Behavioral Finance
Behavioral Finance
Term: Module II - Fall 2011
Lectures: Tuesdays and Thursdays 3:30 PM – 5:20 PM
Instructor: Timothy (Jun) Lu (junlu@phbs.pku.edu.cn)
Office: C-317
Office hour: By appointment.
Course Description
Over the past several decades, the field of finance has developed a successful paradigm based on the notions that investors and managers were generally rational and the prices of securities were generally “efficient.” In recent years, however, anecdotal evidence as well as theoretical and empirical research has shown this paradigm to be insufficient to describe various features of actual financial markets. In this course we examine how the insights of behavioral finance complements the traditional paradigm and sheds light on the behavior of asset prices, corporate finance, and various financial institutions and practices.
The course is taught through lectures. Homeworks will be assigned. In some cases, homeworks will take the form as referee reports of academic papers. There will also be a group project and a final exam. Grading is as follows:
1. Homework (30%)
2. Group project (20%)
3. Final Exam (50%)
As for the group project, up to four (no more than four) students can form a group. Each
member is expected to contribute to the project. Each group should hand in a joint solution.
There will be no make-up final exams.
All students are expected to have completed an introductory finance course at the masters level, in addition to introductory courses in statistics, economics, and/or accounting.
Email communication is compulsory. I will regularly send course materials, including papers, powerpoint presentations, and assignments to you through email. It is your responsibility to make sure that your email works, and that you check your email regularly for the updates.
Tentative Schedule
Weeks 1 and 2: Review of non-behavioral finance
Week 3: Some motivating evidence of behavioral finance
Weeks 4 and 5: Demand by arbitrageurs
Weeks 6, 7, and 8: Demand by average investors
Week 9: Behavioral corporate finance, and review
Reading list
Textbook:
Inefficient markets: An Introduction to Behavioral Finance (Oxford University Press, 2000) by Andrei Shleifer. ISBN-10: 0198292279; ISBN-13: 978-0198292272.
We will also read straight from original academic research papers. In most cases these papers are but a few years old. Required readings are marked with a (*) below. This reading list may seem intimidating at first glance, but fear not! The most important formal models and statistical techniques will be covered in class. When sitting down to read a paper on your own, try to take away the key intuition and results of the paper. Don’t dwell on the details unless you have a particular interest in the topic. Please do make a special effort at the required readings, which are less technical, and at least skim the supplemental readings. I will discuss all or almost all of the articles below in class, at least briefly.
I. Non-behavioral finance
In the beginning (i.e. the 1960s), there was the efficient markets hypothesis.
(*) Fama, Eugene, Lawrence Fisher, Michael C. Jensen, and Richard R. Roll, (1969), The adjustment of stock price to new information, International Economic Review, 10: 1-21.
Jensen, Michael C. (1968). The performance of mutual funds in the period 1945-1964. Journal of Finance, 23: 389-416.
Early authors found strong empirical support for the efficient markets hypothesis.
Fama, Eugene (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, 25:383-417.
II. Some motivating evidence
Over the past few decades, a number of curious patterns in asset returns have been discovered. Such patterns include the market reaction to news and non-news.
Cutler, David, James Poterba, and Lawrence Summers (1989). What Moves Stock Prices? Journal of Portfolio Management, 15(3); 4-12.
Huberman, Gur, and Tomer Regev, 2001, Contagious Speculation and a Cure for Cancer: A non-event that Made Stock Prices Soar, Journal of Finance, 56(1), p. 387-396
Shiller, R.J. (1981). Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? American Economic Review, 71:421-36.
And patterns of return predictability in stocks.
Lakonishok, Josef, and Seymour Smidt, 1988, Are seasonal anomalies real? A ninety-year perspective, Review of Financial Studies 1 (4): p. 403-425.
(*) Bernard, Victor (1992). Stock Price Reactions to Earnings Announcements. In: Thaler, R. (Ed.), Advances in Behavioral Finance. New York: Russell Sage Foundation.
Fama, Eugene, and Kenneth R. French (1992). The cross-section of expected stock returns. Journal of Finance 47: 427-465.
Fama, E. F. and K. R. French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3-56.
Daniel, Kent, and Sheridan Titman, 1997, Evidence on the characteristics of cross-sectional variation in stock returns, Journal of Finance 52: 1-33.
(*) De Bondt, Werner F.M., and Thaler, Richard (1985). Does the Stock Market Overreact? Journal of Finance, 40:793-805.
Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48: 65-91.
