Lecture Notes in Behavioral Finance

Itzhak Venezia

• Publisher: WSPC
• Year: 2018
• eBook ISBN: 9789813231580
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

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This volume presents lecture notes for a course in behavioral finance, most suitable for MBA students, but also adaptable for a PhD class. These lecture notes are based on the author's experience in teaching behavioral finance classes at Bocconi University (at the PhD level) and at the Academic College of Tel Aviv-Yaffo (MBA).

Written in a way that is user-friendly for both teachers and students, this book is the first of its kind and consolidates all the material necessary for a course on behavioral finance, balancing psychological concepts with financial applications. Material formerly presented only in academic papers has been transformed to a format more suitable for students, while the most important issues have been highlighted in boxes that can form the basis of a lecturer's teaching slides.

In addition to corralling all the currently scattered materials into one book, a neat logical order is introduced to the subject matter. Behavioral finance is put in a context relative to the other disciplines of finance, its history is outlined and the way it evolved — from an eclectic collection of counter examples to market efficiency into a bona fide discipline of finance — is reviewed and explained.

The 17 topic-based chapters in this book are each intended for a 90-minute lecture. The first five chapters (Part 1) provide the psychological and financial foundations of behavioral finance. The next 12 chapters (Part 2) are applications: Chapters 6–13 cover the essentials while Chapters 14–17 are special, elective topics.

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--> Contents:

• Psychological and Financial Foundations of Behavioral Finance:
  • Introduction: The History of Behavioral Finance and the Impetus for Its Emergence
  • A Review of Traditional Decision Theory: The Mean–Variance Rule and Utilty Theory
  • Critique of Utility Theory, the Assumption of Rationality and the Efficient Markets Hypothesis
  • Kahneman and Tversky's Essential Cognitive Biases
  • Prospect Theory
• Applications of Behavioral Finance:
  • The Disposition Effect
  • Overconfidence
  • Herding
  • Overreaction and Underreaction
  • The Equity Premium Puzzle and Myopic Loss Aversion
  • The Home Bias
  • Limits to Arbitrage
  • Market Sentiment
  • Biases in Savings and Insurance
  • The Hot Hand
  • Accounting Anomalies
  • Appearance and Disappearance of Anomalies

--> Contents:

• Psychological and Financial Foundations of Behavioral Finance:
  • Introduction: The History of Behavioral Finance and the Impetus for Its Emergence
  • A Review of Traditional Decision Theory: The Mean–Variance Rule and Utilty Theory
  • Critique of Utility Theory, the Assumption of Rationality and the Efficient Markets Hypothesis
  • Kahneman and Tversky's Essential Cognitive Biases
  • Prospect Theory
• Applications of Behavioral Finance:
  • The Disposition Effect
  • Overconfidence
  • Herding
  • Overreaction and Underreaction
  • The Equity Premium Puzzle and Myopic Loss Aversion
  • The Home Bias
  • Limits to Arbitrage
  • Market Sentiment
  • Biases in Savings and Insurance
  • The Hot Hand
  • Accounting Anomalies
  • Appearance and Disappearance of Anomalies

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Sample Chapter(s)
Preface
Notes To Teachers
Lecture 1. Introduction: The History of Behavioral Finance and the Impetus for Its Emergence

--> Readership: MBA and PhD level students and instructors of behavioral finance, corporate finance and decision analysis. -->
Behavioral Finance;Rationality;Prospect Theory;Cognitive and Psychological;Efficient Markets;Market Anomalies;Limits to Arbitrage;Heuristics0 Key Features:

• This book is currently the only text book in behavioral finance (or one of the very few that exist)
• The book provides a balanced mix of theory and application and a well-adjusted blend of psychology and finance, with the ultimate goal of emphasizing the financial applications of all theories and concepts
• The book covers all of the essential applications of behavioral finance and some elective topics

Part I

Psychological and Financial
Foundations of Behavioral Finance

LECTURE 1

INTRODUCTION: THE HISTORY OF BEHAVIORAL FINANCE AND THE IMPETUS FOR ITS EMERGENCE

Agenda

What is Behavioral Finance?

The Topics we’ll Cover in the Course

The History of Behavioral Finance and the Impetus for Its Rise

Review of the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM)

Profitability Measures

Market Inefficiencies/Anomalies

CAPM Extensions and Multi-Factor Asset Pricing Theories

In this lecture, we will first explain what is the area of behavioral finance and we will then briefly describe the main topics to be covered in this course. Subsequently, we will discuss why and how this new area of finance evolved over time. To better understand the evolution of behavioral finance and its contribution to the more general field of finance, we will review the concepts of market efficiency, the capital asset pricing model (CAPM) and some more advanced pricing theories. I will also give a short review of some well-known stock market anomalies.

