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Introduction

Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. Behavioral finance is of interest because it helps explain why and how markets might be inefficient.

Why is behavioral finance necessary?


When using the labels "conventional" or "modern" to describe finance, we are talking about the type of finance that is based on rational and logical theories, such as the capital asset pricing model !"#$% and the efficient market hypothesis &$'%. (hese theories assume that people, for the most part, behave rationally and predictably. )or a while, theoretical and empirical evidence suggested that !"#$, &$' and other rational financial theories did a respectable *ob of predicting and explaining certain events. 'owever, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn+t be explained by theories available at the time. While these theories could explain certain "ideali,ed" events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.

Homo Economicus
-ne of the most rudimentary assumptions that conventional economics and finance makes is that people are rational "wealth maximi,ers" who seek to increase their own well-being. "ccording to conventional economics, emotions and other extraneous factors do not influence people when it comes to making economic choices. .n most cases, however, this assumption doesn+t reflect how people behave in the real world. (he fact is people frequently behave irrationally. !onsider how many people purchase lottery tickets in the hope of hitting the big *ackpot. )rom a purely logical standpoint, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder roughly / in /01 million, or 0.00000012034, for the famous #owerball *ackpot%. 5espite this, millions of people spend countless dollars on this activity.

(hese anomalies prompted academics to look to cognitive psychology to account for the irrational and illogical behaviors that modern finance had failed to explain. Behavioral finance seeks to explain our actions, whereas modern finance seeks to explain the actions of the "economic man" Homo economicus

Important Contributors 6ike every other branch of finance, the field of behavioral finance has certain people that have provided ma*or theoretical and empirical contributions. (he following section provides a brief introduction to three of the biggest names associated with the field. Daniel Kahneman and Amos Tversky !ognitive psychologists 5aniel 7ahneman and "mos (versky are considered the fathers of behavioral economics8finance. 9ince their initial collaborations in the late /31:s, this duo has published about ;:: works, most of which relate to psychological concepts with implications for behavioral finance. .n ;:0;, 7ahneman received the <obel $emorial #ri,e in &conomic 9ciences for his contributions to the study of rationality in economics. 7ahneman and (versky have focused much of their research on the cognitive biases and heuristics i.e. approaches to problem solving%that cause people to engage in unanticipated irrational behavior. (heir most popular and notable works include writings about prospect theory and loss aversion = topics that we+ll examine later.

Richard Thaler While 7ahneman and (versky provided the early psychological theories that would be the foundation for behavioral finance, this field would not have evolved if it weren+t for economist >ichard (haler. 5uring his studies, (haler became more and more aware of the shortcomings in conventional economic theoryies as they relate to people+s behaviors. "fter reading a draft version of 7ahneman and (versky+s work on prospect theory, (haler reali,ed that, unlike conventional economic theory, psychological theory could account for the irrationality in behaviors.

(haler went on to collaborate with 7ahneman and (versky, blending economics and finance with psychology to present concepts, such as mental accounting, the endowment effect and other biases.

Anomalies
(he presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioral finance. (hese so-called anomalies, and their continued existence, directly violate modern financial and economic theories, which assume rational and logical behavior. (he following is a quick summary of some of the anomalies found in the financial literature.

January Effect
(he ?anuary effect is named after the phenomenon in which the average monthly return for small firms is consistently higher in ?anuary than any other month of the year. (his is at odds with the efficient market hypothesis, which predicts that stocks should move at a "random walk". 'owever, a /3@1 study by $ichael 9. >o,eff and William >. 7inney, called "!apital $arket 9easonalityA (he !ase of 9tock >eturns", found that from /300 - @0 the average amount of ?anuary returns for small firms was around B.C4, whereas returns for all other months was closer to 0.C4. (his suggests that the monthly performance of small stocks follows a relatively consistent pattern, which is contrary to what is predicted by conventional financial theory. (herefore, some unconventional factor other than the random=walk process% must be creating this regular pattern. -ne explanation is that the surge in ?anuary returns is a result of investors selling loser stocks in 5ecember to lock in tax losses, causing returns to bounce back up in ?anuary, when investors have less incentive to sell. While the year= end tax selloff may explain some of the ?anuary effect, it does not account for the fact that the phenomenon still exists in places where capital gains taxes do not occur. (his anomaly sets the stage for the line of thinking that conventional theories do not and cannot account for everything that happens in the real world.

The Winner's Curse


-ne assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of some asset and will bid or pay accordingly. 'owever, anomalies such as the winner+s curse = a tendency for the winning bid in an auction setting to exceed the intrinsic value of the item purchased = suggest that this is not the case. >ational=based theories assume that all participants involved in the bidding process will have access to all relevant information and will all come to the same valuation. "ny differences in the pricing would suggest that some other factor not directly tied to the asset is affecting the bidding. "ccording to >obert (haler+s /322 article on winner+s curse, there are two primary factors that undermine the rational bidding processA the number of bidders and the aggressiveness of bidding. )or example, the more bidders involved in the process means that you have to bid more aggressively in order to dissuade others from bidding. Dnfortunately, increasing your aggressiveness will also increase the likelihood in that your winning bid will exceed the value of the asset. !onsider the example of prospective homebuyers bidding for a house. .t+s possible that all the parties involved are rational and know the home+s true value from studying recent sales of comparative homes in the area. 'owever, variables irrelevant to the asset aggressive bidding and the amount of bidders% can cause valuation error, oftentimes driving up the sale price more than ;C4 above the home+s true value. .n this example, the curse aspect is twofoldA not only has the winning bidder overpaid for the home, but now that buyer might have a difficult time securing financing.

Equity Premium Puzzle


"n anomaly that has left academics in finance and economics scratching their heads is the equity premium pu,,le. "ccording to the capital asset pricing model !"#$%, investors that hold riskier financial assets should be compensated with higher rates of returns. 9tudies have shown that over a @0-year period, stocks yield average returns that exceed government bond returns by 1-@4. 9tock real returns are /04, whereas bond real returns are B4. 'owever, academics believe that an equity premium of 14 is extremely large and would imply that stocks are considerably risky to hold

over bonds. !onventional economic models have determined that this premium should be much lower. (his lack of convergence between theoretical models and empirical results represents a stumbling block for academics to explain why the equity premium is so large. Behavioral finance+s answer to the equity premium pu,,le revolves around the tendency for people to have "myopic loss aversion", a situation in which investors = overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains = take a very short-term view on an investment. What happens is that investors are paying too much attention to the short-term volatility of their stock portfolios. While it is not uncommon for an average stock to fluctuate a few percentage points in a very short period of time, a myopic i.e., shortsighted% investor may not react too favorably to the downside changes. (herefore, it is believed that equities must yield a high-enough premium to compensate for the investor+s considerable aversion to loss. (hus, the premium is seen as an incentive for market participants to invest in stocks instead of marginally safer government bonds. !onventional financial theory does not account for all situations that happen in the real world. (his is not to say that conventional theory is not valuable, but rather that the addition of behavioral finance can further clarify how the financial markets work.

ey Concepts of !eha"ioral #inance


ey Concept $o%&% Anchorin' 9imilar to how a house should be built upon a good, solid foundation, our ideas and opinions should also be based on relevant and correct facts in order to be considered valid. 'owever, this is not always so. (he concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a reference point = even though it may have no logical relevance to the decision at hand. "lthough it may seem an unlikely phenomenon, anchoring is fairly prevalent in situations where people are dealing with concepts that are new and novel. A Diamond Anchor !onsider this classic exampleA !onventional wisdom dictates that a diamond engagement ring should cost around two months+ worth of salary. Believe it or not, this "standard" is one of the most illogical examples of anchoring. While spending two months worth of salary can serve as a benchmark, it is a completely irrelevant

reference point created by the *ewelry industry to maximi,e profits, and not a valuation of love.

