emh & investor psychology

8/10/2019 EMH & Investor Psychology

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EMH & InvestorPsychology

Presented By:Prof. Divyang Joshi

FacultySGPIMS- Dharmaj


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Efficient market hypothesis The efficient market hypothesis was first expressed by Louis Bachelier, a

French mathematician, in his 1900 dissertation, "The Theory ofSpeculation". His work was largely ignored until the 1950's; Efficient market hypothesis (EMH) is an idea partly developed in the

1960s by Eugene Fama. It states that it is impossible to beat the market because prices already

incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory. Supporters

of this model believe it is pointless to search for undervalued stocks ortry to predict trends in the market through fundamental analysis ortechnical analysis.

Under the efficient market hypothesis, any time you buy and sell

securities, you're engaging in a game of chance, not skill. If markets areefficient and current, it means that prices always reflect all information,so there's no way you'll ever be able to buy a stock at a bargain price.


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Weak-form efficiency

No excess returns can be earned by using investmentstrategies based on historical share prices or otherfinancial data.

Weak-form efficiency implies that Technical analysistechniques will not be able to consistently produce excessreturns, though some forms of fundamental analysis maystill provide excess returns.

In a weak-form efficient market current share prices arethe best, unbiased, estimate of the value of the security.

Theoretical in nature, weak form efficiency advocatesassert that fundamental analysis can be used to identifystocks that are undervalued and overvalued. Therefore,keen investors looking for profitable companies can earnprofits by researching financial statements.


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Strong-form efficiency

Share prices reflect all information and no one can earnexcess returns. If there are legal barriers to private information becoming

public, as with insider trading laws, strong-form efficiency isimpossible, except in the case where the laws are universally

ignored. Studies on the U.S. stock market have shown thatpeople do trade on inside information. To test for strong form efficiency, a market needs to exist

where investors cannot consistently earn excess returns overa long period of time. Even if some money managers are

consistently observed to beat the market, no refutation evenof strong-form efficiency follows: with tens of thousands offund managers worldwide, even a normal distribution ofreturns (as efficiency predicts) should be expected to producea few dozen "star" performers.


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EMH Tenets and Problems with EMH

First, the efficient market hypothesis assumes that allinvestors perceive all available information inprecisely the same manner . The numerous methodsfor analyzing and valuing stocks pose some problems

for the validity of the EMH. If one investor looks forundervalued market opportunities while anotherinvestor evaluates a stock on the basis of its growthpotential, these two investors will already have arrivedat a different assessment of the stock's fair market

value. Therefore, one argument against the EMH pointsout that, since investors value stocks differently, it isimpossible to ascertain what a stock should be worthunder an efficient market.


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Secondly, under the efficient market hypothesis, nosingle investor is ever able to attain greater profitabilitythan another with the same amount of invested funds: Ifno investor had any clear advantage over another, wouldthere be a range of yearly returns in the mutual fundindustry from significant losses to 50% profits, or more?According to the EMH, if one investor is profitable, itmeans the entire universe of investors is profitable. Inreality, this is not necessarily the case.

Thirdly (and closely related to the second point), underthe efficient market hypothesis, no investor should everbe able to beat the market, or the average annual returnsthat all investors and funds are able to achieve using their

best efforts. There are many examples of investors whohave consistently beat the market - you need look nofurther than Warren Buffett to find an example ofsomeone who's managed to beat the averages year afteryear


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Advantages of EMH

If the EMH is correct there is no need forinvestors to pay the high fees charged byinvestment managers and the analysts,

researchers and fund managers. Just invest inindex fund and can earn market return. Track the index fund, no worries about wrong

selection of the stock. No one can earn superior return. All will have

same return.


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Disadvantages

No extra return. Investors have to happy withthe index/market return.

no motivation for being invested in stockmarket.


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Investor Psychology

Q-1. You have Rs 10,000 for making investment inthe following options. Which option would youselect?

1) 30% probability to earn 5000 Rs2) 40% probability to earn 4000 Rs

Q-2. What was high made by NIFTY 50 in 2008?1) 6387 2) 6257 3) 6417How much confident are you? ______%


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Q-3. In the period of higher volatility in stockmarket, which group of stock would you preferto sell?1) The one which earn profit.2) The one which earn loss.

Q.4. What do you think is the role of intuition(your internal feeling) while taking decision foran important problem?1) No effect 2) Little effect 3) High effect


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Q.5 What was Inflation rate in September 2013?1) 6.45% 2) 6.46% 3) 6.48%

How much confident are you? ______%Q.6 You are having following stocks in your

portfolio. You are in need of 150,000 Rs. Which

stock would you like to sell?


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Q.7 From your holdings, for specific company there arerumors that company is in Problem, what will youdo?

