Heuristic Strategies in Finance – An Overview

This paper presents a survey on the application of heuristic optimization techniques in the broad field of finance. Heuristic algorithms have been extensively used to tackle complex financial problems, which traditional optimization techniques cannot efficiently solve. Heuristic optimization techniques are suitable for non-linear and non-convex multi-objective optimization problems. Due to their stochastic features and their ability to iteratively update candidate solutions, heuristics can explore the entire search space and reliably approximate the global optimum. This overview reviews the main heuristic strategies and their application to portfolio selection, model estimation, model selection and financial clustering.finance, heuristic optimization techniques, portfolio management, model selection, model estimation, clustering

Subjective Beliefs and Asset Prices

Asset prices are forward looking. Therefore, expectations play a central role in shaping asset prices. In this dissertation, I challenge the rational expectation assumption that has been influential in the field of asset pricing over the past few decades. Different from previous approaches, which typically build on behavioral theories originated from psychology literature, my approach takes data on subjective beliefs seriously and proposes empirically grounded models of subjective beliefs to evaluate the merits of the rational expectation assumption. Specifically, this dissertation research: 1). collects and analyzes data on investors' actual subjective return expectations; 2). builds models of subjective expectation formation; 3). derives and tests the models' implications for asset prices. I document the results of the research in two chapters. In summary, the dissertation shows that investors do not hold full-information rational expectations. On the other hand, their subjective expectations are not necessarily irrational. Rather, they are bounded by the information environment investors face and reflect investors' personal experiences and preferences. The deviation from fully-rational expectations can explain asset pricing anomalies such as cross-sectional anomalies in the U.S. stock market. In the first chapter, I provide a framework to rationalize the evidence of extrapolative return expectations, which is often interpreted as investors being irrational. I first document that subjective return expectations of Wall Street (sell-side, buy-side) analysts are contrarian and counter-cyclical. I then highlight the identification problem investors face when theyform return expectations using imperfect predictors through Kalman Filters. Investors differ in how they impose subjective priors, the same way rational agents differ in different macro-finance models. Estimating the priors using surveys, I find Wall Street and Main Street (CFOs, pension funds) both believe persistent cash flows drive asset prices but disagree on how fundamental news relates to future returns. These results support models featuring heterogeneous agents with persistent subjective growth expectations. In the second chapter, I propose and test a unifying hypothesis to explain both cross-sectional return anomalies and subjective return expectation errors: some investors falsely ignore the dynamics of discount rates when forming return expectations. Consistent with the hypothesis: 1) stocks' expected cash flow growth and idiosyncratic volatility explain significant cross-sectional variation of analysts' return forecast errors; 2). a measure of mispricing at the firm level strongly predicts stock returns, even among stocks in the S&P500 and at long horizon; 3). a tradable mispricing factor explains the CAPM alphas of 12 leading anomalies including investment, profitability, beta, idiosyncratic volatility and cash flow duration

Representative agent earnings momentum models: the impact of sequences of earnings surprises on stock market returns under the influence of the Law of Small Numbers and the Gambler's Fallacy

