Lecture 2: Concept of Market Efficiency and Behavioural Finance PDF

Lecture 2 Concept of Market Efficiency and Behavioural Finance 6FNCE001C Investment Risk Management 2024-25 School of Business and Economics  Concept of Market Efficiency School of Business and Economics 2 The Concept of Market Efficiency The Efficient M...

Lecture 2 Concept of Market Efficiency and Behavioural Finance 6FNCE001C Investment Risk Management 2024-25 School of Business and Economics  Concept of Market Efficiency School of Business and Economics 2 The Concept of Market Efficiency The Efficient Market Hypothesis (EMH) is a theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given time. Market efficiency research examines the relationship between stock prices and available information the important research question: Is it possible for investors to beat the market? Prediction of the EMH theory: If a market is efficient, it is not possible to beat the market (except by luck) School of Business and Economics 3  The Concept of Market Efficiency What does “beat the market” mean? The excess return on an investment is the return in excess of that earned by other investments that have the same risk Other investments or other investors? “beating the market” means consistently earning a positive excess return School of Business and Economics 4 The Concept of Market Efficiency Investment Management Strategies Active investment Passive investing Active Investment refers to a Passive Investing: is portfolio management strategy an investment strategy that where the manager makes aims to maximize returns over specific investments with the the long run by keeping the goal of outperforming an amount of buying and selling to investment benchmark index. a minimum.. 5 The Concept of Market Efficiency The random walk  Stock price changes are random and unpredictable  A forecast of future performance leads to favorable or unfavorable current performance Market participants rush to get in on the action before the predicted price jump  If prices immediately jump or fall to fair levels then prices should change only in response to new information 6 The Concept of Market Efficiency How is new information reflected? Three ways: Efficient market reaction News causes prices to adjust to appropriate levels quickly Delayed reaction News is met with indifference Overreaction and correction Trades are placed before news has been properly evaluated 7 The Concept of Market Efficiency Forms of Efficient Market Hypothesis Market Prices Reflect Forms of Efficiency Portfolio Market Past Level of Management Winners Market Public Private Efficiency Information Information information Strategies Data Inefficient Active Technical Analysts + - - Weak form of Market Fundamental Efficiency Efficient Passive Analysts Fundamental + + - Semi-strong Inefficient Active Analysts form of Market Efficiency Efficient Passive Insider Traders + + + Strong form Inefficient Active Insider Traders of Market Efficiency Efficient Passive No One 8 The Behavioural Biases of Individuals 9 The Behavioural Biases of Individuals Behavioral finance examines investor behavior to understand how people make decisions, individually and collectively. Behavioral finance assumes that people does not consider all available information in decision- making and does not act rationally by maximizing utility within budget constraints and updating expectations consistent with Bayes’ formula. 10 The Behavioural Biases of Individuals TF vs BF Traditional finance (TF) focuses on how individuals should behave. It assumes people are rational, risk-averse, and selfish utility maximizers who act in their own self-interests without regard to social values—unless such social values directly increase their own personal utility. Behavioral finance (BF) is descriptive, which focuses on describing how individuals behave and make decisions. It draws on concepts of traditional finance, psychology, adaptive economics, and neuroeconomics. 11 The Behavioural Biases of Individuals TF vs BF Behavioral finance recognizes that the way information is presented can affect decision-making, leading to both emotional and cognitive biases. Cognitive errors. Errors resulting from faulty information processing or memory. These often arise from the brain’s attempt to simplify information processing. Emotional bias. Errors resulting from the priority of human emotions over rational decision-making. Emotions such as joy, hate, fear, and love may result in decision- making that differs from a rational, dispassionate approach. 12 Behavioral Biases Behavioral Biases Cognitive Errors Emotional Biases Information- Loss Aversion Belief Perseverance Processing Biases Overconfidence Conservatism Anchoring and Adjustment Self-control Confirmation Mental Accounting Status Quo Representativeness Framing Endowment Illusion of Control Availability Regret Aversion Hindsight 13 The Behavioural Biases of Individuals Cognitive errors: Belief perseverance Conservatism bias occurs when market participants rationally form an initial view but then fail to change that view as new information becomes available. Consequences and implications of conservatism may include market participants who: Are unwilling or slow to update a view or forecast, and therefore hold an investment too long. Hold an investment too long to avoid the mental effort or stress of updating a view, when the new information is complex to understand. 14 The Behavioural Biases of Individuals Cognitive errors: Belief perseverance Confirmation bias (similar to selection bias) occurs when market participants look for new information or distort new information to support an existing view. Consequences and implications of confirmation may include market participants who: Consider positive but ignore negative information and therefore hold investments too long. Set up the decision process or data screens incorrectly to find what they want to see. Under diversify as they become overly convinced their ideas are correct. Over concentrate in the stock of their employer believing they have an information advantage in to that security. 