2.
There must be some biases when people make investment decision, as normal humans are imperfect. There are lots of different kinds of biases when making investment decision.
Home bias is one of the biases in making investment decision. Home bias indicates that investors tend to overvalue domestic stocks. According to French (1991), a typical Japanese investor held 98.1% in Japanese stocks; a typical U.S. investor held 93.8% in U.S. stocks; and a typical U.K. investor held 82% U.K. stock. The existence of this bias is because investors usually feel optimistic of their local market compared to foreign markets. More information available for local market may also be a reason for the existence of this bias.
Moreover, people also have a bias to overweight the stock prices of familiar brands. According to Laura (2005), institutional holdings are significantly and negatively related to brand recognition, but no discernible impact is present for brand quality. It means people have a high demand for firms with good brand names. This bias can be explained by information advantage of firm with good brand name.
I have only mentioned two biases, and there are still many biases in making investment decision, such as overweighting investment on industry which investors themselves are in. However, major reason of bias is due to informational advantage of that area. As Humans are imperfect and do not have perfect information, they will be affected by different kinds of biases when making investment decision.
3.
If at least some investors/traders demonstrate behavioral biases or irrationality, the stock market can still be efficient.
Efficient market means stock prices have already reflected all available information. In other words, they are correctly priced. For irrational investors, they may buy or sell a lot of stocks that are already correctly priced. For investors having investment biases, they tend to buy stocks which they prefer continuously even if they were in the right prices. Both behavior mentioned before may lead to over-pricing or under-pricing of stocks due to excessive demand or insufficient demand. This means the existence of market inefficiency. However, as long as there are still some rational investors knowing that the stock has been overpriced or underpriced, they will try to buy underpriced stocks and sell overpriced stocks. Finally all prices will back to original level and become correctly priced. Therefore, market can still be efficient even though there are some investors demonstrate biases or irrationality
However, as I have mentioned before, it may be too unrealistic for all investors to behave rationally. Therefore, market efficiency only required one of three supports (Investor rationality, uncorrelated errors and unlimited arbitrage). Even all investors are irrational or having behavioral biases, market can be efficient if one of another two supports hold.
4.
In my opinion, stock prices exhibit certain degrees of inefficiency or irrationality. As there are many irrational behaviors such as overconfidence, investment biases and investment based on emotion in the world, stock price must contain certain degree of irrationality.
There are already many public researches on irrational behavior especially investment based on emotion. According to Hirshleifer and Shumway (2003), they find that good moods resulting from morning sunshine may lead to investment. Clearly investment based on good mood resulting from morning sunshine is an irrational investment. Moreover, data that irrelevant to investment decision such as outcome of football game may also affect investors’ emotion and their decision on investment (Edmans, Garcia and Norli, 2007). Furthermore, Kamstra, Kramer and Levi (2002) report that stock markets fall when traders’ sleep patterns are disrupted due to clock changes with daylight savings time. These kinds of investment decisions are not made by any relevant information about the market. Therefore, these behaviors must be irrational.
Moveover, from my observation, there are some more irrational behaviors in the world. Some people who do not know anything about stock market still try to invest on stocks that are recommended by others. Usually, those who make recommendations also have little knowledge about stock market. Making investment decisions solely based on opinions from non-professional is clearly irrational.
As long as stock markets exist, investors may make mistakes collectively. Undoubtedly, some market participants are demonstrably less then rational. Stock prices contain certain degree of inefficiency or irrationality. If market is perfectly efficient, there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices (Grossman and Stiglitz, 1980). However, according to Burton (2003), whatever patterns or irrationalities in the pricing of individual stocks that have been discovered in a search of historical experience are unlikely to persist and will not provide investors with a method to obtain extraordinary returns.
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Reference list
Ackert, Lucy F., and Deaver, Richard (2010) Behavioral Finance: Psychology, Decision-making, and Markets. South-Western, Cengage Learning.
Burton G. Malkiel (2003), The Efficient Market Hypothesis and Its Critics
Edmans, A., Garcia, D., and Norli, O. (2007) Sports Sentiment and Stock Returns. Journal of Finance 62, 1967-1998.
Fama, E. F., 1970, “Efficient Capital markets: A review of theory and empirical work,” Journal of Finance 31 (1), May, 383-417.
French, K. R., and J. M. Poterba, 1991, “investor diversification and international equity market,” American Economics Review 81, 222-226
Frieder , L., and A. Subrahmanyam, 2005, “Brand perceptions and the market for common stock,” Journal of Financial and Quantitative Analysis 40, 57-85
Grossman, Sanford J. and Joseph E. Stiglitz (1980), “On the Impossibility of Informationally Efficient Markets,” American Economic Review, 70, 393-408.
Hirshleifer, D., and Shumway, T. (2003) Good Day Sunshine: Stock Returns and the Weather. Journal of Finance 58, 1009-1032.
by
kuenjohn (student)
