Historical Rates of Return Background and Market Institutions

The subject of investments is so interesting that I first want to give you a quick tour, instead of laying all the foundations first and showing you the evidence later. I will give you a glimpse of the world of historical returns on the three main asset classes of stocks, bonds, and 'cash," so that you can visualize the main patterns that matter—patterns of risk, reward, and co variation.

This chapter also describes a number of important institutions that allow investors to trade equities.

Having concluded in the previous chapter that behavioural factors, to a large extent, can help us account for cross-sectional anomalies and aggregate stock market puzzles time has come to look into some of the most famous financial bubbles.

In the previous chapters, we argued that behavioural considerations can contribute to an understanding of certain anomalies in the pricing of individual stocks as well as in the aggregate value of the stock market.

The presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioural finance. These so-called anomalies, and their continued existence, directly violate modern financial and economic theories, which assume rational and logical behaviour.

A relevant point of criticism, levied against traditional models in economics and finance, is that they are often formulated as if the typical decision-maker were an individual with unlimited cerebral RAM. Such a decision-maker would consider all relevant information and come up with the best choice under the circumstances in a process known as constrained optimisation.

Standard finance stand on the arbitrage principles of Miller & Modigliani, the portfolio principles of Markowitz, the capital asset pricing theory of Sharpe, Lintner & Black, and the option-pricing theory of Black, Scholes & Merton.

These approaches consider markets to be efficient and are highly normative and analytical.

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