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Market rationality Behavioral Finance vs. Classical Finance. Alexander Nagornov. Main questions. Is classical financial theory old and incapable of explaining most of the market riddles? Or just several modifications will be enough to make it work?
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Market rationalityBehavioral Finance vs. Classical Finance Alexander Nagornov
Main questions • Is classical financial theory old and incapable of explaining most of the market riddles? Or just several modifications will be enough to make it work? • What new can you find in behavioral finance? Can you use the results of research in this field to get excess returns?
Presentation Outline • A question of rationality • Known major deviationsfrom rational behavior • Royal Dutch / Shell Classical example • Classical theory strategic defense • Even more market anomalies
Are people rational? • Rationality Definition • Sometimes it’s really hard to be rational • Have you calculated NPV deciding to study at ABS? • Example of a Singing Professor • Subjective probability Overestimation of small probabilities when dealing with big potential profits and losses 1. Rationality
Rationality in finance • The Prime Directive • Asset prices have to be explained by rational models! • Behavioral Finance • Investors are just people with a great number of deviations from rational behaviour • That’s why there is a variety of effects, which explain market anomalies 1. Rationality
1. Excessive Confidence • Excessive confidence about the precision of private information • Biased self estimation • Willingness to keep “losers” and sell “winners” • Illusion of control – unjustified belief in an opportunity to influence events 2. Deviations from rational behavior
2. Statistical Errors • Gambler’s fallacy: a wish to see patterns where they can not be • Giving too small or too big probabilities to rare events • Giving excessive weight to personal experience • Excessive reaction – giving excessive weight to recent events 2. Deviations from rational behavior
3. Mistakes in statements • Axioms violation (e.g. transitivity) • Influence of sunk costs on financial decisions • Dynamic inconsistency: negative discount rates, etc. • Willingness to take excessive risks • Herding • Overestimation of the model results and theory implications 2. Deviations from rational behavior
Limits to arbitrage Royal Dutch / Shell Deviation John Maynard Keynes: The market can remain irrational longer than you can remain solvent • LTCM tried to make money on arbitrage • They failed • Closing positions made markets even less efficient 3. Limitations to arbitrage
Line of defense #1Market efficiency and rationality • Absolute rationality • all investors are rational • Rationality • “as if rational” • Weak rationality • not rational, but no profit opportunities 4. Classical Theory Defense
Line of defense #2Models are not perfect yet, but… • Rationality really takes into account several behavioral moments: • Greed • Risk aversion • Impatiens: discounting future values • Habit formation: need go away from additive-separable function of utility 4. Classical Theory Defense
Major market anomalies • Bubbles on financial markets • Excessive volatility • Risk premium riddle • Significance of Market-to-Book and Firm size vs. CAPM • Calendar effects 5. More anomalies
Conclusion • Markets are far from being rational and efficient • A variety of anomalies exist where they should not • Behavioral finance comes to the rescue • Takes into account decision making process • Do not ignore costs of thinking • Classical theory defense line: • Point to a weak form of rationality • Search the data errors