Efficient Market Hypothesis - Research Paper Example

TO: FROM: DATE: 27TH FEBRUARY 2016 SUBJECT: Efficient market hypothesis and behavioural finance The efficient market hypothesis and behavioural finance are two economic model that almost contradict each other. While EMH argues that financial markets are efficient and are characterized by rational investors, behavioural theory argues otherwise. This memorandum seeks to discuss the two theories in details. It will also detail out their practical applications in the modern day financial markets. Finally, the memorandum also looks at the reasons behind the decision by the Nobel committee to award the theories proponents ie. Fama and Shiller the 2013 Nobel awards for economics. This will establish that although the two theories contradict each other, Fama and Shiller’s effort at unearthing asset prizing and hence their contribution to the field informed the wards. The Efficient Market Hypothesis (EMH) Concept and critical discussion of its assumptions Introduction A number of economic theories came into being between 1950s and 1970s including the Capital asset pricing model, the EMH and the Miller-Modigliani irrelevance propositions. All these efficient market hypothesis theories shared a common methodology and were based on a set of perfect market assumptions including rationality of investors, availability of perfect information and non-availability of transaction costs. In this essay, the concept of EMH and its assumptions are presented and also critically evaluated with an aim of evaluating its suitability and applicability in the modern day financial markets. The EMH concept In defining EMH, Fama (1970) stated that a market where prices will fully reflect every available information is known as an efficient market. An efficient market is a market characterized by large numbers of rational profit maxmizers who actively compete with one another in an attempt to predict the future market prices of distinct securities. Another characteristic of the market is that vital current information is spontaneously accessible to all market participants (Fama, 1991). The EMH concept therefore postulates that efficient markets exist where certain conditions hold including the presence of many rational profit maximizes (investors) actively participating in the market hence valuing securities rationally. Where some of the investors act irrationally, their irrational trades cancel out one another. Alternatively, rational arbitrageurs will always eradicate their influence without the prices being affected (Ryan, 2016). In such an efficient market, information would be costless and would also be widely accessible to all the market participants together. Such investors act fully and quickly to every new information and this will result in prices adjusting accordingly. The EMH finds its basis on the random walk theory that characterizes price series where every subsequent change in price is a representation of random departure from preceding prices. This means that when information flow is unhampered and such information immediately gets mirrored in asset prices, then tomorrow’s changes in price will only reflect tomorrow’s new information and is independent of today’s price changes. Since news is not predictable, price changes ought also to be unpredictable and random. Thus, prices will wholly mirror all entirely new information and uninformed investors investing in a diversified portfolio at the prevailing market price will obtain similar returns to that obtained by experts with information. According to Fama and Kenneth ( R2004) stock price fluctuations occur independently and have same probability distribution and are hence commonly perceived as being random and unpredictable just as a flipping coin. This is what (Fama,1998) describes as stock prices describing random walks through time with price changes being unpredictable as they occur in response to new information which is also unpredictable. According to EMH, in efficient markets, investors do not earn above average returns unless they accept above average risks. Owing to markets being efficient, both distinct stocks and cumulative stocks are market efficient since they wholly reflect all available information and integrate it in the existing stock price. According to Malkiel (2003), when information arise, it spreads very rapidly and immediately gets incorporated into prices in the efficient market. EMH also postulates that shares on becoming publicly known, they acquire value which reflects the best intelligence judgment concerning them. Fama (1970) identified three forms of market efficiencies including the weak, semi-strong and strong form efficiency. A market is weak form efficient when current security prices have completely incorporated the information contained in past prices. Such information includes historical sequence of price, rate of return, trading volume data as well as other market generated information (Arni and Wydick, 2016). Thus, analyzing past prices cannot help predict future prices and past information has no relationship with future prices. This implies that technical analysis cannot be successfully used in predicting future prices and hence does not lead to extraordinary profits. On the other hand, a semi strong-form efficient market is the one where current prices incorporate all publicly available information. Thus, the analysis of published financial statements does not result in excess profits. A market is strong form efficient when the current prices reflect all information whether public or private including insider information. Critical analysis of Efficient Market Hypothesis assumptions As stated above, the efficient market hypothesis makes a number of assumptions. First, EMH