An in-depth look into the various aspects of behavioral finance
Behavioral finance applies systematic analysis to ideas that have long floated around the world of trading and investing. Yet it is important to realize that we are still at a very early stage of research into this discipline and have much to learn. That is why Edwin Burton has written Behavioral Finance: Understanding the Social, Cognitive, and Economic Debates.
Engaging and informative, this timely guide contains valuable insights into various issues surrounding behavioral finance. Topics addressed include noise trader theory and models, research into psychological behavior pioneered by Daniel Kahneman and Amos Tversky, and serial correlation patterns in stock price data. Along the way, Burton shares his own views on behavioral finance in order to shed some much-needed light on the subject.
Discusses the Efficient Market Hypothesis (EMH) and its history, and presents the background of the emergence of behavioral finance Examines Shleifer's model of noise trading and explores other literature on the topic of noise trading Covers issues associated with anomalies and details serial correlation from the perspective of experts such as DeBondt and Thaler A companion Website contains supplementary material that allows you to learn in a hands-on fashion long after closing the book
In order to achieve better investment results, we must first overcome our behavioral finance biases. This book will put you in a better position to do so.
Preface xi Introduction 1 Part One Introduction to Behavioral Finance Chapter 1 What Is the Efficient Market Hypothesis? 5 Information and the Efficient Market Hypothesis 6 Random Walk, the Martingale Hypothesis, and the EMH 8 False Evidence against the EMH 11 What Does It Mean to Disagree with the EMH? 13 Chapter 2 The EMH and the “Market Model” 15 Risk and Return—the Simplest View 15 The Capital Asset Pricing Model (CAPM) 18 So What Is the Market Model? 23 Chapter 3 The Forerunners to Behavioral Finance 25 The Folklore of Wall Street Traders 26 The Birth of Value Investing: Graham and Dodd 28 Financial News in a World of Ubiquitous Television and Internet 29 Part Two Noise Traders Chapter 4 Noise Traders and the Law of One Price 33 The Law of One Price and the Case of Fungibility 33 Noise 38 Chapter 5 The Shleifer Model of Noise Trading 43 The Key Components of the Shleifer Model 44 Results 49 Why the Shleifer Model Is Important 50 Resolving the Limits to Arbitrage Dispute 51 Chapter 6 Noise Trading Feedback Models 53 The Hirshleifer Model 53 The Subrahmanyam-Titman Model 58 Conclusion 62 Chapter 7 Noise Traders as Technical Traders 65 Technical Traders as Noise Traders 67 Herd Instinct Models 72 Conclusion 76 Part III Anomalies Chapter 8 The Rational Man 81 Consumer Choice with Certainty 81 Consumer Choice with Uncertainty 84 The Allais Paradox 90 Conclusion 92 Chapter 9 Prospect Theory 93 The Reference Point 93 The S-Curve 94 Loss Aversion 96 Prospect Theory in Practice 98 Drawbacks of Prospect Theory 98 Conclusion 100 Chapter 10 Perception Biases 101 Saliency 101 Framing 103 Anchoring 106 Sunk Cost Bias 108 Conclusion 109 Chapter 11 Inertial Effects 111 Endowment Effect 111 Status Quo Effect 116 Disposition Effect 119 Conclusion 120 Chapter 12 Causality and Statistics 123 Representativeness 123 Conjunction Fallacy 127 Reading into Randomness 129 Small Sample Bias 131 Probability Neglect 133 Conclusion 134 Chapter 13 Illusions 135 Illusion of Talent 135 Illusion of Skill 138 Illusion of Superiority 139 Illusion of Validity 141 Conclusion 142 Part IV Serial Correlation Chapter 14 Predictability of Stock Prices: Fama-French Leads the Way 147 Testing the Capital Asset Pricing Model 147 A Plug for Value Investing 149 Mean Reversion—The DeBondt-Thaler Research 151 Why Fama-French Is a Milestone for Behavioral Finance 152 Chapter 15 Fama-French and Mean Reversion: Which Is It? 155 The Month of January 155 Is This Just About Price? 157 The Overreaction Theme 157 Lakonishok, Shleifer, and Vishny on Value versus Growth 158 Is Overreaction Nothing More Than a “Small Stock” Effect? 159 Daniel and Titman on Unpriced Risk in Fama and French 164 Summing Up the Contrarian Debate 165 Chapter 16 Short Term Momentum 167 Price and Earnings Momentum 167 Earnings Momentum—Ball and Brown 168 Measuring Earnings Surprises 170 Why Does It Matter Whether Momentum Is Price or Earnings Based? 173 Hedge Funds and Momentum Strategies 174 Pricing and Earnings Momentum—Are They Real and Do They Matter? 174 Chapter 17 Calendar Effects 177 January Effects 178 The Other January Effect 180 The Weekend Effect 181 Preholiday Effects 182 Sullivan, Timmermann, and White 183 Conclusion 184 Part V Other Topics Chapter 18 The Equity Premium Puzzle 187 Mehra and Prescott 187 What About Loss Aversion? 190 Could This Be Survivor Bias? 191 Other Explanations 192 Are Equities Always the Best Portfolio for the Long Run? 193 Is the Equity Premium Resolved? 194 Chapter 19 Liquidity 195 A Securities Market Is a Bid-Ask Market 196 Measuring Liquidity 197 Is Liquidity a Priced Risk for Common Stocks? 199 Significance of Liquidity Research 200 Chapter 20 Neuroeconomics 201 Capuchin Monkeys 201 Innateness Versus Culture 203 Decisions Are Made by the Brain 203 Decisions versus Outcomes 205 Neuroeconomic Modeling 206 More Complicated Models of Brain Activity 208 The Kagan Critique 208 Conclusion 209 Chapter 21 Experimental Economics 211 Bubble Experiments 212 Endowment Effect and Status Quo Bias 215 Calendar Effects 216 Conclusion 216 Conclusion And the Winner Is? 217 The Semi-Strong Hypothesis—Prices Accurately Summarize All Known Public Information 217 Can Prices Change if Information Doesn’t Change? 219 Is the Law of One Price Valid? 220 Three Research Agendas 221 The Critics Hold the High Ground 223 What Have We Learned? 223 Where Do We Go From Here? (What Have We Not Learned?) 227 A Final Thought 230 Index 231
EDWIN T. BURTON is a Professor of Economics at the University of Virginia, where he has taught behavioral finance to more than 1,800 students in the past six years. He is an active investment consultant for pension funds and endowments and is a Trustee of the Virginia Retirement System. Burton's Wall Street history includes senior positions at Smith Barney, Rothschild Inc., and Interstate/Johnson Lane. He has been an economics professor since 1969 including eleven years on the faculty at Cornell University. Burton currently serves on two public company boards (SL Green Realty Corporation and Virginia National Bank) and numerous private company boards. He first joined the faculty at the University of Virginia in 1988. Burton received his doctorate from Northwestern University in economics and his undergraduate degree in economics from Rice University. SUNIT N. SHAH's experience in finance includes seven years of financial modeling for Life Settlement Consulting and Management, a position at Stanfield Capital Partners modeling movements of credit spreads, and corporate finance analysis at the Boston Consulting Group for a billion-dollar household products company. Prior work also includes founder's roles in both a dot com and a financial start-up as well as consulting for firms such as Investure, LLC and the CFA Institute. Over the past ten years, Shah has taught a number of introductory, intermediate, and advanced undergraduate economics courses in microeconomics, statistics, and finance. Shah received his doctorate in economics as well as his bachelor's in mathematics and economics from the University of Virginia.
