Chapter 6: Robert Shiller: “The People’s Risk Manager”

Ø The framework of Capital Ideas:

n Its structure provide for innovative thinking and application.

n Can be a workhorse for some sensible research, if it is used appropriately.

n It can be a starting point, a point of comparison from which top frame other theories.

Ø When one does produce a model, in whatever tradition, one should do so with a sense of the limits of the model, the reasonableness of its approximations, and the sensibility of its proposed applications.

Ø Shiller is ultimately in the same camp as Merton and Lo – concentrated on institutions, what they do, how they do it, and why they change.

Ø Rational expectations hypotheses:

n Individuals do not simply extrapolate past experience in formation of expectations, to avoid being leaded astray.

n In forming expectations, they make use of all available info (and they understand how to interpret it).

n As such, average opinion is going to be as close to a correct view of the future.

n While average opinion will not correct all the time (due to possible surprises), it will never be systematically wrong – neither too optimistic all the time or chronically pessimistic.

Ø Rational expectations and EMH assumptions permit a theoretician to build models that are neat, with no fuzziness around the edges, with consistency between the whole and the parts, convenient to express and manipulate mathematically.

Ø In a surprising number of cases, these assumptions turn out to be a fair description of reality.

Ø Volatility is the key variable in Shiller’s work:

n Volatility is a vivid indicator of how ignorant of the future we are and how emotionally we respond when the future arrives and fails to conform to our expectations.

n Volatility means people are changing their minds about the future almost from moment to moment (due to new info arrival that is different from their expectations.).

Ø Rational expectations model may explain how people should think about the uncertain future, but the model tells us nothing about how they actually do think about the future as they go on about their business from day to day.

Ø We can only guess. We never have all the available info. The whole process is so difficult, and the odds on being wrong so daunting, that we let our emotional anxieties get in the way (or lean on the heuristics).

Ø The key to how volatility reveals the messy process of decision making in the capital markets is in the magnitude of the swings in security prices relative to the changes in the underlying fundamentals.

Ø All investors are in the forecasting business, whether they like it or not and whether or not they even recognize it.

Ø Too often people are critical of the realism of theory and blame the theoretician for living in the clouds. However, Fama did not assert that EMH is the way the world works. He was explaining how the world would work in a market that is efficient in processing info.

Ø Shiller: “If prices fully reflected all available info, the variability in stock prices would be less, or at the very least not significantly greater, than the variability in the underlying fundamentals.”

Ø Shiller’s tests revealed a consistent pattern of excess volatility. The appraisal of volatility is a key indicator of market behavior, because “excess volatility” means there are times when the markets are “too high” or “too low”. If we can actually identify when stock prices are too high or too low, what the market is going to do become predictable.

Ø Andrew Lo and Craig MacKinlay: “But just something is predictable, we are not guaranteed the ability to predict it correctly.”

Ø At best, forecasting major market moves – or market timing – is a notoriously trying activity even when you are right.

Ø Waiting for the market to correct itself takes longer than most of the bulls or the bears expect, to a point where they are constantly tempted to throw in the sponge too soon and join the other side.

Ø On the other hand, the effort to pick individual stocks can sometimes work – or wipe you out – in a day.

Ø Kurz: “Investors are rational as they think about the risk-return trade off as CAPM describe, but they face an impossible task. The world never stands still and the info on hand is too complex.”

Ø In a non-stationary world, everybody gets it wrong – or gets it right only as a matter of luck.

Ø In Kurz’s Theory of Rational Beliefs:

n Endogenous volatility: volatility that arises from surprise & stems from the forecasting errors at the very heart of the investment process (i.e., excess volatility in Shiller’s language).

n Exogenous volatility: volatility in the underlying fundamentals, such as earnings, dividends, and interest rates.

Ø Both Shiller and Kurz agree that endogenous volatility is about three times as great as exogenous volatility.

Ø Shiller’s studies of volatility conclude that: The EMH wins half the game, the proponents of behaviorally motivated markets win the other half.

Ø Paul Samuelson: “Modern markets show considerable micro efficiency (for the reason that the minority who spot minor aberrations from micro theory can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies). In no contraction to the previous sentence, I had hypothesized considerable macro inefficiency, in the sense of long waves in the time series of aggregate indexes of security prices below and above various definitions of fundamental values.”

Ø Implication of excess volatility: the swings in stock prices seem to reflect investors’ attention to many factors other than the PV of the future stream of dividend payments: fads and fashions, fears and hopes, rumors and restlessness, recent stock price performance, or old saws about how in the long run everything comes out rosy in the stock market.

