The Behavioural Finance: A Challenge or Replacement to Efficient Market Concept

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1 The Behavioural Finance: A Challenge or Replacement to Efficient Market Concept Amlan Jyoti Sharma* *Assistant Professor, Department of Commerce, Naharkatiya College, Naharkatia , Dibrugarh, Assam, INDIA. amlanjsharma{at}gmail{dot}com Abstract Efficient Market Theory has been the single and controlling theory of portfolio management for many years. But the Behavioural Finance discipline has challenged the assumptions of Efficient Market Hypothesis, particularly the investor rationality concept. It has incorporated emotion and psychology too into investment behaviour study. However review of earlier studies shown that very few studies are available focusing on specific contradictions between the two disciplines in detail. So an attempt has been made in this paper to focus on the contradictions between Efficient Market Hypothesis and Behavioural Finance in detail with an endeavor to arrive at a conclusion, which one is better. The study is mainly conceptual and descriptive in nature and is based on the studies available over internet based sources and various other related books and journals. The major finding the study is that there are definite shortcomings of EMH as pointed out by the Behavioural Finance, but at the same it is also to be noted that as a theoretical framework, it is definitely a modest attempt and it has many positive sides in the context of stock market study but it needs more refinement and more rigorous analysis to replace a far impacted theory like EMH. Keywords Behavioural Finance; Contradiction; Efficient Market Hypothesis; Investment Behaviour; Rationality. Abbreviations Efficient Market Hypothesis (EMH). I. INTRODUCTION E FFICIENT Market Hypothesis is one of the most accepted financial market theories. The efficient market hypothesis became one of the most influential concepts of modern economics and a cornerstone of financial economics. It was extended in many directions, and literally thousands of papers were written about it [Alajbeg Denis et al., 2012]. Although being central to the modern portfolio management theories it also has got many criticisms from the scholars. The Efficient Market Hypothesis is considered as the backbone of contemporary financial theory and has been the dominant investing theory for more than 30 years (from the early 60s to the mid 90s). Needless to say, a generation ago, it was the most widely accepted approach by academic financial economists [Konstantinidis et al., 2012]. Thus the theory assumed to be in the superlative position right from its inception to the end of 1990s. But after 1990s various anomalies have been identified and the concept was criticized on many grounds. Such criticisms have given birth to an alternative discipline called Behavioural Finance. This new domain has challenged the assumptions of EMH, particularly the investor rationality concept by incorporating emotion and psychology too in the investment behaviour study. Although many studies are available regarding the principles of both the disciplines, but studies which have specifically and analytically pointed out the contradictions between them in detail are very few. So in this paper an attempt has been made to make a detail analysis of the contradictory points rather than discussing the principles only. Although the study is mainly based on the previous studies but a systematic and specific analysis has been attempted here. The present study would definitely help to understand not only the principles of the two domains but at the same time would assist to arrive at a conclusion which one is better in the context of financial market study. II. PURPOSE OF STUDY The Efficient Market Hypothesis and Behavioural finance are two main but seeming contradictory domains for study of securities market behaviour. Both the concepts have been studied and supported by different authors all over the world. However in spite of this still there exists debate over their individual effectiveness. In this paper an attempt has been made to make an analysis of both the concepts and also to arrive at a conclusion about which one is the best. ISSN: X 2014 Published by The Standard International Journals (The SIJ) 273

2 III. METHODOLOGY V. GROWTH OF BEHAVIOURAL FINANCE The paper is mainly conceptual and descriptive in nature and it is based on the studies available over internet based sources and various other related books and journals. IV. EFFICIENT MARKET CONCEPT As the name implies it tells about how efficient the market is? The efficiency in terms of analyzing and interpreting the financial information relating either directly or indirectly to the investment decisions. An efficient market is defined as a market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants [Fama, 1965]. Thus changes in asset prices can be treated as a function of the flow of new information to the marketplace. A good definition of market efficiency was given by Malkiel (1992). According to him a capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, ɸ t if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, ɸ t, implies that it is impossible to make economic profits by trading on the basis of ɸ t. There are three forms of market efficiency as said by different scholars in the area of finance. They are weak form, semi strong form and the strong form of efficiency. In its weak form all the past information are reflected in stock prices and no one can have an edge by analyzing the past trends or any other past information i.e. technical analysis will be useless. However, one can beat the market and get abnormal returns on the basis of fundamental analysis or on the basis of private information (insider trading).in its semi strong form it includes the public information with the past information as mentioned