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Chapters 4-
4-8
Richard H. Thaler
Advances in Behavioral Science
 °art II - Volatility
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5. What Moves Stock °rices?
6. Does the Stock Market Rationally Reflect
Fundamental Values?
7. Stock °rices and Social Dynamics
8. Stock Return Variances: The Arrival of
information and the Reaction of Traders
 ßfficient Market Model
ƥ   !
ƛ °rice of a stock at time t (°t) equals the optimal
forecast at time t (ßt) of the net present value of
future dividends (° t)
ƛ Since °t is the optimal forecast of ° t: °t=° t+ut
where ut is the forecast error
ƥ ut must be uncorrelated with °t
ƥ var (° )=var (u) + var (°)
ƥ var (°)<=var (° )
 ßfficient Market Model
ƥ Var (°) is smaller if information is revealed in
big lumps occasionally
ƛ Variance loses more from long period of time
when information is not revealed
 Should the ßfficient Market Model
use Dividends or ßarnings?
ƥ Dividends make the most sense because
individuals are concerned with returns
(capital gains plus dividends)
ƛ However, firms only pay a fraction of earnings in
dividends
ƛ BUT since the value of the firm in the future is so
heavily discounted, most of the current value
comes from dividends
 Does the ßfficient Market Model Make
Sense Given the ßmpirical Data?
ƥ Stock price volatility is 5
5--13 times too high to
be attributed to new information about future
real dividends
ƛ One way to save the theory would be to attribute
the movements in stock prices to changes in
expected real interest rates
ƥ The necessary changes in real interest rates are bigger
than the changes in nominal rates
 °art II - Volatility
4. Do Stock °rices Move Too Much to Be
Justified by Subsequent Changes in
Dividends?
ã " 

6. Does the Stock Market Rationally Reflect
Fundamental Values?
7. Stock °rices and Social Dynamics
8. Stock Return Variances: The Arrival of
information and the Reaction of Traders
" 

ƥ The standard view suggests that fluctuations
in asset prices are attributable to changes in
fundamental values. Recent studies (including
this study) have challenged the view that
stock price movements are a reaction to
announcements about significant news.
" 

ƥ Are the announcements of important news
related to the stock price movements?
" 

ƥ The importance of macroeconomic news on
variations in the prices of stocks:
ƛ 1926-
1926-1985: analysis of monthly stock returns
based on two models:
ƥ structured vector autoregression evidence:
macroeconomic news explains about one- one-fifth of the
movement in the stock price
ƥ unrestricted regression evidence: consistent with earlier
studies--substantial fraction of return variation can not be
studies
explained by macroeconomic news
" 

ƥ The importance of macroeconomic news on
variations in the prices of stocks:
ƛ 1871-
1871-1986: analysis of annual stock market
returns also based on two models:
ƥ structured vector autoregression evidence: conclusions
similar to those for the post-
post-1926 period
ƥ unrestricted regression evidence: this approach
consistent with earlier studies
" 

ƥ Or are the Ơbig movesơ in the stock market
related to the Ơbig newsơ?
" 

ƥ Non
Non--economic developments and their impact
on movements in the stock market
ƛ analysis of the S&° Index and major political,
military, and economic policy events, 1941-
1941-1987:
ƥ market fell by 6.62% when °resident ßisenhower suffers
heart attack (September 1955)
ƥ market declined by 4.37%: December 1941, after the
Japanese attack on °earl Harbor
ƥ market declined by 0.27% when °resident Reagan was
shot (1981)
" 

ƥ Non
Non--economic developments and their impact
on movements in the stock market
ƛ analysis of the fifty largest one-
one-day returns on the
S&° Index since 1946 and their Ơcausesơ:
ƥ Ơstock prices advanced strongly chiefly because they had
gone down so longƦơ (S&° Index rose by 3.44%, 1962)
ƥ Ơfurther reaction to Truman victory over Deweyơ (stock
market fell by 4.40%, 1948)
" 

