From Capital Market Efficiency to Behavioral Finance

Table of Contents

I. Table of Figures

1. Introduction

2. The Theory of Market Efficiency
2.1 Forms of information efficient markets
2.1.1 Weak Form
2.1.2 Semi-strong Form
2.1.3 Strong Form
2.2 Asset Pricing
2.2.1 Capital Asset Pricing Model (CAPM)
2.2.2 Arbitrage Pricing Theory (ABT)

3. Recent Development in the US and UK Stock Markets
3.1. The Bubble

3. From Efficient Market Theory to Behavioural Finance
3.1 unrealistic Assumptions in CAPM
3.2 Evidence for additional Factors
3.2.1 Seasonal Effects
3.2.2 Size Effects
3.2.3 Value Effect
3.2.4 Momentum Effect
3.3 Behavioural Approach

4. Alternative Theories in Asset Pricing
4.1 Model of Investor Sentiment
4.2 Overconfidence Model

5. Conclusion

II. Table of Literature
II.a Reference List
II.b Table of Websites

I. Table of Figures

Figure 1: Nasdaq 100, Nasdaq Computer 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 05.03.2003]

Figure 2: Qualcomm Inc.Shares 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 06.03.2003]

Figure 3: FTSE 100 and FTSE Infotech 1993-2003 Source: Onvista AG [online] www.onvista.de (URL:n.a.) [accessed 06.03.2003]

Figure 4: Comparison of US and UK Financial Market Data Source: Own spreadsheet, data provided by Onvista AG [Online] www.onvista.de (URL:n.a.) [accessed 05.03.2003]

Figure 5:Deviation of Market Price from Fundamental Price Source: Shiller, Robert J., “Do stock prices move too much to be justified by subsequent movements in dividends?” American Economic Review, vol.71 (3) 1981: 421-36 [online] www.few.eur.nl/few/people/smant/m- economics/shiller.htm [accessed 09.03.2003]

1. Introduction

Ever since in the history of stock markets, financial theorists try to understand how investors take decisions under uncertainty in order to value stocks precisely and predict their future returns. Their wish to develop a consistent model gave raise for various theoretical approaches and empirical examinations. This work tries to give a short overview on the traditional theory of asset pricing and discusses the need for a paradigm change due to the recent development in the US and UK stock markets.

2. The Theory of Market Efficiency

In 1884 Charles Do and Eddie Jones first published the Dow Jones Average Index (Achleitner, 1999). This index constructed of average share prices of selected US companies was the empirical database for Dows development of his approach to predict share prices, later named the Dow Theory. He supposed a cyclic development of share prices and therefore stated that the technical analyses of charts would give information on future share prices. He recognised general trends, momentum and trend reversals. This was the birth of technical analysis and the chartists approach. Later his work was advanced by Ralph Nelson Elliott (MarketScreen, 2000). He concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. Since his intention was to find a model for general economic development, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves.

An outstanding academic contributing was made by Louis Bachelier in 1900. Examining the dynamics of price developments, he recognised the

numerous factors involved in asset pricing. Therefore he concluded that no certain expectation is possible and that trading is a “Fair Game”. Later, his theory was modified in several papers and gave raise for the theory of the random walk. The level of information efficiency is of the essence within these approaches

2.1 Forms of information efficient markets

Generally, the Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. One of the most known classifications of market efficiency was published by Fama (Olsen et al., 1992 and Fama, 1970) in 1970 and 1991. He distinguished three levels of market efficiency.

2.1.1 Weak Form

The weak form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use in order to gain extra profits. Prices follow a random walk.

2.1.2 Semi-strong Form

The semi-strong form says that all publicly available information is fully reflected in securities prices. Therefore, the analysis fundamental data is not able to enable investors to be better than the market. Only insider trading would allow extra profits.

2.1.3 Strong Form

In the strong form securities prices fully reflected all public and private information. That means even insider information is of no use.

