The Emh, the Financial Crisis and the Behavioral Finance

The EMH, the Financial Crisis and the behavioral Finance 1. Introduction The effectual Market Hypothesis (EMH) that was first proposed by Fama (1965, 1970) is the cornerst angiotensin-converting enzyme of the modern fiscal economic theory. The EMH turn overs that the merchandise is high-octane and summation price reflects any the germane(predicate) learning concerned about(predicate) its return. The genius brain wave provided by the EMH has changed the panache we look at the fiscal crisis thoroughly. However, the beginningization in the EMH is eroded by the new-fangled fiscal crisis.People mass not help to ask if the securities industry place is efficacious and the price of pluss is always correct as suggested by the EMH, wherefore thither exists such a great bubble in the financial commercialise during the fresh financial crisis? obscure from that, the EMH has even been criticized as the perpetrator of the new-fashioned financial crisis. (See no(prenominal) era, 2009 and flurry, 2009) Actu all toldy after the EMH was proposed, numerous anomalies accommodate been effectuate in the financial commercialise place and financial economists have highly- develop many theories in order to explaining these anomalies.Among these the roughly influential one is the so called behavioural pay, which designates that the complex clement behavior counts an important stop in ascertain summation prices. The rest of the essay is arranged as follows. instalment 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 According to Ball (2009), the implication of the EMH can be summarized as follows.The implication of the EMH can be decomposed into two parts. The first brain wave of the EMH is related to to the most pro found insights of classical economics, that is, there is no excess gain ground in a complete commercialize, which is due to the fierce competition in the market. If there exists excess profit in such a market, thence the entry of new producers ordain eventually eliminate it. The second insight is that cultivation is symmetric dissemination, which implies that in pissation can flow freely in the market without court and time lag.Putting these two parts of insights together, the EMH implies that the market is efficient and plus prices reflect all the relevant data concerned about its return, and that investors can sole(prenominal) get commensurate return with the cost of exploiting information due to the competition in the market. According to the EMH, state can and expect to get average return in the stock market and it is insuffer adequate to beat the market continuously. Note that it is futile to exploit information in order to get abnormal return does not plastered th at no one should act to exploit information.As a matter of fact, the EMH is a natural result of the fierce competition in the marketif there is no competition in the market, the market can not be efficient. In other words, asset price can not penetrate its equilibrium level automatically. Ice-cream producers face fierce competition from other producers in the market and it is unrealistic for them to get abnormal profit, but it is foolish for ice-cream producers to shutdown making ice-cream because they will get nothing if they do not work.Fama (1970) classifies the market into three categories the weak form force, the semi- whole form efficiency and the strong form efficiency. In the weak form efficiency market, asset prices reflect all the historical information, so it is impossible to obtain abnormal return using historical data and technological analysis is useless. In the semi-strong form efficiency market, asset prices reflect all the information that is publicly availab le, and thus 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 stock market discharge sharply, banks went bankrupt and the financial system was damaged seriously. This financial crisis has eroded the confidence in the EMH.The validity of the EMH and the existence of the efficient market argon 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 collaps e of Lehman Brothers, turn in Stern and other large financial institutions? Overall, the EMH fails to answer such questions.Moreover, the EMH besides 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 extremely high level which seriously deviates from its fundamental observe that was suggested by the EMH. This apparent bubble is contradicted with the foretelling of the EMH. In fact, the explaining power of the EMH becomes lookout 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 reality may not be that simple.Investors may usher a lot of ill-advised behaviors in the real life, such as overconfident in their ability, following others readily, making wrong ends when in voluptuous state, and so forth. These irrational behaviors of investors without doubt will weaken the explai ning power of the EMH. Apart from that, the EMH assumes that information is symmetric dissemination and can flow freely without cost and time lag, but information in the reality may not be symmetric disseminated, information may not be able to flow freely, this will also affect the validity 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 over of beer. At the lower part of the glass is the real beer, representing the intrinsic abide by of the asset that can be explained by the EMH. At the upper part of the glass is the foam, representing values 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 believe that the notion 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 notion it is unnecessary to look into the intrinsic value of assets, and so fail to be aware of the asset price bubbles, thus the financial crisis occurs.Actually, not currently 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 tend to overreact to unexpected news and events and such irrational behavior affects stock prices Jegadeesh and Titman (1993) found that investors using trading strategies that get past winners and selling past losers can get abnormal returns during the period 1965 to 1989. De Long, Shleifer, Summers and Waldman (1990) argue hat some anomalies such as the excess volatility of asset prices, the mean reversion in stock prices, and so forth, can be explained by the notion of noise trader peril. These studies have challenged the validity of the EMH. 4. The behavioral finance As has been exposit before, there are many anomalies that can not be explained by the EMH. Objectively speaking, these anomalies give impetus to the victimisation 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 mental factors into account when determining asset price. According to Fuller (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 among current literatures in the financial marke t.In the third way, he thinks that the behavioral finance is a suss out that studies how investors make mental mistakes in investment decision making process. The conventional asset pricing theories are developed under the supposition 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 self-reliance that investors are not always rational and human behavior is irrational at some time and that the financial market is sometimes uneffective.This assumption is much much 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 set to changes, people sometimes separate decisions which should be combined together in prin ciple, and so forth. He argues that these irrational behaviors of investors will lead to misevaluation.Another important assumption made 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 consideration that the mispricing of asset is seriously, arbitrager 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 rescue where rational and irrational traders are mixed, the behavior of noise traders can have huge continuous clash on asset prices, because the huge risk arbitragers confront made arbitrage less attractive. The first scholar who stresses the splendor of psychological factors in investment decision making is Keynes.Keynes argues that the animal invigorate of investors is the psychological foundation of irrational exuberance and crash. Kahneman and Tverskys (1973, 1979) description on the belief and preference 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 branch 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 better 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 untapped profitable opportunity 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. Given 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 studies how the behavior of human beings affects asset prices and the financial market. ground 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 maturation field in the financial economics. Reference Ball, R. 2009) The global financial crisis and the efficient market hypothesis What have we learned? , forthcoming in ledger of Applied Corporate Finance, Electronic copy available at http//ssrn. com/ bunco=1502815 (Accessed 10 March 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 market prices, Financial Analyst Jou rnal, 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 Alpha, forthcoming in Journal of Pension aim Investing, Vol. 2, No. 3 Fox, J. (2009) The Myth of the Rational Market A taradiddle of Risk, Reward and Delusion on Wall Street, New York HarperCollins Jegadeesh, N. and Titman, S. 1993) Returns to buying winners and selling losers Implications for stock market efficiency, Journal of Finance, Vol. 48, No. 1, pp. 65-91 Kahneman, D. and Tversky, A. (1973) On the psychology of prediction, Psychological Review, Vol. 80, pp. 237-251 Kahneman, D. and Tversky, A. (1979) Prospect theory An analysis of decision under risk, Econometrica, Vol. 47, pp. 263-291 Nocera, R. (2009) Poking holes in a theory on markets, New York Times, June 5, 2009 Ritter, J. R. (2003) Behavioral finance ,Pacific-Basin Financial Journal, Vol. 11, pp. 42 9-437