Investigation On Behavioral Finance And Market Anomalies Finance Essay

Investigation On Behavioral Finance And Market Anomalies Finance Essay

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The aim of this paper is to provide any academic evidence and theories concerning the main drivers of individual investors' decision making and their reasons to feel confident over the success of active fund management. Our report weighs against the evidence of rational and measurable explanations supporting active managers and their stock picking skills. Not underestimating the power of communication, there is a provision of research studies to show how media and advertising are employed in selling managers' superior skills and their affect on investors' decision making. Next the report tries to understand and solve the puzzle about investors' beliefs in managers' adding value. For this purpose there is reference on the behavioural finance implications and some of the heuristics and biases that can enrich the explanation for most of the investors' behaviour.

2. Rationality

2.1. The benefits from fund managers

Investors' decision to invest in active funds is primary driven by the benefits of large scale investing. Bodie et al. (2008) identified several important functions that allow small investors to benefit from "teaming up" their money. Such are the record keeping and administration, diversification, professional management and the lower transaction costs as result of trading in larger blocks of securities.

In addition, investors argue that the market is a supply pool of managers with different investing styles and that some of them can outperform the index while others cannot. Platinum Capital fund for example, managed by Kerr Neilson, outperformed MSCI world stock index by 35% in 2009. The fund's strategy was based on investing in financial distress companies but with large unexploited potentials for future growth as well as going short on mining companies which he identified as overpriced. Neilson believes that fund's success is due to the quality research that avoids "noisy" public information (Boyd, 2009).

Most of the success in active management is a result of momentum investment strategy that takes long positions on securities which is believed to continue to rise in price and short positions in securities which it is expect to have a downtrend (Chen et al., 2000). Fund managers are knowledgeable to use sophisticated software programs that enables them to perform more precise risk analysis and to enhance their stock picking skills (Barber and Odean, 2008). The same paper suggests that in contrast to regular investors, fund managers are less prone to biases that affect decision making meaning also that they are not attention driven. Cici (2005) suggests that managers get aware of their gains less readily than the case of losses. Quite the opposite, investors do not exhibit any stock picking skills and there is evidence that in total the stocks they buy underperform those they sell (Odean, 1999).

2.2. Managers' persistence

On the other hand, a popular fund like the Long Term Capital Management Fund is an example that concentrated brainstorming power does not necessarily mean that abnormal returns even though achieved, can persist. Little academic evidence is supporting the outperformance of active fund managers. Wermer (2000) backs the momentum strategy. More specifically, his research shows that fund managers can beat the market by 1.3% annually only without accounting for trading costs. However, including the trading costs there is an underperformance of 1% annually. Carhart (1997) observed the performance of equity funds and examined whether funds that have done well will continue to have the same performance in the next period as a result of managers' skills. His study provides evidences that funds' performance does not reflect managers' picking skills and concludes that "investment costs account for almost all of the important predictability in mutual fund returns" (Carhart, 1997, pp. 81). The same paper gives valuable guidelines for investing in funds. According to its findings, investors should be aware that no load funds always outperform load funds and should avoid managers who often rebalance their portfolio since portfolio turnover reduces the fund's performance. Moreover, Bodie et al. (2008) indicate that high portfolio turnover rate can also be tax inefficient. Regarding the momentum strategy, Carhart characteristically claims that some funds can earn higher returns the following year due to pure luck of holding large positions in last years' "winners". Finally, Chen et al. (2000) suggest that the evidence of persistence concerning past winners over past losers is weak.

3. Irrationality

Statman illustrates irrationality by comparing traditional and behavioural finance approaches: "people are rational in standard finance; they are normal in behavioural finance. Rational people care about utilitarian characteristics but not value-expressive ones, and never confused by cognitive errors, have perfect self-control, are always risk averse, and are never averse to regret. Normal people do not obediently follow that pattern" (Statman, 1999, pp. 26). It is clear according to the academic evidence that active mangers provide little or no economic value to investors. Surprisingly however mutual fund industry continues to attract more investors, managing around 1.72 trillion dollars (HedgeFund Intelligence, 2009). What are the drivers of such irrationality?

