Behavioural Finance

Jindal School of Banking and Finance

April-May, 2024

Lecture 4: Efficient Market Hypothesis

Amlan Das Gupta
Recall
 The fundamental edict of neo-classical economics is the efficiency of
markets.

 In order to have efficiency, logical consistency of preferences is

important.

 If we have rationality we can make very powerful predictions.

Rationality
 Rationality assumes that people do the best they can given their limited
means.

 Further you assume that people’s preferences will remain constant over
time and regardless of other events.

 And that their preferences will be logically consistent.

 Under rational preferences
 The market equilibrium is efficient. No other
outcome achieves higher total surplus.
 Govt cannot raise total surplus by changing the
market’s allocation of resources.
 Laissez faire (French for “allow them to do”):
the notion that govt should not interfere with the
market.

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
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product or service or otherwise on a password-protected website for classroom use.
 In Finance
 Eugene Fama’s Efficient Market Hypothesis (1970):
That in an efficient market, prices "fully reflect" available information.

 This implies that beating the market to make a profit is impossible.

 Stock prices follow a random walk!

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
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product or service or otherwise on a password-protected website for classroom use.
EMH.
 The EMH was a dominant force in financial economics for a long time.

 Theoretically it was shown that markets could be efficient.

 Empirical studies followed that showed that stock markets are indeed
efficient.

 In this lecture we will look at the basis of EMH and how behavioural
studies have dented those foundations.
Fundamental Values
 A fundamental problem in finance is to figure out the value of an asset.

 This should be the net present value of its future cash flows discounted using
their risk characteristics.

 Once the intrinsic value is known we buy the asset if price is lower and sell if
price is higher.
Asset 1. Pays you 50 each year forever.

 Suppose you discount your future earnings at the rate of β.

 So 1 rupee in a year is equal to β today. And β<1.
 Discounting can be due to subjective reasons, interest lost or inflation.
Asset 2. Pays something between 50 and 500 each
year with equal probability for ever.
 In this case there is uncertainty about the returns, hence we need to
work with expected payoffs.

However uncertainty may also be about the number of periods.

Theory of EMH

Theoretical basis for EMH can be viewed in three levels:

Level 1:
 Investors are rational.
 They correctly calculate the intrinsic value of assets.
 Any new information is incorporated in their calculations at once.
 So efficiency follows from market equilibrium.
Level 2: Some irrational agents.

 Even if there is a set of irrational traders the market

should still be efficient.

 Imagine a set of traders who trade randomly.

 On average their impact on the price should 0.

Level 3: Irrational traders trade systematically
 If the set of irrational traders trade systematically then their influences will
no longer cancel out.

 However, they will continuously lose money to rational traders who will bet
against them.

 So they should go out of the market soon.

Arbitrage: Main driver of EMH

 Arbitrage is defined as: the simultaneous buying and selling of the same or
similar assets in two different markets for advantageous price differences.​

 Arbitrage is what achieves efficiency in the stock market.​

 It is essential that arbitrage opportunities are identified, carried out as

quickly as possible with minimum transaction costs.
Consider a situation

 Suppose some irrational investors are buying overpriced securities.

 Rational investors can sell these (or sell short) and buy other similar securities
that are undervalued.
 This will result in the lowering of the price of the overvalued security.
Irrational investors

 Irrational investors are going to continuously sell undervalued securities and

buy overvalued securities.
 In each of these trades, they will be losing money and eventually running out
of resources.
 So arbitrage not only keeps prices at their fundamental value, they also help
stop irrational investors from persisting in the market.
Empirical Evidence
Hypothesis
EMH can be tested in two ways:
I. Do prices react quickly and in the correct direction when new information gets
revealed?
 People who get to know later (through media etc.) should not be able to benefit from
the news.
 Prices should adjust in the correct direction. Not too much, not too little.
 There should not be price trends or reversals after the news.

II. If the information is not relevant the prices should not react.
Part I: “Stale” information should not be able to “make money”

Stale information is defined in three ways:

1. Past prices. – Random walk hypothesis (weak).
2. Publicly available information other than past prices (semi-strong).
3. All information either public or private (strong).
Defining “money making”
 This definition is more controversial as the money making is defined as
making abnormal risk adjusted profits.

 Adjusting for risk is a difficult thing to measure. (example CAPM)

 So it is not enough to show that a positive cash flow has been obtained
through information.
Empirical results
 One kind of study tried to test the random walk hypothesis for example
Fama (1965).

 The evidence confirms the hypothesis.

 If past price has gone up there is an equal chance of the price going up or
down.
Event studies
 Another kind of study looks at stock prices around some major event.

 If prices react to it and stay at the new level then it confirms EMH.

 Example, Keown and Pinkerton (1981).

Mental Accounts
Reaction to irrelevant news
 Studies also found that stock prices do not react to irrelevant news.

 Example: Scholes (1972) found insignificant reaction to stock prices in

event studies on the announcement of block sales of stocks.

 If the prices are determined by the intrinsic value of the stock, it should
not depend on availability.
Reaction to irrelevant news
 Arbitrage depends on the availability of close substitutes.
 A close substitute for a given security or portfolio is another security or
portfolio with almost identical cash flows in all states of the world.
 If an irrational investor decides to sell off a large block of securities it
does not change its value relative to close substitutes.
Hegemony of EMH

Till the 1970s EMH was the big success story in finance.

Michael Jensen 1978 “there is no other proposition in economics with more

solid empirical evidence supporting it than EMH”

Next we will look at the challenges to EMH

Theoretical Challenges to EMH
Failure of Rationality
 People sell winners.

 People follow the advise of financial gurus.

 Actively trade stocks and churn their portfolio.

