under-reaction and Over-reaction- biases and mental models Behavioral Phenomenon Under-reaction Over-reaction Biases Conservatism Representative Investor Mental models Mean-reverting state Trending state

4. Explanation of Phenomenon - Bayesian Prospective.

As per Bayesian rule the prior probability along with likelihood of an event determines the future probability of an event happening. Mathematically Posterior probability (future probability) = prior prob. * likelihood Prior probability is the investor’s belief that particular stock will not do well in future and likelihood is conditional on this fact in the face of new evidence. Prior probability can also be referred as weight because it determines the prior beliefs of how a particular stock is going to perform in the market. Similarly likelihood can also be thought of as strength of the new evidence i.e. how reliable is the new evidence. Under-reaction happens when the individual is slow to change their belief when the new evidence comes. This means they people put more emphasis on weight (base rate) rather than on the strength of the new evidence (good earning announcement). Unimpressed by the new evidence investors tend to assign low value to the strength and hence they react mildly to the good news. So in under-reaction people do not sufficiently update their beliefs about the new information. Overreaction, on the other hand, occurs when individual put more value to strength (good earning announcement) and low value to weight (base rate). People tend to belief that past winning streak will continue in the future forever. Moreover, they also forget that stock performance will regress to mean i.e. stock will perform poorly in future. This is a typical case of base rate neglect because investors in their enthusiasm forget that very few stocks will keep outperforming the market for long time. Table 2: Probabilistic description of under-reaction and over-reaction Prior (Base rate) Under-reaction (Conservatism) Over-reaction (Representativeness ) 4. Normative approach High Likelihood (new information) Low Shortcomings Insufficient updating Base rate neglect



Human abilities are not good at judging probabilities. Analytical tools can be used to debias the probability assessment task and improve the decision making process. Two such tools that can be used are: Bayesian decision-making and decision trees. Bayesian approach has been discussed in previous section. By assigning subjective probability we overweight or underweight the probability of an event. Instead that more objective probabilities can be assigned to new information depending on how useful the information is. These new probabilities combined with base rate can be used to figure the correct probability of event happening. The second analytical tool is a decision tree. A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. Decision trees will reduce the influences of biases in decisionmaking. The decision trees can also help to account all the factors that can affect the market prices of the stocks. 5. Important repercussions of these biases in investing There are few important lessons in investing from these behavioral phenomenon. The stocks with consistent record of good news are overvalued and that an investor can earn good returns by betting against this overreaction. Similarly stocks with consistent record of bad news became undervalued and that an investor can subsequently earn superior returns by holding the stocks. Although some of these lessons are based on the premise that sometimes investors are irrational and they send the prices of underlying securities way out of what they should actually be worth. Moreover, these rules cannot be applied blindly to all stocks that seem to exhibit typical behavior of under-reaction and overreaction. There are different trading strategies that can be developed to exploit these behavioral phenomenon. Momentum strategies - This group of strategies reflects the tendency of stock prices to under-react to specific events. For example, when bad news (say, an unexpectedly low earnings announcement) occurs for a specific stock, the stock price immediately falls, but does not fall enough. On average, it will continue to go down in the next few months

(short-term trading strategy). A momentum strategy would hold long positions in stocks that recently had good news, and short positions in stocks that recently had bad news. Figure 1: data showing opening and closing price of Apple stock during earning month for last 6 years. To show how this trading strategy can be used, I collected some data on Apple stock price of last 5 years. The data is collected only for the month when the earnings should be announced (see DATA 1 in Appendix). There are only 6 quarters in last 24 quarters (6 years) when the monthly return is not positive. It was found that average return during earning month is around 6.7%. So this implies that if investors buy the stock on first trading day of earning month and sell the stock on last trading day of the same month, they can earn on average 6.7% on their investment. This data shows the typical under-reaction because moving into earning month the investors does not update their estimate correctly (insufficient updating), sending the price higher after good earning announcement i.e. investors tend to underestimate the upcoming earning announcement. It is only after the good news they update their beliefs. Contrarian strategies - The second category is contrarian type strategies, reflecting mispricing that persist for many months or years. The contrarian effect is the fact that over long periods of time, contrarian stocks (measured by price/book or some other valuation ratio) outperform growth stocks. It reflects the fact that sentiment causes some stocks to be overpriced (growth stocks) and some to be underpriced (contrarian stocks). These types of strategies exploit the market over-reaction because betting against the market optimism or pessimism; investors hope that future returns will be in their favor. These types of strategies exploit the market over-reaction. Contrarian opportunities often appear in stocks of good companies. One of the opportunities arises during the height of recent financial crisis in Chevron stock. The stock was trading at 100$ (Jul 08) when it drop to 60$ (Oct 08) along with other commodities stock. The contrarian would have bought the stock then and enjoyed a decent return till now when the prices are trading at 84$. The stock lost its appeal during the crisis because everyone feared that global economy would go into deep recession, leading to demand slowdown for oil companies.

Figure 2: Data showing opening and closing price of Chevron stock for last three years.

