This week was made interesting by the US financial markets and Chapter 11. And if all the bad news wasn’t enough Google and Chicago Tribune made it more happening by letting everyone think that United Airlines had filed for bankruptcy too to cut costs.
I will let Chicago Tribune give you the story in detail, that sort of fits anyway. Just to give you a gist
The steep sell-off in United’s shares came after a news service in Florida distributed an old story posted on the South Florida Sun-Sentinel Web site six years ago. Monday’s recirculated story gave the appearance that United had filed for bankruptcy protection again. In fact, the story was originally published Dec. 10, 2002, by the Chicago Tribune, marking the airline’s decision at that time to seek protection from creditors.
And more importantly for us, moments after a headline for the story hit Bloomberg, shares in United stock fell from about $12 a share to a low of $3, prompting a halt in trading of United stock.
Of course, once the truth was out the stock got back to a slightly lower $10 odd and will probably now reach its market value of $12 and might start trading in a regular manner.
What Happened Here?
What we saw was a perfect simulation of Panic Selling and to a certain extent noise trading. I intend to cover these two in details later (so watch this space for that).
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Considering the fact that I haven’t blogged here in over 2 weeks, I thought let’s keep the theory a little away today and dig into the evolution of behavioral finance to what it is these days. Hopefully, I have done justice to it, but with over a 100 years of history it wasn’t really easy.
Though research and development of financial models based on behavioural finance started very recently the idea of behavioural finance is not new. Many investors have long considered that psychology plays a key role in determining the behaviour of markets. However it is only in the past couple of decades that a series of concerted formal studies have been undertaken in this area. Paul Slovic’s (1972) paper on individual’s misperceptions about risk and Amos Tversky and Daniel Kahneman’s papers on heuristic driven decision biases and decision frames (1979) being some of the major works in the field. The results of these studies were significantly different from the rational, self-interested decision-maker that by traditional finance models explained.
Yet as said before, Most of the ideas in behavioural economics are not new and actually they return to the roots of neoclassical economics.
When economics first became identified as a distinct field of study, psychology did not exist as a discipline. Many economists moonlighted as the psychologists of their times. Adam Smith, who is best known for the concept of the “invisible hand” and The Wealth of Nations, wrote a less well-known book The Theory of Moral Sentiments, which laid out psychological principles of individual behaviour that are arguably as profound as his economic observations.
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The gambler’s fallacy is the mistaken notion that the odds for something with a fixed probability increase or decrease depending upon recent occurrences. The gambler’s fallacy involves beliefs about sequences of independent events.
By definition, if two events are independent, the occurrence of one event does not affect the occurrence of the second. For example, if a fair coin is flipped twice, the occurrence of a head on the first flip does not affect the outcome of the second flip. What if a coin is flipped five times and comes up heads each time. Is a tail “due” and therefore more likely than not to occur on the next flip?
Since the events are independent, the answer is “no.”
The gambler’s fallacy believing the answer is “yes.”
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§ August 26th, 2008 § Filed under Concepts
Prospect theory proposes a framework for the way people make decisions under conditions of risk and uncertainty. Prospect theory embodies a richer behavioral framework than that of subjective Expected Utility Theory which underlies many economic models. Prospect theory has probably done more to bring psychology into the heart of economic analysis than any other approach.
Unlike much psychology, prospect theory has a solid mathematical basis — making it comfortable for economists to play with. However, unlike Expected Utility theory which concerns itself with how decisions under uncertainty should be made (a prescriptive approach), prospect theory concerns itself with how decisions are actually made (a descriptive approach).
Prospect theory was created by two psychologists, Kahneman and Tversky, who wanted to build a parsimonious theory to fit a number of violations of classical rationality that they and others had uncovered in empirical work.
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§ August 24th, 2008 § Filed under Concepts
The term quasi-magical thinking, as defined by Shafir and Tversky (1992), is used to describe situations in which people act as if they erroneously believe that their actions can influence an outcome (as with magical thinking) but in which they in fact do not believe this. It includes acting as if one thinks that one can take actions that will, in effect, undo what is obviously predetermined, or that one can change history.
In investing, quasi magical thinking can be felt or seen in the way investors sometimes decide to buy or sell stocks. They may do a certain action before making a purchase, take God’s name before making any transaction, wear their left socks first, though they do realize that they do this for their own satisfaction and it does not bear any effect i.e. information-wise in the result of the trade. They do it with the belief that such an action can correct any mistake or help them in not making a mistake, though it seldom happens that way.
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§ August 19th, 2008 § Filed under Concepts
As I have mentioned often on my posts, traditional economics and finance consider agents or investment participants to be rational and that there are no frictions, i.e a security’s price equals its “fundamental value”. This is the discounted sum of expected future cash flows, where in forming expectations, investors correctly process all available information, and where the discount rate is consistent with a normatively acceptable preference specification. The hypothesis that actual prices reflect fundamental values is the Efficient Markets Hypothesis (EMH).
In an efficient market, there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk. Behavioural finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of traders who are not fully rational.
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§ August 16th, 2008 § Filed under Concepts
In the psychological literature there is no precise definition of overconfidence. There are several findings that are often summarized as overconfidence. Under this view, which is the broadest possible that can be found in the literature, overconfidence can manifest itself in the following forms: miscalibration, the better than average effect, illusion of control, and unrealistic optimism. As an investor you might find yourself in such situations often and perhaps not realize that you are showing signs of overconfidence while making investment decisions. The trick is to realize it or to see it in others to make the most of an investment opportunity.
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Economists believe the perception of risk to be the most important factor in investor decision making. Investing decisions are always taken on the basis or the amount of risk involved in the investment. I.e. two people when given the same amount of money needn’t necessarily invest in the same manner. The reason is the perception of risk and the need of the investor. What can be percieved as a huge risk by someone may be the minimum risk involved as perceived by someone else. And some might be willing to bear the effects of the risk involved, while some may not.
Thus practitioners of behavioural finance and finance advisors need to understand the level or the risk perception that their client carry in their mind and need to design investment methods on the same basis. Hence, an understanding of risk and its characteristics is an integral part of behavioural finance.
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§ August 6th, 2008 § Filed under Concepts
Daniel Kahneman and Amos Tversky proposed their award winning prospect theory which forms the foundations of behavioural economics to explain and give remedies to the fallacies in the Efficient Market Hypothesis. In fact behavioural economics and finance came into prominence because it was able to satisfactorily explain the market anomalies that this theory could not explain, hence, study of this hypothesis forms an integral part of behavioural finance, to understand BF better.
Eugene Fama laid the EMH’s empirical foundations, defines efficient market hypothesis as “the simple statement that security prices fully reflect all available information. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always zero”. This meant that any information regarding the stock is reflected in its price when the transaction costs are assumed to be nil, and that the market always knows any information about a stock.
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§ August 4th, 2008 § Filed under General
Hey everyone…
I see that a decent bunch of people of stumbled through this site today, and there while most of them had to rush after giving a thumbs up a few of you stayed back surprisingly long..at least that’s what my analytics tells me. So thank you for doing that and I hope the 2 articles I have written have added some value to you.
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