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Finance Series : Exploring Investor Rationality

Finance Series : Exploring Investor Rationality

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Published by Jason Ng
The question of whether investors are rational as suggested by the Efficient Market Hypothesis or irrational according to many gurus like George Soros, is a question that is left unanswered. This article explores this question in detail and proposes a possible explanation.
The question of whether investors are rational as suggested by the Efficient Market Hypothesis or irrational according to many gurus like George Soros, is a question that is left unanswered. This article explores this question in detail and proposes a possible explanation.

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Published by: Jason Ng on Jan 27, 2009
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05/07/2013

 
Finance Series : Exploring Investor Rationality
The Efficient Market Hypothesis has been under fire since Eugene Fame of the University Of Chicago Graduate School Of Business first suggested it back in the early 1960s. The central ideabehind the Efficient Market Hypothesis is the theory that investors are completely rational ininterpreting and acting on market news and information (which, ostensibly, is fully revealed publicknowledge).It has since come to be known as the Theory of Rational Expectations. This rational investor behavior is factored into the value of all news and information the moment it becomes available.And it happens to the extent that “beating the market” becomes an impossible task. The idea of investor rationality has been under fire by the few "gurus" who have consistentlybeaten the market since its inception. Nobel Laureate and father of Behavioral Finance, DanielKahneman, pointed out that the failure of the rational model is not inherent in the logic of thetheory, but rather in the human psyche. He posited that nobody has the ability to simultaneouslyprocess all incoming stimuli and attain a complete understanding and mastery of that stimuli.From the many arguments for and against the theory of rational expectations, I observed thatmany of the arguments stemmed from a difference in the understanding of what rationality meansin the first place (indeed, that is further proof that “rational” people can look at ideas andapply their own bias and still be regarded as “rational”). If the world is made up of blisteringimbeciles making irrational decisions, like those who argued against the theory suggest, wouldn’tthe world more closely resemble an assembly of monkeys? Yet, if the world is made up of rationalhumans the way the theory postulates, wouldn’t the world be more robotic than human?For too long, academia has debated the theory by taking sides with either the monkeys or therobots without a clear understanding of what constitutes rationality in the first place. Is theinvestor who rushes blindly into the stock market during market bubbles irrational? Are investorsrational beings if they buy undervalued and sell overvalued stocks? Essentially, all reasonablehuman beings are rational! Rationality is the consistency of action based upon a set of logicalvariables. The issue here is that the difference in one's level of knowledge and life experiences isthe determining factor that allows for the installation of a distinct set of logical parameters andvalues in every human being! This means that two human beings looking at and interpretingthe same information can come to two separate conclusions and resulting actions! The result of which is a two-sided market. An investor who has lost a significant amount of money in the stockmarket may prefer to stay out of an overextended stock regardless of how fantastic the news. Onthe other hand, investors who have never been through that same life experience would simplycontinue to buy on the news. Both investors, in this case, are rational in regard to their own levelof knowledge and experience. This explanation of rationality effectively consolidates all thediffering views on the Theory of Rational Expectation. Because investors are rational, two-sidedmarkets are created, making the overall market more and more efficient. Because investors arerational, they rush after price bubbles on the expectation of profits only to be defeated by the Lawof Regression to the Mean.

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