Efficient Market versus Behavioral Finance

[Whomp]

Behavioral finance can be defined as an approach of finance that takes distance from "standard finance", which was based on the EMH (efficient market hypothesis), which has been for decades the standard paradigm.

Do you believe markets are efficient (aka cousin to random walk) or inefficient(behavioral finance)?
Efficient Market Hypothesis

Spoiler :

Professor Eugene Fama at the University of Chicago Graduate School of Business developed EMH as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. The EMH claims that, in large and free markets, the market price of an item reflects exactly and fully all available information and thus is the best estimate of its value. The EMH theorists believe they are rational, and thus maximize their financial "utility" . their decisions lead to a price equilibrium (efficient price, rather stable, in the absence of new information).All in all EMH considers that the market's pricing of an item thus for a stock its current market price: is the exact and full reflection of all available information ideally, the same price.
http://en.wikipedia.org/wiki/Efficient_market_hypothesis

Behavioral Finance (aka Investor Psychology)

Spoiler :

It can be defined as the role of psychology in money matters, and a bit more narrowly as the study of how investor psychology influence market prices and returns. Kahneman & Tversky’s (1979) “Prospect Theory: An analysis of decision under risk" have shown empirically that people are irrational in a consistent and correlated manner. However, the case for the EMH can be made even in situations where the trading strategies of investors are correlated. So long as there are some smart investors and arbitrage opportunities, they will exploit any mispricing and the irrational investors will lose money and eventually disappear from the market.http://en.wikipedia.org/wiki/Behavioral_finance

Poll question 1 for everyone. Choose either A or B.

Spoiler :

You have the choice between two six-sided dice, A and B.

• A is marked 1-1-1-1-1-13.
• B is marked 2-2-2-2-2-2.

Which die do you prefer?

Poll question 2. (Answer only one of these two questions and don't look at both till you've answered.)
Question 2 even.
If your post number is an even number in the thread choose either A or B.

Spoiler :

In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

• A. A sure gain of $500
• B. A 50% change to gain $1,000 and a 50% chance to gain nothing

.

Question 2 odd.
If your post number is an odd number in the thread choose either A or B.

Spoiler :

In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

• A. A sure loss of $500
• B. A 50% chance to lose $1,000 and a 50% chance to lose nothing

.

 

[Swedishguy]

This is the first post, so it's odd: Question 2 A.

 

[Arcadian83]

About Question 1:
What is the goal of the die?
To roll higher on a single roll, B is better, to get a higher sum over multiple (> 6 or so) rolls, A is better.

Is the goal:
"Roll higher than another die to win $10"
or
"Win $x where x is the number you rolled"

I cannot answer until this is known.

 

[Whomp]

Your goal is to roll the die (once) that will give you the highest expected outcome.

 

[Arcadian83]

#1: A
#2 odd: A

For #1:
The expected value (average of equal possibilities) for A is still higher. I was just making sure A wasn't somehow competing with B, where on single rolls it would lose 5/6 times.
In any sort of multiplicity (more rolls or more people making a single roll), the overall outcome is certainly better with A.
The only concern for a single roll is how much worse 1 is than 2. If you need 1.5 to get by, and don't benefit from much beyond that, then B might be better.

For #2 odd:
This was an easy choice: since the expected value was the same, predictability trumps randomness.

 

[JerichoHill]

I've been given 1000 dollars, and now I have the option of another 500 sure or a 50% chance at 1000?

go for the 1000

A

 

[Swedishguy]

I've been given 1000 dollars, and now I have the option of another 500 sure or a 50% chance at 1000?

go for the 1000

A

That's stupid, you might loose all the money!

 

[History_Buff]

Even post, 1A, 2A

Although I have absolutely no idea what that die does, it strikes me as more useful than something guaranteed to roll a two. Negates the purpose of a dice really.

 

[Atropos]

Question 1 doesn't make any sense. Prefer for what? Obviously situations for which certainty is required would use the second one and situations which require randomness would use the first.

Edit: Accidentally chose B for the second. I meant A with the rest of the herd, but it still depends on the situation.

 

[Whomp]

Since it's unlikely we'll get enough answers to the poll I'd like to shift gears.
In the case of the dice the majority of people took the die with the 2's even though the outcome is better by a 3:2 margin in the die with the 1's and a 13.

Here's the results from Kahneman and Tversky Prospect theory study(doctors, CPAs and attorneys).

They presented groups of subjects with a number of problems. One group of subjects was presented with this problem.
1. In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500
B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with another problem.
2. In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group 84% chose A. In the second group 69% chose B. The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.

