Mar292008

Efficient Markets vs Behavioral Finance

Efficient Markets Theory

The efficient markets theory is the idea that speculative asset prices always incorporate the best information about fundamental values and that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information(i). This idea dominated academic fields in the early 1970s. Efficient markets theory is an elegant attempt to tether asset prices to fundamentals through the common-sense notion that people would not behave in irrational ways with their money in financial markets. This theory is encapsulated by the “value investment” paradigm prevalent in much of the investment community.

Efficient Markets Theory

Efficient Markets Theory

 

In an efficient market, prices are tethered to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers will enter the market and purchase the asset until prices reach their perceived value. If prices rise above the market’s perception of fundamental value, then sellers will enter the market to sell the asset at inflated prices. Efficient markets theory explains the majority of market behavior, but it has one major flaw which renders it inoperable as a forecasting tool: it does not explain those instances when prices become very volatile and detach from their fundamental valuations. This becomes painfully obvious when adherents to the theory postulate new metrics to justify fundamental valuations that later prove to be completely erroneous. The failed attempts to explain anomalies with the efficient markets theory lead to a new paradigm: behavioral finance theory.

Behavioral Finance Theory

Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall. The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down. If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved. These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds they “borrow” the collective expertise of the market. In reality, they are just following the herd. This herd-following has long been a valid investment technique employed by traders known as “momentum” investing(ii). It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a “buy and hold” strategy.

Behavioral Finance Theory

Behavioral Finance Theory

 

The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. In the Great Housing Bubble, the primary precipitating factor was the lowing of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason: Herd mentality takes over.

Psychological Stages of Bubble Market

 

Psychological Stages of a Bubble Market(1)


 

(i) Much of the history of the Efficient Markets theory is outlined in Robert Shillers paper (Shiller, From Efficient Market Theory to Behavioral Finance, 2002), “The efficient markets theory reached the height of its dominance in academic circles around the 1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the 1980s, and of evidence of excess volatility of returns. Finance literature in this decade and after suggests a more nuanced view of the value of the efficient markets theory, and, starting in the 1990s, a blossoming of research on behavioral finance. Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.”

(ii) In House Prices, Fundamentals and Bubbles (Black, Fraser, & Hoesli, 2006), the behavior of momentum investors is characterized as evidence against rationality in the marketplace. For the typical amateur speculator this is certainly true, but for momentum traders who have learned how to buy and sell to profit from the momentum, it is a rational and profitable method of speculation.