1. Behavioral Finance
Economics 437

2. Reading (starting Jan 25) “Noise Trading” – Limits to Arbitrage
Black on Toolkit
Shliefer on Toolkit (Chapter 2 in book)
Burton & Shah, pp 1-51

3. Recall Efficient Market Hypothesis (according to Fama 1970)
Three forms:
Weak
Semi-strong
Strong
Differ by what information is used
Weak – past stock prices and returns
Semi-strong – publicly known information
Strong – all information including private
Strong implies S-S implies Weak

4. Fama’s Conclusions Weak form strongly supported by data
Semi-strong seems to be supported but
Some evidence of return correlation
Strong form contradicted by market maker study

5. But “traders” saw things otherwise
January tells the tale
Blue Monday; Happy Friday
Good market precede holidays
Trading Rules
Technical analysis (charting stock prices)
Graham and Dodd “Security Analysis” 1934
Price momentum (related to charting)
Booms and busts

6. The Milton Friedman argument for market efficiency in the presence of “noise traders”
If noise traders are truly “random,” then their effects will “cancel out.” (Kind of a law of large numbers result)
Noise traders are “systematic,” then arbitrage traders will “trade against them” and take all of their money
Thus prices will be efficient in either case

7. The Law of One Price
Can the same product trade at two different prices without some tendency for the two prices to converge to one another?
Law of One Price says “no”
But……..
Oct (22% drop with no information change)
Royal Dutch Shell
Closed End Funds
Palm Pilot Stub
Meanwhile: Kahneman and Tversky
DeBondt and Thaler
Winner’s Curse

8. Fisher Black on “Noise”
Noise is good
Otherwise no trades
Otherwise no liquidity
Is the market efficient?
Yes
Why? – As long as it is within double the “correct” price

9. Shleifer, Chapter 2 (or on Collab)
Four authors: Shleifer, Summers, DeLong, Waldman
Issue: can there be two different prices for two assets with exactly the same “fundamentals”
Can such a discrepancy persist?
Can ‘noise traders’ actually do better than the ‘smart traders?’

10. The End