Behavioral Finance and Disposition Effect

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Questions and Answers

What behavior is exhibited by investors due to the disposition effect when dealing with stocks?

Investors sell winning stocks more frequently than losing ones.

How does the disposition effect differ between stocks and mutual funds?

In mutual funds, investors sell losing funds more frequently than winning ones, contrary to the disposition effect seen in stocks.

What role does manager salience play in the reverse-disposition effect in mutual funds?

Increased manager salience enhances the reverse-disposition effect, encouraging investors to sell losing funds.

Discuss the impact of delegation on the disposition effect as it relates to passively managed funds.

<p>In passively managed funds, the reverse-disposition effect weakens, aligning behavior more closely with stocks.</p> Signup and view all the answers

What psychological mechanism drives both the disposition effect in stocks and the reverse-disposition effect in mutual funds?

<p>Cognitive dissonance drives both effects, as it increases conflict between beliefs about investment decisions.</p> Signup and view all the answers

What role does noise trader risk play in the persistence of mispricing in financial markets?

<p>Noise trader risk leads to increased volatility and prolonged price deviations due to speculative activity by irrational investors.</p> Signup and view all the answers

Explain the concept of sluggish adjustment in the context of market mispricing.

<p>Sluggish adjustment refers to the delays in market corrections due to high implementation costs and market frictions that limit arbitrage.</p> Signup and view all the answers

How do negative stubs demonstrate violations of market efficiency?

<p>Negative stubs represent clear evidence of market inefficiencies and a deviation from the law of one price, indicating that similar assets trade at different prices.</p> Signup and view all the answers

What factors contribute to limits to arbitrage in correcting mispricing?

<p>Short-sale costs and institutional frictions act as practical constraints that prevent arbitrageurs from effectively correcting mispricing.</p> Signup and view all the answers

Discuss the impact of macroeconomic experiences on individual risk preferences as suggested by Malmendier & Nagel's research.

<p>Individuals with lower experienced stock returns exhibit lower risk tolerance and reduced participation in the stock market.</p> Signup and view all the answers

What is the recency bias in the context of financial decision-making?

<p>Recency bias refers to the tendency to give more weight to recent experiences when making financial decisions.</p> Signup and view all the answers

How does market segmentation contribute to the persistence of mispricing?

<p>Market segmentation limits arbitrage activity, creating fragmented markets where irrational investors can drive prices away from fundamentals.</p> Signup and view all the answers

What role did institutional investors play during the DotCom bubble from 1997 to 2000?

<p>Institutional investors were the primary drivers of the price run-up in technology stocks, accounting for 63.6% of purchases.</p> Signup and view all the answers

How did individual investors behave after the burst of the DotCom bubble?

<p>Individuals became major buyers post-burst, accounting for 49% of tech purchases while displaying poor timing.</p> Signup and view all the answers

What were the types of institutional investors most active during the technology stock purchasing phase?

<p>Hedge funds, independent investment advisors, and mutual funds were the most aggressive buyers.</p> Signup and view all the answers

What occurred around the peak of the DotCom bubble in March 2000 regarding institutional selling?

<p>Institutions began coordinated selling as individuals accelerated their buying during the peak.</p> Signup and view all the answers

What was one consequence of institutional buying behavior during the DotCom bubble?

<p>Institutional buying led to larger post-peak reversals in returns, particularly for the largest firms.</p> Signup and view all the answers

What speculative behavior did institutions exhibit during the run-up phase of the DotCom bubble?

<p>Institutions targeted high-price-to-sales (P/S) ratio stocks, suggesting a speculative trading approach.</p> Signup and view all the answers

In what way did institutional investors demonstrate greater sophistication after the DotCom bubble burst?

<p>Institutions reallocated capital to non-tech stocks post-burst, leaving individuals with depreciating assets.</p> Signup and view all the answers

According to the Abreu and Brunnermeier model, how did rational arbitrageurs behave during the bubble?

<p>Rational arbitrageurs ride bubbles until a coordinated selling effort occurs.</p> Signup and view all the answers

What percentage of technology stock purchases did institutions account for during the run-up phase?

<p>Institutions accounted for 63.6% of technology stock purchases.</p> Signup and view all the answers

What was the impact of institutional buying on the market's alignment with fundamentals?

<p>Institutional buying led to prices moving further away from fundamental values.</p> Signup and view all the answers

How did institutional behavior contribute to market trends in the context of equity carve-outs?

<p>Institutional behavior contributed to momentum by amplifying price trends rather than aligning with market fundamentals.</p> Signup and view all the answers

What undermines the assumption that institutions counteract mispricing in the context of market bubbles?

