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Understanding Investor

Behavior – Biases and


Trading Strategies
Behavioral Judgment and Decision
Making

STUDENT ID - 19031977835
1. Introduction
Behavioral finance, use social, cognitive and emotional factors in understanding the
economic decisions of individuals and institutions performing economic functions,
including consumers, borrowers and investors, and their effects on market prices, returns
and the resource allocation. For this application report I have chosen to understand two
widespread phenomenon of over-reaction and under-reaction in stock market through the
prospective of behavioral decision-making.

2. Behavioral phenomenon
Stock markets are often time govern by sentiments rather than underlying fundamentals.
This often leads to irregularities that cannot be explained from rational prospective. The
pervasive irregularities are under-reaction and over-reaction.

Under-reaction - Under-reaction is a phenomenon where the good news such as good


earning news, share buybacks or dividend payouts are slowly incorporated into the stock
price. As a result the stock price does not truly reflect the price of the stock. A related
way to look this point is to argue that current good news has power in predicting positive
returns in the future. As per research from behavioral scientists shows that over the
horizons of perhaps one to twelve months, security prices under-react to good news.
Over-reaction - Over-reaction is a phenomenon where the stocks get over-priced after
they had a long record of good news. Put differently, securities with strings of good
performance received extremely high valuations and these valuations. These high
valuations suggest that future returns will be low. This also works the other way i.e., the
stocks get cheap after series of bad news such as negative earning surprises.

3. Explanation of Phenomenon - Cognition Prospective


The human judgment process is governed by heuristics and biases under uncertainty.
From the physiological prospective, there are certain biases that can explain the under-
reaction and over-reaction.
Representative bias - Representative bias is defined as the tendency to view events as
typical or representative of some specific class. When considering representative
heuristics human judgment tend to ignore the laws of probability and tend to rely on
similarity of the current event with the past events that subject has witnessed. In the stock
market, investors might consider some stocks as growth stocks based on history of
consistent earnings growth, ignoring the fact that there are very few companies that just
keep growing.
An important manifestation of the representative heuristic is that people tend to see
patterns in truly random sequences. Representativeness heuristic explains the
phenomenon of over-reaction. When a company has consistent history of earning growth
over several years accompanied by salient and enthusiastic descriptions of its products
and management, investors might conclude that the past history is representative of a
future earning growth potential. While a consistent pattern of high growth may be
nothing more than random draw of few lucky firms, investors see order among chaos and
infer that the firms profit continue to grow in future. As a consequence investors might
disregard the reality that earnings growth is unlikely to repeat itself. They will overvalue
the company and be disappointed in the future when the forecasted earnings fail to
materialize.
Conservatism bias - Conservatism bias is the tendency where person beliefs are slow to
change in the face of new evidence. Person under grip of conservatism bias tends to
update his belief in the right direction. However, the magnitude is too small compared
from the rational prospective- Bayesian benchmark.
Conservatism explains the phenomenon of under-reaction. Individuals subject to
conservatism might disregard the full information contents of the good news such as
good earning announcement, share buybacks or dividend announcements because they
belief that numbers contained in good news contains large temporary components. With
this belief they continue to support their prior estimates of earnings. Conservatism bias is
typically reflected in value stocks. In spite of consistent earnings growth and good
dividend payouts over the past few years, these stocks does tend to appreciate slowly as
compared to glamour stocks.
Mental Models - Wrong mental models also shape investors behavior. Stocks tend to
follow random walk. However, investors tend to ignore this fact. This ignorance is rooted
on human desire to find pattern in random sequences. Investor believes that the firms
earning does not move randomly but rather moves between two regimes (or states). These
false patterns give hope to the investors that they have found formula to beat the market.
There are two states that are described below:
Mean reverting state – In this state the earnings always trend around the mean value
(average value to company’s normal earning). This state implies that positive earning
shocks are more likely to be followed by negative earning shocks and vice-versa.
Conservatism bias can be explained by this state. An investor using this state to forecast
the earnings reacts too little to good news announcement leading to under-reaction
phenomenon.
Trending state – In this state positive earning shock is more likely followed by another
positive earning shock. Similarly negative earning shocks are more likely to be followed
by another negative shock. In this state the earning tend to follow the past trend.
Representative bias can be explained by this state. After the series of good news, an
investor uses this state to forecast future earnings. Since investor belief that stock is in
trending state they overprice the stock, leading to over-reaction phenomenon.