3.1 Investors' characteristics

Acknowledging their own imperfections is one of the key reasons why investors rely on fund managers. Simon (1978) states that investors present imperfect control and bounded rationality over the uncertain and continuous changing market environment and make final decisions as a result of judgemental errors. Investors are not capable to handle efficiently enormous load of information. Walker (1971) argues that each investor has a certain capacity and upper limit of accumulating information, after which all new information is completely ignored. This indicates that decisions are drawn randomly in an irrational way. Overloaded with information, they tend to follow the financial media that direct their choices.

3.2. Advertising

Advertising seems to work. Investors irrationally focus on advertisements since it appears that funds that have been advertised have more liquidity and attract more individual investors (Jain and Wu, 2000). The media often names fund managers as "the new masters of the universe" which can result in investors believing that superior investing abilities can be achieved through fund managers (Mackintosh, 2007).

Sendhil et al. (2008) examined the logic behind the success of mutual fund industry in a situation where industry adds little to investors' wealth and charges them high. Their research showed evidence that individuals "think coarsely"; more concrete investors that tend to categorize situations according to their own beliefs and use same conclusions for each category. They evidence significant influence of persuasion and advertising on coarse-thinking. Using data of all financial advertisements in "Business Week" (BW) and "Money" they find out that after the market crash, past return data vanish from advertisements, as shown in figure 1. Moreover, in spite of this selective data approach, in downturn market even funds with good performance choose not to advertise themselves. This finding is in line with their model's predictions meaning that enclosure of past return data is used in purpose of selling opportunities, rather than promoting professional advice services or skills.

Figure 1: Stock Mutual Fund Ads Returns / Total Stock Mutual Funds Ads [1] 

3.3. The role of biases and heuristics

The attention grabbing events are often able to drive investors' interest and affect their investment decision. Barber and Odean (2008) name such events: any unusually large trading volumes, prior day movements to the stock price or certain media news. Taffler (2002) suggests that the availability heuristic and the familiarity bias are to be blame for noise trading. The representative heuristic works in accordance to the existence of stereotypes. Investors tend to believe that a good company can be a good investment. Accordingly a good manager can generate great returns. Decisions based on gut feelings are due to the affect heuristic. Concerning biases, investors exhibit behaviour that can be explained on the framework of framing judgemental biases and confirmation biases (Taffler 2002). As for the first, their judgements are based on the way information is presented. As for the second investors will seek for confirming evidence to support their decisions and will neglect any opposing argument.

Despite mutual fund managers' advanced or not investment characteristics, Taffler (2002) suggested that fund managers are also prone to similar cognitive errors, biases and heuristics with investors. More often is the case for fund managers being overconfident and overoptimistic to believe that they have "superior investing abilities".

4. Conclusion

Stock valuation and investment decisions are difficult tasks to be actualized with success. Primarily, financial markets are complex and uncertain, continuously change and are affected by multiple variables. Secondly, investors prove to behave in an irrational manner using mental shortcuts and are subjected to various biases. Investing is often directed by the financial media or relied to fund managers that are supposed to have a more rational behaviour. Our report provides evidence that although investors might have reason to believe fund managers, the actual performance of the latter cannot yield returns that could beat the market by accounting for all costs in a consistent basis. It is therefore the investors' characteristics that lead to have such a rationale and at a lower degree any external factors like the press and advertisements.

References

Barber, B.M. and Odean, T. (2008), 'All that glitters: The effect of attention and news on the buying behaviour of individual and institutional investors', Review of Financial Studies, Vol. 21, No. 2, pp 785-818.

Bodie, Z., Kane, A. and Markus, A.J. (2008), Investments, McGraw-Hill, New York.

Boyd, T. (2009), 'How Australia's richest fund manager beat the market', smartcompany.co.au, August 13 2009, available on the internet at http://www.smartcompany.com.au/index.php?option=com_content&task=view&id=34279&Itemid=27&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+smartcompanynews+(SmartCompany+News).

Carhart, M. (1997), 'On Persistence in Mutual Fund Performance', Journal of Finance, Vol. 52, No. 1, pp 57-82.

Chen, J.L., Jegadeesh, N. and Wermers, R. (2000), 'The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers', Journal of Financial and Quantitative Analysis, Vol. 35, pp 343-368.

Cici, G. (2005), 'The Relation of the Disposition Effect to Mutual Fund Trades and Performance', Working Paper.

HedgeFund Intelligence (2009), 'Global Review Autumn Update', InvestHedge Magazine, available on the internet at http://www.hedgefundintelligence.com/ih/Article.aspx?Task=Report&IssueID=73357.