In other words, people have an irrational tendency to be less willing to gamble with profits than with losses. This means selling quickly when we earn profits but not selling if we are running losses.

 

[Ansar]

Post #11 - Odd.

I choose:

Option 1 - B (2 - 2 - 2 - 2 - 2 - 2)
Option 2 (Odd) - B (50% lose $1000, 50% lose nothing).​

I chose in Option 2 (Odd) - B , because either way I'm still winning money.

 

[Perfection]

I do a diagonal to Marble Arch for a doubling token!

 

[Eukaryote]

Question 1: A

Question 2 Odd: A

 

[Whomp]

I do a diagonal to Marble Arch for a doubling token!

You're good, you.
Though I might be one of the few that gets that.

 

[Arcadian83]

I don't get it. Where's that from?

Also, I am curious as to how exactly the poll questions tie into EMH and Behavioral Finance. From your description it sounds like Behavioral Finance is the noise that surrounds EMH, which to me seems the best bet for the 'true' value.

Value is incredibly subjective, which is why different people buy different things. The market price is an estimate of what will make the quantity supplied equal the quantity demanded.

New information may come about and prove the market value wrong, like the precious metal value of aluminium. Then again, I'd say the current 'market value' of diamonds is more behavioral than 'true'

 

[Whomp]

I don't get it. Where's that from?

It's from Daniel Kahneman's and Amos Tversky's book "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica
Daniel Kahneman, won the Nobel in 2002 and Tversky should have but you can't win posthumously.

Also, I am curious as to how exactly the poll questions tie into EMH and Behavioral Finance. From your description it sounds like Behavioral Finance is the noise that surrounds EMH, which to me seems the best bet for the 'true' value.

EMH theorists would suggest markets are rational and simply doing the random walk will do the trick. The problem with EMH is human behavior doesn't allow for it. Behavorialists would contend humans are hardly rational when it comes to money so opportunities create great opportunities.

As we've seen in the example of loss aversion in the last post.

Value is incredibly subjective, which is why different people buy different things. The market price is an estimate of what will make the quantity supplied equal the quantity demanded.

Were tulips or internet stocks subjectively and efficiently valued? I would contend it was pretty obvious "herd mentality" drove price. Another example of how investors in the US react to information.

From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund.

New information may come about and prove the market value wrong, like the precious metal value of aluminium. Then again, I'd say the current 'market value' of diamonds is more behavioral than 'true'

Information is great case for the behavior of overconfidence. For instance, sometimes additional information can lead to worse decisions, overconfidence and excessive trading (as we saw with mutual fund investors).

Here's an example of experts and overconfidence. There's a study of 8 professional handicappers (set betting odds at horseraces). They had the handicappers move from 5 important pieces of data to 40. It actually slightly decreased handicapping accuracy but doubled the handicapper's confidence. There have been similar results with analysts, doctors and psychologists.

 

[Arcadian83]

Very interesting, a good case for the value of intuition over knowledge.

Properly managed, an excess of knowledge should never lead to worse results, but this shows that we cannot manage excesses of knowledge effectively yet, and become overconfident or incorrectly biased by them.

This is more important than ever before, as data is overflowing, but refining useful information from it, and more importantly, making more correct decisions based on that information, is still lacking.

 

[Whomp]

Agreed but I'd add fix on a discipline and stick to it through thick and thin. I have two mechanisms I use.

One is behavioral that I'd call "Robin Hood investing". Steal from the rich areas (overseas and more specifically China after last year's results) and give to the poor (large cap growth which is working on it's 5th year of underperformance and hated by the public).
The second is purely quantative and does not care about the macro picture or any noise. It starts by filtering through businesses that rank top quartile in EPS (quarter and annual), ROE over the last 5 years and top quartile relative strength ~23 companies.

 

[JerichoHill]

That's stupid, you might loose all the money!

No its not

50% of 1000 is 500

or 500

They are equal. I don't mind the risk, hence I'll gamble.

Try not calling an economist stupid next time...

Perfection, KUDOS TO YOU!

Most people are risk averse, hence the contradiction inherent in the two choices we had. Bird in the hand, so to speak...

 

[Arcadian83]

*braces self as it goes -whoosh- over my head*
Nevertheless, thanks for sharing your great knowledge on the subject.

"Robin Hood Investing" sounds interesting. Do you mean moving investments from the first kind to the second, because one is over-valued and the other under-valued? What if you have nothing in China? Then you simply cannot do it?

I cannot make much sense out of the second part. My knowledge of finances is growing but still small. I plan to invest in index funds, from what I've read.