2.1 Traditional Finance Perspectives on Individual Behavior Traditional finance assumes: Investors are risk averse & self interested.. Investors make decisions based on utility theory
Trang 1“ THE BEHAVIORAL FINANCE PERSPECTIVE ”
1 INTRODUCTION
2 BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES
Traditional VS Behavioral Finance
Grounded in neoclassical economics
Individuals are assumed to be rational, risk averse & utility maximizers
Traditional finance believes in EMH
Grounded in psychology
Based on observed financial behavior rather than idealized financial behavior
Classification
Describe decision making process of individuals
Cognitive errors & emotional biases
Consider anomalies that distinguish market from efficient markets
2.1 Traditional Finance Perspectives on Individual Behavior
Traditional finance assumes:
Investors are risk averse & self interested
Investors make decisions based on utility theory &
revise expectations consistent with Bayes’ formula
Efficient Markets
2.1.1 Utility Theory and Bayes’ Formula
People maximize the PV of expected utility subject to their budget constraints
A rational investor make decision based on following axioms of utility theory:
New information is assumed to update beliefs about probabilities according to Bayes’ formula
Application of conditional probability
Assumes that events are mutually exclusive & exhaustive with known probabilities
⁄ = ⁄
Where P (A/B) & (P (B/A)) = conditional probability of event A, (B) given B, (A)
P (B) = prior probability of event B
P (A) = prior probability of event A
REM = Rational Economic Man
Trang 22.1.2 Rational Economic Man
Maximize utility given budget constraints & available information
Selfishly seek the personal utility maximizing decision
Tries to minimize economic cost
Govern by perfect rationality, perfect self-interest & perfect information principles
2.1.3 Perfect Rationality, Self-Interest, & Information
Prefect rationality ⇒ REM is a rational thinker (ability to reason & make beneficial judgments)
2.1.4 Risk Aversion
Risk Attitudes
Risk Neutral
Investors who prefer a certain alternative over an uncertain one (same expected value)
Diminishing marginal utility of wealth (concave utility function)
Investors are indifferent b/w a certain & uncertain alternative
Constant marginal utility of wealth
Linear utility function
Investors who prefer to invest in uncertain alternatives
Increasing marginal utility of wealth (convex function)
Expected utility theory assumes that investors are risk averse (utility functions are concave & diminishing marginal utility of wealth)
to participate or minimum amount of money a person would accept to not participate in an event with uncertain outcome
2.2 Behavioral Finance Perspectives on Individual Behavior
Behavioral finance challenges assumptions of traditional finance
on the following grounds:
Investors may be unable to make decisions based on utility theory & revise expectations consistent with the Bayes’
formula
Perfect rationality, self interest & prefect information principles’ violation
2.2.1 Challenges to Rational Economic Man
knowledge & cognitive limitations
REM ignores the fact that people can have difficulty prioritizing short term v/s long term goals
Trang 32.2.2 Utility Maximization and Counterpoint
An IC depicts all possible combination of two goods amongst which an individual is indifferent
For perfect substitutes (complements), the IC is a line with constant slope (L-shaped)
IC analysis fails to consider exogenous factors (e.g risk aversion, individual’s circumstances etc)
2.2.3 Attitudes toward Risk
Risk evaluation depends on the:
Wealth level
Circumstances of the decision maker
wealth
Investors are risk averse at & income levels
Investors are risk seeking at moderate income levels
Value function is normally concave for gains, convex for losses & steeper for losses than for gains
2.3 Neuro-economics
Explain how humans make economic decisions under uncertainty
Neuro-economics explains:
Overconfidence & market overreaction
A panicked rather than analytical response after falling market
3 DECISION MAKING
Prospect theory & bounded rationality are based on how people do behave & make decisions(behavioral finance based)
Expected utility & decision theories are based on how people should& make decisions (traditional finance based)
3.1 Decision Theory
Indentify values, probabilities & other uncertainties relevant to a decision & using that information to arrive at a theoretically optimal decision
Based on expected value & traditional finance assumptions
Expected utility can vary from person to person (based on the worth assigned by the decision maker)
Expected value is same for every one (based on price)
3.2 Bounded Rationality
information & stop at a satisfactory decision
