Efficient Market Hypothesis vs. Behavioural Finance PDF

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EFB201 – Financial Markets Assessment 2: Essay

Efficient Market Hypothesis vs. Behavioural Finance

1.0 Introduction For many years now the financial world has been split into two key forms of fund management, with passively and actively managed funds becoming increasingly opposed. A passively managed fund is one that assumes the market is efficient in respect to all available information at the present time and can simply follow a market index and attempt to replicate it’s returns. Alternatively, an actively managed fund allows those controlling it to personally choose when to buy and sell equity giving the fund potential for abnormal returns if the market is not in fact efficient. Since the 1970’s, funds have shifted from being actively managed to passively (see Figure 1) due Eugene Fama’s publication about Efficient Market Hypothesis (EMH) which implies that ‘market price reflects all available information’. Since its origin, many have found both benefits and limitations to EMH which has resulted in opposing arguments, particularly within the theory of Behavioural Finance. This essay will evaluate the opposing ideas within Efficient Market Hypothesis and Behavioural Finance and how they relate to the management of a fund. Figure 1: Total assets in active and passive MFs and ETFs and passive share of total

Source: Harvard Law School

2.0 Market Efficiency 2.1 Theory As previously stated, it was the publications of Nobel Prize winner Eugene Fama that resulted in the Efficient Market Hypothesis becoming a universally accepted theory when dealing with fund management [ CITATION Shl90 \l 3081 ]. It was Fama who said, “a market in which prices always ‘fully reflect’ available information is called efficient.” In his 1970 publication, Fama announced that there were three levels of market efficiency ranging from the weakest to the strongest in terms of the information included. Weak form efficiency refers to a market in which the information that prices the market is only inclusive of past prices (historical information). Semi-strong efficiency will have the same historical information as weak form with a further inclusion of all other public information that may be relevant to market price. Finally, strong form efficiency is inclusive of all historical prices, all public information and all private information; meaning that even if a corporation has not publicised recent news, the effects of such would already be reflected in the share price. Another key point in

the Efficient Market Hypothesis is that market prices only reflect new information and should therefor follow a ‘random walk’ which was a previously understood theory in economics before Fama’s work. Essentially, the main concepts of EMH suggest that no abnormal returns can be made for a fund as any new information that may render a share over or under priced would already be reflected in said value before it could be sold or purchased [ CITATION Bal09 \l 3081 ]. 2.2 Examples & Evidence When a specific informational efficiency level is analysed, it can generally be seen that the EMH theory holds true as in most cases the market is not outperformed. Most of the research surrounding market efficiency and its testing is done so at a semi-strong level. Fama’s original publications in 1970 suggested that there was extensive evidence found that can support market efficiency at this particular level. One main point of argument for opposing theories is to try and present occasions in which markets have adjusted slowly to new information rather than instantaneously. Robert J. Shiller conducted a study in the 1980’s which implied that stock prices were too volatile to be attributed to new information about future earnings [ CITATION Shi81 \l 3081 ] and has developed upon this in more recent years (see Figure 2). In 1998, Eugene Fama responded to this by stating that the theory of EMH can be consistent with anomalies as there are both positive and negative reactions and they end up being evenly distributed, meaning they are not predictive. This is also known as the JointHypothesis Problem and essentially makes it near impossible to disprove EMH [ CITATION Bal09 \l 3081 ]. Figure 2: Volatility of S&P 500 Index vs Earnings and Dividends

(Shiller, 2011)

An effective way of measuring market efficiency would be to take a look the performance of an actively managed fund, as their main purpose is to outperform the market with publicly available information. A study conducted by Michael C. Jensen in the 1960’s observed 115 different funds that were actively managed in the United States, discerning that on average a fund would not outperform the market. It also found that in instances that the market was beaten, this was generally a result of chance rather than predictive investment [CITATION Jen \l 3081 ]. These results are similar to those found in a more recent report given by Spiva, which found that 92.33% of actively managed funds in the U.S. did not outperform their indexes over a 15-year period [ CITATION Soe18 \l 3081 ]. While this

corroborative data would suggest that actively managed funds are ineffective, smaller markets yield different results that don’t seem to be as conclusive. When the same report looked at Australia, it found that only 80.18% of actively managed funds were beaten by their benchmark over the same period of time. One particular fund in Australia that is contributing to these lower numbers is the Tribeca Alpha Plus Fund, which has been actively managing its assets for many years and has beaten the S&P/ASX-200 accumulation index for the past 12 (See Figure 3). These results obviously oppose the theory of EMH, as they show that it is indeed possible to make abnormal returns consistently and beat the market index, meaning that prices must not always reflect current information. Even though this shows that EMH is not entirely true, it was never intended to be a perfect theory and as it is based on approximations could never be completely true. Figure 3: Tribeca Alpha Plus Fund – Class A Performance

