Question

Find a real financial market event/anomaly that caused by behavioral bias(es) and respond to the following questions:

1. Provide detailed background information of the event or describe details of the anomaly (such as asset mispricing)

2. Discuss the possible behavioral bias(es) that might affect corporate/investors’ decisions in the event/anomaly

3. Propose a strategy for correcting the bias(es) or taking advantage of this anomaly (making profit).

Answer 1

1)

Since the past two decades, researchers have found some financial market phenomena that
cannot be explained by traditional finance. After that, the validity of traditional finance started to
be questioned. In traditional finance, three basic models are 1. Behaviors are assumed rational, 2.
Capital asset pricing model shows the way how the price is set, and 3. Capital market is efficient.
Price is the sign which reflects all the information needed in the market. This is also known as
efficient market hypothesis (EMH) in literature.

The reason these anomalies can exist is that, as Keynes discovered, there are limits to the arbitrage process, which can be constrained in various ways. These limits, when they can be identified, can provide us an opportunity to trade against our pernicious behavioral biases.

One general insight from our analysis is that observed return anomalies are the tip of the
iceberg: insofar as behavioral biases cause anomalies, unobservable asset mispricing is much
larger than its observable proxies, such as the value anomaly. The reason is that empirical
anomalies are poor proxies for the errors in investors’ beliefs that cause mispricing. For example,
although the ratio of a firm’s book value to its market value (B/M) is a common proxy for
mispricing, only some of the cross-sectional variation in B/M comes from errors in investors’
beliefs about firms’ future prospects. Much of the variation in B/M comes from rational variation
in expected growth rates across firms. Model simulations show that sorting by firms’ true
expected returns produces a difference in expected returns that is at least three times larger than
the difference produced by sorting by firms’ observable characteristics, such as B/M, investment, and profitability.

2)

Rational decision making is coupled with a structured or reasonable thought process. The choice
to decide rationally can help the decision maker by making the knowledge involved choice open
and specific. The theory of rational choice starts with considering a set of alternatives faced by
the decision maker. Most analysts only consider a restricted set of alternatives that contain the
important or interesting difference among the alternatives.

The prospect theory state that people make decisions based on the potential value of losses and
gains rather than the final outcome. Prospect theory is a behavioral economic theory that
describes decisions between various alternatives that involve risk. Their theory says that people
make decisions based on the potential value of losses and gains rather than the final outcome and
therefore will base decisions on perceived gains rather than perceived losses.

Overconfidence is a second behavioral phenomenon. Investors who are overconfident overrate signal precision and overreact
to private signals about payoffs of economic factors. Consequently, mispricing of factor payoffs
arise and all securities which cash flows are provided from these factors. Therefore, mispricing
occurs from investors’ misinterpretation of information about factor cash flow and reflects
overreaction to cash flow news about fundamental factors.

In a rational world investors make financial decision to maximize their risk-return tradeoff. They
have all the information they need on estimated return and risk. According to these information
the make their choices. Rational investors value the securities for its fundamental value: the net
present value of its future cash flow, minus their risk characteristics. When investors learn new
things about fundamental values, they respond bidding up prices when the news is good and
down when it is bad news.
Models of finance include investment decisions based on expected risk and return associated
with an investment. They use risk-based asset pricing models like Capital Asset Pricing Model to
make investment decision. Decision makers should also take into account the situational factors.
Situational factors do not only relate to the decision maker but also to the environment. So to
make an appropriate decision, the decision maker must consider the variables of the problem
using cognitive psychology. An investor must have a positive vision, foresight and drive to make
successful financial decision.

3)

All investors make errors that can often be traced back to a behavioral bias or emotional mistake.

If under certain circumstances these mistakes are systematic, then it is not a stretch to believe we can develop systematic strategies to profit from them. After all, this is the essence of active portfolio management, finding mispriced assets and benefiting from them.

One potential benefit of this approach is its longevity. Investors have been making emotional / behavioral mistakes in the market for over a century. In a very broad example, Warren Buffett’s quote “Be fearful when others are greedy and greedy when others are fearful” is evidence that some have been profiting from other investors’ behavioral mistakes for a long time.