© The University of Queensland 2024
This content is protected and may not be shared, uploaded, or distributed.
Lecture 1: Behavioural Finance
Bodie, Kane and Marcus 12E McGraw Hill: Chapter 11, 12
Semester 1, 2024
Contents
2
Efficient Market Hypothesis Behavioral Finance Behavioral Biases: Examples
Versions of the EMH The Behavioral Critique Limits to Arbitrage
Types of Stock Analysis Errors in Information Processing Technical Analysis
Efficient market hypothesis is
A. Resources are allocated efficiently
B. Prices react fast and without bias
C. I don’t know what EMH is
D. Prices react fast but with bias
Efficient Market Hypothesis (EMH)
• EMH says stock prices already reflect all available information
• A forecast about favorable future performance leads to favorable
current performance, as market participants rush to trade on
new information.
Result: Prices change until expected returns are exactly
commensurate with risk.
Efficient Market Hypothesis (EMH)
• New information is unpredictable; if it could be predicted, then
the prediction would be part of today’s information.
• Stock prices that change in response to new (unpredictable)
information also must move unpredictably.
• Stock price changes follow a random walk.
Figure 11.1 Cumulative Abnormal Returns Before
Takeover Attempts: Target Companies
Figure 11.2 Stock Price Reaction to CNBC Reports
Versions of the EMH
• Weak
• Semi-strong
• Strong
• All versions assert that prices should reflect available information
Types of Stock Analysis
• Technical Analysis - using prices and volume information to
predict future prices
- Success depends on a sluggish response of stock prices to
fundamental supply-and-demand factors.
- Weak form efficiency
• Relative strength
• Resistance levels
The difference between a martingale (random walk) and a
submartingale is the expected price change in a martingale
(random walk) is____, and the expected price change for a
submartingale is____.
A. Positive; zero
B. Positive; positive
C. Positive; negative
D. Zero; positive
E. Zero; zero
Types of Stock Analysis
• Fundamental Analysis - using economic and accounting information
to predict stock prices
- Try to find firms that are better than everyone else’s estimate.
- Try to find poorly run firms that are not as bad as the market thinks.
- Semi strong form efficiency and fundamental analysis
Behavioral Finance
Conventional Finance Behavioral Finance
• Prices are correct and
equal to intrinsic value
• Resources are
allocated efficiently
• Consistent with EMH
• What if investors don’t
behave rationally?
The Behavioral Critique
Two categories of irrationalities:
1. Investors do not always process information correctly
• Result: Incorrect probability distributions of future returns
2. Even when given a probability distribution of returns, investors
may make inconsistent or suboptimal decisions
• Result: They have behavioral biases
Which of the following do you prefer?
A. $1m with chance of winning of 100%
B. $1m with 89% chance; $0 with 1% chance and
$5m with 10% chance
Which of the following do you prefer?
A. $1m with 11% probability and $0 with 89%
probability or
B. $5m with 10% probability and $0 with 90%
probability.
Rational decision
CHOICE 1
A. $1m with chance of winning of 100%
$1M x 100% = $1M
B. $1m with 89% chance; nothing with 1% chance and $5m with 10% chance
$1M x 89% + $0 x1% +$5M X 10% = $1.39M
CHOICE 2
A. $1m with 11% probability and $0 with 89% probability
$1M x 11% + $0 x 89% = $110,000
B. $5m with 10% probability and nothing with 90% probability.
$5M x 10% + $0 x 90% = $500,000
Linda is 31 years old, single, outspoken, and very bright. She
majored in philosophy. As a student, she was deeply
concerned with issues of discrimination and social justice, and
also participated in anti-nuclear demonstrations.
Which is more probable?
A. Linda is a bank teller
B. Linda is a bank teller and is active in the feminist
movement
Conjunction fallacy
Choosing a very low probability of Linda being a bank teller, say
Pr(Linda is a bank teller) = 0.05 and a high probability that she
would be a feminist, say Pr(Linda is a feminist) = 0.95, then,
assuming independence, Pr(Linda is a bank teller and Linda is a
feminist) = 0.05 × 0.95 or 0.0475, lower than Pr(Linda is a bank
teller).
