Market efficiency assumes all investors have the same information, interpret it the same, and make the same forecasts. This would imply that all assets are priced efficiently (i.e. there is no bias in stock prices). However, people develop investment decisions making rules through experiment, trial and error, or personal experience. Rather than research financial statements and other relevant data, individuals form investment rules and make investment using information that is most prominent in media or otherwise most readily available. Some of the common behavioural traits like Representativeness, anchoring-and-adjustment, frame dependence, and overconfidence, however, can all lead to inefficiently priced stocks.
Representativeness – The behavioural trait of representativeness can lead investors to make incorrect projections based upon stereotypes. Since investors’ perceptions are based upon current or historical information rather than unbiased expectations, stocks can be temporarily mispriced. An example is assuming a stock will perform well in the future because the firm just unexpectedly announced good earnings over the last period. Assuming the good announcement implies good future performance (a winner) investors buy the stock and push its price up. Likewise, a bad earnings announcement (a looser) may be met with selling pressure, which drives the price down. The result is that overpriced “winners” will tend to underperform and underpriced “losers” will tend to outperform, as their prices return to their intrinsic values.
Representativeness can take many forms. Any time an investor (or anyone else for that matter) bases expectations for the future on some past or current characteristics or measure, the individual is applying an “if-then” criteria. That is, if this has happened, then that will happen.
Conservatism – Conservatism refers to inability of analysts to fully incorporate the impact of new information (e.g. earning surprises) on their projections. For example, an analyst may have already made a forecast for the performance of a stock, when the firm releases new information that can have a material effect on the stock price. The analyst, being anchored by his prior projection, will tend to not fully reflect the full vale of the new information in his revised projections. The implication is that negative adjustments in price forecasts (e.g. from lower than expected earnings announcement) tend to be followed by negative surprises (i.e. further decline in price). Positive adjustments (e.g. from higher-than-expected earnings announcements) tend to be followed by positive surprises (i.e. further increase in price). These “patterns” in price performance imply market inefficiency with an accompanying investment strategy: buy stocks that have experienced positive earnings surprises; sell (short) stocks which have experienced negative surprises.
Empirical tests have shown that these strategies out-perform the market and, in fact, the greater the earnings surprise, the greater the potential excess return. Behavioural finance attributes the excess returns to conservatism, while traditional finance explains the results by saying stocks with positive earnings surprises are riskier and, thus should earn a greater return.
Frame dependence – It implies that individuals make decisions and take actions according to the framework within which information is received (i.e. the media) or the individual’s circumstances at the time (i.e. emotional state). In this case, frame dependence refers to investor’s tendency to change (frame) their risk tolerance according to the direction of the market. Loss aversion predicts investors will be hesitant to enter the market. This applies when the market is flat or falling. When the market is in an upward trend, however, investors’ loss aversion falls and they jump in, further pushing prices up.
If investors acted with frame independence, they would make purely economic decisions, and the form within which information is received and the individual’s current circumstances would have no effect on their decision-making. They would base each decision purely on its expected merits.
Overconfidence – It means that people tend to place too much confidence in their ability to predict. There are two important implications of overconfidence and the resulting failure to recognize the true risk of an investment. First, investors tend to make unjustified “bets”. Being overly confident in their ability to interpret information and forecast performance, investors don’t realize they do no have all the information necessary to form unbiased projections. Second, also based upon their perceived ability to interpret information, investors tend to trade more frequently than can be justified by the information.
Like conservatism, overconfidence can also lead to surprises. Since investors continually underestimate the range of possible returns, there is a higher than normal probability of a return outside the predicted range.