Thursday, April 14, 2005

Do Fundamentals or Emotions Drive the Stock Market? - -

Do Fundamentals or Emotions Drive the Stock Market? - -

WELL DONE! Markets are not perfect, but they sure are pretty good. A few highlights:

* "We agree that behavioral finance offers some valuable insights — chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But.... significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions."

* "Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions.." The three conditions are 1. Irrational Behavior 2 Systematic patterns of behavior and 3. Limits to Arbitrage."

* "Academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock's risk premium, because investors ignore the risks associated with a company's size and market-to-capital ratio. (Eugene F. Fama and Kenneth R. French, "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, 1996, Volume 51, Number 1, pp. 55–84.) These statistics could be a proxy for liquidity and distress risk."

There is more and I HIGHLY recommend you take a look! It is EXCELLENT! (BTW this was originally from McKinsey Quarterly.)

I wholeheartedly agree with the article and am comforted by how close this corresponds to what we do in class! :)

1 comment:

Jorge said...

I read it in the McKQ, I think it is a great intro for any EMH class