Efficient Market Hypothesis and Market Behaviour - Essay Example

Efficient Market Hypothesis and Market Behaviour Introduction The financial market is usually affected by a number of factors. One main factor that impacts decisions made by investors relates to the availability of information regarding certain businesses or securities. Occasionally, due to the availability of certain information, investors will act as if directed in one way or another. The decision to act this way may end up being wrong or right for all investors. “When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical” (Warren 1984, p17). This statement was made by Warren Buffett in reference to security prices and how they cannot be determined by individuals. To Buffett, market prices often do not make sense, and therefore he argues that financial experts should not dwell on the stocks themselves, but on stock pickers and investors who frequently determine market indices. However, the Efficient Market Hypothesis offers a totally contrasting view to the issue of market indices. The Efficient Market Hypothesis is a financial theory that affirms that it is not possible to ‘beat the market’ since financial markets are believed to be infomationally efficient. In other words, the theory asserts that efficiency in the stock market normally leads to a clear reflection of relevant information on the existing share prices. According to the EMH theory, stocks will normally trade at their fair value on the market, which would make it impossible for traders to buy undervalued stocks or sell them at inflated prices. As such, it would not be possible to do better than the overall market through market timing or even professional stock selection. If an investor wants to obtain higher returns he would have to purchase riskier investments. Believers of the efficient market hypothesis argue that there is no need to look for undervalued stocks or try and predict trends in the stock market through technical or fundamental analysis. Tenets of Efficient Market Hypothesis EMH was a financial theory developed by Eugene Fama in the 1960s. In his 1965 paper, Fama noted that “on the average, competition will cause the full effects of new information on intrinsic values to be reflected instantaneously in actual prices” (Fama 1970, p386) According to the efficient market hypothesis, when one buys and sells securities, they are not using skill, rather, they are “engaging in a game of chance”. EMH was widely accepted until behavioural finances became mainstream in the 1990s according to Hebner (2007). There are different aspects of what should constitute an efficient market and it all depends on the kind of information that is available (Desai 2011). These aspects are grouped into the three forms of the efficient market hypothesis: the weak form, the semi-strong form and the strong form (Fama 1970). The Forms of Efficient Markets The weak form of EMH asserts that historical market prices and data or information are reflected fully in securities prices (Fama 1970). This implies that technical analysis is not useful at all. Analyzing prices from the past according to this form cannot be used to predict future prices. This means that investment strategies that are based on past share prices and data cannot be used to earn excess returns in the long run (Jung and Shiller 2005). What this implies is that if stock prices are random, then it is not possible to use past prices to foretell future ones. In the weak form of efficient markets, information arrives randomly, thereby making stock price changes to occur randomly. Most financial research supports the view that financial markets are weak. The semi-strong form of efficient markets asserts that securities prices reflect any publicly available information as well as future expectations (Fama 1970). If this is the case, then fundamental analysis of the markets is of no use at all. The semi-strong form of efficient markets implies that prices change very fast to any new information. It also suggests that superior returns cannot be earned through the use of old information. Although evidence is somehow mixed, most financial research supports that idea that markets are semi-strong. According to the strong form concept, securities prices incorporate and dully reflect all information (Fama 1970). Insider information, and knowledge of material cannot be used to earn superior returns. Most financial research does not support this concept of strong markets since there is evidence showing that markets are not efficient up to this level. For example, there are many instances where insider traders have made a lot of money. The Theoretical Role and Motivation of Analysts in Creating Market Efficiency  The implications of the EMH are far reaching. Most people who trade securities, especially stocks, do so while assuming that what they are buying is worth more than what they are paying, while at the same time, what they are selling is worth less than the securities’ selling price (Desai 2011). In the efficient market, competition among intelligent traders leads to a situation in which securities prices incorporate and reflect the impact of information based on past events and those expected in the future. This is to say that the real price of a security is bound to be a vital estimate of its intrinsic value. This implies that the more traders there are, the faster information is likely to be disseminated and the more efficient the market is expected to be. The inconsistency of efficient markets is based on the fact that if all traders believed in the efficiency f a market, then it would mean that the market is not efficient since nobody would analyze securitie prices (Desai 2011). To this effect, efficient markets must depend on market traders and participants who hold the belief that the market is inefficient and they trade securities as they