Question

1.Let’s assume that market is inefficient. They why don’t more people beat the market?

2.Show how efficient markets is the child of free-market thought.

3..Explain what is meant by rational irrationality and explain an example that is not directly related to finance.

4.Why does an efficient market imply a normal distribution in stock returns?

5. Let’s play the following game: Guess a number from 0 to 100 with the goal of making your guess as close as possible to two-thirds of the average guess of those participating in the contest. Now let’s assume, everyone in the game is completely rational. What number will everyone choose? Why?

Answer 1

Answer - 1)

Firstly, primary job of many people is not investing for a living. Thus, it is hard to outperform the average.

Since, market is inefficient, nobody can predict what will happen in the future. Any event may happen which can alter the predicted scenario. There is inherent randomness in some events like politics, war, disasters etc.

Some people have more grip of information and technology as compared to others. Some may have insider information and have most sophisticated computers/ softwares in the industry which is not available to average group of people. The distribution of equity returns is not a normal distribution.

Answer - 3)

'Rational Irrationality' was popularized by economist Bryan Caplan to reconcile widespread existence of rational behaviour with the assumption of rationality made by mainstream economics. This theory asks us to ignore the repercussions of our behaviour. It is when people tailor their degree of rationality at the costs of error.

The most common example is politics where rational irrationality is expected to be common. In large democracies, each voter has bery low probability of influencing the outcome of an election and thus, the expected cost of supporting an erroneous policy is very low. The psychological benefits of supporting policies that feel good (but are infact harmful) may be greater. Thus, voters may be rationally irrational for practical moral reasons.

Answer - 4)

Efficient markets imply that stock markets would follow a normal distribution because if one plots daily movements in a stock, for a year or so, most of the daily movements will be similar in size. Only few instances would occur when daily movements will record big or small changes (since the likelihood of a stock's price to sky rocket up or down is rare unless there has been some news that made it so). Thus, this graph would resemble a bell curve.

Answer - 5)

Let the mean depth of thinking be α

Thus, thus participants choose

Thus, zero depth of thinking would be thinking that the mean is 50, so 2/3rd of that would be about 33.

But, I know that everyone guessed 33 and thus, by First level of thinking, I would suggest that those zero-level dummies' average would be about 33, so I should quest for 2/3rd of that, which would be about 22.

Second level of thinking argues that those first-level thinkers will push the average down to about 22, so 14 or 15 would be better.

And so on.....

Now, assuming that everyone thinks truly deeply, everyone will deduce that 0 is the best guess, and thus, 0 is the average and 0 is 2/3rd of the average. Thus, everyone would choose 0.

But, in practice, not everyone thinks so deeply, thus, pushing the average up.