BehaviorAlpha

A maverick is an independent individual who does not go along with a group or party (courtesy of Merriam-Webster’s definition). In general, going against "the herd" usually means stepping out of the comfort zone, thereby putting yourself on the edge. Failing alone while everyone else achieves their results is far more painful than failing when everyone is failing with you. Similarly, in the financial markets, losing money during a bull run is much worse than losing money during a recession or a crisis. The idea of maverick risk is a compelling one. From a human behavioral standpoint, we are conditioned to think of being outside of the herd as risky. There is plenty of evolutionary logic behind this idea, considering that humans spent much of their existence as both predator and prey. There is safety in numbers. So as much as we know the value of thinking outside the box or being contrarian, and as much as we value and revere those in society who are capable of going it ...

The efficient market hypothesis suggests that whenever mispricing occurs, rational traders get an opportunity for low-risk profit. Riskless profit opportunities do not exist, or only for a noticeably short time because arbitrage will eliminate them. Similarly, you can assume that there are no 100-dollar bills on the pavement, or only for a very short time because someone will pick them up. But what if the best 100-dollar bills collectors (such as the arbitrageurs) are limited in their movements? It might become way more difficult to fully exploit this huge profit opportunity, and thus the bill (or part of it) will stay longer on the pavement. Limits to arbitrage describe how these rational traders are constrained as to how much they can profit from mispricing in the market. Lamont & Thaler (2003) ask if “the market can add and subtract”, and the answer is a clear NO. Their paper focuses on equity carve-outs of US technology stocks. An equity carve-out, also known as a p...

John Maynard Keynes (1936) argued that markets can fluctuate wildly under the influence of investors' “animal spirits,” which move prices in a way unrelated to fundamentals. After Keynes, many other authors have considered the possibility that a significant presence of sentiment-driven investors can cause prices to depart from fundamental values. The classic argument against sentiment effects is that they would be eliminated by rational traders seeking to exploit the profit opportunities created by mispricing. If rational traders cannot fully exploit such opportunities, however, then sentiment effects become more likely. Thus, we can easily say that sentiment plays an important role in asset pricing and it can affect the market. “Nowadays the question is no longer, as it was a few decades ago, whether investor sentiment affects stock prices, but rather how to measure investor sentiment and quantify its effects.” (Baker, Wurgler 2007) Measure the investor sentiment:...

Are bubbles consistent with rationality? If they are, do they, like Ponzi schemes, require the presence of new players forever? Economists and financial market participants often hold quite different views about the pricing of assets. Economists usually believe that given the assumption of rational behavior and of rational expectations, the price of an asset must simply reflect market fundamentals. Market participants on the other hand, often believe that fundamentals are only part of what determines the prices of assets. Extraneous events may as well influence the price, if believed by other participants to do so; crowd psychology (such as “herd behavior”) becomes an important determinant of prices. Technically, a bubble is an economic event in which the prices of speci fi c assets rise dramatically and increase beyond their fundamental value. In general, bubbles are viewed as outbursts of irrationality — self-generating and self-sustaining waves of optimism that drive up asset...

We are generally overconfident; that is, we tend to overestimate how much we know. People often overestimate their ability to predict future events, trust their knowledge more than they should, and believe they have a greater influence on random outcomes than they actually do (so called “ illusion of control ” bias (Langer 1975)). In addition, the overconfidence phenomenon can be reinforced by cognitive biases such as the " self-attribution ” bias, where individuals attribute their successes to their own abilities and blame failures on bad luck, and the " hindsight bias ", where people believe they predicted an event after it has already occurred. (Barberis and Thaler, 2003). Illustrating overconfidence in one’s own skills, and possibly optimism as well, Svenson (1981) finds that 82% of a sample of students placed themselves among the top 30% safest drivers. Overconfidence has also been documented among experts and professionals, including those in the finance pr...

This article is completely based on Huberman, Regev 2001 - Contagious Speculation and a Cure for Cancer: A Nonevent that Made Stock Prices Soar One of the main assumption in classical Efficient Market Hypotesis is that an asset should trade at the risk-adjusted present value of its expected future cash flow. Rational investors form beliefs on these expected future cash flows, and as soon as new information are available, they change their beliefs and price adjusts. This paper study the case of biotech company “EntreMed” (ENMD), and its related disruptive news reporting a recent breakthrough in cancer research for which ENMD owned licensing rights. In this case-study, two main behavioral economics findings are well analyzed: the framing effect and (positive) contagion. FRAMING EFFECT In November 1997 the news had been firstly published as a scientific piece in Nature and in the popular press. The closing price of ENMD was 11.875 on November 26, and on November 28 it was 15.25; thus, the...