try to outperform the market. Herd behaviour and emotional behaviour Herding or herd behaviour basically describes the way individuals that form a group can in unison act without having pre-planned directions. More broadly, the behaviour is often seen in animal herds, schools, flocks as well as in human behaviour. In the financial markets, the herd behaviour is often seen especially during stock market bubbles or when the stock market experiences a crash. Major stock market trends usually start and end with times of frenzied buying and selling. Many financial analysts compare such episodes to that of natural animals especially considering that they are characterized by irrational behaviour and emotion. Emotion in this respect comes to the fore as greed comes to play during economic bubbles while fear plays its best when the market is on a downward trend and on the verge of collapsing. As such, individual investors often tend to join the larger crowd in joining or withdrawing from the market. The most emotional person in the event of a bubble is the one who takes greatest risk (greatest greed) while in the event of a crash, the most emotional person is the most fearful. Some analysts have noted that the herd behaviour often results from the existence of information from private quarters that is not shared publicly. Other experts have noted that uninformed traders in a financial market can end up with certain specific information through the price in so far as the information is efficiently and rightly aggregated. On the whole, while the herd behaviour is rarely ever experienced, its consequences on real markets such as forex and stock markets can be far reaching. Bikhchandani and Sharma (2001) note that the herd behaviour heightens market volatility and fragility, and makes unstable the market. A number of reasons have been credited for the herding of investors. Investors for one may herd if they are knowledgeable of the returns that come with a certain investment, their actions attesting to this. Secondly money managers may imitate their counterparts if the incentives they receive are greater when they herd. Thirdly, individuals may simply have the preference to conform to what the others are doing. It is not always the case that herding becomes profitable. In fact, in some cases, investors may herd on decisions to invest that have adverse effects on all of their securities. Alternative Perspectives on the Pricing of Securities Behavioural Finance Theories provide an alternative method of pricing securities. According to the theories, psychology based theories as well as economic based theories together play a role in explaining the anomalous behaviour of stock markets. Theorists of behavioural finance claim that information structure and market participants’ characteristics influence the decisions of individual investors and the outcomes of the markets. While proponents of the efficient market theory claim that the arbitrage process affects market prices when new information relevant to an organization’s value is known by some investors, behaviourists propose that irrational behaviour is commonplace and not anomalous. For example, behaviourists see it that individuals tend to see the possibility of recovering a loss as vital compared to the possibility of gaining more in the markets. Behavioural theorists also note that investors tend to peg their decisions on small data samples or single sources of information. Conclusion An efficient market is seen as a market whereby there are many rational, actively competing profit-maximizers, with every one of them trying to predict securities values for the future market, and where all participants have free access to important and current information. While financial research mainly supports the Efficient Markets Hypothesis, there is an equal amount of dissension that exists. For instance, investors, like Warren Buffett have time and again beaten the market, something that is considered impossible by the tenets of the EMH. An efficient market means that all securities traded in the market are valued correctly based on the available information. There is ample evidence showing that efficient markets hypothesis is a very good indicator of how markets operate most of the time. The behaviour theory suggests that irrational behaviour is not uncommon even in the financial market. Individual investors make decisions not only based on economic principles but also psychological factors. As such herding in the securities market will most likely be experienced when individual investors react to what they think is reasonable for them at a particular time sometimes irrespective of the current market price. Bothe the behaviour and efficient market theories value the availability of information and information structures in predicting how the market will behave. In many cases the price remains irrational when the herd behavior occurs. Reference List Bikhchandani S. & Sharma S., 2001, Herd Behavior in Financial Markets. IMF Staff Papers Vol. 47, No. 3 pp279-310 Desai, S. (2011). Efficient Market Hypothesis. Accessed 28 November, 2011: http://www.indexingblog.com/2011/03/27/efficient-market-hypothesis/&type=dns&ISN=94774104CB44421BA96B91EAAA58A2B3&ccv=137&cnid=937811&cco=US&ct=3&sc=804b001e Fama, E. 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work". Journal of Finance, 25 (2): 383–417 Hebner, M.T. 2007. Index Funds: The 12-Step Program for Active Investors. London: IFA Publishing Jung, J. and Shiller, R. 2005. "Samuelsons Dictum and The Stock Market". Economic Inquiry, 43 (2): 221–228 Warren E. Buffet, (1984) The Super Investors of Graham-and Dodsville, transcript of a talk given at Columbia University in 1984”.  Columbia Business School Magazine. available at: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Superinvestors%20of%20Graham%20and%20Doddsville%20-%20Hermes.pdf Read More