Behavioral biases and their implications for formation of prices: Theoretical literature review

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Behavioral biases and their implications for
formation of prices Theoretical literature
review
10th INFER Annual Conference 2008 Universidade de
Évora
September 19-21, 2008
Author Dhekra AZOUZI
Co-author Chaker ALOUI
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Motives? The Nobel prize of economy was
awarded, in 2002, to behavioral finance
pioneers.? Unconditional defenders of the
paradigm of the homo economicus(Von Neumann et
Morgenstern, 1944) A rising generation of
researchers believe that individuals are
normal(Statman, 2004)? The presence of
numerous anomalies and the efficient markets
hypothesis unability to resolve it. Some
doubt has been thrown in a crucial hypothesis
which has, since its birth, won a triumphant
victory.
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Plan

• The basic tenets and pillars of the behavioral
  finance.
• The psychological biases.
• the implications of behavioral biases on price
  formation.

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The Efficient Markets Hypothesis apogee

• The emergence of the efficient markets hypothesis
  (EMH)
• two corner stones
• The individuals rationality
  The unlimited arbitrage
• Shleifer (2000)

• All investors are rational and value securities
  rationally they are able to determine security
  prices as the discounted value of expected future
  cash flows.
• If there are investors who are not fully
  rational, the market does not lose its character
  of efficiency they are like random phenomena
  whose effects end up by neutralizing the ones
  with the others without impacting prices.
• - If investors are irrational, they are
  undoubtedly confronted by the arbitrageurs whose
  combined actions sap the irrational investors
  influence on prices.

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The suspicions era

• An anomaly is "an empirical result
  qualifies as an anomaly if it is difficult to
  rationalize or if implausible assumptions are
  necessary to explain it within the paradigm
  (Rabin and Thaler, 2001).
• Schwert (2003) "Anomalies and Market
  Efficiency
• Examples
• The size effect small-capitalization firms
  securities outperform significantly those owning
  by strong-capitalization ones.
• The end of the year effect an abnormal return
  is recorded by small firms during the first two
  weeks of January.
• The momentum effect (Jagadeesh and Titman, 1993)
  securities which have recently outperformed
  will be more powerful during the twelve future
  months.

These anomalies are remained undicepherable
riddles until the behavioral finances arrival.
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Introduction to Behavioral Finance
Behavioral finance
Psychology
Limits to arbitrage
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? Limits to arbitrage

• - Lack of Substitutes the arbitrage is "the
  simultaneous purchase and sale of the same, or
  essentially, similar security in two different
  markets at advantageously different prices"
  (Sharpe and Alexandre, 1990 ). This may not be
  possible since close substitutes are scarce
  Fundamental Risk.
• - Noise Trader Risk nothing guarantees that the
  difference between the fundamental value and the
  security price will not be amplified through
  noise traders beliefs irrationality may not end
  up (De Long et al., 1990)
• - Synchronization Risk is due to this
  uncertainty among arbitrageurs stripped of any
  information about the actions moment of their
  counterparts this risk delays arbitrage (Abreu
  and Brunnermeier, 2002).
• - Forced Liquidation the professional arbitrage
  is "a separation of brains and capital
  (Shleifer and Vishny, 1997and Shleifer, 2000)
  generates agency problems between investors and
  arbitrageurs.
• - Limited Capital The necessary capital for
  arbitrage may be unavailable.
• - Implementation Costs The arbitrage may be
  limited by prohibitory transaction and
  information costs,

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? Psychology

• - Beliefs or Forecasts biases
• - Overconfidence individuals tend to
  overestimate the precisions probabilities of
  their information, their successes and their
  capacities.
• - Optimism Individuals are too bold to
  always think that their futures will be the best.
  
• - Representativeness heuristic when
  trying to determine the occurrences probability
  of an event, individuals account much on its
  similarity with previous events (Fuller, 1998
  Hirshleifer, 2001), they tend to on-balance
  recent observations, memorable prototypes and
  events and under-balance information, in their
  eyes, archaic.

