The psychology of the stock market

My name is Alex Edmans. I'm a professor of finance at London Business School, and I'm here to give a talk on the psychology of the stock market, why the stock market is affected not just by fundamentals, but also by emotions.

I'm going to start with one of the most fundamental and influential theories in finance, which is called the efficient markets hypothesis. It argues that markets are efficient, and what does that mean? It means that prices in financial markets reflect all available information. To make this concrete, let me show you one equation. I promise it's the only equation in the whole talk. It says that the price of anything equals the sum of the future cash flows from that asset, discounted by the discount rate, which is what's in the denominator. The important thing here is the bar I_0, where the bar means 'given' and the I means 'information'. What that means is when you are forecasting the cash flows from a stock, you are using all available information. Now that sounds pretty abstract, so let me make it concrete. Let's say you are a trader trading shares in Apple. You are wanting to forecast the cash flows from Apple stock. What might the relevant information be? Well, the iPhone 13 recently came out. It might be customer reviews on that iPhone 13, or it might be the state of the economy, how quickly we think there's going to be a recovery from the coronavirus pandemic because that's going to affect your sales. Maybe people's views of Tim Cook as a CEO and how good his likely successor will be, and so forth. If the market were efficient, then investors could not make money by trading on information. Somebody might think, we should buy shares in Apple because the iPhone 13 has got some great reviews! But if there have been great reviews, then everybody knows that and the stock price would have already gone up to reflect the fact that the reviews are great. But many people believe that markets are not efficient because stocks are traded by humans, and even very powerful people don't go around solving equations.