Efficient Market Hypothesis
One of the most common challenges for investors is being able to consistently outperform the stock market averages. A controversial strategy that has been continually debated over the years is the Efficient Markets Hypothesis (EMH). This is a belief that it is impossible to time and outperform the major market averages. The reason why is because the indices are a reflection of all relevant information about future expectations for prices. As a result, many proponents of this theory will argue that any kind of attempts to: locate undervalued stocks or identify trends in the markets is nothing more than a waste of time. Instead, everyone should simply purchase an exchange traded fund (ETF) in order to have the best results. (Efficient Market Hypothesis 2012)
However, there have been many situations where this theory has been proven to be inaccurate. The best example of this is the legendary investor Warren Buffet. Since the 1960s, he has been continually outperforming the markets by identifying those situations that are compelling valuations. This strategy has helped Buffet to have an unmatched track record on Wall Street. This is significant in showing how the EMH is not completely accurate in determining the best theory for investing. To determine which theory is most precise requires comparing the EMH with behavioral finance. This is when we can be able to see which strategy will accurately identify the best opportunities for investors. (Efficient Market Hypothesis 2012)
The Efficient Market Hypothesis vs. Other Theories
To determine the effectiveness of the EMH we will compare this theory with events that occurred during the financial crisis from 2007 to 2011. This will take place by examining the ideas from this philosophy with behavioral finance theory. These elements will provide an accurate assessment as to what strategies are most efficient in delivering the best results.
Part I: The Efficient Market Hypothesis
Explain what it is and how it works?
Like what was stated previously, the EMH believes that it is impossible to time the movements of the markets. This is because the motivating factor behind the indices is new data that is being released. Due to the fact that all information must be provided to the public at the same time, means that the markets are always reflecting these expectations. As a result, there is no support for investors to seek out the best price and time to purchase a company. This is how investors can focus their efforts by: not wasting time and money searching for stocks that are not profitable. (Clarke 2008)
Why it has been the dominant theory for so long?
According to proponents, there are mountains of data that support the effectiveness of this theory in understanding the movements of the markets. Evidence of this can be seen by looking no further than comments from Harvard Economist Michael Jensen who said, "There is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis." (Clarke 2008) This is showing how there are lots of economists and analysts who believe it is impossible to time the markets. Instead, they will focus on purchasing companies that can provide the same kind of results as the indices. This is regardless of: the economic, technical or fundamental issues surrounding the company. (Clarke 2008)
Can it be used to help us understand or explain the financial crises, how / why?
The EMH cannot be used to explain the financial crisis. This is because it assumes that everyone knows what is happening with a host of events based on current expectations. The problem is that this theory will not identify when there are changes in the economic cycle until it is too late. A good example of this can be seen with Bear Stearns in 2007 and 2008. Early on, the company was considered to be a solid financial power house. Yet, the firm's exposure to subprime mortgages created a liquidity crisis that would force the company into liquidation. The only event that prevented Bear Stearns from entering bankruptcy was the Federal Reserve arranging for the company to be purchased by JP Morgan Chase. If the EMH is accurate in understanding the financial crisis, the events with Bear Stearns should have been identified early. The fact that no one was aware of these issues (until the firm was on the verge of bankruptcy) is a sign of how these ideas are reactionary. (Sorkin 2008)
What are the positive aspects of this theory -explain how markets behave? Why?
The positive aspects of this theory are that it is providing a foundation for understanding the movements of stock prices. In the future, this helps investors to have a basic knowledge of how the markets will look at a host of events to interpret the present and future value of stocks. Once this takes place, is when investors can purchase stocks that will provide them with returns which are in line with the historical average (without having to worry about actively buying and selling). This is the point that they will not make sudden decisions that could hurt the long-term performance of their portfolio. (Clarke 2008)
What are the negative aspects of this theory -explain how markets behave? Why?
The negative aspects of this theory are that it does not identify changes in the markets. This is problematic, because as the markets are shifting is when the underlying amounts of risk in the portfolio will increase. The reason why is from no one providing any kind of analysis with the price of the stock (such as: if it is at a 52-week / all-time high and the volatility of the firm). The combination of these elements can cause investors to purchase stocks when they are near these price levels (which increases the risks exponentially). Once the trends in the markets change is the point that the stock could decline by 70% (with high amounts of volatility).
A good example of this crisis occurred with Citigroup during the recent financial. Using the EMH, investors could have purchased shares at $54.87 in January 2007. Once the economy and the markets began to shift is when the firm faced tremendous challenges with their liquidity position (which required a government bailout). While this was happening, the price of the stock fell to $.97. Recently, the company completed a 10 for 1 reverse stock split. This increased the price of the stock, but it lowered the total number of shares that investors owned. As a result, anyone who had purchased Citigroup in January 2007 would be down 93% in the position. This is illustrating how the EMH can increase the risks in the portfolio by ignoring the price that investors are paying for the stock. (Citigroup 2012)
Part 2: Behavioral Finance
Explain what it is and how it works?
Behavioral finance is when there is focus on how the psychology of investors will affect buying and selling decisions. The way it works is to see what patterns and ideas the majority of investors are following. This is when prudent individuals will do the opposite. The reason why is because of the belief that most people can identify the trends in the markets. The big challenge is determining when these are shifts occurring. One of the most dominant theories that is embraced by this approach is contrarian investing. (Livingston 2012)
Contrarian investing is when there is focus on the views of the majority of investors. This is because the markets are constantly being driven by the forces of fear and greed. When everyone is feeling good about the investment climate is the point that the stock prices could be overvalued. The reason why is most investors are looking at the past trends when trying to predict the future. As time goes by, they will be able to mirror and in some cases outperform the major market averages by identifying the underlying trends. The problems occur when there are changes in the long-term patterns, with the averages switching from: bullish to bearish or vice versa. This is when the crowd will lose significant amounts of money until it is too late to make any kind of changes. Once this takes place, is when the markets will more than likely reverse and will enter a new long-term trend. (Livingston 2012)
How it might challenge EMH as the dominant theory in relation to decision making and pricing?
The way that this will challenge the EMH is to highlight specific individuals who have been successful using this strategy. As a result, these investors feel that identifying changes in the psychology of the crowd will help them to find potential long-term buys. Some good examples of investors who have been successful using this strategy over the decades includes: Jim Rogers, John Templeton, Sam Zell, Peter Lynch and George Soros just to name a few. During the financial crisis, this strategy helped to identify when there were shifts in the markets. These elements are important, in illustrating…