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Neoclassical Finance, Behavioral Finance and Noise Traders

Table of Contents

Introduction.

Efficient Market Hypothesis.

Behavioural Finance.

Conclusion.

Reference.

Introduction to Efficient Markets Hypothesis

The essay discusses about market efficiency and behavioural finance using real world examples and the management of funds using active and passive methods. The term fund management is primarily related to managing the funds of investors and/ or investors by investing and reinvesting in various financial securities to earn higher returns. In an Actively managed fund, the manager takes decisions based on analysis to outperform index while in a passively managed funds, the manager just invests in the indexes.

Market efficiency is a hypothesis which was well expected in previous decades. It states that market prices are comprised of all available, material information. Thus there is no way to outperform the market. However such hypothesis does not prevails in the current financial scenario and there are various examples where investors have beaten the market.

Such investors, financial analysts and economists strongly believed contrary to the efficient market thesis that future stock prices are predictable. These financial intellectuals emphasized behavioural and psychological elements to determine the stock-price. They observe that future stock prices can be predicted by analysing the historical patterns of stock price.

Efficient Market Hypothesis

In 1970 economist Eugene Fama, developed a hypothesis about Market efficiency which says that the investor can never outperform the market by exploiting the market anomalies because if there are any anomalies are present that it get immediately arbitraged away (Hamid et al. 2017). Efficient Market Hypothesis states that markets are efficient or there is market efficiency. Market efficiency states that market prices are comprised of all available, material information. In other words markets are efficient and all the material information has been already incorporated in the prices of the stocks. This is the reason that there is no way possible to beat or outperform the market. The concept further adds that there is no such thing as overvalued or undervalued financial securities available in the market. Eugene F. Fama won the Nobel Prize of economics for his services in the field of finance.

The efficient market hypothesis leads the passive method of fund management. In passive fund management the analyst and the investors do not try to outperform the market considering the theory and just try to replicate the index funds or invest in the securities which are components of the index.

As per financial analysts, the theory of efficient markets, limits the investors to earn average returns and does not allow above average return expectations. As per Fama’s theory, the efficient markets is a place where large numbers of active investors tries to increase or maximise their profits and thus compete with other investors and the market. They try to predict future values of individual securities. But since all the material and real time information is freely available to all market participants, hence the individual stocks in aggregation performs exactly same as the overall stock market.

Fama’s theory distinguishes efficiency in 3 forms of efficient market hypothesis:

  1. Strong form: In strong-form of efficiency each and every information whether personal, public, or confidential (insider information) contributes in pricing of stock. Therefore, in market efficiency investors are not able to make competitive advantage while making investments (Rossi and Gunardi 2018).
  1. Semi-strong form: In semi strong form of efficiency, the prices of the stock or securities are able to reflect only the information which are available in the public domain for example financial information including announcements of listed companies, annual reports, balanced sheets, assets, etc.).
  1. Weak form: In weak form of efficiency, all historical prices of stocks are accumulated in the current price of that particular stock; therefore analysis of such historical prices cannot be used to predict future stock prices.

In the practical (real) world, efficient market hypothesis does not holds strong as there are tons of cases and examples where market prices of stocks witnessed huge deviation from the fair values. For example the legendary investors and fund managers like Warren Buffett of USA and Kerr Neilson of Australia have outperformed the market consistently over long periods of time. Buffett generated returns of 1,826,000 % after he took control of Berkshire Hathaway about 50 years ago. This results in compounded annual gross returns (CAGR) of 21.6 %. During this period the S&P 500 index of USA managed to generate returns at a CAGR of only 9.9 %. Also Kerr Neilson, of Platinum Asset Management was able to deliver approx.13 % on an annual basis while Australian benchmarking index were able to generate just 6.3 % during the same period.

As per the definition of EMH, the above achievements of Buffett and Neilson remain impossible. Another major event which does not hold the theory of EMH good, are the events such as the stock market crash of 1987, during this period the Dow Jones Industrial Average (DJIA) of America dropped by more than 20 per cent in one single day.

Behavioural Finance

Behavioural finance states the concept of psychology influence on the behaviour of traders, analysts, economists and investors in the process of their decision making especially in the finance industry or while making investments. It states an important fact that investors and traders are not rational always but are influenced by their own biases (Thaler and Ganser 2015).

It states that investor’s psychology and emotionally interprets the available information in the market in order to make investment decisions. They do not behave in a manner which is predictable, rational and unbiased. The concept of behavioural finance puts impacts of behaviour of investors in investments decisions that lead to various market anomalies.

As per Richard Thaler, the founding father of the concept of “Behavioural Finance” said that Behavioural finance is simply open minded finance.

Richard Thaler, a founding father of behavioral finance who made a substantial effort to establish the field as a legitimate part of classical finance (Thaler, 2015 tells a thrilling history of behavioral economics and finance from the perspective of the author). He defines behavioral finance as simply open-minded finance (Thaler, 1993)

 

Typically, the most common reasons that determine the reason behind irrational behaviour of investors in behavioural Finance are:

  1. Anchoring: involves decision making by the investors based on anchoring their beliefs. In various circumstances, investors’ makes estimates about investments for securities like stocks or bonds by taking a value initially and making various adjustments in such values that delivers the final answer. In every case the adjustments made to the initial value remains insufficient (Hirshleifer 2015).