Source: Grant Samuel Funds Management, 2019

2.3 Limitations As can be derived from the previous analysis, EMH is shown to be mostly true, however there are still limitations to this theory. In his discussion with Thaler, Fama states that “investors should behave as if the market were efficient,” (Fama & Thaler, 2016). While this might make sense, in practise it would result in market prices that are entirely disassociated from their fair value [ CITATION Ble17 \l 3081 ]. Without entrepreneurs that seek to make abnormal profit, there would be no proof that there are no profit opportunities [ CITATION Blu04 \l 3081 ]. One short coming can be outlined by economists Lo and Mackinlay when they asked, “if there were no profit opportunities, then why would the smart money incur the expenses of research and transaction costs?” EMH assumes that all profit opportunities have already been taken advantage of which undermines the importance of active profit-seeking investors. As the market is always changing, zero-profit theories such as EMH will always require active investors to validate themselves [ CITATION Pas89 \l 3081 ]. 2.4 Effect on a Firm If Efficient Market Hypothesis were entirely true then to actively manage a fund would never yield positive results, however it has been established that this is not the case. It has been proven that certain funds have been able to repeatedly outperform the market and that actively managed funds play a vital role in the pricing of the market. That said, it cannot be ignored that a very small amount of funds do outperform the market and if that is the case then such a fund should consider adapting a passive strategy.

3.0 Behavioural Finance 3.1 Theory Warren Buffet once said, “I’d be a bum on the street with a tin cup if markets were always efficient.” This famous quote is referring to the fact that much of his return has been the result of treating the market as inefficient and can be somewhat justified through analysis of behavioural finance. Behavioural Finance (BH) has been a topic of economics for hundreds of years, however it has become more popular in modern times due to two particular economics Robert Shiller and Richard Thaler, both Nobel Prize winners. Fama’s EMH is based on the assumption that people always act rationally, whereas Behavioural Finance challenges this suggesting the opposite. Behavioural economists don’t necessarily believe that EMH is wrong and acknowledging that investors cannot systematically beat the market, they do believe that market prices are often wrong and can be utilised to make profit (Fama & Thaler, 2016). The fundamental aspect of BH is that individuals can be biased and don’t always make rational decisions regarding their investments, which leads to over or under priced shares and inefficient markets [ CITATION May01 \l 3081 ]. Human rationality has boundaries that prevent it from being perfect, most significantly heuristic simplification. This suggests that due to having a limited capacity for computation, human brains use algorithms that filter out some information and cannot arrive to a perfect result or decision [ CITATION Gol02 \l 3081 ]. This concept is recognised in Richard Thaler’s concept of mental accounting, which refers to a person’s tendency to separate money based on arbitrary categories without realising the money’s fungibility. Humans involuntarily promote certain biases because of this tendency in their brain to take undercalculated shortcuts. Representative bias is one in particular that incurs when the brain gives recent events too much importance. This can cause investors to assume that past returns will equal future returns and simply chase winning stocks [ CITATION Shi97 \l 3081 ]. Another type is referred to as availability bias, in which what could be seen as impatience or the need for instant gratification causes investors to give importance to thoughts that can be immediately recalled instead of going through in-depth analysis [ CITATION Shi97 \l 3081 ]. When it comes to investing, one major detriment to the human brain is the effect that emotion can have on rationality or logical decision making. Thaler describes the disposition effect as the avoidance of loss where individuals opt not to take action that may yield negative results. In finance, this would be seen when shares are sold before they peak or when a loss isn’t sold in hope of a turnaround [ CITATION Tha99 \l 3081 ]. In relation to emotions, overconfidence is another factor that can lead to investors behaving irrationally [ CITATION Tha16 \l 3081 ]. 3.2 Examples & Evidence Unlike EMH, behavioural finance doesn’t follow a theory that can simply define it’s fundamental trait. This means that whilst important and relevant information, it can be difficult to utilise the theory to profit from market inefficiencies [ CITATION Fam98 \l 3081 ]. Instead, it can be used to assist in explaining certain financial events that don’t fit the Efficient Market Hypothesis theory. A typical event to look at would be the U.S. housing bubble, which occurred during the Great Recession of 2008. Shiller spoke about this, stating that the houses were overvalued due to psychological factors like representativeness and overconfidence [ CITATION Shi07 \l 3081 ]. He used rent prices to represent fundamental value and showed that the value of houses began to exceed what they should be by an obvious amount. 3.3 Limitations

