Efficient Markets Theory and Behavioural Finance - Essay Example

Efficient Markets Theory and Behavioural Finance Introduction Efficient market theory is a theory used in investment that upholds the argument that the market cannot be beaten easily as the efficiency in the market causes existing stock prices to utilize and reflect all useful information. In the light of the 2007 to 2010 financial crisis, the efficient market theory can be based on the market dealings of the subprime mortgage crisis. On the other hand, the behavioural finance theory is a theory that bases the market trends on thee psychology. In this theory, therefore, assumptions are done perpetuating that the information organisation and the behaviour of market participants systematically control individuals’ decisions in investment and the outcomes of the market. According to (Malkiel, 2003) the efficient market theory, has implications of theoretical perspectives to the market trends, while it ignores or under estimate the practical perception of the market. On the other hand, the behavioural finance theory has been thought of being more practical based and focused on people’s behaviour (Ashta & Patil, 2007). Following the event of the financial crises in 2007 to 2010, contention has developed amongst various authors on its implication to popularity of the already criticised efficient markets theory and its contribution to the upsurge of the prevailing interest in behavioural finance theory. This paper compares and contrasts the explanations of efficient market theory and behavioural finance with regard to the financial crisis 2007 to 2010 and identifies the explanation considered to be strongest. Efficient market theory versus behavioural finance theory and the 2007 to 2010 financial crisis The efficient market theory upholds the notion about the randomness in stock prices, based on short-run serial relationships amid successive changes in stock prices (Malkiel, 2003). Such was the case in the year 2001 when the US economy experienced a recession, followed by a boom that led to the dotcom bubble, and accounting scandals. The behavioural market theory regarded such occurrences in a different way from that of the efficient market theory, in that, the fears in individuals’ mind of recession was considerable. Therefore, in regarding to the recession in 2001 being disregarded, the stock market was thought of as not having a memory of the way the price of a stock behaved in the past, so as to determine its future behaviour. The randomness in efficient market theory is questionable, due to the high frequencies with which successive moves towards the same direction occurred in the period of 2001 and 2003 when subprime mortgage grew from 2001 to 2005 (Fligstein, 2011). The efficient market theory is regarded as the main contributor to the 2007 – 2010 financial crises. According to European Economy (2009) there had been some momentum in the short-run prices of stock (Lee & Lee, 2010). In founding the foregoing argument, the campaigners of the efficient market theory have applied some sophisticated nonparametric numerical methods, able to identify patterns and certain signals in stock price and achieved some diffident projecting power. The bubble of the subprime mortgage was recorded to have expanded in 2001 from approximately $173 billion to $665 billion year 2005 (Kan & Andresso-O’Callaghan, 2007). The market information available then indicated increment of this industry with success and mortgage organizations were tied together as decision makers in money lending institutions and investors made risky decisions. The behavioural finance theory was further decremented by the loan defaulters, evidenced within the pre crisis era. The eventual bursting of the mortgage bubble brought down several other organisations, thereby, creating a clear cut distinction between the behavioural and the effective market theory. The changing in the prices of the housing industry was big factor to the 2007 -2010 financial crisis, where mortgages took control of the financial institutions, as well as the stock market. The lending trends were affected as there was negative attitude towards lending to the lower quality borrowers. The mortgage related borrowings were highly regarded from the available market information, thus defining the effective market theory. On the contrary, the melt down of the subprime housing after ignorance had been done on other investments, taught individuals a lesson of credit risks. The credit risks bound to happen were foreseeable in the perspective of behavioural finance, since the lowly regarded investments had a prospectus for the future, but the high lending rates prohibited their blossoming (Fama, 2008). The eventual of the crises of 2007-2010 brought more appreciation to the psychological considerations of individuals in market trends and decision making, other than relying solely on the market information. When the subprime bubble collapsed, the economic growth was impacted through the housing market, because the real estates influenced the economy greatly. At the same time there was a general tendency of individuals withdrawing home equities, thus buoying the spending by consumers over the years (Fligstein, 2011). The values of mortgages reduced in the subsequent years resulting to the start of the 2007-2010 financial crises, where people generally sold their mortgages at prices lower than their purchased prices. This called for the government to intercede by lowering the interests on loans. In retrospect to these