Are we in an efficient market? Or a behaviour driven market?
Looking at the Efficient Market Hypothesis and the Behavioural Market Hypothesis to see which one is more fitting of our current market conditions.
Most people have heard of the Efficient Market Hypothesis (EMH). The Behavioural Market Hypothesis is lesser known, but something a lot of people do start to see makes sense (At least as a theory) when they learn a bit about it. The EMH is accepted as a default truth by many. It's behind a lot of the usual investing advice and warnings you'll have heard. More about these later.
Behavioral Finance or Efficient Market Hypothesis?
Behavioral Finance and Efficient Market Hypothesis have different kinds of
perceptions of the financial literature. While the efficient market hypothesis
supports that people are rational investors who are important part of financial
market. Behavioral finance which is alternative model accepts people as normal and
irrational. When efficient market hypothesis is considered, the assumption is that the
price of stock market will reach equilibrium since prices are informationally efficient.
However, behavioral finance claim that investors tend to have some psychological
and emotional biases which lead to irrationality. Both new and old concepts try to
find solution for ecomomic and financial problems. Therefore, assumptions and
research for these two different models play an essential role to understand and
prevent financial crises. Otherwise, it will be hard to solve the underlying problem of
economic and financial crises. Therefore, Behavioral Finance and Efficient Market
Hypothesis which play an essential role in every branch of finance will be compared.
Behavioral Finance or Efficient Market Hypothesis?
Let's start there.
The EMH puts forward that people are rational investors. Playing a considered and important part in a stable financial system. What's meant by this is that they've done proper security level (Fundamental) analysis. Are working using good data. Have interoperated it correctly. Are investing sums of money that are suitable as a percentage of risk of their annual income/net worth.
The BHM puts forward that people investing in the market are just people. Not everyone is fully aware of all of the above mentioned data points. Probably not looked into every one of them. Chances they are going to be bias towards certain things. Maybe interests they have. Related to hobbies. Peer pressure. Sometimes people who are investing in the markets are making emotional decisions.
I'll let you keep your own scorecard on this one.
EMH and BMH on Speculative Bubbles
A situation in which prices for securities, especially stocks, rise far above their actual value. This trend continues until investors realize just how far prices have risen, usually, but not always, resulting in a sharp decline. Speculative bubbles usually occur when investors, for any number of reasons, believe that demand for the stocks will continue to rise or that the stocks will become profitable in a short time. Both of these scenarios result in increased prices.
With the EMH, speculative bubbles can not occur. Speculation is not efficient. The market is able to gather all the data and if something becomes over-priced there is arbitrage opportunity in coming in to short that stock and correct it back to fair/book/intrinsic value. The longer prices became over-priced the fewer people would be interested in buying them. Correcting the market.
Speculative markets are often described as “informationally efficient” such that predictable price changes are eliminated by traders exploiting them, leaving only residual unpredictable fluctuations.
An Inherent Instability of Efficient Markets
With the BMH speculative bubbles are almost certain. People are likely to think alike, communicate, act upon the same information (Typically lowest common denominator) and this will lead to there being the self feeding effect of people buying because it is going up, and people it's going up people are buying. The value is forgotten. Only the gains are thought of.
The BMH would put forward that human crowd/herd psychology makes speculative bubbles inevitable.
Unthinking ferocity of mob action
Edward David Jones "Economic Crisis"
Written in 1990. Ironically, this would have been around about the time the tech bull rally was starting. Which is usually regarded as the most obvious speculative bubble (If you believe in them).
Second point to score.
EMH: Throughout history any of the major bull runs or any of the major bear rallies have either always been entirely unpredictable. Before the crashes the markets were not over-valued. The crashing of them was due to investors learning of news leading to revaluation. There was never excess opportunity to buy or sell at any point during the rise or fall.
BMH: The speculative boom in tech was a result of stocks that might have been priced well initially being bid up more and more based on enthusiasm and popularity rather than the value of the company. Investor's decisions are being driven by emotional forced that are not related to the underlying value of the assets. When price stops rising, panic is sure. Crash inevitable.
Timing Market Moves
Time in the markets is better than timing the markets
I think. For the EMH take on timing the market read something from John anyway. All EMH's like John.
The whole EMH argument for this can be reduced to a believe that the market will end up higher at some time in the future. Can go up and down in the meantime. There's no way of you knowing how. You can guess. Might get lucky once. Won't get lucky often. Will end up with net lower returning being out the market or hedged.
It is ludicrous to believe that asset bubbles can only be recognized in hindsight.
Dr Michael Burry.
"Big Short" guy. Told everyone about the housing bubble in 2005/6 (Maybe 4). He's Tweeting a lot saying we're currently in a bubble now.
BMH's put forward that not only is it possible to foresee there being speculative bubbles but it's also always going to be possible seeing them setting up. They will even be able to be broken down into phases. In the late phases it will be obvious. It would be crazy to think someone could not look around them and see signs of the BMH at work. The "Unthinking ferocity of crowds" at play.
Do you believe we are in a efficient market? Or a behaviour driven market? Scores out of three.