Last Updated 20 Apr 2022

Comment on the Three Conditions on Market Efficiency

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An efficient capital market is one in which stock prices fully reflect available information. Professor Andrei Shleifer has suggested three conditions lead to market efficiency. (1)rationality, (2)independent deviations from rationality, and (3)arbitrage. This essay will examine investors’ behavioral biases and then discuss the behavioral and empirical challenges to market efficiency. In the attached article, James Montier suggested three behavioral biases that investors had. (1) illusion of control, (2)self-attribution, and (3)over-confident. Illusion of control means people fell they are in control of a situation far more than they are.

Self-attribution means good outcomes are contributed to their skill while bad outcomes are contributed to external, such as back luck. These two biases lead people to be over-optimistic and exaggerate their own abilities. People are always over-confident as well. They always think they are smarter and have better information than they actually do. These three behavioral biases form a potential combination and lead investors to overestimate their ability and knowledge and understate the risks. In reality, there are some other behavioral biases. Investors usually prefer to put their money into a company that they know or familiar with.

This is known as familiarity bias. They will invest heavily in the company they work for. They will also allocate a larger fraction of their investments to domestic stock even though it is easier to diversify investments across geographies. In addition, people tend to perceive probabilities and resonate with their own pre-existing ideas even though the conclusions drawn are statistically invalid. And this is called representativeness. The next bias exists in reality is conservatism, it means that people are too slow in adjusting their beliefs to new information.

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They clings to prior views or forecasts at the expense of acknowledging new information. The last bias I want to mention is herd behavior. This is a tendency for individuals to mimic the actions(rational or irrational) of a larger group. It may comes from social pressure of conformity and/or believing the larger group knows something that they don’t. Most of the above-mentioned behavioral biases contradict Professor Andrei Shleifer’s three conditions for market efficiency. One of the conditions he suggested was rational.

People will adjust their estimates of stock prices in a rational way after new information is released in the marketplace. Are people really rational? Not always. People will exert familiarity bias. They will be too favor the investments in companies they are familiar with. Tendency by investors to invest in domestic stock or the companies they work for. They do not achieve the degree of diversification that they can easily achieve. Others are over-confident and over-optimistic to believe they can pick winners and losers when, in fact, they cannot; this leads them to trade too much, generating both commissions and taxes.

The behavioral view is that not all investors are irrational. Rather, it is some, perhaps many, investors are. Independent deviation from rationality was the second condition for market efficiency suggested by Andrei Shleifer. However, psychologists have long argued that people deviate from rationality in accordance with a number of basic principles. Some of them can apply to finance and market efficiency. One of the most examples in recent memory would be the bursting of the internet bubble. The behavior bias, representativeness can be used to explain this phenomenal.

People perceive their pre-existing idea and draw conclusions from insufficient data. They saw a short history of high revenue growth and extrapolate that it will continue forever. Another behavior bias to explain internet bubble is herd behavior. Investors face pressure of conformity and trust large group irrationally. Result into a tendency for individuals to mimic the actions of a larger group that contributed to Internet bubble as well. Another behavior bias contradict independent deviations from rationality is conservatism. People are too slow in adjusting their beliefs to new information.

In 2005, Kolasinski and Li have done a research by ranking companies by the extent of their earnings surprise. They found that prices adjust slowly to the earning announcements with the portfolio with the positive surprises outperforming the portfolio with the negative surprises. Behavioral finance suggests that investors exhibit conservatism. Professor Andrei Shleifer suggests that domination of rational professional will carry the stock meet its efficient prices by simultaneous purchasing and selling of misprice stock. However, in a world of many irrational amateurs and a few professionals, prices would not adjust to correct level.

The risk of further mispricing may reduce the size of arbitrage strategies. In 1907, Royal Dutch Petroleum and Shell Transport merge interest and split the cash flow in a 60/40 basis. However, empirical finding shows that two parties have rarely traded at parity (60/40) over the 1962 to 2004 period. Deviation from parity could increase in the short run, implying losses for the arbitrageur. There are also a numbers of empirical challenges to market efficiency. The common features among those empirical studies were all in an international basis.

A number of studies of relationship between the return and its market capitalizations have been replicated over different periods and in different countries. They found that return on small stocks was quite a bit higher than the average return on large stocks. It may be not all but merely a compensation for the extra risk. In 1998, Fama and French found the average return on value stocks was above the average return on growth stocks in 12 to 13 major international stock markets. The return difference is so large and these ratios can be obtained so easily.

The results constitute strong evidence against market efficiency. Security prices sometimes move wildly above their true values and eventually fall back to original level. The crashes and bubbles of Internet stock in late 1990 consistent with this bubble theory and constitute evidence against market efficiency. Size, value versus growth, crashes and bubbles were all found in international stock market. And those behavioral biases studies were carried around the world. Therefore, we may expect those behavioral and empirical challenges discussed above may hold in all counties or market setting.

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