...Efficient Market Discussion and Understanding of Finance As the 2013 Nobel Laureates in economic science, both of Eugene Fama, from the University of Chicago and Robert Shiller, from Yale University, have made famous contribution to the finance world. Even though their views toward market efficiency seem mutually contradictory, their theories has been highly valued by the finance academia as well as industry. This paper compares and contrasts the work of both of them and discusses how their work influence my understanding of finance. Fama is known for his work in initiating and developing the “efficient market hypothesis (EMH).” In his paper, Fama defines “efficient market” as “a market in which prices always fully reflect available information” (Fama 1970). If prices did reflect all available information, trading rules and fundamental analysis would not help investors to constantly earn abnormal return. This proposition has been checked by others and himself in the following papers: "Random Walks in Stock Market Prices (Fama 1965)," and "Filter Rules and Stock Market Trading Profits" (Blume, Fama 1966). Stock prices react to new information so quickly that it is almost impossible to trade on that piece of new information and profit from it. Furthermore, investors cannot earn abnormal returns without taking more systematic risk. To address the different types of information that stock prices could reflect, Fama prosed three types of market efficiency: (1) strong-form, where...
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...within Finance Authors: Bernéus, Hannes Sandberg, Carl Wahlbeck, David Tutor: Jönköping Österlund, Urban December, 2008 Acknowledgement We would like to thank our tutor Mr. Urban Österlund for his support and guidance. We are also grateful for all valuable comments and insights from our fellow students during seminar sessions. We would also like to present a special thanks to Johan Sandberg at Swedbank Robur and Viktor Östebo at Nordnet. Without Mr. Sandberg’s and Mr. Östebo’s contribution, this thesis would not have been possible to complete. To all the respondents: thank you for your participation! _____________ Hannes Bernéus ____________ Carl Sandberg Jönköping International Business School Date: 2008-12-11 i _____________ David Wahlbeck Bachelor Thesis within Business Administration Title: Authors: Tutor: Date: Subject terms: Behavioral Finance – Investors’ Rationality. Hannes Bernéus, Carl Sandberg, David Wahlbeck Urban Österlund 2008-12-02 Behavioral Finance, Behavioral Economics, Finance, Economic Psychology. Abstract Purpose: The purpose of this thesis is to examine if professional investors are indicating tendencies of irrational behavior when exposed to certain psychological dilemmas related to the financial world. Background: A new field within financial theory emerged in the 1980s; one which did not build on fundamental cornerstones but from the world of psychology, called Behavioral Finance. The...
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...ABSTRACT Behavioural finance is part of finance that seeks to understand and explain the systematic financial market implications of psychological decision processes. It utilizes knowledge of cognitive psychology, social sciences and anthropology to explain irrational investor behavior that is not being captured by the traditional rational based models. INTRODUCTION Classical investment theories are based on the assumption that investors always act in a manner that maximizes their return. Yet a number of research show that investors are not always so rational. Human become puzzled when the uncertainty regarding investment decision engulfs them. People are not always rational and markets are not always efficient. Behavioral finance explains why individual do not always make the decisions they are expected to make and why markets do not reliably behave as they are expected to behave. Recent research shows that the average investors make decisions based on emotion, not logic; most investor’s buy high on speculations and sale low on panic mood. Psychological studies reveal that the pain of losing money from investment is really three times greater than the joy of earning money. Emotions such as fear and greed often play a pivotal role in investor’s decision; there are also other causes of irrational behavior. It is observed that stock price moves up and down on a daily basis without any change in fundamental of economies. It is also observed that people in the stock market...
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...and Research (Part 1 – Financial Markets and Asset Pricing) Team Member: Haotian Lin; Nan Bai; Wenyi Gu; Yibo Zang Summary Standard finance (modern portfolio theory), compared with Behavioral finance, is no longer modern: dating back to the late 1950s modern portfolio theory was developed (Statman 2008) Behavioral finance offers alternative explanation for investors and markets. Behavioral finance, which has been a controversial subject and is becoming more widely accepted, is finance from a broader social science perspective including psychology and sociology (Shiller 2003). Behavioral finance helps identify the financial market’s inefficient reaction to public information, which cannot be explained by traditional financial models with assumptions such as expected utility maximization, rational investors, and efficient markets (Ritter 2003; Statman 2008). Statman (2008) compares “normal” investors and rational investors by pointing out the difference that normal investors are reluctant to realize losses since normal investors are affected by cognitive biases and emotions. Statman also compares Behavioral Portfolio Theory and Markowitz mean-variance theory. Another comparison made by Statman is between Behavioral Asset Pricing Model (BAPM) and capital asset pricing model (CAPM), stating that the asset pricing model of standard finance is moving away from CAPM toward Fama and French three-factor model, a model similar to the BAPM. Bloomfield’s article discusses anomalies...
