Behavioral Finance Lecture 3

BMME115 Behavioral Finance
Lecture 3
Asset Pricing - Biased Beliefs
Dr. Li He
Rotterdam School of Management
MScFI program
Market Anomalies A Model of Investor Sentiment Extrapolation References
Biased Beliefs
Lecture
I Barberis, N., Shleifer, A., and Vishny, R. (1998). A model of
investor sentiment. Journal of Financial Economics,
49(3):307–343
Presentation
I Barber, B. M. and Odean, T. (2001). Boys will be boys:
Gender, overconfidence, and common stock investment. The
Quarterly Journal of Economics, 116(1):261–292
I Hirshleifer, D. and Shumway, T. (2003). Good day sunshine:
Stock returns and the weather. The Journal of Finance,
58(3):1009–1032
Dr. Li He Asset Pricing - Biased Beliefs 1 / 21

Raeding Wrods with Jubmled Lettres
Cambridge Brain Science
“Aoccdrnig to rscheearch at Cmabrigde uinervtisy, it deosn’t

mttaer waht oredr the ltteers in a wrod are, the olny iprmoetnt
tihng is taht the frist and lsat ltteres are at the rghit pclae. The
rset can be a tatol mses and you can sitll raed it wouthit a
porbelm. Tihs is bcuseae we do not raed ervey lteter by it slef but
the wrod as a wlohe.”

Market Anomalies
Recent empirical research in finance has identified two families of

pervasive regularities
I Underreaction
I Short-term continuation: Post-earnings-announcement drift
I Overreaction
I Long-term reversals: Winner-loser effect

Market Anomalies: Underreaction
I The underreaction evidence shows that over horizons of perhaps

1-12 months, security prices underreact to news.
Post-Earnings-Announcement Drift
I The stocks of firms giving rise to positive (negative) earnings
surprises experience positive (negative) drift after the
announcement.

Short-Term Continuation: Post-Earnings-Announcement Drift
Source: Bernard [1992].

The figure depicts the cumulative abnormal returns for standardized unexpected earnings (SUE) portfolios.

Market Anomalies: Overreaction
I The overreaction evidence shows that over longer horizons of

perhaps 3-5 years, security prices overreact to consistent
patterns of news pointing in the same direction.
Winner-Loser Effect [De Bondt and Thaler, 1985]

I Extreme past losers tend subsequently to outperform the
market, and extreme past winners tend subsequently to
underperform the market.

Long-Term Reversals: Winner-Loser Effect
Source: De Bondt and Thaler [1985].

The figure depicts the cumulative average residuals for winner and loser portfolios of 35 Stocks.

A Model of Investor Sentiment
Barberis, Shleifer, and Vishny (1998)
Journal of Financial Economics

Psychological Foundation
The model presented is motivated by two important phenomena

documented by psychologists:
I Conservatism
I Representativeness

Psychological Foundation: Conservatism
Definition
Individuals are slow to change their beliefs in the face of new

evidence [Edwards, 1982].
Conservatism is extremely suggestive of the underreaction

evidence.
I Individuals might disregard the full information content of an
earnings announcement;
I They believe that this number contains a large temporary
component, and still cling at least partially to their prior
estimates of earnings.

Psychological Foundation: Representativeness
Representativeness
I People think they see patterns in truly random sequences
[Tversky and Kahneman, 1974].
Representativeness heuristic is suggestive of the overreaction
evidence.
I Investors might disregard the reality that a history of high
earnings growth is unlikely to repeat itself;
I They believe that the past history is representative of an
underlying earnings growth potential.

Reconcile Conservatism with Representativeness
Griffin and Tversky [1992]

I People update their beliefs based on the “strength” and the
“weight” of new evidence.
I In revising their forecasts, people focus too much on the
strength of the evidence, and too little on its weight, relative to
a rational Bayesian.

Model Setup
The model features:

I A representative, risk-neutral investor with constant discount
rate;
I A security that pays out 100% of its earnings as dividends, and
the earnings stream follows a random walk;
I The investor thinks that the world moves between two regimes:
I Regime 1: earnings are mean-reverting
I Regime 2: earnings are trending

Random Walk
Random Walk
20
10
Position
-10
-20
0 100 200 300 400 500 600 700 800 900 1000
Step Count
A simple random walk is a stochastic sequence {Sn }, with S0 = 0,

defined by
S n = x1 + x2 + · · · + xn
I {xn } are independent and identically distributed random variables;
I xn = ±1 with p(xn = 1) = p(xn = −1) = 0.5.

Underreaction
Regime 1: earnings are mean-reverting
I An investor using Regime 1 to forecast earnings reacts too little

to an individual earnings announcement.
I Regime 1 generates effects identical to those predicted by
conservatism.

Overreaction
Regime 2: earnings are trending
I An investor using Regime 2 to forecast earnings extrapolates

past performance too far into the future.
I Regime 2 generates effects identical to those predicted by the
representativeness heuristic.

A Different Perspective
The model can also be motivated based on representativeness

alone.
I Regime 1 if observe a sequence of earnings changes that

alternate in sign;
I Regime 2 if observe a sequence of earnings changes that all
have the same sign.

Extrapolation
Definition
The estimate of the future value of a quantity is a positive function

of the recent past values of that quantity. It is also known as
“recency bias.”
“Humans are natural pattern seekers. As a result, when something is

going up, we expect it to continue going up. When it’s going down, we
expect it to continue going down.”
— Michael Mauboussin

An Illustrative Example
Technical Analysis
The figure shows 48 monthly prices of “unnamed stocks”.
Please predict, to the best of your ability, the price 7 and 13 months later.

