1、Behavioral Finance,Introduction,Only two things are infinite, the universe and human stupidity, and Im not sure about the former. Albert Einstein,What is behavioral finance,Behavioral finance (BF) is the study of how psychology affects finance.BF argues that some financial phenomena can plausibly be
2、 understood using models in which some agents are not fully rational. BF acknowledges that investors are not perfectly rationalBF allows for psychological factors of behaviorBF argues that behavioral biases affect prices established in the market,The first theme of BF,Traditional finance (TF) seeks
3、to understand financial markets using models in which agents are “rational”.First, when agents receive new information, they update their beliefs correctly, in the manner described by Bayes law. Second, given their beliefs, agents make choices that are normatively acceptable, in the sense that they
4、are consistent with Savages notion of Subjective Expected Utility (SEU).,The first theme of BF,Are financial investors really rational?Do investors commit errors?BF answers YES, TF answers NOWhy do we make mistakes?Incapability of processing unlimited informationRelying on rule of thumb called “heur
5、istics”Back-of-the-envelope calculation is imperfect,The first theme of BF,Investors commit heuristic-driven biasese.g., representativeness bias, anchoring effect, loss-aversion bias, etc.Investors commit frame-dependence baisesInvestor decision-make is influenced by how problems are framed (present
6、ed).“If you transfer a dollar from your right pocket to your left pocket, you are not wealthier. Franco and I proved that rigorously.” Merton MillerTF assumes frame independence,The second theme of BF,Do behavioral biases systematically affect financial markets?TR argues that errors presented unsyst
7、ematically will be cancelled-out in the market.BF disagreesDo we all commit to same errors and simultaneously?Do we all buy winners and sell losers?Are average investors stupid? Are marginal investors whose actions affect the market stupid? What if Im smart, though you are stupid?,The second theme o
8、f BF,Case study: in April 1997, Financial Times ran a contestReaders chose a whole number between 0 and 100. The winning entry would be the one closest to two-thirds of the average entry.Suppose five people enter the contest and they choose 10,20,30,40 and 50. In this case, the average is 30, two-th
9、irds of which is 20. The person who chose to enter 20 would be the winner.What is the winning number?,The second theme of BF,You are playing to win, you need to understand how the other players are thinking.If everyone is smart and bias-free, the winning entry is 1.In reality, the winning choice is
10、_. If you are smart, but the others are not, you are not the winner.What is the point of this pick-a-number game?People commit errors in the course of making decisionsThese errors cause asset prices to be different from what they would have been in an error-free environment.,The third theme of BF,Ar
11、e markets efficient?TR says yes. All information is incorporated into prices in an unbiased and immediate fashion.Any mispricing due to behavioral biases provides profitable opportunities for smart people (arbitrageurs) and will be corrected by the market force.Is it true? BF says no - limit of arbi
12、trage is substantial enough to prevent risk-free arbitrageSmart money is vulnerable to risks stemming from the errors and emotions of other traders.,The third theme of BF,Case study: Long Term Capital Management (LTCM)A hedge fund headed by fixed-income arbitrage pioneer John Meriwether, Nobel laure
13、ates Myron Scholes and Robert MertonBuilding on the foundation of efficient market theory, LTCM believes the existence of mispricing, which can be quickly exploited by smart money.LTCM held more than $7 billion of capital at year-end 1997, shrinking to $4 billion in 1998.The FRB of NY was forced to
14、implement a rescue plan.,The third theme of BF,LTCM had taken large positions in two companies, Royal Dutch Petroleum (RD) and Shell Transport and Trading (ST), that jointly owned the entity Royal Dutch/ShellA corporate charter linking these two companies divides the joint cash flow of Royal Dutch/S
15、hell between them on a 60/40 basis.In theory, the market value of RD should be 1.5 times as large as that of ST(only in a error-free environment).The shares of ST have traditionally traded at an 18% discount relative to RD.,The third theme of BF,When the discount widened beyond 18%, LTCM did a “pair
16、s” trade, taking a long position in ST and a short position in RD. LTCM would make a profit if the discount reverted to its traditional value.But LTCM encountered the same fate as someone who chose a 1 in the pick-a-number game.The discount widened rather than narrowed.,The key message of BF,BF is n
