Explain how behavioural finance challenges the efficient market hypothesis. Within your explanation discuss the implications of behavioural finance for investment managers?
The superiority of the Efficient Market Hypothesis was challenged due to the emergence of the Behavioral Finance. From that point forward, the conventional standard methodology has been in a consistent clash against this new and progressively acknowledged standard of the investing behavior. The shortcomings of the hypothesis have turned into the investing weapon of the new exploratory methodology (Kartašova, Remeikiene, Gaspareniene and VenclauskienÄ—, 2014). Efficient market process and the investing rationality have contradicted the psychology of investors, market bubbles and biasness of the investors. Efficiency of information and the integration approach of the arbitrage have been found to be conflicting with the inefficient access to the market information as well anomalies in the market in case of long term (Gupta, Preetibedi and mlakra, 2014). This paper will a provide deep and insight analysis regarding the concept of efficient market hypothesis and behavioral finance.
Efficient Market Hypothesis
Efficient market hypothesis is one of the most important investment theories and it is also considered as the spine of the present financial theories. Since early 1960s to the middle of 1990s the efficient market hypothesis was considered to be the principal investing theory and the most popular approach accepted by the financial analysts. According to Malkiel (2003), the efficient markets do not permit the investors to obtain returns which are higher than the average. It can be implied that that the efficient market hypothesis emphasizes on the efficient of the market in terms of the highly efficient level of news, information along with perfect communication (Borges, 2009).
The efficient market hypothesis has described efficient market where huge number of investors who are rational and focuses on profit maximization through actively participating in the competition. In the efficient market, the investors focus on anticipating the future of the financial market for estimating the values of securities. Additionally, one of the most important features of the efficient market is all the relevant and information can be easily accessed by all the investors participating in the market. Hence, the individual stock as well as the aggregate stock market is characterized as efficient as the investors can access the entire available information foe integrating it into the present prices of the stocks. The efficient market hypothesis assumes that when any information or news arise, it gets easily spread within the market and instantly gets incorporated in the stock prices.
Efficient market hypothesis has significantly focused on the integration, efficiency, market information and reflection. Eugene Fama has acknowledged the model and stated that in an actie market which is consisted of various rational as well as investors, stocks will be price appropriately and all the available market information will be reflected on the price of the stocks. The economists and scholars have distinguished efficiency in the market in three major forms. In case of the strong form, the public as well as the private information significantly contributes in pricing of stocks. Consequently, it does not allow the investors for achieving the competitive advantages. In the semi strong form, the stock prices significantly reflect the public financial information such as financial position of the company, announcement of the companies (Westerlund and Narayan, 2013). On the other, in case of the weak efficiency form, all the historical prices of the securities are integrated into the present price. Hence, these factors cannot be used for anticipating the future situation.
In efficient markets, the investors have no scope to outperform and hence, investors cannot achieve higher returns from their investment. As all the information is available, no investor can be differentiated as market specialist or investment expert. Additionally, it has been found that any kind of new news or information in the market do not have the potential for bringing out unusual profit as those information will be easily available to the investors and will be reflected on the prices of stocks. It must be noted that the information which is instantly integrated in the market prices of which is public as well as can be accessed easily (Kartašova, Remeikiene, Gaspareniene and VenclauskienÄ—, 2014). The active managers will be unable to achieve higher level of performance though exploitation of the available private information. The market forecasts the future condition in an unbiased way and the information is reflected in a more objective manner in comparison to the insiders. Additionally, the return maximization from the uninterrupted trading is stopped as all the relevant information is integrated in the price of the stocks (McCauley, Bassler and Gunaratne, 2008).
It is evident that the fundamental analysis of the stocks of a company is conductive for assessing the stock instead of the anticipation of the future price movements. On the other hand, technical analysis cannot be utilized for experiencing the further changes over the time. In case of efficient markets, the graphical representation and other technical studies do not offer significant benefits to the investors as the historical prices are integrated in the present prices. The efficient market hypothesis has found that loge term markets are more efficient (Westerlund and Narayan, 2013).
Concept of Behavioral Finance
The significance of efficient market hypothesis started losing due to the emergence of behavioral finance in the 1990s. This concept focused on consideration of the human behavior on the investment decision. Basically, this concept provides an insight to the influence of human psychology in financial and investment decision making. Behavioral finance has been attempting to describe how human behavior affects the decision making related to investment as well as its impact on the market (Wojcik, Kreston and McGill, 2012). It is evident that there are some financial effects which will be dependent on the psychological variables and biases of an individual. According to Alexakis and Xanthakis (2008), financial investors are not optimal decision makers and the psychological procedures significantly affects financial decision making.
