Behavioral Finance Economics 437 Behavioral Finance Trader Lore

Behavioral Finance Economics 437 Behavioral Finance Trader Lore March 29, 2018

Trader Folk Lore n Stock Price Momentum Charting stocks by tracking stock prices n Trend following n Mean Reversion n Returns will revert to a mean return n Stocks with very high returns will, in the future, underperform stocks with very low returns n Other n Buy in December, Sell on Friday night, buy on Monday night n Behavioral Finance Trader Lore March 29, 2018

Definition of absence of serial correlation Let pt-1, pt-2, pt-3, etc. be a series of past prices Now, think about, pt E[ pt | info, pt-1, pt-2, pt-3, etc. ] = E[ pt | info] Then, no serial correlation Behavioral Finance Trader Lore March 29, 2018

“Cross Section” vs “Time Series” n Cross Section Pick a date (or a time period) n Collect data only for that date (or time period) n Explain variations in the data for that time period only n Time Series n Pick a stock n Collect data for that stock over many time periods n Behavioral Finance Trader Lore March 29, 2018

De. Bondt-Thaler 1984 n “Over-Reaction” Hypothesis n Suggests that: n After a period of “over-reaction, ” markets “revert” back and go the other way. n n n Behavioral Finance Stocks that have done well in the past, do poorly in the future Stocks that done poorly in the past, do well in the future Their article is designed to test whether or not “mean reversion” is true. Trader Lore March 29, 2018

Data n NYSE data n Jan 1926 through December 1982 n Monthly return data n Begin with three year lookback in Dec 1932 n Monthly data from Jan 1930 through Dec 1932 n 36 months or three years data n Form portfolios of L(osers) and W(inners) n Then see how they do for the next three years Behavioral Finance Trader Lore March 29, 2018

De. Bondt and Thaler: “Does the Stock Market Overreact” (1985) n L – three year loses n W – three year winners n Question: How do the W’s do in the next three years? How do the L’s do in the next three years? n Other things worth noting Almost all of the impact is in January n When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation n Behavioral Finance Trader Lore March 29, 2018

De. Bondt-Thaler conclusions n Definite evidence of mean reversion (a form of serial correlation): n L portfolios consistently outperform W portfolios n n 19. 6 % better than the market after end of 3 years W portfolios consistently underperform the market n Behavioral Finance 5 % less than the market after end of 3 years Trader Lore March 29, 2018

Interesting facts n Most of the excess returns are in January n Loser effect more pronounced: Losers earned 19. 6 % more than the market n Winners earn 5. 0 % less than the market n Loser portfolio minus Winner portfolio return = 24. 6 %!!!!! n Most of the return difference is during 2 nd and 3 rd year n Larger loses become larger winners; larger winners become larger losers n Behavioral Finance Trader Lore March 29, 2018

What was the reaction to D-T n Largely ignored by the academic literature n Then, in 1992, along came Fama-French on “Cross-Section” returns Behavioral Finance Trader Lore March 29, 2018

Data in Fama and French n 1962 -1989 data n Book Value (leverage and price/earnings) at previous year end n Returns starting on July 1 of the following year (also use the market n n n equity as of July 1 for size, but use market equity at previous year end for B/M calculation) Calculate monthly returns Each month the cross-section of returns is regressed on explanatory variables. Prior research used “portfolio betas”; F-F use individual stocks Sort stocks into “size deciles” n n Sort each size decile into 10 portfolios based on beta Calculate equal weighted monthly returns on the portfolios for the next 12 months (from July to June). Behavioral Finance Trader Lore March 29, 2018

Results on Beta n Portfolios in size deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return n Large size means lower beta and lower returns n When size deciles are subdivided into beta ranked decile portfolios Larger size firms have lower returns n “no relation between average return and beta” n Behavioral Finance Trader Lore March 29, 2018

Results on Book/Market n What is book to market Book is firm net worth reported on 10 -Ks n Market is: shares outstanding times price Book/market is positively related to returns n Size still matters but B/M is much more important n B/M swamps leverage and E/P Leverage: book or market leverage? January “slopes” twice slopes of other months Overall largest decile book to market beats smallest decile book to market by 1. 53 % per month n n n Behavioral Finance Trader Lore March 29, 2018

Significance of F-F n Provided a simple rule for investing success n Seems to contradict Semi-Strong EMH n Made “respectable’ earlier work that provided simple, but successful investment rules n De. Bondt and Thaler, for example Behavioral Finance Trader Lore March 29, 2018

The End Behavioral Finance Trader Lore March 29, 2018