Behavioral Finance

Behavioral finance is a new field in finance, which has been the subject of an increasing amount of research over the last few years. Over the entire history of finance research, it has been believed that markets are efficient and that prices reflect fundamental values. One reason for these beliefs is that even if investors are biased, these biases should not be systematic. In other words, while different investors may have different biases, these biases should all wash out in the cross-section. In addition, even if investors are systematically biased, unbiased rational investors should be able to take advantage of these biases and irrational investors should eventually be driven out of the market – a survival of the fittest type argument.

Over the last decade however, a number of researchers have documented that, contrary to the efficient markets and portfolio theory hypotheses, anomalies can be observed in returns to firms after an enormous variety of corporate events – from mergers to share repurchases to stock splits.

Classical finance

The paradigms of classical finance and the roles of securities prices in the economy; Asymmetric information; Efficient markets hypothesis (EMH): Definitions; EMH in supply and demand framework; Theoretical arguments for flat aggregate demand curve; Equilibrium expected returns models; Key methodologies; Pro-EMH evidence

In the beginning (i.e. the 1960s), there was the efficient markets hypothesis.

  • Fama, Eugene, Lawrence Fisher, Michael C. Jensen, and Richard R. Roll, 1969, The adjustment of stock price to new information, International Economic Review, 10: 1-21.
  • Jensen, Michael C., 1968, The performance of mutual funds in the period 1945-1964, Journal of Finance, 23: 389-416.

Early authors found strong empirical support for the efficient markets hypothesis.

  • Fama, Eugene, 1970, Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25: 383-417.

And markets still react efficiently.

  • Busse, Jeremy and T. Clifton Greene, 2002, Market Efficiency in Real Time, Journal of Financial Economics, 65 (3): 415-437.

Some motivating evidence for behavioral finance

Return predictability in the stock market; Data mining; Joint hypothesis problem; Predictability in bonds, forex, futures, real estate, and options.

Over the past few decades, a number of curious patterns in asset returns have been discovered. Such patterns include the market reaction to news and non-news:

  • Cutler, David M., James M. Poterba, and Lawrence H. Summers, 1989, What moves stock prices?, Journal of Portfolio Management 15: 4-12.
  • Huberman, Gur, and Tomer Regev, 2001, Contagious speculation and a cure for cancer: A non-event that made stock prices soar, Journal of Finance, 56(1): 387-396.
  • Shiller, R.J., 1981, Do stock prices move too much to be justified by subsequent changes in dividends?, American Economic Review, 71: 421-36.
  • Rashes, Michael S., 2001, Massively Confused Investors Making Conspicuously Ignorant choices(MCI-MCIC), Journal of Finance, 56(5): 1911–1927.

They also include patterns of return predictability in stocks:

  • Lakonishok, Josef, and Seymour Smidt, 1988, Are seasonal anomalies real? A ninety-year perspective, Review of Financial Studies 1 (4): 403-425.
  • Cooper, Michael C., John J. McConnell and Alexei Ovtchinnikov, 2007, The other January effect, Journal of Financial Economics, 82, 315-341.
  • Bernard, Victor L. and Jacob K. Thomas,1989, Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium? Journal of Accounting Research, 27: 1-36.
  • Fama, Eugene, and Kenneth R. French, 1992, The cross-section of expected stock returns. Journal of Finance 47: 427-465.
  • Fama, Eugene F. and Kenneth R. French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3-56.
  • Daniel, Kent, and Sheridan Titman, 1997, Evidence on the characteristics of cross-sectional variation in stock returns, Journal of Finance 52: 1-33.
  • DeBondt, Werner F.M., and Thaler, Richard, 1985, Does the Stock Market Overeact? Journal of Finance, 40:793-805.
  • Lo, Andrew, and A. Craig MacKinlay, 1990, When are contrarian profits due to stock market overreaction? Review of Financial Studies 3: 175-206.
  • Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48: 65-91.
  • Lakonishok, Josef, Shleifer, Andrei, and Vishny, Robert, 1994, Contrarian investment, extrapolation, and risk, Journal of Finance, 49:1541-78.
  • La Porta, Rafael, Lakonishok, Josef, Shleifer, Andrei, and Vishny, Robert, 1997, Good news for value stocks: Further evidence on market efficiency, Journal of Finance, 52:859-74.
  • Fama, Eugene, and Kenneth R. French, 1989, Business conditions and expected returns on stocks and bonds, Journal of Financial Economics 25: 23-49.

There are also curious predictability patterns in bonds, options, forex, futures, real estate, and sports track betting.

