21 - What B.F is2 - Prospect Theory Cognitive Biases Limits To Arbitrage Applications (Inflation & Stock Market Undepricing of IPOs)6 - Countries and cultures in B.F
3Equity markets : increasing volatility and fluctuations Market participants have for a long time relied on the notion of efficient markets and rational behavior when making financial decisions.Idea of fully rational who always maximize their utility and demonstrate perfect self-control is become inadequate.Examples of market inefficiency in the form of anomalies and irrational investor behavior
4Behavioral finance is a new paradigm of finance theory , which seeks to understand and predict systematic financial market implications of psychological decision- making.By understand the human behavior and psychological mechanisms involved in financial decision-making, standard finance models may be improved to better reflect and explain the reality in today’s evolving markets.
5Behavioral finance helps to explain why and how markets might be inefficient. Behavioral finance focuses upon how investors interpret and act on information to make informed investment decisions. Investors do not always behave in a rational, predictable and an unbiased manner indicated by the quantitative models.
6HistoryAdam Smith wrote an important text describing psychological principles of individual behavior, The Theory of Moral Sentiments and Jeremy Bentham wrote extensively on the psychological underpinnings of utility.Economic psychology emerged in the 20th century in the works of different economists : Gabriel Tarde, George Katona and Laszlo Garai.
7Psychologists in this field such as Ward Edwards, Amos Tversky and Daniel Kahneman began to benchmark their cognitive models of decision making under risk and uncertainty against economic models of rational behavior.The most important paper was written by Kahneman and Tversky in 1979:'Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented anomalies in rational economic decision making
9INTRODUCTIONProspect Theory is a mathematical alternative theory elaborated by Kahneman and Tversky to explain the human behavior under uncertainty.Expected utility theory offers a representation (investors are always risk averse) of truly rational behavior under certainty.Groups of individuals have been subjected to questions in the form of choice between two combinations of outcomes and probabilities.By these empirical experiments have been observed certain behaviors constituting violations of the classical theory of expected utility.
10VIOLATIONS OF EXPECTED UTILITY The certainty effect (preference for certain outcomes): subjects between choices with positive results give greater weight to certain results compared to those uncertain that however have an expected value higher than the certain value. Therefore in a positive demain there’s risk aversion.The reflection effect:in a negative domain (situation in which the results of all possible alternatives are negative) there’s the tendency to take up risks. (risk seeking and love for losses)The effect of isolation: tendency of the agents to ignore common elements between more options and to focus the attention and the decision only on differential elements . Unlike the expected utility theory, choices between alternatives aren’t determined only by the final states of wealth.
11FRAME DEPENDENCYOne of the main assumptions of the Prospect Theory is the “Frame dependency” (the decision is determined by how the choices are represented).According to this approach agents evaluate lotteries through a two-level process:1. Phase of editing: the aim of this phase is to organize the options in order to make the subsequent phases of assessment and choice easier. In this phase is crucial the way in which problems are placed (the frame )because,unlike expected utility, the order of preference between various options isn’t invariable. Different contexts of reference lead to various ways of information processing.2. Phase of evaluation which uses a value function- The value function confirms that the utility of an economic agent depends on the gains or losses that can be achieved with respect to a certain level of wealth that is the reference point determined by the subjective impression of individuals of the decision context.
12FRAME DEPENDENCY- Due to the effect certainty, economic agents don’t behave in a mirror way in front of gains and losses:* Their attitude has a convex function in the losses (for wealth levels under the reference point investors are risk seekers to stay above the reference point).* Their attitude has a concave function in gains (for wealth levels after the reference point investors are risk averse to stay at the perceived current level of utility)- The slope of the function in losses exceeds that in gains because the “suffering” produced by losses is higher than the “enjoyment” determined by gains- On the contrary, in expected utility theory the utility function:* doesn’t have a reference point* is focused on final wealth* is concave downward for all levels of wealth because investors are always considered risk averse.
13VALUE FUNCTION KAHNEMAN D VALUE FUNCTION KAHNEMAN D. AND TVERSKY A, “PROSPECT THEORY”: AN ANALYSIS OF DECISION UNDER RISK.
15Emotion and Psychology There are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.Cognitive psychologists have documented many patterns regarding how people behave.Some of these patterns are as follows :
17Heuristic and Anchoring -People often make decisions based on approximate rules of thumb, not strict logic.In particular the concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a reference point and then make adjustments to it to reach their estimate.-Psychologists have documented that when people make estimates may be heavily influenced by previous values of the item..
19Investment anchoringFor example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. In this case, the investor is anchoring on a recent "high" that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount.-Successful investors evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape.
