Asset Mispricing: Inefficient Markets or Investors’ behavioral biases

Asset Mispricing: Inefficient Markets or Investors’ behavioral biases

Let me begin by asking you a question. How good a driver you are?  Most of us reply, above average to this question, does this mean we are overconfident of overoptimistic when doing a self assessment? There are two main implications of this analogy in investor confidence; Investors take bad bets because they fail to recognize that they are at an information disadvantage and they trade more frequently than is prudent, which leads to excessive trading volume.

LTCM members promoted their firm as an exploiter of pricing anomalies in global markets. But they accumulated huge loss over a period of time due to bad bets worsened by leverage. The basis of LTCM investment mythology was benefiting from markets mispricing, so does its failure suggest markets are indeed efficient or is it that Investors’ errors are the cause of mispricing?

Effects stemming from investor’s behavioral biases:

Winner Loser Effect

• Investors who rely on representativeness heuristic become overly pessimistic about past losers and overly optimistic about pas winners and that this instance of heuristic driven bias causes prices to deviate from fundamental value. Specifically pasty losers come to be undervalued and past winners come to be overvalued. But mispricing is not permanent over time the mispricing corrects itself. Then losers will outperform the general market, while winners will underperform
• In traditional finance, losers will be associated with higher returns because they are riskier than the average stock.

Effects stemming from conservatism

• Analysts who suffer from conservatism due to anchoring and adjustment do not adjust their earnings predictions sufficiently in response to the new information contained in earning announcements. Therefore they find themselves surprised by subsequent earning announcements. Unanticipated surprise is the hallmark of overconfidence
• Conservatism in earning predictions means that positive surprises tend to be followed by positive surprises and negative surprises tend to be followed by negative surprises

Effects stemming from Frame Dependence

• Does frame dependence have an impact on price efficiency?
• Answer is a strong yes, in the past loss aversion caused investors to shy away from stocks, therefore stocks earned very large returns relative to risk free government securities
• People might be less tolerant to risks whose magnitude is smaller than those described in the preceding question. When stake is smaller, people actually become more tolerant of risk not less tolerant.
• House money effect - After a market run up, the house market effect kicks in, raising investors’ tolerance for risk and lowering equity premium.

Departure from Fundamental Value: Short Term or Long term

• Heuristic driven bias and frame dependence can cause prices to deviate from fundamental values for long periods. There is more volatility in stock markets and bond markets than would be the case if prices were determined by fundamentals alone
• Prices move away from fundamental value for long periods but eventually revert