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Article-Market_Efficiency_Behavior

Article-Market_Efficiency_Behavior - Does Market Efficiency...

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10/16/08 11:16 AM Does Market Efficiency Trump Behavioral Bias in Finance Decisions? - Graziadio Business Report Page 1 of 6 http://gbr.pepperdine.edu/022/stockmarket.html 2002, Volume 05, Issue 2 Does Market Efficiency Trump Behavioral Bias in Finance Decisions? Understanding the effect of each can improve decision making L. Wayne Gertmenian, PhD, and Nikolai Chuvakhin An understanding of efficient markets and common behavioral biases can help investors reconcile instinct and reason. Once upon a time, two economists were walking together when one of them saw something that caught his attention. "Look," he exclaimed, "here's a great research topic!" "Nonsense," the other one said, "If it were, someone would have written a paper on it by now." For a long time this attitude governed the view of academics toward the stock market. They simply believed that the stock market was not a proper subject for serious study. That attitude has long since changed. The amount of research information available today is overwhelming. The problem has become how to interpret it so that it becomes useful for decision-making, whether from the point of view of a financial services firm or that of an investor. By offering a brief introduction to the basic concepts used in research on the stock market - specifically market efficiency and behavioral aspects of investing - we hope to help an investor define his or her approach to equity investing and give aspiring financial services professionals some food for thought in regard of both portfolio policy and marketing strategy. The Pre-History: Statistical Research Most of the early statistical research of the stock market centered on the question of whether security prices are serially correlated (i.e., are there trends in stock prices) or follow a "random walk," changing to reflect new information. A number of studies concluded that successive daily changes in stock prices are mostly independent. There seemed to be no pattern that could predict the future direction of price movements. In 1959 Roberts plotted the results of a series of randomly-generated numbers to see whether any patterns that were known to technical analysts would be visible. Figure 1 provides an example of Roberts' plot: Figure 1 Simulated stock price path
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10/16/08 11:16 AM Does Market Efficiency Trump Behavioral Bias in Finance Decisions? - Graziadio Business Report Page 2 of 6 http://gbr.pepperdine.edu/022/stockmarket.html Roberts noted that it was virtually impossible to tell if his plots were generated using random numbers or actual stock market data. Today, anyone can replicate Roberts' results using a common spreadsheet program. (See Benninga for detailed instructions). The Origin of the Efficient Market Hypothesis Next came the introduction of the term "efficient market." Fama defined an efficient market as: a market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.
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