A thought strikes my mind at times that how relevant are the models used to outguess markets and predict them? Do they actually work and if so, then to what extent?
The models we use are based on rationality i.e. both, the agents who are the executors and recipients of the models are “rational”. So we assume here that when some information is received, it is interpreted correctly and updated accurately. Unfortunately, after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns and individual trading behavior are not easily understood in this framework.
The models we use are based on rationality i.e. both, the agents who are the executors and recipients of the models are “rational”. So we assume here that when some information is received, it is interpreted correctly and updated accurately. Unfortunately, after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns and individual trading behavior are not easily understood in this framework.
This is where Behavioral Finance comes in. It is argued that it is more intensely applicable in scenarios where factors and agents are not fully rational (e.g. stock markets, interest rate cycles, investor sentiment etc.). It works on 2 key principles:
1. Limits to arbitrage
2. Psychology
“Limits to arbitrage” argues that it can be difficult for rational traders to undo the damage caused by less rational traders.
“Psychology” tries to explain the kind of deviation we might see from full rationality.
So what does this mean? In simple words this means that no matter what your investment advisor tells you, a majority of the traders in the market will invest based on sentiment and irrational beliefs of their own, rather than fundamental analysis. This means that the odds of an analysis working against you are high. This has elements of the Lemon’s Principal.
A very easy to relate to example is that of Reliance Natural Resources Limited and Reliance Power. Reliance power will not be starting full scale operations until 2017 and RNRL so far has only business that defines the term in the dictionary. In spite of this, both the stocks soar high due to the irrational trader belief, the belief that the Reliance brand name brings.
So what does this mean? In simple words this means that no matter what your investment advisor tells you, a majority of the traders in the market will invest based on sentiment and irrational beliefs of their own, rather than fundamental analysis. This means that the odds of an analysis working against you are high. This has elements of the Lemon’s Principal.
A very easy to relate to example is that of Reliance Natural Resources Limited and Reliance Power. Reliance power will not be starting full scale operations until 2017 and RNRL so far has only business that defines the term in the dictionary. In spite of this, both the stocks soar high due to the irrational trader belief, the belief that the Reliance brand name brings.
No comments:
Post a Comment