Tuesday, May 27, 2008

Stock Markets - 4

Observe that the polls represent the votes of many (sportswriters for the AP poll, coaches for the ESPN poll) and what drives the voting of any individual in the poll is perhaps quite idiosyncratic. But we can model their decision. Suppose teams have intrinsic qualities that can't be directly observed. All that we can observe is how the teams do when they play each other. The outcome in any particular game depends on the qualities of the two teams, some other known factors like which is the home team, and a lot of random factors. Luck definitely comes into it. That means after the fact one can infer something about the hidden team quality based on the outcome of the game. The usual inference is that a win indicates your team is as good or better than you thought and a loss indicates the opposite. But everyone can have a bad day and a mediocre team can really shine on occasion.

Following Eugene Fama, a Professor of Finance at the University of Chicago's Graduate School of Business and father of the "Efficient Market Hypothesis" most economists believe that the stock market efficiently utilizes all the current information available. The main implication of that theory is that an investor can't consistently outperform a representative index (such as the S&P 500) of overall market activity. An occasional higher than market performance must be attributed to luck and chance factors. The efficient market hypothesis implies that periods of irrational exuberance, "bubbles" if you will, don't actually happen. If Fama is right, the expression "bubble" is simply an ex post rationalization.

A great Michael Lewis article about a stock dealer who came around to the Fama viewpoint

Fama versus the Behaviorists

Let us see how rational a decision maker you are. You are to consider the following scenario about Linda and then you must rank the three alternatives according to their likelihood, from most likely to least likely. Also provide a brief explanation for your rankings. Linda is thirty-one years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
1. Linda is active in the feminist movement;
2. Linda is a bank teller;
3. Linda is a bank teller and is active in the feminist movement.

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