Economics GU4860 Behavioral Finance. Instructor: Harrison Hong Spring 2017

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1 Economics GU4860 Behavioral Finance Instructor: Harrison Hong Spring 2017 General Information Class Meetings: MW pm Office Hours: 1132 IAB, Tue: 3-4pm TA: Seunghoon Na TA: Agnieszka Dorn Discussions: W pm, F pm Instructor hh2679@columbia.edu TA sn2518@columbia.edu TA add2141@columbia.edu Course Objectives Neoclassical finance theory seeks to explain financial market valuations and fluctuations in terms of investors having rational expectations and being able to trade without costs. Under these assumptions, markets are efficient in that stocks and other assets are always priced just right. The efficient markets hypothesis (EMH) has had an enormous influence over the past 50 years on the financial industry, from pricing to financial innovations, and on policy makers, from how markets are regulated to how monetary policy is set. But there was very little in prevailing EMH models to suggest the instabilities associated with the Financial Crisis of 2008 and indeed with earlier crises in financial market history. This course seeks to develop a set of tools to build a more robust model of financial markets that can account for a wider range of outcomes. It is based on an ongoing research agenda loosely dubbed Behavioral Finance, which seeks to incorporate more realistic assumptions concerning human rationality and market imperfections into finance models. Broadly, we show in this course that limitations of human rationality can lead to bubbles and busts such as the Internet Bubble of the mid-1990s and the Housing Bubble of the mid-2000s; that imperfections of markets such as the difficulty of short-selling assets can cause financial markets to undergo sudden and unpredictable crashes; and that agency problems or the problems of institutions can create instabilities in the financial system as recently occurred during the 2008 Financial Crisis. These instabilities in turn can have feedback effects to the performance of the real economy in the form of corporate investments. 1

2 The course is divided roughly into six modules. Module 1: The Efficient Market Hypothesis and the rejection of the Capital Asset Pricing Model (CAPM), which reviews neo-classical finance and presents different tests of market efficiency. Module 2: Limits of arbitrage emphasizes market imperfections and risks embedded in arbitrage activity to explain the persistence of mispricing. Module 3: Investor psychology provides a summary of key findings from the cognitive and social psychology literature that are useful for the study of investor behavior. Module 4: Disagreement finance provides an account of investor biases that might lead to investor disagreement and speculative behavior and models the effect of speculation on asset prices such as bubbles and crashes. Module 5: Social interactions and norms analyzes how information gets transmitted in financial markets via media versus word-of-mouth through social interactions and implications of this gradual transmission for asset prices. Module 6: Behavioral corporate finance examines the implications of irrational managers and irrational markets for corporate decisions such as capital structure and investments. Prerequisites Economics UN3211 (micro), UN3213 (macro), and UN3412 (econometrics) (or equivalent) are prerequisites for this course. I will assign problem sets that require the use of Microsoft Excel and STATA. So knowledge of this or related software applications is required. Grading Criteria, Exams, Assignments and Course Policy Grading Criteria: Assignments are 30%, Midterm is 30%, and Final is 40% of the grade. Assignments: There will be approximately 8 home works that focus on some of the key models in the class along with empirical exercises. The assignments must be handed in during a lecture and distributed back via assigned boxes 59 and 60. Exams and Dates: Midterm (3/8/2017) and Final (5/10/2017). Exams will be based on the lectures and homeworks. 2

3 Course Policy: The midterm and the final exam are closed book and closed notes. I will allow the use of non-programmable calculators during the exams. I will strictly enforce the university rules on academic integrity. Academic Dishonesty: Cheating on exams is a serious violation. Each of us has a responsibility to participate in scholarly discourse and research in a manner characterized by intellectual honesty and scholarly integrity. Any suspected case of cheating will be reported to the university, and students who breach their intellectual responsibility in this regard should anticipate being asked to leave Columbia. Disabilities: If you are a student with a disability and have a DS-certified Accommodation Letter please send me an confirming your request. If you believe that you might have a disability that requires accommodation, you should contact Disability Services at and disability@columbia.edu. Scheduling: Lecture on Monday 4/3/2017 will be rescheduled to 4/7/2017. Textbooks and Additional Readings Required (distributed in class) Recommended: Lectures Slides Irrational Exuberance (latest edition) Author: Robert J. Shiller Publisher: Random House Inc. Inefficient Markets---An Introduction to Behavioral Finance Author: Andrei Shleifer Publisher: Cambridge University Press Additional readings will be assigned and provided as the course progresses. There are also a number of great academic surveys on behavioral finance, such as: Barberis, Nicholas and Richard Thaler (2003). A Survey of Behavioral Finance. Handbook of the Economics of Finance. Baker, Malcolm and Jeffrey Wurgler (2012). Behavioral Corporate Finance: An Updated Survey. Handbook of the Economics of Finance: Volume 2. Hirshleifer, David. "Investor psychology and asset pricing." The Journal of Finance 56.4 (2001):

