1. Behavioral Finance
Economics 437

2. 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. 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)

4. 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”

5. 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).

6. 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”

7. 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

8. 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

9. The End