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http://mdevitt.blog.uvm.edu/bullfight/bullfight2.jpg
Tim Chung
- Nov. 20th, 2006
Today’s Agenda
Tim Chung Interaction between Noise Traders / Rational Investors v.2
- Nov. 20th 2006 - 2
Interaction between Noise Traders and Tim Chung Nov. 20th, 2006 - - PowerPoint PPT Presentation
Interaction between Noise Traders and Tim Chung Nov. 20th, 2006 - - PowerPoint PPT Presentation
Interaction between Noise Traders and Tim Chung Nov. 20th, 2006 Rational Investors in Financial Markets http://mdevitt.blog.uvm.edu/bullfight/bullfight2.jpg Todays Agenda Prospect Theory and Noise Traders and Explanation of Irrational
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A stock (or share) is a fraction of a company
Tim Chung Interaction between Noise Traders / Rational Investors v.2
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A stock’s price can be viewed as a representative of the value of a company
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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Investors earn money from stocks through two different methods
Dividend Payment Speculation
* Dividends: a portion of a company’s earnings to each of their owners (shareholders)
Source: Google Finance, finance.google.com
The combination of dividends and the expectation of growth creates a “fair value”
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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“Investors will take every rational step to maximize their wealth” “Any stock that trades over or under its fair value creates a risk-free opportunity” “Investors have all the information available to find the ‘fair value’”
The Efficient Market Hypothesis (EMH) suggests a model for market behavior under two assumptions
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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“People can become irrational under risky situations” Such biased behavior creates irrational market behavior such as market bubbles “People usually take risky bets with high potential gains and take safe bets with high potential losses”
Prospect Theory corrects problems that arise from assumptions given by the EMH
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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Market behavior is defined by the coexistence of rational investors and noise traders
Rational Investors
Noise Traders (and short term stock price)
Fair Value
The combination of rational investors and noise traders creates a market dynamic that is initiated by rational investors and executed by noise traders
* Rational Investors: informed investors defined by the EMH * Noise Traders: uninformed traders defined by Prospect Theory
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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The coexistence of rational investors and noise traders increases market volatility
Rational Investors (EMH) : stable Noise Traders (Prospect Theory): volatile Rational Investors + Noise Traders = lots of volatility
Rational investors will pre-anticipate stocks prices while noise traders assume that momentum will drive prices, resulting in a larger combined market volatility
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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The difference in trading strategy of the two groups defines market prices and creates volatility
“Rational investors make educated guesses to find ‘misvalued’ stocks” “Noise traders find stocks with positive
- r negative momentum”
Fair Value
Positive Momentum Negative Momentum Positive Momentum Undervalued Overvalued
Source: Yahoo! Finance, finance.yahoo.com
Such market dynamics create ‘harmony’ where severe irrationality will be corrected
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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Situations when a stock’s market price is much higher than its fair value are called market bubbles
Source: Yahoo! Finance, finance.yahoo.com
- Dec. 31, ‘02 Value: ~1335
Current Value: ~2450
- Mar. 10, ‘00: ~5132
65% Drop
Where did the harmony go?
.com bubble, NASDAQ 1999-2002
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Tim Chung Interaction between Noise Traders / Rational Investors v.2
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Stock market bubbles are created for two reasons
“Rational investors may act like irrational traders at times” “Rational investors may not have the means to stop irrational prices” Rational traders restrain the market from becoming too irrational and too volatile
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Overview
Tim Chung Interaction between Noise Traders / Rational Investors v.2
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