June 07, 2003

Do "prospect theory" and "the house-money effect" trump "efficiency theory" when it comes to stocks? Dirk Olin reports for the NY Times. Snippet:

.. most of us find losses roughly twice as painful as we find gains pleasurable. This radical precept subverts much of ''utility theory,'' the longstanding economic doctrine that says we weigh gain and loss rationally. When combined with the reality that some market winners display the same recklessness as some victorious gamblers .. the market is often revealed to be downright loony. Indeed, the findings of ''behavioral finance'' in recent years have increasingly challenged the fundamental rationality assumed by.. Eugene Fama's famous dictum that prices ''fully reflect available information.''

Just a little note. Although Hayek's work inspired the literature on prices and information, he himself neither believed nor argued that prices fully reflect all available information. In fact, quite the contrary. It remains true, however, that his famous essays "Economics and Knowledge" and "The Use of Knowledge in Society" contain important seeds from which the idea of "efficient markets" eventually arose, however different this conception might be from the specifics of Hayek's own work.

The article includes this bit from Robert Shiller's The New Financial Order: Risk in the 21st Century:

Despite the volatility we observe in speculative markets, no one should conclude from any of my or others' research on financial markets that these markets are totally crazy. I have stressed only that the aggregate stock market in the United States in the last century has been driven primarily by psychology and fads, that it has shown massive excess volatility. But many markets for subindexes relative to the market do not show evidence of excessive volatility, and the market for individual stocks shows substantial evidence supporting the notion that prices in these markets do carry genuine information about future fundamentals.

What was that thing McTeer was saying about the fallacy of composition?

Posted by Greg Ransom