15 The Behavioural Biases of Individuals Cognitive errors: Belief perseverance Representativeness is based on a belief the past will persist and new information is classified based on past experience or classification. Two forms of representativeness include: Base rate neglect, where the base rate (probability) of the initial classification is not adequately considered. Sample-size neglect makes the initial classification based on an overly small and potentially unrealistic sample of data. 16 The Behavioural Biases of Individuals Cognitive errors: Belief perseverance Illusion of control bias exists when market participants think they can control or affect outcomes when they cannot. It is often associated with emotional biases: illusion of knowledge (belief you know things you do not know), self-attribution (belief you personally caused something to happen), and overconfidence biases (an unwarranted belief you are correct). Consequences and implications of illusion of control may include market participants who: Trade more than is appropriate as they mistakenly believe they can control the outcome of a trade or are overconfident in their analysis. Fail to adequately diversify because they analyze a narrow range of investments and fail to consider other investments and asset types. 17 The Behavioural Biases of Individuals Cognitive errors: Belief perseverance Hindsight bias is a selective memory of past events, actions, or what was knowable in the past, resulting in an individual’s tendency to see things as more predictable than they really are. Participants tend to remember their correct views and forget the errors. Hindsight bias is sometimes referred to as the I-knew-it-all- along phenomenon. Consequences and implications of hindsight may include market participants who: Overestimate the rate at which they correctly predicted events which could reinforce an emotional I KNEW IT overconfidence bias. Become overly critical of the performance of others. For example, they might criticize the stock selections of an analyst whose recommendations underperformed the market when the recommendations outperformed the market groups for which the analyst was responsible. 18  The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Anchoring and adjustment bias occurs when market participants use psychological heuristic experience based trial and error rules to unduly affect probabilities. Changes are made but in relation to the initial view and therefore the changes are inadequate. Anchoring and adjustment detection starts with asking questions such as “Am I staying with this stock because I originally recommended it at a higher price. In other words am I becoming dependent on that previous price? Or would I recommend it based on an all new analysis if this was the first time I evaluated it?” Consequences and implications of anchoring and adjustment may include market participants who stay anchored to an initial estimate and do not adjust for new information. 19 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Mental accounting bias arises when money is treated differently depending on how it is categorized. For example a client might mentally treat wages differently from a bonus when determining saving and investment goals. Mental accounting bias is based on the observation that individuals group their expenditures into different categories (e.g., food, rent, investments) and assign each category a different mental account. Consequences and implications of mental accounting may include market participants: Structuring portfolios in layers to meet different priority goals. This may help clients overcome other biases. But it ignores correlation between layers of the portfolio and results can be suboptimal from a traditional perspective. Failing to lower portfolio risk by adding assets with very low correlation. Segregating return into arbitrary categories of income, realized gains and losses, or unrealized gains and losses. The result tends to be an overemphasis on income generating assets, resulting in a lower total return. 20 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Framing bias occurs when decisions are affected by the way in which the question or data is “framed.” In other words, the way the question is phrased affects how the information is processed leading to the answer given. Consequences and implications of framing bias may include market participants who: Fail to properly assess risk and end up overly risk-averse or risk-seeking. Choose suboptimal risk for their portfolio or assets based on the way a presentation is made. Become overly concerned with short term price movement and trade too often. 21 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Framing bias example The United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs have been proposed. If program A is adopted, 200 people will be saved. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds chance that no one will be saved. Which program will people choose? 22 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Framing bias example (2) The United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs have been proposed. If program A is adopted, 400 people will die. If program B is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 will die. Which program will people choose? 