For Finance Decisions Does Market Efficiency Stand Above Behavioral Bias
We need to understand both behavioral biases and market efficiency for it helps the investors to take better and appropriate decisions.
One day when two economists went for a walk, one happened to see something, which he considered interesting and said, “It was a good topic to research on”. The other one felt that if it were that good somebody would have already done so. This was the view of the academics about the stock market for a very long time. They did not consider the stock market a place where a serious case study could be undertaken.
Over the years that seems to have changed. The research material that is available as of today is quite significant. Now the question is, about understanding the same so that it can be used well when decisions have to be made be it from the viewpoint of the investors or that of agencies that provide various finance related services.
This article is basically meant for just help give an idea about stock market research - both as regards efficiency of the market as well as the behavioral biases that exist. This is meant to help investors when thinking of investing in equities and also give some material for thinking for the finance service providers when it comes to their policies about building a portfolio as well as the strategies used for marketing.
The Initial Years: Statistics Available
The initial years of research was meant to find out if the stock prices followed a trend or they just moved randomly. Most studies show that the changes that take place in stock prices are rather independent. It did not follow any set pattern so that anyone is able to predict the movement in the future.
Roberts in the year 1959 just selected a few stock figures on a random basis to check if the analysts who viewed the stocks technically were able to view any sort of trend. The first figure depicts Roberts’ study.
Figure 1
The stock price replicated
Roberts was of the view that one would not be able to tell if the plots used the actual stock market figures or random ones. The same thing what Roberts had done can be replicated today using any computer program.
The Beginning of Efficient Market Theory
Later on the term “efficient market” came into being. This was defined by Fama as a market, wherein many persons who would want to maximize profits compete together, with each one of them predicting the price of different securities and where all the required information is available freely to all.
It is interesting to note that this definition is similar to that of a perfect market, which is mentioned in economics textbooks wherein all sellers earn sufficient amount of profit whereby they are able to sustain their business but not enough to find competition.
If this is said to be the same case with effect to stock markets then just about any news could affect the stock prices. Or else one could start expecting returns that were absolutely abnormal. There are basically three types of the efficient market theory that have been undertaken as a subject of study.
The first one i.e. the weak type reflects that the stock prices are dependent on its previous prices as well as volume. Then there is the semi-strong type, which is of the view that it is not just the history of the prices that are included but also all the information that is available to the public about the company. The third view; i.e. the strong type, is the one most rigid which believes that the stock prices are indicative of all the information available which includes both public as well as private information.
The Tests Undertaken in the 60s to Ascertain Market Efficiency
There were lots of methods used to ascertain the efficient market theory. More studies were required on the successive association of the stock prices. A combination of these methods tested many trading approaches, which were suggested by analysts to find out if there is an investment prospect in any of them. Both these studies derived many a negative results.
A revolution came about in these tests when the “event study” method was put to use. In this approach an illustration of comparable events that have take place in various companies at different times are put together. Then a study is undertaken to determine how the stock prices have been affected due to this.
At first this methodology was used to study the stock splits and later on moved to various other sections. Some of the research that has been undertaken is quite interesting. For instance, Magee, Newman, Nagarajan, and Johnson conducted a study wherein they studied the reactions of the stock market in correlation to the unexpected death of executives.
The result of this study was that the stock prices would decrease in case of such CEO deaths and incase the CEO was the founder then there is a likelihood of the prices rising. This meant that capacity to start a business was not similar to the skill required to run it successfully.
By around 1975 all the information that was gathered concluded that the markets were quite efficient. Studies proved that analysis on a technical basis did not by any means add worth. Studies also showed that the stock market reacts strongly to news and it was concluded that the market efficiency was like that mentioned by strong type.
Tests Conducted after 1975 to Ascertain Market Efficiency
With more researchers conducting studies to test the efficient market theory, many radically different viewpoints came into focus. Kinney and Rozeff were of the opinion that the stock returns in the month of January were greater than the returns of any other month. Hess and Gibbons described what is known as the “Monday Effect”.
They believed that the stock prices reduced on Mondays. These results were way different from the market efficiency as described by the weak type. However, they were also of the view that “Monday Effect” reduced over a period of time. It seemed that some players in the market realized this and were making a profit with this little knowledge that they had and over a period of time their profits began to reduce.
Stiglitz and Grossman were of the view that if all the relevant facts were indicated in the stock market prices then all the traders and others directly involved in the activities of the stock market would not see any reason or motivation to gather any news on the basis of which the prices are dependent. (This later was known as the Grossman-Stiglitz paradox and later on with more such contributions to the field Joseph Stiglitz received the Nobel Prize in the year 2001.)
Latane’, Rendelman and Jones conducted research on earnings surprises and their subsequent effect on stock prices. The sample was divided into ten sections known as deciles depending on whether the earnings surprise was positive or negative. Then the average price path for these stocks was calculated in each of the decile. Figure 2 represents an abstract of their view.
Figure 2
Stock price paths around earnings surprise for each decile.
