Behavioral Finance and Market Efficiency

Posted on May 12, 2024 in Economy

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Stock Market Anomalies

Excess Predictability

Excess stock returns are predictable by dividend yield.
Size, B/M, and many other factors explain excess returns.
Post-Earnings Announcement Drift.
Short-Term Momentum: a stock’s past return (1 to 12 months) positively predicts future returns.
Long-Term Reversal: a stock’s 3-year past return negatively predicts future returns.

Idiosyncratic Volatility

Stocks with higher betas have lower alphas (holds in many asset classes).
Stocks with higher idiosyncratic volatility have lower alphas.

Excessive Trading

The average household underperforms passive benchmarks, and those who do the worst, trade the most.

Turnover

Short-term: high past week volume positively predicts future returns.
Long-term: high past year volume negatively predicts future returns.

Disposition Effect

Investors and mutual fund managers tend to sell stocks trading at a gain relative to purchase price, rather than at a loss (advantageous to realize losses for tax purposes).
Effect more pronounced among less sophisticated investors.
In theory, can help explain momentum.
Selling stocks that have recently performed well and holding onto stocks that have recently performed poorly.

Non-participation

Most US households held no stocks at all historically. In 1984, only 28% of households held any stocks (Mankiw and Zeldes (1991)).

Under-Diversification (“Home Bias”)

Investors tend to under-diversify their portfolios (within asset classes and domestic vs international).
In 1989, 30% of US equity-holding households allocated > 50% of their equity exposure to fewer than 10 stocks (Curcuru, Heaton, Lucas, and Moore (2004)).
In 1989, US investors invested 94% of their equity holdings in US equity (French and Poterba (1991)).
In a sample of 154,401(k) retirement plans, people allocated ~23% of discretionary contribution to own company stock (Benartzi (2001)).

Behavioral Finance Concepts

Prospect Theory

Assumes utility is based on changes in current wealth.
Investor is “risk averse” toward portfolio gains and “risk loving” toward losses.

Bubbles

Bubbles tend to be characterized by:

Departure from fundamentals.
High trading volume.
“New Paradigm” narrative.
Short-sale constraints.
Supply Response.

Momentum Outperformance

Explain the behavioral argument for the outperformance of stocks with high momentum, defined by their return in the last year relative to the market (as discussed in class and in the textbook).

The following are acceptable:

Disposition effect (sell winners, hold on to losers).
Mental accounting leads to disposition effect.
Any discussion of under-reaction to initial news.
Extrapolation (people tend to overweight recent experience).
Conservatism (people too slow to update beliefs).

Financial Concepts

Bond Duration

LONGER DURATION: bonds with lower coupon rates and YTM and longer maturities.

CAPM

IF CAPM IS TRUE: no arbitrage opportunities because it assumes all investors are mean-variance optimizers.
IF NO ARBITRAGE OPPORTUNITIES: doesn’t necessarily mean CAPM is true because it’s so restrictive.
If CAPM holds, all investors hold the same risky portfolio.

Downside Risk Mitigation

Which of the following strategies will help insure your portfolio against downside risk?

Buying as many put options as shares that you have in the underlying asset.
Sell a market value of futures contracts that equates to the market value of the underlying asset, assuming a beta of one.

Efficient Market Hypothesis (EMH)

Price changes are unpredictable (random walks).
Prices only react to new information.
Investors cannot beat the market on a risk-adjusted basis.
Expected returns reflect risk.