The Efficient Market Hypothesis - Literature review Example

Efficient Markets Hypothesis Efficient Markets Hypothesis Introduction Efficient Market Hypothesis (EMH) concept s that prices of financial assets are a reflection of all the relevant information. This implies that prices in average are accurate, which means that financial markets are efficient. The consequences of this are that an active investor is not at a position to continuously beat the market. Consequently, a passive investor may achieve similar profit in average just as the active investor does. This paper will provide a critical analysis of efficient market hypothesis within the context of financial meltdown of 2007-2011. The paper will also offer a discussion of behavioral finance theory as an alternative theory and hypothesis that may be used to give a better explanation for the behaviors of investors and financial markets. Sun, Stewart, and Pollard (2011 p.76) notes that the recent global financial meltdown was occasioned by perfect storm of economic conditions. The conditions include subprime mortgage crisis, liquidity crisis, property collapse, market violation, and an accommodating financial and regulatory environment. The meltdown is also arguably contributed by poor corporate governance. For example, there has been a lot of criticism of chronic and reckless risk-taking by organization’s managements that was catalyzed by bank’s payment policies. Efficient Markets Hypothesis (EMH) The Efficient markets hypothesis holds that current market prices of financial assets is based on the rationality of all the available information about prospective return on shares or assets. It suggests that future uncertainty is of ‘white noise’ type and speculators may be able to succeed in pushing the temporarily away from stability or equilibrium (Palit 2010, p.31). However, when the market clears continuously, EMH agues that rational traders bring back the system to equilibrium by taking countervailing stance and imposing heavy losses on noise traders or speculators who bet against the fundamentals. Equilibrium asset or share prices will therefore be changed in those situations where there is turmoil to the fundamentals, whereas the supply turmoil are inevitable, the severity of demand turmoil can be tempered with using policies aimed at giving more informational access about market participants fundamentals, and avoids policy surprises. In some instances it is used to control share prices in the financial markets (Palit 2011, p.31). The efficient market hypothesis assumptions are one way by which the market disciplines can be explained. The hypothesis is based on the assumption that market securities are efficient. The belief that capital markets are efficient implies that all available information about an organization or company is fully reflected in the shares (Krugman 2009). What is meant by this is that markets are semi-strong in the sense that share prices adjust rapidly in response to public information. When this trend continues for a long time, this has the effect of causing a financial crisis like the one witnessed in 2008. This hypothesis is vital to security regulatory authority since it underlies mandatory disclosure of information and a lot of investor protection rule as noted by Sun, Stewart, and Pollard (2011). However, the assumptions underlying the theory of EMH have been criticized by both empirical and theoretical. It is argued that the hypothesis does not take into consideration the socio-physiological factors. Sun, Stewart, and Pollard (2011 p.77) notes that bubbles and crashes are some of the endemic characteristics of a financial market. The hypothesis also suggests that arbitrage pricing is one-way of correcting any irrationality in the market place. For this reason, the hypothesis implies that the recent financial turmoil experienced in the world was a result of investor’s irrationality, which resulted in price episodicality (Sun, Stewart, and Pollard 2011 p77). In circumstances of an abnormal trading characterized by an increase in the number of investors in the market implies that noise traders would share a common mistaken belief. This gives rise to a shift in arbitrage plans, which move the prices further from efficiency as was the case with the recent financial crisis witnessed in 2008. During this time, all the arbitrage constraints on prices are relaxed and the effects of cognitive biases on prices are likely to result in significant effects than cost-based deviations (Sun, Stewart, and Pollard 2011 P.77). The efficient market hypothesis depends on the flow of information in the market. The flow of information is very important to both the board and the public. When this is not done, a financial crisis may result due to price inefficiencies. For instance, the UK Financial Services Authority (FSA) reveals that information asymmetries between informed contracts for difference (CfD) holders and the informed ordinary investors may result in price inefficiency in the market. Sun, Stewart, and Pollard (2011 p.78) note that uninformed investors may not be in a position to acquire valuable information because it is held by those traders who are informed. Either vital information pertaining to CfDs, which can affect pricing of market share, could include information on the holders of large CfD positions who