The rationality of financial markets has been one of the most hotly contested issues in the history of modern financial economics. In this paper, we extend the findings by Lo and Repin (2002) and investigate the role of emotional mechanisms in financial decision-making using a different sample of subjects and a different method for gauging emotional response. In particular, we recruited 80 volunteers from a five-week on-line training program for day-traders offered by Linda Bradford Raschke, a well known professional futures trader (see J. Schwager, 1994). Subjects were asked to fill out surveys that recorded their psychological profiles before and after their training program, and during the course of the program (involving live trading through their own personal accounts) subjects were asked to fill out surveys at the end of each trading day which were designed to measure their emotional state and their trading performance for that day. We find a clear link between emotional reactivity and trading performance as measured by normalized profits-and-losses.Download (PDF) >
In this article, the current state of the controversy surrounding the Efficient Markets Hypothesis (EMH) is reviewed and a new perspective that reconciles the two opposing schools of thought is proposed. The proposed reconciliation, which is called the Adaptive Markets Hypothesis (AMH), is based on an evolutionary approach to economic interactions, as well as some recent research in the cognitive neurosciences that has been transforming and revitalizing the intersection of psychology and economics. Although some of these ideas have not yet been fully articulated within a rigorous quantitative framework, long time students of the EMH and seasoned practitioners will no doubt recognize immediately the possibilities generated by this new perspective. Only time will tell whether its potential will be fulfilled.Download (PDF) >
We document the empirical properties of a sample of 1,765 funds in the TASS Hedge Fund database from 1977 to 2004 that are no longer active. The TASS sample shows that attrition rates differ significantly across investment styles, from a low of 5.2% per year on average for convertible arbitrage funds to a high of 14.4% per year on average for managed futures funds.We relate a number of factors to these attrition rates, including past performance, volatility, and investment style, and also document differences in illiquidity risk between active and liquidated funds.We conclude with a proposal for the US Securities and Exchange Commission to play a new role in promoting greater transparency and stability in the hedge-fund industry.Download (PDF) >
The returns to hedge funds and other alternative investments are often highly serially correlated. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure and smoothed returns. We propose an econometric model of return smoothing and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.Download (PDF) >
A longstanding controversy in economics and finance is whether financial markets are governed by rational forces or by emotional responses. We study the importance of motion in the decision-making process of professional securities traders by measuring their physiological characteristics (e.g., skin conductance, blood volume pulse, etc.) during live trading sessions while simultaneously capturing real-time prices from which market events can be detected. In a sample of 10 traders, we find statistically significant differences in mean electrodermal responses during transient market events relative to no-event control periods, and statistically significant mean changes in cardiovascular variables during periods of heightened market volatility relative to normal-volatility control periods. We also observe significant differences in these physiological responses across the 10 traders that may be systematically related to the traders’ levels of experience.Download (PDF) >
We examine the implications of portfolio theory for the cross-sectional behavior of equity trading volume. Two-fund separation theorems suggest a natural definition for trading activity: share turnover. If two-fund separation holds, share turnover must be identical for all securities. If (K + 1)-fund separation holds, we show that share turnover satisfies an approximately linear K-factor structure. These implications are examined empirically using individual weekly turnover data for NYSE and AMEX securities from 1962 to 1996. We find strong evidence against two-fund separation and a principal-components decomposition suggests that turnover is well approximated by a two-factor model.
For instructions on how to create your own MiniCRSP database, please see Trading Volume and the MiniCRSP Database: An Introduction and User’s Guide.Download (PDF) >
In this review article, we explore several recent advances in the quantitative modeling of financial markets. We begin with the Efficient Markets Hypothesis and describe how this controversial idea has stimulated a number of new directions of research, some focusing on more elaborate mathematical models that are capable of rationalizing the empirical facts, others taking a completely different tack in rejecting rationality altogether. One of the most promising directions is to view financial markets from a biological perspective and, specifically, within an evolutionary framework in which markets, instruments, institutions, and investors interact and evolve dynamically according to the “law” of economic selection. Under this view, financial agents compete and adapt, but they do not necessarily do so in an optimal fashion. Evolutionary and ecological models of financial markets is truly a new frontier whose exploration has just begun.Download (PDF) >