$any men can+t afford to devote two months of salary towards a ring while paying for living expenses. !onsequently, many go into debt in order to meet the "standard". .n many cases, the "diamond anchor" will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt. "lthough the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two -month standard. Because buying *ewelry is a "novel" experience for many men , they are more likely to purchase something that is around the "standard", despite the expense. (his is the power of anchoring. In"estment Anchorin' "nchoring can also be a source of frustration in the financial world, as investors base their decisions on irrelevant figures and statistics. )or example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. .n this case, the investor is anchoring on a recent "high" that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. While, it is true that the fickleness of the overall market can cause some stocks to drop substantially in value, allowing investors to take advantage of this short= term volatility. 'owever, stocks quite often also decline in value due to changes in their underlying fundamentals. )or instance, suppose that EFG stock had very strong revenue in the last year, causing its share price to shoot up from H;C to H20. Dnfortunately, one of the company+s ma*or customers, who contributed to C04 of EFG+s revenue, had decided not to renew its purchasing agreement with EFG. (his change of events causes a drop in EFG+s share price from H2: to H0:. By anchoring to the previous high of H2: and the current price of H00, the investor erroneously believes that EFG is undervalued. 7eep in mind that EFG is not being sold at a discount, instead the drop in share value is attributed to a change to EFG+s fundamentals loss of revenue from a big customer%. .n this example, the investor has fallen prey to the dangers of anchoring.

ey Concept $o%() *ental Accountin' $ental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of sub*ective criteria, like the source of the money and intent for each account. "ccording to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviors. "lthough many people use mental accounting, they may not reali,e how illogical this line of thinking really is. )or example, people often have a special "money *ar" or fund set aside for a vacation or a new home, while still carrying substantial credit card debt. .n this example, money in the special fund is being treated differently from the money that the same person is using to pay down his or her debt, despite the fact that diverting funds from debt repayment increases interest payments and reduces the person+s net worth. 9imply put, it+s illogical and detrimental% to have savings in a *ar earning little to no interest while carrying credit-card debt accruing at ;04 annually. .n this case, rather than saving for a holiday, the most logical course of action would be to use the funds in the *ar and any other available monies% to pay off the expensive debt. (his seems simple enough, but why don+t people behave this way? (he answer lies with the personal value that people place on particular assets. )or instance, people may feel that money saved for a new house or their children+s college fund is too "important" to relinquish. "s a result, this "important" account may not be touched at all, even if doing so would provide added financial benefit. Mental Accounting In Investing (he mental accounting bias also enters into investing. )or example, some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. (he problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio, his net wealth will be no different than if he had held one larger portfolio. ey Concept $o%+) Confirmation and Hindsi'ht !iases

.t+s often said that "seeing is believing". While this is often the case, in certain situations what you perceive is not necessarily a true representation of reality. (his is not to say that there is something wrong with your senses, but rather that our minds have a tendency to introduce biases in processing certain kinds of information and events. .n this section, we+ll discuss how confirmation and hindsight biases affect our perceptions and subsequent decisions.

Confirmation Bias .t can be difficult to encounter something or someone without having a preconceived opinion. (his first impression can be hard to shake because people also tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationali,ing the rest. (his type of selective thinking is often referred to as the confirmation bias. .n investing, the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. "s a result, this bias can often result in faulty decision making because one-sided information tends to skew an investor+s frame of reference, leaving them with an incomplete picture of the 9ituation . !onsider, for example, an investor that hears about a hot stock from an unverified source and is intrigued by the potential returns. (hat investor might choose to research the stock in order to "prove" its touted potential is real. What ends up happening is that the investor finds all sorts of green flags about the investment such as growing cash flow or a low debt8equity ratio%, while glossing over financially disastrous red flags, such as loss of critical customers or dwindling markets. Hindsight Bias "nother common perception bias is hindsight bias, which tends to occur in situations where a person believes after the fact% that the onset of some past event

was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted. $any events seem obvious in hindsight. #sychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable. While this sense of curiosity is useful in many cases take science, for example%, finding erroneous links between the cause and effect of an event may result in incorrect oversimplifications. )or example, many people now claim that signs of the technology bubble of the late /33:s and early ;:::s or any bubble from history, such as the (ulip bubble from the /1B:s or the 9outh 9ea bubble of /@//% were very obvious. (his is a clear example of hindsight biasA .f the formation of a bubble had been obvious at the time, it probably wouldn+t have escalated and eventually burst. )or investors and other participants in the financial world, the hindsight bias is a cause for one of the most potentially dangerous mindsets that an investor or trader can haveA overconfidence. .n this case, overconfidence refers to investors+ or traders+ unfounded belief that they possess superior stock-picking abilities. Ingroup Bias 9omewhat similar to the confirmation bias is the ingroup bias, a manifestation of our innate tribalistic tendencies. "nd strangely, much of this effect may have to do with oxytocin I the so=called "love molecule." (his neurotransmitter, while helping us to forge tighter bonds with people in our ingroup, performs the exact opposite function for those on the outside I it makes us suspicious, fearful, and even disdainful of others. Dltimately, the ingroup bias causes us to overestimate the abilities and value of our immediate group at the expense of people we don+t really know. Post,Purchase -ationalization >emember that time you bought something totally unnecessary, faulty, or overly expense, and then you rationali,ed the purchase to such an extent that you convinced yourself it was a great idea all along? Feah, that+s post=purchase rationali,ation in action I a kind of built=in mechanism that makes us feel better after we make crappy decisions, especially at the cash register. "lso known as Buyer+s 9tockholm 9yndrome, it+s a way of subconsciously *ustifying our purchases I especially expensive ones. 9ocial psychologists say it stems from the principle of commitment, our psychological desire to stay consistent and avoid a state of cognitive dissonance.

$e'lectin' Probability Jery few of us have a problem getting into a car and going for a drive, but many of us experience great trepidation about stepping inside an airplane and flying at BC,::: feet. )lying, quite obviously, is a wholly unnatural and seemingly ha,ardous activity. Fet virtually all of us know and acknowledge the fact that the probability of dying in an auto accident is significantlygreater than getting killed in a plane crash I but our brains won+t release us from this crystal clear logic statistically, we have a / in 20 chance of dying in a vehicular accident, as compared to a / in C,::: chance of dying in an plane crash Kother sources indicate odds as high as / in ;:,:::L%. .t+s the same phenomenon that makes us worry about getting killed in an act of terrorism as opposed to something far more probable, like falling down the stairs or accidental poisoning. (his is what the social psychologist !ass 9unstein calls probability neglect I our inability to properly grasp a proper sense of peril and risk I which often leads us to overstate the risks of relatively harmless activities, while forcing us to overrate more dangerous ones. .bser"ational /election !ias (his is that effect of suddenly noticing things we didn+t notice that much before I but we wrongly assume that the frequency has increased. " perfect example is what happens after we buy a new car and we inexplicably start to see the same car virtually everywhere. " similar effect happens to pregnant women who suddenly notice a lot of other pregnant women around them. -r it could be a unique number or song. .t+s not that these things are appearing more frequently, it+s that we+ve for whatever reason% selected the item in our mind, and in turn, are noticing it more often. (rouble is, most people don+t recogni,e this as a selectional bias, and actually believe these items or events are happening with increased frequency I which can be a very disconcerting feeling. .t+s also a cognitive bias that contributes to the feeling that the appearance of certain things or events couldn+t possibly be a coincidence even though it is%. /tatus,0uo !ias We humans tend to be apprehensive of change, which often leads us to make choices that guarantee that things remain the same, or change as little as possible. <eedless to say, this has ramifications in everything from politics to economics. We like to stick to our routines, political parties, and our favorite meals at restaurants. #art of the perniciousness of this bias is the unwarranted assumption that another