  • Stein, Jeremy, 1989, Overreactions in the options market, Journal of Finance 44, 1011-1022.
  • Froot, Kenneth A., and Richard H. Thaler, 1990, Anomalies: Foreign Exchange, Journal of Economic Perspectives 4:3 (Summer 1990), 179-192.
  • Roll, Richard, 1984, Orange Juice And Weather, American Economic Review, 74, 861-80.
  • Boudoukh, Jacob, Matthew Richardson, YuQing Shen, and Robert F. Whitelaw, 2007, Do asset prices reflect fundamentals? Freshly squeezed evidence from the OJ market, Journal of Financial Economics 83, 397-412.
  • Case, Karl E., and Robert J. Shiller, 1989, The efficiency of the market for single-family homes, American Economic Review 79: 125-137.
  • Liao, Hsien-hsing, and Jianping Mei, 1998, Risk characteristics of real estate related securities: An extension of Liu and Mei (1992), Journal of Real Estate Research 16, 279-290.
  • Hausch, Donald B. and William T. Ziemba, 1990, Arbitrage strategies for Cross-Track betting on major horse races, Journal of Business, 63, 61-78.

Why do these anomalies persist?

Definition of arbitrageur; Long-short trades; Risk vs. Horizon; Transaction costs and short-selling costs; Fundamental risk; Noise-trader risk; Professional arbitrage; Destabilizing informed trading (positive feedback, predation)

Market prices reflect supply and demand. Aggregate demand can be usefully broken down into the demand of rational and/or highly sophisticated investors, which we’ll call arbitrageurs, and the demand of typical human investors. The survival of the fittest argument mentioned in the introduction says that sophisticated unbiased rational investors should be able to take advantage of biases of individual investors who should eventually be driven out of the market. This section examines the limits to arbitrage – why the arbitrageurs may not be able to return the markets to complete efficiency.

  • Shleifer, Andrei, Inefficient Markets (first chapter).
  • Wurgler,Jeffrey, and Ekaterina V. Zhuravskaya, 2002, Does arbitrage flatten demand curves for stocks? Journal of Business 75, 583-608.

There are a range of costs and risks that deter would-be arbitrageurs.

  • D’Avolio, Gene, 2002. The market for borrowing stock. Journal of Financial Economics 66, 271-306.
  • Miller, Edward M., 1977, Risk, uncertainty, and divergence of opinion, Journal of Finance 32, 1151-1168.
  • Chen, Joseph, Harrison Hong, and Jeremy C. Stein, 2002, Breadth of ownership and stock returns, Journal of Financial Economics 66, 171-205.
  • Jones, Charles M., and Lamont, Owen A., 2002. Short sale constraints and stock returns. Journal of Financial Economics 66: 207-239.
  • Lamont, Owen A., and Richard H. Thaler, 2003, Can the market add and subtract? Mispricing in tech stock carve-outs, Journal of Political Economy 111, 227-268.
  • Mitchell, Mark, Todd Pulvino, and Erik Stafford, 2002, Limited arbitrage in equity markets, Journal of Finance 57, 551-584.
  • Ofek, Eli, Matthew Richardson, and Robert F. Whitelaw, 2004, Limited arbitrage and short sales restrictions: Evidence from the options markets, Journal of Financial Economics 74, 305.
  • Shleifer, Andrei, Inefficient Markets (ch. 4 on delegated arbitrage; based on Shleifer, Andrei, and Robert Vishny, 1997, The limits of arbitrage, Journal of Finance 52: 35-55.)
  • Shleifer, Andrei, Inefficient Markets (ch. 2 on noise trader risk; based on DeLong, Brad, Andrei Shleifer, Lawrence Summers, and Robert Waldmann, 1990, Noise trader risk in financial markets, Journal of Political Economy 98: 703-738).
  • Shleifer, Andrei, Inefficient Markets (ch. 3 on closed-end funds; based on Lee, Charles M., Andrei Shleifer, and Richard Thaler, 1991, Investor sentiment and the closed-end fund puzzle, Journal of Finance 46: 75-110).
  • Froot, Kenneth A., and Emil Dabora, 1999, How are stock prices affected by the location of trade? Journal of Financial Economics 53, 189-216.

In certain circumstances, the smart-money trade may actually reduce market efficiency.

  • Shleifer, Andrei, Inefficient Markets (ch. 6 on positive feedback trading; based on DeLong, Brad, Andrei Shleifer, Lawrence Summers, and Robert Waldmann, 1990, Journal of Finance 45: 375-395).
  • Brunnermeier, Markus K., and Lasse Heje Pedersen, 2004, Predatory trading, Journal of Finance , forthcoming.
  • Brunnermeier, Markus K., and Stefan Nagel, 2004, Hedge funds and the technology bubble, Journal of Finance 59, 2013-2040.

