This essay analyses the Efficient Market Hypothesis and the theory of behavioral finance and if the latter may replace the former in due course of time. Relevant theories in connection with the above are also discussed. Efficient Market Hypothesis is an investment principle which states that it is nearly impossible to beat the stock market as the stock market efficiency causes all the stock and share prices to include all the very relevant current and up-to-date market information. This leads to stocks being traded at their fair value and no one gets an opportunity to predict the future based on earlier trends. Behavioral Finance uses the concept of psychology to explain assets valuation and gives reasons why the prices rise and fall. This essay discusses a bit in detail about the EMH: whether it provides valid explanation for price behavior in the financial markets and also if the behavioral finance theory can replace EMH in explaining market dynamics.
Arbitrage Pricing Theory (APT)
Stephen Ross developed the arbitrage pricing theory (APT) in 1976. Like the CAPM, the APT predicts a Security Market Line linking expected returns to risk, but the path it takes to its SML is quite different. Ross's APT realize on three key propositions:
Securities returns can be described by a factor mode.
There are sufficient securities diversify away idiosyncratic risk, and
Well-functioning security markets do not allow for the persistence arbitrager opportunities.
An arbitrage opportunity arises when investor can earn riskless profits without making net investment. A tribal example an arbitrage opportunity would arises if shares of stock sold of different prices two different exchanges. For example, Suppose ACC is sold for INR 360 in national stock exchange (NSE) but only INR 340 in Mumbai stock exchange (BSE) on 25th FEB 2010. Then you can buy shares in BSE and simultaneously sell them in NSE, clearing a riskless profit of INR 20 per share without tying up any of your capital. The Law of One Price states that if two assets are equivalent in all economically relevant respects they should have same market price. The Law of One Price is enforced by arbitrageurs: if they observe a violation of law, they will engage in arbitrate activity- simultaneously buying assets were it is cheap and selling were it is expensive. In process, they will bid up the price were it is low and force it down where it is high until arbitrage opportunity is eliminated.
The idea that market prices will move to rule out arbitrage opportunities is perhaps is most fundamental concepts in capital market theory. Violation this restriction would indicates the grossest form of market irrationality.
The critical property of a risk-free arbitrage portfolio is that any investor, regardless of risk aversion or wealth, wants to take an infinite position to take. Because those large position is quickly force price's up or down until the opportunity vanishes the security prices should satisfy a "no-arbitrage condition," that is, a condition that rules out the existence of arbitrage opportunities.
There is important difference between arbitrage and risk-return dominance arguments in support of equilibrium price relationships. The dominance holds that when an equilibrium price relationship is violated, many investors will make limited portfolio changes, depending on their degree of risk aversion. Aggregation of these limited portfolio changes is required to create a large volume of buying and selling, which in turn restores equilibrium prices. By contrast when arbitrate exists each investor wants to take position as possible:, hence it will not take many investors to bring about the price pressures necessary to equilibrium. Therefore implication for prices derived from no-arbitrage is stronger than implications derived from a risk return dominance.
The CAPM is an example of dominance argument implying all investors hold mean; variance efficient portfolio. If a security is mispriced then investors will tilt there portfolio toward underpriced away from the overpriced securities. Pressure on equilibrium prices results from many investors shifting their portfolios, each buy a relatively small dollar amount. The assumption that the large number of investors are mean-variance sensitive is critical. In contrast, the implication of a no-arbitrage condition is that a few investors who identify an arbitrage opportunity will mobilize large dollar amounts and quickly restore equilibrium.
Stock Prices and the Random Walk Theory
Stock Prices are determined by a number of factors such as fundamental factors, technical factors and psychological factors.
Fundamental Factors
This evaluates the intrinsic value of the securities by studying the fundamental factors affecting the economy.
Technical Factors
This believes that past behavior of stock prices gives an indication of future behavior. It also believes that stock price movement is quite orderly and not random.
Psychological factors
The new theory which questions this assumption is the random walk theory which states that stock movements as a random walk rather than an orderly movement.