choice will be inferior or make things worse. (he status=quo bias can be summed with the saying, ".f it ain+t broke, don+t fix it" I an adage that fuels our conservative tendencies. "nd in fact, some commentators say this is why the D.9. hasn+t been able to enact universal health care, despite the fact that most individuals support the idea of reform. $e'ati"ity !ias #eople tend to pay more attention to bad news I and it+s not *ust because we+re morbid. 9ocial scientists theori,e that it+s on account of our selective attention and that, given the choice, we perceive negative news as being more important or profound. We also tend to give more credibility to bad news, perhaps because we+re suspicious or bored% of proclamations to the contrary. $ore evolutionarily, heeding bad news may be more adaptive than ignoring good news e.g. "saber tooth tigers suck" vs. "this berry tastes good"%. (oday, we run the risk of dwelling on negativity at the expense of genuinely good news. 9teven #inker, in his book The Better Angels of Our Nature: Why Violence Has Declined , argues that crime, violence, war, and other in*ustices are steadily declining, yet most people would argue that things are getting worse I what is a perfect example of the negativity bias at work. !and1a'on Effect (hough we+re often unconscious of it, we love to go with the flow of the crowd. When the masses start to pick a winner or a favorite, that+s when our individuali,ed brains start to shut down and enter into a kind of "groupthink" or hivemind mentality. But it doesn+t have to be a large crowd or the whims of an entire nationM it can include small groups, like a family or even a small group of office co=workers. (he bandwagon effect is what often causes behaviors, social norms, and memes to propagate among groups of individuals I regardless of the evidence or motives in support. (his is why opinion polls are often maligned, as they can steer the perspectives of individuals accordingly. $uch of this bias has to do with our built=in desire to fit in and conform, as famously demonstrated by the "sch !onformity &xperiments. Pro2ection !ias "s individuals trapped inside our own minds ;08@, it+s often difficult for us to pro*ect outside the bounds of our own consciousness and preferences. We tend to assume that most people think *ust like us I though there may be no *ustification for it. (his cognitive shortcoming often leads to a related effect known as the false consensus

bias where we tend to believe that people not only think like us, but that they also agree with us. .t+s a bias where we overestimate how typical and normal we are, and assume that a consensus exists on matters when there may be none. $oreover, it can also create the effect where the members of a radical or fringe group assume that more people on the outside agree with them than is the case. -r the exaggerated confidence one has when predicting the winner of an election or sports match. The Current *oment !ias We humans have a really hard time imagining ourselves in the future and altering our behaviors and expectations accordingly. $ost of us would rather experience pleasure in the current moment, while leaving the pain for later. (his is a bias that is of particular concern to economists i.e. our unwillingness to not overspend and save money% and health practitioners. .ndeed, a /332 study showed that, when making food choices for the coming week, @04 of participants chose fruit. But when the food choice was for the current day, @:4 chose chocolate.

ey Concept $o% 3) 4ambler's #allacy


When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the onset of events. -ne of these incorrect assumptions is called the gambler+s fallacy.

.n the gambler+s fallacy, an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. (his line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. )or example, consider a series of ;0 coin flips that have all landed with the "heads" side up. Dnder the gambler+s fallacy, a person might predict that the next coin flip is more likely to land with the "tails" side up. (his line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always C:4. &ach coin flip is an independent event, which means that any and all previous flips have no bearing on future flips. "nother common example of the gambler+s fallacy can be found with people+s relationship with slot machines. We+ve all heard about people who situate themselves at a single machine for hours at a time. $ost of these people believe that every losing pull will bring them that much closer to the *ackpot. What these

gamblers don+t reali,e is that due to the way the machines are programmed, the odds of winning a *ackpot from a slot machine are equal with every pull *ust like flipping a coin%, so it doesn+t matter if you play with a machine that *ust hit the *ackpot or one that hasn+t recently paid out. Gam ler!s "allacy In Investing .t+s not hard to imagine that under certain circumstances, investors or traders can easily fall prey to the gambler+s fallacy. )or example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don+t believe that the position is likely to continue going up. !onversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as "improbable". ?ust because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session.

ey Concept $o%5) Herd !eha"ior


-ne of the most infamous financial events in recent memory would be the bursting of the internet bubble. 'owever, this wasn+t the first time that events like this have happened in the markets. (here are a couple of reasons why herd behavior happens. (he first is the social pressure of conformity. Fou probably know from experience that this can be a powerful force. (his is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. (herefore, following the group is an ideal way of becoming a member. (he second reason is the common rationale that it+s unlikely that such a large group could be wrong. "fter all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don+t. (his is especially prevalent in situations in which an individual has very little experience. The 6otcom Herd 'erd behavior was exhibited in the late /33:s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not at the time% have financially sound business models. (he driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing.

" strong herd mentality can even affect financial professionals. (he ultimate goal of a money manager is to follow an investment strategy to maximi,e a client+s invested wealth. (he problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. )or example, a wealthy client may have heard about an investment gimmick that+s gaining notoriety and inquires about whether the money manager employs a similar "strategy". The Costs of Being Led Astray 'erd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy. .nvestors that employ a herd=mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. )or example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. .f biotech stocks are all the rage six months later, he+ll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments.

ey Concept $o%7) ."erconfidence


.n a ;001 study entitled "Behaving Badly", researcher ?ames $ontier found that @04 of the B00 professional fund managers surveyed believed that they had delivered above-average *ob performance. -f the remaining ;14 surveyed, the ma*ority viewed themselves as average. .ncredibly, almost /004 of the survey group believed that their *ob performance was average or better. !learly, only C:4 of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited "s you can imagine, overconfidence i.e., overestimating or exaggerating one+s ability to successfully perform a particular task% is not a trait that applies only to fund managers. !onsider the number of times that you+ve participated in a competition or contest with the attitude that you have what it takes to win = regardless of the number of competitors or the fact that there can only be one winner. 7eep in mind that there+s a fine line between confidence and overconfidence. !onfidence implies realistically trusting in one+s abilities, while overconfidence usually implies an overly optimistic assessment of one+s knowledge or control over a situation. #verconfident Investing

.n terms of investing, overconfidence can be detrimental to your stock-picking ability in the long run. .n a /332 study entitled "Jolume, Jolatility, #rice, and #rofit When "ll (raders "re "bove "verage", researcher (errence -dean found that overconfident investors generally conduct more trades than their less= confident counterparts. -dean found that overconfident investors8traders tend to believe they are better than others at choosing the best stocks and best times to enter8exit a position. Dnfortunately, -dean also found that traders that conducted the most trades tended, on average, to receive significantly lower yields than the market.

ey Concept $o%8) ."erreaction and the A"ailability !ias


-ne consequence of having emotion in the stock market is the overreaction toward new information. "ccording to market efficiency, new information should more or less be reflected instantly in a security+s price. )or example, good news should raise a business+ share price accordingly, and that gain in share price should not decline if no new information has been released since. >eality, however, tends to contradict this theory. -ftentimes, participants in the stock market predictably overreact to new information, creating a larger-than= appropriate effect on a security+s price. )urthermore, it also appears that this price surge is not a permanent trend = although the price change is usually sudden and si,able, the surge erodes over time. Winners and Losers .n /32C, behavioral finance academics Werner 5e Bondt and >ichard (haler released a study in the Journal of inance called "5oes the $arket -verreact?" .n this study, the two examined returns on the <ew Fork 9tock &xchange for a threeyear period. )rom these stocks, they separated the best BC performing stocks into a "winners portfolio" and the worst BC performing stocks were then added to a "losers portfolio". 5e Bondt and (haler then tracked each portfolio+s performance against a representative market index for three years. 9urprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. .n total, the cumulative difference between the two portfolios was almost ;C4 during the threeyear time span. .n other words, it appears that the original "winners" would became "losers", and vice versa.

