Assignment One: Efficient Asset Pricing
Here is a related Solution on the Efficient Market Hypothesis
Background for discussion:
When selecting a portfolio of potential investment opportunities, it is argued that if the market is ‘efficient’ the rational investor should buy equity index mutual funds in an effort to mimic the market at minimal transaction cost, as all relevant ‘news’ information will have already been factored into stock asset prices. However, ‘Behavioural Finance’ proponents dispute assumptions of investor rationality and argue that anomalies to the Efficient Market Hypothesis allow for ‘mispricing’ of assets and the opportunity for abnormal returns.
You are asked to:
1. Explain and critically evaluate the above statements, drawing upon relevant academic literature.
2. Discuss whether investors do this in reality. You may refer to recent case study evidence to support your answer.
Your submission:
- The report should between 1,500 to 2,000 words in length. There will be grading penalties applied for reports that are over or under this word limit.
- Please see the Module Information Pack for information on late submission policies.
- Further clarification can be provided in class seminars
Marking criteria:
Marks will be awarded based on the following:
- Presentation of assignment and clarity of expression. Presentation should show a polished coherent structure. Thoughts and ideas should be clearly expressed in a fluent academic writing style.
- Attention to the purpose of the assignment. The purpose of the assignment should be addressed comprehensively and imaginatively.
- Critical analysis of appropriate literature. The assignment should demonstrate an application of critical analysis and arguments should be well integrated.
- Illustrations. The assignment should show use of examples and evidence. Appropriate examples should be fully and reliably integrated and evaluated.
- Conclusions. Should be analytical and clear, well-grounded in theory and literature showing reflection upon key issues.
Solution
Efficient Asset Pricing
Introduction
Efficiency in an ideal market exists in a situation where the prices are always in a manner that they reflect on the information available. In such a market structure, it is expected for the prices to reflect on the fundamental value which is determined by all the available information (Beckert and Aspers, 2011). Ideally, the efficient market pricing hypotheses call for the following conditions. First, there are no transaction costs for trading the assets. Second, the availability of all significant information at no cost whatsoever for all the participants in the market. Finally, all the participants in the market are in the agreement that any underlying implications on the market information regarding both the current and the future prices of elements such as dividends and futures. Rational investors apply the basics of market efficiency. That is, they use all their efforts in the pursuit of exposing themselves to the least risks of cost transaction losses. However, there are some investors who go beyond the rational expectation and identify some anomalies in the efficient market, which they the take advantage of and trade for abnormal returns (Thaler, 2002).
Literature Review on the Asset Pricing Models
The framework of standard finance stands out as the stronghold of Sharpe’s capital asset pricing theory, the arbitrage principles of Modigliani and Miller, Markowitz’s portfolio principles, as well as Black-Scholes’ option-pricing theory (Krause, 2001). All the above approaches are in high consideration and agreement to market efficiency – believing that it is highly normative and analytical. Ideally, every rational investor features some key common needs that form the basic expectation of their investments: capital security, accumulation of wealth, life cover, tax efficiency, communication and withdrawal ease, as well as general simplicity.
According to Markowitz’s portfolio theory, the modern portfolio theory (MTP), there is a relative insight on the risk assessment in portfolio management (Markowitz, 1959). Ideally, the above portfolio model establishes the fact that the rate of return’s variance plays a significant role in necessitating the measurement of portfolio risk under the underlying assumptions relating to a given investor’s behavior. The suggestion by Markowitz thus is that in the choice of profitable investment, looking at the relationship between returns and risk of the portfolio is not enough (Krause, 2001). That is, it is important for investors to focus not only on the significance of diversification in the pursuit of reducing the entire portfolio risk – the investors should also learn on means to apply sufficient portfolio diversification.
There is a core assumption that stands out as the foundation of the modern portfolio theory; all the investors are always in the pursuit of maximizing their investment returns irrespective of the level of risk under which they operate (Massa, 2005). Notably, all investors have a significant risk averseness aspect. Consequently, if they are to make a choice between two assets that feature similar return rates, they will rationally go for the one with the least level of risk. Markowitz’s demonstration thus demonstrates that it is the risk averseness of the rational investors that call for the combination of assets in a portfolio – all in the pursuit of efficient diversification which reduces the investment risk (Sharpe, 1964). The modern portfolio theory, therefore, exists under the assumption that portfolio risk decreases when the rational investors focus on the variability of various asset returns and this picking the assets that exhibit different price movements. The modern portfolio theory establishes the fact that traditional portfolio analysis, selection, and management methods have a much less possibility to yield profits compared to the most optimal expected results (Vasiliou, 2008). Ideally, the modern portfolio theory is of the opinion that there is the need to apply a more scientific method in the pursuit of establishing a basis for estimating the returns and the risks of a given portfolio, as well as the investor’s attitude regarding the investment in a particular asset. Notably, there are two types of decisions that investors have to make in the pursuit of constructing a rational portfolio. First, there are the decisions regarding asset allocation which feature the choosing among a broad class of assets. Second, there are the decisions regarding security selection where the decision is to choose particular securities that hold for each category of assets (Bodie, 2008).
