Andrew Lo and BF

FROM : ARE FINANCIAL MARKETS EFFICIENT? p25

At the most general level, behavioral finance is the study of human fallibility in competitive markets. It does not simply deal with an observation that some people are stupid, confused, or biased. […] BF theory rest on two major foundations. The first is limited arbitrage, the second namely investor sentiment.

 

Limited arbitrage suggest that arbitrage in real world securities markets is far from perfect. many securities do not have perfect or even good substitutes, making arbitrage fundamentally risky and, even when good substitutes are available, arbitrage remains risky and limited because prices do not converge to fundamental values instantaneously. The fact that arbitrage is limited helps explain why prices do not necessarily react to non-information expressed in uniformed changes in demand. Limited arbitrage thus explains why markets may remain inefficient when perturbed by noise trader demands, but it does not tell us much about the exact form that inefficacy might take. For that, we need the 2nd foundation of behavioral finance: investor sentiment: the theory of how real world investors actually form their beliefs and valuations, and more generally their demands for securities. Combined with limite arbitrage, a theory of investor sentiment may help generate precise predictions about the behavior of security prices and returns.

 

if arbitrage is unlimited, then arbitrageurs accommodate informed shifts in demand as well as make sure that news is incorporated into prices quickly and correctly. Markets then remain efficient even when many investor are irrational.Without investors sentiment, the are no disturbances to efficient prices in the fist pace, and so prices do not deviate from efficiency. A behavioral theory thus requires both an irrational disturbance and limited arbitrage which does not counter.

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