20MENTAL ACCOUNTING The Different Accounts Dilemma Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account..The Different Accounts DilemmaDifferent Source, Different Purpose
21The different accounts dilemma We have a weekly lunch budget and are going to purchase a $6 sandwich for lunch. As we are waiting in line, one of the following things occurs:We find that we have a hole in our pocket and have lost $6;We buy the sandwich but we stumble and our delicious sandwich ends up on the floorIn either case would you buy anothersandwich?
22The different accounts dilemma Because of the mental accounting bias, most people in the first scenario wouldn't consider the lost money to be part of their lunch budget because the money had not yet been spent, consequently they'd be more likely to buy another sandwich, whereas in the second scenario, because the money had already been spent!
23Different source,Different purpose People tend to spend a lot more "found" money, such as tax returns and work bonuses and gifts, compared to a similar amount of money that is normally expected, such as from their paychecks. This represents another instance of how mental accounting can cause illogical use of money.Money should be interchangeable !!!
24HINDSIGHT BIASHindsight Bias tends to occur in situations where a person believes some past event was predictable and completely obvious.Psychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable
26HINDSIGHT BIASFor investors and other participants in the financial world, the hindsight bias is a cause for one of the most potentially dangerous mindsets that an investor or trader can have: Overconfidence. In this case, overconfidence refers to investors' or traders' unfounded belief that they possess superior stock-picking abilities!
28What does arbitrage mean? Arbitrage is the simultaneus purchase and sale of an asset in order to profit from a difference in the price.Arbitrage exists as a result of market inefficiences; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.Limits to arbitrage is a theory that, due to restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time.
29Efficient Market Hypothesis (EMH) In a traditional framework where agents are rational and there are no frictions, a security's price equals its “fundamental value”the discounted sum of expected future cash flows, where in forming expectations, investors correctly process all available information, and where the discount rate is consistent with a normatively acceptable preference specification.
30Behavioural Finance Vs. EMH Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are broughtabout by the presence of traders who are not fully rational.Friedman's objection: rational traders will quickly undo any dislocations caused by irrational traders.
31Behavioural Finance Vs. EMH Friedman's objection is based on two assertions:as soon as there is a mispricing – an attractive investment opportunity is created;rational traders will immediately snap up the opportunity, thereby correcting the mispricingBehavioural Finance disputes the first step: even when an asset is wildly mispriced, strategies designed to correct the mispricing can be both risky and costly, rendering them unattractive. As a result, the mispricing can remain unchallenged.
33KIND OF MISPRICING 1)recurrent or arbitrageable Misvaluations are of two types:1)recurrent or arbitrageablethe market is pretty efficient for these assets, at least on a relative basis.2)non-repeating and long-term in nature.it is impossible in real time to identify the peaks and troughs until they have passed.
34Risks and Costs Fundamental Risk; Noise Trader Risk; Implementation Costs.
35Risks and Costs Fundamental risk: impersonal both in origin and consequence;the losses are not normally caused by one individual and their impact generally falls on a wide range of people.Arbitrageurs are well aware of this risk, which is why they short a substitute security (substitute securities are rarely perfect, and often highly imperfect, making it impossible to remove all the fundamental risk).
36Risks and CostsNoise trader risk: is the risk that the mispricing being exploited by the arbitrageur worsens in the short run.pessimistic investors that become more pessimistic cause an additional lowering of securitity's priceagency feauturearbitrageurs aggresiveness
37Risks and Costs Implementation costs: anything that makes it less attractive to establish a short position than a long one.commissions;bid–ask spreads;price impact;short-sale constraints (the fee charged for borrowing a stock, legal constraints, the cost of finding and learning about mispricing).
39Inflation and the stock market FIRST APPLICATIONInflation and the stock market
40How much the equity of this firm worth? ASSUMPTIONSinflation rate is 6%equity risk premium is zeronominal cost of capital is 10% (a real cost of capital is 4%)Real value of debt unchanged (nominal amount of debt increases by 6% each year)no real growthall free cash flow (if any) is paid out in dividendsHow much the equity of this firm worth?
41DATA Revenue $1,200,000 Cost of Goods Sold $600,000 Administrative Expenses $400,000Interest Expense $200,000Taxes $0After-tax profits $0Debt $2,000,000Book Equity $1,500,000Shares outstanding 10,000Interest rate on debt 10%
42CALCULATION P = Div1/(r – g) P = $12/(0.10 – 0.06) = $300 per share. With inflation at 6% and $2 million in debt, the firm must issue $120,000 more debt next year to keep the real value of its debt constant. This cash can be used to pay dividends. This is $12 per share, and using the growing perpetuity formulaP = Div1/(r – g)with r = 10% and g = 6%,P = $12/(0.10 – 0.06) = $300 per share.So the equity is worth $3 million, or $300 per share.
