EMH and EPP Flashcards
Key themes
Thaler (1999)
Evidence that should worry Efficient market advocates: Volume, Volatility, Dividends, Equity Premium Puzzle, Predictability
Thaler (1999)
Conclusion: We can enrich our understanding of financial markets by adding a human element.
Thaler (1999)
The end of Behavioural finance: He predicts in the not too distant future the term ‘behavioural finance’ will be correctly viewed as a redundant phrase.
Samuelson (1965)
Stock prices should follow a random walk for an efficient market if rational competitive investors require a fixed rate of return. (EMH)
Fama (1970)
Argues that in an efficient market prices reflect all there is to know about a capital asset.
Sharpe, Lintner, Black
CAPM provides a route for testing the EMH.
Michael Jensen (1978)
“the efficient market hypothesis is the best established fact in all of social sciences”
Shiller (1981)
Aggregate stock prices appear to move much more then can be justified by changes in intrinsic value - stock market volatility to be far greater than can be justified by changes in dividends.
De-Bondt and Thaler (1985)
For each year from 1933 portfolios are formed of the best and worst performing stocks over the previous three years. EMH suggests both portfolios will perform equally well on average. (Long-Run Reversion)
Kamstra, Kramer and Levy (2000)
Changes in Daylight Savings Time
Banz (1981) and Reinganum (1981)
Evidence that the CAPM
- Understates cross-sectional average returns of NYSE and AMEX listed firms.
- Overstates those of firms with high market values of equity.
- Effect concentrated in January
Both effects, however, now seem to have disappeared.
October 19th 1987
Doubts about EMH - S&P 500 falls by 22.6%
Cutler et al (1991)
Examine the 50 largest one day stock price movements in the US after WW2- most occurred on days with no major announcements
Roll (1984)
Orange juice futures
Fama (1998)
Argues against behavioural finance,
Thaler (1999)
Argues against behavioural finance - it will soon die out.
Kahneman and Tversky (1979)
Paper represents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory.
Kahneman and Tversky (1979)
Several classes of choice problems in which preferences systematically violate the axioms of EUT. Certainty Effect, Reflective Effect, Isolation Effect
De Bondt (1998)
Behaviour of small investors who manage their own equity portfolios.
De Bondt (1998)
Many people:
1) Discover naive patterns in past price movements
2) Share popular models of value
3) are not properly diversified
4) Trade in suboptimal ways
De Bondt (1998)
Four Classes of Anomalies
1) investors perception of the stochastic process of asset prices
2) investors perception of value
3) the management of risk and return
4) Trading practices
De Bondt (1998)
Popular methods of spotting trends and turning points in stock prices; average rules, trading range break rules, filter rules.
De Bondt (1998)
Why does it matter if small investors do not behave as expected.
1) substandard financial management directly effects peoples well being.
2) Investors behaviour likely affects what happens in markets.
Mehra and Prescott (1985)
Examine how large the risk aversion parameter, a, needs to be to explain the observed equity premium.
- They find that to account for the observed equity premium the risk aversion parameter needs to be in the range of 30-40
- Use the Expected Utility representation of the investment decision. There is an option to try and alternative decision-making model - Prospect Theory.
Arrow (1971)
Empirical estimates of (a) are in the neighbourhood of 1-2.
- Arrow argues on theoretical grounds that a “must hover around 1, being , if anything , somewhat less for low wealths and somewhat higher for high wealths.
Benartzi and Thaler (1995)
Myopic Loss Aversion - The less regularly people monitor their portfolio the more equity they will hold.
Thaler et al. (1997)
Support for myopic loss aversion comes from an experiment by Thaler et al (1997). The subjects have to divide an investment between two funds
- Fund A: behaves like bonds
- Fund B: behaves like equity (and does better on average)
Subjects allocate month by month , others annually, others 5 year time frame.
Thaler et al. (1997)
Also tests for loss aversion. They run a condition called “inflated monthly”
In this condition they increase the level of returns (holding the variance constant) to eliminate the possibility of losses.
Under loss avers, this should increase willingness to take risk, so less should be invested int eh bond fund.
This prediction is borne out.
Eugena Fama
Extreme risk aversion: “a large equity premium is not necessarily a puzzle; high risk aversion may be a fact. roughy speaking, a large equity premium says that consumers are extremely avers to small negative consumption shocks. This is inline with the perception that consumers live in morbid fear of recessions even though, at least in the pos war period, recessions are associated with small changes in consumption.
