Behavioural Finance - Australian Stock Market and Efficient Markets Approach - Literature review Example

Running Head: BEHAVIOURAL FINANCE Behavioural Finance [The Writer’s Name] [The Name of the Institution] Behavioural Finance Introduction Behavioural finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. The behaviourist view suggests that the stock market is inefficient and it is possible to outperform the market. The theory assumes investors are irrational and future share prices movements are forecasting by using historical movements. Therefore investors can outsmart the market by analysing trends and financial reports. Financial markets characterise by many entities that interact and affect each other in the trading process. In this context, there are two different approaches to stocks pricing: efficient markets (EM) and noise trading (NT). Each approach implements different scenarios that lead to different results. Australian Stock Market The share market in Australia has two main functions. Firstly, it provides a link so that listed companies can receive equity funds to expand their operations and so that the people with the funds can invest and receive return in capital gains and dividends income. Secondly, it provide a market place where buyers and sellers can come together for the trading of shares and other securities at the current market price which has been determined by the forces of supply and demand. When there is competition in the stock market and the number of investors is the same, the competition for the supply and demand of shares is manipulated. (Steve Lumby & Chris Jones, 1999, 178) For a company to be successful in competing it will need to make itself more desirable and attractive for investors. This will usually mean higher dividends are paid out to the investors, so as to encourage further investment. As the company increases its supply of shares through a float, the price mechanism will adjust the price and set a new equilibrium to help the company compete in a competitive stock market. Stockbroker organizations between the buyer and the stock exchange are common in the share market. These institutions offer a range of services and advice to both investors who want to invest or trade shares, and to the companies offering the shares. These stockbrokers also adhere to a strict code of ethics, offer investment advice on all kinds of securities, and provide financial and future investment plans. (Shleifer & Summers, 1990, 19) These institutions are beneficial because they allow new shareholders to successfully take part in investing in companies and in turn receiving returns through capital gains or dividends. Efficient Markets Approach Shleifer (2000) defines an efficient market (EM) as "one in which security prices always fully reflects the available information" (p. 1). A prerequisite for this strong version of the approach is that information and trading costs are always zero (Fama, 1991, 1575). A weaker and more rational edition of the EM approach sates that "prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal costs" (Fama, 1991, 1585). Therefore, the approach implies that the price changes are independent of one another. Investors follow this approach named arbitrageurs, fully rational investors whose trading decisions are not subject to sentiment (Shleifer & Summers, 1990, 19). According to Malkiel (1996, 44), the EM approach relies on three main assumptions. First, the market is so efficient in a way that nobody can buy or sell quickly enough to benefit. Second, perfect pricing exists. The approach holds that stocks sell at the best estimates of their basic values. Thus uninformed investors buying at the existing prices are getting full value for their investment, whatever stocks they purchase. (Dimson, Elroy & Massoud Mussavian, 2000, 92) Third, the approach involves that nobody has power over the market and that stock recommendations based on unfounded beliefs do not lead to large buying. (Fama, 1970, 386) The EM approach comes in either weak, semi-strong, or strong form. The weak form in which prices reflect all information contained in the record of past prices whilst the semi-strong form in which prices reflect, in addition to past prices, other published information. (David N. King. 1999, 78) In the strong form, however, prices reflect not just public information but all the information that can be acquired by painstaking analysis of the company and the economy. (Fama, 1998, 289) In general, Malkiel (1996, 45) points out that all these three forms could not help investors. According to Shleifer and Summers (1990, 20-21), substantial evidences shows that arbitrage does not completely counter responses of prices to fluctuations in uninformed demand. Because price changes may reflect new market information which changes the equilibrium price at which arbitrageurs trade, identifying such fluctuations in demand is tricky. (Arnold, 2002, 116) Noise Trading Approach Poterba and Summers (1988, 57) defines noise trading (NT) as "the type of trading performed by investors whose demand for shares is determined by factors other than their expected return". Investors follow this approach of trading named noise traders, "investors who their opinions and trading patterns may be subject to systematic biases" (Shleifer & Summers, 1990, 24). The NT approach, according to Shleifer and Summers (1990, 27), is grounded on two main assumptions. First, investors are not fully rational and their demand for risky assets is affected by the beliefs that are not fully justified by fundamental news. Second, arbitrage is risky and therefore limited. Dimson and Mussavian (1998, 99) suggest that the concept of noise traders has had an impact on financial modelling that goes beyond the field of market microstructure. The NT approach, according to Shleifer and Summers (1990, 27), has threefold. First, theoretical models with the NT approach are more reasonable than those with the EM approach. Second, the NT approach yields a more accurate description of financial markets than the EM approach. Third, the NT approach yields new and testable implications about assets prices. Shleifer and Summers (1990, 30) suggest that although some shifts in investor demand for stocks are entirely rational, some of them appear to be so rational. Such changes to be a response to changes in expectations that are not justified by information and they also can be a response to pseudo-signals that investors believe convey information about future returns but that would not convey such information in a fully rational model. Although these changes in demand are unwarranted by fundamental, they can be related to fundamental, as in the case of overreaction to news. These demand shifts will only matter if they are correlated across noise traders. Investors Behaviour According to Dimson and Mussavian (1998, 121), although the EM approach is supported by an emergent body of empirical research that indicates the difficulty of