Random Walk Theory
It states that a change occurs in the price of a stock only when there has been a considerable change in the economy or the company itself or in any other factor which can influence its price. Unless and until a new piece of information about such a change comes in, the stock prices are unchanged and whenever such information about changes spreads out to everywhere, it is immediately reflected in the stock prices as it immediately goes up or down depending on what actually happened in the market. So the random walk theory suggests that the stock markets now-a-days are so sufficient enough to incorporate all possible information as and when it comes in, so it is efficient. This theory later came to be known as the Efficient Market Hypothesis (EMH) or the Efficient Market Model.
Efficient Market Hypothesis
This hypothesis states that the capital market is efficient in processing information. The Efficient Capital Market is one in which security prices = their intrinsic values at all times, and where most security prices are correctly priced. When someone refers to Efficient Markets, they mean that the security prices fully reflect all available information. (Elton, 1994) The prices of securities observed at any time are based on correct evaluation of all available information available at that time.
The speed at which the information is absorbed by the securities is also relevant according to the EMH. The technicians believe that the past price sequence contains information about how the security has been and so this help the trader to anticipate the future trends of the prices and trade accordingly and effectively. The fundamentalists believe that it may take several days of weeks before the assessed information is absorbed by the security and that this creates a volatile period for the price of the securities. This provides the analyst to extract better returns from that share. But the EMH belives that the information which comes in are readily incorporated into the share prices so that the investor cannot earn excess money by fundamental or technical analysis.
Forms of Market Efficieny
The capital Market is efficient in three forms, each dealing with a different type of information. This was introduced by Eugene Fama in 1970.
The Weak form (deals with past sequence of price movements)
It is pointless basing trading rules on share price history as share prices cannot be decided this way.
Semi-strong form (deals with publicly available information)
It is pointless analysig publicly available information after it has been released, because the market as already absorbed it.
Strong form (deals with all information, public or private)
This says that people at the top managerial level cannot also make abnormal profits from shares because they know more information before the public knows about it.
The Dow theory was developed by Charles Dow who is also the co-founder of the Wall Street Journal. According to this theory the stock market is charecterised by three trends.
Primary Trend - Long standing move in share prices
Intermediate trend - runs for weeks or months before being overtuned by intermediates in different direction. If there is an intermediate trend in a adirection opposite to the primary trend, then it is called Secondary reversal.
Tertiary trend - last for a few days and acer very important. (Arnold, 2008)
Implications of EMH for investors
No single investor can utilise existing or old data to bring about returns from the share market as the information has already been absorbed by the shares and nothing can be changed till another piece of relevant information flies in. Fundamental analysis is a waste of money and that so long as efficiency is maintained, the average investor should only select a portfolio thereby avoiding costs of analysis and transaction.
Investors need to press for a greater volume of timely information
The perception of a fair game market could XXXXXXXXXXXX
Another trend as far as the investors are concerned are their trials to trade through share brokers. These brokers never provide accurate information that comes in and out, but only assists the investor in purchasing it at a low price. (LEE C Shleifer A., 1990)
The notion of efficient market depends of the precise definition of information. (COPELAND, 2005) It is pertinent to note that the capital market is efficient relative to a given information set only after consideration of the costs of acquiring messages and taking actions pursuant to a particular information structure. Cornell and Roll (1981) says that a sensible market structure leaves provision for analysts to work on. They had this feeling that possession of information was a costly activity. It is always reasonable to have efficient markets where people earn different gross rates of return since they pay varied costs for accessing varied sources of information. Professional fund managers are experts in managing portfolios but their gains are not sufficient enough to contain their costs of managing the respective portfolios.
Are Markets Efficient?
The issues
EMH implies that mostof the activities of the portfolio Managers are wasted effort and probably harmful to the clients because it costs money and leads to imperfectly diversified portfolios.
The Magnitude Issue
Market Efficiency and Behavioral Finance
One of the early applications of computers in economics in the 1950's was to analyze economic time series. Business cycle theorists felt that tracing the evolution of several economic variables over time would clarify and predict the progress of the economy through boom and bust periods. A natural candidate for analysis was the behavior of stock market prices over time. Assuming that stock prices reflect the prospects of the firm, recurrent patterns of peaks and troughs in economic performance ought to show up in those prices.
