Behavioral Finance: Understanding the Social, Cognitive, and Economic Debates by Edwin T. Burton and Sunit N. Shah (Wiley, 2013) pits the efficient market hypothesis against behavioral finance in an effort to unearth the essence of financial markets. Their analysis is detailed, their conclusions modest. Both authors teach economics at the University of Virginia and, like most economists, are prone to “on the one hand on the other hand on the third hand” reasoning. But even if they don’t arrive at a grand synthesis, their study is well worth a read.
The book is divided into five parts: introduction to behavioral finance, noise traders, anomalies (such as prospect theory and perception biases), serial correlation (including short term momentum and calendar effects), and other topics. In this post I’m going to concentrate on noise traders since I haven’t dealt with the theme before on this blog—at least not as an intellectual concept.
A noise trader, as defined by Fischer Black in 1985, is someone who trades not on information but on noise and who, he adds, will lose money most of the time. Lest you jump to the conclusion that noise traders are simply short-term, possibly high-frequency, traders, the authors explain that “a noise trader could be as harmless as a year-end tax seller, paying no attention to values at the moment of sale. It could be a grandmother buying a present of stock for a grandchild, where the main interest in the stock is that the company produces something appealing to children, regardless of the inherent investment merits of the company itself.” (p. 38)
In 1990 the Shleifer model of noise trading rewrote Black’s definition to make noise trader activity systematic and to assign profitability to noise traders “for a significant period of time.” The Shleifer model (and in many of its assumptions it is admittedly a rather simplistic model) dispels the notion that similar assets will necessarily always be priced similarly in the marketplace. Overly optimistic or overly pessimistic forecasts by noise traders will presumably shift the locus of risk. “The risk being taken by the noise traders is not, as Shleifer is careful to note, based on any fundamental risk related to the risky asset, of which there is none. The risk being borne arises solely from the existence and activities of the noise traders.” (p. 50) Essentially, Shleifer models the Keynsian notion that “markets can remain irrational a lot longer than you and I can remain solvent.”
Trading based on technical analysis (noise with a capital “N”) has always been a thorn in the side of the efficient market hypothesis. “But regardless of the calumny heaped upon technical analysis by adherents of the EMH, it is an undeniable fact that technical trading underlies a very large amount of actual trading in modern financial markets.” Trend trading, a subset of technical trading, “if widespread, can create and sustain a pricing bubble” (p. 67) which is both irrational and inefficient and which, if Minsky is correct, is also inevitable in financial markets. Regulators may try to make markets less noisy and more rational—and thereby smooth out market returns, but ultimately they will never succeed. If, to mangle Shakespeare, in the final analysis “the risk is not in the fundamentals but in ourselves,” markets can never be truly efficient.
The authors do not reach this one-sided conclusion (which I personally believe to be true). They suggest that we use whichever theory “best serves the immediate purpose. If the goal is to understand why people sell winners, not losers, then behavioral finance seems best positioned to provide an answer. However, if one wishes to know why a stock with higher earnings growth commands a higher price/earnings multiple, the EMH seems to provide the best framework for producing an answer.” (p. 230)