BehavioralFinance(Econ4370)Midterm2Review

1、Serial correlationCross SectionPick a date (or a time period)Collect data only for that date (or time period)Explain variations in the data for that time period onlyTime SeriesPick a stockCollect data for that stock over many time periodsFama and French (FF)FF initially were strong defenders of EMH

2、but their conclusion that stocks with high book-to-market values perform better than stocks with lower book-to-market values in the following 12 months indicates predictability could be gleaned from the pastFindings:1.Most important finding of FF Stocks with higher book to market ratios had higher s

3、tock returns in the following 12 months.(Book Value Net worth figure mentioned on the balance sheet (Assets Liabilities)Market Value Price per share of the stock times the number of shares of stock outstanding)Seems to contradict Semi-Strong EMH unless there is a risk that was being rewarded with th

4、e higher returns2. Strong relation between returns& size: small companies have higher returns in average3. Test CAPM: they find that Beta(relationship between the returns of the stock and the returns of the broad market.) didnt really matter in determining future stock returns:Method:Portfolios in s

5、ize deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return(Large size means lower beta and lower returns)When size deciles are subdivided into beta ranked decile portfoliosLarger size firms have lower returns“no relation between average return and beta”(F

6、F) Value Investing: buying stocks that have low prices compared to their earnings or book value.(Loser Portfolio portfolio that contains stocks whose returns were significantly below market averages in prior periods.)反对：Daniel and Titman(DT): DT found that high book-to-market stocks had much in comm

7、on but an unknown risk factor is not one of the commonalities. The conclusions: FFs research is contrary to the EMH. Lakonishok, Vishny, Shleifer(LSV): LSV Research Value versus GrowthValue Strategies produce higher returns because they are contrary to “nave” investors. When they buy the “glamour” s

8、tocks, stocks that have done very well in the past and are expected to perform well in the future, they become overpriced. (Glamour stocks = Growth Stocks)Their main thrust: “out of favor” stocks by whatever measure can be expected to outperform the market Findings:1) reproduce the results of FF, DB

9、T research.2) Value stocks are not riskier because they outperform in all periods3) Value strategies yield higher returns(10 percent) because they exploit suboptimal behavior of typical investor: individual cannot judge, institutional:thinks glamour stocks are prudent(Extrapolation tie expectations

10、to past performance)the debate between FF and LSV is mainly about whether book-to-market represented a risk factor or a surprise to the market resulted from overreaction by market participants. If it is a risk factor, then it is still consistent with EMH. De Bondt Thaler (DBT)After a period of “over

11、-reaction,” markets “revert” back and go the other way.Their article is designed to test whether or not “mean reversion” is true/overreaction hypothesis:1.extreme movements in stock prices will be followed by subsequent price movements in the opposite direction 2.magnitude: the more extreme the pric

12、e movement, the greater will be the price adjustment Findings: Almost all of the impact is in January (If no jan effect, no mean reversion) When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation Portfolios of prior loser outper

13、form prior winners(past 3 years) in the next 3 years (mean reversion)(L portfolios consistently outperform W portfolios:19.6 % better than the market after end of 3 years; W portfolios consistently underperform the market:5 % less than the market after end of 3 years)o Buy 3year loser, sell 3 years

14、winners Losers experience exceptionally large Jan returns as late as 5 years after portfolio formation Consistent with overreaction hypothesiso Overreaction effect asymmetric it is bigger for losers than winners(The Overreaction Theme, Investors may be naive: Markets tend to overshoot. Good news som

15、ewhat immune to occasional bad news and euphoria reigns, Bad news long string of bad news dramatic shift of sentiment & overreaction takes place on the downside.)(De bondt-Thaler)Contrarian Investing: buying stock that other people dont like. Based on mean reversion, a theory suggesting that prices

16、and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.Reaction to this was not much because 1.many think that once publ

17、ished the predictability would disappear and after all arbitrage closes over time.2.Also a strong suspicion that their research relies critically upon the performance of small stocks, which are not thought to be reliable because of thin trade activity.Two times are different because Fama and French

18、were ardent defenders of EMH, but they confront De Bondt and Thaler, FF explicitly reject mean reversion. They felt that their results suggested that the variables that were important in the predictability of stock returns such as size and book to market, were simply proxies for the risk that had no

19、t been identified.Difference between FF and DBT approach Looking at past prices to predict the future is a different exercise than comparing book values to current market prices.反对：Conrad and Kauls (CK) critique of DBTs research Upward return bias in simple one-period return calculations. Unbalance

20、portfolio loser portfolio contained a disproptionate number of small cap stocks.MomentumShort-term uptrends in prices are sometimes described as momentum.In short term, rising stocks rise further and falling stocks fall furtherBall and Brown(BB): Earnings Momentum: Interested in knowing if stock pri

21、ces “anticipated” favorable and unfavorable earnings announcements.Have to define “unexpected” favorable and unfavorable.Unexpected income changes: the main predictor of a firms announced income is the average income within the industry.Regression to predict earnings from earnings of similar firms d

