Current Issues in FinanceS3 Lecture 5:
EMH and Behavioural Finance
Mark Largan3rd July 2012– 11.30:13.30July 3rd 2012 Mark Largan| Current Issues in Finance| MSc in Finance and Management
EMH
For more than ten years after the publication of Fama’s classic exposition, the efficient markets hypothesis dominated the academic and business scenes. A steady stream of studies and articles, both theoretical and empirical in approach, almost unanimously tended to back up the findings of the EMH. As Jensen (1978) wrote:‘There is no other proposition in economics which has more solid empirical evidence supporting it than the EMH.’
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
EMH
However, as Shleifer (2000) put it,‘strong statements portend reversals’– and in the decades following Jensen’s statement, a growing volume of theoretical and empirical work has either contradicted the EMH outright or sought at least to show that its case was not proven.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
The assumption that all investors are rational and value investments rationally–that is, by calculating the net present values of future cash flows, appropriately discounted for risk– is not supported by the evidence. A new discipline, behavioural finance, has emerged in the face of critiques of the EMH and has shown that, even if there are only a few irrational traders, and the remainder are rational, stock market prices can be affected both significantly and over the long term.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
Behavioural finance
Behavioural finance also argues that the‘there is no free lunch’ argument which applies to rational pricing in an efficient market can also apply to an inefficient market.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
Behavioural finance
There is no reason why either rational or irrational investors can make money out of inaccurate pricing of shares. Both the dot-com boom of the late 1990s and the stock market bubble which preceded the 2008–9 global financial crisis are examples of how prices can stay away from their‘fair’ value for substantial periods of time before major corrections in the markets.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
Behavioural finance
Other examples of mis-pricing are when: the same shares are traded on different stock exchanges at different prices and arbitrage does not eliminate the difference there is a jump in share price when a share is included in an index such as the FTSE 100 in the UK or the S&P 500 in the US part of a business is sold to investors and the sum of the retained part and the new‘carve out’ is different from the original value.
July 3rd 2012
Mark Largan| Current Issues
in Finance| MSc in Finance and Management
Behavioural finance
Behavioural psychologists have tried to explain why and how investors might be irrational.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
Behavioural finance Table: Example of investors’ irrational behaviour
Characteristic Example Overconfidence Investors have unrealistically narrow range forecasts for future stock-market index levels. Overconfidence leads to overtrading and greater losses (Barber and Odean, 2001).
Optimism Investors overestimate how good they are at investing relative to their peer group. Representativeness Investors attribute as much confidence to small sample as to large sample results. Conservatism Investors keep close to the‘base case’ estimate when attributing probabilities. Belief perseverance When forming estimates, investors start with some arbitrary number and adjust from that.July 3rd 2012 Mark Largan| Current Issues in Finance| MSc in Finance and Management
Behavioural finance
The drive to find practical solutions to the problems identified by agency theory has progressed simultaneously on two separate fronts. The problem of information asymmetry has been addressed by imposing ever-increasing disclosure requirements on company management, while the more glaring conflicts of financial interest between shareholders and directors have been tackled by attempts to create a closer relationship between company performance (as measured by increase in shareholder value) and directors’ remuneration. Both of these elements can be viewed as being elements in corporate governance.
July 3rd 2012
Mark Largan| Current Issues in Finance| MSc in Finance and Management
Corporate governance
Corporate governance can be defined as the set of rules governing the way the directors interact both with each other in the effective management of the company, and with the shareholders in their accounting for their stewardship of the company.
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