Day 101 in MIT Sloan Fellows Class 2023, Financial Market Dynamics and Human Behavior 1 - "Is market efficient?"
Course briefing
This course develops a new perspective on the dynamics of financial markets and the roles that human psychology and the business environment play in determining the evolution of investor behavior and institutions. ( From Syllabus)
Who is Andrew Lo?
He is one of the legendary faculty at MIT Sloan. I was quite impressed with not only the course content but also his personality.
He is keen to learn from students and super humble in spite of his outstanding academic and business achievements.
This course is organized between 4pm and 7pm, and the professor gives us a pizza to say thank you to the students. What a kind person he is!
Then, this course is extremely popular in Sloan, you need to bid a lot of credit.
What is Adaptive Markets?
In a nutshell, this new hypothesis is a more precise description of the finance market, which cannot be expressed by the efficient market hypothesis(EMH), with the help of biology and psychology. So it does not deny EMH at all. It says EMH has vulnerability under certain conditions.
In the class, it introduces the efficient market hypothesis in detail, acknowledges its validity, and then leads us to EMH's limitations and exceptions.
Then, just as the economics community has borrowed from physics theory to describe the market (in its simplified form), we cite suitable theories from other disciplines to describe the market.
You can find the detail from the books below.
Wisdom of Crowd
In the first class, we tried auction to highlight the power of "wisdom of crowd".
Bascially, EMH is based on the strong hypothesis that the market reflects all the existing information on the table in pricing. Or even under the table.
The well known story is
"a finance professor and a student are walking to class when they come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, "Don't bother. If it were really a $100 bill, it wouldn't be there."
What a stupid story it is!
Then, another great story demonstrates EMH is The Challenger Disaster.
The Challenger Disaster and Market Efficiency
Lo starts his discussion of the EMH with a dramatic example. On January 28, 1986, the Space Shuttle Challenger exploded 73 seconds into its launch. A blue-ribbon commission of the best minds in spaceflight, physics, and engineering was assembled to identify the reason for the explosion. After five months of an in-depth investigation, the commission concluded that the explosion was due to the failure of the O-rings around the joints of the booster rocket.
There were four publicly traded companies that were major NASA contractors. The commission’s report was good news for three but bad news the maker of the booster rocket, Morton Thiokol, which would cause a drop in the firm’ stock price. But the impact of the disaster did not occur on the day of the report, but rather, five months earlier, within minutes of the explosion. The stock market can be so efficient that it figured out in minutes what took a panel of experts five months to figure out.
Auction demonstration
After those explanation, Lo actually demonstrated wisdom of crowd with auction.
He brought a brown paper bag, and asked students "I can't disclose what is insider this bag. However, let's make a bid for this bag. The winner will show what is inside and pay money for me."
My initial thought is everyone bids just $1 - $2 and some stupid guys will increase the bidding to $20-30 because the professor said there is potentially nothing inside the bag. Actually, I would bid if it's $15 or $20.
The most surprising thing is that the bag whose contents were unknown sold for $250.
$250? Seriously? Yes. It is serious.
What was inside the bag? Apple watch worth $264. Our wisdom of crowd demonstrated very precise prediction with tiny information.
Little analysis
Let's think about and analyze what happened in the classroom.
There are some available information representing some contexts of the classroom.
- Facilitator: Andrew Lo
- Presentation and facilitation by Andrew Lo: enthusiastic and serious
- Situation: classroom 4pm-7pm
- Gift size
- Context of class: the challenger story and deep dive into EMH, etc
- Bidders: students including undergraduates, MBA, and executive MBA.
Then, if EMH is correct, we(bidders) digested all the information above and judged the gift should be around $250.
And I can imagine there is a bunch of psychological effects in this judgment.
Still, EMH demonstrated grand theory and 99% of a phenomenon, but it has countless unexplainable mechanisms behind the consequence.
