26-1

Behavioural Finance and Market Efficiency 26.5

• Can markets be efficient if many traders exhibit economically irrational (biased) behavior?

• The efficient markets hypothesis does not require every investor to be rational

• However, even rational investors may face constraints on arbitraging irrational behavior

LO4

26-2

Limits to Arbitrage

• Firm-specific risk• Reluctant to take large positions in a single security

due to the possibility of an unsystematic event• Noise trader risk

• Noise trader is someone whose trades are not based on information or meaningful financially analysis

• Keynes: “Markets can remain irrational longer than you can remain insolvent.”

• Implementation costs• Transaction costs may outweigh potential arbitrage

profit

LO4

26-3

Bubbles and Crashes

• Bubble – market prices exceed the level that normal, rational analysis would suggest

• Crash – significant, sudden drop in market-wide values; generally associated with the end of a bubble

• Some examples of crashes:• October 29, 1929• October 19, 1987• Asian crash• “Dot-com” bubble and crash• 2008 Financial Crisis

LO4

26-4

Money Manager Performance 26.6

• If markets are inefficient as a result of behavioural factors, then investment managers should be able to generate excess return

• However, historical results suggest that passive index funds, on average, outperform actively managed funds

• Even if markets are not perfectly efficient, there does appear to be a relatively high degree of efficiency

LO4

26-5

Comprehensive Problem

• Warren Buffett, CEO of Berkshire Hathaway, is often viewed as one of the greatest investors of all time. His strategy is to take large positions in companies that he views as having a good, understandable product but whose value has been unfairly lowered by the market.• What behavioural biases is Buffett attempting to identify?• If he successfully identifies these, will he be able to

outperform the market?• How might we analyze whether Buffett has, in fact,

outperformed the market?

LO4