1. Behavioral Finance Fama French March 24 Behavioral Finance Economics 437

2. Behavioral Finance Fama French March 24 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

3. Behavioral Finance Fama French March 24 Definition of absence of serial correlation Let p t-1, p t-2, p t-3, etc. be a series of past prices Now, think about, p t E[ p t | info, p t-1, p t-2, p t-3, etc.] = E[ p t | info] Then, no serial correlation

4. Behavioral Finance Fama French March 24 “Cross Section” vs “Time Series” Cross Section Pick a date (or a time period) Collect data only for that date (or time period) Explain variations in the data for that time period only Time Series Pick a stock Collect data for that stock over many time periods

5. Behavioral Finance Fama French March 24 DeBondt-Thaler 1984 “Over-Reaction” Hypothesis Suggests that: After a period of “over-reaction,” markets “revert” back and go the other way. Stocks that have done well in the past, do poorly in the future Stocks that done poorly in the past, do well in the future Their article is designed to test whether or not “mean reversion” is true.

6. Behavioral Finance Fama French March 24 Data NYSE data Jan 1926 through December 1982 Monthly return data Begin with three year lookback in Dec 1932 Monthly data from Jan 1930 through Dec 1932 36 months or three years data Form portfolios of L(osers) and W(inners) Then see how they do for the next three years

7. Behavioral Finance Fama French March 24 DeBondt and Thaler: “Does the Stock Market Overreact” (1985) L – three year loses W – three year winners Question: How do the W’s do in the next three years? How do the L’s do in the next three years? Other things worth noting Almost all of the impact is in January When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation

8. Behavioral Finance Fama French March 24 DeBondt-Thaler conclusions Definite evidence of mean reversion (a form of serial correlation): L portfolios consistently outperform W portfolios 19.6 % better than the market after end of 3 years W portfolios consistently underperform the market 5 % less than the market after end of 3 years

9. Behavioral Finance Fama French March 24 Interesting facts Most of the excess returns are in January Loser effect more pronounced: Losers earned 19.6 % more than the market Winners earn 5.0 % less than the market Loser portfolio minus Winner portfolio return = 24.6 %!!!!! Most of the return difference is during 2 nd and 3 rd year Larger loses become larger winners; larger winners become larger losers

10. Behavioral Finance Fama French March 24 What was the reaction to D-T Largely ignored by the academic literature Then, in 1992, along came Fama-French on “Cross-Section” returns

11. Behavioral Finance Fama French March 24 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).

12. Behavioral Finance Fama French March 24 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”

13. Behavioral Finance Fama French March 24 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

14. Behavioral Finance Fama French March 24 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

15. Behavioral Finance Fama French March 24 The End