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Behavioural Finance

Behavioural Finance. Fundamentals of Asset Pricing Session 1 Read Daniel, Hirshleifer & Teoh, 2002 Fama, 1991. Outline. Traditional Finance Assumptions Implications Limitations Behavioural Finance Assumptions Implications Limitations. Traditional Finance.

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Behavioural Finance

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  1. Behavioural Finance Fundamentals of Asset Pricing Session 1 Read Daniel, Hirshleifer & Teoh, 2002 Fama, 1991

  2. Outline • Traditional Finance • Assumptions • Implications • Limitations • Behavioural Finance • Assumptions • Implications • Limitations

  3. Traditional Finance • Fama, 1970 Efficient Markets I • Security Prices fully reflect the available information! • Different Forms of Efficiency • Weak Form • Semi-strong form • Strong Form

  4. Traditional Finance • Fama, 1991 Efficient Markets II • Prices reflect information to the point where the benefits of acting on information (profits) do not exceed the marginal costs! • Information and trading costs considered! • Market efficiency as a benchmark! • Market efficiency as an approximation! • Simplification of the world!

  5. Traditional Finance • Joint hypothesis problem • Market efficiency per-se is not testable! • The hypothesis of market efficiency can be tested jointly with an equilibrium model • an asset pricing model • CAPM, • APT, • FF • ….

  6. Traditional Finance • Main Areas of Research • Return Predictability • time series • cross sectional • anomalies??? • Event Studies • Tests of Private Information

  7. Investor Psychology • Historical perspective • 1940s-60s behavioural psychology • Watson (1913) • human behaviour can be explained by conditioning • by means of reinforcement or association • 1970s- cognitive psychology • internal mental states

  8. Investor Psychology • Behavioural concepts developed by • Kahneman, Tversky, Slovic during 1970s • came to the attention of economists • First papers in JF • DeBondt and Thaler, 1985 • Shefrin and Statman, 1985 • Review of past decade • Daniel et.al. (2002) • DeBondt, Muradoglu, Shefrin, Stoikauras (2008)

  9. EMH versus Behaviouralists • Freudian Psychology and Keynesian Economics • interpreted too dogmatically? • Extended beyond realm of validity? • Dominated for decades! • Finance • Efficient Markets Hypothesis • insight is important • security prices are influenced by a corrective force • but, corrective tendency carried to extremes! • Arbitrage by rational traders need not eliminate mispricing! • Prices reflect a weighted average of beliefs!

  10. Policy Implications of EMH • Implications for investors? • Government initiatives • Chicago school versus regulation! • Link between EMH and laissez faire is weak! • Political participants are not immune to bias! • Cognitive limitations make it hard to adjust • uniformly and consistently! • Regulation • to protect ignorant investors and improve risk sharing • education, disclosure, reporting

  11. Behavioural Finance • Review • by Daniel, Hirshleifer and Theoh, 2002 • By DeBondt, Muradoglu, Shefrin, Stoikauras, 2008 • Cognitive Errors • made by investors and Analysts • Extent to which • these biases affect prices

  12. Investors • Herd • Do not invest in certain assets • stocks, bonds, commodities… • home-bias, Levis, Muradoglu, Vasileva, 2011 • funds invest locally • employees invest in own firm • Do not want to realize losses • mental accounting, Thaler (1991), Odeon (1998) • Use past performance  future performance • top performing funds

  13. Analysts • Forecasts and recommendations • are biased-optimistic/buy vs. sell, Muradoglu, 2002 • Forecasts are predictable • Muradoglu and Salamouris, 2004 • Underreact/Overreact • DeBondt and Thaler, 1985,1987,1990

  14. Do biases affect prices? • Can predictability be explained by • risk-based interpretations • psychology based interpretations? • CAPM, APT, FF • January effect? • Funds trading at discount? • Dual listed securities? • Size effect? Value effect? • Momentum versus reversal? • Post-event drifts? • IPOs, SEOs?

  15. Biases in Financial Behaviour • Heuristic simplification • Salience and Availability Effect • Framing • Mental Accounting • Overconfidence • Self-attribution • Confirmatory bias • Hindsight bias

  16. Summary • Efficient markets hypothesis • Joint hypothesis problem • Different forms of efficiency • Behavioural Finance • Biases in financial behaviour • Implications of biases

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