Efficient market hypothesis (EMH), first promulgated by Eugene F. Fama (1970), suggests that financial markets price assets precisely at their intrinsic worth given all publicly available information. Though several empirical works strongly confirm market efficiency, some of the hypotheses do not agree with the efficient market hypothesis, such as behavior finance hypothesis. This essay will discuss the assumption of efficient market hypothesis and implications when these assumptions do not hold. This essay also discusses the differences between neoclassical finance and behavior finance.
Efficient market hypothesis states that if one or more of the following assumption holds, the market will be efficient. It first assumes that investors act rationality. It means that everyone in the stock market will adjust their expectation on the stock price in a rational way after new information announced. EMH also assumes that some investors are independently deviate from rationality meaning they are over optimistic and some of them are over pessimistic over the stock price. As their actions are random, these will neutralize the effect on stock price caused by any irrational investment decision.
The last assumption is that investors will scramble for any arbitrage chance which means “buy low sell high”. When a piece of information is announced, all investors will adjust the expected stock price at the same level and immediately buy the “underpriced” stock or sell the “overpriced stock” to maximize their earnings. Although there are some irrational investors, the arbitrage mechanism helps driving out any mispricing caused by any irrational actions. However, in my opinion, these assumptions are not realistic and may not always hold in the real world.
Some research shows that these assumptions are not correct and are not always hold in the real world. According to F. Black (1986), some investors may not act as rational as EMH assumes. They may buy a particular stock only because of “noise” instead of a piece of particular new information announced. Noise in the article means a large amount of small events adding up together. Kahneman and Riepe (1998) also suggest that investors do not act as rational as EMH assumes which implies maximizing their wealth.
Some investors may use a reference point to measure whether they are gain or not. Their decision will change because they may use a different reference point case by case. The assumption of some investor deviates from rationality which can offsetting all irrationalities does not hold as most of the investors would behave similarly in most of the time is not realistic. The prospect theory suggested by Kahneman, Daniel, and Amos Tversky (1979) shows that people do not acting and make decision randomly, but acting in a particular direction or behavior approach.
Shiller (1984) confirms Tversky’s findings and suggests that when the irrational investor’s behavior is being socialized or everybody hears the same rumor, the above phenomenon will be more obvious. When most investors are in the same line, it seems impossible to have their irrationalities fully offset by the remaining minority. Although EMH suggests when investor faced serial times of failure, they will learn from it and adjusted their expected stock price to what EMH predicts.
It was criticized by Mullainathan and Thaler (2000) saying that the opportunity cost associated with the learning may be too high for those investors to adjust their mind. These findings imply that the market cannot neutralize the effect on stock price which caused by any irrational actions leading mispricing of stocks. The above criticize on assumption implies that the market may not as efficient as EMH predicts and creates financial bubbles and crashes. Financial bubble appears when a specific industry’s market prices do really well, so well that prices seem to rise higher than the EMH dictates.
Jeremy Grantham (2009) has stated flatly that the EMH is responsible for the financial crisis in 2008, claiming that belief in the hypothesis caused financial leaders to have a chronic underestimation of the dangers of asset bubbles breaking which caused the financial crisis. Other than that, in my own observation, investors may not act as rational as EMH assumes. In 2009, the stock price of Hong Kong and Shanghai Bank Corporation drops from $150 in 2007 to $38. This shows that the investors were over pessimistic or over react when there was bad information.
This implies that investors are not always making investment decision rationally. Therefore, EMH cannot fully predict the true value of a stock meaning the market is not fully efficient. As there are some market phenomenon cannot predict or explain by EMH. Therefore, behavior finance emerges to explain the market phenomenons that are not matched with which neoclassical finance predicts. Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effects on markets.
Behavioral finance is of interest because it helps to explain why and how markets might be inefficient. Behavioral finance first assumes that investors are not rational, which is different from EMH assuming that investors are rational. The two other foundations of behavioral finance are cognitive psychology and the limits to arbitrage. Cognitive refers to how people think and the limit to arbitrage when market is inefficient. Behavioral predicts investor behavior likely affects what happens in markets but EMH implies all information available will reflect in the stock price.
Comparing their conformity in terms of real life practice, behavioral finance is better to predict or explain market phenomenon. This is because behavioral finance makes use of human psychology to predict how they make their investment decision. Using this way is more realistic to explain market phenomenon. Using the January effect suggested by Sidney B. Wachtel (1942) as an example, it is a calendar-related anomaly in the financial market where stock prices increase in the month of January.
This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases. This type of pattern in price behavior on the financial market supports the fact that financial markets are not fully efficient. Behavioral finance explain that individual investors, who are income tax-sensitive and who disproportionately hold small stocks, sell stocks for tax reasons at year end and reinvest after the first of the year. This shows that behavioral finance is more realistic as it make use of human psychology to explain the market phenomenon.
To conclude, EMH is supported by analysis and theories while behavioral finance is supported by statistics, psychological biases and illustrations. As mentioned in the essay any one of the three conditions satisfied is sufficient cause market efficiency. Therefore, whether behavioral finance or efficient market hypothesis is better in conforming the real life practice is still an open discussion between theoretical arguments and empirical evidence concerning efficient markets.
