Behavioral Finance Economics 437 Behavioral Finance Mean Reversion

Behavioral Finance Economics 437 Behavioral Finance Mean Reversion March 22

A Few More Anomalies Behavioral Finance Mean Reversion March 22

Mathematical Illusions n Adam switches from a gas-guzzler of 12 mpg to a slightly less voracious guzzler that runs at 14 mpg n The environmentally virtuous Beth switches from a 30 mpg car to one that runs at 40 mpg n Who saves more gas? Behavioral Finance Mean Reversion March 22

The Story n La Traviata n Alfredo and Violetto n Father Germont n Ten minutes at the end n n What if she he didn’t make it in time Duration? n The Mythical Jen n Adding five “slightly happy” years lowered the perception of observers of her overall happiness Behavioral Finance Mean Reversion March 22

The Story Again n Pain experiments n No pain for 2 minutes; pain for 30 seconds n Pain for 1 minute; no pain for 1 ½ minutes n After being administered both, patients preferred the first over the second Behavioral Finance Mean Reversion March 22

How happy are you? n Two groups enter two separate rooms n Each member of one group finds a dollar bill on the ground just as they enter n Which reports being happier? Behavioral Finance Mean Reversion March 22

Thinking Fast and Slow n Fast thinking is probably an evolutionary outcome n Slow thinking is probably the way to go for important decisions (when you have the time) n Some things (like risk aversion) might be bad for you, other things (overoptimisim) might be good for society. Behavioral Finance Mean Reversion March 22

Naïve Diversification n Four Choices: n Three Bond Funds n One Stock Fund n Put ¼ in each n Four Other Choices n Three Stock Funds n One Bond Fund n Behavioral Finance Put ¼ in each Mean Reversion March 22

20 marbles, randomly divided among five children I II Alan 4 4 Ben 4 4 Carl 5 4 Dan 4 4 Ed 3 4 In many rounds of random assignment, which of these results is more likely? Behavioral Finance Mean Reversion March 22

[Mr. Crane and Mr. Tees arrive ½ hour late for a flight. Mr Crane is told that his flight left on time. Mr. Tees is told that his flight was delayed 25 minutes and left five minutes ago. Who was more upset? ] A. [Mr. Crane] B. [Mr. Tees] C. [No Difference] Behavioral Finance Mean Reversion March 22

Here’s an easy one n Two hospitals, large one, small one n 45 babies born each day in large hospital n 15 babies born each day in small hospital n On average, 50 % of babies are male n Over the course of a year, which has hospital has more days when 60% or more babies born are male? The large one or the small one? Behavioral Finance Mean Reversion March 22

If you draw a red marble, you get $ 1, 000 n Urn 1 has 10 marbles, only one is red n Urn 2 has 100 marbles, eight are red Behavioral Finance Mean Reversion March 22

Predictions n Paul Meehl n High school grades; one aptitude test n Outperformed complex batteries of test n “Clinical vs Statistical” Prediction n Dr. Apgar n Five variables: (heart rate, respiration, reflex, muscle tone, color)…give it a 0, 1, 2 n Score of 8 or above – great! n Score of 4 or less – trouble! Behavioral Finance Mean Reversion March 22

Analyzing Past Success n Books about great business leaders n Ignore “right place, right time” phenomenon n Chance may be more important n “Outliers” by Malcolm Gladwell n “I was smart” versus “I was lucky” Behavioral Finance Mean Reversion March 22

Optimism and Overconfidence n Business start ups n Four in five fail n But, no one ever assumes they are in the “four” Behavioral Finance Mean Reversion March 22

Regret n Mr. Brown almost never picks up hitchhikers. Yesterday he gave a man a ride and was robbed n Mr. Smith frequently picks up hitchhikers. Yesterday, he gave a man a ride and was robbed n Which of the two will experience greater regret? n Who will be criticized most severely by others? Behavioral Finance Mean Reversion March 22

Another Framing Example n The one-month survival rate is 90 % n There is a 10 % mortality rate in the first month n Do these sound different to you? Behavioral Finance Mean Reversion March 22

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 Mean Reversion March 22

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. Mean Reversion March 22

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 Mean Reversion March 22

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 Mean Reversion March 22

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 Mean Reversion March 22

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 Mean Reversion March 22

The End Behavioral Finance Mean Reversion March 22