Lakonishok, J., Shleifer, A., and Vishny, R. (1994). Contrarian investment, extrapolation, and risk. Journal of Finance, 49:1541-78.
La Porta, Rafael, Lakonishok, Josef, Shleifer, Andrei, and Vishny, Robert (1997). Good News for Value Stocks: Further Evidence on Market Efficiency. Journal of Finance, 52:859-74.
Lo, Andrew, and A. Craig MacKinlay (1990), When are contrarian profits due to stock market overreaction?, Review of Financial Studies 3: 175-206.
Fama, Eugene, and Kenneth R. French, 1989, Business conditions and expected returns on stocks and bonds, Journal of Financial Economics 25: 23-49.
There are also curious predictability patterns in bonds, options, forex, futures, real estate, and sports bets.
(same paper as above) Fama, Eugene, and Kenneth R. French, 1989, Business conditions and expected returns on stocks and bonds, Journal of Financial Economics 25: 23-49.
Stein, Jeremy, 1989, Overreactions in the options market, Journal of Finance 44, 1011-1022.
(*) Froot, Kenneth A., and Richard H. Thaler, 1990, Anomalies: Foreign Exchange, Journal of Economic Perspectives 4:3 (Summer 1990), 179-192.
Roll, R. (1984). Orange Juice and Weather. American Economic Review, 74:861-80.
Bodoukh, Jacob, Matthew Richardson, YuQing Shen, and Robert Whitelaw, 2002, Do Asset Prices Reflect Fundamentals?: Freshly Squeezed Evidence from the FCOJ Market, NYU working paper.
Case, Karl E., and Robert J. Shiller, 1989, The efficiency of the market for single-family homes, American Economic Review 79: 125-137.
Liao, Hsien-hsing, and Jianping Mei, 1998, Risk characteristics of real estate related securities: An extension of Liu and Mei (1992), Journal of Real Estate Research 16:279-290.
Hausch, Donald, and William Ziemba, 1995, Efficiency of sports and lottery betting markets, In: Handbooks in Operations Research and Management Science, vol. 9 (Elsevier).
III. Demand by arbitrageurs
Market prices reflect supply and demand. Aggregate demand can be usefully broken down into the demand of rational and/or highly sophisticated investors, which we’ll call arbitrageurs, and the demand of typical human investors.
(*) Shleifer, Andrei, Inefficient Markets (first chapter).
(*) Wurgler, Jeffrey, and Zhuravskaya, Ekaterina (2002). Does Arbitrage Flatten Demand Curves For Stocks? Journal of Business 75: 583-608.
There are a range of costs and risks that deter would-be arbitrageurs.
D’Avolio, Gene, 2002. The market for borrowing stock. Journal of Financial Economics 66: 271-306.
Miller, Edward M., 1977, Risk, uncertainty, and divergence of opinion, Journal of Finance 32: 1151-1168.
Chen, Joseph, Harrison Hong, and Jeremy C. Stein (2002), Breadth of Ownership and Stock Returns, Journal of Financial Economics 66:171-205.
Jones, Charles M., and Lamont, Owen A., 2002. Short sale constraints and stock returns. Journal of Financial Economics 66: 207-239.
Lamont, Owen A., and Richard Thaler (2003). Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs, Journal of Political Economy 111: 227-268.
Mitchell, Mark, Todd Pulvino, and Erik Stafford (2002), Limited Arbitrage in Equity Markets, Journal of Finance 57, 551-584.
Ofek, Eli, Matthew Richardson, and Robert Whitelaw, 2003, Limited arbitrage and short sales restrictions: Evidence from the options markets, Journal of Financial Economics forthcoming.
Shleifer, Andrei, Inefficient Markets (ch. 4 on delegated arbitrage; based on Shleifer, Andrei, and Robert Vishny, 1997, The limits of arbitrage, Journal of Finance 52: 35-55.)
(*) Shleifer, Andrei, Inefficient Markets (ch. 2 on noise trader risk; based on DeLong, Brad, Andrei Shleifer, Lawrence Summers, and Robert Waldmann, 1990, Noise trader risk in financial markets, Journal of Political Economy 98: 703-738).
(*) Shleifer, Andrei, Inefficient Markets (ch. 3 on closed-end funds; based on Lee, Charles M., Andrei Shleifer, and Richard Thaler, 1991, Investor sentiment and the closed-end fund puzzle, Journal of Finance 46: 75-110).
(*) Froot, Kenneth A., and Dabora, Emile (1999). How Are Stock Prices Affected by Location of Trade? Journal of Financial Economics, 53(2):189-216.