22、ifferences represent “unexpected” favorable or unfavorableFound that “market begins to anticipate forecast errors early in the 12 months preceding the earnings report”and continue for approximately one month after.”Earnings drift continued for one month after, so recent uptrends implied future uptre

23、nds (both directions)Narasimhan Jegadeesh and Sheridan Titman(JT): The Jegadeesh-Titman research concluded that stocks generally continued upward trends, they labelled this price momentum. Stocks that performed well in the past 3-12 months tended to perform well over the next three years. Buying the

24、 last 6 months winners and holding for six months outperformed market benchmarks by 12 percent annually Profitability NOT due to systematic risk or delayed price reactions After 1 year effect dissipates Momentum/Relative strength trading ruleo Base your predictions in the last 3-12 monthsReason: und

25、erreaction, people underreact to un expected good earnings announcement, the positive impact of earnings feeds into future stock price performance.Tarun Chordia and Lakshmanan Shivakumar(CS) tackled the same issues and conclude that earnings momentum swamps price momentum and portfolios most subject

26、 to this earnings momentum can be viewed as a risk factor that earns a risk premium. (consistent with EMH)price momentum is merely a manifestation of the earnings momentumIf price momentum holds right, then the weak form of EMH is falseIf earning momentum holds right, it could be that it represents

27、a unpriced risk factor, so it could be consistent with the EMH. Chan, Jegadeesh, Lakonishok (CJL) 1996In general, the price momentum effect tends to be stronger and longer-lived than the earnings momentum effect.LLLook at non-US dataFind price earnings LSVAgree generally with Chordia-ShivakumarBut,”

28、we provide additional evidence that international momentum strategies appear to be mostly limited to highly illiquid stocks.”our evidence supports the rationale of momentum being driven by investors underreaction to fundamental news. Moreover, we attribute the persistence of the momentum anomaly to

29、the fact that significant arbitrage costs prevent investors from its exploitation.Sadka, 2005 “Role of Liquidity Risk”Conclusion: “the results suggest that a substantial part of momentum and PEAD (post-earnings-announcement drift) returns can be viewed as compensation of the unexpected variations in

30、 the aggregate ratio of informed traders to noise traders.”“Unexpected systematic variations of (the variable component of) liquidty are shown to be priced within the context of momentum and PEADCalendar EffectsWhether calendar itself has an impact on stock returns, seasonal or calendar-based return

31、 patterns would seem to violate the EMH because it suggests investment strategies that could benefit from past dataLSJanuary Effects: stock returns are higher in January than in the rest of the year; Monthly regularities:Very high January return for small companies but not large companies. Consisten

32、t with the previous findings. Possible Reasons:1.Tax considerations selling a stock at a loss can help you save tax (happens in December). But then in January they stocks doing badly begin to recover.(Artificial tax-induced selling first force the prices down much more than warranted and then in Jan

33、uary these same stocks do better than the market)2.Disposition Effect tendency of investors to sell winners and hang on to losers. 3.Fund managers, those who are ahead of their benchmarks tend to move their portfolios to more nearly match their benchmarks as the year comes to a closeThaler conclued

34、that the January Effect is primarily a small firm effect, and this conclusion was updated by Lakonishok .Weekend EffectLater in the week returns are abnormally high, earlier in the week they are low.Monday: Negative, Friday: Positive. Rates of return on Monday tend to be significantly negative and r

35、ates of return on the last trading day of the week tend to be highPreholiday Effect Market returns are abnormally high on trading days preceding holidays.Preholiday rates are generally two to five times larger than preweekeend rates of return. Within month regularities:Positive rates of return occur

36、 in the stock market only during the first half of each month. Only for April and September the second half has an exceptional performance. End of December: the second half of December has an exceptionally high rate of return. Probably because this period includes two major holidays. The Turn-of-the

37、-Months effect: (last day of previous month+first 3 days of new month) days around the turn of the month exhibit high rates of return. Dividend effect: not enough to explain the turn-of-the Month effect. Higher dividend return during middle month of each calendar quarter. Cooper, McConnell, Outchinn

38、ikov (CMO)The other January Effect Returns in Jan are positively related to the returns over the next eleven months. Jan returns have predictive power for market returns in the next 11 months. Result NOT from riskier stocks Works for small and large stocks, high and low B/M valueSTW research casts d

39、oubt on the calendar effects result of data mining.Jorion & Goetzmann (JG)Equity premium(Index Return - Risk Free Rate) How much a diversified portfolio of stocks is expected to earn above and beyond the returns expected from a risk-free asset.global capital markets have been systematically subject

40、to dramatic changes over this centuryPuzzle: No risk aversion measures for individuals high enough to justify this amount of equity premium, US equities 6% from 1889-1978 (in other words: the difference is too large to reflect a proper level of compensation that would occur as a result of investor risk aversion; therefore, the premium should actually be much lower than the historic average of 6%.)1.Equity Premium Puzzle may be c