What are investor behavioral aspects that might influence prices?

Definition of average investor; Belief biases; Limited attention and categorization; Nontraditional preferences, prospect theory and loss aversion; Social interaction, bubbles, and systematic investor sentiment

Typical human investors hold divergent opinions about individual assets, but on any given day opinions tend to move in the same direction.

  • Bagwell, Laurie Simon, 1992, Dutch auction repurchases: An analysis of shareholder heterogeneity, Journal of Finance 47, 71-105.
  • Barber, Brad, Terrance Odean, and Ning Zhu, 2003, Systematic noise, UC Davis working paper.

Systematic investor sentiment ultimately derives from common cognitive limitations and systematic biases in investors’ perceptions.

  • Tversky, Amos and Daniel Kahneman, 1974, Judgement Under Uncertainty: Heuristics and Biases. Science, 185:1124-31.
  • Kahneman, Daniel, 2003, Maps of bounded rationality: Psychology for behavioral economics. American Economic Review 93: 1449-1475.
  • Kahneman, Daniel, and Riepe, Mark, 1998, Aspects of Investor Psychology. Journal of Portfolio Management, 24:52-65.
  • Shleifer, Andrei, Inefficient Markets (ch. 5 on a model of investor sentiment; based on Barberis, Nick, Andrei Shleifer, and Robert Vishny, 1998, A model of investor sentiment, Journal of Financial Economics 49: 307-343).
  • Poteshman, Allen M., 2001, Underreaction, overreaction, and increasing misreaction to information in the options market, Journal of Finance 56, 851-876.
  • Daniel, Kent, David Hirshleifer, and Avanidhar Subrahmanyam, 1998, Investor psychology and security market under- and over-reactions, Journal of Finance 53, 1839-1885.
  • Hong, Harrison, and Jeremy C. Stein, 1999, A unified theory of underreaction, momentum trading, and overreaction in asset markets, Journal of Finance 54, 2143-2184 .
  • Barberis, Nicholas, Shleifer, Andrei, 2003. Style investing. Journal of Financial Economics, 68 161-199 .
  • Barberis, Nicholas, Andrei Shleifer, and Jeffrey Wurgler, 2005, Comovement, Journal of Financial Economics 75, 283-317.
  • French, Kenneth R., and James M. Poterba, 1991, Investor diversification and international equity markets, American Economic Review 81: 222-226.
  • Huberman, Gur, 2001, Familiarity breeds investment, Review of Financial Studies 14(3): 659-680.
  • Klibanoff, Peter, Owen Lamont, and Thierry A. Wizman, 1998, Investor reaction to salient news in closed-end country funds, Journal of Finance 53: 673-699.
  • Shefrin, Hersh, and Meir Statman, 1985, The disposition to sell winners too early and ride losers too long: Theory and evidence, Journal of Finance 40: 777-790.
  • Odean, Terence, 1998, Are Investors Reluctant to Realize Their Losses?, Journal of Finance 53, 1775-1798.
  • Shefrin, Hersh, and Meir Statman, 1984, Explaining investor preference for cash dividends, Journal of Financial Economics 13: 253-282.

These individual-level biases are consolidated and amplified by social interaction.

  • Hong, Harrison, Jeffrey D. Kubik, and Jeremy C. Stein, 2004, Social Interaction And Stock-market Participation, Journal of Finance 59, 137-163.
  • Shiller, Robert J. 1984. Stock Prices and Social Dynamics, Brookings Paper on Economic Activity, Feb: 457-98.
  • Hong, Harrison G., Jeffrey D. Kubik, and Jeremy C. Stein, 2005, Thy neighbor's portfolio: Word-of-mouth effects in the holdings and trades of money managers, Journal of Finance 60, 2801-2824 .

Armed with some understanding of arbitrageurs’ and average investors’ demands for securities, we are ready to take a more nuanced look at what goes on in “bubbles”

  • Shleifer, Andrei, Inefficient Markets (sixth chapter, p. 169-174).
  • Baker, Malcolm, and Jeffrey Wurgler, 2006, Investor sentiment and the cross-section of stock returns,
  • Ofek, Eli, and Matthew Richardson, 2003, DotCom mania: The rise and fall of Internet stock prices. Journal of Finance 58: 1113-1137.
  • Lamont, Owen A., and Jeremy C. Stein, 2003, Aggregate short interest and market valuations, American Economic Review , forthcoming.

Supply by firms and managerial decisions

Supply of securities and firm investment characteristics (market timing, catering) by rational firms; Associated institutions; Relative horizons and incentives; Regulating inefficient markets; Biased managers

Rational managers try to ‘time’ inefficient capital markets to reduce their overall cost of capital – they supply more of the currently overpriced securities, and buy back the underpriced ones.