under weak form. It means both past and present information which is publicly available is used and interpreted by all the investors in the same way and as a result both technical and fundamental analysis will be useless. However by insider trading one can outperform the market. But in the strong form along with the public and past information the private information available generally to the insiders are also useless to produce higher returns. In its strong form it is impossible to beat the market by any means. Thus in an efficient market to pick up the best stock and to have higher returns on the basis of information is not possible at all and if it happens then it would be due to blind luck only. Temptating advertisements of the past results or the reputation of fund managers is nothing to do with the future position of the stock, as no one can outperform the market and the stock prices already reflect all public and private information. Efficient market concept deals with the information and how the informational accuracy affects the stock market. But the behavioural finance dimensions deal with the market participants behaviour not only on the basis of information but also several other emotional and psychological dimensions. It is the behaviour of the market participants which shapes the ultimate stock market structure. So an in depth study of the behaviour is felt necessary and this job is undertaken by the behavioural finance discipline. One of the main assumptions of the efficient market hypothesis is the investor rationality, which means the investors are always rational while making investment decisions in the stock market. But the behavioural finance says that the investors decision making process is not only based on rational analysis always. Rather they are forced to be the prey of different emotional and psychological attitudes which contradicts rational behaviour. So the studies of these emotional factors are also necessary to analyse the investor behaviour. History of the behavioural finance goes back to Herbert A Simon, the Nobel lieutenant of 1978, for his paper in 1955 A behavioural model of rational choice may be regarded as the first thought that endevoured to state about a new concept called behavioural finance [Simon, 1955]. According to Kannadhassan (2006) in the present scenario, behavioural finance is becoming an integral part of the decision-making process, because it heavily influences investors performance. They can improve their performance by recognizing the biases and errors of judgment to which all of us are prone. Understanding the behavioural finance will help the investors to select a better investment instrument and they can avoid repeating the expensive errors in future. The pertinent issues of this analytical study are how to minimize or eliminate the psychological biases in investment decision process. The systematic study of behavioural finance started actually from the work of Daniel Kahneman & Amos Tversky (1973) where they for the first time discussed about the different heuristics affecting investment decisions. They also founded the very famous Prospect Theory in Tversky & Kahneman (1979) where they found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains and found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Statman Meir (2009), a professor from Santa Clara University wrote in an article published in the Wall Street Journal that most investors were intelligent people, neither irrational nor insane. But behavioural finance tells us we are also normal, with brains that are often full and emotions that are often overflowing and that means we are normal smart at times, and normal stupid at others. ISSN: X 2014 Published by The Standard International Journals (The SIJ) 274

3 VI. CONTRADICTIONS The main grounds of contradiction between the two concepts of investment theories may be stated as under: 6.1. Rationality Concept The main contradiction between the two is on the ground of investor rationality. Efficient market concept is based on the concept of rational investor behaviour, i.e. the investors always behave in a rational way. According to Rohit Kishore (2006) Traditional finance theorists believe that, any mispricing created by irrational traders (noise traders) in the marketplace, will create an attractive opportunity which will be quickly capitalized on by the rational traders (arbitrageurs) and the mispricing will be corrected. Rationality means two things. First, when they receive new information, agents update their beliefs correctly, in the manner described by Bayes law. Second, given their beliefs, agents make choices that are normatively acceptable, in the sense that they are consistent with Savage s notion of Subjective Expected Utility [Nicholas Barberis & Richard Thaler, 2003]. They always make the best and proper use of the information they possess and analyses in an objective manner. But many studies have shown that in most of the times the investors being the social beings, with a brain and a heart full of emotions, behave in an irrational way, in spite of having different important information. They just overlook the rationality attitude and become biased in many cases. Behavioural finance is a new approach to financial markets that has emerged, at least in part, in response to the difficulties faced by the traditional paradigm. In broad terms, it argues that some financial phenomena can be better understood using models in which some agents are not fully rational [Nicholas Barberis & Richard Thaler, 2003] Emotional Investing Most investors are intelligent people, neither irrational nor insane. But behavioural finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others [Statman Meir, 2009]. But there is no place of such emotions in rational investment decisions. The efficient market theory arguments that investors are rational i.e. their investment decisions