9o what happened? .n both the winners and losers portfolios, investors essentially overreacted. .n the case of loser stocks, investors overreacted to bad news, driving the stocks+ share prices down disproportionately. "fter some time, investors reali,ed that their pessimism was not entirely *ustified, and these losers began rebounding as investors came to the conclusion that the stock was underpriced. (he exact opposite is true with the winners portfolioA investors eventually reali,ed that their exuberance wasn+t totally *ustified. "ccording to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news. (his happens in real life all the time. )or example, suppose you see a car accident along a stretch of road that you regularly drive to work. !hances are, you+ll begin driving extra cautiously for the next week or so. "lthough the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you+ll be back to your old driving habits by the following week.

ey Concept $o%9) Prospect Theory


(raditionally, it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. "cademics tend to use "utility" to describe en*oyment and contend that we prefer instances that maximi,e our utility. 'owever, research has found that we don+t actually process information in such a rational way. .n /3@3, 7ahneman and (versky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. (hus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former = even when they achieve the same economic end result. "ccording to prospect theory, losses have more emotional impact than an equivalent amount of gains. )or example, in a traditional way of thinking, the amount of utility gained from receiving HC: should be equal to a situation in which you gained H/:: and then lost HC:. .n both situations, the end result is a net gain of HC:.

'owever, despite the fact that you still end up with a HC: gain in either case, most people view a single gain of HC0 more favorably than gaining H/:: and then losing HC:. !"idence for #rrational Beha"ior 7ahneman and (versky conducted a series of studies in which sub*ects answered questions that involved making *udgments between two monetary decisions that involved prospective losses and gains. )or example, the following questions were used in their studyA /. Fou have H/,000 and you must pick one of the following choicesA !hoice "A Fou have a C:4 chance of gaining H/,000, and a C04 chance of gaining H:. !hoice BA Fou have a /::4 chance of gaining HC::. ;. Fou have H;,000 and you must pick one of the following choicesA !hoice "A Fou have a C:4 chance of losing H/,000, and C04 of losing H:. !hoice BA Fou have a /::4 chance of losing HC00. .f the sub*ects had answered logically, they would pick either """ or "B" in both situations. #eople choosing "B" would be more risk adverse than those choosing """%. 'owever, the results of this study showed that an overwhelming ma*ority of people chose "B" for question / and """ for question ;. (he implication is that people are willing to settle for a reasonable level of gains even if they have a reasonable chance of earning more%, but are willing to engage in risk-seeking behaviors where they can limit their losses. .n other words, losses are weighted more heavily than an equivalent amount of gains. .t is this line of thinking that created the asymmetric value functionA

(his function is a representation of the difference in utility amount of pain or *oy% that is achieved as a result of a certain amount of gain or loss. .t is key to note that not everyone would have a value function that looks exactly like thisM this is the general trend. (he most evident feature is how a loss creates a greater feeling of pain compared to the *oy created by an equivalent gain. )or example, the absolute *oy felt in finding HC: is a lot less than the absolute pain caused by losing HC:. !onsequently, when multiple gain8loss events happen, each event is valued separately and then combined to create a cumulative feeling. )or example, according to the value function, if you find HC0, but then lose it soon after, this would cause an overall effect of -0: units of utility finding the HC: causes N/: points of utility *oy%, but losing the HC0 causes -C: points of utility pain%. (o most of us, this makes senseA it is a fair bet that you+d be kicking yourself over losing the HC: that you *ust found. inancial $ele"ance (he prospect theory can be used to explain quite a few illogical financial behaviors. )or example, there are people who do not wish to put their money in the bank to earn interest or who refuse to work overtime because they don+t want to pay more taxes. "lthough these people would benefit financially from the additional after-tax income, prospect theory suggests that the benefit or utility gained% from the extra money is not enough to overcome the feelings of loss incurred by paying taxes. #rospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning

stocks too soon. (he most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses. When it comes to selling winning stocks prematurely, consider 7ahneman and (versky+s study in which people were willing to settle for a lower guaranteed gain of HC:: compared to choosing a riskier option that either yields a gain of H/,00: or H:. (his explains why investors reali,e the gains of winning stocks too soonA in each situation, both the sub*ects in the study and investors seek to cash in on the amount of gains that have already been guaranteed. (his represents typical risk= averse behavior. (he flip side of the coin is investors that hold on to losing stocks for too long. 6ike the study+s sub*ects, investors are willing to assume a higher level of risk in order to avoid the negative utility of a prospective loss. Dnfortunately, many of the losing stocks never recover, and the losses incurred continued to mount, with often disastrous results. $o1 let us discuss the t1o theories of standard finance 1hich plays an important role in beha"ioral finance and that are
/. ;.

*ar:et efficiency theory Capital asset pricin' model

*ar:et Efficiency and In"estment ;aluation (he question of whether markets are efficient, and if not, where the inefficiencies lie, is central to investment valuation. .f markets are, in fact, efficient, the market price provides the best estimate of value, and the process of valuation becomes one of *ustifying the market price. .f markets are not efficient, the market price may deviate from the true value, and the process of valuation is directed towards obtaining a reasonable estimate of this value. (hose who do valuation well, then, will then be able to make +higher+ returns than other investors, because of their capacity to spot under and over valued firms. (o make these higher returns, though, markets have to correct their mistakes O i.e. become efficient O over time. Whether these corrections occur over six months or five years can have a profound impact in which valuation approach an investor chooses to use and the time hori,on that is needed for it to succeed.

(here is also much that can be learnt from studies of market efficiency, which highlight segments where the market seems to be inefficient. (hese +inefficiencies+ can provide the basis for screening the universe of stocks to come up with a sub= sample that is more likely to have under valued stocks. Piven the si,e of the universe of stocks, this not only saves time for the analyst, but increases the odds significantly of finding under and over valued stocks. )or instance, some efficiency studies suggest that stocks that are +neglected+ be institutional investors are more likely to be undervalued and earn excess returns. " strategy that screens firms for low institutional investment as a percentage of the outstanding stock% may yield a sub=sample of neglected firms, which can then be valued using valuation models, to arrive at a portfolio of undervalued firms. .f the research is correct the odds of finding undervalued firms should increase in this sub=sample. What is an efficient market? "n efficient market is one where the market price is an unbiased estimate of the true value of the investment. .mplicit in this derivation are several key concepts =!ontrary to popular view, market efficiency does not require that the market price be equal to true value at every point in time. "ll it requires is that errors in the market price be unbiased, i.e., that prices can be greater than or less than true value, as long as these deviations are random /. (he fact that the deviations from true value are random implies, in a rough sense, that there is an equal chance that stocks are under or over valued at any point in time, and that these deviations are uncorrelated with any observable variable. )or instance, in an efficient market, stocks with lower #& ratios should be no more or less likely to under valued than stocks with high #& ratios. .f the deviations of market price from true value are random, it follows that no group of investors should be able to consistently find under or over valued stocks using any investment strategy. 5efinitions of market efficiency have to be specific not only about the market that is being considered but also the investor group that is covered. .t is extremely unlikely that all markets are efficient to all investors, but it is entirely possible that a particular market for instance, the <ew Fork 9tock &xchange% is efficient with respect to the average investor. .t is also possible that some markets are efficient while others are not, and that a market is efficient with respect to some investors and not to others. (his is a direct consequence of differential tax rates and transactions costs, which confer advantages on some investors relative to others.

