Compare and Contrast the Efficient Market Theory and the Behavioral Finance Theory. in Your Opinion, Which Is the Most Reflective of Market Behavior?

Examination Number: B058498

Principles of Finance

Tutor: Cong Wang

Word Count: 1128

Compare and contrast the efficient market theory and the behavioural finance theory. In your opinion, which is the most reflective of market behaviour?

There are several different hypotheses on how investors evaluate and visualise stocks and produce their price valuations. In this essay I will be comparing the efficient market theory and the behavioural finance theory. The emergence of the latter has allowed investors to question the accuracy of the former and develop new investing strategies based on the weaknesses of both concepts. I will provide a thorough explanation of the structures of both theories and the evidence surrounding the accuracy of both theories.

Eugene Fama, an American economist, initially developed the efficient market theory in the 1960s and it is considered as the spine for modern financial philosophy. It has been refined over the years as we learn more about investors and stock market behavior, however up until the 1990s it was the most generally acknowledged methodology used by economists. The hypothesis states that stock prices emulate all relevant information, meaning that investors cannot profit from any investment strategy, as bargain prices do not exist. Therefore, the only way to establish income is by making riskier stock purchases. There are three versions of the hypothesis: “weak”, “semi-strong” and “strong”. Weak suggests that a perfectly efficient market exists, reflecting all available information. In addition, previous capital gains or loss from investments will not have any effect on future returns and so profitable strategies are ineffective. Semi-Strong insinuates that stock prices react almost instantaneously to newly released information, therefore investors who discover this information first cannot benefit by acting before the majority of the market to gain a profitable advantage. It also suggests that all information is public, so investors cannot take advantage of unknown information. The strong version implies that private ‘insider information’ ceases to exist, so no investor has an advantage over another. This concept suggests it is impossible for investors to outperform the stock market and achieve more profit than another based on the information available. There are a number of tests that can be carried out to distinguish which of these versions a stock comes under.

The efficient market theory has created a lot of controversy and there are a number of reasons as to why this theory has been criticised. Firstly, all investors analyse information differently – whether it be from corporate press releases, financial statements or news reports for example – and secondly, those who are prompt to react to newly available information can take advantage of a ‘bargain price’ as stock prices take time to respond. Thirdly, human error such as misinterpretation of information, information bias, and overconfidence can lead to bad investments and so the prices do not reflect their true value. The hypothesis also insinuates that investors cannot outperform the market, yet famous stockholders such as Warren Buffet continue to make profits substantially higher than the average investor. Another reason that this theory may be incorrect is it states that “dart-throwing” will produce a portfolio that will be expected to perform as well as investments managed by professional analysts, yet analysts are still in business, implying that their services are worthwhile. Furthermore, investors can act irrationally in the market by seeking a quick method of obtaining profit. This can be done without full acknowledgement of the information available and can lead to abnormalities in the stock price.

The behavioural finance theory makes assumptions based on investors’ perceptions and psychology-based theories to understand irregularities in the marketplace. Stock prices can be driven by a number of different emotions: when prices are ascending, it can attract substantial publicity and potential investors see a viable opportunity to make profit and they purchase the stock in the expectation of further increases in its value and the potential for reward. This, in some cases, can create a ‘bubble’ effect – a spiral of expectation leading to higher prices, which is not sustainable in the long run – and it will eventually burst. On the other hand, when prices are falling, investors may seek to cut their losses in anticipation of their assets continuing to drop in value. This contradicts the efficient market theory as it shows prices are significantly impacted by the mentality of the buyers and sellers, sometimes more so than they are affected by information. Furthermore, another concept of the behavioural finance theory is overconfidence. Overconfident investors can lead to bad investment decisions – an overestimation of their personal attributes, particularly financial analysis, as well as arrogance as a result of recent profitable investments can result in an insignificant stock purchase.

Herd behavior is another aspect of the behavioural finance hypothesis, which is all about humans’ inclination to follow the actions and choices of a larger group and allow them to be influenced into choosing certain stocks. This can be due to the social pressure of being an outcast from a crowd – people generally want to be accepted. It may also be that if a large group of people all believe in one outcome then it is unlikely to be wrong, or they could have unknown information and despite your own views (rational or irrational) the course of action of following the herd may be the best option.

In addition to herd mentality, a thesis developed by Daniel Kahneman and Amos Tversky looked at the human perceptions of gain of loss – if you give an investor an equal choice between two stocks, one outlines the potential gains and the other the potential losses, they will choose the former despite having equal profitability. In other words, if someone gained £500 and another person gained £1000 and then lost £500, people will conventionally choose the latter, despite an equal net profit of £500. This is also known as ‘loss-aversion theory’.