Behavioural Finance and Market Efficiency - Essay Example

? Behavioural Finance and Market Efficiency Total Number of Words: 2,998 Introduction Since 1990s, the study of behavioural finance and market efficiency often goes hand in hand. In most cases, inefficient market can lead to the development of economic recession. As a result of having poor market efficiency, a lot of global investors have become reluctant in investing their money on local and internal businesses. In general, the ability of each country to develop efficient market has something to do with the development of capital asset1. Due to the presence of inefficiency within the global market, the sales and profitability of a company is not only affected but also the country’s ability to build a more reliable capital asset. Therefore, in response to poor market efficiency, the study on behavioural finance has gained importance back in 1990s2. Using knowledge on behavioural finance, the main causes and underlying drivers of the most recent global financial crisis will be identified and tackled in details. As part of analyzing the factors that has triggered the recent global financial crisis, both behavioural and non-behavioural explanation behind such crisis will be compared and contrast. In relation to the presence of irregularities in the global markets, whether or not “value” is riskier than “growth” will be answered based on the theory behind the rational risk pricing. 2. Main Causes and Underlying Drivers of the Most Recent Global Financial Crisis 2.1 Non-behavioural Explanation behind the Most Recent Global Financial Crisis Next to the Great Depression which occurred back in 1930s, the worst global financial crisis happened between 2007 to 2008 when most of the large-scale financial institutions worldwide were at risks of bankruptcy aside from the sudden fall in the stock markets3. Specifically the U.S. real estate bubble in 2006 had caused serious damages to the status of global financial institutions4, 5. Eventually, the prolonged 2007 to 2008 global financial crisis has somehow contributed to the European sovereign-debt crisis6, 7. This increases the risks wherein most of the largest financial institutions such as the Lehman Brothers had serious problems about their liquidity and bank solvency8. Based on the study of macroeconomics, a lot of potential factors have been considered to be the main drivers behind the most recent global financial crisis. Based on the historical trend in the global financial crisis, one thing that is certain is that increase in financial imbalances within the world market has something to do with today’s global financial crisis9. Likewise, it is also suspected that the growing imbalances in the worldwide capital flows are one of the main reasons behind the recent global financial crisis10, 11, 12, 13. Furthermore, it is also possible that the combination of the increasing imbalances in the flow of capital worldwide and the use of monetary policies have contributed to the development of the recent global financial crisis14, 15. Financial crisis is often characterized by having relatively low levels of national savings, huge fiscal and financial deficits, business bankruptcy and foreclosure, low GDP output, high unemployment rate, and huge trade or current account deficits16. With regards to the continuously increasing global financial imbalances, Merrouche and Nier (2010) explained that the incidence of global financial imbalances is somehow strongly connected with the huge dispersion between a huge net capital flows between two or more different countries and the position of the current account across different countries17. In line with this, a country with excessive inflows of capital can have long-term low interest rates which can influence most investors to search for other investment options as most financial institutions would try other means of maintaining their daily operational costs18, 19. Likewise, excessively high inflows of capital can also significantly reduce the wholesale funding cost of the local banks within the international markets20. In some cases, excessively high inflows of capital can somehow increase the local market prices of houses due to the continuous increase in the available supply of credit21. Considering the on-going financial crisis that has occurred within the Eurozone, several studies have considered the central bank’s policy rates to be the main cause of financial crisis22, 23. For some reasons, the rates of the interest when combined with the regulations used in managing the country’s financial system could somehow increase the risks wherein people could develop misperception with regards to the future development of an economy24. Likewise, several studies have pointed out that the interest rates when combined with the existing monetary policy could also affect not only the demand for real estate properties but also the risks of developing financial crisis25, 26, 27. In line with this, Blundell-Wignall, Atkinson and Lee (2008) explained that monetary policies could somehow affect the country’s financial liquidity and that the presence of a serious financial crisis is actually caused by having distorted or ineffective monetary policies used in the past28. In times of poor economic situation, the real value of assets can decrease making investors at risks of losing money29. Specifically the presence of global financial crisis is a sign wherein countries have failed to protect the economic welfare of businesses and financial instutitions30. According to Schwartz (2012), the presence of a global financial crisis is strongly connected to long-term assets such as pension or mortgages31. In line with this, Taylor (2007) explained that relatively low interest rates could somehow increase the demand for real estate properties which eventually would trigger a significant increase in the market price of houses32. Considering the case of the United States, the sudden decrease in the market prices of houses were somehow strongly related not only with the long-term interest rates in this country but also the sudden decline in the U.S.’s GDP and employment rate33. 