Behavioral Finance

Understanding the Social, Cognitive, and Economic Debates

Edwin T. Burton, Sunit N. Shah

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118331927
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

An in-depth look into the various aspects of behavioral finance

Behavioral finance applies systematic analysis to ideas that have long floated around the world of trading and investing. Yet it is important to realize that we are still at a very early stage of research into this discipline and have much to learn. That is why Edwin Burton has written Behavioral Finance: Understanding the Social, Cognitive, and Economic Debates.

Engaging and informative, this timely guide contains valuable insights into various issues surrounding behavioral finance. Topics addressed include noise trader theory and models, research into psychological behavior pioneered by Daniel Kahneman and Amos Tversky, and serial correlation patterns in stock price data. Along the way, Burton shares his own views on behavioral finance in order to shed some much-needed light on the subject.

• Discusses the Efficient Market Hypothesis (EMH) and its history, and presents the background of the emergence of behavioral finance
• Examines Shleifer's model of noise trading and explores other literature on the topic of noise trading
• Covers issues associated with anomalies and details serial correlation from the perspective of experts such as DeBondt and Thaler
• A companion Website contains supplementary material that allows you to learn in a hands-on fashion long after closing the book

In order to achieve better investment results, we must first overcome our behavioral finance biases. This book will put you in a better position to do so.

PART One

Introduction to Behavioral Finance

CHAPTER 1

What Is the Efficient Market Hypothesis?

The efficient market hypothesis (EMH) has to do with the meaning and predictability of prices in financial markets. Do asset markets “behave” as they should? In particular, does the stock market perform its role as economists expect it to? Stock markets raise money from wealth holders and provide businesses with that money to pursue, presumably, the maximization of profit. How well do these markets perform that function? Is some part of the process wasteful? Do prices reflect true underlying value?

In recent years, a new question seems to have emerged in this ongoing discussion. Do asset markets create instability in the greater economy? Put crudely, do the actions of investment and commercial bankers lead to bubbles and economic catastrophe as the bubbles unwind? The great stock market crash of October 19, 1987, and the financial collapse in the fall of 2008 have focused attention on bubbles and crashes. These are easy concepts to imagine but difficult to define or anticipate.

Bubbles usually feel so good to participants that no one, at the time, really thinks of them as bubbles; they instead see their own participation in bubbles as the inevitable payback for their hard work and virtuous behavior—until the bubbles burst in catastrophe. Then, the attention turns to the excesses of the past. Charges of greed, corruption, and foul play accompany every crash.

If the catastrophe and the bubble that precedes it are the result of evil people doing evil things, then there is no reason to suppose that markets are themselves to blame. Simple correctives, usually through imposition of legal reforms, are then proposed to correct the problem and eliminate future bubbles and catastrophes. Casual empiricism suggests this approach is not successful.

What if markets are inherently unstable? What if bubbles and their accompanying catastrophes are the natural order of things? Then what? If prices do not, much of the time, represent true value and if the markets themselves breed excessive optimism and pessimism, not to mention fraud and corruption, then the very existence and operation of financial markets may cause instability in the underlying economy. Prices may be signaling “incorrect” information and resources may be allocated inefficiently. The question of whether asset markets are efficiently priced, then, is a fundamental question. The outcome of this debate could shed light on the efficiency of the modern, highly integrated economies in which a key role is played by financial institutions.

It is important to agree on a definition of market efficiency, but there are many such definitions. Practitioners in the everyday world of finance often use market efficiency in ways that are different than the textbook definitions. We delimit the most common definitions in the next two sections of this chapter.

INFORMATION AND THE EFFICIENT MARKET HYPOTHESIS

The EMH is most commonly defined as the idea that asset prices, stock prices in particular, “fully reflect” information.1 Only when information changes will prices change. There are different versions of this definition, depending on what kind of information is assumed to be reflected in current prices. The most commonly used is the “semi-strong” definition of the EMH: Prices accurately summarize all publicly known information.

This definition means that if an investor studies carefully the companies that he/she invests in, it will not matter. Other investors already know the information that the studious investor learns by painstakingly poring over public documents. These other investors have already acted on the information, so that such “public” information is already reflected in the stock price. There is no such thing, in this view, as a “cheap” stock or an “expensive” stock. The current price is always the “best estimate” of the value of the company.

