4. Efficient Markets and Behavioural Finance Flashcards
Central limit theorem
The distribution of the sum (or average) of a large number of independent, identically distributed variables will be approximately normal, regardless of the underlying distribution
How has the DJI followed the central limit theorem?
It is less clustered around the centre and has fatter tails
Fundamental principle of optimal forecasting
The forecast must be less variable than the variable forecasted
What does shiller argue about markets
There is excess volatility in the aggregate stock market, so substantial that it dominates the movements
What does Malkiel argue about markets?
The market ususally does an effective job of allocating capital to its most productive uses, however there are occasionally bubble periods
What is the efficient market theory about smart money vs ordinary investors
When irrational optimists buy, smart money sells, and when irrational pessimists sell, smart money buys so the effect of irrational traders on the market is eliminated
Theoretical challenges of the smart money vs ordinary investors theory
- smart money can amplify fluctuations by buying ahead of the feedback traders in anticipation
- offsetting risk caused by irrational investors can be risky since it requires short selling
What does prospect theory suggest about investors reluctancy to get out of trades?
Investors are more reluctant to get out of losing stocks since they are willing to take greater risks in order to avoid losses
Rational expectations hypothesis
Market participants form their expectations about the future on the basis of statistically optinal forecasts.
Coibion and Gorodnichenko test
A way of testing if rational expectations hypothesis works
Bayes rule
Describes how a degree of belief, expressed as a probability, should rationally change to account for the availability of related evidence
In the Coibion and Gorodnichenko test what does a positive beta 1 value mean?
The test consistently underpredicts
Rational inattention and under reaction
It is too costly to collect and process all info and thus agents are rationally inattentive to new info. Agents under react to new info
Diagnostic expectation and over reaction
We say a state becomes more representative when new info increases the probability of that state. The agent over reacts to new info
Agent based models
Simulate the simulataneous interactions of multiple agents that operate using simple behavioural rules
