Note 2b: Behavioral Finance and the Efficient Markets

Theory (EMT) or Efficient Markets Hypothesis (EMH).

1.1 When are markets efficient?

The classic statements of the Efficient Markets Hypothesis (or EMH for short) are to be
found in Roberts (1967) and Fama (1970):
An ‘efficient’ market is defined as a market where there are large numbers of rational, profit
‘maximisers’ actively competing, with each trying to predict future market values of
individual securities, and where important current information is almost freely available to
all participants. In an efficient market, competition among the many intelligent participants
leads to a situation where, at any point in time, actual prices of individual securities already
reflect the effects of information based both on events that have already occurred and on
events which, as of now, the market expects to take place in the future. In other words, in
an efficient market at any point in time the actual price of a security will be a good estimate
of its intrinsic value.
The efficiency of a market appears when the price is set equal to the value. The necessary
condition for this is the immediate adjustment of the information. Andrei Shleifer suggests
that there are three conditions that would lead to efficiency.

1. Rationality. If all investors are rational, they will immediately adjust the price to the
new information.
2. Compensatory Irrationalities (independent deviations from irrationality) If half of the
investors are irrationally optimistic and the other half irrationally pessimistic, the price
will be modified in accordance with the prescriptions of market efficiency. So it cannot
be that all the market is irrational at the same time.
3. Arbitrage. If the world is divided in irrational amateurs and rational professionals, then
the latter will sell or buy the shares from the irrational people and make easy profit. If
the arbitrage of the professionals dominates the speculation of the amateurs, the
markets will be efficient.

A market is efficient when the prices of the goods traded in it are a good estimator of the
intrinsic value of those same goods. In other words, the price of the goods matches the value
of these. The theory of the efficient market was developed by the Nobel Prize in Economics
Eugene Fama in 1970. He argued that in a market where intelligent and well-informed
investors existed, the securities would be appropriately valued and would reflect all the
available information. It is not clear if there are very few markets that are of this coincidence;
is the normal thing a difference between price and value?

A market must also have the following characteristics to be efficient:

a) Be homogeneous (i.e. assets are substitutable, so 2 same assets must have exactly the same
price).

b) There are many buyers and sellers (so on average they find the right price)

c) Absence of barriers to entry or exit (so if there is a cheap asset, investors will enter to buy it)

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These three guidelines are the same for the Perfect Market concept, so an efficient market is,
in turn, a perfect market.

The Financial Theory has discovered two paths in the study of the profitability that it should be
required to apply to each asset according to its risk. The first path is the CAPM model (Capital
Asset Pricing Model) while the second is the Efficient Market Theory (EMT). According to this,
the returns offered by the assets in the efficient markets are in balance with their risks. The
EMT uses statistical and econometric methods to check if the prices that govern the market
automatically discount all the information.

However, the EMT clashes with the difficulty of value measurement. There are several
techniques to establish the value of the assets; all are made according to future expectations.
As soon as the expectations are different for each analyst, the value of the assets will be
different. The conclusion is that you can not determine the exact value of an asset, so we will
have different values for the same asset. What can be assumed is that all these values oscillate
randomly around the true value of the asset.

If a market is efficient, all investors have the same odds of winning or losing and this
probability is the same as that of a random portfolio. It does not matter that the investor uses
all his selected time the values of his portfolio based on the information available, he will
obtain the same profitability as a portfolio selected at random. Asset prices change at the time
new information appears, but both the timing of the change and the magnitude of the change
is unpredictable for investors; It is random. Therefore, the chances of obtaining an
extraordinary return are the same as those that would have a portfolio whose assets would
have been chosen at random.

In an efficient market no investor can obtain an extraordinary performance if it is not the

result of chance. Suppose that in an market an asset has a value of 100. Since the market is
efficient, everyone knows and knows the value of that asset. If someone decides to buy it, they
would not pay more than 100 for that asset. But it is also true that, if that investor who has
bought it for 100 decides to sell it, he will not get more than 100, so his benefit will be zero.
The consequence is that the investor has no incentive to buy the asset. This is the paradox of
Grossman - Stiglitz.

1.2 The efficient market paradox

A stock market can behave efficiently when there is a significant number of investors that
operate in that market believing that it is not efficient. They simply cancel each other out! In
1991, Fama warned that the efficiency hypothesis can not be tested, since this would require a
valuation model that took into account all the information, and for this an efficient market
would be needed (so there is no need to test for efficiency if it is already there!).