Ø Shiller: “The broadly based failures in thinking are not wholly attributable to… capriciousness of investors. Instead, these failures reflect lack of systematic attention and automatic reliance on popular or intuitive models.”

Ø John Maynard Keynes:

n Even if all the available info is in fact available, a rational forecast is so complex that many investors make their judgments on the basis of what they think other investors’ judgments are likely to be.

n This explains why LT investors are so scarce.

n When you know only a little, and you know you know only a little, it is tempting to believe others may know more, especially when markets are moving strongly in one direction or another.

Ø Shiller: “Capital Ideas are powerful, but people who do theoretical work in finance who don’t think of those applications. In carrying the theory too far, they miss the broader picture. The world they have constructed is not the world we live in. They either do not know the limitations of the theory or they are not interested in trying to fix those limitations.”

Chapter 5: Andrew Lo: “The Only Part of Economics That Really Works”

Ø Lo looks at finance through a prism in which the theory of finance itself is just one element. He blends finance with a combination of economics, mathematics, the physical sciences, history, and evolutionary biology, as well as sociology and psychology.

Ø Lo aware that institutions play a strategic role in the whole story.

Ø By changing how people looked at markets, EMH has transformed the daily turmoil of the marketplace, and what seemed like an incomprehensible set of theoretical issues, into a relatively simple set of concepts.

Ø To Lo, the trouble with EMH is less with the story itself than with the way many academics have forgotten how these abstractions came from the real world of tumult and confusion in the capital markets.

Ø Lo deplores the way today’s economists believe they do not have to know any history.

Ø Lo: “Economics in the real world owes more to history than to abstract theory… Economics is not a science. History matters in trying to understand and apply it.”

Ø To Lo, EMH pond has been fished out. Behavioral approach is frustrating as well; as these findings are only a collection of anomalies, not a real theory. You need a theory to beat a theory.

Ø Investors are not the automatons of the EMH. They differ in countless ways from one another and, more important, they differ from one another and even themselves across time.

Ø Lo: “I finally decided that markets don’t really follow random walk. The notion is great idealization but not the real thing. And this work got me tenure at MIT!”

Ø Now human behavior and the impact of past experience combine with the rigors of mathematical and scientific analysis to compose the motivating forces in all Lo’s work. The central concept is the notion of change, of dynamics.

Ø In order to survive, species adapt their biology as their environment shifts. Those species that can adapt win out and are the survivors (Charles Darwin, The Origin of Species).

Ø Lo’s Adaptive Market Hypothesis à there is a parallel process of evolution and change at work in the capital markets.

Ø The development of human institutions is contingent on the goals or purposes that motivated their establishment in the first place.

Ø Institutions are a result of trial-and-error, where perfection is impossible, something less-than-perfect can often suffice.

Ø Institutions change as a result of purposeful decisions by the human beings who make use of them, but institutions also change in response to the forces of evolution.

Ø Only those who can continually adapt to the changing environment will make it. Only those who continually innovate can maintain an edge. These kinds of phenomenon are hard to analyze from an EMH viewpoint, but they do lend themselves to analysis from a biological perspective.

Ø Lo: “When I was teaching investments without actually having done it, I felt more like a voyeur than a real professor.”

Ø I really teach differently now – most of all, I teach students to be skeptical of everything. The answers they seek may be in the EMH or portfolio theory or diversification, but not necessarily.

Ø Gottfried von Leibniz’s: “Nature has established patterns originating in the return of events, but only for the most part.”

Ø No model has an R2 of one. Certainty in response to questions does not exist.

“But only for the most part” + “but not necessarily” à explains why there is such a thing as risk in the first place.

Chapter 4: Robert C. Merton: “Risk Is Not an Add-On”

Ø Robert C. Merton (Samuelson’s most famous protégé) has in many ways left theory behind: That job is done.

Ø Merton: “The power of Capital Ideas is the way it cuts through to the core – asset pricing and the role of risk. Wonderful things! You can be comfortable with these abstractions because of their power. They can tell you a lot without any reference to institutional elements.”

Ø These ideas all have risk at their core. Risk is not an add-on; it permeates the whole body of thought.

Ø Merton believes the kinds of flaws in the literature on Behavioral Finance are similar in nature to the flaws in the neoclassical theories because so much of the behavioral material also assumes an atomistic market of individuals.

