The Emh, the Financial Crisis and the Behavioral Finance

The EMH, the Financial Crisis and the behavioural Finance 1. Introduction The Efficient Market conjecture (EMH) that was graduation proposed by Fama (1965, 1970) is the cornerst whizz of the modern fiscal economic surmise. The EMH argues that the grocery is economic and plus equipment casualty contrives tout ensemble the relevant information concern about its strike. The genius insight provided by the EMH has changed the way we cheek at the pecuniary crisis thoroughly. However, the confidence in the EMH is eroded by the late(a) pecuniary crisis.People bath not help to ask if the trade is efficient and the price of assets is incessantly correct as suggested by the EMH, why on that point exists much(prenominal) a peachy bubble in the financial mart during the recent financial crisis? A straggle from that, the EMH has up to now been criticized as the culprit of the recent financial crisis. (See no(prenominal)era, 2009 and Fox, 2009) Actually after the EMH was proposed, many anomalies have been found in the financial market and financial economists have developed many theories in aim to formulateing these anomalies.Among these the most influential one is the so called behavioural finance, which argues that the complex benevolent behavior plays an important part in find out asset prices. The recess of the essay is arranged as follows. character 2 explains what the EMH implies and its limitations. Section 3 emphasizes on explaining the usefulness of the EMH in the context of the recent financial crisis. Section 4 focuses on interpreting the behavioural finance. Section 5 concludes the essay. 2. The implications of the EMH tally to Ball (2009), the implication of the EMH rotter be summarized as follows.The implication of the EMH roll in the hay be decomposed into two parts. The first insight of the EMH is related to the most obscure insights of classical economics, that is, there is no superfluous profit in a complete market, whi ch is payable to the fierce con unraveler in the market. If there exists excess profit in such a market, then the entry of parvenue producers result eventually eliminate it. The second insight is that information is even dissemination, which implies that information bay window flow freely in the market without cost and time lag.Putting these two parts of insights to frustrateher, the EMH implies that the market is efficient and asset prices bounce all the relevant information concerned about its return, and that investors rear altogether get commensurate return with the cost of exploiting information due to the aspiration in the market. According to the EMH, people can only expect to get second-rate return in the line of credit market and it is unworkable to cycle the market continuously. Note that it is futile to exploit information in tell apart to get irregular return does not mean that no one should act to exploit information.As a matter of fact, the EMH is a na tural subject of the fierce competition in the market&8212if there is no competition in the market, the market can not be efficient. In any(prenominal) other(a) words, asset price can not reach its equilibrium take aim automatically. Ice-cream producers face fierce competition from other producers in the market and it is impossible for them to get anomalous profit, plainly it is foolish for ice-cream producers to stop devising ice-cream because they give get nothing if they do not work.Fama (1970) classifies the market into trey categories the lite form strength, the semi-strong form efficiency and the strong form efficiency. In the calorie-free form efficiency market, asset prices reflect all the historical information, so it is impossible to obtain abnormal return using historical selective information and technological analysis is useless. In the semi-strong form efficiency market, asset prices reflect all the information that is publicly accessible, and frankincens e it is impossible to get abnormal return using publicly available information.In the strong form efficiency market, asset prices reflect all the relevant information, including all publicly available information and inside information, so investors can only get average return and it is impossible to beat the market. 3. The performance of the EMH in explaining the recent financial crisis During the recent financial market, the commonplace market fell sharply, banks went bankrupt and the financial system was damaged seriously. This financial crisis has eroded the confidence in the EMH.The daring of the EMH and the existence of the efficient market atomic number 18 questioned broadly. If asset prices are always correct and reflect all the relevant information concerning about its return just as the EMH has suggested, why there exists such a great bubble in the financial market during the recent financial crisis? If the market is efficient, why the market fails to predict the collap se of Lehman Brothers, Bear Stern and other large financial institutions? Overall, the EMH fails to answer such questions.Moreover, the EMH also performs poor in explaining other financial crisis. One example is the Tulipmania that occurred in the 17th century. The prices of the tulip bulbs reached exceedingly high level which seriously deviates from its funda intellectual value that was suggested by the EMH. This probable bubble is contradicted with the omen of the EMH. In fact, the explaining power of the EMH becomes pale when confronting financial crisis. The EMH does not assume that investors are rational, but the EMH does assume that the market is efficient. But the pragmatism may not be that simple.Investors may exhibit a readiness of superstitious behaviors in the strong life, such as positivist in their ability, following others readily, making wrong decisions when in exuberant state, and so forth. These ridiculous behaviors of investors without doubt willing weake n the explaining power of the EMH. Apart from that, the EMH assumes that information is harmonious dissemination and can flow freely without cost and time lag, but information in the reality may not be isosceles disseminated, information may not be able to flow freely, this will also affect the stiffness of the EMH in explaining asset prices in the real life.Besides, factors such as sociological factors also play a part in determining asset prices. In authors opinion, asset price is just like a glass of beer. At the set down part of the glass is the real beer, representing the intrinsic value of the asset that can be explained by the EMH. At the upper part of the glass is the foam, representing value that can not be explained by the EMH. In other word, the EMH can not explain bubbles, which is the systematic deviation of asset prices from their fundamental value.The EMH has even been criticized as the culprit of the financial crisis. In Nocera (2009) and Fox (2009), both of them cogitate that the whimsy of efficiency was responsible for the financial crisis. They argue that since the market is efficient and asset prices reflect all relevant information, the investors and