#1097: Money & the Business Cycle Explain how economic forces other than fundamentals (i.e.

, present discounted value of expected future cash flows) can shape asset prices. According to the efficient market hypothesis, the price of an asset fully reflects all available information about the particular asset. This definition implies that the price of an asset is determined by market forces which should reflect the present discounted value of expected future cash flows generated by the asset. However, in light of the recent financial crisis that peaked in 2008, key questions arise as to whether markets consistently get asset prices right (whether asset prices equal their intrinsic value) and whether asset prices make sense given real world fundamentals like earnings. Shiller (2003) highlighted the existence of excess volatility in the aggregate stock market relative to the present value implied by the efficient markets model. Upon evaluating the present value of the real dividends paid on the S&P Index since 1871, discounted by a constant discount rate equal to the geometric average return over the same time period, Shiller observed a relatively stable trend. However, comparing that with the S&P Index movements over the same time period, he observed the presence of inordinate gyrations as illustrated below. Shiller went on to add then that these gyrations reflect the presence of excess volatility which could not be well-explained by any variant of the efficient markets model and went further to suggest how irrational expectations through feedback models could shape asset prices.

Robet Shiller (2003) - From Efficient Markets Theory to Behavioral Finance The mechanism through which irrational expectations shape asset prices can be explained through feedback theory. Successes for some investors create attention and promote word of mouth enthusiasm and increased expectation for future price increases which in turn increases investor demand and fuels another round of price increases. This feedback loop if not interrupted leads to the formation of bubbles where asset prices are inflated compared to their intrinsic value. This example of irrational optimism replicates itself when the bubble bursts and prices start falling and a wave of irrational pessimism leads to downward price movements fuelling further downward price movements. These feedback mechanisms may thus be an essential source of the apparent unexplainable randomness observed in financial market prices. However, the question arises as to what causes such irrational expectations? A quick scan of the available literature reveals evidence from the study of human behavior which suggest reasons for the existence of such feedback mechanisms in the asset market today. The existence of cognitive biases where humans tend to display systematic biases toward patterns and past observations suggest that in the same manner, people might tend to categorize stock price patterns into salient categories and persistent trends resulting in the formation of feedback dynamics. The study of biased self-attribution or ego bias, where individuals attribute past successes to their own ability and disregard negative events as due to bad luck can also result in the quick formation of irrational expectations in asset markets leading to feedback dynamics. Proponents of the efficient market hypothesis counter this by suggesting that at the aggregate, not all investors are irrational and the market mechanism would function to correct irrational expectations and cause wealth to shift from investors misled by cognitive errors to smart-money investors free from such biases, eventually driving the wealth weighted sum of errors to zero offsetting the effect of irrational traders. However, Shiller (2003) highlights the

#1097: Money & the Business Cycle implication that smart money may not always succeed in fully offsetting the impact of irrational traders and offers evidence from behavioral studies as to how this may be so. Shiller highlights evidence from Kahneman and Tverskys (1979) prospect theory which suggests that individuals might be more averse to losses than favorable to equivalent gain. Such caution limits the tendency of smart money investors to take unnecessary risk and thus limits the extent to which smart investors restore prices to their intrinsic levels. Market limitations too like the increasing cost of shorting additional shares due to rising interest rates also serves to dampen the effect that smart money has on irrational investors. Essentially, the inability of smart money to effectively correct the presence of irrational expectation in the market might serve to explain the observed excess volatility and deviation of asset prices from their fundamentals. In todays increasingly complex financial markets, observation of such feedback dynamics are becoming more commonplace as seen through the 2000 technology bubble and the 2008 housing bubble. While asset prices are still largely determined by their fundamentals in the long run, perhaps much of short term fluctuations are increasingly being shaped by investor sentiment and expectation. Lending practices, central bank policies, fiscal policy and the efficacy of financial market regulation can all affect the way a market responds to information. The extent to which this response is rational remains the key question for us today. 787 Words Tee Chin Min Benjamin (h1350428)