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...Concept Academic research results What it means for us Disposition Effect Shefrin and Statman (1985) predicted that because people dislike incurring losses much more than they enjoy making gains (risk aversion), and people are willing to gamble in the domain of losses, investors will hold onto stocks that have lost value (relative to the reference point of their purchase) and will be eager to sell stocks that have risen in value. They called this the disposition effect. People will hold losing positions hoping that they can close them later at break-even or better. This is how support and resistance are born! Representa-tiveness Heuristic People tend to make judgments in uncertain situations by looking for familiar patterns and assuming that future patterns will resemble past ones, often without sufficient consideration of the reasons for the pattern or the probability of the pattern repeating itself. This anomaly of human judgment, called the representative-ness heuristic, was demonstrated in a number of experiments by psychologists Tversky and Kahneman. Related concept: Overconfidence - people place too much confidence in their own judgement (e.g. thinking they know the “truth” from observing one pattern 3 times), although it is not validated. • Key reason why people use Technical Analysis, and through self-fulfulling prophecy, it becomes relevant • People get used to current market behavior, and through their actions support its continuation leads to stable market regimes ...
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...From Efficient Markets Theory to Behavioral Finance 1. What does Shiller mean by Behavioral Finance? Behavioral Finance is the collaboration between finance and other social sciences. This field of research is focused on determining the precise degree to which various market forces—including rational analysis of company-specific and macroeconomic fundamentals; human and social psychology; and cultural trends—influence investors’ expectations and determine their level of confidence or fear. Behaviorists believe that at times, the real determinants of stock market movements are the forces of human and cultural psychology, oranimal spirits (a term coined by economist John Maynar 2. How does Behavioral Finance contrast with Efficient Market Theory? Behavioral finance takes issue with two crucial implications of the EMH: (1) that the majority of investors make rational decisions based on available information; and (2) that the market price is always right. Behaviorists believe that numerous factors—irrational as well as rational—drive investor behavior. In sharp contrast to efficient markets theorists, behaviorists believe that investors frequently make irrational decisions and that the market price is not always a fair estimate of the underlying fundamental value. Still, many proponents of behavioral finance agree with at least one implication of the efficient market theory—that it’s not possible to reliably earn abnormal returns. 3. What prediction does Efficient...
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...Title Page Introduction a. Global Health Issues b. Economic Impact Behavioral Finance a. Emotional Biases i. Risk Aversion ii. Regret Aversion Market Implications a. Every market in today’s economy was impacted either directly or indirectly by the SARS epidemic. i. Most saw measurable decreases in GDP b. Global cost of lost economic activity due to SARS was approximately $54 billion Conclusion a. Economic damage caused by SARS can be attributed to the behavioral finance emotional biases of loss aversion and regret aversion affecting investors globally. Global Health Issues, Behavioral Finance and the Markets: The Role of Behavioral Finance in how Global Health Issues Impact the Economy Jonathan Davis David A Kennedy Lee V Smith Tayler T Young Syed Zain T Zaidi November 10, 2015 University of Houston- Downtown Global Health Issues, Behavioral Finance and the Markets: The Role of Behavioral Finance in how Global Health Issues Impact the Economy With globalization on the rise, infectious diseases that appear in one country have the opportunity to spread rapidly to others. Recent examples include the 2003 outbreak of Severe Acute Respiratory Syndrome (SARS) and the 2014 outbreak of the Ebola virus. According to the World Health Organization (WHO), 8,098 individuals became infected worldwide with SARS and 774 of those individuals ultimately died from the illness (CDC, 2005). While Ebola killed 5,160 out of the 14,098 people...
