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Behavioral Finance

Behavioral Finance. Economics 437. Definition of absence of serial correlation. Let p t-1 , p t-2 , p t-3 , etc. be a series of past prices. Now, think about, p t. E[ p t | info, p t-1 , p t-2 , p t-3 , etc.] = E[ p t | info]. Then, no serial correlation. “Cross Section” vs “Time Series”.

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. 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

  3. “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 • F-F and J-T are about explaining “cross section” difference in returns

  4. Data in Fama and French • 1962 -1989 data • Book Value (leverage and price/earnings) at year end • Returns starting on July 1 of the following year • 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).

  5. 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”

  6. 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

  7. 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

  8. The End

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