This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
According to EMH, investor's reactions to new information should be normally distributed in a sense that they act in different ways (over react and some may under react) to particular information that is released/already available. That was not the case in housing bubble with lack of "consensus of opinion", where investors just invested everything blindly to maximize their future returns. In case of housing bubble in U.S, investors relied on efficient market hypothesis that prices of the houses reflect all the information meaning that the prices will keep on rising in future as in the past, without considering the fact that the bubble will burst soon. So clearly prices of homes at that time didn't reflect all the information of what will happen in the future and suddenly it crashed bringing the EMH in controversy.
There is a direct relationship of new technological invention with the price of any commodity. Whenever company releases the news of such innovations, demand of that product increases. For instance, when Microsoft released the news of new Windows 7, people bought more shares expecting that share prices will go up when windows 7 comes out, without considering the fact Windows 7 can be a failure. Expectations also result in increase of the value of shares/houses (both normal and abnormal), which eventually increases sales and profits according to CAPM model but this wasn't the case in housing bubble. From that we can just conclude that beta is almost close to 1 because prices don't correlate with the market in these cases making the market inefficient.
Due to corporate fraud that exists to deceive the investors, shareholders and potential investors/ shareholders results in market inefficiency. Most of the time corporate fraud exists because of insider information not being disclosed to investors/ potential investors which makes the market inefficient. This clearly creates an inefficient investment for investors mainly because of conflict of interests between investors and management (agency theory and information asymmetry). Information disclosed might be inaccurate to mislead investors and investors based on that inaccurate information will invest to maximize his/her expected return in the future. Even if the accurate information is disclosed by management on which investors rely; still some investors might not be have all the information of what will or might happen (probability) in the future with certainty, so how can the market be efficient? The prices might go up or down not based on the current information available or historical data which follows a random walk theory. Even though certain rules and regulations like SOX exists to deter any kind of fraud and information asymmetry, but still there are certain loopholes that exists in these regulations with the most important one that SOX doesn't applies to only public companies. It should be applicable to private companies like real estate and mortgage brokering companies aswell in a sense that they have to give all the relevant and material information of what might happen in future to home investors and also because they have the fiduciary duty to work on behalf of investors, which can increase market efficiency.
Inaccurate predictions based on historical statistics/ data made by companies or others (including some financial analysts) to mislead the investors to purchase houses results in an inefficient market. Sometimes even investors themselves make these inaccurate predictions without any research or information. There exists no brainless management who will release predictions of their downfall in future to investors/potential investors; now does this information asymmetry make market efficient? - No.
Information is not always rational because interpretation is required to make a rational decision and most of the time information is not interpreted due to time constraint and also due to the assumption that market is efficient and information need not be interpreted. The truth is that it needs to be interpreted to act rationally, to reduce the risk (also because of "lack of trust" on businesses). Investors are not just "superperson" that they can expect significant return without analyzing the information. Investors just follow other irrational investors which creates a "noise factor". Hence to avoid that and to make better decision investors need to wait and analyze and check the reliability of the information which costs the investors. The time constraint factor plays a vital role because it changes the relevance of the information. So by the time investor's act upon the available information after analyzing; prices might change drastically by that time. Hence, it makes the market inefficient because some of those investors who already had all the relevant information (insider information) on or before it being released are the ones to benefit the most and also according to a condition of EMH that information need not be analyzed is violated, just to make a rational decision.
Sometimes information to be acquired is costly to make a more appropriate decision and it varies with investors how much information they need to acquire to make a decision to invest how much or just not to invest. Even the information acquired needs to be analyzed and this analysis also varies with cost. Also the information analyzed needs to be verified if it's reliable or not which also costs the investor. All these factors vary with the amount the investor spends and hence investors might have different perception of the investee to make a decision.
Investing in stock prices is always a risky investment because of uncertainty of the possible outcome, if investors know the probability of certain outcome for sure then there is still a risk that the outcome will be undesirable. There is no rational investor in reality, people invest based on their judgments and based on other's judgments. Greed, fear and emotions also make a rational investors act irrationally to any available information. This is supported by "bounded rationality decision" model. Investors don't have any subjective probability of what will happen in the future if it will be a good state or a bad state, that's the reason why they can't calculate their expected utility to base their decision on; which might result in an irrational behaviour of investors. Adding to that market is not rational and efficient enough to earn profits in future.
The housing bubble in Canada hasn't burst yet, but one day it eventually will. It is evident due to the recent decrease in home prices in Canada and increased supply of houses which are still unsold are the symptoms that are just being ignored. The housing bubble has already burst in U.S due to several reasons. The one of the biggest concern was that U.S banks lent too much to homebuyers. The loose lending practices in U.S like dropping the rates in subprime market, which also supported the housing bubble. Eventually what happened was that numerous sub-prime mortgage lenders declared bankruptcy in U.S just because they approved mortgages to high risk applicants and at low interest rates. But this is happening in Canada now. The household net borrowing amount of U.S was 7% of disposable income just before the bubble burst. According to 2007 statistics, the household net borrowing amount of Canada was 6.3% of disposable income which is very close to U.S.