Mackintosh, J. (2007), 'Investors Still Pile In', FT.com, April 27 2007, available on the internet at http://search.ft.com/search?queryText=Investors+Still+Pile+In%E2%80%99.

Sendhil, M., Schwartzstein, J. and Shleifer, A. (2008), 'Coarse thinking and persuasion', Quarterly Journal of Economics, Vol. 123, Issue 2, pp 577-619.

Simon, H.A. (1978), 'Rational decision making in business organization', Nobel Memorial Lecture.

Statman, M. (1999), 'Behavioural Finance: Past Battles and future engagement, Association for investment management and research', Financial Analysts Journal, Vol. 55, No.6, pp15-29.

Taffler, R.J. (2002), 'What Can We Learn From Behavioural Finance', Management Focus, pp 8-11.

Walker, J.F. (1971), 'Decision-making under conditions of information overload: Alternative response modes and their consequences', presented at American Educational Research Association Annual Meeting, New York, pp 4 -7.

Wermers, R. (2000), 'Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses', Journal of Finance, Vol. LV, No. 4, pp 1655-1695.

Assignment - Topic 2

Summarise and critically discuss the empirical findings of "post earnings announcement drift" anomaly in international level.

1. Introduction

Since Ball and Brown (1968) identified the post earnings announcement drift (PAD), various other research papers have examined the phenomenon. The aim of this paper is to summarize empirical findings of PAD on a multinational point of view. A crucial research conducted by Fama (1998) although gives reasons for the efficient market hypothesis to be valid, admits that it could be challenged by accounting for the PAD phenomenon. Mendenhall (2004) states three key categories of explaining PAD. First, any unexpected earnings changes might simply be due to the use of different research methods. The second explanation supports the idea of systematic misinterpretation concerning expected returns coming from market expectations following earnings announcements. The third explanation supports the behavioural finance perspective. Many studies imply that PAD is a product of irrational investors and inefficient markets. Interestingly, none of the aforementioned explanations can accurately predict why markets are not reacting to publicly available information, like earnings announcement in a timely way.

2. What is the Post Earnings Announcement Drift

To get a clear understanding of the phenomenon most of the studies look into PAD phenomenon in phases. Initially, the impact of the earnings announcement results in stocks' moving towards new price level. Then the drift in prices makes its presence. This lasts for approximately two months counting from the earnings announcement day. Finally, one more significant adjustment is made around the following announcement concerning next quarter's earnings. Bernard and Thomas (1989) highlighted that the phenomenon could be translated as a portion of price change being lagged in following new information.

The research work of Lev and Ohlson (1982) and Bernard and Thomas (1990) concluded that the PAD is inconsistent to the fundamental Capital Asset Pricing Model (CAPM). The reason is that CAPM is not able to capture the drift. If the CAPM represents a mechanistic tool of pricing stocks, such a drift would be impossible for the CAPM to predict. The papers also provide additional evidence to suggest that the PAD is incompatible with the EMH.

3. Methodology of PAD

The traditional paper of Bernard and Thomas (1989) captures the PAD using the following methodology. There is a formation of portfolios on the basis of the extent and whether the sign of the earnings surprises is positive or negative. The announcements concern for quarterly earnings. Next a comparison is run on actual market prices of stocks and the prices that have been derived using fundamentals. Accordingly any difference between the two prices resulting from a divergence is documented. Therefore all portfolios that present positive earnings surprises are found to have a positive drift in relation to the normative price prediction. In contrast to this, all portfolios that present negative earnings surprises have a negative drift under the normative price prediction. In addition, "the amount of the drift is found to be monotonically positive for increasing positive earnings surprise portfolios and monotonically negative for increasing negative earnings surprise portfolios" (Zhao, 2008, pp. 23).

4. Research in International Level

4.1. Spanish Market

Forner and Sanabria (2008) checked for the existence of PAD in the Spanish stock market using a sample that consisted of 172 firms dating from 1992 to 2003. The researchers have applied certain unconditional adjustments both to the CAPM and the Fama and French three factor model. Specifically they added a liquidity factor in order to control for size and book-to-market ratios as well as with a view to control for any momentum impact. Forner and Sanabria employed SUE and REV [2] measures on their effort to test PAD existence. The research findings of the paper showed that in the Spanish stock market, the suggested PAD strategy could offer significant gains over the months that follow the earnings announcements. These findings are robust for SUE and REV. In addition the phenomenon is tested against Jegadeesh's (1993) momentum hypothesis to check whether the PAD can explain much of momentum. For this test the findings proved also to be robust and therefore strengthened the impossibility of a risk-based explanation in line with the EMH. Moreover there is a clear suggestion that the PAD is more likely to be a result of investors' under reacting or overreacting on earnings announcements. This behaviour can be explained within the framework of behavioural finance were investors are prone to several biases and psychological pitfalls. This explanation is in line with Bloomfield (2000) where it is suggested that PAD is driven by the overwhelming overconfidence that investors believe to holding valuable and accurate information.

