Stock Market Behavior - Investor Biases

Market Tips & Jargons Stock Market Behavior - Investor Biases Random Walk Theory Efficient Market Hypothesis Market Anomaly Investor s Behavioral Biases March 25, 2017 CBMC-RGTC Copyright 2014 Pearson Education, Inc. All rights reserved. 9-1

Relative Wealth of One Dollar Invested on 12/31/1925; U.S. Stock Returns (Small Stocks, Large Stocks, and All Stocks), 30-Year Treasury Returns, 90-Day T-Bill Returns, and Inflation, 1925 2012 Copyright 2014 Pearson Education, Inc. All rights reserved. 9-3

Stock Valuation Methods PV based methods Dividend Valuation Model Dividend and Earnings Approach Zero growth Constant growth Variable growth Relative comparison methods Price/Earnings Approach Price-to-cash-flow ratio Price-to-sales ratio Price-to-book-value ratio Copyright 2014 Pearson Education, Inc. All rights reserved. 9-4

Random Walks and Efficient Markets Random Walk Theory stock price movements are unpredictable, so there is no way to know where prices are headed Studies of stock price movements indicate that they do not move in neat patterns This random pattern is a natural outcome of markets that are highly efficient and respond quickly to changes in material information» Greed & fears (vs) Actual performances Copyright 2014 Pearson Education, Inc. All rights reserved. 9-7

Efficient Market Hypothesis Efficient Market is where securities reflect all possible information quickly and accurately No consistent abnormal return over time information is reflected in prices not only the type and source of information, but also the quality and speed with which it is reflected in prices. The more information that is incorporated into prices, the more efficient the market becomes. Assumptions: Information is widely available to all investors Many knowledgeable investors actively analyzing and trading stocks Investors react quickly and accurately to new information Events, such as labor strikes or accidents, tend to happen randomly Copyright 2014 Pearson Education, Inc. All rights reserved. 9-8

Levels of EMH Weak Form EMH Past data on stock prices are of no use in predicting future stock price changes Everything is random Should simply use a buy-and-hold strategy Semi-strong Form EMH Abnormally large profits cannot be consistently earned using public information Any price anomalies are quickly found out and the stock market adjusts Strong Form EMH There is no information, public or private, that allows investors to consistently earn abnormally high returns Copyright 2014 Pearson Education, Inc. All rights reserved. 9-9

Daily Stock Price Reactions Surrounding Positive Earnings News Source: Andreas Neuhierl, Anna Scherbina, and Bernd Schlusche. Market Reaction to Corporate Press Releases, forthcoming in the Journal of Financial and Quantitative Analysis. Copyright 2014 Pearson Education, Inc. All rights reserved. 9-10

(2) Market Anomalies Calendar Effects Stocks returns may be closely tied to the time of year or time of week Questionable if really provide opportunity Examples: January effect, weekend effect Small-Firm Effect Size of a firm impacts stock returns Small firms may offer higher returns than larger firms, even after adjusting for risk Copyright 2014 Pearson Education, Inc. All rights reserved. 9-14

Market Anomalies (cont d) Post Earnings Announcement Drift (Momentum) Stock price adjustments may continue after earnings adjustments have been announced Unusually good quarterly earnings reports may signal buying opportunity Value Effect Uses P/E ratio to value stocks Low P/E stocks may outperform high P/E stocks, even after adjusting for risk Copyright 2014 Pearson Education, Inc. All rights reserved. 9-16

Possible Explanations Stocks that appear to earn abnormal returns are actually riskier, so higher returns merely represent compensation for risk Some anomalies may simply be patterns in that data that appeared by chance and are thus not likely to persist over time Behavioral biases may cause investors to make systematic (predictable) mistakes when they invest, and those mistakes create inefficiencies in the market Copyright 2014 Pearson Education, Inc. All rights reserved. 9-17

Investor s Behavioral Biases Overconfidence Investors tend to be overconfident in their judgment, leading them to underestimate risks Self-Attribution Bias Investors tend to take credit for successes and blame others for failures Investors will follow information that supports their beliefs and disregard conflicting information è These biases may cause investors to trade too often (2% up è 70% more trading, -3% costs, very next M&A fails) Copyright 2014 Pearson Education, Inc. All rights reserved. 9-18

Investor Behavior and Security Prices (cont d) Loss Aversion Investors dislike losses much more than gains Investors will hang on to losing stocks hoping they will bounce back (volume decrease, reject loss-cut, take profits on small gains etc) Representativeness (Overreaction & Under reaction) Investors tend to draw strong conclusions from small samples Investors tend to underestimate the effects of random chance (ie: value investors, drifting & momentum) Copyright 2014 Pearson Education, Inc. All rights reserved. 9-19

Investor Behavior and Security Prices (cont d) Narrow Framing Investors tend to analyze a situation in isolation, while ignoring the larger context Belief Perseverance Investors tend to ignore information that conflicts with their existing beliefs Familiarity Bias Investors buy stocks that are familiar to them without regard to whether the stocks are good buys or not (ie: domestic only with less diversification effects) Copyright 2014 Pearson Education, Inc. All rights reserved. 9-20

Behavioral Finance at Work in the Markets (cont d) Investor Behavior Investors who believe they have superior information tend to trade more, but earn lower returns Investors tend to sell stocks that have risen in value rather than declined Investors acting on emotions instead of facts may reduce market efficiency Copyright 2014 Pearson Education, Inc. All rights reserved. 9-21

Behavioral Finance at Work in the Markets (cont d) Analyst Behavior Analysts may be biased by herding behavior, where they tend to issue similar recommendations for stocks Analysts may be overly optimistic about a favorite stock s future Copyright 2014 Pearson Education, Inc. All rights reserved. 9-22

Using Behavioral Finance to Improve Investment Results Review the performance of your investment on a periodic basis Don t trade too much Don t chase performance Don t hesitate to sell a losing stock Be humble and open-minded Copyright 2014 Pearson Education, Inc. All rights reserved. 9-23