Topic 10 - BMGT 343: Investments Prof. Anna Obizhaeva...

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1 Market Efficiency Anna A.Obizhaeva BMGT 343: Investments Prof. Anna Obizhaeva Office: VMH 4428 Phone: (301) 405-7934 Email: obizhaeva@rhsmith.umd.edu Section 0101 T Th 9:30-10:45 am in VMH 1336 Section 0201 T Th 11:00-12:15 pm in VMH 1336 Section 0301 T Th 12:30-1:45 pm in VMH 1336 Office Hours : Thu 3:00-4:00 pm or by appointment Market Efficiency Anna A.Obizhaeva Market Efficiency Topic 10: Behavior Finance and Limits to Arbitrage
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2 Market Efficiency Anna A.Obizhaeva Outline for Topic 10 Behavioral finance vs. traditional finance. Cognitive biases. Preference-based biases. Do behavioral biases affect asset prices? (Diverging opinions) Anomalies. Limits-to-Arbitrage. Market Efficiency Anna A.Obizhaeva 1. Behavioral vs. Traditional Finance. There are two schools: traditional finance and behavior finance .
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3 Market Efficiency Anna A.Obizhaeva The Traditional Finance Paradigm Investors are rational : After receiving new information, correctly update their beliefs . Make investment and consumption choices to maximize subjective expected utility (e.g., the mean-variance utility). Markets are efficient : Asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". Market Efficiency Anna A.Obizhaeva Behavior Finance Investors are irrational : Fail to update their beliefs correctly (cognitive biases). Make choices that are incompatible with subjective expected utility (preference-based biases). Markets might be inefficient : Some securities might be mispriced.
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4 Market Efficiency Anna A.Obizhaeva Question … According to a leading Chinese legislator, the Chinese stock market is developing into a “bubble” and investors are in danger of behaving irrationally. He warned that the mainland stock market could be overheated…. (FT, January 2007) Does this statement fit a behavior or traditional finance paradigm? Market Efficiency Anna A.Obizhaeva Seven Habits of Highly-Defective Investors ( Paul Krugman, 1997) – “ I like the theory of efficient financial markets as much as anyone. But unless you spent the past five months in a Tibetan monastery, you must have noticed that markets have been behaving pretty strangely of late. Here's what I learned: the seven habits that help produce the anything-but-efficient markets that rule the world: 1. Think short term 2. Be greedy 3. Believe in the greater fool 4. Run with the herd 5. Overgeneralize 6. Be trendy 7. Play with other people’s money
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Market Efficiency Anna A.Obizhaeva 2. Cognitive Biases Psychological experiments reveal that people often exhibit heuristic biases and erroneous reaction to new information, i.e. cognitive biases: A. Representativeness Heuristics B. Availability Heuristics C. Overconfidence Investors are irrational. They fail to update their beliefs correctly. Market Efficiency
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This note was uploaded on 12/02/2011 for the course BMGT 343 taught by Professor Staff during the Fall '08 term at Maryland.

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Topic 10 - BMGT 343: Investments Prof. Anna Obizhaeva...

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