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1 Behavioral Finance – Exercise Course IV Dr. Heiko Jacobs
Behavioral Finance – FSS 2012 Exercise Course IV
2 Behavioral Finance – Exercise Course IV Dr. Heiko Jacobs
Linking individual behavior and market outcomes
Should we care about individual investor behavior if we are primarily
interested in economic aggregates?
Yes!
We will study implications of
Overconfidence (very briefly)
Disposition effect
Limited Attention
Agenda
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• Investors overestimate the precision of their knowledge or underestimate
the variance of stock returns.
• Incorporating overconfidence in different types of models (e.g. Diamond
and Verrecchia (1981), Kyle (1985)) leads to the following conclusion:
Overconfident traders trade more than rational traders.
The higher the degree of overconfidence, the higher trading volume.
Overconfidence and differences of opinion are not mutually exclusive
“Excessive” trading volume as a result of overconfidence
Exercise 1
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Seller Buyer Seller Buyer
no overconfidence overconfidence
trading activity
no opportunity for trading
90
100
110
120
130
140
150
Overconfident traders base their decision on confidence intervals, which are “too narrow”
Trade more
aggressively
Higher trading
volume
The intuition behind the result
Exercise 1
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Does the purchase price (or any other reference from the past)
affect the willingness to sell?
past future Price
today
What is the disposition effect?
Exercise 2a)
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Yes, the purchase price / reference point effects the willingness to sell!
Investors have the tendency to sell shares whose price is increasing,
while keeping assets that have dropped in value,
so they tend to ''sell winners too early and ride losers too long“
Exercise 2a)
„Investors tend to • sell winners too early
• and ride losers too long“
Disposition effect
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Why is prospect theory one possible explanation for the disposition effect?
Past prices serve as a reference point,
Different risk attitude for gains and losses:
Risk seeking in the loss domain, risk averse in the gain domain
Gain Loss
convex =>
risk seeking
Gain Loss
concave =>
risk averse
Gains
Losses
Sell!
Hold!
Exercise 2b)
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Exercise 2
9 Behavioral Finance – Exercise Course IV Dr. Heiko Jacobs
=> Yes, investors may also believe that winners and losers will mean revert
Fundamental misunderstanding of random processes and stock market
efficiency:
• If stock prices follow a random walk, past price movements say nothing
about future price movements
• Similar to “Gambler’s fallacy”: people are likely to predict reversal
Exercise 2b)
Can you think of another possible explanation for the disposition effect?
10 Behavioral Finance – Exercise Course IV Dr. Heiko Jacobs
Exercise 2c)
From a welfare-point of view what is the problem if investors are disposed to
selling winners and holding losers?
Problems associated with the Disposition effect:
• The behavior is tax-inefficient: Optimal tax-behavior predicts holding
profitable investments to postpone taxable gains and selling
investments with paper losses to receive a tax rebate
• Losing stocks held underperform winning stocks sold!
• Possible explanation: momentum in stock returns
Winning stocks sold Paper losses not sold
Average excess return after
252 trading days: 2.35%.
Average excess return after
252 trading days: -1.06%.
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Data:
• American discount broker
• 10,000 accounts
• 1987-1993
How does Odean (1998) measure the disposition effect?
Exercise 2d)
Terrance Odean, "Are Investors Reluctant to Realize Their
Losses?", Journal of Finance, Vol. LIII, No. 5, October 1998,
1775-1798.
(From his homepage):
“MEDIA: Over 1,000 Television, Radio,
and Print interviews and discussions
of research”
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How does Odean (1998) measure the disposition effect?
Methodology:
• he looks at the frequency with which investors sell winners and losers relative to their
opportunities to sell
• each day a sale takes place in a portfolio of two or more stocks, he compares the
selling price for each stock sold to its average purchase price to determine whether
that stock is sold for a gain or a loss
• each stock in the portfolio at the beginning of the day, that is not sold, is considered to
be a paper (unrealized) gain or loss (or neither) by comparing its high and low price for
that day to its average purchase price
• other reference points: highest purchase price, first purchase price, most recent
purchase price
Exercise 2d)
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How does Odean (1998) measure the disposition effect?
