Efficient Market Hypothesis and Behavioral Finance †Is a Compromise in Sight

Legend has it that once upon the duration devil economists were walking together when virtuoso of them saw something that struck his disposition. Look, he exclaimed, heres a s comfortably look into topic Nonsense, the new(prenominal) one utter, If it were, someone would waste scripted a paper on it by now. For a long duration this attitude g overned the picture of economists toward the hold grocery. Economists simply meand that the beginning foodstuff was non a proper subject for serious study.Indeed, closely of the pre-1960 look into on gage tolls was actu all(prenominal)(a) toldy done by statisticians. The Pre-History Statistical Research slightly of the early statistical research of the stresstaking commercialise concentrated around the same question atomic number 18 shelter be serially correlated? Do security wrongs follow a haphazard walk? ar prices on any given day as identically to go up as they atomic number 18 to go d ingest? A number of studies reason that successive daily changes in post prices atomic number 18 aroundly in accountent. on that point fronted to be no pattern that could predict the future direction of price movements. unriva guide of the most interesting (and on-goingly relevant) research projects of that get toer era was under dribblen by Harry Roberts, a statistician at the University of Chicago. In his paper, wrinkle food food trade Patterns and Financial Analysis, promulgated in the Journal of pay in 1959, Roberts wrote If the melody trade be take awayd like a mechanically imperfect roulette wheel, quite a little would notice the imperfections and, by acting on them, remove them. This perspicaciouse is appealing, if for no other reason than its value as counterweight to the democratic view of dribble merchandise irrationality, yet it is obviously incomplete.Roberts generated a series of random numbers and plotted the results to see whether any patterns that were known to sk ilful analysts would be visible. omen 1 de intermits an causa of Roberts plot expeditious grocery store supposal And behavioral financeIs A via media In kettle of fish? suppose 1. Simulated pains price path Those somewhat acquainted with technical patterns mogul recognize a familiar head and shoulders make-up, which technical analysts commit to be one of the surest indicators of a trend ralwayssal. At this point, the reader whitethorn take pause. Are these blood price patterns of value or not?If they move even on decidedly random series, isnt on that point a contradiction? Maybe not. Consider a hypothetical example of a stock price path in traffic pattern 2. If tomorrow the price of this stock goes down, in that location leave be a come aroundly visible head and shoulders pattern, which should signalise a trend reversal. If, however, the price goes up, the resulting formation result look much like a pennant pattern, which, tally to market technicians, si gnals the renewal of the trend. In other words, technical patterns argon patrician to see just now when it is too late to act on them. P P t Figure 2. Hypothetical example of technical patterns formation tToday, anyone so-and-so replicate Roberts results employ a third estate spreadsheet program. In his popular textbook, Financial Modeling, Simon Benninga of the Wharton Business School devotes an entire chapter to simulating stock price paths using Microsoft Excel. 2 Efficient trade conjecture And Behavioral FinanceIs A agree In parade? Returning to Harry Roberts, his paper turned extinct to be almost prophetic in one major(ip) respect. He wrote Perhaps the traditional academic suspicion ab come forth the stock market as an object of scholarly research leave behind be overcome. As we shall see during the rest of this presentation, Roberts was sound.The Pre-History CRSP Another enabling factor for the soon-to-follow holler in stock market research was provided by an ini tially low-down outfit ground at the University of Chicago, the Center for Research in Securities legal injurys (CRSP). CRSP was established by James H. Lorie in 1960 and provided comprehensive info on all stocks traded on the New York Stock Exchange since 1926. From day one, CRSP data were gettable in machine-readable form, a r atomic number 18 and pleasant occurrence to anyone involved in economic research at the time. Also important is the fact that CRSP data contained a negligibly small number of errors.Overall, CRSP database was one of the richest data sets usable. E precisething was ready for a revolution. Indeed, the revolution was soon to begin. The Origin of the Efficient marketplace dead reckoning The display of the term economical market is usually attributed to Eugene Fama. In his 1965 paper, Random Walks in Stock commercialise Prices, published in the Financial Analysts Journal, Fama relates, among other things, his earlier study of serial co high-octane of correlations in daily price changes of 30 stocks that check the Dow Jones Industrial Average index (The Behavior of Stock Market Prices).He cogitate that daily changes had a very small authoritative correlation, approaching zilch for