A Survey of Behavioral Finance

Nicholas Barberis Richard Thaler

Presented by Ryan Samson

Traditional vs. Behavioral

Traditional
Rational
Correct Bayesian Updating
Choices Consistent with Expected Utility

Behavioral
Some are Not Fully Rational Relax One or Both Tenets of Rationality

Behavioral Finance Limits to Arbitrage Psychology

Limits to Arbitrage vs. Market Efficiency

EMH
Prices Reflect Value Mispricings Corrected by Arbitrageurs

Limits to Arbitrage
Strategies May not be Arbitrage Problems Entering Position?
Correct Prices => No Free Lunch No Free Lunch > Correct Prices Why Care?

Theory Supporting Limits to Arbitrage

Fundamental Risk Negative Shock and no Perfect Substitute (e.g. Ford and GM) Noise Trader Risk Continued Widespread Irrationality
Forced Liquidation (Separation of Brains and Capital) Horizon Risk Trading in the Same Direction

Theory Supporting Limits to Arbitrage 2

Implementation Costs
Commission Bid/Ask Spread Price Impact Short Sell Costs
Fees Volume Constraints Legal Restraints

Identification Cost
Mispricing > Predictability

Evidence Supporting Limits to Arbitrage

Mispricings Hard to Identify
Test of Mispricing => Test of Discount Rate Model

Twin Shares
Royal Dutch (60%) and Shell (40%)
Only Risk is Noise Traders

=> PriceRD = 1.5*PriceS

Evidence Supporting Limits to Arbitrage 2

Index Inclusions
Stock Price Jumps Permanently 3.5% Average

Fundamental Risk
Poor Substitutes (best R2 < 0.25)

Noise Trader Risk

Index Fund Purchases etc.

Evidence Supporting Limits to Arbitrage 3

Internet Carve-Outs
3Com Sells 5% of Palm in IPO, Will Spin Off Remainder in 9 Months 1 Share of 3Com will own 1.5 Shares of Palm PPalm = $95 3Com should be $142 P3Com = $81 Value of 3Com Excluding Palm = -$60

Evidence Supporting Limits to Arbitrage 4

Why? Very Few Shares of Palm available to Short Arbitrage was Limited Mispricing Persisted

Psychology
Beliefs
Overconfidence
98% CI only captures 60% 100% is actually 80% and 0% is actually 20%

Optimism / Wishful Thinking

Unrealistic View of Personal Abilities / Prospects 90% of Drivers Claim Above Average Skill 99% of Freshman Claim Superior Intelligence

Psychology 2
Beliefs Continued
Representativeness
Base Rates are Under-Emphasized Relative to Evidence Sample Size Neglect in Learning Distribution
(6 Tosses vs. 1000 Tosses)

Law of Small Numbers

Gamblers Fallacy

Conservatism
Base Rates are Over-Emphasized Relative to Evidence

Psychology 3
Beliefs Continued
Belief Perseverance
Search for Contradictory Evidence Treatment of Contradictory Evidence

Anchoring
Initial Arbitrary Value and Make Adjustments

Availability Biases
Recent or Salient Events

Psychology 4
Beliefs, Final Notes
People Display Poor Learning in Application Experts Often do Worse Increasing Incentives Doesnt Help

Psychology 5
Preferences
Expected Utility vs. Prospect Theory or Ambiguity Aversion

Prospect Theory
Value of a Gamble is: (p)*v(x)+(q)*v(y) Utility Defined over Gains and Loses Concave over Gains, Convex over Losses Nonlinear Probability Transformation
Especially Large Weight on Certain Outcomes

Psychology 6
Ambiguity Aversion
People Avoid Uncertain Probability Distributions Aversion Changes Based on Perceived Competence at Assessing Relevant Distribution
Preference for Familiar

Application 1: Aggregate Stock Market

3 Puzzles:
Equity Premium High Volatility in Returns and P/D Ratios Predictable Returns (D/P alone R2 = 0.27)

Equity Premium
Risk Premium Seems too High Possible Explanations Under Prospect Theory
Benartzi and Thaler
Ev[(1-w)Rf,t+1 + wRt+1 1], and v as before Given Historical Returns, Investors are Indifferent to w = 1 and w = 0 Calculate Implied Length of t 1 Year (Taxes? Annual Reports?) Result is Myopic Loss Aversion

Equity Premium 2
Possible Explanations Under Prospect Theory Continued
Need Intertemporal Model Barberis, Huang, Santos
Utility From Consumption (Source 1) AND Utility From Changes in Value of Risky Assets (Source 2) Utility From Source 2 Captures Loss Aversion (Not Convexity, Concavity, or Nonlinearity of ) Explanatory power based on weight of Source 2

Equity Premium 3
Possible Explanations Under Prospect Theory, Final Notes
Why? Regret Bounded Rational:
P(C(Labor Income, Stock Returns) < Habit) P(C(Stock Returns) < Habit)

t = 1 Year Based on Presentation

Equity Premium 4
Explanations Under Ambiguity Aversion
Max[Min[E[U]]] (i.e. Playing Malevolent Opponent) Requires High Equity Premium

Volatility
Rational Approaches Must Focus on Changing Risk Aversion to Explain Volatility Explanations Under Beliefs
Overreaction to Dividend Growth Volatile Prices
Law of Small Numbers Overconfidence in Opinion

Overreaction to Returns
Law of Small Numbers

Confusion Between Real and Nominal Rates

Volatility
Explanations Under Preferences
Same Model as Used for Equity Premium Add zt, a State Variable, to Source 2 of Utility Several Price Increases Less Scared Price Decreases Scared

Application 2: Cross-Section of Average Returns

You Can Form Groups of Stocks w/ Different Average Returns, Not Explained by CAPM
Size Premium (Small Stocks +0.74%/month) Long Term (3 Yr) Reversal (8%/Yr) Price Ratios
B/M (High B/M +1.53%/month) P/E (High P/E +0.68%/month)

Momentum (6 Month Winners +10%/Yr)

Cross-Section of Average Returns

Anomalies Continued
Earnings Announcements (Over 60 Days +4% for Good Over Bad) Dividend Initiation / Omission Stock Repurchases

Problems w/ Anomalies
Difficult Statistics (Cross-Sectional Correlation) Data-Mining (Test Out of Sample)

Multi-Factor Models

Cross-Section of Average Returns

Explanations Under Beliefs
Conservatism (Underweight New Info)
React Slowly to Earnings Reports

Representativeness
Overreact Now, Reversal Later

Overconfidence
Ignore Unfavorable Public Info Reversal Too Much Attention to Favorable Public Info Momentum

All Imply P Around Earnings Report

Cross-Section of Average Returns

Belief Based Continued
Positive Feedback
Momentum Post Earnings Drift Long Term Reversal A Result of Law of Small Numbers?

Cross-Section of Average Returns

Belief Based w/ Institutional Friction (i.e. Short Sell Constraints)
Bearish Cannot Short Reversal or Momentum Effect of Higher Incentives on Short Prices

Cross-Section of Average Returns

Preference Based Explanations
Same BHS Model Applied to Individual Stocks
Price Reversal (Not Momentum)