Lecture 13

Exam Revision

• Topic 1: Intro to Behavioral Finance : Introduction to Behavioral Finance and Traditional Finance Theories
• Topic 2: Prospect Theory
• Topic 3: Challenges to Market Efficiency
• Topic 4: Overconfidence and Investors
• Topic 5: Application of Managerial Overconfidence in Corporate Finance
• Topic 6: Heuristics and Biases and Its Implications
• Topic 7: Emotional Foundations and Individual Investors
• Topic 8: Behavioural Explanations for Anomalies
• Topic 9: Behavioral Factors and Stock Market Puzzles
• Topic 10: Behavioural Investing

Topic 1: Introduction to Behavioral Finance and Traditional Finance Theories

Reference: AckertDeaves Chapters 1 & 2

[Part One – Introduction to Behavioral Finance]

• Overview of neoclassical economics
  • (1) Preference Relation
  • (2) Utility Function and Expected Utility Theory
  • (3) Brief Introduction to Behavioural Finance

[Part Two – Foundations of Finance]

• Foundations of Finance II: Asset Pricing, Market Efficiency and Agency Relationships
  • (1) Risk and Return Relationship
  • (2) CAPM model and Fama and French
  • (3) Market Efficiency (brief introduction = > more details in Topic 3)
  • (4) Agency Relationships and Corporate Governance

Part One

Neoclassical economics (normative theory)

1. Rational preferences

• Completeness
• Transitivity

2. Maximise utility

• The Expected Utility Theory of Prospect
• Properties of Utility Functions
• Certainty Equivalents

3. Independent decisions based on all “relevant” information

Introduction to Behavioural Finance

• Loss Aversion
• Representative
• Mental Accounting
• Fear of Regret

• Introduce neoclassical economics (traditional)

Part Two

Foundations of Finance

1. Portfolio Risk & Return

• Security/Portfolio Expected Return & Standard Deviations
• Efficient Frontier & CML

2. CAPM Model
3. Market Efficiency (more discussed in Lecture 3)
4. Agency Relationships & Corporate Governance

• Agency Costs (Direct vs Indirect)

• Some of the foundations concepts in finance
• EMH - need to know
  • not in the way of other finance courses, not the same as CAPM or EMH

Topic 2: Prospect Theory, Framing and Mental Accounting

Reference: AckertDeaves Chapters 3

[Part One – Prospect Theory]

• Overview about Prospect Theory
  • (1) Risk Aversion vs. Risk Seeking
  • (2) Development of Prospect Theory
• Prospect Theory Value Function
• The Weighting Function

[Part Two – Mental Accounting]

• Mental Accounting
  • (1) Integration vs. Segregation
  • (2) Theater Ticker Problems
  • (3) Opening and Closing Accounts

• utility function is upper sloping
• reference dependent
  • Treat positive versus negative domain differently

Prospect Theory

1. Risk aversion vs Risk seeking vs Loss aversion
2. Value Function

• Reference dependent
• Risk averse in positive domain
• Risk seeking in negative domain
  • Loss aversion

3. Weighting Function

• Overweighting low probabilities
• Underweighting medium-high probabilities
• Certainty effect

4. Framing & Mental Accounting Effect

• Segregation vs Integration (reference point)
• Silver lining effect & House money effect

• Influence our decision to be less rational

Topic 3: Challenges to Market Efficiency

Reference: AckertDeaves Chapters 4

[Part One – Efficient Market Hypothesis]

• Overview of Efficient Market Hypothesis
• Theoretical foundations and assumptions

[Part Two – Challenges to Market Efficiency]

• Rationales supporting the Efficient Market Hypothesis
• Theoretical Challenges and Empirical challenges

Market Efficiency

1. 3 levels of efficiency
2. Implications: Better off do passive investing
3. Random Walk vs. EMH

• “Prices are right” vs “No free lunch”

4. Theoretical Foundations

• Universal Rationality
• Uncorrelated Errors
• Unlimited Arbitrage

5. Rationales Supporting Efficiency vs
   Effective Trading Rules (Anomalies?)

• Challenges to EMH
  • under EMH, universal rationality
  • As long as we have unlimited arbitrage, it is ok too
• Have limits to arbitrage, however

Arbitrage

1. Triangular Arbitrage
2. Limits to Arbitrage

• Fundamental Risk
• Noise-trader Risk
• Implementation Costs

Topic 4: Overconfidence & Investors

Reference: AckertDeaves Chapters 6 & 9

[Part One – Overconfidence]

• Overview about Overconfidence
• Miscalibration / Other Strains of Overconfidence
• Factors Impeding Correction

[Part Two – The Impact of Overconfidence on Financial Decision-making]

