Finance Essays - Evaluating Behavioural Finance

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Evaluating Behavioural Finance.

How to evaluate the bubble and market crash. using behavioural finance to explain the bubble, and efficiency market theory cannot explain it. therefore, behavioural finance has a good solid basis. Outline of research: in the project, the client mainly critically evaluates two theories, EMH and behavioural finance. they want to investigate how behavioural finance can explain the bubble and market crash. EMH cannot. Most specifically, they will use behavioural finance to explain the reason of bubble and crash, and how institutional investors could explain bubble.

Note: This is literature review. Critical evaluate the relative theory. the project does not involve empirical work on your part.

Literature Review
In this section I will be looking at the relevant literature surrounding the efficient market hypothesis (EMH) and behavioural finance. I will also look at literature that relates to market bubbles. I will start with the literature looking at the EMH.

Efficient Market Hypothesis
Efficient Market Hypothesis (EMH) is the theory behind efficient capital markets. An efficient capital market is one in which security prices reflect and rapidly adjust to all new information. The derivation of the EMH is mostly credited to the work of Fama. In 1965 the doctoral dissertation written by Fama was republished. In this Fama looks at the current literature on stock price behaviour and examines the distribution and dependence of stock price returns. He concluded that, 'it seems safe to say that this paper has presented strong and voluminous evidence in favour of the random walk hypothesis.'

Due to a better understanding of price formation in competitive markets, the random walk model was now seen as a set of observations that can be consistent with the efficient markets hypothesis. This switch began with observations published in a paper by Samuelson in 1965. Samuelson presented his proof in the general form, which helped in the understanding of the notion of a well-functioning market. His paper had the observation 'in competitive markets there is a buyer for every seller. If one could be sure that a price would rise, it would have already risen.' Samuelson stated that 'arguments like this are used to deduce that competitive prices must display price changes...that perform a random walk with no predictable bias.'

Following on by the work done by Samuelson, as mentioned in the previous paragraph, a paper was published by Fama in 1970. This paper consisted of a comprehensive review of the theory and evidence of market efficiency. He defined an efficient market as 'one in which trading on available information fails to provide an abnormal profit.' This paper was one of the firsts to distinguish between the three forms of market efficiency. The three forms of market efficiency are the weak form, semi-strong form and strong form. He concluded that "the results are strongly in support" of the weak form of market efficiency and that "in short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse."

I will now summarise some papers that have been written on the criticism of the EMH. Although there has been a vast amount of literature published on the development and the support of the efficient market theory, there has also been various studies published criticising the EMH. This criticism comes about due to the fact that the EMH is difficult to test. A number of studies indicate anomalous behaviour, which appears to be inconsistent with market efficiency. Such anomalies include the small firm effect as talked about in a paper by Banz in 1981. Banz analysed monthly returns over the period 1931-75 on shares listed on the New York Stock Exchange. Over this interval, the fifty smallest stocks outperformed the fifty largest by an average of one percentage point per month, on a risk-adjusted basis. After the publication of this paper, many other authors published their own papers examining the subject of the small firm effect.

A paper by Ball in 1978 points out that the evidence could equally indicate the shortcomings of the models of expected return. A paper by Fama in 1998 concludes that further study should not be done on developing behavioural based theories of stock markets that take into account the apparent anomalies, but that search for better asset pricing models should take president.
There is also the area of behavioural finance that criticises EMH. I will look at this in more depth in the next section.

Market Bubble
While the EMH is generally regarded as the best theory that can describe the actions of market prices it is not perfect and sometimes events occur that contradict the EMH. One of these events is that of the bubble. A bubble is when a specific industry's market prices do really well, so well that prices seem to rise higher than the EMH dictates. Eventually, the bubble bursts and prices return to a price more in line with EMH. One famous bubble was that of the bubble. EMH does not explain why this bubble exists in the first place. This is one of the major criticisms of the EMH. Many academics have turned to the relatively new theory of behavioural finance to explain the bubble.

Behavioural Finance
One area that has recently undermined the EMH is the work published looking at behavioural finance. As observed by Shleifer (2000) 'At the most general level, behavioural finance is the study of human fallibility in competitive markets.' Behavioural finance incorporates elements of cognitive psychology into finance in an effort to better understand how individuals and entire markets respond to different circumstances. Behavioural finance is based on the principle that all investors are not rational. Some investors can be over-confident, while other less knowledgeable investors might be prone to herding effects. Shefrin (1999) was one such author to talk about behavioural finance. He is one author who argues that 'a few psychological phenomena pervade the entire landscape of finance.' Harrington (2003) agrees with the notion that overconfidence can lead to irrational behaviour. She states that 'investors can become irrational and their irrational behaviour affects their ability to profit from owning stocks and bonds.'

Of course, behavioural finance does have its draw backs. One of which is the fact that using instincts alone can result in a loss. This is due to human error. The person that is using their instincts in determining where to invest might not have the greatest financial knowledge in the first place. Also, this person might be having a bad day or be under a great deal of stress or be distracted in some other way. This could result in the wrong decision being made. Therefore, it is a good idea to use both behavioural finance on top of the traditional theories already in use today. This view is supported by an article by Malkiel (1989) who agrees with the notion that behavioural aspects have a great importance in stock market valuation.

