ExcessiveVolatilityRobert J. Shiller (1981) The American Economic ReviewDo stock prices move too much to be justified by subsequent changes in dividends? Summary: Stock prices volatility is greater than can be justified by fundamentals (i.e. a new info about change in dividends) Purpose: What accounts for movements in stock prices? theremay be a human element addingtovolatility
High volatility of stock market prices compared to fundamental prices
Short-term momentum Positive short-term (6-12 months) autocorrelation in stock returns (underreaction) – news is incorporated slowly into prices Momentum Strategies: (To exploit short lags) • Create zero-cost arbitrage portfolios by buying most winners and selling most losers of the past 3-12 months, hold them for the next 3-12 months. • Jegadeesh and Titman (1993) and Rauwenhorst (1998): report around 1% monthly average excess returns to this strategy.
Long-term reversal Negative long-term (3-5 years) autocorrelation in stock returns Contrarian Strategies: (To exploit long lags) Buy most losers and sell most winners of the past 3-5 years, hold the portfolio for the next 3-5 years. DeBondtand Thaler (1985) report significantly positive returns to this strategy Yesterday's top performers become tomorrow's underperformers, and vice versa. Short-lag positive and long-lag negative autocorrelation in Rtseries are a violation of weak form of efficiency.
TheProfitabilityof Technical Analysis (Trends, Trend Reversals): Itmay be possibletomakemoneybyfollowingtrends. IPO Stocks’ Underperformance Ritter(1991): IPO stocksyieldbelow normal returnsin the 36 monthsfollowingthe IPO. Investorsbecome too optimistic about IPO firms, inflating the initial IPO return (buy at a high price, stocks later underperform)
2. Behavioral Theories Designed to Explain These Anomalies…
Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment • Underreaction due to Conservatism bias: • Individuals are slow to change their beliefs in the face of new evidence • Information is reflected step-by-step in prices rather than in a single step • Stock prices underreact to earnings announcements • This creates positive short-term autocorrelation in returns and explains the profitability of momentum rule
Barberis, Shleifer, Vishy (BSV)Journal of Financial Economics (1998)A model of investor sentiment • Overreaction due to Representativeness Bias: Tendency of people to underweight statistical properties of population/see patterns in random sequences/reemphasize the most recent and salient
Representativeness Bias • Investor might think that high earnings growth of a company is trending (when it is not) and overvalues the company • Stock prices overreact to consistent patterns of good/bad news, creating excessive volatility (continuing trends, then reversals) • This explains negative long-term autocorrelation in returns and profitability of contrarian strategy
Effect on the market • Conservatism + Representativeness Bias: • Short-run momentum (continuation) • Long-run reversal
Daniel, Hirshleifer, SubrahmanyamThe Journal of Finance (1998)DHS model Overconfidence: An investor tends to be overconfident about the information he has generated but NOT about public signals. Biased self-attribution: When confirming public information is received – investor’s confidence rises. When disconfirming public information is received – investor’s confidence falls only modestly, if at all.
OVERREACTION to private information And UNDERREACTION to public information Q: HOW DO THESE BIASES AFFECT MARKET BEHAVIOR? Tend to produce: • Short-run momentum • Long-run reversals E.g. Bubbles
Shleifer and Summers Journal of Economic Perspective(1990)The Noise Trader Approach to Finance Efficient markets approach: Random trades SHOULD cancel out. Noise Trader approach: Random trades DO NOT cancel out. Movements in investor sentiment are an important determinant of prices
Fama’s critique of behavioral theoriesMarket efficiency, long-term returns, and behavioral finance (1998), Journal of Financial Economics • Long-term return anomalies – NO EVIDENCE AGAINST EFFICIENT MARKET THEORY • anomalies are chance results, underreactions are equally likely as overreactions, so they cancel each other out • unpredictability of behavioral facts • methodology problem • temporarityof behavioral facts
Thaler (1999)The End of Behavior Finance“After all, to do otherwise would be irrational “ • Evidence that should worry the efficient market advocates • Volume • Volatility • Predictability Fama 1970/1991 • Dividents (MM - 1958) • Why do most large companies pay cash dividends? • And why do stock prices rise when dividends are initiated or increased? • “Behavioral finance" will be correctly viewed as a redundant phrase • “After all, to do otherwise [not include the human factor in trading ] would be irrational “