Markowitz’s theory was further extended by Sharpe, who brought forth the non-systematic and systematic risk notion (Sharpe, 1964). In light of the above, the above extension inspired the capital asset pricing model (CAPM). Ideally, CAPM introduces the notion of simplicity where all the investors are in the pursuit of maximizing the economic utility of their portfolio investments. That is, the investors trade without taxation and transaction costs, they are price takers, they prefer trading securities that are easily divisible, and they assume that all the market information is available to all the investor and at the same time. In short, CAPM depicts investors who are highly risk averse and rational. Sharpe brought forth CAPM after finding out that the return on a portfolio of assets needs to be equal to the cost of capital (Sharpe, 1964). In light of the above, CAPM finds its basis upon the idea that there are two types of risks featured under individual investments. That is the systematic risk of holding the market portfolio and the non-systematic risk that is unique to the individual assets in the portfolio (Pandey, 2008).
Irrespective of the above asset pricing models establishing that the investors apply rationality in their selection and management of portfolios and individual assets, there are behavioral theories that denote otherwise. Notably, investors at times fall under the influence of emotional and cognitive bias that pushes them to engage in irrational investment manners (Pompian, 2006). In the pursuit of modeling the financial markets in agreement with the behavior of firms, the current finance theories feature a set of axioms that are normatively appealing regarding the behavior of individual investors. Ideally, it is common for investors to be risk averse and unbiased forecasters. But behavioral finance has shown that the above standard finance model does not always apply. According to Raines and Leathers (2011), nowadays it is common to see financial behaviors originating from psychological propensities. According to Keynesian theorists, professional investors are all about what the market finds valuable. In light of the above, behavioral finance contradicts all the basic provisions and assumptions of standard finance such as the aspect of cognitive dissonance, mental accounting, representativeness, regret avoidance, anchoring, as well as overconfidence and the aversion of loss (Elvin, 2004).
Discussion and Evidence of Behavioral Finance Tendencies
Since the year 2008 financial crisis hit the entire globe, there has been extreme volatility that has notably plagued the financial markets – from a worldwide perspective (Barker, 2007). Behavioral finance has seen the sentiments of the investors in the financial markets to feature as the key market movement determinants. In light of the above, it is true that there has been an increase of investors initiating financial transactions from aspects such as gear, anticipation, and greed. Specifically, overconfidence, herding, regret aversion, the fallacy of gamblers, representativeness, cognitive dissonance, anchoring, and hindsight bias have featured a lot in the recent financial markets environment, even without their knowledge. (Pompian, 2012). Illustration 1 below shows a contingency table for the awareness on behavioral finance with investors of companies comprising the SANSEX index in India.
From the perspective of a practitioner, behavioral finance sums up various aspects and concepts that make an investor behave in an irrational manner and the process making suboptimal decisions (Redhead, 2008). A smart investor who intends to implement behavioral finance to the best of his or her advantage ought to undertake a critical analysis and evaluation of his or her particular investment decisions (Grou, 2008). It is a fact that human beings are overly susceptible to different behavioral anomalies – anomalies that have the possibility to end up as the greatest obstacles facing the investors in their pursuit to maximize their profits. For instance, in the presence of anchoring – one of the anomalies that results from an investor relying too much on just one source of information – an investor like Warren Buffet could lose up to billions in a transaction such as buying shares in Wal-Mart. It is not that such great investors do not have such flaws. They have them but are seasoned enough not to feature emotions in their trading. According to Parikh (2011), they do so by way of using the following two-step model. The first step is seeking an understanding of their personal psychological and emotional weaknesses from taking the time to study all the anomalies that have been known to be common with most investors. The second step is fostering an understanding of the consequences mistakes made by other investors who have been victims of irrational finance behavior (Lin, 2011).
As an example of a case of how behavioral finance has affected investors in the recent past features SENSEX. SENSEX is amongst India’s most famous and oldest stock market index on the Bombay Stock Exchange with 30 stock components that represent the best performing and established companies spanning across all the lucrative and critical industrial sectors (Brown and Reilly, 2009). In the year 2008, it touched an all-time closing high at 20, 873 points in the month of January. Fifteen months later in the month of March in the year 2009, the SENSEX index had plunged to 8,160 points with the global spread of the financial crisis at that time. In November of the year 2010, it rose to a new high of 20,893 before tanking again as a result of the Sovereign debt crisis that started in Europe a while later (Sinha, 2012). Illustrations 2 and 3 below show statistics from the research by Subash (2012) on investors in SENSEX refereeing to the hindsight bias that is a major aspect of behavioral finance.
Illustration two shows tested the ease of convincing the investors about the year 2008 fianancila crash with before it actually happened.
Illustration 3, on the other hand, shows the impact and the effect of the hindsight bias to the above investors (investors SENSEX) after the occurrence of the year 2008 crash.