practical purposes. The stock market reckoned to work in a musical mode that sanctioned all cultivation reflected in past prices to be incorporated into the current price. In other words, the market efficiently processed the information contained in past prices. Fama defined an efficient market as a market where there ar big(a) numbers of rational profit maximizers actively competing, with each trying to predict future market determine of unmarried securities, and where important current information is almost freely available to all participants. Efficient Market scheme And Behavioral FinanceIs A via media In army? Note that this exposition is very similar to that of a perfectly competitive market out of a micro economics textbook. An d in a perfectly competitive market, every seller earns a normal profit, i. e. , the add of profit sufficient to stay in business, but insufficient to cajole a competitor. If we assume that this is neat of the stock market, it follows that any new information that becomes available to the market volition be very quickly reflected in the prices.Otherwise, there will be opportunities for abnormal returns. In Famas own words, In an efficient market, on the modal(a), competition will cause the beat loadings of new information on intrinsic values to be reflected instantaneously in actual prices. The efficient market supposition has been formulated. The time has come to test it. Tests of Market Efficiency in the 1960s A number of different approaches were used to test the efficient market hypothesis. genius of the most obvious ones was to do to a greater extent studies on serial correlation of security prices.A variation of this approach would be to test various employment strat egies recommended by technical analysts to see if they have any investing value. some(prenominal) have been tried, and invariably came back with mostly negative results. An interesting neighborhood of research dealt with the nature of return distributions. in that respect ar some clearly visible asymmetries in stock returns. If we look at the ten biggest one-day movements in S&P 500 index since 1947, nine of them would be declines. The market crash of October 1987 resulted in a negative return that was 20 exemplification deviations away from the mean.It turned out that stock returns ar not normally distributed. They follow some sort of distribution, but, to our knowledge, no one has figured out what kind of distribution it is. On several occasions, stable Paretian distribution and bookman t-distribution were put in to be better approximations than the normal distribution. Needless to say, this poses a bulky methodological problem for researchers who, for lack of a better a ssumption, are free assuming normal distributions for drawing statistical inferences. An important break through with(predicate) in testing market qualification came with the advent of the instance study methodology.In an core study, researchers take a sample of similar characters that occurred in different companies at different times and determine how, on average, this event impacted the stock price. And what would a researcher stick out to see as the outcome of an event study? Assuming that we are studying favorable events, the outcome would depend on whether or not the event is anticipate by the market and, of course, on whether or not the market is efficient. In all cases, we would expect the stock price to go up. The question is, when? 4Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? Consider an out of the blue(predicate) event first. If the market were efficient, the stock price would adjust upward very quickly. If not efficient, it will dr ift upward for some time spare-time activity the event (see Figure 3). P Efficient Market P ineffectual Market Event Time t Event Time t Figure 3. Market defendion to an unanticipated favorable event If the event were anticipated, the price would drift upward for some time before the event, and, in an efficient market, likely stabilize on the event date (see Figure 4). PEfficient Market P Inefficient Market Event Time t Event Time t Figure 4. Market reaction to an anticipated favorable event The first event study was designed and conducted by Eugene Fama, Lawrence Fisher, Michael Jensen, and Ric heavily Roll. Their denomination, The Adjustment of Stock Prices to New Information, was published in the International economical Review in 1969 and quickly take in itself a nickname, the FFJR study. FFJR studied the stock market reaction to announcements of stock splits. Typically, stock splits are believed to be evidently inexplicable advantageously news for investors.One possib le reason was reported by FFJR themselves they found that 72% of starchys in their sample announced above-average dividend increases in the category after the split. Stock splits seemed to signal future dividend increases. (Actually, the term signaling was proposed in the early 1970s by Michael Spence, who won the 2001 Nobel prize for, among other things, his research on signaling in labor markets. ) 5 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? What FFJR found is that, on average, stock prices