Behavioral Finance Economics 437 Behavioral Finance Noise Traders

Behavioral Finance Economics 437 Behavioral Finance Noise Traders Jan 22, 2019

Reading (starting Jan 22) “Noise Trading” – Limits to Arbitrage n Black on Toolkit n Shliefer on Toolkit (Chapter 2 in book) n Burton & Shah, pp 1 -51 Behavioral Finance Noise Traders Jan 22, 2019

Recall 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 n Strong implies S-S implies Weak Behavioral Finance Noise Traders Jan 22, 2019

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 Noise Traders Jan 22, 2019

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 Noise Traders Jan 22, 2019

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 Noise Traders Jan 22, 2019

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 Noise Traders Jan 22, 2019

Fisher Black on “Noise” n Noise is good n Otherwise no trades n Otherwise no liquidity n Is the market efficient? n Yes n Why? – As long as it is within double the “correct” price Behavioral Finance Noise Traders Jan 22, 2019

Shleifer, Chapter 2 (or on Collab) n Four authors: Shleifer, Summers, De. Long, Waldman n Issue: can there be two different prices for two assets with exactly the same “fundamentals” Can such a discrepancy persist? n Can ‘noise traders’ actually do better than the ‘smart traders? ’ n Behavioral Finance Noise Traders Jan 22, 2019

The End Behavioral Finance Noise Traders Jan 22, 2019