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Experiment: Each player is asked to choose a number between 0 and 100 (0 and 100 inclusive, up to two decimal places). The one with the chosen number being closest to 0.67 times the average guess wins a prize of RMB 10. If two or more players win, the winner will be randomly chosen.
What is the result? • Average number submitted? • Wining number?
Efficient Market Hypothesis (EMH) • It will be useful to study the EMH before we discuss the relationship between the result of the beauty contest game and the financial market.
Efficient Market Hypothesis (EMH) An efficient capital market is a market that is efficient in processing information. The prices of securities observed at any time are based on ‘correct’ evaluations of all information available at that time. In an efficient market, prices ‘fully reflect’ available information. (Eugene Fama, 1976)
Two Components of EMH:1. Price is right • the idea is that any asset will sell for its true “intrinsic value.” If the rational valuation of a company is $100 million, then its stock will trade such that the market cap of the firm is $100 million. This principle is thought to hold both for individual securities and for the overall market. • Source: Richard Thaler “The Making of Behavioral Economics: Misbehaving” Chapter 21
“For years financial economists lived with a false sense of security that came from thinking that the price-is-right component of the EMH could not be directly tested—one reason it is called a hypothesis. Intrinsic value, they reasoned, is not observable. After all, who is to say what the rational or correct price of a share of General Electric, Apple, or the Dow Jones Industrial Average actually is? There’s no better way to build confidence in a theory than to believe it is not testable.” Source: Richard Thaler “The Making of Behavioral Economics: Misbehaving” Chapter 21
Two Components of EMH:2. No free lunch • there is no way to beat the market. • because all publicly available information is reflected in current stock prices, it is impossible to reliably predict future prices and make a profit.
Example • Suppose a stock is selling for $30 a share, and I know for certain that it will soon sell for $35 a share. • It would then be easy for me to become fabulously wealthy by buying up shares at prices below $35 and later selling them when my prediction comes true. • But, of course, if the information I am using to make this prediction is public, then I am unlikely to be the only one with this insight. • As soon as the information becomes available, everyone who is in possession of this news will start buying up shares, and the price will almost instantaneously jump to $35, rendering the profit opportunity fleeting. • Supporting Evidence: professional money managers perform no better than simple market averages.
Three forms of EMH • There are three forms of EMH: • The weak form of the EMH claims that prices on traded assets (e.g.,stocks, bonds, or property) already reflect all past publicly available information. • The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. • The strong form of the EMH additionally claims that prices instantly reflect even hidden "insider" information.
Implications of EMH • It is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information. • fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.
Fundamental Analysis • fundamental analysis: is the analysis of a business's financial statements(usually to analyze the business's assets, liabilities, and earnings); health; and competitors and markets. • It is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives: • to conduct a company stock valuation and predict its probable price evolution; • to make a projection on its business performance; • to evaluate its management and make internal business decisions and/or to calculate its credit risk. • to find out the intrinsic value of the share. • markets may incorrectly price a security in the short run but that the "correct" price will eventually be reached.
Technical Analysis • An analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume. • The efficacy of both technical and fundamental analysis is disputed by the efficient-market hypothesis which states that stock market prices are essentially unpredictable. • It is believed that price action tends to repeat itself due to the collective, patterned behavior of investors. • Hence technical analysis focuses on identifiable price trends and conditions.
Testing EMH using data • A database of stock prices • Center for Research in Security Prices, known as CRSP (pronounced “crisp”).
Testing assumptions of EMH • The EMH is based on the concept of equilibrium. • In particular, the rationality of investors. This can be tested using experiments.
Conflicting Evidences • momentum effect identified by Jegadeesh and Titman. • Stocks that have performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over the next 3 to 12 months. • The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns.
Assumptions about rationality • Game theory models often make assumptions about rationality of decision makers. • One common form of rationality assumed is the ability for performing strategic reasoning such as iterative reasoning.
The question • Given that most equilibrium concepts rely on the decision makers to have infinite reasoning capacity, it is important to check if decision makers in reality conform to such degree of rationality. • While the idea that individuals may not conform to such degree can be at least traced back to the newspaper game by Keynes (1936).
Keynes • remembered primarily for his contributions to macroeconomics and especially for his controversial argument that governments should use fiscal policy to stimulate demand during recessions or depressions. • The General Theory of Employment, Interest and Money • Keynes’s observations were based in part on his considerable experience as an investor. For many years, he successfully managed the portfolio of his college at Cambridge, where he pioneered the idea of endowments investing in equities.
He thought that emotions, or what he called “animal spirits,” played an important role in individual decision making, including investment decisions. • He noted the fact that shares of ice companies were higher in summer months when sales are higher. This is strictly verboten by the EMH. • He likened picking the best stocks to a common competition in the male-dominated London financial scene in the 1930s: picking out the prettiest faces from a set of photographs:
P Beauty Game (Nagel, 1995, AER) • Became the main method used in experiments for measuring depth of thinking. • Each player is asked to choose a number between 0 and 100 (0 and 100 inclusive). The one with the chosen number being closest to p (e.g., two-thirds) of the average guess wins a prize.
Depth of thinking (method 1) • There are different ways to classify the level of thinking. Here is one method (method 1): • Subjects who are choosing randomly (choosing around 50) will be classified as level zero. • Level one: choose around 50*0.67=33 • Level two: choose 33*0.67=22 • Level three: choose 22*0.67=15 • And so on…
Depth of thinking (method 2) • Subjects more than 67 will be classified as level zero. Let the number chosen be x. • Level one: 70<x<= 70*0.67 • Level two: 70*0.67<x<= 70*0.67*0.67 • Level three: 70*0.67*0.67<x<=70*0.67*0.67*0.67 • And so on…
Concept of Equilibrium • a number that if everyone guessed it, no one would want to change their guess. • the only Nash equilibrium in this game is zero. • To see why, suppose everyone guessed 3. Then the average guess would be 3 and you would want to guess two thirds of that, or 2. But if everyone guessed 2 you would want to guess 1.33, and so forth. If and only if all participants guessed zero would no one want to change his or her guess.
Are you satisfied with the Beauty Contest Game as a measure of depth of thinking?
Beautiful Mind • Play the video
Li and Rong (2018) :Distribution of Numbers Chosen in P Beauty Game
Depth of Thinking and Bubbles • Investors need to consider not only his own valuation on the asset but also other market participants valuation.
If you know there is a price bubble on a stock, but you are not sure when will the bubble burst, would you be willing to buy the stock? • Li and Rong （2018）: Subjects with strategic reasoning： 25% Said yes Subjects without strategic reasoning：56.26% Yes