• Overview: The Impact of Overconfidence on Financial Decision-making
• Overconfidence and Excessive Trading – A simple Model
• Under diversification and excessive risk taking

Overconfidence

Strains of Overconfidence

1. Miscalibration

• Calibration Tests
• Confidence Interval Approach

2. Better-Then-Average Effect
3. Illusion of Control
4. Excessive Optimism

Impact on Financial Decision-Making

1. Excessive Trading

• Unfounded belief in own ability to identify companies

1. Under Diversification

• Underestimating downside risks

• link with investment decision
• overconfidence - what it really is
• Different strains of overconfidence
  • Miscalibrated - mean value and range tests
    • Expected value you predict to have
    • 95% confidence interval, giving a narrow range indicates you think your answer is correct

Any questions asking about overconfidence

• If the question is not specific about a strain - saying they are saying
  • really specific strain - then be specific
• EXAM TIP - asking for more general bias, in particular 'showing' illusion of control e.g.
• Don't give extra assumptions

Impact on decision making

• underdiversification - illusion of control - maybe a bit of miscalibration
  • underestimation of the risk that they may encounter

Topic 5: Application of Managerial Overconfidence

Reference: AckertDeaves Chapters 6 & 9

[Application of Managerial Overconfidence]

• Brief Introduction: Application of Managerial Overconfidence
• Capital Budgeting:
• Payback and Ease of Processing,
• Allowing Sunk Costs to Influence the Abandonment Decision,
• Allowing Affecting to Influence Choices
• Managerial Overconfidence
• Investment and Overconfidence
• Can Managerial Overconfidence have a Positive Side?

Managerial Overconfidence

Capital Budgeting

1. Ease of Processing
2. Loss Aversion (Abandonment)

• Sunk Costs
• Ex-Post Mistake
• Attachment/Involvement

3. Affect

Managerial Overconfidence

1. Overinvestment

• Unfounded belief in own ability to identify companies

2. Higher Sensitivity of Investment to Cashflows
3. More Active in M&A
4. Too Quick to Start New Businesses

• CEO Overconfidence Not All Negative

• institutional - more knowledgable
  • Still exhibit overconfidence but for different reasons
• Managers decision can be affected
  • Capital budgeting
  • Should act in the best interest of shareholders
• Make decision based on the best approach - may choose the other because it is easier
• Loss Aversion
  • Start an investment, do not stop evaluation
  • Should not continue, stop/terminate it but do not because of loss aversion
  • Take into account sunk cost
  • Treat it as the money that you pay

Affects will influence decision making as well

• may choose something suboptimal but may have a positive feeling

Managerial overconfidence

• Tend to overinvest
• Higher sensitivity to cashflows
• Not all overconfidence is bad

Topic 6: Heuristics & Biases

Reference: AckertDeaves Chapters 5 & 8

[Part One – Application of Heuristics and Biases]

• Brief Introduction: Application of Heuristics and Biases
• Perception, Memory and Heuristics
• Familiarity & Representatives and Related Heuristics
• Anchoring; Irrationality and Adaptions

[Part Two – Implications of Heuristics and Biases for Financial Decision-Making]

• Introduction: Implications of Heuristics and Biases for Financial Decision-Making
• Financial Behavior Stemming from Familiarity & Representativeness
• Anchoring to Available Economic Cues

Part One

• Perception & the Frame

  • Primacy vs Recency Effects

• Heuristics (Mental Shortcuts)

  • Type 1 (Autonomic)
  • Type 2 (Cognitive)
    • E.g. Ambiguity Aversion, Endowment Effect

• Representativeness

  • Conjunction Fallacy (Joint Probability)
  • Base Rate Neglect (Bayes’ Rule)
  • Hot Hand Phenomenon & Gambler’s Fallacy
  • Overestimating Predictability

• Bias Related to Representativeness

  • Recency
  • Salience
  • Availability

• Anchoring

  • Seems contradicting with Representativeness
  • Coarsely Calibrated

• perceptions will effect how we evaluate situations
  • different heuristics
• not always influenced by primacy or recency effects
  • Time gap in between, more effect by the latency effect

Heuristics

• Mental shortcuts
• not the same as mental biases
• Type 2 heuristics can override type 2 decision

Representativeness

• Two most important is conjunction fallacy and base rate neglect
• Conjunction
  • thinking the joint has a higher probability that the base rate
• Base rate neglect
  • Conditional probability - forecasting rent e.g.
  • Adding new information, influenced and miscalculate the base rate
  • Difficult calculations from the course

Hot hand phenomenon

• Really good past performance, high chance they are going to perform good in future

