III. Financial Markets
A good place to start in an
evaluation of the potential importance of less-than-fully-rational agents is
financial markets. I say this because financial markets have the features that
should make it hardest to find evidence of misbehavior.
VOL. 106 NO. 7 THALER: BEHAVIORAL ECONOMICS: PAST,
PRESENT AND FUTURE 1587
These markets have low transaction costs (transaction costs are expenses incurred
when buying or selling a good or service. In a financial
sense, transaction costs include brokers' commissions and spreads,
which are the differences between the price the dealer paid for a security and
the price the buyer pays, https://www.youtube.com/watch?v=O5nhroJ7aMM ), high stakes, lots of
competition (except perhaps in some banking sectors) and crucially, the ability
to sell short (Short selling is an investment or trading
strategy that speculates on the decline in a stock or other securities price.
It is an advanced strategy that should only be undertaken by experienced
traders and investors, https://www.youtube.com/watch?v=l_wTFIWyN6E ). It is short selling that
allows for the possibility that even if most investors are fools, the
activities of “smart money” arbitrageurs can assure that markets behave “as if”
everyone were smart. This is the intellectual underpinning (an important basic part of
something that allows it to
succeed or continue to exist) of the
efficient market hypothesis (EMH). The efficient
market hypothesis (the efficient market hypothesis (EMH),
alternatively known as the efficient market theory, is
a hypothesis that states that share prices reflect all information
and consistent alpha generation is impossible, https://www.youtube.com/watch?v=AEv9AszJ4_U ) really has two distinct
components. The first, what I call the “no
free lunch” provision, is that it is not possible to “beat the market (the phrase "beating the market" means earning
an investment return that exceeds the performance of the Standard & Poor's
500 index. Commonly called the S&P 500, it's one of the most popular
benchmarks of the overall U.S. stock market performance. Everybody
tries to do beat it, but few succeed, https://www.youtube.com/watch?v=4Wg0MERlpW4 )” on a properly risk-adjusted basis (risk-adjusted return
defines an investment's return by measuring how much risk is involved
in producing that return, which is generally expressed as a number or rating).
There is an enormous literature devoted to testing this hypothesis, with many
arguments on each side. The difficulty in evaluating competing claims is in
agreeing on the way to account for risk. For example, there is widespread
agreement in the literature that a strategy of buying “value stocks (examples of what are commonly viewed as value
stocks are Citicorp (C), ExxonMobil (XOM)and JPMorgan Chase (JPM). Growth
companies, by contrast, boast rapidly expanding profits and revenues, and
their stocks typically command high valuations. Think Amazon.com
(AMZN) and Facebook (FB), https://www.investopedia.com/terms/v/valuestock.asp ),”
for example those with low ratios of price to earnings or book value, earns
higher returns than buying “growth
stocks (a
company stock that tends to increase in capital value rather than yield high
income),” which have high price-earnings ratios. However, there is a
debate about the explanation for these excess returns. Behavioralists (for
example De Bondt and Thaler 1985, 1987; Lakonishok, Shleifer, and Vishny 1994)
argue that the excess returns reflect mispricing of some sort. On the other
side, efficient market advocates such as Fama and French (1993) argue that the
high returns to value stocks occur because those stocks are risky. Although it
would not be right to say that this argument has been settled to everyone’s
satisfaction, I do think that no one has been able to identify a specific way
in which value stocks are riskier than growth stocks.
(For example, value stocks
tend to have lower betas (a beta value
of less than 1.0 means that the security is theoretically less
volatile than the market, meaning the portfolio is less risky with the stock
included than without it. For example, utility stocks often have low
betas because they tend to move more slowly than market averages, https://www.investopedia.com/terms/b/beta.asp ),
the traditional measure of
risk in the Capital Asset Pricing Model.)
Still, while academics debate about the correct interpretation of these
empirical results, one important fact first documented in Jensen’s (1968) PhD
thesis remains true: the active mutual
fund (an investment programme funded by
shareholders that trades in diversified holdings and is professionally managed,
https://www.investopedia.com/terms/m/mutualfundtheorem.asp )
industry on average does not
beat the market. So from the point of view of an investor, this aspect of the
efficient market hypothesis can safely be considered to be at least
approximately true. Nevertheless, it is important not to misinterpret this
finding. The lack of predictability in stock market returns does not imply that
stock market prices are “correct.” This is the second aspect of the EMH, what I
call the “price is right” component. The inference
(an opinion that you
form about something that is based on information you
already have) that unpredictability implies rational prices is what
Shiller (1984, p. 459) once called “one of the most remarkable errors in the
history of economic thought.” It is an error because just as the path of a
toddler running around on a playground might be completely unpredictable, the
path is also not likely to be the result of maximizing some well-formed objective function (the objective
function is a mathematical equation that describes the production output
target that corresponds to the maximization of profits with respect to
production. It then uses the correlation of variables to determine the value of
the final outcome, https://www.youtube.com/watch?v=_jtj_4hCJok ) (other than having fun). The
price is right component of the EMH
(the Efficient
Market Hypothesis (EMH) essentially says that all known information about
investment securities, such as stocks, is already factored into the prices of
those securities) is, in my opinion, by far the more important of
the two ingredients of the theory. It is important because if prices are
“wrong” then capital markets are not doing an efficient job of allocating
resources.[6]
The problem has been to come
up with a convincing test of this part of the theory because the intrinsic
value (Intrinsic
value is a measure of what an asset is worth. This measure is arrived at by
means of an objective calculation or complex financial model, rather than using
the currently trading market price of that asset, https://www.youtube.com/watch?v=TmWW7tsCuGQ ) of a security is normally
unknowable.
If the price of Apple Inc.
were too high or too low, how would we know? It turns out that there are
classes of assets for which we can say something definitive, namely those for
which we can use the law of one price as a test. Although we don’t know the
rational price.
[5] This
section draws on Barberis and Thaler (2003).
[6] Which,
of course, is not to say that some other system would do better
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