1. Behavioral Finance
Economics 437

2. 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”

3. DeBondt-Thaler 1984 “Over-Reaction” Hypothesis Suggests that:
After a period of “over-reaction,” markets “revert” back and go the other way.
Stocks that have done well in the past, do poorly in the future
Stocks that done poorly in the past, do well in the future
Their article is designed to test whether or not “mean reversion” is true.

4. Data NYSE data Begin with three year lookback in Dec 1932
Jan 1926 through December 1982
Monthly return data
Begin with three year lookback in Dec 1932
Monthly data from Jan 1930 through Dec 1932
36 months or three years data
Form portfolios of L(osers) and W(inners)
Then see how they do for the next three years

5. DeBondt and Thaler: “Does the Stock Market Overreact” (1985)
L – three year loses
W – three year winners
Question: How do the W’s do in the next three years? How do the L’s do in the next three years?
Other things worth noting
Almost all of the impact is in January
When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation

6. DeBondt-Thaler conclusions
Definite evidence of mean reversion (a form of serial correlation):
L portfolios consistently outperform W portfolios
19.6 % better than the market after end of 3 years
W portfolios consistently underperform the market
5 % less than the market after end of 3 years

7. Interesting facts Most of the excess returns are in January
Loser effect more pronounced:
Losers earned 19.6 % more than the market
Winners earn 5.0 % less than the market
Loser portfolio minus Winner portfolio return = 24.6 %!!!!!
Most of the return difference is during 2nd and 3rd year
Larger loses become larger winners; larger winners become larger losers

8. Data in Fama and French 1962 -1989 data
Book Value (leverage and price/earnings) at previous year end
Returns starting on July 1 of the following year (also use the market equity as of July 1 for size, but use market equity at previous year end for B/M calculation)
Calculate monthly returns
Each month the cross-section of returns is regressed on explanatory variables.
Prior
research used “portfolio betas”; F-F use individual stocks
Sort stocks into “size deciles”
Sort each size decile into 10 portfolios based on beta
Calculate equal weighted monthly returns on the portfolios for the next 12 months (from July to June).

9. Results on Beta
Portfolios in size deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return
Large size means lower beta and lower returns
When size deciles are subdivided into beta ranked decile portfolios
Larger size firms have lower returns
“no relation between average return and beta”

10. Results on Book/Market
What is book to market
Book is firm net worth reported on 10-Ks
Market is: shares outstanding times price
Book/market is positively related to returns
Size still matters but B/M is much more important
B/M swamps leverage and E/P
Leverage: book or market leverage?
January “slopes” twice slopes of other months
Overall largest decile book to market beats smallest decile book to market by 1.53 % per month

11. Jegadeesh and Titman (1993)
Relative strength strategies, sometimes called “earnings momentum” strategies
Find past winners and and past losers (using 3 to 12 month holding periods) generate gains (winners gain; losers lose)
Construct W portfolio and L portfolio
W-L (using 6 month periods) earns more than12 % better than market portfolio
Longer term portfolios do best in next 12 months
Interpretation in “event time”
Doesn’t work in January

12. Ball & Brown 1986 Market “underreacts” to earnings surprises
Article generally ignored until Jagdeesh-Titman
Time span suggests that Ball-Brown effect may be the same thing as Jagdeesh-Titman

13. The End