These mental models led investors to falsely belief that by seeing the patterns they can
beat the overall market. If the market just moves randomly then there is good chance that
these types of pattern appears often in different stocks from time to times. By falsely
believing that these stocks are following some patterns, investors are falling prey to their
flawed judgment and decision-making process.
In summary the under-reaction and over-reaction can be summarized by the following
table:
Table 1. Under-reaction and Over-reaction- biases and mental models
Behavioral Phenomenon Biases Investor Mental models
Under-reaction Conservatism Mean-reverting state
Over-reaction Representative Trending state

4. Explanation of Phenomenon - Bayesian Prospective.


As per Bayesian rule the prior probability along with likelihood of an event determines
the future probability of an event happening. Mathematically
Posterior probability (future probability) = prior prob. * likelihood

Prior probability is the investor’s belief that particular stock will not do well in future
and likelihood is conditional on this fact in the face of new evidence. Prior probability
can also be referred as weight because it determines the prior beliefs of how a particular
stock is going to perform in the market. Similarly likelihood can also be thought of as
strength of the new evidence i.e. how reliable is the new evidence.
Under-reaction happens when the individual is slow to change their belief when the new
evidence comes. This means they people put more emphasis on weight (base rate) rather
than on the strength of the new evidence (good earning announcement). Unimpressed by
the new evidence investors tend to assign low value to the strength and hence they react
mildly to the good news. So in under-reaction people do not sufficiently update their
beliefs about the new information.
Overreaction, on the other hand, occurs when individual put more value to strength (good
earning announcement) and low value to weight (base rate). People tend to belief that
past winning streak will continue in the future forever. Moreover, they also forget that
stock performance will regress to mean i.e. stock will perform poorly in future. This is a
typical case of base rate neglect because investors in their enthusiasm forget that very few
stocks will keep outperforming the market for long time.

Table 2: Probabilistic description of under-reaction and over-reaction


Likelihood (new
Prior (Base rate) Shortcomings
information)
Under-reaction Insufficient
High Low
(Conservatism) updating
Over-reaction
(Representativeness Low High Base rate neglect
)

4. Normative approach
Human abilities are not good at judging probabilities. Analytical tools can be used to de-
bias the probability assessment task and improve the decision making process. Two such
tools that can be used are: Bayesian decision-making and decision trees. Bayesian
approach has been discussed in previous section. By assigning subjective probability we
overweight or underweight the probability of an event. Instead that more objective
probabilities can be assigned to new information depending on how useful the
information is. These new probabilities combined with base rate can be used to figure the
correct probability of event happening.
The second analytical tool is a decision tree. A decision tree is a decision
support tool that uses a tree-like graph or model of decisions and their
possible consequences, including chance event outcomes, resource
costs, and utility. Decision trees will reduce the influences of biases in decision-
making. The decision trees can also help to account all the factors that can affect the
market prices of the stocks.

5. Important repercussions of these biases in investing


There are few important lessons in investing from these behavioral phenomenon. The
stocks with consistent record of good news are overvalued and that an investor can earn
good returns by betting against this overreaction. Similarly stocks with consistent record
of bad news became undervalued and that an investor can subsequently earn superior
returns by holding the stocks. Although some of these lessons are based on the premise
that sometimes investors are irrational and they send the prices of underlying securities
way out of what they should actually be worth. Moreover, these rules cannot be applied
blindly to all stocks that seem to exhibit typical behavior of under-reaction and over-
reaction. There are different trading strategies that can be developed to exploit these
behavioral phenomenon.
Momentum strategies - This group of strategies reflects the tendency of stock prices to
under-react to specific events. For example, when bad news (say, an unexpectedly low
earnings announcement) occurs for a specific stock, the stock price immediately falls, but
does not fall enough. On average, it will continue to go down in the next few months
(short-term trading strategy). A momentum strategy would hold long positions in stocks
that recently had good news, and short positions in stocks that recently had bad news.

