Behavioral Finance

1. Behavioral Finance Economics 437

2. Immediate Reading (today, Jan 24) • Malkiel (online) • Shiller (online) • Shleifer (book, Ch 1)

3. 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

4. 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

5. The Malkiel View • Burton Malkiel, author of “Random Walk Down Wall Street” • His view is that the evidence shows that money managers cannot beat simple indexes like the S&P500 over time • To Malkiel, that means the market is efficient

6. 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

7. A Martingale Process • Imagine a process X(t) over time • For any t, E[X(t)] is the “expected value of X at time” • Either: • ∑ Xi*P(Xi) for i: 1 to n if only discrete values of X • ∫X*f(X) dX where f(X) is a probability density function • “Expected value” is an average (weighted) • A Martingale Process is defined as a process with the following property: • E[X(t)] = X(s) for all t, s where s > t

8. Example of a “Martingale Process” • Coin flip • X(t) where X(0) = 0 • X(t+1) = X(t) plus F(t) • Where F(t) = +1 if coin flip is heads • Where F(t) = -1 if coin flip is tails • If p(H) = P(T) = ½ • Then E[X(t+1)] = X(t) • And E[X(s)] = X(t) where s> t • Hence X(t) is a Martingale Process

9. Can stock returns be a “Martingale Process?” • E[P(s)] = P(t) for all s > t ? • But shouldn’t stocks earn a return? • Suppose the mean return of a stock is r • Create a new variable, Q and assume s > t • Let Q (s) = P(s)*(1+r)-n where n = s – t • Then Q(t) = P(t) • E[Q(s)] = Q(t) for all s > t • Means that, after subtracting out a mean return of r, P(t) is a Martingale Process

10. Modern Finance Assumes • Stock Prices (Adjusted) Follow a Martingale Process • This is the definition of EMH in the modern finance literature • Also known as “random walk”

11. The End