Published September 19th, 2007
in Efficient Market.
The following example is taken from the work of Kahneman and Tversky:
Consider the following scenario: Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which is more likely?
- Linda is a bank teller.
- Linda is a bank teller and is active in the feminist movement.
If you answered 2, you were wrong. Kahneman and Tversky coined this the conjunction bias although it is just a matter of probability rules we were (hopefully) taught in highschool. The probability of one event happening is greater than the probability of two events happening in conjunction. More intuitively, imagine the group of all bank tellers. Wouldn’t you agree that the group of bank tellers includes also the group of active feminists? so the group of active feminists inside the group of bank tellers is smaller.
Conjunction bias in trading
What does it have to do with trading you ask? it has everything to do with trading. Especially in volatile days when investors and traders make the wrong decisions just because the above bias. For example, recall that a month ago the market was VERY volatile and it seemed all the world markets would collapse.
If I were to ask you back then what is more likely:
- A drop in the market of more than 3%
- A drop in the market of more than 1%
If you answered 1, then you were wrong. This is because although the market was very volatile and it seemed that a drop of more than 3% was very likely, for it to drop more than 3% it has to first drop 1%! hence option 2 is ALWAYS more likely.
How to apply it
To apply it, you have to be aware it exists. For instance, consider options. If people think a 3% drop is more likely, put options deep in the money should be expensive relative to at the money options. This happens mostly in volatile situations as described above. As a good exercise, you could think of other situations where anomalies in prices occur due to the above bias.
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Published June 6th, 2007
in Efficient Market.
In all the blogs about trading and investing, I rarely see a discussion about the Efficient Market Hypothesis. The reason I’m always bringing it up is only because knowing what an efficient market means can help you make better trading decisions. Here is an example from a forum I used to participate in, about an analysis of certain events
I saw in a finance magazine that foreign investors are going to increase their investing in the local stock market, so I’m going to buy now some stocks as I think the market is going to be bullish
This all seems like a valid claim, although there is something missing from this analysis. Firstly, the person has seen this in a financial magazine. Unless he is the only subscriber to the magazine, this is public information that all investors can see. This means that by the time he buys the stock or the option, the price will be actually higher to reflect the bullish news. In the end, our investor did not make any profit from this unless he suspects that the market will go even higher. At this point we are talking about speculation and diverging from the bullish news. The subtle point to remember here is that you may have thought you bought a bargain, but you really just bought what the market consensus thinks is the fair price.
The great speculator George Soros once said that in order to make money in the stock market, you need to be a contrarian and do exactly the opposite of what most people do. This has a little bit of merit considering the fact that most information available today is public and most markets are efficient in the way information flows in it.
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Published April 16th, 2007
in Efficient Market.
This is a continuation of the posts about the Efficient Market hypothesis. In the last post about the EMH, I talked about what is known as Weak Form Efficiency. The next category is known as the semi-strong efficiency. The semi strong efficiency basically assumes that the prices reflect all public information. Here are a few examples:
- Financial reports
- Price information
- Possible upcoming mergers
- The competition the company has
In a semi strong market, as long as information about the company has not been made public, it does not affect its price.
Is it possible to predict future market moves from public information?
For the next paragraph, I’ll use the term abnormal returns. This means that the return of the stock minus the expected return by the CAPM model is positive. If you don’t know what is the CAPM model, don’t worry, I’ll post about it in the future.
According to the semi strong efficiency, no. There are several interesting research papers who studied the impact of public information on the price of the market. For instance, is it possible to make money by analysts recommendations? several researchers have tried to reach a conclusion and there wasn’t any clear conclusions. Some research indicated that stocks that received a Buy/Strong Buy recommendation, achieved abnormal returns and vice versa. The question is that needs to be answered though, what came first? Is it the analysts recommendations that made the stock rise in price ?
It is also interesting to consider the effect of stock repurchase/buy back (This means that the company that issued the stocks buys some of the stocks back). Recent research has shown that there is abnormal returns for stocks that have been repurchased. What does it mean? It appears intuitive to assume that the market participants assume that the company has more information and hence, if the company buys back it’s share, it means they are doing good.
To conclude, there are many more research papers that examined the effect of a phenomenon on the market and in most cases, the market appears to be efficient.
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