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.