This thesis examines the response of a representative agent investor to sequences (streaks) of quarterly earnings surprises over a period of twelve quarters using the United States S&P500 constituent companies sample frame in the years 1991 to 2006. This examination follows the predictive performance of the representative agent model of Rabin (2002b) [Inference by believers in the law of small numbers. The Quarterly Journal of Economics. 117(3).p.775 816] and Barberis, Shleifer, and Vishny (1998) [A model of investor sentiment. Journal of Financial Economics. 49. p.307 343] for an investor who might be under the influence of the law of small numbers, or another closely related cognitive bias known as the gambler s fallacy. Chapters 4 and 5 present two related empirical studies on this broad theme. In chapter 4, for successive sequences of annualised quarterly earnings changes over a twelve-quarter horizon of quarterly earnings increases or falls, I ask whether the models can capture the likelihood of reversion. Secondly, I ask, what is the representative investor s response to observed sequences of quarterly earnings changes for my S&P500 constituent sample companies? I find a far greater frequency of extreme persistent quarterly earnings rises (of nine quarters and more) than falls and hence a more muted reaction to their occurrence from the market. Extreme cases of persistent quarterly earnings falls are far less common than extreme rises and are more salient in their impact on stock prices. I find evidence suggesting that information discreteness; that is the frequency with which small information about stock value filters into the market is one of the factors that foment earnings momentum in stocks. However, information discreteness does not subsume the impact of sequences of annualised quarterly earnings changes, or earnings streakiness as a strong candidate that drives earnings momentum in stock returns in my S&P500 constituent stock sample. Therefore, earnings streakiness and informational discreteness appear to have separate and additive effects in driving momentum in stock price. In chapter 5, the case for the informativeness of the streaks of earnings surprises is further strengthened. This is done by examining the explanatory power of streaks of earnings surprises in a shorter horizon of three days around the period when the effect of the nature of earnings news is most intense in the stock market. Even in shorter windows, investors in S&P500 companies seem to be influenced by the lengthening of negative and positive streaks of earnings surprises over the twelve quarters of quarterly earnings announcement I study here. This further supports my thesis that investors underreact to sequences of changes in their expectations about stock returns. This impact is further strengthened by high information uncertainties in streaks of positive earnings surprise. However, earnings streakiness is one discrete and separable element in the resolution of uncertainty around equity value for S&P 500 constituent companies. Most of the proxies for earnings surprise show this behaviour especially when market capitalisation, age and cash flow act as proxies of information uncertainty. The influence of the gambler s fallacy on the representative investor in the presence of information uncertainty becomes more pronounced when I examine increasing lengths of streaks of earnings surprises. The presence of post earnings announcement drift in my large capitalised S&P500 constituents sample firms confirms earnings momentum to be a pervasive phenomenon which cuts across different tiers of the stock markets including highly liquid stocks, followed by many analysts, which most large funds would hold

Heuristic reasoning in the setting of hurdle rates and in the projection of cash flows in investment appraisal

A growing body of literature in investment appraisal has focused on bounded rationality of managerial decision-makers. It mostly addresses the actual investment decision stage, i.e. project approval. The investment decision is usually supported by a financial appraisal of the investment projects under consideration. Bounded rationality of the decision-makers determining the parameters of a financial appraisal have, however, attracted little attention. In the field of judgement and decision-making, decision-makers have been found to rely on a variety of effort-reducing strategies, i.e. heuristics, when making a judgement. This work addresses heuristic reasoning in the narrow field of setting the parameters required for a discounted cash flow analysis. Both dimensions, the projection of cash flows and the setting of a risk-adjusted hurdle rate, have been found to incorporate a high degree of subjective judgement. Moreover, given the complex and uncertain environment of companies and of the investment context in particular, optimal parameters may be difficult to determine. This work identifies heuristics that actors involved in this narrow stage of investment appraisal intuitively apply. It proceeds in two steps. First, and based on a conceptual framework, a qualitative study of practitioners detects and classifies indications of judgement in the projection of cash flows and in the setting of a hurdle rate. The findings that are indicative of heuristics translate into hypotheses for a second, quantitative study: Five experiments on practitioner-proxies are used to examine heuristic reasoning in the narrow contexts of investment appraisal. We find evidence that the affect heuristic and the anchoring effect substitute the more difficult judgement of a project’s risk that is manifested in a project-specific hurdle rate. Our hypothesis that the availability heuristic may also be involved in judging project risk cannot be confirmed; it is not found to contribute to an explanation of the paradox of setting hurdle rates higher than appropriate. As regards the projection of cash flows, application of the representativeness heuristic was not found to be applicable – despite strong indications in the qualitative study. Strong evidence is found in favour of the anchoring effect in making cash flow estimates – with finance or accounting experts being particularly prone to rely on arbitrary anchors. A sixth experiment investigates the practice of adjusting hurdle rates to mitigate the risk of overconfident cash flow projections.This work therefore contributes to an enhanced understanding of the role of judgement and the underlying judgemental processes in the two dimensions of investment appraisal. It highlights boundedly rational behaviour of the actors involved in the vital process of investment decision-making which has not been systematically addressed elsewhere. It can contribute to an improved understanding of organisational behaviour and ultimately to corporate success