4 Course Outline and Readings This is a tentative course outline. Readings will be assigned as the course progresses. Lectures 1 and 2. Efficient market hypothesis (EMH). Reminders on neoclassical finance. CAPM. Early evidence. Demand curve for stocks. Fama, Eugene (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, 25: Malkiel, Burton (2003). The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives, 17:59-82 Jensen, Michael C. (1968). The performance of mutual funds in the period Journal of Finance, 23: Roberts, Harry (1959). Stock Market ``Patterns'' And Financial Analysis: Methodological Suggestions. Journal of Finance, 14:1-10. Keown, Arthur and John Pinkerton (1981). Merger Announcements and Insider Trading Activity: An Empirical Investigation. Journal of Finance, 36: Sharpe, William F., (1964), Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance 19.3: Lectures 3 and 4. Excess predictability tests: Medium and long-horizon predictability in the stock market Summers, Lawrence H., (1985), On economics and finance, Journal of Finance 40, Summers, Lawrence H., (1986), Does the stock market rationally reflect fundamental values? Journal of Finance 41, Shiller, Robert J., (1981), Do stock prices move too much to be justified by subsequent changes in dividends?. American Economic Review, 71: Cutler, David, James Poterba, and Lawrence Summers, (1989), What Moves Stock Prices? Journal of Portfolio Management, 15: Blanchard, Olivier J., and Mark W. Watson, (1982), Bubbles, rational expectations and financial markets. NBER Working Paper. De Bondt, Werner F.M., and Thaler, Richard (1985). Does the Stock Market Overreact? Journal of Finance, 40: Fama, Eugene, and Kenneth R. French (1992). The cross-section of expected stock returns. Journal of Finance, 47:

5 Novy Marx, Robert (2013). The Other Side of Value: The Gross Profitability Premium, Journal of Financial Economics 108(1): Sloan, Richard (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? The Accounting Review, 71 (3): Fama, Eugene and Ken French, (1998), Value versus growth: The international evidence, Journal of Finance 53, Lakonishok, Josef, Andrei Shleifer and Robert W. Vishny, 1994, Contrarian investment, extrapolation and risk, Journal of Finance 49, Jegadeesh, Narasimhan, and Sheridan Titman (1993). Returns to buying winners and selling losers: Implications for stock market efficiency. Journal of Finance, 48: Clifford Asness, Tobias Moskowitz, and Lasse Pedersen (2013). Value and Momentum Everywhere. Journal of Finance, 68: Lectures 5 and 6. Quasi-experiments: Law of one price, indexing, calendar, and drift tests Lakonishok, Josef, and Seymour Smidt (1988). Are seasonal anomalies real? A ninetyyear perspective, Review of Financial Studies, 1 (4): p Keim, Donald (1983). Size-related Anomalies and Stock Return Seasonality. Journal of Financial Economics, 12: Hong, Harrison, and Jialin Yu., (2009), Gone fishin : Seasonality in trading activity and asset prices. Journal of Financial Markets 12.4: Lamont, Owen A., and Richard Thaler (2003). Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs. Journal of Political Economy, 111: Hwang, Byoung-Hyoun (2011). Country-specific sentiment and security prices. Journal of Financial Economics, 100: Scruggs, John T. (2007). Noise trader risk: Evidence from the Siamese twins, 10: Froot, Kenneth A., and Dabora, Emile (1999). How Are Stock Prices Affected by Location of Trade? Journal of Financial Economics, 53(2): Chang, Yen-cheng, Harrison Hong and Inessa Liskovich. Regression Discontinuity and The Price Effects of Stock Market Indexing. Review of Financial Studies. Wurgler, Jeffrey, and Zhuravskaya, Ekaterina (2002). Does Arbitrage Flatten Demand Curves For Stocks? Journal of Business, 75:

