Divergent views on market behaviour

That economists can seldom agree over anything has always been the case. The Nobel Prize for Economics this year drives home this point.

While Eugene Fama, the proponent of the Efficient Market Hypothesis (EMH) holds that markets are efficient such that stock prices fully reflect all the information available at any point, Yale professor, Robert Shiller has been one of the foremost critics of the theory.

EFFICIENT MARKET HYPOTHESIS

According to the EMH, markets are efficient. That is, at any point in time, they correctly factor in all the available information. That is, at a particular instant, the price of a stock reflects exactly what it is worth, it is neither undervalued nor overvalued.

As new information flows in, stock prices quickly change assimilating the additional news.

Thus any future change in price will be a result of only future news. That this future news is not known today implies that it is not possible to predict how the price will change in future and that any movement in price will, therefore, be random. So what are the implications of the EMH? If we go by this theory, it would imply that it is not possible to outsmart the markets (which have already factored in the existing information) and make money except by chance.

So, how can investors make money in the markets? According to Fama since it is impossible to beat the market, the only way one can make money is by moving with the market.

People can do this by investing in index funds that track the performance of market indices such as the S&P 500.

The EMH has, however, been discredited by many including Robert Shiller, over the years.

THE OPPOSITION

According to Shiller, the existence of prolonged periods of mispricing in the market (bubbles) which are driven by irrational human behaviour (such as a high degree of optimism) go against the Hypothesis. His book, Irrational Exuberance, which was released around the burst of the dot com bubble in 2000, talked about how the markets were overvalued around that time. The existence of market bubbles can be understood based on Behavioural Finance which explains how human emotions and biases can drive stock prices up or down, in an irrational way which may not justified by the fundamentals of a stock (as under the EMH).

For instance, based on an overly optimistic view of a stock, certain individuals will start to invest in a stock driving up its price. More and more investors (driven by the herd mentality) on learning that stock prices are going up, will start buying the stock, pushing up prices to unjustifiably high levels.

>maulik.tewari@thehindu.co.in

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