The Relationship between Rationality of Investors and Market Efficiency - Essay Example

The Relationship between Rationality of Investors and Market Efficiency Introduction The relationship between market efficiency and rationality of investors is a topic of intense debate among various academicians such as economists, financial professionals and investors. Keynes always thought that psychological aspects play a role in economic conduct. In 1940’s and 1950’s, there was recurrence of a hypothesis of rational markets based on the rational conduct of individuals. In this hypothesis, economists led by Samuelson postulated that investors have an optimal marginal utility; investors made investment choices that corresponded to their respective efficient frontier (Higgins, 2009, p. 33). In 1950’s, Simon set out to develop a fresh model to describe the resolution making processes. Simon postulates that well-meaning investors undertake rational choices under various constraints. These constraints create boundaries in which rational resolutions can be taken; these draw into question the postulations of rational selection in the utility curve (Livanas, 2004, p. 3). In 1960’s, Eugene Fama developed the Efficient Market Hypothesis; Fama argued that in an active market, which includes various intelligent and knowledgeable, securities will be aptly priced and replicate all available information (Fama, 1995, p. 2). This paper seeks to examine the relationship between market efficiency and rationality of investors based on these theories. Investment Decisions Researchers argue that investors make investment decisions under various constraints. These constraints can be exterior to the investor or arise from the predispositions intrinsic in the investor’s knowledge and reference point. These constraints comprise the constraint of investment choices available to the investor; the comparative preferences of the investor to each of the investment alternatives; and the limited variety of outcomes anticipated from each alternative (Higgins, 2009, p. 35). Simon hypothesizes that an investor trying to optimize the returns from an investment resolution will make the best resolution available to him or her within his or her capability to assess the options, and accomplish a decision (Livanas, 2004, p. 4). As Livanas (2004, p. 5) notes, Simon suggested three ways which a resolution maker can endeavor to optimize their returns. First, using max-min rule of the game theory, every investor deems the worst possible result for every investment and builds a portfolio, which will generate the biggest value when made up of a mixture of these minimum values. However, it is worth noting that there is no rational investor who would select securities, given that the worst likely result for equities is loss. Secondly, an investor can build a mixture of investment alternatives where the likelihood of every outcome is maximized. The combination of these investment alternatives will depend of the risk profile of every portfolio. Jones (2009, p. 325) observes that investment risk is positively related to the returns of that investment, implying that the investment with high risks generates higher returns. Rational investors will undertake investments which correspond to their risk tolerance categories. Thirdly, Simon visualizes the investor selecting one entire portfolio from a set of alternatives which will maximize the value. This may be selecting a portfolio containing bonds only, equities only, from accessible investment alternatives. Simon deems that the complexity of computation in relation to real human choice circumstances is beyond the average investor; however, with market efficiency these calculations can be performed. In an efficient market, significant information is freely accessible to all participants. Researchers argue that with the current availability and utilization of complicated modeling in capital markets and with substantiality superior revelation and analysis, superior approximations of returns may be made by expert investors (Keim & Ziemba, 2000, p. 255). These computations of returns approximations are possible where there are efficient market mechanisms. Therefore, there is a positive relationship between market efficiency and rationality of investors. The Efficient Market Hypothesis In 1900, Louis Bachelier developed hypotheses of investment payoffs. The Efficient Market Hypothesis is one of these theories of investment payoffs. The Efficient Market Hypothesis hypothesizes that, at any given time, equity prices fully replicate all accessible information. The propositions of the efficient marketplace hypothesis are profound (Fama, 1995, p. 4). Most traders who sell and buy equities do these under the postulation that the equities they are selling are worth below the selling price while equities they are purchasing are worth in excess of the price that they are disbursing. However, if there is an efficient market and current prices fully replicate all information, then selling and purchasing in an endeavor to outperform the marketplace will efficiently be a game possibility rather than expertise (Jones, 2009, p. 329). The random walk hypothesis states that price fluctuations will not trail any patterns and that past price fluctuations cannot be utilized to forecast future price fluctuations. Bachelier concluded, “The mathematical anticipation of the speculator is zero,” and he considered it as a reasonable game (Fama, 1995, p. 6). There are three categories of the efficient market theory: first, the “Weak” form states that all previous market prices and data are entirely reflected in equities prices, implying that technical analysis is useless. Investors may not methodically profit from marketplace inefficiencies since prices fluctuations are fundamentally random. Nevertheless, there are investigations of interim price trends, which are inconsistent with weak form effectiveness. Secondly, the “Semi-Strong” form states that all freely accessible details are entirely reflected in equities prices, implying fundamental analysis is useless and that markets adapt instantaneously to novel