2.2 Behavioural Explanation behind the Most Recent Global Financial Crisis Investment behaviour usually occurs between the business managers and the local or foreign investors. Based on the study of behavioural finance, it is possible to predict rational behaviour of finance and market efficiencies using different theoretical models such as prospect theory, belief-based model, the capital asset pricing model, and the efficient market hypothesis among others34, 35, 36, 37. When analyzing the recent global financial crisis, investment behaviour should be analyzed on a per country basis (i.e. country A vs. country B, etc.). There are several behavioural explanations behind the most recent global economic crisis. In line with this, the market prices of goods and services is one of the key factors that could significantly affect the behaviour of people when it comes to purchasing products and services in the world market. As mentioned earlier, one of the main factors that may have contributed to the on-going global financial crisis is the significant increase in financial imbalances worldwide38, 39, 40, 41, 42, 43, 44. In relation to global market competition, it is given that most countries that would purchase homogenous items are most likely to purchase goods and services coming from countries that are capable of selling them the same type and quality of goods at relatively much lower prices. 2.2.1 Prospect Theory Religiously purchasing items from developing or emerging countries can be explained through the use of prospect theory. In most cases, prospect theory is commonly used when making important economic, business, or purchasing decisions that has certain levels of risks and uncertainties45. As a common knowledge, it is more common for people to avoid experiencing the adverse emotional effects of losing certain amount of money as compared to potential monetary gains. For example, assuming that people can easily purchase a T-shirt made in China for as low as US$1 each as compared to purchasing the same shirt made in Italy for US$5 each; given the fact that buyers can save as much as US$4 for each shirt purchased from China, there is a higher chance wherein China could sell more shirt as compared to Italy. Through the use of the prospect theory, people who study behavioural finance can develop an idea with regards to having a fixed reference outcome based on the choices that people would make in relation to potential monetary gains and losses46. The same idea or business concept applies to each foreign investor. In order to exploit the lower cost of labour in most developing countries worldwide, a lot of large-scale international companies based in developed countries have entered into merger and acquisition agreement with another company in order to expand their business operations in foreign lands47, 48, 49. This type of business practices is feasible because the business owner can enjoy the long-term benefit of being able to enjoy more gains than losses by simply trying to reduce the company’s fixed monthly operating costs. With this in mind, one can easily argue that the ability of most developing countries to sell basic products and services to the world market makes them able to capture the biggest market share in the world. In fact, this is one of the most obvious reasons why there has been a huge global financial imbalance between most developed and developing or emerging countries worldwide. Eventually, differences in the global demand for goods and services could result to the huge dispersion between a huge net capital flows between two or more different countries50. 2.2.2 Belief-based Model Another factor that has contributed to the recent global financial crisis is the real estate bubble that happened in the United States back in 2006 which had caused serious damages to the status of global financial institutions51, 52. Basically, the U.S. real estate bubble burst happened when people in the United States who had housing loans with the banks could no longer pay for the principal and interests of their housing loans. The belief-based model can be used to explain the U.S. real estate bubble. In line with this, there is a strong possibility whereby the real estate bubble was created at the point in time where there was a short-sale restriction53, 54. In almost all cases, public investors can either have a positive or negative opinion about certain assets which could be a good future investment. In line with this, short-sale restriction could happen when the market price of houses is based only on the point-of-view of the seller which often times can lead to a significant overvaluation of the real estate property55. Also based on the theory of belief-based model of overvaluation, another possible reason behind the increased risk for real estate bubble is due to the fact that most investors could manipulate the figures concerning the default rates, growth in earnings, and expected returns56. Other than overvaluation of real estate properties, the belief-based theory on overconfidence can also be used to explain the U.S. real estate bubble back in 2006. In the with this, the theory behind overconfidence strongly suggest that there will always be the risks wherein people would tend to overestimate the value of their real estate properties solely based on their personal prediction57. Due to overconfidence, there are higher risks wherein the owner of the real property tends to increase the price of their assets way more than its true market value. 