behavioural factors and stock market puzzle

8/9/2019 Behavioural Factors and Stock Market Puzzle

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Do Behavioral FactorsExplain Stock MarketPuzzles?

Behavioural Finance

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Big market puzzles

• Several big puzzles relate toaggregate stock market – behavioralfnance has partial explanations or

some o these puzzles: – Equity premium puzzle: stock returns are

higher than they should be given risk borne byinvestors in stock markets

– Bubbles: hy do markets get so ar out o lineith undamentals!

– Excess volatility: stock returns are morevolatile than they should be given that stockprices are present values o uture expected

cash"os 2


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Historical (realized e!uit"premium in #$S$

• #istorically$ a ell%diversifedportolio o stocks has substantiallyoutperormed fxed income

securities&• 'mportant to look at real returns

hich control or in"ation e(ects&

• )i(erence beteen expected equityreturn and fxed%income return isknon as equity premium. – *his is return or bearing additional risk

o stocks relative to bonds or bills3


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%otal nominal return indexes& ')*+',,-

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Siegel, J.J.. From "The Future Value of an 1802 Dollar Invete! in Different et #lae $in nominal term%," in Sto&' for the (ong )un 2n! *!ition $+&ra- ill, /e-

or', /e- or'%, 18. 18 34 +&ra-5ill, In&. ll right reerve!. )e6ro!u&e! 34 6ermiion.


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%otal real return indexes& ')*+',,-

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Siegel, J.J.. From "The Future Value of an 1802 Dollar Invete! in Different et #lae $in real term%," in Sto&' for the (ong )un 2n!

*!ition $+&ra- ill, /e- or', /e- or'%, 18. 18 34 +&ra-5ill, In&. ll right reerve!. )e6ro!u&e! 34 6ermiion.


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.verage historical real returns/or stocks0 1onds and 1ills

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Siegel, J. J.. From "verage )eal )eturn $in 7% on Sto&', on! an! ill," in Sto&' for the (ong )un, 2n! *!ition, 18 $+&ra- ill,

/e- or', /e- or'%. 18 34 +&ra-5ill, In&. ll right reerve!. )e6ro!u&e! 34 6ermiion.


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2s e!uit" premium toohigh?• +any theorists believe equity premium is too

large or actual risk&

• Especially clear hen e look at longerhorizons: – ,t longer horizons stocks almost alays

outperorm&

– -lus risk o stocks declines more quickly than ouldbe expected&

– .atter is due to mean reversion o stock returns& – +any say high premium since //0 is probably notsustainable&

– *hough 0112 had a large negative impact onoverall postar average3

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E!uit" premium seems toohigh

• *heorists have shon that realizedequity premium implies animprobably large degree o risk

aversion&

• 'n an economy ith reasonableparameters$ average return on stock

market ould be 4ust 1&56 higherthan risk%ree rate$ not 7&86 9orhigher observed in most studies&

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M"opic loss aversion ande!uit" premium puzzle

• ;esearchers have linked prospect theoryto equity premium puzzle& –


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M"opic loss aversion ande!uit" premium puzzle

cont$• >?ES*'@A: iven prospect theoryapproach$ hat evaluation period isconsistent ith historically observed

market risk premium!• ,AS/E;: ,bout a year – hich is logicallyho oten a typical investor gives hisportolio a careul look&

• ;easons: – *ax is paid annually – -ortolio assessment and ad4ustments are oten

annual

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2llustration

• 'ndividual has 0 choices: – 'nvest C511 in a savings account 9assume zero

return

– @r buy stock ith D1D1 distribution or net

earnings o C011 or %C511

• ' e assume loss aversion and linearity$value unction is:

v9zFz or zG1 and v9zFHz or zI19HJ5• ' H F 0&D$ investor ill not invest in stock

9assuming she looks at portolio once per

year&•11


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2llustration cont$

Ao she ill invest in stocks because: &0D9K11L&D9511L&0D9%011M0&DJ1

Aote: e have assumed or simplicity thatreturns are additive 90116 or 0 years isK116&

.ess requent evaluation leads to:

higher demand or stockhigher price o stock loer equity premium

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Experimental 1u11les

• Experimental asset markets haveprovided ne insights into homarkets ork&

• @ne o most perplexing fndings romthis research is tendency o prices torise ar above undamental value andthen later crash&

• Nirst study to report bubbles inexperimental asset markets aspublished in 5822&

• Since then many studies have

investigated actors that both13


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Experimental 1u11lescont$• 'n a typical bubbles design$ sub4ects

trade an asset over a fxed number operiods&

• ,sset has a common dividend that isearned on all units and determined atthe end o a trading period using aknon probability distribution&

• ' risk neutrality is assumed$ e caneasily compute undamental value oasset by multiplying number o tradingperiods by expected dividend eachperiod& 14


