Cornell University Johnson Graduate School Of Management

Traditional finance theories assume that financial market participants are rational, and argue that the financial market is always efficient and prices are always right.

Behavioral finance, on the other hand, argues that securities market prices can be wrong, and that a lot of financial market phenomena can plausibly be understood only under the assumption that some market participants are not fully rational. This course gives an introduction to behavioral finance, and discusses its applications in investment management. We will first introduce the conceptual framework of behavioral finance, and then apply the framework to the study of individual stock trading and portfolio management. Topics covered in the course include: limits of arbitrage (i. e. why stock market mispricing can persist), investor psychology and behavior (and how to overcome our own irrational biases in stock trading), stock index predictability and market timing, stock portfolios that were shown to beat the market (including value, momentum, size, earnings quality, volume, earnings management, and many other effects), and applications of behavioral finance in quantitative asset management. As a summary of the course, we will apply the conceptual framework of behavioral finance to the understanding of China’s financial market (as an example of emerging markets).

PREREQUISITES You must have taken an introductory level finance course that covers basic topics such as stocks and bonds, the CAPM, and the efficient market hypothesis. COMMUNICATING WITH ME My office hours are Monday, 4:30-6:00pm. You should also feel free to communicate with me by email. 1 TEXTBOOK AND SUPPLEMENTARY READINGS The required textbook is Richard H. Thaler (ed. ), Advances in Behavioral Finance, Vol. II, Russell Sage Foundation and Princeton University Press, 2005. For each session, there will be required reading and (occasionally) optional reading.

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All required readings are either included in the course packet or will be handed out in class. All optional readings will be posted on Blackboard. All classroom handouts will also be posted on Blackboard. The following books are optional supplementary readings and can be purchased in many bookstores or from online vendors. Behavioral Finance: A User’s Guide, by James Montier, Wiley Finance Series, 2002. ? An introduction of behavioral finance from a practitioner’s perspective. Advances in Behavioral Finance, edited by Richard Thaler. The first volume preceding our textbook. Contains some important early academic articles on behavioral finance. Irrational Exuberance, by Robert Shiller. ? A great book on the Internet bubble. The Myth of the Rational Market – A History of Risk, Reward, and Delusion on Wall Street, by Justin Fox (2009). ? On the history of efficient market theory and behavioral finance. Behavioral Finance and Wealth Management – How to Build Optimal Portfolio That Account for Investor Biases, by Michael M. Pompian. ? Written from the perspective of a wealth manager and practitioner.

When Genius Failed, by Roger Lowenstein. ? An account of LTCM failure. CLASS PREPARATION There will be a reading, as well as an occasional case assignment, to prepare for each session. You are expected to be prepared for each session by doing the reading and working on the assignment for the case. Each individual is required to turn in the case assignment prior to the class during which the case is discussed. Those listed in the syllabus are subject to change during the semester, which will be announced in class when applicable. 2 GRADING

The grade will be based on problem sets (10%), class participation and case assignments (10%), an exam (50%), and the final individual term project (30%). PROBLEM SETS Three problem sets will be assigned during the course, with the following preliminary schedule: Problem Set 1 Problem Set 2 Problem Set 3 Assignment Date 10/17 (Wed) - Session 2 10/29 (Mon) – Session 5 11/7 (Wed) – Session 8 Due Date 10/24 (Wed) – Session 4 11/5 (Mon) – Session 7 11/ 14 (Wed) – Session 10 Problem sets are not included in the course packet, but will be handed out in class.

Late submissions will not be accepted. You may work with other students in the class (from either section) for all the problem sets. (Of course, there is no reason to believe that an organized group is the best approach for everyone. ) A team of people need only submit one copy of their solution for a particular problem set. However, the number of students submitting one problem set solution is limited to no more than four. Every member of a group submitting a problem set solution will receive the same grade on that problem set. Solutions to each problem set will be made available.

Grades on problem sets will be recorded by giving a "check-plus," "check," or "check minus. " Typically, the problem sets will not be discussed in class. EXAM There will be a (closed-book) in-class exam on Monday, November 19. TERM PROJECT A term project is the final requirement for the course. A detailed assignment on the term project will be handed out during the semester. Each individual needs to submit a written term project (into a box marked “NBA 5980” in 304 Sage Hall) no later than 1pm, December 6 (Thursday). ATTENDANCE POLICIES As mentioned above, class participation is a factor in determining the final grade.

It is expected that all students attend all classes. It is also expected that students will be on time for class and will not disrupt the class by leaving early or by leaving and returning to class. We recognize that there are medical and other special circumstances that may cause a student to miss a class. Special circumstances may also arise that cause a student to miss part of a class. If such circumstances arise, students should contact the instructor (preferably by e-mail) and explain why it was necessary to miss part or all of a class session.

