Modes of Behavioral Finance

  • Feedback Models

    • Observations
      • academic research has until recently hardly addressed the feedback model.
      • The same feedback may also produce a negative bubble, downward price movements propelling
      • there is a tendency for stock prices to continue in the same direction over intervals of six months to a year, but to reverse themselves over longer intervals. (Thaler, De Bondt, 1985)
    •  Representation Heuristic – Tversky and Kahneman
      • judgments tend to be made using a representativeness heuristic, whereby people try to predict by seeking the closest match to past patterns, without attention to the observed probability of matching the pattern.
      • people may tend to match stock price patterns into salient categories such as dramatic and persistent price trends, thus leading to feedback dynamics, even if these categories may be rarely seen in fundamental underlying factors
    • Biased Self-Attribution – Daryl Bem (1965, underlying phenomenon); Daniel, Hirschleifer and Subramanyam (1999, promoting feedback)
      • attribute events that confirm the validity of their actions to their own high ability, and attribute events that disconfirm their actions to bad luck or sabotage.

  • Smart Money vs. Ordinary Investors
    • Observations
      • It must somehow be the case that a smaller element of “smart money” or the “marginal trader” is able to offset the foolishness of many investors and make the markets efficient.
      • The efficient markets theory, as it is commonly expressed, asserts that when irrational optimists buy a stock, smart money sells, when irrational pessimists sell a stock, smart money buys, thereby eliminating the effect of the irrational traders on market price.
      • But, finance theory does not necessarily imply that smart money succeeds in fully offsetting the impact of ordinary investors.
    • Problems
      • in one model with both feedback traders and smart money, the smart money tended to amplify, rather than diminish, the effect of feedback traders, by buying in ahead of the feedback traders in anticipation of the price increases they will cause (De Long, Shleifer, Summers and Waldman, 1990b)
      • Style — The smart money are rational utility maximizers. Barberis and Shleifer presented a numerical implementation of their model and found that smart money did not fully offset the effects of the feedback traders. Style classes go through periods of boom and bust amplified by the feedback.

FROM EFFICIENT MARKET THEORY TO BEHAVIORAL FINANCE

—Robert Shiller on Behavioral Finance