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Dividends and value

• Nocus on standard asset$ leaving lottery asset orlater&

• ,sset trades or telve fve%minute periods so iyou buy one unit in period 5 and hold it until theend o the experiment$ you ould earn telve

dividends&• Expected value o dividend each period is sum oprobability%eighted possible dividends:

1&K2M1&D1 L &1K2M1&81 L 1&1KM5&01 F C1&O0

• /hat is asset orth! – ' you are risk neutral: 1&O0 M 50 F C2&PK – Nundamental values in all subsequent periods

can be computed 4ust as easily by multiplying

number o periods remaining times expectedvalue o C1&O016


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%"pical price paths

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Source: This is Figure 1 from Ackert, L F, ! "h#ru$#t, % & "hurch,#'( ) *e#+es, 2006, -#rgi', short se..i'g, #'( .otteries i' e/$erime't#. #sset m#rkets,Southern Economic Journal 732, $#ge 427


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2nterpretation

• *ypical price pattern in bubblesmarkets is di(erent rom hat oneould expect&

• Solid line indicates undamentalvalue each period$ beginning atC2&PK in period 5 and alling by C1&O0

each period&• )ashed lines sho median

transactions prices per period or

our di(erent bubbles markets&18


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2nterpretation cont$

• /hat happened! – ?sually price in period 5 is belo

undamental value but quickly rises high

above this point• -rice in frst period may be lo due to

sub4ects= initial risk aversion because theyare trading in an environment in hich theyare inexperienced

• Some o bubbles in this fgure are quitepersistent %% but all eventually crash back toundamental value as remaining tradingperiods become small

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3essons /rom experimental1u11le markets

• *hough experimental bubbles marketsare simple and do not include allimportant eatures o a complex market

9like AQSE$ they teach us ho realbubbles might be generated&

• -rice bubbles are more moderate and

disappear aster hen traders areexperienced&

• -otential or short%selling leads tobubble dissipation&

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3essons /rom experimental1u11le markets cont$

• 'n some experiments$ to assets aretraded in order to investigate hetherpricing di(ers across the assets&

• @ne study alloed trading o toassets: a standard asset and a Rlotteryasset&

• Second asset is reerred to as lotteryasset because its payo(s are similar toa lottery& – -ayo( usually zero$ but K6 o the time

asset earns large dividend payment o21


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3essons /rom experimental1u11le markets cont$ ii$

• ,lthough standard and lottery assets haveidentical expected values$ traders ereilling to pay more or lottery asset&

• Suggests that traders may be sub4ect toprobability 4udgment error 9overeightingsmall probabilities&

• ,nother possible explanation is that

speculation or gambling plays into hopeople determine hat they ill pay toacquire an asset& – /illing to pay more or lottery asset because

they become more risk taking as trading heatsup 22


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4hat explains real+5orld1u11les?

• Irrational Exuberance by ;obertShiller frst came out in 0111 hen)o as approaching 50$111&

• +ain argument o book as thatmarket at end o 5888 as in grip oa ma4or bubble3

• Events proved to be on Shiller=s side&

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S6P 7)) P8E

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Shiller, )o3ert. From "Figure 9: )eal S;< =00 Sto&'


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Historical P8E ratios

• +arket levels out o line ith earningslevels& – Seen by looking at -E ratio

• +arket run%up during this bull market asunprecedented&

• *hree other ma4or peaks in stock markethistory: 5815T 5808T and 58PP& – Nrom these peaks subsequent perormance

turned out to be sub%par

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Market moves vs$ ne5s?

• D1 biggest market moves o last D1 yearsmatched against explanation in New YorkTimes.

• @n several days Times actually reportedthere as no apparent cause 9e&g&$ Sept& 7$58KP&

• +any other times Rcause doesn=t seem

important enough – doesn=t seem thatthere is really any ne meaningulinormation&

• Suggests excess volatilityV–

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Shiller and theor"

• Shiller tackles excess volatility taking atheoretical approach&

• #e shoed that it is diWcult to explain thehistorical volatility o stock returnsV

– ,ssuming investors are rational and discount ratesare constant

• Existing volatility implies a great deal ovariation in dividend groth rates – hich isfne i these expectations are realized&

• ?sing constant groth model$ he consideredgroth rate orecast changes needed to

4ustiy realized changes in stock prices&• iven a constant discount rate these ould

be unreasonably high&28


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Prices vs$ rational prices

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Shiller, )o3ert J.. From Do to&' 6ri&e move too mu&h to 3e @utifie! 34 u3eAuent &hange in !ivi!en!B, meri&an *&onomi& )evie-,C1$9%, 6. 22. meri&an *&onomi& )evie-. )e6ro!u&e! -ith the 6ermiion of the 6u3liher an! the author.


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behavioural factors and stock market puzzle

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