around the date of the split behaved as shown in Figure 5. Figure 5.Averaged stock price performance around the split date According to FFJR findings, the market begins to anticipate a stock split more than two years before it actually happens and figures out the consequences of the split the day it is announced. The event study techniques were further refined by other researchers. Some of the research designs are quite clever. A peculiar example appeared in a 1985 article in the Journal of story and Economics by Johnson, Magee, Nagarajan, and Newman. The title of the article, An Analysis of the Stock Price reply to Sudden Executive Deaths, is self-explaining.The creators found that upset(prenominal) CEO deaths are associated with stock price decreases. However, in cases when the CEO was the company founder, the stock market tends to react by a price increase, begging the inference that the ability to establish a business is different from the ability to run one. The efficacy of paid investors is another enduring question. Can they, on average, provide better enthronisation performance? The research here was focused primarily on rough-cut ancestrys. Regrettably, most headmaster money managers are not able to provide superior returns.By 1975, the preponderance of grounds argued that markets were efficient. Statistical studies showed that technical analysis did not add value ( coherent with the weak form of market qualificati on). Event studies found that the market quickly reacts to new information (consistent with the semi- blotto form of market efficiency). And studies of professional investors performance made a strong case for the strong form market efficiency. Tests of Market Efficiency after 1975 As more and more researchers tested the efficient market hypothesis, some rather controversial evidence began to appear. Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? In 1976, Rozeff and Kinney published their article on stock market seasonality. They found that January stock returns were higher(prenominal)er than in any other month. In 1981, Gibbons and Hess reported the Monday effect stock prices tended to go down on Mondays. two of these findings were clearly inconsistent with the weak-form market efficiency. Interestingly enough, Gibbons and Hess noticed that the Monday effect seemed to decrease over time (see Figure 6).Figure 6. The Monday effect In the nine-year fi nale of 1962-1970, the S&P 500 returned rough -0. 16% on an average Monday. In the following nine-year period, 1970-1978, the S&P 500 would only exonerate by 0. 10% on average. It appears that the effect has been known to some market participants for a age, and they were taking advantage of this private information, which, in turn, caused their gains to decrease over time. A growing body of research indicated that profitable selection rules could be based on publicly available information.In particular, stocks with low price- winnings ratio and high dividend yield outperformed the market. And, while small capitalization stocks have a great fortune than large-cap stocks, the return premium seemed to be too large for the degree of supererogatory risk taken. The discovery of these and other market anomalies prompted the tower board of the Journal of Financial Economics to publish a fussy issue in June 1978 on a dozen of those market anomalies. An unexpected blow to the efficient market hypothesis came from academic economists.In 1980, Sanford Grossman and Joseph Stiglitz published their article On the Impossibility of Informationally Efficient Markets in the Ameri flowerpot Economic Review. They argued that if all relevant information were reflected in market prices, market agents would have no incentive to acquire the information on which prices are based. This line of debate came to be known as Grossman-Stiglitz paradox and, along with his other contributions, earned Joseph Stiglitz his Nobel prize in 2001. The empirical research, of course, did not stop there. 7Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? In 1981, Henry Oppenheimer tested stock selection criteria developed by asa dulcis Graham. Most of us probably know Ben Graham as the author of the clean, Security Analysis, but he excessively wrote another, somewhat less technical, book, called The thinking(a) Investor. In each new edition of the book, Graham updated his investment ad frailty to his readers, whom he called defensive investors. Oppenheimer back-tested this advice as if he purchased every edition of The Intelligent Investor and acted on it after reading it.It turned out that Grahams advice did have significant value. Moreover, it actually had more value than Graham himself claimed. In 1982, Rendelman, Jones, and Latane published their article, Empirical Anomalies Based on Unexpected Earnings and the Importance of the riskiness Adjustments, in the Journal of Financial Economics. They studied earnings surp recrudesces and their effect on the stock price. They divided their sample into ten categories (deciles in statistical parlance) agree to how positive or negative the earnings surprise was.Then they calculated averaged price paths for stocks in