What is Behavioral Finance?

Behavioral finance is the area in finance that studies the intersection of finance and psychology and explores the effect of cognitive biases on the behavior of market participants, on the functioning of capital markets and on the prices of capital and other assets.

Behavioral finance is the fastest growing area in academic research in finance. It started its meteoric rise circa the mid-1980s and it is by now an important part of finance in investments and in corporate finance. Finance is a dynamic area and it has developed many sub-areas over time either because of new theoretical findings, market developments and legislation. For example, the market for options grew in the 1970s, in part, because of the theoretical advances in the pricing of options. Likewise, the area of behavioral finance was developed as a reaction to theoretical findings in psychology and to evidence from financial markets that did not sit well with market efficiency. These findings prompted the fusion of insights from the two distinct fields to create behavioral finance. The new area, as we shall see during this course, contributes considerably to the understanding of the behavior of capital markets and capital markets participants. Behavioral finance has many applications that help individuals, corporations, analysts, professional investors and legislators to make better financial decisions and to improve the functioning of capital markets.

Since behavioral finance explores biases, it may seem that it mainly points at activities that decision makers need to avoid. However, revealing the cognitive biases of decision makers and becoming aware of flaws in their judgments, allows us to find ways to overcome these biases and to design policies to improve financial decision making and the functioning of capital markets. Authors such as Ariely (2008, 2010), Kahneman (2011), and Thaler and Sunstein (2009), popularized behavioral finance by making the concepts of this area more accessible to academics, analysts, professional investors and laypeople.

List of the Topics Covered

Efficient Markets, Rationality and Utility Theory

Prospect Theory

The Disposition Effect

Overconfidence

Herding

Overreaction and Underreaction

The Risk Premium Puzzle and Loss Aversion

The Home Bias

Limits to Arbitrage

Market (investors) Sentiments

Biases in Savings and Insurance

The Hot Hand

Accounting Anomalies

Appearance and Disappearance of Anomalies

Although the list of topics is extensive, it does not exhaust all topics in behavioral finance. While this area is relatively new, it has become quite large, and covering all topics is not only prohibitive but also counterproductive. Instead, this course will cover the most important theories and issues. We will emphasize the broad significance of the psychological and financial concepts rather than go in detail over their statistical and theoretical fine points.

The History and Evolution of Behavioral Finance and the Impetus for Its Emergence

It is hard to pinpoint when exactly behavioral finance started, but its origins however can be traced to sometime in the mid-to late 1980s. During the 1970s and 1980s, there was a growing dissatisfaction and frustration in finance from the failure to deal with findings (anomalies) that did not match the Efficient Market Hypothesis (EMH) and the assumption of investors rationality. These anomalies in addition to numerous financial crises and well-documented bubbles (a bubble is an occurrence where the prices of assets rise without apparent reasons and eventually crash) posed a major challenge to main stream finance that extolled the EMH and investors rationality. Examples for bubbles and crashes that preceded the birth of behavioral finance abound, but we will mention only the following: The Dutch Tulip Mania aka “Tulipomania” of 1634–1637, the Stock Market Crash of 1929, the Mississippi Bubble (1716–1720), the Florida Real Estate Bubble of the 1920s, the savings and loan crisis of the 1980s and Black Monday — the Stock Market Crash of 1987 (which reinforced behavioral finance in its early days).

For brevity, we will go over just few of these phenomena: Tulips, because of their rarity and beauty became favorites of the Dutch high society and speculators in the 17th century, causing their prices to soar to “insanely” high levels. At some point, according to British journalist Charles Mackay (cited in Thompson, 2007), 12 acres of land were offered during that period for a Semper Augustus bulb. Some tulip bulb prices became worth the equivalent of tens of thousands of dollars (in current values) and many Dutch tulip speculators became fantastically wealthy. However, when prices fell to their “sane” levels many investors were ruined and Dutch commerce suffered a severe shock throwing the Netherlands into a mild economic depression that lasted for many years.

Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed. The Dow Jones Industrial Average (DJIA) fell by 22.61%, the largest one day percentage fall of the DJIA. There were no apparent reasons for such a crash, and despite the efforts of many researchers to explain this event, no explanation prevailed. Following the stock market crash, a group of 33 eminent economists from vari...

Table of contents

• Cover Page
• Title
• Copyright
• Dedication
• Preface
• Notes to Teachers
• Acknowledgments
• Contents
• Part I. Psychological and Financial Foundations of Behavioral Finance
• Part II. Applications of Behavioral Finance
• Readings by Chapters and References
• Index