assumes that an efficient market is the one having many rational profit maximizing investors who are active market participants thus valuing the securities rationally. Secondly, where some investors fail to be rational, the irrational trades cancel out one another. Otherwise rational arbitrage eliminates such traders influence without having to affect prices. Lastly, there is no cost of information in the efficient market (Gupta, 2014). Information is also widely accessible to the participants at more or less the same time with investors reacting fast and wholly to such information resulting in prices adjusting accordingly. However, these assumptions while considered as necessary conditions for EMH may not necessarily hold for an efficient market owing to various factors. The EMH assumes markets to be efficient as far as information is concerned implying that since every individual has information available to them, then no one can exploit investment news for a profit. However, the issue of accessibility and availability are subject to discussion. This is because in theory, all the participants access information equally and at the same time while practically this may not be possible. This is because their different lifestyles lead to different time availability and information access methods. Thus, rapid movement of time events, the increasing number of investment methods and the globalized markets imply people are unable to catch up with changes. Though people receive information through different channels, they are unable to assimilate and elaborate on the available information in a similar manner. This implies that constantly changing information is an investing battle where there are winners and losers, losses and profits. It is also not necessarily true that information is available to the participants at the same time. This is because information is at times available to a few investors or speculators before being publicly available. Such investors or speculators may take full advantage of it. Thus, financial markets are at times informationally inefficient. EMH postulates that those investing in the market have rationality of behavior in their action and are concerned with expected utility outcomes and hence for profit maximization that is endorsed by their rational expectations. Thus, investors are painted as though they were well preserved machines. However, it is worth noting that this may not always be the case. If markets are efficient with investors acting rationally, it is unclear why investing bubbles regularly appear as well as long durations in the stock market. The .com bubble and the real estate market collapse fail to be expounded by the assumption of rationality of behavior. All these critical reflections on the assumptions of EMH show that the assumptions do not necessarily hold at all times and that the markets are not necessarily efficient as far as the various dimensions are concerned. In fact, research indicates that markets are efficient in the weak-from and the semi-strong form but failing to be efficient in the strong form. Behavioral Finance Introduction As stated above, the EMH fronted by Fama (1970) links investors’ behavior to rationality. However, Shiller (1980) contradicted this by stating that any explanation of investors’ behavior cannot be fully based on rationality and hence the role of psychology in investor behavior has to be acknowledged. Shiller (1980) demonstrated that stock prices tend to fluctuate more than corporate dividends which should not be the case if investors are fully rational given that stock prices forecast future dividends. His findings were confirmed by Hansen that swings in asset prices cannot be explained through standard models based on rationality. These findings are the basis of behavioral finance as explained in this essay. Behavioural finance Behavioural finance is defined as the examination of the influence that psychology has on financial investors behaviour and hence the consequent effect on markets. Thus, Behavioural finance is useful in explaining why and how markets are likely to be inefficient. Behavioural finance stems from the anomalies of the efficient market theory and it aims to show that market practitioners or investors are not always guided by rationality but sometimes they do act irrationally and hence markets are not always efficient (Mishkin, 2004). Such anomalies include January effect caused by the returns on securities in January being higher than the rest of the year owing to smaller capitalization stocks in early January. Behavioural finance makes use of psychology based theories in explaining stock market anomalies. Behavioural finance assumes that individual investment decisions as well as market outcomes are influenced by the information structure and characteristics of the market participants. Individuals investing behaviour is not always rational as postulated by EMH. Several studies indicate that individual biases and emotions cloud over investors’ rational thinking as well as decision making. Some of the cognitive and emotional biases as explained below include loss aversion, herding, media response and market timing. Such biases impact the overall performance of investors’ investments. Assumptions of Behavioural finance Behavioural finance is premised on a number of assumptions. It assumes that investors exhibit information processing biases in processing information which cause them to under or over-react. It also assumes that individual investors’ biases in information processing are correlated across investors so that they are not averaged out. Thirdly, behavioral finance assumes limited arbitrage implying that existence of rational investors is not enough to make markets efficient. These