Behavioral Finance Economics 437

Trader Folk Lore Stock Price Momentum Charting stocks by tracking stock prices Trend following Mean Reversion Returns will revert to a mean return Stocks with very high returns will, in the future, underperform stocks with very low returns Other Buy in December, Sell on Friday night, buy on Monday night

Accounting Background Double-Entry Accounting Balance Sheet As of Specific Date “Book Value” is Net Worth On the balance sheet Assets Liabilities Can be obtained from SEC “Edgar” website for all Public companies Net Worth (= A – L)

Trading Background Stocks trade in “two-sided” markets Bid – highest price anyone wishes to buy the stock Offer – lowest price anyone wishes to sell the stock At any moment, there is a “bid-offer” market Last price is not necessarily a “true price” as in the sense of the price of something you might purchase in a store “Wall Street Traders” (Morgan Stanley, Goldman Sachs) are actually “market makers”

Data in Fama and French 1962 -1989 data Book Value (leverage and price/earnings) at previous year end Returns starting on July 1 of the following year (also use the market equity as of July 1 for size, but use market equity at previous year end for B/M calculation) Calculate monthly returns Each month the cross-section of returns is regressed on explanatory variables. Prior research used “portfolio betas”; F-F use individual stocks Sort stocks into “size deciles” Sort each size decile into 10 portfolios based on beta Calculate equal weighted monthly returns on the portfolios for the next 12 months (from July to June).

Results on Beta Portfolios in size deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return Large size means lower beta and lower returns When size deciles are subdivided into beta ranked decile portfolios Larger size firms have lower returns “no relation between average return and beta”

Results on Book/Market What is book to market Book is firm net worth reported on 10-Ks Market is: shares outstanding times price Book/market is positively related to returns Size still matters but B/M is much more important B/M swamps leverage and E/P Leverage: book or market leverage? January “slopes” twice slopes of other months Overall largest decile book to market beats smallest decile book to market by 1.53 % per month

Significance of F-F Provided a simple rule for investing success Seems to contradict Semi-Strong EMH Made “respectable’ earlier work that provided simple, but successful investment rules DeBondt and Thaler, for example

The End