A Behavioral Approach to Asset Pricing

Transcription

1 A Behavioral Approach to Asset Pricing Second Edition Hersh Shefrin Mario L. Belotti Professor of Finance Leavey School of Business Santa Clara University AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO Academic Press is an imprint of Elsevier

2 Preface to Second Edition Preface to First Edition About the Author xix xxiii xxix Introduction Why''Read This Book? Value to Proponents of Traditional Asset Pricing Value to Proponents of Behavioral Asset Pricing Organization: How the Ideas in This Book Tie Together Heuristics and Representativeness: Experimental Evidence Heuristics and Representativeness: Investor Expectations Developing Behavioral Asset Pricing Models Heterogeneity in Risk Tolerance and Time Discounting Sentiment and Behavioral SDF Applications of Behavioral SDF Behavioral Preferences Future Directions and Closing Comments Summary 13

3 Heuristics and Representativeness: Experimental Evidence 15 Representativeness and Bayes Rule: Psychological Perspective Explaining Representativeness Implications for Bayes Rule Experiment Three Groups Bayesian Hypothesis Results Representativeness and Prediction Two Extreme Cases Representativeness and Regression to the Mean Results for the Prediction Study Strength of Relationship Between Signal and Prediction How Regressive? Summary 25 Representativeness and Bayes Rule: Economics Perspective The Grether Experiment Design Experimental Task: Bayesian Approach Representativeness Results Underweight ing Base Rate Information Summary 34 A Simple Asset Pricing Model Featuring Representativeness First Stage, Modified Experimental Structure Expected Utility Model Bayesian Solution Equilibrium Prices Representativeness Second Stage: Signal-Based Market Structure Sentiment, State Prices, and the Pricing Kernel Summary 46 Heterogeneous Judgments in Experiments Grether Experiment Heterogeneity in Predictions of GPA 48

4 vii 5.3 The De Bondt Experiment Forecasts of the S&P Index: Original Study Replication of De Bondt Study Overconfidence Why Some Commit "Hot Hand" Fallacy and Others Commit Gambler'sFallacy Summary 61 II Heuristics and Representativeness: Investor Expectations 63 6 Representativeness and Heterogeneous Beliefs Among Individual Investors, Financial Executives, and Academics Individual Investors Bullish Sentiment and Heterogeneity The UBS/Gallup Survey Heterogeneous Beliefs Hot Hand Fallacy The Impact of Demographic Variables Own Experience: Availability Bias Do Individual Investors Bet on Trends? Perceptions and Reactions to Mispricing The Expectations of Academic Economists Heterogeneous Beliefs Welch's 1999 and 2001 Surveys Financial Executives.. / Volatility and Overconfidence Summary T" 78 7 Representativeness and Heterogeneity in the Judgments of Professional Investors Contrasting Predictions: How Valid? Update to Livingston Survey Heterogeneity Individual Forecasting Records Frank Cappiello Ralph Acampora Gambler's Fallacy Forecast Accuracy Excessive Pessimism Predictions of Volatility 94

5 7.5 Why Heterogeneity Is Time Varying Heterogeneity and Newsletter Writers Summary 99 III Developing Behavioral Asset Pricing Models A Simple Asset Pricing Model with Heterogeneous Beliefs A Simple Model with Two Investors Probabilities Utility Functions State Prices Budget Constraint Expected Utility Maximization Equilibrium Prices Formal Argument Representative Investor Fixed Optimism and Pessimism Impact of Heterogeneity Ill 8.4 Incorporating Representativeness Ill 8.5 Summary Heterogeneous Beliefs and Inefficient Markets Defining Market Efficiency Riskless Arbitrage Risky Arbitrage Fundamental Value When n Is Nonexistent Market Efficiency and Logarithmic Utility Example of Market Inefficiency Sentiment and the Log-Pricing Kernel Equilibrium Prices as Aggregators Market Efficiency: Necessary and Sufficient Condition Interpreting the Efficiency Condition When the Market Is Naturally Efficient Knife-Edge Efficiency When the Market Is Naturally Inefficient Summary A Simple Market Model of Prices and Trading Volume The Model Expected Utility Maximization 131

