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Inefficient Markets: An Introduction to Behavioral Finance
TL;DR: In this paper, an alternative approach to the study of financial markets is described: behavioral finance, where less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems.
Abstract: The efficient markets hypothesis has been the central proposition in finance for nearly thirty years. It states that securities prices in financial markets must equal fundamental values, either because all investors are rational or because arbitrage eliminates pricing anomalies. This book describes an alternative approach to the study of financial markets: behavioral finance. This approach starts with an observation that the assumptions of investor rationality and perfect arbitrage are overwhelmingly contradicted by both psychological and institutional evidence. In actual financial markets, less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems. The book presents and empirically evaluates models of such inefficient markets. Behavioral finance models both explain the available financial data better than does the efficient markets hypothesis and generate new empirical predictions. These models can account for such anomalies as the superior performance of value stocks, the closed end fund puzzle, the high returns on stocks included in market indices, the persistence of stock price bubbles, and even the collapse of several well-known hedge funds in 1998. By summarizing and expanding the research in behavioral finance, the book builds a new theoretical and empirical foundation for the economic analysis of real-world markets.
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TL;DR: Kahneman as mentioned in this paper made a statement based on worked out together with Shane Federik the quirkiness of human judgment, which was later used in his speech at the Nobel Prize in economics.
Abstract: Daniel Kahneman received the Nobel Prize in economics sciences in 2002, December 8, Stockholm, Sweden. This article is the edited version of his Nobel Prize lecture. The author comes back to the problems he has studied with the late Amos Tversky and to debates conducting for several decades already. The statement is based on worked out together with Shane Federik the quirkiness of human judgment. Language: ru
4,462 citations
Cites background from "Inefficient Markets: An Introductio..."
...There has also been some discussion of the role of speci c judgment biases in economic phenomena, especially in nance (e.g., Werner F. M. De Bondt and Thaler, 1985; Robert J. Shiller, 2000; Andrei Shleifer, 2000; Matthew Rabin, 2002)....
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...In contrast, intuitive thinking operates with exemplars or prototypes that have the dimensionality of individual instances and lack the dimension of extension....
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TL;DR: In this paper, the authors show that current capital structure is strongly related to historical market values, and that firms are more likely to issue equity when their market values are high, relative to book and past market values.
Abstract: It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market. IN CORPORATE F INANCE, “equity market timing” refers to the practice of issuing shares at high prices and repurchasing at low prices. The intention is to exploit temporary f luctuations in the cost of equity relative to the cost of other forms of capital. In the efficient and integrated capital markets studied by Modigliani and Miller ~1958!, the costs of different forms of capital do not vary independently, so there is no gain from opportunistically switching between equity and debt. In capital markets that are inefficient or segmented, by contrast, market timing benefits ongoing shareholders at the expense of entering and exiting ones. Managers thus have incentives to time the market if they think it is possible and if they care more about ongoing shareholders. In practice, equity market timing appears to be an important aspect of real corporate financial policy. There is evidence for market timing in four different kinds of studies. First, analyses of actual financing decisions show that firms tend to issue equity instead of debt when market value is high, relative to book value and past market values, and tend to repurchase equity when market value is low. 1 Second, analyses of long-run stock returns fol
2,516 citations
TL;DR: In this paper, the authors present a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.
Abstract: The basic paradigm of asset pricing is in vibrant f lux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.
1,796 citations
TL;DR: In this paper, the authors compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays, and support explanations of post-earnings announcement drift based on underreaction to information caused by limited attention.
Abstract: Does limited attention among investors affect stock returns? We compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays. If inattention influences stock prices, we should observe less immediate response and more drift for Friday announcements. Indeed, Friday announcements have a 15% lower immediate response and a 70% higher delayed response. A portfolio investing in differential Friday drift earns substantial abnormal returns. In addition, trading volume is 8% lower around Friday announcements. These findings support explanations of post-earnings announcement drift based on underreaction to information caused by limited attention.
1,440 citations
Cites background from "Inefficient Markets: An Introductio..."
...This is a long-standing theme in finance (Baker, Ruback, and Wurgler, forthcoming; DeLong et al., 1990; Shleifer, 2000) and it has more recently been applied to firm pricing (DellaVigna and Malmendier, 2004; Gabaix and Laibson, 2006)....
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TL;DR: In this paper, the authors study asset prices in an economy where investors derive direct utility not only from consumption but also from fluctuations in the value of their financial wealth, and they find that investors are loss averse over these fluctuations, and the degree of loss aversion depends on their prior investment performance.
Abstract: We study asset prices in an economy where investors derive direct utility not only from consumption but also from fluctuations in the value of their financial wealth. They are loss averse over these fluctuations, and the degree of loss aversion depends on their prior investment performance. We find that our framework can help explain the high mean, excess volatility, and predictability of stock returns, as well as their low correlation with consumption growth. The design of our model is influenced by prospect theory and by experimental evidence on how prior outcomes affect risky choice.
1,362 citations