Behavioral Finance Introduction January 13, 2015 Behavioral Finance Economics 437

Behavioral Finance Introduction January 13, 2015 Course Information Three Books Andre Shleifer – “Inefficient Markets” Daniel Kahneman – “Thinking: Fast and Slow Edwin Burton – Sunit Shah – “Behavioral Finance” Online Reading at Toolkit Reading is difficult I-Clickers - required Lectures Exams Two mid terms Mch 3 and April 16 Final May 7: 2PM Office Hours 11-12: Tues, Wed, Thur at VNB office (not on grounds)

Behavioral Finance Introduction January 13, 2015 Course Topics Review of MPT & EMH Limits to Arbitrage Anomalies Serial Correlation in Stock Returns

Behavioral Finance Introduction January 13, 2015 Immediate Reading (today, Jan 13) Malkiel (online) Shiller (online) Shleifer (book, Ch 1) Fama (online)

Behavioral Finance Introduction January 13, 2015 Reading (starting Jan 19) “Noise Trading” – Limits to Arbitrage Black on Toolkit Shliefer on Toolkit Kahneman, pp Burton & Shah, pp 1-51

Behavioral Finance Introduction January 13, 2015 The Efficient Market Hypothesis (EMH) Price captures all relevant information Modern version based upon “No Arbitrage” assumption Why do we care? Implications Only new information effects prices Publicly known information has no value Investors should “index” Allocation efficiency

Behavioral Finance Introduction January 13, 2015 The Milton Friedman argument for market efficiency in the presence of “noise traders” If noise traders are truly “random,” then their effects will “cancel out.” (Kind of a law of large numbers result) Noise traders are “systematic,” then arbitrage traders will “trade against them” and take all of their money Thus prices will be efficient in either case

Behavioral Finance Introduction January 13, 2015 But, then October 19, , Article by Eugene Fama and Ken French The Tech Bubble The Rise of Hedge Funds

Behavioral Finance Introduction January 13, The “Rip Van Winkle” Year July 2700 Jan 2200 October Dec 2200

Behavioral Finance Introduction January 13, 2015 Fama and French Both authors are staunch supporters of EMH 1992 Article gave a simple formula to pick stocks that “beat the market” consistently This lead “respectability” to a growing literature that simple formulae could “beat the market”

Behavioral Finance Introduction January 13, 2015 The Tech Bubble 1999 Nasdaq up 100 percent for the year Priceline: Came public at 20, rose to 200, fell to under 1 No news of substance Nasdaq peaked at 5000 in March 2000 Fell to 1800 by 2002

Behavioral Finance Introduction January 13, 2015 Hedge Funds Industry grew from cottage industry to massive industry Charges very, very high fees to customers Idea: they can outperform the market; thus they deserve the big fees Used by Harvard and Yale endowments (UVA as well)

Behavioral Finance Introduction January 13, 2015 The Efficient Market Hypothesis (according to Fama 1970) Three forms: Weak Semi-strong Strong Differ by what information is used Weak – past stock prices and returns Semi-strong – publicly known information Strong – all information including private

Behavioral Finance Introduction January 13, 2015 Fama 1970 Article Random Walk f(r j, t+1 |Φ t ) = f(r j, t+1 ) Where the density function f t is the same for all t Special Case is the “Fair Game” model E(p j, t+1 |Φ t ) = [1 + E(r j, t+1 |Φ t )]p j,t Sub-martingale E(p j, t+1 |Φ t ) ≥ p j,t or E(r j, t+1 |Φ t ) ≥ 0

Behavioral Finance Introduction January 13, 2015 Fama’s Conclusions Weak form strongly supported by data Semi-strong seems to be supported but Some evidence of return correlation Strong form contradicted by market maker study

Behavioral Finance Introduction January 13, 2015 And There Things Stood In 1970

Behavioral Finance Introduction January 13, 2015 The End