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? Psychology

• The conservatism this anchoring bias implies
  that individuals seem to be reticent to change
  their opinions but they agree to adjust their
  opinions but too timidly.
• The availability or accessibility biases
  individuals try to find the relevant information
  likely to weigh on the estimate of the
  probability of an event. This procedure is
  vulnerable it produces biased estimates
  according to Kahneman (2003) who asserts that
   Some attributes are more accessible than
  others, both in perception and in judgment .
• The familiarity bias (Massed and Simonov, 2002)
  encourages investors to prefer placing their
  funds in companies called "closed by" i.e.
  located with their proximity "what is familiar,
  being understood better, is often less
  risky(Hirshleifer, 2001).

- Beliefs or Forecasts biases
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? Psychology- Nonstandard preferences

• - Loss aversion individuals are much more
  sensitive to losses than to gains (Kahneman and
  Tversky, 1979).
• - Mental accounting or framing is the
  method used by investors to categorize items,
  facilitate mental processing and evaluate
  financial transactions (Barberis and Huang, 2001
  and 2004).
• - Ambiguity aversion to solve the
  ambiguity problem, Savage (1964) proposed a
  nonlinear transformation of objective
  probabilities to obtain subjective ones.
• - Prospect theory individuals take their
  decisions by comparing the wealths fluctuations
  to a reference point and not on the basis of the
  final wealths level "the carriers of utility
  are profits and losses (Kahneman and Tversky,
  1979).

Value function
Weighting function
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Psychological biases impact on prices

• Irrational behavior pushes prices away from
  fundamental values.

The model of Barberis, Shleifer and Vishny
(1998) "A model of investor sentiment.
The model of Daniel, Hirshleifer and Subramanyam
(1998).
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The model of Barberis, Shleifer and Vishny
(1998) "A model of investor sentiment"

• ? Representativeness and conservatism are the
  main roots behind under and overreaction
  (Barberis, Shleifer and Vishny ,1998).
• Under-reaction is the slow integration of
  new information (good or bad) in prices and is
  observed for a horizon of twelve months.
• Over-reaction is detected on a horizon from
  three to five years and appears by a reversal of
  securitiesreturns following a series of new
  information.
• Hypothesis
• - A risk neutral investor endowed with an
  unrisky security and only another one whose value
  is equal to the net discounted value of future
  flows.

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The model of Barberis, Shleifer and Vishny
(1998) "A model of investor sentiment"
Securities earnings are not random two regimes
are exclusive
Mean-reversion
Trend
Representativeness heuristic
Conservatism
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The model of Barberis, Shleifer and Vishny
(1998) "A model of investor sentiment"

• The difference between the securitys price in
  the presence of irrational investors and its
  intrinsic value , at time t, is

The mean-reversion occurrences probability
The securitys price
The shock
The securitys intrinsec value
Constants
Conservatism and representativeness cooperate to
deviate securities prices from their fundamental
values.
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The model of Daniel, Hirshleifer and Subramanyam
(1998)

• Hypotheses
• - There are, in the market, informed investors
  over-estimating the quality and the precision of
  their private information they are overconfident
  as for the private signal and uninformed ones who
  have only public information they are rational.
• On the market, there are two securities an
  unrisky one whose value is equal to unit value
  and a risky security whose value ? is normally
  distributed, with a null average and a standard
  deviation.
• The model distinguishes between four dates
• At date 0, all investors beliefs
  related to the future value of the risky security
  are identical.

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The model of Daniel, Hirshleifer and Subramanyam
(1998)

• At date 1, informed investors receive a signal
  about the evolution of the risky security value
• The ratio between the price prevailing at date 1,
  and the price which would have prevailed in the
  absence of irrational investors exceeds unity.
• 
  
  
  
• The price determined by irrational investors
  exceeds the one which would prevail in the
  virtual case where there are no irrational
  investors.

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The model of Daniel, Hirshleifer and Subramanyam
(1998)

• At date 2, a public signal arrives, it is
  correctly estimated by all investors
• From this date and even if the private signal
  continue to influence the risky securitys price
• Its impact is henceforth moderated because of the
  public information arrival it ends up by being
  cancelled at date 3.

Overconfidence contributes to push
securitiesprices far from their fundamental
values.
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Conclusion

• Behavioral finance Vs. Efficient Markets
  Hypothesis
• Individuals are not fully rational.
• Behavioral biases lead to the departure of
  securities prices from their fundamental values.
• Further work
• - An empirical study devoted to surround
  empirically psychological biases impacts on
  securities prices.

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• Thank you for attention
• Dhekra AZOUZI