Efficient Market Theory & Behavioural Finance with regard to Financial Crisis 2007-2010 - Essay Example

?Efficient Market Theory & Behavioural Finance with regard to Financial Crisis 2007 Contents Introduction 3 Analysis 3 Efficient Market Hypothesis 3 6 Behavioural Finance Theory 6 Financial Crisis 2007-10 & its Reasons 7 Conclusion 8 References 10 Introduction This paper is an attempt to provide a comparative analysis of Efficient Market Theory and Behavioural Finance in the light of Global Financial Crisis 2007-2010. Professor Eugene Fama gave the Efficient Market Hypothesis in his survey article ‘Efficient Capital Markets’. Since then this theory has been a basis for many share market studies, financial economists’ research, models used by banking and share market regulators such as SEC, US Federal Bank, British Financial Services Authority. Behavioural Finance is a blend of psychology with finance, a contribution by Psychologists Daniel Kahneman and Amos Tversky, along with Richard Thaler, a University of Chicago professor and his colleague Nicholas Barberis. Their works have encouraged many scholars to pursue research in this unusual and different-from-classical-approach field. In this paper, there is the analyses of the two theories, the causes of the Financial Crisis and if EMH has direct implications in it. There is an explanation how behavioural finance can explain the anomalies which have persisted too long to lead to this crisis situation. Analysis Efficient Market Hypothesis A market is efficient with respect to the available information set if the market prices fully reflect that information (Fama, 1970, p.383). Therefore, in an efficient market it is impossible for investors and portfolio managers to earn excess returns by holding a portfolio of randomly selected stocks with comparable risks. The efficient market hypothesis is based on the Random Walk Hypothesis, which states that the changes in a stock’s price are a random departure from its previous price. The set of assumptions, which imply an efficient capital market, are: 1. A large number of profit-maximizing investors analyze and value the security independently of each other. 2. New information regarding a security comes in a random manner. 3. The investors adjust security prices quickly to reflect the new information. Efficient Market Hypothesis has three forms- Weak form Efficiency, Semi strong form Efficiency and Strong form Efficiency. In the Weak form efficiency, historical prices are irrelevant in predicting future prices and therefore, cannot earn excess returns from the investment strategies based on historical data. In Semi strong form efficiency, share prices quickly reflect the publicly available information in an unbiased manner; therefore, it is impossible to earn excess returns from fundamental analysis or technical analysis. In strong-form efficiency, share prices reflect both public and private information and it is impossible to earn excess return, provided there are no barriers for private information to become public. The idea behind EMH, which is very simple, is that the competition enforces revenues and costs to come into equilibrium, new entry eliminates the excessive profits, if any, and the asset prices are a function of flow of information to the financial markets (Ball, 2009, p.9). Evidence in Support of EMH: Eugene Fama conducted the strong-form tests to know whether the investors had any monopolistic access to the information relevant to the security’s price (Fama, 1970, p.383). In 1991, Fama gave his second review of EMH in which he found that instead of weak-form tests, the first category now covers more areas of tests for return predictability (Sewell, 2011, p.5). In his third review, Fama concluded that market efficiency survives the challenge from the literature on the long-term anomalies (Fama, 1998, p.283). In his paper “The Efficient Market Hypothesis and its Critics”, Malkiel examines the criticism of EMH and concludes that the capital markets are efficient and less predictable (Malkiel, 2003, p.77). In Figure 1 Malkiel has calculated the percentage of actively managed funds, which support the EMH, as they could not outperform the benchmark index. In figure 2, he has removed the survivorship bias from the analysis of mutual funds and compared them to S&P 500 index for the period 1970-2001. This result also supports EMH as barely 14% of the surviving mutual funds have managed to outperform the benchmark index. Figure 1: Comparison of Actively Managed Funds with Benchmark Indexes 1991-2001 (Source: Malkiel, 2003, p.79) Figure 2: Returns of Surviving Mutual Funds vs. S&P 500, 1970–2001 (Source: Malkiel, 2003, p.80) Using fractal analysis, Onali and Goddard studied six developed European markets and found five of them consistent with the EMH (Onali and Goddard, 2011, p.1). Behavioural Finance Theory Behavioural Finance is a study of how the behaviour of investors affects the share market prices and decision-making. It asserts that mispricing of a security can persist because often it is difficult to earn returns out of mispriced assets (Brigham and Ehrhardt, 2010, p.961). In Behavioural Finance, there is more emphasis on identifying the portfolio anomalies explained by investors’ psychological traits and the instances of earning above average returns by exploiting the biases of the traders. Some of the biases that negatively affect the rational decision-making of an investor are confirmation bias and escalation bias (Reilly and Brown, 2009, p.83). Confirmation bias is the overconfidence in forecasts where investors look for information that will support their prior decision and opinion. Escalation bias is the tendency of an investor to put more money into a failure that he/she feels responsible for, rather than into a success. Investors hold on to loser stocks too long and sell winner stocks too soon, maybe because they fear losses more than they value gains. The Prospect theory explains this bias. Noise traders are those stock traders, who base their decisions to buy, hold, or sell a stock on irrational premise. Fischer Black developed the definition of noise trading in 1986 in his seminal paper “Noise” (Burghardt, 2010, p.14). Proponents of behavioural finance often cite the cases of October 1987 crash in which stock market lost almost one-third of its value and dot-com bubble where too much money flowed to the hi-tech stocks and related telecommunication companies. The recent financial crisis has strengthened notion of irrationality of the capital markets. Financial Crisis 2007-10 & its Reasons The financial crisis started in the last decade with the collapse of housing bubble in USA, causing the prices of securities tied with the US real estate to plummet. Following this, the major financial institutions in US and Europe collapsed. These institutions had taken positions in derivative instruments and other complex financial instruments that were hedged by credit default swaps. The first bank to go bankrupt was Bear Stearns in 2007, followed by the bankruptcy of Lehman Brothers in the next few months, and so on (Mason, 2009, p.5). Decline in credit availability and reduced investor confidence had an impact on global capital markets. In January 2011, the Financial Crisis Enquiry Report gave reasons for the financial crisis: 1. Failures in financial regulation of sub-prime lending; 2. Poor corporate governance and firms taking on too much risk; 3. Excessive risky borrowing by households and Wall Street that put the financial system on the brink of collision with crisis; 4. Ill preparation for the crisis by key policy makers, lacking a full understanding of the financial system; 5. Low levels of ethics and accountability in the system (Financial Crisis Enquiry Commission, 2011, p.1). The Financial Crisis has led to worldwide criticism of Efficient Market theory and many economists such as George Akerlof have openly blamed EMH for the crisis. According to Akerlof, erroneous models such as EMH failed to describe reality that the asset values were divulging away from their fundamental values and this has led to the present financial crisis. It was widely believed that free and open financial markets ensure efficiency, which led to the creation of new altered financial institutions and the shadow banking system. These institutions enjoyed low levels of regulations in comparison to the traditional banks. They found a way to earn profits from speculation and in order to do so they took high leveraged positions. There were new complex financial instruments, hedged by credit default swaps (INETeconomics, 2010). Therefore, in order to make markets more efficient such risky activities went unregulated. Conclusion This paper has tried to analyze efficient market theory, behavioural finance and the causes of the financial crisis. Many economists have blamed EMH for the failure of economic systems around the world and asked for the dismissal of the theory. The basic assumptions underlying EMH are that information comes into the market in random manner and investors adjust security prices in a rapid manner to reflect this new information. What the theory does not account is the validity of the new information, and the role the financial institutions and regulators play in the economy. After looking at the reasons stated by Financial Crisis Enquiry Commission, it can be found that investors and regulators did not have the understanding of the modern day complex financial system. Before the crisis, many reputed Wall Street analysts and policy-makers assured that the current market valuations are justified but they were wrong. The investors and traders cannot keep the theoretical models of efficient markets like EMH as the descriptors of real world markets because the actual markets work in a versatile and complex environment. Nevertheless, EMH has been studied and tested for empirical evidence and it cannot be completely denied. Fama in his 1998 revision of EMH concluded that most reasonable anomalies tend to disappear with changes in techniques. However, he did not mention the time period for which the anomalies will persist. It could be seen from the financial crisis that these anomalies persisted too long and present recession is a proof that they have ended. Therefore, an eclectic approach is needed to base the conclusions on a more pragmatic model based on both EMH and Behavioural Finance. References Ball, R. (2009). 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