Efficient Markets and Behavioral Finance

Question 1

what is normal distribution?

Answer 1

CLM = the distribution of the sum of a large number of independent variables will be approximately normal

Question 2

why do we have fat tails in finance - when we plot the monthly movements of Dow Jones index according to frequency

Answer 2

• theoretical models predict = ND
• what we actually see:
• less clustering around the average
• more outliers
• fatter tails
• extreme events happen a lot more frequently than theoretical models suggest

Question 3

is it possible to beat the market
- can mutual funds out perform the stock market (S&P500)

Answer 3

• data from 1970-2001 suggest that mutual funds do worse
• there are examples of times where funds have made larger average annual returns compared to S&P = shows that you can beat the market
• but 2000 crash = S&P outperformed overall = would have made more money without as much risk

Question 4

what is a mutual fund

Answer 4

companies that invest in a diversifies portfolio of securities
- want to make a return on investment

professional investors trying to beat the market

Question 5

what is the s&p 500?

Answer 5

broad measure of the U.S. stock market’s performance by tracking the stock prices of 500 large-cap companies

Question 6

so if you cant consistently beat the market and make profits then the markets must be efficient?
random walk model

Answer 6

• variance (pt+1) = var (pt) + var (pt)
• var cant be negative
• so var (pt+1) > var (et)
• the forecast must be less variable than the variable forecasted
• implies attempt to beat the market consistently through forecasting is difficult

Question 7

why does Shiller disagree with the argument of efficient markets theory that the stock price represents an optimal forecast of the present value

Answer 7

• shiller plotted discounted value of real dividends (plot of profits)
• found that their profits go up and down but their variance is small
• compared to the larger variance of prices
• according to EMH = if prices are efficient then prices should reflect the profitability of companies - allocates resources efficiently
• so if variance in profit < variance in prices = inefficient markets
• shiller = financial markets are not efficient
• Malkiel = most of the time allocate efficiently but dont sometimes (bubbles)

Question 8

what are the reasons why markets arent efficient
- why don’t prices reflect all info

what are the 3 behavioural approaches to financial markets?

Answer 8

1. feedback models
2. smart money vs ordinary investors
3. prospect theory

Question 9

what is the feedback model?

Answer 9

suggests that market prices may not always fully reflect all available information, as feedback effects can influence short-term price movements

• investors action and market movements create a feedback loop
• if price increases, investors are more optimistic - increase their expectations and price increases further
• this is because investors use past prices to influence their decisions - they believe there is a trend

= herding = everyone buys because everyone else is buying

Question 10

what is experimental evidence of the feedback model?

what is a natural experiment of feedback models (prices increase - expectation increases - therefore prices increase more)

Answer 10

when people were preconditioned on bubbles, they were more likely to expect a bubble - as a result more bubbles were generated
- shows investors can create bubbles just because given past information about them

pyramid schemes = if everyone believes in it it will work - support it

Question 11

what is cognitive support for feedback models?
representative heuristic
biased self attribution

Answer 11

representative heuristic = when people try to predict they use what happened most recently as an anchor for their decision making - ignoring observed probability

biased self attribution = investors attribute success in the markets as a result of their own high ability and attribute losses due to bad luck
- so if they do well = feel smart = so overinvest emotionally - not caring about chances

Question 12

what is the smart money theory
first what happens in EMH
then what happens in real life

Answer 12

EMH = expect there to be noise from irrational optimists but smart investors correct this

real life = smart investors want to be ahead - outsmart the system
- can amplify fluctuations by buying ahead of feedback traders - announcement to get the prices to increase get people to buy = self fulfilling prophecy

• short selling –> disadvantages = potential losses are infinite

Question 13

what is prospect theory

• make fast decisions use system 1 = emotional

Answer 13

your utility at any given point in time depends on how much wealth you have at that point

if wealth decreases from reference point:
investors are loss averse - they are more willing to take greater risks in order to avoid losses
- dont want to sell when the stock is in a bad place
- would rather take a gamble between bigger losses and a definite loss

if wealth increases from reference point:
risk averse