are made according to their risk aversion, which is measured by the mean and variance of the returns. However according to Michael Pompian (2006) rationality is not the sole driver of human behaviour. In fact, it may not even be the primary driver, as many psychologists believe that the human intellect is actually subservient to human emotion. They contend, therefore, that human behaviour is less the product of logic than of subjective impulses, such as fear, love, hate, pleasure, and pain. Humans use their intellect only to achieve or to avoid these emotional outcomes. Over the last 25 years, scholars began to discover empirical results that were not consistent with the view that market returns were determined in accordance with the efficient market theory. Additionally, empirical research shows that, when selecting a portfolio, portfolio managers not only consider statistical measures such as risk and return, but also psychological factors such as sentiment, overconfidence, overreaction, etc. As these factors begun to be identified by scholars, a new school of thought began to emerge; that of Behavioural Finance [Aguila Natalia del, 2009] Information based Concept Efficient market hypothesis whether in weak, semi strong or strong form all are based on the concept of use of information only without considering other factors. The EMH says that financial markets are informationally efficient although in different forms i.e. weak, semi-strong, and strong form. But the behavioural finance concept is not only based on the information but also it covers different other factors related to human psychology and cognitive and emotional factors which definitely affects the investment decisions Informational Accuracy Efficient market concept always believes that the investors have access to all information and stock prices reflect that information instantly. But in practice, this may not be possible always because all the investors may not have access to all information at the same time. In the world of investing, there is nearly an infinite amount to know and learn; and even the most successful investors don t master all disciplines [Michael Pompian, 2006]. As a result stock prices may not reflect always the true picture of informational analysis by the investors. The presence of noise traders is an example to prove this Demographic Factors In an efficient market there is no difference between a new and an experienced investor and all are treated as equally rational, equally specialised while making investment decisions. But behavioural finance says that the demographic factors like, age, sex, education, income level etc. all are having different effects on investors behaviour. In fact an experienced investor may make a better decision than a naïve investor. Even the cultures, personality etc.these all are also have binding effect on investment decisions. Wang & Hanna, (1997) found that relative risk aversion decreased with the increase in age. Similarly Farrell James found that women, in general, were shown to take less risk than men Interdisciplinary grounds: Efficient market hypothesis is mainly based the concepts of economics only, like perfect market concept or expected utility theory etc., but behavioural finance is an multidisciplinary subject which has borrowed different concepts of human behaviour from other disciplines like, sociology, psychology etc. to best study the human behaviour in respect to investment world. Victor Ricciardi & Helen K Simon (2000) has rightly said that when studying concepts of behavioural finance, traditional finance is still the centerpiece; however, the behavioural aspects of psychology ISSN: X 2014 Published by The Standard International Journals (The SIJ) 275

4 and sociology are integral catalysts within this field of study. According to Rohit Kishore (2006), It utilizes knowledge of cognitive psychology, social sciences and anthropology to explain irrational investor behaviour that is not being captured by the traditional rational based models. Therefore the person studying behavioural finance must have a basic understanding of the concepts of psychology, sociology, and finance to become acquainted with overall concepts of behavioural finance Market Bubbles and Market Crisis: Had the financial markets been really efficient, the different financial crisis or the investment bubbles might not have Investor Rationality occurred as according to EMH a big positive or negative move of the stock prices is caused only by the good or bad news about the future prospects of the company. But behavioural finance postulates that the investors were not always acted as rational as predicted by the efficient market concept. So there is definitely something which is missing to better judge the investors behaviour. Behavioural finance is also not an end to it, but definitely one step forward on this direction to better understand the investors by studying their behaviour from different other angles and to study the bubbles and crashes. Behavioural finance says that such crisis or bubbles are the result of investor irrationality. Summary of Contradictions Basis Efficient Market Hypothesis Behavioural Finance EMH presumes that investors in the financial market are always rational in respect of analysis of information and decision making. irrationality. Role of Emotions Informational Accuracy Demographic Factors Interdisciplinary Base Market Crisis There is no place for emotions in decision making process as per EMH. Strong form of EMH says that all the investors have equal access to all information and the stock price reflects that information and as such the prices happen to be informationally accurate. EMH does not make any distinction between a new and experienced investor. EMH is mainly based on the principles of Economics. Had the EMH actually been exist, there would not have found any market crisis or market bubbles, as