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...Behavioural Finance Security Analysis and Portfolio Management Behavioural Finance This is referred as a field of study that combines behavioural and cognitive psychological theory with conventional economics and finance to explain why people tend to behave in unpredictable and irrational manner. It tries to explain how investors often tend to differ from the traditional and rational economic assumptions because misrepresentation, over-confidence, biases aversion to ambiguity etc. Prospect Theory This theory states that investors pay attention to change in each transaction than the total value and have a tendency to get more distressed by the prospective losses than the happiness from prospective gains in an investment. 1. Frame Dependence: Example: 2. Mental Accounting: It explains how current and future assets are divided into different groups and therefore differently treated which explains the change in their investment decision and behaviour. Example: If given an option to buy either a piece of land at Rs.1000000 and save Rs.50000 on the deal or a car at Rs.500000 and save Rs.50000, most people will buy the car. Even though the savings is the same in both the cases, the amount saved on car is a more powerful motivator than the savings on the piece of land. 3. House money effect: This effect was given by Thaler and Johnson. Example: A set of twenty investors are given Rs.25000 and given a chance to toss where they either win Rs.10000 or lose...
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...global mutual funds/investment management, across cash management, equity, fixed income segments as well as alternative asset classes, such as private equity and real estate. It has a worldwide client base of institutional and retail clients, including governments, corporations, endowments, foundations and individuals. The equities segment accounts for $370 bn1 AUM spread over a mix of qualitative and quantitative approaches including $76 bn in Behavioral Finance (“BF”) strategies. Hence, BF represents 10% of the AUM of the group and is growing at a fast pace. In the United States, the BF AUM has increased from $100m to $20bn within a space of three years. How do they compete in managing and marketing retail mutual funds? JP Morgan competes with other retail funds by introducing investment strategies to retail investors that are not widely present in the retail mutual fund industry and having an effective and strong marketing. It was among the first global funds to innovate and introduce a retail mutual fund based on behavioral biases by drawing on the relatively recent body of academic findings in BF. The JP Morgan marketing programme is designed to educate brokers to help clients avoid common human tendencies that affect the ability to pick stocks and understand market prices. By being sensitive to biases like overconfidence, loss aversion, recency and anchoring the team establishes a strong basis to develop trust and relationships with clients and customers. What...
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...THE JOURNAL OF BEHAVIORAL FINANCE, 11: 82–91, 2010 Copyright C The Institute of Behavioral Finance ISSN: 1542-7560 print / 1542-7579 online DOI: 10.1080/15427560.2010.481981 Psychological and Cultural Factors in the Choice of Mortgage Products: A Behavioral Investigation Masaki Mori International University of Japan Julian Diaz III and Alan J. Ziobrowski Georgia State University Nico B. Rottke European Business School Using data from three countries that differ economically, culturally, and geographically, this study examines the role of Prospect Theory’s reflection effect, a psychological factor, in combination with Uncertainty Avoidance (UA), a cultural factor, on the choice of mortgage products. Experiments were conducted using business professionals in the United States, Germany, and Japan. The results suggest that risk-averse people tend to become more risk seeking, leaning more toward adjustable-rate mortgages (ARMs) when choosing a mortgage type, and that this psychological effect may underlie the mortgage choices of people who tend to choose ARMs, even across countries with different cultures. Keywords: Adjustable-rate mortgage, Fixed-rate mortgage, Prospect theory, Uncertainty avoidance, Experiment INTRODUCTION In terms of household risk management, the choice of a residential mortgage is one of the most significant decisions to make. At the end of second-quarter 2005, the value of outstanding U.S. residential mortgages was $8 trillion, 65% of the...
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...The current issue and full text archive of this journal is available at www.emeraldinsight.com/1086-7376.htm A reformulated asset pricing model based on contrarian strategies Zhongzhi (Lawrence) He Faculty of Business, Brock University, St Catharines, Canada, and Reformulated asset pricing model 185 Lawrence Kryzanowski John Molson School of Business, Concordia University, Montreal, Canada Abstract Purpose – Researchers have proposed characteristics-based pricing models as an alternative to risk-based pricing models. While supported empirically, these characteristic-based models lack theoretical support. This paper seeks to reformulate an asset-pricing model (RAPM) to demonstrate why firm characteristics help to explain stock returns. Design/methodology/approach – The RAPM is grounded in an economic setting where two groups of agents hold different beliefs about firm fundamental values, and the more sophisticated ¨ group (rationals) adopts contrarian strategies against the naıve group (quasis). The model is derived in a static equilibrium within the consumption-investment framework with heterogeneous agents. Findings – The key theoretical result is a parsimonious equation of cross-sectional expected returns that not only are specified by the traditional risk-return relation, but also are determined by contrarian adjustments at both market-wide and firm-specific levels. When the model is taken to empirical specifications, it leads to consistent explanations for the behaviors...