Heuristics is a major basis of the behavioral finance which is perceived as the pattern of human behavior. This concept majorly focuses on the obtaining knowledge or achieving a desirable outcome through employment of a smart guesswork instead of application of particular formula. Heuristics is involved with simple techniques which are based on experience and used for solving problem. It is known as shortcuts or rule of thumbs and responsible for explaining the decision making procedure of the investors (Mehra, 2008). This technique is more applicable when the investing decisions are made with poor information. Alternatively, the investment decision making procedure in case of market volatility and complicated investing atmosphere, where the decision making becomes extensively difficult, can be analyzed with the help of this concept.
The cognitive heuristics significantly help in explaining the implications of the rules. Additionally, it provides evidence of the irrational decision making of the investors. Representativeness is one of the common heuristics that states that the investor tends to attempt for fitting into a new as well as unknown event into an existing event. Therefore, they focus on identification of the mutual components in the entirely distinct events. Additionally, it has been argued that that investors judge the probabilities by the degree of one element in comparison to other element. Anchoring is considered to be one of the important cognitive heuristic. It has been found that anchoring is significantly associated with the decision making procedure of an investor which is based on the initial anchor. It means the investors focus on estimating through starting from the initial value which will be adjusted to the yield. These adjustments are often found to be erroneous which leads to irrational decision making. Another common cognitive heuristics is herding which states that the investors seek to join a group and therefore eventually develops a collective behavior in case of decision making. In this situation, people prefer to follow others instead of using their cognitive ability and information. Overconfidence is another factor that states that investors may have a tendency of overestimating their cognitive and decision making skills (Shefrin, 2001).
Theories and research studies have exhibited that fallacies significant dominate the investors and it prevents them from making right investment decision. Investors have a tendency to become risk averse for losses instead of profits (Zeelenberg and Pieters, 2004). It has been found that previous gains help in reducing risk and previous loss enhances it. Mental accounting is referred to a set of rational operations utilized by the human being for organizing evaluating and keeping track of the investment activities (Smith, 2008). It engaged the tendency of an individual for generating various mental accounts on the basis of special traits and registers the events which have been encountered. Regret aversion is associated with the desire of an investor for avoiding pain which is generated from the poor investment decision such as postponing the sale of stocks which leads to loss (Muradoglu and Harvey, 2012).
Apart from the above stated considerations the investing decision is significantly affected by the cognitive bias, socio economic atmosphere and culture along with the personality. It has been found that these biases lead to different logical fallacies. Behavioral finance has exhibited significant concern for the investment time. Additionally, it has suggested that the stock market bubbles are not short term. Hence the loss bubble will not be easily reimbursed immediately (Goldberg and Nitzsch, 2001).
Implication of behavioral finance for investment mangers
Investment management may be defined as the financial process of managing the securities and tangible assets of an individual or an organization to meet specific goals (Muneer and Rehman, 2012). Investment decision making is a complex process involving various alternative scenarios. Some of the personal factors like age, education and income effect the investor’s decisions. To make effective investment decision the investor has to use various technical models like CAPM. Hence, the le of behavioral finance is extensive in case of understanding the investment decisions of an individual. (Alajbeg, Bubas and Sonje, 2012) has suggested that the selection of portfolios and stocks can be increased with the use of behavioral tools. However, at the time of relying on the portfolio managers for the investment decisions, the investors will have to accept the behavioral mistakes of the portfolio managers. In majority of cases, the portfolio mangers are seen to adopt a regret aversion strategy (Baker and Nofsinger, 2010).
Barnes (2010) opined that the major psychological biases like over confidence, anchoring, cognitive dissonance, mental accounting and regret aversion and gambler fallacy. Due to the effect of these biases, the investors tend to take poor investment decisions. The relation between the biases and the investment decisions can be explained with the help of the following theories namely
Heuristic decisions process
Under this process of decision-making, the investor uses the common emotional norms and mixes them with the rational thoughts in order to arrive at suitable investment decisions. The following factors are responsible for the Heuristic decisions making process.
Representativeness: In cases of making investment decisions high degree of stereotyping occurs. The investors make the decisions depending upon some past investment result. Hence, if the investor has a bad experience with a similar kind of bond investment then in the future the investor will reject any investment of the similar nature or of the similar bonds (Beck and Levine, 2002).
Overconfidence: Confidence is the emotional factor within the individual investor that provokes the investor to take right decisions (Shefrin, 2000). Suppose if an investor suffers a high degree of loss in an investment then he gains encouragement in form of confidence to make effective investment decision in future.
Anchoring: In this case, the investor’s decision is guided by irrational price levels as an important process of decision-making and therefore the investors misses investment opportunities and at times makes a wrong entry into the investment market (Marx and Mpofu, 2010).
