The stock market has gone many ups and downs that are not consistent with standard or modus operandi of stock market mechanism. The mechanism are by far has been governed by the theories postulated by economist and also financial practitioners. The underlying working were based on the Rational Hypothesis by John Muth and Efficient Market Hypothesis by Eugene Fama. Both these hypothesis are becoming to be proven 'inefficient' and 'irrational' when it is unable to concretely estimate the market conditions either using all available public information thus the sudden cumulative information onset triggering collapse of stock markets. It is obvious that high valuations seen in the aggregate markets and its P/E ratios were a precursor to a speculative bubble when much of its fundamentals were not supported, in the case of subprime crisis that impacted the Dow Jones by shedding 50% of its value. The negative fundamentals of risky borrowings, high possibility of default risk and real estate market bubble were information that were publicly available but was not taken into consideration due to irrational exuberance in investors who had herded into believing the rationality of other market investors. The market overall was deemed rational. A few like Professor Nouriel Roubini who were warned of eminent collapse was an exception to the rule of Efficient Market Hypothesis that proclaim that there will be few irrational inputs about the market.
The history of the stock market is complete anomalies that defies rational expectations thus the Great Crash of 1929, the Go-Go Years of the late 1960s, the bubble of the early 1970s, and the Black Monday crash of October 1987 and market crashes in Asian Financial Crisis 1997-1998. All these stock market anomalies refer to drastic level or change in stock prices that goes against the core of rationality and inefficiency. The standard finance model using the Efficient Market Hypothesis, where its tenet of unemotional investors always "force capital market prices to equal to the rational present value of expected future cash flows", has considerable difficulty in fitting these patterns of ups and downs. (Baker & Wurgler, 2006)
That in return creates so much volatility when discarded true economic realities are suddenly factored in causing a panic of realities thus a herding effect of mass pull out from the market. At this point an 'efficient' market created in part by a less-than-rational investor behavior and human judgment collapses, clearly showing investment objectives and factors influencing investment decision-making are different during heydays and downturns.
As a result the market expectation for continued returns on flawed fundamentals cannot be rational.
Having seen the situation of herding of investors, researchers in behavioral finance are endeavoring to understand flaws of standard models built on two assumptions:
Rational Expectation Hypothesis
This hypothesis by John Muth is a projection of kinds of expectations that is closest or best guess of the future earnings or optimal forecast. It uses all available information thus the outcome can never be too far off from the market balanced rest point or equilibrium. Thus the rational investor in the market is always promised of the most accurate information that gets reflected in the prices of the stocks and its overall market. In this near perfect view of assimilated information into the markets, there will be very minimal (random) systematic differences from informative projections thus the expectations are always rational.
However this model lacks the potency in evaluating the rationality behind mass movement of investors from certain markets that causes economic crisis such that of Asian Financial Crisis 1997-1998. The Singaporean and Malaysian economies were fundamentally sound as compared to Thailand which had a property bubble that was impacted the stock market. The rational theory does not make sufficient leeway to include a festering fundamental flaw but rather exaggerates the irrational exuberance seen in the Asian region for funds exiting flow.
Though the theory of rational expectations says that the actual price will only deviate from the expectation if there is an 'information shock' caused by information unforeseeable at the time expectations were formed it rather defeats the rational purpose when it is inefficient in assimilating all information ensuring a valid equilibrium rather a forced one.
Efficient Market Hypothesis (EMH)
The most used version of the efficient-market hypothesis was created and condensed by Eugene Fama who states investors (arbitrageurs) are correct when pertinent economic or financial information surfaces giving them an immediate update of their expectations of returns. The EMH has exit clause that give investor's rationality a lesser concern when it allows a portion of investors to overreact or underreact. All that is required by the EMH is that investors' reactions can be random but adheres to a normal distribution pattern or curve bell so that the net effect (long tails or over reactors and under reactors) on market prices cannot be reliably exploited to make an abnormal profit. It therefore stipulates that any one investor can be wrong about the market but the market as a whole is always right. . In other words the EMH does not assume that all investors are rational, but it does assume that markets are rational. However these markets have been proven very wrong when severe corrections are seen during market crashes. This where the efficiency prior to crashes are questionable.
At this juncture the rationality of many investors that represent the markets are unable to defend the position thus take flight against what they have previously believed to be true. This cascades into a herding effect when market movers are believed to be right.
In addition to the information provided above it has to noted that the EMH has three common forms in which the efficient-market hypothesis is commonly stated-weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which has different implications for how markets work.
Behavioural Finance
Since the early 1900's usual and current academic finance theories focused on such theories as modern portfolio theory and the efficient market hypothesis, however the shadow field now has become an emerging field into behavioral finance investigates the psychological and sociological issues that explores the decision-making process of individuals, groups, and organizations.
Behavioral finance is making inroads to understand the reasoning patterns of investors, including the emotional processes involved and the degree to which they influence the decision-making process.(Ricciardi & Simon, 2000)
Current markets as dictated by behavioral finance attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. Many believe that the forces behind EMH has created 'chronic underestimation of the dangers of asset bubble bursting' thus the need to better understand financial behavior.
Herding
Malcolm Baker an Associate Professor of Finance, Harvard Business School aptly said "Behavioural finance builds on the two broader and more irrefutable assumptions-sentiment and the limits to arbitrage-to explain which stocks are likely to be most affected by sentiment. In particular, stocks of low capitalization, younger, unprofitable, high volatility, non-dividend paying, growth companies, or stocks of firms in financial distress, are likely to be disproportionately sensitive to broad waves of investor sentiment". At many times a gambling scenarios ensues as seen in investments for speculative stocks like that of techonology and syndicate driven profiteering in Kuala Lumpur Stock Exchange.
