Market Efficiency and Behavioral Finance Flashcards
Why are stock prices often assumed to follow a random walk and what does this mean for stock market predictability
Random walk = process in the discrete period, it’s a sequence of random states that are connected to each other (price changes are random)
Randomness is not a sign of irrationality: it’s consistent with rational market participants. With new information, prices adjust accordingly (only the fastest traders make a profit from new info)
The concept of market efficiency and its implications for price formation on financial markets
Prices in financial markets immediately and correctly reflect all publicly available information.
Unpredictability: price changes reflect a random flow of info, so they occur randomly
Random walk: prices change erratically, as new info arrives
Three forms of market efficiency
weak-form efficiency: not possible to achieve systematic superior investment performance on the basis of analysis of historical prices and returns
semi-strong-form efficiency: not possible to achieve systematic superior investment performance on the basis of publicly available information (usual market efficiency)
strong-form efficiency: not possible to achieve systematic superior investment performance on the basis of any information (public and private)
Researchers have documented empirical evidence for and against market efficiency
By analyzing how fast security prices respond to different types of information (earnings, dividends, or takeover announcements).
Understanding market efficiency:
“There is no free lunch”: no arbitrage opportunities
“prices are equal to the value”: the market price of a security is equal to its fundamental value
- these definitions aren’t identical
challenging market efficiency:
the two above assumptions can be violated:
“Siamese twin companies: Royal Dutch Shell”: with the merger, the ratio of both prices was always different, violating the assumption that two assets with identical CF have the same price
“Equity carve-outs: 3Com”: selling off business in IPO - despite this, very high share price
might be rare anomalies, but can also be the tip of the iceberg
Momentum: a challenge too weak to form efficiency
it’s a strategy that buys past winner stocks and sells short past loser stocks.
- scaling the strategy is difficult, it works in an academic setting
- the larger the shares, the cheaper it is to execute the strategy.
- you rank all shares over 6 months and then buy the best ones to hold for 3 months after closing (strategy worked well during dotcom bubble burst)
How behavioral finance challenges human rationality and explains observed inefficiencies with (distorted) risk attitudes and beliefs about probabilities
Behavioral finance tries to explain why prices can depart from fundamental values.
People aren’t always rational (people’s attitude about risk and their beliefs about probabilities - hard to overcome biases): it relies on insights from psychology and attempts to explain empirically observed patterns that are inconsistent with rational investors and efficient markets
Behavioral finance: attitude about risk
people are risk-averse when it comes to choices involving gains.
people are risk-seeking when it comes to choices involving losses.
- Rational person wouldn’t be influenced by the framing of the lottery, but: the disposition effect (when people trade in portfolios, they always sell winners and cash out a loss when selling - they gamble for resurrection and sell best-performing stocks)
Behavioral finance: beliefs about probability
People make all sorts of systematic biases when assessing the likelihood of uncertain events or when interpreting data.
- anchoring: purchase price serves as an anchor when deciding whether to sell the stock in the future - is irrational
- overconfidence: people are overconfident when assessing probabilities about uncertain events or when comparing themselves to their peers
- ambiguity aversion: we prefer a gamble in which we know the odds and know as much as possible. Avoidance of ambiguity can result in us making inconsistent decisions
Behavioral finance: individual trading behavior
Overconfident people can trade more excessively and psychological research has shown that men are overconfident in their trading abilities: men trade more, but gross performance is the same between men and women - only high trading costs for men
Behavioral finance: an explanation for momentum
The momentum pattern is consistent with underreaction to news and delayed overreaction: conservatism
Behavioral corporate finance: CEO overconfidence
overconfidence is measured by CEO’s personal over-investment in their company and CEO’s press portrayal
- odds of making M&A are higher if the CEO is overconfident (they overestimate their ability to generate returns and if they have access to internal financing, effect is higher)
