I recommend  Andrew W. Lo’s Mit Finance course on I tunes U. Lecture 19

Behavioral Finance :   Watch the one on efficient markets 2

Are markets efficient?  Buffett says clearly no. They are subject to animal spirits.    Market efficiency requires rationality which comes and goes in waves.  Behavioral finance says people suffer from loss aversion, overconfidence, overreaction, herding, and mental accounting.

Daniel Ellsberg,  most famous for releasing the Pentagon Papers in 1969 came up with the Ellsberg paradox.    People will pay less for a gamble with less clear odds.   When there is uncertainty about risk people shy away. We are hard wired to avoid things we don’t understand because these could kill you, to avoid hidden crocodiles.  That is why when markets get scary people shy away although the expected return is increased.

Frank Knight looked at why entrepreneurs are paid so much.  He decided that it is because they take on uncertainty and not just risk.   Uncertainty is the risk that no one can quantify e.g. Nanotechnology. 

Lastly, people tend to see only what they are looking for. 

Since people are unable to assess odds, they are susceptible to be Dutch Booked.

It is though that his provides a limit to irrationality.  Smart people will take advantage and the market will correct.   An example is arbitrage. 

Efficient market folks feel that market forces will force people to be rational if there are enough rational people around.

However Keynes said the market can stay irrational longer then you can stay solvent. 

Antonio Damasio, a neurosurgeon, wrote a book DescartesError in which he argued that rationality stems from emotion.   He describes a patient who had a brain tumor removed.  Although he tested normally in math or logic he was unable to function in the world and quickly lost his job.  After the surgery he had no emotion reactions as shown by eye blink tests.   You have to be able to feel to act rational.

This relates to the triune brain.    The reptile brain regulates heart rate and vital functions. The mammalian brain sits over this and it regulates fear, greed, love, and emotion.   The hominid brain or neocortex is responsible for language, math and logical deliberation.    Under the stress  of shock such as loss of blood the reptile brain shuts last.   People faint but keep breathing.   In fact you can be brain dead and continue breathing.  Of the remaining brains the hominid brain shuts down first when under stress.   Evolution favors running from thetiger.   Experiments have shown under stress or pain the neocortex does not resume normal function for hours after an insult.  Under stress, body shunts blood away from the cortex.   When stressed people cannot use the cortex and don’t think. 

That is why love makes you stupid.

Emotion is necessary for rationality but too much emotion impairs rationality.

Best advice:  Be clear about your goals.  Decide what you want to achieve and ask will my current actions help or hinder the objectives. 

Lo developed the Adaptive Market Hypothesis

He says that prices in the market reflect available information and the number of species in the economy.  Species means professionals, pension managers, hedge fund managers, and individual investors.    When people are stressed either positive or negative, they are not rational. 

This theory takes a biological view of markets.  We are both creatures of our rational brains and emotional brains.

Adaptive market theory properties are that:

Individuals act in their self-interest

They make mistakes

They learn and adapt

Competition drives adaptation and innovation

Natural selection shapes the market ecology

Evolution determines market dynamics

It takes negative feedback to cause us to learn and develop adaptive heuristics or thought process shortcuts . 

The implications of the Adaptive Market Hypothesis are that:

Risk reward is not stable because individual preferences are not stable

Risk premiums are time varying. 2007 is different from 2008

Limited arbitrage (free lunches) exist from time to time 

Strategies wax and wane

Adaptation and innovation are key to survival

Survival is all that matters

Market efficiency goes in cycles that depend on the population of investors that are interacting with each other.   These cycles can be anticipated and perhaps  some profit can be made.