each decile. Figure 7 presents a summary of their findings. Figure 7. Stock price paths around earnings announcement by decile plot of land the market did react to earnings surprises qu ickly, the prices overly drifted in the direction of the earnings surprise following the announcement. In other words, the market commonly underreacts to the every quarter earnings announcements. This suggests the validity of an earnings momentum strategy (buying stocks that just had a positive earnings surprise).A number of later studies produced results consistent with this thinking. However, in a somewhat puzzling twist, there were studies which suggested that the stock market actually overreacts to original announcements. In 1981, Robert Shiller published his article, Do Stock Prices Move Too untold to Be Justified by Subsequent Changes in Dividends? in the American Economic Review and concluded that they do. This phenomenon came to be known as extravagance volatility. 8 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight?In 1985, Werner De Bondt and Ric exhausting Thaler published their article, Does the Stock Market Overreact? in the Journal of Fin ance. Their conclusion was that the stock market tends to overreact to long series of bad news. So by 1985, there were enough anomalies discovered to seriously doubt the validity of the efficient market hypothesis. Reconciling the Theory and the Reality This is a salutary point at which to consider the efficient market hypothesis and identify those assumptions that whitethorn be inconsistent with reality as we know it. head start of all, as ironic as it sounds, there is no way to test market efficiency per se. We can only test a joint hypothesis stating that, first, the market is efficient in equating asset prices with their intrinsic values, and, second, we know what the intrinsic values are i. e. , we have a perfect asset pricing theoretical account. Whenever an anomalousness is found, we dont know (and have no way of knowing) which part of this joint hypothesis did not work. Returning to Famas definition of an efficient market, he assumes that important current information is almost freely available to all participants.This appears to be an accurate assumption however, both the processing of this information and the subsequent action have associated costs. An institutional investor mustiness hire security analysts and portfolio managers. Even an individual investor slips an opportunity cost with every portfolio evaluation. Both face transactional costs large portfolios, in addition, may be subject to additional costs caused by market impact. The transactional cost considerations prompted Michael Jensen to argue that an efficient market should adjust prices within limits imposed by the cost of affair.In his 1978 paper, Some abnormal Evidence Regarding Market Efficiency, published in the Journal of Financial Economics, he maintained that if, for example, transactional costs are 1%, an abnormal return of 1% must be considered within the bounds of efficiency. Indeed, if inefficiency cannot be exploited for profit interlocking of costs, is the market re ally inefficient? This, of course, begs a question what is the level of transactional costs at which we can no longer call a market efficient in spite of its being within the bounds of efficiency?There may also be some effectuate caused by the way security prices are reported (market microstructure effects, in the fiscal economics lingo). A typical research assumption has been that trades can be penalize at the closing price as recorded by a data provider such(prenominal)(prenominal) as CRSP. However, the average NYSE-AMEX stock has a quoted bid- remove spread of about 3%. For NYSE-AMEX stocks priced under $5, the average spread is about 6%. In addition, sometimes it is impossible to execute at quoted spreads because of illiquidity or market impact. 9 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight?In fact, Donald Keim used on the nose this argument to explain the January effect. In his 1989 paper, Trading Patterns, Bid-Ask Spreads, and Estimated Secur ity Returns, published in the Journal of Financial Economics, he reported that stocks tend to close to the highest degree the bid in late December, but close prices move toward the ask in early January (although we still have to come up with the bill of why it happens). Also, there is a sententious-selling issue. In an efficient market, mulct sales are unrestricted. In reality, 70% of mutual funds state in their prospectus that they will never engage in a short sale.Interestingly enough, recent empirical evidence seems to suggest that, while undervalued investments are hard to come by, overvalued ones are much more common. For example, a 1999 article by Mark Finn, Russell Fuller, and John Kling, Equity Mispricing Its Mostly on the short circuit Side, in the Financial Analysts Journal concludes that in 1983-1998 overvalued large-cap U. S. stocks tended to be overpriced by as much as four times the inwardness of underpricing observed in undervalued large-cap U. S. stocks. Final ly, there is the unavoidable issue of investor heterogeneity. Investors are