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Market imperfections. “Have no fear of perfection - you'll never reach it.” Salvador Dalí. -A Market in which prices always “fully reflect” available information is called “perfect” (Eugene F. Fama , Efficient Market Hypothesis)
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Market imperfections “Have no fear of perfection - you'll never reach it.” Salvador Dalí
-A Market in which prices always “fully reflect” available information is called “perfect” (Eugene F. Fama, Efficient Market Hypothesis) Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed Theory assumes that all information is reflected to traders, which implies that it is impossible to make any profit from any trading strategy. However, the majority of traders simply live on that earnings. There are some strong arguments, why the efficient market hypothesis may be errant. Why life is not perfect?
Axiom I: The truth is one. the points of views are different
Axiom Ii: Information spreads slowly, but people react fast • Traders who get some new information about stocks first will benefit more, than those who will get it later. • Most generally they can take the advantage of the situation, when they notice or understand some anomalies (“The Big Short”, House Market Failure)
Although the ban of the government to manipulate on stock exchange market, people tend to do it as well. Axiom IIi: People are not rational machines • Stock prices can be affected by • Human errors • Emotional decision making Good example is Gold Price fixing, which is organized in every business day at 10.30am and 3pm, by London time, by some group of people who can easily manipulate the prices and get extremely high profits.
Definition of inefficient market • An inefficient market is a theory which asserts that the market prices of common stocks and similar securities are not always accurately priced and tend to deviate from the true discounted value of their future cash flows. • Empirical Evidence on investor behaviour: • investors fail to diversify. • investors trade actively (Odean). • Investors may sell winning stocks and hold onto losing stocks (Odean). • extrapolative and contrarian forecasts. “Life is not always perfect. Like a road, it has many bends, ups and down, but that’s its beauty.” Amit Ray, World Peace: The Voice of a Mountain Bird
Black Monday (1987) Crash of 1987: 22.6% decline without any apparent news.
Herd Behavior • Herd behavior describes how individuals in a group can act collectively without centralized direction. • Individual investors join the crowd of others in a rush to get in or out of the market. • Many traders make the error of following a lead and assuming that if so many people are doing it, it must be the right move. What they do not realize is that those “so many people” had the same thought just moments before. Now this can work to your advantage if you get in in the beginning of such a trend, but if you join late, it might work against you.
Prospect Theory Kahneman and Tversky presented an idea that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. According to prospect theory, losses have more emotional impact than an equivalent amount of gains. For example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50. However, despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favourably than gaining $100 and then losing $50.
Prospect Theory (example) Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved making judgments between two monetary decisions that involved prospective losses and gains. For example, the following questions were used in their study: You have $1,000 and you must pick one of the following choices: Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0. Choice B: You have a 100% chance of gaining $500. You have $2,000 and you must pick one of the following choices: Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. Choice B: You have a 100% chance of losing $500.
Prospect Theory (results) Please raise the hands all of those who have chosen Choice A for both of the questions. Please raise the hands all of those who have chosen Choice B for both of the questions. For the rest: turn off your emotions, Think rationally
Anchoring effect The Misconception: You rationally analyze all factors before making a choice or determining value. The Truth: Your first perception lingers in your mind, affecting later perceptions and decisions. In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point(anchor), may be suggested by the formulation of the problem, or it may be the result of partial computation. In either case, adjustments are typically insufficient…that is, different starting points(anchors) yield different estimates, which are biased toward the initial values. Judgment Under Uncertainty” by Kahneman, Tversky
Anchoring effect(examples) Is it more or less then 600$? Is it more or less then 1000$? How much approximately? How much approximately?
Anchoring effect(examples) And the winner is Any question, in fact, would have created the anchor. Does that seem rational? Of course not.
Overconfidence "No problem in judgment and decision making is more prevalent and more potentially catastrophic than overconfidence".Plous (1993) "There are two main implications of investor overconfidence. The first is that investors take bad bets because they fail to realize that they are at an informational disadvantage. The second is that they trade more frequently than is prudent, which leads to excessive trading volume."Shefrin (2000) Overconfidence can cause investors to underreact to new information.
Underreaction "In predicting the future, people tend to get anchored by salient past events. Consequently, they underreact."Shefrin The underreaction evidence shows that security prices underreact to news such as earnings announcements. If the news is good, prices keep trending up after the initial positive reaction; if the news is bad, prices keep trending down after the initial negative reaction Shleifer ‘Rather, what we find is apparent underreaction at short horizons and apparent overreaction at long horizons.’
Overreaction According to market efficiency, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.Is this always TRUE? Not exactly. Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.
the Availability Bias According to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news. This happens in real life all the time. For example, suppose you see a car accident along a stretch of road that you regularly drive to work. Chances are, you'll begin driving extra cautiously for the next week or so. Although the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you'll be back to your old driving habits by the following week.
Conclusion “The true genius shudders at incompleteness — imperfection — and usually prefers silence to saying the something which is not everything that should be said.” ― Edgar Allan Poe, Marginalia The information flow is always asymmetric People always speculate to make more money How people behave, their feelings always affects the market prices and decision-making Even if information is available to everyone people react differently under different emotional affection by over(under)reacting or even just by being manipulated