Behavioral Finance FSS 2012

Exercise Course IV

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Agenda

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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 1

Excessive trading volume as a result of overconfidence

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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 1

The intuition behind the result

Overconfident traders base their decision on confidence intervals, which are too narrow
150

no overconfidence
140

overconfidence

Trade more aggressively Higher trading volume

130 no opportunity for trading trading activity

120

110

100

90

Seller

Buyer

Seller

Buyer

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 2a)

What is the disposition effect?

Price

past

future

today

Does the purchase price (or any other reference from the past) affect the willingness to sell?
Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

Exercise 2a)

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

Disposition effect
Investors tend to sell winners too early
and ride losers too long

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 2b) 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
concave => risk averse

Gains

Loss

Gain

Sell!

convex => risk seeking

Losses

Loss

Gain

Hold!

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 2

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Exercise 2b) Can you think of another possible explanation for the disposition effect? => 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 Gamblers fallacy: people are likely to predict reversal

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

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!

Winning stocks sold

Average excess return after 252 trading days: 2.35%.

Paper losses not sold

Average excess return after 252 trading days: -1.06%.

Possible explanation: momentum in stock returns

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

10

Exercise 2d) How does Odean (1998) measure the disposition effect? 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
Data:
American discount broker 10,000 accounts

1987-1993
Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

11

Exercise 2d) 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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

12

Exercise 2d) How does Odean (1998) measure the disposition effect?
Realized gains

Proportion of gains realized:

PGR =

Realized gains + unrealized gains

Realized losses

Proportion of losses realized:

PLR =

Realized losses + unrealized losses

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 JanuaryNovember
Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

13

Exercise 2d) Odean (1998), Results:

Entire year, H1:

20% 20%

December, H2:
15% 12.8%

14.8%
15%

9.8%
10% 5% 0% 10% 5% 0%

10.8%

PGR

PLR

PGR

PLR

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

14

Exercise 2e)
Portfolio X Stock Gain/ Loss + + + Portfolio Y Stock Gain/ Loss + + -

A B C D E F

G H I J

A+B+C

are sold

is sold

Realized Gains: A + B + H Paper Gains: D + I

Realized Losses: C Paper Losses: E + F + G + J

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

15

Exercise 2e) Realized Gains: A + B + H Paper Gains: D + I Realized Losses: C Paper Losses: E + F + G + J
Realized gains

Proportion of gains realized:

PGR =

Realized gains + unrealized gains

Realized losses

Proportion of losses realized:

PLR =

Realized losses + unrealized losses

PGR

A, B, H 3 3 A, B, H D, I 3 2 5

PLR

C 1 1 C E, F, G, J 1 4 5

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

16

Exercise 2f) What do Weber and Camerer (1998) do to test the existence of the disposition effect? What is different to the analysis of Odean (1998)? 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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

17

Exercise 2g) Why is it rational to buy winners and sell losers? Asset prices Price increase or decrease, assets independent Probability for an price increase: ++ + 0 -: 65% : 55% : 50% : 45% : 35%

(2 assets)

Price change 1, 3, or 5 DM, assets independent

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

18

Exercise 2g) Example: Rational expectations after period 5

Participants have to look at the price paths to calculate which asset is of the type ++ , + , 0 , 0 , - , - Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

19

Exercise 2g) Example: Rational expectations after period 5

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
Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

20

Exercise 2g) But: actual behavior

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

21

Exercise 2h) How can the disposition effect be reduced? (Weber / Camerer) Alternative design Trading phase new prices purchases/sales
Automatic selling of holdings Possibility of redemption at the old price

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

Trading phase new prices purchases/sales

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

22

Exercise 2h) 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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

23

Exercise 2i) Explain how the disposition effect might influence stock returns. 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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

24

Exercise 2j) Frazzinis research design (The Disposition Effect and Underreaction
to News, Journal of Finance, 2006) 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
Fund A B C Total No. Microsoft shares 20 70 50 140 Purchase Price $25 $30 $40 Total trading amount $500 $2,100 $2,000 $4,600
Average purchase price=$4,600/140= $32.86

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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

25

Exercise 2j) Frazzinis research design (The Disposition Effect and Underreaction
to News, Journal of Finance, 2006) 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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

26

Exercise 2j) Frazzinis results (The Disposition Effect and Underreaction

to News, Journal of Finance, 2006)
1,50% 1,11% 1,00% 0,50% 0,00% -0,50% -1,00% -0,98% -1,50% "Overhang" Stocks Other Stocks 0,35%

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
Good News Bad News

-0,43%

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
27

Large return drift if price is far away from the average purchase price
Dr. Heiko Jacobs

Smaller (and insignificant) return drift if price is close to average purchase price
Behavioral Finance Exercise Course IV

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)

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

28

Linking individual behavior and market anomalies: Attention constraints 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.

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)

Empirical analysis

What prompts individual investors to buy a certain stock?

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

29

Linking individual behavior and market anomalies: Attention constraints

Main result: Individual investors buy Attention-grabbing stocks

Proxies for attention-grabbing stocks:

Stocks with abnormal trading volume Stocks with an extreme (positive or negative) one day price movement Stocks that are in the news

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

30

Linking individual behavior and market anomalies: Attention constraints

Explanation

Attention-grabbing stock simplify the search problem

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

vs

Conclusion

Attention is a major factor determining the stocks individual investors buy.

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

31

Linking individual behavior and market anomalies: Attention constraints 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

Attention grabbing events

(Barber/Odean (2008, RFS)

Investor distraction events limited attention (not enough?)

excessive attention (too much?)

Asset Pricing Implications

Should we care about investors attention constraints?

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

32

Market anomaly: Post earnings announcement drift (PEAD)

Post earnings announcement drift

Returns continue to drift up for firms with good earnings news and down for "bad earnings news" firms.

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

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

33

Market anomaly: Post earnings announcement drift (PEAD)

Post earnings announcement drift

Returns continue to drift up for firms with good earnings news and down for "bad earnings news" firms.
"unexpectedly good earnings announcements"

Cumulative abnormal returns

Bernard/Thomas (1989)

"unexpectedly bad earnings announcements"

Earnings announcements at day 0

Behavioral Finance Exercise Course IV

Dr. Heiko Jacobs

34

Limited Attention: PEAD

Possible explanation Does limited attention play a role?

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 DellaVigna/Pollet (2009, JF)
(Investor Inattention and Friday Earnings Announcements)

Limited Attention Proxy Fridays

Motivation Investors might be distracted by the upcoming weekend The number of competing stimuli increases Media disseminate information to a broad audience
35

Hirshleifer/Lim/Teoh (2009, JF)

(Driven to Distraction: Extraneous Events and Underreaction to Earnings News)

Number of same day earnings announcements (Lack of) media coverage

Peress (2008, WP)

(Media Coverage and Investors Attention to Earnings Announcements)

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

Limited Attention: PEAD

DellaVigna/Pollet (2009, JF)

...the initial response for earnings announcements on Friday is weaker

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

36

Limited Attention: PEAD

DellaVigna/Pollet (2009, JF)

And the post-earnings-announcement drift stronger => Consistent with the limited attention hypothesis
Dr. Heiko Jacobs Behavioral Finance Exercise Course IV

37

Limited Attention: PEAD Similar results in Hirshleifer et al. (2009, JF)

Immediate response

Post-earnings-announcement drift

=> Attention constraints do matter for market outcomes!

Dr. Heiko Jacobs

Behavioral Finance Exercise Course IV

38