Market Efficiency and Behavioural Finance

Market Efficiency and
Behavioral Finance
Efficient Market Theory
 Efficient market theory states that the share price
fluctuations are random and do not follow any regular
pattern.
 The expectations of the investors regarding the future

cash flows are translated or reflected on the share
prices.
 The accuracy and the quickness in which the market

translates the expectation into prices are termed as
market efficiency.
Two Types of Market Efficiencies
 Operational efficiency: Operational efficiency is
measured by factors like time taken to execute the
order and the number of bad deliveries. Efficient
market hypothesis does not deal with this efficiency.
 Informational efficiency: It is a measure of the
swiftness or the market’s reaction to new information.
 New information in the form of economic reports, company
analysis, political statements and announcement of new
industrial policy is received by the market frequently.
 Security prices adjust themselves very rapidly and
accurately.
History of the Random-Walk
Theory
 French mathematician, Louis Bachelier in 1900 wrote
a paper suggesting that security price fluctuations
were random.
 In 1953, Maurice Kendall in his paper reported that
stock price series is a wandering one.
 Each successive change is independent of the
previous one.
 In 1970, Fama stated that efficient markets fully
reflect the available information.
Forms of Efficiencies
They are divided into three categories:
 Weak form
 Semi-strong form
 Strong form
The level of information being considered in the

market is the basis for this segregation.
Market Efficiency
Strongly efficient market
All information is reflected
on prices.
Semi-strong efficient market

All public information is
reflected on security prices
Weakly efficient market

All historical information
is reflected on security
prices.
Levels of Information and the Markets
Weak Form of EMH
 Current prices reflect all information found in the
volumes.
 Future prices can not be predicted by analyzing the

prices from the past.
 Buying and selling activities of the information

traders lead the market price to align with the intrinsic
value.
Semi-Strong Form
 The security price adjusts rapidly to all publicly
available information.
 The prices not only reflect the past price data, but also
the available information regarding the earnings of
the corporate, dividend, bonus issue, right issue,
mergers, acquisitions and so on.
 The market has to be semi-strongly efficient, timely
and correct dissemination of information and
assimilation of news are needed.
Strong Form
 All information is fully reflected on security
prices.
 It represents an extreme hypothesis which
most observers do not expect it to be literally
true.
 Information whether it is public or inside
cannot be used consistently to earn superior
investors’ return in the strong form.
Market Inefficiencies
 Announcement effect- Over reaction to
corporate news.
 Low PE effect – stocks with low P/E yield

higher returns than stocks with higher P/E.
 Small firm effect – investing in small firms

provides superior risk adjusted returns.
Behavioral Finance
 The anomalies of the efficient market
hypothesis led to the evolution of behavioral
finance.
 It borrows concepts from the social sciences
such anthropology, sociology, and psychology
to explain the behaviors of security price.
 Behaviour finance explains that the stock
market bubbles are due to the social contagion
effect and overconfidence of the investor.
 The media and word-of-mouth enthusiasm
create stock market bubbles.
 Once the stock prices go up, the investor feels
it will rally in future.
 This leads to a positive feedback loop, and
stock prices continue to move up.
 This creates a speculative bubble without the
backing of strong fundamentals.
 This could result in a stock market crash.
Heuristic- Driven Biases
 Representativeness – tendency to form judgments based on sterotypes.
 Overconfidence – people tend to be overconfident and hence overestimate
the accuracy of their forecasts.
 Anchoring – after forming an opinion, people are often unwilling to change
it, even though they receive new information that is relevant.
 Familiarity – people are comfortable with things that are familiar to them.
 Confirmation bias – people tend to overlook information that is contrary to
their views in favour of information that confirms their views.
 Illusion of control – investors have an inflated view of how much control
they have over outcomes, leading to over – optimism.
 Affect heuristic – people decide mostly on what feels
right to them emotionally.
 Regret aversion – people avoid action that causes
regret
 Aversion to ambiguity – people are fearful of
ambiguous situations where they feel that they have
little information about the possible outcomes.
 Innumeracy – people have difficulty with numbers
Critics
 BF is observational
 Only counter examples
 No unifying theory
Strategies for overcoming
psychological biases
 Understand the biases

 Focus on the big picture
 Follow a set of quantitative investment criteria
 Diversify
 Control your investment environment
 Strive to earn market returns
 Review your biases periodically
Thankyou

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Market Efficiency and

 The expectations of the investors regarding the future

 The accuracy and the quickness in which the market

They are divided into three categories:

The level of information being considered in the

Semi-strong efficient market

Weakly efficient market

 Future prices can not be predicted by analyzing the

 Buying and selling activities of the information

 Low PE effect – stocks with low P/E yield

 Small firm effect – investing in small firms

 Understand the biases

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