1. Indifferent2.Maintain position/ keep investing.3. Reduce/ sell half of the share.4. Sell all shares and liquidate position.

Q.8 Your friend had purchased RIL @ price of Rs 1200and it goes high up to Rs 2500. Now due touncertainty price goes down to Rs 700. Your friendbares big loss. Do you think this was...?

1) A Mistake2) A bad luck


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Q.9 From your holdings of different companies share, there ispositive news for specific company. What will do?

1) Indifferent 2) Maintain position/ keep investing 3) Increase/ purchase half of the share 4) Sell other share and invest in news specific company

Q.10 During your investment experience, what contribution hasbeen made by following factors which led you towards profit ?


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Q.1 & Q.4 Rationality Q.2 & Q.5 Overconfidence

Q.3 & Q.6 Disposition Effect Q.7 & Q.9 Conservation Q.8 & Q.10 Regret Theory


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Biases of Judgment

Psychology is the scientific study of behavior and mentalprocesses, along with how these processes are affected by ahuman beings physical, mental state and externalenvironment.

Decision making includes beliefs and preferences. Decisions theorists argue that any significant decision can bedescribed as a choice between gambles, because the

outcomes of possible options are not fully known in advance. People make judgments about the probabilities; they assign

values (sometimes called utilities) to outcomes; and theycombine these beliefs and values in forming preferencesabout risky options.

That is called Judgment. In Judgment the systematic error iscalled Biases of Judgment.


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Rationality A rational decision is one that is not just reasoned, but is

also optimal for achieving a goal or solving a problem.Rabin (1998) discussed and compared the view ofeconomist and psychologist and concluded that in shortduration investors were irrational but in long duration thehuman nature became rational.

In question-1, investors who supposed to be rational wouldlike to select option 2 because compare to option 1 option2 is profitable.

In question no. 4 As per Rationality theory of behaviorfinance, intuition of investors is not playing any role indeciding or taking decision. The investors who are Rationalthey select option 1, that contain no effect of intuitionand who are irrational investors they select option 2 & 3


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Disposition Effect The common behavior of investors to hold

looser stocks too long and sell the winner stocktoo early is called disposition effect (Grinblattand Han, 2002). Investors may rationally, orirrationally, believe that their current losers infuture will outperform their current winners.They may sell winners to rebalance theirportfolios or they may refrain from selling losers

due to the higher transactions costs of tradingat lower prices. The Q.3 and Q.6 when person sells the winner

and the looser, it is disposition effect.


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Regret theory According to Investopedia simply regret theory deals with the

emotional reaction people experience after realizing they'vemade an error in judgment. Faced with the prospect of selling astock, investors become emotionally affected by the price atwhich they purchased the stock. So, they avoid selling it as away to avoid the regret of having made a bad investment, aswell as the embarrassment of reporting a loss.

Overconfidence Overconfidence defines as an overestimation of the

probabilities for a set of events by Mahajan, J. (1992).Operationally, it is reflected by comparing whether the specificprobability assigned is greater than the portion that is correctfor all assessments assigned that given probability. J.

Michailova (2010) tests the overconfidence bias among thegender with the help of questionnaire of 50 questions. Sheconcludes that there is no significant difference amongexpressed overconfidence by both the genders and they did notappear to be associated with overconfidence.


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Conservatism Conservative is simply means traditional. Conservatism as

psychological attitude means human being has some excessattachment to the things which they have already with them.And something new offer to them then they are not ready toaccept that new thing or slowly and gradually they are acceptthat new thing. Edward (1962) explains conservatism bias. Itmeans Investors are too slow (too conservative) in updatingtheir beliefs in response to recent evidence. This means that

they might initially under react to news about a firm, so thatprices will fully reflect new information only gradually. Such abias would give rise to momentum in stock market returns.

Financial Cognitive Dissonance As individuals, we attempt to reduce our inner conflict

(decrease our dissonance) in one of two ways: 1) we changeour past values, feelings, or opinions, or, 2 we attempt to justify or rationalize our choice. This theory may apply toinvestors or traders in the stock market who attempt torationalize contradictory behaviors, so that they seem to follow

naturally from personal values or viewpoints.


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Mental Accounting

Narrow framing. Investors if offered for gamble, they evaluate

it as it is the only gamble they face in theworld rather than merging it with the pre-existing bets to see the new bet is worthwileor not.


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Situation of ambiguity Prospect theory Prospect theory deals with the idea that people

do not always behave rationally. This theory holdsthat there are constant biases motivated bypsychological factors that influence peopleschoices under conditions of uncertainty.

There are 2 box. In 1 st box 50 Red balls and 50blue balls. In 2 nd box 100 balls are there, butcolored not known. You offered to select one ballfrom the box without seeing. If it is red you willearn 1000 Rs. Which box u will preferred?


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emh & investor psychology

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