The markets reacted to earnings surprises instantly but at the same time the prices moved in the same direction as the earnings surprise. That is to say that the markets did not react instantly to the earnings of each quarter. At the same time some other studies depicted that the market overreacts in such situations.
Shiller was of the opinion that the change in the prices of the stocks was so much that the ensuing changes in the dividends could not be justified. This later was known as “excess volatility”. Thaler and De Bondt were of the view that a continuous flow of adverse news made the market overreact. At the end of it all, i.e. around the year 1985 the conclusion that was drawn was that there were so many differences that the authenticity of efficient market theory itself came under a shadow of doubt.
Integration of Hypothesis and Facts
This is done to check the efficient market theory with all its assumptions, which may actually be quite far away from the truth. At the beginning let us understand the fact that there is no such foolproof method to test the market efficiency. We could assume that the market is efficient enough so as to compare the prices of the assets along with its inherent value; and at the same time stating that the inherent value is known.
This goes to show that there is an ideal asset-pricing example. At all times when there is differences found there is no way of knowing which part of these two assumptions is wrong.
Jensen was of the view that an efficient market should be in a position to make an adjustment of the prices to a certain limit, which has been forced by the cost of trading. He summarized the same with the following example wherein if the transactional cost is about 1%, then an abnormal return of 1% should be measured within the parameters of efficiency.
Here we would also have to consider at what levels of transactional costs will, we cease to call a market efficient even though it is within the parameters of efficiency? Some effects may also be due to the manner in which the security prices stated (this is known as the market microstructure effect).
A characteristic hypothesis that is made is that the trade can be completed at the closing price that has been recorded. Nevertheless, 3% is the average bid-ask spread on the NYSE-AMEX stock, which can increase to around 6% for all stocks that are valued at under $5.
There is also the problem of short selling. Short selling is not restricted in a perfectly efficient market. Almost about 70% of mutual funds claim that they would not be in the business of short selling. However there is evidence to prove that you would not find too many undervalued investments but it is just the opposite in case of over valued ones.
Then there is the case of diversity among investors. The tax status is a very fine example. The investors exempted from tax, the ones who are taxable and the ones whose tax have been deferred would all go for a different plan of action when faced with problems of the same nature.
In this case what is the investor supposed to choose? Is the Fama approach the best one to choose? If not then what is the next best alternative and how does that help in understanding investors actions?
A Different Model for Behavioral Pattern
There is a school of though to introduce more lessons on behavioral science into the finance sector. The persons who advocate this are of the opinion that the reality is too far away from the efficient market theory. The major point of difference is the surplus volatility. Something similar is that of the volume that is involved in trading. If all know that each one is rational in his or her approach then at during every trade the seller would wonder what is it that the buyer knows that he doesn’t and vice versa.
As per Miller and Modigliani’s theory in an ideal scenario the investors should not distinguish between capital gains and dividends. But this is not the case and the US tax policy is such that the investors would always favor capital gains in comparison to dividends and companies would also have a bias towards share repurchase as compared to dividends. But most big companies do spend a substantial amount on paying dividends.
When there is an increase in dividends it is reflected with a definite increase in share prices. The other big question pertains to the equity premium. The benefits of this are much larger. The returns that would be gained in the future can be predicted to a certain extent on the basis of past records.
Even after so many irregularities, the actual managers who handle portfolio find it difficult to out perform the market. What is more is that just because the Company has performed well this particular year does not necessarily mean that it would show the same result in the consecutive year.
Keeping this in mind, we shall study the facts about behavioral finance.
At the outset we need to understand what behavioral finance is. In a nutshell it assumes that different investors have biases depending on their thought process; according to how they perceive the reality. Given below are a few biases about finance according to each ones thought perceptions.
Psychological Accounting – Dividends are considered to be a bonus on the disposable income but that is not the case with capital gains.
Prejudiced Anticipation – Most people become a tad bit overconfident when making calculations regarding the future. The period from 1973 to 1990 has shown that the errors as regards the earnings have varied 25-65% from the actual figures.
Dependence on Indications – Investments are made many a time by the references that the investor has. Supposing a stock was being traded at about $25 and later on fell to about $10 after which it made a recovery and went up to $15, the investor decision to buy more of this stock would depend on if he has bought the same at an earlier price of $10 or $25.
Understanding by Oneself – Most people consider that a good company is equal to a good stock. This is correct to a large extent but in most cases they are valued quite fairly and the scope for an upside is limited.
What is the Significance of Behavioral Finance?
All products have some USP i.e. its unique selling point. Is it the same with investments? If that will be the case then there definitely will be a difference in the price of these stocks which otherwise look similar in a lot of aspects. Just a glance at the advertising strategies adopted by different mutual funds suggests that this is the case.
Is there a Solution?
Are there irreconcilable differences between conventional finance and behavioral finance? This is not necessarily true. But at the same time people who advocate behavioral finance also know limits. At the same time those who advocate conventional finance are also now open to studying the results of behavioral finance.