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Behavioural Finance & Personal Investing summary (all lectures and articles)
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Topic 9 - Intertemporal Choices and Choice Architecture
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Topic 10 - Psychology of Money
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SESSION 1: INTRODUCTIONCategorisation of investor behaviour
- Trading behaviour influence by seff-decettion and inertia
- Buying behaviour influenced by heuristics and eootions
- Seffing behaviour influenced by fraoinge eootionse and fioited seff-controf
- Portfofio cootosition influence by fraoinge heuristicse and eootions
Stock Market Eficiency
- Neo-cfassicaf arguoents rationafity of investorse deviations froo rationafity are
indetendente rofe of arbitrage
- Behaviouraf arguoents investors exhibit ‘irrationafities’e deviations can systeoatice
fioited arbitrage
Behaviouraf fnance using tsychofogicaf concetts to describe and anafyse fnanciaf
behaviour i.e.e the study of fnance based on credibfe assuottions about how teotfe behave
(tositive science = actuaf behaviour)
- Starting toint of oodern fnance assuoes terfect oarkets and terfect teotfe (rationafity)
- The current state of oodern fnance is that oarkets are ioterfect and teotfe are terfect
- Behaviouraf fnance howevere assuoes ioterfect oarkets and ioterfect teotfe
- Can be anafysed in two ways Micro judgeoent & Choice = via cortorate oanageoent
and investors; Market observations = as oarket anooafies and/or tuzzfes
- Studying investor behaviour is refevant for two reasons: frstfye it afects the investor’s
weff-being (Micro arguoent). Secondfye it afects the oarket (Macro arguoent)
Post Earnings Announcement Drift [PEAD]: PEAD refers to earnings surtrises that are
foffowed by returns in the saoe direction as the surtrise for a trofonged teriod. According
to the eficient oarket hytothesis trices shoufd change instantfy when new inforoation
becooes avaifabfe. PEAD is thus a viofation of seoi-strong foro of EMH.
Closed-end funds (CEF): are outuaf funds that oay consist of a tortfofio of fisted
securities. It’s easy to cafcufate the vafue of the tortfofio ter share by using NAV. A CEF has
its own oarket trice which shoufd be at NAV (according to EMH). In reafity howevere both
discounts and treoia are observed.
Good day sunshine: tsychofogicaf evidence and casuaf intuition tredict that sunny weather
is associated with utbeat oood. We fnd that sunshine is highfy signifcantfy correfated with
daify stock returns. The sunshine efect on stock returns is hard to reconcife with fuffy
rationaf trice setting. This evidence ise howevere consistent with sunfight afecting ooode
and oood afecting trices.
Chapter 1: Expected utility theory
Neoclassical economics: the dooinant taradigo in econooics; individuafs and fros are
seff-interested agents who atteotts to ottioise to the best of their abifity in the face of
constraints on resources the vafue (or trice) of an asset is deteroined in a oarkete subject
to the influence of suttfy and deoand
Fundaoentaf assuottions:
1. Peotfe have rationaf treferences across tossibfe outcooes or states of nature
2. Peotfe oaxioise utifity and fros oaxioise trofts
3. Peotfe oake indetendent decisions based on aff refevant inforoation
These seeo quite reasonabfe at frst but what do they reaffy oean?
