Financial Education

In behavioral finance, escalation bias causes investors to invest more in money-losing investments for which they feel responsible than they invest in an ongoing successful investment. The popular concept of “averaging down” to reduce the average price paid for the investment may be representative of this bias.

The rational, traditional finance model would expect investors to re-evaluate holdings for potential bad news that they had failed to incorporate into their initial valuation. If the re-evaluation supports the investment, then more could be added. Otherwise, it would be wiser to exit the position and take the loss.

The value premium refers to the fact that stocks with priced at a low multiple of book value tend to perform better than would be explained by the Capital Asset Pricing Model. Proponents of the Efficient Market Hypothesis (EMH) argue that the value premium results from a risk factor not captured by Beta. Opponents argue that the value premium is evidence that the EMH is not valid.

Fama and French, among others, have developed models that attribute the value premium to risk factors. Typically these studies use company size as a proxy for liquidity risk. In the Review of Finance, Phalippou replicates these studies in their original form, and then using institutional ownership as an alternative liquidity proxy. In this second iteration, the value premium persists and cannot be explained by the risk factor models.

Phalippou concludes that if the value premium is attributable to risk factors, the risk factors are not the ones identified in previous research.

Behavioral finance theory has pointed to research that shows short-term momentum and long-term reversals in pricing as signs that markets are not fully efficient. In the December 2007 Journal of Finance George and Hwang show that the trends may be at least partially attributable to the differential tax rates applied to short-term and long-term capital gains.

The authors first note an asymmetry between the reversals of stocks with capital gains and stocks with capital losses. In the latter case, there is no tax incentive for holding over longer periods. They then test the capital gains hypothesis by comparing U.S. results to Hong Kong, where there are no capital gains taxes. They find no evidence of reversals in Hong Kong, supporting the thesis that short term momentum may be a means of compensating holders for additional taxes, while long-term reversals result as the tax effects subside.

The study is reminiscent of Harti’s study showing underperformance around the anniversary dates of large price swings, which would also appear to be tax-driven.

“Affect” is the term used in behavioral finance to refer to automatic feelings investors feel toward a specific company or investment. It is, in a sense, the gut reaction one has to the company itself.

Affect is known to play a role in the pricing of many assets such as cars, houses and watches. In a Perspective presented in the March/April 2008 Financial Analysts Journal Statman, Fisher and Anginer examine the role of affect in investment valuation.

Using the Fortune magazine list of most admired companies, the authors form two portfolios: one consisting of “Admired” companies and the other consisting of “Spurned” companies. They found that the spurned companies generated higher returns than admired companies, even after adjusting for CAPM risk.

The authors also find that subjective risk is associated with negative affect. While objective risk factors such as those used in the CAPM or the Fama-French 3 factor model typically assume that higher risk will lead to higher returns, the authors posit that higher perceived risk, manifest as low affect, is also associated with higher return.

Prospect theory is a branch of behavioral finance that contends that an investor’s utility depends on deviations from moving reference points rather than absolute wealth.

An example of prospect theory is the general bias among investors to hold on too long to stocks that have declined, and to sell stocks too quickly when they have risen. The fear of realizing a loss, apparently, is stronger than the value assigned to unrealized gains.

If the semistrong form of the efficient market hypothesis holds, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

There are two types of studies frequently used to test the semistrong form of the EMH:

1. Return prediction studies attempt to predict the future rates of returns for the market or individual stocks using public information such as valuation, dividend yield, or risk premium. Another type of return prediction study is event studies, which examine abnormal returns immediately following a major announcement to determine whether returns predictably persist or reverse.
2. Cross-sectional return prediction studies test whether variables such as valuation to predict the relative returns of all stocks in a sample.

Return prediction studies have generally shown little success in predicting short-term returns. However, they have successfully been used to predict long-term returns. For example, high dividend yields, high default spreads and high term structure spreads all tend to predict higher long-term returns for stocks.

Studies have also demonstrated that markets do not rapidly process the information related to earnings surprise, or unanticipated changes in earnings. If markets are semistrong efficient such information should be reflected on the day of the earnings announcement. However, as much as half of the total change in stock price can occur in the 90 days following the day of the announcement.

Cross-sectional studies have demonstrated several anomalies that appear to contradict the efficient market hypothesis. On a risk adjusted basis: low P/E stocks tend to outperform high P/E stocks; small stocks tend to outperform large stocks; stocks with low price/book ratios outperform stocks with high price/book ratios.

Event studies of stock splits, IPOs (after issuance), accounting changes and corporate finance events generally support the efficient market hypothesis in that the news of such items is quickly and fully incorporated into the market price.

Traditional finance theory assumes that investors act rationally to maximize profit. Behavioral finance considers how psychological traits may affect how investors act individually or in groups.

Although there is no unified theory of behavioral finance, practitioners attempt to identify anomalies that can be explained by investor behavioral traits, and to identify opportunities to profit from exploiting the biases of other investors.

If the weak form of the efficient market hypothesis holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Researchers testing weak form market efficiency generally use one of two groups of tests when studying weak-form market efficiency.

1. Statistical tests of independence measure either the significance of positive or negative correlation over time (autocorrelation) or by comparing the number of runs (consecutive moves in the same direction) with that expected in a normal sample. In general, statistical tests of independence have shown no relationship between current and future price movements.
2. Tests of trading rules seek to mechanically simulate various trading strategies. For example, testing whether a strategy of buying when the stock price closes above the 50 day moving average and selling when the price closes below the moving average. In general, these tests have supported the weak-form efficient market hypothesis by showing no excess returns (after trading costs, compared to a buy-and-hold strategy) from following such rules. However, the results are not unanimous - some rules have been shown to offer superior returns.

Technical analysts criticize the existing tests as being too naive or simplistic to capture the

An investment policy statement (IPS) summarizes a client’s circumstances, objectives, and constraints and outlines policies to accommodate them. It is a document of understanding that can help protect both the client and the adviser.

For clients, developing an IPS can be an educational process that results in greater understanding of the investment process and less reliance on blind faith in an adviser. If a second opinion or change in advisers becomes necessary, the document can help the new adviser appreciate the situation.

For an adviser, having the IPS creates a framework for decisions that can be referred to when particular decisions are questioned.

At the CFA Intstitute Efficient Market and Behavioral Finance conference in June 2007, Legg Mason’s Michael Mauboussin suggested that both market efficiency and behavioral anomalies could be explained by viewing the market as a complex adaptive system.

Under this model the only conditions required are that investors have diverse opinions, that there is an aggregation mechanism to bring information together, and that there are incentives for being right and penalties for being wrong.

The model explains breakdowns in market efficiency (bubbles and busts) as violations of one or more of the conditions. The most likely violation is diversity of opinion, and the occasional herding tendency of investors. It can also occur on a smaller scale when short-term noise is interpreted incorrectly as signal.