4.2. Finnish and Swiss Market

Kallunki (1996) based his research on the behaviour of the stock market when having earnings announcements. For this purpose he employs a method to estimate risk using a sample made of Finnish companies in order to prove whether any possible market reaction delays are varying significantly across positive and negative unexpected earnings. Any significance of the results is interpreted as employing wrong measuring methods of abnormal returns. Geoffrey et al. (2006) paper is a study on whether the PAD is sound when dealing with non institutional trades. The data employed is from the stock market of Helsinki for the period 1996 to 2000. The main finding is that the positive news concerning extreme earnings and their resulting returns are positively correlated. The same holds for negative earnings. They have also show a significant correlation due to PAD.

As for the Swiss market the research paper of Isakov and Christophe (2005) investigated the acute volatility observed around the days of an earnings announcement. The hypothesis developed was of a decreasing volatility once the announcements of earnings were set out. It appeared however that the volatility changes were related to the type of news. Lakshmanan (2007) provides additional evidence that when an earnings announcement as an information is being broken down into more news can generate surprisingly higher returns when compared to cases where the news where announced once and concentrated. Such a finding is in line with the under reaction explanation of the PAD phenomenon.

4.3. Hong Kong Market

Zhao's (2008) research emphasized on two things: on the way prices are distributed as a result of their reaction to news and on further changes in prices. These two are believed to be able to generate significant explanations concerning the analysis of PAD. The paper is sampling the stock market of Hong Kong through the period 1987 till 2006. The key finding following SUE methodology was that the PAD is a robust phenomenon to that specific exchange as well. Furthermore, the study highlights the need to have more emphasis on negative stock prices reflections on earnings announcements. That is because according to Zhao such an emphasis can undermine significantly the vastly reported under reaction explanation of PAD. Another main point of the paper is that "non-earnings information" can be valuable in affecting reactions of stock prices and therefore drifting them further. Finally Zhao finds that hedging strategies that based on "non-earnings information" could yield abnormal returns on long periods. As a result in Hong Kong market "the corroboration effect between earnings and non-earnings information is significant" (Zhao, 2008, pp. 53).

4.4. US Market

Abnormal returns after an earnings announcement are examined by Pope (1996). He argues that PAD and the bid-ask spread are strongly correlated and abnormal returns are due to the arbitrage opportunities produced from the market inefficiency. Bernard and Thomas (1989) also documented abnormal returns of 18% per annum which persist for minimum six months. In this direction, they found that expectation of future earning to match last year's quarter earnings will be reflected in the stock price. Moreover, the paper indicates that market participant may under react to the earnings news due to the transaction and information costs. Sadka (2005) took into consideration liquidity risk and argues that PAD returns can be viewed as risk compensation created from the unpredictable shifts in the aggregate ratio of informed traders to noise traders. Garfinkel and Sokobin (2008) argue that there is a significant positive correlation between PAD and unexplained friction of the trading volume, indicating on existence of deviation among investors' opinions.

5. Conclusion

The review of aforementioned research papers shows that PAD as a robust phenomenon has international dimension, with its presence documented not only in mature stock markets such as US and Europe, but as well in emerging markets such as Hong Kong and China. Two aspects of PAD draw most of the attention among the academics. Main focus is put on the absence of comprehensive framework about PAD as result of various interpretations of the current earnings' impact towards the future earnings. Moreover, market participants do not posses predictive power to future abnormal returns based on earnings announcement, and have little understanding that returns are considered to follow a random walk. Transaction costs also contribute investors to lag in their response to the PAD. The other focus is on the behavioural finance where most researchers concluded that PAD results from deviations in investors' behaviour, such as overconfidence and self attribution. Thus, investors will rather rely on their own private information than publicly available information, resulting in overreaction or under reaction to the stock markets.