9 -- Part 2: Market Efficiency and Behavioral Finance
Money managers are incorporating concepts from vol.
Researchers in behavioral finance believe that investors' decisions are affected by a number of psychological biases that lead them to make systematic, predictable mis takes in certain decision-making situations.
The pre dictable patterns in stock prices that create opportunities for other investors to earn high profits without accepting high risk may be the result of these mistakes.
Let's take a look at some of the behavioral factors that might affect the actions of investors.
Try this experiment.
Ask people in a large group if they think they have above average, average, or below average skill in driving a car.
Most of the group believes that they have above-average ability, and almost no one will claim to have below-average skill.
Some people have to be above average and some people have to be below average.
Some people in the group are over confident in their driving ability.
Self-attribution bias is linked to overconfidence.
It's straightforward to overconfidence.
A decision made by an individual leads to a favorable outcome.
Self-attribution bias causes the individual to discount the role that chance may have played in determining the outcome and to put too much emphasis on his or her actions as the cause.
The individual becomes over confident.
There are bargains with Warren Buffett.
If the investor's portfolio earns summarized summarized high returns in a particular year, that would be a good example.
Perhaps the high returns are due to a booming stock dence in acquisitions in one of his market, but perhaps in addition the investor's stock picks performed even famous letters to shareholders: "many managements apparently better than the overall market."
It's not easy to separate the roles of skill and luck, but most investors would probably attribute the favorable outcome to their own investing in which the imprisoned prowess is.
One study found that investors had portfolios from a toad's body to a princess.
They are certain of their managerial activity because they have outperformed the market in the past.
These investors increased their trading activity more than 70% after beating the market average by 2% per year for several kisses.
The group of investors trailed the market by 3% each year.
Individual investors are not the only ones who have this tendency.
A recent study found that CEOs exhibit similar behavior when they acquire other kisses even after their firms.
Corporate backyards are more likely to be acquired by the CEO if the acquisition target performs well.
There are a number of questions.
You just won $8,500 in a game of chance.
You can either risk your winnings or walk away from them.
There is a chance that you will win an additional $1,500, but there is a chance that you will lose everything.
The majority of people who are asked this question say they would take $8,500.
The expected value from the addi tional gamble is $500.
In this case, the decision to take the $8,500 indicates that the individual is willing to take a risk.
The expected $500 gain is not worth the risk of losing $8,500.
Most people respond differently if we rephrase the question.
In a game of chance, you have already lost $8,500.
You can either walk away or gamble again.
If you gamble, there is a chance that you will lose more money, but there is a chance that you will win more money.
Most people will take the risk to try to get even even, even though the expected value of this gamble is -$500.
People are showing risk-seeking behavior.
They are accepting a risk that they don't have to take and it has a negative expected return.
Selling at the current market price would realize the loss for these homes because they force them to owners.
When prices are falling, trading activity can dry up because investors are reluctant to sell.
A study of residential real homes in Boston found that they sat on the market for months at a time.
When market prices were rising, homeowners were willing to sell their properties.
People feel the pain of loss more than the pleasure of gain.
Loss aversion can lead people to hold onto investments that have lost more money than they should.
Many studies show that investors are more likely to sell a stock that has gone up in value than a stock that has gone down.
The tendency for the stocks that investors sell to perform better than the stocks that they choose to hold has been documented in other studies.
Six people were asked to flip a coin 20 times and count the number of heads that came up.
Six people were asked to imagine flipping a coin 20 times and write down the sequence of heads and tails.
The results were reported by each group.
Group A only imagined flipping coins.
In the M10_SMAR3988_13_GE_C09.indd group that actually tossed the coins, the number of heads varied widely.
Group A subjects assume that the probability of getting a heads on a single flip of a coin is 50%, but they also assume that in 20 flips of a coin, it is very likely that heads will come up exactly 10 times.
It is true that 10 is the average number of heads that one should expect, and that the average number of heads flipped by both groups was about 10.
Individual results vary a bit around that average.
The results of Group B's coin flips clearly show that it is unusual to get 10 heads in 20 flips.
There are a lot of other outcomes that are likely.
Consider the analogy.