not identical.Even if they have precisely the same information available to them, they are likely to interpret it differently. More importantly, they tend to act on it differently. One obvious example is assess status. Tax-exempt, tax-deferred, and taxable investors acting rationally will often choose different courses of action when presented with the same problem. Liquidity necessarily can also play a role. Speaking more broadly, is Fama-style rational profit maximizing the only possible model of investor behavior? Are there other models? This, of course, leads us straight into the brave new realism of behavioral finance.An Alternative Behavioral Model? Since the early 1980s, there has been a movement toward incorporating more behavioral science into finance. The proponents of behavioral finance cite several key areas where the reality seems to be most at betting odds with the efficient market hypothesi s. One is the excess volatility problem that we discussed above. Price movements seem to be much greater than an efficient market would allow. A related puzzle is that of affair glitz. If everyone knows that everyone (including themself) is rational, then every trader might wonder what information the seller has that the buyer doesnt, and vice versa.Figuring out merely how little trading should be occurring under the efficient market hypothesis is difficult, because people have liquidity and rebalancing needs, but the proponents of behavioral finance believe it is safe to say that a billion or so partings a day on NYSE alone is a little more than one should expect in an efficient market. 10 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? Next is the great dividend puzzle. In a perfect world consort to Modigliani and Miller, investors should be indifferent surrounded by dividends and capital gains.In the real world, because of the structure of the U. S. tax system, investors should prefer capital gains to dividends, and companies should prefer share repurchases to dividends. At the same time, most large companies do pay dividends. In addition, stock prices tend to rise when dividends are increased or initiated. The current literary productions treats dividends as moreover another instance of signalingcompanies that increase or initiate dividends post a signal of their financial health to the investors. Another puzzle is that of the candour premium.Historically, this benefit has been much greater than can be explained by risk alone. (To the defense of the efficient market hypothesis, the equity premium implied in dividend yields tends to be significantly lower. ) Finally, it seems that future returns can, at least partially, be predicted on the instauration of various historic measures such as price-earnings and price-to-book ratios, earnings surprises, dividend changes, or share repurchases. However, in spite of all these irregularities, real-world portfolio managers are still having a hard time trying to beat the market.Most of the studies of mutual funds and pension fund performance still show that, on average, active managers do no better than the market. Moreover, earnest performance this year consistently fails to predict good performance next year. With this in mind, lets examine the case for behavioral finance. First of all, what is behavioral finance? In short, it postulates that investors have cognitive biases. What is a cognitive bias? Simply put, it is an imperfection in human perception of reality. (Have you ever noticed how much bigger the moon looks when it is just above the horizon compared to when it is high? Here are a few of the most common cognitive biases in finance. Mental accounting. It seems that the majority of people perceive a dividend dollar differently from a capital gains dollar. Dividends are perceived as an addition to disposable income capital gains usually are not. Biased expectations. tidy sum tend to be overconfident in their predictions of the future. If security analysts believe with an 80% confidence that a indisputable stock will go up, they are right about 40% of the time. Between 1973 and 1990, earnings forecast errors have been anywhere between 25% and 65% of actual earnings.Reference dependence. Investment decisions seem to be affected by an investors reference point. If a trusted stock was once trading for $20, then dropped to $5 and finally find to $10, the investors propensity to increase holdings of this stock will depend on whether the previous purchase was made at $20 or $5. 