5efinitions of market efficiency are also linked up with assumptions about what information is available to investors and reflected in the price. )or instance, a strict definition of market efficiency that assumes that all information, public as well as private, is reflected in market prices would imply that even investors with precise inside information will be unable to beat the market. -ne of the earliest classifications of levels of market efficiency was provided by )ama /3@/%, who argued that markets could be efficient at three levels, based upon what information was reflected in prices. Dnder weak form efficiency, the current price reflects the information contained in all past prices, suggesting that charts and technical analyses that use past prices alone would not be useful in finding under valued stocks. Dnder semi=strong form efficiency, the current price reflects the information contained not only in past prices but all public information including financial statements and news reports% and no approach that was predicated on using and massaging this information would be useful in finding under valued stocks. Dnder strong form efficiency, the current price reflects all information, public as well as private, and no investors will be able to consistently find under valued stocks.

Implications of mar:et efficiency "n immediate and direct implication of an efficient market is that no group of investors should be able to consistently beat the market using a common investment strategy. "n efficient market would also carry very negative implications for many investment strategies and actions that are taken for granted =.n an efficient market, equity research and valuation would be a costly task that provided no benefits. (he odds of finding an undervalued stock would always be C:AC:, reflecting the randomness of pricing errors. "t best, the benefits from information collection and equity research would cover the costs of doing the research. .n an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy, that created larger information and execution costs. (here would be no value added by portfolio managers and investment strategists. .n an efficient market, a strategy of minimi,ing trading, i.e., creating a portfolio and not trading unless cash was needed, would be superior to a strategy that required frequent trading. .t is therefore no wonder that the concept of market efficiency

evokes such strong reactions on the part of portfolio managers and analysts, who view it, quite rightly, as a challenge to their existence. .t is also important that there be clarity about what market efficiency does not imply. "n efficient market does not imply that = stock prices cannot deviate from true valueM in fact, there can be large deviations from true value. (he only requirement is that the deviations be random. no investor will +beat+ the market in any time period. (o the contrary, approximately half of all investors, prior to transactions costs, should beat the market in any period. c% no group of investors will beat the market in the long term. Piven the number of investors in financial markets, the laws of probability would suggest that a fairly large number are going to beat the market consistently over long periods, not because of their investment strategies but because they are lucky. .t would not, however, be consistent if a disproportionately large number B of these investors used the same investment strategy. .n an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long term, though there may be deviations from these expected returns in the short term.

$ecessary conditions for mar:et efficiency $arkets do not become efficient automatically. .t is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that make markets efficient. (he necessary conditions for a market inefficiency to be eliminated are as follows = (he market inefficiency should provide the basis for a scheme to beat the market and earn excess returns. )or this to hold true = (he asset or assets% which is the source of the inefficiency has to be traded. (he transactions costs of executing the scheme have to be smaller than the expected profits from the scheme. (here should be profit maximi,ing investors who recogni,e the +potential for excess return+ can replicate the beat the market scheme that earns the excess return have the resources to trade on the stock until the inefficiency disappears (he internal contradiction of claiming that there is no possibility of beating the market in an efficient market and requiring profit=maximi,ing investors to constantly

seek out ways of beating the market and thus making it efficient has been explored by many. .f markets were, in fact, efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. .t makes sense to think about an efficient market as a self=correcting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously as investors find them and trade on them. #ropositions about market efficiency " reading of the conditions under which markets become efficient leads to general propositions about where investors are most likely to find inefficiencies in financial markets= #roposition /A (he probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. (o the extent that investors have difficulty trading on a stock, either because open markets do not exist or there are significant barriers to trading, inefficiencies in pricing can continue for long periods. (his proposition can be used to shed light on the differences between different asset markets. )or instance, it is far easier to trade on stocks that it is on real estate, since markets are much more open, prices are in smaller units reducing the barriers to entry for new traders% and the asset itself does not vary from transaction to transaction one share of .B$ is identical to another share, whereas one piece of real estate can be very different from another piece, a stone+s throw away. Based upon these differences, there should be a greater likelihood of finding inefficiencies both under and over valuation% in the real estate market. #roposition ;A (he probability of finding an inefficiency in an asset market increases as the transactions and information cost of exploiting the inefficiency increases. (he cost of collecting information and trading varies widely across markets and even across investments in the same markets. "s these costs increase, it pays less and less to try to exploit these inefficiencies. !onsider, for instance, the perceived wisdom that investing in +loser+ stocks, i.e., stocks that have done very badly in some prior time period should yields excess returns. (his may be true in terms of raw returns, but transactions costs are likely to be much higher for these stocks since= they then to be low priced stocks, leading to higher brokerage commissions and expenses the bid=ask spread, a transaction cost paid at the time of purchase, becomes a much higher fraction of the total price paid. trading is often thin on these stocks, and small trades can cause prices to change resulting in a higher +buy+ price and a lower +sell+ price.

!orollary /A .nvestors who can establish a cost advantage either in information collection or transactions costs% will be more able to exploit small inefficiencies than other investors who do not possess this advantage. (here are a number of studies that look at the effect of block trades on prices, and conclude that while they affect prices, that investors will not be exploit these inefficiencies because of the number of times they will have to trade and their transactions costs. (hese concerns are unlikely to hold for a specialist on the floor of the exchange, who can trade quickly, often and at no or very low costs. .t should be pointed out, however, that if the market for specialists is efficient, the value of a seat on the exchange should reflect the present value of potential benefits from being a specialist. (his corollary also suggests that investors who work at establishing a cost advantage, especially in relation to information, may be able to generate excess returns on the basis of these advantages. (hus a ?ohn (empleton, who started investing in ?apanese and other "sian markets well before other portfolio managers, might have been able to exploit the informational advantages he had over his peers to make excess returns on his portfolio. #roposition BA (he speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the inefficiency can be replicated by other investors. (he ease with which a scheme can be replicated itself is inversely related to the time, resources and information needed to execute it. 9ince very few investors single=handedly possess the resources to eliminate an inefficiency through trading, it is much more likely that an inefficiency will disappear quickly if the scheme used to exploit the inefficiency is transparent and can be copied by other investors. (o illustrate this point, assume that stocks are consistently found to earn excess returns in the month following a stock split. 9ince firms announce stock splits publicly, and any investor can buy stocks right after these splits, it would be surprising if this inefficiency persisted over time. (his can be contrasted with the excess returns made by some +arbitrage funds+ in index arbitrage, where index futures are bought sold%, and stocks in the index are sold short bought%. (his strategy requires that investors be able to obtain information on index and spot prices instantaneously, have the capacity in terms of margin requirements and resources% to buy and sell index futures and to sell short on stocks, and to have the resources to take and hold very large positions until the arbitrage unwinds. !onsequently, inefficiencies in +index futures pricing+ are likely to persist at least for

the most efficient arbitrageurs, with the lowest execution costs and the speediest execution times. (esting market efficiency (ests of market efficiency look at the whether specific investment strategies earn excess returns. 9ome tests also account for transactions costs and execution feasibility. 9ince an excess return on an investment is the difference between the actual and expected return on that investment, there is implicit in every test of market efficiency a model for this expected return. .n some cases, this expected return ad*usts for risk using the capital asset pricing model or the arbitrage pricing model, and in others the expected return is based upon returns on similar or equivalent investments. .n every case, a test of market efficiency is a *oint test of market efficiency and the efficacy of the model used for expected returns. When there is evidence of excess returns in a test of market efficiency, it can indicate that markets are inefficient or that the model used to compute expected returns is wrong or both. While this may seem to present an insoluble dilemma, if the conclusions of the study are insensitive to different model specifications, it is much more likely that the results are being driven by true market inefficiencies and not *ust by model misspecifications.

