presentation on the topic of behavourial finance

hi

1. An Introduction to Behavioral Financ e

2. ‹#›

3. Modern financial economics relies on the notion of efficient markets which assumes that individuals act in a rational way. In particular, the whole field is based on the assumption that the “representative agent” is rational which does not imply that all agents are rational. An Introduction to Behavioral Finance ‹#›

4. Behavioral Finance is the study of the way in which psychology influences the behavior of market practitioners, both at the individual and group level, and the subsequent effect on markets. According to Thaler and Barberis (2002) , market imperfections has two building blocks: limits to arbitrage and psychology . Arbitrage is the process of exploiting differences in the price of an asset by simultaneously buying and selling it. In the process the arbitrageur pockets a risk-free return. Differences in prices usually occur because of imperfect information. When people realize that a security is cheaper in one market than another, their interest in exploiting the opportunity will drive up the price of the "cheap" security and drive down the price of the "expensive" security until there is no longer a price difference ‹#› An Introduction to Behavioral Finance

5. Efficient markets hypothesis Large number of market participants Incentives to gather and process information about securities and trade on the basis of their analysis until individual participant’s valuation is similar to the observed market price Prices in such markets reflect information available to the participants, which means opportunities to earn above-normal rates of return on a consistent basis are limited An Introduction to Behavioral Finance (contd..) ‹#›

6. Limits to arbitrage seek to explain the existence of arbitrage opportunities which do not quickly disappear. It is associated with arbitrageurs coexisting with not -fully rational investors in the market and themselves not being able to profit from market dislocations. Behavioral finance researchers often need to specify the form of the agents’ irrationality. This is related to how they misapply Bayess law or deviate from the Subjective Expected Utility theory. ‹#›

7. Behavioral finance Widespread evidence of anomalies is inconsistent with the efficient markets theory Bad models, data mining, and results by chance Alternatively, invalid theory Challenge in developing a behavioral finance theory of markets Evidence of both over- and under-reaction to events ‹#› An Introduction to Behavioral Finance

8. Behavioral finance theory rests on the following three Assumptions/characteristics Investors exhibit information processing biases that cause them to over- and under-react Individual investors’ errors/biases in processing information must be correlated across investors so that they are not averaged out Limited arbitrage: Existence of rational investors should not be sufficient to make markets efficient ‹#› An Introduction to Behavioral Finance

9. Human information processing biases Information processing biases are generally relative to the Bayes rule for updating our priors on the basis of new information Two biases are central to behavioral finance theories Representativeness bias (Kahneman and Tversky, 1982) Conservatism bias (Edwards, 1968). Other biases: Over confidence and biased self-attribution ‹#› Behavioral finance theories

10. Human information processing biases Representativeness bias causes people to over-weight recent information and deemphasize base rates or priors E.g., conclude too quickly that a yellow object found on the street is gold (i.e., ignore the low base rate of finding gold) People over-infer the properties of the underlying distribution on the basis of sample information For example, investors might extrapolate a firm’s recent high sales growth and thus overreact to news in sales growth Representativeness bias underlies many recent behavioral finance models of market inefficiency ‹#› Behavioral finance theories

11. Human information processing biases Conservatism bias: Investors are slow to update their beliefs, i.e., they underweight sample information which contributes to investor under-reaction to news. Conservatism bias implies investor under reaction to new information ‹#› Behavioral finance theories

12. Human information processing biases Investor overconfidence Overconfident investors place too much faith in their ability to process information Investors overreact to their private information about the company’s prospects Biased self-attribution Self-attribution bias is a long-standing concept in psychology research and refers to individuals’ tendency to attribute successes to personal skills and failures to factors beyond their control. ‹#› Behavioral finance theories

13. Recently, this bias is also being studied in household finance research and is considered to underlie and reinforce investor overconfidence. To date, however, the existence of self-attribution bias amongst individual investors is not directly empirically tested Overreact to public information that confirms an investor’s private information Underreact to public signals that disconfirm an investor’s private information Contradictory evidence is viewed as due to chance ‹#›

14. Human information processing biases Investor overconfidence and biased self-attribution In the short run, overconfidence and biased self-attribution together result in a continuing overreaction that induces momentum. Subsequent earnings outcomes eventually reveal the investor overconfidence, however, resulting in predictable price reversals over long horizons. Since biased self-attribution causes investors to down play the importance of some publicly released information, information releases like earnings announcements generate incomplete price adjustments. ‹#› Behavioral finance theories

15. In addition to exhibiting information-processing biases, the biases must be correlated across investors so that they are not averaged out People share similar mentality. Focus on those that worked well in our evolutionary past Therefore, people are subject to similar biases Experimental psychology literature confirms systematic biases among people ‹#› Behavioral finance theories

16. Behavioral finance assumes arbitrage is limited. What would cause limited arbitrage? Economic incentive to arbitrageurs exists only if there is mispricing Therefore, mispricing must exist in equilibrium Existence of rational investors must not be sufficient Notwithstanding arbitrageurs, inefficiency can persist for long periods because arbitrage is costly Trading costs: Brokerage, Holding costs: Duration of the arbitrage and cost of short selling Information costs: Information acquisition, analysis and monitoring ‹#› Behavioral finance theories

17. Investors exhibit many behavioral biases If the biases are similar across individuals and arbitrage forces are limited, then the behavioral biases can cause prices to deviate systematically from economic fundamentals Recent attempts to test the effects of behavioral biases in stock price data Aggregate earnings data and stock returns Individual firms’ financial data and stock returns Stock returns associated with external financing decisions Stock returns due to investors’ alleged inability to process information in accounting accruals ‹#› Conclusions

18. Box 1: 16 Box 2:30 Box 3:? ‹#›