For example investors do not want to quantify newly available information about some particular market or security, for example it is a belief all around the world that investing or trading in share market is gamble or speculation but actually it is like any other traditional business which requires market knowledge, understanding and requires analysis of the available information. The investors sometimes stick to the fact that banking stocks are always good and ignore some new information about involvement of a particular bank in some scam or fraud.

  1. Herding: this concept states that, individual investors feel the requirement to join groups to share important information, these groups are called herds. Such group of investors utilize the herd behaviour while making decisions about investments. In other words, investors follow others like the herd of sheep follows one another without analysing or utilization of the information available to them.

For example: the retail investors are mostly affected and impacted by the herding bias. Such investors have access to the most limited sources of information and also reach very lately to them. Also such investors do not possess the competence to analyse the financial markets like stock market and make their decisions based on influences or advices.

  1. Loss aversion: The concept of loss aversion means that the investors do not like to take higher risks which can cause losses. However they want to get compensated with additional returns for every unit of additional risks they are exposed to. In other words for exposing for the risks of higher losses investors expects higher gains.

For example: the investors who don’t want to take higher risks or exposed to higher possibilities of incurring losses usually invests in risk free securities like bank deposits, fixed deposits, government bonds, etc. such securities delivers very low returns and sometimes even are not able to beat the inflation factor (Al-Khazali and Mirzaei 2017). The risk loving investors or the investors who wants higher returns can invest in securities like shares and derivatives of stocks and commodities or currencies. Such securities expose the investors to high level of risks and allow them to earn higher rate of returns.

  1. Mental accounting: this concept is very much related to the process of budgeting, which leads to make choices because the sources have limited availability. This is the set of activities performed by each and every individual, business and households in order to evaluate and organize the financial activities to determine the overall financial health.
  1. Overconfidence: this concept determines the tendency of investors where they are overconfident about their abilities, knowledge, skills and received information and generally overestimates them. Such overconfidence leads the investors in making wrong investing decisions. (Han, & Hirshleifer, 2015). This also determines that investors have a wrong attitude of arrogance towards the financial markets. Economists like Plous said that for investments, the process of decision making, the most important problem that is largely prevalent and highly catastrophic is the behaviour of overconfidence.
  1. Representativeness: the investors attempt to fit an unknown and fresh event into an event which already exists, this leads to determination of common components in very much different events.
  1. Regret aversion: this concept states that investors usually postpone the selling of their financial securities like stocks and bonds which are incurring losses. It is said that investors tries to avoid and justify the pain of losses incurred by poor and wrong investment decision and thus they hesitates to realize their final loss (Ramiah, Xu and Moosa 2015).

Conclusion on Efficient Markets Hypothesis

As per the Efficient Market Hypothesis (EMH), financial markets are considered as informational efficient. That means information is freely available and each and every individual have its access, thus exploitation of financial news is not possible.

EMH has generated debate related to the two important concepts of access and availability because all the investors do not have the availability to all the information available in the market, also not all the investors have the access to the information which are available at the real time.

Material information is broadcasted using various information channels including social media, news websites, analysts blogs, radio, TV, etc. such dissemination of information takes time, some people receives them early and other later. Investors are also not much capable of elaborating the available information and are also not fully competent to analyse and utilize such information. Such difference of availability of material information and its access creates a difference of winners and losers that creates gains and losses in the financial industry.

That is why Behavioural Finance puts the opinion that the financial markets in terms of access and availability of information are inefficient. That means there are anomalies present in the markets and investors can exploit them to outperform the benchmarking indexes.

Based on the discussion, the fund can switch its strategies towards active management of portfolio. The fund can analyse the stock market by using methods of fundamental and technical analysis in order to forecast the future in order to exploit the market anomalies. 

Reference for Efficient Markets Hypothesis

Al-Khazali, O. and Mirzaei, A. 2017. Stock market anomalies, market efficiency and the adaptive market hypothesis: Evidence from Islamic stock indices. Journal of International Financial Markets, Institutions and Money, 51, pp.190-208.

Hamid, K., Suleman, M. T., Ali Shah, S. Z., Akash, I. and Shahid, R. 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets. Available at SSRN 2912908.

Han, B. and Hirshleifer, D. A. 2015. Self-enhancing transmission bias and active investing. Available at SSRN 2032697.

Hirshleifer, D. 2015. Behavioral finance. Annual Review of Financial Economics7, 133-159.

Ramiah, V., Xu, X. and Moosa, I. A. 2015. Neoclassical finance, behavioral finance and noise traders: A review and assessment of the literature. International Review of Financial Analysis41, 89-100.

Rossi, M. and Gunardi, A., 2018. Efficient market hypothesis and stock market anomalies: Empirical evidence in four European countries. Journal of Applied Business Research (JABR), 34(1), pp.183-192.

Thaler, R. H. and Ganser, L. J. 2015. Misbehaving: The making of behavioral economics. New York: WW Norton.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

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