1. Gulnur Muradoglu1 Behavioural Finance Fundamentals of Asset Pricing Session 1 Read Daniel, Hirshleifer & Teoh, 2002 Fama, 1991

2. Gulnur Muradoglu2 Outline zTraditional Finance yAssumptions yImplications yLimitations zBehavioural Finance yAssumptions yImplications yLimitations

3. Gulnur Muradoglu3 Traditional Finance zFama, 1970 Efficient Markets I ySecurity Prices fully reflect the available information! yDifferent Forms of Efficiency xWeak Form xSemi-strong form xStrong Form

4. Gulnur Muradoglu4 Traditional Finance zFama, 1991 Efficient Markets II yPrices reflect information to the point where the benefits of acting on information (profits) do not exceed the marginal costs! yInformation and trading costs considered! yMarket efficiency as a benchmark! yMarket efficiency as an approximation! xSimplification of the world!

5. Gulnur Muradoglu5 Traditional Finance zJoint hypothesis problem yMarket efficiency per-se is not testable! yThe hypothesis of market efficiency can be tested jointly with an equilibrium model xan asset pricing model CAPM, APT, FF ….

6. Gulnur Muradoglu6 Traditional Finance zMain Areas of Research yReturn Predictability xtime series xcross sectional xanomalies??? yEvent Studies yTests of Private Information

7. Gulnur Muradoglu7 Investor Psychology zHistorical perspective y1940s-60s behavioural psychology xWatson (1913) xhuman behaviour can be explained by conditioning by means of reinforcement or association y1970s- cognitive psychology xinternal mental states

8. Gulnur Muradoglu8 Investor Psychology zBehavioural concepts developed by y Kahneman, Tversky, Slovic during 1970s xcame to the attention of economists yFirst papers in JF xDeBondt and Thaler, 1985 xShefrin and Statman, 1985 yReview of past decade xDaniel et.al. (2002) xDeBondt, Muradoglu, Shefrin, Stoikauras (2008)

9. Gulnur Muradoglu9 EMH versus Behaviouralists zFreudian Psychology and Keynesian Economics xinterpreted too dogmatically? xExtended beyond realm of validity? xDominated for decades! zFinance yEfficient Markets Hypothesis xinsight is important security prices are influenced by a corrective force –but, corrective tendency carried to extremes! –Arbitrage by rational traders need not eliminate mispricing! –Prices reflect a weighted average of beliefs!

10. Gulnur Muradoglu10 Policy Implications of EMH zImplications for investors? zGovernment initiatives yChicago school versus regulation! zLink between EMH and laissez faire is weak! yPolitical participants are not immune to bias! yCognitive limitations make it hard to adjust x uniformly and consistently! yRegulation xto protect ignorant investors and improve risk sharing xeducation, disclosure, reporting

11. Gulnur Muradoglu11 Behavioural Finance zReview yby Daniel, Hirshleifer and Theoh, 2002 yBy DeBondt, Muradoglu, Shefrin, Stoikauras, 2008 zCognitive Errors ymade by investors and Analysts zExtent to which ythese biases affect prices

12. Gulnur Muradoglu12 Investors zHerd zDo not invest in certain assets xstocks, bonds, commodities… xhome-bias, Levis, Muradoglu, Vasileva, 2011 xfunds invest locally xemployees invest in own firm zDo not want to realize losses xmental accounting, Thaler (1991), Odeon (1998) zUse past performance  future performance xtop performing funds

13. Gulnur Muradoglu13 Analysts zForecasts and recommendations xare biased-optimistic/buy vs. sell, Muradoglu, 2002 zForecasts are predictable xMuradoglu and Salamouris, 2004 zUnderreact/Overreact xDeBondt and Thaler, 1985,1987,1990

14. Gulnur Muradoglu14 Do biases affect prices? zCan predictability be explained by yrisk-based interpretations ypsychology based interpretations? xCAPM, APT, FF January effect? Funds trading at discount? Dual listed securities? Size effect? Value effect? Momentum versus reversal? Post-event drifts? IPOs, SEOs?

15. Gulnur Muradoglu15 Biases in Financial Behaviour zHeuristic simplification zSalience and Availability Effect zFraming zMental Accounting zOverconfidence zSelf-attribution zConfirmatory bias zHindsight bias

16. Gulnur Muradoglu16 Summary zEfficient markets hypothesis zJoint hypothesis problem zDifferent forms of efficiency zBehavioural Finance zBiases in financial behaviour zImplications of biases