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...* PILLARS People are rational and seek to maximize their expected utility Markets are efficient, with no arbitrage opportunities ANOMALIES These are not confirmed in real life, so we study the reason behind the anomalies in the models using: Field data Lab experiments Computer simulations Brain scans * STUDY TOPICS Alternatives to Expected Utility Theory Time Preferences Predicting Human Behavior in Strategic Situations Self-Confidence Cognitive Biases & Consequences Using Experiments to Test Finance Theories Saint Petersburg Paradox Coin-flipping; payoff for the first heads that appears; payoff doubles for every coin flip. How much are you willing to pay to play this game? Expected utility is ∞, but people aren’t willing to pay much E = ½ (1) + ¼ (2) + ⅛ (4) + ... E = ½ + ½ + ½ + ... + ½ E = ∞ Expected Utility Theory Indifference Curve: combination of goods & services that maintain a certain level of satisfaction People maximize their well-being The roll of government is to maximize social well-being Pareto Efficiency (most outward point as possible) Utility cannot be measured or observed directly, but are revealed through preferences and through experiments. Remember: preferences are not necessarily choice, but a probability of choosing that. Cardinal preferences – objects are given values Ordinal preferences – objects are ranked against others Be careful: you can’t compare utility across individuals Axioms Completeness...
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...Question 1: (A) EEG, PET, and FMRI are tools that help in measuring brain activity. It is important to ask how good these tools are when measuring brain activity based on timing and location. Temporal resolution is a measure of the timing or how quickly and accurately can these tools pick on brain activity. Temporal resolution includes the smallest neural activity in the brain that can be detected. Spatial resolution is a measure of where the neural activity, with precision, is located. So how good is the graphic display or how well is the image. (B) EGG is a really good measure of timing; it can pick up when the electrical impulses happen relatively quickly. It is related as the best temporal resolution measure from all the tools; however, it is a poor measure of mentioning where the impulses happen. It is ranked as the worst from all the three in terms of spatial resolution. FMRI is the best measure in term of spatial resolution. It can detect a spatial range from mm to cm. In terms of temporal it is the second best, it can detect neural activity within almost two seconds and with technological improvements it is getting faster and faster. (C) FRMI would be better to measure the brain activation in the limbic system. FMRI essentially uses the same technology as the MRI but it more function. Brain activity can be measure through the blood flow. FMRI tells us essentially tells us what is happening in out brain while we are making our decisions. It will have a good read...
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...Behavioural Finance Financial Risk Management Table of Contents Table of Contents 1 Risk Management Paper ........................................................................................................ 2 1.1 Introduction and interpretation .................................................................................................... 2 1.2 Implementation ............................................................................................................................ 4 1.2.1 Aspects to consider ....................................................................................................................... 4 1.2.2 Implementation Process ............................................................................................................... 8 2 Appendix I – References ....................................................................................................... 10 Date: 24 of May 2012 th i Risk Management Paper 1 1.1 Risk Management Paper Introduction and interpretation If at the beginning of 2011, a highly respected person advised me that I was going to live through three major earthquakes within a year I would have struggled to believe them and justify arguing with the historical and scientific data, which clearly states the converse...
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...Suggested Solution to Homework 4, part 1 and part 2 Chapter 11 7.(20 points) The following effects seem to suggest predictability within equity markets and thus disprove the Efficient Market Hypothesis. However, consider the following: a. Multiple studies suggest that “value” stocks (measured often by low P/E multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time. However, another rational argument may be that traditional forms of CAPM (such as Sharpe’s model) do not fully account for all risk factors which affect a firm’s price level. A firm viewed as riskier may have a lower price and thus P/E multiple. b. The book-to-market effect suggests that an investor can earn excess returns by investing in companies with high book value (the value of a firm’s assets minus its liabilities divided by the number of shares outstanding) to market value. A study by Fama and French 1 suggests that book-to-market value reflects a risk factor that is not accounted for by traditional one variable CAPM. For example, companies experiencing financial distress see the ratio of book to market value increase. Thus a more complex CAPM which includes book-to-market value as an explanatory variable should be used to test market anomalies. c. Stock price momentum can be positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon). Historical data seem to...
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