Behavioral

Finance
Professor David McLean
Alberta School of Business

What We Will Discuss

Evidence Against Efficient Markets
Gangnam Style!
Systematic Evidence

Define behavioral finance

Contrast with market efficiency

Psychology and Finance

Costly Arbitrage

Contradicting Market
Efficiency
Last lecture we saw a good deal of evidence that
suggests markets are efficient
Now Ill show you some evidence that contradicts
market efficiency
This evidence does not mean that you can make
money trading in the stock market, but it does
suggest prices are not right
Ill later explain that these effects might exist
because people cannot easily make money from
them

Sometimes Investors are Just

Confused
DI Corp Maker of
Gangnam Style

Semiconductor
Equipment

Gangnam Style and DI

Corp
The hit song Gangnam Style is sung and
performed by the South Korean rapper PSY
PSYs father is the Chairman and CEO of DSI corp.,
a maker of semiconductor equipment
DSI corp. has no financial interest in the Gangnam
Style hit
Yet DSIs stock price surged 800% around the time
of the songs popularity, and then fell back to
normal levels

Gangman Style and DI

Corp

Stock Market Anomalies

Recall that in an efficient market, stock returns
follow a random walk
Stock returns only reflect compensation for risk,
and do not have any alpha or excess returns
It turns out there are numerous strategies that
can predict stock returns, and thus contradict
market efficiency
Well discuss a few of the more prominent ones

Trading Rules: Return

Anomalies
January Effect
Size Effect
Momentum Effect
Long-Term Reversal
Value Effect
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Post-Earnings Announcement Drift

The January Effect

Source : Haug and Hirschey (2006)

Size Effect

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Momentum and Reversal

Momentum: Returns persist over 3-12
month horizons
Winners remain winners, and losers remain
losers

Long-term reversal: Returns reverse

over 2-5 year horizon
Winners become losers, and losers become
winners

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Momentum

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Source : Jegadeesh and Titman
(2001)

Long-Term Reversal

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Book-to-Market Effect

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Post-Earnings Announcement
Drift

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My Own Research on This

Replicated strategies from 95 different studies purporting to show
evidence of stock return predictability
You can read about it here (optional):
http://www.ft.com/intl/cms/s/2/6b82b18a-24e1-11e2-86fb00144feabdc0.html#axzz2HrqjnEIl
Found that after the papers were published, the alpha of the average
strategy decline by 50%
Declines were smaller for strategies that are more costly to trade in
(more on this in the slides that follow)
Trading activities in stocks that belong in the strategy portfolios also
increase after publication

Bottom Line: investors learn about alpha and then trade on it, making
markets more efficient

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Do Practitioners Read Academic

Papers?

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Efficient Markets Hypothesis

(EMH)
Recall that EMH contends that prices
reflect all available information
The market is efficient if each
securitys price = its fundamental
value
Markets are efficient because either
People are rational as in the CAPMor
Arbitrageurs correct all mispricing

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Behavioral Finance
Contends that financial markets can be
inefficient, even for long periods of time
Investors can be irrational when making
investment decisions mispricing
Such mispricing cannot be fully
exploited because arbitrage is costly
Therefore mispricing can persist

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Behavioral Finance

2 Main Building Blocks

Psychology
Investors are irrational in a systematic way
Irrational here does not mean crazy, it just
means that people do not make investment
decisions like the CAPM says they do

Costly Arbitrage
Arbitrage is costly and therefore limited

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Psychology
Well discuss three psychological
effects that seem to matter for
finance
Nave Extrapolation
Biased Self Attribution
Conservatism

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Nave Extrapolation
Nave extrapolation is the tendency to
extrapolate the past into the future
Example: Housing prices climbed over
the last 5 years, so it must be that
housing is always a good investment
Example: Tech stocks have gone up a
lot over the last few years, so theyll
keep going up over the next few years

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Nave Extrapolation and Market

Forecasters
From a recent study by Greenwood and Shleifer
(2014)
Examine surveys that ask professional investors to
forecast stock market returns
Six separate surveys show that investor
expectations are the opposite of future returns
When professional investors expect high returns,
subsequent returns are low, and vice-versa
Investors expect future returns to be high (low)
when past returns were high (low), i.e., nave
extrapolation

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Nave Extrapolation and Return

Anomalies
Here are a few examples of return anomalies that might
be explained by nave extrapolation
Value vs. Growth or Glamour:
Stocks with high (low) price-to-book and price-to-earnings
ratios have low (high) returns

Long-term reversal:
Stocks with high (low) returns over the last 5 years
reverse and have low (high) returns over the next 5 years

Sales growth
High (low) sales growth over the last 5 years portends
(low) high stock returns

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Nave Extrapolation and Value

Investing

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Nave Extrapolation and Mutual

Funds
Nave extrapolation could explain how
investors choose investment managers
A mutual fund had really high returns over
the last few years, so investors conclude
that the fund has a good fund manager
Based on this information, investors invest
in the fund
But they might be choosing a lucky fund
manager, and not a good one