1.3 Three types of market efficiency:

Fama identified three distinct levels (or ‘strengths’) at which a market might actually be
efficient.
Strong-form EMH
In its strongest form, the EMH says a market is efficient if all information relevant to the value
of a share, whether or not generally available to existing or potential investors, is quickly and
accurately reflected in the market price. For example, if the current market price is lower than
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the value justified by some piece of privately held information, the holders of that information
will exploit the pricing anomaly by buying the shares. They will continue doing so until this
excess demand for the shares has driven the price up to the level supported by their private
information. At this point they will have no incentive to continue buying, so they will withdraw
from the market and the price will stabilise at this new equilibrium level. This is called the
strong form of the EMH. It is the most satisfying and compelling form of EMH in a theoretical
sense, but it suffers from one big drawback in practice. It is difficult to confirm empirically, as
the necessary research would be unlikely to win the cooperation of the relevant section of the
financial community – insider dealers.
Semi-strong-form EMH
In a slightly less rigorous form, the EMH says a market is efficient if all relevant publicly
available information is quickly reflected in the market price. This is called the semi-strong
form of the EMH. If the strong form is theoretically the most compelling, then the semi-strong
form perhaps appeals most to our common sense. It says that the market will quickly digest
the publication of relevant new information by moving the price to a new equilibrium level
that reflects the change in supply and demand caused by the emergence of that information.
What it may lack in intellectual rigour, the semi-strong form of EMH certainly gains in empirical
strength, as it is less difficult to test than the strong form.
One problem with the semi-strong form lies with the identification of ‘relevant publicly
available information’. Neat as the phrase might sound, the reality is less clear-cut, because
information does not arrive with a convenient label saying which shares it does and does not
affect. Does the definition of ‘new information’ include ‘making a connection for the first time’
between two pieces of already available public information?
Weak-form EMH
In its third and least rigorous form (known as the weak form), the EMH confines itself to just
one subset of public information, namely historical information about the share price itself.
The argument runs as follows. ‘New’ information must by definition be unrelated to previous
information, otherwise it would not be new. It follows from this that every movement in the
share price in response to new information cannot be predicted from the last movement or
price, and the development of the price assumes the characteristics of the random walk. In
other words, the future price cannot be predicted from a study of historic prices.
A way to study the weak efficiency of a market is through the Test of Signs. In a random series
there must be as many positive signs as there are negative signs, since the variation from one
period to another is done in a random way. If the market behaves like a Random Walk, then
there must be as many positive variations as negative returns.

In the following chart you can see how the proportion of positive changes has evolved
compared to the negative ones in the S & P 500. We note that the number of positive
variations is always, slightly higher, than the number of negative variations. These data
reinforce the idea that the market behaves, like a Random Walk, with a positive trend.

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Another way to test for weak-form efficiency is to examine the autocorrelation (or serial
correlation) in returns. If markets are weak for efficient then there should be no correlation
since returns should not be predictable based on past returns. On the other hand, if there is
correlation, then returns exhibit momentum, which is a common trading strategy (related to
herding). The chart below shows that there is on average 0 serial correlation in daily US
returns.

Daily correlation in S&P 500 returns from 1950 to 2016.

Implications of the three forms of efficiency

Each of the three forms of EMH has different consequences in the context of the search for
excess returns, that is, for returns in excess of what is justified by the risks incurred in holding
particular investments.

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If a market is weak-form efficient, there is no correlation between successive prices, so that
excess returns cannot consistently be achieved through the study of past price movements.
This kind of study is called technical or chart analysis, because it is based on the study of past
price patterns without regard to any further background information.
If a market is semi-strong efficient, the current market price is the best available unbiased
predictor of a fair price, having regard to all publicly available information about the risk and
return of an investment. The study of any public information (and not just past prices) cannot
yield consistent excess returns. This is a somewhat more controversial conclusion than that of
the weak-form EMH, because it means that fundamental analysis – the systematic study of
companies, sectors and the economy at large – cannot produce consistently higher returns
than are justified by the risks involved. Such a finding calls into question the relevance and
value of a large sector of the financial services industry, namely investment research and
analysis.
If a market is strong-form efficient, the current market price is the best available unbiased
predictor of a fair price, having regard to all relevant information, whether the information is
in the public domain or not. As we have seen, this implies that excess returns cannot
consistently be achieved even by trading on inside information. This does prompt the
interesting observation that somebody must be the first to trade on the inside information and
hence make an excess return. Attractive as this line of reasoning may be in theory, it is
unfortunately well-nigh impossible to test it in practice with any degree of academic rigour.

