Behavioral Finance Economics 437

Ross Lecture on Anomalies Two Criteria Are They True? Are They Important? Ross Concludes Anomalies are not usually both true and important Anomalies covered Closed end funds Small stocks January effect

Meanwhile

General Theme: Predictability Fama French: “Cross Section” Article Book/Market and Size => Stock Returns “Value Investing” or “Contrarian Investing” DeBondt Thaler: “Over Reaction” Buy past losers; Sell past winners Value? Investing; Contrarian Investing Jegadeesh Titman: “Price Momentum” Possibly “Earnings Momentum”

The Counter Attack Comes Swiftly Conrad and Kaul 1993 Data Problems with all three articles Small Stocks mainly the issue Impact of “January” Ball, Kothari, Shanken 1995 Small stock measurement problems Mostly December, very low priced stocks Priced at the bid, 1/8 error makes huge difference Changing the months, changes the results

Single Period Return Calculations (Pt+1 – Pt)/Pt is rate of return for single period, ignoring dividends But that is not what is observed What is observed is either bid side or offer side of the market The arithmetic biases the calculation upward (see pages 160-161 of Burton Shah)

Now think of a holding period of two periods Calculate average returns over two periods: Imagine up 50%, down 50% Start with $ 100 $ 100 goes to $ 150, falls to $ 75 Yet average return is zero Imagine down 50%, up 50% $ 100 goes to $ 50, rises to $ 75 Again, average return is zero

Another Example Calculate average returns over two periods: Imagine up 10%, up 20% Start with $ 100 $ 100 goes to $ 110, rises to $ 132 Average return is 15 %, which would mean $100 goes to $ 115, then to $ 132.25 Imagine up 20%, up 10% $ 100 goes to $ 120, then to $ 132 Again, average return is 15 %, but again 15% return would get to $132.25

Conclusion Averaging single period returns biases the reported returns upward. Actual returns that would be achieved are lower.

So, how are these papers calculating returns Monthly returns, averaged But cumulative returns actually would be much lower But, there is also no rebalancing

What is rebalancing At the end of the month, some stocks have gone up more than others In a real world portfolio that changes the “weights” as stocks that have gone up more carry more “weight” in the portfolio But, that is assumed away in these articles There is an implicit assumption on monthly rebalancing

The End