ƥ In order to better understand asset price
movements, two types of research are
recommended:
1. should model price movements as functions of evolving
consensus opinions about the implications of given news
regarding fundamental values as investors reexamine
existing data or present new arguments.
2. should develop and test Ơpropagation mechanismsơ that
can explain why shocks with small effects on discount
rates or cash flows may have large effects on prices.
 °art II - Volatility
4. Do Stock °rices Move Too Much to Be
Justified by Subsequent Changes in
Dividends?
5. What Moves Stock °rices?
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7. Stock °rices and Social Dynamics
8. Stock Return Variances: The Arrival of
information and the Reaction of Traders

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ƥ Both the theoretical and empirical foundation
of the ßfficient Markets Hypothesis have been
questioned. The types of statistical tests
which have been used to date cannot
establish that financial markets are efficient in
the sense of rationally reflecting
fundamentals. Due to absence of compelling
arguments, it has been suggested that large
valuation errors are common in speculative
markets.

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ƥ The following conclusions have been drawn
as a result of testing the Hypothesis of
Market ßfficiency:
ƛ failure to reject the hypothesis of market
efficiency have been taken as evidence that
professional portfolio managers can not
outperform the market to an important extent by
using publicly available information (Merton
(1985) further argues that evidence that any
individual can outperform the market is weak,
thus suggesting that no Ơhidden modelsơ with
market forecasting ability are being used)

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ƥ The following conclusions have been drawn
as a result of testing the Hypothesis of
Market ßfficiency:
ƛ evidence of market efficiency is often viewed as
establishing that financial market prices represent
rational assessments of fundamental values.

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ƥ It is difficult to detect certain types of
inefficiency in market valuations using
standard methods, by looking at observed
returns: some studies suggest that market
valuations diverge from fundamental values
and that much of market volatility is self-
self-
generating, leading to valuation errors.
ƥ The evidence on the view that market prices
represent rational assessments of
fundamental values is very weak.
 Are abnormal returns possible using
only publicly available information?
ƥ A case study: is it surprising that Ơsenatorsƞ
stocks beat the market by 12 percentơ. What
does it suggest? (Financial Times, February
24, 2004).
ƛ US senators' personal stock portfolios
outperformed the market by an average of 12 per
cent a year in the five years to 1998, according to
a new study
ƛ first time senators did especially well, with their
stocks outperforming the market by 20% a year,
on average, outperforming many professional fund
managers and senior executives
 Are abnormal returns possible using
only publicly available information?
ƥ A case study: is it surprising that Ơsenatorsƞ
stocks beat the market by 12 percentơ. What
does it suggest? (Financial Times, February
24, 2004).
ƛ on the contrary, a separate study in 2000 showed
that the average householdƞs portfolio
underperformed the market by 1.44 % a year, on
average.
 °art II - Volatility
4. Do Stock °rices Move Too Much to Be
Justified by Subsequent Changes in
Dividends?
5. What Moves Stock °rices?
6. Does the Stock Market Rationally Reflect
Fundamental Values?
± 