He argues that behavioural factors play an important role in stock valuation alongside traditional valuation theories. This is summed up by the following quote, 'market valuations rest on both logical and psychological factors. The theory of valuation depends on the projection of a long-term stream of dividends whose growth rate is extraordinarily difficult to estimate. Moreover, the appropriate risk premiums for common equities are changeable and far from obvious either to investors or economists. Thus, there is room for the hopes, fears, and favourite fashions of market participants to play a role in the valuation process.' Another article from the Banker (2004) also supports the view that behavioural finance has a role to play alongside the traditional views.

In this section I will look at literature that tries to see if behavioural finance can explain this bubble. Many authors have argued that bubbles can be caused by over enthusiasm. For example, the new communication technology of the 1990's was exaggerated (causing the bubble). By this I mean that the new innovation is by some corners, i.e. the media and governments, over triumphed. This can lead to irrational behaviour of investors. This can lead to investors becoming over confident in the technology or industry.

Another factor of this over enthusiasm is that it could attract herding behaviour. The irrational investor will be more likely to invest in something that is being hyped up as they feel that others are doing the same thing. They will feel that if others are doing it then it must be a good idea for them to do it as well.

A factor that will have led to the development of a bubble is that of speculation. One such author that observed the speculation effect on the boom was Giombetti (2000). Many informed investors would have probably over invested in a specific industry going against market theory. They will have done this on the hope that their investment will pay off. Even if their investment were initially at a loss they would have stayed with it. Authors of behavioural finance outline this behaviour. This behaviour of these investors would have distorted the market conditions for other investors. Also, the herding effect would have been greater due to this.

These factors would have led to the stock prices of a certain industry being vastly over priced. This would, therefore, cause the bubble. This bubble that has been created will, in turn, attract other investors. These investors will invest as they feel they are missing out on a good thing. This is another example of herding. This meant that when the bubble burst stock prices would have fell rapidly, causing investors to lose vast sums of money. This would cause them to pull out of the industry, which, in turn, causes the companies themselves to collapse. If it were not for irrational investment then investors might have pulled out earlier, before the collapse. This might have even meant that the collapse would not have happened.

Other authors talk about some of the factors that cause investors to become irrational. On such author are Johnsson, Lindblom and Platan (2002). In their masters dissertation they talk about the various factors of irrationality. One of these is the observation that investors will hang on to losing shares longer than market theory dictates. They say that this is because they are waiting for the performance of the share to change for the better. This is referred to as loss aversion. This is an example of a psychological factor that is effecting the investment decision.

Another psychological factor that affects investors, causing irrational behaviour is that of the feeling of regret. Authors argue that past bad decisions cause investors to feel regret and this alters their behaviour in such a way as to become irrational.

Another factor that causes irrational behaviour is that of when the investor uses mental shortcuts in investment decisions. These shortcuts usually make investors choose the right decision but occasionally cause the investor to make the wrong decision. Optical illusions are a good example of how shortcuts can cause mistakes. A paper on is one such paper that covers this point.

Of course there are many authors who do not believe in the theory of behavioural finance. These authors argue that traditional financial theory can still be used to explain current market conditions. One such author is the person credited with the idea of the efficient market hypothesis, Eugene Fama. Fama (1998) argues that anomalies can be explained by traditional market theory. He argues that, 'apparent overreaction of stock prices to information is about as common as under-reaction' and he suggests that this finding is consistent 'with the market efficiency hypothesis that the anomalies are chance events'

Other authors have argued that behavioural finance is only a study of individual investor behaviour. They argue that this theory has not been proven on a market wide scale. The tradition theories of finance have been.

References (1999) Introduction to Behavioral Finance
Ball R. (1978) Anomalies in Relationships Between Securities' Yields and Yield-Surrogates, Journal of Financial Economics, 6, pp. 103-26.
Banz R. (1981) The Relationship Between Return and Market Value of Common Stocks, Journal of Financial Economics, 9, pp. 3-18.
Fama E. F. (1965) The behaviour of stock market prices, Journal of Business 38 (1), 34-105.
Fama E. F. (1970) Efficient capital markets: a review of theory and empirical work', Journal of Finance 25 (2), 383-417.
Fama, E. (1998a). 'Efficiency survives the attack of the anomalies', GSB Chicago
Alumni Magazine, (Winter):14-16.
Giombetti R. (2000) The Bubble. Vol 4, Issue 23
Harrington C. (2003) Head games: Helping quell investors' irrational antics. Accounting Today, v17 i11 p5(2)
Johnsson M., Lindblom H. & Platan P. (2002) Behavioral Finance - And the Change of Investor Behavior during and After the Speculative Bubble At the End of the 1990s
Malkiel B. G. (1989) Is the stock market efficient? Science, v243 n4896 p1313(6)
Samuelson P. (1965) Proof That Properly Anticipated Prices Fluctuate Randomly. Industrial Management Review, 6, pp. 41-49.
Scholes M. (1972) The Market for Securities: Substitution Versus Price Pressureand the Effects of Information on Share Prices. Journal of Business, 45, pp. 179-211.
Shefrin H. Beyond Greed and Fear. (1999) Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press.
Shleifer A. (2000) Inefficient Markets. An introduction to behavioural finance. Oxford university Press
The Banker (2004) Cover feature: how much risk can you manage? - Banks have a huge range of resources available to aid risk managers, but human nature can still result in a bad decision. Behavioural finance and prospect theory lifts the veil on poor investment judgement