In the investment decision process, an investor must decide on how much he wants to con- sume, safe and what portfolio of assets he prefers to hold. Asset prices and trading decisions, therefore, rely on investor preferences. In this connection, the expected utility model is most commonly referred to the major theory on decision-making under risk, given the individual's preference. Von Neumann and Morgenstern (2007) developed the expected utility framework, which represents an individuals’ utility function if the preferences satisfy four distinctive axi- oms (completeness, continuity, independence, and transitivity).
Due to the systematic violation of the axioms, found in the empirical studies on the expected utility framework, a number of non-expected utility theories evolved. These descriptive (how the world looks like) studies aimed to answer the questions that normative (how the world should look like) models failed in. In the financial literature, one of the most relevant descrip- tive theories of decisions under risk is the so-called “prospect theory” by Kahneman (1979). The prospect theory claims that investors tend to sell winners and hold on to losers which contradicts the suggestions of classical theories. The authors describe, in particular, two stages involved in the decision process. The first “editing” stage describes the framing of choices by
This figure shows the value function by Tversky and Kahneman (1981), p. 454.
decision makers regarding potential gains and/or losses in relation to a fixed reference point. In the second “evaluation” stage, decision-makers evaluate the choice based on an S-shaped utility function, which is shown in Figure 2-4. The concavity in the gains region and the con- vexity in the loss region displays the risk-aversion (risk-seeking) in the gains (loss) region (Kahneman, 1979). The prospect theory, shortly, concludes that an investor facing a price de- cline (the reference point) in his asset, chooses in an equiprobable situation of further losses or the limitation to the realized loss, the riskier option. In the hope that prices recover, the investor clings to loser stocks but is, on the other hand, disposed to sell winners (Shefrin and Statman, 1985). The greater sensitivity to losses than to gains is referred to “loss aversion” (Barberis and Thaler, 2003). Another closely related phenomenon is the disposition effect by Shefrin and Statman (1985). The authors suggest that investors tend to sell winners to quickly and hold on losers too long. The prospect theory is in their model an elementary foundation for this behavior next to the concepts of mental accounting, aversion to regret, and self-control.11
This section provided insights on how investor beliefs and preferences potentially lead to irrational trades. These irrational trades might occur in the form of patterns or so-called market anomalies that might repeat in history. The concepts on belief formation and preferences of
11 Please refer to Shefrin and Statman (1985), p. 779ff, for details on the disposition effect.
decision making are, thus, the foundation for the existence of market anomalies. We briefly describe the most common market anomalies that are relevant for this dissertation in the fol- lowing section.
Market Anomalies
The Efficient Market Hypothesis and the Capital Asset Pricing Model gave rise to the promi- nent view on rationally priced securities under uncertainty. Consequently, higher returns are inevitably related to higher compensation for risks. Price deviations that cannot be explained by systematic risk must, hence, result from model misspecifications. However, various studies in the finance literature have observed a number of corporate financing and return patterns, so- called anomalies, that earned higher returns than justified by the underlying systematic risk (Shleifer and Vishny, 1997). Fama and French (1998) explain these observations with chance deviations from rational pricing in the short run.
Daniel et al. (1998), yet, stress the disagreement amongst researchers on the interpretation of asset mispricing and associated return predictability out of such patterns. He summarizes the most common market anomalies as follows: “1. Event-based return predictability (public- event-date average stock returns of the same sign as average subsequent long-run abnormal performance); 2. Short-term momentum (positive short-term autocorrelation of stock returns, for individual stocks and the market as a whole); 3. Long-term reversal (negative autocorrela- tion of short-term returns separated by long lags, or "overreaction"); 4. High volatility of asset prices relative to fundamentals; 5. Short-run post-earnings announcement stock price "drift" in the direction indicated by the earnings surprise, but abnormal stock price performance in the opposite direction of long-term earnings changes.” (p. 1839-40).
These anomalies are potentially the result of preparatory, cognitive-influenced investment processes based on the beliefs and preferences discussed in Section 2.5. Ramiah et al. (2015) summarize the general links between the psychological concepts of beliefs and preferences with market anomalies in Figure 2-5. Common critiques on behavioral related explanations of asset prices enumerate the nearly unrestricted universe of behavioral patterns and the limited out-of-sample explanatory power of the models (Daniel et al., 1998). In search of the “correct” asset pricing model, a vast amount of literature evolved on risk factor and behavioral-related
This figure by Ramiah et al. (2015), p. 92, depicts the connections between individual psy- chological concepts and their resulting market anomalies. The rectangles contain the beliefs and preferences whereas the circles describe the market anomalies.
asset pricing models. As a result, Cochrane (2001) coined the term “factor-zoo” to describe the bulk of literature aiming to explain the cross-section of returns. In this section, we provide a brief overview of the most prominent and, for this dissertation, most relevant market anoma- lies: Over- and underreaction, excessive volatility, and momentum.
Overreaction Excessive Volatility Momentum Panics and Crashes Underreaction Holding Losers too Long Selling Winners too Quickly Overconfidence Conservatism Anchoring Availability Confirmation Representativeness Belief Perseverance Herding Disposition Effect