If markets are efficient, there is a 50% chance that a stock will do better than average and a 50% chance that it will do worse than average.
Group A investors believe that if one buys 20 stocks it is very likely that the portfolio will be average because 10 stocks will do better than average and 10 will perform worse than average.
Group B knows that a portfolio of 20 stocks could perform better or worse than the average.
In an efficient market, some portfolios will do very well while others will lag behind.
In this experiment, subjects were asked if they obtained a string of five heads or five tails in a row in the course of flipping a coin.
Here are their answers to the question.
The subjects in Group B who actually flipped coins 20 times, getting a string of five flips in a row with the same outcome, was relatively common.
Group A subjects didn't think they would see a string of identical outcomes.
The subjects know that there is a 50% chance of getting heads in every flip, so they imagine that on a series of flips they will see a kind of oscillation in outcomes.
They believe that a sequence of alternating heads and tails is more likely than a sequence with several heads in a row.
This is a representation of what happens at work.
Group A subjects underestimate the likelihood of getting the coin to come up heads or tails several times in a row because they think a 50% gamble is more likely to result in alternating heads and tails.
This feature of representativeness can affect the behavior of investors.
Think about the investors who are trying to make a decision.
50% chance of beating the market in a particular year.
If investors misinterpret that they buy funds that have randomness like the subjects in Group A did, they will believe that it is very exhibited recent good performance and sell funds that have poor recent unlikely for a fund manager to have a string of several good years in a row.
The market is efficient.
These investors will interpret a string that reduces the of good years as a sign that the market is not efficient, at least not for the average investor's return by 1.5% fund manager achieving that string of good performance.
Research shows that investors overreact to a string of good performance and pour money into successful funds, enriching the fund managers but not necessarily them selves.
Many investors see a string of good performance and underestimate the likelihood that the trend will continue.
Even though there is no objective evidence that past performance is a good predictor of future success, investors overreact to the past.
The value phenomenon may be explained by this logic.
Value stocks have low prices compared to earnings or book value.
Several years of declining prices puts these stocks in the value category.
The results of a very simple trading rule were studied in one of the earliest studies of the value effect.
When you're most frightened is the best time to buy the growth stocks.
The researchers said it was due to representativeness.
They proposed that investors who watched certain stocks decline in value for three years in a row overreacted and bid the prices of these stocks below their true values.
After watching other stocks do well for several years in a row, investors assumed that this excellent performance would continue, and they bid up the prices of these stocks above their true values.
When the firms that had been performing poorly rebounded, the firms that had been earning great returns failed to do so.
Value investors made money when the price trends reversed.
Individual investors are likely to be affected by representativeness.
Consider a firm that wants to make an acquisition.
Recent increases in sales might be a criterion.
There is research evidence that says no.
There is no correlation between how fast firms have grown in the past and how fast they will grow in the future.
That is a fundamental prediction of basic economic theory.
Other firms will enter the industry when one firm has great success.
The percentage of households with higher incomes tors, particularly those with lower and greater wealth who owned stocks rose from 2010 incomes and wealth, displayed particularly poor to 2013).
In other words, the rich got richer because of the downturn in the stock market in 2008 and the timing of their investment decisions.
They continue to invest in the market.
The percentage of lower-income households who did not benefit from the subsequent stock market owned was less from the Fed's triennial Survey of Consumer Finance.
Managers pay a larger premium when they acquire firms that experienced rapid growth prior to the acquisition, even if the growth is low.
Representation can cause investors to underreact to new information.
Consider the problem from statistics.
There are 100 sacks of poker chips on the table.
The sacks contain 70% black and 30% red chips.
There are 55 bags that hold 70% red and 30% black chips.
The majority of people get this answer right.
If 45 out of 100 bags contain mostly black chips, then the chance of picking a bag that has mostly black chips is 45%.
This is a more difficult problem.
If you choose one bag at random and take out 12 chips, you won't notice the others.
8 of the chips are black and 4 are red.
If the sample of 12 chips taken from the bag has a majority of black chips, the probability that the bag has mostly black chips is higher than in the first problem where we pick a bag at random and learn nothing more about it.
