Efficient Markets Theory to Behavioral Finance

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does feedback explain stock price volatility?

Investors’ confidence in bull markets (as well as their fear, or pessimism, in bear markets) is amplified through a feedback mechanism, often called a feedback loop, by which the market sends signals back to investors in the form of price increases (or decreases). These price signals confirm their investment decisions and encourage more investors to follow suit, creating a cycle that continuously repeats itself. Shiller believes that changes in earnings estimates, whether up or down, are themselves part of the same psychological feedback that amplifies the bubble or downturn—or, negative bubble, to use Shiller’s terminology.

11. Why, according to Shiller, doesn’t “smart money” drive stock prices to “fundamental values”?

The EMT asserts that when irrational optimists buy a stock, smart money sells, and when irrational pessimists sell a stock, smart money buys, thereby eliminating the effect of the irrational traders on market price. In recent years, research in behavioral finance has shed some important light on the implications of the presence of these two classes of investors for theory and also on some characteristics of the people in the two classes. From a theoretical point of view, it is far from clear that smart money has the power to drive market prices to fundamental values. For example, in one model with both feedback traders and smart money, the smart money tended to amplify, rather than diminish, the effect of feedback traders, by buying in ahead of the feedback traders in anticipation of the price increases they will cause. In a related model, rational, expected- utility-maximizing smart money never chooses to offset all of the effects of irrational investors because they are rationally concerned about the risk generated by the irrational investors and do not want to assume the risk that their completely offsetting these other investors would entail.

12. What, according to Shiller, is the connection between “short sale constraints” and stock price volatility?

If selling short is difficult, a number of individual stocks could become overpriced. It would also appear possible that major segments of the stock market, say the Nasdaq in 1999, or even the entire stock market, could wind up owned by, if not zealots, at least relatively optimistic people. Short-sale constraints could be a fatal flaw in the basic efficient markets theory.

13. What, in your view, is the significance of the Shiller article and the research on which it reports?

Behavioral Finance had important findings to broaden our knowledge of the financial market. Though the anomalies in the financial market are a sign of the EMT becoming unreliable, we should not abandon it, thinking that someone can make excessive profits from the market. However it can be very wrong in other ways. Evidence from behavioral science suggests that we can explain the misdeeds from the market in a pretty ‘rational way’ without fully abandoning the EMT. EMT can, however, work as a general theory that supports a researcher in understanding core characteristics of a financial market.

14. Do you agree with Shiller that it is important to “distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information” (p. 102)?

Yes, in certain circumstances EMT is not useful on its own when trying to understand anomalies in the financial market. EMT should be used as a foundation, a starting point, by which behavioral finance can build upon. I believe as society becomes more entwined with up to the date information, an increase in anomalies will be observed in the financial market, and thus it is critical we continue to invest in behavioral finance research.