Section 4 Flashcards
what is the efficient market hypothesis?
The idea that security prices instantaneously reflect all available information
stock price reflects all available information - thus impossible to beat stock market in long run
fundamental analysis is pointless as past events are no use in terms of the randomness of the markets in future.
what if true does efficient market hypothesis mean?
That the market prices of securities will always equal the fair or fundamental values of those securities - and if they are not equal, then the difference is so small it cannot be exploited net of transactional costs
According to EMH when do prices change?
Only in response to new information, which is unpredictable. Therefore they follow a random path
According to EMH what should it be hard for active traders in financial markets to do?
Outperform passive investment strategies such as holding market indices
What are the three versions of EMH?
Weak form
Semi-strong form
Strong form
What is Weak form EMH?
security prices already reflect all information contained in the past history of market prices and volume. Hence technical analysis is a fruitless activity.
What is weak form EMH consistent with?
Random walk hypothesis which says that price changes are independent and suggests that one could only beat the market by using fundamental analysis or insider trading .
What is semi-strong form EMH?
all publicly available information about a firm (e.g. annual reports) is already contained in the stock price. Since past prices are a part of publicly available information, then weak form also holds.
at this level can’t use fundamental analysis
What does strong form EMH state?
A security price reflects all information relative to a firm, including information only available to company insiders. This is an unlikely and extreme case, as it would often involve the use of illegal inside info. If strong form holds then so does weak and semi-strong
no investor can beat over the long run over a risk adjusted basis
According to EMH what conditions are needed for an efficient market?
- A large number of rational, profit-maximising investors exist who actively participate in the market hence securities are valued rationally
- If some investors behave non-rationally then this is random and hence they cancel each other out - or rational arbitrageurs eliminate the influence of irrational agents
- Information is free and widely available, but if activities of irrational traders are correlated, then arbitrageurs act to eliminate the mispricing
what does EMH not negate?
that risker investors can win in short term
What acts as evidence against EMH?
- anomalies in the market e.g. seasonal variations / weekend effects
- announcements relating to earnings seem to have a relatively long-lasting impact on stock prices even after adjusting for risk and transactions costs
What are the basic tenets of standard finance / modern portfolio theory?
1) investors are rational
2) markets are efficient
3) investors design their portfolios according to mean-variance portfolio theory
4) expected returns depend on risk alone
What does behavioural finance suggest as alternatives to standard finance / modern portfolio theory?
1) Investors may not be rational and they are real people who make decisions in ways that may be considered normal but not necessarily rational
2) Markets are not efficient, even if they are hard to beat
3) Investors design portfolios according to rules of behavioural theory not mean variance portfolio theory
4) Expected returns are driven by a range of factors as well as risk
According to behavioural finance when making decisions what do investors do ?
- do not always process information correctly, and therefore do not infer the appropriate probability distribution of future returns
- often make inconsistent or systematically suboptimal decisions. This can lead to mispricing and profit opportunities which will persist if there is limited arbitrage activity.
what is framing bias?
Decisions are influenced by how choices are framed
what is memory bias
too much weight given to recent experience when making forecasts.
What is overconfidence bias in behavioural finance?
agents overestimate the precision of their beliefs or forecasts and hence they tend to overestimate their abilities.
what is confirmation bias in behavioural finance?
when an agent is more open to information which confirms their pre-existing values
what is conservatism bias in behavioural finance?
when investors are too slow in updating their beliefs in response to new evidence.
what is sample size neglect in behavioural finance?
agents infer wider population behaviour from a small sample. Trends are then extrapolated too far into the future
what is endowment effect in behavioural finance?
when an investor places a higher value on an asset they own than they would if they did not own it
what is prospect theory / loss aversion in behavioural finance?
refers to the fact than individuals have been shown to value gains and losses differently (including selling winning stocks too soon and holding loosing stocks too long)
what is anchoring in behavioural finance?
placing too much emphasis on irrelevant facts e.g. previous stock price
what is faulty framing in behavioural finance?
where normal investors fail to mark their stocks to market prices and maintain them at the purchase price in mental accounts. they instead mark stocks to market only when they sell the stocks and close the mental account. Normal investors do not acknowledge paper losses
what is hindsight bias in behavioural finance?
misleads investors into thinking that what is clear in hindsight was just as clear in foresight. leads to thinking they could have foreseen losing stocks and avoided them.
what is herd behaviour in behavioural finance?
tendency for individuals to mimic the actions of a larger group regardless of whether they are rational, even though they may not make the same choice as an individual.
what is mental accounting in behavioural finance?
agents segregate certain decisions. e.g. a savings account with low interest and credit account with high rate rather than seeing these as integrated and netting them out.
what does the behavioural finance alternative to standards modern portfolio theory involve?
dividing money into many mental accounts corresponding to goals such as retirement and eduction for which attitudes to risk vary
what does the asset pricing of behavioural finance reject?
The standard CAPM single-factor model
what does the asset pricing of behavioural finance align with?
More towards the multi-factor models
what is the key feature of behavioural finance in relation to risk?
Conventional finance treats factors such as the market of value as sources of risk, whereas behavioural interpretation sees these factors as reflections of emotions and cognitive biases
what do advocates of behavioural finance believe in terms of arbitrage
Behavioural biases would not matter for stock pricing if mistakes were always corrected by rational arbitrage by profit-seeking investors.
But advocates of behavioural finance believe that such arbitrage is limited by implementation costs, model risk (and whether it is really correct for valuing the security), and the uncertain time horizon required for the correction
what is the criticism of behavioural finance
it is a collection of interesting anecdotes with little predictive power than can be rigorously tested. But some e.g. disposition hypothesis have been tested
what does behavioural finance directly attempt to rationalise?
the existence of anomalies
what is financial amnesia?
a phenomenon where financial market participants behave in a way which suggests they have forgotten the lessons of financial market history
what is a bubble?
when financial valuations become removed from fundamentals
