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There has been a forceful attack on the the efficient markets hypothesis, EMH, by finance specialists drawing on a combination of human behavioural literature and their knowledge of markets. At one time, the financial economists, hot on algebra and modeling the world (or, at least, a world), readily dismissed the behaviouralists as lacking robustness in their descriptions of financial decision making.
They find it very difficult to be so dismissive now that we have four Noble Prize in Economics winners from the behavioural economics/finance area.
The latest was announced only this month. Richard Thaler (star of The Big Short film, writer of academic papers such as a leading one on the return reversal phenomenon, and inspirer of government “Nudge” units) drew heavily and worked with leading thinker in the field Daniel Kahneman (Noble Prize in 2002 for work on experiments in the psychology of judgement and decision-making) and Robert Shiller (winner in 2013 for work on excessive stock market movements relative to fundamentals, CAPE, the emotional drivers of traders and irrational exuberance). Herb Simon was a pioneer, who won a Noble in 1978 for his work on the theory of corporate decision making, bounded rationality, satisficing and preferential attachment.
Application to the pricing efficiency of stock markets
Vast amounts of work is being produced on the behavioural influences on markets, and pricing efficiency more specifically. Thus, I can only give you a flavor it in the next couple of Newsletters.
The efficient markets hypothesis, since its development in the 1960s, has always rested on the assumption that all investors are rational, or, even if there are some irrational investors, that the actions of rational informed investors will eliminate pricing anomalies through arbitrage.
The behavioural finance proponents, on the other hand, argue that investors frequently make systematic errors and these errors can push the prices of shares (and other financial securities) away from fundamental value for considerable periods of time.
Behavioural finance models offer plausible reasoning for the phenomena we observe in the pattern of share prices. They offer persuasive explanations for the outperformance of low PER, high dividend yield and low book-to-market ratio shares as well as the poor performance of ‘glamour’ shares.
They can also be drawn on to shed light on both return reversal and momentum effects. In addition, behavioural science has a lot to offer when it comes to understanding stock market bubbles and irrational pessimism.
Many of the investors who made a fortune in the twentieth century have been saying all along that to understand the market you must understand the psychology of investors.
In the 1960s, 1970s and even the 1980s, they were denounced as naive at best by the dyed-in-the-wool quantitative financial economist – the economists had ‘scientific proof’ of the market’s efficiency.
Financial economists insisted that even if investors were generally irrational the market had inherent mechanisms to arrive at the efficient price, leaving no abnormal returns to be had.
The successful investors were merely lucky. Worse! They were lucky and had the nerve to go against the scientific ‘evidence’ and publicly declare that they believed that there are sound investment principles which permit out-performance.
The successful investors continued to believe in the irrationality and exploitability of markets despite the onslaught from many university economists who were characterised as believing that ‘It might work in practice, but it’ll never work in theory’.
Eventually a growing band of respected academics provided theoretical and empirical backing to the behavioural view of financial markets. Now the debate has reached a fascinating point with high-quality modelling and empirical evidence on both sides.
The three lines of defence for EMH
To defend the EMH its adherents have three progressively stronger arguments which have to be surmounted if the behavioural finance advocates are to be able to attack the core. (These………………
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