1) Behavioural finance argues that financial markets are inefficient because rationality is limited and people rely on heuristics and are influenced by others. 2) Random walk hypothesis states that past asset price movements cannot predict future prices, but some argue smart investors can still predict trends. 3) Irrational exuberance refers to periods of speculative bubbles driven by psychological factors rather than fundamentals, as seen in the 1990s tech stock boom.

1. Mark Johnston King’s College, Auckland January 2013
Behavioural Finance
As with behavioural economics, the them. Additionally this information should be updated
conventional view of finance assumes that regularly so only the objective information affects
markets are efficient and that the price of people’s decision-making – Bayseian Updating.
shares, bonds and other financial instruments Bayseian Updating refers to people who are willing
and able to modify their beliefs based on new, objective
are a reflection of the fundamental economic
information. However in their decision-making,
values that they represent. Behavioural rationality of individuals is limited by the information
finance is all about understanding why they have and people don’t always know what good
and how financial markets are inefficient. or objective information on the financial markets
If there is a difference between the market actually looks like.
price of a share or bond and its fundamental
value then in conventional economics no Random Walk Hypothesis
one can make money in financial markets This refers to the idea that financial asset price
by exploiting the difference. movements follow a random walk. This was made
famous by Burton Malkiel who wrote "A Random
Why are financial markets not efficient? Walk DownWall Street". He argued that past
In an efficient financial market, share and bond movements in asset prices do not provide the
prices move up and down according to the information information required to predict future prices. Basically
about changes in the real economy. However this you cannot get rich by beating the market, although
information must be accurate and unbiased and if by selling advice to those who believe you can beat
there are errors people should be able to identify the market might earn you a high salary.

2. Mark Johnston King’s College, Auckland
Some behavioural economists largely support this Speculative bubbles encourage investment confidence
perspective that financial asset prices largely follow and enhance animal spirits of investors who are
a random walk. Consequently using simple heuristics being motivated by the excitement and the behaviour
(enabling someone to work something out for of others. Economists John Maynard Keynes and
themselves) as an investment strategy is an intelligent John Kenneth Galbraith emphasized psychological
move. Other behavioural economists, such as Robert and sociological factors as well as the spread of
Shiller, state that there is easy money to be made misleading and overconfidence-breeding information,
on stock markets by smart investors which implies, as a key to stock market booms and crashes.
along with bubbles, that financial markets are
inefficient. This assumes that you can make money Final thought
from market inefficiencies and the past can predict In society today consumers do not have the ability
the future. Shiller argues that people can’t predict or the perfect information to understand complex
day-to-day changes in stock prices but it doesn’t alphabet soup of financial investments from Collateral
mean that smart investors can predict nothing at all. Debt Obligations (CDOs) to Credit Default Swaps
(CDSs). Too often people’s decision making is
Irrational Exuberance influenced by the behaviour of others including
In 1996 Alan Greenspan, former chairman of the experts and those at the higher end of the income
US Federal Reserve, used the term ‘irrational ladder. However you don’t have to look much further
exuberance’ to describe one of the greatest increases than former head of the NASDAQ Bernard Madoff
in the US stock market. The Dow Jones Industrial to see how someone who had immense respect
Average increased from 3,600 points in early 1994 amongst investors was in reality running a ponzi
to just under 12,000 by the start of 2000. This boom scheme.
and bust during this time was dominated by tech
stocks – shares in IT related companies. Shiller References:
believes that irrational exuberance is the psychological Behavioural Economics for Dummies –
basis of speculative bubbles in contrast to a price Morris Altman. 2012
increase based on increases in fundamental values.