assumptions are analyzed below (Howden, 2009). Behavioral crisis proponents hold that markets can never be efficient. If indeed markets are efficient, there would be no financial crashes such the 1923 stock market crash or the recent global financial crisis. Such crashes could only have their explanations from investors’ emotions and not rationality which is all behavioural finance is concerned with. Thus, such phenomena could only have their solution in behavioral finance. Emotions and biases that cloud investors Psychologists cite overconfidence as influencing investor behavior by causing them to overrate their knowledge, overstress their capacity for controlling events and underestimate risks. This is a common trait for all investors. Another bias is representativeness in that when a company makes an announcement; some investors will correlate the announcement with historical announcements and hence make decisions based on historical announcement with no consideration that past announcement may have no bearing with the current one. Herding is another irrational mistake investors tend to make in this regard, investors fail to buy or sell stock even where the decision is backed by technical and fundamental analysis but they are pressurized by peer influence (Johansen, 2012). This means that investors are influenced by the judgment of others concerning their investment decision and hence the decisions they make fail to reflect own individuality. Anchoring is another psychological situation that occurs when investors give superfluous significance to statistically random as well as psychologically influenced anchors leading to investment decisions that are irrational. Another bias is cognitive dissonance which is the mental conflict experienced by people when confronted with evidence about their beliefs being wrong. Resulting from the conflict, investors ignore new information likely to contradict known decisions and beliefs hence reducing their capability of making rational as well as fair investment decisions. Another psychological inaccuracy that interferes with investors’ rationality is regret aversion which is excessively focusing on feelings of regret when making investment decisions. This is caused by the tendency by individuals not wanting to admit their mistakes. Thus, investors often avoid carrying out decisive actions as they fear making mistakes. Mental accounting also causes irrational behavior by investors. In this regard, individuals use a number of perceptive operations in organizing, evaluating and keeping financial activities records hence resulting in tendency for them to organize their money into different accounts based on a number of individual reasons (Rodrigo, 2011). Individuals will allocate differing functions to differing asset group leading to often negative and irrational effect on the individual’s consumption decisions as well as behaviour. Another bias is likely to result from hindsight or tendency by an investor to contemplate that they would have been aware of real events before their occurrence. Thus, the investor would take wrong decision. For instance if the investor incurs a loss on a certain stock, they pretend that they expected it and hence they fail to learn from their wrong decisions leading to more future failures. The availability bias also affects investor’s rationality. This implies that if an investor has recently incurred a colossal loss in an investment portfolio, then he would avoid investing in such an avenue in future. In other words, investors would have fear of the stock market where they recently have experienced a stock market crisis (Frankurter and McGoun, 2000). Finally, investor conservatism means that the investor makes decision based on past information though faced with new information. Thus, an investor would buy shares in a high profile company though its future prospects may be on the decline. Limited arbitrage As stated above, behavioural finance assumes arbitrage is limited. Economic incentives for arbitrageurs ought to exist in equilibrium and hence mispricing has to exist in equilibrium. As stated above, existence of rational investors is not sufficient for behavioural finance (Hagin, 1979). Despite there being arbitrageurs, inefficiencies may continue for extended times since arbitrage is expensive owing to trading costs, holding costs and information cost. Arbitrageurs are unable to eliminate limited arbitrage since arbitrage would call for assembling of information concerning the firm’s projections, noticing of mispriced stocks and trading in them till the mispricing is removed. It should be noted that analysts with the information usually lack capital for trading. Whiles firms have capital, they have to delegate decision making to those with information and agents who are compensated depending on the outcomes. It is to be noted that the principals limit the amount of capital available to agents. The limited capital on the other hand implies limited arbitrage. Unlike EMH, behavioural finance attempts to prove that investors will not always act in a rational manner owing to their psychological and cognitive errors described above as well as the limited arbitrage. Such factors are deemed important in the financial markets as they determine the kinds of decisions made by investors as well as the results of their actions. As stated by Clarke (2011), where the environment is uncertain and complex, biases and heuristics are effective and efficient aim for making decisions. This makes rational decision making impossible. According to BF, psychology plays a great role in making investment decisions and hence participants in the financial markets do not always exhibit rationality. Practical applications of both EMH and BF including the work of Messrs.’ Fama and Shiller As indicated above, the works of both Fama and Shiller to a large extent find their use in the way financial markets operates and in guiding investors’ behaviour as far as making investment decisions is concerned. Fama’s work suggests that markets are efficient with regard to information since investors instantly integrate any news in the price of a portfolio. The implication of EMH is therefore that published reports by financial analysts may not be very valuable to the investors. Investors ought to be skeptical of hot tips and they should also be aware of the fact that stock prices might fall on good news. Investors therefore should not try to outguess the market (Forbes, 2009). They ought to buy and hold while diversifying with no load mutual fund. The suggestions put forth by Fama in the efficient market hypothesis are still relevant to the participants of the financial markets even today in guiding their behavior especially as far as making their investments is concerned. On the other hand, the financial markets use the suggestions in ensuring efficiency of the markets. For instance, using the efficient market hypothesis in making an investment in the financial market, I would solely rely on publicly available information in deciding which portfolio to invest in. As Novickyte and Degutis (2014) found out in their research, markets world over are only weak and semi-strongly efficient. As such, future news would not be relevant in making an investment decision. Markets being informationally efficient, the investment decision would solely be based on publicly available information. Thus, in choosing to invest in HSBC, my decision would solely be based on the publicly available information including its annual reports and any published news that is currently publicly available. If the publicly available information paints a bad picture for the company, then I would not invest in the HSBC portfolio. In determining the amount of returns to expect from HSBC portfolio, one could make use of CAPM in coming up with the required rate of return which should guide the decision on whether to acquire it or not. In so doing, we make use of the publicly available information (Zack, 2012). Note that CAPM is preferred in this case owing to its similarity to EMH. CAPM assumes that capital markets are efficient. This means there are no transactional costs, free entry or exit, existence of many rational buyers and information is free and accessible. In this case, we assume a market beta of 1 and that of the investor to be 1.8. We also assume a current risk free rate of 7% and a market return of 15% for the portfolio. The required rate of return is calculated as follows; RRR= RF Rate+ (Market return- RF rate)* Beta RRR = 7%+ (15%-7%)*1.8 =21.4% Using the EMH as the basis of decision making, one would expect to get a return of at least 21.4% by investing on HSBC portfolio. Thus, if the investor thinks that the portfolio will not give such a return considering all the publicly available information, then he/she should consider not investing in the portfolio and going for an alternative investment. This is an example of how investors make their investment decisions on the basis of efficient markets hypothesis. However, it should be noted that in this case the investment made would not be based on other factors with the exception of the publicly available information. Behavioural finance puts into consideration investors rationality in making investment decisions. Investors are not robots and hence their emotions as well as illogical factors will influence their investment decisions. In the example of above concerning investing in HSBC shares, the investor would not rely on the publicly available information in making decision solely if he was to apply behavioural finance. Other factors as discussed above would also come into play. For instance, future prospects would be taken into consideration and hence if there is some intelligence that the company’s profitability would decline, then the investor would shun investing in the company (Koppel, 2014). An investor would also apply technical and fundamental analysis in deciding whether to invest in the company. Past experience with the stock or company would also come into play in making the investment decision. There are many examples that show how various investors practically apply behavioural finance in making investment decisions in real life. The Fuller and Thaler growth fund is an example of how behavioural finance is practically applied in making investment decisions. This is a fund that is aimed at locating assets that have been mispriced as a result of market under reaction. This growth fund is focused on companies found in mature industries as well as those having financial difficulties. The fund uses three steps in the companies’ evaluation. The fund first evaluates the companies through the use of quantitative methods. They then determine whether such a company’s earnings are temporary or permanent (Harder, 2013). Based on whether the company has surprise earnings increases, the fund applies behavioural analysis in establishing that the market is underreacting. Owing to the fact that the companies face financial difficulties or are in the mature industries, the market surfers from such biases as anchoring or overconfidence hence believing the earnings to be a fluke. Behavioural finance finds very many practical applications in today’s world owing to the fact that investors do apply their emotions in making investment decisions. However, it should be noted that EMH still forms the basis on which investment decisions are made before application of business finance. Whether the Nobel Prize Committee saw common features in the works