Primary difference between traditional financial theory and behavioral finance theory
(BKM - 12)
traditional financial theory assumes investors are rational, behavioral finance theory does not
Complaint from behavioral financial theorists about traditional financial theory
(BKM - 12)
traditional financial theory ignores how people actually make decisions and that people make a difference (b/c investors do not always behave rationally)
Types of irrationalities under behavioral financial theory (2)
(BKM - 12)
- information processing errors
2. behavioral biases
Information processing errors
BKM - 12
mis-estimations of probabilities of events or the associated ROR
Behavioral biases
BKM - 12
investors often make inconsistent, sub-optimal, or otherwise irrational decisions
Types of information processing errors (4)
BKM - 12
- forecasting errors
- overconfidence
- conservatism
- sample size neglect & representativeness bias
Forecasting errors (aka memory bias) information processing error & related phenomenon explained
(BKM - 12)
tendency to give too much weight to recent experience compared to prior beliefs when making forecasts
> > may explain why high P/E ratio firms perform worse than low P/E ratio firms
Overconfidence information processing error & related phenomenon explained
(BKM - 12)
investors overestimate their ability to accurately predict stock returns
> > may explain popularity of active portfolio management despite underperformance
Conservatism information processing error & related phenomenon explained
(BKM - 12)
investors may be too slow to update beliefs in response to new information
> > may explain the momentum effect if investors are slow to recognize news
Sample size neglect & representativeness bias information processing error & related phenomenon explained
(BKM - 12)
investors may not account for sample size & treat small samples as though they are equally representative compared to large samples (e.g. infer patterns too quickly and extrapolate them too far into the future)
> > consistent with overreaction & correction anomalies
Types of behavioral biases (5)
BKM - 12
- framing
- mental accounting
- regret avoidance
- affect
- prospect theory
Framing behavioral bias
BKM - 12
decisions are impacted by how choices are framed
> > risky gains are more likely to be rejected compared to risky losses
Mental accounting behavioral bias
BKM - 12
investors differentiate decision making based on different goals that may elicit different levels of risk aversion
ex: standard brokerage account vs. child’s education fund
Anomalies that may be explained by the mental accounting behavioral bias (2)
(BKM - 12)
- disposition effect
- momentum in stock prices - more willing to invest more when they are ahead because the funds are viewed as coming from capital gains vs. out of pocket
Regret avoidance behavioral bias and anomalies explained (2)
(BKM - 12)
investors feel more regret when less convential investments go bad (b/c it reflects bad decision making vs. bad luck)
> > may explain:
- small firm effect
- high book-to-market ratio effect
Affect behavioral bias
BKM - 12
feeling of “good” or “bad” that investors may attach to a stock
Examples of affect behavioral bias (3) and trend in prices and ROR
(BKM - 12)
- public perception of socially responsible policies
- attractive working conditions
- popular products
generally see increased prices and lower ROR
Prospect theory behavioral bias and findings (2)
BKM - 12
alternative view of relationship b/w wealth and risk aversion that plots utility against changes in wealth and finds:
- risk aversion does not decrease as wealth increases
- investors are risk-seeking regarding losses
Traditional relationship between utility, wealth, and risk aversion
(BKM - 12)
utility increases at a decreasing rate as wealth increases»_space; leads to higher risk aversion
Reason that mis-pricing from behavioral biases does not lead to arbitrage opportunities under behavioral finance theory
(BKM - 12)
b/c of the limits to arbitrage
Limits to arbitrage under behavioral finance theory (3)
BKM - 12
- fundamental risk
- implementation costs
- model risk
Fundamental risk limit to arbitrage
BKM - 12
risk of under-pricing becoming worse in the short-term when buying an under-priced stock
(e.g. price does not converge to it’s intrinsic value within the investment horizon)
Implementation cost limit to arbitrage & examples (3)
BKM - 12
possible to profit from short-selling when securities are over-priced, but high costs of short-selling can be a barrier
Ex:
- high cost to borrow shares
- short-selling may not be possible due to trading restrictions
- shares may not even be available to short
Model risk limit to arbitrage
BKM - 12
risk that the model used to identify mis-priced securities is flawed
> > makes exploiting arbitrage opportunities risky
-
BKM Chapter 627
-
BKM Chapter 725
-
BKM Chapter 834
-
BKM Chapter 948
-
BKM Chapter 1030
-
BKM Chapter 1152
-
BKM Chapter 1239
-
BKM Chapter 1469
-
BKM Chapter 1528
-
BKM Chapter 1648
-
BKM Chapter 2323
-
Panning29
-
Coval35
-
Cummins - Capital52
-
Cummins - CAT40
-
Butsic40
-
Goldfarb76
-
Bodoff39
-
Ferrari23
-
McClenahan15
-
Feldblum42
-
Robbin - UW50
-
Robbin - IRR48
-
Kreps48
-
Mango44
-
Excel formulas & tricks1
