Archive for June 6th, 2011

Limits to arbitrage?

 

Behavioral finance used mean reversion cycles to challenge the classical economics (21 Apr article), but preferred to explain mean reversion through sentiment and not ‘Time’. We can’t expect Markowitz and Fama to open up this fissure and crack the dam open and fight back, because not only this means that they have to accept that classical economics failed to answer more than a few questions, accept that the finance we are still taught at ivy league could be far from complete, undo 100 years of research and only then can there be a new academic war.

The new fissure (weak argument) behavioral finance has is that though there is a limit to what can be arbitraged and inefficiencies can last longer, price reversal happen every 2-3 years. So what the practitioners say is that on a large time frame arbitrage is possible (buying the worst 3 year losers and selling the best 3 year performers) but not on small time frames. Even this time they explain how it’s the sentiment and investor profile that is to be blamed. Because investors are loss averse they over-react pushing losers lower. Investors also suffer from under-reaction. This is the reason momentum continues and tops extend. The over-reaction and under-reaction takes years to unwind.

Above this…

This article was written for Business Standard

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