Week 10: Behavioral Finance

Gene Fama's Nobel Prize

financial markets are markets for information

markets are informationally efficient if market prices today summarize all available information about future values

informational efficiency is a natural consequence of competition

a natural implication of market efficiency is that simple trading rules should not work

event study (p.7)

stock returns are not predictable (random walk) at short horizons, but it is predictable at long horizons

stock prices and the economy (p.9)

in recession: more risk aversion

during boom: more risk tolerant

high return (high risk): great macroeconomic stress

sometimes, predictably high returns not been closely associated with macroeconomic difficulties

Bob Shiller's Nobel

Shiller contrasts the actual stock price with the "ex-post rational price"

actual price varies tremendously more than the ex- post discounted value (is that the predicted price?)

markets sometimes over-reacted

markets are rational

on average, times of high prices relative to current dividends are not followed by higher returns => according to Shiller the model is not good enough

Time varying returns (p.13)

Fama and Shiller different views

Fama: it is a business cycle related risk premium

Shiller: the variation in risk premiums is too big

Other problems with market efficiency

Information

suppressed or delayed of bad news

in some cases, firms release intentionally misleading information

Behavioural Finance

seeks to understand and predict systematic financial market implications of psychological decision processes

Conventional Finance vs Behavioral Finance (p.17)

Market inefficiency

Irrational Investors

Limits to arbitrage

The Monty Hall Judgement Error

Prospect Theory vs Expected Utility Theory

standard finance: investors are rational and make decisions as if they are always risk averse

prospect theory: investors think about gain and loss relative to some reference point (loss aversion)