<p>The active participation of sophisticated investors in speculative trading during the bubble period undermines this assumption.</p> Signup and view all the answers

What was the impact of individual investors' market timing during the crash?

<p>Individual investors exhibited poor market timing by buying depreciating assets during the crash.</p> Signup and view all the answers

What did the results reveal about market efficiency and the role of sophisticated investors?

<p>The results challenge the assumption of market efficiency and highlight the destabilizing influence of sophisticated investors.</p> Signup and view all the answers

According to Cheng, Raina & Xiong (2014), how did securitization agents behave during the housing bubble period?

<p>Securitization agents increased their housing exposure by purchasing second homes and upgrading to more expensive properties.</p> Signup and view all the answers

How did the performance of the overall housing portfolio of securitization agents compare to that of control groups?

<p>The overall housing portfolios of securitization agents performed better compared to those of control groups.</p> Signup and view all the answers

What is one challenge presented by the behavior of institutional investors during the run-up to market bubbles?

<p>Their behavior presented a challenge to the expectation that they would help correct market inefficiencies.</p> Signup and view all the answers

What behavioral characteristic was common among securitization agents during the housing bubble?

<p>Over-optimism and belief distortions were common among securitization agents during the bubble.</p> Signup and view all the answers

Why is understanding speculative motives crucial in analyzing bubble dynamics?

<p>Understanding speculative motives is crucial as it provides insight into how bubbles form and burst.</p> Signup and view all the answers

What unusual behavior did institutional investors demonstrate prior to price corrections in equity carve-outs?

<p>Institutional investors engaged in active purchasing that fueled further price increases before mispricing was corrected.</p> Signup and view all the answers

How do beliefs and preferences in behavioral finance challenge traditional models of risk?

<p>They highlight that beliefs and preferences are dynamic, influenced by experiences rather than static.</p> Signup and view all the answers

What does the paper by Rhodes-Kropf et al. suggest about market misvaluation and merger activity?

<p>It suggests that high market-to-book ratios drive merger waves and influence the acquirer-target relationship.</p> Signup and view all the answers

What are the three components of the market-to-book ratio (M/B) identified in the study?

<p>Firm-specific deviations, sector-wide deviations, and long-run value to book.</p> Signup and view all the answers

According to the study, what role do overvalued firms play in acquisitions?

<p>Overvalued firms typically acquire less overvalued firms during market or sector valuation waves.</p> Signup and view all the answers

What does the Rational Target Managers’ View suggest about their interpretation of acquirer valuations?

<p>Rational target managers misinterpret high valuations as evidence of synergies, which can lead to misguided decisions.</p> Signup and view all the answers

In what manner does the method of payment in mergers relate to valuation waves?

<p>Stock-based transactions dominate during overvaluation waves while cash targets tend to be undervalued.</p> Signup and view all the answers

What behavior is typically observed among stock acquirers compared to cash acquirers?

<p>Stock acquirers are generally more overvalued than cash acquirers, who seek undervalued targets.</p> Signup and view all the answers

What motivation might drive target managers to accept overvalued stock according to behavioral theory?

<p>Short-term gains motivate target managers to accept overvalued stock transactions.</p> Signup and view all the answers

What theories are tested in the study regarding merger waves?

<p>The study tests Neoclassical Q Theory, Correlated Asymmetric Information (RKV), and Behavioral Theory.</p> Signup and view all the answers

Flashcards

Disposition Effect

Investors are more likely to sell stocks that have gained value (winners) compared to stocks that have lost value (losers).

Reverse Disposition Effect

Investors tend to sell mutual funds that have performed poorly more often than those that have performed well.

Delegation and the Reverse Disposition Effect

The reverse disposition effect is stronger when investors believe they have less control over a fund's performance, such as in passively managed funds.

Justification and Cognitive Dissonance

Making investors justify their initial investment decisions can amplify both the disposition effect in stocks and the reverse disposition effect in funds.

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Manager Salience and the Reverse Disposition Effect

Highlighting the role of fund managers can also strengthen the reverse disposition effect.

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Mispricing

The price of a security deviates from its intrinsic value, often due to irrational investor behavior.

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Noise Traders

Investors who base their decisions on short-term trends or speculation rather than fundamental analysis.

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Limits to Arbitrage

The concept that market imperfections like high trading costs and short-selling constraints prevent prices from rapidly adjusting to their fundamental values.

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Greater Fool Theory

The theory that irrational investors drive prices further away from fundamentals by buying assets based on the expectation that 'someone else will pay more later'.

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Experience Hypothesis

The study of how past economic experiences, especially market returns, influence individuals' risk tolerance and investment decisions.