3. Is “Value” Riskier than “Growth”? Time-varying risk is actually a method which can be used to predict uncertainties that varies with time (i.e. conditional market or price volatility, etc.)58. Because of the presence of time-varying risks, there are cases wherein the value of stocks can increase more as compared to the future growth of stocks59. In relation to rational asset pricing and the study of behavioural finance, Petkova and Zhang (2002) purposedly conducted a cross-sectional variation with regards to the beta-premium sensitivities on different investment portfolios based on book-to-market and size. Based on conditional CAPM, Petkova and Zhang (2002) found out that conditional betas in stock values can positively affect the expectations of investors when it comes to risk premium and that the stock growth could somehow negatively affect the expectations of investors when it comes to risk premium60. Furthermore, Petkova and Zhang (2002) also concluded that as compared to the growth of stocks, the stock values are riskier each time the economy is not good and that the stock values are less riskier each time the economy is good61. However, the presence of uncertainties is not always considered as a factor that can create premium on value. For instance, there are cases wherein value is higher as compared to growth in times of good economic situation but low during a bad economic situation62. On the contrary, there are also cases wherein value does not increase investors’ risks on becoming a victim of mispricing such as overvaluation of the market prices of stocks or goods63, 64. With regards to the question on whether or not “value” is riskier than “growth”, Petkova and Zhang (2005) mentioned that most of the previous studies on behavioural finance would support the idea that value is not or will never be riskier than growth65. In line with this, Barberis and Thaler (2003) explained that based on rational risk pricing model, risks are being measured as a covariance of return from the actual consumption of marginal utility and that often times, stocks are considered as risky only if it does not pay a high marginal utility when the economy is not good66. Despite the explanation given by Barberis and Thaler (2003), Petkova and Zhang (2005) mentioned that there is not much concrete evidence that can really prove or confirm the idea that all types of investment portolios will not yield a very high avarage returns during a bad economic situation. In fact, the previous study made by Lakonishok, Shleifer and Vishny (1994) strongly suggest that even though the economy is in a recession, it is still possible that investors’ stock value can still perform well as compared to the growth of stocks67. Based on the research findings of Petkova and Zhang (2005) and Lakonishok, Shleifer and Vishny (1994), even though there is a global financial crisis going on today, people who invest on stocks are not always at risks of losing the value of their stocks. In line with this, Bernstein (2002) mentioned that behavioral factors involved in the movements of stock prices could somehow affect the present or current value of their future stock earnings and dividends68. In most cases, having a negative stock earnings would mean more difficulty in increasing the growth of stocks as compared to the value of stocks69. In other words, the “value” of stocks will never be riskier as compared to the “growth” of stocks. On the contrary, Zhang (2005) adopted the use of neoclassical framework in analyzing the rational expectations with regards to value and growth of firms70. In line with this, Zhang (2005) found out that during economic situation, the value of firms tend to become inflexible in terms of being able to adopt with the business challenges caused by external forces71. As a result, the company’s overall value becomes very much affected making the firm exposed to more risks as compared to the growth of the business. 4. Conclusion Behavioural finance is somehow related to market efficiency in the sense that efficient or inefficient market could somehow affect the way people would behave or predict their future investments not only in the stock market but also in other possible investment portfolios. In general, inefficient market can lead to the development of economic recession. Likewise, inefficient market can lead to financial instability. In response to poor market efficiency, the study on behavioural finance has gained importance back in 1990s The most recent global financial crisis can be explained using both behavioural and non-behavioural explanations. With regards to non-behavioural explanation, factors such as the use of inefficient monetary and fiscal policy when combined with exchange rate volatility or relatively low interest rates could somehow increases the risks of global financial crisis. With regards to behavioural explanations, the use of prospect theory is more applicable when it comes to explaining the rationale behind the growing worldwide financial imbalances whereas belief-based model can be used to explain the behavioural explanation behind the U.S. real-estate bubble. In the study of financial economics, the use of non-behavioural factors is more commonly used when explaining the rationale behind the recent global financial crisis. The concept of behavioural finance is rather new as compared to the study of economics. Therefore, there is a limitation as to how the available theories in behavioural finance can be used in explaining the reasons behind the real causes of global financial crisis. With regards to the question as to whether or not “value” is riskier than “growth”, the answer is that “value” may or may not be riskier as compared to “growth” and that often times, the risks associated with “value” or “growth” is highly dependent on a case to case basis. If we are talking about stock value, the answer is that value is not always or will never be riskier than growth72, 73. This is possible because public investors have the choices to either buy or sell stocks based on their own timing and free will. As compared to the growth of stocks, Petkova and Zhang (2002) revealed that the stock values are riskier each time the economy is not good and that the stock values are less riskier each time the economy is good74. Because of the absence of uniformity in the existing research studies on “value” and “growth”, it is possible that some other factors other than the rational risk pricing could affect the risks associated with “value” and “growth”. 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