John Rae’s inter-temporal choices explained the statistical nature of human behavior in 1834. However, despite the subject’s insight in the objectiveness of behavior, inter-temporal choices remains a peripheral science. This paper takes a sequential approach to question how inter-temporal choices could be behind human behavior, behavioral anomalies and even market anomalies. If these inter-temporal anomalies were consistent, unarbitrageable and explain asset returns better than the Fama and French Factor model, this could further our understanding of asset pricing models by establishing a new duration factor which could subsume both size and value factors.
There is no disagreement regarding the statistics of mean reversion. What goes up comes down and vice versa. Campbell and Shiller (1988) said that the simple theory of mean reversion was basically right. Fama and French (1989) also suggest that valuation ratios forecast five-year returns with quantifiable accuracy. It is the failure of reversion (divergence) that has not been reconciled with the expression of reversion. Why is the society so keen to accept reversion as statistical, but its failure as behavioral? John Bogle’s (2001), Star, Comets and the Sun analogy to the idea of reversion around investing styles reinforces the idea, that all failure of reversion is an error while reversion is a statistical reality. The reason Bogle suggests not to focus on investing styles, as markets are anyway going to recoil back to the statistical mean. Thaler (1999), goes a step further explaining reversion failure as driven by behavioral errors. How strong is the behavioral case? Should reversion and diversion both be statistical?
It was in 1968 that Ball and Brown considered the content of accounting information, the flow of information, the relevance of information, its predictive powers and its continuity and time dependence. The observed reversion was used as a validation of predictive content in earnings. This relevance was later shown to cause a drift, an anomaly, un unexplainable behavior of a market. Bernard and Thomas (1989) showcased a seasonal positive autocorrelation in partial periods connected to the news followed by a seasonal negative autocorrelation.
The modern city I knew as a child keeps changing. There used to be more roads and fewer cars, now there are only cars. If you want to see roads and have driving pleasure you have to skip two-thirds of the day. Ok, this may be more valid coming from an emerging market like India or China, but the emerging market outlook for auto has been assumed to be significant globally.
In finance, arbitrage is an essential framework to understand asset pricing. However, the study of anomalies also called as premiums, which are not arbitrageable has led to a debate regarding whether markets are efficient in correcting price imbalances or is inefficiency a reality. This is why the Economics Nobel prize 2013 was awarded to both the behavioral and fundamental school. This paper explains the circular argument between the three schools of thought. The Fama school which uses factors to explain asset performance, the behavioral school which is focused on psychological biases and the old Beta school which consider the arguments of value vs. growth are all fleeting.
Information is an assumption for modern finance. The Efficient Market Hypothesis uses information to back its case for efficiency. The EMH case is weak, but as Martin Swell (2011) explains until a flawed hypothesis is replaced by better hypothesis, criticism is of limited value. This paper challenges the information assumption in EMH based on the idea laid out first by Kenneth E. Boulding (1966), highlights the body of work discussing information relevance, information irrelevance, information content since Ball and Brown (1968) and illustrates how ‘Mean Reversion Framework’ (2015) can be used to re-explain the transformation of information from relevance to irrelevance, also referred to as the ‘Reversion Diversion Hypothesis’.
Searching for alpha is searching through inefficiency because there are no supernormal returns in efficiency. This seems intuitive and correct because there is a cost to searching through inefficiency. And agents who spend that cost have to be rewarded for that effort. The case for inefficiency is unassailable.
I really don’t know why Richard Thaler chose this headline for a research paper. Many other behavioral finance academic papers also capture attention. “Can the markets add and subtract?”; “The winner’s curse”; “The gambler’s fallacy”, “Does the stock market overreact?” While the popularity of the subject has increased and behavioral biases have got so pervasive that everybody seems to be biased, the question is whether the behavioral finance experts are bias-free?
Style box for the investor is a visual representation of investment characteristics for stocks, fixed income and mutual funds offered as a comparative tool to investors around the world for helping them determine asset allocations based on their risk preference.