Efficient Market Hypothesis V's Behavioural Finance

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In 2008, share prices dropped mainly due to the US sub-prime crisis, which started in 2007 (Lixi, 2008). This had a huge impact on the P/E ratio for 2008, which is slightly below the threshold of 10 times. The P/E ratio for ANZ was higher than NAB in 2009 and there was lesser fluctuation in ratio. Share prices tend to rise with improved economic conditions, and with stimulus packages being distributed all over the world, there was uplift in the global economy, hence driving share prices (Larsen, 2012). However, falling earnings over 2009 caused both P/E ratios to rise. NAB’s P/E ratio increased a significant amount and overtook ANZ’s. Over the 5 years, NAB’s P/E ratio fluctuation is observed to be consistently higher than ANZ’s. Moreover, NAB’s higher P/E ratio might be due to investors’ high expectations, which were not supported by earnings.

Black, F. & Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. The Journal of

Further influence of EMH on financial practice seems to be active in attitude of investors towards diversified portfolios. As theory implicate “public information cannot be used to earn abnormal returns” (Arnold, 2009) thus traders are becoming more sceptical about outcomes of fundamental analysis. The most reasonable action is to create well-matched selection of securities that would rule out analysis and transaction costs, making returns proportionally greater. The vast majority of investors were convinced by those trends and decided

When establishing financial prices, the market is usually deemed to be well-versed and clever. In a stock market, stocks are based on the information given and should be priced at the accurate level. In the past, this was supposed to be guaranteed by the accessibility of sufficient information from investors. However, as new information is given the prices would shift. “Free markets, so the hypothesis goes, could only be inefficient if investors ignored price sensitive data. Whoever used this data could make large profits and the market would readjust becoming efficient once again” (McMinn, 2007, ¶ 1). This paper will identify the different forms of EMH, sources supporting and refuting the EMH and finally

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

Efficient Market Hypothesis has been controversial issues among researcher for decades. Until now, there is no united conclusion whether capital markets are efficiency or not. In 1960s, Fama (1970) believed that market is very efficient despite there are some trivial contradicted tests. Until recently, both empirical and theatrical efficient market hypothesis was being disputed by behavior finance economist. They have found that investor have psychological biases and found evidences that some stocks outperform other stocks. Moreover, there are evidences prove that market are not efficient for instance financial crisis, stock market bubble, and some investor can earn abnormal return which happening regularly in stock markets all over the world. Therefore, the purpose of this essay is to demonstrate that Efficient Market Hypothesis in stock (capital) markets does not exist in the real world by proofing four outstanding unrealistic conditions that make market efficient: information is widely available and cost-free, investor are rational, independent and unbiased, There is no liquidity problem in stock market, and finally stock prices has no pattern.

The weak-form efficiency cannot explain January effect. In semi-strong-form efficient market, to test this hypothesis, researchers look at the adjustment of share prices to public announcements such as earnings and dividend announcements, splits, takeovers and repurchases. As time goes, later tests tend to be not supportive to EMH. For instance, semi-strong-form efficiency cannot explain the pricing/earning effect. In strong-form efficiency, the highest level of market efficiency, Fama (1991) pointed out the immeasurability of market efficiency and suggested that it must be tested jointly with an equilibrium model of expected. However, perfect efficiency is an unrealistic benchmark that is unlikely to hold in practice.

As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the

The more efficient the capital market is, the more likely the market will find its highest risk adjusted return. The efficiency of the capital markets is the “glue” that bonds the present value of a firm’s net cash flows,

In the CAPM, betas are generally estimated from the stock’s characteristic line by running a linear regression between past returns on the stock in question and past returns on some market index. Bringham and Ehrhardt (2005) define betas developed in this manner as historical betas. However, Fama and French (1992) argue about the reliability of beta in explaining the differences in expected returns. According to their studies, they have found empirical evidence that firm size, book-to-market, and earnings-to-price have significant explanatory power for average returns, calling into question the descriptive validity of the CAPM of Sharpe (1964), Lintner (1965), and Black (1972). The validity of the CAPM is questioned because of the CAPM posits a positive linear relation between ex ante expected returns and betas, while other firm specific variables such as firm size, book-to-market, and earnings-to-price should not have any ability to explain average cross-sectional returns. The empirical evidence of Fama and French thus contradicts the CAPM.

The efficient market hypothesis states that financial markets are profitable and that the prices in the stock market already embed all familiar information regarding a stock or other security and that the prices adjust quickly to new information which includes current and future expectations about a stock. It further explains that if all needed information concerning the investment is known, it will be difficult for any investor to outperform the market since he/she will be working with the same information as everyone else. Also, that it is impossible to consistently beat the market by stock-picking.

The above argument can fall into the theory of representativeness and conservatism. The principle of representativeness implies overweighting the results of small sample. Financial economists have argued that representativeness leads to overreaction in stock returns (Eugene Fama F1998). In the case of internet companies, great revenue growth for a short time in the late 1990s, causing many to believe that this growth would continue indefinitely. Stock prices rose (too much) at this point. When, at last, investors realized that this growth could not be sustained, prices plummeted. On the other hand, the theory of conservatism states that individuals adjust their beliefs too slowly to new information. A market composed of this type of investor would likely lead to stock prices that under-react in the presence of new information. This is shown in the example of earning surprises .

Empirical results in US market of recent literature have manifested that size factor are less influential. Israel and Moskowitz suggested no strong evidence of size premium was found over the entire sample period of 1927 to 2011 by investigating both long only and long-short portfolios. But he further hypothesized the interaction between firm size and value and momentum factor. This is consistent with Cakici and Tan where a positive, but statistically insignificant size effect in US market as illustrated below.

Numerous studies have confirmed a "January Effect". This effect is that returns for the month of January tend quite constantly to surpass returns for any other of the eleven months. This January effect seems most prominent during the first five trading days in January and the last trading day in December. nevertheless, the January effect continues to persist throughout the month. In addition, this January effect seems to have a greater effect on the shares of smaller companies than on the shares of larger firms. It emerges that much of the January effect can be explained by the tendency for December transactions to be seller initiated and complete at bid prices while January transactions are buyer commence and execute at offer prices.