Investor takes steps to achieve intermediate goals, as long as they advance the investor towards the desired goals
Trang 43.3 Prospect Theory
Investors analyze risk relative to possible gains & losses rather than relative to expected return
Investors are more concerned with the change in wealth & place greater value on a loss than on a gain of same amount
Phases to Making a Choice
+
People compute a value function based on potential outcomes
& their probabilities
Where
, = Potential outcomes
, = Probabilities
W = Probability weighting function
V = Function that assigns a value to an outcome
The value function states:
People overreact (underreact) small (mid-sized & large) probabilities events
People are loss averse
Preferences are determined by attitudes towards gains &
losses
Prospects are framed as gains or losses using heuristics
Steps in Editing
Investors identify & code outcomes as gains or losses & assign a probability to each
Codification
Investor combines those outcomes with identical value
Combination
The riskless component of any prospect
is separated from its risky component
Segregation
Identical outcomes b/w choices can be eliminated
Cancellation
Investors will tend not to think in precise numbers (rounded off the prospects)
Simplification
Investor will eliminate any choice that is strictly dominated by another
Detection of Dominance
Trang 54 PERSPECTIVES ON MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION
Market participants are REM
Population updates its expectations as new relevant information appears
Relevant information is freely available to all participants
4.1 Traditional Perspectives on Market Behavior
Traditional finance assumes EMH
Forms of Market Efficiency
Consistently excess return is not possible using technical analysis
Reflect all historical price &volume data
All publically available information
is fully reflected in securities prices
Excess return on continuous basis is not possible using technical &
fundamental analysis
All public & private information is fully reflected in securities prices
Even insiders are unable to generate excess return on consistent basis
Grossman-Stiglitz paradox ⇒prices must offer returns to information acquisition otherwise the market can’t be efficient
4.1.2 Studies in Support of the EMH
Test whether security prices are serially correlated or whether they are random
Studies conclude that security prices are random, (support weak form of the EMH)
Event studies
Announcement of the event (not event itself) appear
to be reflected in prices
4.1.3 Studies Challenging the EMH: Anomalies
Investor generates excess return based on some fundamental characteristics of the firm
Small cap firms appear to outperform large cap firms
Value stocks appear to outperform growth stocks
avg prices rise above the long (short) avg prices, this is an indication of strength (weakness)
resistance level & then reverse direction (act like a ceiling)
upward after support level reached)
Trang 64.1.3 Studies Challenging the EMH: Anomalies
returns during the month of January
returns on the last day & 1st
four days of each month
Markets are neither perfectly efficient not completely anomalous
4.1.3.5 Limits to Arbitrage
Uncertain need for liquidity limits the ability of arbitrage to force prices to their intrinsic values
Implicit in the limit to the arbitrage idea is that the EMH does not hold
4.2 Traditional Perspectives on Portfolio Construction
Rational portfolio:
Meets investor’s objective & constraints
Choose from mean-variance efficient portfolios
4.3 Alternative Models of Market Behaviorand Portfolio
Construction
Behavioral life-cycle theory incorporates:
portions of their wealth to meet different goals
4.3.1 A Behavioral Approach to Consumption and Savings
Behavioral assets pricing model adds a sentiment premium (stochastic discount factor) to discount rate
Sentiment premium ⇒ based on analysts’ forecasts
The dispersion of analysts’ forecasts, the sentiment premium, the discount rate & the perceived value of the assets
4.3.2 A Behavioral Approach toAsset Pricing
Uses of probability-weighting function rather than the real probability distribution
Investor’s structure their portfolio in layers & composition of each layer is determined by interaction of following five factors
The importance of the goals
Required return
The investor’s utility function
Access to information
Loss aversion
mean-variance efficient)
Trang 7Revised version of the EMH that considers bounded rationality, Satisficing&
evolutionary principles
The competition & adaptable the participants, the likelihood of not surviving
Five implications:
Risk premiums change over time
Active management can add value
Consistent outperformance is impossible
Investors must adapt to survive
Survival is the essential objective
4.3.4 Adaptive Markets Hypothesis