In particular, this definition implies that knowing past prices is of no value. The idea that past stock price history is irrelevant is an example of the weak form of the EMH: Knowledge of past prices is of no value in predicting future stock prices.

The semi-strong form implies the much weaker version of the EMH embodied in the weak form of the EMH. It is possible that the weak form is true but that the semi-strong form is false.

The weak form of the EMH is interesting because it directly attacks a part of Wall Street research known as “technical” research. In technical research, analysts study past prices and other historical data in an attempt to predict future prices. Certain patterns of stock prices are said by “technicians” to imply certain future pricing paths. All of this means, of course, that by studying past prices you can predict when stock prices are going to go up and when they are going to go down. Put another way, technical research is an attempt to “beat the market” by using historical pricing data. The weak form says that this cannot be done.

Unlike other versions of the EMH, the weak form is especially easy to subject to empirical testing, since there are many money managers and market forecasters who explicitly rely on technical research. How do such managers and forecasters do? Do they perform as well as a monkey randomly throwing darts at a newspaper containing stock price names as a method of selecting a “monkey portfolio”? Do index funds do better than money managers who utilize technical research as their main method of picking stocks? These questions are simple to put to a test and, over the years, the results of such testing have overwhelmingly supported the weak form version of the EMH.

The semi-strong version of the EMH is not as easy to test as the weak form, but data from money managers is helpful here. If the semi-strong version is true, then money managers, using public information, should not beat the market, which means that they should not beat simple indexes that mirror the overall market for stocks. The evidence here is consistent and overwhelming. Money managers, on average, do not beat simple indexes. That doesn't mean that there aren't money managers who seem to consistently outperform over small time samples, but they are in the distinct minority and hard to identify before the fact. Evidence from institutional investors, such as large pensions funds and endowments, are consistent with the view that indexing tends to produce better investment results than hiring money managers.

If this were all we knew, then the EMH would be on solid ground. But we know more. There is growing evidence that there are empirical “regularities” in stock market return data, as well as some puzzling aspects of stock market data that seem difficult to explain if one subscribes to the EMH.

We can identify three main lines of attack for critics of the semi-strong form of the EMH:

1. Stock prices seem to be too volatile to be consistent with the EMH.

2. Stock prices seem to have “predictability” patterns in historical data.

3. There are unexplained (and perhaps unexplainable) behavioral data items that have come to be known as “anomalies,” a nomenclature begun by Richard Thaler.2

The evidence that has piled up in the past 20 years or so has created a major headache for defenders of the EMH. Even though money managers don't necessarily beat the indexes, the behavioralists' research suggests that perhaps they should.

There is a third form of the EMH that is interesting but not easy to subject to empirical validation. The third form is known as the strong form of the EMH: Prices accurately summarize all information, private as well as public.

The strong form, of course, implies both the semi-strong and the weak forms of the EMH. However, both the semi-strong and weak forms can be true while the strong definition can be false. The strong form includes information that may be illegally obtained—or, perhaps, information that is legally obtained but illegal to act upon. Needless to say, those breaking the law are not likely to provide performance data to researchers attempting to ascertain whether they are beating the market.

There seems to be a general consensus that the strong form of the EMH is not likely to be true, but one should not rush to such a conclusion simply because relevant data may be hard to come by. What little data we have from those who have obtained illegal information and then acted upon it is mixed. Sometimes crooks win, sometimes they appear to lose. When Ivan Boesky, probably the most famous insider information trader in history, concluded his investment activities and was carted off to jail, it was clear that investors who owned index funds made better returns than investors in Boesky's fund, even before the legal authorities got wise to Boesky's activities. If Boesky couldn't beat the market with inside information, it does give one pause.

Of the three informational definitions of the EMH, it is the semi-strong hypothesis that commands most interest. It is widely believed that the weak form is likely to be true, it is commonly assumed that the strong form is not likely to be true, so interest focuses mainly on the semi-strong hypothesis. Information determines prices and no one can really exploit publicly known information—that is the content of the semi-strong EMH hypothesis.

RANDOM WALK, THE MARTINGALE HYPOTHESIS, AND THE EMH

There is an alternative, mathematical view of the stock market related to the EMH. The mathematical...