You have been employed as a consultant to an actively managed equity fund. Your task is to write a critical essay evaluating the arguments for and against the efficient markets hypothesis and behavioural finance and the implications of these for the future direction of the fund.
Your essay should include (but not only be) a discussion of the work of Nobel Laureates Eugene Fama, Robert Schiller and Richard Thaler. You should utilise existing literature (scholarly journals) on market efficiency and behavioural finance as well as real world examples to support your arguments. Your essay should include a conclusion on the validity of market efficiency and any implications of your research for the future direction of the fund.
Overview of Efficient Market Hypothesis
The efficient market hypothesis was widely accepted by the financial economist over the past few decades ago. Such a wide acceptance was due to the fact that the stock prices were typically reflected by the information that was provided by the securities market. The above idea depends on the random walk theory which entails a price series in which there is often a change in the price of stock randomly from the previous prices. According to this hypothesis, it prevents the various investors from earning revenues which are above the average returns and this usually occurs without agreeing to the above average risks (Degutis & Novickyt?, 2014)
It, therefore, insists on an efficient financial market and this is in regards to the communication, news, and information involved. An efficient financial market occurs when there are numerous individual profit maximizers competing against each other and aims at forecasting on the future market values of the securities.
Based on the work of Eugene Fama, he argued that the prices of the stock were a reflection of the fundamentals of economics and that the prices changed randomly in the financial markets.Fama, defined the efficient market hypothesis as a market which is competitive and that the random feature of fluctuation is based on the price converges to the value which is considered to be fundamental. He defended the Random walk because he considered it as a good description of the fluctuations existing in the market for the stock and this is because the random walk is a better estimation of the behavior of price. He also introduced the rationality concept where he argued that an efficient market contains a huge number of rational profit maximizers who are competing with the aim of forecasting the future market values.
Robert Shiller however opposed the efficient market theory and this was specifically on the random walk theory. He argued that the response of the stock market to new information was never predictable.
The behavioral finance involves a study of the behavior of the investor market and this is usually based on the psychological principles in the process of making certain decisions. Such decisions usually involve those providing insights on the reasons as to why certain individuals purchase and sell stock. The concept of behavioral finance has been associated with the behavioral cognitive which focuses on studying the economics of financial market and decision making by human beings (De Bondt, Muradoglu, Shefrin & Staikouras, 2015). The primary goal of the above concept is to focus on the interpretation of the investors and also their actions towards the making of certain informed decisions on investment. Richard Thaler in his work identified certain anomalies and the first one was in regards to the closed end funds. He defined closed funds as the money which raises the investor’s capital and then it is later allocated to stock or any other asset. Additionally, he suggested for a behavioral framework to comprehend the closed end fund prices and this is because some of the prices would change based on an investor’s sentiments.
Arguments For Efficient Market Hypothesis and Behavioral Finance
Further, there is a certain reason which makes the behavioural finance to be considered as an irrational behavior by the investors and such may include, the representativeness which entails various individuals seeking to fit in certain new events (De Bondt et al., 2015).
In the real world, the above concepts are applied by most of the investors when making certain fundamental investment decisions (Rad, 2016). For example, the efficient market hypothesis has been sued by the investors to prevail over a particular stock market and this entails the use of information availed in such markets as an investment weapon. The behaviourial finance on the other hand has been used by the investors to make certain rational decisions on investment.
Arguments for Efficient Market Hypothesis and Behavioural Finance
There are various reason why the above mentioned concepts are selected while making investment decisions by a variety of investors. Some of the arguments for efficient market hypothesis and behavioural finance are as indicated below;
According to ?i?an (2015), the efficient market hypothesis, financial markets are typically efficient in regards to information. It, therefore, implies that every particular investor will generally have an access to information available and thus there will no exploitation on the investment news. Additionally, the efficient market hypothesis provides generally some of the best techniques of communicating various investment decisions to the individual investors. Some of the methods used in communicating the information include the use of market analysts and financial journals. The behavioural finance, on the other hand, plays a key role in ensuring that the information which is inefficient is made efficient and this is usually in terms of the availability and access to such an information by the individual investors.
