Other event studies including, mergers and acquisitions, seasoned equity offerings, dividend announcements, etc... have generally shown similar results, meaning abnormal returns cannot be expected by trading on the announcement date.
Another study by Michael Jensen, found that over the period 1955 to 1964 mutual funds on average achieved a risk-adjusted performance of approximately zero percent per year; the funds on average were unable to outperform a passive strategy (Keane 1983, p.43). The inability of fund managers to outperform the market, implies that the market is efficient in at least the weak and semi-strong levels, but because there is no evident use of insider information, implications for strong level efficiency isn’t clear.
If the strong form efficiency hypothesis were to hold true, investors who have private information should not be able to profit from trading on their information. However, a study by Rozeff and Zaman (1988), showed that even after a assumed deduction of 2 percent due to transaction costs, profits from insider trading are still 3 percent per year (Clarke, Jandik and Mandelker, p.17).
Evidence against the EMH
DeBont and Thaler (1985) formed a portfolio of stocks which over previous three years had really low and high returns and compared these to the returns of these stocks over the following five years. The results indicated that stocks with low past returns tend to have higher future returns and vice versa (Shleifer 2000, p.17). This difference in returns is due to an overreaction of stock prices. Another study by Jegadeesh and Titman (1993) showed evidence of momentum. Stocks with high returns in the past year continued to have high returns over next few months. This implies that unlike long-term trends which tend to reverse, short term trends continue (Shleifer 2000, p.17). These results appear to be inconsistent with the weak form EMH, since past returns are being used to predict future returns .
Futhermore, Rolf Banz uncovered a anomaly in 1981; he found that small firms tend to have higher abnormal returns than do larger firms. Subsequent research indicated that most of the difference in returns between them occurred in the month of January (Clarke, Jandik and Mandelker, p.20). There is no evidence that small stocks are much riskier in January, therefore, since both a company's size and coming of the month of January is information known to the market, the excess returns based on stale information, contrasts the semi strong form efficiency hypothesis.
Although no theory is perfect, the is an abundance amount of evidence supporting the EMH, at least in the weak and semi-strong form efficiency. However, the substantial noise that is apparent in the markets have led academic researchers to turn to other theories.
2) Discuss the behavioural challenge to market efficiency.
As mentioned, the EMH assumes that decision makers are considered to be rational and utility maximising. However, in reality, there are many instances where emotion and psychology influences peoples decisions, causing unpredictable or irrational behaviour. This had led to the emergence of behavioural finance, which provides reason for some of the anomalies mentioned in part 1 and hence questions the conventional methods of modelling investor behaviour.
Both cognitive and social sources of psychology that are useful in suggesting how real people behave will be examined.
Heuristic Decision Processes
Heuristic decision processes are where people make mental ‘short cuts” instead of rationally collecting all relevant information and evaluating objectively (Brabazon 2000, p.2)
Human beings are often overconfident causing them to overestimate their knowledge, underestimate risks and exaggerate their ability to control events. Overconfidence can lead investors to poor trading decisions, which often are excessive trading, risk taking and ultimately portfolio losses (Nofsinger 2002, p.15).
Representativeness refers to the tendency of decision makers to observe patterns that may not be relevant or may not exist; patterns may appear even if random numbers where plotted. Investors also tend to assume recent events in price movements will continue, hence buying stocks that have been recently performing well (Brabazon 2000, p.3). This might explain the overreaction affect by DeBondt and Thaler that was mentioned in part 1 which revealed that stocks with low past returns outperform stocks with high past returns.
Availability bias emerges when people tend to heavily weight their decisions on whats the most easily available information, hence often makes any new opinion biased towards the latest news.
Prospect Theory
Prospect theory describes how people frame and value a decision involving uncertainty. There are a number of states of mind that influence one’s decision making processes (Brabazon 2000, p.3).