of the academics The three academics Eugene Fama, Lars Peter Hansen and Robert Shiller according to the Nobel Peace Committee won the prize for dedicating their time in studying asset prizes and their movement hence helping explain how they are determined (Malkiel, 2011). However, their works are very different especially for Fama and Shiller whose works are directly opposite as has been evidenced in the discussions above. Fama is credited for the efficient market hypothesis which emphasized on investors rationality while on the other hand Shiller’s work on behavioural finance emphasizes on the role of psychology and inefficient markets in determining investors’ behaviour. Hansen’s work to a large extent revolved around high-tech econometric techniques which have found their use even beyond finance. However, all the three academics’ work have one thing in common in that they have all concerned themselves in understanding how asset prices can be predicted. In awarding them the prize, the committee stated that there lacks a way of predicting whether bond or stock’s prizes will either rise or decline during the coming few days or weeks (Miller, 2013). However, it would be possible to predict how their prizes will behave over a long period of time say in three or five years. Though the findings seem contradictory and surprising, the academics are the ones who came up with them and hence the reason why they were awarded. As stated above, the three academics seem contradictory to think they can be given the same prize. Mr. Fama is the father of the efficient markets hypothesis while Shiller has succeeded in contradicting it by pocking holes on its assertions. However, their contribution to the field of asset pricing gives them clear similarity in that they all work on how the value of financial assets differ over time including how they can be measured. Fama succeeded in showing that predicting how asset prices will behave in the short run is very difficult. He showed that market prices always react very fast to new information and that stock price movements are unpredictable and hence follows a random walk (nobelprize.org, 2013). On the other hand, Shiller showed that dividends vary less compared to stock prices hence making future stock price movements easily predictable. Fama showed that markets are efficient and that investors are guided b rationality while on the other hand, Shiller suggested that investors’ psychology and emotions have a role to play in investor behaviour and that markets are not necessarily efficient. However, despite their differences, the committee did award them the prize for working to show how the value of financial assets differs over time including how they could be measured. Based on their works, it would be fair to conclude that the Nobel Prize Committee saw commonality in the academics work in that they all came up with new methods of studying asset prices before using the methods in conducting detailed data investigations on the behaviour of prices of assets such as stocks and bonds as well as other assets (Katie, 2013). The result of their work therefore is methods that have found use as standard tools of academic research in finance. In addition, the insights of the academics have been useful in providing guidance for theory development and also for professional investment practice in the contemporary world. Though one may not fully comprehend the determination of asset prices determinants, the work of the academics definitely reveal some important regularities that helps in arriving at better explanations regarding asset prices. It is also worth noting that Fama’s work mainly deals with conditions that would make markets efficient. On the other word, Shiller’s work seems to dwell on situations that would limit market efficiency. Thus, it can be said that the two do not contradict one another but they reinforce each other. In conclusion, it could also be argued that in awarding the prize to the academics, the Nobel Committee saw similarity in their work in the way all their works has been relevant to market practitioners and academics. For instance, Shiller came up with the monthly case-Shiller housing indices which measures home prices across US thus helping investors’ measure investments in housing hence insuring them against fluctuations. On the other hand, Fama’s hypothesis that markets will immediately incorporate all viable information in stock prices has led into careful re-examining of the merits of stock picking as well as mutual funds’ performance. In addition, the fact that stock movements lack predictability has given rise to index funds which are aimed at replicating the movements of a specific market as opposed to second guessing where they are headed to. Thus, it is right to conclude that the Nobel Prize Committee saw common features in the works of the academics especially as far as their work on asset pricing is concerned. References: Fama, E1991, Efficient capital markets: II, The Journal of Finance, vol.46, no. 5, pp. 1575-1617. Fama, E1998, Market efficiency, long-term returns, and behavioural finance, Journal of Finance Economics, vol 49, pp. 283-306. Fama, E&, Kenneth, R2004, The capital asset pricing model: Theory and evidence, Journal of Economic Perspectives, vol. 18, no. 3, pp.25-46. Ryan, D2016, Can behavioural finance stop a financial crisis, Retrieved on 26th February 2016, from; http://www.thinkadvisor.com/2012/07/19/can-behavioral-finance-stop-a-financial-crisis Arni, M&, Wydick, B2016, How efficient are Africa’s emerging stock markets? Novickyte, L&, Degutis, A2014, The efficient market hypothesis: A critical review of literature and methodology, Ekonomika, vol. 93, no. 2, pp.1-17. 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