Inefficient Markets: An Introduction to Behavioral Finance

by Andrei Shleifer

The efficient markets hypothesis has been the central proposition in finance for nearly thirty years. It states that securities prices in financial markets must equal fundamental values, either because all investors are rational or because arbitrage eliminates pricing anomalies. This book describes an alternative approach to the study of financial behavioral finance. This approach starts with an observation that the assumptions of investor rationality and perfect arbitrage are overwhelmingly contradicted by both psychological and institutional evidence. In actual financial markets, less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems. The book presents models of such markets. These models explain the available financial data more accurately than the efficient markets hypothesis, and generate new predictions about security prices. By summarizing and expanding the research
in behavioral finance, the book builds a new theoretical and empirical foundation for the economic analysis of real-world markets.

Genres: Economics, Finance, Psychology, Nonfiction, Business

224 pages, Paperback

First published March 9, 2000

Reviews

[Yuekun Liu]

This is the text book of Wurgler’s behavioural finance class. The book is a collection of papers. Short, simple and systematic.

Andrei Shleifer states that the behavioural finance theory rests on two major foundations. The first is limited arbitrage, and the second the investor sentiment (how real-world investors actually form their beliefs).

The first four chapters focus on the limited arbitrage. The key point it that securities do not have perfect substitutes, or even the substitutes exist, the arbitrage remains risky because of the limited horizon and the prices do not go back to the fundamental instantaneously. The fifth chapter gives a model of sentiment. The last chapter provides some open questions in this area.

Feel frustrated on myself since I find it hard to fully understand the models. haha, usually feel like….a dumb when reading.

Recommend to any graduate student in finance. Maybe taking some theoretical classes would be helpful (serious face).

[Michael Quinn]

Certainly not the easiest read, and definitely not for everyone, but this is by far the most intense and insightful book I've read yet on behavioral finance.

[Ashley]

I am a finance undergrad who read this book for a research paper on the efficient market hypothesis and behavioral finance in contemporary investing. This book is wonderful. If you ever want an introduction to EMH and behavioral finance, this book should be your first stop.

[Rachel Childers]

A classic in academic finance, bringing together work on the interaction of institutional market structure and behavioral theory to explain asset prices and funds. The lasting contribution here is the demonstration that limits to arbitrage through portfolio constraints that prevent pricing purely based on risk factors open up a window for non-rational traders to impact markets, and, through their interaction with constrained arbitrageurs, explain a variety of financial market phenomena, from classic asset pricing puzzles like the closed end fund premium or the January effect (demonstrated fairly convincingly) to Fama-French factor pricing (shown a little less convincingly, though making a fairly strong case that we should look to explanations other than risk). The dynamic adjustment models with noise traders are able to give somewhat richer dynamics than just adding a pricing spread as in some more basic institutional asset pricing models, because the price movements that cannot be arbitraged away become another factor that must be taken into account by the rational decision makers and itself may impacts the degree of constraint. The idea that irrational traders will be competed away is here partially true; the "noise traders", simple model stand-ins for uninformed retail investors do incur a cost for their poor trading acumen. But if they lack alternatives, a persistent positive cost can remain part of a market indefinitely.

The parts in this book about specific behavioral biases that might afflict investors are a little less developed, inferred indirectly from market phenomena like slow price adjustment after news, that likely arise from a mix of market structure and behavioral factors, along with evidence from behavioral psychology which may or may not generalize to the setting faced by traders in the relevant markets. But the book is over 20 years old, and as both more precise data on market participant behavior and institutional structure and continued refinement of behavioral modeling have continued, the basic ingredients of a theory of financial markets described in this book remain an important part of the foundations of contemporary finance research.

[Amie]

I found Inefficient Markets to be a fascinating and clear introduction to behavioural finance, and a strong challenge to the assumptions of the Efficient Market Hypothesis (EMH). While I'll confess the dense and heavy math / formulae did my head in at times, Shleifer does a great job of showing how real-life investor behaviour—driven by sentiment, bias, and limits to arbitrage—can lead to persistent anomalies in markets that EMH can't explain away.

One of the most interesting sections for me was the discussion of closed-end funds. Shleifer explores how these funds often trade at prices that deviate from their net asset value (NAV), largely due to irrational investor sentiment and arbitrage limitations. I hadn’t appreciated how much this inefficiency contributed to the rise of open-end funds, which avoid the issue by allowing investors to redeem shares at NAV—such a good example of how behavioural insights lead to practical financial innovation.

I appreciated how clearly Shleifer laid out both theory and real-world implications. A very worthwhile read that adds depth to how we think about markets, especially when they don’t behave as they’re "supposed" to.

[Nicolas]

Good book for getting a basic insight into challenges to market efficiency. However, as someone not trained as an economist the formulas can be a bit much. The main take-aways can still be understood though, even when ignoring the formulas.

[Alex Song]

Interesting but not useful for the most part.

Read the first and last chapters only for the interesting takeaways.

[Jan]

The book's okay as an introduction.

[Lime Street Labrador]

Purely theoretical and rather impractical

[Yogi Saputro]

TL;DR --> only read this if you are in academia, or trying to build market prediction model (I am in latter camp).

[Bill]

Very good summary of Shleifer's contributions to behaviourial finance - lucid writing. It has a significant amount of mathematics though, which is used in an academic manner. As a 19 year old kid stuck in NS, that characteristic of the book did not help me to understand his theory better, but I sure hope that I will be and can definitely see myself pleasantly surprised by the clear mathematical presentation of theory when I read this again during/after university.

[Jilany]

econ1 to-read wishntref

[Steve]

I read this book when it first came out and have re-read it several times, it's so good. It's the best book on this subject that I know. I have been dipping my toe in this area ever since.

[Rosyfeelsgood]

The first chapter is a gem.