{"id":361,"date":"2018-11-28T19:02:42","date_gmt":"2018-11-28T19:02:42","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&p=361"},"modified":"2018-11-28T19:02:42","modified_gmt":"2018-11-28T19:02:42","slug":"13-2-market-behavior","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/13-2-market-behavior\/","title":{"raw":"13.2 Market Behavior","rendered":"13.2 Market Behavior"},"content":{"raw":"
\r\n
\r\n

Learning Objectives<\/h3>\r\n
    \r\n \t
  1. Define the role of arbitrage in market efficiency.<\/li>\r\n \t
  2. Describe the limits of arbitrage that may perpetuate market inefficiency.<\/li>\r\n \t
  3. Identify the economic and cultural factors that can allow market inefficiencies to persist.<\/li>\r\n \t
  4. Explain the role of feedback as reinforcement of market inefficiencies.<\/li>\r\n<\/ol>\r\n<\/div>\r\n \r\n\r\n<\/div>\r\n

    Your economic behaviors affect economic markets. Market results reflect the collective yet independent decisions of millions of individuals. There have been years, even decades, when some markets have not produced expected or \u201crational\u201d prices because of the collective behavior of their participants. In inefficient markets, prices may go way above or below actual value.<\/p>\r\n

    The efficient market theory<\/strong>[footnote]The idea that the market works best when prices reflect all available information, implying that the market price represents an unbiased estimate with an equal chance that stocks are over- or undervalued.[\/footnote] relies on the idea that investors behave rationally and that even when they don\u2019t, their numbers are so great and their behavioral biases are so diverse that their irrational behaviors will have little overall effect on the market. In effect, investors\u2019 anomalous behaviors will cancel each other out. Thus, diversification (of participants) lowers risk (to the market).<\/p>\r\n

    Another protection of market efficiency is the tendency for most participants to behave rationally. If an asset is mispriced so that its market price deviates from its intrinsic value, knowledgeable investors will see that and take advantage of the opportunity. If a stock seems underpriced they will buy, driving prices back up. If a stock seems overpriced, they will sell, driving prices back down. These strategies are called arbitrage<\/strong>[footnote]Trading that profits from the market mispricing of assets in the capital markets.[\/footnote], or the process of creating investment gains from market mispricings (arbitrage opportunities<\/strong>[footnote]A market mispricing that provides an opportunity for unusual gain or loss.[\/footnote]). The knowledgeable investors who carry out market corrections through their investment decisions are called arbitrageurs<\/strong>[footnote]Traders who seek arbitrage opportunities.[\/footnote].<\/p>\r\n

    There are limits to arbitrage, however. There are times when the stock markets seem to rise or fall much more or for much longer than the dynamics of market correction would predict.<\/p>\r\n\r\n

    \r\n

    Limits of Arbitrage<\/h2>\r\n

    Arbitrage may not work when the costs outweigh the benefits. Investment costs include transaction costs, such as brokers\u2019 fees, and risk, especially market risk.<\/p>\r\n

    An investor who sees an arbitrage opportunity would have to act quickly to take advantage of it, because chances are good that someone else will and the advantage will disappear along with the arbitrage opportunity. Acting quickly may involve borrowing if liquid funds are not available to invest. For this reason, transaction costs for arbitrage trades are likely to be higher (because they are likely to include interest), and if the costs are higher than the benefits, the market will not be corrected.<\/p>\r\n

    The risk of arbitrage is that the investor rather than the market is mispricing stocks. In other words, arbitrageurs assume that the current valuation for an asset will reverse\u2014will go down if the valuation has gone too high, or will go up if the valuation has gone too low. If their analysis of fundamental value is incorrect, the market correction may not occur as predicted, and neither will their gains.<\/p>\r\n

    Most arbitrageurs are professional wealth managers. They invest for very wealthy clients with a large asset base and very high tolerance for risk. Arbitrage is usually not a sound practice for individual investors.<\/p>\r\n\r\n<\/div>\r\n

    \r\n

    Causes of Market Inefficiency<\/h2>\r\n

    Market inefficiencies can persist when they go undiscovered or when they seem rational. Economic historians point out that while every asset \u201cbubble\u201d is in some ways unique, there are common economic factors at work.Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes<\/em>, 5th ed. (Hoboken, NJ: John Wiley & Sons, Inc., 2005).<\/span> Bubbles are accompanied by lower interest rates, increased use of debt financing, new technology, and a decrease in government regulation or oversight. Those factors encourage economic expansion, leading to growth of earnings potential and thus of investment return, which would make assets genuinely more valuable.<\/p>\r\n

    A key study of the U.S. stock market points out that there are cultural as well as economic factors that can encourage or validate market inefficiency.Robert J. Shiller, Irrational Exuberance<\/em>, 2nd ed. (New York: Random House, Inc., 2005).<\/span> Examples include<\/p>\r\n\r\n