Inefficient Markets: An Introduction to Behavioral Finance
Product Description
The efficient markets hypothesis has been the central proposition in finance for nearly thirty years. It states that securities prices in financial markets must equal fundamental values, either because all investors are rational or because arbitrage eliminates pricing anomalies. This book describes an alternative approach to the study of financial markets: behavioral finance. This approach starts with an observation that the assumptions of investor rationality and perfect arbitrage are overwhelmingly contradicted by both psychological and institutional evidence. In actual financial markets, less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems. The book presents models of such markets. These models explain the available financial data more accurately than the efficient markets hypothesis, and generate new predictions about security prices. By summarizing and expanding the research in behavioral finance, the book builds a new theoretical and empirical foundation for the economic analysis of real-world markets.
Inefficient Markets: An Introduction to Behavioral Finance
Comment by Gaetan Lion
Markets are not efficient in part because Investor Sentiment is a strong factor creating momentum (either upward or downward trend, whether sentiment is positive or negative). Also, arbitrage is very weak, as there are no proper securities substitutes, shorting the indexes is too risky. The “Noise Trader Risk” is too great. Meaning equity values may continue to diverge long enough for the arbitrageurs to loose their shirt betting on convergence. The investor type is a very important characteristic to factor. This explains the close end fund puzzle. The discount on closed end fund tracks the fate of small cap stocks. When small cap stocks do poorly, the discount on closed end funds deepens. This is because both investments are dominated by the same type of investors: individuals – small investors. Thus, both investment types are subject to small investors’ sentiments.
Rating: 4 / 5
Posted on November 28, 2009 at 3:43 pm
Comment by Dr. Martingale
Beneath my comments, writes Roseblatt:
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In chapter 4, he is concerned with the ‘limits of arbitrage’ (the original title of this paper, published in the JOF in 1997). This paper is definitely worth reading to understand the problems with hedge funds and other arbitrageurs. However, linking the limits of arbitrageurs to ‘inefficiency of the market’ is erroneous. The very fact that arbitrageurs can not take advantage of what they think are mispriced assets, due to collateral constraints (Schleifer’s hypothesis), shows that the market is efficient, since no free money is floating around.
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No, with the ‘limits of arbitrage’, the mispricing cannot be corrected quickly. The logic lies like this: suppose A sees the arbitrage opportunity, but due to the “limit”, he can only trade certain shares, and makes $10 FREE MONEY. He knows there is still another $10 “on the table”, but he cannot take action anymore. At this point, if no one else sees this arbitrage opportunity, the market remains inefficient until another arbitrageir B jumps in and remove that “remaining $10 on the table”. Of course A and B made “free money”. Shleifer’s treatment is perfectly Okay. Roseblatt’s rebuttal is illogic and obviously wrong.
However, EMH itself is a hoax. It is not scientific at all. I believe in the early days, financial economics was dominated by people who had little quantitative or science training, therefore, they could only do something like EMH sort of soft libral arts type of research. To me, it is not EMH, it is how quickly the information gets reflected in stock prices; and how big is the limit of arbitrage. Nothing else. I suggest the new generation of high-level finance researchers should totally discard this spurious EMH topic. Period.
Rating: 2 / 5
Posted on November 28, 2009 at 4:00 pm
Comment by Anonymous
There is too much maths in the book. However, the comments and interpretation on various models are very interesting. The authour distinguish between arbitrageurs and noise traders. He also give us a theory of substituability which is interesting but inapplicable in reality. Too much theory also with a lot of hypothesis that are not respected in real markets.
I was looking more for a book on investment psychology and I was disappointed.
Rating: 3 / 5
Posted on November 28, 2009 at 6:50 pm
Comment by Robert Stephenson-padron
As has been admitted by even the staunchest former proponents of financial economics (such as Burton Malkiel), the multi-decades old dominant intellectual field in academic finance has piled up against itself persistent anomalous data. Thus, it is no surprise, as the science of economics advanced, that a new intellectual field would develop to challenge and replace the old. Behavioral finance, which relaxes some of the key assumptions in financial economics, utilizes survey data, and integrates knowledge from psychology to better understand financial markets, is that new intellectual field.
