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Behavioral Finance: Understanding the Social, Cognitive, and Economic Debates

Behavioral Finance: Understanding the Social, Cognitive, and Economic Debates

Edwin Burton, Sunit Shah

ISBN: 978-1-119-20360-5

Sep 2015

256 pages


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.

Related Resources

Preface xi

Introduction 1

Part I 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 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 II 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 Over-reaction Theme 157

Lakonishok, Shleifer and Vishny (1994) on Value Versus Growth 158

Is Over-reaction 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 or 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 White183

Conclusion 184

Part V Other Topics

Chapter 18 The Equity Premium Puzzle 187

Mehra and Prescott (1985) 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

Neuraleconomic 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