6 Huberman, Gur, and Tomer Regev (2001). Contagious Speculation and a Cure for Cancer: A non-event that Made Stock Prices Soar. Journal of Finance, 56: Bernard, Victor (1992). Stock Price Reactions to Earnings Announcements. In: Thaler, R. (Ed.), Advances in Behavioral Finance. New York: Russell Sage Foundation. Hong, Harrison, Walter Torous, and Rossen Valkanov. (2007) Do industries lead stock markets?." Journal of Financial Economics 83.2: Cohen, Lauren and Andrea Frazzini (2008). Economic Links and Predictable Returns. Journal of Finance, 63: DellaVigna, Stefano and Joshua Pollet (2007). Demographics and Industry Returns. American Economic Review, 97: DellaVigna, Stefano and Joshua Pollet (2007). Investor Inattention and Friday Earnings Announcements. Journal of Finance. 64: Lectures 7 and 8. Limits of arbitrage: Trading costs and shorting costs D'avolio, Gene (2002). The market for borrowing stock. Journal of Financial Economics, 66: Almazan, Andres, Keith Brown, Murray Carlson and David A. Chapman (2004). Why constrain your mutual fund manager? Journal of Financial Economics, 73: Koski, Jennifer and Jeffrey Pontiff (1999). How Are Derivatives Used? Evidence from the Mutual Fund Industry. Journal of Finance, 54: Lectures 9 and 10. Limits of arbitrage: Fundamental versus noise trader risks DeLong, J. Bradford, Andrei Shleifer, Lawrence H. Summers and Robert Waldmann, (1990), Noise trader risk in financial markets, Journal of Political Economy 98, Mitchell, Mark, Todd Pulvino, and Erik Stafford (2002). Limited Arbitrage in Equity Markets. Journal of Finance, 57: Brunnermeier, Markus and Stefan Nagel (2004). Hedge Funds and the Technology Bubble. Journal of Finance, 59: Lecture 11. Investor Psychology: Biases, heuristics, and overconfidence Odean, Terrance, (1999), Do Investors Trade Too Much?, American Economic Review 89, Odean, Terrance. (1998), Are investors reluctant to realize their losses?. The Journal of finance 53.5:

7 Chen, M. Keith, Venkat Lakshminarayanan, and Laurie R. Santos. (2006) How basic are behavioral biases? Evidence from capuchin monkey trading behavior. Journal of Political Economy 114.3: Chen, M. Keith. (2013) The effect of language on economic behavior: Evidence from savings rates, health behaviors, and retirement assets. The American Economic Review 103.2: French, Kenneth R., and James M. Poterba. (1991) Investor diversification and international equity markets. No. w3609. National Bureau of Economic Research. YC Chang, H Hong, L Tiedens, B Zhao, (2014) Does Diversity Lead to Diverse Opinions? Evidence from Languages and Stock Markets, Columbia University Working Paper. Lecture 12. Investor Psychology: Prospect theory Kahneman Daniel and Amos Tversky (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47: Odean, Terrance (1998). Are Investors Reluctant to Realize Their Losses? Journal of Finance, 53: Ganzach Yoav, and Nili Karsahi (1995). Message Framing and Buying Behavior: A Field Experiment. Journal of BusinessResearch, 32, Pope, Devin and Maurice Schweitzer (2011). Is Tiger Woods Loss Averse? Persistent Bias in the Face of Experience, Competition, and High Stakes American Economic Review 101: Kahneman, Daniel, Jack L. Knetsch and Richard H. Thaler (1990). Experimental Tests of the Endowment Effect and the Coase Theorem. Journal of Political Economy. 98: Fryer, Roland, Steven D. Levitt, John List, Sally Sadoff (2012). Enhancing the Efficacy of Teacher Incentives through Loss Aversion: A Field Experiment. Working Paper. Shlomo Benartzi, and Richard H. Thaler (1995). Myopic Loss-Aversion and the Equity Premium Puzzle. Quarterly Journal of Economics, 110: Lectures 13 and 14. Investor Psychology: Self-Control and Savings Americks and Zeldes, 2000, How do household portfolio shares vary by age? Coumbia University Working Paper. Benartzi and Thaler, 2001, Naïve diversification strategies in retirement saving plans, American Economic Review 91,

