BFC3241 Equity and Investment Analysis Class 4 (week 7) 1 Behavioural Finance SHILLER’S IDEA • Contrasts the actual stock index price P, ex-post rational price P* • p is the expected discounted value of dividends. • p∗is ex-post therefore captures new events that are not expected (ex-ante). • One would expect that these new events add volatility to the price series, but as you see in the Figure, actual prices vary tremendously more than this ex-post discounted value • Therefore, investors do not react like the DDM suggests. 2 TIME VARYING RETURNS where that time-varying expected return comes from? • To Fama, the time-varying expected return is a business cycle related risk premium. • To Shiller, no. The variation in risk premia is too big. He sees irrational optimism and pessimism in investor’s heads. other explanations: • Information (especially bad news) is sometimes suppressed or delayed by managers seeking a better time to release it. • In some cases, firms release intentionally misleading information about their current conditions and future prospects to financial markets. 3 CONVENTIONAL VS. BEHAVIORAL FINANCE Conventional • Prices are correct and equal to intrinsic value • Resources are allocated efficiently • Consistent with EMH Behavioral Finance • What if investors do not behave rationally? • Limits to arbitrage prevent rational investors exploiting • errors/biases. 4 CASE STUDY: LONG TERM CAPITAL MANAGEMENT 5 Kelly Shue and Richard research 1. CAR Cumulative abnormal returns. 2. Event study is a technique to analyse how stock price react to news (see previous lecture) 3. Quintile: 1/5 of the population. In the graph they sort the prices according to magnitude. 4. The convergence to the mean value in the long run is well known as long-run reversal. The abnormal returns should be zero on average. Given you adding in CAR, a flat series of CAR means that the new abnormal returns are zero. 6 20 Kelly Shue and Richard research-APPLICATION Shue and Townsend (2020) find that stocks with low share prices, controlling for size have: • Higher total volatility • Higher idiosyncratic volatility • Higher market beta 7 PROSPECT THEORY (KAHNEMAN AND TVERSKY, 1979) • Standard finance teaches that investors are rational and make decisions as if they are always risk averse. Utility is solely a function of wealth • Prospect theory teaches that investors think in terms of gains and losses relative to some reference point • People are more sensitive to outcomes the nearer to the ref point • Concave for gains: risk averse • Convex for losses: risk taking • Utility is not a function of wealth levels – gains and losses affect choices 8 Application Imagine that you face the following choice: a sure gain of $1,000, or a 50% chance of winning $2,000 and a 50% chance of $0 Which choice would you prefer? Imagine that you face the following choice: a sure loss of $1,000, or a 50% chance of a loss of $2,000 and a 50% chance of zero loss Which choice would you prefer? 9 Disposition effect • Investors are generally predisposed to sell their winners too soon but hold on to their losers too long PT and Disposition effect(opposit) • To convince her to buy a stock, the return has to be relatively high (due to risk aversion). • After a gain, she is therefore further from the kink (where she is really loss averse). • When you are further from the kink, you become less risk averse( For small concavity/convexity), therefore you are willing to hold gains more often. Then, if a loss occurs then you sell quickly since you are back to the initial point. • PT generates the opposite of disposition effect. 10 REALIZATION UTILITY 11