A recent study found that it is primarily reading firms' earnings announcements when drawing poker chips out of a bag.
Individual investors underreact a mix of good and bad news in earnings announcements.
Representativeness may cause investors to make announcements when a company announces good or bad news.
It's possible that investors don't appreciate the fact that individuals tend to sell their shares very good earnings news this quarter if they think the news next quarter will be bad.
When the firm announces earnings, investors are surprised.
If the news is positive, the firm's stock price will go up again.
The post earnings announcement drift could be explained by Profes sional investors.
A reader may object that we have said that representativeness can lead to both overreaction and underreaction in the case of value stocks.
There are important differences in the nature of the information that investors are reacting to.
In the value phenomenon, inves tors see a string of good and bad years.
When earnings announcement drift occurs, investors respond to a single new piece of information that is either good or bad.
People tend to ignore the larger context when analyzing a situation in isolation.
The asset allocation decisions that investors make in their retire ment plans are a common example in investments.
The retirement savings plans offered to employees of two firms are summarized in the table below.
Employees of Firm A can invest in a stock fund or a bond fund.
Firm B has two options--a stock fund and a blended fund that holds 50% stocks and 50% bonds.
Research shows that many investors follow a simple guideline of putting 50% into one fund and 50% into the other, because they view this decision through a narrow frame of two choices.
It's like investors know that they should invest in more than one option, so they divide their investments equally.
The asset allocation of individual funds affects the overall position of investors' portfolios.
The options offered by each company combined with the narrow frame creates an odd out come.
If employees of Company A divide their money between the stock fund and bond fund, they will end up with portfolios with 50% stocks and 50% bonds.
The stock fund and blended fund are the two funds that employees of Company B divide their money between.
An overall portfolio allocation of 75% stocks and 25% bonds is achieved by splitting money equally between those options.
The retirement portfolios held by employees of Company B are riskier than those held by workers at Company A, but not necessarily because Company B's employees prefer to take more risk.
The risk of their portfolios is influenced by framing.
They tend to discount any signs of trouble if they believe a stock is good.
They don't gather new information for fear it will change their opinion.
It would be better to view each stock owned as a new stock when periodi calls and asks if the information available at that time would cause you to buy or sell the stock.
It is well known that a firm's past rate of growth in revenues is not a good predictor of its future growth rate.
When individuals are asked to predict the sales growth rate for a firm, information about the firm's past growth rate can influence their projections.
When individuals know that a firm's past growth rate has been low, they tend to predict faster sales growth.
The expected return on the market is a key component of the capital asset pricing model.
An expectation for the market's future return is required to use the CAPM.
They anchor on the market's recent returns.
According to surveys of investors, when the previous year's stock market return was high, investors expect a higher return in the following year compared to cases in which the previous market return was low.
When investors base their forecast on recent past returns, they were overestimating the market's return, because high past returns are not a reliable signal for high future returns.
There are a number of analytical methods that investors can use to decide if they want to purchase an investment.
According to research, investors tend to invest in stocks located close to their homes.
Professional investors are not immune to this bias.
According to a recent study, mutual fund managers tend to invest more in their home states.
It's not a bad thing to invest in something familiar.
Being familiar with a company may help investors decide if that company's stock is a good buy.
If familiarity helps give investors an information edge, inves tors should earn higher returns on their investments based on familiarity.
The evidence on this question is mixed among professional investors.
One study found that mutual fund managers earned high returns on their investments in nearby firms, but other studies found that investing in companies based on familiarity influenced fund managers to form portfolios that were not fully diversified.
The funds did not earn higher returns, but they did experience higher risk.
There is a potential downside to investing heavily in familiar stocks.
Specific geographic areas are where industries are concentrated.
If investors invest mostly in companies from northern California, they will form portfolios that are heavily weighted in tech firms, neglecting other sectors of the economy.
Underdiversified portfolios may be held by investors because of familiarity bias.
Diversification opportunities bear more risk for investors who don't take full advantage of them.
Behavioral finance can play an important role in investing, according to our discussion of the psychological factors that affect financial decisions.
The debate on the efficiency of markets will continue for a long time.
There are a number of behavioral factors that influence investors' decisions and adversely affect their returns.