Two hypothesis to be tested:
• Hypothesis 1:
Investors tend to sell their winners and hold their losers:PGR > PLR (for entire year)
• Hypothesis 2:
In December investors are more willing to sell losers and less willing to sell winners
than during the rest of the year: PLR - PGR in December > PLR - PGR in January-
November
Proportion of gains realized: PGR =
Proportion of losses realized: PLR =
Realized gains
Realized gains + unrealized gains
Realized losses
Realized losses + unrealized losses
Exercise 2d)
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Odean (1998), Results:
14.8%
9.8%
0%
5%
10%
15%
20%
PGR PLR
10.8% 12.8%
0%
5%
10%
15%
20%
PGR PLR
Entire year, H1: December, H2:
Exercise 2d)
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Realized Gains: A + B + H Realized Losses: C
Paper Gains: D + I Paper Losses: E + F + G + J
Portfolio X Portfolio Y
Stock Gain/ Stock Gain/
Loss Loss
A + G -
B + H +
C - I +
D + J -
E -
F -
A + B + C are sold H is sold
Exercise 2e)
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5
1
41
1
J,G,F,EC
CPLR
5
3
23
3
I,DH,B,A
H,B,APGR
Proportion of gains realized: PGR =
Proportion of losses realized: PLR =
Realized gains
Realized gains + unrealized gains
Realized losses
Realized losses + unrealized losses
Realized Gains: A + B + H Realized Losses: C
Paper Gains: D + I Paper Losses: E + F + G + J
Exercise 2e)
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• Experimental validation of the disposition effect, instead of empirical analysis
• Stock exchange in the laboratory, controlled environment:
- six assets (A-F), different probabilities of price increases/decreases
- probabilities known + fix, but unknown which probability refers to which asset
- prices are not determined by supply and demand but by a chance process
• Notional investment amount: 10,000 DM
What do Weber and Camerer (1998) do to test the existence of the disposition
effect? What is different to the analysis of Odean (1998)?
Exercise 2f)
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Asset prices
• Price increase or decrease, assets independent
• Probability for an price increase:
• Price change 1, 3, or 5 DM, assets independent
++ : 65%
+ : 55%
0 : 50% (2 assets)
- : 45%
-- : 35%
Why is it rational to buy winners and sell losers?
Exercise 2g)
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Participants have to look at the price paths to calculate which asset is of the type ++ , + , 0 , 0 , - , - -
Example:
Rational expecta-
tions after period 5
Exercise 2g)
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Rational:
probability of a price increase is fixed over time
the stock that has risen most frequently is most likely to be the ++ stock,
the stock that has fallen most frequently is most likely to be the - - stock,
...
strategy: sell losers, buy winners
Example: Rational expectations after period 5
Exercise 2g)
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But: actual behavior
%
Exercise 2g)
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How can the disposition effect be reduced? (Weber / Camerer)
Trading phase
• new prices
• purchases/sales
Automatic selling
of holdings
Possibility of redemption
at the old price
Trading phase
• new prices
• purchases/sales
Alternative design • 2 different designs:
– Experiment I:
voluntary selling of holdings
after each period
– Experiment II:
automatic selling of all holdings
but possibility of redemption of
the assets at the old prices
Exercise 2h)
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How can the disposition effect be reduced?
Possible counteractions:
• do not look at the purchase price, only current price is important
• ask yourself the question: “By now would I buy the stock again?“
• use stop-loss prices
• keep distance to your investments
Exercise 2h)
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Explain how the disposition effect might influence stock returns.
Exercise 2i)
The Disposition effect may affect the supply of stocks:
• If stock prices rise above the reference point: Investors will be more willing
to sell thereby increasing the supply of stocks temporary downward
pressure on current stock prices positive drift in stock returns
• If stock prices fall below the reference point: Investors will be averse to sell
thereby restricting supply temporary upward pressure on current stock
prices negative drift in stock returns
However:
• Every investor may have a different reference point Is there an effect in
aggregate?
• Rational investors may “step in” to assure that prices reflect the
fundamental value
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Frazzini’s research design (The Disposition Effect and Underreaction
to News, Journal of Finance, 2006)
Exercise 2j)
Methodology:
• he looks at the holdings of mutual funds which constitute a large fraction of the market
• For each individual stock he constructs an individual reference point =average
purchase price of the funds which hold the particular stock in a particular quarter
• Example: 3 funds A, B, and C which hold Microsoft shares
• If Microsoft stocks currently trade above (below) $32.86, most current stock holders of
Microsoft have a paper gain (paper loss) in their books capital gains (loss)
overhang
Fund No. Microsoft shares Purchase Price Total trading amount
A 20 $25 $500
B 70 $30 $2,100
C 50 $40 $2,000
Total 140 $4,600
Average purchase
price=$4,600/140=
$32.86
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Frazzini’s research design (The Disposition Effect and Underreaction
to News, Journal of Finance, 2006)
Exercise 2j)
Methodology:
• Frazzini then looks at major corporate news announcements (e.g. Microsoft
announcing a delay of the launch of a new operating system)
• In the absence of frictions the news should be immediately incorporated into prices
and there will be no predictable price trend afterwards
• However, if the Disposition effect has an impact on stock prices there will be a
(stronger) post-event announcement drift
Negative news Positive news
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Frazzini’s results (The Disposition Effect and Underreaction
to News, Journal of Finance, 2006)
Exercise 2j)
1,11%
0,35%
-0,98%
-0,43%
-1,50%
-1,00%
-0,50%
0,00%
0,50%
1,00%
1,50%
"Overhang" Stocks Other Stocks
Good News
Bad News
Large return drift if price
is far away from the
average purchase price
Smaller (and insignificant)
return drift if price is close
to average purchase price
Methodology:
• Frazzini looks at the abnormal
return in the month after the
corporate announcement
• In fact, he finds a large price
drift for “overhang” stocks
• Stocks with good news have a
1.11% higher return in the next
month if most current stock
holders have a capital gain,
stocks with bad news have a
0.98% lower return if most
current stock holders have a
capital loss
• Disposition effect influences
stock prices
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Linking individual behavior and market anomalies: Attention constraints
Exercise 3
a) Briefly summarize the main findings of Barber/Odean (2008, RFS) with regard to
their empirical analysis of individual investors’ buying patterns. Why do individual
investors behave in that way?