In economics, a bubble is defined as a market in which it’s investors ignore fundamentals and simply purchase assets in anticipation of rising prices [ CITATION Mur10 \l 3081 ]. Those who follow the Efficient Market Hypothesis would suggest that this information is untrue as a bubble cannot exist, that the change in price is actually explained by new information that relates to said assets [ CITATION Fre13 \l 3081 ]. Behavioural economics, as previously stated, believe that a drastic change in market price is due to the irrational behaviour of investors and their psychological downfalls. One common counterargument to this is that it is unrealistic for prolonged dramatic changes in price to be justified with irrationality as one rational thought from another investor would put the market back into a correct and efficient state. A certain mechanism that prevents markets from correcting themselves is central banks. As they artificially control interest rates, the appeal of price correction becomes obsolete [ CITATION Mis49 \l 3081 ]. 3.4 Effect on a Firm As previously stated, Fama showed that while behavioural finance may be able to assist in explaining why certain events occur, there is no theory within that can really aid in predicting what actions investors should take, i.e. cannot produce abnormal returns [ CITATION Fam98 \l 3081 ]. While BH may be more suited to help justify trends when EMH cannot, its theory and its shortcomings show no confidence in supporting an actively managed fund. Regardless of this, if a fund is actively managed, then behavioural finance theory may help in minimising the negative effects of psychological handicaps within the human brain. 4.0 Conclusion & Recommendations It has been shown that while Efficient Market Hypothesis is an exaggeration of human rationality and cannot be considered entirely true, it does maintain to be beneficial in approximating the truth. Behavioural finance is evidently capable of better illustrating certain trends in the market when it doesn’t seem to be efficient, yet cant really be used to predict the market, or sequentially aid in making informed investment decisions. BF theory is capable of helping an actively managed fund mitigate losses by making those who manage the fund more aware of their own psychological downfalls. If said fund is making a profit then it should continue to be actively managed, however, if this still doesn’t result in the fund outperforming the market, a passively managed fund should be implemented so prevent further losses.

5.0 Bibliography Ball, R. (2009). The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned. Journal of Applied Corporate Finance, Volume 21, Number 4. Bleiberg, S. D., Priest, W. W., & Pearl, D. N. (2017). The Impact of Passive Investing on Market Efficiency. Epoch Investment Partners Inc. Blumen, R. (2004). Are Bubbles Efficient? Mises Daily Articles. Fama, E. (1998). Market efficiency, long-term returns and behavioural finance. Journal of Financial Economics, 283-306. French, D. (2013). Nobel Prize Winner: Bubbles Don't Exist. Casey Research. Goldstein, D. G., & Gigerenzer, G. (2002). Models of Ecological Rationality: The Recognition Heuristic. Phychological Review, 75-90. Jensen, M. C. (1967). The Performance of Mutual Funds In The Period 1945-1964. Journal of Finance, Volume 23, Number 2, 389-416. Mayer, C. (2001). The Assault on Mathematical Economics. Mises Daily Articles. Mises, L. V. (1949). Human Action: A Treatise on Economics. Yale University Press. Murphy, R. P. (2010). Bursting Eugene Fama's Bubble. Mises Daily Articles. Pasour, E. C. (1989). The efficient-markets hypothesis and entrepreneurship. The Review of Austrian Economics. Shiller, R. J. (1981). Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? . The American Economic Review, 421-436. Shiller, R. J. (1997). Human Behaviour and the Efficiency of the Financial System. Federal Reserve Bank of New York. Shiller, R. J. (2007). Understanding Recent Trends in House Prices and Homeownership. Cowles Foundation for Research in Economics. Shleifer, A., & Summers, L. H. (1990). The Noise Trader Approach to Finance . Journal of Economic Perspectives, 19-33. Soe, A. M., & Poirier, R. (2018). Spiva U.S. Scorecard: S&P Global. Spiva Statistics and Reports. Thaler, R. H. (1999). Mental Accounting Matters. Journal of Behavioural Decision Making, 183-206. Thaler, R. H. (2016). Behavioural Economics: Past, Present and Future. The American Economic Review, 1577-1600. W. Lo, A., & Craig Mackinlay, A. (1999). A Non-Random Walk Down Wall Street. Princeton University Press....