ch9outline - Chapter 9 I. The Behavioral Critique A. The...

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Chapter 9 I. The Behavioral Critique A. The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference B. Some economists have come to interpret the anomalies literature as consistent with several ”irrationalities” that seem to characterize individuals making complicated decisions 1. These irrationalities fall into two broad categories: a. First, that investors do not always process information correctly and therefore infer incorrect probability distributions about future rates of return b. And second, that even given a probability distribution of returns, they often make inconsistent or systematically suboptimal decisions C. The second leg of the behavioral critique is that in practice the actions of such arbitrageurs are limited and therefore insufficient to force prices to match intrinsic value D. If behaviorists are correct about limits to arbitrage activity, then the absence of profit opportunities does not necessarily imply that markets are efficient E. Money managers’ failure to systematically outperform passive investment strategies need not imply that markets are in fact efficient F. Information processing 1. Errors in information processing can lead investors to misestimate the true probabilities of possible events or associated rates of return 2. Some of the more important biases are: Forecasting errors, overconfidence, conservatism, and sample size neglect and representativeness. 3. Forecasting Errors a. When people give too much weight to recent experience compared to prior beliefs when making forecasts(sometimes dubbed a memory bias ) and tend to make forecasts that are too extreme given the uncertainty inherent in their information b. The P/E effect can be explained by earnings expectations that are too extreme 4. Overconfidence a. People tend to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities b. Such overconfidence may be responsible for the prevalence of active versus passive investment management c. An interesting example of overconfidence in financial market is provided by Barber and Odean, who compare trading activity and average returns in brokerage accounts of men and women d. They find that men trade far more actively than women, consistent with the greater overconfidence among men well- documented in the psychology literature 5. Conservatism
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a. A conservatism bias means that investors are too slow in updating their beliefs in response to new evidence b. This means that they might initially under react to news about a firm, so that prices will fully reflect new information only gradually c. Such a bias would give rise to momentum in stock market returns 6. Sample size neglect and representative a. The notion of representativeness holds that people commonly do not take into account the size of a sample, apparently reasoning that a small sample is just as representative of a population as a large one
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ch9outline - Chapter 9 I. The Behavioral Critique A. The...

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