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Behavioral Finance – A Challenge to Market Efficiency Henry Fiebelkorn Behavioral Economics Dr. D. Kuebler, SS2003.

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Presentation on theme: "Behavioral Finance – A Challenge to Market Efficiency Henry Fiebelkorn Behavioral Economics Dr. D. Kuebler, SS2003."— Presentation transcript:

1 Behavioral Finance – A Challenge to Market Efficiency Henry Fiebelkorn Behavioral Economics Dr. D. Kuebler, SS2003

2 Seminar Behavioral Economics SS Behavioral Finance | Structure Introduction Behavioral Finance and Overview Summary and Outlook Market Phenomena - Anomalies I V II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV

3 Seminar Behavioral Economics SS Behavioral Finance | Introduction „Modern finance theorists have turned finance into a science, but they forgot that it is a social science!“ State of Modern Finance: Current State: Behavioral Finance: PerfectPerfect Perfect Markets & Perfect People ImperfectPerfect Imperfect Markets & Perfect People Imperfectmperfect Imperfect Markets & Imperfect People BF:is the application of psychology to financial behavior – the behavior of practioners. Aim: recognize, understand and avoid mistakes.

4 Seminar Behavioral Economics SS Behavioral Finance | Behavioral Finance Classification Framing Aspects HeuristicsSelf-Concept Mental Accounting Prospect Theory Representativeness Availability Anchoring Ambiguity Aversion Overconfidence Self-Attribution Cognitive Dissonanz Self-Control Confirmation Bias Herding Conservatism Underlying Concepts: 1.Bounded Rationality 2.Emotions

5 Seminar Behavioral Economics SS Behavioral Finance | Structure Market Phenomena - Anomalies Summary and Outlook II V Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV Introduction Behavioral Finance and Overview I

6 Seminar Behavioral Economics SS Behavioral Finance | Anomalies Volume Volatility Dividends Equity Premium Puzzle Book-to-Market Ratio 1.Anomalies are consistent 2.Violate the Efficient Market Hypothesis

7 Seminar Behavioral Economics SS Behavioral Finance | Structure Introduction Behavioral Finance and Overview Summary and Outlook Market Phenomena - Anomalies I V II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV

8 Seminar Behavioral Economics SS Behavioral Finance | Model of Investor Sentiment Existing Approaches “Inefficient Markets” by Shleifer (2000) Abitrageurs: Follow Standard CAPM: No cognitive errors Utility expressed motives Try to exploit Noise Trader Information TraderNoise Trader Outside CAPM (BAPM): Cognitive errors: listen to gurus, follow rumors Value expressed motives = Investor Sentiment

9 Seminar Behavioral Economics SS Behavioral Finance | Model of Investor Sentiment Existing Approaches Abitrage is limited because: 1.Securities don´t have obvious substitutes 2.Abitrage is risky (Risk Aversion) 3.Noise Trader Risk Price changes in absence of fundamental news! Belief about Noise Trader determines price

10 Seminar Behavioral Economics SS Behavioral Finance | Model of Investor Sentiment Existing Approaches Price Determination: Two Earning Regimes: Prior views No revaluation due to News ConservatismRepresentativeness give up old model Attach to new model due to Underreaction Overreaction

11 Seminar Behavioral Economics SS Behavioral Finance | BSV - Model Existing Approaches Captures 2 Judgement Biases: Barberis, Shleifer, Vishny (1998) Representative- ness Bias Conservatism Underreaction of Stock Prices Overreaction of Stock Prices Investors: 2 Earning Regimes: Barberis, Shleifer, Vishny (1998) Earnings are meanreverting Firms´ earnings are trending (+) (-) Change temporarely Long-term- Change

12 Seminar Behavioral Economics SS Behavioral Finance | DHS - Model Existing Approaches Captures 2 Judgement Biases: Daniel, Hirshleifer, Subramanyam (1997) OverconfidenceSelf-Attribution Exaggerate Privat Information Downweight Public Information (+) (-) Special Prediction: Selective Items

13 Seminar Behavioral Economics SS Behavioral Finance | Behavioral Asset Pricing Model (BAPM) Existing Approaches 16 Strong: Jewelry Less: Automobiles Absent: Laundry value expressed characteristics Enable user to identify value of products Risk: Automobiles : Laundry Utilitian characteristics Rational Utility Utilitarian characteristics vs. Value expressed characteristics (Timex /Rolex example) “Behavioral Asset Pricing Theory” by Shefrin, Statmen (1994) BAPM

14 Seminar Behavioral Economics SS Behavioral Finance | Model Requirements Identification of preferences of the buyers/sellers Characteristics capturing value expressive (VEC) & utilitarian preferences (UC) Conclude with equilibrium prices Behavioral Asset Pricing Model: Should include: 1.What investors think 2.How they asses risk 3.How they forecast growth 4.What rules they follow

15 Seminar Behavioral Economics SS Behavioral Finance | Structure Introduction Behavioral Finance and Overview Summary and Outlook Market Phenomena - Anomalies I V II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV

16 Seminar Behavioral Economics SS Behavioral Finance | Applying Behavioral Finance Investors Limitations Internal Mental Accounts Heuristics Self-Deception External Biases information Limitation of time &resources Practical restrictions

17 Seminar Behavioral Economics SS Behavioral Finance | Applying Behavioral Finance Emotional Feelings Investor Performance Pressure Time & Resource Constraints Uncertainty Overload of Information Heuristics Practical Restrictions Biased Information

18 Seminar Behavioral Economics SS Behavioral Finance | Coping with Limited Rationality Applying Behavioral Finance 4. Heuristics 1. Identify / Framing 2. Editing 3. Decomposition „People are intendedly rational but limited to do so!“

19 Seminar Behavioral Economics SS Behavioral Finance | Applying Behavioral Finance Behavior: Overreaction Underreaction Extrapolation Herd Behavior Investment Strategies Value Investing Mean Reversion Strategy Momentum Strategy Event Studies Earning Revision Strategies Combination Studies

20 Seminar Behavioral Economics SS Behavioral Finance | Loss Aversion Behavioral Finance leads to product development Applying Behavioral Finance Guaranteed products RenteMaXX Best of World Garant Fund Overconfidence Absolute Return Daytrading Hedge Funds: Event driven Opportunistic Relative value

21 Seminar Behavioral Economics SS Behavioral Finance | Structure Introduction Behavioral Finance and Overview Summary and Outlook Market Phenomena - Anomalies I V II Financial Asset Pricing Theory – Behavioral Models III Applying Behavioral Finance IV

22 Seminar Behavioral Economics SS Behavioral Finance | ll 1.Be aware of information biases: seek and screen information actively 2.Avoid narrow framing, anchoring, overconfidence 3.Follow rules of decision making under uncertainty Investor Market 1.Market and people are imperfect 2.There are systematic and recurring market inefficiencies Anomalies are consistent and can´t be ignored 3.Sensible implementation of irrational human behavior into asset pricing models necessary VEC as well as UC must be included Summary What lessons does Behavioral Finance teach us? Thanks for your attention!


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