events, the market did not retain the trends as the rates eventually climbed back due to forces of individuals’ psychological actions of holding to their mortgages that led to a further rise in the interests on loans. Clearly, the efficient market theory and the behavioural finance was antagonist to each other. The efficient market theory was thus defined by the decisions made based on the information on stock prices trends and the behavioural finance was defined by the course of actions by individuals due to the varying market trends. The behavioural finance theorists are opposed to the perfect market theorists in the claim that the market behaves like a perfect mathematically correct formula. In a study carried out by Tan, Chong & Yeap (2010), the Malaysian stock market was scrutinized, and it proved that the market had some significant levels of randomness. It could not be a perfect model as the efficient market theory asserts. The Malaysian economy had also obtained the tendency of relying on the perfect market theory, while it ignored the social input in to the decision making (Ashta & Patil, 2007). In retrospect to this contrast, it is essential to differentiate between economic significance and statistical significance (Watson, 2009). This is because, when the market is viewed as being operated by the economy where real figures counted, an objective basis for the two opposing theories would be obtained. The behaviour of individuals including the investors and consumers is significant in an economy. More over, rationality is involved in decision making by these individuals. The investors on the verge of the expanding bubble of the housing industry were not rational; they did not involve the long-term possibilities of a biased economy (Famai, 1998). This led to the entanglement of several institutions and called for bailing out of the industry. The eventual crisis was an evidence of rationality being ignored. There has been arguments that investors and credit lending agencies in the United States failed to price the risk that was involved with the products that related with the mortgage dealings accurately. This was evidence that the models used in the efficient market theory are not accurate. At the same time, the governments are m blamed because they failed to adjust their regulatory duties in addressing the monetary policy expansion in the 21st century. Other than failing to regulate the fiscal policies, the government was also silent in the institutional bailing outs that led to the crisis (Fligstein, 2011). The failure of the government gave room to rising short term hypothesis making the market trends virtually effective. As a result, the sociological factors and scientific reasoning failed to be effected at the time. The report by the United States Financial Inquiry Commission admitted that there was a preference bandwagon during the period that led to the 2007-2010 financial crisis. According to the report, there were failures in financial regulation to the extent that the Federal Reserve failed to tame the lethal mortgages. There were also cases of corporate governance breakdown with the financial firms included. In general, it can be argued that the economy had lost the social sense (Fligstein, 2011). The behavioural aspects were shunned, and the economy took the path of hypothetical operations. It was rather like a time bomb that tickled, only to blast at a time a bit late for the financial crisis to be avoided. On critical assessment, the information that hit the United States’ stock market failed to receive the response that it efficiently called for (Watson, 2009). There were evident surprises in the events like surprise dividends, surprise initial public offers, mergers, and earning surprises, which led to hasty decision making by investors. Such responses in the perspective of behavioural finance were not efficient (Fama, 2003). In the light of such a stand by the behavioural finance model, such a crisis as occurred in the year 2007 to 2010 could have been avoided. The behavioural model contrasts significantly with the efficient market theory in the aspect of serial correlation pattern, in the market (Shriller, 2003). The efficient market theory bases the decisions making by individuals from the available information. As it is common, patterns in the stock market coincide to varied degrees over time and products (Bell & Quiggin, 2006). Baghestani (2009) argues that such opportunities are normally credited as a win over the market portfolio to risk taking managers in efficient market. On the other hand, the behavioural finance views it differently (Ramiah & Davidson, 2007). (Bartov, 2008) Of course, there are dangers associated with such opinions, since there can be events of negative serial reactions. Conclusion The stock market in the short run can be a voting mechanism, but in the long run, it becomes a weighing mechanism (Malkiel, 2003). Following the bases for the efficient market and behavioural finance theories on the financial crises of 2007 to 2010, the efficient market theory has been shown to have determined rising in the subprime mortgages and thus favouring investments to it. There followed a period of economic recession that the behavioural finance would be defined as having predicted its eventuality due to psychological reactions by individuals on rising mortgages rates and lowering housing equities. Following these definitions, the behavioural finance has been shown to be stronger than the efficient market theory. 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