Hello, I am Arzu Ozoguz, and I would like to welcome you to the third course in our Investment and Portfolio Management specialization. Welcome to Biases and Portfolio Selection. Some of you already know me, I'm the instructor for the four course Investment and Portfolio Management specialization. You can call me Arzu or Dr. O, which is what my students here at Rice sometimes call me. Now if you've completed the first two courses, I would like to congratulate you. >> [APPLAUSE] >> Not only are you halfway done, but you also completed the most challenging part of the specialization. Course two was a really challenging course. And it was meant to be challenging. So now you're over the hill, so to speak. So you can just cruise down to the finish line. Okay, so what are we going to do in this course? Well, I'm going to tell you about the many ways people or markets misbehave. That is the ways in which they are not consistent with the idealized models of economic theory. But let me first tell you a story, a story that I heard from one of my senior colleagues. So, my colleague, early in his teaching career, he inadvertently managed to get most of his students in his finance classes really really mad at him. It was because of a mid term exam. He designed the exam to make sure that there was quite a bit of dispersion in the scores, to be able to distinguish the good students from the bad students. And the exam serves this purpose. There was, indeed, quite a bit of dispersion in the scores. But the students were really mad that the average score was only 70 out of 100. Now, this really doesn't make a whole lot of sense, because if you're familiar with the US grading system, the average score has absolutely no real effect on the distribution of the final grades. Right? Because the grades are typically a sign based on a curve. Right? Where the average corresponds to, let's say a B or B+. And the rest of the grades are distributed accordingly around the average. And indeed he did curve and the resulting distribution of the grades was no different than any other class. But the students were really upset with him. He was concerned, right? He didn't want to lose his job. He wanted to keep his job, but he didn't really want to make the exam any easier either. So what did he do? Well the next time, he made the exam to be a total of 137 points instead of 100. The exam was similar in difficulty, such that about 70% of the students got it right. But now the average score was 96 points and the students were happy. They were delighted. No actual grades were really any different because of this. But everyone was happy, right? So from then on, he always gave exams with a total of 137 points instead of 100. And it was a useful lesson for me too when I started my career. But why were the students happier? My senior colleague would say, well in the eyes of an economist they were misbehaving, right? Because there is really no difference between an average of 96 points out of 137, which is the same, which is 70%, and 70 out of 100. So, in this course, you're going to learn the ways in which investors appear to be misbehaving. In other words, they're not behaving like the homoeconomical step or rationally economic models have them to behave. But first you're going to learn in this module what we would expect to see if all behaved and there were no frictions, right? What would market efficiency look like? Specifically you're first going to learn about the efficient market hypothesis, right? Pioneered by the Nobel laureate Eugene Fama in the 1970s. It is a very important concept. According to the efficient market school, investors can't rationally expect to beat the market, except by taking on more systematic risk. The meaning of market efficiency is that prices reflect fundamental values, not that you won't ever find a $20 bill lying on the sidewalk. So I will also show you evidence that goes against market efficiency. And, why smart money may stop short of exploiting all the missed pricing that they can identify, what we call limits of arbitrage. All right, here we go, enjoy.