Criticism of Behavioral Economics: Difference between revisions
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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. | |||
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. | |||
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. | |||
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. | |||
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. | |||
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. | |||
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Revision as of 01:22, 3 May 2007
Work In Progress... Still Adding On.
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.
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.
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. 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.
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.
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.
