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