The financial world as mentioned by Avanidhar Subramanyam in his Behavioural Finance: A review and Synthesis is in constant assessment using the following central paradigms:
(i) portfolio allocation based on expected return and risk,
(ii) risk-based asset pricing models such as the CAPM and other similar frameworks,
(iii) the pricing of contingent claims, and
(iv) the Miller-Modigliani theorem and its augmentation by the theory of agency
However due to the nature of herding which arises when investors imitate observed decisions and movements of the market as true indicators on a biased perception. The believes may not lead to efficient market environment. Key assumption in understanding investor's market behavioural are their subject to sentiment, a belief about future cash flows and the second assumption there are limits to arbitrage.
A good example is the extraordinary investor sentiment that boosted prices that is difficult-to-value technology stocks to speculative levels in the late 1990s as prices that were merely high went higher still before an eventual crash (Investor Sentiment in the Stock Market
Malcolm Baker and Jeffrey Wurgler)
In addition, a well postulated theory that has helped understand investors behaviour is the Prospect Theory by Daniel Kahneman and Amos Tversky in 1979. This theory as compared to the utility theory which is undeniably sensible representations of basic requirements of rationality has pointed the raw realities of human behaviour that cannot be discounted. The prospect theory holds that there are persistent biases motivated by psychological factors that influence people's choices under conditions of uncertainty (Ricciardi & Simon 2005).
To illustrate, consider an investment selection between
Option 1: A sure profit (gain) of $ 5,000 or
Option 2: An 80% possibility of gaining $7,000, with
a 20 percent chance of receiving nothing ($ 0).
Question: Which option would give you the best chance to maximize your profits?
Most people (investors) select the first option, which is essentially is a "sure gain or bet." Two theorists of prospect theory, Daniel Kahneman and Amos Tversky (1979), found that most people become risk averse when confronted with the expectation of a financial
gain. Therefore, investors choose Option 1 which is a sure gain of $5,000. Essentially, this appears to be the rational choice if you believe there is a high probability of loss. However, this is in fact the less attractive selection. If investors selected Option 2, their
overall performance on a cumulative basis would be a superior choice because there is a greater payoff of $5,600. On an investment (portfolio) approach, the result would be calculated by: ($7,000 x 80%) + (0 +20%) = $5,600.
A simplified reasoning for such behavioural patterns are rooted in biases derived from mentality as discussed under cognitive biases. People or in this case investors behave in patterns that are discernible to cognitive psychologists. Some of these patterns are as follows:
Heuristics
Heuristics refers to experience-based techniques that results from problem solving, learning, and discovery. Using this a rules of thumb investors have decision-making easier. However biases can play a negative input role when situations change and there are no clear reference points thus
suboptimal investment choices..
Overconfidence
Investors can be overconfident about their abilities to make the most from the market. Some call it beating market. Entrepreneurs are especially likely to be overconfident. Thus the manifestation is seen in little diversification in portfolios that they are most familiar or used to. Another case is with employees of company overly confident in the returns of the company shares thus singular investments of dunds into it.
Mental Accounting
People sometimes separate decisions that should, in principle, be combined. The perplexing nature of having budgets for eating at home (cheap fish n chips) and a restaurant (lobster n shrimp), when expensive food is often ordered outside and cheaper meals for home. But the situation reversed, same meals can be enjoyed at cheaper rates at home. Because they attached a condition precedence they limited the food choice at home. The same applies for buying expensive stocks thinking dollar returns will be greater of the fact over total percentile by investors.
Framing
Framing or suggestive induced reactions leads investors to believe to gain better value in instances of early bird or packaged. In the realm of investing, herding mentality mere suggestive remarks makes upsurge in purchase although the percentile earning is same. Once a suggestive indicators is floated in cases of superior stocks buying is swayed not because of fundamentals but rather notional value.
Representativeness
Investors have tendencies to under play long-term averages. Due to the law of small numbers investors perception is swayed into believing that recent experiences like that of Malaysian bull rally from 1993 to 1996 begin to believe that high equity returns are "normal" thus the ineffective risk scoping
Conservatism
When things change, people tend to underreact to changes and chaotic reaction ensues. Conservatism bias is a total opposite of representativeness bias. However react towards long enough patterns investors will adjust to it and possibly overreact, underweighting the long-term average.
Disposition effect
The disposition effect is a pattern when investors are impacted by sudden losses tend to keep the said investment until it regains its full value. The EMH concept does not apply here when all publically available information is not manifested in the so called portfolio thus a greater propensity not to exercise best available profit opportunity and letting go under panic when market tipping point creates heavy losses.
Human nature is utility driven and fear of losing out forces markets to be manipulated and unsound fundamentals to be followed. The issues of rationality is relative in terms perceived biases.
CONCLUSION
Due to the nature of human character that is flawed by biases that pursues utility maximization in investments, it does not necessarily generate an outcome of market rationality as declared in the Efficient Market Hypothesis by Professor Eugene Fama. The episodes of sudden and violent movements within the financial markets especially the stock market augurs well for the flaws of investors whom have countered the fundamentals of the rational market setting.
The Asian Financial Crisis of 1997-1998, the Tech Bubble in early 2000 and the Subprime Crisis of 2007-2008 that triggered the severe recession not seen since the Great Depression all pinpoint to a collective act of herding by investors that were assumed to be dictated by a rationale market.
Fear had its role against the markets and rationale markets if they true as predicted must be a vehicle of continuous prosperity that quickly corrects itself by including negative but true data in an incremental basis thus continuous correction. This gives the option of true valuation of stock market and its members and avoids the pitfalls of sudden movements of shock or surprises of disregarded information deemed true. Speculative nature of market players clearly show irrational exuberance of players that is reflective of greed or utility maximization at the expense of the uninformed and cascading into a herding scenario that pushes markets in bull or bear territory.
