Inefficient Markets: The Third Theme

Hersh Shefrin

in Beyond Greed and Fear

Published in print October 2002 | ISBN: 9780195161212
Published online November 2003 | e-ISBN: 9780199832996 | DOI:

Series: Financial Management Association Survey and Synthesis Series

 Inefficient Markets: The Third Theme

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Markets are efficient when prices coincide with intrinsic value. Heuristic‐driven bias and frame dependence combine to render markets inefficient. Representativeness leads to the winner–loser effect, whereby investor overreaction causes prior long‐term winners to become future long‐term losers, and prior long‐term losers to become future short‐term winners. Conservatism leads security analysts to underreact to earnings surprises, thereby generating short‐term momentum in stock prices. Frame dependence leads investors to frame stock returns in terms of short horizons instead of long horizons. As a result, investors require a larger equity premium than they would if they framed returns using longer horizons. Prices can deviate from fundamental value for long periods, with excess volatility the result.

Keywords: equity premium puzzle; irrational exuberance; Long‐term Capital Management; overconfidence; overreaction; post‐earnings announcement drift; representativeness; winner–loser effect

Chapter.  3370 words.  Illustrated.

Subjects: Financial Markets

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