Ø Merton emphasizes that form follows function. The novel institutional impulses (i.e., computerized trading, new instrument, global interlocks and etc) do not change the theory of finance, but they do extend its range of applications in revolutionary fashion. These changes in both form and function are among the most powerful forces shaping the evolution of Capital Ideas.

Ø Just as Behavioral Finance exposes alpha opportunities, so the fluidity of institutional structures and functions has profound implications for how markets work, how investors behave, how investors should behave, and where we should look for improvements and enhancements to what we see around us today.

Ø Essential role of institutions à the functions can actually change the form of the whole investment process.

Ø Merton is convinced that innovations developed by profit-seeking institutions, like mutual funds and insurance companies, can mitigate and even overcome the behavioral anomalies and market inefficiencies created by individual investors in the real world.

Ø The continuous process of institutional creativity is what leads to change and dynamics. At the forefront of those developments are the derivatives markets.

Ø The task now is to go back to the ideas, see how they work in an institutional setting, and and find out how we can do it better.

Ø Merton: “You can move from the unrealistic world of theory in which everybody agrees about asset prices and risks to the real world in which everybody agrees to use institutions.”

Ø To Merton, option markets are the crown jewels of the whole system, because derivative instruments have greatly expanded opportunities for risk sharing, have lowered transaction costs, and have reduced info and agency costs.

Ø Merton’s overriding vision is right there: The process has no borders. It need not stop, and will not stop, in any area of finance. As the process advances, today’s anomalies will shrink under the pressure of institutional competition, new technologies, and the inexorable decline in transaction costs. And then, as pointed out earlier, “the predictions of the neoclassical model [Capital Ideas] will be approximately valid for asset prices and resource allocation.”

Ø Anomalies in Taiwan stock market (late 1990s), here, institutions have been the clear winners, and unsophisticated investors are the clear losers.

Ø Daniel Kahneman: “It is quite remarkable that you have those individuals losing money, and there seems to be an endless supply of individuals, because this is not a transitory phenomenon. So the equilibrium is a very strange equilibrium that seems to exist out there.”

Ø In time, one would expect individuals to figure out what is happening to them. Then these investors would give up trying to manage their own money and would transfer their funds to institutional investors to invest for them.

As a result, competition among institutional investors in the Taiwan market would become more intense, and beating the market would become more difficult as the anomalies of the individual investors disappear.

Chapter 3: Paul A. Samuelson – The Worldly Philosopher

Ø The ambitious goal of leading theories in the field of finance represents a powerful idea: the forces can be unleashed to improve the functional resemblance between the markets in the real world and the markets as they are defined and described in Capital Ideas.

Ø Although reality may never duplicate the way information is disseminated and comprehended in the EMH, the positive and systematic correlation between risk and return as defined in CAPM is coming closer all the time.

Ø Samuelson still believes there are no easy pickings in the stock market. Even when somebody’s track record indicates they have outperformed the averages after adjustment for risk, i.e., alpha.

Ø Benchmarks are mushy, risk measurements are arbitrary, and what we want to classify as alpha, or beating the market, if often just the return to systematic risk, or beta. Previous alpha tells you nothing on the future alpha.

Ø Samuelson notice that people are not time consistent, and they often try to control themselves with decisions designed to bind their future, such as the “behavior of men who make irrevocable trusts, in taking out life insurance as a compulsory savings measure.”

Ø However, Samuelson also pointed out that most investors “do not even understand how to capitalize on the behavioral anomalies, even if they are skeptics about efficiency and fans of behavioral theories. Indeed, part of their own irrationality is their unwillingness to accept the volatility and kinds of risks that do average out to be profitable.”

Ø Samuelson à the existence of positive alpha somewhere is not an exception to the EMH but a kind of vindication of the logic of it. It is efficient for that alpha to be corrected and it is logically implied that those with better info have to make money.

Ø Samuelson does agree that we cannot take the EMH as dogma, but he also believes most evidence of beating the market is merely hot hands – a run of good luck.

Ø Samuelson: “My twist is that modern bourses display what I like to call Limited Micro Efficiency. So long as a minute minority of investors, possessed of considerable assets, can seek gain by trading against willful uninformed bettors, then Limited Efficiency of Markets will be empirically observable.”

Ø My pitch on this occasion is not exclusively or even primarily aimed at practical men. The less of them who become sophisticated, the better for us happy few.

Ø Speculative prices behave like what mathematicians called a ‘martingale,’ where in the nest period prices may as likely change more than the total market index or change less.

Ø Frank Fabozzi: “It is a paradox but nevertheless true that stock prices are so hard to predict because stock prices are themselves predictions of the future.”