(here are a number of different ways of testing for market efficiency, and the approach used will depend in great part on the investment scheme being tested. " scheme based upon trading on information events stock splits, earnings announcements or acquisition announcements% is likely to be tested using an +event study+ where returns around the event are scrutini,ed for evidence of excess returns. " scheme based upon trading on a observable characteristic of a firm price earnings ratios, price book value ratios or dividend yields% is likely to be tested using a +portfolio+ approach, where portfolios of stocks with these characteristics are created and tracked over time to see if, in fact, they make excess returns. (he following pages summari,e the key steps involved in each of these approaches, and some potential pitfalls to watch out for when conducting or using these tests. A% !"ent &tudy "n event study is designed to examine market reactions to, and excess returns around specific information events. (he information events can be market=wide,

such as macro=economic announcements, or firm=specific, such as earnings or dividend announcements. (he steps in an event study are as follows = /% (he event to be studied is clearly identified, and the date on which the event was announced pinpointed. (he presumption in event studies is that the timing of the event is known with a fair degree of certainty. 9ince financial markets react to the information about an event, rather than the event itself, most event studies are centered around the announcement date0 for the event. ;% -nce the event dates are known, returns are collected around these dates for each of the firms in the sample. .n doing so, two decisions have to be made. )irst, the analyst has to decide whether to collect weekly, daily or shorter=interval returns around the event. (his will, in part, be decided by how precisely the event date is known the more precise, the more likely it is that shorter return intervals can be used% and by how quickly information is reflected in prices the faster the ad*ustment, the shorter the return interval to use%. 9econd, the analyst has to determine how many periods of returns before and after the announcement date will be considered as part of the +event window+. (hat decision also will be determined by the precision of the event date, since more imprecise dates will require longer windows.

>=*n .................

>*:

..................>N*n

QQQQQQQQQQQQQRQQQQQQQQQQQQQQQQQQQQQQQRQQQQQQQQQQQQQQQQQQQQQQQQR QQQQQQQQQ >eturn windowA =n to Nn where, >*t S >eturns on firm * for period t t S =n, ...,:, .... Nn% B% (he returns, by period, around the announcement date, are ad*usted for market performance and risk to arrive at excess returns for each firm in the sample. )or instance, if the capital asset pricing model is used to control for risk =

&xcess >eturn on period t S >eturn on day t O >iskfree rate N Beta T >eturn on market on day t%

&>=*n ................. &>*:

..................&>N*n

QQQQQQQQQQQQQRQQQQQQQQQQQQQQQQQQQQQQQRQQQQQQQQQQQQQQQQQQQQQQQQR QQQQQQQQQ >eturn windowA =n to Nn where,

&>*t S &xcess >eturns on firm * for period t t S =n, ...,:, .... Nn%

0% (he excess returns, by period, are averaged across all firms in the sample and a standard error is computed. C% (he question of whether the excess returns around the announcement are different from ,ero is answered by estimating the t statistic for each n, by dividing the average excess return by the standard error = ( statistic for excess return on day t S "verage &xcess >eturn 8 9tandard &rror .f the t statistics are statistically significant C, the event affects returnsM the sig n of the excess return determines whether the effect is positive or negative. #llustration '%(: !)am*le of an e"ent study + !ffects of O*tion Listing on &toc, *rices "cademics and practitioners have long argued about the consequences of option listing for stock price volatility. -n the one hand, there are those who argue that options attract speculators and hence increase stock price volatility. -n the other hand, there are others who argue that options increase the available choices for investors and increase the flow of information to financial markets, and thus lead to lower stock price volatility and higher stock prices. -ne way to test these alternative hypotheses is to do an event study, examining the effects of listing options on the underlying stocks+ prices. !onrad /323% did such a study, following these steps = &te* (: (he date on which the announcement that options would be listed on the !hicago Board of -ptions on a particular stock was collected

&te* -: (he prices of the underlying stock *% were collected for each of the ten days prior to the option listing announcement date, the day of the announcement, and each of the ten days after. &te* .: (he returns on the stock >*t% were computed for each of these trading days. &te* /: (he beta for the stock *% was estimated using the returns from a time period outside the event window using /:: trading days from before the event and /:: trading days after the event%. &te* 0: (he returns on the market index >mt% were computed for each of the ;/ trading days. &te* 1: (he excess returns were computed for each of the ;/ trading days = &>*t S >*t = * >mt .......... t S =/:,=3,=2,....,N2,N3,N/:

(he excess returns are cumulated for each trading day.

&te* 2: (he average and standard error of excess returns across all stocks with optio

Capital Asset (CAPM)

Pricing Model

We now assume an idealized framework for an open market place, w ere all t e risk! assets refer to (sa!) all t e tradea"le stocks a#aila"le to all. $n addition we a#e a risk-free asset (for "orrowing and%or lending in unlimited &uantities) wit interest rate rf . We assume t at all information is a#aila"le to all suc as co#ariances, #ariances, mean rates of return of stocks and so on. We also assume t at e#er!one is a risk-a#erse rational in#estor w o uses t e same financial engineering mean-#ariance portfolio t eor! from Markowitz. A little t oug t leads us to conclude t at since e#er!one as t e same assets to c oose from, t e same information a"out t em, and t e same decision met ods, e#er!one as a portfolio on t e same efficient frontier, and ence as a portfolio t at is a mi'ture of t e risk-free asset and a uni&ue efficient fund ( (of risk! assets). $n ot er words, e#er!one sets up t e same optimization pro"lem, does t e same calculation, gets t e same answer and c ooses a portfolio accordingl!. ) is efficient fund used "! all is called t e market portfolio and is denoted "! M . ) e fact t at it is t e same for all leads us to conclude t at it s ould "e computa"le wit out using all t e optimization met ods from Markowitz* ) e market as alread! reac ed an e&uili"rium so t at t e weig t for an! asset in t e market portfolio is gi#en "! its capital #alue (total wort of its s ares) di#ided "! t e total capital #alue of t e w ole market (all assets toget er). $f, for e'ample, asset i refers to s ares of stock in Compan! A, and t is compan! as +0,000 s ares outstanding, eac wort ,-0.00, t en t e captital #alue for asset i is .i / (+0, 000)(,-0) / ,-00, 000. Computing t is #alue for eac asset and summing o#er all n (total num"er of assets) !ields t e total capital #alue of t e w ole market, . / .+ 0 0 .n , and t e weig t wi / .i %. is t e weig t used for asset i in t e market portfolio. ) e general idea is t at assets under ig demand will fetc ig prices and !ield ig e'pected rates of return (and #ice #ersa)1 repeated trading of t e assets o#er time ad2usts t e #arious prices !ielding an e&uili"rium t at reflects t is1 t e optimal weig ts wi for t e market portfolio are t us go#erned "! suppl! and demand. $n t e end, we don3t need to use t e optimization met ods nor an! of t e detailed data (co#ariances, #ariances, mean rates, nor e#en t e risk-free rate rf ) to determine t e market portfolio1 we onl! need all t e .i #alues. 4ote in passing t at all t e weig ts wi are positi#e (no s orting e'ists in t e market portfo- lio). ) is implies t at e#en if apriori we ruled out s orting of t e assets in our framework, t e same e&uili"rium market portfolio M would arise. Also note t at since presuma"l! all risk! assets a#aila"le on t e open market a#e a non-zero capital #alue, all risk! assets are included in t e portfolio (alt oug some a#e #er! small weig ts). ) e a"o#e e&uili"rium model for portfolio anal!sis is called t e Capital Asset Pricing Model