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Nave Extrapolation and Mutual

Funds

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Psychology Attribution Bias

Self-Attribution Bias
Events that confirm a persons ability
are because of the persons high ability
My portfolio did well because I am smart, as
opposed to lucky

Events that disconfirm a persons

ability are due to bad luck or sabotage
I did poorly on the midterm because David
made an unfair exam, as opposed to my not
studying enough

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Self Attribution and Random

Walks
Recall from last section that in an
efficient market stock prices follow a
random walk
Lets assume that stock prices mostly
follow a random walk, at least over daily
intervals (this is mainly true)
Could this cause an investor with a selfattribution bias to confuse luck for skill?

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Self Attribution and Random

Walks
Lets consider a nave investor with a
self-attribution bias
Due to randomness, half of the investors
trades would be good, and half would not
be good
This person would think they are a good
trader, and perhaps would trade excessively
because of this
Some evidence from academic research

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31

Psychology Conservatism
Conservatism
Slow updating when facing new information
that contradicts current beliefs
As an example, I think a firm is a fastgrowing firm, so I ignore new information
that suggest its growth is beginning to slow
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Conservatism and Post-Earnings

Drift
Recall the post-earnings drift
effect from the market efficiency
section
Firms with positive (negative) earnings
surprises have stock price drifts in the
direction of the surprise
Could reflect underreaction to news that
suggests a change in direction for the firm

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Costly Arbitrage
If investors are irrational, and systematically
make mistakes, then why dont other people just
capitalize on this, and keep markets efficient?
Because arbitrage is costly, and things that are
costly are limited
Rational arbitragers only trade if the benefit of a
trade exceeds its costs
So long as arbitrage is costly, some level of
mispricing can persist

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Arbitrage Costs
Two types of costs involved with arbitrage
both reduce the arbitrageur's utility
Transaction Costs
Occur when you open or close a position
E.g., Commissions, bid-ask spreads, price impacts

Holding Costs
Occur while a position is open
Lending fees on borrowed shares, margin rates
Noise trader risk, fundamental risk

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Costly Arbitrage
Its easy to see the effects of
transaction costs and some holding
costs on arbitrage
As an example, if mispricing is $1 and
arbitrage costs are $2, then the
arbitrageur will not trade
Arbitrage costs are an upper bound on
the level of mispricing in the security

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Arbitrage and Transaction

Costs

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X = Transaction
Costs

Costly Arbitrage
The effects of other holding costs,
namely arbitrage risks, are more
subtle
How risk affects arbitrage depends on
the level of the risk and the
arbitrageur's risk aversion

Well consider two types of risk

Noise trader risk
Fundamental risk

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Costly Arbitrage
Noise traders
Irrational investors who trade on noise as if it were
real information

Noise trader risk

The risk that mispricing will get worse before it gets
better

Example
A stock is trading for $80 per share, but worth $100
Do you buy the stock?
How do you know the price wont go to $70, or $50
before it corrects?

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Costly Arbitrage
Fundamental Risk
The risk that the intrinsic value of an
investment changes after you buy it
The fundamentals of companies can
be volatile, so fundamental value can
vary
Fundamental volatility can cause
arbitrageurs to lose money; this in
turn reduces arbitrage in volatile
investments

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Arbitrage Risks and Fund

Managers
Noise trader risk and fundamental risk
can be especially problematic for
professional investors
Professional investors are mainly
judged on past performance
Risk can make performance look bad,
even if the fund manager made good
bets
For this reason, fund managers might
avoid positions that are highly volatile

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Noise Trader Risk Example

Banks

Tech

Value

100

100

Price at t=0

90

90

Price at t=1

100

80

Profit at t=1

10

-10

Mispricing at
t=1

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Fundamental Risk Example

Banks

Tech

Value

100

100

Price at t=0

90

90

Value at t=1

100

80

Price at t=1

100

80

Profit at t=1

10

-10

Mispricing at
t=1

0
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Volatility, Arbitrage, and Market

Efficiency
What the last few slides show is that all else equal,
arbitrageurs prefer less volatile assets
Recall that systematic volatility can be hedged, so
what arbitrageurs need to avoid is idiosyncratic or
unhedgeable volatility
Hence, we might expect less efficiency or more
mispricing in high idiosyncratic risk assets
Consistent with the CAPM lecture
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Good deal of empirical research supports this

From the CAPM/Arbitrage

Lecture
1
Max U E(rc) A c2
wi , wm
2
N
i
E(rm )-rf
wi 2 ; wrm
; wrf (1 wi wm)
2
A ie
A m
i1

Unhedgeable
risk limits
arbitrage

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What you should know

Describe the return anomalies
Describe behavioral finance
Two main building blocks

Psychology
Three effects that are especially pertinent to
finance

Costly Arbitrage
Transaction costs
Holding costs

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