The myth about the stock market
A lot of analysts are trying to know the truth and separate the myth about the stock market. Is the efficient market theory really correct? Which explains that the stock market automatically just adjust in time? Or from the side of behavioral scientists such as Werner De Bondt and Richard Thaler who have studied that the reaction of people and saw the effects of this reaction in relation to the stock market.
The purpose of this essay is to try to answer the question raised by both De bond and Thaler and discuss what their basis was on coming up with their own study. This study will also provide a discussion and tackle the criticism on Efficient Market theory and criticism on Behavioural Finance as well. And lastly as evidence on De Bondt and Thaler’s theory; this essay will provide examples of events on the stock market that has led to the birth of behavioural finance. Overreaction
The basis of overreaction have not really originated from both De Bondt and Thaler, fundamental stock price experts Benjamin Graham and David Dodd have stated in their book Security Analysis, that investors always, if not a lot of times misinterpret the stock market and has led these investors astray with losses incurred by wrong decisions of both buying and selling (Graham and Dodd 2008). A lot of stock investors based their decisions to either buy or sell based on emotions and following the popular decision of the crowd, that is why they often fail on their investments.
There are some People who also feels like they are already experts in stocks, only focuses on one characteristic of a good stock then they will buy, if that characteristic for them is bad then they will sell. This is far from the truth according to the way Graham and Dodd suggest people to invest, and they want investors to invest in value, since there is no single characteristic to analyze a value of the stock people need to really check all other characteristics as well (Graham and Dodd 2008: xix).
Basically what De Bondt and Thaler tries to explain is the argument contradicting the efficient market hypothesis, first expressed by the French mathematician Louis Bachelier; in which this theory and including the Capital Asset Pricing model (CAPM) assumes that investors in general act and decide using their brains and are often expected. The Brownian method in which Bachlier applied to estimate stock options, as he explained in his thesis the Theory of Speculation, that the price of a security or stock options are following to the rules of physics (Bachelier, L.
, Davis, M. & Etheridge, A. 2006). Behavioural scientists De Bondt and Thaler opposed these theories describing inconsistencies, such an example is that overreaction from the investing public have caused past losing stock positions to become under priced and also past winning stocks to become overpriced (1985). Before De Bondt and Thaler expressed this argument, it was Kahneman and Tversky who first show a relationship of psychological concepts with suggestion for behavioural finance.
Cognitive biases and heuristics were the focus of efforts by Kahneman and Tversky on research. They stated that when people see one favourable characteristic which stands out they will predict an outcome already based on that one factor alone. Those kinds of predictions are highly unreliable and often times wrong (Kahneman, Slovic, and Tversky 1982:8).
In their studies, Kahneman and Tversky shows company with the characteristic of high profit and when potential investors even just see this description, they will get excited and buy shares from this company quickly. And if the said company shows signs of low profit, the investors will think that this is not a good choice to buy, if investors already have this stock and have seen this sign of low profit they will immediately decide to sell, since this one factor affects their emotions and they will act upon it (same as Kahneman, Slovic, and Tversky 1982:8).
In other words it only takes one stand out factor of a stock of a company for investors to predict and decide what to do which is clearly a sign of poor judgment and deciding based on excitement if the description is favourable or fear if it is not. David Dreman, who is also a supporter of the overreaction hypothesis; have created a book that demonstrates how investors can beat the market just simply not following the majority’s decisions on most popular stocks, this what he calls his Contrarian Strategies (1998).
Dreman continued to explain in his books that people in general are having difficulty with their own overreaction and have caused wrong stocks to be both underpriced and overpriced. In his book he also explains his strategy on how he beat the market by not following the investors overreaction, instead focused on studying the stock thoroughly. Criticism on Behavioural Finance One of the leading supporter of the efficient market theory, have explained the so-called inconsistencies by the theory is just for short term (1998:304).
He still believes that the market can correct itself in time, and it is not only overreaction but under action as well which he explains are still predictable that is why it is efficient. Fama also discussed the anomalies by De Bondt and Thaler are because of the use of small stocks on the study which he considers a sure source of bad model problems, since these kinds of stocks always show signs of difficulties in examination of stock pricing models and are not applicable in tests of market efficiency on long term returns (same as 1998:304).
Another supporter of the Efficient Market theory (EMT) is Burton Malkiel, in his paper The Efficient Market Hypothesis and Its Critics (1993), in which he believes that even with the stockmarket crash like the dotcom bubble, the stock market is still efficient because it still has recovered in time and has corrected itself. Incidents of Mania/Bubbles due to Overreaction
As Behavioural Finance clinicians call the Herd Mentality which basically means that that investors or people in general are inclined to follow others, especially on a volatile situation as the stock market in which investors become quite unsure of the prediction of actual trends they just follow what others are doing (Phung 2010). Tulip Mania The story of tulipmania begins in 1559 when Conrad Guestner brought the first tulip bulbs from Constantinople to Holland and Germany, and people fell in love with them (Barnes n. d.