8 Bernheim and Garrett, 1996, The determinants and consequences of financial education in the workplace: Evidence from a survey of households, Working paper, NBER. Choi, Laibson and Madrian, 2004, $100 bills on the sidewalk: Violations of no-arbitrage in 401(k) plans, Harvard University Mimeo. Choi, Laibson, Madrian and Metrick, 2001, For better or for worse: Default effects and 401(k) savings behavior, Perspectives on the Economics of Aging, edited by David Wise. Chicago: Univ. of Chicago Press. Choi, Laibson, Madrian and Metrick, 2002, Defined contribution pensions: Plan rules, participant choices and the path of least resistance, edited by James Poterba, Tax Policy and the Economy 16, Midterm Review 3/6/2017 and Midterm 3/8/2017 Lectures 15 and 16. Are Smarter Markets Better Markets? Shleifer, Andrei and Robert W. Vishny (1997). The Limits of Arbitrage. Journal of Finance: Hong, Harrison, Jeffrey Kubik and Tal Fishman, (2011), Do Arbitrageurs Amplify Economic Shocks? Journal of Financial Economics (2012): Chevalier, Judy and Glenn Ellison, (1999), Career concerns of mutual fund managers, Quarterly Journal of Economics 114, Hong, Harrison, Jeffrey D. Kubik and Amit Solomon, (2000), Security analysts career concerns and herding of earnings forecasts, Rand Journal of Economics 31, Scharfstein, David and Jeremy C. Stein, (1990), Herd behavior and investment, American Economic Review 80, Stein, Jeremy C., (1989), Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior, Quaterly Journal of Economics, 104, Hong, Harrison and Jeremy C. Stein, 1999, A unified theory of underreaction, momentum trading and overreaction in asset markets, Journal of Finance 54, Hong, Harrison, Terence Lim and Jeremy C. Stein, 2000, Bad news travels slowly: Size, analyst coverage and the profitability of momentum strategies, Journal of Finance 55, Lectures 17 and 18. Disagreement: The low risk, high return puzzle Hong, Harrison and Jeremy C. Stein, (2007), Disagreement and the Stock Market, Journal of Economic Perspectives, Spring. 8

9 Ang, Andrew, Robert J. Hodrick, Yuhang Xing, and Xiaoyan Zhang, (2006). The Cross- Section of Volatility and Expected Returns. Journal of Finance, 61: Baker, Malcolm, Brendan Bradley, and Jeffrey Wurgler, (2011). Benchmarks as limits to arbitrage: Understanding the low volatility anomaly. Financial Analysts Journal, 67. Frazzini, Andrea and Lasse Pedersen (2014). Betting against Beta. Journal of Financial Economics, 111: Miller, Edward (1977). Risk, uncertainty, and divergence of opinion. Journal of Finance, 32: Diether, Karl, Christopher Malloy and Anna Scherbina (2002). Journal of Finance, 57: Chen, Joseph, Harrison Hong, and Jeremy C. Stein (2003). Breadth of Ownership and Stock Returns. Journal of Financial Economics. 66: Hong, Harrison and David Sraer (2014). Speculative Betas. Forthcoming Journal of Finance. Lectures 19 and 20. Disagreement: Speculation, bubbles and crashes Hong, Harrison, and Jeremy C. Stein. "Disagreement and the stock market." The Journal of Economic Perspectives 21.2 (2007): Scheinkman, Jose A., and Wei Xiong. (2003) Overconfidence and speculative bubbles. Journal of Political Economy 111.6: Hong, Harrison, Jose Scheinkman and Wei Xiong, (2006), Asset float and speculative bubbles, Journal of Finance 61, Hong, Harrison and David Sraer, (2013), Quiet Bubbles, Journal of Financial Economics : Lectures 21 and 22. Social interaction and norms in financial markets Hong, Harrison, Jeffrey D. Kubik and Jeremy C. Stein, (2005), Thy Neighbor s Portfolio: Word-of-Mouth Effects in the Holdings and Trades of Money Managers, Journal of Finance 60, Hong, Harrison, Jeffrey D. Kubik and Jeremy C. Stein, (2004), Social Interaction and Stock Market Participation, Journal of Finance 59, Cohen, Lauren, Andrea Frazzini, and Christopher Malloy. (2008) The small world of investing: Board connections and mutual fund returns. Journal of Political Economy 116:

10 Hong, Harrison, and Marcin Kacperczyk. "The price of sin: The effects of social norms on markets." Journal of Financial Economics 93.1 (2009): Lecture 23. Behavioral Corporate Finance: Irrational Managers Malmendier, Ulrike, and Geoffrey Tate. "CEO overconfidence and corporate investment." The journal of finance 60.6 (2005): Bertrand, Marianne, and Antoinette Schoar. "Managing with style: The effect of managers on firm policies." The Quarterly Journal of Economics (2003): Moskowitz, Tobias J., and Annette Vissing-Jørgensen. "The returns to entrepreneurial investment: A private equity premium puzzle?." The American Economic Review 92.4 (2002): Lectures 24 and 25. Behavioral Corporate Finance: Irrational Markets Stein, Jeremy, (1996), Rational capital budgeting in an irrational world, Journal of Business 69, Baker, Malcolm, Jeremy Stein and Jeffrey Wurgler, (2003), When does the market matter? Stock prices and the investment of equity-dependent firms, Quarterly Journal of Economics 118, Baker, Malcolm and Jeffrey Wurgler, (2002), Market timing and capital structure, Journal of Finance 57, Hong, Harrison, Jiang Wang, and Jialin Yu, (2008) Firms as Buyers of Last Resort, Journal of Financial Economics 88.1 (2008): Final Review 5/1/2017 and Final 5/10/