Efficient Markets Theory to Behavioral Finance

From Efficient Markets Theory to Behavioral Finance

1. What does Shiller mean by Behavioral Finance?

Behavioral Finance is the collaboration between finance and other social sciences. This field of research is focused on determining the precise degree to which various market forces—including rational analysis of company-specific and macroeconomic fundamentals; human and social psychology; and cultural trends—influence investors’ expectations and determine their level of confidence or fear. Behaviorists believe that at times, the real determinants of stock market movements are the forces of human and cultural psychology, oranimal spirits (a term coined by economist John Maynar

2. How does Behavioral Finance contrast with Efficient Market Theory?

Behavioral finance takes issue with two crucial implications of the EMH: (1) that the majority of investors make rational decisions based on available information; and (2) that the market price is always right. Behaviorists believe that numerous factors—irrational as well as rational—drive investor behavior. In sharp contrast to efficient markets theorists, behaviorists believe that investors frequently make irrational decisions and that the market price is not always a fair estimate of the underlying fundamental value. Still, many proponents of behavioral finance agree with at least one implication of the efficient market theory—that it’s not possible to reliably earn abnormal returns.

3. What prediction does Efficient Market Theory make about stock prices?

Samuelson and Fama state that Efficient Market Theory predicts that stock prices reflect all known information and instantaneously adjust to reflect new information. Fama defined an efficient market as a market: (1) with a large numbers of rational profit maximizers actively competing against each other to predict future market values of individual securities; and (2) in which important current information is almost freely available to all participants. “In an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected instantaneously in actual prices” (Fama 1965).

4. With which Efficient Market predictions does Behavioral Finance disagree?

See answer to Q2.

5. According to Shiller, does Behavioral Finance make its own predictions about stock price movements or does it simply object to some of the predictions of efficient market theory?

Behavior Finance can make its own prediction about stock price movements. For example, in Shiller’s book Irrational Exuberance, published at the very peak of the stock market bubble in March 2000, he argued that a feedback loop, transmitted by word-of-mouth as well as the media, was at work in producing the bubble we were seeing then. He further argued that the natural self-limiting behavior of bubbles, and predicted the possibility of downward feedback after the bubble was over, suggested a dangerous outlook for stocks in the future.

6. What does Shiller mean when he says that stock prices are too volatile for the Efficient Market Theory to be true?

Shiller shows that stock prices appear too volatile to be consistent with rational valuation. He points out that US stock prices during the period 1871-1979, varied five to thirteen times as much as would be rationally expected given the actual observed volatility in the dividend stream. Shiller also confirms this in a second study, which evaluates long-term interest patterns. He concluded that long rates seemed more volatile than would be predicted from either short-term interest rates or the term structure theory.

7. What does Shiller mean by “too volatile”?

A simple model (EMT) that is commonly used to interpret movements in corporate common stock price indexes asserts that real stock prices equal the present value of rationally expected or optimally forecasted future real dividends discounted by a constant real discount rate. Shiller states that stock price indexes seem too "volatile," that is, that the movements in stock price indexes could not realistically be attributed to any objective new information, since movements in the price indexes seem to be "too big" relative to actual subsequent events. It appears that financial asset prices are too volatile to accord with EMT.

8. How does Figure 1 illustrate excess volatility of stock prices?

If one computes for each year since 1871 the present value subsequent to that year of the real dividends paid on the Standard & Poor’s Composite Stock Price Index, discounted by a constant real discount rate equal to the geometric average real return 1871–2002 on the same Standard & Poor Index, one finds that the present value, if plotted through time, behaves remarkably like a stable trend. In contrast, the Standard & Poor’s Composite Stock Price Index shows excess volatility. How, then, can we take it as received doctrine that, according to the simplest efficient markets theory, the stock price represents the optimal forecast of this present value, the price responding only to objective information about it?

9. According to Shiller how can Behavioral Finance explain observed volatility in stock prices?

Behavior Finance takes into account the forces of human and cultural psychology to explain the real determinants of observed volatility in the stock market.

10. What does Shiller mean by “feedback” and how