Behavioral Finance – A Challenge to Market Efficiency

1. Behavioral Economics Dr. D. Kuebler, SS2003 Behavioral Finance – A Challenge to Market Efficiency Henry Fiebelkorn

2. Structure Introduction Behavioral Finance and Overview I Market Phenomena - Anomalies II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Summary and Outlook V

3. Introduction „Modern finance theorists have turned finance into a science, but they forgot that it is a social science!“ BF:is the application of psychology to financial behavior – the behavior of practioners. Aim: recognize, understand and avoid mistakes. State of Modern Finance: Perfect Markets & Perfect People Current State: Imperfect Markets & Perfect People Behavioral Finance: Imperfect Markets & Imperfect People

4. Classification Behavioral Finance Heuristics Self-Concept Framing Aspects Representativeness Availability Anchoring Ambiguity Aversion Overconfidence Self-Attribution Cognitive Dissonanz Self-Control Confirmation Bias Herding Conservatism Mental Accounting Prospect Theory • Underlying Concepts: • Bounded Rationality • Emotions

5. Structure Introduction Behavioral Finance and Overview I Market Phenomena - Anomalies II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Summary and Outlook V

6. Anomalies Volume Volatility • Anomalies are consistent • 2. Violate the Efficient Market Hypothesis Dividends Equity Premium Puzzle Book-to-Market Ratio

7. Structure Introduction Behavioral Finance and Overview I Market Phenomena - Anomalies II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Summary and Outlook V

8. Existing Approaches Model of Investor Sentiment “Inefficient Markets” by Shleifer (2000) Information Trader Noise Trader • Abitrageurs: • Follow Standard CAPM:No cognitive errors • Utility expressed motives • Try to exploit Noise Trader • Outside CAPM (BAPM): • Cognitive errors: listen to gurus, follow rumors • Value expressed motives • = Investor Sentiment

9. Existing Approaches Model of Investor Sentiment • Abitrage is limited because: • Securities don´t have obvious substitutes • Abitrage is risky (Risk Aversion) • Noise Trader Risk Price changes in absence of fundamental news! Belief about Noise Trader determines price

10. Existing Approaches Model of Investor Sentiment Price Determination: Two Earning Regimes: News News • Prior views • No revaluation due to • give up old model • Attach to new model due to Conservatism Representativeness Underreaction Overreaction

11. Existing Approaches BSV - Model Captures 2 Judgement Biases: Barberis, Shleifer, Vishny(1998) Investors: 2 Earning Regimes: Barberis, Shleifer, Vishny(1998) (+) Long-term- Change Firms´ earnings are trending Representative-ness Bias (-) Earnings are meanreverting Change temporarely Conservatism Overreaction of Stock Prices Underreaction of Stock Prices

12. Existing Approaches DHS - Model Captures 2 Judgement Biases: Daniel, Hirshleifer, Subramanyam(1997) Overconfidence Self-Attribution (-) (+) Exaggerate Privat Information Downweight Public Information Special Prediction: Selective Items

13. Existing Approaches Behavioral Asset Pricing Model (BAPM) BAPM Rational Utility Enable user to identify value of products Utilitiancharacteristics value expressedcharacteristics Risk: Automobiles : Laundry Strong: Jewelry Less: Automobiles Absent: Laundry “Behavioral Asset Pricing Theory” by Shefrin, Statmen (1994) Utilitarian characteristics vs. Value expressed characteristics (Timex /Rolex example) 16

14. Model Requirements Identification of preferences of the buyers/sellers Characteristics capturing value expressive (VEC) & utilitarian preferences (UC) • Behavioral Asset Pricing Model: • Should include: • What investors think • How they asses risk • How they forecast growth • What rules they follow Conclude with equilibrium prices

15. Structure Introduction Behavioral Finance and Overview I Market Phenomena - Anomalies II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Summary and Outlook V

16. Applying Behavioral Finance Investors Limitations • External • Biases information • Limitation of time &resources • Practical restrictions • Internal • Mental Accounts • Heuristics • Self-Deception

17. Applying Behavioral Finance Emotional Feelings Performance Pressure Overload of Information Biased Information Investor Heuristics Time & Resource Constraints Practical Restrictions Uncertainty

18. Applying Behavioral Finance Coping with Limited Rationality 1. Identify / Framing „People are intendedly rational but limited to do so!“ 2. Editing 3. Decomposition 4. Heuristics

19. Applying Behavioral Finance • Investment Strategies • Value Investing • Mean Reversion Strategy • Momentum Strategy • Event Studies • Earning Revision Strategies • Combination Studies • Behavior: • Overreaction • Underreaction • Extrapolation • Herd Behavior

20. Applying Behavioral Finance Behavioral Finance leads to product development • Guaranteed products • RenteMaXX • Best of World Garant Fund Loss Aversion Overconfidence • Daytrading • Hedge Funds: • Event driven • Opportunistic • Relative value Absolute Return

21. Structure Introduction Behavioral Finance and Overview I Market Phenomena - Anomalies II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Summary and Outlook V

22. Summary What lessons does Behavioral Finance teach us? ll Market Investor • Be aware of information biases: • seek and screen information actively • 2. Avoid narrow framing, anchoring, overconfidence • 3. Follow rules of decision making under uncertainty • Market and people are imperfect • There are systematic and recurring market inefficiencies • Anomalies are consistent and can´t be ignored • Sensible implementation of irrational human behavior into asset pricing models necessary • VEC as well as UC must be included Thanks for your attention!