In 2005 builders built too many houses in U.S, supply was too high. In 2000 government decreased the interest rates to soften the effect of recession, which eventually reduced the mortgage rates and demand for houses increased. When demand increased prices of home increased to bring down the demand to match the supply. Then banks started lending money to home buyers for no down payment, with poor credit and even to those who had no jobs. Eventually prices rose even further because demand increased more because a rational investor would assume that prices will go up even more and buyers always assume "it's an investment to buy a real estate property". But in 2005, due to recession again supply increased because people lost their jobs and had their homes for sale and demand decreased because people couldn't afford to buy homes and when supply is more than demand, prices drops and it dropped significantly resulted in a decrease in interest rate (mortgage rates) to bring the demand up. That is what happening in Canada now. And investors are not the only one to blame in this case. Realtors would never want to holdback buyer or seller to get into an agreement due to their own commission purposes (conflict of interests). So there comes the trust problem, should a rational investor trust a realtor to make an investment in real estate property. Afterall, buyers don't have the information that realtors and mortgage brokers have in terms of what might happen in future if it can pose a problem or can result in a loss of that investment (information asymmetry).
Investors consider themselves as a part of self-attribution game in a sense that as long as the prices of houses are increasing they will admire their decision making skills and the decision making skills of realtors, but in 2005 in U.S when home prices started decreasing they blamed other factors for it. And eventually this strengthens their confidence more and what will happen is that home buyers will keep on investing after they get some early signs that recession is about to end.
In case of housing market, it was good news for investors which persisted from 2002 to late 2005 in U.S, so investors assumed it as an ideal state and made assumptions to have some utility in terms of their future returns. But the reality is that we are under a non-ideal conditions and the future is more likely to be independent of the current situation.
What happened in U.S in 2005 is now taking place in Canada. In early 2009, banks dropped the mortgage rates and government provided more incentives for home buyers to invest in real estate property by providing various tax advantages. The consequence for that was people started buying more again and demand increased as a rational investor assumes that the prices will go up in future when we are out of recession, which will result in an increase of mortgage rates. Also supply is reduced just because sellers will hold back their properties and predict the prices to increase in future to sell at higher price (risk averse investors). But due to information asymmetry, new home buyers/ multiple home owners don't consider the other negative side of the current mortgage rates which might go up when they renew their mortgage term after 5 years; hence these buyers don't realize due to lack of clear alternatives that interest rate might go up when they have to renew their mortgage after 5 years, will they be able to pay back their debt (including principal amount and interest payments) considering they have other household expenses too. These buyers might default on their mortgage payment and who will own their collateral capital asset/ rental property? Banks will. So it is a risky investment just like stock markets. But realtors and mortgage brokers argue that buyers are getting mortgages at low mortgage rates and hence they save almost 3% of the debt annually as their reduced interest payments, assuming that mortgage rate before (2 years ago) was 5% and now is nearly 2%. And they argue that what home buyers save for reduced payments due to lower mortgage rates can be used to pay the principal amount for 5 years which will increase their equity in homes and will eventually decrease the interest payments after 5 years due to less debt outstanding. But most of the buyers don't have information on these viable alternatives. So, investors are lured away with these ideas to invest more and more in real estate properties, even though they don't have permanent jobs and some investors are buying multiple homes just to gamble. But who could predict that housing prices will just drop due to recession? And who can predict now that it will increase and when it will increase? And most importantly the reason behind the government decreasing the mortgage rates is to increase or to atleast maintain the present values of homes.
rates Banks can and employees working in banks, realtors and mortgage brokers might be able to do so (information asymmetry). Also, investors don' think that once the recession is over, mortgage rates will go up and in normal case the home prices will decrease or stay stable depending on other factors, but very less chances of being going up. Nonetheless, home prices are not just based on interest rates, other factors that affect home prices are the number of jobs and new home construction in a local area. So if the number of jobs increases and also the number of houses built by homebuilders decrease (might be restricted by Government) and interest rates go up, does it necessarily mean the prices will decrease or stay the same? Not necessarily, so how can the market be efficient? Government intervention in the real estate property business is a major factor in Canada to avoid any housing bubble like in U.S, but the housing prices can't keep on sky rocketing, hence it will burst one day eventually.
Home buyers are just speculating that they can earn at least $50,000 or more in 2 years on a $300,000 investment now in real estate property, even if they have to pay approximately $12,000 in interest payments for two years at a low mortgage rate as of now. Hence these low prices lead rational investors to speculate to maximize their future returns, but can they really? Even if they can, don't they have to buy a house to live eventually at the fair market value at that time? It might be true for those owners who own multiple houses, but they will lose money for interest plus principal payments for those 2 years (assuming it's not rented), also no tax advantage as it won't be principal residences and gain will be taxed as business income rather than capital income. So eventually the return they get is not a real investment, instead it's just they are just getting what they paid for. Investors just assume that home prices will go up eventually when recession is over and people will have more jobs which might increase the demand of houses (assuming that Government will still have restriction on home builders not to build too many houses and population increases)
Media is also the one to blame to increase recession and as a result of low mortgage rates. According to the research, people tend to absorb more of the bad news rather than good news, demand decreases and as a result prices drop and banks have to eventually lower the interest rates to give an incentive to investors to keep on investing to boost the economy. Hence some financial analyst suggests that investors should act optimistically by seeing the positive side/good news to recover from recession.
We conclude that market is not to be termed as strong form efficient just because insiders do have the information that is not released to outsiders (information asymmetry) at proper time which does have an impact on investor's decision as seen in the case of housing bubble. But we can conclude that market is a weak form efficient or almost inefficient because clearly in the case of housing bubble and dotcom bubble historical prices or available informat0ion or current prices of these assets didn't reflect any future returns. So basically this recent housing bubble in U.S made the market inefficient and unreliable because the probability of the future events/returns due to which investors invested to maximize their returns was completely erroneous and uncertain. And finally banks should be considered lemon because they do have all the information that can change the investor's decision. Investing in real estate hence cannot be considered a reliable investment because market is inefficient.
That is why we need accountants; auditors and financial analysts to atleast try to help investors not to act irrationally by reducing their behavioural biases to some extent.