Ø This kind of complexity in the behavior of markets leads stock prices to have momentum in one direction in the short run but tend to reserve the momentum over the longer run as more info becomes available.

Ø The market reverts toward the mean in the long run because investors finally begin to recognize that it is “too high” or “too low.” (i.e., there is always a drive toward efficiency in the market, and it becomes most potent when prices have moved far enough away from equilibrium to lure investors to change the market’s direction.)

Ø Samuelson concludes: “No book can make you rich; few can keep you rich; many will speed up your loss of fortune.”

Ø Samuelson ultimate conclusion: “wide diversification of portfolios is the canny way to sleep nights and husband one’s life-cycle savings”

Samuelson recognizes that there are few who can outperform. The trouble is that you and I can’t identify that special few. But suppose we can? We can’t buy their prowess cheap. Stubbornly looking for them can cost us dear.

Chapter 2: The Strange Paradox of Behavioral Finance: “Neoclassical Theory Is a Theory of Sharks”

Ø Behavioral Finance argues that most investors make decisions and choices based upon an inability, or unwillingness, to analyze situations in the cool, detached and fully informed manner of the investors in the CAPM or EMH.

Ø Black: “Noise traders buy and sell on what they would like to believe is informed opinion and analysis, but in most instances they act on what is in fact misinformation – in the broadest sense of the word.”

Ø As a matter of fact, many investors will be beating the market at any given moment – “the market”, after all, is the average result of what everybody is doing – so some people will be performing better than the market and others will be performing more poorly.

Ø This is not the same thing as outperforming after adjustment for risk, with consistency year after year.

Ø The record suggests that only a handful of investors are outperforming the markets with any degree of consistency (in which, what these investors do, although seemed simple, are remarkably hard to emulate).

Ø Studies of institutional investing continue to show that most active managers underperform in both equities and fixed-income markets.

Ø Although many mutual funds show a tendency to outperform the market before fees and expenses, they then display a propensity to give that margin away in the turnover costs, taxes, and management fees that cut into the returns accruing to their shareholders.

Ø Even is the evidence suggests that most mutual funds do underperform, are there any funds with some identifiably consistent ability to outperform – and if so, do we have any way to identifying them in advance?

Ø Two studies provide some basis for both the likelihood that such skills exist and the likelihood that those skills can be identified in advance:

n A sizable minority of managers pick stocks well enough to more than cover their costs. Moreover, the superior alphas of these managers persist.

n The tests consistently indicate that the large positive alphas of the top 10% of funds, net of costs, are extremely unlikely to arise solely due to sampling variability (luck).

n Harlow and Brown find a number of factors explaining past superior performance especially costs and turnover rates, as well as past alpha, tends to predict future alpha.

n We have no knowledge of how these managers would perform after they were identified by investors using the Harlow-Brown paradigm (if identification of superior managers becomes simple, those managers will be buried under an avalanche of new money to a point which they can’t deliver the superior performance).

Ø By definition, most investors cannot outperform the market because they are the market.

Ø On the other hand, the available evidence suggests that fewer investors are able to win out over the others than would be the case if the markets were not so competitive. What the crowd knows is already in the price, but it is not easy to think outside the crowd.

Ø Jack Treynor (one of the pioneer of CAPM) believes that systematic errors provide many opportunities to earn excess returns:

n His favorite approach is to tell people about the stocks that look especially attractive to him. If they agree right away that he is on to something, he figures the price of the stock already reflects this idea, and he goes on to something else.

n “Slow ideas” – ideas that will take time to bear fruit and therefore have no attraction for most investors.

n Comment: this is why Fuller and Thaler seek opportunity in the smaller capitalizations. Pickings are easier and the gains are surer, while the huge composite of large growth mutual funds can barely squeak through with something resembling outperformance before taxes and fees.

Ø Under no-arbitrage, the debate between the doctrines of Capital Ideas and Behavioral Finance vanishes.

n Stephen Ross (one of the most distinguished scholars of Capital Ideas): “I never thought people are all that rational. But that was never the point of financial theory. Neoclassical theory is a theory of sharks and not a theory of rational homo economicus and that is the principal distinction between finance and traditional economics. Well-financed arbitrageurs spot these opportunities (resulting from behavioral errors), pile on, and by their actions close aberrant price differentials [emphasis added]”

n Andrei Shleifer and Robert Vishny counter argue that: “There are limitations to arbitrage. There are possibilities that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them.”

n Well aware of the risks involved, these arbitrageurs may stand aside or, on occasion, actually join in the fun and drive values even farther apart.

n The greatest risk to arbitrageurs is momentum risk (“Don’t fight the tape!” is an old saw on Wall Street that can still ring true from time to time).

n As a result, price discrepancies in special cases (particularly securities with narrow market that are difficult or costly to borrow) can persist for long periods of time, and failure of the EMH is there for all to see.

