ECON 4370 Exam 2
Bayes Theorem
Adjusts expected probability for changes in new information How probabilities should be assessed
P/E FF
Argues price to earnings ratios is also well captured by size and B/M
FF stance on leverage?
Argues that book and market leverage is well captured by B/M
Anchoring
Bias that arises when attempting to make a guess about an unknown value, information presented prior anchors your guess close to that info
Anomalies can explain?
Bubbles, the one thing econ cant
Proof of endowment effect?
Buyers and sellers have different reservation prices...Max they'd buy/sell
Value investing
Buying out of favor, beaten up stocks
Examples of market models and implications
CAPM, Arb pricing theory Markets can be efficient still
Risk aversion
Certain grant is better than ev=grant
Why does book to market change
Changes in market cap, largely due to overreaction
What causes utility to be path dependent
Changing reference points and loss aversion
Assumptions for valid utility theory
Comparability, universal, transitive
3 characteristics of Prospect theory
Consumers have S shaped utility functions due to loss aversion. Where the prospect has an assumed reference point. Utility is diminshing
Out of sample evidence?
Does the phenomenon appear in data outside of the original sample space? january effect does
Whats the flaw in prospect theory?
Doesn't deal with disappointment and regret
Significance of FF
Easy way to beat market Validated earlier works such as Debond Thaler Created behavioral finance
Allais paradox
Empirical proof against Expected Utility, people can be confused when making a decision Proof: U(1)> .89U(1) + .1U(5) + .01U(0) .89U(0) + .11U(1) < .9U(0) + .1U(5)
Equity premium puzzle
Equity returns-bond returns, the larger this spread the more risk averse people are
Econ deals with what type of utility
Ex-ante utility- Prior to the decision
What theory does typical economics teach about decision making?
Expected utility theory People make decisions based on wealth
System 1
Fast, automatic, instinctual
Who got to author each paper?
Flipped a coin to decide
Who doesn't show loss aversion?
Gamblers and successful wall street traders
Libertarian paternalism
Government should give several options, but the one it deems the best should be the default in accordance with the status quo effect
Opposite of value stock?
Growth (Low Book/market)
Kahneman's explanation for why money doesn't follow endowment effect?
He argues money is simply a placeholder for other goods
FF definition of value?
High book to market Total assets-Total liabilities/Market cap
Conservative bayesians
How Kahneman describes decision makers, people adjust in the proper direction when they learn new information, but not far enough... Anchored to orginal
Substitution
How people answer unknown questions. We substitute an easier question
Representativeness
If something matches your prototype you ignore the base rate of whether that item belongs to a category Example- Randomness should look random and not have patterns, therefore flipping coins and having 5 in a row is less likely than having head tail head tail
Beta risk
If the market suffers how much will we suffer?
Disposition effect
Investors are reluctant to recognize losses, and eager to recognize gains. Sell at the wrong time
Heuristics
Kahneman and Tverskys rules of thumb and assumptions that people use when making decisions
Experience utility-
Kahneman pain study, how much did the person enjoy the behavior in the past
DeBondt and Thaler
Looked at mean reversion of stocks Mean reversion- Stocks over the long run revert to their long run average growth rate
Fama and french data
Looked at stocks based on size deciles, and the predictability of their cross section of returns using beta
What causes Status quo, prospect theory, and endowment effect?
Loss aversion and reference points Reference point is the default/your item
Loss aversion
Losses hurt more than equivalent gains
Madden curse
Mean reversion, small samples cause extreme outcomes. Example of causality
Debandt and Thaler article
Mean reversions and the overreaction hypothesis Possible for prices not to reflect true value in SR due to overreaction
What causes the disposition effect?
Mental accounts
Market model (FF)
Models of what determine asset prices
Kahneman's stance on irrationalities
No way to learn your way out of them
Does prospect theory provide insight into asset pricing models?
No, but there are no suitable replacements that do
Debandt and thaler public response?
Not published initially as it directly contradicted EMH
Reference point effect on utility theory
Past status affect current decision, so indifference curves cross
Utility depends on
Path to final location, current status vs past
Comparative ignorance
People are more confident when choosing from a gamble with known probabilities than unknown probabilities
conjuction fallacy
People assume 2 conditions are more likely than one, impossible
Why does the status quo effect happen?
People believe switching from the default will cause more regret The starting option is always the reference point
Cuasality
People irrationally assume one things causes another, we like stories
Saliency
People overweigh highly memorable events
Kahneman pain study
People prefer more total pain, as long as it ends in no pain
Why do people not follow the strategies of FF article?
People prefer the winners over the losers
Loss aversion and litigation
People prefer to gamble when dealing with losses, but want sure gains
Regret and decision making
People regret when they choose something they don't normally choose and it goes wrong
Why do the indifference curves cross for the endowment effect?
People require a lot of the other good to switch, so the slopes are extreme. The reference point determines which one you are on
Mental accounting
People's tendency to illogically create subjective separate accounts for money instead of focusing on income in general
Halo effect
Peoples tendency to let overall impressions of other things affect their impressions of unknown characteristics
January effect
Phenomenon where january is the best predictor of how well the market will do over the rest of the year. FF data was most profound over this period
Cross section
Picking a subset of time and looking at returns and any explainable variations only within that period
Indifference curve and economic theory
Points should be transitive, but in practice aren't reversible. Path dependent, so net happiness isn't the same
Status quo effect-
Reluctance for decision makers to consider alternatives and simply choose the default option
3 heuristics of judging?
Representativeness, Availability, Anchoring
Fama/French regression model
Rs= a + B1(Mr) + B2(Value) + B3(size)
System 2
Slower, analytical, effortfull
Small stock effect
Small market cap stocks outperform larger stocks
Results of FF
Small stocks, high value outperformed by 1.5% a month
Anomaly
Something that shouldn't happen, and can't be explained by economic theory
Relationship between system 1 and 2
System 1 often dominates and steers 2. System 2 must be used to correct for errors made by system 1
Endowment effect
Thaler, you value something you own over the equivalent cash it takes to buy them Directly defies economic theory over specific reservation prices
Best predictor when you have little information?
The base rate
What does CAPM stress?
The importance of Beta
Beta
The relation of the stocks return to the overall markets return
Naive diversification
Thinking that spreading money among highly correlated assets is diversification
Coherence, coherent stories etc
To help understand a situation, we assume intention and causality. While neglecting randomness
Goal of FF
To test the CAPM market model, does beta actually predict stock returns? Nothing economic about it
Data in Debandt Thaler
Took data from over 60 years, formed 3 year portfolios of best/worst stocks Best got killed, worst did great
Mental shotgun
We compute way more than we need to
Confidence over doubt
We prefer certainty, so system 1 creates causal narratives
Do other animals show financial anomalies?
Yes, Capuchin monkey
