Question

4. Briefly explain how the two key building blocks of behavioural finance are incompatible with the notion of efficient capital markets.

6. Clearly explain the following terms:

1. Cognitive psychology
2. Heuristics
3. Cognitive Dissonance

7. According to Hong and Stein (1999) large firms are less prone to mispricing when there is divergence of opinion. Briefly explain this statement.

Answer 1

1.

a) LIMITS TO ARBITRAGE

if prices fully reflect all the available information and satisfy the no free lunch with vanishing risk condition, then there are no admissible strategies that produce positive, expected, risk-adjusted returns.

The question that remains to be answered is why arbitrage opportunities do not quickly disappear even if investors know how to exploit them?. The idea is that strategies designed to correct the mispricing can be both risky and costly

Fundamental risk refers to the risk that new bad information arrives to the market after you purchased the security. Theoretically this risk could be perfectly hedged by buying a closely related product. Unfortunately substitute securities are rarely perfect, making it impossible to remove all the fundamental risk.

Noise trader risk is very important because of its link to other agency problems. It can force people, such as institutional investors and hedge fund managers, to liquidate their positions early, bringing them unwanted and unnecessary steep losses. Hence if investors lack the knowledge to evaluate the managers strategy, they may simply evaluate him based on his returns. If a mispricing worsens in the short run and generates negative returns, investors made decide to withdraw their funds and force him to liquidate his business.

b)

INDEX EFFECT

Shares should not change in price upon inclusion in an index. After all, the fundamental values remained intact. Professors Thaler and Barberis argue that this is not only a mispricing but also an evidence of limited arbitrage because if an arbitrageur wished to exploit this mispricing he would have to short a good substitute for the stock being included in the index, and this entails considerable risk. Furthermore, they note that there is also noise trader risk because the share price can continue to increase in the short run, preventing the arbitrageur from closing the mispricing.

On the other hand, in some markets, institutional investors like mutual funds, pension funds and insurance companies for example, can only buy shares of companies that are part of an index like the S&P 500. There is a possibility that share price increase because when they start trading as part of an index, there is more demand.

2.

a) cognitive psychology

Cognitive psychology involves the study of internal mental processes—all of the things that go on inside your brain, including perception, thinking, memory, attention, language, problem-solving, and learning. While it is a relatively young branch of psychology, it has quickly grown to become one of the most popular subfields.

There are numerous practical applications for this cognitive research, such as providing help coping with memory disorders, increasing decision-making accuracy, finding ways to help people recover from brain injury, treating learning disorders, and structuring educational curricula to enhance learning.

For example, by recognizing that attention is both a selective and limited resource, psychologists are able to come up with solutions that make it easier for people with attentional difficulties to improve their focus and concentration.

b) Heuristics

Heuristics are a problem-solving method that uses shortcuts to produce good-enough solutions given a limited time frame or deadline. Heuristics are a flexibility technique for quick decisions, particularly when working with complex data. Decisions made using an heuristic approach may not necessarily be optimal. Heuristic is derived from the Greek word meaning “to discover”.

for example, Fast Food ABC expanded its operations to India and its stock price soared. An analyst noted that India is a profitable venture for all fast food chains. Therefore, when Fast Food XYZ announced its plan to explore the Indian market the following year, the analyst wasted no time in giving XYZ a “buy” recommendation.

Although his shortcut approach saved reviewing data for both companies, it may not have been the best decision. XYZ may have food that is not appealing to Indian consumers, which research would have revealed. Other prevalent heuristic approaches for decision-making and problem-solving include Availability Bias, Anchoring and Adjustment, Familiarity Heuristic, Hindsight Bias and naive diversification

c) Cognitive Dissonance

The term cognitive dissonance is used to describe the mental discomfort that results from holding two conflicting beliefs, values, or attitudes. People tend to seek consistency in their attitudes and perceptions, so this conflict causes feelings of unease or discomfort.

This inconsistency between what people believe and how they behave motivates people to engage in actions that will help minimize feelings of discomfort. People attempt to relieve this tension in different ways, such as by rejecting, explaining away, or avoiding new information.

3.

Various behavioral models have been developed to explain the empirical findings. investors suffer conservatism bias and use the representativeness heuristic. Conservatism means that individuals are slow to change their beliefs in the face of new evidence and can explain why investors would fail to take full account of the implications of an earnings surprise. The representativeness heuristic means that individuals assess the probability of an event or situation based on superficial characteristics and similar experiences they have had rather than on the underlying probabilities. This approach can mean that investors, seeing patterns in random data, could extrapolate a company’s recent positive earnings announcements further into the future than is warranted, creating overreaction.

Overconfidence leads investors to overweight their private information in assessing the value of securities, causing the stock price to overreact. When public information arrives, mispricing is only partially corrected, giving rise to underreaction. Furthermore, biased self-attribution means that when public information confirms the initial private signal, investor confidence in the private signal rises, leading to the potential for overreaction.

Finally, Hong and Stein (1999) present a model populated by “news watchers,” those who base their trades on private information but not past prices, and “momentum traders,” those who base their trades on past price trends. News spreads slowly among the news watchers, causing initial underreaction, but it is followed by momentum buying that can create an eventual overreaction