( C A P M ) .
+

+.+ Capital market line and CAPM formula


5et (6M , r M ) denote t e point corresponding to t e market portfolio M . All portfolios c osen "! a rational in#estor will a#e a point (6, r) t at lies on t e socalled capital market line r
M

r/r 0
f

r
f

6
M

6, (+)

t e efficient frontier for in#estments. $t tells us t e e'pected return of an! efficient portfolio, in terms of its standard de#iation, and does so "! use of t e so-called price of risk r M rf , 6 (-)
M

t e slope of t e line, w ic represents t e c ange in e'pected return r per one-unit c ange in standard de#iation 6. $f an indi#idual asset i (or portfolio) is c osen t at is not efficient, t en we learn not ing a"out t at asset from (+). $t would seem useful to know, for e'ample, ow r i rf , t e e'pected e'cess rate of return is related to M . ) e following formula in#ol#es 2ust t at, w ere 6M,i denotes t e co#ariance of t e market portfolio wit indi#idual asset i* ) eorem +.+ (CAPM (ormula) (or an! asset i r i rf / 7i (r M rf ), w ere 7i 6 M /, i6
M i

is called t e "eta of asset i. ) is "eta #alue ser#es as an important measure of risk for indi#idual assets (portfolios) t at is different from 6 - 1 it measures t e nondi#ersifia"le part of risk. More generall!, for an! portfolio p / (8+ , . . . , 8n ) of risk! assets, its "eta can "e computed as a weig ted a#erage of indi#idual asset "etas* r p rf / 7p (r M rf ), w ere 6 n 7p 6M,p 8i 7i . 9 / / M
i/ +

i i i i

:efore pro#ing t e a"o#e t eorem, we point out a couple of its important conse&uences and e'plain t e meaning of t e "eta. (or a gi#en asset i, 6 - tells

us t e risk associated wit its own fluctuations a"out its mean rate of return, "ut not wit respect to t e market portfolio. (or e'ample if asset i is uncorrelated wit M , t en 7i / 0 (e#en presuma"l! if 6 - is uge), and t is tells us t at t ere is no risk associated wit t is asset (and ence no ig e'pected return) in t e sense t at t e #ariance 6 - can "e di#ersified awa! (recall our e'ample in 5ecture 4otes ; of di#ersification of n uncorrelated assets). ) e idea would "e to collect a large num"er of uncorrelated (and uncorrelated wit M ) assets and form a portfolio wit e&ual proportions t us dwindling t e #ariance to 0 so it "ecomes like t e risk-free asset wit deterministic rate of return rf . <o, in effect, in t e world of t e market !ou are not rewarded (#ia a ig e'pected rate of return) for taking on risk t at can "e di#ersified awa!. <o we can #iew 7i as a measure of nondi#ersifia"le risk, t e correlated-wit -t e-market part of risk t at we can3t reduce "! di#ersif!ing. ) is kind of risk is sometimes called market or s!stematic risk. $t is not true in general t at ig er "eta #alue 7i implies ig er #ariance 6 - , "ut of course a ig er "eta #alue does impl! a ig er e'pected rate of return* !ou are rewarded (#ia a ig e'pected rate of return) for taking on risk t at can3t "e di#ersified awa!1 e#er!one must face t is kind of risk. )!pes of assets t at would "e e'pected to a#e ig "eta #alues (toda!) would "e t ose w ic are deepl! related to t e general market suc as stocks in "ig name companies like =eneral >lectric, Cisco <!stems, Coca-Cola, $:M, Procter ? =am"le and so on. Proof *@CAPM formulaA

We form a portfolio of asset i and t e market portfolio M 1 (8, + 8), wit 8 @0, +A. ) e rate of return is t us r(8) / 8ri 0 (+ 8)rM . Asset i is assumed not efficient1 it3s point lies in t e feasi"le region "ut not on t e efficient frontier. ) us as 8 #aries t is portfolio3s point traces out a smoot cur#e in t e feasi"le (6, r) region 8 (6(8), r(8)) parametrized "! 8, w ere r(8) / 8r 0 (+ 8)r / 8(r i rM ) 0 r M , (B) 0 (+ 8)- 0 -8(+ 8)6 6M,i i M

8 6 i

&

6(8)
-

/
&
M

/ 8- (6 - -6 0 6i M

)0 -8(6
M,i M,i

6- ) 0 6- . (;)
M M

W en 8 / 0, (6(0), r(0)) / (6M , r M ) and w en 8 / +, (6(0), r(0)) / (6i , r i ). ) us t e cur#e touc es t e captital market line at t e market point (6M , rM ), "ut ot erwise remains off t e captital market line "ut (of course) wit in t e feasi"le region w ere it also its t e point (6i , ri ). We conclude t at t e cur#e is tangent to t e capital asset line at point (6M , r M ) and t erefore w en 8 / 0 t e cur#e3s deri#ati#e d r ( 8 ) d 6 ( 8 )
8 / 0

is identical to t e slope of t e capital asset line at point M . ) e slope (t e price of risk) of t e line is gi#en "! (-). We t us conclude t at w en 8 / 0 dr(8) rM rf / . d6(8 (C) ) 6
M

) e composition rule from calculus !ields

dr(8) / dr(8)%d 8 d6(8)


M

d6(8)%d8

Differentiating (B) and (;) and e#aluating at 8 / 0 !ields dr(8)%d8 r r i M (6/ 6 - )%6 d6(8)%d M,i M 8 .

(rom (C) we deduce t at


M

r r
i M

(6M,i 6 - )%6M

rM / rf 6.
M

<ol#ing for r i t en !ields t e CAPM formula for asset i, r i rf / 7i (r M rf ), as was to "e s own. (or t e more general portfolio result, o"ser#e t at r r
p f

/ r 0 n 9 8r
f i / + i i i i

n 8 (r r ) / 9 i/+ f

n 8 7 (r / 9 i/+ i i M

r ) (CAPM formula for single asset i)


f

/ (r
M

r )n 9 87.
f i / + i i

4ote t at w en 7p / + t en r p / r M 1 t e e'pected rate of return is t e same as for t e market portfolio. W en 7p E +, t en r p E r M 1 w en 7p F +, t en r p F rM . Also note t at if an asset i is negati#el! correlated wit M , 6M,i F 0, t en 7i F 0 and r i F rf 1 t e e'pected rate of return is less t an t e risk-free rate. >ffecti#el!, suc a negati#el! correlated asset ser#es as insurance against a drop in t e market returns, and mig t "e #iewed "! some in#estors as a#ing enoug suc ad#antages so as to make it wort t e low return. $n#esting in gold is t oug t to "e suc an e'ample at times.

+.-

>stimating t e market portfolio and "etas

$n t e real open market place w ere t e num"er of assets is enormous, tr!ing to actuall! construct t e market portfolio would "e an awsome and unrealistic task for an! financial anal!st. ) us so-called inde' funds (or mutual funds) a#e "een created as an attempt to appro'imate t e market portfolio. <uc an inde' is a smaller portfolio made up of w at are #iewed as t e markets3 most dominant assets, t at captures t e essence of M . ) e most well-known suc inde' is t e <tandard ? Poor3s C00-stock inde' (<?P), made up of C00 stocks. A "eta for a gi#en asset is t en estimated "! using t e <?P in replace of M , and t en collecting past data for "ot rates of return. (or e'ample consider an asset A for w ic we wis to estimate its "eta. ) ese estimates are computed using sample means, #ariances and co#ariances as follows* We c oose 4 time points suc as t e end of eac of t e last +0 !ears k / +, -, . . . , 4 . r and r denote t e k t suc sample #alues for rate of return !ielding estimatesAk
<?P k

GrA /

+ 9 4 rAk

k /

Gr<?P
<?P

+ 4

+ 4

r<?P k .
k/+

) e #ariance 6-

is t en estimated "!

+
4

H /4

(r<?P k

<?P Gr ) ,

k / +

and t e co#ariance 6<?P

,A

is estimated "! +
4

9 /4 +

(r<?P k Gr<?P )(r<?P k GrA ).


k/+

) e "eta #alue is t en estimated "! taking t e ratio 9%H .

