Question

Differentiate between predictability and volatility puzzles

 

Critically discuss how research in behavioural finance provides insight into understanding these puzzles.

Answer 1

Most work on predicting stock returns is based on statistical, economic, and fundamental factor analysis models in the predictability problem. Sentiment, overconfidence, optimism and wishful thinking, conservatism, euphoria and gloom, self-deception, cursedness, belief persistence, and anchoring are some of the behavioural characteristics that proponents of behavioural finance believe might lead to stock return predictability. Stock predictability is not included in the BSM model for pricing options with money value near one since stock predictability is the same for both types of traders. In other words, in this scenario, both spot and options traders are equally knowledgeable about the stock market (Boucher, 2016). The variance risk premium, the difference between implied and realized variance, may be used to forecast stock market returns. Some academics have looked at the influence of stock return predictability on linked asset pricing, motivated by empirical evidence that stock returns are predictable.

On the other hand, the terms "volatility puzzle" and "excess volatility problem" have been used to describe two market observations: idiosyncratic volatility puzzle and "excess volatility riddle." In terms of the former, several empirical research have looked at the link between future return and risk. According to financial theory, expected return and risk should have a positive relationship. Many empirical investigations have found a good correlation (Zhou & Bollerslev, 2016). Idiosyncratic risk and future return have an inverse connection, contrary to what finance theory predicts. According to proponents of behavioural finance, investors believe the mean dividend growth rate is more changeable than it is. Similarly, according to behaviourists, price dividend ratios and returns may be overly volatile because investors project previous returns too far into the future when establishing expectations of future returns.

 Behavioural finance, a branch of behavioural economics, theorizes that psychological factors and biases influence investors' and financial practitioners' financial behaviour. Furthermore, effects and biases may be used to explain a variety of market abnormalities, particularly market anomalies in the stock market, such as sharp price increases or declines. Behavioural finance may be examined from several angles. Stock market returns are one area of finance where psychological factors are frequently thought to impact market outcomes and returns, although there are various ways to look at it. Behavioural finance categorization aims to understand better why people make particular financial decisions and how those decisions influence markets. Financial players are believed to be psychologically influential with relatively normal and self-controlling inclinations in behavioural finance, rather than entirely rational and self-controlling (Rachev et al., 2020).

Although some of the significant concepts were indicated in John Maynard Keynes' 1936 classic, The General Theory of Employment, Interest, and Money, behavioural finance study began in earnest in the late 1980s. According to Sonmez, “Keynes detailed all kinds of investment behaviour, investor biases, and how investors construct their beliefs.” However, over the next 45 years, finance and economic thinking concentrated on rational finance and market efficiency, seemingly obviating the necessity to analyze the behaviour of the system's participants. The traditional idea that underlying value is correctly represented in the market is called into doubt by behavioural finance research. The traditional theory was unable to provide persuasive explanations for evident mispricing, therefore behaviourists sought alternatives. Researchers began to spread out when their articles were published in academic publications, focusing on investor trading behaviour - investors' belief systems or expectations, and how those expectations are created. Furthermore, behavioural finance research aids in the understanding of the function of behaviour in corporate finance financing and investment choices such as mergers and acquisitions.

 

Most work on predicting stock returns is based on statistical, economic, and fundamental factor analysis models in the predictability problem.