The New Finance - Overreaction, Complexity and Uniqueness

Couverture du livre 'The New Finance - Overreaction, Complexity and Uniqueness'

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In this Third Edition, Robert Haugen focuses on the evidence, causes, and history of overreactive pricing in the stock market. He argues that, unlike the other social sciences, economic models aggregate from the assumed behaviors of individuals to predictions about market pricing. These models fail to capture the complexity of human interaction. In addition, Haugen argues that each interaction is entirely unique. The complexity and the uniqueness of interactions make it impossible to generalize from the preferences of individuals to meaningful conclusions about the structure and behavior of market prices. The logical conclusion: Both rational and behavioral économies should be reconsidered.

Bob Haugen is Professor Emeritus at the University of California, Irvine. He serves as Managing Partner to Haugen Custom Financial Systems, which licenses portfolio management software to pension funds, endowments, and institutional and high-net-worth money managers.

For further study on thé author's unique approach to stock market analysis, read the entire Bob Haugen series, The Inefficient Stock Market, What Pays Off and Why, and Beast on Wall Street.

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This work makes the case for an inefficient stock market, where the complexity and uniqueness of investor interactions has important market pricing implications.

The efficient market's paradigm is at the unlikely extreme end of a spectrum of possible states. As such, the burden of proof falls on its advocates. It is their burden to deflect the stones and arrows flung at the paradigm by the nonbelievers. It is their burden to reveal the inaccuracies of those who present evidence contending that the paradigm doesn't square with the facts.

Moreover, the case of market efficiency has been made many times by others.1 In fairness to the growing number of advocates for the other side, I present here, and in the two other books of this trilogy, Beast on Wall Street: How Stock Volatility Devours Our Wealth and The Inefficient Stock Market: What Pays Off and Why, a comprehensive and organized collection of the evidence and the arguments that constitute a strong and persuasive case for a complex and, at times, nearly chaotic stock market that overreacts to most things—in particular, to past records of success and failure on the part of business firms. It is a market that prices with great imprecision, with signals coming from the prices of other stocks as its dominant driver.

In the course of this work, I shall make a case for the following assertions:

  • Players in today's stock market persistently make a fundamental mistake— overreacting to records of success and failure on the part of business firms. This mistake was also made in the distant past, only to be rectified. Stock investors began making the mistake once again in the late 1950s, and they continue to make it today. Those who recognize the mistake can build stock portfolios, or find mutual funds, that will subsequently outperform the market averages.
  • Owing to the foregoing mistake, the stocks that can be expected to produce the highest returns in the future are the safest stocks. Risky stocks can be expected to produce the lowest returns!
  • Because of agency problems in the investment business, the opportunity that is there now is likely to remain there in the future.
  • Models in financial economics aggregate from assumed preferences to conclusions about market pricing. Game-theoretic models consider interactions among market participants, but given the preferences, wealth, information, and other aspects explicitly considered, responses to identical stimuli are presumed to be identical. The New Finance argues that each interaction must be considered as entirely unique, making aggregation, in any way, from the preferences and behaviors of interacting individuals to meaningful conclusions about the structure and behavior of market prices a meaningless exercise. Thus, both rational and behavioral economics need to be reconsidered.

1 See, for example, E. Fama, "Efficient Markets II," Journal of Finance (December 1991).


CHAPTER 1    Search for the Grail1
 The Searchers1
 The Celebrated F&F Study1
 Low Risk, High Return?7
CHAPTER 2    The Old Finance11
 The Tool12
 The Theory14
 The Fantasy18
CHAPTER 3    How Long Is the Short Run?21
 The Short Run and the Long Run21
 The Engine That Drives Us to Diamond Head25
CHAPTER 4    The Ancient Finance32
 Growth Stocks Weren't Always32
 The New Era36
 The Renaissance39
CHAPTER 5    The Past and the Future42
 Higgledy Piggledy Growth42
 Higgledy Piggledy Growth in America44
 Flip for It47
 The Christmas Tree50
CHAPTER 6    The Race Between Value and Growth55
 In Search of Mediocrity55
 The Many Faces of Value and Growth57
 Removing the Size Effect from GO61
 GOing Around the World62
CHAPTER 7    Surprise or Risk Premium?65
 Learning How to Make GO Disappear65
 The Debate over the Nature of GO66
 When We GO to Diamond Head68
CHAPTER 8    "Bearing" Risk in the Stock Market74
 One-Month Horizon Tests of the Relationship Between Risk and Expected Return74
 The Neglected Horizon Problem74
 The Heretics and the Zealots Finally Agree81
 Why You Don't See This in the Textbooks83
 Does Risk Still Carry a Negative Payoff?88
CHAPTER 9    The Holy Grail92
 Looking Down the Roads to Diamond Head and Diamond Bar93
 The Relative Position of the Perceived and True Growth Horizons97
 Bottom Fishers and Rodeo Drivers107
 Two Compelling Questions109
 Baaaaaaaaah Humbug!112
CHAPTER 10    Rational Finance, Behavioral Finance, and the New Finance116
 The New Finance116
 Rational and Behavioral Economic Models117
 Order, Complexity, and Chaos119
 The Financial Circus123
 Scaling the Stock Market130
 The Tool Is Cool...133
 The New Corporate Finance135
Appendix to Chapter 10139
CHAPTER 11    Final Words144

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