Behavioral Finance Economics 437 Behavioral Finance EMH January

Behavioral Finance Economics 437 Behavioral Finance EMH January 23, 2018

Review of EMH n Four Different Articles addressing what EMH means and the history of Behavioral Finance Shleifer (Chapter 1) n Schiller (on Collab at course website) n Malkiel (on Collab at course website) n Fama (on Collab at course website) n Behavioral Finance EMH January 23, 2018

Reading (starting Jan 25) “Noise Trading” – Limits to Arbitrage n Black on Toolkit n Shliefer on Toolkit or Chapter 2 in book n Burton & Shah, pp 1 -51 Behavioral Finance EMH January 23, 2018

The Milton Friedman argument for market efficiency in the presence of “noise traders” n If noise traders are truly “random, ” then their effects will “cancel out. ” (Kind of a law of large numbers result) n Noise traders are “systematic, ” then arbitrage traders will “trade against them” and take all of their money n Thus prices will be efficient in either case Behavioral Finance EMH January 23, 2018

The Efficient Market Hypothesis (according to Fama 1970) n Three forms: n Weak n Semi-strong n Strong n Differ by what information is used n Weak – past stock prices and returns n Semi-strong – publicly known information n Strong – all information including private Behavioral Finance EMH January 23, 2018

Fama’s Conclusions n Weak form strongly supported by data n Semi-strong seems to be supported but n Some evidence of return correlation n Strong form contradicted by market maker study Behavioral Finance EMH January 23, 2018

Others: n Shiller: focuses on who volatile stock prices are relative to how stable are things that are supposed to determine stock prices – expected future interest rates, dividends, etc. n Malkiel: argues that it is extremely difficult to “beat the market” implying that must mean that EMH is likely to be true n Shleifer: makes the “limits to arbitrage” argument to counter the Friedman view that arbitrageurs will make markets efficient Behavioral Finance EMH January 23, 2018

But “traders” saw things otherwise n January tells the tale n Blue Monday; Happy Friday n Good market precede holidays n Trading Rules n Technical analysis (charting stock prices) n Graham and Dodd “Security Analysis” 1934 n Price momentum (related to charting) n Booms and busts Behavioral Finance EMH January 23, 2018

The Law of One Price n Can the same product trade at two different prices without some tendency for the two prices to converge to one another? n Law of One Price says “no” n But……. . n Oct 19 1987 (22% drop with no information change) n Royal Dutch Shell n Closed End Funds n Palm Pilot Stub n Meanwhile: Kahneman and Tversky n De. Bondt and Thaler Winner’s Curse n Behavioral Finance EMH January 23, 2018

The End Behavioral Finance EMH January 23, 2018