BehaviorAlpha

The efficient market hypothesis suggests that whenever mispricing occurs, rational traders get an opportunity for low-risk profit. Riskless profit opportunities do not exist, or only for a noticeably short time because arbitrage will eliminate them. Similarly, you can assume that there are no 100-dollar bills on the pavement, or only for a very short time because someone will pick them up. But what if the best 100-dollar bills collectors (such as the arbitrageurs) are limited in their movements? It might become way more difficult to fully exploit this huge profit opportunity, and thus the bill (or part of it) will stay longer on the pavement. Limits to arbitrage describe how these rational traders are constrained as to how much they can profit from mispricing in the market. Lamont & Thaler (2003) ask if “the market can add and subtract”, and the answer is a clear NO. Their paper focuses on equity carve-outs of US technology stocks. An equity carve-out, also known as a p...

John Maynard Keynes (1936) argued that markets can fluctuate wildly under the influence of investors' “animal spirits,” which move prices in a way unrelated to fundamentals. After Keynes, many other authors have considered the possibility that a significant presence of sentiment-driven investors can cause prices to depart from fundamental values. The classic argument against sentiment effects is that they would be eliminated by rational traders seeking to exploit the profit opportunities created by mispricing. If rational traders cannot fully exploit such opportunities, however, then sentiment effects become more likely. Thus, we can easily say that sentiment plays an important role in asset pricing and it can affect the market. “Nowadays the question is no longer, as it was a few decades ago, whether investor sentiment affects stock prices, but rather how to measure investor sentiment and quantify its effects.” (Baker, Wurgler 2007) Measure the investor sentiment:...

Are bubbles consistent with rationality? If they are, do they, like Ponzi schemes, require the presence of new players forever? Economists and financial market participants often hold quite different views about the pricing of assets. Economists usually believe that given the assumption of rational behavior and of rational expectations, the price of an asset must simply reflect market fundamentals. Market participants on the other hand, often believe that fundamentals are only part of what determines the prices of assets. Extraneous events may as well influence the price, if believed by other participants to do so; crowd psychology (such as “herd behavior”) becomes an important determinant of prices. Technically, a bubble is an economic event in which the prices of speci fi c assets rise dramatically and increase beyond their fundamental value. In general, bubbles are viewed as outbursts of irrationality — self-generating and self-sustaining waves of optimism that drive up asset...

  The Disposition Effect   Have you ever found yourself in the middle of a stock market nightmare, gripping onto a losing stock like a desperate ex-boyfriend who just can't let go? You know it's not good for you. You know it's not going to work out. But you can't help but hold on, convinced that one day, that stock will bounce back and make everything better. And then, in the end, the stock just keeps plummeting, leaving you feeling like an idiot.   On the flip side, have you ever sold a stock that was doing great, just because you were too anxious to lock in your gains? You sell it, and then watch as the stock keeps climbing, and you're left kicking yourself for not holding on just a little longer.   If you've ever found yourself in either of these situations, you're in good company. This phenomenon takes the name of disposition effect , and it's a common behavioral bias that affects investors of all levels of experienc e .    The dispo...