6 ix 10.2 Analysis of Returns Market Portfolio Risk-Free Security Analysis of Trading Volume Theory Example Stochastic Processes Available Securities Initial Portfolios Equilibrium Portfolio Strategies Markov Structure, Continuation, and Asymmetric Volatility Arbitrage State Prices Summary Efficiency and Entropy: Long-Run Dynamics Introductory Example The Market Budget Share Equations Portfolio Relationships Wealth Share Equations Entropy Numerical Illustration Markov Beliefs Heterogeneous Time Preference, Entropy, and Efficiency Modeling Heterogeneous Rates of Time Preference ' Market Portfolio,.' Digression: Hyperbolic Discounting Long-Run Dynamics When Time Preference Is Heterogeneous Entropy and Market Efficiency Summary 166 IV Heterogeneity in Risk Tolerance and Time Discounting CRRA and CARA Utility Functions Arrow-Pratt Measure Proportional Risk Constant Relative Risk Aversion Graphical Illustration Risk Premia 171

7 x Contents 12.4 Logarithmic Utility Risk Premium in a Discrete Gamble CRRA Demand Function Representative Investor Example Aggregation and Exponentiation CARA Utility CARA Demand Function Aggregate Demand and Equilibrium Summary Heterogeneous Risk Tolerance and Time Preference Survey Evidence Questions to Elicit Relative Risk Aversion Two Waves Status Quo Bias Risky Choice Extended Survey Time Preference Summary Representative Investors in a Heterogeneous CRRA Model Relationship to Representative Investor Literature Additional Literature Modeling Preliminaries 197 ; 14.3 Efficient Prices Representative Investor Characterization Theorem 199 ' Discussion Nonuniqueness Comparison Example Pitfall: The Representative Investor Theorem Is False Argument Claiming That Theorem 14.1 Is False Identifying the Flaw Summary 210 V Sentiment and Behavioral SDF Sentiment Intuition: Kahneman's Perspective Relationship to Theorem Defining Market Efficiency 216

8 xi 15.2 Sentiment Formal Definition Example Featuring Heterogeneous Risk Tolerance Example Featuring Log-Utility Representativeness: Errors in First Moments Overconfidence: Errors in Second Moments Link to Empirical Evidence Evidence of Clustering Sentiment as a Stochastic Process Summary Behavioral SDF and the Sentiment Premium The SDF Sentiment and the SDF Example Pitfalls Pitfall: The Behavioral Framework Admits a Traditional SDF Pitfall: Heterogeneity Need Not Imply Sentiment Pitfall: Heterogeneity in Risk Tolerance Is Sufficient to Explain Asset Pricing Sentiment and Expected Returns Interpretation and Discussion Example Illustrating Theorem Entropy and Long-Run Efficiency Formal Argument Learning: Bayesian and Non-Bayesian Summary / 248 VI Applications of Behavioral SDF Behavioral Betas and Mean-Variance Portfolios Mean-Variance Efficiency and Market Efficiency Characterizing Mean-Variance Efficient Portfolios The Shape of Mean-Variance Returns The Market Portfolio Risk Premiums and Coskewness Behavioral Beta: Decomposition Result Informal Discussion: Intuition Formal Argument Example Summary 268

9 xii Contents 18 Cross-Section of Return Expectations Literature Review Winner-Loser Effect Book-to-Market Equity and the Winner-Loser Effect January and Momentum General Momentum Studies Glamour and Value Factor Models and Risk Differentiating Fundamental Risk and Investor Error Psychology of Risk and Return Evidence About Judgments of Risk and Return Psychology Underlying a Negative Relationship Between Risk and Return Implications for the Broad Debate Analysts' Return Expectations How Consciously Aware Are Investors When Forming Judgments? How Reliable Is the Evidence on Expected Returns? Alternative Theories The Dynamics of Expectations: Supporting Data Summary Testing for a Sentiment Premium Diether Malloy Scherbina: Returns Are Negatively Related to Dispersion AGJ: Dispersion Factor Basic Approach Factor Structure General Properties"bf the Data Expected Returns Findings Volatility Direction of Mispricing Opposite Signs for Short and Long Horizons Estimating a Structural SDF-Based Model Proxy for h z,o Findings Summary A Behavioral Approach to the Term Structure of Interest Rates The Term Structure of Interest Rates 305