+.B
Wit

More on s!stematic risk


t e CAPM formula in mind, for a gi#en asset i let us e'press ri as ri / rf 0 7i (rM rf ) 0 (I)
i

w e re

/ ri rf 7i (rM rf ),

(J)

a random #aria"le, is t e error term. 4ote ow we replaced deterministic r M wit random rM in t e CAPM to do t is. Kur o"2ecti#e is to determine some properties of t e error term. $t is immediate from t e CAPM formula t at >( i ) / 0. Moreo#er C o#( i , rM ) / 0 as is seen "! direct computation and t e definition of 7i * co#( i , rM ) / co#(ri rf rf ), rM ) co#(r 7 (r r ), r ) i M7 co#(r f M r ,r ) co#(ri , r ) co#(ri , rM ) 7i co#(rM , r f ) M i M M 6 i M / 6M,i
M, i

7i (rM / / /

6 6
M

/ 6 M,i 6 / 0 .
M,i

<o t e error term as mean 0 and is uncorrelated wit t e market portfolio. $t t en follows "! taking t e #ariance of "ot sides of (I) t at 6 -

/ 7 6 0 #ar( ). i i i M (L)

We conclude t at t e #ariance of asset i can "e "roken into two ort ogonal components. ) e first, 7 - 6 - , is called t e s!stematic risk and represents t at part of t risk inmarket asset as a w ole. ) e ot er part, #ar( ), is called t e i (of M in#esting i) eassociated wit t e nons!stematic
i i

risk. ) e nons!stematic risk can "e reduced (essentiall! eliminated) "! di#ersification, "ut t e s!stematic risk, w en 7 - E 0, can not "e di#ersified awa!. <ol#ing for 6 in terms of r in t e capital market line !ields t e in#erse line for efficient portfolios r rf r 6 / M rf 6M .

Msing t e CAPM formula rp rf / 7p (r M rf ) and plugging into t is in#erse line formula, we conclude t at for an! efficient portfolio p, 6p / 7p 6M 1 t ere is onl! s!stematic risk for efficient portfolios, no nons!stematic risk. ) is makes perfect sense* Clearl! M as onl! s!stematic risk since 7M / +. We know t at all efficient portfolios are a mi'ture of M and t e risk-free asset (e.g., t e! all a#e points on t e capital market line). <ince t e risk-free asset is deterministic it does not contri"ute to eit er t e #ariance or t e "eta of t e portfolio, onl! M does1 so all of t e risk is contained in M w ic we 2ust pointed out is pure s!stematic risk.

+.; Pricing assets


Consider an asset wit price P / 90 at time t / 0, pa!off (random) N / 9+ and e'pected pa!off N / >(9+ ) at time t / +. ) en "! definition r / (>(9+ ) 90 )%90 / (N P )%P . <ol#ing for P !ields P / N%(+ 0 r), w ic e'presses t e price as t e discounted pa!off (present #alue) if using r as t e discount rate. :ut since r / rf 0 7(r M rf ) from t e CAPM formula, we conclude t at N P / + 0 rf 0 7(r M r )
f

(Pricing #ersion of CAPM formula) (O)

We can re-e'press t is formula "! using r / (N P )%P / (N%P ) +, t en computing C o#(r, rM ) / C o#((N%P ) +, rM ) / C o#((N%P ), rM ) / P
M

+ o#(N, rM )1 C

o"taini ng

7 / (C-o#(N, P)%6 ). rM Plugging into t e pricing #ersion of CAPM formula !ields N P / <ol#ing for P !ields
+

+ 0 rf 0

. (C P o#(N, rM )%6 )(r M rf ) M

N
C o#(N,rM )(r M 6 Prf )
-

. (+0)

P r/ +0
M

) is e&uation is interesting since it e'presses t e price as t e present #alue of an Qad2ustedR e'pected pa!off. $f t e asset is uncorrelated wit t e market, t en t e price is e'actl! N%(+0rf ), t e present #alue of t e e'pected pa!off. ) e ad2ustment 6 C o#(N, rM )(r M rf )
M

!ields a lower price if t e asset is positi#el! correlated wit t e market, and a ig er price if t e asset is negati#el! correlated wit t e market.

6ra1bac:s of !eha"ioral finance )


A narro1< limited critique of economic theory !ataloging the many ways humans fail to think rationally about money, investments and risk is a good start. But in most ways, behavioral finance leaves intact the problematic assumptions of traditional finance, pulling its punches, so to speak. "mong the most noteworthy examplesA a$ Behavioral finance remains stuck at the individual level of analysis "s in traditional finance and economics, the ob*ect of inquiry in behavioral finance is the individualIdespite rafts of evidence going back decades that individuals donUt make decisions about money, risk or investing in a vacuum, but as a result of social influences. -f course, this evidence comes from those allied social sciences that are being so studiously ignored. )or example, economic psychologist Peorge 7atonashowed BC years ago that

most people choose investments based on word of mouth recommendations from their friends and neighbors. (his influence of social forces in economic decision=making has been demonstrated with equal or greater impact among finance professionalsIfor instance, in a study of Wall 9treet pension fund managers by economic anthropologists -UBarr and !onley, and more recently in a sociological study of arbitrage traders by Beun,a and 9tark . .n the past, there were encouraging signs that behavioral finance might break through the limitations imposed by sticking to the individual level of analysis, most strikingly in >obert 9hillerUs /33B statement that V.nvesting in speculative assets is a social activity.W But thus far, the implications of such statements, and the plethora of evidence supporting them, remain unexplored. $ Behavioral finance limits itself to %ointing out failures of cognition and calculation "s important as those factors are in distorting financial decision=making, there are a host of others that we know aboutIbased on research in those allied social sciences that behavioral finance doesnUt acknowledgeIthat are excluded from research in behavioral finance. (his includes emotions, and social phenomena like status competition, both of which play a significant role in the findings of economic sociology, psychology and anthropology. (he cognitive8calculative failures may interact with the socio=emotional phenomena, but we wonUt know as long as behavioral finance pretends the latter donUt exist. (hatUs a loss for all of us interested in markets, money and investing. c$ Behavioral finance doesn&t e'%lain ho( individual acts and decisions %roduce aggregate outcomes "s a consequence of keeping the analytical focus on individualsIavoiding the social and interactive aspects of economic activityIbehavioral finance doesnUt have the theoretical means to address mechanisms through which individual acts and decisions aggregate. (hat means it canUt explain institutions and other manifestations of collective behavior which form the context for all the individual behavior it examines. -f course behavioral finance canUt answer all questions about money and markets, but it ought to be able to explain what happens when hundreds, or hundreds of millions, of people fall prey to the Vhot handW fallacy or availability bias? .f behavioral finance wonUt touch questions like that, who will? (he consequences for ignoring the other social sciences and mounting a very narrow critique of traditional finance and economics, includeA

Limited *redicti"e *o3er Behavioral finance tells us more about what people wonUt do e.g., behave according to notions of rationality outlined in economic theory% than what they will do. Contradictory im*lications "re investors risk=averse or overconfident? 'ow should we reconcile seemingly contradictory findings like these? Behavioral finance doesnUt tell us, because of itsX ailure to offer a "ia4le alternati"e to the theories it challenges #ointing out all the ways that real life behavior doesnUt bear out the predictions of traditional economics and finance is interestingIeven fascinating, at timesIbut itUs not an alternative theory. V#eople arenUt rationalW isnUt a theoryA itUs an empirical observation. "n alternative theory would need to offer an explanation, including causal processes, underlying mechanisms and testable propositions. "ll this keeps behavioral finance dependent on traditional economics and finance rather than allowing it to grow into a robust theoretical realm in its own right. #erhaps someday the field will develop into something more truly challenging to economic orthodoxy. Dntil then, behavioral finance will have to play 9tatler and Waldorf to the 5u**et &ho3 of mainstream financeI providing entertaining critique, but not replacing the marquee acts.