Behavioral Finance
Economics 437
Behavioral Finance
EMH
January 24, 2017
Review of EMH
Behavioral Finance
EMH
January 24, 2017
Immediate Reading
 Malkiel (online)
 Shiller (online)
 Shleifer (book, Ch 1)
 Fama (online)
Behavioral Finance
EMH
January 24, 2017
Reading (starting Jan 26)
“Noise Trading” – Limits to Arbitrage
 Black on Toolkit
 Shliefer on Toolkit
 Burton & Shah, pp 1-51
Behavioral Finance
EMH
January 24, 2017
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
EMH
January 24, 2017
Fama 1970 Article
 Random Walk


f(rj, t+1|Φt) = f(rj, t+1)
Where the density function ft is the same for all
t
 Special Case is the “Fair Game” model

E(pj, t+1|Φt) = [1 + E(rj, t+1|Φt)]pj,t
 Sub-martingale

E(pj, t+1|Φt) ≥ pj,t or E(rj, t+1|Φt) ≥ 0
Behavioral Finance
EMH
January 24, 2017
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
EMH
January 24, 2017
But “traders” saw things otherwise
 January tells the tale
 Blue Monday; Happy Friday
 Good market precede holidays
 Trading Rules


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Technical analysis (charting stock prices)
Graham and Dodd “Security Analysis” 1934
Price momentum (related to charting)
 Booms and busts
Behavioral Finance
EMH
January 24, 2017
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
EMH
January 24, 2017
The Law of One Price

Can the same product trade at two different prices without some tendency for
the two prices to converge to one another?

Law of One Price says “no”

But……..
 Oct 19 1987 (22% drop with no information change)
 Royal Dutch Shell
 Closed End Funds
 Palm Pilot Stub

Meanwhile: Kahneman and Tversky

DeBondt and Thaler
Winner’s Curse

Behavioral Finance
EMH
January 24, 2017
The End
Behavioral Finance
EMH
January 24, 2017