An Illustrative Example
Technical Analysis

Empirical Evidence
Source: Greenwood and Shleifer [2014].

The role of past stock market returns in explaining survey expectations.

Overcoming Extrapolation Biases?
“Be fearful when others are greedy, and be greedy when others are
fearful.”
— Warren Buffet
Mutual Fund Disclaimer
“Past performance is not indicative of future results.”

Reference I
Barber, B. M. and Odean, T. (2001). Boys will be boys: Gender,

overconfidence, and common stock investment. The Quarterly Journal of
Economics, 116(1):261–292.
Barberis, N., Shleifer, A., and Vishny, R. (1998). A model of investor
sentiment. Journal of Financial Economics, 49(3):307–343.
Bernard, V. L. (1992). Stock price reactions to earnings announcements: A
summary of recent anomalous evidence and possible explanations. In Thaler,
R., editor, Advances in Behavioral Finance, pages 303–340. Russell Sage
Foundation, New York.
De Bondt, W. F. M. and Thaler, R. (1985). Does the stock market overreact?
The Journal of Finance, 40(3):793–805.
Edwards, W. (1982). Conservatism in human information processing. In
Kahneman, D., Slovic, P., and Tversky, A., editors, Judgment under
Uncertainty: Heuristics and Biases, chapter 25, pages 359–369. Cambridge
University Press.
Greenwood, R. and Shleifer, A. (2014). Expectations of returns and expected
returns. Review of Financial Studies, 27(3):714–746.

Reference II
Griffin, D. and Tversky, A. (1992). The weighing of evidence and the

determinants of confidence. Cognitive Psychology, 24:411–435.
Hirshleifer, D. and Shumway, T. (2003). Good day sunshine: Stock returns and
the weather. The Journal of Finance, 58(3):1009–1032.
Tversky, A. and Kahneman, D. (1974). Judgment under uncertainty: Heuristics
and biases. Science, 185(4157):1124–1131.

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BMME115 Behavioral Finance

Asset Pricing - Biased Beliefs

Dr. Li He Asset Pricing - Biased Beliefs 1 / 21

Raeding Wrods with Jubmled Lettres

Cambridge Brain Science

“Aoccdrnig to rscheearch at Cmabrigde uinervtisy, it deosn’t

Dr. Li He Asset Pricing - Biased Beliefs 2 / 21

Recent empirical research in finance has identified two families of

Dr. Li He Asset Pricing - Biased Beliefs 3 / 21

Market Anomalies: Underreaction

I The underreaction evidence shows that over horizons of perhaps

Dr. Li He Asset Pricing - Biased Beliefs 4 / 21

Short-Term Continuation: Post-Earnings-Announcement Drift

Source: Bernard [1992].

Dr. Li He Asset Pricing - Biased Beliefs 5 / 21

Market Anomalies: Overreaction

I The overreaction evidence shows that over longer horizons of

Winner-Loser Effect [De Bondt and Thaler, 1985]

Dr. Li He Asset Pricing - Biased Beliefs 6 / 21

Long-Term Reversals: Winner-Loser Effect

Source: De Bondt and Thaler [1985].

Dr. Li He Asset Pricing - Biased Beliefs 7 / 21

A Model of Investor Sentiment

Barberis, Shleifer, and Vishny (1998)

Journal of Financial Economics

Dr. Li He Asset Pricing - Biased Beliefs 8 / 21

The model presented is motivated by two important phenomena

Dr. Li He Asset Pricing - Biased Beliefs 9 / 21

Psychological Foundation: Conservatism

Individuals are slow to change their beliefs in the face of new

Conservatism is extremely suggestive of the underreaction

Dr. Li He Asset Pricing - Biased Beliefs 10 / 21

Psychological Foundation: Representativeness

Dr. Li He Asset Pricing - Biased Beliefs 11 / 21

Reconcile Conservatism with Representativeness

Griffin and Tversky [1992]

Dr. Li He Asset Pricing - Biased Beliefs 12 / 21

The model features:

Dr. Li He Asset Pricing - Biased Beliefs 13 / 21

A simple random walk is a stochastic sequence {Sn }, with S0 = 0,

I {xn } are independent and identically distributed random variables;

I xn = ±1 with p(xn = 1) = p(xn = −1) = 0.5.

Dr. Li He Asset Pricing - Biased Beliefs 14 / 21

Regime 1: earnings are mean-reverting

I An investor using Regime 1 to forecast earnings reacts too little

Dr. Li He Asset Pricing - Biased Beliefs 15 / 21

Regime 2: earnings are trending

I An investor using Regime 2 to forecast earnings extrapolates

Dr. Li He Asset Pricing - Biased Beliefs 16 / 21

The model can also be motivated based on representativeness

I Regime 1 if observe a sequence of earnings changes that

Dr. Li He Asset Pricing - Biased Beliefs 17 / 21

The estimate of the future value of a quantity is a positive function

“Humans are natural pattern seekers. As a result, when something is

Dr. Li He Asset Pricing - Biased Beliefs 18 / 21

The figure shows 48 monthly prices of “unnamed stocks”.

Dr. Li He Asset Pricing - Biased Beliefs 19 / 21

Dr. Li He Asset Pricing - Biased Beliefs 19 / 21

Source: Greenwood and Shleifer [2014].

Dr. Li He Asset Pricing - Biased Beliefs 20 / 21

Overcoming Extrapolation Biases?

Mutual Fund Disclaimer

“Past performance is not indicative of future results.”