  • Stein, Jeremy, 1996, Rational capital budgeting in an irrational world, Journal of Business, 69:429-55.
  • Graham, John R., and Harvey, Campbell R., 2001, The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics 60: 187-243.
  • Ikenberry, David, Josef Lakonishok, and Theo Vermaelen, 1995, Market underreaction to open market share repurchases, Journal of Financial Economics
  • Jenter, Dirk, 2004, Market timing and managerial portfolio decisions, Journal of Finance , forthcoming.
  • Loughran, Timothy, and Ritter, Jay, 1995, The New Issues Puzzle, Journal of Finance, 50:23-51.
  • Loughran, Timothy and Anand M. Vijh, 1997, Do Long-Term Shareholders Benefit from Corporate Acquisitions?, Journal of Finance, 52, 1765-1790.
  • Rau, P. Raghavendra and Theo Vermaelen, 1998, Glamour, value and the post-acquisition performance of acquiring firms, Journal of Financial Economics, 49, 223-253.
  • Baker, Malcolm, and Jeffrey Wurgler, 2000, The equity share in new issues and aggregate stock returns, Journal of Finance 55, 2219-2257 .
  • Henderson, Brian J., Narasimhan Jegadeesh, and Michael S. Weisbach, 2006, World markets for raising new capital, Journal of Financial Economics 82, 63-101.
  • Loughran, Timothy, and Ritter, Jay, 1997, The operating performance of firms conducting seasoned equity offerings, Journal of Finance 52:5, 1823-1850.
  • Baker, Malcolm P., and Jeffrey Wurgler, 2002, Market timing and capital structure, Journal of Finance 57, 1-32.
  • Baker, Malcolm, Robin Greenwood, and Jeffrey Wurgler, 2003, The maturity of debt issues and predictable variation in bond returns, Journal of Financial Economics 70, 261-291.
  • Teoh, Siew Hong, Ivo Welch, and T.J. Wong, 1998, Earnings management and the underperformance of seasoned equity offerings, Journal of Financial Economics 50, 63-99.
  • Shleifer, Andrei, and Robert W. Vishny, 2003, Stock market driven acquisitions, Journal of Financial Economics 70, 295-311.
  • Dong, Ming, David Hirshleifer, Scott Richardson, and Siew Hong Teoh, 2006, Does investor misvaluation drive the takeover market? Journal of Finance 61, 725-762.
  • Kadiyala, Padma, and P. Raghavendra Rau, 2004, Investor reaction to corporate event announcements: Under-reaction or over-reaction?, Journal of Business 77, 357-386.

Rational firms also try to keep their stock prices high by “catering” to investors – i.e., adopting whatever characteristics that investors currently demand.

  • Cooper, Michael J., Orlin Dimitrov, and P. Raghavendra Rau, 2001, A by Any Other Name, Journal of Finance 56, 2371-2388 .
  • Cooper, Michael J., Ajay Khorana, Igor Osobov, Ajay Patel, and P. Raghavendra Rau, 2004, Managerial actions in response to a market downturn: Managerial actions in response to a market downturn: Valuation effects of name changes in the dot.Com decline Journal of Corporate Finance 11, 319-335.
  • Cooper, Michael J., Huseyin Gulen, and P. Raghavendra Rau, 2005, Changing Names with Style: Mutual Fund Name Changes and Their Effects on Fund Flows, Journal of Finance 60, 2825-2858 .
  • Baker, Malcolm, and Jeffrey Wurgler, 2004, A Catering Theory of Dividends, Journal of Finance 59, 1125-1165.

Managers, like average investors, are also subject to psychological biases.

  • Bertrand, Marianne, and Antoinette Schoar, 2003, Managing with style: The effect of managers on firm policies, Quarterly Journal of Economics 118: 1169-1208.
  • Heaton, James Breckinridge, 2002, Managerial optimism and corporate finance Financial Management 31, 33-45.
  • Malmendier, Ulrike, and Geoffrey Alan Tate, 2005, CEO overconfidence and corporate investment, Journal of Finance 60, 2661-2700.
  • Roll, Richard, 1986, The Hubris Hypothesis of Corporate Takeovers, Journal of Business 59: 197-216.
  • Malmendier, Ulrike, and Geoffrey Alan Tate, 2005, Does overconfidence affect corporate investment? CEO overconfidence measures revisited, European Financial Management 11, 649-659.
  • Rau, P. Raghavendra and Aris Stouraitis, 2007, The timing of corporate event waves Working paper, Purdue University.
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