Financial Markets and Human Behavior

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Financial Markets and Human Behavior

• By
• Gur Huberman
• Columbia Business School

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Outline

• Objects of interest Prices, aggregate
  quantities.
• Parsimony simplicity of economics
• A major challenge asymmetry of information.
• The As-if approach
• How important are assumptions and their
  credibility?
• Market efficiency

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Outline (cntd) Market Efficiency

• How, and what information is discounted into
  prices?
• Price Value?
• Violations of the Law of One Price.
• Limits of Arbitrage.
• Relation to behavior Why do people trade?

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Merton Miller Markets are Our Principal Concern

• For individual investors stocks are usually
  more than just the abstract "bundles of returns"
  of our economic models. Behind each holding may
  be a story of family business, family quarrels,
  legacies received, divorce settlements, and a
  host of other considerations almost totally
  irrelevant to our theories of portfolio
  selection. That we abstract from all these
  stories in building our models is not because the
  stories are uninteresting but because they may be
  too interesting and thereby distract us from the
  pervasive market forces that should be our
  principal concern.

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Friedmans The Methodology of Positive Economics

• A hypothesis is important if it explains much by
  little To be important, therefore, a hypothesis
  must be descriptively false in its assumptions.
• the relevant question to ask about the
  assumptions of a theory is not whether they are
  descriptively realistic, for they never are,
  but whether they are sufficiently good
  approximations for the purpose in hand.

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Credibility of assumptions Should We Care?

• Do individuals rationally optimize?
• Do they systematically deviate from rational
  optimization?
• Implications of such deviations
• For markets
• For individuals
• The as if approach

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Rational Decision Making

• Bernoulli.
• Von Neumann Morgenstern Ramsey, De Finetti,
  Savage.
• Behavioral attacks, arguing with experiments
• Allais,
• Ellsberg,
• Kahneman Tversky.

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Adam Smith

• How optimally do people behave, and how
  reasonable are their beliefs?

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Adam Smith Individual Optimization

• It is not from the benevolence of the butcher,
  the brewer, or the baker that we expect our
  dinner, but from their regard to their own
  interest.

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Adam Smith Self-Assessment

• The over-weening conceit which the greater part
  of men have of their own abilities, is an ancient
  evil
• The chance of gain is by every man more or less
  over-valued, and the chance of loss is more or
  less under-valued, and by scarce any man, who is
  in tolerable health and spirits, valued more than
  it is worth.

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Individual Decisions Markets

• Recall general equilibrium
• Parsimony
• Economy of information
• Results are institution-free.
• Security prices contain information, which
  considerably complicates muddles the issues.
• How much information?
• How do traders use the information?
• How does information get into prices?

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Bachelier (1900, 1950s)

• Past, present, and even discounted future events
  are reflected in market price, but often show no
  apparent relation to price changes

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Bachelier (cntd)

• Artificial causes also intervene the Exchange
  reacts on itself, and the current fluctuation is
  a function, not only of the previous
  fluctuations, but also of the current state. The
  determinants of these fluctuations depend on an
  infinite number of factors it is, therefore,
  impossible to aspire to mathematical predictions
  of it The dynamics of the exchange will never
  be an exact science.

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Early empirical studies Markets Are Hard to
Beat, and Returns Hard to Predict

• Cowles (Econometrica, 1933) Market beats
  investment advisers.
• Working (JASA, 1934) changes in commodity prices
  are largely random.
• Kendall (J Royal Stat Soc, 1953) weekly U.K.
  stock prices grouped by industries, and Chicago
  wheat prices the pattern of events in the price
  series was much less systematic than is generally
  believed.

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Samuelson Proof That Properly Anticipated Prices
Fluctuate Randomly

• We would expect people in the marketplace, in
  pursuit of avid and intelligent self-interest, to
  take account of those elements of future events
  that in a probabilistic sense may be discerned to
  be casting their shadows before them. (1965)

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Famas Definition of Mkt Efficiency

• An efficient capital market is a market that is
  efficient in processing information. The prices
  of securities at any time are based on correct
  evaluation of all information available at that
  time. In an efficient capital market, prices
  fully reflect available information. (1970)

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Easy Implications of Efficiency

• Over time
• Asset prices should NOT move on no-news.
• Are returns too volatile?
• Asset prices should move immediately after news
  arrival.
• Cross-sectional
• Law of one price same claims to cash flows,
  however packaged, should trade for the same price.

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Adam Smith on Stock Prices Anything Goes (?)

• The value of a share in a joint stock is always
  the price which it will bring in the market and
  this may be either greater or less, in any
  proportion, than the sum which its owner stands
  credited for in the stock of the company.

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Blacks Noise (1986)

• we might define an efficient market as one in
  which price is within a factor of 2 of value
• The factor 2 is arbitrary, of course
• By this definition, I think almost all markets
  are efficient almost all the time. Almost all
  means at least 90.