43CONCLUSIONThe true economic earnings are higher than the accounting earnings, because accountants measure the cost, but not the benefit to equity-holders, of debt financing when there is inflation.Nominal interest expense appears on the income statement. The decrease in the real value of nominal liabilities due to inflation does not appear on the income statement.That why investors don’t take it into account, and hence undervalue equities when inflation is high.
44CONCLUSIONIf the market makes this mistake, then stocks become riskier, because they fall more than they should when inflation increases, and they rise more than they should when inflation decreases. Over a full inflation cycle, these two effects balance out, which is why stocks are less risky in the long run than they are in the short run.
46Prospect theory is a descriptive theory of choice under uncertainty Prospect theory focuses on changes in wealthProspect theory also assumes loss aversionProspect theory also incorporates framing—if two related events occur, an individual has a choice of treating them as separate events (segregation) or as one (integration).
47WE USE PROSPECT THEORY TO EXPLAIN THE SEVERE UNDERPRICING OF SOME IPOS. If an IPO is underpricedpre-issue stockholders are worse off because their wealth has been diluted.if an entrepreneur receives the good news that he or she is wealthy because of a higher than expected IPO pricethe entrepreneur doesn't bargain as hard for a higher offer pricebecause the person integrates the goodnews of a wealth increase with the bad news of excessive dilution
48Underwriters take advantage of this mental accounting and severely underprice these deals.offer price has been raised (a little)the market price goes up a lotthat leave a lot of money on the table
50HOW DO THE CULTURAL DIFFERENCES MAY INFLUENCE ON INVESTORS' BEHAVIOR? In “Does Culture Affect Economic Outcomes?” (Guiso, Sapienza, and Zingales, 2006) defined culture as “those customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation.”Culture matters, and it is persistent.
51THE CASE Completely Fair, Acceptable, Unfair, or Very Unfair. Paul Bond is a lawyer at the Brown & Long law firm. One day he overheard John Grand, another lawyer, talking with an associate about his work on a proposed purchase of the Pillow company by the Down company for $120 per share. Paul Bond had no role in the work on the proposed purchase of Pillow and Brown & Long represented only Down, not Pillow. Paul Bond bought 1,000 shares of Pillow for $70 per share. Please rate Paul’s behavior as:Completely Fair, Acceptable, Unfair, or Very Unfair.
52PERCEPTIONS OF THE FAIRNESS OF INSIDER TRADING BY FINANCE PROFESSIONALS IN EIGHT COUNTRIES Country and percentage of who rated Bond’s behavior Completely Fair or Acceptable:Turkey %India %Italy %Tunisia %Australia %Israel %Netherlands %United States %
53THE SURVEY FOCUSED ON THE PROPENSITY FOR RISK Suppose you are the only income earner in the family, and you have a good job guaranteed to give you and your family income every year for life. Now you are given an opportunity to take a new and equally good job.The new job has a 50/50 chance to increase by 50% OR to reduce by X percent your standard of living each year during your lifetime (circle the maximum X percent reduction you are willing to accept).
55RELATIONS BETWEEN THE VARIABLES - China and Vietnam were the most willing to take risk- Germany and Switzerland were the least willing- Men are more willing than women to take risk with their income and portfolio- People who are ready to take risks with their income are generally also more willing to take risks in their portfolio (except Tunisia)
56TRUST IS THE ASPECT OF A CULTURE The other variable that is consistently related in a significant way to the propensity to take income and portfolio risk is trust:- Trusting people are more willing to invest in stocks and to take risk.- Women are less trusting than men.- China ranked the highest in agreeing that most people can be trusted.
57CONCLUSIONThe ideas of behavioral portfolio theory explain the difference in the responses:Investors tend to think about their money in layers, and job income makes up the basic layer (the safe money), portfolio wealth is in a layer above job income.
59People in low-income countries have high aspirations relative to their current income. But it is not that they like risk. Rather, they pay with risk for a chance to move up in life.Another difference among cultures occurs along the individualism-collectivism line:People in collectivistic countries can afford to take more risk because their in-groups provide downside protection.In individualistic societies, ties among individuals are loose and all are expected to look after themselves and people have a lower propensity for risk.
60AN AWARENESS OF THE CULTURE THAT CLIENTS COME FROM IS IMPORTANT, AND THAT INSIGHT WILL ALLOW ADVISERS TO SERVE THEIR CLIENTS WELL. CULTURES VARY, AND CULTURE MATTERS.