Criticism of Behavioral Economics: Difference between revisions

From Dickinson College Wiki
Jump to navigationJump to search
← Older edit
No edit summary
No edit summary
 
(6 intermediate revisions by the same user not shown)
Line 1: Line 1:
Work In Progress... Still Adding On.
=== Rational Expectations ===


Opponents of Behavioral Economics argue in favor of the traditional neoclassical point of view of rationality.  Such economists perceive people as rational decision makers.  Such a belief stems from the concept of rational expectations, a theory first proposed by John F. Muth of Indiana University during the early sixties.  Proponents of rational expectations claim that people behave in ways that maximize their utility or profit.  In this case “rational” is somewhat different from its standard definition in that it is used to refer to consistent decision making given the same actions, preferences, and options.  In other words, individuals base their expectations on the information provided to them by the markets.  Therefore, rational expectations are governed by the market, which is perceived to be efficient, leading to a convergence between said expectations and the market’s equilibrium.  Such outcomes do not differ systematically or predictably from what people expected them to be.  Although, the chances of error are present, yet still small.  Muth’s theory played a key role in the development of other major economic theories including the “Efficient-Market Hypothesis” and the “Random Walk” theory. 


It's crucial. One can get excellent suggestions from experiments, but economics theory is not about how people act in experiments, but how they act in markets. And those are very different things. It is similar to asking people why they do things. That may be useful to get suggestions, but it is not a test of the theory. The theory is not about how people answer questions. It is a theory about how people behave in market situations. Once you recognize that, it is essential to have a dialogue between market behavior and the theory in order to test various hypotheses.
=== Efficient-Market Hypothesis (EMH) ===


One of the earliest and most striking applications of the concept of rational expectations is the efficient markets theory of asset prices. A sequence of observations on a variable (such as daily stock prices) is said to follow a random walk if the current value gives the best possible prediction of future values. The efficient markets theory of stock prices uses the concept of rational expectations to reach the conclusion that, when properly adjusted for discounting and dividends, stock prices follow a random walk. The chain of reasoning goes as follows. In their efforts to forecast prices, investors comb all sources of information, including patterns that they can spot in past price movements.  
Rational expectation helped usher in the Efficient-Market Hypothesis (EMH).  EMH was introduced by University of Chicago Economics professor Eugene Fama in 1970.  Fama theory examines how much, how fast, and how accurately available information is incorporated into security prices. EMH observes the dynamic of a stock’s value when new relevant information appears.  Such an event brings the security closer to its true future value leading to speculation over the value of stock.  The profit opportunities represented by the existence of “undervalued” and “overvalued” stocks motivate competitive trading by investors. This leads to movement in the price of stocks toward the present value of the future cash flows.  The search for mispriced stocks by investors and their subsequent trading helps the market maintain its efficiency, and brings about the true fundamental value of a security. The market, in general, self regulates its own prices regardless of what side of the trade the investor is on because under EMH the market is always right.  Financial economists often classify efficiency into three categories based on what is meant as "available information"—the weak, semistrong, and strong forms.


Investors buy stocks that they expect to have a higher-than-average return and sell those that they expect to have lower returns. When they do so, they bid up the prices of stocks expected to have higher-than-average returns and drive down the prices of those expected to have lower-than-average returns. The prices of the stocks adjust until the expected returns, adjusted for risk, are equal for all stocks. Equalization of expected returns means that investors' forecasts become built into or reflected in the prices of stocks. More precisely, it means that stock prices change so that after an adjustment to reflect dividends, the time value of money, and differential risk, they equal the market's best forecast of the future price. Therefore, the only factors that can change stock prices are random factors that could not be known in advance. Thus, changes in stock prices follow a random walk.
**<b>Weak-Form Efficiency</b> occurs when the current price of a security reflects all the information contained in past prices and returns. If capital markets are weak-form efficient, then investors’ returns become stagnant. Therefore, stock returns are not predictable, and so-called technical analysis (analyzing patterns in past price movements) is useless.  
The random walk theory has been subjected to literally hundreds of empirical tests. The tests tend to support the theory quite strongly. While some studies have found situations that contradict the theory, the theory does explain, at least to a very good first approximation, how asset prices evolve


The study of capital market efficiency examines how much, how fast, and how accurately available information is incorporated into security prices. Financial economists often classify efficiency into three categories based on what is meant as "available information"—the weak, semistrong, and strong forms. Weak-form efficiency exists if security prices fully reflect all the information contained in the history of past prices and returns. (The return is the profit on the security calculated as a percentage of an initial price.) If capital markets are weak-form efficient, then investors cannot earn excess profits from trading rules based on past prices or returns. Therefore, stock returns are not predictable, and so-called technical analysis (analyzing patterns in past price movements) is useless.  
**<b>Semistrong-Form Efficiency</b>, all information involving that security is opened to the public. Therefore, only traders with access to nonpublic information (inside trading), can earn excess profits. Due to the public nature of semistrong-form efficiency the market reacts extremely fast when given new information eliminating any chance at capitalizing on the public information through trading.