17、ot about how to beat the marketAlthough behavioral errors do create abnormal profit opportunities for the smart money, these errors also introduce an additional source of risk, above and beyond fundamental risk.Caution on “use BF to make a killing”The collapse of LTCMThe biggest surprise to LTCM did
18、 not come from unanticipated fundamental risk, but from unanticipated sentiment-based risk!,How BF developed,Psychologists work play a central role in the field of BFe.g., Tversky and Kahneman (1974) in Science dealing with heuristic-driven errors; Kahneman and Tversky (1979) in Econometrica dealing
19、 with frame dependenceEmpirical results inconsistent with the view of traditional finance theoryReturn anomalies: small-firm effect, January effect, weekend effect, and holiday effectTraditional finance was incapable of explaining these anomalies,Key figures in BF,Robert Shiller, Yale University, au
20、thor of Irrational ExuberanceRichard Thaler, University of Chicago Hersh Shefrin, Santa Clara University, author of Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of InvestingAndrei Shleifer, Harvard University, author of Inefficient Markets: An Introduction to Behavioral
21、 FinanceDaniel Kahneman and Vernon Smith, Nobel laureates, awarded for achievement in psychology research,How pervasive are behavioral phenomena?,BF plays an important role in the major areas of finance: portfolio theory, asset pricing, corporate finance and pricing of optionsThese area correspond t
22、o works recognized for Nobel prizes in economicsHarry Markowitz portfolio theory (1990)Merton Miller theory of corporate finance (1990)William Sharpe capital asset pricing model (1990)Myron Scholes and Robert Merton option pricing theory (1997)The course will lay out the implications of BF with resp
23、ect to above mentioned areas.,How traditional finance react?,A story from Hersh Shefrin who proposed a behavioral explanation of the dividend puzzleNobel laureate Merton Miller, the developer of the traditional theory of dividends commented:“the approach might apply to his own Aunt Minnie”“the stori
24、es were too interesting: they were distracting and diverted the attention of scholars away from the identifying the fundamental forces that drive markets.”Behavioral phenomena are both ubiquitous and germaneUbiquitous: behavioral errors are pervasiveGermane: behavioral errors are expensive,How tradi
25、tional finance react?,Eugene Fama, the founder of Efficient Market Hypothesis “Efficiency survives the attack of the anomalies” (Fama, 1998) defenses the EMH.First, “in an efficient market, apparent underreaction will be about as frequent as overreaction.”Second, “the long-term return anomalies are
26、sensitive to methodology.”BF is nothing more than “anomalies dredging”In the traditional framework where agents are rational and there are no frictions, a securitys price equals its “fundamental value”.,How traditional finance react?,Three forms of EMHWeak form of EMHSemi-strong form of EMHStrong fo
27、rm of EMHThe rationality of investor behaviorInvestors are fully rational. Some investors are irrational. Their behaviors are unsystematic and are canceled outInvestors could make mistakes, which should, however, be corrected by rational investors,Some practical views on BF,BF shows great promise fo
28、r practitioners who seek to outperform the inefficient market.Could behavioral pricing mistakes be capitalized on resulting in a positive alpha?In the early 1990s, JP Morgan launched the first “behavioral fund” called the JP Morgan Undiscovered Value Fund (ticker: UBVLX).The fund was managed by LVS
29、Asset Management and overseen by Russell Fuller and Richard Thaler.Since then, dozens of funds have been formed to take advantage of market misbehavior.,Some practical views on BF,“Behavioral Finance: Are the Disciples Profiting from the Doctrine?”, 2006, by Colby Wright, Prithviraj Banerjee and Van
30、eesha Boney“behavioral mutual funds are tantamount to value investing and not much more.”“Behavioral Finance: An Analysis of the Performance of Behavioral Finance Funds,” 2010, by Alessandro Santoni and Arun Kelshiker, Journal of Index InvestingNo clear evidence that behavioral mutual funds outperfo
31、rmed their benchmarks. The capacity of behavioral funds to forecast marketing turning points is difficult to support. Limited consistency in performance. On the positive side, there is the capacity to exploit some common behavioral biases such as the January effect.,What does this course cover?,Psychological foundationHeuristic-driven biasFrame dependenceThe limits of arbitrageApplications of BF investor behaviorApplications of BF asset pricingApplications of BF corporate finance,