are in a position to currently or prospectively exercise ownership rights over the shares referenced (Sun, Stewart, and Pollard 2011 p.78). During the recent financial crisis, it was evident that share prices of banks were temporarily altered by short selling (Sun, Stewart, and Pollard 2011 p.78). The international Organization of Securities Commission (IOSCO 2008) suggests that there are circumstances under which short selling can be used as a tool to mislead the market. Firstly, it can be used in a downward manipulation in which a manipulator sells a company’s share short and then spread false rumors about a company’s negative prospects. These harm investors and issuers as well as the reputation of the market (Sornette 2004). When the rumors continues for a long time this may affect the value of share prices in the market resulting in a financial meltdown as was the case with the 2007-2011 crisis. The IOSCO noted of the recent financial crisis that short selling is problematic in the midst of a loss in market confidence, which creates credit crisis. In this case, short selling made many solvent bans experience liquidity challenges. A decrease in share price induced by short selling resulted into credit crisis for the banks in question. Consequently, this resulted into a financial crisis due to liquidity problems (Sun, Stewart, and Pollard 2011 p.78). Sun, Stewart, and Pollard (2011) suggest that these is the reasons that made many regulators among them being UK and Ireland to introduce provisional ban on short selling of securities of listed firms dealing in provision of financial services. The ban was later on lifted because it was later noted that short selling plays vital role in market efficiency as put forward by efficient market hypothesis. The reasons being, short selling eliminates market bubbles, provide efficient price discovery, increases market liquidity, facilitate risk management activities, and mitigates upward market manipulations (Sun, Stewart, and Pollard 2011 p.78). Behavioral Finance Theory Savona, Kirton and Oldani (2011 p.59) notes that behavioral finance theory offer better explanations for the behavior of investors and financial markets. It offers an explanation on finance theory puzzles, like the equity premium puzzle, overconfidence of investors and earnings forecast biases. The theory suggests that market players have limited rationality, use information available in a biased way, and follow the market in a rational manner (Savona, Kirton and Oldani 2011 p.59). It is also based on rationality and psychology. According to Motier (2007 p.445), a behavioral expert ones commented, “Risk is the most misunderstood concept in finance.” Therefore when carrying out an assessment on the success of an investment decision, many people have a propensity to focus mostly on returns and rarely consider how risk they are exposed to impact on their overall financial objectives (Baker and Nofsinger 2011, p.137). Baker and Nofsinger 2011, p138) suggest that investment domain is “not similar to other fields of endeavors because uncertainty is logged in its heart.” For this reason, he argues that when we think that we know the future then we are probably in trouble. Therefore, investors should be in a position to understand the potential price fluctuations of the investment products in developing and implementing an effective financial strategy. One of the major behavioral financial principle suggested by Bruce (2010, P.130) that may help in explaining investors behavior is that of mental compartment. Shiller (1998, P.18) argues that there is human tendency to put particular events into mental compartments based on superficial attributes. He notes that instead of analyzing countries macro-economic fundamentals, many investors tend to look at individual similarities autonomously. Consequently, individuals may tend to put their investments into arbitrarily separate mental compartments, which they then react separately to investments based on the compartments they find themselves in. This fact is evident in risk management during a financial turmoil. Shiller (1998) argues that mental compartments can result in overconfidence or under reaction, which is due to ‘representativeness heuristic’. That is, when making probability estimates; individual investors overstress the importance of categorization, ignoring evidence about the underlying probabilities. He suggests that this offers an explanation of the general market overreaction or excess volatility of investor’s speculative asset prices during financial crisis (Bruce 2010, p. 130). Bruce (2010, p. 130) also takes notice to anomalies, which offers highlights of the impacts of change of public attention with regard to investment decision making. Shiller (1998, p. 41) suggest that the volatility of speculative asset prices is related to unpredictability of the public attention. He also believed that the major crashes witnessed in the financial markets could be taken as a phenomenon of attention. In this case, inordinate amount of public attention is focused on the markets. The focus is however, sometimes put on markets in specific areas. Based on the behavioral financial principles outlined, Bruce (2010, p. 130) argues that when a country is hit by a financial meltdown , due to representativeness heuristic and attention anomalies, he