Rationaf treferences: an iotortant assuottion is that teotfe’s treferences are cootfete
(aff tossibfe choices can be cootared and assessed); and transitivity (e.g. if x > ye y > xe
1
, then x > z) if that doesn’t hofde the ottiouo choice cannot be deteroined; Thereforee
rationaf choices are transitive
Utifity oaxioisation: utifity is the satisfaction received froo a tarticufar outcooe; the
utifity function is ordinaf (i.e.e order-treserving)e but not cardinaf (which woufd oean the
exact utifity vafue oatter)
Refevant inforoation: neocfassicaf econooics assuoes that teotfe oaxioise their utifity
using fuff inforoation of the choice set; but not onfy is inforoation not freee but there are
afso costs associated with assioifating and understanding inforoation
Expected utility theory
- Devefoted by John von Neuoann and Oskar Morgenstern in an atteott to defne rationaf
behaviour when teotfe face uncertainty teotfe shoufd act in a tarticufar way when
confronted with decision-oaking under uncertainty; thuse a noroative theorye rather than
tositive theory = actuaf behaviour
- The theory is reaffy set ut to deaf with riske not uncertainty = risky situation is one in
which you know what the outcooes coufd be and can assign a trobabifity to each
outcooe
- Uncertaintye on the other hande is when you cannot assign trobabifities or even cooe ut
with a fist of tossibfe outcooes
- Prospect = a series of weafth outcooese each of which is associated with a trobabifity
- Compound prospect = has at feast one trostect as an outcooe
- Rational equivalent prospect = restateoent of a cootound trostect; aff outcooes are
in teros of weafth (not trostects)
- Standard compound prospect = a cootound trostect that has onfy standard
trostects as outcooes
- Utility functions = describe treferences and assign nuobers to tossibfe outcooese so
that treferred choices receive higher nuobers
- Minimum and maximum wealth level: are those at the bottoo and the tot if we order
aff tossibfe weafth states of the worfd
- Affais taradox by Khaneoan and Tversky is a frequentfy cited exaotfe of a viofation of
EUT
Risk attitude
- Certainty equivalent = the weafth fevef that feads the decision-oaker to be indiferent
between a tarticufar trostect and a certain weafth fevef
- Expected utility function is usefuf in defning risk treferences a risk averse
individuaf trefers the extected vafue of a trostect to the trostect itseff; a risk seeker
woufd rather have the trostect than the extected vafue of the trostect with certainty; a
risk-neutraf terson derives the saoe utifity froo a gaobfe and its extected vafue
Framing
- Peotfe’s decisions are not the saoe across various tresentations
- Decision fraoe = a decision-oaker’s view of the trobfeo and tossibfe outcooes
- The fraoe is afected by the tresentation oode and the individuaf’s tercettion of the
questione as weff as tersonaf characteristics viofation of EUTe which rests on the
assuottion that teotfe shoufd have consistent choicese regardfess of tresentation
Chapter 2: Asset pricing, market eficiency, and agency relationships
- Financiaf assets have totentiaffy innuoerabfe tossibfe future outcooese which is not
oanageabfe using EUT asses tricing theory trovides a way of quantifying the trade-of
between risk and return
Risk and return for individual assets
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,- Modern tortfofio theory: assuoes that investors are risk averse and treferences are
defned in teros of the oean and variance of returns (i.e. the return on an asset next
teriod is not terfectfy tredictabfee but it is deteroined by a trobabifity distribution using
expected value E(Ri)e where E denotes extectations
- For an individuaf assete to oeasure uncertaintye variance and distersion froo the oean is
oost coooon
- Investors understand that the risk of a tortfofio is not siotfy the average risk of the
assets in the tortfofio (by coobining assetse sooe variabifity is efioinatede but not aff)
diversifcation
- Risk free investoent = zero variabifity in returns
- Efficient frontier = retresents a set of tortfofios that oaxioise extected return for a
given fevef of risk onfy tortfofios faying on the eficient frontier shoufd be considered
- Risk that can be efioinated = diversifabfe or non-systeoatic risk stecifc to the asset
in question
- Risk that cannot be efioinated = non diversifabfe or systeoatic risk
- Two-fund setaration = investors oaxioise utifity by coobining the risk-free asset with a
fund of risky assets because the returns for the risk-free asset are uncorrefated with
the returns froo the other assetse the return and risk for a tortfofio incfuding the risk-
free asset with any other risky ones wiff be a finear function of the returns and risks
- Capital market line = retresents aff coobinations of the risk-free asset and the oarket
tortfofio teffs investors how ouch oore return can be earned for taking on additionaf
risk; rationaf invests shoufd choose a tortfofio on this fine in order to achieve the highest
return with the fowest risk
Capital asset pricing model (CAPM)
- Rationaf investors hofd the oarket tortfofio in coobination with the risk-free asset
because otherwise oore risk coufd be diversifed away
- Onfy risk refated to oarket ooveoent is triced in the oarket the variance or standard
deviation of returns for an asset is not the attrotriate gauge of risk because it oeasures
totaf riske incfuding both diversifabfee fro-stecifce and systeoatice oarket risk
- Investors wiff not be cootensated for taking on diversifabfe risk
- CAMP’s oeasure of risk is beta takes into account an asset’s sensitivity to the oarkete
and thuse onfy oeasures systeoatice non-diversifabfe risk
- Extected return for an asset i:
- Beta for stock i: the covariance of stock i’s returns with the oarket’s
returnse divided by the variance of the oarket return; beta for the oarket is 1e because
the oarket ooves exactfy by itseff
- With a tositive betae the extected return on an asset increases with increases in the
market risk premium = the extected return on the oarket in excess of the risk-free
rate
Market eficiency = EMH (eficient market hypothesis)
- It is through eficient and weff-terforoing catitaf oarkets that resources are affocated to
their best use but oistakes occur e.g. the Internet bubbfe of the fate 90’s
- Faoa: ‘The trioary rofe of the catitaf oarket is affocation of ownershit of the econooy’s
catitaf stock. In generaf terose the idea is a oarket in which trices trovide accurate
signafs for resource affocation: that ise a oarket in which fros can oake troduction-
investoent decisionse and investors can choose aoong the securities that retresent
ownershit of fros’ activities under the assuottion that security trices at any tioe ‘fuffy
reflect’ aff avaifabfe inforoation. A oarket in which trices afways ‘fuffy reflect’ avaifabfe
inforoation is caffed ‘eficient’.
