Significance of investor speculation

Notes

Significance of investor speculation

For a while, evidence suggested that CAPM, EMH etc explained things well.

However, as time went on, academics found behaviours that couldn't be explained by these theories. The real world proved to be a very messy place in which market participants often behaved very unpredictably.

For example, many buy lottery tickets, despite the odds of them winning FAR outweighing the potential return

Behavioural finance tries to help explain this, using cognitive psychology

It suggests that sometimes shares may be overvalued due to the number of people interested in the share - making it seem more attractive and thus, irrationally, more valuable

Another anomaly is that the market premium is historically 6-7%, compared to only 3% for bonds. However shares are not that much riskier - so why such a return premium?

The answer, according to behavioural finance, is that humans are much more highly tuned to losses. This loss aversion means the market must return very high premiums to overcome any short term losses

Another example is anchoring. This means an investor anchors the “value” of a share to its recent amounts. Lets say that a share was trading at $100 but loses a key customer and thus falls to $50.

An investor though may now, incorrectly, see this share as undervalued because he is anchored as seeing this share so high before

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