Maurice Kendall examined this proposition in 1953. He found to this great surprise that he could identify no predictable patterns in stock prices. Prices seemed to evolve randomly. They were as likely to go up as they were to go down on any particular day, regardless of past performance. The data provided no way to predict price movements. At first blush, Kendall's results were disturbing to some financial economists. They seemed to imply that the stock market is dominated by erratic market psychology, or 'animal spirits' - that it follows no logical rules. In short, the results appeared to confirm the irrationality of the market. On further reflection, however, economists came to reverse their interpretation of Kendall's study.
More generally, one might say that any information that could be used to predict stock performance should already be reflected in stock prices. As soon as there is any information indicating that a stock is underpriced and therefore offers a profit opportunity, investors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates of return can be expected. These ordinary rates are simply rates of return commensurate with the risk of the stock.
However, if prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease only in response to new information. New information, by definition, must be unpredictable; if it could be predicted, then the prediction would be part of today's information. Thus stock prices that change in response to new (unpredictable) information also must move unpredictably. This is the essence of the argument that stock prices should follow a 'random walk', that is, that price changes should be random and unpredictable. Therefore, the notion that stocks already reflect all available information is referred to as the 'efficient market hypotheses'.
A Behavioral Interpretation
The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference. A growing number of economists have come to interpret the anomalies literature as consistent with several 'irrationalities' individuals exhibit when making complicated decisions. This leg of argument is important when we interpret tests of market efficiency. Virtually everyone agrees that if prices are right (i.e. Price=intrinsic value), then there are no easy profit opportunities. But the reverse is not necessarily true. If behaviorists are correct about limits to arbitrages activity, then the absence of profit opportunities does not necessarily imply that markets are efficient. Most tests of the EMH have focused on the existence of profit opportunities, often as reflected in the performance of money managers. But their failure to perform well need not imply that markets are in fact efficient. Even if information processing were perfect, individuals might make less-than-fully rational decisions of risk versus return and therefore make risk- return trade-offs.
Evaluating the Behavioral Critique
The efficient market hypothesis implies that price usually "are right "and therefore there are no easy profit opportunities. Behaviorists emphasize that these two implications (correct prices and no profit opportunities) can be severed: prices can be wrong, but still not give rise to easy profit opportunities. Thus evidence that profit opportunities are scare does not necessarily imply that prices are right.
As investors, we are concerned with the existence of profit opportunities. The behavioral explanations of efficient market anomalies do not give guidance as to how to exploit any irrationality. For investor, question is still whether there is money to be made from miss pricing, and the behavioral literature is largely silent on this point.
However one of the important implications of the EMH is that security prices severe as reliable guides to the allocation of real capital. If prices are distorted, then capital market will give miss leading signal as to where the resources are best allocator. In this important sense, the behavioral critique of the EMH is potentially important. There is considerable debate among financial economist concerning the strength of the behavioral critique. Many believe that the behavioral approach is too unstructured, and effect allowing virtually any anomaly to be explained by some combination of irrationality chosen from a laundry list of behavioral biases.
More fundamentally, others are convinced that the anomalies literature as a whole is a convincing indictment of the EMH. Fama reviews the anomalies literature and mounts a counterchallenge to the behavioral school. He argues that anomalies are inconsistent in terms of their support for one type of irrationality versus another. For example, many papers document long term corrections while many other document long-term continuations of abnormal returns. Moreover the statistical significance results is less than meets the eye. Even small errors in choosing a benchmark against which to compare return can cumulate to large apparent abnormalities when applied to long term returns. Therefore many of these results in these studies are sensitive to small benchmarking errors, and Fama finds that seemingly minor changes in methodology can have big impacts on conclusions.
Conclusion
Behavioral finance is still in its infancy. Its critique of full rationality in investor decision making is well-taken, but the extent to which limited rationality affects assets pricing is controversial. It is probably still too early to pass judgment on the behavioral approach, specifically which behavioral models will 'stick' and becomes part of the standard tool kit of financial analysts.
It is conclude that markets are very efficient, but that rewards to the especially diligent, intelligent, or creative may in fact to be waiting.