notes that other countries perceived to be facing the same mental category are subject to an access volatility in asset prices. This is due to overreaction on the part of investors. This principle gives a better explanation of the behaviors of the investors and financial market that the efficient market hypothesis with regard to financial crisis. Behavioral finance theory gives an analysis in which risk is based on an assortment of both objective and subjective factors. Baker and Nofsinger (2010, p.137) notes that qualitative and quantitative factors influence how people make decisions regarding the type of financial services or investment products to sell, buy, hold or reject. For example, the theory hold that the more an individual investor perceives a benefit from any potential risky venture, the more the individual will be willing to accept and the less anxious they would feel over the risky venture, or event. This implies that investors are rational ad would be willing to take risk when they perceive benefit to outweigh risk involved. The behavioral finance theory provides an adequate explanation as to individual’s perception with regard to catastrophic potential. In this regard Baker and Nofsinger (2010, p.137) notes that investors display a tendency of having an increased level of risk for events that injures or destroy a large quantity immediately and thoroughly. The behavioral finance also suggests that individuals in most cases undertake more risk when they feel personally being in control. This is due to the fact that they are more likely to trust their individual abilities and skills when engaging in a risky activity (Baker and Nofsinger 2010, p.137). Baker and Nofsinger (2010, p.137) notes that behavioral finance postulates that people become more anxious or dread of a crisis whom they perceive their severity to be beyond their control. These kinds of risks include those, which are hard to prevent, lethal, catastrophic, involuntary, threatening to future generations, and unfair. The behavioral finance also offers a better explanation with regard to familiarity with the situation in the market as opposed to just the availability of information as efficient market hypothesis suggest. I this case, it argues that investors in most cases are more comfortable and tolerant of risks when they are personally familiar with the events, activities, and situations in the market (Krugman 2009). In conclusion, the efficient market hypothesis (EMH) is a vital linguistic device that may be used to overcome some of the problems that investors face like the one experienced during the recent financial crisis. Since it is based mainly on availability of information, this helps investors understand the important aspects of the market in which they operate. Its not that easy to make money reliably and faster in the financial markets (Shrivastava and Statler 2011, p. 284). The EMH suggests that financial markets are often right. For example if share are sold out relatively cheaper, then the market might have a reason for this pricing. This also points to the investors to be on the look out before investing in actively managed mutual funds. Despite the explanations put forward by the efficient market hypothesis, it has faced a lot of criticism in which many economists believed can be solved using other theories and hypothesis. In this regard, they feel that behavioral finance gives a better explanation. Behavioral finance is based on the fact that market players have limited rationality, use information available in a biased way, and follow the market in a rational manner. This offers an explanation on finance theory puzzles, like the equity premium puzzle, overconfidence of investors and earnings forecast biases. The theory also holds that qualitative and quantitative factors influence how people make decisions regarding the type of financial services or investment products to sell, buy, hold or reject. This offers better explanation than the one postulated by the efficient market hypothesis that is only based on availability of information in the market. This contradicts the argument by efficient market hypothesis rationale behind financial market being right. References Baker, H.K., & Nofsinger, J.R. (2010). Behavioral Finance: Investors, Corporations and Markets. New Jersey: John Wiley & Sons, Inc. Bruce, B. (2010), Handbook of behavioral finance. Cheltenham: Edward Elgar Publishing Limited. Krugman, P. (2009). How did economists get it wrong? New York Times. Vol.3, 121-147, March, 2011. Montier, J. (2007) Behavioural investing: A practitioners guide to applying behavioural finance. New Jersey: John Wiley and Sons. Palit, A. (2011), South Asia: Beyond the Global financial Crisis. Danvers: World scientific Publishing Co. Pte. Ltd. Savona, P., Kirton, J., & Oldani C. (2011), Global financial crisis: Global impact and solutions. Farnham: Ashgate Publishing Limited. Shiller, R. (1998), Macro Markets: Creating Institutions for managing Society’s Largest Economic Risks. Oxford: Oxford University Press. Sornette, D. (2004). Why stock Markets Crash: Critical events in complex financial systems. New Jersey: Princeton University Press. Sun, W., Stewart, J., & Pollard, D. (2011), Corporate Governance, and the Global Financial Crisis: International Perspectives. New York: Cambridge University Press. Read More