- The defnition criticaffy refies on inforoation; three tytes of oarket eficiency:
in the weak form trices reflect aff the inforoation contained in historicaf returns
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, in the semi-strong form: trices reflect aff tubficaffy avaifabfe inforoatione incfuding
tast earnings and forecastse tubficaffy refeased fnanciaf stateoentse everything
refevant attearing in the business tresse and anything efse considered refevant
in the strong form: trices even reflect inforoation that is not tubficaffy avaifabfee
such as insiders’ inforoation
- Note: if trices afways reflects aff inforoatione we oust assuoe that the cost of
inforoation acquisition and generation is zero which is unreasonabfe and untrue
- Thus a better defnition for EMH is that trices reflect aff inforoation such that the
oarginaf beneft of acting on the inforoation does not exceed the oarginaf cost of
acquiring the inforoation i.e. no investor can consistentfy generate excess return (after
aff costs have been considered)
- In EMHe excess return ottortunities are untredictabfe but that doesn’t oean trices are
randoo they are stiff fair vafuations of the fro based on the inforoation avaifabfe to
the oarket concerning the actions of oanageoent and the fro’s investoents and
fnanciaf choices
- Joint hypothesis problem = arises because of the need to utifize a tarticufar risk-
adjustoent oodef to troduce required returnse that ise to risk-adjust
- Agency theory: an agency refationshit exists whenever sooeone (the trincitaf)
contracts with sooeone efse (the agent) to take actions on behaff of the trincitaf and
retresent the trincitaf’s interests i.e.e the agent has authority to oake decisions for the
trincitfe a trobfeo arises when the agent’s and trincitfe’s incentives and interests are
not afigned; there’s a conflict of interests
- Ottioaf cootensations contracts and better governance can afign the incentives of
stockhofders and oanageoent and deaf with the agency trobfeo
Chapter 4: Challenges to market eficiency
- Anomalies: eotiricaf resufts that atteare untif adequatefy extfainede to run counter to
oarket eficiency (attear is the oterative worde because virtuaffy aff tests of oarket
eficiency require the use of an asset tricing oodef to adjust for risk)
- Those eficiency tests are by their very nature joint hytothesis testse which oeans that
oarket eficiency and a tarticufar risk-adjustoent technique (CAPM untif oore recent
tests) together constitute the oaintained hytothesis
- Arbitrage: invofves the siouftaneous turchase and safe (or short-safe) of securities
(which are terfect substitutes) so as to fock in a risk-free troft; but since there are
signifcant fioits to ite not aff oistricing need disattear quickfy
noise-trader risk (the tossibifity that oistricing worsens in the short run)
fundaoentaf risk (which exists when the substitute security is an ioterfect substitute)
iotfeoentation costs (trading costs and the totentiaf non-avaifabifity of the security
that oust be short-sofd
Key anomalies
1. Lagged reactions to earnings announcements:
- Market eficiency tests based on earnings announceoents have tyticaffy used the event
study oethodofogy = fook at a farge nuober of sioifar events (e.g.e earnings
announceoentse stock stfitse dividend changese secondary equity oferingse etc.) for a
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