Although still controversial, young economists and financial professionals should become versed in this new field as early as possible: 1) because there is huge room for new research where creative economists can flex their muscle and 2) financial professionals that drop the old adherence to financial economics will have an edge over those that don’t. Andrei Shleifer’s work is the best introductory work on behavioral finance that I’ve come across, and I thus strongly recommend it to those who want a quick and easy to understand introduction to this field which is the wave of the future of academic finance (well, I hope).
Robert Stephenson-Padron
MSc student (economics & finance)
University of Navarra, Spain
Rating: 5 / 5
Posted on November 28, 2009 at 8:14 pm
Comment by Leonard J. Wilson
Inefficient Markets by Harvard economist Andrei Shleifer provides a strong argument against the Efficient Market Hypothesis (EMH) in its various forms and an introduction to Behavioral Finance. Shleifer’s main points are summarized below.
1. The EMH comes in three forms. The Weak Form states that an investor can not achieve returns above the market averages based on the analysis of historical stock price patterns (Technical Analysis). The Semi-Strong Form states that all publicly available news is reflected in stock prices almost instantaneously and that an investor can not beat the market averages by diligently tracking company earnings and other events (Fundamental Analysis). Finally, the Strong Form says that an investor can not beat the market even by using information that is not available to the public (Insider Trading). The Strong Form can be dismissed by considering the number of corporate executives currently under indictment or serving time for insider trading. Evidence against the Semi-Strong and Weak Forms can be found in the Small Stock Effect (small stocks outperform the market) and January Effect (the market does best in January) which seemed to hold until they were widely publicized but have presumably been negated since then by arbitrage. Additional evidence against the EMH can be found in the less than perfect correlation between the price movements of Royal Dutch and Shell Transport and Trading shares which jointly own the Royal Dutch Shell enterprise in a fixed 60%/40% ratio. Furthermore, the prevalence of a 10% to 20% discount in the share price of closed end funds relative to their net asset values suggests that the market is less than efficient.
2. In Chapters 2-4, Shleifer demonstrates the limits of arbitrage in maintaining efficient markets. He develops a mathematical model for predicting the returns of arbitrageurs (who accurately perceive the values of stocks) and noise traders (who incorrectly perceive the same values). His Noise Trader Model explains how noise traders can sometimes achieve higher returns than arbitrageurs based on the “hold more” and “create space” effects. The “hold more” effect is based on the community of noise traders egging each other on as was seen in the technology bubble that burst in 2000. The “create space” effect says that the wider the range of incorrect perceptions held by noise traders, the less effective arbitrageurs will be in bring stock prices back to their correct values. Shleifer uses the Noise Trader Model to make additional predictions about the market behavior of closed end funds and shows that, unlike the EMH, it accurately models such phenomena as the rise in share price to the underlying net asset value upon liquidation or reorganization as an open end fund. Finally, he shows that professional arbitrageurs, such as hedge fund operators, are forced to adopt more conservative tactics than individual arbitrageurs by their need to retain clients and funding.
3. In Chapters 5 and 6, Shleifer develops a model of Investor Sentiment based on investors’ patterns of psychological underreaction and overreaction. Investors tend to underreact to new information (such as reported earnings) by modifying their perception of a stock’s value by less that the new information would suggest and continuing to extrapolate the old stock price trend. If confronted with repeated inputs of new information that consistently points in the same direction, investors tend to overreact by discarding the old model, accepting the recent trend as the new model, and extrapolating it into the future. Finally, he shows how investor sentiments can form a positive feedback trading environment in which arbitrage can actually destabilize the market.
This is a book for serious students of finance. It’s not a “Behavioral Finance for Dummies”. However, the math does not require more than a year of calculus and a good understanding of calculus-based probability and statistics. Shleifer’s writing style is remarkably clear for an academic economist (many of whom I find able to obfuscate the simplest concepts). Overall, Inefficient Markets is a long-overdue reexamination of the theoretical underpinnings of modern finance theory.
Rating: 5 / 5
Posted on November 28, 2009 at 9:20 pm