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Experienced Returns & Risk Tolerance

People who have experienced low stock market returns tend to be more risk-averse, invest less in stocks, and allocate less of their liquid assets to equity investments.

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Recency Bias in Investment

Past market experiences, even those from long ago, can influence investment decisions, with recent experiences having a more significant impact.

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Market-to-Book Ratio (M/B)

The extent to which a company's market value exceeds its book value.

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Merger Waves

Periods of heightened merger activity, often driven by market misvaluation or specific industry trends.

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Neoclassical Q Theory

A theoretical framework suggesting that firms with high M/B ratios, indicating overvaluation, are more likely to engage in mergers.

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Correlated Asymmetric Information (RKV)

A theory suggesting that merger waves are driven by correlated valuation errors and misperceptions of synergies, particularly when acquirers are overvalued.

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Behavioral Theory (Shleifer-Vishny)

A behavioral theory suggesting that overvalued acquirers use their inflated stock prices to acquire less overvalued targets, benefiting short-term managers.

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Overvalued Firms as Acquirers

Overvalued firms, often driven by market or sector misvaluation, tend to acquire less overvalued firms.

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Role of Payment Method

Stock-based transactions become more prevalent during overvaluation waves, with cash targets being undervalued and stock targets being overvalued.

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Stock Transactions during Overvaluation

When acquirers are significantly overvalued, stock transactions are favored as target managers may misinterpret the high stock price as evidence of synergies.

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Implications for Behavioral Finance

The findings suggest that behavioral biases and learning impact asset pricing and market behavior, challenging traditional static models of risk preferences.

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Who drove the Dot-Com bubble?

Institutional investors were the primary drivers of the price increase in technology stocks during the Dot-Com bubble (1997-2000), while individuals were the main buyers after the bubble burst.

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How did institutions fuel the Dot-Com bubble?

Institutions, particularly hedge funds, independent advisors, and mutual funds, made significant discretionary purchases of high-priced technology stocks, often exceeding their intrinsic value.

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What happened when the bubble reached its peak?

Institutional investors began selling their technology stocks in a coordinated manner around the peak of the bubble in March 2000.

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How did individuals react after the bubble burst?

Individuals, particularly those using discount brokerage services, bought technology stocks as prices were collapsing, demonstrating poor timing.

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What happened after the Dot-Com bubble burst?

After the bubble burst, individuals continued to buy technology stocks while institutions shifted their investments to non-tech sectors, indicating a difference in market sophistication.

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Did institutions contribute to mispricing?

Institutional buying led to larger post-peak reversals in returns, especially for the largest companies, suggesting that they played a role in mispricing.

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How did institutions contribute to mispricing?

Institutional investors exhibited speculative behavior by trading based on factors other than fundamental values, leading to price deviations.

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How did institutions contribute to the bubble's collapse?

Institutions bought technology stocks aggressively, driving prices away from fundamental values, which led to larger price corrections after the bubble burst.

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What data did the study use to analyse institutional behavior?

The study uses data on NASDAQ technology firms to examine whether institutional investors contributed to mispricing or traded based on fundamentals.

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How does the study's findings align with existing models?

The study's findings align with the Abreu and Brunnermeier (2003) model, which explains how rational arbitrageurs participate in bubbles until a coordinated selling effort occurs.

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Role of Institutions in the Housing Bubble

Institutional investors actively participated in the housing bubble by buying overpriced assets, fueling the bubble further, then selling off their investments, triggering the market crash.

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Role of Individuals in the Housing Bubble

Individuals invested in depreciating assets during the crash despite the declining market, sustaining the demand for these assets.

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Market Efficiency Hypothesis

The widespread belief that markets operate efficiently, meaning prices reflect all available information, is challenged by the study's findings.

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Study Objective

The study aims to determine if securitization agents were aware of the housing bubble and the impending market crash during 2004–2006.

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Securitization Agent Behavior

Securitization agents, instead of showing cautious behavior, increased their housing exposure by purchasing second homes and upgrading to more expensive ones.

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Mechanism for Securitization Agent Behavior

The behavior of securitization agents, contrary to expectations, suggests over-optimism and a distorted belief in the housing market's performance.

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Market Timing Hypothesis

Securitization agents were more likely to divest homes during the bubble period, indicating a potential awareness of the market's vulnerability

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Cautiousness Hypothesis

Securitization agents were less likely to acquire additional housing exposure, suggesting caution and anticipation of a potential market downturn

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Performance Hypothesis

The overall housing portfolio performance of securitization agents was expected to be better due to their perceived expert market knowledge

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Conservative Consumption Hypothesis

Securitization agents were expected to make purchases more conservatively relative to their income, implying a cautious approach to spending

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Study Notes

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