11 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? Representativeness heuristic. In cognitive psychology this term mode simply that people tend to judge Event A to be more probable than Event B when A appears more deterrent example than B.In finance, the most common instance of representativeness heuristic is that investors dislocate good companies for good stocks. Good companies are well-known and in most cases fairly valued. Their stocks, therefore, may not have a significant upside potential. One of the most peculiar manifestations of cognitive biases in finance is the reluctance to realize losses. Investors seem to have a problem admitting to themselves that they have made a mistake and avoid selling securities at a loss, even though such sale has some tax incentives.Now, what are the implications of behavioral finance for the markets? In his 1999 article, The End of Behavioral Finance, published in the Financial Analysts Journal, Richard Thaler offers this aboveboard model Suppose a market has two kinds of investors rational investors (rationals), who behave like agents in economics textbooks, and similar-rational investors (quasis), people who are trying to make good investment decisions but make predictable mistakes. Suppose also that two assets in this market, X and Y, are objectively worth the same amount but cannot be transformed from one into the other.Finally, assume that the quasis think X is worth more than Y, an opinion that could change (quasis often change their minds) while rationals know that X and Y are worth the same. What conditions are necessary to assure that the prices of X and Y will be the same, as they would be in a world with only rational investors? This question is complex, but some of the essential conditions are the following. First, in dollar-weighted terms, such a market cannot have too many quasis (in order for the rational investor to be marginal).Second, the market must allow costless short selling (so that if prices get too high, the rationals can pull them down). Third, only rational investors can sell short otherwise, the quasis will short Y when the two prices are the same because they believe X is worth more than Y. Fourth, at some date T, the true relationship between X and Y must become clear to all investors. Fifth, the rational s must have long horizons, long enough to take date T. These conditions are tough to meet.Thaler seems to suggest that the belief by quasi-rational investors that certain assets are undervalued may lead to an asset bubble, which will burst as soon as quasi-rational investors sentiment changes. (Did somebody say Internet? ) why is behavioral finance important? 12 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? As most marketers know, any product has its unique set of utilitarian and valueexpressive characteristics. The value-expressive characteristics are the most visible in jewelry and almost absent in laundry detergents.An interesting question to ask, then, is, do investments have value-expressive characteristics? If they do, we should not be surprised that pricing differences exist between otherwise identical investments, based entirely on their value-expressive characteristics. A casual look at stock exchange advertisements suggests a positive answer to this question. The NYSE promotes itself as solid, while NASDAQ claims it is innovative. A review of mutual funds marketing can also give us a few insights. In 1983, faithfulness Investments put Charles Jarvie in charge of marketing its mutual funds.Prior to joining faithfulness, Jarvie marketed Tide and Pringles at Procter Gamble. Jarvie immediately noticed two deficiencies in Fidelitys marketing. Fidelitys flagship product, the Magellan fund, was not advertised as Fidelity Magellan the company was underemphasizing its fault name. Also, almost no attention was paid to cross-selling. Under Jarvies leadership, Fidelity redefined itself as a family of funds and built itself one of the strongest brands in the financial services industry. Other mutual fund companies followed quickly.Even more interesting are the studies of investment fellowships. Over 35,000 of these clubs exist in the United States. An investment club usually includes 10-15 members (friends, co-workers, or relati onals) who, on average, contribute $25 a month to the clubs account. In 1998, Brad Barber and Terrance Odean of the University of California at Davis studied performance of 166 investment clubs that had accounts with a large brokerage firm and found that 60% of the clubs lagged the market. The average underperformance was 3. 8% a year. So it seems that investment clubs lack utilitarian characteristics.What about value-expressive ones? Also in 1998, Brooke Harrington of Harvard University studied the personal identity formation in investment clubs. Her sample included three clubs an all-mens club where all members were sports car hobbyists, an all-womens club where all members belonged to the American Association of University Women, and a mixed-gender club where all members met each other through a church singles group. She concluded that investment clubs are also social clubs. In terms of our marketing approach, they do have strong value-expressive characteristics.The importance o f behavioral finance and its role in the professionals decision making process appears self-evident. While it may fail to upraise our capacity to beat the market, it can help us understand the beliefs and motivations of our clients and remediate the service provided. Is a Compromise in Sight? Are the differences between traditional finance and behavioral finance irreconcilable? Recent literature suggest a negative answer to this question. 