b) Illustrate how investors’ attention constraints might affect market outcomes by
sketching the idea and main results in Hirshleifer et al. (2009, JF) and
DellaVigna/Pollet (2009, JF)
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Large sample of US individual investors
66.000 investors of a large discount broker
14.000 investors of a small discount broker
647.000 investors of a retail broker (with investment advice)
Brad Barber and Terrance Odean (2008): "All that Glitters: The Effect of
Attention and News on the Buying Behavior of Individual and Institutional
Investors“, Review of Financial Studies, 21, 785-818.
What prompts individual investors to buy a certain stock? Empirical analysis
Linking individual behavior and market anomalies: Attention constraints
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Main result:
Individual investors buy
Stocks with abnormal trading volume
Stocks with an extreme (positive or negative) one day price movement
Stocks that are in the news
Proxies for attention-grabbing stocks:
„Attention-grabbing stocks“
Linking individual behavior and market anomalies: Attention constraints
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Number of listed companies in 2008
(World Federation of Exchanges)
America: 11,790
Asia Pacific: 20,819
Europa/Africa/Middle East: 14,097
=> Total: 46,706
Attention-grabbing stock simplify the search problem Explanation
“Attention is a major factor determining the stocks
individual investors buy.“ Conclusion
Linking individual behavior and market anomalies: Attention constraints
vs
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“Attention is a scarce cognitive resource and attention to
one task necessarily requires a substitution of cognitive
resources from other tasks”
(Kahneman (1973))
Psychological
research
Should we care about investors’ attention constraints? Asset
Pricing Implications
„Attention grabbing events“ (Barber/Odean (2008, RFS)
excessive attention (too much?)
„Investor distraction events“
limited attention (not enough?)
Linking individual behavior and market anomalies: Attention constraints
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Market anomaly: Post earnings announcement drift (PEAD)
Returns continue to drift up for firms with “good earnings
news” and down for "bad earnings news" firms. Post earnings
announcement drift
Empirical challenge: How to measure „good/bad earnings news“
One of several commonly used approaches:
Actual earnings per share – Median analyst forecast
Share Price
Sort firms into „earnings surprise“ deciles based on that measure
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Market anomaly: Post earnings announcement drift (PEAD)
Bernard/Thomas (1989)
"unexpectedly good
earnings announcements"
"unexpectedly bad
earnings announcements"
Returns continue to drift up for firms with “good earnings
news” and down for "bad earnings news" firms. Post earnings
announcement drift
Earnings announcements at day 0
Cumulative
abnormal
returns
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Limited Attention: PEAD
Does limited attention play a role? Possible explanation
At least in some situations, investors might not pay adaquate attention to the
information incorporated in the earnings announcement
=> At least a portion of the price response to new information will be delayed.
Paper Limited Attention Proxy Motivation
DellaVigna/Pollet (2009, JF) („Investor Inattention and Friday Earnings
Announcements“)
Fridays Investors might be
distracted by the
upcoming weekend
Hirshleifer/Lim/Teoh (2009, JF) (Driven to Distraction: Extraneous Events and
Underreaction to Earnings News)
Number of same day
earnings announcements
The number of
competing stimuli
increases
Peress (2008, WP) (Media Coverage and Investors‘ Attention to Earnings
Announcements)
(Lack of) media coverage Media disseminate
information to a
broad audience
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Limited Attention: PEAD
DellaVigna/Pollet
(2009, JF)
...the initial response for earnings announcements on Friday is weaker
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Limited Attention: PEAD
And the post-earnings-announcement drift stronger
=> Consistent with the limited attention hypothesis
DellaVigna/Pollet
(2009, JF)
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Limited Attention: PEAD
Similar results in Hirshleifer et al. (2009, JF)
Immediate response Post-earnings-announcement drift
=> Attention constraints do matter for market outcomes!