Behavioral finance understanding the social, cognitive, and economic debates

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