Ø Entertaining as these anomalies may be, that very feature reveals that violations of the non-arbitrage condition are not typical of the vast majority of situations in the market. These promising opportunities sound tempting, but we rarely encounter them.

Ø Evidence supporting the case for market inefficiency:

n Irrational pricing in the market as a whole in contrast (namely, gross inefficiency).

n Mispricing of individual securities.

n Rational bubble à rational investors pick off the mispricings provided for them by the noise traders – follow the crowd into a bubble on the assumption that this irrational exuberance is an opportunity to make money and that they will be so smart they will know how to get out in time.

Ø Merton Miller: “What can the poor kids (Behavioral Finance) do? The filed of finance is kind of a mature field now.”

Ø Eugene Fama: “Consistent with the EMH that anomalies are chance results, apparent overreaction of stock prices to information is about as common as underreaction. And post-event continuation of pre-event abnormal returns is just about as frequent as post-event reversal. Most important, the LT anomalies are fragile… The evidence does not suggest that market efficiency should be abandoned.”

Ø I would argue there is more to Behavioral Finance than its critics are willing to admit.

Ø The issue is not whether the markets perform precisely as Capital Ideas prescribes. Rather, the issue is how wel Capital Ideas have survived the attack from the behavioral side.

Ø The whole lesson embedded in Modern Portfolio Theory is that financial management is a risky business, and the contribution of Behavioral Finance has deepened our understanding of how investors reach decisions and how they interact with one another under conditions of uncertainty.

Ø Kahneman: “I think behavioral models can be very important to institutional design, but it isn’t as clear that in the end they are going to have dramatic explanatory power for asset prices”

Ø Ultimately, however, all mispricings arise from the heuristics investors employ in the daunting task of valuing financial assets.

Ø More precisely, behavioral anomalies are where alpha is born.

Ø Jeffrey Gould: “In order to protect returns, we don’t show anyone else what we do or don’t do. It would give people a leg up. We want them to keep doing what doesn’t work, because it lets us capture more alpha.”

Ø Behavioral Finance is planting the seeds of its own destruction. The ultimate result is a market in the real world that bears a closer resemblance to the theoretical models.

Ø Stanford Grossman, however, highlighted a strange paradox: “When a price system is a perfect aggregate of info it removes private incentives to collect info. If info is costly, there must be noise in the price system so that traders can earn a return on information gathering. If there is no noise and info collection is costly, then a perfect competitive market will break down because no equilibrium exists where one collects info.”

Chapter 1: Who Could Design a Brain…

Ø Economics… examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being. Thus it is on the one side a study of wealth; and, on the other, and more important side, a part of the study of man (Alfred Marshall, Principles of Economics).

Ø Despite Marshall noble words above, a fundamental feature of the study of man has no place in his classical economics (which concentrated on the study of wealth).

Ø Marshall’s approach was finally dislodged, with great difficulty and after many years of dispute, by the publication in 1936 of his student John Maynard Keynes’s masterwork, The General Theory of Employment, Interest and Money.

Ø Marshall’s approach was finally dislodged, with great difficulty and after years of dispute, by his student John Maynard Keynes’s masterwork, The General Theory of Employment, Interest, and Money.

Ø Capital Ideas (appeared between 1952 and 1973), owe little to Keynes and almost everything to Marshall.

Ø The entire underlying structure of Capital Ideas rests on the overriding assumption: investors have no difficulty in making optimal choices in the bewildering jumble of facts, rumors, discontinuities, vagueness, and black uncertainty that make up the real world around us.

Ø However, the ideal concept of human rationality and the coarse reality of our daily lives has become an increasingly contentious issue which led to the emergence of Behavioral Finance.

Ø Daniel Kahneman: “The failure in the rational model is… in the human brain it requires. Who could design a brain that could perform in the way this model mandates? Every single one of us would have to know and understand everything, completely and at once.”

Ø However, the real issue is this: do the teachings of behavioral Finance lead us to alpha – an excess return on our investments after adjustment for risk?

Ø Kahneman: “Nobody has ever figured out a perfect technique for dealing with uncertainty. Consequently, in making choices and decisions, we tend to overweight certain outcomes relative to uncertain outcomes, even when the uncertain outcomes have a high probability.”

