The behaviour of contemporary financial markets is explained by two competing theories, the Efficient Market Hypothesis (EMH) and Behavioural Finance. The EMH assumes full rationality of investors, instant distribution of information across the market and thus its complete absorption by stock prices. Meanwhile, behavioural finance accounts for psychological factors and motives in investor behaviour claiming that these motives may significantly influence the investor’s decision making.
The EMH asserts that current stock prices take into account all present information that might affect the company value. Even the famous mean-variance approach to portfolio management is based on EMH. The weak form of the EMH coincides with the Random Walk Theory as it assumes that changes in stock prices occur randomly as new information is revealed to investors. This implies that no investor can persistently receive abnormal profits higher than market averages in a long run. The EMH is connected with one of the most indigenous financial issues, namely why stock prices change and what the reasons for these changes are.
The EMH proposes that beating the market and receiving extra profits from studying historical stock prices is impossible in theory. The core driving force affecting price changes is the appearance of new information. In an “efficient” market, prices react to information instantly, reflecting it objectively and without bias. Thus, stock price cannot be “too low” or “too high” as it objectively reflects current situation. Stock prices change fast and any arbitrage opportunities that may emerge resolve very quickly. Even financial ratio analysis and fundamental analysis of stocks is believed to be useless in pursuit of abnormal returns. The main driver of the appearance of an efficient market is strong competition among investors and traders. The skill to recognise mispriced stocks with their market value deviating from the fair value is very useful as investors would be able to make riskless profits but according to the EMH this is impossible. For obtaining new information faster, investors strive to reveal mispriced stocks and spend many resources on that. Gradually, more investors compete for gaining advantage and probability for arbitrage becomes lower and lower. In reality, only a very small group of large investors whose deals can affect market prices will benefit from recognising mispriced stocks, while for most investors the costs of receiving information and transaction fees will be higher than potential profit.
EMH is based on several assumptions that simplify the reality. However, these simplifications are too rough; so, they do not hold in real life and are a point of criticism of the theory. The most significant criticism of the EMH comes from the behavioural finance, which links investment decisions to human psychology and explores human subjective motives for particular actions in the financial markets. Critical remarks of behavioural finance regarding the EMH are the following.
The main underlying assumption of the EMH is that investors exhibit totally rational behaviour. This implies that they are risk averse and are interested in acquiring assets with the highest yields or returns given a certain acceptable level of risk. It is noteworthy, however, that the EMH does not require all investors to be fully rational. The market may be still efficient if some individual investors are irrational but group decisions are rational.
Empirical evidence shows that the assumption of complete investor rationality does not hold in real life. First, total rationality is difficult to determine as there always may be a chance of temporary irrational actions or motives. Second, human behaviour is frequently unforeseeable, and subjective motives such as emotions, herd instinct or panic behaviour may prevail over rationality. The investor rationality as a concept is linked to the conservative scientific paradigm of mechanistical essence of human being. It was suggested in the previous centuries that the nature and people are only mechanistic systems comprising visible elements without accounting for complex relationships between the parts of these systems. Therefore, spiritual and moral values, illogicality of a human’s mind, absence of direct and clear interest and serendipity are not perceived as substantial determinants of the economic thinking. Only later, research and experiments in the fields of psychology, sociology and economics revealed the important role of these stimuli in human decision making.
It is also important to emphasise the presence of numerous market anomalies such as the day-of-the-week effect, January effect, the effect of Holy Islam Days, and seasonal anomalies. The concept of irrational behaviour is also likely to explain the presence of numerous market bubbles of different size.
The next underlying assumption of the EMH is that current prices of assets in the market have already absorbed all public and available information that could affect the value of these assets. However, behavioural finance suggests that information is only a common concept, which can be interpreted in many different ways. Due to personal traits, individuals perceive and assimilate information differently and therefore it is too simplistic to assume that all market participants can absorb the same information in the same extent and make the same conclusions.
Moreover, information can be ambiguous and hard to interpret for practical use. Besides, technology and methods of analysis are constantly changing making the spread of news faster and costs of acquiring new information smaller, which attracts more investors. However, large and small investors still have access to different flows of information as some proprietary data may be too costly for small traders. Thus, large investors and high frequency traders (HFT) have more opportunities and facilities for accumulating, aggregating and analysing information and thus extracting profit.
The EMH asserts that most investors are risk averse. But different investors are able to accept different degrees of risk depending on their goals and abilities. They do not respond instantly to the incoming information as they need time for processing it and planning further actions. Moreover, it is not always clear what information is more important and will have more significant consequences, what might seriously damage investor’s positions and what will be harmless. This explains the presence of different levels of inertia in investors’ decisions. Thus, in most cases, there is a time gap between the arrival of information and reaction to it. Those investors who are able to react faster and more properly are likely to benefit from the information while those who react late, get into the mainstream and hence cannot outperform the market. Moreover, too late reaction to the circumstances may have a negative impact on the investor’s positions. That is, velocity of reaction to information is unequally distributed across the market. This applies to both regularly arriving information including routine events such as governmental reports and current news, and shocks such as bankruptcy of large institutions, natural disasters and unexpected political decisions.
An adjacent assumption of the EMH is that investors always react to similar information in the same way while, in reality, their behaviour is non-linear. Besides individual traits of character, investors may be affected by fleeting emotions or expectations. Particular forms of such behaviour may be over-confidence or overreaction to information. Some assets with high yields in previous periods could have smaller current yields whereas other assets with humble yields in the past could provide higher profit within the next periods. Thus, those investors who used to make decisions relying on the previous performance of the stocks, could be misled by this phenomenon in stock performance. These anomalies can be explained by over-reaction to incoming information.
Thus, two reasons for market inefficiency regarding distribution of information can be distinguished, namely psychical and technical. This explains the appearance of time gaps between reception and implementation of information. This allows for differentiating between two groups of market participants with distinct perception of market information. These are mostly rational investors that use only relevant and objective information and regular participants that are also exposed to the effect of rumours and current trends. The behavioural finance also criticises the tendency to model stock prices as a random walk process. The price history according to the behavioural finance reflects investor moods.
In conclusion, behavioural finance explains that underlying assumptions of the EMH do not hold in real life. In particular, investors’ behaviour cannot be fully rational due to individual traits of character, different perception of the level of acceptable risk, different expectations, current mood and fleeting emotions. The concept of instant distribution of information, which is the second important mechanism of market efficiency, appears to be too idealistic as well. Investors have different tools and opportunities for receiving and utilising information. Also, they may react to the same information in different ways and with different time lags, which makes the effect of information distribution suboptimal. These findings from behavioural finance also cast doubts on the validity of the third assumption of the EMH that asset prices follow a random walk.
Anna Clarke is the owner of online writing company 15 Writers. She is a successful entrepreneur with over 20 years’ experience in both freelancing and academic writing industries, specialising in Business, Economics, Finance, Marketing and Management.