Figure 1: data showing opening and closing price of Apple stock during earning
month for last 6 years.

To show how this trading strategy can be used, I collected some data on Apple stock
price of last 5 years. The data is collected only for the month when the earnings should be
announced (see DATA 1 in Appendix). There are only 6 quarters in last 24 quarters (6
years) when the monthly return is not positive. It was found that average return during
earning month is around 6.7%. So this implies that if investors buy the stock on first
trading day of earning month and sell the stock on last trading day of the same month,
they can earn on average 6.7% on their investment.
This data shows the typical under-reaction because moving into earning month the
investors does not update their estimate correctly (insufficient updating), sending the
price higher after good earning announcement i.e. investors tend to underestimate the
upcoming earning announcement. It is only after the good news they update their beliefs.
Contrarian strategies - The second category is contrarian type strategies, reflecting
mispricing that persist for many months or years. The contrarian effect is the fact that
over long periods of time, contrarian stocks (measured by price/book or some other
valuation ratio) outperform growth stocks. It reflects the fact that sentiment causes some
stocks to be overpriced (growth stocks) and some to be underpriced (contrarian stocks).
These types of strategies exploit the market over-reaction because betting against the
market optimism or pessimism; investors hope that future returns will be in their favor.
These types of strategies exploit the market over-reaction.
Contrarian opportunities often appear in stocks of good companies. One of the
opportunities arises during the height of recent financial crisis in Chevron stock. The
stock was trading at 100$ (Jul 08) when it drop to 60$ (Oct 08) along with other
commodities stock. The contrarian would have bought the stock then and enjoyed a
decent return till now when the prices are trading at 84$. The stock lost its appeal during
the crisis because everyone feared that global economy would go into deep recession,
leading to demand slowdown for oil companies.
Figure 2: Data showing opening and closing price of Chevron stock for last three
years.

6. Conclusions
Efficient market assumes that markets are rational and all agents take into account all the
available information before taking any decisions. However, as learned in this course, lot
of biases and heuristics play a critical role in human judgment process. Investors
make systematic errors in evaluating information. They may over-react
to dramatic news and under-react to mundane news. The under-
reaction is caused by conservatism bias and when investors failed to
update their beliefs after the good news. Similarly, over-reaction is
caused by representativeness bias and when investors belief that good
news will continue in the future, neglecting the base rate in the
process.
These behavioral patterns often result in mispricing of stocks that can
be exploited by various trading strategies. Some these strategies are
discussed in this paper. These strategies can be classified in two forms.
Momentum strategies assume that investor places the directional bet
that stock will continue to go down after bad news or it will continue to
go up after good news. These are short-term bets. The other trading
strategy is contrarian strategy in which investor take the contrarian
long-term view and buy the under-price securities and sell the
overprice securities. Different behavioral phenomenon and
corresponding biases, mental models and trading strategies are
summarized below:

Table 3: Summary of behavioral biases and trading strategies


adopted to exploit the biases.
Investor
Behavioral Trading
Biases Mental
Phenomenon Strategies
Models
Under- Mean-reverting
Conservatism Momentum
reaction state
Representativen Trending state
Over-reaction Contrarian
ess
APPENDIX
DATA 1: Stock price data for Apple from 2004-2010