The other reason for the argument for the efficient market hypothesis and behavioural finance is because they enable rational behavior among the investors in the stock market. The efficient market hypotheses argue that the investors in the stock market are usually rational in their behavior and that their major concern is on profit maximization which is controlled by certain rational expectations (Rad, 2016). The picture which is created by the efficient market hypothesis depicts the investors as machines which are well preserved and therefore they comply with the existing rules on investment, which is usually rationality. The rational behavior is an essential component of the behavioural finance and this is the reason it is argued for by the various investors in the financial markets.
Arguments Against Efficient Market Hypothesis and Behavioral Finance
There have been a variety of arguments against the efficient market hypothesis which has made it non-efficient for application in the world of economics. For example, there has been an assumption that most investors are considered to be rational and hence they value their investments in a rational manner (Arthur, 2018). However, the estimation of the net present values for the future cash flows is not supported by such an assumption.
Further, it has been argued that there are certain anomalies which have been identified in the various patterns of historical share prices. Some of the anomalies which have been as a result of the efficient market hypothesis include mean reversion, January effect and the small firm effect (Thaler, 2016). The above mentioned factors indicate that the efficient market hypothesis does not lead to rational behavior among the investors and hence it has become the center of criticism.
The other argument against the efficient market hypothesis has been based on the result of volatility tests. According to the results of the test, it was found out that the movement of stock prices is not a result of the rational expectations of the particular investors but it also entails certain irrational elements. The irrational elements are displayed in the noise trading and this, therefore, implies that the assertion made by the efficient market hypothesis is unrealistic.
The behavioural finance has been criticized for various reasons which makes it irrelevant in the application to the investment decisions made in the financial markets (Tuyon & Ahmad, 2016). For example, the behavioural finance has a limited critique of the economic theory and this is illustrated by the concept remaining only in the individual level of analysis and this is even though most of the investment decision are not made individually especially those relating to risk and money.
The other reason for its limitation on criticizing the economic theory is based on the fact that it does not give an explanation on the way various individual investors’ actions and decisions result in certain aggregate outcomes. Such an argument has been attributed to the fact that the behavioural finance does not take into account the interactive and social aspect of various economic activities (Statman, 2014). The other argument against the behavioural finance is based on its failure to identify the various findings relating to the allied social sciences. Such a failure has become a huge rigid separation and boundary implementation and it is argued that it limits the advancement of knowledge on various shared interest by a variety of scholars.
In summary, the efficient market hypothesis and behavioural finance will have an impact in the future direction of the fund and this is because they will be used in forecasting the future prices of the stock in the market. The long and short term moving averages will be used in the prediction of the future prices of stocks. According to the efficient market hypothesis, once an information will be made available in the financial markets, the prices of the stock will shift in future. Further, the strategy of technical analysis of the behavioural analysis indicates that the stock market prices will shift in trends based on the rational behavior of the investors.
Arthur, W. B. (2018). Asset pricing under endogenous expectations in an artificial stock market. In The economy as an evolving complex system II (pp. 31-60). CRC Press.
De Bondt, W. F., Muradoglu, Y. G., Shefrin, H., & Staikouras, S. K. (2015). Behavioral finance: Quo vadis?.
Thaler, R. H. (2016). Behavioral economics: past, present, and future. American Economic Review, 106(7), 1577-1600.
Degutis, A., & Novickyt?, L. (2014). The efficient market hypothesis: a critical review of literature and methodology.Ekonomika, 93(2).
Tuyon, J., & Ahmad, Z. (2016). Behavioural finance perspectives on Malaysian stock market efficiency. Borsa Istanbul Review, 16(1), 43-61.
Statman, M. (2014). Behavioral finance: Finance with normal people. Borsa Istanbul Review, 14(2), 65-73.
Rad, H. (2016). Pairs trading and market efficiency using an adaptive market hypothesis framework: A pitch. Accounting and Management Information Systems, 15(1), 178-185.
?i?an, A. G. (2015). The Efficient Market Hypothesis: review of specialized literature and empirical research. Procedia Economics and Finance, 32, 442-449.