). Tulips became the ultimate symbol of wealth, and during the years 1600 to 1634 the price of tulips climbed, as owning the flower became an absolute must for any man or woman of wealth, by 1635 the entire Dutch population had become so obsessed with owning tulips that even the poorest citizens caught the mania and invested their entire life savings on it (Jupiter 1999:35). Then it was offered the Amsterdam Stock Exchange and other exchanges in Holland the demand for the Tulip was rising and it the price went as high as ?
20 000 in today’s prices for a single tulip bulb (Barnes n. d. ). Then suddenly people began to sell rapidly, 90 percent of its value has been decreased in just 6 weeks (Barnes n. d. ). South Sea Bubble Basically another case of share prices ramping up beyond its value, due to extravagant rumours concerning the value of its projection of commerce in the New World. The share price rose from ? 128 in January 1720 to ?
1000 on August, after reaching its so-called peak, significant number of share has been actively being sold by the directors of South Sea Company, and before the end of the year the price to fell to ? 100 (Barnes n. d. ). After the discovery of shareholders that the directors of South Sea Company sold their shares, more selling occurred followed up by a massive panic selling, the damage on these was so significant the stock market crushed (Barnes n. d. ).
Even the great Isaac Newton wasn’t spared on this manic public as he got caught in the South sea mania in which he stated that he can calculate the motions of the heavenly bodies, but not the madness of people. The Internet/ dot. com crash Majority of the investors just love the sound of an advance technology like the internet and had the amazing belief that would provide them with huge amounts of wealth once they invest. That belief was not only coming from ordinary people but a lot of sophisticated and professional investors as well.
People just invest without even thinking what possibly a particular dot com company’s real business is and if it has a chance of earning a profit. Then suddenly the bubble burst, a lot of critics and financial analysts have deemed that dot com stocks are overpriced, and then the collapse happened. Conclusion As for our conclusion, we have discussed both large studies in the field of finance, the first for Behavioural Finance, which explains that people a lot of times invest not on logic or rationality but on what they think and feel.
The Study of De Bondt and Richard Thaler exposed some of the anomalies of conventional finance and its popular theories such as the Efficient Market Theory. Their discussion on market overreaction was supported by other behavioural finance analysts and presented their own evidences in agreement with the hypothesis. The Efficient Market theory supporters also defend the attacks by discussing that the anomalies happened only on small stocks and ha short term impact, they believe that again the market will correct itself in time despite its continuous difference.
In this study we have discussed also the example of the influence of behaviour of people on the Stock market, from the early Tulip Mania , to just the recent crash of the internet bubble, which have solidified evidences that indeed people at times act irrationally and when the number reaches a critical mass it can influence the stock market and either over value or under value any particular stock.
List of References
Bachelier, L. , Davis, M. & Etheridge, A. (2006) Louis Bachelier’s theory of speculation: the origins of modern finance, Volume 13. Princeton University Press Barnes, P (n. d.) Stock Market Efficiency, Insider Dealing and Market Abuse. [PDF] Available from <http://www. ashgate. com/pdf/SamplePages/Stock_Market_Efficiency_Insider_Dealing_ Ch4. pdf>. [26 Apr 2010]. De Bondt W. & Thaler, R. (1985) Does the Stock Market Overreact?. The Journal of Finance Dreman, D. (1998) Contrarian investment strategies: the next generation: beat the market by going against the crowd. Simon & Schuster Fama, E. (1998) Market efficiency, long-term returns, and behavioural finance. Journal of Financial Economics 49 Chicago: University of Chicago Graham, B. , & Dodd, D. (2008) Security Analysis: Principles and Technique.
McGraw Hill Professional Jupiter, M. (1997) Savvy Investing for Women: Strategies from a Self-Made Wall Street Millionaire. New Jersey: Prentice Hall Press Kahneman, Slovic, P. , & Tversky, A. , (1982) Judgment under uncertainty: heuristics and biases. Cambridge University Press Phung (2010). Behavioral Finance: Anomalies. [Online] Available from <http://www. investopedia. com/university/behavioral_finance/behavioral3. asp> [26 Apr 2010]. Malkiel, B. (2003) The Efficient Market Hypothesis and Its Critics. CEPS Working Paper No. 91. Princeton University Thaler, R (1994). Quasi rational economics. Russell Sage Foundation