Behavioral Finance

EDWIN T. BURTON is a Professor of Economics at the University of Virginia, where he has taught behavioral finance to more than 1,800 students in the past six years. He is an active investment consultant for pension funds and endowments and is a Trustee of the Virginia Retirement System. Burton's Wall Street history includes senior positions at Smith Barney, Rothschild Inc., and Interstate/Johnson Lane. He has been an economics professor since 1969 including eleven years on the faculty at Cornell University. Burton currently serves on two public company boards (SL Green Realty Corporation and Virginia National Bank) and numerous private company boards. He first joined the faculty at the University of Virginia in 1988. Burton received his doctorate from Northwestern University in economics and his undergraduate degree in economics from Rice University. SUNIT N. SHAH's experience in finance includes seven years of financial modeling for Life Settlement Consulting and Management, a position at Stanfield Capital Partners modeling movements of credit spreads, and corporate finance analysis at the Boston Consulting Group for a billion-dollar household products company. Prior work also includes founder's roles in both a dot com and a financial start-up as well as consulting for firms such as Investure, LLC and the CFA Institute. Over the past ten years, Shah has taught a number of introductory, intermediate, and advanced undergraduate economics courses in microeconomics, statistics, and finance. Shah received his doctorate in economics as well as his bachelor's in mathematics and economics from the University of Virginia.

• Preface xiIntroduction 1Part One Introduction to Behavioral FinanceChapter 1 What Is the Efficient Market Hypothesis? 5Information and the Efficient Market Hypothesis 6Random Walk, the Martingale Hypothesis, and the EMH 8False Evidence against the EMH 11What Does It Mean to Disagree with the EMH? 13Chapter 2 The EMH and the “Market Model” 15Risk and Return—the Simplest View 15The Capital Asset Pricing Model (CAPM) 18So What Is the Market Model? 23Chapter 3 The Forerunners to Behavioral Finance 25The Folklore of Wall Street Traders 26The Birth of Value Investing: Graham and Dodd 28Financial News in a World of Ubiquitous Television and Internet 29Part Two Noise TradersChapter 4 Noise Traders and the Law of One Price 33The Law of One Price and the Case of Fungibility 33Noise 38Chapter 5 The Shleifer Model of Noise Trading 43The Key Components of the Shleifer Model 44Results 49Why the Shleifer Model Is Important 50Resolving the Limits to Arbitrage Dispute 51Chapter 6 Noise Trading Feedback Models 53The Hirshleifer Model 53The Subrahmanyam-Titman Model 58Conclusion 62Chapter 7 Noise Traders as Technical Traders 65Technical Traders as Noise Traders 67Herd Instinct Models 72Conclusion 76Part III AnomaliesChapter 8 The Rational Man 81Consumer Choice with Certainty 81Consumer Choice with Uncertainty 84The Allais Paradox 90Conclusion 92Chapter 9 Prospect Theory 93The Reference Point 93The S-Curve 94Loss Aversion 96Prospect Theory in Practice 98Drawbacks of Prospect Theory 98Conclusion 100Chapter 10 Perception Biases 101Saliency 101Framing 103Anchoring 106Sunk Cost Bias 108Conclusion 109Chapter 11 Inertial Effects 111Endowment Effect 111Status Quo Effect 116Disposition Effect 119Conclusion 120Chapter 12 Causality and Statistics 123Representativeness 123Conjunction Fallacy 127Reading into Randomness 129Small Sample Bias 131Probability Neglect 133Conclusion 134Chapter 13 Illusions 135Illusion of Talent 135Illusion of Skill 138Illusion of Superiority 139Illusion of Validity 141Conclusion 142Part IV Serial CorrelationChapter 14 Predictability of Stock Prices: Fama-French Leads the Way 147Testing the Capital Asset Pricing Model 147A Plug for Value Investing 149Mean Reversion—The DeBondt-Thaler Research 151Why Fama-French Is a Milestone for Behavioral Finance 152Chapter 15 Fama-French and Mean Reversion: Which Is It? 155The Month of January 155Is This Just About Price? 157The Overreaction Theme 157Lakonishok, Shleifer, and Vishny on Value versus Growth 158Is Overreaction Nothing More Than a “Small Stock” Effect? 159Daniel and Titman on Unpriced Risk in Fama and French 164Summing Up the Contrarian Debate 165Chapter 16 Short Term Momentum 167Price and Earnings Momentum 167Earnings Momentum—Ball and Brown 168Measuring Earnings Surprises 170Why Does It Matter Whether Momentum Is Price or Earnings Based? 173Hedge Funds and Momentum Strategies 174Pricing and Earnings Momentum—Are They Real and Do They Matter? 174Chapter 17 Calendar Effects 177January Effects 178The Other January Effect 180The Weekend Effect 181Preholiday Effects 182Sullivan, Timmermann, and White 183Conclusion 184Part V Other TopicsChapter 18 The Equity Premium Puzzle 187Mehra and Prescott 187What About Loss Aversion? 190Could This Be Survivor Bias? 191Other Explanations 192Are Equities Always the Best Portfolio for the Long Run? 193Is the Equity Premium Resolved? 194Chapter 19 Liquidity 195A Securities Market Is a Bid-Ask Market 196Measuring Liquidity 197Is Liquidity a Priced Risk for Common Stocks? 199Significance of Liquidity Research 200Chapter 20 Neuroeconomics 201Capuchin Monkeys 201Innateness Versus Culture 203Decisions Are Made by the Brain 203Decisions versus Outcomes 205Neuroeconomic Modeling 206More Complicated Models of Brain Activity 208The Kagan Critique 208Conclusion 209Chapter 21 Experimental Economics 211Bubble Experiments 212Endowment Effect and Status Quo Bias 215Calendar Effects 216Conclusion 216Conclusion And the Winner Is? 217The Semi-Strong Hypothesis—Prices Accurately Summarize All Known Public Information 217Can Prices Change if Information Doesn’t Change? 219Is the Law of One Price Valid? 220Three Research Agendas 221The Critics Hold the High Ground 223What Have We Learned? 223Where Do We Go From Here? (What Have We Not Learned?) 227A Final Thought 230Index 231