23 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias Availability bias starts with putting undue emphasis on the information that is readily available. Availability bias occurs when individuals judge the probability of an event occurring by the ease with which examples and instances come easily to mind. Availability bias can be further broken down into the following overlapping causes: Retrievability. If an idea or answer can be thought of quicker than others can, it is often chosen as correct, even if it is not. Categorization. This is the tendency to place items in categories that share what individuals perceive as common characteristics (e.g., growth and value stocks, investment-grade bonds, junk bonds, or classifying stocks by industry type). Narrow range of experience. This results from an individual with a narrow range of experiences using her experience as a frame of reference when estimating probabilities for the population. Resonance. If a piece of information or an event strikes a chord with an individual’s own beliefs and desires, the individual may overweight the importance of this information when making decisions. 24 The Behavioural Biases of Individuals Cognitive errors: Information-processing bias An information cascade is the transmission of information from those participants who act first and whose decisions influence the decisions of others. Those who are acting on the choices of others may be ignoring their own preferences in favor of imitating the choices of others 25 The Behavioural Biases of Individuals Emotional biases Loss aversion refers to the tendency of people to dislike losses more than they like comparable gains. This results in a strong preference for avoiding losses as opposed to achieving gains 26 The Behavioural Biases of Individuals Emotional biases Loss aversion example (1) An individual is given $10. The individual is then given the following options: 1. Take an additional $5 with certainty. 2. Flip a coin and win an additional $10 if it lands heads up, or nothing if it lands tails up. Which option will you choose? 27 The Behavioural Biases of Individuals Emotional biases Loss aversion example (2) An individual is given $20. The individual is then given the following options: 1. Take a $5 loss with certainty. 2. Flip a coin and lose nothing if it lands heads up, but lose $10 if it land tails up. Which option will you choose? 28 The Behavioural Biases of Individuals Emotional biases Overconfidence bias occurs when market participants overestimate their own intuitive ability or reasoning. It can show up as illusion of knowledge where they think they do a better job of predicting than they actually do. Combined with selfattribution bias, individuals will take personal credit when things go right (selfenhancing) but blame others or circumstances for failure (self-protecting). Consequences and implications of overconfidence may include: Underestimate risk and overestimate return. Under-diversification. Excessive turnover and transaction costs resulting in lower return. 29 The Behavioural Biases of Individuals Emotional biases Self-control bias occurs when individuals lack self-discipline and favor immediate gratification over long-term goals. Self-control bias is evident when there is a conflict between short-term satisfaction and long-term goals. Often, individuals are not prepared to make short-term sacrifices to meet their long-term goals. Consequences and implications of self-control may include: Insufficient savings accumulation to fund retirement needs, resulting from favoring current spending over saving. Taking excessive risk in the portfolio to try and compensate for insufficient savings accumulation. An overemphasis on income producing assets to meet shorter-term income needs. 30 The Behavioural Biases of Individuals Emotional biases Status quo bias occurs when comfort with the existing situation leads to an unwillingness to make changes. If investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out; status quo choices become more likely. Status quo bias is caused by the interaction of loss aversion bias, endowment bias, and regret aversion bias. Consequences and implications of status quo may include: Holding portfolios with inappropriate risk. Not considering other, better investment options. 31 The Behavioural Biases of Individuals Emotional biases Endowment bias occurs when an asset is felt to be special and more valuable simply because it is already owned. For example, when one spouse Brand new holds onto the securities their deceased spouse purchased for some reason like sentiment that is $30,000 unrelated to the current merits of the securities. Consequences and implications of endowment may include: Failing to sell an inappropriate asset resulting in inappropriate asset allocation. Holding things you are familiar with Owned car because they provide some intangible sense of comfort. $35,000 32 The Behavioural Biases of Individuals Emotional biases Regret-aversion bias occurs when market participants do nothing out of excess fear that actions could be wrong. They attach undue weight to actions of commission (doing something) and don’t consider actions of omission (doing nothing). Their sense of regret and pain is stronger for acts of commission. Consequences and implications of regret-aversion may include: Excess conservatism in the portfolio because it is easy to see that riskier assets do at times underperform. Therefore, do not buy riskier assets and you won’t experience regret when they decline. This leads to long-term underperformance and a failure to meet goals. Herding behavior is a form of regret-aversion where participants go with the consensus or popular opinion. Essentially the participants tell themselves they are not to blame if others are wrong too. 33 The Behavioural Biases of Individuals Emotional biases Herding behavior has been advanced as a possible explanation of under reaction and overreaction in financial markets. Herding occurs when investors trade on the same side of the market in the same securities, or when investors ignore their own private information and/or analysis and act as other investors do. Herding is clustered trading that may or may not be based on information. Herding may result in under- or over-reaction to information depending upon the direction of the herd 34 Homework 35 Please, read the workshop case study uploaded to the intranet (W2.docx). 37