Behavioral finance Study Guide

📖 Core Concepts Behavioural finance – studies how psychology (biases, limited self‑control) shapes investor/analyst actions and creates market inefficiencies. Traditional finance – assumes rational agents, uses Modern Portfolio Theory (MPT) (expected return, risk = standard deviation, correlation) and the Efficient‑Market Hypothesis (EMH) (all public info already in prices). Central issue – why market participants repeatedly make systematic irrational errors that lead to price/return distortions. Cognitive vs. social biases – Cognitive (e.g., anchoring) tend to cancel out across many traders; social (e.g., herd behavior) can create feedback loops that push prices away from “fair” values. Anomaly requirement – for an observed pattern to truly contradict EMH, an investor must be able to trade it profitably after costs. Thaler’s price‑reaction model – three phases after news: underreaction → adjustment → overreaction (excessive move that later reverses). Market microstructure – how trading rules, order flow, quotes, and transaction costs shape price formation and can amplify behavioural effects. --- 📌 Must Remember Behavioural finance ≠ “all investors are crazy.” It identifies predictable biases that aggregate to affect markets. Efficient portfolio = highest expected return for a given risk (or lowest risk for a given return). EMH = no free‑lunch from public information; the best passive strategy is owning the market. Anomaly ≠ tradable profit – must survive transaction costs and be exploitable. Social bias → feedback loop → can sustain mispricings longer than cognitive bias alone. Price‑reaction phases: Underreaction – market initially ignores news. Adjustment – prices move toward the “correct” level. Overreaction – prices overshoot, later reverse. Key historic examples: 1987 crash, dot‑com bubble, Shiller’s Irrational Exuberance, Vernon Smith’s experimental markets. --- 🔄 Key Processes Evaluating an Efficient Portfolio (MPT) Estimate expected returns $E(Ri)$ and covariances $\sigma{ij}$. Form the portfolio variance $\sigmap^2 = \mathbf{w}^\top \Sigma \mathbf{w}$. Choose weights $\mathbf{w}$ that maximize $E(Rp)$ for a target $\sigmap$ (or vice‑versa). Applying Thaler’s Price‑Reaction Model Step 1: Identify news/event. Step 2: Observe market’s immediate price change (likely muted → underreaction). Step 3: Track gradual price drift as information is digested (adjustment). Step 4: Look for an exaggerated move beyond fundamentals (overreaction). Step 5: Anticipate reversal after overreaction peaks. Testing an Anomaly for EMH Violation Detect pattern (e.g., post‑earnings drift). Simulate a trading strategy that exploits it. Subtract realistic transaction costs and slippage. If net abnormal returns persist, the anomaly challenges EMH. --- 🔍 Key Comparisons Behavioural finance vs. Traditional finance Behavioural: focuses on psychology, predicts systematic errors. Traditional: assumes rational agents, markets always price information correctly. Cognitive bias vs. Social bias Cognitive: individual misperceptions (anchoring, loss aversion). Social: group dynamics (herding, contagion) → can create self‑reinforcing price moves. Underreaction vs. Overreaction Underreaction: price change smaller than news magnitude, gradual adjustment. Overreaction: price change exceeds news impact, later correction. EMH (strong) vs. Market inefficiency Strong EMH: even private info instantly incorporated. Inefficiency: observable patterns where prices deviate from fundamentals for a measurable period. --- ⚠️ Common Misunderstandings “All anomalies are exploitable.” Many fade after accounting for costs or are not repeatable. “Behavioural finance disproves EMH completely.” It highlights exceptions; markets can still be broadly efficient. “Social biases are just another kind of cognitive bias.” Social biases generate feedback loops that can sustain mispricings. “Overreaction means markets are always wrong after big news.” Overreaction is a phase; markets eventually correct, but timing matters. --- 🧠 Mental Models / Intuition Feedback Loop Model: Think of a crowd pushing a swing – each participant’s move amplifies the swing’s motion, creating larger swings than any single push would. Noise vs. Signal: Treat behavioural “signals” like a faint radio station; heavy “noise” (random events) can drown it out unless you filter carefully. Anchoring Anchor: Investors stick to the first price they see; adjust slowly → underreaction → later swing to new anchor → overreaction. --- 🚩 Exceptions & Edge Cases Anomalies that cannot be arbitraged because of high transaction costs, liquidity constraints, or regulatory limits. Social bias‑driven mispricings that persist during market stress (e.g., panic selling). Microstructure‑induced price jumps that look like behavioural overreactions but are purely mechanical (e.g., large block trades). --- 📍 When to Use Which Passive long‑run investing → rely on EMH, use market‑cap weighted index funds. Short‑term tactical trading → examine behavioural cues (herd sentiment, price‑reaction phases). Risk management → incorporate bias checklists (overconfidence, loss aversion) to avoid systematic errors. Regulatory analysis → focus on social‑bias feedback loops that could threaten market stability. --- 👀 Patterns to Recognize Sharp price spikes followed by rapid reversals → classic overreaction pattern. Gradual drift after earnings releases → underreaction → adjustment phase. Clustering of volatility around major news → may signal market‑wide behavioural response. Consistent deviation of price from fundamentals during bubbles → social bias feedback. --- 🗂️ Exam Traps Distractor: “Behavioural finance proves that markets are always inefficient.” → Wrong; it identifies situational inefficiencies. Distractor: “If an anomaly exists, anyone can profit from it.” → Ignoring transaction costs, liquidity, and risk‑adjusted returns. Distractor: “Cognitive biases are never observable in aggregate market data.” → Some aggregate effects (e.g., disposition effect) are documented. Distractor: “Overreaction always leads to a price drop of exactly the same magnitude as the overshoot.” → Reversals vary; magnitude depends on liquidity, sentiment, and subsequent news. ---