information. Thirdly, the “Strong” form states that all information is entirely reflected in equities prices, implying that insider information is useless since that information is already in the stock’s price (Evans, 2003, p. 56). The strengthening of efficient market theory is that investors are rational; markets are effectively priced since potential prices may not be forecast from precedent performance, and markets may instantaneously respond to fresh information, including internal information. There are three aspects that characterize rational investors: first, asset integration; stockholders prefer equities in their investment portfolios to options, not in their investment portfolios. Secondly, risk aversion: given two investments with equal anticipated returns, a stockholder will always select the alternative, which is less risky. Thirdly, rational expectation: investors incorporate all accessible information in a coherent and unbiased way (Evans, 2003, p. 60). In1990’s, behavioral finance economists and researchers started challenging the basic postulations of the efficient market hypothesis. Malkiel (2003, p. 3) noted that in the efficient market hypothesis, it was believed that stocks markets were enormously efficient in replicating information about individual securities and about the entire capital market. The conventional view was that when fresh information arises, the novel information spreads exceptionally swiftly and is incorporated into the securities’ prices instantly. Consequently, neither technical investigation, which is the study of previous security prices in an endeavor to forecast prospect prices, nor even basic analysis, which is the study of monetary information such as asset values, company earnings among others, to assist investors choose undervalued securities, would enable a stockholder to attain payoffs in excess of those that could be gained by holding a randomly preferred portfolio of individual securities with equivalent risk (Evans, 2003, p. 64). The efficient market theory is related to the notion of “random walk,” which is a concept used to characterize a series of prices where all consequent price alterations represent random departure from past prices. The sense of random walk notion is that if flow of details is unhindered and information is instantaneously replicated in security prices, then tomorrow’s price alteration will replicate only tomorrow’s news and will be autonomous of the price alterations today. However, news is unpredictable, and, consequently, resulting price alterations should be random and unpredictable. Consequently, prices entirely replicate all known details, and even unknowledgeable investors purchasing a diversified portfolio at market prices will attain a return rate equivalent to that attained by experts (Malkiel, 2003, p. 4) In the recent capital market conditions, the fundamental assumptions of efficient market hypothesis fail to hold in given scenarios. For instance, studies have established that securities with dividend increases or low price per earnings ratios outperform the universal marketplace. The global financial crisis of 2008 resulted in fluctuations in the financial markets. The outcomes of these market fluctuations testify that it is risky to presume that existing prices efficiently replicate all accessible information. Recent studies have argued that even if marketplaces are inefficient, it does not mean that investors are irrational. Capital markets should be inefficient since prices cannot probably embody all details. This is because the price of a share relies on the future money flows, and details about the future are inevitably elusive (Koller, Goedhart & Wessels, 2010, p. 387). As an alternative, investors should learn about this information from strident and imperfect signals. This learning may result in conduct that looks incoherent with effectual markets, even if investors are all rational (Keim & Ziemba 2000, p. 260). Market efficiency is a depiction of how prices in competitive marketplaces respond to fresh information. In this scenario, investors do not have access to perfect market information, and their investment decisions may result in low returns even though they made rational decisions. Conclusion Efficient market hypothesis is a theory which was developed in 1960’s by Fama. This hypothesis is one of the theories of investment payoffs. This hypothesis describes the relationship between market efficiency and rationality of investors. Efficient Market Hypothesis hypothesizes that at any given time, equity prices entirely replicate all accessible information. Investors make investment decisions on the basis of various factors including stocks prices and individuals’ risk tolerance category. If stocks prices entirely reflect all accessible information, then investors will be capable of making rational investment decisions. However, recent capital market scenarios experienced during the global financial crisis indicates that current stocks prices do not fully reflect all the new information. Therefore, investment decisions made on the basis of these prices may be irrational even though the investor is rational. References List Evans, L. L. (2003). Why the Bubble Burst: Us Stock Market Performance Since 1982, Edward Elgar Publishing, New York. pp.56-64. Fama, E. F, (1995). Random Walks in Stock Market Prices, University of Chicago, Chicago. pp. 2-7. Higgins, R. C. (2009). Analysis for Financial Management, Irwin/McGraw-Hill, New York. pp.33-36. Jones, C. P (2009). Investments: Analysis and Management, John Wiley & Sons, New York. pp. 325-330. Keim, D. B. & Ziemba, W. T. (2000). Security Market Imperfections in Worldwide Equity Markets, Cambridge University Press, Cambridge. pp. 255-260. Koller, T., Goedhart, M. & Wessels, D. (2010). Valuation: Measuring and Managing the Value of Companies, John Wiley & Sons, New York. p. 387. Livanas, J. (2004). How Can the Market be Efficient if Investors are Not Rational?, University of Sydney, Sydney. pp. 3-9. Malkiel, B. G. (2003). The Efficient Market Hypothesis and Its Critics, Princeton University, Princeton. pp. 1-6. Read More