In certain circumstances, the smart-money trade may actually reduce market efficiency.
Shleifer, Andrei, Inefficient Markets (ch. 6 on positive feedback trading; based on DeLong, Brad, Andrei Shleifer, Lawrence Summers, and Robert Waldmann, 1990, Journal of Finance 45: 375-395).
Brunnermeier, Markus K., and Lasse Heje Pedersen, 2002. Predatory trading. NYU working paper.
Brunnermeier, Markus K., and Stefan Nagel, 2002. Hedge funds and the technology bubble, Journal of Finance forthcoming.
IV. Demand by average investors
Typical human investors hold divergent opinions about individual assets, but on any given day opinions tend to move in the same direction.
Bagwell, Laurie Simon. 1992. Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity, Journal of Finance.
Barber, Brad, Terrance Odean, and Ning Zhu, 2003, Systematic noise, UC Davis working paper.
Systematic investor sentiment ultimately derives from common cognitive limitations and systematic biases in investors’ perceptions.
Tversky, Amos and Daniel Kahneman (1974). Judgement Under Uncertainty: Heuristics and Biases. Science, 185:1124-31.
(*) Kahneman, Daniel, 2003, Maps of bounded rationality: Psychology for behavioral economics. American Economic Review 93: 1449-1475.
Kahneman, Daniel, and Riepe, Mark (1998). Aspects of Investor Psychology. Journal of Portfolio Management, 24:52-65.
(*) Shleifer, Andrei, Inefficient Markets (ch. 5 on a model of investor sentiment; based on Barberis, Nick, Andrei Shleifer, and Robert Vishny, 1998, A model of investor sentiment, Journal of Financial Economics 49: 307-343).
Poteshman, Allen, 2001, Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market, Journal of Finance 56 (3), 851-876.
Daniel, Kent, Hirshleifer, David, and Subrahmanyam, Avanidhar (1998). Investor Psychology and Security Market Under- and Overreactions. Journal of Finance, 53:1839-85.
Hong, Harrison, and Jeremy C. Stein, 1999, A unified theory of underreaction, momentum trading, and overreaction in asset markets, Journal of Finance 54, 2143-2184.
Barberis, Nicholas, Shleifer, Andrei, 2003. Style investing. Journal of Financial Economics, 68 161-199.
Barberis, Nicholas, Shleifer, Andrei, and Jeffrey Wurgler. (2002) Comovement, Journal of Financial Economics forthcoming.
French, Kenneth R., and James M. Poterba, 1991, Investor diversification and international equity markets, American Economic Review 81: 222-226.
Huberman, Gur, 2001, Familiarity Breeds Investment, Review of Financial Studies 14(3): 659-680.
Klibanoff, Peter, Owen Lamont, and Thierry A. Wizman, 1998, Investor reaction to salient news in closed-end country funds, Journal of Finance 53: 673-699.
Shefrin, Hersh, and Meir Statman, 1985, The disposition to sell winners too early and ride losers too long: Theory and evidence, Journal of Finance 40(3): 777-790.
Odean, Terrance (1998). Are Investors Reluctant to Realize Their Losses?. Journal of Finance, 53:1775-98.
Shefrin, Hersh, and Meir Statman, 1984, Explaining investor preference for cash dividends, Journal of Financial Economics 13: 253-282.
Yuan, Yu, 2009, Attention and Trading, working paper.
These individual-level biases are consolidated and amplified by social interaction.
Hong, Harrison, Jeffrey D. Kubik, and Jeremy C. Stein, 2003, Social Interaction and Stock-market participation, Journal of Finance, forthcoming.
Shiller, R.J. 1984. Stock Prices and Social Dynamics. Brookings Paper on Economic Activity, Feb: 457-98.
Hong, Harrison, Jeffrey D. Kubik, and Jeremy C. Stein, 2003, Thy neighbor’s portfolio: Word-of-mouth effects in the holdings and trades of money managers, Stanford University working paper.
Antweiler, Werner, and Murray Z. Frank, Is All that Talk just Noise? The Information Content of Internet Stock Message Boards, Journal of Finance 59: 1259-1294.
Kaustia, Markku, and Samuli Knupfer, 2011, Peer Performance and Stock Market Entry, Journal of Financial Economics, forthcoming.
Lu, Timothy (Jun), 2011, Social Interaction Effects and Individual Portfolio Choice: Evidence from 401(k) Pension Plan Investors, working paper.
Armed with some understanding of arbitrageurs’ and average investors’ demands for securities, we are ready to take a more nuanced look at what goes on in “bubbles”
(*) Shleifer, Andrei, Inefficient Markets (sixth chapter, p. 169-174).
