Asset Management Lecture 19

Agenda Behavioral finance (Chapter 12) Challenges to market efficiency Limits to arbitrage Irrational investors

Market Efficiency Fama: “The market price at any time instant reflects all available information in the market”. Cannot “make money” using “stale information”. Three forms Weak form: past prices and returns. Semi-strong form: all public information. Strong form: all public AND private information. Michael Jensen: “there is no other proposition in economics which has more empirical support than the EMH”.

Are Financial Markets Efficient? Weak form of market efficiency supported to a certain extent. Challenges: Excess market volatility Stock price over-reaction: long time trends (1-3 years) reverse themselves. Momentum in stock prices: short-term trends (6-12 months) continue. Size and B/M ratio (stale information) may help predict returns.

What Makes Markets Efficient? Competition among information providers Arbitrage traders Critical Factors Behind Efficient Markets Investor Rationality Irrational Behavior is Not Systematic Rational Arbitrage Traders

Behavioral Finance Irrational Investors Limits to Arbitrage

Investor Irrationality Empirical Evidence on investor behavior: investors fail to diversify. investors trade actively Investors may sell winning stocks and hold onto losing stocks extrapolative and contrarian forecasts. Systematically irrational trading by investors Information processing Suboptimal decisions

Psychology Beliefs Overconfidence Optimism / Wishful Thinking Miscalibration Better-than-average-effect 90% of Drivers Claim Above Average Skill 99% of Freshman Claim Superior Intelligence Illusion of control Rolling dice in craps

Psychology Beliefs Representativeness Base Rates are Under-Emphasized Relative to Evidence “Law of Small Numbers” – gambler’s fallacy Example: fair coin tossing. T H T H T H H H H H H P(T) = ?, P(H) = ?.

Psychology Beliefs Conservatism Base Rates are Over-Emphasized Relative to Evidence Belief Perseverance Anchoring Availability Biases

Psychology Behavioral biases Framing Mental accounting Preference for dividends Holding on to loser stocks for too long “house money effect” Regret avoidance Prospect Theory Utility Defined over Gains and Loses Concave over Gains, Convex over Losses

“Irrational” Behavior of Professional Money Managers Herding: may select stocks that other managers select to avoid “falling behind” and “looking bad”. Window-dressing: add to the portfolio stocks that have done well in the recent past and sell stocks that have recently done poorly.

Limits to Arbitrage Fundamental Risk Horizon Risk Model Risk Lack of Substitutes Limited Capital Legal Constraints Implementation Costs

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

Limits to Arbitrage Twin Shares: Royal Dutch (60%) and Shell (40%) Only Risk is Noise Traders Price RD = 1.5*Price S

Limits to Arbitrage Nick Leeson Jan 16, 1995, Short Straddle on Tokyo stock exchange Jan 17, 1995, Kobe Earthquake Riskier tools to bet on recovery of Nikkei Stock Average Losses reached £827 million, twice the bank's available trading capital. Feb 26, 1995, Barings Bank filed bankruptcy.

Summary Investor behavior does have an impact on the behavior of financial markets. Both “social” and “psychological” must be taken into account in explaining the behavior of financial markets. Market “anomalies” may be widespread. Behavioral Finance: does not replace but complements traditional models in Finance.