Gambler’s fallacy: At times depending on positive past experience the investors tend to take high investment risks. Since the experiences have fetched the investor, good returns hence the tendency to opt for more returns pushes the investor to take risky investment decisions. This situation may either prove to be positive or negative for the investor suggesting that the investor knowingly takes chances of high losses.
The prospect theory states that the individuals while making investment decisions chose between probabilistic alternatives that involve risk and the probabilities of outcomes are known. For instance, the investor will conceive the loss of $ 1 more painful compared to the gain of twice $ 1 (He and Shen, 2010). The theory is also termed as the loss aversion theory. The mental condition of the investor forces the investor to take poor investment decisions so that risk can be avoided. The key concepts of this theory are as follows:
Framing: This concept states that the method of presentation of facts influences the decisions of the investor. Hence, a negative representation will result in a loss on the part of the investment decision.
Loss aversion: Since the human psychology is to avoid risks, hence when the price of a share decreases the investor refuses to sell the same and continues to retain the shares with an expectation of future price growth (Hunton, 2009).
Regret aversion: This psychology induces the investor to omit any good investment opportunity so that the individual can avoid any regrets of a loss resulting from the investment.
Mental accounting: Mental accounting tendency prompts the individual to categories the sources of income according to their respective expenses. Hence, the investment decision depends on the prioritizing of the income categories.
Challenges faced by efficient market hypothesis due to Behavioral Finance
According to Mockus and Raudys, (2010) the process of efficient market hypothesis helps the investors to be acquainted with efficient share market information. Since all investors have access to the available share information, hence it is not possible to exploit the investors. However, the rapid movement within the stock market makes it difficult for the individuals to access all information at all time of investments. Since the stock market, information is available though elaborative channels of communication hence it is difficult for the individual to combine and assimilate the same. Moreover, the emotional status of the investor also hampers the assessment of the information. KeršytÄ— (2012) opined that majority of the cases the information of stock market is available to a limited group of investors.
With the help of fundamental analysis and technical analysis, the investors try to analyze the security market. If the information supplied by these analysis techniques are positive then the investor frames a positive image about the company thereby fostering a sense of confidence in respect of the investing decision. However, the technical analysis produces a forecast of the direction of the share prices hence the investors relying on the forecasts may suffer losses in future. Thus, they may form a stereotype decision on the investments and develop a sense of risk aversion in this matter.
De Bondt (2009) further stated that the EMH highlights that the individuals engaged in a stock market investment decision are individuals with common characteristics namely lack of unique personality, sharing common investing traits, lack of social life and engaging in common discussions. Thus, the hypothesis creates a wrong impression on the investors and they tend to stay away from the stock markets.
Rozeff (2011) commented that when the market remains efficient the investors act rationally and take efficient investing decisions. However, the occurrences of investment bubbles like the internet bubble and the real estate market bubble has shown the instances that the market is not always efficient. The addition of “.com” after internet based organizations. The major reason for the growth of the share prices of the internet companies was the investor’s speculation that the addition of .com after the internet based companies would make the companies more profitable. Hence, Simmons (2012) suggested that behavioral finance has huge affect on the market efficiencies. The financial anomalies arise majorly due to the effect of behavioral finance on the EMH.
Although the investing techniques have been changed over the time however, the EMH strategies remain unmodified for the contemporary and old stock markets (Ross et al. 2004). The information supplied by the hypothesis still takes the investors to be irrational. However, with the changing time the investors have become rational and have tended to change their investment techniques. The use of modern tools like credit default swaps in the global stock markets suggests that the efficient market hypothesis has become invalid in the eyes of the investors.
Moreover, Beck and Levine (2002) argued that the efficient market hypothesis suggests that the investing is a long-term decision and the stock markets should acquire efficiency in long run. However, the fact is contradicted by modern concepts of stock market that suggests that the stock investment is now a short-term decision. The profit seeking and the risk aversion psychology of the investors suggest that the investors are relying on the short-term gains so that high risk of loss can be avoided. Since the primary concept of behavioral finance is to frame the investment structure based on the behavior patterns of the investors, hence it is more effective in attractive gainful investments compared to the use of market hypothesis.
The essay shows that the major three components of a stock market are the behavioral finance, efficient market hypothesis and the investing decision. On ascertaining, the relation between the three it can be noted that behavioral finance has a huge impact on both investment decision and market hypothesis. Depending on the emotional biases, the individual designs the investment decisions. The nature of the individual will contribute to the investment decision. Moreover, the change in the behavioral patterns of the investors influences the validity of the efficient market hypothesis. With the changes in the behavioral pattern, the investors have shown that not all market hypotheses are efficient and correct. Hence, it is advisable on the part of the individual to make rational investing decisions based on the present and current information available on the stock prices of the investments. IT is also noted that due to the behavioral weaknesses the majority of the investing decisions fail.
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