Extrapolating Expectations: An Explanation for Excess Volatility, Overreaction and Limited Informati

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Extrapolating Expectations An Explanation for
Excess Volatility, Overreaction and Limited
Information Albany-MIT System Dynamics Colloquium

• Mila Getmansky
• Jannette Papastaikoudi
• April 5, 2002

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Efficient Capital Markets

• The efficient market hypothesis (EMH) has been
  one of the cornerstones of modern financial
  theory
• Price is a martingale, conditional on all
  available information
• Price changes are unforecastable if properly
  anticipated i.e. prices fully incorporate the
  expectations and the information of all market
  participants

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Yet Some Facts Speak Against EMH

• Excess volatility exhibited in financial markets,
  i.e. the variation of stock returns cannot be
  explained by the variation in fundamentals
  (earnings/dividends)
• Excess volatility is equivalent to predictability
  in stock price
• One form of return predictability is momentum
• Momentum in general refers to the tendency of
  stocks that had positive (negative) abnormal
  returns to continue to outperform (underperform).
  This implies a positive autocorrelation in
  returns

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And What About Information Transmission?

• Financial analysts are information intermediaries
  in markets, influence informational efficiency
• Speed which prices reflect public information
  increases in analyst coverage
• Yet, evidence shows, analysts reports are
  systematically biased.
• Why?
• Optimistic reports generate investment banking
• Biasing upwards allows for increased management
  access
• Inexperienced analysts overreact to good/bad news

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Put Two And Two Together

• Combine all three research topics
• Explain excess market volatility by means of
  momentum and incomplete information
• Recognize behavior of market participants and its
  effects on investors wealth
• Effect of excessive price movements with respect
  to fundamentals can be caused either by
  irrational trend chasing behavior of investors,
  or by distorting the available information used
  to form fundamental prices

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Related Literature

• Excess volatility
• Shiller 1981
• Campbell Shiller 1988
• Momemtun
• Jegadeesh Titman 1993, 2001
• Daniel, Hirshleifer Subrahmanyam 1998
• Analyst coverage
• De Bondt Thaler 1990
• Easterwood Nutt 1999
• Hong, Lim Stein 2000
• Lim 2001

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Goal

• Formulate a model of financial market volatility
  that is grounded in the system dynamics approach
  to modeling decision making
• Explain excess volatility and price oscillations
  (excess volatility volatility of return
  volatility in the trend in earnings)

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Assumptions

• Two types of assets risky and riskless
• Market making mechanism is built into the price
  formation process
• Two types of investors value and momentum
• Inexperienced analysts

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Pricing
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Momentum Investor Decision
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Change in Investors Type Fraction
Equal fraction Investors Type Fraction
0.5 Fundamental dominates Investors Type
Fraction 0.8 Momentum dominates Investors
Type Fraction 0.2
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Change in Investors Type Fraction
Equal fraction Investors Type Fraction
0.5 Fundamental dominates Investors Type
Fraction 0.8 Momentum dominates Investors
Type Fraction 0.2
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Momentum Investors Lose on Average
Fundamental Dominates Investors Type Fraction
0.8 Momentum Dominates Investors Type Fraction
0.2
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Momentum Listening to Inexp. Analysts Reduces
Exc. Vol.
Investors Type Fraction 0.2 Momentum Dominates
Momentum Weight 1 Momentum Listens to UA
Momentum Weight 0.5, UA Weight 0.5
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Reducing Excess Volatility
Investors Type Fraction 0.2 Momentum Dominates
Momentum Weight 1 Momentum Listens to UA
Momentum Weight 0.5, UA Weight 0.5
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Fundamental Listening to Inexp. Analysts
Increases Excess Vol.
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Increasing Excess Volatility
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Conclusions

• Excess volatility cannot be explained by EMH
• Excess volatility is primarily due to speculative
  investors who chase market prices
• Decision rules and bounded rationality of
  investors lead to the overall oscillations in
  prices and excess volatility

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Conclusions

• Momentum investors are not driven out even if
  most of the traders are fundamental investors
  (80)
• Excess volatility is higher when initially there
  are more momentum traders than fundamental ones
• Excess volatility is increased when fundamental
  investors listen to inexp. analysts
• Excess volatility is decreased when momentum
  investors listen to inexp. analysts