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Join 6, other followers. Sister blog Prof. Jayanth R Varma's blog on computing. Buffett first dabbled in relative value arbitrage when he was working for Graham at the firm Graham-Newman. Buffett, not to be dissuaded, kept sending Graham ideas for stocks until Graham finally hired him. When Buffett first came to Graham-Newman, he was 24 years old and raring to go. In there was a shortage, and the price rocketed up. The company did not want to sell the cocoa outright because there would have been a tax consequence.
He pointed out a provision that said it could distribute the cocoa to shareholders without incurring the almost 50 percent tax liability if it were part of a restructuring that reduced the scope of its cocoa business. The company then offered to repurchase its shares in exchange for cocoa as opposed to dollars. His only risk was that the price of cocoa would fall below the level he was paying for the shares. Since he would attempt to do these sales as simultaneously as possible, his risk was negligible.
So, again, that was then and this is now. This translated to a huge cash bonanza for the company. At this point only four percent of the company was available to the trading public. So one would think that COMS now would be trading… where? Mispricing in Tech Stock Carve-outs. Lamont and Richard H.
Published by the University of Chicago. The stub value the market-implied value of the 3Com assets minus its PALM shares converged to zero, and finally above zero, by September of when 3Com finally spun out the shares to shareholders. This would have been an immensely profitable arbitrage. Recent IPOs are often difficult to short. An example of such a trade where investors lost an immense amount of money occurred in early in Japan with the Eifuku fund.
The Eifuku fund made a massive leveraged bet that the spread would close. Instead, the spread widened and within seven days the fund lost over 90 percent of its value, closing down when Goldman Sachs took control and closed all of its positions. Instead, the disparity is often much more. They turned him down, but Buffett was definitely sniffing around for a good cause.
Are we wasting our time, then? Mark Mitchell, Todd Pulvino, and Erik Stafford examine every situation between and in which the market capitalization of a company traded for less than the sum of its parts. They note that there are two types of risk in this strategy.
The first is fundamental risk, the risk that the shares of the two securities might never converge. The parent company, for instance, can go bankrupt, having used the value of shares in the spin-off as collateral before finally collapsing. Creative spun out 20 percent of Ubid to the public on December 4,
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Humans in the real world, Thaler points out, behave in ways that are strikingly inconsistent with rational models, are frequently concerned with the welfare of others even to their own detriment and are rarely capable of optimization. True, we can be rational, calculating, self-centered and disciplined—but within limits. This is the essential insight that Thaler insists his fellow economists use to modify neoclassical theory. Without it, findings will hold little relevance to reality.
He illustrates this regularly with research into areas as disparate as health care, retirement planning, investing, NFL football drafts and British game shows. Nonetheless, the burgeoning field of behavioral economics has long encountered stiff resistance.
Thaler is thoroughly schooled in mainstream economics. By no means does he reject the fundamentals—supply and demand, for example, or cost-benefit analysis. He has taught for years at the University of Chicago—long considered a bastion of neoclassicism—and maintains a sharp, healthy and often humorous exchange with his skeptics there.
Over time, his views and those of other behavioralists have been accepted more widely. The Nobel Prize in economic sciences, for example, was awarded to Daniel Kahneman, a Thaler collaborator since the late s, for integrating insights from psychology into economics—a crisp definition of behavioral economics. Another sign: In , Thaler will become president of the American Economic Association—an ironic but telling indicator of the gradual embrace of behavioral economics by a profession undergoing continuous evolution.
That research was squarely within the mainstream of the discipline, based on expected utility theory. Region: But by , it seems, your focus had changed to the limits of and alternatives to the standard model. And soon you were working with psychologists Daniel Kahneman and Amos Tversky Long-time collaborators who developed many of the fundamental psychological concepts behind behavioral economics. After accepting the Nobel Prize in economics in for this work, Kahneman reportedly said that he considered it a joint prize with Tversky, who had died in The Nobel is not awarded posthumously.