(*) Baker, Malcolm, and Jeffrey Wurgler, 2003, Investor sentiment and the cross-section of stock returns, Journal of Finance 61: 1645-1680.
Ofek, Eli, and Matthew Richardson, 2003, DotCom mania: The rise and fall of Internet stock prices. Journal of Finance 58: 1113-1137.
Lamont, Owen A., and Jeremy C. Stein, 2003, Aggregate short interest and market valuations, American Economic Review , forthcoming.
Baker, Malcolm, Jeffrey Wurgler, and Yu Yuan, 2011, Global, Local, and Contagious Investor Sentiment, Journal of Financial Economics, forthcoming.
(*) Baker, Malcolm, and Jeffrey Wurgler, 2007, Investor Sentiment in the Stock Market, Journal of Economic Perspectives 21, No.2: 129-151.
Huang, Byoung-Hyoun, 2011, Country-specific Sentiment and Security Prices, Journal of Financial Economics 100: 382-401.
V. Supply by firms and managerial decisions
Rational managers try to ‘time’ inefficient capital markets to reduce their overall cost of capital – they supply more of the currently overpriced securities, and buy back the underpriced ones.
Stein, Jeremy, 1996. Rational Capital Budgeting in an Irrational World. Journal of Business, 69:429-55.
Graham, John R., and Harvey, Campbell R., 2001, The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics 60: 187-243.
Ikenberry, David, Lakonishok, Josef, and Vermaelen, Theo (1995). Market Underreaction to Open Market Share Repurchases. Journal of Financial Economics, 39:181-208.
Jenter, Dirk, 2002, Market timing and managerial portfolio decisions. MIT Sloan working paper.
(*) Loughran, Timothy, and Ritter, Jay (1995). The New Issues Puzzle. Journal of Finance, 50:23-51.
Baker, Malcolm, and Jeffrey Wurgler (2000). The equity share in new issues and aggregate stock returns. Journal of Finance, 55: 2219-2258.
Henderson, Brian, Narasimhan Jegadeesh, and Michael S. Weisbach, 2003, World markets for raising new capital, U. of Illinois working paper.
Loughran, Timothy, and Ritter, Jay (1997). The operating performance of firms conducting seasoned equity offerings. Journal of Finance 52:5, 1823-1850.
Baker, M., and J. Wurgler (2002) Market timing and capital structure Journal of Finance 57: 1-32.
Baker, Malcolm, Robin Greenwood, and Jeffrey Wurgler (2003). The maturity of debt issues and predictable variation in bond returns. Journal of Financial Economics 70, 261-291.
Teoh, Siew H., Welch, Ivo, and Wong, T.J. (1998). Earnings Management and the Post-Issue Under Performance of Seasoned Equity Offerings. Journal of Financial Economics 50:63-99.
(*) Shleifer, Andrei, and Robert Vishny, 2003, Stock market driven acquisitions, Journal of Financial Economics, forthcoming.
Dong, Ming, David Hirshleifer, Scott Richardson, and Siew Hong Teoh, 2003, Does investor misvaluation drive the takeover market?, Ohio State U. working paper.
Rational firms also try to keep their stock prices high by “catering” to investors – i.e., adopting whatever characteristics that investors currently demand.
P. Raghavendra Rau, Michael J. Cooper and Orlin Dimitrov, 2001, A rose.com by any other name, Journal of Finance 56: 2371-2388.
Baker, Malcolm, and Jeffrey Wurgler (2002). A catering theory of dividends. Journal of Finance, forthcoming.
Managers, like average investors, are also subject to psychological biases.
Bertrand, Marianne, and Antoinette Schoar, 2003, Managing with style: The effect of managers on firm policies, Quarterly Journal of Economics 118: 1169-1208.
Heaton, J. B., 2002, Managerial Optimism and Corporate Finance, Financial Management, 31: 33-45.
Malmendier, Ulrike, and Geoffrey Tate, 2003, CEO overconfidence and corporate investment, Stanford University working paper.
Roll, R., 1986, The Hubris Hypothesis of Corporate Takeovers, Journal of Business 59: 197-216.
Malmendier, Ulrike, and Geoffrey Tate, 2003, Who makes acquisitions? CEO overconfidence and the market’s reaction, Stanford University working paper.
Survey of behavioral corporate finance
(*) Baker, Malcolm, Richard Ruback, and Jeffrey Wurgler, 2004, Behavioral corporate finance: A survey, NYU working paper.