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8. Stock Return Variances: The Arrival of
information and the Reaction of Traders
 Stock °rices and Social
Dynamics
ƥ Most people who buy and sell stocks take it
for granted that social dynamics affect stock
prices
ƛ Never the less, most finance academics have not
accepted this theory
ƥ Questionable Logic Defending ßfficient Market
Model
ƛ Because returns cannot be forecasted, the real
price of the stock must be close to its intrinsic
value
 There is no reason that fashion should
not impact financial markets
ƥ °sychology is present in virtually every part of
life
ƥ The financial market is not as
professionalized as one might think
ƛ Individuals held 65% of all NYSß stocks in 1980
ƛ As long as the percentage of smart investors is
small, returns will not be affected
ƥ The ambiguity of Stock value lends itself to
being influenced by fads
 There is no reason that fashion should
not impact financial markets
ƥ Investorsƞ opinions are influenced by a variety
of media
ƛ i.e. mass media, family, friends, coworkers
ƥ °ost WWII upward trend can likely be
attributed to increased optimism
ƛ °ercentage of people participating in stock market
increases from 4 to 15 in the 18 years up to 1970
 An Alternative Model to the
ßfficient Market Model
ƥ Relies upon the existence of Ơsmart money
investorsơ
ƥ States that the real price of stock is affected
by the discounted value of expected future
dividends and the expected future demand of
ordinary investors
 An Alternative Model to the
ßfficient Market Model
ƥ Different views on what causes the demand
of stock by ordinary investors
ƛ Affected only by what is fashionable; Independent
of dividends
ƛ Responds to past returns
ƛ Responds to current and lagged dividends
 Over--Reaction to Dividends??
Over
ƥ Over time, stock prices are highly correlated
with dividends
ƥ HOWßVßR, stock prices are much more
volatile than dividends
ƥ °rices tend to be relatively high when
dividends are relatively high
ƛ ƠIt is as if the optimism of investors is too volatile,
influenced by departures from trends rather then
trends themselvesơ
ƛ A high dividend-
dividend-price ratio predicts high returns
 Over--Reaction to Dividends??
Over
ƥ Shiller hypothesizes that the overreaction to
dividends is more pronounced in the demand
of ordinary investors
ƛ The presence of smart money investors lessens
the effect on prices
 °art II - Volatility
4. Do Stock °rices Move Too Much to Be
Justified by Subsequent Changes in
Dividends?
5. What Moves Stock °rices?
6. Does the Stock Market Rationally Reflect
Fundamental Values?
7. Stock °rices and Social Dynamics
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ƥ ßquity Returns are more volatile during
exchange trading hours than during non-
non-
trading hours
ƥ On an hourly basis the variance when the
exchanges are open is between 13 and 100
times larger
 á('
1. More public information arrives during
normal business hours
ƛ Higher volatility is caused by the abundance of
public announcements such as tender offers,
buyouts, and judicial decisions during normal
business
 á('
2. °rivate information
ƛ Volatility is caused by the use of private
information. This information only affects prices
through the trading of informed investors

ƛ Assumption: If informed investors are more likely to trade when the

exchanges are open, return variances will be higher during this
period
ƛ Question: Is this a reasonable assumption? Why not use other
options such as ADRs etc.?
 á('
3. Trading introduces noise into stock returns
ƛ Investors overreact to each otherƞs trades
ƛ Trading noise would increase return variances
when the exchanges are open since more people
trade on the exchanges
 #$'
ƥ Results are consistent with both the private
information hypothesis and the trading noise
hypothesis.
ƥ However, mispricing causes only 4% 4%--12% of daily
return variance
ƥ ßven if all of mispricing occurs during the trading
day, the effect is small
ƥ Conclusion: Variance is caused by differences in the
arrival and incorporation of information during
trading and non-
non-trading periods.

ƛ Question: Why not the first hypothesis?

 
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'
ƥ °rivate information
ƛ ßxamples: Analyst reports, original research,
insider trading
ƛ °rivate information only affects prices through
trading
ƛ Information is produced by investors and
security analysts
ƛ Most private information is incorporated into
prices during trading hours
 
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'
ƥ °rivate information
ƛ °roduction of private information is more
common when the exchanges are open
ƛ Security analysts are more likely to work at this
time
ƛ Benefits of producing private information are
larger when the exchanges are open and
information can be acted on quickly and
conveniently
 
$)($
'
ƥ °rivate information
ƛ ßven if information is produced at a constant
rate during both trading and non-
non-trading periods
only when the information is used in trading can
prices be affected
ƛ Informed investors trade on their information for
more than one day

ƛ Question: Why would investors trade on their information for

more than one day?
 
$)($
'
ƥ Noise
ƛ The process of trading introduces noise into
stock returns
ƛ The cause is divided into two parts:
ƥ An information component that reflects a rational
assessment of the information arriving that day
ƥ Independent or positively correlated error component
ƛ Some noise is not corrected during the trading
day in which it occurs

ƛ Question: Why does noise take so long to correct?

')á$

ƥ ßxchange holidays reduce the value of
private information
ƛ Informed investors both must delay acting on
their info and run the risk that someone else will
discover it
ƛ Or they must find a less convenient way to trade
ƥ Therefore less private information will be
produced
')á$

ƥ If less information is produced on exchange
holidays:
ƛ More will be produced on succeeding days
ƛ With more information available to produce the
cost of generating any amount should fall
ƛ Some of the information that is not produced
privately because the exchanges are closed
might become publicly observable after a few
days
')á$

ƥ If huge trading return variances are caused
by trading noise the variance should fall
when exchanges are closed and the
variance that is lost should not be recovered