 Fail to diversify.
FOR1: Choice under uncertainty
 We don’t make choice under uncertainty using expected utility.
 Our choices depend on reference points and we demonstrate loss
aversion.

Consequence:
 Tendency to hold on to loosing stocks and sell winners.
 Equity premium puzzle: The returns needed for people to invest in
stocks is absurdly high compared to the risks.
FOR 2: Representative bias
 We tend to ignore the rules of probability when we make estimates of chance.
 Base rate neglect, mean reversion neglect and neglect of the importance of sample
size are some examples.

Consequences
 People use limited historical data to make long-term predictions.
FOR 3: Framing

 We choose differently based on how the question is framed.

Consequences:
 People may change their investment decision based on whether
they see the long term or short term trajectory of the same stock.
Can irrational traders cancel each other out?

 We are not randomly irrational but predictably irrational as

per Dan Ariely.

 So people would tend to buy and sell in the same direction.

 This is only exacerbated due to herd behaviour.

Role of professional fund managers

 Apart from general human biases fund managers are also subject to hind
sight bias.

 People are quick to forget past judgements in the light of current events.

 So people who take decisions for us are likely to be blamed for failures.
Final defence: Arbitrage.
 If there are irrational agents who trade systematically
they will eventually run out of business.

 Happens through quick and efficient arbitrage.

 In contrast to EMH behavioural finance claims that

arbitrage is risky and hence limited.
Arbitrage
Suppose a rational investor sees that an irrational investor is willing to pay a
higher price she has a few options:
1. If she holds those stocks she can sell it and buy it back later.
2. She can short-sell it if she does not own them.
3. She can set up a put option.

But are these truly riskless arbitrage?

Arbitrage: Main driver of EMH

 A perfect arbitrage is when you sell the overpriced stock in one market and
buy it at the correct price in another market.

 Or you buy similar stock.

 But for this to happen the overpriced stock has to have close substitutes.

 The moment you don’t have perfect substitutes you run arbitrage risks.
Close substitutes

 Some individual stocks may have close substitutes.

 However, the arbitrageur still runs the risk of idiosyncratic factors.
 So, now the possibility of convergence in prices is high rather than a
certainty.
Noise trader risk
 Even if perfect substitutes are available there is still the risk that price
corrections take a long time.

 There is a chance that mispricing continues.

 So arbitrageurs will suffer losses in the short run.

Example

 At the beginning of 1998 economists like Shiller and Campbell as well as

policy makers like Alan Greenspan pointed out that prices were inflated.

 The S&P 500 index stocks were trading at market value to earnings ratio
of 32 compared to the post war average 15.

 At the beginning of 1998 this ratio was already 24.

Example

 But the inflation in prices would continue through 1997 till the end of 1998.

 If a rational arbitrageur would short the S&P at the start of 1998 she would be
at a loss of 28.6% by year end.

 If she went short at the start of 1997 she would lose an additional 33.4%.

 Most traders would be out of business if they attempt this.

Will irrational traders be run out of the
market
 When both are taking risks returns depend on risk taken.
 If irrational traders take more risks they may be rewarded with higher than
average returns.
 A risk neutral trader may be having positive expected returns and still get
bankrupt with near certainty.
Empirical Evidence
First challenge
 In 1981 Shiller pointed out that the variability in stock returns was much
more than what would be predicted by a simple model of risk-adjusted
returns.

 However, the work was criticized for using a constant discount factor and
assumptions on the dividend process.
De Bondt and Thaler (1985)
 Tests the hypothesis that past prices cannot predict current prices (weak
form of EMH).

 For each year constructs a portfolio for the top and bottom performing
stocks.

 Follows the two sets over time from the time of formation.
Results
 The losers clearly show higher rates of return than the winners.

 Difficult to explain by the riskiness of the extreme losers.

 Better explained using reversion to the mean.

Short term trends

 Unlike long term trends reported by Bondt and Thaler, short term trends (6-12
months) tend to be persistent.
 Jegadeesh and Titman 1993:
 “… strategies which buy stocks that have performed well in the past and sell
stocks that have performed poorly in the past generate significant positive
returns over 3- to 12-month holding periods”.
Reaction to publicly available information
 In the NYSE small stock have done better than large stocks.

 1926-1986, top decile 9.8% return vs bottom decile 13.8%

 Smaller stocks do particularly well in the month of January.

 These reactions to stale news were observed between 1926 and 1996 and
have since disappeared.
Market to book ratio

 The ratio of the value of a company in the stock market to that indicated in
its accounting books is called the market to book ratio.

 Just as shown by De Bondt and Thaler, portfolios chosen on the basis of low
and high market to book ratio also exhibit predictable differences in returns.

 Criticised on the argument that risk is reflected in market to book ratios. (3

factor model of Fama and French 1993, 1996)

 But then how did the effect disappear?

Reaction to non-information

 Monday, October 19 1987, the Dow Jones Industrial Average (DJIA) fell by 22.6%.

 On May 6, 2010, between 2:32 PM to 2:45 PM, DJIA fell by 998.5 (9.2%) points wiping away
nearly one trillion dollars from investors’ wealth.

 Not exception: Over fifty large stock price movements post WW2 happened without
any apparent reason (Cutler et al. 1991).
Reaction to non-information

 Roll (1984, 1988): Only about thirty percent of price variation can be explained by
aggregate economic movement.

 Wurgler and Zhuravskyaya: Entry to S&P 500 index leads to a rise in price.
Mental Accounts
 What explains lack of evidence before 1980

1. Data snooping, sample selection non adjustment for risk?

2. Lack of data: Time series predictions need a lot of data.

3. Bias: Unwillingness to publish studies that attack EMH.

Readings

 An Introduction to Behavioral Finance, by Andrei Shleifer, chapter 1