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Equilibrium as a concept in economics means a state where supply equals demand. Economists predict that prices of goods, just like water seeking its own level, adjust based on supply and demand conditions until equilibrium is reached. This applies to petrol, soccer game tickets, iPods, and the stocks of companies.

Introduction


In real life, equilibrium is a constantly moving target. We cannot say that the stock market is in equilibrium at the end of the day or week or year. Prices move based on the perception of brokers and shareholders, driven by information (Fama, 1970), psychology (Kahneman and Tversky, 1982), or anything under the sun (Barberis, Shleifer, and Vishny, 1998). As investors try to maximise returns or minimise losses, they either push up or pull down stock prices, or keep it level, the differences between the demand of buyers and the supply of sellers being reflected in stock price changes.
This is equilibrium, which is not a static point but more of a dynamic process where adjustments constantly take place, reflecting the free agreement of investors in the market that stocks are bought and sold at the right price. Of course, one side thinks the price will go up, while the other side thinks it will go down. By 'assuming' equilibrium as an ideal state towards which everything moves, finance academics have discovered a tool that allows them to pin down a moving target - the behaviour of stock prices over the last fifty years, for example - so they can study it, test their theories, develop a mathematical model, and see if the model explains reality.
One such aspect of reality that is being studied for the last half a century is the relationship betwe ...
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