Region: This work all blended economics with psychology, as has your subsequent research. What led to that transition from the traditional model? Do you view it as a major discontinuity or a more gradual evolutionary process? The chronology you have is right, but a little bit misleading. In Thaler: Right. I went to a conference and met a couple of psychologists, Baruch Fischhoff and Paul Slovic, who introduced me to the work of Kahneman and Tversky.
My thesis adviser was Sherwin Rosen, who was very much a Chicago price theory guy. And my thesis was a straight econometrics exercise: How much do you have to pay people to get them to take risky jobs? How much would you pay to eliminate that risk?
And how much would you have to be paid to take that risk? Now standard economic theory says that those answers have to be approximately the same. But I got answers that were off by two or more orders of magnitude. Thaler: Yes, students in classes I was teaching, but I would ask everybody. I showed these to Rosen, who was unimpressed and told me to go back to running regressions. But I was interested in this discrepancy. Thaler: Yes, later I would call them anomalies The title of a column in the Journal of Economic Perspectives in which Thaler and other economists have analyzed economic behaviors that appear to contradict the predictions of expected utility theory.
I mean, at first they were just stories. Like, a buddy of mine and I were given tickets to a basketball game. Another thing on the list was a story about having a group of fellow grad students over for dinner and putting out a large bowl of cashew nuts. We started devouring them. After a while, I hid the bowl in the kitchen and everyone thanked me. But as econ grad students, of course, we immediately started asking why we were happy about having a choice removed.
It was just a list. Thaler: Yeah, quirky human behavior, right. The initial information becomes the reference point or "anchor" for subsequent deliberation, as when negotiations start with a specific dollar figure that becomes the amount from which buyer and seller seek to bargain. Psychologists and behavioral economists suggest that humans use this strategy to simplify the difficulty of calculating probabilities, deciding that if an event or characteristic is easily remembered, it likely occurs frequently.
As Kahneman and Tversky wrote in their paper on this heuristic, "A person could estimate the In behavioral economics, the phrase is often used to describe the result of using cognitive shortcuts. In Nudge , Thaler and co-author Cass Sunstein write, "Although rules of thumb can be very helpful, their use can also lead to systematic biases.
And the reason is, he had bounded rationality The term used by economist Herbert Simon to describe the limited capacity of humans to think and act in fully rational ways, thereby limiting their ability to optimize as posited in conventional economic theory. Bounds include incomplete information, inability to process information without bias or error, and restricted time in which to make decisions and judgments.
Simon argued that although individuals may intend to make rational decisions, these limits result in their "satisficing" instead of optimizing—that is, making the most adequate or satisfactory decisions given bounded rationality. He was a real Renaissance man. He did all kinds of things. And, essentially, my list was systematic ways that people deviated from the classical model. I went to Stanford for that year.
I begged and pleaded with anyone I could find at Stanford who could give me a job for a year. Originally, it was just for the fall semester, but then I sweet-talked him into a longer stay. I spent that year out there with Kahneman just up the hill at the Center for Advanced Study in the Behavioral Sciences and Tversky down on campus in the psychology department. I took a course from him, Tversky, but spent hundreds of hours talking to both of them and taking walks with them.
It only came out in an obscure journal, Journal of Economic Behavior and Organization , in its first issue. Then I was working on the self-control stuff with Shefrin. That we got into the JPE , but only after a big, big fight. The lead article is not an accident and at least in my case, I think, being the last article was not an accident. Sunstein and Thaler. It discusses flaws in human decision-making, and how to improve the process through better choice architecture—that is, better organizing the context in which decisions are being considered.
Nudge suggests government policies, corporate practices and individual measures that could be taken to improve outcomes in a variety of areas, including investing and health care. Region: That addition to the list leads well to my question. I believe in the endowment effect, for example. Region: What would you say to that logic, that markets essentially compensate for the irrational behavior of humans?
Thaler: Well, there are two things. Of my more recent papers, one of my favorites is about the National Football League draft. It also took a long time to get published, but finally it did come out. We have a quote from Becker in there, similar to the one you have. His quote appeared in a University of Chicago magazine article about me. We find that prices for those players are way off relative to their value to the team. Region: Meaning that people with great incentive to make smart financial decisions, and the resources to do so, are making irrational choices—pricing decisions inconsistent with the evidence.