supervisors feel it is unnecessary to work out into the intrinsic value of assets, and so fail to be aware of the asset price bubbles, thus the financial crisis occurs.Actually, not soon after the EMH was first proposed, scholars have found many anomalies that contradict with the prediction of EMH. De Bondt and Thaler (1985, 1987) found that investors break away to overreact to unexpected news and events and such senseless behavior affects stock prices Jegadeesh and Titman (1993) found that investors using trading strategies that buying retiring(a) winners and selling past losers can get abnormal returns during the period 1965 to 1989. De Long, Shleifer, Summers and Waldman (1990) argue hat whatever anomalies such as the excess volatility of asset prices, the mean retroflection in stock prices, and so forth, can be explained by the notion of noise monger guess. These studies have challenged the validity of the EMH. 4. The behavioral finance As has been described before, there are many anomalies that can not be explained by the EMH. Objectively speaking, these anomalies give impetus to the development and breakthrough of financial economic theories. Scholars so far have developed many models so as to explaining there anomalies, among which the most influential one is the behavioral finance.The behavioral finance takes psychological factors into account when determining asset price. According to overflowing (2000), the behavioral finance can be described in three ways. In the first way, he thinks that the behavioral finance is the integration of psychology and decision making science with the classical financial economic theory. In the second way, he views the behavioral finance as an attempt to explain the anomalies that have been observed and reported amo ng current literatures in the financial market.In the terce way, he thinks that the behavioral finance is a discipline that studies how investors make mental mistakes in investment decision making process. The traditional asset determine theories are developed under the guess that investors are rational and thus can make right decisions, that is, investors will not hurt themselves when making decisions. But the behavioral finance theory is developed under the premiss that investors are not always rational and human behavior is irrational at some time and that the financial market is sometimes uneffective.This guess is much more reasonable than that of the traditional asset pricing theories. Ritter (2003) summarizes some irrational behavior of human beings, such as people tend to follow heuristics or rules of thumb, which sometimes lead to biases, people are overconfident about their abilities, people act slowly to adjust to changes, people sometimes separate decisions which sh ould be combined together in principle, and so forth. He argues that these irrational behaviors of investors will lead to misevaluation.Another important assumption do by the behavioral finance is the limits to arbitrage. In a market where arbitrage can be carried out without limitation, mispricing of asset will be eliminated quickly. But if there are limits to arbitrage, for instance, short sale is not allowed in the financial market, the misprcing of asset may not be eliminated. Under the circumstance that the mispricing of asset is seriously, arbitrageur will even choose to give up arbitrage due to the huge risk involved in the arbitrage.This assumption implies that the market is inefficient when there are limits to arbitrage. De Long, Shleifer, Summers and Waldman (1990) maintain that in an economy where rational and irrational traders are mixed, the behavior of noise traders can have huge continuous impact on asset prices, because the huge risk arbitragers confront made arbit rage less attractive. The first scholar who stresses the importance of psychological factors in investment decision making is Keynes.Keynes argues that the animal spirits of investors is the psychological ft of irrational exuberance and crash. Kahneman and Tverskys (1973, 1979) description on the belief and penchant of investors under uncertainty lays the theoretical foundation for the behavioral finance. After that, the behavioral finance develops rapidly and gradually become the most important get-go of financial economics.By economic intuition, since that the behavioral finance takes psychological factors into account when determining asset prices and that these factors do have important impact on the decision-making behaviors of investors, we can say that in the short run the behavioral finance provides a fail for the behavior of investors and the financial markets than the EMH. But in the long run, investors will eventually realize and correct their irrational behavior, and the EMH will perform better than the behavioral finance. . Conclusion Under certain assumptions, the EMH maintains that asset prices reflect all the relevant information about the asset, thus it is impossible for investors to get abnormal return and beat the market. The EMH implies that there is no unexploited profitable chance in the financial market. Although the EMH provides a useful insight through which we look at the financial market, the EMH fails to explain the more and more anomalies in the financial market.The EMH provides little useful explanation about the recent financial crisis. The validity of the EMH is questioned and the confidence in the EMH declines. Moreover, the EMH has even been criticized as the culprit of this financial crisis. inclined the criticism the EMH suffers, scholars have developed varieties of theories so as to explain the anomalies in the financial market. Among these the most influential one is the behavioral finance.The behavioral finance stud ies how the behavior of human beings affects asset prices and the financial market. Based on the assumption that investors are sometimes irrational and the market is inefficient and that there are limits to arbitrage, the behavioral finance overall gives better explanations concerning the anomalies in the financial market than the EMH. The behavioral finance is a rapidly developing field in the financial economics. Reference Ball, R. 2009) The global financial crisis and the efficient market supposal What have we learned? , forthcoming in Journal of Applied incorporated Finance, Electronic copy available at http//ssrn. com/abstract=1502815 (Accessed 10 borderland 2010) De Bondt and Thaler (1985) Does the stock market overreact? , Journal of Finance, Vol. 40, No. 3, pp. 793-805 De Long, Shleifer, A. , Summers, A. S. and Waldman, R. J. (1990) Noise trader risk in financial market, Journal of Political Economy, Vol. 98, No. 4, pp. 703-738 Fama, E.F. (1965) Random walk in stock marke t prices, Financial psychoanalyst Journal, Vol. 21, No. 5, pp. 55-59 Fama, E. F. (1970) Efficient market hypothesis A review of theory and empirical work, Journal of Finance, Vol. 25, No. 2, pp. 383-417 Fuller, R. J. (2000) Behavioral Finance and Sources of important, forthcoming in Journal of Pension Plan Investing, Vol. 2, No. 3 Fox, J. 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