Finance - SS200 Behavioural Economics - 3 March 2004 by Martin Barner

Papers Hirschleifer (2001): ”Investor Psychology and Asset Pricing”. Barberis & Thaler (2003): ”A Survey of Behavioral Finance”.

Agenda Introduction to behavioural finance, Have a closer look at limits to arbitrage. Violations of the Efficiency Market Hypothesis – one of the cornerstones in modern finance. Experiment on arbitrage in asset markets. Conclusions and perspectives.

Motivation The Efficiency Market Hypothesis was consensus in finance – Fama (1970). o Prices fully reflect all available information Merton: If you had invested $1 in 1926 in one-month US Treasury bills (and reinvested every month), the investment would by 1996 be worth $14. If you on the other hand had invested $1 in S&P500, the amount would have grown to $1,370. o This is essentially the equity premium puzzle What if you invested optimal?

Overview of behavioral finance Question rationality Two building blocks:  Limits to arbitrage  Psychology o Prospect theory o Disposition effect o Mental accounting o House money effect

Figure 1: - from Lamont & Thaler (2003),

Figure 2: - from Froot & Dabora (1999),

Figure 3: - from Lee, Shleifer & Thaler (1991),

Experiment on Arbitrage Rietz (2003): ”Trader Behavior, Arbitrage and Efficiency in Experimental Asset Markets”. Basic setup. o Oral double auction o !0 subjects doing 15 periods á 5-7 minutes o Two types of subjects and two asset (+cash). How to test arbitrage opportunities. Dynamics of price movement

Conclusion Clear violations of the efficiency market hypothesis as shown by the limits to arbitrage. Is it the iceberg?

Behavioural perspectives At the beginning of a research field Research is boundedly rational too! o Interplay between limits to arbitrage and cognitive biases. Competing behavioural explanations o A weakness? o How to compare alternative theories:  Empirical tests  Laboratory experiments