Third Theme – Inefficient Markets

Market Efficiency: All investors have the same information, interpret it the same way and make same projections based on it. It implies that the assets are perfectly (efficiently) priced.

However, the behavioral traits exhibited by investors contribute to the inefficiencies in the market. The major ones and their resulting impact on the markets are as below:

a) Representativeness:

  • By basing decisions on stereotyping past information and/or incidents incorrect projections can be made.
  • Stocks can be temporarily over/under priced.
  • Over-priced “winners” will underperform (as they would have been wrongly over valued).
  • Under-priced “losers” will over-perform (as they would’ve been wrongly under valued despite credible fundamentals).

b) Anchoring and Adjustment:

  • This is put simply, conservatism.
  • Positive news would lead to positive surprises (due to not being fully incorporated in the revised forecasts).
  • Similarly negative news would lead to negative surprises.

c) Overconfidence:

  • The biggest pitfall due to this is not realising one’s limitations.
  • As a result investors tend to make “unjustified” bets, thereby resulting in mispriced securities.
  • It can also lead to excessive trading.

d) Frame Dependence:

  • Information is not objectively analysed but viewed as per the “frame” it is received through.
  • It results in the tendency to change risk tolerance per market direction.
  • Investors get over-active in upward markets.
  • But become hesitant/inactive in slow/downward markets.

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