Ø The proponents of Behavioral Finance have drawn heavily on the writings and teachings of Kahneman and Tversky. They have made human quirks like the failure of invariance, framing, and the illusion of validity the core of their confrontation with the assumptions of the rational model that motivates and supports the structure of Capital Ideas.

Ø Kahneman and Tversky defined these kinds of inconsistencies in decision making as “failure of invariance.”

Ø Framing à the passive acceptance of the formulation given (Kahneman).

Ø Invariance cannot be achieved by a finite mind (Kahneman).

Ø Hose money effect à if you have money in your pocket, you will choose the gamble. If you have no money in your pocket, you would rather have the $30 for certain than take the risk of ending up with $21 (Thaler).

Ø House money effect matters in real world. Investors who are already wealthy are willing to take significant risks because they can absorb the losses, while investors with limited means will invest conservatively because of fear they cannot afford to lose the little they have.

Ø Although human beings have extraordinary reasoning power compared with animals, something other than cool analysis and calculation seems to take over when we are faced with difficult choices – even though, on many occasions, we honestly believe we have made a rational decision.

Ø This struggle is especially intense when it comes to decisions involving our wealth. Finance and investment are bets on future outcomes – investing means we pout away money today because we expect to earn a future return on it.

Ø Speaking psychologically, investors have “cognitive difficulties” in their efforts to arrive at profitable decisions.

Ø Yet people who are not so smart frequently become rich. If they are lucky enough to avoid being wiped out immediately, they can survive for a long time and create all kinds of mispricings that scare away more sober investors.

Ø Keynes observes that the market could stay at crazy levels longer than most people could even imagine.

Ø Use of shortcuts (heuristics) in decision making:

n We faced with uncertainty and complexity in investing process.

n But the shortcuts we use to extricate ourselves from these dilemmas lead to inadequate processing of information, or avoiding the use of info entirely and relying on our gut to guide us.

n Many of the problems we encounter in this process of oversimplification and instinctive responses stem from the limits of our imagination (which cause imbalance in our imagination), although sometimes we impose limits we do not have to impose.

n One of the most dangerous of these habits is to believe low-probability events will not happen.

n Due to imbalance of imagination:

u We tend to focus on the short term because the long term is too vague (and anyway, it is not the domain in which we live).

u We extrapolate recent developments into the longer run future without questioning their significance for s constantly changing world.

u We cling to our preconceptions even when the evidence in front of us shows they are outdated.

u We are content being inconsistent because consistency may be too demanding.

u The possibilities of regretting a decision dilutes our ability to make a rational decision in the first place.

u We often make the mistake of heeding what others say when they agree with us, even when they may know les than we do.

u We display a tendency to take greater risks when faced with losses than when faced with gains.

u We make judgments on the basis of small samples of information that are far from representative of the broad generalization on which we want to base our decision, largely because we often have nothing else available.

Ø Impact of heuristics can be costly. Davis research shows that: “In studying the trading activities in a large number of investor accounts at a nationwide discount brokerage house. It is found that with extraordinary frequency, that the stocks these investors sold went on to earn higher returns than the stocks these investors purchased to replace those holdings.”

Ø Overconfidence:

n We display overconfidence in our own beliefs even though our better judgment should recognize the high risks in thinking we know more than the consensus of the people in the marketplace.

n Many of those individuals have more information and understand the situation better than we do.

n Kahneman: “The central characteristic of agents is not that they reason poorly but that they often act intuitively. And the behavior of these agents is not guided by what they are able to compute, but by what they happen to see at a particular moment.”

Ø We are human beings. Financial theory has to take account of that incontestable fact.

Ø Richard Thaler compile a list of “anomalous behaviors” – behaviors that went against the predictions of the standard models in finance.

Ø Kahneman: “I am now quick to reject any description of our work as demonstrating human irrationality. When the occasion arises, I carefully explain that research on heuristics and biases only refutes an unrealistic conception of rationality, which identifies it as comprehensive coherence”

Ø Thaler: “People are not blithering idiots, but they are a long way from hyper-rational automatons”

Ø Nobel Laureate Herbert Simon proposed the concept of “bounded rationality” à people facing an uncertain future aim to reach rational decisions, but they often fail because the demands of the process are too great and the variety of possible outcomes too bewildering.

Ø Fuller and Thaler able to achieve encouraging results from fund management, but the time period may have been too short to reach any strong judgments about what it has been able to accomplish.