Lecture 2 (intro to behaviour finance market microstructure) Flashcards
What is an efficient market?
An efficient market is one that cannot be beaten and therefore implies holding the market index
What are the 4 reasons as to why prices are efficient
1) investors are rational, evaluating information probabilistically
2) prices settle at equilibrium
3) instantaneous price change only when new information arrives
4) prices follow a random walk and are non-random, do not trend
How does a stock move in RANDOM price movement?
Prices should move in step fashion
How does a stock move in NON-RANDOM price movement?
Prices should move in waves
Name 4 aspects that EMH implies
1) it should rule out the possibility of trading systems
2) No one should be able to consistency beat the market
3) No payoff for information gathering and processing
4) With no new info, prices should oscillate in random and unbiased fashion
Name 2 false notions of market efficiency
1) Price movements are random and at rational values at all times
2) No one can beat the market: however this has been proven otherwise by practitioners (ex: Warren Buffet)
Name one aspect under SEMI-STRONG form efficiency that is evidence in favour of EMH
Prices should neither overreact or under react to news, a security’s price adjusts quickly and accurately to news.
Name one aspect under WEAK form efficiency that is evidence in favour of EMH
Stale, past information already public should have no predictive power - TA fails and does not generate superior risk adjusted returns
Name one aspect under CAPM & APT risk factors that is evidence in favour of EMH
To challenge EMH it must be demonstrated that gains are excessive after adjusting for risk
What are the 3 critiques that can be made about EMH assumptions
1) investors are rational (prices adjust instantaneously, quickly to new info)
2) investors errors are uncorrelated (prices follow a RW & returns are normally distributed)
3) Arbitrage forces are possible (If valuations of irrational investors turn out to be biased, then arbitrage forces prices back to equilibrium)
What are some problems with the idea that assumption that investors are rational
-investors are not as rational as you they appear
-price adjustment to equilibrium can be gradual, can under and over react
-Investors departures from rationality: inaccurate risk assessments, they make behavioural mistakes, commit poor probability judgements.
What are some problems with the idea that assumption that investors errors are uncorrelated
-the assumption is contradicted by psychological research showing that investors tend to make similar errors and do not deviate from rationality randomly
-errors can be correlated: a bad buy often times leads to a bad sell, herding, follow the leader, “window dressing”, retail clients act irrationally
What are some problems with the idea that assumption that arbitrage forces are possible
-arbitrage activities are more limited then it seems
-Improper use of leverage
-lack of perfect substitute to hedge
-cannot always borrow securities at will for short sells
What are the 3 empirical challenges to EMH
1) Excessive price volatility
2) Predictability studies with stale/past info
3) Predictability studies with excess risk-adjusted returns
Describe excessive price volatility in the 3 empirical challenges to EMH
-Prices are more volatile than fundamentals warrant
-Some price movements cannot be explained by financial analysis
Describe predictability studies with excess risk-adjusted returns in the three empirical challenges to EMH
-Contradict the semi-strong EMH, which implies that no abnormal returns can be made by acting on publicly available technical and fundamental information
-Serveral studies have shown that excess risk adjusted returns are possible using past fundamental infromation
what is bridging the gap?
Empirical studies need to prove why TA works and explain why does EMT/RWT not always hold, hence the into of a new model called behavioural finance
What is behavioural finance analysis or (BA)
-The study of how psychology affects finance and investment decisions
-Explains why investors depart from full rationality using elements of cognitive psychology, economics and sociology
What are limits of arbitrage?
Lack of perfect substitutes
What is limits of rationality?
Inefficiencies will occur but under what circumstances? Human judgment errors
What are the 10 psychological factors, judgement & cognitive errors all investors make
1) Conservatism bias
2) Confirmation Bias
3) Anchoring
4) Optimism/overconfidence
5) Crime of small numbers
6) Imitative behaviour/herding
7) Mental accounting
8) Ponzi schemes/bubbles
9) Self attribution
10) Prospect theory
What is CONSERVATISM BIAS under the 10 psychological factors, judgement & cognitive errors all investors make
-Too little weight given new information
-Your prior beliefs are not modified as much as new information warrants. You conserve your prior beliefs
What is CONFIRMATION BIAS under the 10 psychological factors, judgement & cognitive errors all investors make
-An investor’s beliefs become more extreme over time
-Info that confirms the investors position is given more credence, contradictory info is not payed attention to.
What is ANCHORING under the 10 psychological factors, judgement & cognitive errors all investors make
-An individual inability to sway from initial estimates, forecasts, opinion, personal bias
-Investor picks his position and stays with it no matter what
-Anchoring is the biggest factor that leads to investment losses