EMH believes that the investors always act rationally. VII. CONCLUSION From the above analysis we see that there are definitely different shortcomings of EMH, as all the good theories have. The theory has been tested many times at different situations leading to conclusions sometimes favorable to it and vice versa. Those shortcomings actually are pointed out by the behavioural finance dimensions, specially the investor rationality concept. We cannot say that behavioural finance is an original development in nature, because it must lend its back to the EMH and other traditional portfolio models. Due to the shortcomings of those theories and models a new outlook was necessitated and behavioural finance is one such idea. As Subash Rahul (2012) pointed out in his thesis The science does not try to label traditional financial theories as obsolete, but seeks to supplement the theories by relaxing on its assumptions on rationality and taking into consideration the premise that human behaviour can be understood better if the effects of cognitive and psychological biases could be studied in context where decisions are made. There is no doubt that investors being the human beings must be affected by emotions and individual psychological foundations. If the investor rationality concept of the EMH is refined and thereby adding the elements of behavioural finance too, will definitely lead to a good new development to define the stock Behavioural Finance discipline says that investors are not always rational. Most of the times their behaviour shows Behavioral finance has incorporated emotion and psychology too in the investment behaviour study. Behavioural finance denies the equal access to information principle of EMH and says that stock prices do not always reflect all information. Behavioural Finance makes distinction between investors as per age, sex, income, education level, experience etc. Behavioural Finance includes the theories of psychology, sociology and also other disciplines too in some cases. The market crisis or bubbles are better described by Behavioural finance saying that in decision making process the investor rationality is not the only ground and various other issues should also to be analysed. market anomalies. However the behavioural finance alone cannot be said to be a perfect one because the discipline is not too old to accept as a theory. And the behavioural finance is only a collection of ideas and thoughts which are descriptive and advisory in nature but they are not exhaustive. More discussions and studies are required to point the limitations of behavioural finance itself so as to refine it to be a good theory. Till then we must admit that it is a theoretical framework, which is definitely a modest attempt and it has many positive sides in the context of stock market study but it needs more refinement and more rigorous analysis to replace a far impacted theory like EMH. REFERENCES [1] H.A. Simon (1955), A Behavioural Model of Rational Choice, The Quarterly Journal of Economics, Vol. 69, No. 1, Pp [2] E.F. Fama (1965), Random Walks in Stock-Market Prices, Financial Analyst Journal, Retrieved from handouts/fama_randomwalksstockprices.pdf. [3] Daniel Kahneman & Amos Tversky (1973) On the Psychology of Prediction, Psychological Review, Vol. 80, No. 4, Pp [4] A. Tversky & D. Kahneman (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol. 47, No. 2, Pp ISSN: X 2014 Published by The Standard International Journals (The SIJ) 276

5 [5] B. Malkiel (1992), Efficient Market Hypothesis, New Palgrave Dictionary of Money and Finance, London: Macmillan. [6] H. Wang & S. Hanna (1997), Does Risk Tolerance Decrease with Age?, Financial Counseling and Planning, Vol. 8, No. 2, Pp [7] Victor Ricciardi & Helen K Simon (2000), What is Behavioural Finance?, Business, Education and Technology Journal. [8] Nicholas Barberis & Richard Thaler (2003), A Survey of Behavioural Finance, Handbook of the Economics of Finance (2003), Editors: G.M. Constantinides, M. Harris & R. Stulz, Elsevier Science B.V. [9] M. Kannadhassan (2006), Role of Behavioural Finance in Investment Decisions, Available at [10] Michael Pompian (2006), Behavioural Finance and Wealth Management, John Wiley & Sons, New Jersey. [11] Dr. Rohit Kishore (2006), Theory of Behavioural Finance and its Application to Property Market: A Change in Paradigm, Twelfth Annual Pacific Rim Real Estate Society Conference, Auckland, New Zealand. Available at cation_property_market.pdf. [12] Statman Meir (2009), The Mistakes We Make and Why We Make Them, The Wall Street Journal, Available at [13] Aguila Natalia del, (2009), Behavioural Finance: Learning from Market Anomalies and Psychological Factors, Revista de instituciones, ideas y mercados, No. 50, Pp Available at pdf. [14] Alajbeg Denis, Bubuas Zoran & Sonje Velimir (2012), The Efficient Market Hypothesis: Problems with Interpretations of Empirical Tests, Available at [15] A. Konstantinidis, A. Katarachia, G. Borovas & M. Voutsa (2012), From Efficient Market Hypothesis to Behavioural Finance: Can Behavioural Finance be the New Dominant Model For Investing?, Economic Sciences, Vol: 11, No. 2. [16] Subhash Rahul (2012), Role of Behavioural Finance in Portfolio Investment Decisions: Evidence from India, Master Thesis, Available at Amlan Jyoti Sharma. He earned his Masters Degree in Commerce from Dibrugarh University, Assam, India and has been acting as an Assistant Professor in the Department of Commerce, at Naharkatiya College, Dibrugarh since His areas of interests are Accountancy, Behavioural Finance, Investment Behaviour, and Capital Market. He has published three papers in national and international journals and attended four seminars in various subjects. He is currently pursuing his Ph.D. on a topic related to investment behaviour under Assam University, Silchar. ISSN: X 2014 Published by The Standard International Journals (The SIJ) 277