Thaler: And even more to the point are papers that I, since , and other economists have been writing about financial markets. The biggest surprise about behavioral economics, I think, looking back on it all, is that the subfield where behavioral has had the biggest impact is finance. But for me, of course, that was exactly the attraction of studying finance, and I got into it because I had a graduate student who wanted to do finance, Werner De Bondt.
I wanted to ask about your research on stock markets. You did papers with De Bondt in the mid- to lates, I think. Region: And you found that investors overreacted to both good and bad news; also, they were overconfident in their investing ability. According to Eugene Fama, one of the idea's earliest and best-known proponents, "Market efficiency [means] that the deviation of the realized price from the equilibrium expected value is unpredictable based on any past information.
Only by taking on additional risk can investors earn higher returns. Then in , with Owen Lamont, you studied equity carve-outs A partial spinoff by a parent company of a minority stake in a subsidiary. Carve-outs involve a company listing part of its operation as an initial public offering, or IPO. The parent usually continues to hold a controlling share of the subsidiary's equity for a while, thereby remaining in control of its operation.
Thaler: Yes. Region: Random walk theory The idea that an amount or price changes without any consistent pattern—a "random walk. Applied to shots by a basketball player or deals to a poker player, the theory is also used to refute the idea of a "hot hand. And so, we set out to predict an anomaly. Nearly your next-door neighbor, but your polar opposite in theory? Thaler: Yes, he has exactly the same office on the west side of the building.
In the old building, his office was directly above mine. Werner and I thought we should look at this. Until that existed, it was hard to do rigorous asset pricing research. Thaler: Yes, exactly. So we thought, well, suppose this outperformance is overreaction.
Suppose those price movements are overreaction to something. We observe mean reversion in everything else in life. Very tall fathers have shorter kids, right? So, we constructed the simplest possible experiment of ranking the biggest winners and the biggest losers and seeing what happened.
Because it could be a drunken walk. So that research with De Bondt was an attack on the unpredictability, the idea that market movements are purely random. Closed-end funds are interesting because unlike the usual so-called open-end funds, an investor cannot simply send in more money and buy more of the assets the fund holds.
Others had written about this, as far back as Benjamin Graham, but we showed that the discounts on closed-end funds seemed to be a measure of individual investor sentiment. This caused quite a stir, resulting in a four-part debate in the Journal of Finance with Merton Miller and two of his graduate students.
Thaler: Yes, a great story. The brief version of the story is this: 3Com owned Palm, maker of the then-sexy Palm Pilot. They decided to spin off Palm via an IPO. But they sold only about 5 percent of the share value of Palm. The rest of the shares were to be distributed to 3Com shareholders, and each share of 3Com would include 1.
A first principle of asset pricing is that equity cannot have negative value, but in this case it did! I was saying that this was just the tip of the iceberg—that the market was full of such mispricing—and Gene was saying this was the whole iceberg—that for the most part, markets get it right. His argument was: Look, you have closed-end funds, you have Palm and 3Com. These are cute little examples, but there were very few shares of Palm floated.
And he had a point. There was a grad student here who was spending all his time trying to borrow shares of Palm to short. Every time he was able to borrow some Palm shares to sell short, he would buy an appropriate number of 3Com shares to complete the hedge. We just had another financial crisis. What are your thoughts about the EMH today, given the recent financial crisis? Now, Gene will say, correctly, that neither I nor anyone else was able to say when that bubble would break.
Even for my friend Bob Shiller. He correctly predicted the Nasdaq crash and the housing crash. But in both cases, he was about three years early. That makes him very wise, but not very helpful to an investor, because if you shorted the Nasdaq in , when he gave his irrational exuberance talk to Greenspan, you were in trouble.
Even if there were a way—Shiller tried to create markets in that, so that you could have shorted it—you might have gone broke before you were right. But I think of these two components. These forces drive prices to fair value. First of all, whether DFA is purely passive or not is open to question.