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Behavioral Finance Literature Summar Essay

3294 words - 14 pages

Course Number: FINA 6278 - MSF Program 11 / 07 / 2012
Course title: Financial Theory and Research (Part 1 – Financial Markets and Asset Pricing)
Team Member: Haotian Lin; Nan Bai; Wenyi Gu; Yibo Zang

Summary
Standard finance (modern portfolio theory), compared with Behavioral finance, is no longer modern: dating back to the late 1950s modern portfolio theory was developed (Statman 2008) Behavioral finance offers alternative explanation for investors and markets. Behavioral finance, which has been a controversial subject and is becoming more widely accepted, is finance from a broader social science perspective including psychology and sociology (Shiller 2003). ...view middle of the document...

Chan, Frankel and Kothari (2002) find some evidence that investors underreact to a one-year trend in accounting performance.
There are other robust anomalies.
1. Book-to-market (BTM) effect. Firms with low BTM have higher earning than those with high ratio.
2. Size effect. Firms with small market capitalization have higher return than those with large capitalization.
3. Momentum effect. Strong movement upward or downward over a 3 to 6 month period is has high probability to continue in that direction over the next 3 to 6 months.
Other controversial anomalies include: long-term price reversal, equity premium puzzle, home bias puzzle, excessive volatility and excessive volume, and accruals anomaly.
Bloomfield also discusses how behavioral factors explain the market anomalies. Four streams are featured:
1. Prospect Theory. One of its implications is the “disposition effect”, in which traders will lock in gains by quick close position in profitable investment but will hold losing investment or invest even more. Disposition effect was introduced in the early period of behavioral finance. According to Statman (2008), disposition effect can be rejected by data analysis, but has been overwhelmingly supported by many empirical studies. Under disposition effect, there is a short-term momentum that traders demand more compensation for risk after price declines and demand less for risk after price increases. Ritter (2003) refers to disposition effect as well in his article. He describes disposition effect as patterns that people avoid realizing paper losses while seek to realize paper gains. Statman (2008) also addresses the same notion as the cognitive bias of faulty framing, where normal investors do not recognize paper losses because they hope that stock prices will rise and losses will turn into gains. A relevant concept of Prospect Theory is “mental accounting”. Mental accounting, as a cognitive bias, is also explained by Ritter (2003). Ritter illustrates an example of household budget for food and entertaining: At home, people will eat fish instead of lobster because lobster is more expensive; But in a restaurant, people will eat lobster even though fish dinner costs cheaper; The reason is that people think separately about restaurant food and home meals.
2. Miscalibrated confidence (overconfidence). There are many evidences that traders tend to be overconfident in their ability to identify mispriced securities, thus leading to excessive trading. But in fact they have very poor information. At the firm level, many executives are overconfident in their firms’ future.
3. Pattern recognition. Many traders use “technical analysis” strategies even though there is little evidence that the pattern can predict future direction movement.
4. Limited attention. People’s decision may be affected by irrelevant factors such as formatting and ordering of text. Limited attention leads to home bias puzzle, with which people...

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