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Arbitrage and the Law of One Price

• Two characteristics of financial markets
• One can easily be a buyer or a seller.
• Low entry barriers.
• Implication arbitrage is easy to execute, and
  therefore we expect prices to reflect no
  arbitrage opportunity.
• Theoretically, the law of one price applies even
  in (competitive) real goods markets, because of
  the equilibrating market forces.

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Limits of Arbitrage (ShleiferVishny JF 97)

• Limited funds, because the traders and owners of
  money arent the same.
• Traders arent fully trusted by money owners, so
  funds for arbitrage are limited.
• The previous deviations from the law of one price
  dont lend themselves to safe, outright
  exploitation.

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Applications of No-Arbitrage

• Covered interest rate parity
• Modigliani-Miller Capital structure, dividend
  policy irrelevance.
• Restrictions on option prices, e.g., put-call
  parity.
• Black-Scholes formula
• Requires dynamic hedging, which requires
  liquidity in the future.

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Limits of No-Arbitrage

• Closed-end funds price varies from NAV
• Discounts are cross-sectionally correlated
• Discounts shrink when small stocks do well, and
  during hot IPO periods.
• Investor sentiment?
• Siamese twins, e.g., of Royal Dutch and Shell.

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Royal Dutch/Shell

• Siamese-twin stock example.
• There are other examples of deviations form the
  law of one price.

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NY Times of Sunday, May 3 1998

• HOPE IN THE LAB A Special Report.
• A Cautious Awe Greets Drugs That Eradicate Tumors
  in Mice

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NY Times of Sunday, May 3 1998

• Judah is going to cure cancer in two years,
  said Dr. James D. Watson, a Nobel LaureateDr.
  Watson said Dr. Folkman would be remembered along
  with scientists like Charles Darwin as someone
  who permanently altered civilization.

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EntreMed (ENMD)

• A biotech company with licensing rights to the
  technology.
• ENMD stock closed on Friday, May 1 at 12,
• Opened on Mon at 85, and closed at 52.
• 330 close-to-close return -- third highest among
  28 million daily returns 1963-1997.

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Substantial Permanent Price Appreciation

• Close of Friday, May 8 33
• Close of Friday, May 15 30
• Above 20 till Aug 26.

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No Substantive New-News on May 3!

• Nature of 11/27/97, as well as NYT, Newsday, and
  some national TV broadcasts mention the
  scientific discovery
• NYT TV mention ENMD.

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Market Knew that NYT of May 3 Carried No New-News

• NYT Business Section of May 10 Reality
  Punctures Entremeds Bubble
• The biggest mistake might have been believing
  that Entremed was an undiscovered company.
  Professional investors have long been familiar
  with its cancer-therapy research and had
  reflected that in its pre-runup price of about
  12 a share.

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Excess Price Variability

• October 1987 one-day market drop in excess of
  20 with no discernable news.
• Cutler, Poterba Summers, What Moves Stock
  Prices? (J. Port. Management, Spring 1989)
  many of the 50 largest market movements in
  recent years have occurred on days when there was
  no major news events.

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Non-Optimizing Individuals

• Individual behavior deviates systematically from
  expected utility maximization
• Experimental field evidence.
• But, what about institutional behavior?
• Challenge from investor behavior to investor
  sentiment to asset prices.

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Most Stock Trading Unexplained by Traditional
Economics

• Savings/dissavings -- lifecycle considerations
• Risk sharing innovations in personal risk
  exposures may lead to hedging them in the market.
• Speculation seems to account for most trading.

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Speculation

• Buy what will appreciate, sell what will
  depreciate, or to finance a purchase.
• Most trading speculative
• Trading delivers liquidity.
• What is the counter-partys motive?

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Smith on Trading

• Nobody ever saw a dog make a fair and deliberate
  exchange of one bone for another with another dog.

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Speculation in Financial markets

• Why speculate?
• Superior information?
• Illusion of it?
• Have superior information, earn rent on it?
• Akerlof-type counter argument The rational who
  has no informational advantage will withdraw from
  the market, and market will unravel.

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• Why NOT speculate?
• Respect for the other side
• Milgrom-Stokey no speculative trade, but prices
  adjust to reflect new information.
• Individual vs. institutional traders.
• Effect of trading on prices?
• Marginal traders?

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A Theory of Trading Should Say

• Which securities will trade more,
• When will securities trade more,
• Who are the people who will trade more and when,
• How and which institutions are likely to trade
  more,
• Tie these insights to asset prices

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Summary

• Asset prices may deviate from values.
• Individuals may systematically deviate from
  rational behavior.
• A pricing theory which starts from individual
  behavior should incorporate a model of trading,
  for individuals and institutions.