Loss aversion is based on the idea that people value losses greater than gains. The utility lost when losing x amount of money is greater than the utility gained from getting the same amount. A key assumption in the EMH is that investors are risk averse, however in reality, there is evidence that people are risk averse when protecting gains, but become risk seeking when in a losing position in an attempt to escape out (Brabazon 2000, p.4).
Regret aversion is when people avoid the emotional pain of regret. Selling a poorly performing stock means realizing your poor purchase decision and will feel regret. Hence, to avoid regret, investors sell winners and hold onto losers. This is also known as the disposition effect (Nofsinger 2002, p.22). This behaviour contradicts traditional market advice- run your winners and cut your losses. Barber and Odean (1999) used data from 10 000 accounts at a US brokerage firm over the period 1987-93, results showed that investors sold a higher percentage of their winnings compared with their losing stocks.
Furthermore, when investors create ‘mental accounts’ of their investments and are risk adverse in their downside protection accounts and risk seeking in their more speculative accounts, interactions between accounts are ignored and overlooked and investment portfolios become inefficient (Brabazon 2000, p.4).
Social Psychology
Human interaction and peer effects are also important in financial decision making.
Herding is where individuals tend to follow the actions of the majority. The underlying reason behind this theory is that of social pressure. The general consensus is that the majority decision is less likely to be wrong. Moreover, as regret aversion suggests, regret of a bad investment is lower when you know other have make the same mistake.
Herding can lead to speculative bubbles, which historically have resulted in stock market crashes. People base their decisions on what the herd does, instead of rigorous analysis. When such psychological biases exist, the market swings on the basis of very little information, which can push stock prices far above their actual worth (Nofsinger 2002, p.80)
Challenge to EMH
Such psychological behaviors affect the EMH in a number of ways. Moreover, if the theory behind behavioral finance is in fact correct, we can assume a number of possible behavioral patterns within financial markets. These patterns include: an over or under-reaction to price changes or news, extrapolation of past trends for future, lack of attention to fundamentals underlying a stock, target on popular stocks, and seasonal price cycles (Brabazon 2000, p.6).The implications of these patterns provide a basis for investors to exploit pricing anomalies as means of obtaining superior risk adjusted returns, challenging the EMH.
On the other hand, Fama argues that prices are just as likely to over-react as they are to over-react (Shleifer 2000, p.47). They are chance events that will balance each other out overall, suggesting that the EMH is still accurate and relevant. Further, these anomalies from irrational behaviour is argued to be met by other rational investors where arbitrage will drive prices back to their ‘correct’ level.
Bibliography
Barber, B.M. and Odean, T., 1999. The Courage of Misguided Convictions. Financial Analyst Journal, 55 (Issue 6), pp. 41-55)
Brabazon, T., 2000. Behavioural Finance: A New Sunrise or a False Down?, [online]. Available at: <http://wenku.baidu.com/view/03d9b56baf1ffc4ffe47ace7.html> [Accessed 20 October 2011].
Clarke, J., Jandik, T. and Mandelker, G., The Efficient Market Hypothesis. Available at: <http://www.e-m-h.org/ClJM.pdf> [Accessed 22 October 2011].
Dimson, E. and Mussavian, M., 2000. Market Efficiency, The Current State of Business Disciplines, [online]. Available at: <http://faculty.london.edu/edimson/assets/documents/spellbou.pdf> [Accessed 15 October 2011].
Fama, E.F., 1970. Efficient Capital Markets: A review of theory and empirical work. Journal of Finance, 25, pp. 383-417.
Keane, S.M., 1983. Stock Market Efficiency: Theory, Evidence and Implications. Oxford: Philip Allan Publishers Limited.
Lofthouse, S., 2001. Investment Management. 2nd ed. West Sussex: John Wiley & Sons Ltd
Nofsinger, J.R., 2002. The Psychology of Investing. 3rd ed. New Jersey: Prentice Hall.
Shleifer, A., 2000. Inefficient Markets: An Introduction to Behavioral Finance. New York: Oxford University Press.
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