Under semistrong-form efficiency, security prices fully reflect all public information. Thus, only traders with access to nonpublic information, such as some corporate insiders, can earn excess profits. Under weak-form efficiency, some public information about fundamentals may not yet be reflected in prices. Thus, a superior analyst can profit from trading on the discovery of, or a better interpretation of, public information. Under semistrong-form efficiency, the market reacts so quickly to the release of new information that there are no profitable trading opportunities based on public information.  
**<b>Strong-Form Efficiency</b> occurs when all information, even insider information, is incorporated in the company’s stock price. Eliminating any chance of investing for a profit, regardless of whether or not they are trading on public or insider information.


Finally, under strong-form efficiency, all information—even apparent company secrets—is incorporated in security prices; thus, no investor can earn excess profit trading on public or nonpublic information.


=== Random Walk ===


{{Behavioral Economics Nav Bar}}
A Random Walk is a mathematical term made famous by Professor Burton Malkiel when he published his book <i> A Random Walk Down Wall Street </i>.  In economics a random walk happens when investors buy stocks that they expect to have a higher-than-average return and sell those that they expect to have lower returns. When they do so, they bid up the prices of stocks expected to have higher-than-average returns and drive down the prices of those expected to have lower-than-average returns. The prices of the stocks adjust until the expected returns, adjusted for risk, are equal for all stocks. Equalization of expected returns means that investors' forecasts become built into or reflected in the prices of stocks. More precisely, it means that stock prices change so that after an adjustment to reflect dividends, the time value of money, and differential risk, they equal the market's best forecast of the future price. Therefore, the only factors that can change stock prices are random factors that could not be known in advance. Thus, changes in stock prices follow a random walk.

Latest revision as of 14:45, 3 May 2007

Rational Expectations

Opponents of Behavioral Economics argue in favor of the traditional neoclassical point of view of rationality. Such economists perceive people as rational decision makers. Such a belief stems from the concept of rational expectations, a theory first proposed by John F. Muth of Indiana University during the early sixties. Proponents of rational expectations claim that people behave in ways that maximize their utility or profit. In this case “rational” is somewhat different from its standard definition in that it is used to refer to consistent decision making given the same actions, preferences, and options. In other words, individuals base their expectations on the information provided to them by the markets. Therefore, rational expectations are governed by the market, which is perceived to be efficient, leading to a convergence between said expectations and the market’s equilibrium. Such outcomes do not differ systematically or predictably from what people expected them to be. Although, the chances of error are present, yet still small. Muth’s theory played a key role in the development of other major economic theories including the “Efficient-Market Hypothesis” and the “Random Walk” theory.

Efficient-Market Hypothesis (EMH)

Rational expectation helped usher in the Efficient-Market Hypothesis (EMH). EMH was introduced by University of Chicago Economics professor Eugene Fama in 1970. Fama theory examines how much, how fast, and how accurately available information is incorporated into security prices. EMH observes the dynamic of a stock’s value when new relevant information appears. Such an event brings the security closer to its true future value leading to speculation over the value of stock. The profit opportunities represented by the existence of “undervalued” and “overvalued” stocks motivate competitive trading by investors. This leads to movement in the price of stocks toward the present value of the future cash flows. The search for mispriced stocks by investors and their subsequent trading helps the market maintain its efficiency, and brings about the true fundamental value of a security. The market, in general, self regulates its own prices regardless of what side of the trade the investor is on because under EMH the market is always right. Financial economists often classify efficiency into three categories based on what is meant as "available information"—the weak, semistrong, and strong forms.

    • Weak-Form Efficiency occurs when the current price of a security reflects all the information contained in past prices and returns. If capital markets are weak-form efficient, then investors’ returns become stagnant. Therefore, stock returns are not predictable, and so-called technical analysis (analyzing patterns in past price movements) is useless.
    • Semistrong-Form Efficiency, all information involving that security is opened to the public. Therefore, only traders with access to nonpublic information (inside trading), can earn excess profits. Due to the public nature of semistrong-form efficiency the market reacts extremely fast when given new information eliminating any chance at capitalizing on the public information through trading.
    • Strong-Form Efficiency occurs when all information, even insider information, is incorporated in the company’s stock price. Eliminating any chance of investing for a profit, regardless of whether or not they are trading on public or insider information.


Random Walk

A Random Walk is a mathematical term made famous by Professor Burton Malkiel when he published his book A Random Walk Down Wall Street . In economics a random walk happens when investors buy stocks that they expect to have a higher-than-average return and sell those that they expect to have lower returns. When they do so, they bid up the prices of stocks expected to have higher-than-average returns and drive down the prices of those expected to have lower-than-average returns. The prices of the stocks adjust until the expected returns, adjusted for risk, are equal for all stocks. Equalization of expected returns means that investors' forecasts become built into or reflected in the prices of stocks. More precisely, it means that stock prices change so that after an adjustment to reflect dividends, the time value of money, and differential risk, they equal the market's best forecast of the future price. Therefore, the only factors that can change stock prices are random factors that could not be known in advance. Thus, changes in stock prices follow a random walk.

Retrieved from "https://wiki.dickinson.edu/index.php?title=Criticism_of_Behavioral_Economics&oldid=25951"