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Agenda
• Behavioral finance (Chapter 12)• Challenges to market efficiency
• Limits to arbitrage
• Irrational investors
Market Efficiency
• Fama: “The market price at any time instant reflects all available information in the market”.
• Cannot “make money” using “stale information”.
• Three forms
• Weak form: past prices and returns.
• Semi-strong form: all public information.
• Strong form: all public AND private information.
• Michael Jensen: “there is no other proposition in economics which has more empirical support than the EMH”.
Are Financial Markets Efficient?
• Weak form of market efficiency supported to a certain extent.
• Challenges:
• Excess market volatility
• Stock price over-reaction: long time trends (1-3 years) reverse themselves.
• Momentum in stock prices: short-term trends (6-12 months) continue.
• Size and B/M ratio (stale information) may help predict returns.
What Makes Markets Efficient?
• Competition among information providers
• Arbitrage traders
• Critical Factors Behind Efficient Markets• Investor Rationality
• Irrational Behavior is Not Systematic
• Rational Arbitrage Traders
Investor Irrationality
• Empirical Evidence on investor behavior:
• investors fail to diversify.
• investors trade actively
• Investors may sell winning stocks and hold onto losing stocks
• extrapolative and contrarian forecasts.
• Systematically irrational trading by investors
• Information processing
• Suboptimal decisions
Psychology
• Beliefs
• Overconfidence
• Optimism / Wishful Thinking
• Miscalibration
• Better-than-average-effect
• 90% of Drivers Claim Above Average Skill
• 99% of Freshman Claim Superior Intelligence
• Illusion of control• Rolling dice in craps
Psychology
• Beliefs
• Representativeness
• Base Rates are Under-Emphasized Relative to Evidence
• “Law of Small Numbers” – gambler’s fallacy
Example: fair coin tossing.
T H T H T H H H H H H
P(T) = ?, P(H) = ?.
Psychology
• Beliefs
• Conservatism
• Base Rates are Over-Emphasized Relative to Evidence
• Belief Perseverance
• Anchoring
• Availability Biases
Psychology
• Behavioral biases• Framing• Mental accounting
• Preference for dividends• Holding on to loser stocks for too long• “house money effect”
• Regret avoidance• Prospect Theory
• Utility Defined over Gains and Loses• Concave over Gains, Convex over Losses
“Irrational” Behavior of Professional Money Managers
• Herding:
• may select stocks that other managers select to avoid “falling behind” and “looking bad”.
• Window-dressing:
• add to the portfolio stocks that have done well in the recent past and sell stocks that have recently done poorly.
Limits to Arbitrage
• Fundamental Risk • Horizon Risk• Model Risk• Lack of Substitutes • Limited Capital • Legal Constraints • Implementation Costs
Limits to Arbitrage
• Implementation Costs
• Commission
• Bid/Ask Spread
• Price Impact
• Short Sell Costs
• Fees
• Volume Constraints
• Legal Restraints
Limits to Arbitrage
• Twin Shares: Royal Dutch (60%) and Shell (40%)• Only Risk is Noise Traders• PriceRD = 1.5*PriceS
Limits to Arbitrage
• Nick Leeson • Jan 16, 1995, Short Straddle on Tokyo stock exchange• Jan 17, 1995, Kobe Earthquake• Riskier tools to bet on recovery of Nikkei Stock Average• Losses reached £827 million, twice the bank's available trading
capital. • Feb 26, 1995, Barings Bank filed bankruptcy.
Summary
• Investor behavior does have an impact on the behavior of financial markets.
• Both “social” and “psychological” must be taken into account in explaining the behavior of financial markets.
• Market “anomalies” may be widespread.
• Behavioral Finance: does not replace but complements traditional models in Finance.