You can improve your portfolio's performance by following simple guidelines.
Don't hesitate to sell a losing stock.
If you buy a stock at $20 and it goes to $10, ask yourself if you would buy it again if you had $10 in cash.
Hang onto the answer if it's yes.
Sell the stock and buy something else.
Don't chase your performance.
Past performance is not a good guide to future performance according to the evidence.
The best performing mutual funds in the last year or five years are not likely to perform as well in subsequent years.
Don't buy the hottest mutual fund because of its performance.
Keep your investment objectives and constraints in mind.
Many investment professionals are often wrong in their predictions.
Don't be afraid to take corrective action if you make a mistake.
All investors make mistakes, but the smart ones learn from them, so reviewing your mistakes can be a very rewarding exercise.
Learning from your mistakes is one way to avoid losing in the market.
You should review the performance of your investments on a regular basis.
Don't be afraid to make changes as your situation changes.
Investment portfolios are included.
Investment returns are uncertain.
Evidence shows that investors who trade frequently perform poorly.
The mistakes of some investors may be related to the profit opportunities for others.
Our advice on how to keep your own mistakes to a minimum can be found in Table 9.1.
Value stocks tend to do better than growth stocks.
There are many good reasons to believe that stock prices are inherently unpredictable in the first section of this chapter.
The second section presented the behavioral finance challenge to market efficiency and discussed the evidence that there is at least some predictability in stock returns.
If investors know about them and can spot them early, they can earn better-than-average returns.
Tech nical analysis uses past price movements to predict future returns, which is fundamentally at odds with the weak form of market efficiency.
Technical analysis remains controversial because of this.
It's another piece of information to use when making a decision on whether to buy, hold, or sell a stock.
It's the only thing they use in their investment decisions.
Technical analysis is a waste of time.
There was no such thing as an industry or company analysis in the 1800s.
Detailed financial information about individual com panies was not made available to the general public.
The market was the only thing investors could study.
Some investors used charts to watch market operators.
The purpose of the charts was to show when major buyers were moving into or out of a stock and to provide useful information for profitable buy-and-sell decisions.
The stock price movements were the focus of the charts.
When the time was right to buy or sell a stock was indicated by certain movements.
The principle is the same.
Technical analysts argue that internal market factors, such as trading volume and price movements, reveal the market's future direction long before financial statistics.
If we use technical analysis to assess the market, we need a tool or measure to do it.
Charts are popular with investors because they give a visual summary of the behavior of the market and the price movements of individual stocks.
Some investors prefer to study market statistics.
They may look at trends in market indexes or other aspects of market behavior such as trading volume, short selling, or trading behavior of small investors.
Technical analysis addresses factors in the marketplace that can affect the price of stocks in general.
The idea is to understand the general condition of the market and to gain some insights into where the market may be headed over the next few months.
We summarize some of the more common approaches that try to do that.
The yield on 10 intermediate-grade bonds is related to the average yield on 10 high-grade corporate bonds.
The yield spread is the difference between high-grade bonds and intermediate grade bonds.
The confidence index should never exceed 1.0 because the yield on high-grade bonds should always be lower than the average yield on a sample of intermediate-grade bonds.
According to the theory, the two sets of bonds will get smaller and smaller.
The idea is that as investors become more confident about the economy, they will be willing to invest in riskier bonds, driving down their yields and pushing up the confidence index.
Consider a point in time where high-grade bonds are yielding 4.50%, while intermediate-grade bonds are yielding 5.15%.
This would result in a yield spread of 65 "basis points," or 65/100 of 1%, and a confidence index of 4.50.
These show that investors are demanding a lower premium in yield for riskier bonds in order to show more confidence in the economy.
This theory suggests that a rise in the confidence index is indicative of a rise in the stock market, because the trend of "smart money" is usually revealed in the bond market before it shows up in the stock market.
The amount of investor interest in a stock is reflected in the market volume.
The end of the bull market may be signaled by the drop in investor sentiment and volume.
The average one-day return on the U.S. stock market is lower for stocks that go up in price.
The average return on a day with a principle behind it is that the number of advances and declines in a major airline disaster is indicative of investor sentiment.