This work is written in the form of summary of Shiller (2003)*, a paper explaining how psychology came into an important role in financial economics theory and practice.
I. Pure finance
peddling to explain market anomalies
In
the 1970s, Efficient Market Theory gained its strength in academic circles in
financial economics. At that time, the rational expectation was received with
utmost enthusiasm. Thus, with the rational expectations assumption, the
efficient market theory (EMT) described the financial market in one eloquent
model. There were perfect information and the rational agents in the economy
used all the information to maximize their happiness. Of course there was also
the time trend.
However,
the 1970s also saw hesitations rising over the EMT. Academicians started taking
notice of some of the anomalies in the market that wasn’t consistent with EMT. Since
1980s, financial economists began contemplating about whether the already
popularized EMT really described the market. In Shiller (1981) and LeRoy and
Porter (1981) argued that the stability of the present value through time
suggests that there is excess volatility in the aggregate stock market,
relative to the PV implied by the efficient markets model.
In
the paper, Shiller (2003) compared the present value of future stock prices
between 1872-2002 by discounting them with constant discount rate, interest
rate and marginal consumption rate.
- Constant discount rate discount
- Interest rate discount
- Marginal consumption discount
All
of them were not consistent with the real stock price in the next year. Thus,
depending on what kind of discount factor you use, the present value can be
calculated differently which will not lead to single conclusion.
The
paper mentions many works by other academics concerning the validity of
efficient market such as Shiller (1981, 1982, 1990); Hansen and Jagannathan,
Vuolteenaho (2002) on consumption discount model; Cohen, Polk and Vuolteenaho
(2002) on book-to-market ratios on forecasting firms earning; Jung and Shiller
(2002) on price-dividend ration on predicting the present value of future
dividend changes. But still there is no specific variant of efficient market
model that can explain the market changes by looking only at the present value
of future earnings of a firm.
II. Behavioral
finance taking its toll
There
was something more “irrational” or “unexpected” explanation needed. Therefore,
the Science of Behavioral Finance started blossoming. The paper illustrates on
two examples of behavioral finance explaining the market volatility: feedback
model and smart money investor vs. zealots.
Feedback
model is based on the viral “gossiping” among ordinary investors about some
improvements or downfall in a market of specific stock. An example is cited in
the paper that in the 17th century, tulip bulb was a ravishing
market with profit turnovers of 10, 20 or even 100 percent. However, in the
long run as it becomes clear that the booming market was nothing but natural
flowers, the short term riches succumbed to huge losses.
Shiller
dubs this behavior in the market: word-of-mouth optimism and word-of-mouth
pessimism. This state of bubbling is highly dangerous for the stocks in the
future. This feedback also can describe some of the randomness in the stock
market. However, due to its ambiguity, this feedback model is hard to be
expressed in academic framework.
The
other example, ordinary vs. smart money investors concern the case of more
reasonable investor or a feedback trader. While the ordinary feedback
investment follows a certain style popularized at that moment of time, the
smart money goes the other way. For instance, feedback traders buy stocks when
the price is rising while the smart money sells the stock at that time of
arousal.
Because
all of the market agents are solely divide into these two groups, they are the
key determiners of the equilibrium price. In Miller (1977), the author argued,
for one stock market, zealots have bought all of the available stocks with its
price soaring upwards due to its lack of supply. During these times, the smart
money knows that this is just an empty bubble, so that they won’t buy the
stock. Because that they don’t have any stocks to short and gain profits, they
can’t benefit from their knowledge. This is one paper that raises discussion
since it was published.
Several
other papers surveying the market volatility and returns on stock trading
comparing them with many possible variables. An example would be Scherbina
(2000) who looked at the difference of opinions about the market and stock
return. She finds that high dispersion of analyst’s forecasts had lower
subsequent returns. Thus she explained the low returns with respect to
uncertainty.
Another
work is Jones and Lamont (2001) that was conducted using data of interest on
the loan of shares in the 1920s and 1930s. They finds that a share with high
shorting costs or interest rate was more expensively priced. Moreover, the
more-expensive-to-short stocks were on average had lower returns.
III. Conclusion
Behavioral
Finance had important findings to broaden our knowledge of the financial
markets. Though the anomalies in the market is a sign of the EMT becoming
unreliable, we should not abandon it, thinking that one can make excessive
profits from the market. However, it can be very wrong in other ways. Evidence
from behavioral science suggest that we can explain the misdeeds of the market
in a pretty “rational way” without fully abandoning the EMT. EMT can, however,
work as a general theory that supports a researcher in understanding core
characteristics of a financial market.
* American economist, Yale University professor and best-selling author
