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Behavioral Finance

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New!  Valuation, Efficiency, & Behavioral Finance

This week’s lesson subjects highlighting the importance of utilizing a top-down approach in conducting security analysis regarding an investor’s possible investment in a specific company stock, was particularly useful.  In many ways, this amount of research devoted to selecting an optimum security appears essential in ensuring a profitable investment return is achieved all the while investment goals are met.  However, the concept of the efficient market brought up some valid points to ponder whether or not this amount of time devoted to research is even required at all.  According to Smart, Gitman, and Joehnk (2017), an efficient market ensures that securities trade closely to their correct values at all times and therefore, it is impossible to outperform the market.  In addition, according to the efficient market hypothesis, a security analysis will not be effective in identifying a security such as a mispriced stock unless it has occurred by random chance.  Therefore, if an investor is truly a follower of the efficient market, the amount of time that is devoted to researching and finding the optimal security that will outperform the stock market would be considered a waste of time. However, in some cases the efficient market hypothesis has worked.  The Economist (2017), attributes the efficient market hypothesis in helping create index-tracker funds in the 1970’s.  Index tracking funds, are simply funds whose managers purchase all stock shares that are found within a popular market index such as the S&P 500.  The Economist (2017), has reported that this index tracking strategy has paid off for many investors as returns have generally been steadily rising over the years. 

Behavioral finance, is the concept derived from behavioral economics that attempts to understand how people such as investors make choices in the financial markets (Hubbard & O’Brien, 2018).  This particular theory states investors generally behave rationally and given the information that is available to them, they usually are able to meet their investing goals.  However, an investor can act irrationally if his or her investment behaviors are inconsistent with the long-term investing goals.  One such example of an investor acting irrationally, can be exhibited by acting overconfidently.  Overconfidence, is a psychological trait that can be exhibited by an investor who puts too much faith in his or her ability to perform complex tasks associated with investing (Smart, Gitman, & Joehnk, 2017). 

Regarding the financial crisis of 2007-2009, I can see how both the efficient market and behavioral finance theories have led to failure and perhaps, have caused more damage than good.  In relation to behavioral finance, overconfidence on the part of investors and banking institutions, may have helped in not foresee the building of the housing market bubble that eventually led to staggering investment losses.  Hubbard and O’Brien (2018), state that during economic bubbles, it is of much difficulty for well-informed investors to force prices back to fundamental values because investors generally do not act rationally as portrayed in the efficient market hypothesis and behavioral finance theories.  Regarding the downfall of stock prices during that same timeframe, the Dow Jones, S&P 500 and NASDAQ declined by 54, 57 and 56 percent respectively (Hubbard and O’Brien, 2018).  In my opinion, these losses were not a result of the efficient market correcting itself because of overvalued securities or perfect information however, it was simply investors increasing their equity returns in a manner that would compensate them for risks that may be incurred.  Furthermore, Hubbard and O’Brien (2018), attribute the Gordon growth model to the decline of stock prices because under that particular financial model, an increase of return on equities and a decrease of dividends will cause stock prices to fall.            

In conclusion, I would not be dismissing the importance placed on conducting research and attempting to choosing a security that has the greater potential for future growth and monetary returns. 

References:

Hubbard, R.G., O’Brien, A.P. (2018). Money, Banking, and the Financial System. New York, NY: Pearson.

Smart, S.B., Gitman, L.J., and Joehnk, M.D. (2017). Fundamentals of Investing (13th ed.). Upper Saddle River, NJ: Pearson Education, Inc.

The Economist. (2017). Is efficient-market theory becoming more efficient? Retrieved from https://www.economist.com/finance-and-economics/2017/05/27/is-efficient-market-theory-becoming-more-efficient

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Kelly Brinkel(Oct 24, 2018 12:53 PM)- Read by: 1

The efficient market hypothesis states that stock prices will encompass all relevant information in a competitive financial market. This means that all information surrounding the market as a whole and each individual stock is taken into consideration when pricing different stocks, and essentially means that nobody would be able to 'out smart' the stock market. This theory has been highly criticized over time, but especially after the financial crisis that occurred between 2007 and 2009. Many people have the same question - if all information was taken into consideration when pricing stocks, how and why did the market crash so hard?

Perhaps one thing that many critics fail to take into consideration is that all theories, hypothesis, etc. will have an extent of limitation. We cannot assume that this hypothesis is perfect. Different factors will affect the stock market at any given time, and though the prices may have taken all knowledge and information into consideration, there are still several unknowns in the world. The stock market is not a perfectly predictable thing. If it were - many more people would become rich off of the stocks they invest in.

In my opinion, one thing that may have helped to cause the financial crisis between 2007 and 2009 is investor's heavy reliance on such a theory. If too many investors found this theory to be fool proof, too many actions may have been taken to cause such a crash. To put this into perspective, consider the following. Stock 'XYZ' that has been showing very high and continually increasing returns over the past period of time suddenly drops by a large percentage. This stock has a very large number of shares sold on the market due to its successful history. One day, this stock faces a large loss. So many of the investors that hold shares of this stock assume the efficient market hypothesis is perfect and therefore pull out of this stock as there is 'clearly' information that shows this stock is no longer worthwhile. As more and more investors pull out, the market continues to decline more and more. If this scenario were to apply to a large number of stocks, the market as a whole would crash. In theory, this may have been what happened to cause such a serious crisis.

My opinions are not to say that the efficient market hypothesis is not reliable or relevant. Surely this hypothesis has helped many investors to make important decisions in their portfolios and has likely lead to high successes and returns for many. Perhaps the issue with this hypothesis is that like all other theories in this world, there are limitations and exceptions that make it imperfect. If we rely too heavily on something an act too fast, it can have a chain reaction and lead to poor outcomes.

Reference

https://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/Ball_2009%20EMH%20and%20the%20GFC.pdf