Gamblers fallacy

• complete opposite

Overestimating predictability

• Overestimating the predictability of using one to predict the other

Salience

• What information are we using to represent something else
• More dramatic, going to be in your memory more

Availability

• Easier to recall, effected by that more

Anchoring

• not adjusting
• contradicting representativeness
  • Which is more influence by later information
• More effected by new information
• Can suddenly switch to representativeness

Part Two

• Home Bias
  • Implied Under Diversificaiton
  • Language & Culture
  • Information Advantage
• Representativeness
  • Good Companies vs. Good Investments
• Anchoring
• Momentum-Chaser vs. Contrarian

• tend to under-diversify our portfolio
  • nationally - know language/culture, safer decision

Representatives

• Tend to think good companies are good investments
  • Good management characteristics, making good products
  • Should already be reflected in the price
  • Good companies does not mean they are good investments

Momentum anomalies

• Look at momentum,
• see something increasing, believe it is going to decrease

Topic 7: Emotional Foundations and Individual Investors

Reference: AckertDeaves Chapters 7 & 10

[Part One – Emotional Foundations]

• Brief Introduction: Emotional Foundations
• The Substance of Emotion
• Cognitive Antecedents; Intentional Objects, Physiological Arousal; Physiological Expressions; Valence; Action Tendencies
• A Short History of Emotion Theory
• Evolutionary Theory
• The Brain / Emotion and Reasoning

[Part Two – Individual Investors and the Force of Emotion]

• Brief Introduction: Individual Investors and the Force of Emotion
• Is the Mood of Investor the Mood of the Market / Pride and Regret
• The Disposition Effect (Important)
• House Money / Affect

Emotions

• Substance of Emotion (6 of them)

• History of Emotion Th

  • Evolutionary Theory

• The Brain

• Emotion & Reasoning

  • Phineas Gage & Elliot

• Emotion is not all Bad

• Pride & Regret

• Disposition Effect

  • Tendency to sell the winners too early and hold on to losers too long
  • Explain using Prospect Theory & Mental Accounting

• Sequential Decisions

  • House Money Effect (Winning)
  • Snake-Bit Effect & Break-Even Theory (Losses)

• Affect

• Six things to meet an emotion

History of emotion theory

• All treated as a conscious response

• Evolutionary theory treated differently

• Communicate more effectively

  • Can be a reaction

• NOT TESTED ON BRAIN

• Frontal lobe effecting emotion

• Emotions help you make decisions and negotiate better as well

Pride and regret

• Linked to loss aversion

Disposition effect

• Emotional side, because of pride and regret
• tendency to sell winners early and hold onto losers
• risking seeking and risk aversion aligning with prospect theory

Sequential decisions

• contradiction with prospect theory
• Don't have a proxy to identify sequential decisions

Snake bit effect

• Loss now, dont want to lose more

Break-even

• more risk-seeking to regain the losses

Topic 8: Behavioural Explanations for Anomalies

Reference: AckertDeaves Chapters 13

[Behavioral Explanations for Anomalies]

• Brief Introduction: Behavioral Explanations for Anomalies
• Earnings Announcements and Value vs. Growth
  • What is behind lagged reactions to earnings announcements
  • What is behind the value advantage
• What is Behind Momentum and Reversal
  • Daniel -Hirshleifer -Subrahanyam Model
  • Grinblatt -Han Model and Explaining Momentum
  • Barberis -Shleifer -Vishny Model and Explaining Momentum and Reversal
• Rational Explanations
  • Important Risk Adjustment
  • Fama-French Three Factor Models/Factor Zoo – Tutorial

Anomalies

• Value Premium
  • Mistakes of Judgment
  • Agency Considerations
• Momentum & Reversal
  • DHS Model (Reversal)
  • GH Model (Momentum)
  • BSV Model (Momentum & Reversal)
• Rational Explanation
  • Inappropriate Risk Adjustment
  • Fama-French 3 Factors Model
• Factor Zoo Concern

• Value firms outperform growth firms
  • Value firms tend to sell at a cheaper price
  • How do you know they are undervalued?
  • Doesn't work with traditional model

Mistakes on Judgement

• Error in expectations
• Growth stocks will perform a lot better
• representativeness
  • Talking about portfolio performance in general

Agency

• growth stocks portfolio for agency issue
  • easier to explain for investors
  • Value stocks to realise returns takes longer

Momentum and reversal

• Momentum is the underreaction
• reversal is the overreaction
  • DHS - overconfidence
  • Calculations, rational investor will predict the price
  • GH
  • Not adjusting reference point quickly enough
  • Reference point is not adjusting quick enough to fundamental value
  • Underreaction, not to the fundamental because the reference point is not changing
  • Do not worry about big equations, but understand how it works

