Behavioral finance

When considering the anomalies and their explanations, theory and former studies mentioned in the literature review often refer to behavioral factors as being one reason behind deviations from market efficiency. Ultimately what this means is that if we can consider all individual investors to be rational and weigh properly their investment decisions with all available information, deviations would not exist. However, often this is not the case. Investors tend to make irrational decision when it comes to allocating their funds. This irrationality has given rise to behavioral finance. Behavioral finance attempts to answer the questions regarding investor behavior, capital allocation and risk-adjusted differences in stock returns. In the context of this research, behavioral factors may accelerate fundamental anomalies and seasonalities inside these anomalies or even in some instances incrementally

generate them. This section offers a holistic view on behavioral factors that may be behind nested anomalies.

3.2.1. Limits to Arbitrage

In behavioral finance, deviations from fundamental value of stock are caused by the presence of investors who are not fully rational. Basic question is, why anomalies exist and why are they not eliminated by arbitrageurs? Limits to arbitrage describes the constraints and limitations arbitrageurs face. These factors may result in a situation where arbitrageurs fail to bring prices close to the intrinsic or fundamental values described by standard models. In a way, limits to arbitrage can be viewed as a force that prevents rational investors to fully exploit these deviations from fundamental value and adjust the mispricing. As Warren Buffett concludes: “Markets can stay irrational longer than you can stay solvent.”

(Hämäläinen & Oksaharju, 2016)

Leverage constraints faced by arbitrageurs may be one driving force, that keeps the prices from adjusting. Arbitrageurs are faced with risk driven by irrational investor, which is that prices may not adjust to fundamental values in time for arbitrageurs, which may lead to situation where arbitrageur faces margin call because of the leverage. Therefore, it creates constraint for leveraging of arbitrageurs because of the risk of losses. Furthermore, as irrational investors noise-traders may cause fluctuations in stock price that could result in more substantial mispricing rather than closer to fundamental value. (Cromb & Vayanos, 2010)

Another limit to arbitrage causing the anomalies investigated in this thesis in time-horizon.

This might happen in a situation when mutual fund manager has an investing strategy exploiting market mispricing that would result in substantial returns in the long run.

However, because of the investors demand for returns in the short run, manager may be forced to sell the position when facing short run losses, thus mispricing will endure. (Shleifer and Vishny, 1997)

Benchmarking can also be seen as a limit to arbitrage and one reason for risk and low-beta anomalies to exist. This results from the fact that typically institutional investors have

a certain mandate to outperform certain fixed benchmark index, thereby discouraging arbitrageurs actions in some asset classes and declines demand towards some highly yielding assets. (Baker, Bradley, and Wurgler, 2011) Respectively, high-risk stocks can be hard-to-arbitrage stocks represented by small capitalization, young, illiquid, non-dividend paying and unprofitable companies (Baker and Wurgler, 2007).

Implementation costs are also viewed as a factor causing anomalies to persist. Transaction costs stemming from rebalancing and cost for borrowing stock for short selling may dilute the profits gained by arbitrageur. Prices for borrowing a stock are usually low, but there might be situations when they are higher and, in some instances, it might be even impossible to short sell a stock. In addition to this, there might be legal constraints for some institutional investors that prohibit short selling. (Barberis & Thaler, 2003)

3.2.2. Non-fundamental demand

In addition to limits to arbitrage, there are some behavioral factor driving non-fundamental demand of stocks. Lottery demand described by Bali et al. (2017) is suggested to be one possible factor affecting non-fundamental demand for high volatility stocks.

Representativeness heuristic is investors tendency of assuming that one thing means another.

Investors may conclude that a company that has performed well in the past will keep on performing well. (Shiller, 2000, 144) This might lead to deviations from market efficiency and for example, momentum investors can exploit this behavioral bias.

Another factor behind non-fundamental demand is overconfidence. According to Baker, Bradley and Wurgler (2011) overconfidence might be reason behind anomalies like bet against beta. This is the situation, when investors put too much trust on their own abilities to predict outcomes. Moreover, overconfidence with constraints on short selling might lead to a situation where overoptimistic investors actually set the price for a stock thereby leading to low future returns. (Miller, 1977) Anchoring is yet another behavioral bias investor tends to make in the stock markets. This means the tendency to make investment decisions based on assumptions or information received in the past rather than adjust the decision with new information. For example, investor may have a “right” price for the stock in their minds

based on the past price formation and therefore, they can consciously ignore new information about the underlying company. (Hämäläinen & Oksaharju, 2016, 150)

Loss aversion of individual investors can cause deviations from stocks’ fundamental value.

Investors do not like to admit their mistakes and therefore tend to hold on for losses in hope that someday prices will rise again. In some cases, investors even double up their initial investment as stock drops in value. This leads to distortion in stock prices. (Damodaran, 2002, 29) Herd behavior is also one potential explanation accelerating mispricing of stocks.

Even rational investors tend to participate in herd behavior when they take other people’s opinions into account. Herd behavior produces group behavior in the markets which is often irrational and leads to deviations from market efficiency. (Shiller, 2000, 151) Investors also seem to suffer from information overload. This leads to tendency of reacting to the latest piece of news, which can create mispricing of certain assets and ultimately results in a lower return for investor. (Damodaran, 2002, 29)