Percentage
earning
change
(compared
Average from past
Month's Month's return for Earning prev. year
Date Open Close the month data quarter)
7/1/10 254.3 257.25 1.160047188 3.51 74.62686567
4/1/10 237.41 261.09 9.974306053 3.33 46.24624625
-
1/4/10 213.43 192.06 10.01265052 3.67 31.88010899
10/1/09 185.35 188.5 1.699487456 2.77 54.51263538
7/1/09 143.5 163.39 13.86062718 2.01 40.7960199
4/1/09 104.09 125.83 20.88577193 1.79 35.19553073
1/2/09 85.88 90.13 4.94876572 2.5 29.6
-
10/1/08 111.92 107.59 3.868834882 1.26 19.84126984
-
7/1/08 164.23 158.95 3.215003349 1.19 22.68907563
4/1/08 146.3 173.95 18.89952153 1.16 25
-
1/2/08 199.27 135.36 32.07206303 1.76 35.22727273
10/1/07 154.63 189.95 22.84162194 1.01 38.61386139
7/2/07 121.05 131.76 8.847583643 0.92 41.30434783
4/2/07 94.14 99.8 6.012322074 0.87 45.97701149
-
1/3/07 86.29 85.73 0.648974389 1.14 42.98245614
10/2/06 75.1 81.08 7.962716378 0.62 19.35483871
7/3/06 57.52 67.96 18.15020862 0.54 31.48148148
4/3/06 63.67 70.39 10.55442123 0.47 27.65957447
1/3/06 72.38 75.51 4.324399005 0.65 46.15384615
10/3/05 54.16 57.59 6.333087149 0.5
7/1/05 36.83 42.65 15.80233505 0.37
-
4/1/05 42.09 36.06 14.32644334 0.34
1/3/05 64.78 76.9 18.70947823 0.35
10/1/04 39.12 52.4 33.94683027
DATA 2: Stock price data for Coca-Cola from 2004-2010

Percentage
earning change
Average (compared from
Month's Month's return for Earning past prev. year
Date Open Close the month data quarter)
10/1/10 59.04 59.12 0.135501355
7/1/10 50.3 55.11 9.562624254 1.02 13.7254902
-
4/1/10 55.36 53.45 3.450144509 0.69 18.96551724
-
1/4/10 57.16 54.25 5.090972708 0.66 53.48837209
-
10/1/09 53.4 53.31 0.168539326 0.81 0
7/1/09 48.48 49.84 2.805280528 0.88 44.26229508
-
4/1/09 43.76 43.05 1.622486289 0.58 -9.375
1/2/09 45.4 42.72 -5.9030837 0.43 -17.30769231
-
10/1/08 52.62 44.06 16.26757887 0.81 14.08450704
-
7/1/08 51.92 51.5 0.808936826 0.61 -23.75
-
4/1/08 61.01 58.87 3.507621701 0.64 18.51851852
-
1/2/08 61.45 59 3.986981286 0.52 79.31034483
10/1/07 57.61 61.76 7.203610484 0.71 14.51612903
-
7/2/07 52.65 52.11 1.025641026 0.8 2.564102564
4/2/07 48.2 52.19 8.278008299 0.54 14.89361702
-
1/3/07 48.36 47.88 0.992555831 0.29 -19.44444444
10/2/06 44.9 46.72 4.053452116 0.62 14.81481481
7/3/06 43.2 44.5 3.009259259 0.78 8.333333333
-
4/3/06 42.1 41.96 0.332541568 0.47 11.9047619
1/3/06 40.79 41.38 1.446432949 0.36
-
10/3/05 43.21 42.78 0.995140014 0.54
7/1/05 41.96 43.76 4.289799809 0.72
4/1/05 41.83 43.44 3.848912264 0.42
-
1/3/05 41.9 41.49 0.978520286
10/1/04 40.48 40.66 0.444664032
-
7/1/04 50.51 43.86 13.16570976
4/1/04 50.48 50.57 0.178288431
1/2/04 50.8 49.24 -
3.070866142
REFERENCES
1) A model of investor sentiment – Nicholas Barberis, Andrei Shleifer and Robert
Vishny (1998)
2) Investor psychology and asset pricing – David Hirshleifer (2001)
3) Behavioral Finance and Wealth Management Michael Pompian – John Wiley and
Sons
4) Data from Yahoo finance