Proponents of EMH typically advocate
A. An active trading strategy.
B. Investing in an index fund
C. A passive investment strategy
D. An active trading strategy and investing in an
index fund
E. Investing in an index fund and a passive
investment strategy
Errors in Information Processing: Misestimating
True Probabilities
1. Forecasting Errors: Too much weight is placed on recent
experiences
2. Overconfidence: Investors overestimate their abilities and the
precision of their forecasts
3. Conservatism: Investors are slow to update their beliefs and
under react to new information
4. Sample Size Neglect and Representativeness: Investors are too
quick to infer a pattern or trend from a small sample
Behavioral Biases: Examples
1. Framing
• How the risk is described, “risky losses” vs. “risky gains,” can
affect investor decisions
2. Mental Accounting
• Investors may segregate accounts or monies and take risks
with their gains that they would not take with their principal
If you are faced with the following choice, which
alternative would you chose?
A. A sure gain of AUD 240
B. A 25% chance to gain AUD 250 and a 75%
chance to gain nothing.
If you are faced with the following choice, which
alternative would you chose?
A. A sure loss of AUD 750
B. A 75% chance to lose AUD 1000 and 25%
chance to lose nothing
Imagine you have bought a AUD 50 ticket to a concert. When
you show up at the door and realise you have lost your ticket,
do you buy another?
A. Yes
B. No
Now imagine say you hadn’t bought the ticket yet, and you
show up at the door of the concert hall to buy your ticket.
Unfortunately, you realised you have lost AUD 50 in cash since
you walked from your car. LUCKILY, you still have enough in
your wallet though to cover the cost of the ticket. Do you buy
the ticket?
A. Yes
B. No
Behavioral Biases: Examples
3. Regret Avoidance
• Investors blame themselves more when an unconventional or
risky bet turns out badly
4. Prospect Theory
• Conventional view: Utility depends on level of wealth
• Behavioral view: Utility depends on changes in current wealth
Traditional finance presumes that investors_____, and
behavioral finance presumes that they______.
A. Are irrational; are irrational
B. Are rational; may not be rational
C. Are rational; are rational
D. May not be rational; may not be rational
E. May not be rational; are rational
Limits to Arbitrage
• Behavioral biases would not matter if rational arbitrageurs could
fully exploit the mistakes of behavioral investors
• Fundamental Risk:
-“Markets can remain irrational longer than you can remain solvent”
- Intrinsic value and market value may take too long to converge
Limits to Arbitrage
• Implementation Costs:
- Transactions costs and restrictions on short selling can limit
arbitrage activity
• Model Risk:
- What if you have a bad model and the market value is actually
correct?
Technical Analysis:Trends and Corrections
• Momentum and moving averages
- The moving average is the average level of prices over a
given interval of time, where the interval is updated as time
passes
• Bullish signal: Market price breaks through the moving
average line from below, it is time to buy
• Bearish signal: When prices fall below the moving
average, it is time to sell
Figure 12.3 Moving Average for INTC
Technical Analysis: Relative Strength
• Relative strength
- Measures the extent to which a security has out- or
underperformed either the market as a whole or its particular
industry
- Pricing ratio implies outperformance
Security Price
Relative Strength=
Industry Price Index
Technical Analysis: Relative Strength
• Breadth
• Often measured as
the spread between
the number of
stocks that
advance and
decline in price
Technical Analysis: Sentiment Indicators
• Trin Statistic
Volume declining
Number declining
Trin =
Volume advancing
Number advancing
- Ratios above 1.0 are bearish
Technical Analysis: Sentiment Indicators
• Confidence Index
- The ratio of the average yield on 10 top-rated corporate
bonds divided by the average yield on 10 intermediate-
grade corporate bonds
- Higher values are bullish
Technical Analysis: Sentiment Indicators
• Put/Call Ratio
• Calls are the right to
buy
- A way to bet on rising
prices
• Puts are the right to
sell
- A way to bet on falling
prices
• A rising ratio may signal
investor pessimism and a
coming market decline
• Contrarian investors see a
rising ratio as a buying
opportunity
Thank you