1.4 When Markets are Irrational:

There is a school of thought that considers that finances are influenced by the behavior of
investors. This behavior does not respond to rational but to psychological criteria. If we
analyze these criteria, we realize that due to the behavior of the investors, we cannot reach
any of the three Shleifer conditions. This is what is called behavioral finance. It can happen if:

1. Rationality breaks down. Investors are not rational, but they are Biased. This is mainly
because there are investors who rely on feelings (Heuristics and rule of thumb). Others
do not diversify (e.g. they prefer the shares only in their home country). Others buy
and sell so often that commissions and taxes eat up their profitability.
2. Compensatory irrationalities break down. Psychologists suggest that people
collectively deviate from rationality according to various basic principles.
a. Representativeness. For example, investors who rely on heuristics draw
conclusions from insufficient data. They consider the small sample (e.g. 5 year
past) that they have observed more representative than it really is (should see
100 year past!). This could lead to the formation of bubbles.
b. Conservatism. People are too slow to adjust their opinions to the new
information. Therefore you get momentum and shares slowly form a trend.
c. Insitutional factors. If all fund managers buy the same shares they all perform
relatively equal (so they get a bonus)
• Arbitrage not possible. In a market with many amateurs, professionals need to have
large positions to set prices. The risk of an incorrect evaluation, even without any new
information, will cause a decrease in the professionals’ arbitration positions. Therefore
there are Limits to arbitrage. Although investors buy the undervalued and sell the
overvalued, they are not guaranteed success. Keynes said that markets can maintain
the irrationality of investors longer than their solvency.

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This makes us wonder if markets are really efficient. There are many documented biases. Here
are some examples:

SELF-DECEPTION
Overoptimism: People overestimate their ability. The classic behavioural example is when
members of a random group are asked if they are above-, below-, or average drivers. The
results invariably reveal a majority of above-average drivers, a statistical impossibility.
Overconfidence: People feel more confident than they should. Men exhibit this trait more
than women. Studies have shown greater hubris in men leads to excessive turnover and
underperformance in investing. Complicating this, behavioural experiments have shown that
the more (and often irrelevant) information we accumulate, the more confident we become.
Self-attribution: People credit their skill for good outcomes and blame bad luck for bad
outcomes. Hindsight: People forget or overlook what they knew and when they knew it. This is
also called “success at correctly predicting the past.”

SIMPLIFICATION
Anchoring: People grasp non-relevant information, often believing they are making better
decisions. Montier gives the classic example of this as the experiment by Nobel Laureates,
Amos Tversky and Daniel Kahneman, using a rigged wheel similar to roulette, but one which
always stops at either 10 or 65.3 Two groups asked the same percentage-based question
responded differently depending on which number they saw after spinning the wheel.
Representativeness: People judge by appearance rather than likelihood. E.g. a short-term
positive profit results can be projected into the future so the stock price over-reacts, whereas
over the long-term we get back to the average. As Montier points out, people like a good story
rather than hard facts, and if numbers are involved, people are often quite bored.
Framing: People can give different answers depending on the same, but differently framed,
questions.
Conservatism. When companies increase their profits, prices react to the rise. The Theory of
Efficiency predicts that the change will be immediate. But behavioral finance says otherwise:
prices adjust slowly because investors are conservative and this implies slowness to take on
new information.
Loss aversion: People typically give more weight to losses than to corresponding gains.

EMOTIONAL
Regret theory: The fear of being wrong may outweigh the cost in objective economic terms,
and lead individuals or groups to non-optimal conclusions.

SOCIAL INTERACTION
Herding: Neurologists have found that real pain and social pain are felt in the same part of the
brain. Contrarian strategies are the investment equivalent of seeking out social pain.

These biases can lead to opportunities to make money easy (i.e. inefficient markets):
• Size. Companies with low capitalization present higher returns than companies with
high capitalization. Part of this difference in profitability arises from the risk of being
small, but studies say that not all the difference comes from risk.

• Value or Growth. The performance of the companies’ value is, historically, higher than
performance of the stock growth. The difference is very large and is a proof against the
efficiency of the market, but some authors indicate that these differences may come

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 because value stocks are riskier, meaning that investors require higher compensation!
The debate is ongoing……

• Bubbles. Over the years, the markets have experienced different bubbles and
collapses: the 29’s Crash, the Fall of 87, the Crisis of 2008 ... none of them has been
fully explained. There is the so-called Bubble Theory, through which markets rise
unchecked upwards and at a given moment there is a sudden correction that brings
prices to their original level. But there are authors who contend that this movement is
rational because it is based on expectations, which are real but change suddenly!

And now? 30 years ago, market efficiency was indisputable. Economists are now divided
between those who still believe in it and those who consider that behavioral finances prevail.
Representativeness says that investors overreact to the news and that's why they cause price
bubbles. On the other hand, conservatism tells us that investors adjust to information very
slowly, so that prices increase slowly. As we can observe, these are contradictory theories so
we must understand at all times the current psychological trend of the market. WHO IS THE
MARKET?

Reference: “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance”

James Montier, John Wiley & Sons, Ltd, 2007