6. Conclusions Efficient market assumes that markets are rational and all agents take into account all the available information before taking any decisions. However, as learned in this course, lot of biases and heuristics play a critical role in human judgment process. Investors make systematic errors in evaluating information. They may over-react to dramatic news and under-react to mundane news. The underreaction is caused by conservatism bias and when investors failed to update their beliefs after the good news. Similarly, over-reaction is caused by representativeness bias and when investors belief that good news will continue in the future, neglecting the base rate in the process. These behavioral patterns often result in mispricing of stocks that can be exploited by various trading strategies. Some these strategies are discussed in this paper. These strategies can be classified in two forms. Momentum strategies assume that investor places the directional bet that stock will continue to go down after bad news or it will continue to go up after good news. These are short-term bets. The other trading strategy is contrarian strategy in which investor take the contrarian long-term view and buy the under-price securities and sell the overprice securities. Different behavioral phenomenon and corresponding biases, mental models and trading strategies are summarized below: Table 3: Summary of behavioral biases and trading strategies adopted to exploit the biases.

Behavioral Phenomenon Underreaction Over-reaction

Investor Biases Mental Models Mean-reverting state Trending state

Trading Strategies Momentum Contrarian

Conservatism Representativen ess

APPENDIX DATA 1: Stock price data for Apple from 2004-2010
Percentage earning change (compared from past prev. year quarter) 74.62686567 46.24624625 31.88010899 54.51263538 40.7960199 35.19553073 29.6 19.84126984 22.68907563 25 35.22727273 38.61386139 41.30434783 45.97701149 42.98245614 19.35483871 31.48148148 27.65957447 46.15384615

Date 7/1/10 4/1/10 1/4/10 10/1/09 7/1/09 4/1/09 1/2/09 10/1/08 7/1/08 4/1/08 1/2/08 10/1/07 7/2/07 4/2/07 1/3/07 10/2/06 7/3/06 4/3/06 1/3/06 10/3/05 7/1/05 4/1/05 1/3/05 10/1/04

Month's Open 254.3 237.41 213.43 185.35 143.5 104.09 85.88 111.92 164.23 146.3 199.27 154.63 121.05 94.14 86.29 75.1 57.52 63.67 72.38 54.16 36.83 42.09 64.78 39.12

Month's Close 257.25 261.09 192.06 188.5 163.39 125.83 90.13 107.59 158.95 173.95 135.36 189.95 131.76 99.8 85.73 81.08 67.96 70.39 75.51 57.59 42.65 36.06 76.9 52.4

Average return for the month 1.160047188 9.974306053 10.01265052 1.699487456 13.86062718 20.88577193 4.94876572 3.868834882 3.215003349 18.89952153 32.07206303 22.84162194 8.847583643 6.012322074 0.648974389 7.962716378 18.15020862 10.55442123 4.324399005 6.333087149 15.80233505 14.32644334 18.70947823 33.94683027

Earning data 3.51 3.33 3.67 2.77 2.01 1.79 2.5 1.26 1.19 1.16 1.76 1.01 0.92 0.87 1.14 0.62 0.54 0.47 0.65 0.5 0.37 0.34 0.35

DATA 2: Stock price data for Coca-Cola from 2004-2010
Percentage earning change (compared from past prev. year quarter) 13.7254902 18.96551724 53.48837209 0 44.26229508 -9.375 -17.30769231 14.08450704 -23.75 18.51851852 79.31034483 14.51612903 2.564102564 14.89361702 -19.44444444 14.81481481 8.333333333 11.9047619

Date 10/1/10 7/1/10 4/1/10 1/4/10 10/1/09 7/1/09 4/1/09 1/2/09 10/1/08 7/1/08 4/1/08 1/2/08 10/1/07 7/2/07 4/2/07 1/3/07 10/2/06 7/3/06 4/3/06 1/3/06 10/3/05 7/1/05 4/1/05 1/3/05 10/1/04 7/1/04 4/1/04 1/2/04

Month's Open 59.04 50.3 55.36 57.16 53.4 48.48 43.76 45.4 52.62 51.92 61.01 61.45 57.61 52.65 48.2 48.36 44.9 43.2 42.1 40.79 43.21 41.96 41.83 41.9 40.48 50.51 50.48 50.8

Month's Close 59.12 55.11 53.45 54.25 53.31 49.84 43.05 42.72 44.06 51.5 58.87 59 61.76 52.11 52.19 47.88 46.72 44.5 41.96 41.38 42.78 43.76 43.44 41.49 40.66 43.86 50.57 49.24

Average return for the month 0.135501355 9.562624254 3.450144509 5.090972708 0.168539326 2.805280528 1.622486289 -5.9030837 16.26757887 0.808936826 3.507621701 3.986981286 7.203610484 1.025641026 8.278008299 0.992555831 4.053452116 3.009259259 0.332541568 1.446432949 0.995140014 4.289799809 3.848912264 0.978520286 0.444664032 13.16570976 0.178288431 -

Earning data 1.02 0.69 0.66 0.81 0.88 0.58 0.43 0.81 0.61 0.64 0.52 0.71 0.8 0.54 0.29 0.62 0.78 0.47 0.36 0.54 0.72 0.42


REFERENCES 1) A model of investor sentiment – Nicholas Barberis, Andrei Shleifer and Robert Vishny (1998) 2) Investor psychology and asset pricing – David Hirshleifer (2001) 3) Behavioral Finance and Wealth Management Michael Pompian – John Wiley and Sons 4) Data from Yahoo finance

You're Reading a Free Preview

/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->