beating the market, testing for market efficiency is difficult. In contrast, Dimson and Mussavian concluded that anomalous behaviour which appears to be inconsistent with market efficiency. When investors are rational, according to Shleifer (2000, p6), they value each security for its fundamental value. However, the EM approach does not operate by investors rationality. In many cases where there are noise traders, markets are still predicted to be efficient. This argument is quite limited because it relies on the lack of correlation in the strategies of the noise traders. The case for the EM approach, however, can be made even in situations where the trading strategies of investors are correlated. Risks Involved Trading through the EM or the NT approach involves certain risks. Historically, the equity premium has been huge. Although one would expect retunes to be higher, the return differential of certain percent a year is much too great to be explained by risk alone (Thaler, 1999, 12). Shleifer and Summers (1990, 32) point out that primary risk and unpredictability of the future resale price risk are two types of risk face arbitrageurs. In contrast, De Long et al. (1986, 36) point out that noise traders incorrectly consider that they have special information about the future price of the risky asset. Therefore, they select their stocks on based on inaccurate beliefs such as stock brokers, giving opportunities to arbitrageurs to exploit their irrational misperceptions. Moreover, noise traders might be on average more aggressive that arbitrageurs and so bear more risk. If risk-taking is rewarded in the market, noise traders can earn higher returns than arbitrageurs (Shleifer & Summers, 1990, 33). Dividends In the EM approach, according to (Fama, 1991, 1614), the forecast power of dividends states that "prices are high relative to dividends when discount rates and expected returns are low, and vice versa." Moreover, dividends are irrelevant in an efficient market with no taxes. However, under the tax system, dividends are taxed at a higher rate than capital gains and companies can make their taxpaying shareholders better off by repurchasing shares rather than paying dividends.(Thaler, 1999, 14). On the other hand, in the NT approach, low dividends signal high stock prices that will move back toward fundamental values. Predictability According to (Thaler, 1999, 15), in an efficient market future retunes cannot be predicted on the basis of existing information. Financial economics though this most basic assumption of the EM approach was true. However, everyone agrees now that stock prices are at least partly predicted on the basis of past returns. Moreover, the EM approach was challenged on both theoretical and empirical grounds, according to Shleifer (2000, p7). In fact, it is difficult to sustain the case that people in general, and investors in particular, are fully rational. Many investors react to irrelevant information in forming their demand for securities, and therefore, they trade on noise rather than information. Using a constant discount rate and some specific assumptions about the dividend process, Shiller's (1981, 422) work on stock market volatility showed that stock market prices are far more volatile than could be justified by a simple model in which these prices are equal to the expected net present value of future dividends. (Shleifer, 2000, p7) In a rational world, moreover, stock prices are more volatile than advocates of the EM approach would predict (Thaler, 1999, 17). Conclusion In general, the EM approach continues to provide a framework that is widely used by financial economists. In contrast, the NT approach creates the opportunity to trade profitably, but at the same time makes it difficult to trade profitability. Technological advances in relation to the stock market have been beneficial in making the stock exchange a more reliable and secure place to trade. It is no longer run by hand and tickertape machines; everything is automated and the current share prices can be kept accurately up to date. Shares can also be traded almost instantly without the need to issue a certificate, but the use of a digital certificate instead. The share market has a significant impact on the activity that goes on in an economy. This impact is mostly caused by the purpose of shares to create investment opportunities and in time affect the total pattern of investment. One of the most important impacts of the share market is that it facilitates more efficient investment in the economy. Without the share market or well-developed financial systems in an economy, most of the investment will occur through borrowing. When the individuals in this economy choose not to consume, they save their incomes with intermediary financial institutions and the companies that require investment funds must borrow through these institutions. The problem with this system of lending and borrowing through financial institutions is that only limited benefits are passed on to the individuals saving their income and the companies borrowing funds - as the returns on the savings are usually quite low, and the cost of borrowing is quiet high. References Arnold, G. (2002) Corporate Financial Management, 2nd Ed., Harlow: FT Prentice Hall, 115-18 Black, F (1986) Noise, Journal of Finance, 41 (3), 529-534 David N. King. (1999) Financial Claims and Derivatives; London: International Thomson Business Press. p78 De Long, J, Shleifer, A, Summers, L. and Waldmann, R (1986) Noise Trader Risk in Financial Markets, J. Bradford De Long's Working Papers, 124, University of California at Berkeley, Economics Department. 36 Dimson, E and Mussavian, M (1998) A Brief History of Market Efficiency, European Financial Management, 4 (1), 91-193 Dimson, Elroy & Massoud Mussavian. 'Market Efficiency'; the Current State of Business Disciplines, 2000 (10), 90-93 Fama, E (1970), Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25, 383-417 Fama, E. (1991) Efficient Capital Markets II, Journal of Finance, 46 (5), 1575-1617 Fama, Eugene F. 'Market efficiency, long-term returns, and behavioural finance'. Journal of Financial Economics; 1998 (49): 283-306 Malkiel, B (1996) A Random Walk Down Wall Street, 6th Edition, Norton: London, 44-47 Poterba, J and Summers, L (1988), Mean Reversion in Stock Prices: Evidence and Implications, Journal of Financial Economics, 22, 57 Shiller, R (1981), Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?", American Economic Review, 71, 421-436 Shleifer, A (2000) Inefficient Markets: An Introduction to Behavioural Finance, 6th Edition, Oxford: Oxford University Press. 6-7 Shleifer, A and Summers, L (1990) The Noise Trader Approach to Finance, Journal of Economic Perspectives, Spring, 19-34 Steve Lumby & Chris Jones. (1999: 6th Ed.). Investment Appraisal & Financial Decisions. London: International Thomson Business Press. 177-79 Thaler, R (1999), The End of Behavioural Finance, Financial Analysts Journal, November-December, 12-17 Read More