The Limping Bull 4.1

A few weeks ago at work we did a function for JB Were. I wasn't working on that night, thank God. One of my lecturer was there I heard. One tough guy (or at least he wanted us to think so). He did a good job of setting a high standard for the course. He gave us the single hardest assignment I ever had at uni. But I am still very disappointed by his class. It was representative of my whole degree in a way.

I made it through university, learned a great deal about market mechanisms and finance theory. We were fed tons of research papers on CAPM and alternative asset pricing models (you know, multifactor models and all). We were taught Black-Scholes option pricing model. All this based on so many assumptions that at first I thought it was a joke. Ah, and the Efficient Market Hypothesis (EMH). Great stuff too.

But we were rarely told the reality of the Market. We only brushed the idea that actual models are flawed because the assumptions upon which they are based are violated every day. Many of the models we studied are to varying extent reliant on or derived from the CAPM. Now recall some of model's assumptions:

• Investors are risk averse
• Investors maximise expected utility of the portfolios over a single period planning horizon
• Individual investors are price takers
• Investors are rational mean-variance optimisers
• Investors have homogeneous expectations

Great stuff. But until now, I am convinced that investors have a tendency to over and under-react to information released. Wait, not only do they over-react but their decisions are affected by non-economic factors (or remotely economically relevant factors). In my opinion, this isn't just a few rogue investors and speculators but rather the large majority of market participants.

Continues ...

Posted by Editor on Monday, December 06, 2004 at 1:34 PM | Permalink