The semi-strong form is the empirically most relevant form of market efficiency, approved by event studies, Run-test and examinations of serial correlation of returns (Achleitner, 1999).

2.2 Asset Pricing

Supposing a certain grade of market efficiency gives raise to the question whether we need portfolio management, financial analysis and other institutional participants. The more efficient a market is, the more doubts we should have about systematic predictions and strategies. One of the best examples for such a systematic selection of stocks is the strategie of Index-funds. I.e., if a market is efficient, there cannot be systematic serial correlations between the single securities. If the market is strong-form efficient only a passive investment strategie should be considered, but since the empirical evidences mostly matches the semi-strong form, an active investment strategy is preferable.

2.2.1 Capital Asset Pricing Model (CAPM)

One of the most frequently used equilibrium model based on the efficient market hypothesis for asset pricing is the Capital Asset Pricing Model, developed by Sharpe in 1964. This model relates to Markowitz` theory of portfolio management and explains the basic relation of receiving a risk premium for taking on systematic risk. It shows the movements of the market in relation to a stable equilibrium and the relation of an expected return to an assets risk. Employing this model enables the investor to derive the expectable return of an asset. The risk premium (E(ri) may be regarded as the sum of the interests received from an risk free investment (rf) and a risk-proportional premium. The premium is the product of the investment specific risk (b) and the premium for the default market risk (E(rM)-rf). The b-coefficient represents the relative volatility of the investment to the market volatility, i.e. the systematic risk of the investment:

E(ri) = rf + b(E(rM) - rf).

Betas can be received by use of regression models of historic returns. Therefore theoretically, risk can be eliminated by portfolio diversification.

The model assumes, that there is a risk free investment with unlimited availability, that markets are efficient and investors process information to homogenous expectations, i.e. investors act fully rationally.

2.2.2 Arbitrage Pricing Theory (ABT)

“There is no such thing as a free lunch.” (Milton Friedman)

As an alternative to the CAPM and an example for other multi-factor models the Arbitrage Pricing Theory shall be mentioned shortly. Other than the CAPM it is less restrictive and employs more than one determining factor in asset pricing. It takes taxes into account and allows over-time simulations, but still it assumes fully rational behaviour and frictionless markets. A portfolio cannot achieve extra profits because the arbitrage process levels of price differences between similar risky investments and brings the market back to equilibrium.

Here, the return of an investment is calculated as the sum of the expected return (E(Ri)) and the products of different determining factors (F) and their influence on the return (b) and an factor for error adjustment (ei):

Ri = E(Ri) + b1F1 + b2F2 + … + bkFk + ei.

This rough overview on the two main models basically tries to explain the restrictive assumptions and their implications for the predictability of the real world. In the following we will see the why the validity of these models has raised an enormous challenge for academic finance over the last years. For more detailed information on the econometrics of these models see one of the various papers and books published, e.g. Campbell, Lo and MacKinley (Campbell et al., 1997).

3. Recent Development in the US and UK Stock Markets

The History of stock markets is as well a history of formations of speculation bubbles and their collapses. The further the extend is to which speculation drives the market, the bigger is the challenge on the efficient market hypothesis. The most tragical bubble in the history of stock markets occurred in the last 5 years. The following will examine this market anomaly by use of examples of the US and UK stock markets.

3.1. The Bubble

In the years 1998/1999 stock market indices started skyrocketing.

illustration not visible in this excerpt

Figure 1: Nasdaq 100, Nasdaq Computer 1993- 2003

The Nasdaq 100 started its rally from about 1500 points up to its peak in march 2000 of 5132 points, which sums up in 3421% in 18 month

(figure 1). It plummeted during the next month for more than 33%, during the next year down to 1802 points, 30% of its peak value. During this period several Nasdaq companies had price- earnings rations higher than 200:1. The irrational extremeness might be even clearer regarding some of the top flying shares of these days.

[...]