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Behavioral Finance

Behavioral Finance. Economics 437. Trader Folk Lore. Stock Price Momentum Charting stocks by tracking stock prices Trend following Mean Reversion Returns will revert to a mean return Stocks with very high returns will, in the future, underperform stocks with very low returns Other

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Trader Folk Lore • Stock Price Momentum • Charting stocks by tracking stock prices • Trend following • Mean Reversion • Returns will revert to a mean return • Stocks with very high returns will, in the future, underperform stocks with very low returns • Other • Buy in December, Sell on Friday night, buy on Monday night

  3. Definition of absence of serial correlation Let pt-1, pt-2, pt-3, etc. be a series of past prices Now, think about, pt E[ pt | info, pt-1, pt-2, pt-3, etc.] = E[ pt | info] Then, no serial correlation

  4. “Cross Section” vs “Time Series” • Cross Section • Pick a date (or a time period) • Collect data only for that date (or time period) • Explain variations in the data for that time period only • Time Series • Pick a stock • Collect data for that stock over many time periods

  5. DeBondt-Thaler 1984 • “Over-Reaction” Hypothesis • Suggests that: • After a period of “over-reaction,” markets “revert” back and go the other way. • Stocks that have done well in the past, do poorly in the future • Stocks that done poorly in the past, do well in the future • Their article is designed to test whether or not “mean reversion” is true.

  6. Data • NYSE data • Jan 1926 through December 1982 • Monthly return data • Begin with three year lookback in Dec 1932 • Monthly data from Jan 1930 through Dec 1932 • 36 months or three years data • Form portfolios of L(osers) and W(inners) • Then see how they do for the next three years

  7. DeBondt and Thaler: “Does the Stock Market Overreact” (1985) • L – three year loses • W – three year winners • Question: How do the W’s do in the next three years? How do the L’s do in the next three years? • Other things worth noting • Almost all of the impact is in January • When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation

  8. DeBondt-Thaler conclusions • Definite evidence of mean reversion (a form of serial correlation): • L portfolios consistently outperform W portfolios • 19.6 % better than the market after end of 3 years • W portfolios consistently underperform the market • 5 % less than the market after end of 3 years

  9. Interesting facts • Most of the excess returns are in January • Loser effect more pronounced: • Losers earned 19.6 % more than the market • Winners earn 5.0 % less than the market • Loser portfolio minus Winner portfolio return = 24.6 %!!!!! • Most of the return difference is during 2nd and 3rd year • Larger loses become larger winners; larger winners become larger losers

  10. What was the reaction to D-T • Largely ignored by the academic literature • Then, in 1992, along came Fama-French on “Cross-Section” returns

  11. Data in Fama and French • 1962 -1989 data • Book Value (leverage and price/earnings) at previous year end • Returns starting on July 1 of the following year (also use the market equity as of July 1 for size, but use market equity at previous year end for B/M calculation) • Calculate monthly returns • Each month the cross-section of returns is regressed on explanatory variables. • Prior • research used “portfolio betas”; F-F use individual stocks • Sort stocks into “size deciles” • Sort each size decile into 10 portfolios based on beta • Calculate equal weighted monthly returns on the portfolios for the next 12 months (from July to June).

  12. Results on Beta • Portfolios in size deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return • Large size means lower beta and lower returns • When size deciles are subdivided into beta ranked decile portfolios • Larger size firms have lower returns • “no relation between average return and beta”

  13. Results on Book/Market • What is book to market • Book is firm net worth reported on 10-Ks • Market is: shares outstanding times price • Book/market is positively related to returns • Size still matters but B/M is much more important • B/M swamps leverage and E/P • Leverage: book or market leverage? • January “slopes” twice slopes of other months • Overall largest decile book to market beats smallest decile book to market by 1.53 % per month

  14. Significance of F-F • Provided a simple rule for investing success • Seems to contradict Semi-Strong EMH • Made “respectable’ earlier work that provided simple, but successful investment rules • DeBondt and Thaler, for example

  15. The End

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