Notably, volatility of stocks had dominated the financial markets since the 2008 global crisis. Therefore, the extreme movements in the stocks in India surfaced as a result of investors initiating transactions owing to their anticipation and fear (Subash, 2012). That is, the investment decisions observed with the extreme low and high closing of the SENSEX index in such short periods is evidence that the decisions of the investors were purely based on psychological biases – behavioral finance anomalies (Schindler, 2007).
Conclusion
Volatility is an aspect that has dominated the world of financial stock
markets in a significant manner since the year 2008. Ideally, the global
finance crisis that peaked in that year sparked a trigger that led to many
investors swerving away from the traditional financial theories that promote
risk-averse and rational behavior of the investors in the financial stock
market (Subash, 2012). Behavioral finance is not very old as applied in the
context of the financial stock market. However, investors in the recent past
have been experimenting on employing the non-traditional provisions of
behavioral finance – that lack risk averseness and rationality (Ritter, 2003).
By implementing the behavioral finance provisions, however, the investors do
not render the traditional financial theories obsolete. Rather, they all they
seek is supplement the traditional theories through relaxing the strict
rationality perception and promoting the notion that human behavior is at times
equally useful in making decisions relating to successful investment in the
financial stock markets.
List of References
Barker, L. (2007) ‘The Geography of S&P 500 Stock Returns’, Journal of Behavioral Finance, Vol.8, No.4, pp 177-190
Beckert, J. & Aspers, P. (2011) ‘The Worth of Goods: Valuation and Pricing in the Economy’, Oxford: Oxford University Press.
Bodie, Z. (2008) ‘Investments4th Edition’, New York: McGraw Hill.
Brown, C. K. & Reilly, F, K. (2009): Investment Analysis and Portfolio Management, 9th Edition, South Western College.
Chandra, A. (2008) ‘Decision Making in the Stock Market: Incorporating Psychology with Finance’, Department of Commerce & Business Studies, New Delhi, 2008
Elvin, M. (2004) ‘An Introduction to the Psychology of Trading and Behavioral Finance’ John Wiley and Sons
Evans, D.A. (2006) ‘Subject perceptions of confidence and predictive validity in financial cues’, Journal of Behavioral Finance, Vol.7, No. 1, pp 12–28.
Grou, T. (2008) ‘Ambiguity Aversion and illusion of Control: Experimental Evidence in an Emerging Market’, The Journal of Behavioral Finance, Vol. 9, No.1, pp 22-29
Krause, A. (2001) ‘An Overview of Asset Pricing Models’, Somerset, UK: University of Bath.
Lin, H.W. (2011) ‘Elucidating Rational Investment Decisions and Behavior Biases: Evidence from the Taiwanese Stock Market,’ African Journal of Business Management, Vol. 5, No. 5, 1630-1641.
Markowitz, H. M. (1959) ‘Portfolio Selection: Efficient Diversification of Investments’, New Haven, CT.
Massa, S. (2005) ‘Behavioral Biases and Investment’, Review of Finance, Vol.9, pp 483 – 507
Pompian, M. (2006) ‘Behavioral Finance and Wealth Management – How to Build Optimal Portfolios That Account for Investor Biases’, New York: John Wiley and Sons.
Pompian, M. (2012) ‘Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions’, New York: John Wiley & Sons.
Raines, J.P. & Leathers, C.G. (2011) ‘Behavioral Finance and Post Keynesian Institutional Theories of Financial Markets’, Journal of Post Keynesian Economics
Redhead, K. (2008) ‘Personal Finance and Investments: A Behavioral Finance Perspective’ New York: Taylor and Francis Group. https://doi.org/10.4324/9780203895634
Ritter, R.J. (2003) ‘Behavioral Finance’, Pacific Basin Finance Journal, Vol. 2, No. 14.
Schindler, M. (2007) ‘Rumors in Financial Markets: Insights into Behavioral Finance’ John Wiley and Sons
Sharpe, W. F. (1964) ‘Capital Asset Prices: A Theory of Market equilibrium Under Conditions of Risk’ Journal of Finance, Vol. 19, pp 425–442.
Shleifer, A. (2000) ‘Inefficient Markets – An introduction to Behavioral Finance’, Oxford University Press
Singh, R. (2010). Behavioral Finance Studies: Emergence and Developments, Contemporary Management Research, (4)2, 1-9.
Subash, R. (2012) ‘Role of Behavioral Finance in Portfolio Investment: Evidence from India’, Master Thesis, Prague: Charles University.
Subrahmanyam, A. (2007) ‘Behavioral Finance: A Review and Synthesis’, European Financial Management, Vol. 14, pp12-29
Thaler, R. (2002) ‘Individual investments behavior’, New York: McGraw-Hill
Vasiliou, E. P. (2008) ‘Incorporating Technical Analysis into Behavioral Finance: A Field Experiment in the Large Capitalization Firms of the Athens Stock Exchange’, International Research Journal of Finance and Economics, Issue 14