BSV

• Overreaction and underreaction
• Even though share price should be random walk, cannot predict future
• Believe market is in regime 1 or 2, changing or persistent
• belief effects reaction to past earning
• In regime 1, underreact to past earning signals
• Underreact to new information
• Regime 2, overreact - positive is going to continue

Factor Zoo

• Other things included
• Include all different factors (over 300 in some model)
  • Really identifying new factors,

Topic 9: Behavioural Factors & Stock Market Puzzles

Reference: AckertDeaves Chapters 14

[Behavioral Factors and Stock Market Puzzles]

• Brief Introduction: Behavioural Explanations for Stock Market Puzzles
• Equity Premium Puzzle
  • The Equity Premium
  • Why is the Equity Premium a Puzzle?
  • What Can Explain This Puzzle?
• Real-World Bubbles
• Experiment Bubble Market
  • Design of Bubbles Markets
  • What can we learn from these experiments?
• Excessive Volatility / Markets in 2008

Puzzles

• Equity Premium Puzzle
  • Extreme Risk Aversion (Rational)
  • Ambiguity Aversion (Behavioural)
  • Myopic Loss Aversion (Behavioural)
• Bubbles
  • Greater Fool Theory
• Excessive Volatility
  • Overreaction
  • Recency Effect

• Equity earns higher returns for given risk level
  • investors have to be extremely risk averse
  • Behaviour averse and ambiguity averse
• Don't want to engage in something that we don't have some degree of control
• More reluctant to join

Myopic

• more frequently you evaluate, to more risky it appears

Bubbles

• False belief in fundamental stuff
• Price continue to increase - more unrealistic
  • greater fool theory, people jumping in and pushing the price further away
• Investors more experienced, more motivated and can disappear quicker
• Short selling will make bubbles disappear faster as well

Excessive volatility

• Public information effects market price
• market is more volatile than what the market says
• Overreaction
• Growth rate, be only for a short period of time
  • Treat that as a permanent change
  • overreact to negative or positive news

Recency effects

• rely on new information too much
• Causing overreaction to current information

Topic 10: Behavioural Investing

Reference: AckertDeaves Chapters 19

• 10-1: Anomaly Attenuation, Style Peer Groups, and Style Investing
• 10-2: Refining Anomaly Capture:
  • Refining Value Investing using Accounting Data
  • Refining Momentum-Investing using Volume
  • Momentum and Reversal (Value)
• 10-3: Multivariate Approaches
• 10-4: Style Rotation
• 10-5: Is It Possible To Enhance Portfolio Performance Using Behavioral Finance
  • Early Evidence
  • What is Behavioral Investing

Puzzles

• Anomaly Attenuation

  • Anomaly dissipation is expected in efficient market

• Peer Group

• Style Investing

  • Style Tilting vs. Style Rotation

• Refining Value Investing (Accounting Data)

• Refining Momentum Investing (Volume)

• Momentum & Reversal

  • Term Structure & Consistency

• Momentum & Value

• Multivariate Approaches

• Can Behavioural Finance Enhance Portfolio Performance?

  • No Conclusion

Anomalies

• Not behaving the same as EMH
• Should use it to capture profits

Peer group Evaluation

• Based on strategies - linked to style investing
• Should still diversify
• Tilting, more general - add slightly more in value firms
  • rotation, more aggressive, based on short term evaluation

Refine value investing

• Simply using accounting data with F-score

Momentum

• Capture momentum cycle, capture the timing to enter/buy stock
• Capture using volume

Momentum and reversal

Momentum and Value investing

• Do not see these effects, capturing different things, small portfolio capturing both criteria

Multivariate

• look at all the factors
• separate into five categories, found that we can outperform the market
• momentum, value and volumes are the three values that are most inportant

Does behavioural finance actually work?

• not providing strong evidence suggesting otherwise

Final Exam

• Final examination will be held centrally by the University at the specified time. The final exam will be a face to face on campus exam.
• There is NO formula sheet attached to the exam
• Reading: 10 minutes
• Duration: 120 minutes
• Format: Short answer, Short essay, Problem solving
• Task Description: The final assessment will be based on all materials covered in the course (from Topics 1-10). The exam includes short answers, short essays, and problem-solving questions. No MCQ

• need to know how to apply that in a scenario

How to Prepare for the Exam

• Go through the slides in detail (including examples)
• Practice lecture examples, tutorial questions, & practice exam and try to get a deep understanding of the examples and questions.
• Read the reference chapters of the textbook and other references (for the relevant content)
• It is more important to understand the concepts and know how to apply them, rather than simply memorising the definitions (won’t give you full marks)