13 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? One the one hand, the sensible proponents of behavioral finance recognize the limitations of this approach.Meir Statman of Santa Clara University said it best Market efficiency has two meanings. To some, market efficiency message that there is no systematic way to beat the market. To others, it means that security prices are rational that is, reflect only fundamental or utilitarian characteristics, such as risk, but not psychological or value-expressive characteristi cs, such as sentiment I argue that finance scholars and professionals would do well to accept market efficiency in the beat-the-market sense, but reject it in the rational-pricing sense.On the other hand, the standard finance begins to produce some research that models effects of opinion differences. Earlier, we talked about the seemingly excessive trading volumes. It appears that trading volume varies directly with the difference in investors opinions. Figure 8 provides a simple Marshallian cross analysis of a widening difference in opinions. Both supply and demand for a particular security shift to the right as both number of buyers and number of sellers increase.While the effect on price cannot be determined without additional information such as relative magnitude of shifts in supply and demand, the volume is bound to increase. P (price) S S D D Q0 Q1 Q (volume) Figure 8. Opinion difference and trading volume An interesting thing to discuss here would be the work of Joseph Chen and Harrison Hong of Stanford University and Jeremy Stein of Harvard Business School. In their 1999 paper, Differences of Opinion, Rational Arbitrage and Market Crashes, Hong and Stein propose the following model. 14 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight?There are two investors, A and B, and a class of fully rational, risk-neutral arbitrageurs. A and B each receive a different private signal affecting their rational perception of the value of the same stock. Both signals are useful, but A only pays attention to his signal, even if that of B is revealed to him, and vice versa. Arbitrageurs, on the other hand, recognize that the best estimate of the stocks value is to be found by averaging both signals. However, if A and B face short sale constraints and the signals they receive are negative, the arbitrageurs simply will not see those signals.In other words, the negative private information will not have any effect on market price. This is consiste nt with the empirical research findings of equity mispricing being mostly on the short side. So if the arbitrageurs only hear the good news, the stock price may well be trending up, until some of the arbitrageurs begin to suspect overvaluation and take short positions in the stock. As a result, the trading volume would increase, reflecting the increase difference of opinion among the arbitrageurs. If the stream of good news consequently ceases or private signals of A and/or B become public information, the stock price would collapse.In a later paper, Forecasting Crashes, Chen, Hong and Stein found that the probability of a crash is positively correlated with an increase in trading volume relative to trend over prior six months and positive returns over the prior thirty-six months. Overall, it appears that many stock market anomalies can be explained through either behavioral biases or institutional imperfections. In fact, Richard Thaler suggests applying the behavioral model to ins titutional investing and corporate finance. What immediately comes to mind here is a Nobel-winning economist Herbert Simon and his 1947 book, Administrative Behavior.Here is how the outcome of Simons research was summarized by the Nobel committee He rejects the assumption made in the classic theory of the firm as an omniscient, rational, profit-maximizing entrepreneur. He replaces this entrepreneur by a number of cooperating decision makers, whose capacities for rational action are limited, both by a lack of knowledge about the total consequences of their decisions, and by personal and social ties. A classic example of this approach is a 1956 paper by John Lintner, Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes, published in the American Economic Review.Lintner started by interviewing the corporate executives about their dividend policy decisions. These interviews led him to a very simple model. Companies move the dividend toward a desired payo ut ratio, but try to avoid having to cut the dividend. This model remains an accurate description of dividend policy to this day. Conclusion We conclude this presentation by quoting Meir Statman 15 Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight? People are rational in standard finance they are normal in behavioral finance.Rational people care about utilitarian characteristics, but not valueexpressive ones, are never confused by cognitive errors, have perfect selfcontrol, are always averse to risk, and are never averse to regret. Normal people do not obediently follow that pattern. Standard finance asks for too much when it asks for market efficiency in the rational sense, and investment professionals ask for too much when they insist that the primary contribution of behavioral finance is its potential help in beating the market.