On the rise of behavioral finance: Shiller (2003)

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 17^th 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