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Behavioral Finance

Behavioral Finance. Economics 437. Reading by Today. Malkiel (online) Shiller (online) Shleifer (book, Ch 1). Shleifer’s Chapter One. Begin’s with Fama’s Definition and then argues that EMH had appeal: Theoretically Empirically That appeal would be undermined

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Reading by Today • Malkiel (online) • Shiller (online) • Shleifer (book, Ch 1)

  3. Shleifer’s Chapter One • Begin’s with Fama’s Definition and then argues that EMH had appeal: • Theoretically • Empirically • That appeal would be undermined • Limits to arbitrage arguments • Predicability in stock prices

  4. Shleifer is more guarded about the evidence from psychology • Page 25: • “There is a lot of psychology that might be relevant for the formation of investor sentiment, and no obvious way of deciding which psychological biases are the most important. As a consequence, the research on investor sentiment has been more tenative.”

  5. 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

  6. Definition of EMH (Eugene Fama’s Definition) from Shleifer’s Chapter One • Weak Hypothesis: past prices and returns are irrelevant • Semi-Strong Hypothesis: all publicly known information is irrelevant • Strong Hypothesis: public and private information is irrelevant

  7. The Malkiel View • Burton Malkiel, author of “Random Walk Down Wall Street”: • Page 60: • “By the start of the twenty-first century, the intellectual dominance of the EMH had become far less universal.” • “Economists….came to believe that future stock prices are somewhat predictable…”

  8. Most interesting • Malkiel’s Treatment of Oct 19, 1987: • Page 73: • “A number of factors could rationally have changed investors’ views about the proper value of the stock market in October 1987.” • Quoting Merton Miller: “..on Oct 19, some weeks of external events, minor in themselves…cumulatively signaled a possible change a possible change in what had been up to then a very favorable political and economic climate for equities….and….many investors simultaneously came to believe they were holding too large a share of their wealth in risky equities.”

  9. Robert Shiller’s View • Prices should be based upon fundamental • Future cash flows (or dividends) and future interest rates • Prices are way too volatile as compared to the modest changes over time in expectations of future cash flows and interest rates • Thus, the market is not efficient – prices are too volatile to be consistent with efficiency

  10. The End

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