10 xiii 20.2 Pitfall: The Bond Pricing Equation in Theorem 20.1 Is False Identifying the Flaw in the Analysis Volatility Heterogeneous Risk Tolerance Expectations Hypothesis Example Summary Behavioral Black-Scholes Call and Put Options Risk-Neutral Densities and Option Pricing Option Pricing Equation Option Pricing Equations 2 and Option Pricing Examples Discrete Time Example Continuous Time Example Smile Patterns Downward-Sloping Smile Patterns in the IVF Function Heterogeneous Risk Tolerance Pitfall: Equation (21.12) Is False Locating the Flaw Pitfall: Beliefs Do Not Matter in Black-Scholes Locating the Flaw Summary Irrational Exuberance and Option Smiles Irrational Exuberance: Brief History Sentiment. T Risk-Neutral Densities and Index Option Prices Butterfly Position Technique Continuation, Reversal, and Option Prices Price Pressure: Was Arbitrage Fully Carried Out? Heterogeneous Beliefs General Evidence on the Mispricing of Options Summary Empirical Evidence in Support of Behavioral SDF Bollen-Whaley: Price Pressure Drives Smiles Data Trading Patterns ' Buying Pressure and Smile Effects 362

11 xvi Contents 27.9 Real-World Portfolios and Securities Empirical Evidence Examples Summary Equilibrium with Behavioral Preferences The Model Simple Example Neoclassical Case Prospect Theory Investors Boundary Value Property Equilibrium Pricing Additional Insights Regarding Convexity and Existence Weighting and Heterogeneous Beliefs Portfolio Insurance Testable Prediction Risk and Return: Portfolio Insurance in a Mean-Variance Example Heterogeneous Preferences and Heterogeneous Beliefs: Equilibrium with a Mix of SP/A Investors and EU-Investors Behavioral Preferences and the Signature of Sentiment Further Remarks on Skewness and Coskewness Summary 484 ; 29 The Disposition Effect: Trading Behavior and Pricing Psychological Basis for the Disposition Effect Evidence for the Disposition Effect Investor Beliefs Odean's Findings A Size Effect A Volume Effect Momentum and the Disposition Effect Theoretical Hypotheses Empirical Evidence Extensions Summary Reflections on the Equity Premium Puzzle Basis for Puzzles in Traditional Framework Brief Review Attaching Numbers to Equations 507

12 xvii 30.2 Erroneous Beliefs Livingston Data The Market and the Economy: Upwardly Biased Covariance Estimate Alternative Rationality-Based Models Habit Formation Habit Formation SDF Habit Formation SDF Versus the Empirical SDF Behavioral Preferences and the Equity Premium Myopic Loss Aversion Transaction Utility Risks, Small and Large Summary 522 VIII Future Directions and Closing Comments Continuous Time Behavioral Equilibrium Models General Structure Continuous Time Analogue Linear Risk-Tolerance Utility Function Dynamics Driven by a Single Brownian Motion Analyzing the Impact of a Public Signal Two-Investor Example When One Investor Holds Objectively Correct Beliefs Signal Structure: General Issues Continuous Time, Signal Structure Jump Processes and Stochastic Volatility Theoretical Framework Empirical Procedure Issues Pertaining to Future Directions Summary Conclusion Recapitulating the Main Points Current and Future Directions Issues Involving Investor Benefits Issues Involving Behavioral Preferences Issues Involving Behavioral Beliefs and Behavioral Preferences Final Comments 560 References 563 Index 587