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)