Theme 3: Inefficient Markets
- Representativeness, and the market’s treatment of past
winners and losers
- Anchoring-and-adjustment, and the market’s reaction to
- Loss aversion, and the risk premium on stocks
- Sentiment, and market volatility
- Overconfidence, and the attempt to exploit mispricing
Is the market efficient or inefficient?
This is one of the most fiercely debated questions in all of finance!
- results in mispricing
o smart money can exploit mispricing
- representative heuristic reliance results in investors
becoming overly optimistic about past winners and
overly pessimistic about past losers.
o That is past winners are overvalued and past losers
- Study done by De Bondt and Thaler shows that
cumulative returns for past winners is negative (about
10%), while for past losers it is positive (about 30%)
when considered in a 5-year (60 month) time horizon.
o Took stocks in the 10th percentile of returns in the
market and stocks in the bottom 10th percentile as
their bases for separating stocks into winners and
- NOTE: traditional finance would say that the pattern
we’re talking about here; namely, a steady rise in the
“loser portfolio” and a steady decline in the “winner
portfolio” reflects compensation for risk
o That is, losers are associated with higher returns
because they are riskier than the average stock; the
opposite holds for winners
o DeBondt and Thaler look at risk adjusted returns to
see if the above phenomenon holds and they find
that the investor who bought losers and sold
winners short would have beaten the market by
What does this tell you?
Adhering to the representative statistic could
be a good (robust?) policy for contrarians to
follow, perhaps, no?
Analysts who suffer from conservatism due to anchoring-and-adjustment do
not adjust their earnings predictions sufficiently in response to the new information
contained in earnings announcements
- As such they find themselves surprised by subsequent
o As we’ve seen, unanticipated surprises is the
hallmark of overconfidence
- In this case, though, there is more than
overconfidence at play here
Conservatism in earnings predictions means that
positive surprises tend to be followed by positive
surprises, and negative surprises tend to be followed
by negative surprises
Does conservatism in analyst earnings predictions cause mispricing?
If it does, then we should find that stocks association with recent
positive earnings surprises should experience higher returns than the overall
market, while stocks associated with recent negative earnings surprises should earn
lower returns than the overall market.
- Researchers have shown that in the sixty days following
an earnings announcement, the stocks with the highest
earnings surprises outperform the overall market by
about 2%, while the stocks with the most negative
earnings surprises underperformed the overall market
by about 2%.
o Behavioral finance suggests that heuristic-driven
errors cause mispricing.
Evidence supporting inefficient markets
Frame Dependence Effects
Question: Does Frame dependence have an impact on price efficiency?
Benartzi and Thaler (1995) suggest the answer is a strong YES!
- they argue that in the past, loss aversion caused
investors to shy away from stocks; therefore, stocks
earned very large returns relative to risk-free
- Siegal documents that over the last two centuries the
real return to stocks has been about 7% more than risk
o From a theoretical perspective this is huge!
This has come to be known as the equity
To understand the equity premium puzzle, consider the following example:
Suppose that you are the only income earner in your family, and you have a
good job guaranteed to give you your current (family) income every year for life.
You are given the opportunity to take a new and equally good job, with an even
chance it will double your (lifetime family) income and an even chance that it will
cut your (lifetime family) income. Indicate exactly what the percentage cut x would
be that would leave you indifferent between keeping your current job or taking the
new job and facing a 50-50 chance of doubling your income or cutting it by x
- people typically respond about 23%
- to justify the historical equity premium people would
need to respond somewhere around 4%.
- Why is there such a difference?
o One suggestion is that people use timelines for
evaluation that are too short, hence the reluctance to
Those prone to this type of myopic loss
aversion, can increase their comfort with
stocks, by monitoring their performance less
frequently, say, once a year.
• Typically, people who hold stocks,
tend to look at them far more
o As a result, tend to suffer from
a timeline that is too short
when maintaining their
o NOTE though, that after a
market run-up, the equity
premium seems to diminish,
which may imply that some
sort of house money effect is
That is, people’s
tolerance for risk
increases after a run up
Departure from Fundamental Value: Short run or long run?
Behavioral finance purports that heuristic driven bias and frame dependence
can cause prices to deviate from fundamental values for long periods.
Researchers have shown that stock and bond markets tend to be more
volatile than fundamental values would predict; that is, prices tend to fluctuate
greater than that which would be predicted by fundamental values.
- Remember your traditional finance teaching
o E/P and D/P form the basis for stock returns in a
rationally priced market
The claim is that historically, when the
dividend yield has been low and the P/E high,
the return to holding stocks over the
subsequent ten years has tended to be low.
o But note that when it comes to long run stock
returns, compounded dividends tend to trump stock
As such, the future course of earnings and
dividends would have to be dramatically
better than in the past to rationalize high
subsequent returns in a low D/P and E/P
Before the federal reserve board in 1998
Shiller and Campbell argued that based on
the information they gathered, the market
would likely lose about 40% of its value
o Historical P/E = 14.2
o Dec 1996 = 28
o Historical D/P = 4.73%
o Late 1996 = 1.9%
• In his address, after the Shiller and
Campbell, Alan Greenspan must have
been somewhat moved because he
used the phrase “Irrational
Exuberance” to describe the state of
Shiller’s work asks a more fundamental, pardon the pun, question:
Do stock prices only change in response to fundamentals?
The jury is still out on this one.
Ask yourself, “What informational advantage do we have over other traders?”
- Scholes asked this question of his LTCM partners when
they started to use a strategy that essentially bet on
which way foreign currency would move
o The question is an important one where markets
and investing are concerned.
How good a driver are you? Relative to the drivers you encounter on the
road, are you above average, average or below average?
Response: about 65-80% of the people who answer the driver question rate
themselves above average.
- now note, that we all want to be above average. The
reality is, only half of us really are!!
- Overconfidence about driving, tends to be analogous
about peoples investing
o Or so the evidence seems to support
- Overconfidence characteristics
o Investors take bad bets because they fail to realize
that they are at an informational disadvantage.
o Investors trade more frequently than is prudent,
which leads to excessive trading volume.
Does this overconfidence lead to a mispricing?
Perhaps. This is why money managers try so hard to avoid being
The mispricing could lead to significant losses!
The departure of price from fundamental value does not automatically
lead to risk-free profit opportunities. In fact, the “smart money” may avoid
some trades, although they have identified mispricing. Why? Because of
nonfundamental risk, meaning the risk associated with unpredictable