Behavioral Finance

Behavioral Finance Economics 437

Course Information • Three Books • Andre Shleifer – “Inefficient Markets” • Daniel Kahneman – “Thinking: Fast and Slow • Edwin Burton – Sunit Shah – “Behavioral Finance” • Online Reading at Toolkit • Reading is difficult • I-Clickers - required • Lectures • Exams • Two mid terms • Feb 20 and April 1 • Final May 1: 2PM • Office Hours 11-12: Tues, Wed, Thur at VNB office (not on grounds)

Course Topics • Review of MPT & EMH • Limits to Arbitrage • Anomalies • Serial Correlation in Stock Returns

Immediate Reading (today, Jan 14) • Malkiel (online) • Shiller (online) • Shleifer (book, Ch 1) • Fama (online)

Reading (starting Jan 23)“Noise Trading” – Limits to Arbitrage • Black on Toolkit • Shliefer on Toolkit • Kahneman, pp. 3-40 • Burton & Shah, pp 1-51

The Efficient Market Hypothesis(EMH) • Price captures all relevant information • Modern version based upon “No Arbitrage” assumption • Why do we care? • Implications • Only new information effects prices • Publicly known information has no value • Investors should “index” • Allocation efficiency

The Milton Friedman argument for market efficiency in the presence of “noise traders” • If noise traders are truly “random,” then their effects will “cancel out.” (Kind of a law of large numbers result) • Noise traders are “systematic,” then arbitrage traders will “trade against them” and take all of their money • Thus prices will be efficient in either case

But, then • October 19, 1987 • 1992, Article by Eugene Fama and Ken French • The Tech Bubble • The Rise of Hedge Funds

1987 - The “Rip Van Winkle” Year 2700 2300 2200 2200 2200 1700 Jan July October Dec

Fama and French • Both authors are staunch supporters of EMH • 1992 Article gave a simple formula to pick stocks that “beat the market” consistently • This lead “respectability” to a growing literature that simple formulae could “beat the market”

The Tech Bubble • 1999 Nasdaq up 100 percent for the year • Priceline: • Came public at 20, rose to 200, fell to under 1 • No news of substance • Nasdaq peaked at 5000 in March 2000 • Fell to 1800 by 2002

Hedge Funds • Industry grew from cottage industry to massive industry • Charges very, very high fees to customers • Idea: they can outperform the market; thus they deserve the big fees • Used by Harvard and Yale endowments (UVA as well)

The Efficient Market Hypothesis (according to Fama 1970) • Three forms: • Weak • Semi-strong • Strong • Differ by what information is used • Weak – past stock prices and returns • Semi-strong – publicly known information • Strong – all information including private

Fama 1970 Article • Random Walk • f(rj, t+1|Φt) = f(rj, t+1) • Where the density function ft is the same for all t • Special Case is the “Fair Game” model • E(pj, t+1|Φt) = [1 + E(rj, t+1|Φt)]pj,t • Sub-martingale • E(pj, t+1|Φt) ≥ pj,t or E(rj, t+1|Φt) ≥ 0

Fama’s Conclusions • Weak form strongly supported by data • Semi-strong seems to be supported but • Some evidence of return correlation • Strong form contradicted by market maker study

And There Things Stood • In 1970

The End

Behavioral Finance