This should be done before the absence if the absence is foreseen in advance and as soon as possible after the absence if the absence was unanticipated. Students who miss parts of class sessions or class sessions in their entirety without reasonable justification should expect that their class participation grade may be adversely affected in a significant way. 3 Schedule of Sessions and Reading List (Note: Advances is the abbreviation for our textbook: Richard Thaler (ed. ), Advances in Behavioral Finance, Vol. II, Russell Sage Foundation and Princeton University Press, 2005. ) Session 1 0/15 (Mon) Topics: Introduction and Examples of Extreme Mispricing Overview of the course, efficient market hypothesis, and extreme examples of market mispricing. Advances (pp 1-2; 8-12), Chapter 1, sections 1; 2. 3 How Did Economists Get It So Wrong? by P. Krugman (in packet) Anomalies: The Law of One Price, by Lamont-Thaler (in packet) Greenp Concedes Error in Regulatory View (NYT) (in packet) Ignoring the Oracles, by Justin Lahart (in packet) Has Financial Development Made the World Riskier? by Raghu Rajan (2005) (posted on Blackboard) Advances (pp 102-169), Chapters 3-4

Required Reading: Optional Reading: Session 2 10/17 (Wed) Topics: Limits of Arbitrage LTCM and convergence bets, noise trader risk and other reasons for limits of arbitrage. Advances (pp 3-8), Chapter 1, sections 2. 1-2. 2 HBS Case: Long-Term Capital Management, L. P. (A) (in packet) Assignment on the Case of Long-Term Capital Management (to be submitted at the beginning of class on 10/17) How the Eggheads Cracked, by Michael Lewis (in packet) Advances (pp 79-101), Chapter 2 (academic and theoretical) Required Reading: Assignment: Optional Reading:

Session 3 10/22 (Mon) Topics: Investor Psychology: Overcoming Our Own Biases Common human psychological biases in beliefs and risk preferences. How to overcome our own biases in stock trading? Advances (pp 12-22), Chapter 1, section 3 Aspects of Investor Psychology, by Kahneman-Riepe (in packet) Required Reading: 4 Session 4 10/24 (Wed) Topics: Behavior of Individual Investors Behavior of individual investors, home bias and naive diversification, individual buying and selling decisions, disposition effects, individuals vs. institutions.

Advances (pp 50-56), Chapter 1, section 7 Advances (pp 543-569), Chapter 15 Advances (pp 570-601), Chapter 16 Required Reading: Optional Reading: Session 5 10/29 (Mon) Topics: Stock Index: Predictability and Market Timing Stock index-return predictability, equity premium puzzle, market timing and tactical asset allocation Advances (pp 173-201), Chapter 5 Change Agent: How Greenp Finally Came to Terms …, by Schlesinger (in packet) Advances (pp 22-35), Chapter 1, section 4 (academic and theoretical) Required Reading: Optional Reading: Session 6 10/31 (Wed) Topics: Anomalies in Stock Portfolio Returns

Portfolios that beat the market (even after adjusting for beta); the price effect of investor mis-reactions, momentum and reversal, post-earning-announcement drifts, post-corporate-event returns Advances (pp 35-41), Chapter 1, section 5. 0 Does the Stock Market Overreact? by DeBondt-Thaler (in packet) Advances (pp 353-388), Chapter 10 Required Reading: 5 Session 7 11/5 (Mon) Topics: Value and Momentum – Theories and Explanations Explanations of value and momentum effect; combining value and momentum; using volume to improve return predictability Advances (pp 41-47), Chapter 1, sections 5. -5. 3 (theoretical) Contagious Speculation and a Cure for Cancer, by Huberman and Regev (in packet) Price Momentum and Trading Volume, by Lee and Swaminathan (on Blackboard) All the News That’s Fit to Reprint, by Tetlock (on Blackboard) Required Reading: Optional Reading: Session 8 11/7 (Wed) Topics: Earnings Quality and Corporate Governance How to measure earnings quality? How to rank firms’ corporate governance? Can we use them to predict stock returns? Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? y Sloan (in packet) Corporate Governance and Equity Prices, by Gompers, Ishii, and Metrick (posted on Blackboard) Earnings Quality and Stock Returns, by Chan, Chan, Jegadeesh, and Lakonishok (posted on Blackboard) Required Reading: Optional Reading: Session 9 11/12 (Mon) Topics: Effect of Short-Sale Constraints on Stock Prices The asymmetry between buying stocks and shorting stocks; the costs and risks of short-selling stocks; disagreement of valuations among investors, short-sale constraints, trading volumes, and their effects on stock prices Read the Wikipedia coverage of stock short selling: http://en. ikipedia. org/wiki/Short_(finance) Disagreement and the Stock Market, by Hong-Stein (in packet) Short Sale Constraints and Overpricing, by Lamont (posted on Blackboard) Required Reading: Optional Reading: 6 Session 10 11/14 (Wed) Required Reading: Guest Speaker TBA None EXAM: 11/19 (Mon) 11/21(Wed): Monday, November 19, in class. No class, Thanksgiving Break Session 11 11/26 (Mon) Topics: Applications of Behavioral Finance in Asset Management Do value and momentum still work? What happened in August 2007?

Discussion of issues in practical applications of portfolio strategies based on anomalies in behavioral finance Papers Study August Crisis, by Anderson (in packet) What Happened to the Quants in August 2007? by Khandani and Lo (posted on Blackboard) Required Reading: Optional Reading: Session 12 11/28 (Wed) Topics: Application: Understanding the Chinese Stock Market (As an Example of Emerging Markets) Try to appreciate that many other markets around the world are quite different from the US stock market; understanding the Chinese stock market as an example of emerging markets. None Required Reading: 7

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